Transfer Pricing and Business Restructurings

Transfer Pricing and Business Restructurings Streamlining all the way Edited by Anuschka Bakker IBFD

Foreword Acknowledgements Abbreviations and Common References v ix xi Part A Setting the Scene Chapter 1: Introduction 1. Drivers of business restructuring 3 1.1. Global business models to maximize synergies and economies of scale 4 1.2. Improvement of productivity of the supply chain 5 1.3. Other external and internal factors 7 2. Business restructuring from an economic perspective 8 2.1. Business perspective 8 2.2. Stakeholder's perspective 9 3. Tension between commercial aims and tax environment 9 Chapter 2: Business Models 1. Introduction 13 2. Business modelling for tax and transfer pricing purposes 16 2.1. Manufacturer 19 2.1.1. Toll manufacturer 20 2.1.2. Contract manufacturer 21 2.1.3. Fully fledged manufacturer 22 2.2. Distributor 24 2.2.1. Commission agent 26 2.2.2. Commissionaire 27 2.2.3. Classic buy-sell distributor 29 2.2.4. Fully fledged distributor 30 Xlll

2.3. Service provider 32 3. Business restructurings 36 3.1. Intangible property transfers 37 3.2. Conversion from fully fledged to contract manufacturing model 41 3.3. Conversion from fully fledged distributor to stripped distributor model 43 4. Centralized services and cost allocation agreements 45 Chapter 3: OECD Policy Framework 1. OECD policy framework in the area of international taxation 49.1. OECD in general 49.2. OECD tax work 50.3. Arm's length principle and OECD Guidelines 50.3.1. Comparability analysis 51.3.2. Transfer pricing methods 52.3.3. Recent developments 54.3.4. Other relevant guidance in the OECD Guidelines 54 1.4. Permanent establishment issues 54 1.4.1. Definition of a permanent establishment 54 1.4.2. Attribution of profits to permanent establishments 56 2. Prevention and resolution of transfer pricing and other international tax disputes 58 2.1. Dispute resolution 58 2.2. Dispute prevention 60 3. OECD project on business restructuring 61 3.1. Restructurings that are within the scope of the OECD project 61 3.2. Origins of the project 62 3.3. Transfer pricing dimension of business restructurings 62 3.4. Presentation of the OECD Discussion Draft 64 3.4.1. Relationship with permanent establishment issues 64 3.4.2. Relationship with domestic anti-abuse rules 65 3.5. Main tentative conclusions from the OECD Discussion Draft 65 3.5.1. Issues Note 1: Special considerations for risks 65 xiv

3.5.2. Issues Note 2: Arm's length compensation for the restructuring itself 68 3.5.3. Issues Note 3: Remuneration of post-restructuring controlled transactions 74 3.5.4. Issues Note 4: Recognition of the actual transactions undertaken 78 4. Conclusion 83 Chapter 4: EU Policy Framework 1. Developments with EU legislation 85 1.1. Impact of existing secondary EC law on business restructuring 85 1.1.1. Parent-Subsidiary Directive 85 1.1.2. Merger Directive 87 1.1.3. Interest and Royalties Directive 88 1.1.4. Arbitration Convention 88 1.2. Impact of proposed secondary EC law on business restructuring: Common Consolidated Corporate Tax Base and Home State taxation 89 1.2.1. Common Consolidated Corporate Tax Base 89 1.2.2. Home State taxation 90 1.2.3. Impact of Common Consolidated Corporate Tax Base and Home State taxation 90 1.3. Impact of proposals of the EU Joint Transfer Pricing Forum on business restructuring 91 2. Impact of case law on business restructuring 91 2.1. General 91 2.2. CLT-UFA S.A. case 92 2.3. FCE Bank case 94 3. Coordination in the field of exit taxes 96 Chapter 5: Art 9 of the OECD Model Convention 1. Introduction 99 2. Arm's length (comparability) analysis and recognition, or non-recognition of transactions undertaken 100 2.1. Introduction 100 xv

