Transfer pricing. This is one of the most complex and controversial areas of corporate tax, occupying considerable time and energy on the part of many of TEI’s members, especially in the last twelve months.
What exactly is transfer pricing? According to Mike Patton and Eric Ryan, partners at the law firm of DLA Piper, transfer pricing refers to what related companies charge each other for goods, services, financing, or use of intellectual property (IP). “Transfer pricing has traditionally been a well-established source of tax planning opportunity for multinational enterprises (MNEs), both large and small, Patton and Ryan note. “However,” they explain, “over the last year, transfer pricing has increasingly been at the center of what looks to become a global tax war.”
Really? A global tax war? Aggressive enforcement of transfer pricing requirements by tax authorities has become the norm in the fast-growing economies of the BRIC countries (Brazil, Russia, India, and China), as well in the developed economies of Europe, Japan, and the United States, according to the DLA Piper attorneys. In the United States, for example, the Internal Revenue Service is emphasizing transfer pricing issues by significantly increasing the number of international examination agents and economists who focus on transfer pricing issues, by establishing administrative groups within IRS dedicated solely to transfer pricing issues, and by adopting a risk-adjusted approach to examinations—with transfers of intangibles and cost-sharing arrangements at the highest risk level, Patton and Ryan explain.
In addition, they assert, President Obama’s 2015 revenue plan includes proposed legislation that would broaden the definition of intangibles to include items traditionally treated as goods. The revenue plan also contains proposals to tax as current U.S. income “excess” profits of foreign subsidiaries attributable to intangibles transferred from the United States to a low-taxed foreign affiliate.
Focused transfer pricing examination approaches are also being taken in other countries, including China, where the tax authorities have targeted key Chinese taxpayers for transfer pricing examinations, the attorneys note.
Prep for Exams
Transfer pricing issues are extremely fact- and document-intensive, and, thus, it becomes critical to have your company’s controversy strategy fully developed during an exam, experts agree. Here’s how the DLA Piper attorneys explain it: “Transfer pricing disputes involve the application of a complex set of general principles to a specific set of facts. Most … concern the price or profit that should be attributed to a specific set of controlled party transactions, [and most] transfer pricing disputes involve answering this question: ‘What price would be charged, or profit earned, in arm’s length transactions, for the controlled transactions being analyzed?’”
“Most transfer pricing disputes involve answering this question: ‘What price would be charged, or profit earned, in arm’s length transactions, for the controlled transactions being analyzed?’”—Mike Patton and Eric Ryan
Under the recently adopted IRS Appeals Judicial Approach and Culture (AJAC) process, those taxpayers filing appeals will be trying to reach a resolution of the disputed issues based on the record made before examination. It is critical, therefore, if the taxpayer thinks a dispute may end up being referred to appeals that exam be presented with all facts, including details of comparable transactions, that the taxpayer will want to rely on before appeals. Raising factual issues for the first time at appeals may result in the arguments being ignored or in having the case returned to exam for comment and further development.
In light of the burgeoning global tax war, will Alternative Dispute Resolution (ADR) be used more frequently? “It is difficult to predict whether ADR will become more popular as transfer pricing disputes increase. On the one hand, the United States and the OECD member countries are generally in favor of mandatory arbitration of unresolved competent authority cases. On the other hand, only a few of the U.S. treaty-mandated arbitration provisions have actually been implemented,” the attorneys say. “Whether ADR is appropriate for specific tax disputes needs to be evaluated based on the facts and circumstances of the case. Where the tax authority is taking a clearly arbitrary position, a ‘baseball’ arbitration (winner-take-all based on last, best offer) can present an attractive alternative to traditional dispute-resolution procedures, which tend to adopt a split-the-baby approach,” they explain.
The BEPS Effect
The remainder of 2015 is shaping up to be a watershed year for bringing the multiyear BEPS efforts closer to fruition, Patton and Ryan assert.
In February 2015, the finance ministers of the G-20 reiterated their commitment to implementing key BEPS action items during 2015. In the offing are the following BEPS-related actions that will affect transfer-pricing based international tax planning, according to Patton and Ryan:
- Finalization of the template for country-by-country (C-by-C) reporting and establishment of procedures for automatic exchange of C-by-C templates among tax treaty or tax information exchange agreement partners. The first automatic exchanges are planned to take place in 2017 based on reporting by multinational companies for tax year 2016.
- C-by-C reporting will enable countries to pinpoint double nontaxed or lightly taxed income reported in jurisdictions with few employees or low local brick-and-mortar investment.
- Finalization of revised rules for evaluating returns to contractual assumption of risks related to developing intangible property, as well as rules for re-characterizing transactions that are based solely upon contractual assumptions of risks.
- Finalization of a multilateral instrument (treaty protocol) that will potentially amend hundreds of existing OECD-based treaties. Amended treaty provisions would impose limitation of benefits provisions, place restrictions on the deductibility of interest in one jurisdiction that does not result in an income inclusion in the payee jurisdiction, and adopt changes to long-standing permanent establishment rules.
One general theme of the changes being considered is that taxable (or nontaxable) profits should follow economic substance, the attorneys point out. In the case of risks, emphasis will be placed upon the actual management of the functions that give rise to the reward that is inherent in the risk being assumed. “Current OECD BEPS proposals emphasize that a rigorous functional analysis should be undertaken to justify returns to a controlled transaction and that the returns being allocated should reflect commercial reality. In an environment that abounds with ‘nattering nabobs of negativism,’ is tax-planning possible to justify profits in tax-favored jurisdictions?” they ask. The attorneys affirmed that tax-planning will survive BEPS, but that post-BEPS planning will need to leverage off a company’s business substance in various countries.
Then there’s the intriguing question of whether companies are seeing any difference in IRS exam procedures resulting from the “transfer pricing roadmap.” “Our experience, and the conclusion drawn from discussions with a number of companies, is that the IRS field economists are not following the transfer pricing roadmap. This conclusion is apparent from the conduct of transfer pricing examinations after the roadmap was issued, where similar examination procedures have been followed before and after issuance of the roadmap.”
In particular, Patton and Ryan explain, the roadmap emphasizes that there be a dialog between the IRS Exam team and the taxpayer to discuss the Exam team’s initial hypothesis about the correct transfer pricing methods or profit targets, that Exam engage in fact-finding to confirm the hypothesis, and that Exam modify the hypothesis based on the facts found. Experience before and after the issuance of the roadmap is that field economists begin the exam with a theory about the “correct” transfer pricing method or profit target, conduct limited fact finding to attempt to confirm the theory, do not engage in a dialog with the taxpayer, and do not change the theory even if the facts do not support the initial theory, they note.
Are companies expecting to change their approach to transfer pricing examinations because of the issuance of the roadmap? Given that the Exam teams are generally not following the roadmap, the general answer is no. However, following issuance of the roadmap, some taxpayers have made an effort to engage in a dialogue with Exam and to affirmatively present the facts relating to their transfer pricing policies and practices, as suggested by the roadmap, Patton and Ryan indicate.
Patton and Ryan further note that companies should expect levels of transfer pricing and international tax controversy to increase as the BEPS recommendations are implemented. It is prudent for companies to review existing structures and transfer pricing policies in anticipation of facing these future challenges, they advise.