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OECD’s recent discussion drafts give broad power to the taxing authorities

During the past year, there have been a number of international tax developments that are relevant to large multinationals, including some related to the OECD's base erosion and profit shifting (BEPS) project. We will discuss two of the BEPS developments.

Hard-to-value intangibles

The OECD's 2015 Final Report on BEPS Actions 8-10 ('Aligning Transfer Pricing Outcomes with Value Creation') mandated the development of guidance on the implementation of the approach to pricing hard-to-value intangibles (HTVIs). Accordingly, the OECD released a couple of HTVI discussion drafts, including a May 23 2017 'implementation' discussion draft. The discussion draft is entitled 'Implementation Guidance on Hard-to-Value Intangibles'. It clarifies some important concepts from an earlier BEPS discussion draft that also addresses HTVIs.

The HTVI approach is intended to allow tax administrators to use after-the-fact profit information as presumptive evidence about the appropriateness of the parties' transfer prices. However, related party transfer prices must be determined prior to the transaction without the availability of after-the-fact profit information, just as in real-life unrelated party transactions. Thus, these new rules are quite controversial, and would seem to deviate from the arm's-length standard. The major concern is how tax administrators will apply them in practice. The new approach to HTVIs deviates from how unrelated parties in the real world deal with the issue.

This new implementation draft is helpful to the extent it makes it clear that tax administrators are not to base transfer prices and valuations solely on the ex post (after-the-fact) income. Application of these rules in practice will determine the reasonableness of the new rules in the context of the OECD transfer pricing guideline's (TPG's) overriding theme that related parties are supposed to deal at arm's length.

Specifically, under the new discussion draft, tax administrators are only supposed to consider ex post outcomes as presumptive evidence about the appropriateness of the pricing arrangements if the intangible is a HTVI. The term 'HTVI' covers intangibles for which:

  • No reliable comparables exist; and

  • The projections of future profit, or the assumptions used in valuing the intangibles are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.

Defining 'HTVI' by using subjective terms like "highly uncertain" and "making it difficult" are at the root of the problem, of course.

Pursuant to the draft, when the actual profit ex post is significantly higher than the anticipated profit, that alone can constitute presumptive evidence that the projected profit used in the original valuation should have been higher and requires extra scrutiny by a country's tax authority, taking into account what was known and could have been anticipated when valuing the profit.

The TPGs contain a list of exemptions from the use of ex post adjustments. Under point one, taxpayers can overcome the presumption of a HTVI ex post approach by preparing a robust valuation that considers various possibilities and addresses the certainty of profit and risk possibilities. This needs to be done before the transaction, of course. The taxpayer then must prove that different profit results were due to an unforeseen circumstance. It would be helpful, however, if the OECD were to provide examples demonstrating how the taxpayer could overcome the presumption by proving either:

  • The original valuation properly took into account a particular possibility; or

  • That the development that affected the parties' profits was unforeseeable.

Another exemption applies if the actual profitability ex post does not deviate by more than 20% of the ex ante pricing. The discussion draft states that the measurement of materiality and the relevant time periods will be reviewed by 2020.

Notably, an HTVI ex post adjustment cannot be used based on the comparable uncontrolled transaction method (CUT), which is a transaction-based method based on at least one or more reliable comparable transactions. HTVI only affects profit-based methods such as the comparable profit method (CPM) and the profit-split method.

While it's good to see this new implementation guidance emphasising the limitations on the use of ex post results, the concern of many taxpayers is how tax administrators will apply the TPGs dealing with HTVIs, as stated above. The concern is that tax administrators will take this new HTVI guidance and start to apply ex post outcomes more broadly than the TPGs intend.

Profit attribution and permanent establishments

The OECD's BEPS report on Action 7 ('Preventing the Artificial Avoidance of Permanent Establishment Status') stated that additional guidance was necessary regarding how the rules of Article 7 of the OECD Model Treaty would apply to permanent establishments (PEs) in order to take into account other BEPS action plan changes, in particular those dealing with transfer pricing and the work related to intangibles, risks and capital.

The OECD's committee on fiscal affairs released a July 2016 discussion draft intended to provide guidance for public comment and held a consultation in October 2016. The discussion draft was based on a 2010 'Authorised OECD Approach' (AOA) to determine the proper profit allocation to a PE. This approach, however, was rejected by a number of OECD and non-OECD countries and in the UN Model Tax Convention. Thus, the discussion draft applied an approach that is not contained in most treaties.

The OECD released a new discussion draft on June 22 2017, entitled 'Additional Guidance on Attribution of Profits to Permanent Establishments'. It is intended to provide additional high-level guidance for the attribution of profits to PEs. In particular, the new discussion draft covers PEs arising from Article 5(5) of the OECD Model Treaty, including examples of a commissionaire structure for the sale of goods, an online advertising sales structure, and a procurement structure. It also includes guidance related to PEs created as a result of changes to Article 5(4) of the OECD Model Treaty, and provides an example on the attribution of profits to PEs arising from the anti-fragmentation rule.

Generally, once it is determined that a PE exists under Article 5(5), due to the activities of an agent, the rights and obligations resulting from the contracts to which that provision refers should be allocated to the PE. This does not necessarily mean that all of the profits resulting from the performance of these contracts should be attributed to the PE. The determination of the profits attributable to the PE are governed by the rules of Article 7. Under Article 7, the only profits attributable to the PE are those that it would have derived if it were a separate and independent enterprise performing the activities on behalf of the non-resident enterprise. This draft states that this principle applies regardless of whether a tax administration adopts the AOA contained in Article 7 of the 2010 version of the multinational tax treaty.

However, the examples in the new discussion draft, which are key to understanding it, utilise the AOA and additionally restructure the parties' actual transactions. In one example, a commissionaire transaction is restructured so that the PE is treated as operating as a buy/sell subsidiary with the buy/sell profits in excess of the commission constituting income of the PE. This restructuring goes beyond the authority provided pursuant to Model Treaty Article 7. The example restructures the parties' transaction by moving assets and income producing functions and activities owned and performed by the buying and selling company in one country and treating them as though they were hypothetically owned and performed by the PE in another country. These functions are performed in the first country and the income from the functions is already taxed by that country's tax authority.

The discussion draft states in a footnote that the restructuring in this example is "conceptually equivalent to the amount paid by the PE for the inventory 'purchased' from [the corporation]" and that "[t]his would correspond to a 'dealing' under the AOA". Reliance on the AOA was a problem with the OECD's last PE discussion draft. Moreover, the new discussion draft states that the principles of profit attribution to a PE apply "regardless of whether a tax administration adopts the [AOA] contained in Article 7 in the 2010 version of the MTC as outlined in the 2010 Report on the Attribution of Profits to [PEs]". Yet, in the discussion draft, it used the AOA as the basic underpinning for moving assets and taxable income into the PE. Using these concepts to restructure transactions goes beyond the authority provided pursuant to Model Treaty Article 7.

Final thoughts

The most recent BEPS discussion drafts released by the OECD include troubling concepts that provide for broad powers to the tax authorities, both within the context of intangible property and profit attribution to PEs.

It is unclear what legal pronouncements allow the tax authorities to have such powers, which are beyond the scope of the arm's-length standard and violate the language in the OECD's Model Income Tax Convention.


Larissa Neumann and Julia Ushakova-Stein

Fenwick & West

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