There has been a lack of practical guidance on applying transfer pricing rules to business restructurings which could potentially lead to uncertainty for both multinational enterprises ("MNEs") and tax authorities. While guidance is contained in the OECD (Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 1995 (the "Guidance") and the OECD Model Tax Convention on Income and Capital (the "Model Treaty"), it did not specifically address the issue.
The OECD has therefore published the Discussion Draft on the Transfer Pricing Aspects of Business Restructurings (the "Draft Paper") which was published on 19 September 2008 and is open to public comment until 19 February 2009.
The OECD defines the term "business restructuring" as a situation whereby MNEs are involved in cross border redeployment of functions, assets and/or risks by associated entities, including transfers of intangibles ranging from patents and trade secrets to human resources such as employee ability and knowledge. Such activity raises transfer pricing issues and the application of the arm's length principle.
The Draft Paper acknowledges the conceptual difficulties in applying the arm's length principle to MNE restructurings, which, in effect, treat associated entities of an MNE group as if they were independent parties.
The Draft Paper covers four main issues:
- the allocation of risks between associated entities and whether these are consistent with the arm's length principle;
- the application of the arm's length principle and the Guidelines to the restructuring itself;
- the application of the arm's length principle and the Guidelines to post-restructuring arrangements; and
- the exceptional circumstances when a tax authority may consider not recognising a transaction or structure adopted by an associated entity.
Issue one: risk allocation
Profit reallocations are a typical feature of business restructurings and a result of a reallocation of risk between associated entities.
The Draft Paper recommends that an examination of the allocation of risks should start with looking at the contractual terms in place between associated entities. However, a mere review of these terms, of itself, is not sufficient as it is possible such arrangements may have no economic substance. Therefore, according to the OECD, the parties' conduct should be examined as the best evidence regarding whether a contract has been conformed to and the true allocation of risk.
The examination should consider whether the terms of the contract are at arm's length. The best evidence of this is reliable data evidencing a similar allocation of risk within a contract between comparably situated independent parties. However, the mere fact that an independent enterprise may allocate risks differently is insufficient for non-recognition of risk allocation in a controlled transaction between associated entities. Where no such comparables exist, the Draft Paper recommends looking at which party is in control over risk. 'Control' in this context is the capacity to make a decision to take on the risk, to place capital at risk in order to achieve this and to take a view as to how to manage the risk. As such, control is not transferred by simply using another party to administer and monitor the risk on a daily basis. The party that has been allocated the risk, which has been found to be consistent with the arm's length principle, must bear the costs of managing the risk.
Issue two - arm's length principle and the restructuring
The Draft Paper looks at the circumstances in which, at arm's length, a restructured entity would receive compensation for the transfer of functions, assets and/or risks.
Potential to profit or loss is not an asset itself that requires compensation on a reallocation of risks. There must be a discernable right or asset that carries a profit or loss potential. It is only then that the question of remuneration at arm's length arises.
Factors the Draft Paper examines in determining whether compensation is due are:
- the business reasons for the restructuring and the anticipated benefits;
- changes that have actually taken place and how these have affected the 'functional analysis' of the parties; and
- what other options are realistically available at arm's length.
It is not sufficient that a restructuring is motivated by commercial reasons at the group level. Rather, the relevant point to consider is whether there was an arm's length transfer from the perspective of the transferor and transferee. The arm's length principle treats the associated entities of an MNE as separate entities rather than as part of a single unified business.
In determining whether such a transfer occurred at the transferor and transferee level, factors to consider are the expected returns to the transferor and transferee after the restructuring and the compensation that might be required to remunerate the transferor's surrender of the business opportunity, i.e. the profit potential.
The Draft Paper also considers whether a restructured entity, under the arm's length principle, would be entitled to indemnification, e.g. for termination, non-renewal or substantial renegotiations of existing arrangements. It concludes there is no presumption that such indemnification is required. Considerations include whether there are legal entitlements or other assets realistically available, at arm's length, to the associated entities at the time of the restructuring and whether the contract that is terminated etc., expressly provided for indemnification. Another consideration is what another party, at arm's length, would have been willing to indemnify in such a situation.
