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Jim Fuller |
David Forst |
A fundamental principle of US transfer pricing rules is that transactions structured between related parties are to be respected unless the transactions lack economic substance (see Treasury Regulations §§ 1.482-1(d)(3)(ii)(B) and (iii)(B)). This is an important rule that respects a central pillar of the US tax system – separate entities should be treated separately. The rule also contributes to predictability and stability in worldwide tax administration.
However, while this principle has generally been adhered to worldwide, the BEPS Project has begun to erode it. An example provided in BEPS Actions 8-10 illustrates how business arrangements between related entities (and not just their transfer pricing) are subject to a greater risk of disruption. While this example has primarily been discussed in the US in an outbound context, it also can raise issues in an inbound context.
The example provides that Company P and Company S, P's wholly owned subsidiary, have entered into a written contract pursuant to which Company P licenses intellectual property to Company S for use in Company S's business. Company P performs negotiations with third-party customers to achieve sales for Company S, provides regular technical services support to Company S so that Company S can deliver contracted sales to its customers, and regularly provides staff to enable Company S to fulfil customer contracts. Among other factors, a majority of customers insist on including Company P as joint contracting party along with Company S, although fee income under the contract is payable to Company S. The example states that Company S is not capable of providing the contracted services to customers without significant support from Company P, and is not developing its own capability. The example concludes that while Company P has given a license to Company S, it in fact controls the business risk and output of Company S to such an extent that it has not transferred risk and function consistent with a licensing arrangement, and acts not as the licensor but the principal. Therefore, the license agreement may be disregarded.
The result put forward under the example above makes the issue more than a simple transfer pricing issue. Now, the very relationship between the parties can be under question. This can have far-reaching ramifications, for example involving withholding tax and income characterisation under anti-deferral regimes. It also could lead to more complicated competent authority proceedings since not only transfer pricing, but also income source and characterisation issues could be at stake.
For example, if the US, in applying the traditional standard, were to respect the transaction described in the example as a license, but a BEPS country were to treat the transaction as the provision of a service, then a competent authority proceeding could get very complicated. Coming to an agreement on pricing would be more difficult because license and services transactions are priced with different comparables and often using different methods. Further, ancillary (and very important issues) such as the applicability of withholding tax, and source of income/creditability could also be at issue.
Furthermore, could an IRS examining agent assert, or a US competent authority official agree, that this BEPS example applies for US tax purposes in an inbound context? US Treasury representatives have stated that BEPS and the new OECD transfer pricing guidelines are sufficiently similar to the US transfer pricing rules that changes in the § 482 regulations are not necessary. However, the example arrives at a conclusion different from the one under the US transfer pricing rules unless the facts showed that there was no economic substance to the parties' transaction as governed by their written agreement.
Indeed, an OECD spokesperson recently stated that the new BEPS-influenced transfer pricing rules might not be exactly an application of arm's-length principles. Is this example one of those instances where the OECD is deviating from the arm's length standard and, therefore, one that will create conflicts between a country that follows the OECD but has a treaty with another country that incorporates the arm's length standard?
Only time will tell if the BEPS Project will, as it purports to do, foster transfer pricing unity among the world's economies or will, in fact, create more disunity than existed before.
Jim Fuller (jpfuller@fenwick.com) and David Forst (dforst@fenwick.com)
Fenwick & West
Website: www.fenwick.com
