If you ask a tax professional which topic is currently hot in international tax, the odds are high their answer is either “transfer pricing” or “BEPS”. In this short article, we discuss the relation between these two topics.
According to the OECD, BEPS refers to “tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity or to erode tax bases through deductible payments such as interest or royalties” (source).
The literal meaning of BEPS is “Base Erosion and Profit Shifting” and these are two common practices for multinational enterprises (MNEs) to lower their corporate tax bill:
“Base Erosion” refers to the practice of reducing the taxable base. Right, it’s time for an example:
Taco Tony Germany and Taco Tony NL form part of the Taco Tony Group. Taco Tony Germany operates restaurants in Germany, is loss-making and does not pay corporate tax. Taco Tony NL operates restaurants in the Netherlands, is highly profitable and pays corporate tax.
Even though Taco Tony NL has enough cash reserves, Taco Tony Germany grants them a loan with an interest rate that is higher than the market interest rate. Taco Tony NL tax-deducts the interest expenses on the loan, and this reduces the taxable base and, thus, the corporate tax payable.
Taco Tony Germany includes the interest income in its taxable income which increases the taxable base but does not result in the payable of corporate tax. After all, Taco Tony Germany is loss-making! So, on balance the loan transaction has reduced the total tax bill of the Taco Tony Group in the Netherlands and Germany.
“Profit shifting” refers to the practice of shifting taxable profits from high-tax jurisdictions to low-tax jurisdictions. Let’s again look at an example from the website of the tax justice network:
“World Inc. grows a crop in Africa, then harvests and processes it and transports and sells the finished product in the United States. It has three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a zero–tax haven) and USA Inc. (in the U.S.). Africa Inc. sells the produce to Haven Inc. at an artificially low price. So Africa Inc. has artificially low profits – and therefore an artificially low tax bill in Africa. Then Haven Inc. sells the product to USA Inc. at a very high price – almost as high as the final retail price at which USA Inc. sells the processed product. So USA Inc. also has artificially low profits, and an artificially low tax bill in the U.S. But Haven Inc. is different: it has bought cheaply and sold at a very high price, creating very high artificial profits. Yet it is located in a tax haven – so it pays no taxes on those profits. Voila! A tax bill disappears” (source).
BEPS Action on Transfer Pricing
The OECD, G20 and several other international organizations perceived BEPS a major issue in international taxation and it was raised at a G20 meeting in June 2012. Shortly after, the OECD published its first report on BEPS, in which transfer pricing regulation was named as a crucial tool in the battle against BEPS. This was followed by an “Action Plan on BEPS,” published in July 2013, which included 15 Actions to combat BEPS (the Action Plan). The Action Plan includes four actions related to transfer pricing, which we discuss below.
Actions 8,9 and 10
Actions 8,9 and 10 are aimed to “assure that transfer pricing outcomes are in line with value creation.” The background of these actions is that the view of the G20/OECD was that existing transfer pricing guidance could result in outcomes that did not align operational profits with the economic activities which generate them.
Action 8 – Intangibles
Develop rules to prevent BEPS by moving intangibles among group members. This will involve: (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and (iv) updating the guidance on cost contribution arrangements.
Action 9 – Risks and capital
Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. The rules to be developed will also require alignment of returns with value creation. This work will be coordinated with the work on interest expense deductions and other financial payments.
Action 10 – Other high-risk transactions
Develop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to: (i) clarify the circumstances in which transactions can be recharacterized; (ii) clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains; and (iii) provide protection against common types of base eroding payments, such as management fees and head office expenses.
The combined report on Actions 8,9 and 10 contains revised guidance which responds to the issues identified and ensures that transfer pricing rules secure outcomes that better align operational profits with the economic activities which generate them. It also contains guidance on transactions involving cross-border commodity transactions as well as on low value-adding intra-group services. The OECD guidelines have been amended accordingly.
Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNEs provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.
