EMEIA: Base erosion, profit shifting and the effects on transfer pricing
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EMEIA: Base erosion, profit shifting and the effects on transfer pricing

Base erosion and profit shifting (BEPS) is intended to describe the phenomenon that governments lose substantial corporate tax revenue because of planning aimed at eroding the taxable base and/or shifting profits to locations where they are subject to more favourable tax treatment. Oliver Wehnert, Ernst & Young’s EMEIA transfer pricing leader, explains the impact the project may have on transfer pricing.

After numerous media reports in relation to the relatively low level of tax payments of multinational enterprises, the political pressure is rising to prevent suspected base erosion by the relocation of profits. Based on public discussions, the OECD released a report titled "Addressing Base Erosion and Profit Shifting" (BEPS report) on February 14 2013. According to the statement of the OECD, the increasingly aggressive tax planning strategies of multinational enterprises are the basis of this erosion. These aggressive tax planning strategies in the next step are based on the fact "that the domestic rules for international taxation and internationally agreed standards may not have kept pace with changes in global business practices, in particular in the area of intangibles and the development of the digital economy". The interaction of these domestic tax systems sometimes leaves gaps, which result in an item of income not being taxed anywhere, thus resulting in so called double non-taxation.

Based on the erosion of the tax base the BEPS discussion has reached the political level and thus has become a very important issue on the agenda of several OECD and non-OECD countries. The political importance of BEPS was demonstrated in particular through the declaration of the G20 leaders dated June 19 2012 who said: "We reiterate the need to prevent base erosion and profit shifting and we will follow with attention the ongoing work of the OECD in this area."

In compliance with the global interest, the OECD BEPS report asks for a "global and comprehensive action plan based on in-depth analysis of the identified pressure areas with a view to provide concrete solutions to realign international standards with the current global business environment."

This article summarises the BEPS report, focusing on the transfer pricing aspects outlined in this document. In addition to the concrete transfer pricing considerations with respect to intellectual property and intercompany financing, the article also includes aspects that are related to transfer pricing concepts such as permanent establishments.

Key areas of the BEPS report

To find solutions for the identified problems the OECD has defined the following key pressure areas:

  • International mismatches in entity and instrument characterisation including hybrid mismatch arrangements and arbitrage;

  • Application of treaty concepts to profits derived from the delivery of digital goods and services;

  • The tax treatment of related party debt-financing, captive insurance and other inter-group financial transactions;

  • Transfer pricing, in particular in relation to the shifting of risks and intangibles, the artificial splitting of ownership of assets between legal entities within a group, and transactions between such entities that would rarely take place between independents;

  • The effectiveness of anti-avoidance measures, in particular GAARs, CFS regimes and thin capitalisation rules; and

  • The availability of preferential regimes for certain activities.

BEPS and transfer pricing

According to the BEPS report, the different components of the action plan will include two different proposals for developments in the area of transfer pricing:

  • Improvements or clarifications to transfer pricing rules to address specific areas where the current rules produce undesirable results from a policy perspective. The work of the OECD on intangibles, which is a particular area of concern, would be included in a broader reflection on transfer pricing rules.

  • Updated solutions to the issues related to jurisdictions' right to tax (PE issues), in particular in the areas of digital goods and services. These solutions may include a revision of treaty provisions.

The following sections of the report include a discussion of these transfer pricing related aspects.


As described above, the BEPS report identifies transfer pricing treatment of intangibles as a key pressure area and states that "the current rules provide opportunities for multinational enterprises to associate more profits with legal constructs and intangible rights and obligations, and to legally shift risk intra-group, with the result of reducing the share of profits associated with substantive operations". Thus the OECD highlights the importance to revise the rules. The revision of the rules in relation to intangibles will be based on the revised version of the OECD paper released in June 2012 which covers the treatment of intangibles. The revised version of the OECD report is expected to be released during 2013. The final OECD paper should lead to a revision of chapter VI of the OECD transfer pricing guidelines.

To systematically assess the impact of the changes it is inevitable to await the release of the revised version of the OECD report. Still, based on the current discussion draft, a tendency can be identified as to what changes can be expected. The objective of the revised version of chapter VI of the transfer pricing guidelines is to provide special rules for transactions which include the use or the transfer of intangibles. Thus the discussion draft contains a proposal for the wording of the new chapter VI of the transfer pricing guidelines.

Section B of the draft includes a discussion of the question about which of the group companies of a multinational entity the profits should be allocated to. Therefore, the definition "intangible related return" was established. According to paragraph 28, the intangible related return attributable to a particular intangible is the economic return from business operations involving use of that intangible after deducting (i) the costs and expenses related to the relevant business operations, and (ii) returns to business functions, assets other than the particular intangible in question, and risks, taking into account appropriate comparability adjustments. "The outcomes of the transfer pricing allocation in cases involving intangibles should reflect the functions performed, assets used, and risks assumed by the parties".

This means that neither the legal ownership of intangibles nor the bearing of research and development costs, in isolation or in combination, can justify the allocation of intangible related returns. This statement is important because a lot of multinationals' tax planning structures are based on structures that allocate the legal ownership to companies located in low-tax countries and bear the research and development costs. In the future these structures should not be sufficient for the allocation of profits to those companies.

