Tax Policy Bulletin www.pwc.com Discussion drafts released in six BEPS-related areas raise more concerns for MNEs 23 December 2014 In brief Multinational enterprises (MNEs) may be concerned about various aspects of the six Discussion Drafts released last week as part of the Base Erosion and Profit Shifting (BEPS) Action Plan. Three of the papers are within Action items 8 to 10 of the BEPS Action Plan dealing with assuring that transfer pricing outcomes are in line with value creation. One of the other papers is the first step towards producing best practice rules to address base erosion and profit shifting through the use of interest expense within Action item 4 of the Plan. The latest proposed additions to the draft International VAT/GST Guidelines relate to supplies of services and intangibles to consumers, raised in the initial report on the digital economy within Action 1. The final paper is an overarching look at the resolution process involving cross-border tax disputes. Business will be keen to see how much tax authorities are prepared to adopt the much-needed improvements necessary for existing mutual agreement procedure (MAP) and alternative methods to provide an effective means for resolving controversy and preventing double taxation. Businesses have an opportunity to respond in writing to each of the Discussion Drafts and should seriously consider doing so. There are also public meetings at which businesses can convey their main points in person and some may find this an attractive proposition. In detail Between 17 and 19 December 2014, various Discussion Drafts were released for public consultation by the Organisation for Economic Cooperation and Development (OECD) in relation to the G20- sponsored BEPS project. The OECD Action Plan on Base Erosion and Profit Shifting, published in July 2013, identifies 15 actions to address BEPS in a comprehensive manner and sets deadlines to implement these actions. These latest papers, discussed in turn below, cover several of these action items. They effectively form part of the second phase of BEPS with actions to be agreed by September 2015. In some cases, the papers provide firm recommendations while in other cases they set out options for general comment before recommendations are finalised.Tax Policy Bulletin 2 PwC 1. VAT B2C Guidelines (Action 1, International VAT/ GST Guidelines) There are two interlinked items within one overall Discussion Draft dealing with the collection of VAT in businessto-consumer (B2C) transactions. They are for insertion into the International VAT/GST Guidelines as Chapters 3 and 4. The first part addresses Guidelines on the place of taxation of B2C supplies of services and intangibles; the second part provides supporting provisions which present approaches for facilitating the proper and consistent implementation of the principles of the Guidelines in national legislation, as well as their consistent interpretation by tax administrations. B2C Guidelines for services and intangibles General rule As for the B2B supplies of services and intangibles (services) Guidelines adopted at the OECD’s Global Forum in Japan in April, the OECD is proposing that most services supplied B2C should be taxed on the basis of the destination principle, i.e., based on the customer’s usual residence, as the best proxy for identifying the place of consumption – Guideline 3.6. ‘On the spot’ services However, the OECD quite rightly points out that the above rule may not give a good indication of the place of consumption in the case of ‘on the spot’ services – generally where the services are actually performed. Under Guideline 3.5 such services: are physically performed at a readily identifiable location, and are ordinarily consumed at the same time as and at the same place where they are physically performed, and ordinarily require the physical presence of the person performing the supply and the person consuming the service or intangible at the same time and place where the supply of such a service or intangible is physically performed. Specific rules In addition, the OECD accepts that even with the two above rules, taxation may not take place where the consumption is located in relation to certain services, e.g., passenger transport, and that a specific rule should be applied to tax such a service. In order to determine whether there should be a ‘specific rule’, the OECD provides in the Guidelines a framework (two step approach) against which governments should test the need for a ‘specific rule’. Step one: The first step is to test whether the relevant general rule leads to an appropriate result under the criteria set out under Guideline 3.7 (i.e., the taxing rights over internationally traded services or intangibles supplied between businesses may be allocated by reference to a proxy other than customer location as laid down in Guideline 3.2, when both the following conditions are met: a. The allocation of taxing rights by reference to customer location does not lead to an appropriate result when considered under the following criteria: – Neutrality – Efficiency of compliance and administration – Certainty and simplicity – Effectiveness – Fairness. b. A proxy other than customer location would lead to a significantly better result when considered under the same criteria. Similarly, the taxing rights over internationally traded business-toconsumer supplies of services or intangibles may be allocated by reference to a proxy other than the place of performance as laid down in Guideline 3.5 and the usual residence of the customer as laid down in Guideline 3.6, when both the conditions are met as set out in a. and b. above. Where this is the case, there is no need for a specific rule. Where the analysis suggests that the relevant general rule would not lead to an appropriate result, the use of a specific rule might be justified. In such case, a second step is required. Step two: The second step is to test the proposed specific rule against the criteria of Guideline 3.7. The use of a specific rule will be justified only when this analysis suggests that it would lead to a significantly better result than the use of the relevant general rule. The OECD’s objective here is to encourage governments to limit the numbers of ‘specific rules’, to make VAT/GST systems more transparent and legally certain for both business and tax authorities. Immovable and movable property services The last major category of exceptions to the general place of supply rules, identified by the OECD, relates to those services related to real estate, where in Guideline 3.8 it is noted ‘For Tax Policy Bulletin 3 PwC internationally traded supplies of services and intangibles directly connected with immovable property, the taxing rights may be allocated to the jurisdiction where the immovable property is located.’ For example in the case of leasing or letting of real estate, or construction work, the place of taxation would be where the building is located. The OECD further suggests that a specific place of supply rule may be required in relation to services connected with movable property, e.g., hiring of vehicles, their repair etc., to again ensure that taxation and consumption are at the same place. Simplified registration and compliance In the Annex to chapter 3 (it would perhaps be better if this was in the main body of the Guidelines as an integral part of the ‘destination system’ proposals) the OECD proposes in its Guidelines that governments adopt a ‘Simplified Registration and Compliance Regime for non-Resident Suppliers’. This is very much inspired by the EU’s Mini One-Stop Shop (MOSS) system which takes effect on 1 January 2015, whereby non-resident suppliers will collect the tax in each country where the customers are located but would remit the tax via a simplified compliance system. Supporting provisions Chapter 4 of the OECD’s Guidelines deals with Mutual Cooperation, Dispute Minimisation and Application in Cases of Evasion and Avoidance. As the OECD points out, the “objective of the Guidelines is to provide guidance to jurisdictions in developing practical legislation that will facilitate a smooth interaction between national VAT systems in their application to international trade, with a view to minimising the potential for double taxation and unintended non-taxation and creating more certainty for business and tax authorities.” The OECD suggests that more use be made of existing instruments and points out, for example, that the OECD Model Tax Convention, in its article 26, specifically provides for the exchange of information in relation to any taxes (including VAT/GST) and not just those covered by the Convention. In attempting to provide a balance, the OECD insists that governments provide more attention to the provision of data and information to taxpayers such that the latter find it easier to comply with their reporting obligations. Observations: The B2C Guidelines notably provide a response to the key conclusion on VAT/GST formulated in the Report on Tax Challenges of the Digital Economy, which was prepared in the context of the work on Action 1 of the BEPS Action Plan (digital economy). That report concluded that the collection of VAT in B2C transactions is a pressing issue that needs to be addressed urgently to protect tax revenue and to level the playing field between foreign suppliers relative to domestic suppliers. This is clearly a very key part of the BEPS Action Plan and is very important to a number of countries. 2. Interest deductions and other financial payments (Action 4) The aim of Action 4 of the BEPS Action Plan is to produce best practice rules to address base erosion and profit shifting through the use of interest expense. The first Discussion Draft on this item sets out various options for addressing this issue. Construction of the paper The paper examines various current interest limitation rules and their success in tackling BEPS using interest expense. It concludes that current rules do not address the underlying BEPS concerns. It then looks at a number of different approaches and design features of rules designed to address BEPS through interest deductions, including group-wide rules, fixed financial ratio rules, targeted rules and combinations of these approaches. Whilst the key policy objective of the paper is to deal with BEPS, other policy considerations include: minimising distortions to competition and investment, promoting economic stability, providing certainty, avoiding double taxation, and reducing administrative and compliance costs. The paper also notes: the need to consider a different approach to specific sectors (banks, insurers, infrastructure, extractive industries are all mentioned), the importance of addressing EU law, and the interaction with other BEPS action items (covering for example rules on controlled foreign companies, hybrids, pricing of debt, treaty abuse, risks and capital, country-by-country reporting and dispute resolution).Tax Policy Bulletin 4 PwC Proposed approaches The paper makes it clear that a conclusion has not been reached in relation to the best practice recommendations. However, the following are identified as potential best practice rules: 1. A group-wide interest allocation or ratio approach (group-wide tests). This would either limit net interest deductions to a proportion of the group’s actual net third party interest expense, based on a measure of economic activity such as earnings or asset value (interest allocation) or limit interest deductions based on applying a group-wide ratio (such as net interest as a proportion of earnings). The interest allocation approach is broadly similar to a US budget proposal (the Green Book), and also has a number of similarities to the existing UK debt rules, albeit that the current UK limit is the entire worldwide interest expense rather than an allocation. A similar rule to the group ratio operates in Australia, Finland, France, Germany and New Zealand. However, in these countries the group ratio operates as a carve-out from the fixed ratio test rather than as a primary restriction. 