In this edition: The OECD has released final guidance on the appropriate application of the Transactional Profit Split Method and on implementing the approach to Hard to Value Intangibles; the ECJ found that a transfer pricing adjustment made under Germany's foreign tax act is compatible with EU legislation; Transactions being undertaken in association with U.S. tax reform bring focus to anti-churning rules of Internal Revenue Code § 197; New Zealand's Taxation Bill passed its second reading and will soon become law; the Australian Taxation Office extended the timelines for filing the Australian Local Files for Country-by-Country reporting for taxpayers; and the Australian Taxation Office's Deputy Commissioner spoke at the TP Minds Australia Conference where Duff & Phelps was the Co-Partner.
The OECD Releases New Guidance for the Application of the Transactional Profit Split Method
On June 21, 2018, the OECD released long-awaited final guidance on the appropriate application of the Transactional Profit Split ("TPS") Method and on Implementing the OECD's guidance on Hard to Value Intangibles ("HTVI"). Both pieces of guidance were issued in association with the OECD Base Erosion and Profit Shifting Project (or OECD BEPS Action Plan) that began in 2013 under Action Items 8-10. The OECD had issued several discussion drafts and held multiple public consultations on these matters over several years.
The last draft guidance issued on TPS Method came in July 2017, and this final guidance makes only minor modifications to that guidance.
There had been concerns that the BEPS project might yield guidance which vastly expanded potential applications of the TPS Method – a goal that was clearly being pursued by certain delegates and stakeholders over the course of the BEPS project. This was particularly the case when the first discussion draft related to the TPS Method came out in December of 2014.
The final guidance (which largely makes changes to TPS guidance in Chapter II) takes a considerably more measured approach to the application of the TPS Method than that early draft guidance, stressing that the TPS Method is likely to be most appropriate only when multiple parties make unique and valuable contributions, when business operations are highly integrated so that independent contribution evaluation cannot be meaningfully performed, and/or when multiple parties share the assumption of economically significant risks under the accurately delineated transaction. The final guidance makes clear that the use of external comparables (e.g., as in a comparable profit split approach under U.S. Treas. Reg. § 1.482-6 or the use of routine comparables) is still a valid approach where applicable and available, and the existence of reliable comparable data may make it unlikely that the Transactional Profit Split Method will be the most appropriate method. Furthermore, it stresses that the lack of comparables is not, in isolation, a sufficient condition for applying the TPS Method – a position that had been advocated by certain delegates.
Some of the factors that may yield appropriate TPS Method applications under this guidance (for instance a high level of business integration) may be interpreted differently by different parties and could yield an increase in tax disputes over the appropriate application of profit splits.
The final guidance on profit splits is available here.
The HTVI guidance aims to improve consistency and reduce the risk of economic double taxation by presenting the principles that should underlie the application of the HTVI approach by tax authorities. The HTVI approach refers, generally, to the consideration of information that becomes available after a transaction occurs (i.e. ex-post information) as presumptive evidence about the appropriateness of ex ante pricing arrangements for HTVI. Additionally, the revised guidance addresses the interaction between the HTVI approach and access to Mutual Agreement Procedure ("MAP") under the applicable tax treaty.
The HTVI approach as incorporated into Section D.4 of the OECD Transfer Pricing Guidelines was intended to protect tax authorities from the negative effects of asymmetric information available to them (relative to that available to taxpayers) associated with HTVI. Specifically, the HTVI guidance allows tax administrations to make adjustments to HTVI transaction consideration when the projected income or cash flows used in the original valuation differ significantly from the actual income or cash flows for, but only when certain conditions hold. Those conditions generally relate to the taxpayer's lack of appropriate consideration about what could reasonably be foreseen at the time of the transaction. As a general matter, much of the HTVI guidance hews closely to the U.S. guidance on commensurate-with-income ("CWI") adjustments discussed in U.S. Treas. Reg. § 1.482-4. This recently issued implementation guidance is meant to provide guidance about what should be done when the HTVI approach is applicable given the facts and circumstances. This guidance notes that it would be incorrect to base a revised valuation on the actual results (the approach generally prescribed under the U.S. regulations) without also taking into account the probability, at the time of the transaction, of the actual income or cash flows being achieved. The guidance offered in this final release is fairly broad and does not offer a prescriptive approach to making adjustments. Rather, it raises general principles that should be followed (for instance, consistency of application, refraining from automatic substitution of actual results, etc.) and offers a few examples.
