performing a beps diagnostic - mayer brown · performing a beps diagnostic seminar ... technology...

Performing a BEPS Diagnostic

SEMINARRecent Developments:Tax Controversy and Tax Reform

Kenneth Klein

Partner, Washington, DC

(202) 263-3377

[email protected]

Jason Osborn

Partner, Washington, DC

(202) 263-3386

[email protected]


Agenda

• Typical US Multinational Company IP Planning – Irish IPCo

• Case Study: L Corporation

› Proposal 1: “Single Irish Structure”

› Proposal 2: “Double Irish Structure”

› US and Foreign Tax Sensitivities› US and Foreign Tax Sensitivities

• The Country-by-Country Report as a Roadmap

• Beyond the CbC Report – An in-depth assessment under BEPS Actions 8-10

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Typical US MNC IP Planning


Typical US MNC IP Planning — Irish IPCo

• “Irish Structure”: Common IP planning technique for US MNCs, especially in thetechnology and life sciences sectors.

• A significant portion of the profits of most economic activities is attributable to IP,assumption of risk and capital.

• Ownership of IP and capital is more mobile and flexible than certain other components• Ownership of IP and capital is more mobile and flexible than certain other componentsof profit. Risk can be assumed by contract.

• Planning objectives:

› Existing IP: Migrate to foreign IPCo in low-tax jurisdiction.

› Future IP: Ensure that IPCo is the developer and beneficial owner of the future IP from “day one.”

• Ensure that IPCo is well-capitalized and contractually assumes most of the risk of thebusiness.

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Case Study


Case Study — L Corporation

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L Corporation — Background

• Approximately 40% of L Corp’s revenues are from non-US sources and that percentage isexpected to grow significantly in coming years.

• L Corp is considering putting additional resources and infrastructure in Europe to supportits growing international operations.

• In light of this consideration, the question has arisen as to whether a structure should be• In light of this consideration, the question has arisen as to whether a structure should beconsidered to lower L Corp’s 39% effective tax rate.

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L Corporation — Two Restructuring Proposals

• Proposal 1: Creation of an Irish IP Co/Distributor (“Single Irish”).

• Proposal 2: Creation of an Irish non-resident IP Company and an Irish residentDistributor (“Double Irish”).

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L Corporation — Proposal 1

• L Corp forms an Irish subsidiary (“L Ireland”).

• L Corp licenses or sells the non-US rights to the L technology to L Ireland (see infra repossible transfer of US rights); L Corp. and L Ireland enter into a cost sharing agreementto jointly develop the future enhancements to the L technology.

• L Ireland enters into a contract manufacturing agreement with a third party in Ireland• L Ireland enters into a contract manufacturing agreement with a third party in Irelandunder which the third party agrees to produce products for L Ireland.

• L Ireland forms subsidiaries in different jurisdictions to act as commissionaires on itsbehalf.

› A commissionaire sells product to customers in its own name. The principal is contractuallybound to the commissionaire to deliver the goods to the customer and the commissionaire iscontractually bound to the principal to remit the purchase price. The commissionaire never takestitle to the product. Often used by US MNCs to avoid related party sales / subpart F income.

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L Corporation – Proposal 1

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L Corporation — Proposal 1 Tax Analysis

• Under Irish law, L Ireland’s income would be subject to the 12.5% Irish corporate tax ratefor active business income.

• L Ireland’s sales do not create current taxation in the US under the subpart F regime:

› No related party sales because the commissionaire does not take title to the product.

› Additionally, L Ireland should benefit from the “manufacturing exception” to foreign base› Additionally, L Ireland should benefit from the “manufacturing exception” to foreign basecompany sales income.

• No need to provide US tax on L Ireland’s earnings if indefinitely reinvested outside the US(APB 23).

