The finalised update to the OECD transfer pricing guidelines under the base erosion and profit shifting (BEPS) initiative has the potential to generate substantial tax controversy for multinational corporations in the financial services industry (FSI). In this section, we focus on three of the issues with the potential to generate increased tax controversy for FSI taxpayers under the BEPS initiative: cash boxes, permanent establishments, and interest expense deductions.
Actions 8, 9, and 10 of the BEPS Action Plan focus on "cash-boxes", or capital-rich entities without any other relevant economic activities. Footnote 2 in the report states:
"The guidance in this chapter, and in this section on risk in particular, is not specific to any particular industry sector. While the basic concept that a party bearing risks must have the ability to effectively deal with those risks applies to insurance, banking, and other financial services businesses, these regulated sectors are required to follow rules prescribing arrangements for risks, and how risks are recognised, measured, and disclosed. The regulatory approach to risk allocation for regulated entities should be taken into account and reference made as appropriate to the transfer pricing guidance specific to financial services businesses in the Report on the Attribution of Profits to Permanent Establishments (OECD, 2010)."
The rest of Actions 8, 9, and 10 can be read as indicating that the returns associated with risk bearing should be allocated to entities that perform value-creating people functions, rather than to entities that "merely" provide capital, and that "cash boxes" should earn risk-free rates of return.
Individual member states and others implementing BEPS-driven legislation will have some latitude with respect to how much weight they give the footnote, as opposed to the balance of Actions 8, 9, and 10. To the extent that member states try to downplay the importance of capital, tax authority views may be in direct conflict with those of financial regulators, who have different objectives with respect to capital and its remuneration. Under the Basel Accords, financial regulators treat net income and retained earnings as sources of capital for the legal entities that book them. This difference in view between the guidance from financial regulators and from anti-tax avoidance-driven BEPS documents has the potential to generate controversy between tax authorities, as well as conflicts between the remits of taxation authorities and regulators.
The new guidance on permanent establishments may cause strife between FSI firms and tax authorities because they commonly have corporate structures that separate operating and financing functions across legal entities. Before the BEPS initiative, the OECD guidance relied on an objective standard to determine permanent establishments based on whether an entity has "an authority to conclude contracts". The revised language introduces a more subjective standard based on whether an entity "plays the principal role leading to the conclusion of contracts". Given that the implementation of this guidance will depend on the facts and circumstances of each case, the subjectivity of this standard may give rise to controversy between tax authorities in specific applications. As an example, the Financial Stability Board has recently introduced a standard for systemically important financial institutions that delineates the capital required to be held by such institutions, as well as its composition and location. This capital requirement will be based on legal ownership, not "people functions", which could lead to a significant divergence of capital amounts in a given jurisdiction for regulatory and for tax purposes.
Action 4 of the BEPS Action Plan provides guidelines for limiting interest expense deductions. Although the 2015 Final Report defers the issuance of rules specific to the banking and insurance sectors to a later date, these new guidelines broadly aim to mitigate base erosion due to intercompany lending between related affiliates. In an FSI context, multinational corporations often have an economic rationale for the parent company to raise third-party debt and to extend loans to its subsidiaries, because the parent may have a stronger credit profile and a lower cost of capital. In addition, significant economies of scale may exist in external capital raising. Efforts by tax authorities to limit interest expense deductions by subsidiaries may result in parent companies financing their subsidiaries through more equity instead of debt than they otherwise might. Paradoxically, tax authorities governing parent companies may view these efforts as base eroding for their own tax jurisdictions. This difference in view could give rise to additional tax controversy over the appropriate classification of intercompany financing.
For the technology, media, and telecommunications (TMT) industry, the BEPS initiative has the potential to create controversy in at least four areas: offshore structures; the change in characterisation of local affiliates; issues related to the elimination of exclusive distribution clauses; and the valuation models for content that have long lead times. This section discusses the implications of BEPS for each of these areas in turn.
With respect to offshore structures, TMT companies will need to pay particular attention to the BEPS language concerning the development, enhancement, maintenance, protection, and exploitation (DEMPE) of intangibles. See Actions 8-10: 2015 Final Reports, Changes to Chapter VI of the OECD Guidelines, including the Annex to Chapter VI. In particular, TMT companies will need to make sure they bolster their structures before reporting under BEPS. They should map their current-state global value chain and prepare a complete overview of their on- and off-balance sheet assets. They should also run a global profit split before any of the taxing authorities do.
