The OECD embarked on a project to look at base erosion and profit shifting following discussions with the G20 in spring 2012 and released their first report on February 12 2013. This report is a first substantive step with respect to the review and analysis of base erosion and profit shifting and basically serves as a background document to set the scene for further work to be done by the OECD.
In the author's view, the OECD has created a balanced report providing insight from the perspective of the various stakeholders. The report represents an advancement of previous trends, particularly in relation to transfer pricing and intangibles with potentially some out-of-the-box developments in the digital economy. However, what seems really new is drawing together multiple strands of activity in a more holistic approach.
In summary, the report describes studies and data available in the public domain relating to the existence and magnitude of base erosion and profit shifting; global developments in business practice and their impact on corporate taxation; and examines the key principles underlying the taxation of cross-border activities followed by how this, in the view of the OECD, creates BEPS opportunities.
The BEPS report identifies six key pressure areas for further work, namely:
- International mismatches in entity and instrument characterisation;
- Application of treaty concepts to profits derived from the delivery of digital goods and services;
- Tax treatment of related-party debt financing, captive insurance, and other intra-group financial transactions;
- Transfer pricing, particularly in relation to shifting of risks and intangibles, artificial splitting of ownership of assets between legal entities, and transactions between related party entities that would rarely take place between independent entities;
- Effectiveness of anti-avoidance measures, in particular GAARs, CFC regimes, thin capitalisation rules, and rules to prevent tax treaty abuse; and
- Availability of harmful preferential regimes.
Some of these key pressure areas were already identified in earlier OECD work on aggressive tax planning and some are being examined elsewhere in the OECD. The OECD Working Party No 6, for example, is already examining transfer pricing and intangibles. In the report, the OECD comes to the conclusion that some of the pressure areas follow from the fact that the international tax standards may not have kept pace with the changes in global business practices.
The OECD is now working on an action plan that will be approved by the Committee on Fiscal Affairs in June and then will be released publicly sometime in July. The OECD's work, in developing this action plan, and then in taking that action plan forward, has been divided into three clusters and those three areas will be pursued in parallel. One of the main clusters is transfer pricing and that work is being chaired by the UK. The second cluster is jurisdiction to tax and that area is being chaired by France and the US jointly. The last cluster is effectively everything else related to countering base erosion, and that area of the work is being chaired by Germany.
It is also important to note that non-OECD member countries, such as India and China, will be invited to contribute to the action plan. This is in line with the general strategy of the OECD to include emerging countries in the debate.
Specific transfer pricing issues in the BEPS report
The BEPS report explicitly identifies transfer pricing as one of the key pressure areas: "Transfer pricing, particularly in relation to shifting of risks and intangibles, artificial splitting of ownership of assets between legal entities, and transactions between related party entities that would rarely take place between independent entities."
The report indicates that in today's multinationals (MNEs) the individual group companies undertake their activities within a framework of group policies and strategies that are set by the group as a whole. The separate legal entities forming the group operate as a single integrated enterprise following an overall business strategy. Management personnel may be geographically dispersed rather than being located in a single central location, with reporting lines and decision-making processes going beyond the legal structure of the MNE. The report also indicates that the international standards should be able to deal with such developments.
The report mentions that arrangements relating to risk-shifting raise a number of difficult transfer pricing issues. At a fundamental level they raise the question of how risk is actually distributed among the members of a multinational group and whether transfer pricing rules should easily accept contractual allocations of risk. They also raise issues related to the level of economic substance required to respect contractual allocations of risk, including questions regarding the managerial capacity to control risks and the financial capacity to bear risks. Finally, the question arises as to whether any indemnification payment should be made when risk is shifted between group members. It is interesting to see that the questions the report raises are similar to the ones raised in the business restructuring project, which led to the introduction of chapter IX of the OECD transfer pricing guidelines in 2010. It almost seems that the OECD is reopening the discussion on these fundamental issues. It may well be that the only recently introduced guidance on risk allocation and control is perceived as not giving enough practical guidance, or that the existing guidance is leading to unwanted outcomes. As the report phrases it: "In summary, the Guidelines are perceived by some as putting too much emphasis on legal structures (as reflected, for example, in contractual risk allocations) rather than on the underlying reality of the economically integrated group, which may contribute to BEPS."
