BEPS is now! Andrew Hickman, John Neighbour, and Matt Whipp, KPMG in the UK, London Base Erosion and Profit Shifting: the Action Plan and impact in the UK Although the Action Plan on Base Erosion and Profit Shifting released by the OECD in July 2013 presents an 18-month timeframe for delivery, the transfer pricing actions are already current in the UK. BEPS is now because the transfer pricing rules in the UK are already being applied in a cuttingedge way to deal with some of the more difficult issues relating to intangibles, risk and capital that are highlighted in the Action Plan. The BEPS project will make current applications more widespread, and in due course provide greater clarity and authority, but in many ways the outcomes are likely to be an endorsement of creative approaches already developed by HMRC. To wait until December 2015 when the Action Plan anticipates reporting on the last of the actions may not be advisable. The direction of travel for transfer pricing is clear. There is a desire on the part of governments to: s Neutralise capital and contractual risks and promote labour, whether inside or outside the arm s length principle s Make the value chain more central to the individual country analysis s Make documentation more consistent and transparent The project is expected to deliver changes quickly. This is not a typical OECD project, but one led by G20 Finance Ministers. In a sense the OECD are managing it on behalf of Finance Ministers, and these Finance Ministers want to report outcomes. Politicians are involved because there is a public perception that in a time of austerity multinationals are not hurting as much as the man on the street. The increased focus on perceived tax avoidance coupled with extreme pressure on public finances has led to a widespread sentiment that something must be done. If current international tax rules and frameworks do not lead to appropriate policy outcomes, these have to change. The timetable is ambitious. Several of the reports must be completed in just over a year, the rest, albeit with a few exceptions, in 2015. This in OECD terms is an incredibly rapid rate of progress, and we have already seen an example of this pace with the re-drafted intangibles paper already released, together with the White Paper on Transfer Pricing Documentation. For businesses, changes to pricing, commercial operations, contracts and other documentation will take time, but time may not be available. Some of the conclusions arising from BEPS may simply re-interpret or clarify existing rules and guidance, with the effect that the BEPS outcomes may describe how these rules should always have been applied. One consequence is that it may be unwise to assume that BEPS will have only prospective application. Another consequence may be that Advance Pricing Agreements are not paralysed by BEPS, but rather energised by it: working through transfer pricing and permanent establishment issues now in the context of an APA is likely to bring valuable certainty that will extend beyond the period in which formal changes to the rules may occur: an Action Plan Antidote, perhaps. Businesses need to consider actions to address BEPS now, because BEPS will change things quickly and because aspects of BEPS already apply. l. The Action Plan The Action Plan identifies 15 clear areas of targeting, illustrated in the table: Table: Action Plan timing Action Deadline Addressing the tax challenges of Sept 14 the digital economy Neutralise the effects of hybrid Sept 14 mismatch arrangements Strengthen CFC rules Sept 15 Limit base erosion via interest Sept/Dec 15 deductions/other financial payments Counter harmful tax practices Sept 14 & more effectively taking into Sept/Dec 15 account transparency and substance Prevent treaty abuse Sept 14 Prevent the artificial avoidance of Sept 15 PE status Assure that TP outcomes are in line with value creation: intangibles Sept 14 & Sept 15 09/13 Transfer Pricing International Journal BNA ISSN 2042-8154 1
Action Deadline Assure that TP outcomes are in Sept 15 line with value creation: risks/ capital Assure that TP outcomes are in Sept 15 line with value creation: other high-risk transactions Establish methodologies to Sept 15 collect and analyse data on BEPS/actions to address it Require taxpayers to disclose Sept 15 their aggressive tax planning arrangements Re-examine TP documentation Sept 14 Make dispute resolution Sept 15 mechanisms more effective Develop a multilateral instrument Sept 14 & Dec 15 For the purposes of this article we will concentrate on the actions which specifically focus on transfer pricing issues. A. Intangibles A revised discussion draft on the transfer pricing aspects of intangibles was released on July 30. The redraft responds to many of the concerns business commentators expressed, and in particular the new version steps back from the brink and acknowledges the role of capital and legal ownership. The focus on Significant People Functions (SPFs) in determining how to allocate the returns from intangibles remains. Transfer pricing analyses will need to focus on the functions within the value chain to understand who contributes to the management of risks associated with intangibles. Cost contribution arrangements are not currently part of the revised draft, but are included in the BEPS Action Plan. It remains to be seen how cost contribution arrangements will be integrated with the new approach to intangibles which focuses less on contractual allocation of risk and funding, and more on the management of the key development functions. The revised draft contains no changes