No topic in transfer pricing has led to more international discussion and publications than business restructuring. It would be unwise to underestimate the impact of this discussion – including the introduction of Chapter IX of the OECD Transfer Pricing Guidelines on the transfer pricing aspects of business restructurings – on local regulatory and tax audit activities. Indeed, the impact extends to the current discussion on the revision of Chapter VI of the OECD transfer pricing guidelines on intangibles.
Although the internationally available legal precedent on business restructuring primarily addresses the question of a permanent establishment exists (DSM Vitamins case in Spain, Dell in Norway, Zimmer in France, and Boston Scientific in Italy) the potential for exit charges is high on the agenda for both taxpayers and tax authorities.
What does the term "exit charge" mean?
In the context of restructuring a multinational enterprise, it usually refers to a payment made to compensate for the removal of an asset belonging to an entity whose activity in the business is being simplified or reduced. For example, moving from a full-fledged distributor to an "undisclosed agent" of an overseas principal may comprise an exit charge.
Chapter IX of the OECD transfer pricing guidelines notes that in a restructuring, tangible or intangible assets might be transferred away, or valuable business contracts might be terminated or renegotiated (such contracts are also intangible assets). The OECD notes that, between unrelated parties, these transfers might lead to a payment in recompense; which is what is meant by an exit charge.
An exit charge is not justified solely by reason of a reduction in profit earned by an enterprise. There must be evidence that the party held an asset, including valuable contracts; that the party transferred it; and that between unrelated parties payment would have been made for that asset (see paragraphs 9.65 and 9.106 of the OECD transfer pricing guidelines). The first step is to perform a functional analysis to understand what the entity had prior to the restructuring. Identification of actual tangible assets, like equipment, or intangible assets like patents, or valuable contracts is a critical step. Comparing this to the functional analysis post-restructuring will show what remains in the entity and what does not. For each tangible and intangible asset and each valuable contract that is proven to exist before restructuring but does not remain in the entity after restructuring, we must analyse whether:
- The asset has been lost, not transferred. In that case, an exit charge is unlikely to arise;
- It was within the entity's power to retain the asset or contract, but it chose to allow the transfer. In that case, there may be an exit charge based on the value an unrelated party would seek in recompense in similar circumstances;
- Commercial law provides that compensation must always be paid in these circumstances. Thus, an exit charge may be applicable, equivalent to the compensation due in law; and
- The contract under which the entity operates provides for compensation on termination of the arrangement. In that case, an exit charge may arise based on the value provided for in the contract.
Due to the special relationships that exist within an MNE, an additional element of analysis is required in the last two cases. It is very unlikely that the entity would take legal action against a fellow group member, even if in theory that would be possible. Therefore, the absence of a claim to compensation is not accepted for transfer pricing purposes, and the claim to compensation is deemed to have been made and paid. When considering the contractual right to compensation, the actual contract is the starting point but, again due to the special relationship, it is necessary to consider whether those terms are themselves arm's-length in nature.
As part of a business restructuring, it is usual to observe not only changes in the functional and risk profile of the group entities involved, that may give rise to a termination or substantial renegotiation of existing inter-company agreements, but also cross-border transfers of valuable tangible or intangible assets between related group entities.
However, two categories of changes regarding exit charges may be distinguished in practice and in principle. First, changes of the risk profile stipulated by the contractual arrangement between the parties, and second, restructurings that go beyond purely contractual changes and entail changes in the functional profile as well as the allocation of intangibles. We will consider these categories separately with the aid of examples.
Change of risk profile: Conversion of a distributor into a commission agent
Company A is a distributor of finished products manufactured by related company B, located in a jurisdiction other than where A is located. The supply of finished products from B to A is based on a distribution agreement. A sells and delivers the products in its own name and own account, performs marketing, advertising, and invoicing and collection activities, and handles its own inventory. Consequently, A bears the price, volume, inventory, and credit risks associated with these functions, and receives an arm's-length remuneration for these activities.
Besides the customer base, which can be considered a routine intangible of a distribution entity, A does not own any valuable intangible assets. In the context of a group restructuring, the distribution agreement is terminated according to the arm's-length terms of the agreement, and a commission agent agreement is concluded between A and B instead. After the restructuring, A acts as a commission agent on behalf of B and carries out some marketing and advertising activities in addition to sales order contracting. A negotiates and signs the customer sales contracts on behalf of B and issues the invoices in B's name. Title to the goods passes directly from B to the customer. Risks previously borne by A, such as price, credit, and inventory risks, are now borne by B. The profit that A now receives for its agent activities takes into account A's reduced functional and risk profile and complies with the arm's-length principle.