Issue three - arm's length principle and post-restructuring
The Draft Paper is based on the premise that the arm's length principle should not apply differently to post - restructuring transactions compared to those structured from the beginning.
However, the comparables may differ due to factual circumstances from the changes resulting from a business restructuring. A comparability analysis should be carried out for both the pre- and post-restructuring arrangements.
The Draft Paper offers a discussion on the issues arising on the selection and application of a transfer pricing method. It advises that the comparable uncontrolled price method, being a comparison with a transaction involving independent parties, is always preferable to the transactional profit methods, as it provides the most direct evidence of arm's length conditions. However, the OECD recognises that reliable data is not always available and selection also depends on the functions, assets and/or risks of the associated entities.
The OECD specifically comments on the possible relationship between compensation for a business restructuring itself and that for post-restructuring transactions and the role of comparison of profits before and after a restructuring in determining an arm's length charge, noting that differences in profits are insufficient to support a transfer pricing adjustment on their own, but could form part of a comparability analysis.
There is a brief comment on location savings derived from a business restructuring and how such savings should be attributed among related parties under the arm's length principle. The Draft Paper recommends that any allocation should take into account what independent parties would have agreed, bearing in mind, e.g., their respective functions and bargaining powers.
Issue four - non-recognition of a transaction
The Draft Paper discusses important notions relating to the exceptional circumstances where a tax authority may consider not recognising a transaction or structure adopted by associated entities.
Where there is no dispute as to the fact that a controlled transaction or structure has been adopted, a tax authority may adjust the price or other conditions if they are not found to be at arm's length, with consideration to the contractual terms and whether the conditions of a controlled transaction differ from those between independent parties.
However, the OECD recognises that there are some business restructurings where a tax administration is unable to base its examination on the transaction actually undertaken by the associated entities, such as:
- where the actual structure impedes determination by a tax administration of an appropriate transfer price; and
- where such a transaction would be unlikely to be adopted by independent entities acting in a commercially rational manner, for example where a transaction is particularly detrimental to one of the related parties and it would be highly unlikely to be conducted on an arm's length basis.
Such apparent non-arm's length behaviour should, as far as possible, be dealt with by pricing adjustments rather than non-recognition. The fact that an arrangement is not seen between independent parties does not necessarily mean it is not arm's length. The OECD comments that tax authorities should not ordinarily interfere with the decision of an MNE on how to structure its business arrangements and it is recognised that there can be legitimate group level business reasons for an MNE to restructure. However, it should be borne in mind that the OECD recognises that the arm's length principle treats associated entities of an MNE as separate entities and as such it is not sufficient that a restructuring makes commercial sense for a group as a whole. Rather, it must be arm's length for each of the tax paying entities. Notably, the Draft Paper considers that business restructuring to obtain tax savings can be commercially rational from an arm's length perspective, as long as an actual transfer takes place.
The Draft Paper warns there should be severe caution in determining that a controlled transaction is not one which independent parties acting in a commercially rational manner would have chosen. Only in exceptional circumstances should this lead to non-recognition of the arrangements. It is advised that despite the fact that commercially rational independent parties, on an arm's length basis, do not enter such transactions and despite the fact that a tax administration may have doubts as to the commercial rationale, it is still often possible to determine an arm's length transfer price by analysing the circumstances of the case.
The Draft Paper recognises that it is not always possible to arrive at an appropriate transfer price and a tax authority may be able to disregard a transaction as sometimes there are arrangements relating to a transaction which differ from those independent parties behaving in a commercially rational manner would have adopted.
The Draft Paper provides practical guidance for taxpayers and tax authorities on the issues surrounding transfer pricing relating to MNEs. Business restructuring in this context can be significantly different to that which independent parties acting in a commercially rational manner may choose to adopt. As has been shown, this does not necessarily preclude the arm's length principle being applied in determining an appropriate transfer price but such application must be applied at the level of the tax paying entity involved in each side of the arrangement, rather than at the group level. Non-recognition of a transaction on the basis that it does not reflect commercially rational behaviour should be the last resort for a tax authority and the Draft Paper states that tax authorities should not ordinarily interfere with MNE business decisions on the structure of its arrangements.