The Chamber of Tax Consultants 4 th INTERNATIONAL TAX CONFERENCE UN s Practical Manual on Transfer Pricing for Developing Countries TPOstwal
Where and why did the OECD/UN model treaty police arise as it has? In 1920-1923, the ICC commenced a process to develop a model income tax treaty in the immediate aftermath of World War I. This was the period of conception for the model treaties of today. This work has been lost as the world has evolved. It is instructive with respect to the current tax policies being espoused by Source Countries. 2
The Post-World War I World (1920 1923) Imagine a world, long ago, in which the paradigm of commerce and international taxation was a developed country (let s call it England ) and an under-developed country that was a colony of England ( India ). A global war ended, with England having enormous war debt. There was a material flow of commerce between England and India. For the most part, England transferred to affiliates in India capital, technology, and access to global markets. India responded with commodities and produced goods. England was a creditor and India a debtor. The policy issue for consideration was how income from these activities should be shared between Resident and Source countries. 3
ICC Proposal in 1923 In its interim report in 1923, the ICC proposed what we would call today a profit split or formulary allocation methodology to address income allocation between Residence (Creditor) and Source (Debtor) countries. Rather close to the combined income methodologies that we typically use today to resolve major CA cases between countries with an MNE in the middle. Frankly, it is also similar to the methodologies for evaluating intangibles in the 2012 OECD discussion draft. League of Nations (1923 1928) The ICC work was taken over by the League of Nations in 1923. The LofN took an entirely different approach. It formulated 5 principles: 4
League of Nations (1923 1928) cont 1. Source Country (India) should tax local operations, including property or other pertinent matters. 2. Residual income should be earned by the country of Residence, which provided the knowledge and capital for the business. 3. Presence of an interim holding company should be treated as a Residence Country. Why was this assumed?: All countries would adopt a common model! 4. Subsidiaries should not be treated as a PE. 5. TP is to be evaluated on a consistent basis. The model treaties that eventually became the OECD Model, and subsequently the UN Model, are based on these 5 principles. 5
What was the net impact of these principles? Answer: A system that allowed: 1.Source Country earns a routine return. 2.Residence Country receives the residual income. 3.Interim holding companies would be treated as Residence Countries, even if located in a low tax country. 6
MNE Tax Planning Strategies Not surprisingly, the international tax and effective tax rate ( ETR ) strategies of MNEs evolved based on this treaty model. Common structures included what we today describe as: 1.Global/regional principal 2.Centralized risk-taker, kt k intangibles owner 3.Limited risk activities in high tax countries 7
Effective Tax Rates ( ETR ) strategies are often based on easily applied one-sided TP methodologies, which typically test the earnings of Source Country affiliates. These strategies are precisely what was contemplated in the work of the LofN, which is the model of OECD/UN model treaties. Today, MNEs are commonly pilloried for base stripping Source Countries. 8
Imperial Paradigm 9
Is the criticism appropriate? Whether this answer is yes or no, it is apparent to me that this is the behavior that was encouraged by the LofN model. At the time, it may have been intended to facilitate repatriation of revenue to Residence countries to repay war debts. 10
Preface While it is for each country to choose its tax system, UN s TP Guidance is addressed at countries seeking to apply the arm s length standard to transfer pricing issues, this approach minimizes Double taxation disputes with other countries Improve investment climate Combating potential profit shifting between jurisdictions where a MNE operates. Helping achieve common understandings di on transfer pricing ii issues can also improve trust between taxpayers and tax authorities, both avoiding some differences between them and helping resolve others more quickly. In offering practical guidance to policy makers and administrators on the application of the arm s length principle, the Manual does not seek to be prescriptive. In particular it recognizes that the needs of countries, along with their capabilities, will evolve over time. A phased or life cycle approach, with a transfer pricing capability strategy identifying short, medium and longer term objectives and areas of focus will therefore often yield the best results. It follows that many developing countries may find the early history of transfer pricing in developed countries to be of special relevance, as well as the current practices in other, especially developing, countries. DEC 2012 11