The termination of the existing agreement and the entering into a new, less valuable agreement raises the questions about whether A is entitled to any indemnification under civil or commercial law, and whether the contract provides for compensation on termination of the agreement. If an agreement is terminated in accordance with its contractual terms and the notice period has been observed, a contractual claim generally should not be justified. Conversely, termination of the same agreement without adequate notice would very likely lead to an exit charge based on the indemnification for profits that would have been generated either in the notice period or in the period remaining if the agreement had expired without being terminated (see Kroppen/Silva, General Report, Cahiers de droit fiscal international, Vol. 96a, 2011, p. 28).
The form of the business before restructuring is also important to the question of whether an exit charge will arise. EU countries have country-specific laws granting a statutory right to compensation for the termination of a "commercial agent". This rule typically does not extend to other forms of distributors, because it is based on the logic that an agent builds goodwill in its customer base only for the principal, whereas other forms of distributor are also able to use that customer goodwill for other purposes. This compensation may take the form of either compensation or an indemnity, depending on the law enacted in each country (see Commercial Agents (Council Directive) Regulations 1993). In Germany, statutory compensation for commission agents is laid down in section 89b of the German Commercial Code. Over time, this compensation right granted to agents has been extended to commissionaires and buy-sell distributors, if certain requirements are met. For valuation purposes, the raw compensation (future losses of distributor provisions are determined based on the actual customer base that has been built up by the distribution entity) and the maximum compensation (yearly average provision over the last five years of the commission agent function) must be identified; the lower of those two amounts determines the compensation for the distribution entity (see Achim Roeder and Richard Schmidtke in: Bakker, Anuschka (Ed.) Transfer Pricing and Business Restructuring, IBFD 2009, p.285).
Would it be possible to extend this right to compensation under section 89b to other forms of distributor?
Only in very limited circumstances. A compensation claim under civil or commercial law for termination of a non-agent distributor relationship should be possible only if the distributor faces a loss of access to the customer base in the same way an agent would face. In the case at hand, the agreement between A and B is terminated but the distribution activities continue, though on a different contractual basis. The distributor continued to sell to the same customers; hence, it was not deprived (by the contract) of the benefit of access to that customer base in its business. In these circumstances, it seems likely that no compensation could be claimed by extension of section 89b.
Tax authorities in some jurisdictions may take the view that marketing or other self-created intangibles have been transferred from A to B, which could lead to an exit charge. In France, for instance, it could be argued that the conversion from a distributor to a commission agent amounts to a formal transfer of clientele, triggering a potential capital gain and the application of registration duties to the value of the clientele transferred (see Leclercq/Seroin, France, Cahiers de droit fiscal international, Vol. 96a, 2011, p. 344). From a Dutch point of view, if it appears that a transfer of the customer list has taken place, it may be deemed a transfer of an intangible asset that must be properly valued (see De Looze/Verweij, Netherlands, Cahiers de droit fiscal international, Vol. 96a, 2011, p. 525).
If there is no compensation right, under civil or commercial law, one must ask how third parties would behave under comparable circumstances. The change in profit potential in itself does not justify a compensation payment under the arm's-length principle (paragraph 9.65). Considering the example above, the higher and possibly more volatile profits related to A's former distribution activities, which also entailed greater risks, have been replaced by a lower and more stable return.
From an economic point of view, this should not be subject to compensation, as the net present values of the income streams should be the same before and after the business restructuring when considering risk-adjusted interest rates (see Kroppen/Silva, General Report, Cahiers de droit fiscal international, Vol. 96a, 2011, p. 19). Further, it could be argued that the reduction of A's risk position has already been compensated by the shift of profit potential from company A to B, which in turn renders additional compensation unnecessary.
Finally, the conversion from distributor to commission agent may also lead to the transfer of tangible assets (for instance, inventories owned by A before the restructuring), that must be priced at arm's-length.
Change of functions: Substitution of a specific product during its life cycle
Company C produces and sells Product 1 in its local market. C has developed a successor product to Product 1. Because Product 1 is outdated in C's market, it will be withdrawn from C's product portfolio and no longer distributed in C's market. Nevertheless, for related entity D – located in a jurisdiction other than where C is located – Product 1 has a value and might be successfully sold in D's market. Therefore, C licenses all product know-how related to Product 1 to D, and thereby grants D the right to produce Product 1 and to sell it in its own market. C ceases the production of Product 1 and starts the production of the successor product. C's turnover, profits, and employees remain unchanged. By taking over the production and sales of Product 1, D has increased its profit.