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L Corporation — Proposal 1 ETR Results

FY 2016

Revenues $200

Pre-Tax Income $50 ($30 US1 + $20foreign)foreign)

Provision for Taxes $14.2 ($11.7 US + $2.50foreign)

Effective Tax Rate 28.4%

$30 of US income (i.e., combination of income from US rightsand royalty income on non-US rights)* 39% US ETR

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L Corporation — Proposal 2

• L Corp forms a “non-resident” Irish subsidiary managed and controlled from Malta(“NRI”); NRI forms an Irish subsidiary (“L Ireland”).

• L Corp licenses or sells the non-US rights to the L technology to NRI (see infra re possibletransfer of US rights); L Corp. and NRI enter into a cost-sharing agreement to jointlydevelop the future enhancements to the L technology.

• NRI licenses the non-US rights to the developed L technology to L Ireland (and sub-licenses the existing non-US rights, as applicable).

• L Ireland enters into a contract manufacturing agreement with a third party in Irelandunder which the third party agrees to produce products for L Ireland.

• L Ireland forms subsidiaries in different jurisdictions to act as commissionaires on itsbehalf.

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L Corporation – Proposal 2

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• NRI’s royalty to L Corp: not subject to withholding under Maltese domestic tax law.

• L Ireland’s royalty to NRI:

› Irish Tax Perspective:

• Not subject to Irish income tax because NRI is not considered an Irish tax resident; and

• generally no withholding under Irish domestic law and EU Royalty Directive.• generally no withholding under Irish domestic law and EU Royalty Directive.

› Maltese Tax Perspective: Under Maltese domestic tax law, tax is only imposed if income isremitted to a Maltese bank account.

› US Tax Perspective: No subpart F income: (1) payment is disregarded; and (2) same-countryexception.

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• L Ireland’s Sales Income:

› Irish Tax Perspective: Irish transfer pricing rules generally allow leaving a relatively small profitmargin in Ireland (e.g., 10%, as a result of a significant part of the revenue being paid out as adeductible royalty to NRI).

• Thus, the group’s foreign income would be subject to approximately a 1.25% effective tax rate (i.e., 12.5% Irishtax rate * 10%; 0% Maltese tax rate * 90%).tax rate * 10%; 0% Maltese tax rate * 90%).

› US Tax Perspective (NRI’s sales income): No subpart F income (see Proposal 1 Tax Analysis).

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L Corporation — Proposal 2 Etr Results

FY 2016

Revenues $200

Pre-Tax Income $50 ($30 US1 + $20foreign)foreign)

Provision for Taxes $11.95 ($11.7 US + $0.25foreign)

Effective Tax Rate 23.9%

1$30 of US income (i.e., combination of income from US rightsand royalty income on non-US rights)* 39% US ETR

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L Corporation —US Tax Sensitivities

• Tax-efficient repatriation of offshore cash.

• What if, in addition to the non-US IP rights, L Ireland acquired the US IP rights and soldproducts into the US?

› US taxable presence issue

• No treaty protection for NRI in Proposal 2.• No treaty protection for NRI in Proposal 2.

• Can the “effectively connected income” rules be managed?

› Section 956(c)(1)(D) (“investment in US property”) issue

• “Managerial and operational control” - compare Treas. Reg. sec. 1.482-1(d)(3)(iii)(B)(2) withBEPS “control of risk” framework discussed infra.

• Valuation of non-US IP rights transferred to L Ireland (in Proposal 1) or NRI (inProposal 2):

› The Veritas and Amazon cases.

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L Corporation —Irish Tax Sensitivities

• Ensure L Ireland has enough substance on the ground in Ireland to secure the 12.5% taxrate for active business income: high/middle management on the ground; regular boardmeetings with substantive business discussions; leased space; ideally, some R&D activityin Ireland.

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L Corporation — ROW Tax Sensitivities

• BEPS Action 7:

› “[I]t is clear that in many cases commissionaire arrangements and similar strategies were put inplace primarily in order to erode the taxable base of the state where sales took place.”

