On October 2, 2012, TEI filed comments on the OECD's discussion drafts regarding Timing Issues related to transfer pricing, and the proposed revision to the Safe Harbours section of the OECD Transfer Pricing Guidelines. TEI's comments strongly recommended against the Timing Issues draft's apparent approval of the use of hindsight by tax authorities in setting transfer prices, especially in relation to intangible assets. In respect of the Safe Harbours draft, TEI praised the OECD's generally positive approach to the use of safe harbours in setting transfer prices, a change from the prior OECD guidelines, while noting that safe harbours should be optional for taxpayers.
The comments were prepared under the aegis of TEI's European Direct Tax Committee, whose chair is Anna Theeuwes of Shell International B.V. Benjamin R. Shreck, TEI Tax Counsel, serves as liaison to the Committee and coordinated the preparation of the Institute's comments.
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In 2010, the Committee on Fiscal Affairs of the Organisation for Economic Co-operation and Development (OECD) announced a project on the transfer pricing aspects of intangible assets in respect of the OECD’s Transfer Pricing Guidelines (OECD Guidelines). The OECD subsequently published a scoping paper and held three public consultations with interested commentators. On 6 June 2012, the OECD released three discussion drafts setting forth proposed revisions to the OECD Guidelines and recently announced a public consultation on the three drafts, which will be held on 12-14 November 2012. On behalf of Tax Executives Institute, Inc., I am pleased to provide the following comments on the Draft on Timing Issues Relating to Transfer Pricing (Timing Issues Draft) and the Draft regarding proposed revisions of the section on Safe Harbours in Chapter IV of the OECD Guidelines (Safe Harbour Draft).
General Comments on the Timing Issues Draft
The Timing Issues Draft notes that countries have adopted two different approaches to applying the arm’s length principle: (i) the "arm’s length pricing approach," which is based on information available at the time the transaction was undertaken (also called an "ex ante approach") and (ii) the "arm’s length outcome testing approach," which tests the actual outcome of controlled transactions, generally undertaken at the end of the relevant year or when the return is filed (also called an "ex post approach").
As a general matter, TEI recommends that the OECD discourage the use of an ex post or "hindsight" analysis. The pricing determination should be based on information that was known by or reasonably available to the related company at the time the transaction was undertaken. The point of any contract is that the parties agree on specific terms in advance and commit to performing their obligations pursuant to the contract's terms, upon pain of a lawsuit if there is a breach. In contrast, ex post testing suggests that related parties should be free to re-negotiate the contract at any moment or, at least, tax authorities may adjust taxes based on the assumption that the contract may be unilaterally re-negotiated. This is both conceptually and practically unrealistic.
Further, the Timing Issues Draft suggests that the two approaches are contradictory. We disagree. As a general principle, the price (or the price-setting formula) is agreed to by parties in advance, whether the parties are related or unrelated. In our view, an ex post analysis merely tests certain key performance indicators or profit-level indicators against what has been agreed to. This process, however, does not presume the parties would agree on a different price or formula than that previously agreed to if the contract were re-negotiated at the time the testing or tax audit is conducted. The rationale of ex post testing as described paragraph 3.70 of the proposed revisions is not the application of "another" approach to transfer price setting but, rather, the determination of whether the agreed-upon price setting method was applied correctly.
The Timing Issues Draft acknowledges that these differing approaches implicate the nature of guidance that can be provided on situations where valuation of intangibles is highly uncertain at the date of the transaction, as well as situations "in which tax administrations should be permitted to assume the existence of a renegotiation, price adjustment clause, milestone payment, or other risk sharing mechanism within an agreement between controlled parties which does expressly contain such a mechanism." The Timing Issues Draft notes that some countries are "less willing to accept valuation techniques based on financial projections if the Guidelines take a restrictive view of the . . . ability of tax administrations to impute renegotiation clauses or other risk sharing mechanisms to address the uncertainty of the valuation."
