Transfer pricing, the allocation of income or loss between members of a controlled group, (TP) continues to be the critical taxation issue in the cross-border world (international, federal or state), whether in planning, controversy or other purposes. Why is this case? Because the tax consequences of each entity begins with its income or loss posture.
In 2016, there were many areas of evolution:
Overall Turmoil and Uncertainty
In our taxation world, turmoil has become even more apparent in 2016. Countries are actively defining how their domestic tax base can be maximized to provide revenue for economic progress, as multi-national entities (MNEs) are evaluating their effective tax rate planning strategies (ETR Strategic Plans) to address the changing world. This is an epochal process, reflecting a rather stunning transformation from all sides of the table, reflecting the ever-weakening foundation of the tax models implemented just after World War I.
Opportunities for international tax planning are, and always have been, largely a consequence of navigating rules developed by countries for their own purposes (rather than anything MNEs have created on their accord). In the face of the uncertainties existing in the international tax world, all MNEs are, or should be, in the process of reassessing their ETR Strategies.
While there is turmoil, the good news is that adapting the evolving world is a voyage that has been undertaken in many contexts in the past. Learning from that experience should provide a beacon for MNE groups to chart the way forward to cope with the evolving world.
The G-20 Base Erosion and Profit Shifting process (BEPS) is turning toward implementation of many of the final reports issued in late 2015 (an aggregate of almost 1,800 pages). The reports for the TP Actions 8-10 were essentially precatory in nature intended to provide a base for ensuring that transfer pricing outcomes will better align with value creation. Specifically, it is intended that the role of capital-rich, low-functioning entities in BEPS planning will become less relevant.
The TP focus was in the following areas:
- Intangibles: Action 8 addressed the perception that base erosion may have been achieved via misallocation of income from valuable intangibles.
- Risk: Action 9 addressed the role of risk in TP. The central question is whether a party denominated as the risk taker actually has the capacity to manage the exposures and earn income that is allocated to such functions. A related issue involves so-called cash-boxes, in which a capital-rich member of an MNE may be allocated income that is greater than would be the case for the level of activity actually undertaken by such entity.
- Commercially Reasonable Allocations: Action 10 focused on other areas where profit allocations may not reflect commercial rationality. In such cases, it may be appropriate to re-characterize the respective functional responsibilities of the parties to provide for a commercially reasonable allocation. One area is management fees and head office expenses.
- Utilization of Profit-Split Methodologies: As a result of the BEPS process, including Actions 8 through 10 and the CbC requirements, it can be anticipated that tax authorities will make increasing use of profit-split methodologies.
This new guidance will be supplemented.
The initial element of the BEPS process to be adapted in many countries is the so-called “country-by-country” reporting regime (CbCR), which will require virtually all MNE groups to prepare global documentation packages. The purpose of the CbCR process is to provide tax authorities with information needed to make TP and tax base protection determinations in the most efficient manner. Like the TP Actions noted above, it is likely that CbCR will ultimately generate more profit split-type proposed adjustments.
The most recent BEPS-related element is the publication in November of a draft multilateral instrument (MLI), which is intended to implement many of the BEPS Action items in treaty language to prevent having to renegotiate some 3,000 treaties. While consistency is obviously an intended result, the MLI recognizes the reality that many countries will not agree to all of the provisions. Accordingly, countries are allowed to sign the agreement (anticipated deadline in mid-2017), but then opt out of specific provisions or make appropriate reservations with respect to specific treaties. In other words, like the other elements of BEPS, the MLI will be a continuing source of potential turmoil for ETR Strategies.
US Tax Base Defense and Continuing Court Case Losses
The US response to these developments has been interesting. It is unclear whether the US will ultimately support some or all of the BEPS developments, including the MLI. The coming to power of the Trump Administration with an avowed intention to undertake significant tax reform, these issues will remain uncertain for a period of time.
While the IRS has suffered from budget cutbacks, it has responded with an increased focus on TP-related matters, including the development of updated internal strategies to successfully develop cases. At the same time, the Service has continued to suffer stinging defeats in the courts. The most important case in 2016 was Medtronic, Inc. v. Commissioner, TC Memo 2016-112 (2016). See generally Anthansiou, “IRS Acted Arbitarily in Medtronic Transfer Pricing Case,” 2016 TNT 112). A US-based medical technology company had developed the patents and related IP for a series of medical devices, operating in some 120 countries. The case involved licenses granted by parent to its subsidiary authorized to do business in Puerto Rico, which had been the subject of prior periods agreements with an IRS examination team. In the current examination, an adjustment was proposed under Section 367(d) transfer (“commensurate with income” adjustment). The court was critical of the IRS expert’s approaches, ultimately finding the IRS position to be arbitrary, capricious, or unreasonable.
The Service had lost on similar issues in an earlier case (Veritas Software Corp. and Subsidiaries v. Comm’r, 133 TC 297 (2009)).Thereafter, the Services adopted proposed and temporary regulations under Sections 367(d) and 482 seeking to establish its positions in such cases via regulatory action, some portions of which were finalized in late 2016. In this regard, the Service’s action is a rather transparent effort to give credence to the litigating position it lost in Veritas.
The positions asserted by the Service in these types of cases are similar in nature to those asserted by other countries, which the Service is then in the position of defending in Competent Authority, APA, or other contexts.
One focus of BEPS has been the digital economy (which was Action 1). In view of the ever-expanding universe of digital transactions, this is a critical issue from the standpoint of all MNEs and countries. Unfortunately, the various BEPS reports on this subject have merely noted different theories that countries could use to defend their tax bases. In the absence of clear guidance, countries are beginning to consider various means of, including:
- A specific nexus standard applicable to digital presence (i.e., downloading of content)
- Modification of permanent establishment (PE) standards (via expansion of reach or narrowing of exceptions)
- Replacement of PE rules in the digital context with a significant presence test (for example, via customer contact) and a gross basis tax on digital transactions
- Withholding tax
- Consumption tax
- Other forms to be developed
US Tax Reform
As noted, its seems highly likely at this point that there will be material tax reform in 2017 or shortly thereafter, which is likely to produce a material alteration of traditional rules for corporate and international taxation. Any such evolution would certainly add to the turmoil in our international tax world.
Anticipation of Controversy: Focus on Dispute Resolution
In view of these various evolutions, there is broad consensus that governments and MNEs alike can anticipate a continuing surge in tax controversy, certainly involving TP issues. In the cross-border context, the so-called Competent Authority process has been a successful means of resolving such disputes between the few countries with experience in handling the cases. Unfortunately, the vast majority of countries have little or no experience with such processes. In the BEPS process, there has been demand for the use of binding mandatory arbitration to resolve such disputes. Such an approach is roundly rejected by many countries for a variety of reasons, including their experience of tax dispute arbitration in the context of investment treaties.
The United Nations is actively working on a range of alternative dispute resolution mechanisms that would complement the demand for mandatory binding arbitration.
Reevaluation of ETR Strategies
As a result of these various elements, most MNEs are undertaking processes to carefully evaluate and update their ETR Strategies. The working group approaches and checklists developed reflect broad understanding of the potential opportunities in a world of turmoil to develop evolutions that will have materially improved overall results.
To the say the very least, it is an interesting TP world.