to the discussion of hard-to-value intangibles since this is now a specific action in BEPS. It is likely that both issues will target the September 2014 completion date. The way in which the revised draft builds on existing guidance on comparability and on the control and management of risks found in the OECD Transfer Pricing Guidelines lends welcome coherence. The approach in the draft is likely to provide a platform for the BEPS approach to substance: returns to intangibles will take into account funding and contractual risk, but will focus on the people functions which manage the risks. B. Risk and capital The return to risk and capital has historically been a key issue for tax administrations who view the location of risk and capital as too easy to manipulate. To a certain extent, the issue of risk has been dealt with by Chapter IX of the Guidelines which has shifted the focus to the management and control of the risk, rather than merely the contractual location. There remain difficult issues, however, in determining the nature and level of activity required to demonstrate management and control. Actions emerging from BEPS are likely to go further in seeking to ensure that inappropriate returns will not accrue to an entity solely for providing capital or contractually assuming risk. However, the extent to which they do this is a delicate point. The arm s length principle is based on open market arrangements, and markets recognise that the provision of capital performs an economic function. If a re-insurance company in Bermuda provides capital, under the arm s length principle it is recognised that this is part of the value chain and the Bermudan entity should receive an economic return which encompasses the risk of loss. If no return is allocated to this economic function there will be a deviation from the arm s length principle which has long been the central tenet of transfer pricing. There are references in the Action Plan to special measures that look at the SPFs in the value chain and override the contractual provision of capital, going beyond the arm s length principle. However, it is not yet clear to what extent this will be implemented; whether capital will be fully reallocated based on a SPF/Key Entrepreneurial Risk Takers ( KERT ) analysis or whether it will instead just receive a risk free return unless there is additional substance. The revised draft of the intangibles paper has moved on from denying a return to capital to allocating a riskweighted return to capital. However, the process of risk-weighting is not explained, and there seems to be a potential imbalance between a tendency to limit the return where there is no active management and acknowledging that the capital provider could lose that capital. C. Thin capitalisation: a global move towards formulaic earning stripping rules? The payment of interest is perceived as a very effective way for multinationals to shift profit between entities so it is not surprising that the OECD is encouraging countries to introduce or improve thin capitalisation rules. While it is unclear how the transfer pricing aspects of cross-border financial transactions will be dealt with and to what extent special measures in a thin capitalisation context will be implemented, we can expect to see a global move towards more formulaic earnings stripping rules at the expense of approaches that reflect the individual facts and circumstances. This is likely to lead to double taxation unless there is international agreement on the formulaic approaches. One potential creative approach could be regulations that seek to reclassify debt as equity and so not permit any interest deduction where the interest rate and/or quantum of debt is beyond a certain level. Limitations around treaty benefits for interest and transfer pricing rules dealing with financial transactions are likely also to be proposed. D. Re-characterisation of transactions It is clear from the Action Plan that there is an increased focus on the quality of comparables. 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will be a greater onus on businesses to ensure that comparables are true and accurate reflections of the economic reality identical in function and risk to the tested transaction. This may include a need to adjust for issues which may currently be ignored. Since Comparable Uncontrolled Prices ( CUPs ) are already extremely difficult to find we can expect to see a significant shift towards profit split analysis across the value chain. More challenges are likely to arise around the use of comparables to identify whether transactions would be entered into between third parties. The would test in the past has been used to prevent recharacterisation if you can find a market comparable for the transaction then the transaction is commercially rational and not in re-characterisation territory. This has meant that historically recharacterisation has only been possible in very specific circumstances. However, this would test is likely to be expanded not only to discuss whether similar transactions occur in the open market, but also to question whether, in the case of this particular transaction and the situation of the parties, third parties would really have transacted in the way that is characterised. So there is going to be a lot more pressure on businesses to find good comparables; not necessarily to support the pricing itself, but to support the characterisation of the arrangement and why it is commercial rational. If the re-characterisation rules are likely to allow greater scope for re-characterisation, then the outcome