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4 November 2015CopyrightLinda Pfatteicher

Tax and IP: follow the money

In the wake of the October 5, 2015 release of the final package of “Base Erosion and Profit Shifting (BEPS)” reports from the OECD, as well as the European Commission’s decision on October 21 accusing Fiat and Starbucks of violating EU state aid rules, multinational corporations are looking at their intangible property ownership globally and assessing what, if any, changes need to be made to their global transfer pricing structures.

Actions 8 to 10 (“Aligning transfer pricing outcomes with value creation, actions”) focus on the idea that profits attributable to value creation should be closely aligned with the economic substance of the transaction, while action 13 (“Transfer pricing documentation and country-by-country reporting”) focuses on more detailed transfer pricing documentation and provides a template for providing financial information on a country-by-country basis (CBC template).

In actions 8 to 10, the report indicates that the focus of any analysis should be on allocation of risk and intangible ownership. In discussing allocation of risks, the OECD focuses on aligning risk-taking with the entity that actually is bearing the risks, can control such risks, and has the financial ability to assume those risks. For intangibles, the report highlights the point that legal ownership of intangibles alone will not be sufficient to justify an allocation of profits and notes that bearing economic risks and rewards associated with intangible ownership should be the driver of profit allocation.

Local rules

With both of these concepts—bearing risk and intangible ownership—current transfer pricing concepts often already require the economic activity to follow the receipt of residual profits in order to be treated as satisfying the arm’s length standard. To the extent that these concepts are not yet incorporated into local standards, these transfer pricing concepts may have more immediate implications since many local jurisdictions incorporate by reference, or otherwise rely on, the OECD transfer pricing guidelines for their local application of the rules. The OECD further notes that actions 8 to 10 can be enforced through the use of the compliance requirements outlined in action 13.

Action 13 calls for a “three-tiered standardised approach” to transfer pricing documentation. Specifically, the report suggests that all companies should prepare both a master file providing a high-level overview of their global operations and a local file of transfer pricing documentation specific to each country. In addition, companies with consolidated group revenue equal to or exceeding €750 million ($828 million) should prepare a CBC report to summarise jurisdiction revenue, pre-tax income, income tax paid and accrued, employees, stated capital, retained earnings, and tangible assets.

“This standardised approach is meant to put local tax authorities on an even playing field in terms of being able to view the entire global picture of a company.”

This standardised approach is meant to put local tax authorities on an even playing field in terms of being able to view the entire global picture of a company. In theory, this should prevent multinationals from being able to easily shift profits out of high tax jurisdictions since they will now be required to disclose to such high tax jurisdictions where those profits are being shifted, as well as the volume and margins associated with the profits.

While many multinationals may believe these general transfer pricing concepts are not new and that they are generally in compliance with such rules, a detailed analysis of one’s global tax structure, including an analysis of the location of intangible property ownership and profit-generating activities may be warranted.

For example, intellectual property holding company structures that use a tax haven jurisdiction may have difficulty demonstrating that real risk is being borne in that tax haven location if there are no or minimal employees located there. In addition, CBC reporting will provide a roadmap of all inter-company transactions, enabling countries to see where multinationals are treating the same income differently for different countries or shifting significant amounts of income away from the jurisdictions where they may have the most employees.

As noted, transfer pricing historically has required profits to follow risks, but multinationals have been able to achieve a shift in profits to locations with intangible property ownership, but with less substance, as they were not necessarily required to tell a consistent story globally. Since the BEPS reports suggest that the magnitude of the substance should be proportionate to the profits received and the CBC template may expose areas where this is not the case, multinationals should consider a thorough review of their supply chains to identify areas of potential exposure and consider making structural revisions to better align the ‘boots on the ground’ with the accumulation of profits.

Some multinationals have already begun preparing a draft CBC template based on 2015 financials in order to confirm they can pull the data in a format necessary to complete the report, and also be able to identify any weak points in the supply chain that might need to be enhanced ahead of the 2016 reporting tax year. Other multinationals are looking to undertake planning projects before year-end in order not to be required to disclose significant transactions on the CBC template.

This process of self-assessing potential global transfer pricing risks may be further complicated by the commission’s decision that transfer pricing rulings granted to Fiat by Luxembourg and to Starbucks by the Netherlands were in violation of EU state aid rules. In these cases, Fiat and Starbucks believed they had gained certainty on their transfer pricing policy for those jurisdictions by obtaining a ruling from the local tax authorities, only to later find those rulings trumped by the commission decision.

Although Luxembourg and the Netherlands have publicly stated that they do not agree with the ruling and Fiat and Starbucks have stated their intentions to appeal against it, the ruling alone has created uncertainty among multinationals about whether their transfer pricing policies will withstand scrutiny under various levels of review. If multinationals must not only look at the taxing jurisdiction itself, but also at regional oversight commissions and the court of public opinion, for example, multinationals may find it necessary to take a more conservative approach when allocating their profits globally.

The BEPS reports indicate that the goal is to have the new transfer pricing documentation standards in place for the 2016 tax year, but they acknowledge that some jurisdictions may “need time to follow their particular domestic legislative process” in order to mandate such reporting. Even though this may be the case, particularly in jurisdictions such as the US given the current political climate, the time is now for multinationals to establish a process for gathering the required information, determine how they will compile that information to tell a consistent transfer pricing story worldwide, and shore up any potentially weak areas in their global supply chain that might attract unwelcome attention in this new ‘post-BEPS’ environment.

Linda Pfatteicher is a partner at  Squire Patton Boggs. She can be contacted at: linda.pfatteicher@squirepb.com

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