› Proposed changes to the definition of permanent establishment (“PE”) in the OECD Model Treaty– PE triggered when the subsidiary “habitually plays the principal role leading to the conclusion ofcontracts that are routinely concluded without material modification” by the principal (even if thecontracts that are routinely concluded without material modification” by the principal (even if thesubsidiary does not have authority to bind the principal).

› U.K. Diverted Profits Tax

› The Dell case in Spain

• Mitigate risk by converting commissionaires to buy/sell distributors? If so, full-fledged or limited-riskdistributors?

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The Country-By-Country Report (CbCR) As aBEPS Roadmap

• On June 30, 2016, the US Treasury and the IRS published the final US country-by-country(“CbC”) reporting regulations.

• The regulations generally adopt the guidelines set forth under BEPS Action 13 and thetemplate report therein.

• The regulations apply to tax periods of the ultimate parent entity that begin on or after June30, 2016.30, 2016.

• Rev. Proc. 2017-23 allows voluntary filing by US parent multinationals for tax periods thatbegin on or after January 1, 2016.

• The following slides show a hypothetical CbC report for L Corp. under two scenarios: (1) theProposal 1 structure described above and (2) a “revised” Proposal 1 structure in which:

› R&D employees are relocated from the U.S. to Ireland;

› L Germany and L Japan are converted from commissionaire’s to full-fledged distributors.

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Proposal 1 — Country-by-Country Report

Name of the MINE group: L Corporation and AffiliateFiscal year concerned: 2020

Currency used: USD (in thousands)

Revenues

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TaxJurisdiction

Profit (Loss)before

Income Tax

Income TaxPaid (on

CashBasis)

Income TaxAccrued -Current

YearStatedCapital

AccumulatedEarnings

Number ofEmployees

Tangible Assetsother

Than Cash andCash

Equivalents

UnrelatedParty

RelatedParty

Tota l

United States 12,000 500 12,500 5,000 1,750 1,750 1,000 15,000 300 5,000

Ireland 15,000 0 15,000 5,800 725 725 10 30,000 2 50

Germany 0 157.5 157.5 1.575 0.45 0.45 10 3.5 1 10

Japan 0 113 113 1.13 0.35 0.35 10 2 1 5


Revised Proposal 1 — Conversion OfCommissionaire to Buy/Sell Distributor

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Revised Proposal 1 — Country-by-Country Report

Name of the MINE group: L Corporation and AffiliateFiscal year concerned: 2020

Currency used: USD (in thousands)

Revenues

24

TaxJurisdiction

Profit (Loss)before

Income Tax

Income TaxPaid (on

CashBasis)

Income TaxAccrued -Current

YearStatedCapital

AccumulatedEarnings

Number ofEmployees

Tangible Assetsother

Than Cash andCash

Equivalents

UnrelatedParty

RelatedParty

Tota l

United States 12,000 500 12,500 5,000 1,750 1,750 1,000 15,000 287 5,000

Ireland 12,295 2,536 14,831 5,631 704 704 10 30,000 15 500

Germany 1,575 0 1,575 7.87 2.25 2.25 10 17.5 5 500

Japan 1,130 0 1,130 5.65 1.75 1.75 10 10 3 400


Full-fledged V. Limited Risk Distributors

• Limited-risk distributor (“LRD”):

› LRD bears no (or very limited) market risk and inventory risk.

› Arrangements may be structured so that LRD bears customer credit risk.

• Full-fledged distributor:

› Full-fledged distributor bears market risk, inventory risk and customer credit risk.› Full-fledged distributor bears market risk, inventory risk and customer credit risk.

› Full-fledged distributor may develop marketing intangibles.

• The use of limited risk distributors (as opposed to full-fledged distributors) may allow toreduce the profitability of the distributor and retain greater profits in the jurisdiction ofthe principal company (Ireland, in Structure 1; Malta, in Structure 2).

