CPAs & ADVISORS experience direction // SUBSTANCE IS KING IN THE NEW WORLD ORDER TAX EXECUTIVES INSTITUTE, INC. MARCH 1, 2018 William D. James Principal Transfer Pricing & David H. Whitmer Director Transfer Pricing
AGENDA Evolution of Substance Base Erosion Profit Shifting (BEPS) Initiative Substance Conduct over Form Value Creation Risks Intangibles People Post BEPS Considerations Case Study 2// experience direction
EVOLUTION OF SUBSTANCE Early 1990s no substance Structures often involved entities in tax havens (mostly Caribbean countries) with no personnel Cash boxes 3// experience direction
EVOLUTION OF SUBSTANCE (CONT.) Late 1990s substance outsourced Structures often still involved entities in tax havens (mostly Caribbean countries) with outsourced personnel ( man & his dog ) 4// experience direction
EVOLUTION OF SUBSTANCE (CONT.) 2000s Substance created in principal structures Swiss & Irish principal structures More substance still question of real decision-making capabilities Contract Manufacturers Swiss Principal = Sale = Payment Limited Risk Distributors 3 rd Party Customers 5// experience direction
EVOLUTION OF SUBSTANCE (CONT.) Pre & Post BEPS - Crackdown by foreign taxing jurisdictions 6// experience direction
EVOLUTION OF SUBSTANCE (CONT.) 2013 today - OECD s BEPS Project The aim of the (BEPS) measures is to realign taxation with economic substance & value creation, while preventing double taxation. Another stated goal, The BEPS action plan is to ensure that profits are taxed where actual business activity is performed & where value is created. The BEPS Project aims to end the use of shell companies used to stash profits offshore or unduly claim treaty protection & neutralize all schemes that artificially shift profits offshore. Though the BEPS Project is not about dictating whether countries should have a specific corporate income tax rate, it will have an impact on regimes that seek to attract foreign investors without requiring any economic substance. Treaty shopping generally refers to arrangements through which a person who is not a resident of one of the two States that concluded a tax treaty may attempt to obtain benefits that the treaty grants to residents of these States. These strategies are often implemented by establishing companies in States with desirable tax treaties that are often qualified as letterboxes, shell companies or conduits because these companies exist on paper but have no or hardly any substance in reality. (Source: Top 10 FAQs about BEPS OECD) 7// experience direction
OECD ACTION PLAN ON BASE EROSION & PROFIT SHIFTING (BEPS) Three (3) Tenets of BEPS Action Plan 1. New international standards must be designed to ensure the coherence of corporate income taxation at the international level BEPS issues may arise directly from existence of loopholes, as well as, gaps, frictions or mismatches in interaction of countries domestic tax laws 2. A realignment of taxation & relevant substance is needed to restore the intended effects & benefits of international standards, which may not have kept pace with changing business models & technological developments Involvement of shell companies in third countries with little or no substance in terms of office space, tangible assets & employees undermines preventing double-taxation through tax treaties involving two tax treaty countries 3. The actions to counter BEPS cannot succeed without further transparency, nor without certainty & predictability for business 8// experience direction
OECD ACTION PLAN ON BASE EROSION & PROFIT SHIFTING (BEPS) Coherence Hybrid Mismatch Arrangements (2) CFC Rules (3) Interest Deductions (4) Harmful Tax Practices (5) Substance Preventing Tax Treaty Abuse (6) Avoidance of PE Status (7) TP Intangibles (8) TP Risk & Capital (9) TP High Risk Transactions (10) Transparency & Certainty Measuring BEPS (11) Disclosure Rules (12) TP Documentation (13) Dispute Resolution (14) Address Challenges: Digital Economy (1) Execution: Multilateral Instrument (15) 9// experience direction
FRAMEWORK FOR SUBSTANCE People Conduct over Form Value Creation Substance Intangibles Risks People 10// experience direction
CONDUCT OVER FORM Conduct over Form Substance 11// experience direction
CONDUCT OVER FORM (CONT.) Concept that is emphasized throughout the 2017 OECD Guidelines* Not a new concept, but historically, subject to interpretation and inconsistently applied New guidance offers a framework for ensuring outcomes are aligned with value creation Meant to ensure when justifying a transfer pricing position: The actual business transactions undertaken by associated enterprises (AEs) are identified Transfer pricing is based on economic reality and not on contractual arrangements to the contrary *OECD s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017 ( 2017 OECD Guidelines ) 12// experience direction
CONDUCT OVER FORM (CONT.) Application of the arm s-length principle involves a comparability analysis, a two-step approach (2017 OECD Guidelines, 1.33): Step 1: Identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated The emphasis is the accurate delineation of the actual transactions between associated enterprises The transaction is not simply delineated by what is set out in a contract Step 2: Compare the conditions and the economically relevant circumstances of the controlled transaction as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent enterprises OECD s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2017 ( 2017 OECD Guidelines ) 13// experience direction