The BEPS report also mentions work on documentation requirements. Until now documentation requirements were a domestic issue. The OECD transfer pricing guidelines only describe best practices but no standardised global requirements. The report says work will be done on documentation, including such global requirements. According to the report, the documentation should be such that tax authorities will be provided with the full picture of business operations worldwide.
Possible direction of BEPS future work: a look into the crystal ball
Although it is hard to predict the direction of the future transfer pricing work of the OECD in view of BEPS, let us take a look into the crystal ball.
At first sight, introduction of a system of formulary apportionment, like the proposed Common Consolidated Corporate Tax Base (CCCTB) in the EU, may seem an alternative to the arm's-length principle, potentially solving some of the issues described above. However, I believe the OECD will not move in this direction. In the 2010 update of chapter I of the transfer pricing guidelines, the OECD member countries reiterated their support for the consensus on the use of the arm's-length principle, and rejected global formulary apportionment. Members of the OECD Centre for Tax Policy and Administration (CTPA) recently expressed their support for the underlying principles of transfer pricing. Finally, the experience with the CCCTB has shown that it will be hard to convince countries to implement such a system.
Insight into the full value chain
The 2010 update of chapter III of the transfer pricing guidelines already made clear that sometimes information on the non-tested party is needed for a transfer pricing analysis. The report is going beyond that. Besides referring to global documentation requirements, according to the report, the documentation should be such that tax authorities will be provided with the full picture of business operations worldwide. This seems to imply that full insight into the total value chain should be provided to all countries involved. Such transparency would be close to (public) country-by-country reporting, as was recently suggested by France in the EU, and supported by The Netherlands. This may well lead to increased enquiries by some tax authorities. Should the OECD move to such a value chain overview, this effect should be taken into consideration.
The report mentions financing as a possible area for future work, but it does not explicitly mention this as a transfer pricing topic. At the same time, in the current project on the revision of chapter VI on intangibles, it is clear that the funding component, when determining the profit allocation, is a very relevant component. It is also clear that the OECD countries have not reached a consensus yet on the remuneration of funding in relation to the new concept of intangible-related returns. Some 10 years ago, Working Party No 6 embarked on a project on cross border financial dealings. It was acknowledged that this was an important project, but the OECD Secretariat also indicated it was difficult to reach consensus. In the end, no official publications came out of this project. One element of the project was the definition of an arm's-length amount of debt. Given the holistic approach proposed in the report it may well be that the OECD will start looking at arm's-length allocation of debt and equity to an entity again. Should this be the case, it would seem like a further move towards the approach followed in the application of article 7, in which risks follow functions and capital follows risks.
Location specific advantages: Use of markets
According to the report, international tax 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. As an example it is mentioned that today it is possible to be heavily involved in the economic life of another country, for example, by doing business with customers located in that country via the internet, without having a taxable presence there or in another country that levies tax on profits. There is no clear indication that this perceived divergence between the international tax standards and the global business models will trigger changes in the transfer pricing rules. From the report, it is clear that an important element of future work will be the finalisation of the project on intangibles. The question comes up about whether the OECD will move in the direction already taken by China and India, as described in the UN manual on transfer pricing. China and India are of the view that their countries have unique economic and geographic factors which (should) contribute to the profitability of their taxpayers. It is a short step to arguing that making use of a market as such should lead to taxation. It is interesting to note that during a press conference on May 30 2013, the director of the CTPA, Pascal Saint-Amans, indicated that the digital economy may be a good case study for international tax policy and BEPS.