2.2. Meaning of "conduct of parties" 101 2.3. Determining whether terms and conditions between the respective parties are arm's length from a commercial or financial perspective 102 2.4. Choice between comparability adjustment or nonrecognition of (part of) a transaction 106 2.5. Endeavouring to understand the envisaged tests by means of examples 111 2.6. Trade-off between equity and efficiency 117 2.7. Valuing the restructuring itself and the post-restructuring transactions 118 3. Arm's length compensation for intangibles and related risks 120 3.1. Introduction 120 3.2. Building the commercial business case 121 3.2.1. Comparison of pre- and post-restructuring scenarios 121 3.2.2. Business reasons for and the expected benefits from the restructuring 126 3.2.3. Existence of probable alternative commercial choices; possible indemnities 129 3.3. Determining exit values: valuation methods used by appraisers and valuation practitioners 131 3.3.1. Income-based approach: excess earnings approach 132 3.3.2. Income-based approach: incremental margin analysis 135 3.3.3. Market-based methods 136 3.3.4. Methods to establish bargaining power 137 3.3.5. Rule of thumb used in civil court cases as a last resort 138 3.3.6. Intangible transferred at a point in time where it does not have an established value 139 3.4. Impact of intangibles and related risks in the postrestructuring valuation 140 3.5. The use of one-sided transfer pricing methods 141 3.5.1. More emphasis on two-sided methods, especially profit split methods 141 3.5.2. Role of control in a post-restructuring situation 143 Chapter 6: Permanent Establishment Issues 1. The presence of a permanent establishment 145 xvi

2. Allocation of profits to permanent establishments: Art. 7 of the OECD Model 153 Chapter 7: VAT Aspects of Business Restructuring 1. Introduction 159 1.1. General 159 1.2. Introduction to the VAT system of the European Union 160 2. Group financing activities 161 3. Transfer of assets 163 3.1. Scope of the non-taxability 164 3.2. Definition of "totality of assets" 165 3.3. Successor's intention to continue the business 166 3.4. Business licence or authorization 166 3.5. Right to deduct VAT 167 4. Transfer of shares 169 4.1. General 169 4.2. Selling of shares outside the scope of VAT 170 5. Issue of new shares 170 6. Outsourcing 172 7. Changes to the business model as described in Chapter 2 174 7.1. Transfer of intellectual property 174 7.2. From fully fledged manufacturer to contract manufacturer 175 7.3. From fully fledged distributor to stripped distributor 175 7.4. Commissionaires 175 Chapter 8: Customs Duties 1. Introduction 177 2. Customs law 177 3. General Agreement on Tariffs and Trade; World Trade Organization 180 3.1. General Agreement on Tariffs and Trade 180 xvu

3.1.1. 3.1.2. 3.2. 3.2.1. 3.2.2. The Geneva Conference Fundamental principles World Trade Organization Uruguay Round New order 180 180 181 181 182 4. 4.1. 4.2. 4.3. The European Union The European Communities: ECSC, EEC and EAEC/ Euratom EU customs law Basic legal provisions 183 183 185 186 5. Customs in the United States 187 5.1. The Customs Modernization Act 187 5.2. Valuation 188 5.3. Free trade agreements 188 6. Association of Southeast Asian Nations 189 6.1. ASEAN Free Trade Area 189 6.2. Customs rules 190 6.3. Valuation 190 7. Determining the value of goods 191 7.1. Transaction value 191 7.2. Significance of "relationships" between buyer and seller 192 7.3. Alternative measures of value 193 7.4. Additions and exclusions to the transaction value 194 8. Customs value and transfer pricing 195 8.1. Two sides of the same coin 195 8.2. A new trend: the holistic approach 197 8.3. Arm's length principle: a shared principle? 199 8.4. Controls of transactions: an operational convergence 200 8.5. How to reconcile methods for determining customs values and transfer prices 202 9. The strength of the double approach before tax audits 204 Chapter 9: Tax Accounting Considerations 1. Introduction 207 xviu

2. International accounting framework 209 2.1. General 209 2.2. Income tax accounting standards 210 3. Tax law considerations 214 3.1. Plant closures 215 3.2. Migration of intangibles 216 3.3. Conversion into limited-risk entities 217 4. Specific tax accounting impacts 218 4.1. Transfer pricing uncertainties 219 4.1.1. FIN 48: a further overview 220 4.1.2. IAS 12 versus FIN 48: overview and key differences 226 4.1.3. Accounting for transfer pricing tax uncertainties: specific considerations 228 4.2. Deferred tax accounting 230 4.2.1. Pre-tax accounting: deferred tax implications 231 4.2.2. Intercompany asset transfers 231 4.2.3. Realizability of deferred tax assets 234 4.2.4. Outside basis differences 236 4.3. Comprehensive example 237 5. Conclusion 244 Chapter 10: China PartB Country Chapters 1. Introduction 249 2. Corporate income tax framework 250 2.1. Corporate income tax system 250 2.2. Taxable entities 250 2.3. Taxable income 251 2.4. Tax losses 251 2.5. Tax rates 251 2.6. Tax treatment of R&D expenses 251 2.7. Taxation of intellectual property 252 3. Tax consequences of various models 252 xix

