Your Taxes: OECD Swings Into Action – Transfer Pricing
The OECD is at the forefront of an international campaign to try and collect more taxes from multinational groups.
These groups are perceived by some governments as being over-successful in shifting profits to sunny offshore locations. Many billions of tax dollars and euros are thought to be at stake. Israel joined the OECD in 2010. On December 19, 2014, the OECD published a discussion draft on revisions to OECD transfer pricing guidelines, as “actions” 8-10 of its Action Plan on Base Erosion and Profit Shifting (BEPS) and the public was invited to comment by February 6, 2015. A version of this article has, therefore, been submitted to the OECD.
The OECD’s recommendations are not binding, but they do show parliaments and tax authorities what measures to consider adopting in their own country.
Multinational groups will need to adapt their tax strategies. Even Israeli start-ups with “preferred enterprise” status and international clients should take note.
The main aim of the OECD Discussion Draft is to assure that intra-group transfer pricing outcomes are in line with value creation. Risk Assessment: Tax planning techniques within multinational groups include allocating profit to offshore companies that own intangible assets and/or bear substantial business risks.
This is because in business, there is often a risk-return trade-off.
The Discussion Draft takes aim at the risk-based techniques. If the asset owner does not have the ability to control risks associated with the exploitation of the asset, the legal owner of the asset is in substance only providing financing equating to the cost of the asset and should merely be remunerated on that basis. Value Generation: The Discussion Draft states: “… it is important to understand how value is generated by the group as a whole …and the contribution that the parties make to value creation…While one party may provide a large number of functions, it is the economic significance of those functions in terms of their frequency, nature and value…that is important”.
Potential Special Measures: The Discussion Draft proposes special (controversial) measures. There are five “options”. Option 1 deals with “hard-to-value intangibles” (HTVI). The OECD proposes to permit a tax administration to adjust their price based on the actual outcome, imputing a contingent payment mechanism. This use of hindsight by a tax administration may only be rebuttable if the taxpayer can demonstrate “the robustness of its ex ante projections”. Option 2 deals with inappropriate returns for providing capital in a capital-rich asset-owning company (presumably offshore) that depends on another company to generate a return from the asset. The OECD says capital (i.e. assets) should be reallocated to the other company (presumably onshore) as that would be a more rational investment opportunity for an independent investor. Option 3 deals with “thick capitalization”. A capital adequacy ratio would be determined and excess capital would be deemed to generate interest income for the provider (presumably onshore) of the excess capital. Option 4 deals with a so-called minimal functional entity. If a company lacks qualitative attributes (unable to create value) or quantitative attributes (performs mainly routine functions), its profits would be re-allocated to other more functional entities in the group. Option 5 deals with ensuring appropriate taxation of excess returns. This would involve standardizing existing rules in most western countries regarding controlled foreign corporations (CFCs) that pay tax below an unspecified tax rate over the last three years, less a foreign tax credit. Our Comments:
We have many comments on the OECD’s discussion draft. Unfortunately, it reads like a return to communism with a reallocation of capital to onshore countries. ·The text discussing risks and value generation is very long and can apparently be summarized in one sentence: Profit should be allocated to countries where people, such as engineers, generate value rather than offshore companies that lack the people to manage assets and risks. The OECD should confirm whether this is its message. ·By contrast text containing proposed special measures is very short, unclear in many places and full of jargon. The proposed measures are not fully evaluated. Instead, respondents (like us) are invited to do so by reference to a list of criteria. ·The proposals in Option 1 for valuing hard—to-value intangibles require immense powers of prophesy, failing which the tax administration can apply hindsight to tax a different amount. This means MNCs must become hardened gamblers. And if taxpayers overvalue their intangibles, will they later receive a tax refund? The OECD should allow normal professional valuation techniques to be used without fear of hindsight adjustment later on. ·The proposals in Option 2 (capital rich companies) are very vague and brief. Each onshore country in which an MNC operates seems likely to allocate capital and assets to their taxing jurisdiction, resulting in multiple taxation. Option 2, should be dropped, it seems unworkable. Please see our alternative recommendations below. ·Option 3 (thick capitalization, taxing deemed interest) looks likely to be ineffective so long as interest rates remain low. Moreover, if good use is made of capital, such as investment in research and development into life-saving drugs, why should such good use be penalized by taxation? R&D costs money which is usually funded by capital not loan finance. Option 3 should be dropped, it seems unworkable and unreasonable. ·Options 4 and 5 (minimal functional entities, taxing excess returns) seem to add little to existing legislation in most western countries dealing with (a) transfer pricing, (b) central management and control, and (c) controlled foreign corporations. Our Alternative Suggestions to the OECD:
All in all, the OECD proposals seem likely to result in multiple taxation and uncertainty. Alternative proposals are called for.