Hypothetical third-party behaviour
The report states that the transfer pricing guidelines are perceived by some as putting too much emphasis on legal structures, rather than on the underlying reality of the economically integrated group. The report explicitly refers to "the transactions between related parties that rarely would take place between independent parties". In the current transfer pricing guidance, it is accepted that associated enterprises may engage in transactions that independent enterprises would not undertake. The mere fact that a transaction may not be found between independent parties does not of itself mean that it is not arm's-length. Part of the broader reflection on transfer pricing may be moving more towards a hypothetical third party analysis. Departing from contractual reality and putting more emphasis on hypothetical third party behavior would also mean a move in the direction where risks follow functions.
Suggestions and recommendations
Should the OECD follow the directions described above, I would like to make the following general suggestions and recommendations.
Increasing the importance of third party behaviour, and of economic substance, rather than referring to comparable transactions between third parties and legal contracts, will inevitably increase the uncertainty for both tax administrations and taxpayers, potentially leading to more controversy and double taxation. Hence, it is very important that the OECD transfer pricing guidelines contain a robust framework for analysing a transaction from a transfer pricing perspective. Any changes should not undermine the predictability of the rules, and vague concepts should be avoided.
Dispute resolution and resolving double taxation
In 2008, the guidance on dispute resolution was updated. Notwithstanding this update, the current practice with regard to advance pricing agreements (APAs) and mutual agreement procedures (MAPs) can be improved, which also follows from the increasing number of cases pending in the various countries. The importance of such mechanisms will only increase where significant changes in transfer pricing guidelines are adopted. Potential adjustments based on the non-alignment of contracts and functions in practice are often perceived as re-characterisation, and may be considered to be an application of anti-avoidance measures. Some countries do not allow access to double tax treaties in cases of anti-avoidance, which could lead to double taxation. Traditional adjustments of the transfer price are leading to MAPs with regard to one specific year. Diverging views with regard to risk allocation, and the consequences of the risk allocation, can lead to discussions relating to various years: the discussion on the risk allocation in the year the transaction itself takes place, and a discussion in the later year in which the risk crystallises. This may also lead to practical problems in the application of MAPs. Hence, where significant changes are implemented, it is recommended that the OECD also pays attention to double taxation mechanisms. In my view, both the theoretical and the practical aspects of dispute resolution may well be part of the simplification project.
OECD's Working Party No 6 has already started a project on the simplification of the transfer pricing rules. A first outcome of this was the publication of a revised chapter IV on the application of safe harbours in May 2013. OECD's CTPA has repeatedly expressed the importance of simplification, both for developed and developing countries. In combination with the global documentation requirements, referred to above, it may well be that this will lead to a streamlined documentation requirement, making the current statement on proportionality of the documentation more concrete, and providing more guidance on the level of detail of information needed for standard transactions and for more complex transactions. To maintain the arm's-length standard and the acceptance of it by tax authorities and taxpayers all over the world, in particular in developing countries, it is very important that any changes in the transfer pricing guidelines do not increase the complexity of the existing rules.
At the recent annual OECD conference, which took place on June 3 and 4, it was noted that plans for transfer pricing work in the BEPS project are still under development but there will be a substantial transfer pricing component in the action plan to be released in July. The OECD reiterated that, with respect to the issue of transfer pricing, the focus should be on those areas where refinements could be made to address the most difficult questions and not on a wholesale reconsideration of core transfer pricing principles.
It will be important for companies to carefully review the action plan when it is released by the OECD next month and to evaluate the implications for their business models of the areas that are being targeted for potential change. At the same time companies should consider becoming part of the global tax dialogue on the international tax issues that are of greatest significance to them by engaging with the OECD and with tax policymakers in the countries where they operate.
Ronald van den Brekel
Ernst & Young
Tel: +31 88 407 9016
Ronald van den Brekel, Partner, Transfer Pricing & Tax Effective Supply Chain Management with Ernst & Young in The Netherlands.
The views reflected in this article are the views of the author and do not necessarily reflect the views of the global Ernst & Young organisation or its member firms.