Business restructurings and TP controversy
Froukje Frerichs, Stefano Lavore, and Nicola Lostumbo of Deloitte provide a guide to the most common tax authority challenges in the business restructuring context and present a three-pronged approach to mitigating this risk.
The attention of tax authorities on supply chain reorganisations, which impact the operations of multinational enterprises (MNEs), has noticeably increased following the issuance of the OECD’s transfer pricing aspects of business restructurings (the OECD published guidance on business restructurings in draft form in 2009 and subsequently included it as final in the latest edition of the OECD Transfer Pricing Guidelines (TPG), issued in January 2022).
The OECD’s guidance on business restructurings is squarely aimed at analysing the impact of such reorganisations on local taxable income, outlining bases for challenges if such restructurings are deemed not to be driven by business reasons and/or (not properly documented as being) at arm’s length. The number of transfer pricing adjustments relating to business restructurings has increased significantly in recent years, and tax authorities from various jurisdictions worldwide have also become more proficient in handling such matters and have improved their technical ability to scrutinise and challenge such restructurings.
Business restructuring definition
There is no universally agreed definition of a ‘business restructuring’, and most jurisdictions do not specifically address business restructurings in their tax legislation. Nevertheless, the tax consequences that may accompany complex reorganisations of multinational businesses are of interest to tax authorities worldwide.
Chapter IX of the OECD TPG does provide a reference for tax authorities when addressing the “transfer pricing aspects of business restructurings”. The definition provided by the OECD TPG states that “business restructuring refers to the cross-border reorganisation of the commercial or financial relations between associated enterprises, including the termination or substantial renegotiation of existing arrangements. Relationships with third parties (e.g. suppliers, sub-contractors, customers) may be a reason for the restructuring or be affected by it” (OECD TPG, paragraph 9.1).
In short, a business restructuring occurs when an MNE modifies and reshapes its operations, be it with the intention of doing one or more of the following (non-exhaustively):
Improving the business;
Reducing company costs; and/or
Rearranging roles within the company.
As a starting point, a business restructuring will require the taxpayer to have accurately delineated the controlled transaction by analysing the economically relevant characteristics of the transaction (OECD TPG, paragraphs 1.139 and 9.34). To understand the arm’s-length character of a business restructuring, the OECD emphasises the need to assess “how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation… While one party may provide a large number of functions relative to that of the other party to the transaction, it is the economic significance of those functions in terms of their frequency, nature, and value to the respective parties to the transaction that is important” (OECD TPG, paragraph 1.51).
Therefore, the process of identifying the economically relevant characteristics of the commercial or financial relations and of the connected restructuring “should include consideration of the capabilities of the parties, how such capabilities affect options realistically available, and whether similar capabilities are reflected in potentially comparable arm’s length arrangements” (OECD TPG, paragraph 1.53).
It is important to analyse not only the functions performed but also the risks assumed by the parties involved in a business restructuring. Most significantly, the OECD mentions that a “functional analysis is incomplete unless the material risks assumed by each party have been identified and considered since the actual assumption of risks would influence the prices and other conditions of transactions between the associated enterprises. Usually, in the open market, the assumption of increased risk would also be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised” (OECD TPG, paragraph 1.56).
In addition to analysing the functional and risk profile, it is essential to investigate if any item of value has been transferred; i.e., whether the restructured entity should be entitled to compensation for transfers made as part of the business restructuring. Any compensation should be based on the profit potential (if any) linked to the activities of each entity, computed by analysing the available options of the parties, which is consistent with how independent enterprises would likely negotiate with each other in a similar factual setting.
The OECD states in this regard that “’profit potential‘ means ’expected future profits‘. In some cases it may encompass losses. The notion of ‘profit potential’ is often used for valuation purposes, in the determination of an arm’s length compensation for a transfer of intangibles or of a going concern, or in the determination of an arm’s length indemnification for the termination or substantial renegotiation of existing arrangements, once it is found that such compensation or indemnification would have taken place between independent parties in comparable circumstances” (OECD TPG, paragraph 9.40).
Common aspects of business restructurings that may be closely reviewed by tax authorities generally include the following:
Transfer of intangible property (IP), and connected development, enhancement, maintenance, protection, and exploitation (DEMPE) functions (such as trademarks, technical IP, know-how);
Relocation of functions, including termination of activities and change of functional profile (for example, from full-fledged to limited-risk manufacturer or distributor); outsourcing of functions; and centralisation of functions (for example, procurement);
Transfer of going concern value; and
Financial restructuring (for example, transfer of commercial/financial credits and centralisation of treasury/financial functions; and renegotiations of intercompany receivables in distressed situations).
