Over several decades and in step with the globalisation of the economy, world-wide intra-group trade has grown exponentially. Transfer pricing rules, which are used for tax purposes, are concerned with determining the conditions, including the price, for transactions within a Multinational Enterprise (MNE) group resulting in the allocation of profits to group companies in different countries. The impact of these rules has become more significant for business and tax administrations with the growth in the volume and value of intragroup trade.
A significant step in combating Base Erosion and Profit Shifting
On 5 October 2015, the OECD presented the final package of measures for a comprehensive, coherent and co-ordinated reform of the international tax rules, and these were endorsed by G20 Finance Ministers at their meeting on 8 October, in Lima, Peru. The OECD/G20 Base Erosion and Profit Shifting (BEPS) Project provides governments with solutions for closing the gaps in existing international rules that allow corporate profits to disappear or be artificially shifted to low/no tax environments, where little or no economic activity takes place. Revenue losses from BEPS are conservatively estimated at USD 100-240 billion annually, or anywhere from 4-10% of global corporate income tax (CIT) revenues. Given developing countries’ greater reliance on CIT revenues as a percentage of tax revenue, the impact of BEPS on these countries is particularly significant.
The Need for Change
As the 2013 Action Plan on BEPS identified, the existing international standards for transfer pricing rules needed to change to ensure that transfer pricing outcomes are aligned with value creation and not merely the legal arrangements companies have put in place.
The arm’s length principle is used by countries as the cornerstone of transfer pricing rules. A shared interpretation of the principle by many of those countries is set out in the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter: “Transfer Pricing Guidelines”). The principle requires that transactions between associated enterprises are priced as if the enterprises were independent, operating at arm’s length and engaging in comparable transactions under similar conditions and economic circumstances. Where the conditions of the transaction are different to those between third parties in comparable circumstances, adjustments to the profits may be needed for tax purposes.
The arm’s length principle has proven useful as a practical and balanced standard for tax administrations and taxpayers to evaluate transfer prices between associated enterprises, and to prevent double taxation. However, with its perceived emphasis on contractual allocations of functions, assets and risks, the existing guidance on the application of the principle has also proven vulnerable to manipulation. This manipulation can lead to outcomes which do not correspond to the value created through the underlying economic activity carried out by the members of an MNE group.
The BEPS Actions on Transfer Pricing
In the area of transfer pricing, the guidance on the arm’s length principle has been upgraded to ensure that what dictates results is the economic rather than the paper reality. These are BEPS Actions 8‑10.
- Work under Action 8 looked at transfer pricing issues relating to transactions involving intangibles, since misallocation of the profits generated by valuable intangibles has contributed to base erosion and profit shifting.
- Work under Action 9 considered the contractual allocation of risks, and the resulting allocation of profits to those risks, which may not correspond with the activities actually carried out. Work under Action 9 also addressed the level of returns to funding provided by a capital-rich MNE group member, where those returns do not correspond to the level of activity undertaken by the funding company.
- Work under Action 10 focused on other high-risk areas, including the scope for addressing profit allocations resulting from transactions which are not commercially rational for the individual enterprises concerned (re-characterisation), the scope for targeting the use of transfer pricing methods in a way which results in diverting profits from the most economically important activities of the MNE group, and neutralising the use of certain types of payments between members of the MNE group (such as management fees and head office expenses) to erode the tax base in the absence of alignment with value creation.
The OECD Transfer Pricing Guidelines now contain a clear framework indicating that while contractual arrangements are important and serve as the starting point of any transfer pricing analysis, the arm’s length principle does not and cannot rely on self-serving contracts which do not reflect the conduct of the parties on the ground. The revised guidance provides a framework for analysing risks within a group of companies, clarifies how returns from the exploitation of intangibles or intellectual property (IP) shall be allocated, and contains detailed guidance on the transfer pricing treatment of group synergies, location-savings and local market features, as well as assembled workforce. Recognising that tax administrations are often faced with information asymmetries which exacerbate the difficulties of evaluating transactions involving IP, an approach for hard-to-value intangibles has been devised which, in specific circumstances, would allow tax administrations to use actual outcomes as presumptive evidence about the appropriateness of the pricing arrangements. The guidance also ensures a consistent approach is applied to Cost Contribution Arrangements.
The guidance on transfer pricing is linked in a holistic way with other BEPS Actions. Together, they will ensure that so-called “cash boxes” without any relevant economic activities will not be entitled to any excess profits.
Furthermore, a simplification mechanism has been developed for low-value adding services, and there is new guidance in respect of commodity transactions, two areas of particular relevance to developing countries, and for which their contribution was paramount to understand the concerns and identify the best way to address them. The scope for new and more detailed guidance on the application of transactional profit-split methods for global value chains has been agreed and such guidance will be finalised soon.
Additional Action for Greater Transparency of MNE Operations
In a major step toward greater transparency on MNE operations, the requirements for transfer pricing documentation have also been substantially revised (Action 13). MNEs will be required to submit information regarding their global business operations and transfer pricing policies in a “Master File,” as well as more detailed information regarding relevant related party transactions and the amounts involved in such operations in a “Local file.”
Country-by-country reporting will provide a clear overview of where profits, sales, employees and assets are located and where taxes are paid and accrued. Guidance and tools to ensure a swift and consistent implementation of country-by-country reporting across countries have been developed, to ensure the widest possible dissemination of information among tax administrations, while respecting the agreed safeguards on confidentiality, appropriate use and consistency. The first country-by-country reports are expected to be filed and exchanged in 2017.
Further Information is at the OECD Website: http://www.oecd.org/tax/beps-2015-final-reports.htm