It is rarely the case, however, that a contract between unrelated parties will have a "re-valuation" clause addressing circumstances where the parties have gotten the price "wrong." To be sure, many contracts involving the transfer or use of intellectual property (IP) between unrelated parties are contingent on the production or utilisation of the IP, but the price for the IP – even if it is a per transaction or per item amount – is set in advance. That is, contrary to the suggestion in the quoted language, very few contracts will include an "automatic" re-pricing clause that will apply retrospectively where it becomes apparent that one party has gotten the better of a deal.
Independent parties are free to decide whether to transfer a specific item, such as IP rights, from one party to another, or, alternatively, to jointly exploit the item. In the latter case, they may create a joint venture or negotiate a specific risk and profit split agreement. The Timing Issues Draft suggests, however, that tax authorities should have a right to re-characterise buy/sell agreements into joint venture agreements, even if the buy/sell agreements are concluded at arm’s length. In other words, it arrogates to the tax authorities the right to disregard a genuine arm’s length agreement where such agreements are "uncertain" for one of the participants, a situation generally not observed in unrelated party dealings.
For these reasons, the use of hindsight by tax authorities in revaluing or re-pricing the terms of a contract is fundamentally at odds with the arm's length principle. Departing from this principle by applying even a partially ex post documentation or testing requirement imposes additional compliance burdens on taxpayers and increases the risk of double economic taxation and tax litigation for multi-national enterprises (MNEs). If the contractual arrangement does not allow for an ex post adjustment, then there should be no re-characterisation of the contract by tax authorities.
If the revisions to the OECD Guidelines permit a more expansive use of the ex post approach, TEI recommends that the Guidelines explicitly state that tax authorities may not pick the ex ante or ex post approach depending on which method produces the best outcome for the authorities in a particular year, and then switch to the other method when that one becomes more favourable. Instead, if a taxpayer has consistently chosen to use the ex ante method or ex post method (however formulated), tax authorities should not, with the benefit of hindsight, be permitted to choose the other method; they should instead follow the approach used by the taxpayer. That said, one concern with our suggested modifications to an expanded use of the ex post method is that taxpayers will be effectively compelled to conduct both ex ante and ex post analyses, an expensive proposition that could well produce different prices and enable taxing authorities to choose the more favourable one. We urge the OECD to revise the Guidelines in a manner that avoids this situation.
TEI further recommends that any more expansive ex post approach approved in the Guidelines be used only in conjunction with safe harbour rules, and that taxpayers be permitted to select either the safe harbour or the standard arm’s length approach.
Comments on Proposed Revisions in the Timing Issues Draft
The Timing Issues Draft, in addressing the ex ante approach, proposes to add the following sentence to paragraph 3.69: "Where such an approach is followed, pricing determinations should be based on information that was known or reasonably foreseeable by the associated enterprises at the time the transaction was entered into." This is a change from the current language, which states that the associated enterprise need only base its arm’s length price "on information that was reasonably available to them at" the time the transaction was entered into. (Emphasis added.) Thus, there has been a shift from reasonably available information to reasonably foreseeable information.
TEI opposes this change in the standard of information that associated enterprises must take into account. Reasonably foreseeable is a more uncertain and vague standard than reasonably available. If, for example, the price of gold increased for seven straight days, it is in no way "reasonably foreseeable" that it will again increase tomorrow. It could well fall. Comparable uncertainty exists for almost any price in a free market. Further, when a transaction is audited several years after it was negotiated, it is extremely difficult to decide the information that was reasonably foreseeable several years before. For this reason, tax authorities might be expected, by default, to apply an ex post approach and use hindsight to determine foreseeability.
A similar issue arises with the insertion of the following language in the same paragraph: "[Information to be considered includes] information on economic and market changes likely to occur after the time the transaction was undertaken, that could have reasonably been anticipated at the time the transaction was undertaken and that would have affected the pricing that would have been agreed between independent enterprises in similar circumstances." This language misapprehends how business is conducted and may lead tax authorities to construct a model of business based on "ideal" behavior and then seek to tax that model, rather than the actual results.
For these reasons, TEI recommends that these two proposed insertions be stricken from the Draft and the language of paragraph 3.69 revert to its current form.
