Transfer Pricing Notes

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III Transfer pricing and thin capitalisation rules

A Various approaches to the determination of profits of branches and associated enterprises: (Page 469)

1. Unitary taxation/global formulary apportionment 2

As an alternative to Arm's length this type of system would apportion global profits of the group according to a formula (e.g incorporating factors such as sales/payroll). This can be seen in Federal States such such as US, Canada, Switzerland for apportionment between the States/Cantons.

+ It is simple and easy to enforce

Components can be manipulated

2. Arm’s length approaches 3

1928 the US congress granted the IRS the power to adjust the accounts of related companies

1935 League of Nations Model Tax treaty introduced a requirement for the arms length principle. Where Arms Length was difficult to determine unitary taxation was the fallback.

1951 the UK brought in transfer pricing provisions to deal with enforcement of Article 9. These were updated in 1999 to bring more in line with Art. 9 and more suitable for the sophistication of multi-national groups.

The growth of international tax planning in the 1950s and 1960s led to the US s482 regulations of 1968.

1979 OECD TP Guidelines for multi-national Enterprises and Tax Administrations - opposing unitary taxation

1994 update reconfirmed opposition to unitary and added chapters on Intangibles and cost sharing agreements.

2010 - further revised

Many prefer the US s482 guidelines for the greater detail, and greater level of certainty. OECD guidelines considered as too general by many.

B State practice with respect to transfer pricing:

1. Consideration of examples of domestic transfer pricing legislation

(US, UK, Germany, Australia) 2

United States

Very extensive guidelines not always entirely in line with OECD

Strict "best method" rule. In practice Comparable Profits Method is widely used

US is and always has been the trendsetter in TP

No use of secret comparables by IRS

United Kingdom

Follows OECD

Applies to domestic transactions also

Combines Transfer Pricing and Customs

One of the leaders in the current BEPS discussions

HMRC only uses secret comparables to identify audit targets

Germany

OECD generally followed, however some differences such as selection of best method based on comparability

Strong limitations on use of TNMM. Database analysis may not be sufficient as only evidence of arm length

Legal and formal aspects are very important

Extensive rules on exit taxation and transfer of functions

Tax authorities have a database but can't really use it due to data secrecy restraints

Brazil

TP regime does not follow OECD guidelines

Change of method even during the year is accepted

Specific margins/safe harbour rates are to be applied in order to comply

The tax authorities may use secret comparables

C Transfer pricing and DTCs – Art. 9 OECD MTC 3

Both Article 7 and 9 allow for profits to be computed as though the two parties were unconnected. Art 7 is used to determine the split between a head office and a branch. Article 9 for companies in the same group.

If one State makes an upward adjustment to the profits then Art 9 provides that a downward adjustment may be made in the other State. However the adjustment is to the profit not the tax!

MAP Art 25 for situations where the treaty does not allow for a downward adjustment

D Advanced pricing agreements 3

An APA is a binding agreement between a taxpayer and a tax authority

Can be unilateral, bi-lateral, multi-lateral

CPM and TNMM tend to be most common

Gives more certainty but can take some time to obtain agreement

E The OECD Transfer Pricing Guidelines:

1. Consideration of the methodologies in the Guidelines 3

Comparability Analysis (chapter 1)

Relevant for all 3 transactional methods

5 factors

Transactional Methods (chapter 2 part 2)

These methods look at gross profit

Comparable Uncontrolled Price (CUP)

Often difficult to obtain

Can "reasonably accurate adjustments" be made?

Resale Price Method (aka Resale Price Minus, RPM)

Limited use: distribution models where the distributor ads little or no value other than distribution (buy/sell)

Starting point is final consumer price and then deduct a suitable gross margin

Often gives rise to practical issues with ERP systems etc.