Controversy around business restructurings
Tax authority challenges in the business restructuring context typically fall within four main areas.
1. An assertion that the restructuring is solely for tax purposes
While tax considerations may be relevant to commercial behaviour between independent enterprises, tax authorities require associated enterprises to demonstrate that there were non-tax drivers behind the business restructuring. The OECD TPG states: “The fact that a business restructuring arrangement is motivated by a purpose of obtaining tax benefits does not of itself warrant a conclusion that it is a non-arm’s length arrangement. The presence of a tax motive or purpose does not of itself justify non-recognition of the parties’ characterisation or structuring of the arrangement” (OECD TPG, paragraph 9.38).
Nevertheless, properly documenting the non-tax rationale (for example, re-alignment of manufacturing footprint and operational structure to increase speed-to-market) is critical. It is important that MNEs can substantiate the business, non-tax drivers for any business restructuring to the tax authority(ies), in the event of a review or an audit down the track.
2. An assertion that the restructuring has no commercial rationale
The OECD and tax authorities globally recognise that there are valid commercial reasons that may support a reorganisation or realignment of intercompany functions, assets, and/or risks. As such, companies strengthen their ability to defend against a future assessment if they can point to similar behaviour between independent enterprises. However, if arm’s-length evidence cannot be found, it does not necessarily mean that the intercompany realignment commensurate with the business restructuring will not be respected (OECD TPG, paragraph 9.109).
In this case, the burden of proof is on the taxpayer. Further analyses could focus on additional expected profits and commensurate additional risks taken by the related parties due to the restructuring. Demonstrating what the added functions are, and appropriately measuring the risks of realising such expected profits, will factor into the TP analysis of what, if any, compensation may be due as a result of the restructuring.
3. An assertion that one or more items of value were transferred as a result of the restructuring
Tax authorities are focused on ensuring that no identifiable assets (intangible or otherwise), together with the associated profit potential, are transferred without compensation in a business restructuring. The OECD TPG reads: “The question is whether there is a transfer of something of value (an asset or an ongoing concern) or a termination or substantial renegotiation of existing arrangements and that transfer, termination or substantial renegotiation would be compensated between independent parties in comparable circumstances” (OECD TPG, paragraph 9.39). As such, the traditional TP focus on functions, risk, and assets of the relevant legal entities pre and post restructuring is key to determining whether an asset has been transferred and if so, what compensation is due to the transferor of the asset.
However, this does not mean that intercompany transfers always require compensation. For example, a transfer of certain individual employees in the context of a business restructuring will not necessarily warrant compensation between intercompany parties (OECD TPG, paragraphs 1.174 and 1.175). No compensation will be warranted unless the transfer or secondment of one or more employees “result[s] in the transfer of valuable know-how or other intangibles”. As a further example, if certain entities involved in a business restructuring have consistently generated taxable losses, this may call into question whether the transfer of that business should require any compensation at all (OECD TPG, paragraphs 9.72 and 9.73).
4. Challenges regarding the amount of consideration paid for the restructuring
Inevitably, there are many instances in which the taxpayer and the tax authority find common ground on the first three aforementioned areas but disagree on the amount of consideration paid in a business restructuring context. Disagreements can often arise based on the selected valuation method and assumptions and parameters used in the application of such method. This is increasingly an issue in transfers of IP, for example, and if taxpayers can triangulate on a range of values supported by more than one valuation method, it can prove helpful in reducing disputes in this area.
Pre-emptive measures and procedure against double taxation under litigation procedures
Companies can take a proactive approach to mitigate the risk of TP disputes regarding their business restructuring transactions by following these three steps:
Monitor and identify the business restructuring;
Comprehensively and contemporaneously document intercompany transactions and the business purpose associated with the business restructuring; and
Consider whether proactive engagement with the tax authorities could reduce audit risk.
The first step is to monitor and identify business restructurings as they occur. By being vigilant in monitoring restructuring activities, MNEs can address TP concerns in a timely manner.
MNEs should establish mechanisms to track any significant changes within their operations that may trigger TP implications. This may include:
The relocation of key decision makers;
The shifting of functions, risks, or assets; and
Any potential exit tax considerations.