Another issue that will arise with the advent of the digital economy is the characterisation of local affiliates as service providers rather than as distributors. This will lead to fewer profits being left in the local countries now that there is no longer the need for physical flows of goods or the holding of physical inventory, such as newspapers, movie tapes, etcetera. Because of this, local affiliates are now changing their function, asset, and risk profiles due to digitalisation. This shift in profiles is expected to lead to controversy, as local tax authorities may argue that the same amount of profits should be left in the local jurisdiction as before, even though the new function, asset, and risk profiles may not warrant the same return.
Along with the shift in profiles will be the elimination of exclusive distribution clauses in contracts with cable and telecom content providers. Traditionally, these clauses have limited the rights of the content providers to stream their content via the internet. Elimination of these clauses will increase streaming access by customers and further erode the video segments on the video providers. As a result, this may increase the value of the content and erode the value of distribution in the value chain. This, too, could lead to controversy with local tax authorities.
Finally, the valuation models for some content will be impacted if there is a long lead time before the content is profitable. Under this scenario, the initial launches are more of an investment, and the return on that investment in the form of profits does not arrive until the reruns begin. This return might not be realised for several years, however, and the legal entity earning the rerun revenue might be different than the entity that paid for the initial development. This will affect valuation models, such as valuation models for platform contribution transaction (PCT) payments.
Each of these areas could give rise to significant controversy in light of the new BEPS rules. Companies in the TMT Industry should be aware of them and plan accordingly.
For the life sciences industry, corporate taxation may matter more than it does to other industries. Given the long product development cycles, companies strive to keep their cost of capital competitive. A quick glance at the list of companies considering or implementing "inversions" would confirm the presence of many life sciences companies. This may be driven by specific factors.
First, life sciences companies can more easily bolt-on products to their existing supply chain and commercial sales and distribution networks. This fact accounts for the high number of uncontrolled licensing arrangements in the industry, as well as significant synergistic savings indicated as a result of acquisitions that are typically the means for "inversions". Life sciences companies deal with significant government regulation and rules regarding how they make their products, how they monitor the safety and efficacy of their products, and how they promote their products. The established regulatory guidelines and industry best-practices combine to allow companies to operate in similar ways. This means that most companies can potentially outsource a significant part of their operations, or quickly hire the talent to scale-up when needed. From the transfer pricing perspective, this depresses the routine returns attributable to functions, but puts an emphasis on the management of capital, and management of the risk for the capital investments, be it for R&D, new product acquisitions, or supporting supply arrangements.
Second, the life sciences industry has historically had one of the lowest levels of indebtedness, ranking in the top quartile of industries in terms of low leverage (CSIMarket). As such, life sciences companies have more to gain from an "inversion", which allows them to generate synthetic debt leverage.
Third, investors and stock analysts focus more keenly on effective the tax rates of life sciences companies than in other industries because the effective tax rate is a major driver of shareholder value and cost of capital.
These factors pressure life sciences companies to align their transfer pricing and operations to minimise their cost of capital, which means deploying their capital from jurisdictions with lower tax rates. This attempt is met with the scrutiny of the tax administrations. Such scrutiny typically comes because of the relatively high profit margins once a product is approved. The life sciences industry has struggled to educate the general public and policy makers on the long product cycles and significant capital commitments needed for the development of new drugs.
Deloitte. 2015. "BEPS update: release of the final package." Pages 15, 26 & 38.
Plunkett, Robert, Bill Yohana, and Brian Green. 2014, "Risk and recharacterisation – Does it make sense in a financial services context," International Tax Review.
OECD/G20 Base Erosion and Profit Shifting Project. Explanatory Statement. 2015 Final Reports.
OECD/G20 Base Erosion and Profit Shifting Project. Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. ACTION 4: 2015 Final Report.
OECD/G20 Base Erosion and Profit Shifting Project. Limiting Base Erosion Involving Interest Deductions and Other Financial Payments. Aligning Transfer Pricing Outcomes with Value Creation. ACTION 8-10: 2015 Final Report.
Principal and transfer pricing leader
Aydin Hayri is a principal and the transfer pricing leader in Deloitte Tax's Greater Washington office. He serves as the life sciences industry leader for the transfer pricing practice, and also manages the Philadelphia transfer pricing practice group. He has been with Deloitte since 1998.