2. A fixed ratio test operating to restrict interest expense to a specified proportion of earnings, assets or equity of a company. This type of approach is already widely used by a number of countries, for example the restriction of interest deductions based in Germany on the level of taxable EBITDA in Germany or based in the United States on the adjusted taxable income. The paper acknowledges, however, the difficulty in setting an appropriate benchmark ratio that is low enough to address BEPS concerns without giving rise to significant double taxation risk. In both cases, the paper would exclude from the calculations assets generating tax exempt or deferred income (e.g., foreign participations). The paper also recommends that the allocations or ratios are based on interest rather than debt, to deal more directly with BEPS concerns. The paper considers a combination of fixed ratio and group-wide ratio tests; the combination seems to be the approach the OECD currently prefers. One would be used as the default rule and the alternative only applied where the first test led to non-deductible interest. The fixed ratio would be set ‘deliberately low’ so that it would only permit full interest deductions for entities which pose little risk of BEPS. This is because the paper concludes that current fixed ratios may be too generous to prevent BEPS. In the figures illustrating this point, the OECD took a PwC list of the ‘Global Top 100 Companies by market capitalization’ from a March 2014 update and then calculated interest to EBITDA ratios; the OECD methodology’s use of consolidated figures seems somewhat flawed. Compliance and design A large proportion of the paper is devoted to various aspects of the design of any new rule and the plethora of options available. The challenges involved in designing a best practice rule to be applied consistently by all countries is evident throughout the paper. The compliance burden associated with any best practice rule will vary depending on how it is implemented but it will be necessary to consider consistency with regard to the use of accounting figures under different GAAP (for example in determining a fixed ratio-based deduction, or on allocating a group’s net interest expense globally). The OECD recognises the potential for mismatches to arise between accounting and tax amounts in this context as well. In order to be effective the OECD states that any rules should not just deal with interest expense, but rather should apply to all forms of debt, payments economically equivalent to interest and expenses incurred in connection with the raising of finance. A question remains regarding the ability to design such a rule to deal appropriately with the variety of commercial transactions groups undertake. Experience from the UK worldwide debt cap indicates that this is particularly difficult in practice, for example in dealing with derivatives. Observations: The potential impact of annual movements in figures which drive the allocation of interest across a group could also create uncertainty regarding the level of deductible interest annually in each territory. This could make it difficult for groups to forecast their tax position, thereby impacting strategic decision making such as financing future investments. Furthermore, there is a real risk that the introduction of a cap based on an allocation of worldwide interest across territories will lead to groups not being able to deduct for tax purposes the full amount of their external interest expense because of:Tax Policy Bulletin 5 PwC the interaction of the rules with other restrictions applied by individual territories, restrictions on being able to introduce debt into territories to match the allocation of the interest expense, groups having territories with a net financing income position, which will effectively lead to disallowances elsewhere, and the need constantly to adjust debt levels in different territories in line with the allocation basis applied. All of these factors could lead to double taxation. In order to reduce this risk the OECD considers that interest restriction rules should apply to the level of net interest expense (rather than gross). They also recognise the need to include a carry forward of excess interest (or unused capacity to deduct interest), similar to rules which exist in a number of territories today, including the US and Germany. Such measures, however, are likely to only partially reduce double taxation. A key question posed by the discussion draft is the potential impact an interest cap allocation rule would have on investment decisions for businesses. It appears possible that the proposed group-wide test could create an uneven playing field between multinational and purely domestic groups in relation to debt financing an acquisition in the same territory in favour of purely domestic businesses. It could also impact the effective cost of capital, thereby reducing real investment. It is clear from the consultation document that these proposals are likely to have significant and far reaching implications for multinational groups, not to mention the associated compliance burden. The impact on specific groups would depend significantly on the nature of the group, and how any interest allocation would be made. 3. Risk, characterisation and special measures (Actions 8-10) A Discussion Draft on revisions to Chapter I of the Transfer Pricing Guidelines addressing risk, recharacterisation, and special measures is divided into two parts and includes various proposals developed by Working Party No. 6. Part I is a proposed revision to Section D of Chapter I of the Transfer Pricing Guidelines designed to emphasize the importance of accurately delineating the actual transactions in accordance with the substantive commercial and financial relationships of the parties. The proposed revisions include guidance on the relevance and allocation of risk, determining the economically relevant characteristics of the controlled transactions, and recharacterisation or non-recognition of transactions. Part II of the discussion draft sets forth options for various special measures with regard to intangible assets, risk and over-capitalization, as contemplated by the BEPS Action Plan released in July 2013. As indicated in that Action Plan, the main objective of the Transfer Pricing Guidelines is to align economic transfer pricing outcomes with value creation, in effect, to eliminate ‘double non-taxation of income’. In order to achieve this alignment, the Action Plan suggested that “special measures, either within or beyond the arm’s length principle, may be required.” The discussion draft contains a series of questions relating