Thorough and contemporaneous documentation is imperative to ensure compliance with international guidelines and provide a robust defence supporting the economic substance and rationale behind the restructuring.
Documentation of commercial rationale and the reasoning behind the restructuring and intended post-restructure benefits for the multinational group often plays a pivotal role in addressing TP challenges associated with business restructurings. Contemporaneous documentation demonstrates that the taxpayer has considered the implications of the business restructuring up front, and could help to shift the burden of proof for a potential adjustment to the tax authorities.
MNEs should ensure appropriate intercompany contracts and TP compliance documentation also exist, which accurately reflect the legal and economic substance of the business restructuring and align with the arm's-length principle. This includes accurately delineating the transaction, documenting the business rationale, functional analysis, benchmarking studies, and relevant economic analyses. It is essential to diligently follow the steps outlined in the OECD TPG, as well as any local legislation and regulatory requirements.
In addition, given the detail and focus required in business restructuring disputes, preparing a more comprehensive defence file is strongly recommended (OECD TPG, paragraphs 9.12, 9.24– 9.37. See also the realistic alternatives concept, referenced in US Internal Revenue Code Section 482 and US Treasury Regulations sections 1.482-1(f)(2)(ii)(A), 1.482-3(e)(1) and 1.482-4(d)(1)).
Documenting the business case for the restructuring is crucial. This includes outlining the objectives, anticipated synergies, and expected benefits for any relevant impacted legal entity. Businesses should provide detailed evidence supporting the rationale behind the restructuring, such as market analysis, cost savings projections, or strategic considerations. The business case documentation should clearly articulate the intended outcomes and economic justifications for the restructuring, and the options realistically available to the parties of the restructuring.
To demonstrate and evidence decision-making processes and options which were considered, it is important to document meeting notes and internal communications. Meeting minutes, emails, memos, and other internal communications should be diligently maintained. These documents provide a record of the decision-making process, demonstrating the thought process, considerations, discussions, deliberations, alternative options evaluated during the restructuring, and ultimate reasoning for undertaking the business restructuring.
Finally, understanding and documenting financial projections is critical to support the economic analyses and discussion of any compensation required. Revenue estimates and expense forecasts should clearly outline the assumptions made in any modelling exercise, including market conditions, pricing strategies, and anticipated changes in costs or revenues. An arm’s-length charge for the restructuring may be determined based on a comparison of the profit potential pre and post restructuring (with appropriate consideration of the options realistically available to the parties), and from the perspective(s) of the transferee and/or transferor (OECD TPG, paragraphs 6.157 and 9.93). Additionally, it is crucial to document the risks identified and considered in the forecasts, providing transparency on the potential uncertainties and challenges faced by the restructured business and pre-empting potential challenges, such as claims a ‘hard-to-value intangible’ was transferred.
By diligently preparing a business restructuring documentation and defence file that encompasses these key components, companies can demonstrate the arm's-length nature of transactions and more quickly resolve any TP disputes that arise.
Engaging with tax authorities fosters transparency and can be a key component of pre-emptively addressing TP disputes. In certain cases, companies may consider proactive communication with tax authorities, to provide a clear understanding of the economic rationale behind the business restructuring and the TP implications on a real-time basis. Potentially seeking input from tax authorities and addressing any concerns at an early stage can help to prevent potential disputes from escalating. This proactive engagement can:
Foster a cooperative relationship with tax authorities; and
Reduce the likelihood of protracted disputes.
Business restructuring has become a focal point for tax authorities worldwide, with increasing attention on supply chain reorganisations within MNEs subject to TP regulations. The latest OECD TPG on business restructurings has provided tax authorities with the basis to challenge restructurings lacking legitimate business reasons and arm's-length documentation.
In light of the increased scrutiny by tax authorities, companies engaging in business restructurings must take a proactive approach to reduce the risk of TP disputes. The three-step strategy of monitoring and identifying the business restructuring, comprehensively documenting the business restructuring (including the commercial rationale and keeping strong internal records of decision making), and consideration of strategies to proactively engage with tax authorities provides businesses with a stronger chance of successfully defending against potential tax assessments.
By adhering to international guidelines and local regulations, companies can demonstrate the arm's-length nature of restructurings that they have undertaken for legitimate business reasons and not solely for tax purposes. Ultimately, clear and convincing evidence supporting the economic substance and rationale behind the restructuring will be key to successfully navigating potential TP disputes in this area.