must also provide for agreement on what replaces the actual transaction, and how extensive the consequences of re-characterisation might be. E. Head office expenses: an issue of fairness The mention of head office expenses in the Action Plan is the clearest indication that the OECD is trying to take on the concerns of non-oecd members. While management charges have long been an issue with regard to double taxation, they have not previously been viewed as a tool used in tax planning and profit shifting. However, there is a view that Head Office expenses from high cost locations can wipe out tax bases in developing countries. Due to pressure from the G20, these will therefore be examined in line with the value creation principles in the Action Plan. F. Multilateralism: making dispute resolution more effective The OECD recognises that in a BEPS world, with an emphasis on the bigger picture there must be a greater commitment towards multilateralism in two ways. Firstly, it will not be practicable to implement BEPS changes quickly through amendments to thousands of bilateral treaties, and so instead multilateral instruments would be drawn up to agree on the effect of those changes. Secondly, there must also be a much bigger commitment to resolving issues between countries and in a way that gives some consistency and fairness in application between the different jurisdictions. The use of multilateral instruments will hopefully mean that MAPs are less reliant on the bilateral nexus of treaties and will further allow a number of countries to get together and resolve the double taxation across the value chain. Triangulation issues are becoming even more problematic when dealt with through a series of bilateral treaties, and these may be accommodated and resolved through multilateral agreements. Additionally, APAs across the value chain and not just for one bilateral transaction will become increasingly necessary in order to gain certainty around pricing, especially with the focus moving towards profit split mechanisms. G. Transfer pricing documentation: enhancing transparency There are potentially big changes in the world of documentation. The White Paper has started a reexamination of the purpose of documentation, and the BEPS action strongly suggests that transfer pricing documentation may move towards a version of country-by-country reporting. National or one-sided transfer pricing documentation will be even less appropriate going forward given the expectation of greater sharing of information between jurisdictions and the probability that future documentation will likely need to disclose the global allocation of profits and potentially tax paid by country. H. Conflicts with requirements of regulated businesses Some of the key proposals of BEPS sit uneasily with the characteristics and requirements of regulated businesses, especially in the financial sector. A SPF/ KERT approach which seeks to charge tax mainly in the location of key employees, disregards the location of capital and so creates a potential conflict with the capital requirements imposed by the regulators. A case in point would be where individuals in one jurisdiction are involved in the decisionmaking process regarding loans that are recognised on the books of an entity in a different jurisdiction. Under the BEPS proposals, profit should be attributed to the people functions involved in making the decision to enter into the transaction. However, regulators will base their view of where capital needs to be located on where the loan is booked, which may not be where the majority of profits and losses would likely be recognised for tax purposes under BEPS. Regulators are also increasingly recognising the importance of capital and liquidity in the regulated value chain and are insisting on financial enterprises having a lot more of both. Regulators are often concerned that the implied return on capital after transfer pricing is inappropriately low leading to an insufficient level of profit being built up to absorb potential future losses. This view would conflict with the potential BEPS view that returns to pure risk-taking are often overstated and should be reduced. These issues could cause huge problems in regulated industries and could lead to asymmetric recognition of profit for regulatory/statutory purposes and tax purposes, leading to much wider concerns. ll. Act now The main lesson that can be taken from the Action Plan is that businesses need to change their approach to transfer pricing. Whilst the exact form in which 09/13 Transfer Pricing International Journal BNA ISSN 2042-8154
BEPS will happen is not yet clear, the direction of travel is well signposted in the Action Plan. There is unhappiness with the relevance of capital in economic activity and a greater interest in labour and people functions. Businesses can no longer rely solely on contractual allocation of risk as a starting point, nor on the provision of capital. Neither can transactional, disaggregated approaches be applied without looking at the bigger picture. Instead it will be necessary to examine the functions that manage risk. There is a noticeable movement to understanding the full value chain, and mapping remuneration and profit through it. Having said this, it seems that the actions of the BEPS project will build on, rather than abandon, the longstanding rules of international taxation. For the most part, the aim seems not to develop new methods on which to base transfer pricing, but to properly enforce the arm s length principle (albeit with special measures which may supersede the arm s length