The guidance also recommends that tax authorities apply audit practices that ensure HTVI transactions are identified and acted upon as soon as possible to evaluate the assumptions made by the taxpayer in valuing the intangible. To avoid double taxation and enhance tax certainty in HTVI transactions, the OECD made certain clarifications around Advance Pricing Arrangements ("APAs") and dispute resolution. In cases the transfer of a HTVI is covered by a bilateral or multilateral APA, the HTVI approach is not applicable. In the event that the HTVI approach leads to double taxation, the dispute should be resolved through access to the MAP under the applicable treaty.
This guidance has been incorporated into the OECD Transfer Pricing Guidelines as an annex to Chapter VI.
The final guidance on HTVI implementation is here.
ECJ Upholds Sec 1 of Germany's AstG Against Potential Freedom of Establishment Challenges
In a recent landmark judgement (Hornbach, C-382/16), the ECJ found that a transfer pricing adjustment made under Germany's foreign tax act (Außensteuergesetz, AStG), which only applies to cross-border transactions, is compatible with EU legislation, i.e. does not violate the freedom of establishment. The freedom of establishment allows businesses from any member state of the EU to conduct their business (including setting up subsidiaries) in any other member state without unjustified restrictions. Sec 1 AStG allows the German tax authorities to impose income adjustments on taxpayers if they find that their cross-border transactions with related parties are not conducted at arm's length, but only for cross-border cases. No similar adjustment mechanism would be imposed in certain domestic cases. One such cross-border case, concerning a guarantee given by a German parent to two Dutch subsidiaries at non-arm's length terms, has been brought before a German fiscal court, which in turn referred the case to the ECJ to answer the question whether Sec 1 AStG violates the freedom of establishment.
In line with its earlier jurisprudence (SGI, C-311/08), the ECJ held that Sec 1 AStG is, "[...] in principle a restriction on freedom of establishment, but that it pursues legitimate objectives concerning the need to maintain the balanced allocation of the power to tax between the Member States and that of preventing tax avoidance." However, according to the Court, it is also a requirement that Sec 1 AStG complies with the principle of proportionality. In order to be compliant with this principle (amongst other things), the tax payer must be given the opportunity to provide evidence of any commercial justification.
The ECJ stated that such "commercial justification" can also relate to the parent/subsidiary relationship of the parties involved. This creates some dichotomy, as commercial reasons generally are already being taken into account (as third parties would) when assessing the arm's length nature of an intercompany transaction. However, the ECJ now takes this one step further and explicitly allows "commercial reasons" that are due to the parent/subsidiary relationship to be brought forward in order to explain otherwise non-arm's length pricing. This could be positive for tax payers, as it gives them a potential argument to defend non-arm's length pricing but creates uncertainty in what may be accepted as commercial reasons.
The ECJ did not give any definitive ruling on the case at hand, as to whether the "commercial justification" brought forward by the tax payer is acceptable, and rather referred this question back to the referring Fiscal Court in Germany. This court will now be tasked with interpreting the ECJ judgment and rule over this question from a German perspective.
Overall, the upholding of Sec 1 AStG did not come as a surprise, and should probably be welcomed by taxpayers, given the obvious alternative that the legislation would otherwise very likely be amended to cover domestic transactions as well.
The Court's reasoning on the "commercial justification" may cause some complications in applying the arm's length principle. The Court mentioned not only commercial reasons in line with arm's length pricing which might occur between independent parties, but also justifications that might link to commercial reasons associated with the shareholding relationship (and therefore may result in accepting a non-arm's length transaction). Given that it is a ECJ judgement, it will not only affect German cases, but could potentially have an impact across the EU.