3.1. Characterization of manufacturing entities 252 3.2. Principal manufacturer versus contract or toll manufacturer 253 3.3. Characterization of distributing/selling companies 255 3.4. Conversion from fully fledged distributor to a limited-risk distributor 256 3.5. Service company or commissionaire or agent 257 3.6. Contract service providers 258 4. Transfer pricing details 258 4.1. Issues arising upon restructuring 258 4.2. Issues arising with regard to intangibles 260 4.3. Post-restructuring issues 260 4.4. Recognition of transactions 261 4.5. Consequences of restructurings not subject to recharacterization 262 4.6. Treatment of business restructuring expenses 262 4.7. The bargaining theory applied to business restructuring 263 4.8. Specific industries 264 4.8.1. Automotive industry 264 4.8.2. Pharmaceutical industry 264 4.8.3. Banking industry 264 5. Permanent establishment perspective 265 5.1. Existence of a permanent establishment 265 5.2. Allocation of profits to a permanent establishment 266 5.2.1. General concept 266 5.2.2. Allocation of assets 266 5.2.3. Valuation and depreciation of assets 267 5.2.4. Capital gains 267 5.2.5. Allocation of risks 268 5.2.6. Intra-company dealings 268 5.2.7. Difference with authorized OECD approach 268 5.2.8. Specific industries 268 6. Anti-avoidance provisions 269 7. Case law 271 Chapter 11: Germany 1. Corporate income tax framework 273 xx

1.1. Corporate income tax system, taxable entities, taxable income 273 1.2. Tax losses 274 1.3. Tax rates 274 1.4. Tax treatment of R&D expenses and taxation of intellectual property 274 1.5. Specific rules on business restructurings 274 1.5.1. Hypothetical arm's length test 274 1.5.2. Implications of EU law and income tax treaties 275 1.5.3. Transfer of function 276 1.5.4. Transfer package 277 2. Tax consequences of various models 278 2.1. Characterization of manufacturing entities 278 2.1.1. Assembler or toll manufacturer 278 2.1.2. Contract manufacturer 279 2.1.3. Manufacturer under licence 279 2.1.4. Fully fledged manufacturer 280 2.2. Principal manufacturer versus contract or toll manufacturer 280 2.2.1. Physical carve-out and transfer 280 2.2.2. Duplication of activities 280 2.2.3. Termination of inbound licence 281 2.2.4. Conversion to toll or contract manufacturing 281 2.3. Characterization of distributing/selling companies 281 2.3.1. Commission agent 282 2.3.2. Commissionaire 282 2.3.3. Limited-risk distributor 282 2.3.4. Fully fledged distributor 282 2.4. Conversion from fully fledged distributor to a limited-risk distributor 283 2.5. Business restructuring including commissionaires or commission agents 284 2.5.1. Conversion from full-risk distributor to commissionaire or commission agent 284 2.5.2. Termination of distribution activities 285 2.6. Contract service providers 285 3. Transfer pricing details 286 3.1. Issues arising upon restructuring 286 3.1.1. Contractual basis of restructuring 286 3.1.2. Documentation 287 xxi

3.2. Issues arising with respect to intangibles 287 3.3. Post-restructuring issues 288 3.3.1. Adjustment period for uncertainties in valuation 288 3.3.2. Duplication of functions 289 3.4. Recognition of transactions as presented by a taxpayer 289 3.5. Consequences of restructurings not subject to recharacterization 290 3.6. Treatment of business restructuring expenses 291 3.7. The bargaining theory applied to business restructuring 292 3.8. Specific industries 292 3.8.1. Automotive industry 292 3.8.2. Pharmaceutical industry 293 3.8.3. Financial services industry 293 4. Permanent establishment 293 4.1. Existence of a permanent establishment 294 4.2. Allocation of profits to a permanent establishment 294 4.2.1. General concept 294 4.2.2. Allocation of assets 295 4.2.3. Valuation and depreciation of assets 296 4.2.4. Capital gains 296 4.2.5. Allocation of risks 296 4.2.6. Intra-company dealings 296 4.2.7. Difference with authorized OECD approach 296 4.2.8. Specific industries 297 5. Anti-avoidance provisions 297 6. Case law 297 Chapter 12: India Corporate income tax framework 299. 1. Corporate income tax system 299.2. Taxable entities 300.3. Taxable income 300.4. Tax losses 300.5. Tax rates 300.6. Tax treatment of R&D expenses 301.7. Taxation of intellectual property 301 2. Tax consequences of various models 301 xxu