It is to be expected that more focus will be given to actual substance. The allocation of intangibles will have to follow the allocation of people who are responsible for developing and maintaining an intangible from a commercial perspective. This follows the significant people function approach introduced by OECD as to the allocation of profits to PEs under the AOA and would be able to eliminate structures by which intangibles are allocated based on contracts or paper only. Therefore, in the future, multinational enterprises will likely have to focus much more on (people) substance. The increasing focus on actual substance is also likely to become a big conflict area for transfer pricing in general because the subjective perception of the value contribution of certain activities performed by group entities in different countries diverges significantly in the view of the respective tax authorities involved. Therefore, it is to be expected that documentation requirements as to the substantiation of the functional analysis or value chain analysis will increase significantly in the future.

In summary we would expect that the transfer pricing guidelines will focus on a functional approach which anticipates the transfer of profits based on allocation of the legal ownership and the research and development costs.

Permanent establishments

Based on the economic environment, characterised by multinational companies acting within different countries, the rules in relation to permanent establishments will likely be subject to necessary changes.

"The current concepts in relation to permanent establishments were developed when physical presence was necessary for a corporation to do business in a country" (according to Garry Stone and Rizwan Syed, Adressing base erosion and profit shifting: An examination of the OECD's recent report,Transfer Pricing International Journal (BNA), Highlights 05/17/2013). The OECD report states that today, multinational enterprises can be involved in the economic life of another country without having taxable presence in this country. Thus there is a potential risk that the current rules in relation to permanent establishments probably do not address all relevant aspects.

Potential changes of the regulations in relation to permanent establishments could include the definition of the permanent establishments as well as upcoming questions in relation to the emerging digital economy, for example, should a distinction be made between whether the e-commerce is the source of profits or is simply used by the company?

Once such concepts have been developed, the question is how they should be implemented in the international taxation practice. This is because OECD papers of any nature are not law for the countries affected but rather the individual bilateral tax treaties are. So changes of OECD positions would normally have to be transferred into such treaties and/or globally consistent into national law. It will be interesting to see how this is going to happen.

More precision needed

Because of the discussion draft of the BEPS report and related OECD initiatives, the OECD has specified reasons for the necessary revision of the transfer pricing regulations. The need to revise the transfer pricing guidelines is based on the changes in the economic environment characterised by multinational entities with an important portion of cross-border transactions. Thus the OECD has set out an action plan for the stakeholders to review the transfer pricing rules.

The suggested revision of the transfer pricing guidelines will probably lead to an increasing focus on transfer pricing aspects which, as the next step, will cause increasing attention on transfer pricing methods used to demonstrate the arm's-length character of prices set between related entities. In relation to the focus on transfer pricing it is possible that the stakeholders will create rules which demand a clear presentation of the full supply chain. This would put the tax authorities in a better position to challenge the transfer pricing if they saw the whole picture rather than just the elements involving their territory. On the other hand, it would obviously increase the documentation burden for multinational enterprises.

However it is necessary that governments bear in mind that not all transfer pricing arrangements are based on the intention to transfer profits to low-tax countries. The arrangements are more often based on economic considerations of the relevant decision makers. Furthermore the question arises about whether transfer pricing regulations are the right instrument to avoid abusive tax arrangements, given that the rules are intended to determine the correct prices and not to assess if there is a sufficient economic reason for the relevant transactions.

In addition to the concerns raised above, the current OECD papers are not precise enough to avoid different interpretations of the rules. In particular, the criteria in relation to the allocation of intangible related returns are not clear. This could lead to different interpretations of the rules within different countries. In the next step the different interpretations will lead to potential double taxation. Overall this will have a negative impact on the planning certainty of multinational entities. To ensure a uniform interpretation of the rules, it would be necessary to specify the current definitions within the upcoming OECD papers.

To assess the actual impact of the proposed changes on the transfer pricing guidelines it is necessary to wait for the final OECD paper in relation to base erosion and profit shifting. A revised version of the paper is expected at the beginning of June after the G20 meeting in St. Petersburg.



Oliver Wehnert

Ernst & Young

Tel: +49 211 9352 10627

Email: oliver.wehnert@de.ey.com

Oliver Wehnert is an international tax partner in the Düsseldorf office of Ernst & Young. He is Ernst & Young's EMEIA transfer pricing leader and also heads Ernst & Young's transfer pricing practice in Germany, Switzerland and Austria. He joined Ernst & Young in 1998 after spending six years at PwC. He is a certified tax consultant and completed his MBA at the University of Paderborn in 1992.

Oliver Wehnert has vast experience in client services on transfer pricing design, international tax planning for intangible transfers, tax effective supply chain projects as well as controversy cases in scope of mutual agreement procedures and bi- and multi-lateral advance pricing agreement projects.

Oliver Wehnert is focused on German based multinational enterprises interacting with their subsidiaries in particular in North America, Asia & Pacific as well as Europe. His clients are multinational enterprises in the pharmaceutical, chemical, consumer products and automotive industry.

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