United States: Increased Focus on the Anti-Churning Rules of IRC Section 197
In response to U.S. tax reform implemented through the Tax Cuts and Jobs Act in December 2017, many companies have considered the impact of transferring intangible assets to the United States. One of the issues often involved in this consideration is the amortization treatment of the intangible assets potentially being transferred. This brings into play Internal Revenue Code ("IRC") § 197, which details the amortization deduction rules for many types of intangible assets.
Many taxpayers are increasingly focused on the anti-churning provisions contained in IRC § 197. Generally, these provisions identify intangible assets for which amortization deductions are not allowed and applies to intangible assets which existed prior to August 11, 1993. The specific intangible assets subject to the anti-churning rules of IRC § 197 are goodwill, going concern and other intangible assets such as trademarks and tradenames, which existed prior to August 11, 1993, but which were not amortizable in the context of an asset purchase pursuant to IRC § 1060 or an IRC § 338(h)(10) election. When transferring intangible assets to the United States, these "tainted" section 197 intangible assets must be identified and separated from other section 197 assets, as the tainted section 197 intangible assets will not receive amortization benefits.
The identification of these tainted section 197 intangible assets requires a detailed analysis of intangible assets that exist as of the time of the contemplated transfer and the connections between those intangibles and intangible assets (especially goodwill) in existence in 1993. Valuation techniques and methodologies need to be developed to value the tainted section 197 intangible assets, which can often be complex due to the need to separate the value of the tainted section 197 intangible assets from other intangible property. The outcome of this analysis is often of significant importance to decisions regarding the desirability and feasibility of such property transfers. The Transfer Pricing and Valuation professionals at Duff & Phelps have expertise in providing advice and analysis relating to the identification and valuation of tainted section 197 assets subject to the anti-churning rules. Those wishing to learn more about our offerings in these areas should contact the Duff & Phelps Transfer Pricing leadership team.
Revised Interest Limitation Rules in New Zealand
In May 2018, New Zealand's Taxation (Neutralizing Base Erosion and Profit Shifting) Bill passed its 'second reading' and will soon become law. The legislation applies to income years commencing on or after July 1, 2018 and will amend and/or introduce various provisions of the Income Tax Act 2007 (ITA) and the Tax Administration Act 1994 (TAA).
The Bill in particular includes:
- New interest limitation rules;
- New Permanent Establishment ("PE") rules;
- Various amendments to the Transfer Pricing provisions;
- New Hybrid and branch mismatch rules; and
- Expanded access to offshore information provisions.
Perhaps the most controversial provisions concern new interest limitation rules for inbound finance transactions, which the Inland Revenue (IRD) is, in practice, seeking to also apply to outbound finance transactions even though not statutorily sanctioned.
The key elements include:
- A 'stepped approach' for
determining the applicable credit rating for purposes of
establishing/reviewing the spread, leading to one of the following
assigned credit ratings for the borrower's indebtedness:
- Default credit rating – equivalent to the credit rating that the borrower has for long-term senior unsecured debt or, in the absence of such, the credit rating the borrower would have under an arm's length analysis. This default rating is applicable only if the other potential ratings are neither required nor elected; or
- Restricted credit rating
– the credit rating of a borrower that is controlled
by either a non-resident co-ordinated group or a group acting in
concert is equivalent to the higher of:
- BBB-, or an equivalent rating assigned by a ratings agency;
- the credit rating the borrower would have if its New Zealand Group had a debt percentage below 40%, or its actual debt percentage if below 40%; or
- Group credit rating
– the credit rating of a high BEPS-risk borrower is
equivalent to the higher of:
- the rating of the worldwide group member with the highest level of long-term senior unsecured debt, minus 1 notch (if below BBB+) or 2 notches (if BBB+ or above); or
- the credit rating determined under an arm's length analysis for long-term senior unsecured debt; or
- Optional credit rating – if elected, the credit rating of a borrower is equivalent to the rating on, or the rating corresponding to the interest rate on, existing long-term senior unsecured debt of the borrower or its New Zealand Group with third parties, applicable for up to four times the amount of related party debt.