CONDUCT OVER FORM (CONT.) Comparability factors that need to be identified in commercial and financial relations to accurately delineate actual transactions (Id., 1.36): The contractual terms of the transaction The functions performed, assets used, and risks assumed by each of the parties to the transaction and how the functions relate to value generation by the group (i.e., functional / value chain analysis) The characteristics of property transferred or services provided The economic circumstances of the parties and of the market in which the parties operate The business strategies pursued by the parties 14// experience direction
CONDUCT OVER FORM (CONT.) Contractual Terms: Written agreements (if available) provide the starting point for delineating transactions Outline intended responsibilities, obligations and rights, assumption of risks, and pricing arrangements May also look to other forms of documentation other than written contracts Compare with evidence from the other four comparability factors If conduct is inconsistent with the terms of the written agreement, then must look further into actual conduct (i.e., functional analysis) Where there is inconsistency, actual conduct will determine substance Is a contract still important? Provides evidence for intended risk assumption when risk has not yet materialized 15// experience direction
VALUE CREATION Value Creation Substance 16// experience direction
VALUE CREATION (CONT.) Comparability factors that need to be identified in commercial and financial relations to accurately delineate actual transactions (Id., 1.36): The contractual terms of the transaction The functions performed, assets used, and risks assumed by each of the parties to the transaction and how the functions relate to value generation by the group (i.e., functional / value chain analysis) The characteristics of property transferred or services provided The economic circumstances of the parties and of the market in which the parties operate The business strategies pursued by the parties 17// experience direction
VALUE CREATION (CONT.) Functional Analysis An important process to delineate the controlled transactions Identify the functions performed by AEs and the assets used and risks assumed in performing those functions Focus on actual activities of the AEs and the capabilities they provide Decision-making functions regarding strategy and risk Assets used (i.e., intangibles, PP&E, financial assets) Value Creation Structure and organization of the group How the group generates value (i.e., supply chain / value chain analysis) The contributions of the individual AEs to that value creation 18// experience direction
RISKS Substance Risks 19// experience direction
RISKS (CONT.) Contractual risk allocations are respected only when they are supported by actual decision-making and financial capacity to assume the risk Process to Analyze Risks (Id., 1.6): 1. Identify the economically significant risks 2. Determine how these risks are contractually assumed by the AEs 3. Determine (via functional analysis) how AEs operate with respect to the economically significant risks. In particular, which AEs perform control and risk mitigation functions and have the financial capacity to assume the risk. 4. Determine if the AE that contractually assumes the risk also performs functions to control the risk and has the financial capacity to assume the risk 5. If there is an inconsistency identified in Step 4, allocate the risk to the entity that controls the risk and has the financial capacity to assume the risk 6. Price the transaction with the appropriate allocation of assumed risks 20// experience direction
RISKS (CONT.) Let s drill down on the terms: Risk Assumption ( 1.63): Taking on the upside and downside consequences of the risk, including the financial consequences if the risk materializes Risk Management ( 1.61): Function of assessing and responding to risk. Capability and actual performance of functions relating to decisions to take on, lay off, or decline risk-bearing opportunities Capability and actual performance of functions relating to decisions on whether and how to respond to risks associated with opportunities Capability and actual performance of functions to mitigate risk (i.e., perform functions to affect risk outcomes) Control Over Risk ( 1.65): Comprised of first two items under risk management above Day-to-day risk mitigation activities may be outsourced Financial Capacity to Assume Risk ( 1.64): Access to funding to take on / lay off risk, pay for risk mitigation activities, and to bear the consequences if the risk materializes 21// experience direction
INTANGIBLES Substance Intangibles 22// experience direction