Guiding Principles for drafting UN TP Guidance This is a practical manual rather thanalegislative model; The drafting should be as simple and clear as the subject matter permits; The Manual will be prepared initially in English, but with a recognition that this will not be the first language of most users; it should be translated at least into the other official UN languages; A key value added of the Manual is to be its practicality addressing real issues for developing countries (and of course those dealing with the administrations of such countries) in a practical and problem solving way. It therefore seeks to address the theory of transfer pricing, but in a way that reflects developing country realities in this area; The Manual, as a product of the United Nations Committee of Experts on International Cooperation in Tax Matters, has a special role in reflecting the diversity of the United Nations Membership and placing transfer pricing in its developmental perspective. This recognizes both the importance to development of fair and effective tax systems, but also the fact that foreign investment, on appropriate terms, is seen as an important path to development by most countries; (contd) DEC 2012 12
Guiding Principles for drafting UN TP Guidance (contd).. Helpful guidance in this complex area must, in particular, be geared to the inevitable limitations in some countries administrations, and deficits in information and skills that many countries are affected by in this area. Issues of building and retaining capability, focus and efficiency in dealing with limited resources, in particular, bear strongly on the approach taken in the Manual; Practical examples relevant to developing countries have been especially relied upon, because the experiences of other developing countries in addressing the challenges of transfer pricing are an important way of finding effective solutions that work in their context, and of doing so in the most cost and time effective ways; and Consistency with the OECD Transfer Guidelines has been sought, as provided for in the Subcommittee s mandate and in accordance with the widespread reliance on those Guidelines by developing as well as developed countries. While manual is a consensus document where as chapter 10 of the manual represents country practices which represents an outline of country administrative practices contributed by the administrative representatives of respective countries and not a debated and consensus document. DEC 2012 13
UN s TP Guidance : A living work Certain differences between the Model Commentaries; While the OECD one is based on the consensus of 34 developed countries, UN has membership of 193 economies and its working is not consensus based. Finally, it should be noted that UN s Manual is conceived as a living work that should be regularly revised and improved, including by the addition of new chapters and additional material of special relevance to developing countries. This will only improve its relevance to users and its significance as a work that can be relied upon in the capacity building efforts of the United Nations and others that are aeso needed in this field. ed DEC 2012 14
Mandate of the UN TP Manual Committee of Experts on International Cooperation in Tax Matters at its Annual Session in 2009 constituted the Subcommittee on Transfer Pricing Practical Issues Mandate laid down the following principles : - Reflect the operation of article 9 of the UN MTC - Arm s-length principle p - To be consistent with relevant commentaries of the UN MTC - Reflect the realities for developing countries at the relevant stages of their capacity development; - Special attention to be paid to the experience of other developing countries; Objective:- To provide a simplified and coherent guide to developing countries on practical transfer pricing Assists policy makers and administrators in dealing with complex transfer pricing issues Assists taxpayers in their dealings with tax administrations. DEC 2012 15
History of the Subcommittee s work The Subcommittee has been by far the largest in the Committee s history Subcommittee has benefitted greatly from the breadth and depth of experience of the Members. The draft Manual is commended to the Committee as a product of great deal of effort. The draft Manual was presented before the Committee of Experts on International Cooperation in Tax Matters at Geneva Meeting and approved on 15 th October 2012 DEC 2012 16
List of Chapters covered in Practice Manual Chapter Topic 1 An Introduction to Transfer Pricing 2 Business Framework 3 General Legal Environment 4 Establishing Transfer Pricing Capability in Developing Countries 5 Comparability Analysis & Appendix I - Comparability 6 Transfer Pricing Methods 7 Documentation & Appendix II - Documentation 8 Audits and Risk kassessment 9 Dispute Avoidance and Resolution 10 Introduction to Country Practices 10.1 Country Practices in Brazil 10.2 Country Practices in China 10.3 Country Practices in India 10.4 Country Practices in South Africa DEC 2012 17
Chapter 1 - An Introduction to Transfer Pricing What is Transfer Pricing? Basic Issues underlying Transfer Pricing such as Jurisdiction/Allocation/ Valuation is dealt with How Transfer Pricing evolved and History behind it While applying li Arm s length principle i which h factors are involved and comparability analysis process or steps & selection of most appropriate transfer pricing method Special Issues Related to Transfer Pricing Intangibles Safe Harbors Intra Group Services Cost Contribution Agreement Secret Comparables CFC Thin Capitalization APAs DEC 2012 18