Recent public criticism of tax planning by multinationals relates primarily to intangible assets/intellectual property (IP) in high tech and low tech..
IP includes technology (knowhow), brands, trade names, and so forth.. ·First, the OECD should clarify criteria for recognizing the existence and legitimacy of IP. Tax enforcement is needed only against phony or non-existent IP. Regard should be had to patents, brand names, engineers, size of the global market, technical requirements, languages and cultures, and so forth. ·Second. the OECD should clarify criterial for considering how developed is the IP.Undeveloped IP should not be taxed. Many high tech companies and projects – in Israel and elsewhere – fail when R&D fails to generate hoped-for technological products. Likewise, many pharmaceutical projects do not result in useful new drugs, and if they do, exhaustive clinical trials is needed lasting many years. Many movies fail at the box office. Catchy trade names and interesting designs often do not catch on after all. ·Third, competition should be quantified. If competitors emerge with a better product or a new disruptive technology, the IP can lose great value rapidly, as BlaclBerry found out. Likewise, patents near or at the end of their term lose value, as Teva investors know. ·Fourth, there are many valuation techniques and it would not be appropriate to prescribe in advance which technique(s) should be applied.
Nevertheless, as a safe harbor, we recommend that if IP is transferred within a group, net present value (discounted cash flow) techniques applied in a bona fide manner should be allowed and respected by tax authorities as being arm’s length, even if the unexpected subsequently occurs. Furthermore, when assessing payments for the use of IP, net present value (discounted cash flow) techniques applied in a bona fide manner should again be treated as an arm’s length safe harbor. To sum up: The OECD proposals look a little rushed. In their present form they could be bad not only for big multinationals, but also for Israeli hi-tech start-ups that take advantage of Israeli tax breaks for preferred enterprises and then sell into US, European and Asian markets. Let’s hope the OECD does a re-boot. As always, consult experienced tax advisors in each country at an early stage in specific cases. leon @hcat.co
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.
These groups are perceived by some governments as being over-successful in shifting profits to sunny offshore locations. Many billions of tax dollars and euros are thought to be at stake. Israel joined the OECD in 2010. On December 19, 2014, the OECD published a discussion draft on revisions to OECD transfer pricing guidelines, as “actions” 8-10 of its Action Plan on Base Erosion and Profit Shifting (BEPS) and the public was invited to comment by February 6, 2015. A version of this article has, therefore, been submitted to the OECD.
The OECD’s recommendations are not binding, but they do show parliaments and tax authorities what measures to consider adopting in their own country.
Multinational groups will need to adapt their tax strategies. Even Israeli start-ups with “preferred enterprise” status and international clients should take note.
The main aim of the OECD Discussion Draft is to assure that intra-group transfer pricing outcomes are in line with value creation. Risk Assessment: Tax planning techniques within multinational groups include allocating profit to offshore companies that own intangible assets and/or bear substantial business risks.
This is because in business, there is often a risk-return trade-off.
The Discussion Draft takes aim at the risk-based techniques. If the asset owner does not have the ability to control risks associated with the exploitation of the asset, the legal owner of the asset is in substance only providing financing equating to the cost of the asset and should merely be remunerated on that basis. Value Generation: The Discussion Draft states: “… it is important to understand how value is generated by the group as a whole …and the contribution that the parties make to value creation…While one party may provide a large number of functions, it is the economic significance of those functions in terms of their frequency, nature and value…that is important”.
