Transfer Pricing Aspects of BEPS. Introduction. Ronan Finn Transfer Pricing Partner, PwC Ally McCaffrey Transfer Pricing Manager, PwC

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1 74 Transfer Pricing Aspects of BEPS Ronan Finn Transfer Pricing Partner, PwC Ally McCaffrey Transfer Pricing Manager, PwC Introduction In July 2013, in response to political and economic pressures, and a growing climate of austerity and focus on the contribution from business, the Organisation for Economic Co-operation and Development (OECD) issued its Action Plan on Base Erosion and Profit Shifting (BEPS). The Action Plan, which was drafted with the participation of its Member States and endorsed by the G20 leaders, sought to address the perceived flaws in the international tax rules that the OECD had identified, with the key focus being to: improve the interaction of domestic tax systems to prevent non-taxation of arrangements, address situations where profits of multinational enterprises (MNEs) are divorced from activities and are moved to locations to be subject to a more favourable tax regime and increase the transparency of MNEs activities for tax administrations. The Action Plan contained 15 separate work streams, some of which were further split into specific actions or outputs, with

2 2015 Number 4 75 a timeline of 12 to 24 months for completion. In the last two years the OECD has produced a number of draft outputs, sought feedback and consulted with business, tax administrations and other key stakeholders. On 5 October 2015, the OECD presented its final package of measures for a comprehensive, coherent and coordinated reform of the international tax rules. The package consisted of 13 separate papers and was endorsed by the G20 Finance Ministers at their meeting on 8 October in Lima, Peru. With the BEPS reports finalised, it has been agreed that certain follow-on actions will take place during The primary focus of 2016 and beyond will be on the implementation and monitoring of the agreed Actions. This article looks at some of the key developments in the BEPS project that relate specifically to transfer pricing (TP), namely: Action 7: Artificial avoidance of permanent establishment (PE) status, Actions 8, 9 and 10: Alignment of TP outcomes with value creation, and Action 13: TP documentation and country-by-country reporting (CbCR). It comments on the key changes introduced by the final set of TP-specific reports and highlights some of the impacts for both MNEs and tax administrations. Overall, it is clear that the BEPS initiative is one of the biggest game-changers in international tax policy in recent times. The impact of the Action Plan will fundamentally change the way multinational organisations engage in international business, related-party dealings and business restructurings. Artificial Avoidance of PE Status The PE threshold test as set out in the OECD Model Tax Treaty, which has been reflected in many countries domestic tax laws and double taxation treaties, defines when a business has sufficient activity in another territory to create a taxable presence (i.e. a PE) in that other territory. Broadly, under the current test in the Model Treaty a PE can be triggered: where an enterprise operates a fixed place of business in another territory, or where a person acting on behalf of an enterprise has, and habitually exercises, an authority to conclude contracts on behalf of that enterprise ( dependent-agent rule ). This is supplemented by a number of exemptions outlining specific activities that will not trigger a PE. The OECD identified that some MNEs have structured their activities overseas to avoid triggering a PE in foreign territories. In line with the general theme of the BEPS Action Plan to align value creation and substance to profitability and taxation, the OECD has made a number of changes to the current test, with an increased focus on the substance and the reality of the international arrangements entered into by MNEs in the current business environment. These include; An extension to the scope of the dependent-agent rule such that where the activities of an intermediary (such as a commissionaire) result in the conduct of agency activities that involve concluding contracts or playing the principal role leading to the conclusion of contracts that are routinely concluded without material modification [by the principal], the foreign enterprise should be considered to have a taxable presence in the intermediary s country (save in limited circumstances). A restriction of the specific-activity exemptions to include only activities that are of a preparatory or auxiliary character, to prevent businesses relying on these exemptions when the activities may be a core activity for their business. The final guidelines include a number of examples, such as: where an enterprise of State R maintains in State S a very large warehouse in which a significant number of employees work for the main purpose of storing and delivering goods owned by the enterprise that the enterprise sells online to customers in State S, [the exemption] will not apply to that warehouse since the storage and delivery activities that are performed through that warehouse, which represents an important asset and requires a number of employees, constitute an essential part of the enterprise s sale/distribution business and do not have, therefore, a preparatory or auxiliary character. Therefore, a large warehouse used for the storage and delivery of goods for an online business, which previously may not have created a PE, would under the proposed changes be likely to fail the preparatory or auxiliary test and to create a PE. Inclusion of anti-avoidance rules to prevent the artificial fragmentation of business activities in an attempt to benefit from the specific-activity exemptions set out above.