to the options with a view toward taking the responses to these questions into account when considering the appropriateness and design of each option. Substance of commercial and financial relations controls transfer pricing characterisation In general, consistent with other proposed changes to the Transfer Pricing Guidelines, the basic theme of the modifications is that, while contractual allocations of risk may be a starting point, such contractual allocations are subject to a substantive analysis of the economic behavior of the parties in the context of the entire value chain of the MNE. Contractual terms, therefore, are subject to being recast and superseded in light of what risk allocation measures parties in a similar relationship would take. In effect, the OECD is proposing to look at contractual terms in light of the substance of the ‘commercial and financial relations’ between related parties with a view towards analyzing how third parties would interrelate for these purposes. Additionally, the discussion draft takes the position that risks must be identified and evaluated with respect to the wider value chain of the MNE group, rather than just the parties to the transaction. The discussion draft makes clear that the OECD views it as permissible for tax authorities to supplement or supplant what is in a written contract to reflect the functions perceived to be actually performed and the risks Tax Policy Bulletin 6 PwC actually assumed by the parties. In paragraph 5 Section D.1 it states: “Where there are differences between contractual terms and factual substance, the conduct of the parties in their relations with one another, and what functions they actually perform, the assets they actually employ, and the risks they actually assume and manage, in the context of the consistent contractual terms, should ultimately determine the delineation of the action transaction.” Paragraph 5 further states that: “[i]t should not be automatically assumed that the contracts accurately or comprehensively capture the actual commercial or financial relations between the parties.” On a related topic, the Discussion Draft also invites comments regarding the consideration of a ‘moral hazard’ between unrelated parties, i.e., where one party would assume risk without control over any of the consequences related to that risk. In this situation, the draft suggests that parties acting at arm’s length would take steps to mitigate any moral hazard created by a lack of incentive to guard against risk where a party is protected from the consequences. Accordingly, the draft aims to use its concepts to allocate risk between related parties based on which party actually manages and controls the consequences related to the risk. See Discussion Draft, Additional Points Box, page 13. The Discussion Draft then invites comments addressing to what extent “imputed moral hazard and contractual incentives play [a role] with respect to determining the allocation of risks and other conditions between associated enterprises.” Discussion Draft, page 14. Functional analysis and risk assessment In furthering its objective to examine the actual economic behavior between the parties to effectively allocate risk, the Discussion Draft modifies provisions that describe the information that should be considered in a functional analysis of the taxpayer. Most significantly, paragraph 36, Section D.2, states that: “identifying risks goes hand in hand with identifying functions and assets and is integral to the process of identifying the commercial or financial relations between the associated enterprises and of accurately delineating the transaction or transactions.” Risks that should be considered include strategic or marketplace risks, infrastructure or operational risks, financial risks, transactional risks and hazard risks. With respect to risk, the Discussion Draft continues to emphasize the importance of identifying the party that controls risk. Paragraph 39 of the same section describes how: “[C]ontrol over risk should be understood as the capability to make decisions to take on the risk and decisions on whether and how to respond to the risk … Control should not be interpreted as being limited to the decision to adopt risk mitigation measures, since in assessing risks businesses may decide that the uncertainty associated with some risks, after being evaluated, should be taken on and faced with little or no mitigation in order to create and maximise opportunities.” Finally, the Discussion Draft includes new Section D.3, which discusses how all the information gathered should be interpreted for purposes of the transfer pricing analysis. The draft, in paragraph 81, emphasizes: “[e]very effort should be made to determine the pricing for the actual transaction as accurately delineated under the arm’s length principle.” Non-recognition Section D.4, Non-recognition, discusses the circumstances under which transactions can be recharacterised. In particular, paragraph 84 states: “[w]here the same transaction can be seen between independent parties in comparable circumstances, non-recognition would apply. Importantly, the mere fact that the transaction may not be seen between independent parties does not mean that it should not be recognised.” In paragraph 88 of the same section, the Discussion Draft replaces the notion of ‘commercial rationality’ test in the former Transfer Pricing Guidelines with the concept of ‘fundamental economic attributes’. As described in paragraph 89, the fundamental economic attributes test evaluates the actual arrangement in light of what alternatives the parties could have pursued. “If the actual arrangement, viewed in its entirety, would not afford such an opportunity to each of the parties, or would afford it to only one of them, then the transaction Tax Policy Bulletin 7 PwC would not be recognized for transfer pricing purposes. In applying the criterion, it is relevant to consider whether there exists an alternative for one or more of the parties, including the alternative of not entering into the transaction, which does provide the opportunity to enhance or protect their commercial or financial positions.” Potential special measures Part II of the Discussion Draft sets forth options for some