In relation to the ex post approach, the Draft proposes to insert the following language in paragraph 3.70 "pricing confirmations should be based on information available at the time the tax return is prepared, providing such information is related to the outcome of comparable uncontrolled transactions undertaken at the same time as the controlled transaction . . . ." Regrettably, this proposed requirement does not take into account the practical issues involved in updating information on an ex post basis when filing a tax return.
For example, suppose a transfer price between related parties was negotiated in November 2012 for the year 2013, based on benchmarking studies covering 2008-2010 (because more recent information is not available), and the 2013 tax return is due on 31 December 2014. The proposed language would require a taxpayer, when filing its 2013 return in December 2014, to take into account changes in the comparables data for 2011 and 2012 (and maybe even 2013), and adjust transfer prices accordingly. Such re-pricing, however, would not be undertaken by unrelated parties and constitutes a significant deviation from the arm’s length principle. In addition, this approach would necessitate significant compliance efforts by requiring taxpayers to assemble benchmarking studies other than those used to set the initial price. We therefore recommend striking this insertion and reverting to the current language of paragraph 3.70.
We appreciate that the proposed language may have been prompted by concerns about a situation where a taxpayer has a three-year old comparable uncontrolled price (CUP) of, say, $120 and then just after year-end a new CUP is found at, say, $360. In such a case, a question may then arise of how much, if any, of this new information should be taken into account when assessing the correctness of the transfer price for the year at issue. We note that, while such an example is possible, it is very improbable. There will always be extreme situations, but attempting to address each extreme situation in the Guidelines significantly complicates matters for taxing authorities and taxpayers. Because, under the ex ante approach, the $360 CUP is not available at the time the price was set, tax authorities should respect the arm’s length price in the contract.
In this regard, there may be examples where taxpayers appear to be using hindsight, but in reality are taking into account market conditions and true arm’s length results to validate the initial pricing. For example, certain businesses set their transfer pricing so that a manufacturer earns cost plus a mark-up (say, 5%) and the distributor earns the residual profit. The 5% mark-up is based on a transfer pricing study where the interquartile range of comparable companies was 4% to 6%. At the beginning of each year, the mark-up is reviewed to see what the manufacturer actually earned in the preceding year since it is rare that the mark-up will be exactly 5% as the price was set on budgeted, and not actual, costs. In addition, there may be a year where the actual mark-up earned is outside the 4% to 6% range. Hindsight could be used to require the manufacturer to adjust the price in the prior year so that it falls within the range. This would be administratively burdensome, including, e.g., custom duties adjustments, and moreover would not be acceptable to jurisdictions that do not allow the use of hindsight. Instead, an adjustment is only made if at the end of a three-year period the manufacturer’s mark-up is outside of the prescribed, arm’s length range. Further, at the end of each three-year period another full comparability study is performed to determine a new arm’s length mark-up and adjust the transfer price if necessary.
We believe this example shows that the consistent use of a transfer pricing methodology that allows for a narrow range of transfer prices with some variability between years and is updated every three years to reflect market conditions is a practicable application of the arm’s length standard that avoids the need for yearly transfer pricing adjustments that may not be acceptable to all jurisdictions, potentially resulting in double taxation.
Comments on the Safe Harbour Draft
TEI commends the OECD for its work in creating the Safe Harbour Draft. Many tax authorities currently use safe harbours (also known as simplified tax regimes) and we applaud the OECD for moving away from the previous, generally negative view of safe harbours to a more balanced one. We also welcome the Draft’s focus on using safe harbours for non-entrepreneurial, routine tasks because such an approach will make taxpayer transfer pricing compliance less burdensome.
TEI agrees with the statement in several paragraphs6 that transfer pricing safe harbours should be optional for taxpayers and not be imposed in lieu of the normal, arm’s length approach. Thus, if a taxpayer decides that it is simpler and less expensive to elect a safe harbour for a particular transfer price, the taxpayer should be permitted to choose the safe harbour, but the arm’s length approach should also be available. Concededly there is some potential downside to the use of safe harbours – including the potential loss of tax revenue when taxpayers determine whether to pay the lesser of the safe harbour or arm’s length prices – but we believe any adverse selection will be outweighed by the time, cost, and resource savings for both taxpayers and tax authorities.