Chapter 1 - An Introduction to Transfer Pricing (contd).. Attention ti is given to Lack of Comparables Lack of requisite skill sets and knowledge from administration s perspective Growth of E-Commerce Economies Location Savings Losses Chapter 2 and Chapter 3 Business Framework Legal Structure Managing the transfer pricing function in an MNE General Legal Environment is explained DEC 2012 19
Chapter 4 - Establishing transfer pricing capability in Tax Administration Relationship of policy and administration Identifying needs and gaps Establishing a transfer pricing unit Models of organisational structure Building team and cultural issues Effective and efficient processes Integrity Country examples of capacity building in transfer pricing Japan India Malaysia DEC 2012 20
Chapter 5 Comparability Analysis Rationale for Comparability Analysis Five Comparability factors, include: characteristics of the property or service transferred functions performed by the parties taking into account assets employed and risks assumed, in short referred to as the functional analysis contractual terms economic circumstances and business strategies pursued. Functional analysis explained in a very comprehensive manner with practical examples. Functions performed and Assets Employed are explained in a greater detail. DEC 2012 21
Ch - 5 : Risks Assumed in FAR Analysis Type of risk in general (Depending on the nature of transaction) : Financial i risk Product risk Market risk Collection risk Entrepreneurial risk General business risk Country/regional risk Which entity bears the risk - Identification of party having control over risk involves - Examination of factors Core functions Key responsibilities Key decisions Level of individual responsibility for the key decisions Example 1 Control over risk by parent company Example 2 Control over risk by its subsidiaries Risk is a by-product of functions performed and assets employed and it is not independent (Refer Sec 92 C of Indian Income Tax Act 1961 which also gives importance to only functions performed. DEC 2012 22
Ch 5 : Location Savings Location savings, Location Specific Advantage, Location rent and Market Premium Who gets location rents? Multinationals generate enormous cost-savings by off-shoring. Often these savings end up in a tax haven or back in the home country. UN manual proposes an approach that would give developing countries a bite of the apple. The approach can be summarised as follows: 1. Calculate gross location savings based on the reduction in unit labour costs achieved by relocating to the developing country. 2. Calculate the net location savings by subtracting so-called dis -savings such as extra transport costs imposed by moving so far from the market. Cost savings Dissavings savings = Net location savings (e.g. cheap abour) - (e.g. high transportation cost) (contd).. DEC 2012 23
Ch 5 : Location Savings (contd).. 3. Calculate total location specific advantages (LSA) by adding in further benefits realized by moving offshore. Net location savings 4. Determine how much of the LSA will be captured in extra profits, known as location rent as opposed to being passed on to customers in lower prices. Other Location Location Specific +/ Specific Benefits = Advantages ( LSAs ) +/ Other Location Location Specific Location Rent Specific Benefits = Advantages ( LSAs ) => (i.e. incremental profit) 5. Lastly, Allocate the location rent between the counter-parties to the transaction based on relative bargaining power and other indicators DEC 2012 24
Market Premium Country Practices China s view Market Premium OECD s view Market size / premium is not an intangible Because it is "not capable of being owned, controlled or transferred by a single enterprise". But it does acknowledge that market factors "should be taken into account in a comparability analysis". Whereas in Chapter 10 - Country Practices in China suggests Market premium will need to be factored into transfer pricing analysis As an LSA or As a comparability factor. It can no longer be ignored. DEC 2012 25
Ch5 : Identification of potentially comparable transactions or companies Information sources for third-party or external comparables. - Electronic data compilations - Other comparable data sources Government sources Trade institutions and organisations o o o o Chambers of commerce Trade and professional organisations Embassies, Consulates, Trade missions International organisations (such as UN agencies, OECD, World Bank, IMF). DEC 2012 26
Ch 5 : Issues regarding comparability analysis Some of the common concerns surrounding comparability analysis are : - Timing issues o Timing of origin o Timing of collection o Valuation of highly uncertain at the outset and unpredictable events o Data from years following the year of transaction - Lack of reliable comparables o Due to lack of data o Use of new technologies, products and services o Consolidation and Vertical Integration o Non - availability of data - Cherry-picking of comparables DEC 2012 27