special measures with regard to intangible assets, risk and over-capitalization, as contemplated by the BEPS Action Plan. The questions include ways to deal with value creation that are either within or beyond the arm’s length principle. Observations: The OECD seems to cast doubt on the inherent trustworthiness of the terms of contracts entered into between related parties as a standalone basis for risk allocation, because such parties have less incentive to bargain for their own interests or to proportionately allocate risk based on which parties are the most exposed to the consequences of the risk. The change to focus on the concept of ‘fundamental economic attributes’ is proposed because the commercial rationality test can be difficult to apply since it is difficult to delineate what independent enterprises behaving in a commercially rational manner would have done. In essence, Part II leaves the discussion open-ended and invites responses to questions posed in relation to special measures. 4. Commodity transactions (Action 10) A Discussion Draft offers a useful insight into the OECD’s thinking with respect to traders that conclude commodity-related intercompany transactions. This is part of the wider item 10 of the BEPS Action Plan dealing with assuring that transfer pricing outcomes are in line with value creation. It seeks to reconcile the developments in the taxation of commodity transactions with existing transfer pricing guidance, focusing on the broadly defined ‘Sixth Method’ – the entrenched method for the purposes of commodity-specific taxation in many developed countries (e.g., petroleum revenue tax in the UK or Norway) – which has also recently increased in popularity for other commodities in developing countries. Comparable Uncontrolled Price The Draft confirms that Sixth Methods are, in effect, variations of the Comparable Uncontrolled Price (CUP) method and, if properly applied, can be reconciled with the OECD principles. The suggested wording to be added to Chapter II of the Transfer Pricing Guidelines effectively creates a framework for tax authorities and taxpayers to apply such methods within the existing transfer pricing systems, in particular with respect to comparability adjustments. The Draft recognises that the application of the CUP method will require additional comparability adjustments to the quoted prices to account for physical differences in the product, different specifications, freight, processing costs, etc. In parallel, the OECD and the World Bank will explore ways to identify common adjustments to quoted prices to account for physical and functional differences in the controlled transaction in order to supplement the ongoing work with practical tools to help developing economies make maximum use of quoted prices for commodities. The Draft specifies that this research will initially focus on mineral commodities traded as ores or in intermediate forms, initially covering iron ore, copper and gold. In terms of compliance, the Draft specifies that the application of the CUP method should be documented through the written transfer pricing policy, presenting details of the application of market data (including formulae used). Considering that such details (especially the pricing formulae) typically vary between commodities and markets and are often highly confidential, taxpayers are likely to welcome further guidance on the level of detail to be shared with the tax authorities and the inputs from the OECD and the World Bank Group around common adjustments to be made to quoted prices. Deemed pricing date The Discussion Draft recognises that limited expertise and resources may exist within tax authorities in the commodity-dependent developing countries. One of the challenges faced in such situations relates to the difficulties in verifying the pricing date used, especially if the commodities-related contract allows for optionality in fixing the pricing date (rather than committing to a fixed date or other measure, such as rolling-average market prices) and in the absence of reliable evidence of the pricing date actually agreed. Tax Policy Bulletin 8 PwC The OECD recognises that when the pricing date actually agreed by the related parties is inconsistent with their behaviour, tax administrations may impute a date consistent with the evidence provided by other facts of the case and industry practices and, in the absence of such evidence, may deem the pricing date to be the date of shipment, subject to any appropriate comparability adjustments. This area is likely to attract a lot of responses, mainly as the commodities industry is one of the most complex in terms of pricing. In order to avoid over-simplification, certain commodities (e.g., power) might need to be explicitly excluded from being priced at delivery, while the specifics of other activities (e.g., pricing of optionality around the delivery dates or price risk management through physical storage that actually protects the tax base in the long-term through reducing price volatility) will have to be accounted for through means other than the choice of the pricing date, e.g., by comparability adjustments. Links to other BEPS actions The paper specifies that commodityrelated transactions should be analysed through the prism of additional guidance to be provided under BEPS Actions 9 (on risk and capital), 10 (especially on recharacterisation and low value-adding services) and 13 (transfer pricing documentation and country-bycountry reporting). Transfer pricing practitioners might be particularly interested in the interaction of the paper with the Action 9 deliverable on risk and capital as the use of the notional pricing date (as opposed to multi-day or weeks’ averages) can expose the local commodity-exporting entity to a price risk that is effectively managed elsewhere within the vertically integrated group. Further clarification on such aspects of the commodity pricing would certainly be appreciated. Observations: It remains to be seen how detailed final guidance will be and how burdensome it will be for taxpayers to comply with it in practice. Many transfer pricing practitioners dread the prospect of having to explain to the uninitiated the minute details of market pricing (e.g., does the CUP price