INTANGIBLES (CONT.) Legal ownership does not entitle an AE to intangible returns from exploitation AE s should be appropriately compensated for functions performed, assets used, and risks assumed with respect to development, enhancement, maintenance, production, and exploitation (DEMPE) of intangibles Entitlement to profits from exploitation of an intangible requires: Important functions related to DEMPE of intangibles Examples (Id., 6.56): Design and control of R&D and marketing programs Direction and establishing priorities for creative undertakings Strategic decisions regarding development programs Management and control of budgets Decisions regarding defense and protection of intangibles Quality control over functions by other AEs that could affect value of intangible Other DEMPE related functions may be outsourced Control functions related to economically significant risks Financial capacity to assume such risks 23// experience direction
INTANGIBLES (CONT.) Process for Analyzing Intangible Transactions (Id., 6.34): 1. Identify intangibles used or transferred and economically significant risks associated with the DEMPE of intangibles 2. Identify the full contractual arrangements, including legal ownership, rights, obligations, and assumption of risks 3. Identify (via functional analysis) the parties performing functions, using assets, and managing risks related to the DEMPE of intangibles, as well as the parties that control outsourced functions and control risks 4. Confirm consistency between the terms of the contractual arrangements and the conduct of the parties. Determine if the AE that contractually assumes the risk also performs functions to control the risk and has the financial capacity to assume the risk related to the DEMPE of the intangibles. 5. If there is an inconsistency identified in Step 4, delineate the actual controlled transaction(s) and allocate risk to the entity that controls and has the financial capacity to assume the risk 6. Price the transactions according to each AE s contributions to functions, assets, and risks 24// experience direction
INTANGIBLES (CONT.) Use of Assets (Id., 6.56): Particular focus is on entities that provide funding for intangibles development, but do not perform functions or bear risks related to the funded activity If the AE does assume financial risk, it should earn a risk-adjusted return Must have control of this risk Return would need to consider riskiness of the investment If the AE does not assume financial risk, it should earn a risk-free return This also applies to physical assets (see example from 1.85) 25// experience direction
PEOPLE People Substance People 26// experience direction
PEOPLE (CONT.) Level of Substance - no set number of employees or level of management established by the OECD to definitively create an appropriate level of substance in a taxing jurisdiction Must satisfy the control requirement as outlined in Chapters I and VI: Capability and actual performance of decision making functions related to risk and outsourcing of DEMPE functions Decision-makers should have competence and relevant experience This will vary by case Consideration to background, education, and experience What does not qualify for control? (Id., 1,66) Formalizing the outcome of key decisions in other locations Setting of the policy environment relevant for the risk Headcount - quality versus quantity? What functions to perform or outsource? Maintain evidence to demonstrate control 27// experience direction
FRAMEWORK FOR SUBSTANCE REVISITED People Conduct over Form: Economic reality vs. legal reality Delineate actual contributions Value Creation: Identify value drivers Functions, assets, and risks Intangibles: DEMPE functions Important functions vs. other functions Appropriate allocation of risks Attribute benefits according to contributions to value creation Funding receives risk-adjusted return Substance People Risks: Economic reality vs. legal reality Performance of control functions Financial capacity to assume the risk Allocate risk and price accordingly 28// experience direction
FRAMEWORK FOR SUBSTANCE REVISITED (CONT.) Tax authorities may disregard transactions when circumstances of commercial irrationality apply People Conduct over Form: Economic reality vs. legal reality Delineate actual contributions Value Creation: Identify value drivers Functions, assets, and risks Intangibles: DEMPE functions Important functions vs. other functions Appropriate allocation of risks Attribute benefits according to contributions to value creation Funding receives risk-adjusted return Substance People Risks: Economic reality vs. legal reality Performance of control functions Financial capacity to assume the risk Allocate risk and price accordingly 29// experience direction
IMPORTANCE OF ALIGNMENT Intercompany Contracts Transfer Pricing Documentation Actual Conduct Alignment 30// experience direction
POST BEPS: WHAT IS AT RISK? Commissionaire Structures Principal Structures Cash Box Structures IP Structures CV/BV Structures Creation of Permanent Establishments (PEs) Treaty Shopping 31// experience direction
POST BEPS: WHAT TO DO? Determine if the actual conduct of the parties matches the intercompany contracts and functional analysis Are substance and risk-taking aligned with contractual terms? Need to perform functional analysis interviews Determine if ample decision-making and performance of valuable functions occurs in the entity aligned to earn the residual profits Is there a need to bolster substance in entrepreneurial entity? May be a need to hire or move senior level executives into entrepreneurial entity Monitor and audit the structure on an annual basis 32// experience direction