Cost Plus Method (CPM)

Useful when there is no comparable sale - e.g. intermediate product

Most common for specific services or contract manufacturing

Transactional profit methods (chapter 2 part 3)

These methods look at the net profit on a transaction. The guidelines give examples of where it may be appropriate - where each party makes valuable and unique contributions or where the parties are engaged in highly integrated services

Transactional Net Margin Method (TNMM)

Involves a comparison of Earnings Before Interest and Tax (EBIT) as a ratio of Sales

Step 1: compare EBIT/sales over a number of years

Step 2: calculate working capital differences (R+I-P)/Sales [Receivables -Inventory - Payables]

Step 3: Notional interest must be calculated on working capital difference and reduced from the EBIT/sales ration of the company with more working capital

Profit Split Method (PSM)

Aims to split the total profit earned on a transaction between all the group companies involved using an equitable formula

Step 1: identify the profit to be split

Step 2: split those profits on an economically viable basis that approximates the division of profits that would be anticipated in an arm's length situation

Popular in IP situations and with companies where there is a high degree of vertical integration (raw materials - processing - finished product - e.g. Pharma, automobiles, telecoms)

(comparable profits method - US, Canada)

Not OECD recommended

Operating profit of a company is compared to operating profit of comparable companies

Operating profit/sales ratios compared

It is popular because it is easy for the IRS to apply and because it is a broad brush approach it is more popular for APAs

2. Practical application of the methodologies and the resolution of 3

transfer pricing disputes

TP disputes can involved in one of 2 ways

Mutual Agreement procedure of the treaty (Art 25 OECD)

The EU Arbitration Convention (if both are EU)

MAP (Art 25)

Must be made to the country in which you are tax resident within 3 years from the first notification of the action resulting in taxation. ("reasonably prudent person" would have realised he was being subjected to double taxation)

Weaknesses:

The tax authorities are not required to involve the taxpayer

Poor decisions due to incomplete information/understanding

Taxpayer needs to co-operate fully, make available information etc. While in theory information provided should be confidential, taxpayers may be wary that tax authorities might use it in the future.

Many treaties do not have the arbitration provision in which case the countries only need to "endeavour to resolve" - i.e. there may be no resolution

3. Valuation of intangibles 3

4. Cost sharing/contribution arrangements 3

5. Intra-group services 3

6. Documentation 3

F State practice with respect to thin capitalisation:

1. Consideration of examples of thin capitalisation legislation (US, UK, Germany) 3

Essentially thin cap rules are a subset of Transfer Pricing rules specifically aimed at the temptation of multinationals to fund companies with a large amount of debt (tax deductible interest) vs equity (non deductible dividends). Thin cap legislation reclassifies part of the interest deduction as a dividend, recognising that at least part of the debt capital is permanent capital.

Equity = Issued share capital + retained profit

Debt = total loans

Legislation varies from general to extremely prescriptive.

US rules are the latter:

No adjustment will be made to a US paying company's taxable profits under US Thin Cap rules provided that interest amounts to

A ratio of 3:1 is more common. Usually interest paid on third party loans guaranteed by other group companies is also caught by Thin Cap legislation.

UK legislation is more general.

The borrowing capacity of a company is examined on a standalone basis as though it were not part of any group. The UK authority would then consider:

Whether a loan would have been made at all without the special relationship.

The amount the loan would have been in the absence of the special relationship

The rate of interest and other terms that would have been agreed in the absence of that relationship

So a ratio over 3:1 is not necessarily problematic in the UK - factors such as trading history, future prospects, quality of security available to a lender will be taken into account.

Brazil

Interest payments to a Low Tax Regime Jurisdiction affiliate are not deductible if the debt of the Brazilian subsidiary exceeds 200% of the investment (2:1)

Interest payments to a LTRCO foreign creditor (affiliated or not) are not deductible if the debt with all LTRCO entities exceeds 30% of the equity of the Brazilian borrower

Germany

Langkhorst case: Germany infringed on taxpayer's freedom of establishment and Germany had to revise its rules so that now the thin cap rules apply to domestic transactions in the same way as they do to cross border transactions. This ruling led to many EU countries extending their rules to domestic transaction leading to an increase in compliance costs as transfer pricing documentation rules applied to more transactions

Equity or Debt?

It is not always obvious - Australian tax legislation provides some helpful tests for determining which it is. It provides that where an instrument could qualify as both, it should be treated as debt (to the obvious benefit of Australian Revenue)

G Thin capitalisation legislation and DTCs 3

Both Article 7 and 9 allow for profits to be computed as though the two parties were unconnected. Art 7 is used to determine the split between a head office and a branch. Article 9 for companies in the same group.

Branches (page 452)

OECD 2010 report on the attribution of profits to Permanent Establishments (Page 1049 KVR)

Thin Cap: OECD devised methods of determining what level of debt finance may be appropriate to the branch by apportioning total equity according to asset values in each location

Notional interest charges from head office to branch

Approaches

State Practice

DTCs/APAs

OECD Guidelines

Thin Cap