correspond to bid, ask, mid-point or settle), the details of pricing methodology (e.g., can actual price be tested against market using interquartile ranges or rather other measures of volatility, such as the statistical distribution of prices) or trying to reconcile these between commodities as similar as Brazilian or Columbian coffee beans (e.g., is stronger coffee better). The thought of having to reconcile their own formulae with the ones their competitors have previously communicated to tax authorities is even more daunting. To some extent, the paper might help with such discussions through the expanded commentary regarding the implementation which will be added to Chapter II (which already contains some useful commodity-related examples of application of the CUP method to Brazilian and Columbian coffee beans in Para 2.18). It is also important to remember that many commodity-dependent developing countries are not members of the OECD and often choose to select only some aspects of its guidance. One can only hope that the final recommendations encourage consistency on a global basis, rather than resulting in new countries introducing different variations of the Sixth Method, thinly disguised as an application of the CUP method. 5. Profit splits (Action 10) A Discussion Draft deals specifically with the Use of Profit Splits in the Context of Global Value Chains. This is part of the wider item 10 of the BEPS Action Plan dealing with assuring that transfer pricing outcomes are in line with value creation. Responses to the various questions posed will be reviewed by Working Party No. 6 in considering revisions to the guidance on the use of the transactional profit split method in Chapter II of the Transfer Pricing Guidelines. Note that the views and options included in this paper do not represent the consensus of all parties involved but they do provide a useful overview of the current thinking and areas that will ultimately be addressed following the consultations. Value chains The Discussion Draft acknowledges that in many cases, the structure of an MNE’s value chain permits one-sided methods and transactional profit splits are not appropriate merely because an MNE’s value chain covers multiple jurisdictions. However, the Discussion Draft recommends transactional profit splits may be more reliable than one-sided methods where there is pooling of entrepreneurial functions and risks and the success of the business depends on integration of related parties. The paper notes that transactional profit splits may be preferable where Tax Policy Bulletin 9 PwC an integrated business model reflecting a global value chain allows various entities to carry out interdependent functions. The OECD Transfer Pricing Guidelines note that transactional profit splits may be most appropriate in cases where both parties make ‘unique and valuable contributions’ to a transaction. The phrase ‘unique and valuable contributions’ is utilized in the amendments to Chapter VI contained in the 2014 Report, Guidance on the Transfer Pricing Aspects of Intangibles suggesting ‘unique and valuable contributions’ involve contributions constituting a key source of competitive advantage for the business. The Discussion Draft questions whether it should define the phrase ‘unique and valuable contributions’ similarly for the purposes of the transactional profit split method. Integration and sharing of risks The Discussion Draft notes that transactional profit splits may be appropriate where an MNE’s business is highly integrated and strategic risks may be jointly managed and controlled by more than one entity. Such an analysis therefore requires an appropriate consideration of strategic risk, further confirming the OECD’s continued reliance on detailed functional analyses. Fragmentation Many MNEs split functions within a value chain whereby certain entities undertake only limited, specific functions (e.g., logistics, marketing etc.). Due to fragmentation, the Discussion Draft argues that comparables that are similarly limited to comparable specific and discrete functions may be difficult to identify. As such, it may be preferable to undertake a transactional profit split approach as a corroborative method identifying comparable companies that combine multiple functions and utilizing the principles of a contribution analysis to divide the benchmarked profit. Such an analysis appears aligned with a reliability analysis in determining the best comparables in the marketplace to be used as benchmarks. Lack of comparables The Discussion Draft considers transactional profit split methods to be a solution in situations where a lack of comparables renders one-sided methods unreliable. In addition, the Discussion Draft considers the ability to use transactional profit split methods to allow flexibility in remuneration based on the levels of consolidated profits or sales. Importantly, this section notes that one-sided methods can often be reliable even with a lack of comparables via expanding the comparable search to other jurisdictions with similar economic conditions and by making reasonable and accurate comparability adjustments. In such situations, however, the Discussion Draft considers a transactional profit split as a way to support the primary method and the positioning within the benchmarked range. Aligning taxation with value creation This subsection considers transactional profit splits to be a means of achieving the BEPS pillar of aligning profit with value creation. Nevertheless, the Discussion Draft identifies the perceived subjectivity of transactional profit splits due to the difficulty of objectively verifying allocation keys. In response, the Discussion Draft asks how to develop objectivity in profit split factors and whether there are particular factors which are likely to reflect value creation in the context of a particular industry or sector. Such value creation factors should be identified in any functional analysis and it is therefore not clear why such suggested factors or weights may be useful. In fact, suggested factors or weights may lead to the unintended results of forcing taxpayers and tax authorities to expend greater effort questioning why the presumed items may not be appropriate in certain scenarios