principle in some cases) in order to remedy some areas of discomfort for tax authorities. lll. Future rules already apply Actions will be wide-ranging. Some points (e.g., in relation to hybrids and treaty abuse) may be addressed through changes to the Model Tax Convention and there may be recommendations regarding the design of domestic law (e.g., CFC rules, interest deductions). However the key point here is that some major changes that might be the outcome of BEPS (e.g., in relation to ensuring TP outcomes are in line with value creation) may not require new legislation at all, but a change in guidance. A change in guidance effectively clarifies the existing law, so in fact the future rules could already apply we just do not know what these are. In fact, some of these ideas are already being applied. You can see the drafting hand of HMRC in the Action Plan. And indeed a lot of the actions are current in the UK; transfer pricing rules are already being applied in a cutting edge way to deal with the key issues around transfers of intangibles. So what impact will BEPS actually have in the UK if it is already happening? Firstly, it will likely bolster the current actions of the tax authorities and give greater authority to these lines of approach. It should also give rise to greater consistency and more widespread application around the world. IV. Actions to consider s Look through the BEPS lens Firstly, and probably most importantly, you should consider looking at your current transfer pricing policy through the BEPS lens. Whilst the exact changes are not clear, the direction of travel is: there will be much more focus on people and value creation rather than contractual allocations of risk and capital so consider your whole value chain in light of the BEPS recommendations. In the worst case scenario assume what it would look like under an HMRC view of a KERT or SPF viewpoint and identify areas which may produce different results to your current transfer pricing. Particular focus should be placed on hotspots that have been flagged up in the Action Plan: the use and exploitation of intangibles, hybrid instruments, dependence on specific PE exemptions, commissionaires, international financing structures. If changes are required to your operational or pricing model, make these now as they will take time to implement. Clearly also make sure any future planning arrangements are BEPS proof. s Communication strategy It is not enough to just consider arrangements within Tax and Finance, but also how they are understood by others. Since a large driving force behind BEPS was the political pressure stemming from the public perception of tax avoidance, the importance of perception should not be underestimated. Develop a clear communication strategy for both internal and external stakeholders. s APAs Think about whether APAs may be appropriate. There may be a question about whether APAs will retain value when international tax rules are going through such a major change. We believe these doubts are unfounded. Working through the issue in the context of an APA now can anticipate the BEPS outcomes, and the APA will extend beyond the period covering formal change in the rules. In fact, now more than ever, an APA is a source of certainty in an uncertain world. s Treatment of employees Consider also the treatment of employees. Bearing in mind people functions are a focal point of BEPS, how employees are treated and referred to will become a significant pointer to transfer pricing value. What do employment contracts, job adverts and incentive schemes imply? Tax inspectors have access to LinkedIn accounts too: if you advertise an opportunity in an exciting, entrepreneurial sales role, do not expect your limited risk distributor argument to remain unchallenged. HMRC has been active in looking at job descriptions and compensation schemes and drawing conclusions from these, and we have already seen this in business restructuring cases. This theme continues into documentation. Many functional analyses tend to jump directly from contractual terms into a description of the functions. In a BEPS world the focus is not just on what happens, but how it happens; so strengthen your documentation with information about key employees and governance of decisionmaking. s Respond to consultation Lastly, the exact impact BEPS will have on international tax regulations is yet to be decided. There is a Public Consultation in Paris on October 1 and we will continue to see subset consultation on actions as the months go by. Make sure your voices are heard. There are a number of channels through which information can be filtered back to the OECD: as well as the more formal channels, professional services firms and industry bodies collate viewpoints and pass these onto the focus groups. There may well be unintended consequences for particular industries as a result of looking at the general application of these potential new rules so it is particularly important for specialised industries 4 09/13 Copyright 2013 by The Bureau of National Affairs, Inc. TPIJ ISSN 2042-8154
to point out consequences of the routes down which the policy-makers are going. Andrew Hickman, John Neighbour, and Matt Whipp, are members of KPMG in the UK s Transfer Pricing Services team. They may be contacted by email at: andrew.hickman@kpmg.co.uk john.neighour@kpmg.co.uk matthew.whipp@kpmg.co.uk http://www.kpmg.com/uk The authors thank Sasha Rankin for help in preparing this article. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP (UK). 09/13 Transfer Pricing International Journal BNA ISSN 2042-8154