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Beyond the CbC ReportAn in-depth assessment under BEPS Actions 8-10


Beyond the CbC Report – What’s next for LCorporation?

• Assume that despite measures to mitigate its BEPS exposures and file more robust CbCreports, L Corporation is selected for a transfer pricing audit.

• What additional things could L Corporation and its subsidiaries do to further mitigate itsexposure once the tax administrators move beyond the risk assessment stage to examine itstransfer pricing in detail?

• Here, we turn to the substantive guidance in the BEPS Actions 8-10 Reports as our guide:

› BEPS Actions 8-10 is now part of the OECD Transfer Pricing Guidelines (“TPG”) and is currently effective.

› While the United States does not officially follow the TPG, US Treasury view is that the OECD TPG(including BEPS Actions 8-10) and section 482 regulations are consistent.

› Certain provisions of the section 482 regulations, discussed infra, seemingly foreshadow BEPS Actions8-10.

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BEPS Actions 8-10: Its all About Risk

• The OECD’s basic concern revolves around the presumption that greater risk should leadto greater reward.

• To justify higher returns under this presumption, members of MNE groups might assignrisks to other group members that could not meaningfully control or financially assumethat risk, at times “without any change in the business operations.”

› In effect, the concern is that such a risk assumption has no substance.

• When such a risk assumption without substance does occur, the new BEPS Actions 8-10guidance would allocate that risk to the group member that can meaningfully control orfinancially assume that risk.

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OECD BEPS Actions 8-10 – Types of Risk

• Under BEPS Actions 8-10, not all risks are treated equal. Key focus is on “economicallysignificant risks,” which can include:

› Strategic or Marketplace Risks: These are the systemic risks, which include economic, political,technological, and social change.

• Ex.: New geographical market.

› Infrastructure or Operational Risks: The report describes these risks as those “associated with thecompany’s business execution.”

• Ex.: Delay in product shipment.

› Financial Risks: The subset of risks that relate to the company’s cashflow, liquidity, andcreditworthiness.

› Transactional Risks: “Pricing and payment terms in a commercial transaction.”

› Hazard Risks: “Accidents and natural disasters.”

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OECD BEPS Actions 8-10 – Risks Related toIntangibles

• Certain risks are specific to the transfer and development of intangibles.

› Development Risk: The cost of R&D, the “timing of the investment,” and the risk that the entireproject ends up being a commercial failure.

› Product Obsolescence: The chance that competitors will develop some technology thatundermines the value of the intangible.

›› Infringement Risk: The time and financial cost of defending the intangible in court, taking intoaccount the possibility of losing in court.

› Product Liability: The risk of the product leading to legal liability.

› Exploitation Risk: The cost of variable, uncertain returns from the intangible.

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OECD BEPS Actions 8-10 – New Transfer PricingGuidance on Risk: “Control” Controls

• BEPS Actions 8-10 provides a new, multi-step framework for analyzing risk in relatedparty transactions

• Under this framework, related party contracts remain the starting point for analysis.

• However, if a related party that contractually assumes a risk “does not exercise controlover the risk or does not have the financial capacity to assume the risk, then the riskover the risk or does not have the financial capacity to assume the risk, then the riskshould be allocated to the enterprise exercising control and having the financial capacityto assume the risk.” ¶1.98.

• Control framework applies equally to cost contribution arrangements (CCAs) as it doesto other types of related party transactions involving intangibles.

› Thus, the notion of cost sharing as “safe harbor” is unequivocally dispelled.

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OECD BEPS Actions 8-10 – New Transfer PricingGuidance on Risk: What is “Control”?

• For purposes of BEPS Actions 8-10, “control” means more than just oversight or rubber-stamping:

› Control over risk involves (i) the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function and(ii) the capability to make decisions on whether and how to respond to the risks associated withthe opportunity, together with the actual performance of that decision-making function. ¶1.65.the opportunity, together with the actual performance of that decision-making function. ¶1.65.

