The Organisation for Economic Co-operation and Development (OECD) has released a public Discussion Draft providing implementation guidance to tax administrations with respect to the approach to hard-to-value intangibles (HTVI).
The HTVI approach was described in the 2015 final report on BEPS Actions 8-10 (Aligning Transfer Pricing Outcomes with Value Creation) and incorporated into Chapter VI of the OECD Transfer Pricing Guidelines on the transfer pricing aspects of intangibles.
Under the HTVI approach, tax administrations can propose adjustments to the prices used in intra-group transfers of rights in intangibles based on ex-post outcomes. Differences between ex-ante projections and ex-post results not resulting from unforeseeable developments or events may indicate that the pricing arrangement agreed upon at the time of the transfer does not reflect the arm's length principle. Under this approach, tax authorities may reserve the right to adjust prices used by multinationals in their intra-group HTVI transfers for up to five years after the year in which the HTVI first generated third-party revenues.
The Discussion Draft, released on May 23, 2017, provides guidance to tax administrations on implementing the HTVI approach. It discusses:
- the principles underlying the implementation of the HTVI approach
- three examples illustrating the practical implementation of a transfer pricing adjustment resulting from applying the HTVI guidance in different scenarios and
- the interaction between the HTVI approach and access to the mutual agreement procedure under the applicable treaty.
While this Discussion Draft does not yet represent consensus views of the Committee of Fiscal Affairs of the OECD, it does give stakeholders an opportunity to provide public comments by June 30, 2017.
Principles underlying the implementation of the HTVI approach
The rationale of the HTVI approach is to protect tax administrations from the negative impact of information asymmetry between tax administrations and taxpayers in valuing the transfer of HTVI. Under this HTVI approach, tax administrations can consider ex-post outcomes as presumptive evidence about the appropriateness of the ex-ante pricing arrangements. The HTVI approach will not apply under certain exemptions. For example, the taxpayer can rebut the presumptive evidence by demonstrating the reliability of the information used at the time of the transfer. Another exemption applies when taxpayers have obtained a bilateral or multilateral advance pricing arrangement on the HTVI transfer.
The principles underlying the implementation of the HTVI approach allow tax authorities to adjust pricing used in HTVI transfers in case the actual income or cash flows after the transfers are significantly higher than the anticipated income or cash flows used in the original valuation. There is presumptive evidence that the projected income or cash flows used in the valuation at the time of the transfer should have been higher and that scrutiny is needed on the probability weighting of such ex-post outcome considering what was known at the time of the transfer. However, it is incorrect to base the revised valuation on the actual income or cash flows without considering the probability of achieving such income or cash flows at the time of the HTVI transfer.
Timing issues are important to consider under the HTVI approach. Tax administrations should apply audit practices to identify and deal with HTVI transactions as early as possible. However, it is only after some years that the HTVI transfer tax administrations may be able to consider whether the HTVI transfer is priced at arm's length under the HTVI approach. In addition, the elapsed time between the HTVI transfer and the availability of ex-post outcomes may not always correspond with audit cycles or with administrative and statutory time periods, especially for HTVI that will be commercially exploited long after the transfer. Short audit cycles or statute of limitations may result in difficulties for some countries to implement the HTVI approach. These countries may consider targeted changes to procedures or legislation to deal with these difficulties (such as the requirement to promptly notify the transfer or license of a HTVI, or amendment of the normal statute of limitations).
The Discussion Draft provides that transfer pricing adjustments made by tax administrations in implementing the HTVI approach may include adjustments of the pricing structure used by the taxpayer (e.g., milestone payments and price adjustment clauses).
The Draft's three examples
The Draft describes three examples to illustrate the practical implementation of a transfer pricing adjustment arising from applying the HTVI guidance.
Example 1, Scenario A, proposes a case in which a taxpayer cannot demonstrate that its original valuation properly considered the possibility that commercialization would start earlier, and cannot demonstrate that such a development was unforeseeable. Hence, the tax administration is allowed to use the presumptive evidence based on ex-post outcome to value the HTVI. Scenario B of Example 1, however, illustrates that the HTVI approach does not apply if the valuation discrepancy is not more than 20 percent as compared to the original transfer value.
Example 2 proposes a case in which a taxpayer cannot demonstrate that its original valuation properly considered the possibility that sales would achieve certain levels, and cannot demonstrate that such a development was unforeseeable. This allows tax administrations to make an adjustment based on ex-post outcomes. Rather than re-assessing the price at the moment of transfer, tax administrations may consider whether adjustments based on an alternative payment arrangement might be more appropriate. Such an alternative payment arrangement can be based on pricing arrangements found between third parties in the same business sector. For example, in the pharmaceutical sector, patent rights are commonly transferred through initial lump sum payments together with additional contingent payments based on successful completion of development phases.
Example 3 proposes that the amount of primary adjustment to be assessed and the corresponding adjustment to be granted following the application of the HTVI approach will be determined in accordance with the domestic law of each country and the rules on statute of limitations. The Discussion Draft encourages countries involved to resolve double taxation cases under the MAP (mutual agreement procedure) in the relevant treaty. The guidance in this regard should therefore be read together with the final report under BEPS Action 14 on "Making Dispute Resolution Mechanisms More Effective."
Comments: significant risks
The Discussion Draft contains proposed implementation guidance with respect to the HTVI approach under which tax administrations can consider ex-post outcomes as presumptive evidence about the appropriateness of the ex-ante pricing arrangements. The guidance is intended to improve consistency in the application of the HTVI approach by tax administrations and to reduce the risk of double taxation. Still, the endorsement for tax authorities to utilize hindsight to price HTVI transactions represents a significant risk for multinationals.
It is clear that the HTVI approach will put more burden on taxpayers to substantiate and document pricing of HTVI transactions. Among the questions that may arise: what objective evidence needs to be presented by a taxpayer to demonstrate that its original valuation properly considered all developments at the time of the HTVI transaction and, when developments occur that were not taken into account, that these were unforeseeable developments?
The risk of double taxation is also considerable, despite efforts to improve the effectiveness of MAP. The MAP process remains one in which countries shall endeavour, without any legal commitment, to resolve double taxation cases. Further, not all countries that may adopt the HTVI approach will have committed to the mandatory binding arbitration process proposed under Action 14 of the G20/OECD BEPS Action Plan.
In practice, the only way to manage this risk in a concrete manner is through bilateral or multilateral APAs.