In the evolving world of international transfer pricing, it can be risky to assume that planning strategies to achieve the lowest possible effective tax rates, as encouraged by the operative provisions of the Organisation for Economic Co-operation and Development and the UN Model Treaties, will necessarily be effective—or respected.
One of the most interesting evolutions in international transfer pricing (TP) is the tug of war between the Organisation for Economic Co-operation and Development (OECD) and the United Nations concerning model income tax treaty policies that are of interest to the principal source countries, conventionally referred to as BRICS (Brazil, Russia, India, China and South Africa, as well as other emerging economies) (Source Countries). The essential issue is that the Source Countries insist on taxing income using the source of the underlying economic activity as the basis, not the residence of the parent company.
Residency has been the fundamental basis of OECD and U.S. tax policy since modern treaty policies were formulated just after World War I, the model for which was the existing imperial/creditor (such as the United Kingdom) and colony/debtor (such as India) relationship of capital-exporting versus importing countries. Over time, the economic relationship of these groups has changed. For the most part, the former have become the latter and vice versa. The current question then is whether the Source Countries will follow the OECD Model Tax Convention, to which the UN Model Treaty is largely similar.
India has long offered lip service to the OECD TP Guidelines, though it has insisted on greater Source Country taxing rights. Into the vortex of this continuing drama, India has materially increased the stakes by two recent developments.
The first was a letter sent to the UN that specifically rejected the OECD Model Tax Convention and UN Model Treaty as bases for the determination of taxability of a multinational enterprise (MNE) in India due to the “source” provisions being deemed inappropriate. The context of the discussion was the evolving UN Practical Transfer Pricing Manual for Developing Countries.
The second was the introduction of India’s Finance Bill 2012, which contains many provisions that strike unique stakes in the ground with respect to the taxation of MNEs in that country. The proposed provisions, if enacted, would significantly alter Indian taxation of MNEs, with as much as half a century of retroactive effect. The proposals would also reverse many cases decided in favor of MNEs and adverse to positions of the tax authority in India. Individually, and in the aggregate, the proposals signal India’s intention to breach its treaty obligations and undermine the rule of its own law. In addition, this policy direction is inconsistent with prevailing international norms. When combined with the difficulties India has in resolving many bilateral disputes, such an enactment could produce serious risk of double or multiple taxation for MNEs. These proposals make it impossible for MNEs to predict the costs and risks of doing business in India and undermine any confidence that their results in past years will be respected.
The proposed Finance Bill seems to underscore a belief by the tax authority in India that it is able to attract foreign investment regardless of the country’s taxation policies and practices. If the proposed Finance Bill is enacted, the response of the MNE community and its respective tax authorities will be intense. The resultant conflict will have an important impact on the direction of the existing OECD Model Tax Convention and the UN Model Treaty versus Source Country controversy.
On a collective level, MNEs are lining up along with their governments to oppose the Indian situation. At the individual level, an escalating issue for all companies is an effective means of defending effective tax rate (ETR) strategies in the face of serious challenge from the Source Countries. Such strategies are often based on one-sided TP methodologies, which contemplate testing the earnings of Source Country affiliates, pursuant to the MNE’s TP strategies, on the basis of financial results in the country.
TP disputes typically arise when the Source Country seeks a greater share of the global income of the MNE group that, in its view, should be attributable to the functions and risks performed in such country. These controversies can drag on for long periods. It is often necessary to justify the one-sided TP methodologies in comparison to two-sided methodologies, which address the desire of the Source Country to examine global financial results, not just those reported in its country. Similar one- and two-sided approaches also are often utilized to resolve bilateral advance pricing agreements (APAs).
MNEs would do well to prepare for TP controversy utilizing a two-sided analysis to confirm the one-sided analysis typically prepared for TP documentation purposes. This has a variety of benefits, including: confirming the ETR strategy; preparing for examinations; realistically assessing exposures; responding to FIN 48 issues raised by financial auditors; preparing for APA or other advance resolution processes, as appropriate; and providing internal comfort that the ETR can be defended, even in an aggressive Source Country. Though it is not necessary to include such analysis in documentation, it is good to have it prepared for the reasons noted.
Finally, resolution of such matters, whether in advance or after controversy has erupted, is facilitated by respectfully addressing the concerns of the country in question and, if necessary, doing so in the context of the relationship of the in-country functions and risks versus those on a global basis.
In the evolving world of Source Countries, it is risky to assume that following global tax planning approaches, as encouraged by the OECD Model Tax Convention and the UN Model Treaty, to achieve the lowest possible effective tax rates will necessarily be respected.
This newsletter was developed with contributions from members of American Appraisal’s financial valuation practice: Gerald Mehm, senior managing director, and Carlo Carpino, director.