• Further:

› Neither a mere formalising of the outcome of decision-making in the form of, for example,meetings organised for formal approval of decisions that were made in other locations, minutes ofa board meeting and signing of the documents relating to the decision, nor the setting of thepolicy environment relevant for the risk . . . , qualifies as the exercise of a decision-makingfunction sufficient to demonstrate control over a risk. ¶1.66.

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BEPS Actions 8-10: DEMPE Functions andControl

• Much of the BEPS 8-10 attention has focused on so-called DEMPE functions (development,enhancement, maintenance, protection, and exploitation) related to intangibles

• An owner of an intangible must perform all of the functions, contribute all assets used andassume all risks related to DEMPE to be entitled to retain all of the returns from theexploitation of that intangible. See ¶6.51.

But, a related party need not perform DEMPE functions itself to enjoy returns from an• But, a related party need not perform DEMPE functions itself to enjoy returns from anintangible.

• Outsourcing of DEMPE functions to other related parties (e.g., R&D services) is sufficient toattribute intangibles-related profits, but only if the intangibles owner (or other principal)controls the DEMPE functions that are outsourced. ¶6.53.

• Bottom line: Adding employees to perform DEMPE functions may help, but adding “control”may help even more.

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BEPS Actions 8-10: “Control” and the Return toCapital

• The BEPS Actions 8-10 Reports propose to substantially limit returns for providing capital or“funding” without more (e.g., bearing R&D costs under cost sharing). Effectively, there arethree levels of returns for three levels of “control.”

› “Cash Box” - Entities that provide funding without exercising any control over the financial risk ofproviding funding (i.e., so-called pure “cash boxes”) are treated as not assuming any risk at all.Accordingly, such related parties are limited to a risk-free return. ¶1.103.Accordingly, such related parties are limited to a risk-free return. ¶1.103.

› “Smart Cash” - Entities that “exercise[] control over the financial risk associated with the provisionof funding, without the assumption of, including the control over, any other specific risk” (i.e., so-called “smart cash” providers) are limited to “an appropriate risk-adjusted return.” ¶ ¶ 6.61 and6.62.

› High functionality/substance – Only entities that control additional risks – e.g., the operationalrisks of the business – and/or perform or control DEMPE functions are contemplated to earnpremium returns greater than “an appropriate risk-adjusted return” on capital.

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“Control” and Return to Capital– an Example

• Example 6: The Development Agreement

› Companies A and B enter into a development agreement. Per the agreement, B performs allactivities related to the development of the intangible. Also per the agreement, A funds thedevelopment and takes ownership of the intangible.

• Analysis finds that Company A contractually assumes the financial risk, has the financial capacity to assumethat risk, and exercises control over that risk.that risk, and exercises control over that risk.

› After development, the intangible is assumed to lead to $550M in yearly profit.

› B licenses the intangible from A, and pays A for that right based on returns of comparablelicenses. After such payments are made, B is left with $200M in profits.

› After review by Country B’s tax administration, A, having only funded development, is found tohave earned only a risk-adjusted rate of return (which is assumed to be $110M).

› B is then allotted the rest of the profit, here $440M, rather than the $200M previously.

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“Control” and Return to Capital– a SecondExample

• Example 16: Sale of IP and R&D Services

› Parent company Shuyona and its group produce and sell consumer goods.

› In Year 1, Shuyona sells its IP (including rights to on-going research) to a new subsidiary, CompanyT. Company T establishes a manufacturing facility and begins to supply products to related partiesaround the world.

›› Company T enters into two cost-plus R&D agreements: one with Shuyona and one its affiliateCompany S. Under these agreements, Company S agrees to bear the financial risk of future R&D.

› Company T has no technical personnel capable of conducting or supervising the researchactivities. Parent company Shuyona continues to set research program, establish budgets, makedecisions on particular R&D projects, etc.

