On December 19, 2014, the OECD released a public discussion draft entitled "BEPS Actions 8, 9 & 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterisation, and Special Measures)." On December 16, the OECD also issued two additional discussion drafts related to Action 10, one related to cross-border commodity transactions and the other related to the use of profit splits in the context of global value chains.
Actions 8, 9, and 10 are the actions that are designated to "assure that transfer pricing outcomes are in line with value creation" under the OECD’s Action Plan on Base Erosion and Profit Shifting ("BEPS"). Specifically, the stated goal of Actions 8 and 9 is to develop rules to prevent BEPS by either moving intangibles among group members (Action 8), or transferring risks among, or allocating excessive capital to, group members (Action 9). The goal of Action 10 is to develop rules to prevent BEPS by engaging in transactions that would not, or would only very rarely, occur between third parties. Each of the three discussion drafts is discussed below.
BEPS Actions 8, 9 & 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines
Part I of the discussion draft sets out lengthy proposed revisions ("Proposed Revisions") for Chapter I, Section D of the OECD Transfer Pricing Guidelines (i.e., "Guidance for applying the arm's length principle") (the "Guidance"). Much of the original guidance is incorporated into the Proposed Revisions. However, the
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Proposed Revisions significantly adjust and expand very fundamental areas, including the treatment of contracts, comparability analysis, functional analysis, the approach to the analysis of risks, and the non-recognition of transactions.
1. Expanded Functional/Comparability Analysis: The Proposed Revisions focus on the differences between independent enterprises and related parties in their incentives to enter, enforce, and modify contracts. As a result, the Proposed Revisions require examining the conduct of the parties as well as the terms of the relevant contract, and call for further analysis if the conduct of the related parties is not consistent with the contractual terms. In cases in which the contract terms do not reflect the factual substance, then the conduct, functions, assets, and risks assumed and managed "should ultimately determine the delineation of the actual transaction." The Proposed Revisions also place comparability analysis "at the heart of the application of the arm's length principle" rather than as a general starting point. Two aspects of comparability analysis are identified in the discussion draft. First, the identification of the commercial or financial relations between the related parties within the comparability analysis allows for the description of the controlled transaction. Second, the comparability analysis examines the conditions of the controlled transaction against the conditions of potential comparable transactions between independent enterprises.
2. Expanded Analysis of Risks: The Proposed Revisions include a greatly expanded discussion of risks. They note differences in the manner risks are managed at arm's length versus between related parties, and expand the prior guidelines’ discussion on how risk is managed, where the costs are borne, and how risk management should be rewarded.. The Proposed Revisions posit that mere ownership of assets and the financial capacity to bear risks may not be sufficient to entitle the owner to a risk-based return, where that owner does not have the ability to control, mitigate, or manage the risk. The theory behind this approach is that an unrelated party generally would not contractually assume risks that were controlled by the other party to the contract, and that such an allocation of risks in a related-party context is therefore suspect.
Key to this discussion is the concept of “moral hazard,” which refers to the lack of incentive to guard against risk where one is protected from its consequences. For example, moral hazard may exist at arm's length due to the unaligned incentives and asymmetric information of the parties, while related parties may have aligned incentives and symmetric information due to their common control. Another key concept is the risk- return trade-off (i.e., that a higher but less certain stream of income and a lower but more certain stream of income can have the same present value). The Proposed Revisions state that in related-party risk transfers, the risk-return trade-off should not be used on its own to justify the appropriateness of a risk transfer (on the theory that the same net risk remains in the controlled group after the transfer). Moral hazard, the risk-return trade-off, and the risks associated with financial transactions are highlighted as areas for further discussion.
3. Non-Recognition: The Proposed Revisions also include a substantially new discussion regarding circumstances under which accurately defined related-party transactions could potentially be disregarded or recharacterized by tax administrations, on the ground that they lack "the fundamental economic attributes of arrangements between unrelated parties." The Proposed Revisions state that the mere fact that a particular transaction does not occur between unrelated parties does not necessarily mean that it should be recharacterized. However, the draft suggests that the non-recognition option is necessary because controlled
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groups have the ability to structure transactions that lack arm’s-length characteristics, and that cannot therefore be priced under an arm's-length standard.
The Proposed Revisions would add to the Guidance a number of controversial concepts (e.g., moral hazards, risk-return trade-off, non-recognition) that could, if adopted, dramatically change the way taxing authorities analyze intercompany transactions. In fact, the Proposed Revisions appear to encourage taxing authorities to second guess taxpayer contractual arrangements, leading to re-characterization and controversy. Practitioners have expressed concerns that the Proposed Revisions incorrectly assume the assumption of risk is inseparable from decision making and that ownership of assets has limited impact upon risk allocation. Many practitioners are also concerned that many of the assumptions made in the Proposed Revisions are moving away from the arm’s-length standard. In addition, another issue practitioners have cited regarding the draft is the level of detail at which transactions are expected to be analyzed. Throughout the draft, there is an emphasis on precision, which may be impractical to achieve in routine cases.