Aydin assists clients with transfer pricing planning involving intellectual property development, cost sharing, and licensing strategies; and planning and implementation of supply chain and business model restructurings. In addition to the life sciences industry, his transfer pricing and tax planning experience covers the defense/aerospace, high-technology manufacturing, and software industries.
Aydin has provided thought leadership by developing and applying China and the Far East sourcing strategies, as well as analysis for manufacturing and distribution risk differences, and adjustments for economic downturns, and developing profit potential analyses for licensing transactions. Aydin recently published a highly accessible book, Transfer Pricing in Action, sharing his experiences in a business novel, case study format.
Before joining Deloitte, Aydin was an assistant professor of economics at Charles University, Prague; the University of Warwick, England; and a research fellow at Princeton University. His primary specialization was industrial organization, with emphasis on the economics of risk, uncertainty, and valuation. He taught courses on this subject, published articles in international journals, and obtained grants from the European Commission, the Economic and Social Research Council, and the World Bank. Aydin still teaches occasional courses for MBA students.
He holds a PhD and MA in economics from Princeton University and a BA in economics from Bogazici University in Istanbul, Turkey.
Principal New York, NY USA
Tel: +1 212 436 5261
Robert Plunkett is the managing principal of Deloitte Tax's transfer pricing group in the East Region. In addition, he leads the firm's Financial Services Transfer Pricing practice.
Rob has served a wide array of the firm's clients, including those involved in banking, investment banking, asset management, insurance, insurance brokerage, private equity, and hedge fund management. In serving these and other clients, Rob has worked on contemporaneous documentation, planning, audit defence, and APAs.
Some of the banking projects on which Rob has worked have involved income and expense allocation among branches for activities ranging from global trading to provision of ancillary/support services. His investment banking experience includes analysis of global trading of derivatives, merger & acquisition activity, loan syndication, and prime brokerage. In global trading transactions, Rob has helped to price the assumption of market risk, the assumption of credit risk, the performance of trading functions, and the provision of sales/marketing services.
He has assisted insurance companies in pricing the transfer of risk among entities, and in allocating income and expense from global placements. He has worked on risk transfers involving both facultative and treaty contracts. He has also worked on developing arm's-length ranges for ceding commissions.
Rob has assisted with the transfer pricing of investment advisory functions for registered investment companies, for alternative investment advisors, and captive investment managers working with insurance companies. Transactions covered include the pricing of advisory functions, subadvisory functions, custody functions, and brokerage functions.
Rob has spent a considerable amount of time in the pricing of intercompany lending, intercompany guarantees, and various intangible assets and intangible asset transfers.
Rob has published numerous articles on transfer pricing and speaks frequently on transfer pricing issues.
He holds a BA in economics from Harvard University and a PhD in economics from UCLA.
New York, NY
Kristine Riisberg is a principal in Deloitte Tax's New York office. She has more than 17 years of transfer pricing and international tax experience with Deloitte, and spent four years in Deloitte's Washington National Tax Office.
Kristine has extensive experience in company financial and quantitative research analysis and industry data analysis in a range of industries. She has prepared economic analyses, documentation, planning, competent authority requests, and cost sharing studies for clients in the following industries: technology, online retailers, media and entertainment, publishing, telecommunications, digital, computer software, semiconductors, oil and gas upstream and field services sectors, power generation and renewable energy, chemical industries, healthcare and medical industry, consumer goods, high-end luxury goods, financial services, commodities, automotive, quick service restaurants, and travel industries.
With her international background and experience working in Deloitte TP teams in Copenhagen and London, Kristine has acquired extensive knowledge of global TP matters. She is the global and US TP industry leader, and the Americas TP leader of the TMT industry programme. She is the global lead tax partner for the world's largest container shipping conglomerate, the global lead TP partner for one of the world's largest online retail companies, and the global lead TP partner for the largest European-headquartered consumer and industrial goods conglomerate.
Kristine has given numerous speeches and presentations at the American Conference Institute, Tax Executives Institute, BNA, Atlas, Thompson Reuters, CITE, Deloitte Dbriefs, and conferences on transfer pricing issues, including recently as:
Kristine also regularly contributes comments and article to leading publications including ITR's Transfer Pricing Industry Guide, Intangible Property Guide and TMT Guide, among others.
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