when such analysis would otherwise be clear from the functional analysis. In addition, the usefulness of RACI (responsible, accountable, consulted, informed) matrices is considered in weighing the contributions of the parties to value creation. Hard-to-value intangibles Transactional profit splits may be applied to the valuation of partially developed intangibles although the Discussion Draft asks what aspects may be particularly relevant in determining arm’s length outcomes for transactions involving hard-tovalue intangibles. Dealing with ex ante/ ex post results The Discussion Draft questions how the transactional profit split method can be applied to deal with unanticipated results. Scenario 8 offers the transactional profit splits’ ability to be used without splitting profits, for instances such as in determining a royalty. Dealing with losses Scenario 9 addresses a situation where it may be appropriate to split Tax Policy Bulletin 10 PwC losses different from how profits are shared. Such consideration is meant to account for the fact that significant losses may occur that may not be appropriately reflected or accounted for by the allocation factors. As such, the Discussion Draft asks in what circumstances splitting losses different from profits may be appropriate. While it is appreciated that the OECD is considering this issue and appears to do so in the context of financial services companies, the examples fail to mention capital and other factors that may relate to any losses. Observations: These scenarios and accompanying questions cover many of the most controversial areas of transfer pricing and pose many questions with differing, reasonable opinions as to how to best approach them. As such, the broad scope of difficult questions may inhibit the OECD’s ability to modify Chapter II in a flexible manner that considers the diverse array of situations faced by taxpayers. 6. Dispute resolution (Action 14) Action 14 of the OECD’s Action Plan recognized that actions to counter BEPS should be complemented by efforts to improve the effectiveness of MAP. The current Discussion Draft does not represent the consensus views of the Committee on Fiscal Affairs. Rather, the intent is to provide proposals and options for analysis and comment and arrive at specific measures that will constitute a minimum standard to which participating countries will commit. Recognizing that global consensus on the use of mandatory binding arbitration will be difficult to achieve in the short term, the Discussion Draft proposes the need for complementary solutions that are not only practical, but also impactful. Taking a holistic view, the Draft is to be read in the context of a three-pronged approach that would improve resolution of disputes through MAP. This threepronged approach would: consist of political commitments to effectively eliminate taxation not in accordance with the tax convention, provide new measures to improve access to MAP and improved procedures, and establish a monitoring mechanism to check the proper implementation of the political commitment. The political commitment and the measures to improve MAP are grounded in four principles that form the basis of the OECD recommendations. These four principles are the framework of the Discussion Draft: 1. Ensuring that treaty obligations related to MAP are fully implemented in good faith 2. Ensuring that administrative processes promote the prevention and resolution of treaty-related disputes 3. Ensuring that taxpayers can access MAP when eligible 4. Ensuring that cases are resolved once they are in MAP The obstacles and options Applying the four principles, the Discussion Draft addresses a number of obstacles that preclude countries from resolving treaty-related disputes and identifies corresponding measures and options to prevent such obstacles. At the threshold, the goal of ensuring that treaty obligations are implemented in good faith is critical, and accordingly, the Draft proposes revisions to the Commentary of Article 25 of the OECD Model that would oblige competent authority “to seek to resolve” cases in a “practical, fair and objective manner.” This clarifying language is an important step towards ensuring treaty obligations are fully implemented in good faith. It is well known that many tax authorities lack sufficient resources and that the MAP process can be lengthy, inefficient, and unpredictable. The results of the BEPS initiatives, combined with unilateral actions being taken by governments in response to BEPS, will undoubtedly place further strain on administrative processes. Accordingly, the Draft proposes a number of administrative best practices, including the need for sufficient resources that are autonomous from the audit function as well as the use of performance indicators that appropriately incentivize resolution of cases. The Draft also encourages the use of alternative dispute resolution options, such as bilateral Advance Pricing Agreements (APAs), which would proactively increase certainty and decrease the risk of double taxation. The use of APAs to cover multipleyear issues (including roll-back years) would be an effective use of resources and avoid duplicative MAP requests. An effort to address obstacles to MAP access is an important initiative as auditors in certain countries are Tax Policy Bulletin 11 PwC increasingly raising serious roadblocks where a taxpayer indicates a desire to pursue MAP. The Draft emphasizes the importance of transparency into the procedures required to access and use MAP, including appropriate time limits on access and avoiding onerous documentation requests. The current backlog of MAP cases is direct evidence of the need to improve MAP processes. Indeed, recent OECD statistics show the highest pending inventory of MAP cases in history and a 94% increase over the numbers in 2006. Hence, the Draft encourages the use of principled approaches to resolving MAP cases as well as increased cooperation of competent authorities. The Discussion Draft sets forth a number of other obstacles that prevent the four principles from being fully implemented and corresponding proposed solutions. This list is not exclusive, however, and all interested parties are asked to comment on the identified obstacles