CASE STUDY: OVERVIEW Taxpayer is a large U.S. retail company that sells a variety of branded and private-label goods in retail stores, catalogs, and online For its private-label business, it has established an Asian entity ( AsiaCo ) to manage the supply chain for identifying, selecting, monitoring and purchasing from third-party manufacturers located in Asia Reflects the overall trend in the business and industry to sourcing manufactured goods from Asian vendors AsiaCo acts as the key risk-taking entrepreneur in the structure while the US entity ( USCo ) acts as a limited-risk retail entity that markets and sells the products to third-party customers Since its inception, AsiaCo has been very profitable (approx. 25% of consolidated operating profit), as the private label business has grown significantly 33// experience direction
Low-Tax Asian Entity AsiaCo Third-Party Asian Manufacturers U.S. Entity USCo Third-Party Customers 34// experience direction
AsiaCo manages the identification, selection, training, and monitoring of third-party vendors that manufacture the privatelabel products AsiaCo Arm s Length Price Goods Third-Party Asian Manufacturers USCo Third-Party Customers 35// experience direction
AsiaCo Third-Party Asian Manufacturers Transfer Price Goods USCo Third-Party Customers 36// experience direction
AsiaCo Third-Party Asian Manufacturers USCo Retail Price Goods Third-Party Customers 37// experience direction
AsiaCo Third-Party Asian Manufacturers Transfer Price is set such that USCo receives a fixed operating margin on its sales of private label products to third-party retail customers Transfer Price USCo Goods Retail Price Goods Third-Party Customers 38// experience direction
AsiaCo Third-Party Asian Manufacturers AsiaCo pays a royalty based on its purchases of goods from 3P manufacturers USCo USCo licenses IP for trademarks and product designs to AsiaCo Third-Party Customers 39// experience direction
AsiaCo pays a service fee, either cost-plus or cost only AsiaCo USCo Third-Party Asian Manufacturers USCo provides procurement, supply chain management, and management/ administrative services Includes sourcing and vendor compliance services Third-Party Customers 40// experience direction
AsiaCo Arm s Length Price Goods Third-Party Asian Manufacturers Royalty Service fees Transfer Price Goods Trademark / design IP Procurement/supply chain/administrative services USCo Retail Price Goods Third-Party Customers After payment of the transfer prices, AsiaCo retains the residual profit as the risk-taking entrepreneur 41// experience direction
KEY EMPLOYEES IN EACH LOCATION AsiaCo General manager Vendor compliance personnel Quality assurance personnel Fabric evaluation team USCo Executive management Merchandising function / retail buyers Designers Global sourcing/procurement Marketing Planning and inventory Global IT systems, including electronic data interchange (EDI) 42// experience direction
ISSUES RAISED IN TRANSFER PRICING EXAMINATION Which entity maintains ultimate control and authority of the key decisions necessary for the private label business? Not only are the functions important but where those functions are performed is also important (even if paid by AsiaCo) Detailed questions on the functions performed by each entity Requesting specific details on the policies, procedures, and documentation developed by AsiaCo vs. USCo that is used in the private-label business Information on the IT systems used by AsiaCo that may be owned by USCo Value of the license agreement between USCo and AsiaCo Additional questions on the costs of further development of the intangibles Costs incurred by AsiaCo related to the business risks it undertakes 43// experience direction
SUBSTANCE IS KING Thank you, thank you very much 44// experience direction
QUESTIONS 45// experience direction
CONTACT DETAILS Will James Transfer Pricing Principal St. Louis, MO (314) 802-1556 wdjames@bkd.com David Whitmer Transfer Pricing Director Houston, TX (281) 501-4946 dwhitmer@bkd.com 46// experience direction
Tax professionals that practice before the IRS are required to adhere to certain professional standards prescribed by the Department of Treasury and the IRS. These standards require us to include the following statement in certain written federal tax advice: This advice is not intended or written to be used, and it cannot be used, for the purpose of avoiding penalties that may be imposed. These discussions and conclusions are based on the facts as stated and existing authorities as of the date of this letter. Our advice could change as a result of changes in the applicable laws and regulations. We are under no obligation to update this letter if such changes occur. Our advice is based on your unique facts and circumstances as you communicated them to us and should not be used or relied on by anyone else. 47// experience direction
THANK YOU FOR MORE INFORMATION // For a complete list of our offices and subsidiaries, visit bkd.com or contact: William D. James // Principal wdjames@bkd.com // 314.802.1556 David Whitmer // Director dwhitmer@bkd.com // 281.501.4946