› Tax authority in Company T’s jurisdiction limits Company T to: (1) a manufacturing return, and (2)a risk-free return on its funding under the R&D agreements, on the ground that it exercised nocontrol over the financial risks of the R&D.

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BEPS Actions 8-10: Compare with TreasuryRegulation sec. 1.482-1

• Treas. Reg. sec. 1.482-1(d)(3)(iii)(B)(2) – “[T]he allocation of risks specified orimplied by the taxpayer's contractual terms will generally be respected if it isconsistent with the economic substance of the transaction.”

• Factors relevant to economic substance include:

1) Whether the pattern of the controlled taxpayer's conduct over time is consistent with the1) Whether the pattern of the controlled taxpayer's conduct over time is consistent with thepurported allocation of risk between the controlled taxpayers . . .

2) Whether a controlled taxpayer has the financial capacity to fund losses that might beexpected to occur as the result of the assumption of a risk . . .

3) The extent to which each controlled taxpayer exercises managerial or operational controlover the business activities that directly influence the amount of income or loss realized.

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BEPS Actions 8-10 and IRC section 482 – What’sNext?

• While the regulation seemingly foreshadowed the BEPS “control” framework, note that“financial capacity” and “control” are merely relevant factors and not necessarily hardand fast requirements.

• Nevertheless, it seems that the IRC section 482 regulations and the BEPS Actions 8-10 reports can be applied consistently.10 reports can be applied consistently.

• If so, how should US-based MNEs structure their activities so as to prevent theunfavorable application of BEPS principles?

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What can L Corp. do to manage its exposure?

• Consider ways to provide L Ireland (in Proposal 1) or NRI (in Proposal 2) with “control”over funding of R&D under the CSA. For example:

› Require L Corporation to submit quarterly budgets for L Ireland/NRI’s approval (expenses in excessof approved budget subject to L Ireland/NRI’s prior written approval).

› Require Corporation to provide monthly reports to L Ireland/NRI, including statements of incurredcosts and description of material risks related to the R&D activity.costs and description of material risks related to the R&D activity.

› Ensure that proposed budgets and reports are subject to substantive discussion at Board meetingsprior to any approvals are granted; Board should scrutinize and propose changes to proposedbudgets as appropriate.

› Document the Board’s discussions, proposed changes to the budget and approvals inappropriately detailed minutes.

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What can L Corp. do to manage its exposure? -continued

• Analyze and identify all “economically significant risks” faced by the L group’s business –beyond just the risks associated with funding R&D.

› Consider analogy of a public company identifying its risk factors for SEC reporting purposes.

› Consider how L Ireland/NRI can manage such risks in theory and in practice.

› Use this analysis of “economically significant risks” to guide the selection of Directors and› Use this analysis of “economically significant risks” to guide the selection of Directors andprioritize which executives and functions should be placed in Ireland (see below).

• Consider including one or more top-level executives of L Corp. on the Board(s) ofDirectors of L Ireland and/or NRI.

› Need to define roles in a way that would avoid making L Ireland and/or NRI subject to tax in theUnited States.

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What can L Corp. do to manage its exposure? –continued

• Further consider hiring appropriately high-level executives resident in Ireland who:

› Have “the capability to make decisions to take on, lay off, or decline” risks; and

› Actually perform these decision-making functions on a day-to-day basis, within theparameters set by the Board(s) of Directors.

• Also consider whether a high-level executive resident in the US can also be an• Also consider whether a high-level executive resident in the US can also be anemployee of L Ireland/NRI without making L Ireland/NRI taxable in the US.

• Take care not to create unintended exposures in L Germany or L Japan.

› Avoid having these entities perform DEMPE functions or exercise too much “control” inorder to retain their status as routine buy-sell distributors.

› “Economically significant risks” specific to these local markets should ideally by managedand controlled by L Ireland/NRI.

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