3 76 A multilateral instrument, announced through the BEPS Action Plan, will effectively be used as a means to implement these changes, as opposed to requiring individual changes to the tax treaties of each territory. It is proposed that this instrument will be ready for signature by the end of One area that was not addressed in Action 7 is the question of the attribution of profit to a PE. The OECD has committed to discussing and addressing this issue during The changes will have a significant impact on the taxation of existing business processes and arrangements, effectively lowering the threshold for a PE in certain areas and leading to a greater shift towards source-based taxation. The guidance on the PE test is somewhat foggy, probably because of the last-minute nature of some of the changes. Therefore, the OECD has indicated that the guidance will be reviewed in Finally, the speed with which the new measures are implemented in existing bilateral tax treaties will be heavily dependent upon the success, or otherwise, of the proposed multilateral instrument that the OECD has reported can be applied without any obvious technical barriers, although practical issues may be of more concern. Align TP Outcomes with Value Creation One of the primary aims of the BEPS project from the perspective of transfer pricing is to ensure that TP outcomes are in line with value creation, and three action items in particular sought to achieve this objective. Action 8: Transfer pricing aspects of intangibles The OECD identified that intangible property (IP) was a significant value-driver in many businesses and therefore set out to revise specific guidelines that were in place in relation to the transfer pricing aspects of IP. This work began in 2012 (before the BEPS Action Plan), and in September 2014 revised guidance on the TP aspects of IP was released. The overall aim of the revisions was to ensure the appropriate allocation of profits in accordance with value creation. Increased focus on substance was the underlying theme. Historically, legal ownership and funding of research and development often equated to earning the returns attributable to IP. Going forward, there will be greater emphasis on the substance of the arrangements. Returns from IP should accrue to the entities that carry out the development, enhancement, maintenance, protection and exploitation functions, and not necessarily the legal owner of the IP. Special measures for transfers of hard-to-value intangibles (which have not yet been finalised) and revised guidance to introduce changes to cost contribution arrangements (CCAs) have also been introduced to bring the guidance in these areas in line with revised guidance on TP aspects of intangibles and the treatment of risk and capital (outlined below). CCA participants must have the capability and authority to control risks associated with the risk-bearing opportunity. Current contributions can be valued at cost, but pre-existing contributions should be valued under the guidance of Chapters I, II and VI of the OECD TP Guidelines. Action 9: TP and risk and capital The OECD sought to develop rules that would prevent the erosion of the tax base via the contractual allocation of risk among group members. The OECD has moved to ensure that the substance and form of the transactions align. The return for risk should be accredited to the party that controls the risk and that has the financial capacity to assume it. To help tax administrations and MNEs to assess the treatment of risk from a TP perspective, the OECD provided a six-step analytical framework on the treatment of risk. Significant emphasis will now be placed on the decision-making process in assessing a party s control over risk. As part of this action item, the OECD also targeted the treatment of cash-box entities, which can be broadly defined as capital-rich entities which perform few economic activities. Under the new guidance, a cash-box entity that is not exercising control over the financial risk should be entitled to receive/retain no more than a risk-adjusted rate of return for the funding itself. Action 10: TP and other high-risk transactions The OECD also sought to introduce rules to prevent base erosion by engaging in transactions that would not realistically occur between third parties. In this regard, the OECD clarified the use of specific TP methods (emphasis has been placed on the use of profit splits) and the guidelines around the use of head-office or management charges to erode a company s taxable base. A safe harbour of 5% has been established for low-value-adding intra-group services.

