Revised OECD TP Guidelines important for all taxpayers involved in Transfer Pricing
Deloitte Belgium Tax Quarterly, Issue 43 - March 2011
On 22 July 2010, the Organisation for Economic Co-operation and Development (OECD) released major revisions of its Transfer Pricing Guidelines.
Chapters I, II and III of the revised OECD Transfer Pricing Guidelines (“revised Guidelines”) have been reworked to reflect practical tax administration and taxpayer’s experience gained over the past 15 years, since the guidelines were last issued. In the revised chapters I through III, the OECD attempted to reach a balance between the business comments requesting more detailed guidance and those concerned with the guidance being too prescriptive.
Over time, concerns arose on the hierarchy of methods as contained in the Guidelines and the explicit treatment of profit methods as a “last resort”. Reflecting taxpayers’ practices over the years, the revised Guidelines have now adopted a “most appropriate method” rule that puts the different transfer pricing methodologies on an equal footing. Furthermore, the revised Guidelines include an extensive discussion of comparability analysis based on countries’ practical experience and provide detailed guidance on what can sometimes become a subjective element in a transfer pricing analysis. While the revisions to Chapters I-III will not cause Belgian transfer pricing rules to be out of sync with the OECD’s overall approach, they will provide relevant guidance on the subject for taxpayers, practitioners and tax authorities.
Also, a new Chapter IX has been added and addresses the transfer pricing issues arising from business restructuring. Business restructuring is defined as the cross border redeployment by a multinational enterprise of functions, assets and/or risks. Importantly, this Chapter provides valuable insights to matters that need to be considered when embarking on a business restructuring project or when considering the transfer pricing outcomes from existing structures.
The Arm’s Length Principle (Chapter I)
Revised Chapter I discusses the arm’s length principle and reaffirms its status as the international transfer pricing standard. Significantly, the revised Guidelines also maintain the OECD’s rejection of global formulary apportionment approaches. The revised Guidelines reiterate the significance of a comparability analysis and the meaning of “comparable”. This Chapter also reformulates the statement that the arm’s length principle is based on the premise that independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that is clearly more attractive.
The existing transfer pricing practice in Belgium largely aligns with the various comparability factors discussed in the revised Guidelines. Still, taxpayers and tax authorities will benefit from the detailed guidance on the relative importance of these factors as discussed in the revised Guidelines.
Transfer Pricing Methods (Chapter II)
The OECD’s TP Guidelines have two categories of transfer pricing methods: the traditional transaction methods and the transactional profit methods. Previously, the OECD advised that the transactional profit methods were a method of last resort, to be used only where there was no or insufficient data available to use one of the traditional transaction methods. The revised Guidelines now state that the selected transfer pricing method should always be the “most appropriate” method for a particular case. Furthermore, the most appropriate method should be selected after considering:
- the strength and weaknesses of each of the recognised methods;
- the nature of the controlled transaction (determined through a functional analysis);
- the availability of reasonable reliable information (particularly on uncontrolled comparables); and
- the degree of comparability of controlled and uncontrolled transactions, including the reliability of comparable adjustments that may be needed to eliminate differences between them, if any.
The revisions also include very detailed guidance as to the application of the transactional profit methods. The revisions discuss many important aspects of the practical application of the two transactional profit methods, including a discussion on the use of the Berry ratio as profit level indicator for a return on functions under the transactional net margin method.
The revised Guidelines confirm formally the current practice where the transactional profit methods are used in the majority of the cases and are no longer last-resort choices. The Belgian tax authorities have always accepted the use of the transactional net margin method (and other profit methods), but this revision can be important in relation to countries that have a dislike of applying profit based methods.
Comparability Analysis (Chapter III)
The revised Guidelines also provide a comprehensive discussion on comparability analysis, which is of extreme importance since it is considered to be at the heart of the application of the arm’s length principle. Chapter III addresses issues such as the process of a comparability analysis, the selection of the tested party, information on the controlled transactions, internal and external comparables and secret comparables, selection / rejection of comparables, and arm’s length range, extreme results or “outliers”, timing issues in comparability and the compliance burden on taxpayers.
The discussion on comparability analysis will be of benefit for taxpayers in Belgium and abroad, since it helps to strengthen the framework to follow in attaining transfer pricing compliance.