Potential Special Measures: The Discussion Draft proposes special (controversial) measures. There are five “options”. Option 1 deals with “hard-to-value intangibles” (HTVI). The OECD proposes to permit a tax administration to adjust their price based on the actual outcome, imputing a contingent payment mechanism. This use of hindsight by a tax administration may only be rebuttable if the taxpayer can demonstrate “the robustness of its ex ante projections”. Option 2 deals with inappropriate returns for providing capital in a capital-rich asset-owning company (presumably offshore) that depends on another company to generate a return from the asset. The OECD says capital (i.e. assets) should be reallocated to the other company (presumably onshore) as that would be a more rational investment opportunity for an independent investor. Option 3 deals with “thick capitalization”. A capital adequacy ratio would be determined and excess capital would be deemed to generate interest income for the provider (presumably onshore) of the excess capital. Option 4 deals with a so-called minimal functional entity. If a company lacks qualitative attributes (unable to create value) or quantitative attributes (performs mainly routine functions), its profits would be re-allocated to other more functional entities in the group. Option 5 deals with ensuring appropriate taxation of excess returns. This would involve standardizing existing rules in most western countries regarding controlled foreign corporations (CFCs) that pay tax below an unspecified tax rate over the last three years, less a foreign tax credit. Our Comments:
We have many comments on the OECD’s discussion draft. Unfortunately, it reads like a return to communism with a reallocation of capital to onshore countries. ·The text discussing risks and value generation is very long and can apparently be summarized in one sentence: Profit should be allocated to countries where people, such as engineers, generate value rather than offshore companies that lack the people to manage assets and risks. The OECD should confirm whether this is its message. ·By contrast text containing proposed special measures is very short, unclear in many places and full of jargon. The proposed measures are not fully evaluated. Instead, respondents (like us) are invited to do so by reference to a list of criteria. ·The proposals in Option 1 for valuing hard—to-value intangibles require immense powers of prophesy, failing which the tax administration can apply hindsight to tax a different amount. This means MNCs must become hardened gamblers. And if taxpayers overvalue their intangibles, will they later receive a tax refund? The OECD should allow normal professional valuation techniques to be used without fear of hindsight adjustment later on. ·The proposals in Option 2 (capital rich companies) are very vague and brief. Each onshore country in which an MNC operates seems likely to allocate capital and assets to their taxing jurisdiction, resulting in multiple taxation. Option 2, should be dropped, it seems unworkable. Please see our alternative recommendations below. ·Option 3 (thick capitalization, taxing deemed interest) looks likely to be ineffective so long as interest rates remain low. Moreover, if good use is made of capital, such as investment in research and development into life-saving drugs, why should such good use be penalized by taxation? R&D costs money which is usually funded by capital not loan finance. Option 3 should be dropped, it seems unworkable and unreasonable. ·Options 4 and 5 (minimal functional entities, taxing excess returns) seem to add little to existing legislation in most western countries dealing with (a) transfer pricing, (b) central management and control, and (c) controlled foreign corporations. Our Alternative Suggestions to the OECD:
All in all, the OECD proposals seem likely to result in multiple taxation and uncertainty. Alternative proposals are called for.
Recent public criticism of tax planning by multinationals relates primarily to intangible assets/intellectual property (IP) in high tech and low tech..
IP includes technology (knowhow), brands, trade names, and so forth.. ·First, the OECD should clarify criteria for recognizing the existence and legitimacy of IP. Tax enforcement is needed only against phony or non-existent IP. Regard should be had to patents, brand names, engineers, size of the global market, technical requirements, languages and cultures, and so forth. ·Second. the OECD should clarify criterial for considering how developed is the IP.Undeveloped IP should not be taxed. Many high tech companies and projects – in Israel and elsewhere – fail when R&D fails to generate hoped-for technological products. Likewise, many pharmaceutical projects do not result in useful new drugs, and if they do, exhaustive clinical trials is needed lasting many years. Many movies fail at the box office. Catchy trade names and interesting designs often do not catch on after all. ·Third, competition should be quantified. If competitors emerge with a better product or a new disruptive technology, the IP can lose great value rapidly, as BlaclBerry found out. Likewise, patents near or at the end of their term lose value, as Teva investors know. ·Fourth, there are many valuation techniques and it would not be appropriate to prescribe in advance which technique(s) should be applied.
Nevertheless, as a safe harbor, we recommend that if IP is transferred within a group, net present value (discounted cash flow) techniques applied in a bona fide manner should be allowed and respected by tax authorities as being arm’s length, even if the unexpected subsequently occurs. Furthermore, when assessing payments for the use of IP, net present value (discounted cash flow) techniques applied in a bona fide manner should again be treated as an arm’s length safe harbor. To sum up: The OECD proposals look a little rushed. In their present form they could be bad not only for big multinationals, but also for Israeli hi-tech start-ups that take advantage of Israeli tax breaks for preferred enterprises and then sell into US, European and Asian markets. Let’s hope the OECD does a re-boot. As always, consult experienced tax advisors in each country at an early stage in specific cases. leon @hcat.co
The writer is a certified public accountant and tax specialist at Harris Consulting & Tax Ltd.