In this example, it is questionable whether C has solely granted a license to D or has also transferred profit potential or business opportunities to D that might entail an exit charge. Therefore, it is necessary to analyse whether profit potentials or business opportunities are "valuable intangible assets" under local regulations and so might be subject to a compensation payment.
The majority of European countries do not have specific provisions regarding the substitution or discontinuation of a specific product. Thus, the example detailed above should be considered as being compliant with the arm's-length principle, provided D pays arm's-length compensation for the use of the old technology.
The rules are different in Germany, where this same transaction would be deemed a transfer of functions under section 1(3) of the Foreign Tax Code. If a business restructuring qualifies as a transfer of function, a transfer package must be determined, which is defined as a combination of a function and its associated risks and opportunities, as well as the assets and benefits that the transferring entity (C in this case) transfers or concedes to the receiving entity (D). Thus, German regulations require a valuation of the transferred profit potential as a whole, considering the perspective of both the transferring entity as well as the receiving entities.
A similar two-sided concept may be inferred from the discussion draft of chapter VI of the OECD transfer pricing guidelines (paragraph 6.148). In fact, most countries in Europe, including Austria, Denmark, France, Italy, Spain, and the UK, require the transfer of an intangible asset to trigger some form of exit charge, that is, the arm's-length compensation for making such asset permanently or temporarily available to the related party. The difference, compared to Germany, is that there is no deemed transfer package and so the question is whether there has been a transfer of assets, and the valuation of that transfer is driven only by the arm's-length standard.
For an exit charge to apply in an arm's-length situation, related taxpayers will have to voluntarily transfer away, or waive, their existing property (tangible and intangible) rights. These may include indemnification rights under the law, a contract, or more often ownership or usage rights for intangible property.
A mere change in profitability will not, of itself, justify an exit charge. However, the change in profitability may be informative in determining the value of an exit charge, should one apply. The amount of the exit charge will rarely equate the full amount of the fall in profits; for example, a license terminated by the licensor in accordance with arm's-length terms does not deprive the licensee of any asset at all, but it does result in a fall in profits for the licensee.
Partner, Global Transfer Pricing Team
John Henshall is a partner in Deloitte's Global Transfer Pricing group based in London and global colead for Business Model Optimisation (BMO) services. He specialises in BMO and intellectual property (IP) transfer pricing, which are significant value drivers for professional service providers. This work often leads to advance pricing agreements, tax audit defence work, or competent authority claims.
Training initially with the UK Inland Revenue, Mr Henshall became a Deloitte UK partner in 2001. He began transfer pricing work in 1991 and has been involved with transfer pricing on a full-time basis for more than 10 years.
Mr Henshall has been consulted by overseas governments concerning the modernisation of their approach to international taxation and transfer pricing. He participated as a delegate to the November 2011 meeting of the OECD Working Party 6, which addressed the update of Chapter VI of the OECD transfer pricing guidelines. Mr Henshall also participated in the OECD's recent public consultation on the discussion draft regarding the transfer pricing treatment of intangibles.
Mr Henshall lectures on supply chain reorganisations and the transfer pricing of intangibles, both to industry and to tax authorities, and he is regularly published in international and transfer pricing journals, including Practical US/International Tax Strategies, Tax Planning International: Transfer Pricing, and the Tax Journal.
Achim Roeder is a partner in the Transfer Pricing Practice of Deloitte Touche Tohmatsu's German member firm and heads Deloitte's regional Europe, Middle East, and Africa transfer pricing practice. He has more than 16 years of experience in international taxation and transfer pricing.
Mr Roeder has advised leading multinationals in various industries. His projects include transfer pricing planning in respect of European supply chain reorganisations, as well as transfer pricing documentation and German audit defense.
Before joining Deloitte, Mr Roeder acquired experience working in management consulting. This experience is supplemented by his extensive work in research projects in accounting and audit-related issues, as well as in corporate finance and the financial services industry.
Mr Roeder lectures on international tax law at the University of Bochum and is a frequent speaker at international conferences. His publications include a volume on the economics of anti-avoidance legislation in international German tax law, a commentary on Chapter VI of the OECD Guidelines (Special Considerations on Intangible Property), as well as a number of publications covering a broad range of business and economic topics.
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