2.1. Characterization of manufacturing entities 301 2.2. Principal manufacturer versus contract or toll manufacturer 302 2.3. Characterization of distributing and selling entities 303 2.4. Conversion of fully fledged distributor to a limited-risk distributor 303 2.5. Service company or commissionaire or agent 304 2.5.1. Commission agent 304 2.5.2. Characterization of service-based companies 305 2.6. Contract service providers: centralization of R&D activities, contract maintenance and contract marketing 306 3. Transfer pricing details 307 3.1. Issues arising upon restructuring in case of stopping activities and post-restructuring issues 308 3.2. Issues arising in case of transfer of intangibles 311 3.3. Post-restructuring issues 313 3.4. Recognition of transactions as presented by the taxpayer 315 3.5. Consequences of restructurings not subject to recharacterization 316 3.6. The bargaining theory and business restructuring 316 3.7. Specific industries 317 3.7.1. Automotive industry 317 3.7.2. Pharmaceutical industry 318 3.7.3. Global trading of financial instruments 319 4. Permanent establishment 319 4.1. Existence of a permanent establishment 319 4.1.1. Fixed place permanent establishment 319 4.1.2. Agency permanent establishment 321 4.1.3. Service permanent establishment 322 4.2. Allocation of profits to a permanent establishment 325 4.2.1. General concept 325 4.2.2. Allocation of assets 326 4.2.3. Valuation and depreciation of assets 326 4.2.4. Capital gains 326 4.2.5. Allocation of risks 326 4.2.6. Intra-company dealings 326 4.2.7. Difference with authorized OECD approach 327 5. Anti-avoidance provisions 328 xxm

6. Case law 329 Chapter 13: Switzerland Corporate income tax system 331.1. Taxable entities 332.2. Taxable income 332.2.1. General corporate income tax regime 332.2.2. Federal and cantonal tax privileges 333.3. Tax losses 334.4. Tax rates 334.5. Tax treatment of R&D expenses 335 1.5.1. General provisions 335 1.5.2. R&D incentives 336 1.5.3. Other incentives applicable for R&D activities 336 1.6. Taxation of intellectual property 336 1.6.1. Swiss holding company as beneficial owner of intellectual property 337 1.6.2. Cantonal and communal tax privileges and beneficial IP ownership 337 1.7. Transfer pricing rules and regulations 338 2. Tax consequences of various conversion structures 339 2.1. General comments 339 2.2. Current approach 340 2.3. Characterization of manufacturing entities 341 2.3.1. Key features 341 2.3.2. Tax consequences of a conversion 342 2.4. Principal manufacturers versus contract/toll manufacturers 343 2.5. Characterization of distribution and selling companies 344 2.6. Conversion from fully fledged distributor to limited-risk distributor 346 2.6.1. General observations 346 2.6.2. Conversion of an existing Swiss company into a principal company 347 2.7. Service company or commissionaire or agent 347 2.8. Contract service providers 349 3. Transfer pricing details 350 3.1. Legal framework 350 3.1.1. Transfer pricing and international tax law 350 xxiv

3.1.2. Transfer pricing and Swiss internal tax law 350 3.2. Issues arising upon restructuring: indemnification for terminating activities 351 3.3. Issues arising with regard to intangibles 353 3.4. Post-restructuring issues 353 3.5. Recognition of transactions as presented by a taxpayer 353 3.6. Treatment of business restructuring expenses 354 3.7. The bargaining theory applied to business restructuring 354 3.8. Specific industries 355 4. Permanent establishments 355 4.1. Definition of "permanent establishment" under Swiss tax law 355 4.1.1. Taxation of a permanent establishment 356 4.1.2. Existence of a permanent establishment in various arrangements 356 4.2. Allocation of profits to a permanent establishment 357 4.2.1. General concept 357 4.2.2. Allocation of assets 358 4.2.3. Valuation and depreciation of assets 359 4.2.4. Capital gains 360 4.2.5. Allocation of risks 360 4.2.6. Intra-company dealings 360 4.2.7. Difference with authorized OECD approach 361 4.2.8. Specific industries 361 5. Anti-avoidance provisions 361 6. Case law 363 Chapter 14: United Kingdom 1. Corporate income tax framework 367 1.1. Corporate income tax system 367 1.2. Taxable entities 367 1.3. Taxable income 368 1.4. Tax losses 368 1.5. Tax rates 369 1.6. Tax treatment of R&D expenses 369 1.7. Taxation of intellectual property 369 2. Tax consequences of various models 369 xxv