Action 13 contains a three-tiered standardized approach to transfer pricing documentation, including a minimum standard on CBCR. First, the guidance on transfer pricing documentation requires MNEs to provide tax administrations with high-level information regarding their global business operations and transfer pricing policies in a Master File. Second, it requires that detailed transactional transfer pricing documentation be provided in a Local File specific to each country, identifying material related-party transactions, the amounts involved in those transactions, and the company’s analysis of the transfer pricing determinations they have made. Third, large MNEs are required to file a Country-by-Country Report that will provide annually and for each tax jurisdiction in which they do business the amount of revenue, profit before income tax, income tax paid and accrued, and other indicators of economic activity.
Impact of BEPS on Transfer Pricing
The magnitude of the BEPS developments is something not seen before in the area of international tax. Accordingly, transfer pricing rules and practices have changed drastically and below we highlight three key changes:
First change: value creation
Tax authorities more strictly assess whether transfer pricing outcomes are in line with value creation. In other words: do the operational profits align with the economic activities which generate them. This may sound vague for a layman so let’s make it clearer with an example.
Diamond Bag Group sells exclusive designer handbags that only the very rich can afford. The Group’s headquarters are in France and takes care of all corporate functions. The Group has subsidiaries in most European countries which run stores and take care of local sales (EU Cos). The Group also has a subsidiary in the infamous tax haven British Virgin Islands (BVI Co), that owns all the intellectual property (IP) of the Group, such as brands, names, designs etc. The BVI Co does not have employees, rents an office from an external service provider, has two local nominee directors and is not involved in the development, enhancement, maintenance, protection and exploitation of the IP. BVI Co has granted a license to the EU Cos for the use of the IP. In return, the EU Cos pay BVI Co an annual royalty fee and tax-deduct this expense, which lowers their taxable bases. BVI Co does not pay taxes on the royalty fee income.
In IP structure like the one at hand was quite common for MNEs until not so long ago, and in a lot of cases the tax authorities did not have proper tools to challenge it. Following various BEPS reports, especially the Guidance on Transfer Pricing Aspects of Intangibles (the Intangibles Report), tax authorities nowadays have much more ammunition to challenge these types of structures with the argument that “the operational profits do not align with the economic activities which generate them.” For example, it is now widely accepted that legal ownership as such is not enough to allocate revenues of intangible assets.
In short, a legal owner of an intangible will only be entitled to all profits derived from the exploitation of the intangible if he in substance:
- Performs and controls all of the functions related to the development, enhancement, maintenance, protection and exploitation of the intangible.
- Provides all assets, including the funding necessary for the development, enhancement, maintenance, protection and exploitation of the intangible.
- Bears and controls all the risks related to the development, enhancement, maintenance, protection and exploitation of the intangible.
In case the specified functionality is not present, tax authorities can try to adjust the terms and conditions of controlled transactions. These adjustments can be significant, especially when businesses are concerned for which intangible assets are an important value driver, such as luxury fashion brands like the Diamond Bag Group.
Second change – compliance
Second, transfer pricing documentation and compliance requirements are now being implemented or tightened in numerous jurisdictions globally, whereby mostly the OECD three-tiered standardized approach is followed. A consequence of this is that the compliance burden and costs for MNEs are increasing. Another consequence is that tax authorities have secured a fine access to a significant and valuable pool of transfer pricing data. To analyze that pool of data, tax authorities are investing heavily in qualified data professionals and technology. MNEs therefore need to ensure the quality of the data they submit.
Third change – disputes
Last but certainly not least, the number of transfer pricing disputes between MNEs and tax authorities will increase. There more transparency on transfer pricing arrangements of MNEs (as discussed above) and tax authorities have much more “ammunition” to challenge those arrangements. MNEs on their end will not simply accept those challenges and the potential impact to their tax bill.
The logical consequence is more transfer pricing disputes and this can be costly and timely process, especially in cross-border situations where multiple tax authorities are involved. To address this, the OECD is investing in developing tools to ensure an effective (transfer pricing) dispute resolution.