- An administrative safe harbour, with an interest rate cap, applies to indebtedness below NZD 10m. Also, a related-party loan with the same interest rate as the borrower's foreign parent will generally be accepted.
- Terms and conditions ("exotic" features) that could result in an excessive interest rate are ignored for spread pricing purposes, such as payment in kind, interest payment deferral beyond 12 months, controllable interest rate or principal repayment contingency terms, tenors exceeding 5 years, and subordination, unless the taxpayer can demonstrate equivalent third-party debt featuring such terms and conditions, but subject to complex calculations.
- Covered loans under APAs entered into before July 1, 2018 are 'grandfathered'; however, modifications thereto may alter this.
As noted, the Bill also includes various other provisions concerning the transfer pricing rules, PE avoidance, hybrid structures and administrative laws. These will be discussed in the July 2018 issue of the Duff & Phelps Transfer Pricing Times.
Australia: ATO extends CbC lodgment of Part A to September 14, 2018
The Australian Taxation Office ("ATO") has recently extended the timelines for filing the Australian Local Files for Country-by-Country ("CbC") reporting for taxpayers with year ended December 31, 2017 ("FY 2017") or later.
Originally, the CbC rules requires Australian taxpayers to submit a unique Local File to the ATO each year, and to ensure that ATO will have access to the Master File, either through local submission or the exchange of information framework. However, to avoid duplication in the disclosure of the intercompany transactions in Part A of the Local File and questions on the International Dealings Schedule (IDS), Australian taxpayers may choose to lodge Part A their Local File by the due date of the income tax return. However, the ATO has extended filing date of Part A lodgements to September 14, 2018 for purposes of enabling implementation and testing of software updates.
In the meantime, Australian taxpayers can choose to lodge other sections of the Local File (e.g. Part B and the Short Form) with Part A, or at some other time prior to the due date of the full Local File (12 months after the reporting year-end).
Australia: ATO at TP Minds Conference in Sydney
At the end of May 2018, Duff & Phelps co-sponsored the first Australian TP Minds Conference in Sydney. Among the speakers was the Australian Taxation Office's ("ATO") Deputy Commissioner, International Mr. Mark Konza. Mr. Konza's speech covered a wide-range of issues including the OECD's BEPS project and Australia's role in that project; the significance of risk and how the arm's length principle is evolving based on risk attribution; international cooperation and tax transparency including Australia's involvement in the OECD's International Compliance Assurance Program ("ICAP"); Australia's new BEPS-based anti-avoidance regimes that apply to Significant Global Entities, being the Multinational Anti-Avoidance Laws and Diverted Profits Tax; and the ATO's establishment of its Tax Avoidance Taskforce. He also discussed Australia's advanced pricing agreement program and its mutual agreement procedures. As part of this latter point, he discussed the acceptance by the ATO of arbitration for certain MAP matters starting on July 1, 2019.
In closing, Mr. Konza made the following statements, emphasizing the ATO's ongoing compliance program and warning taxpayers to play fair:
"The Australian Government and its tax office are committed to ensuring that multinational enterprises pay the correct amount of tax under the law. As I hope I have demonstrated, even within a period of rapid change, the Australian Taxation Office has continued to balance a strategy of cooperation with all those seeking to comply with the law and a resolute response to those seeking to not comply.
The transfer pricing landscape has had seismic shifts. Collectively their direction heads towards a transparent alignment of tax outcomes with value creation. For those MNEs who may previously have sought to game the system, there is increasing pressure to get on board and use real substance and real commercial drivers in making their pricing decisions. It is up to those MNEs and their advisers to get with those who have been doing the right thing all along and to get real."
A copy of the speech is available on the ATO's website here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.