2.1. Characterization of manufacturing entities 369 2.2. Principal manufacturers versus contract or toll manufacturers 371 2.3. Characterization of distributing/selling companies 372 2.4. Conversion from full distributor into limited-risk distributor 373 2.5. Service company, commissionaire or agent 374 2.6. Contract service providers 375 2.6.1. General 375 2.6.2. R&D credits 375 3. Transfer pricing details 376 3.1. Issues arising upon restructuring 376 3.2. Issues arising with respect to intangibles 377 3.2.1. Goodwill 377 3.2.2. Other intangible assets 378 3.2.3. Valuation 379 3.3. Post-restructuring issues 379 3.3.1. Substance 379 3.4. Recognition of transactions as presented 380 3.4.1. Disregarding transactions 380 3.4.2. Recharacterizing transactions 381 3.5. Consequences of restructurings not subject to recharacterization 381 3.5.1. Compensation 381 3.5.2. Commercial agents 382 3.5.3. Transfer pricing 383 3.6. Treatment of business restructuring expenses 383 3.7. The bargaining theory applied to business restructuring 384 3.8. Specific industries 385 3.8.1. Automotive industry 385 3.8.2. Pharmaceutical industry 385 3.8.3. Banking industry 385 3.8.4. Global trading 386 3.8.5. Insurance industry 387 4. Permanent establishments 387 4.1. Existence of a permanent establishment 388 4.1.1. Agents 389 4.1.2. Commissionaires 389 4.1.3. Limited-risk distributors 389 4.1.4. Contract or toll manufacturers 390 xxvi

4.2. Allocation of profits to a permanent establishment 390 4.2.1. General concept 391 4.2.2. Allocation of assets 391 4.2.3. Valuation and depreciation of assets 392 4.2.4. Capital gains 392 4.2.5. Allocation of risks 392 4.2.6. Intra-company dealings 393 4.2.7. Difference with authorized OECD approach 393 4.2.8. Specific industries 394 5. Anti-avoidance provisions 395 6. Case law 396 Chapter 15: United States Corporate income tax framework 399.1. Corporate income tax system 399.2. Taxable entities 400.3. Taxable income 401.4. Tax losses 401.5. Tax rates 402.6. Tax treatment of R&D expenses 402.7. Taxation of intellectual property 403 2. Tax consequences of various models 403 2.1. Characterization of manufacturing entities 406 2.2. Principal manufacturer versus contract/toll manufacturer 408 2.3. Characterization of distributing/selling companies 410 2.4. Conversion from a fully fledged distributor to a limited-risk distributor 411 2.5. Conversion from a fully fledged distributor to a service company or commissionaire 413 2.6. Contract service providers: centralization of R&D activities, contract maintenance and contract marketing 413 3. Transfer pricing details 415 3.1. Issues arising upon restructuring, such as indemnification for termination of activities 417 3.2. Issues arising with respect to intangibles 418 3.3. Post-restructuring issues 420 3.4. Recognition of transactions as presented by a taxpayer 422 xxvu

3.5. 3.6. 3.7. 3.8. 3.8.1. 3.8.2. 3.8.3. 3.8.4. 3.8.5. 4. 4.1. 4.2. 4.2.1. 4.2.2. 4.2.3. 4.2.4. 4.2.5. 4.2.6. 4.2.7. 4.2.8. 5. 5.1. 5.1.1. 5.1.2. 5.2. 5.3. Consequences of restructurings not subject to recharacterization Treatment of business restructuring expenses The bargaining theory applied to business restructuring Specific industries Automotive industry Pharmaceutical industry Banking industry Global trading Insurance industry Permanent establishment perspective Existence of a permanent establishment Allocation of profits to a permanent establishment General concept Allocation of assets Valuation and depreciation of assets Capital gains Allocation of risks Intra-company dealings Difference with authorized OECD approach Specific industries Anti-avoidance provisions The Code and Treasury Regulations Inversions Other Common law Summary 426 426 427 428 428 429 430 430 431 431 431 433 433 434 434 434 434 434 435 435 435 435 436 436 437 437 6. 6.1. 6.2. 6.3. 6.4. 6.5. Case law Johnson Bronze Company case Hospital Corporation of America case United Parcel Service of America, Inc. case E.I. Du Pont de Nemours case Bausch & Lomb. Inc. case 438 438 440 442 443 444 XXVUl

Chapter 16: Case Study China - Case Study 452 Germany - Case Study 457 India - Case Study 460 Switzerland - Case Study 463 United Kingdom - Case Study 466 United States - Case Study 473 Chapter 17: Conclusion PartC Conclusion 1. Introduction 481 2. Business perspective and business models 483 3. Tax consequences of various models 485 4. Indirect taxes 488 5. Tax accounting 489 6. OECD Report 490 7. Future prospects 493 xxix