Ch 5 : Issues regarding comparability analysis - Losses o Start-up losses o Deliberate business strategies o Losses caused by recession o Losses arising from increased competition o Losses arising i from product life cycle issues o Losses arising from quality issues - Evaluation of separate and combined transactions - Intentional set-offs - Use of customs valuations - Use of secret comparables - Overall process complexity DEC 2012 28
Ch 5 Comparability Adjustment & Examples Different type of Comparability Adjustments Accounting consistency Balance sheet Adjustments Functional differences subdivided into Working capital Functional mix Significant intangibles Risk adjustment Transactional Structure To provide a clearer understanding of functional analysis and explain the chapter in a more practical manner, following are the hypothetical examples (Placed in Appendix I Comparability) : Part 1: Example related to Functional Analysis (Manufacturing Entity) Part 2: Example related to Functional Analysis (Distributor) Part 3: Functional Analysis Checklists Part 4: Case Study based on a hypothetical Example DEC 2012 29
Methods, Documentation, Audit, Dispute Resolution Chapter 6 : Transfer Pricing Methods Selection of Most Appropriate Transfer Pricing Method explained in very brief and simple manner (in line with OECD s TP Guidelines) Chapter 7 : Documentation - Explained in detail and has an Appendix covering sample documentation exhibit Chapter 8 : Audits and Risk Assessment Chapter 9 : Dispute Avoidance and Resolution Chapter 10 : Some Country Practices 1. Brazil 2. China 3. India 4. South Africa DEC 2012 30
Country Practices China and India s views Refer note on page 13 Legal contracts asserting IP is held offshore will be disregarded If it is found that the developing country subsidiary has engaged in activities that put it in control and create intangibles. Routine cost-plus returns will no longer be acceptable for those contract R&D companies that are found to exert control or to enjoy a high-tech status. Limited risk distributors spending an excessive amount on AMP will be expected to enjoy ashare of the excess profits related to the locall intangibles they are creating. Location rents should be booked in the developing country under certain circumstances rather than being booked in either the tax favoured jurisdiction or the home country. Companies engaged in toll manufacturing will need to add back the cost of the consigned materials into their cost base. DEC 2012 31
Country Practices China and India s views (contd).. Comparables should be viewed with caution given the paucity of information in developing countries. MNEs that operate multiple entities, each with a single function, may not be able to claim that each entity is entitled to only a routine return A holistic approach would be more appropriate. Where a significant percentage of the global employees or assets are actually in developing country A formulary approach may be the best method DEC 2012 32
Country Practices Brazil and South Africa s views (contd).. Brazil Follows only three transactional methods with substantial difference from OECD and also does not recognize profit based method. Fixed margin is recognized as minimum threshold in cost+ and resale price method. South Africa Guidelines are aligned towards OECD guidelines Major challenge faced is lack of comparables and data base Holistic approach is favored and hence does not necessarily rely on comparables. DEC 2012 33
Future of Transfer Pricing in Developing Countries The economic significance of the OECD is in rapid decline. In 2000, OECD nations controlled 60% of gross world product. Now it is at 50% and is expected to drop to about 40% in 2030. Power and influence will need to be shared between developed and developing countries With new players such as Brazil, Russia, India, China, and South Africa (BRICS), and the UN entering the fray, India and China see themselves as "exceptional countries" and will want a say in writing the rules, whether it is greenhouse gases, transfer pricing, or intellectual t l property, and thatt is the wayit will be. Confidence levels among Indian and Chinese tax authorities are growing It is clear that these developing countries will not allow themselves to be pushed around much longer. Over 70% of the global transfer pricing litigation worldwide is in India a sign of that country's independent thinking. (contd) DEC 2012 34
Future of Transfer Pricing in Developing Countries The big question is whether India and China will pass new regulations to incorporate the positions expressed in the UN manual. If so, the nature of global transfer pricing will shift. Location rents and local intangibles will become part of the analysis. Finally, every global tax director of an MNE will need to figure out a new strategy Because the principal structure used to provide developing countries a routine profit will get terminated DEC 2012 35
UN s TP Guidance will help developing countries transfer pricing regulations and establishing transfer pricing capabilities. It may add fuel to fire as two different set of documents coming into play simultaneously. DEC 2012 36
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