and proposed options, and offer additional examples of obstacles to MAP and/ or options to make MAP more effective. Arbitration Pursuant to Action 14, consideration was given to the noticeable absence of mandatory binding arbitration in the majority of treaties. The Discussion Draft, however, concludes that a universal adoption of mandatory binding arbitration would be difficult, if not impossible, in the immediate term, due to policy concerns with respect to national sovereignty, access to and scope of arbitration, and coordination of MAP arbitration and domestic legal remedies. Nevertheless, the Draft outlines a number of options that would encourage widespread adoption of arbitration provisions. This includes, but is not limited to, increasing transparency, tailoring scope, and clarifying coordination with domestic legal remedies. The Discussion Draft states that countries could, but are not required to, develop guidance on alternative decision making mechanisms and the use of a default approach for MAP arbitration. The form of decision making could adopt the ‘independent opinion’ approach whereby the parties present the facts and arguments to the arbitration panel, and the panel makes an independent decision based on the applicable law. In the alternative, the form of decision making could adopt the ‘final offer’ approach (informally referred to as ‘baseball arbitration’) in which the competent authorities present their respective proposed resolution to an arbitration panel and the panel adopts one of the proposed resolutions. Peer review process Specific measures that will implement the political commitment will be determined as part of future work on Action 14. Such measures will likely be supplemented by a monitoring (peer review) process that will evaluate the functionality of MAP and include an overall assessment as to the commitment made by individual countries. This monitoring process, while not described in the Discussion Draft, is expected to be performed by a select forum of competent authorities. Observations: There are a number of emerging trends that are shaping today’s global tax environment and influencing the actions of stakeholders around the world. Tax administrations continue to scrutinize cross-border transactions – and often engage in aggressive audit tactics – as a means to grow revenue and build infrastructures. The resolution process involving cross-border tax disputes is in need of drastic improvement to be an effective means for resolving controversy and preventing double taxation. The inventory of MAP cases is at a record high level, and looking forward, BEPS reform is likely to lead to more disputes, which in turn, will place extreme pressure on the MAP process. In this environment, it is disappointing to learn that the OECD has been unable to reach broad consensus on the need for mandatory binding arbitration, an alternative that has already proven to be a major improvement in avoiding deadlock between tax authorities in crossborder cases in certain countries. There is an acute need for an arbitration mechanism that resolves difficult and complex cases without imposing double taxation on business. The Discussion Draft is, however, an important step towards identifying practical and legal impediments to effective and efficient MAP resolution and proposing solutions that would have measureable impact. It is through this effort that we hope a minimum standard of specific measures (that can be built upon) can be agreed to by as many countries as possible to enhance resolution procedures so that MAP processes can work more effectively in the new BEPS environment. The takeaway We recommend that groups take the time to consider how the various Tax Policy Bulletin 12 PwC proposals and options could impact them. Responding directly to the OECD with specific examples is the most powerful way that businesses can address issues which would arise if proposals were adopted. Businesses may also like to consider attending and speaking at the various public consultation meetings on these papers at the OECD’s offices in Paris. The deadlines are as follows for written responses (together with the associated public meeting dates): 16 January for the dispute resolution paper (23 January), 6 February for the three transfer pricing papers (19-20 March) and the interest deductibility paper (17 February), and 20 February for the VAT/ GST paper (25 February). Let’s talk For a deeper discussion of how these issues might affect your business, please call your usual contact. If you don’t have one or would otherwise prefer to speak to one of our global specialists, please contact one of the people whose details are set out below, ordered by BEPS action area. BEPS generally Richard Collier, London +44 (0) 20 7212 3395 email@example.com Stef van Weeghel, Amsterdam +31 (0) 88 7926 763 firstname.lastname@example.org Pam Olson, Washington +1 (202) 414 1401 email@example.com Phil Greenfield, London +44 (0) 20 7212 6047 firstname.lastname@example.org VAT B2C Guidelines (Action 1, International VAT/GST Guidelines) Stephen Dale, Paris +33 156 574161 email@example.com John Steveni, London +44 (0) 207 213 3388 firstname.lastname@example.org Interest deductions (Action 4) Bernard Moens, Washington +1 (202) 414-4302 email@example.com Neil Edwards, London +44 (0) 20 721 32201 firstname.lastname@example.org Risk, characterization, special measures (Actions 8- 10) Lili Kazemi, Washington +1 (202) 346 5252 email@example.com Kathryn O’Brien, Washington +1 (202) 414 4402 firstname.lastname@example.org Commodity transactions (Action 10) Szymon Wlazlowski, London +44 (0) 207 212 1889 email@example.com Jonas Van de Gucht, Antwerp +32 9 2688336 firstname.lastname@example.orgTax Policy Bulletin 13 PwC Profit splits (Action 10) John Cianfrone, New York +1 (646) 471-0486 john.cianfrone @us,pwc.com Adam Katz, New York +1 646 471 3215 email@example.com Dispute resolution (Action 14) David Swenson, Washington +1 (202) 414 4650 firstname.lastname@example.org Michael Bersten, Sydney +61 2 8266 6858 email@example.com SOLICITATION This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC does do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. © 2014 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.