Part II of the discussion draft sets out five proposals for potential “special measures” in connection with intangible assets, risk, and over-capitalization. The draft states that the accurate description of the actual transaction, proper treatment of risk, and non-recognition of transactions that lack the fundamental attributes of arrangements between related parties will go a long way in aligning profits and value creation. However, according to the OECD, residual BEPS risks remain, which could potentially be addressed by special measures. Those risks relate mainly to information asymmetries and the ease of allocating capital to low- taxed, minimal functional entities. The five proposals on special measures are briefly described below:
1. Hard-to-value intangibles: Similar to the commensurate-with-income rules found in the Treasury Regulations to Code § 482, this proposal suggests that, if projected returns on a transferred intangible deviate significantly from actual results, taxing authorities could retrospectively adjust the price based on an imputed contingent payment mechanism.
2. Independent Investor: The target of this proposal is a capital-rich, asset-owning company (Company C) that depends on another company (Company R) to generate a return from the asset. In sub-option one, the independent investor (a party making an investment in a non-related entity) would consider Company R as offering a better investment option and invest directly in that company, which would be deemed to own the asset; therefore no return would be allowed to Company C. In the second sub-option, any income attributable to Company C would be reallocated to the parent company.
3. Thick Capitalization: This option depends on determining and applying a thick-capitalization rule based on a pre-determined capital ratio. Under this option, excess capital would be treated as a loan, and interest would be deemed paid to the parent. The draft does not address if these interest payments would be interest payments for all purposes.
4. Minimal Functional Entity: This option involves triggers that relate to the qualitative and quantitative attributes of the entity. It proposes a threshold of functionality under which, if certain triggers are met, the income would be reallocated either based on a pre-determined factor, to the parent, or to the company providing functional capacity. Functional capacity relates to the ability to create value through exploitation of assets and performance of risk management.
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5. Ensuring Appropriate Taxation of Excess Returns: The primary proposal would apply a CFC rule taxing earnings to the parent if the income in the CFC is subject to a tax rate below a certain threshold. Additionally, a secondary rule would apply if none of the parent jurisdictions of a CFC has applied the primary rule. This would allocate taxing jurisdiction over the CFC’s excess returns, where the effective tax rate is below a certain percentage, to other jurisdictions based on a pre-determined rule.
Practitioners have criticized the special-measure proposals as going beyond the scope of transfer pricing, and suggested that the concerns they are intended to address could be better covered by other BEPS Action items. US government officials have also expressed concerns with the special-measure proposals, as well as the risk and recharacterization proposals in Part I of the discussion draft.
BEPS Action 10: Discussion Draft on the Use of Profit Splits In the Context of Global Value Chains
This discussion draft addresses nine scenarios where one could argue it may be difficult to apply one-sided transfer pricing methods to benchmark the arm’s-length range. The situations described include transactions where the parties to a transaction are highly integrated, sharing key functions and risks. In these situations, the draft notes that the transactional profit split method would reliably account for interdependence of functions and risks.
The draft asks 32 questions within these scenarios in order to solicit responses to understand when it may be more appropriate to use a transactional profit split method to ensure that transfer pricing outcomes are in line with value creation. Specifically, the draft seeks to understand how the existing guidance on the transactional profit split method, provided in Chapter II of the OECD Transfer Pricing Guidelines, is applied in practice. The comments received will be taken into account by the OECD in considering revisions to their guidance. The draft notes that the various views and proposals presented do not represent a consensus view of the OECD, but are intended to provide stakeholders with substantive proposals for analysis and comment.
The key topics on which comments are requested include, but are not limited to, the following:
• Understanding of how transfer pricing methods such as the transactional profit split methods apply to and address challenges posed by global value chains;
• Use of transactional profit split methods in dealing with hard-to-value intangibles results, unexpected results, and losses;
• How transactional profit split methods help achieve alignment between valuation creation and profits; and
• The correct scope for the application of transactional profit split methods.
BEPS Action 10: Discussion Draft on the Transfer Pricing Aspects of Cross-Border Commodity Transactions
This discussion draft discusses proposed additions to Chapter II of the OECD Transfer Pricing Guidelines. The first proposal involves adding guidance stating that the comparable uncontrolled price (“CUP”) method would generally be the most appropriate transfer pricing method for commodity transactions. Under this proposal, the arm’s-length price for the controlled commodity would be referenced to a quoted price. The logic behind this proposal is that, for transactions involving the sale or purchase of commodities, the quoted price (after any adjustments needed to account for comparability differences) will provide a reliable benchmark to determine if the price is arm’s length. The guidance also proposes that, in
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cases where there is an absence of evidence of the pricing date agreed to by the parties, the pricing date should be the shipment date of the commodities.
The discussion drafts discussed herein are not consensus documents (i.e., not all of the parties in the working groups that produced the drafts agree with all portions of the drafts). Written comments on the three drafts were due by February 6, and the OECD will hold a public consultation on these discussion drafts and other topics in Paris on March 19-20.