We can imagine that all this BEPS violence is frightening, and this was probably the intention in the first place. But this does not mean that you have no other option than to sit back and wait for the storm to come. Rather, you could look at some of the tips below to manage risks!
1. Examine the transfer pricing position
Transfer pricing arrangements must reflect economic reality, period. Anything else is likely subject to scrutiny by the tax authorities at some point in time. To understand if this is the case you need to ask basic questions like:
- What is the business model?
- Where are the employees based and what are their roles?
- How are the associated enterprises remunerated? Is any of them losing out?
- Which part of the model is likely to be challenged by tax authorities?
- Are there any aggressive positions in the model?
Try to be the devil’s advocate to ensure a critical review of the position. The review probably shows some weaknesses and you can take measures to address those. In many cases, basic things such as improving transfer pricing documentation can significantly reduce exposures.
Let’s look at an example:
Cory Consulting provides tax advisory services in four different locations through associated enterprises Cory Nigeria, Cory Botswana, Cory Namibia and Cory Gambia. The business model of Cory Consulting is simple: sell as many man hours as possible. The associated enterprises operate independently, which means they have their own P&L and employ the employees, who are the only valuable assets. Cory Nigeria is on a roll and wins a massive commission with an oil company which also requires some work in the other three locations. Cory Nigeria signs a contract with the oil company and sub-contracts part of the work to the associated enterprises based on an agreed hourly rate, in line with the rates charged to third parties. There is no transfer pricing policy or documentation.
Is this business model risky in terms of BEPS? It doesn’t seem so. The business model is simple, and the associated enterprises are acting in accordance with the arm’s length principle by charging each other hourly rate in line with the rates charged to third parties. But the issue here is that there is no policy and/or documentation that substantiates the transfer pricing applied. And without this, there is a risk that tax authorities simply take the position that Cory Consulting is engaged in Base Erosion and Profit shifting unless it proves otherwise. This may sound unbelievable, but it is a reality in some countries. The best thing to do in this situation is to prepare a transfer pricing policy and documentation.
2. Understand and manage the Effective Tax Rate
The second tip is to understand and manage the effective tax rate (ETR). The ETR resembles the average rate of tax an enterprise pays over its taxable income. It is a key metric for stakeholders of an MNEs, like investors and tax authorities. An ETR which is out of line with industry standards could be an indication of BEPS and raise questions from stakeholders. It is important to be ahead of such questions by analyzing the ETR, understanding any abnormalities and, where possible, manage the ETR.
This should not be underestimated as in some cases a low ETR has been the starting point of a public discussion about MNEs using transfer pricing to avoiding paying their “fair share” of taxes. A famous example is the low ETR that Starbucks reported in the United Kingdom, for which transfer pricing practices were deemed as the root cause. Politicians and media called it a sham, which led to customers protesting in front of Starbucks shops and even to Starbucks making a voluntary “tax” payment to the UK tax authorities (source).
3. Ensure timely compliance
As a taxpayer, you don’t want to give authorities a stick to hit you with. Non-compliance or a non-timely compliance can result in an audit by the tax authorities. During an audit, tax authorities often request a large amount of information to assess the tax position. This can be costly and time-consuming. Therefore, it is of paramount importance that all local transfer pricing and tax compliance stipulations are met in time. Examples of such compliance requirements are CBCR, but also corporate tax returns.
4. Develop relationship with the tax authorities
It is common sense, but often forgotten: develop (and nourish) a good relationship with the authorities. Until tax collection is fully atomized, if ever, your counterpart at the tax authorities will be a human being. And we as human beings tend to be nicer to the people we know and like. So invest some time to get to know your counterpart(s) at the tax authorities and maintain a good relationship. It also helps you to defend your position better.
We hope you have enjoyed the read. Interested to learn more about transfer pricing, take a look at our transfer pricing course.