Further, since the price set by a safe harbour should be elective for a taxpayer, it should not be treated as a rebuttable presumption of the "correct" arm’s length price by tax authorities. Instead, the price should be treated as an option for a taxpayer to simplify its transfer pricing compliance burden, and the Draft should acknowledge that the true arm’s length price may or may not fall within the safe harbour, depending on the circumstances.
In general, we disagree with the Safe Harbour Draft’s approach of encouraging the use of bilateral memorandums of understanding (MOUs). The bilateral safe harbour MOU approach would complicate rather than simplify the multinational tax system. Monitoring multiple MOUs with different rules and ranges will require continuous supervision of each transaction by the tax department. MNEs that leave their business units free to set prices and then document the arm’s length nature of the transactions will be unable to continue using that practice in a multi-MOU world.
In addition, from a practical point of view, it seems unlikely that tax authorities will extensively use MOUs. Negotiating an MOU will be a complex and time-consuming process, perhaps comparable to the effort required to negotiate bilateral advance pricing agreements or similar competent authority agreements. If few or no Member States use MOUs to set bilateral safe harbours, the credibility of this OECD initiative will be undermined.
We recommend that the Safe Harbour Draft move away from stating that MOUs are the recommended approach and acknowledge that unilateral safe harbours are widely used and will remain the most common form of safe harbour. If tax authorities have the time and resources, entering into a bilateral MOU on safe harbours could be another option.
The Safe Harbour Draft expressly declines to address "tax provisions designed to prevent ‘excessive’ debt in a foreign subsidiary (‘thin capitalisation’ rules)." Since thin capitalisation rules are one of the most commonly used safe harbours, there may not be a need to discuss them in the Draft, but we recommend that the OECD explain why it chose not to include such rules.
If the MOU approach is retained, we note that the Safe Harbour Draft does not discuss or provide a sample MOU for interest rate safe harbours, which are also widely used. In contrast with a thin capitalisation safe harbour, which depending on its form could have significant adverse consequences for MNEs, we believe that an interest rate safe harbour and MOU could benefit taxpayers and tax authorities, and recommend that the OECD develop one.
Regrettably, the Draft does not suggest ranges for the proposed safe harbours in its sample MOUs, but instead leaves these to the Member States to decide. Even if the ranges were bracketed in the Draft’s MOUs, they would provide Members States with rough guidance on what might be the "appropriate" range for certain activities. This would promote uniformity across MOUs, further decreasing transfer pricing compliance costs and disputes.
Finally, the Draft could be improved by providing a list of transactions that are viewed or are recommended to be viewed as possible candidates for a safe harbour. For example, return on sales for low-risk distributors, back office functions, shared services centers, interest rates, low value-added services generally, etc., in addition to those already included in the Draft. This would also promote uniformity across MOUs.
TEI appreciates the opportunity to comment on the OECD’s Discussion Drafts. These comments were prepared under the aegis of TEI’s European Direct Tax Committee, whose Chair is Anna M. L. Theeuwes. If you have any questions about the submission, please contact Ms. Theeuwes at +31 70 377 3199 (or An.M.L.Theeuwes@shell.com) or Benjamin R. Shreck of the Institute’s legal staff, at +1 202 638 5601 (or firstname.lastname@example.org).
1 TEI commented on the OECD discussion draft on the Transfer Pricing Aspects of Intangibles on 21 September 2012.
2 See Timing Issues Draft at 3.
3 Moreover, some regulations (e.g., German Transfer Pricing Administrative Principles 2005) explicitly provide that ex post transfer pricing adjustments are accepted only if the parties have agreed in advance on the principles/rules/formulae of such adjustments.
4 Timing Issues Draft at 3.
5 Id. at 4.
6 See, e.g., Safe Harbour Draft at paragraphs 19, 22, and 35.