4 2015 Number 4 77 The guidelines in relation to aligning TP outcomes with value creation place a significant amount of emphasis on the substantive (as opposed to the contractual) analysis underpinning an MNE s economic behaviour in the context of the entire value chain. Although contractual terms form the starting point of a TP analysis, a transaction may be disregarded if it does not have the fundamental economic attributes of arrangements between unrelated parties and the substance of the transaction is not aligned to form. More detailed analysis and documentation will therefore be required in the future, particularly around the functions undertaken, assets used (e.g. funding) and risks assumed (including the mitigation of those risks) from a transfer pricing perspective. The decision-making process, particularly with respect to risk, will be a primary focus of documentation going forward, and so too will the alternative options realistically available to the parties. TP Documentation and CbCR The final report issued by the OECD in relation to TP documentation provides a more coherent and consistent framework under which MNEs should prepare global TP documentation, while simultaneously improving the ability of tax authorities to make better-informed risk assessments and to conduct more targeted TP audits. Under the finalised guidance, MNEs will be required to meet detailed three-tiered documentation requirements as follows: A master file (MF), which is intended to provide a complete picture of the MNE s global operations. Specific information is required to be contained in the MF report, including: the group s organisational structure, the MNE s business(es), including detail of the entire supply chain, profit-drivers and participation by individual group entities in contributing towards value creation, the MNE s IP, including transfers of interests in IP and TP policies regarding IP, the MNE s inter-company financial activities, such as treasury and loan transactions, and the MNE s financial and tax positions. The level of information to be included in the MF has therefore broadened significantly from existing documentation requirements. A local file (LF) for each country in which an MNE has operations, which provides more detailed information relating to the MNE group members specific inter-company transactions; and For large MNEs (i.e. groups with global turnover of 750m or more), a new requirement to file a CbCR template. This requires MNEs annually to file a template containing specific financial data covering their income, taxes and other key measures of economic activity, allocated by territory. The OECD suggests that CbCR should first apply to FY2016 yearends, with information being provided in FY2017, and that the CbCR template should be filed by the ultimate parent of the MNE. There are secondary filing requirements if the ultimate parent is not obliged to file a CbCR in its jurisdiction or a mechanism for sharing the CbCR is not available. Finance Bill 2015 includes legislation introducing CbCR for Irishparented multinational enterprises. The proposed legislation requires Irish-parented MNEs with consolidated annualised group revenue of 750m or more to comply with the CbCR requirements. The first CbC report should be prepared for fiscal years beginning on or after 1 January 2016 and filed within 12 months of the year-end. Several other countries have also started to legislate for the introduction of CbCR, including the UK, Australia, Spain, Mexico, the Netherlands and Denmark. The European Parliament has also recommended CbCR for all MNEs across the Member States. The developments in the area of TP documentation to date are some of the most talked about and concrete concepts arising from the BEPS Action Plan. The finalised guidance represents a steep change in TP documentation requirements. It means that MNEs will need to commit time and resources to meet the more onerous documentation requirements and will result in the reporting of a variety of financial and tax information to tax authorities for the first time. The new measures, and particularly CbCR, will likely be seen by tax authorities globally as a positive move towards improved transparency, providing them with the risk-assessment tool necessary to identify BEPS activity. However, the effects

5 78 and repercussions of the updated guidance remain to be seen, particularly in relation to concerns that have been repeatedly raised by business regarding confidentiality of information and the increasing compliance burden. Tax transparency is no longer just an issue for the Head of Tax. Engagement at board level early on will be crucial in ensuring that CbCR (and wider TP documentation requirements) are implemented effectively and in line with the organisation s tax strategy and approach to transparency. Conclusion Since announcing the BEPS Action Plan in 2013, the OECD has met its ambitious two-year commitment to tackling the 15 Actions, with the publication of 13 final reports following feedback from business and other stakeholders. There has been unprecedented political backing and collaboration by the OECD Member States. For TP specifically, significant changes have been introduced to the OECD s transfer pricing guidelines and to the PE definition in the Model Treaty as a result of the OECD s work. These will have major implications for MNEs globally. In the future, there will be far more emphasis on the substance and the economic behaviour underpinning the transaction in the context of the entire value chain, as opposed to the contractual analysis. The finalised guidelines, which provide for increased levels of TP documentation, will also result in unprecedented levels of transparency. Overall, it is clear that the BEPS initiative is one of the biggest game-changers in international tax policy in living memory. The impact of the Action Plan will fundamentally change the way multinational organisations engage in international business, related-party dealings and business restructurings in the future. Coming soon Global Transfer Pricing for Irish Business Connect to your local CTA Network > LinkedIn is one of the most popular ways to keep in touch with your professional contacts. > The Irish Tax Institute has an official LinkedIn page. We have also created discussion groups for each of the CTA Networks around Ireland. > Connect with your CTA Network in the Groups Area, under Interests in LinkedIn and stay in contact with CTAs in Ireland and Internationally. Talk to Samantha on or sfeely@taxinstitute.ie