New Chapter IX: Transfer Pricing Aspects of Business Restructurings
Chapter IX is organised in four key parts. Part One provides guidance on the allocation of risks between related parties when, as part of a business restructuring, a multinational reallocates risk between various entities. It states that such a reallocation cannot be done without regard to certain principles. First, the contractual allocation of risk between associated enterprises will be respected only to the extent that is has economic substance. Next, the chapter defines and clarifies the concept of “economically significant” risks and further states that a higher risk should be compensated with a higher average return only when the underlying risk is economically significant. Finally, actual conduct should be in sync with the proposed assignment of risk.
The OECD recognises that business restructuring exercises are often prevalent among multinational entities. Accordingly, similar reallocation of functions, assets and risks may not be observed between independent entities. Hence, mere lack of independent entities not having undertaken a restructuring will not translate to a rejection of the restructuring to be non arm’s length.
The allocation of risk between two parties will be deemed reasonable (and possibly acceptable) if risk is bestowed on that entity which has greater control over it. “Control” is defined as the capacity to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider. Moreover, the risk bearing entity should have “the financial capacity to assume the risk”. Examples are provided to better explain and clarify the manner by which a conclusion on control and financial capacity to bear the risk can be determined.
Part Two focuses on the application of the arm’s length principle to the restructuring itself, and provides guidance on when an “exit charge” may be warranted when an entity’s operations are scaled down as part of the restructuring exercise. The concept of “profit potential” is introduced in this context. Profit potential means “expected future profits” (which could include “losses” too) and should not be interpreted as simply the profits / losses that would occur if the pre-restructuring arrangement were to continue indefinitely. The discussion clearly states that no compensation is required for a mere decrease in the expectation of an entity’s profits or that a transfer of profit potential per se does not warrant any compensation. The estimation of any compensation to the restructured entity is intimately linked to the transfer of the functions, assets and risks and the profit potential that may be embedded in such a transfer. This note also discusses whether the restructured entity is entitled to any indemnification charged as a part of the restructuring exercise.
Part Three discusses the application of the Guidelines to post-restructuring arrangements. It reiterates that the Guidelines do not apply differently to post restructuring transactions than to transactions that were structured as such from the beginning. While this may be seen obvious, the subtle implication of this is to account for facts and circumstances that existed prior to the restructuring and how such operations may have an influence on the post restructuring analysis. For example, if a full-fledged distributor is converted into a limited risk distributor as part of a business restructuring exercise, the local presence and relationships should be accounted for while determining the arm’s length compensation for the limited risk distributor. This part also addresses the issue of location savings and asserts that location savings should be attributed among the parties depending on what independent parties would have agreed, and depends on each party’s functions, assets, and risks and on their respective bargaining powers, and in particular on whether or not the relocated activity that gives rise to the locations savings is a highly competitive one.
Part Four discusses important notions regarding exceptional circumstances in which a tax administration may disagree on a transaction or structure adopted by a taxpayer. It highlights and advocates that non-recognition of transactions by tax authorities should not be the norm, but an exception to the general principle. A tax administration’s examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them, using the methods applied by the taxpayer insofar as they are consistent with the Guidelines. The actual transactions can be disregarded when:
- economic substance differs from form; or
- independent enterprises would not have characterised the transaction the same way.
Tax authorities, taxpayers and practitioners all rely on the OECD TP Guidelines in corroborating transfer pricing principles when there is ambiguity in interpretation.
The revised Chapters I-III recognise to a large extent how transfer pricing practice has evolved over the years in terms of applying the arm’s length standard. As such, the revised guidance creates some convergence with many items currently existing Belgian transfer pricing practice. Moreover, it provides taxpayers and tax authorities with some additional and useful insights on how to comply with the arm’s length standard.
The commentary on business restructuring in Chapter IX is important for all multinationals planning or undertaking business restructuring exercise. With the new Chapter IX, the OECD has attempted to reflect a balanced and pragmatic presentation of the most important transfer pricing issues arising in the context of business restructuring. Moreover, the views on the “rightful” allocation of risks, the allocation of location savings and the principles governing transfer pricing analysis when an operation undergoes change will have more generic applicability even when there are no business restructuring exercises being undertaken by the taxpayer per se.