pwc tp perspectives challenging times

8/12/2019 Pwc Tp Perspectives Challenging Times

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Transfer pricing

perspectivesThriving through challenging times

The current state of play onsubstance: a plea to monitorgeographically dispersedcorporate brainpower

Highlights of the proposalsfor updating the OECDsTransfer Pricing Guidelines

Business restructuring inEurope: where are we now?

How business responses tosustainability are generatingtransfer pricing issues

Financial transactionsin todays world:observations from a transferpricing perspective

Transfer pricing in China:service transactions

Transfer pricing inuncertain economic times:embracing opportunities

Regulation, documentationand transfer pricing 2014

Services, intangibles and exitcharges: the evolving views

on inter-company transfersof services

Revisiting procurement:emerging opportunities

In this issue:

Transfer Pricing

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It is my pleasure to present this new edition of PricewaterhouseCoopersTransfer pricing perspectives.

The past year had been tough for the world economy. Although now weare seeing signs of a recovery there are still potential troubles ahead, asseveral major territories adopt new or revised requirements for transferpricing as well as the increase of disputes globally. Documenting andsustaining transfer pricing in this economic environment can also createmany difficult issues for tax departments. The continuing uncertaintax positions generated by the transfer pricing process means thatmultinational companies are having to satisfy the increasing demands oftax authorities and stakeholders. The present economic situation which has made the former more aggressive and the latter more cautious has only aggravated this fundamental challenge.

The articles in this edition remind us that a longer-term view with a globalperspective is vital to achieving satisfactory results now and exploitingchange for long-term benefit.

Perspectives: Thriving through challenging timesoffers strategies on howto meet the increased transfer pricing challenges and we hope that thisedition will give you greater insights into how your business can bettermanage the risks and opportunities arising from these challenging times.

To keep up to date with the latest transfer pricing developments around theworld, sign up to our PKN alerts by visiting pwc.com/pkn. Our 2010 GlobalTransfer Pricing Conference will be held in Budapest, Hungary from 20 to22 October. Further details will be launched in late May/early June and willbe available via your usual transfer pricing PwC contact. I look forward toseeing you there.

Foreword

Garry Stone

Global transfer pricing network leaderPricewaterhouseCoopers (US)

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Contents

1.The current state ofplay on substance:

A plea to monitorgeographicallydispersed corporatebrainpower

Page 4

9.Services, intangiblesand exit charges:the evolving viewson inter-companytransfers of services

Page 48

5.Financial transactionsin todays world:observations froma transfer pricingperspective

Page 24

2.Highlights of theproposals for

updating the OECDsTransfer PricingGuidelines

Page 12

10.Revisitingprocurement:emergingopportunities

Page 54

6.Transfer pricingin China: servicetransactions

Page 32

3.Businessrestructuring in

Europe: whereare we now?

Page 16

Transfer pricingcountry leaders

Page 60

7.Transfer pricing inuncertain economictimes: embracingopportunities

Page 36

4.How businessresponses to

sustainability aregenerating transferpricing issues

Page 20

8.Regulation,documentation andtransfer pricing 2014

Page 40

1.The current state ofplay on substance:

a plea to monitorgeographicallydispersed corporatebrainpower

Page 4

2.Highlights of theproposals for

updating the OECDsTransfer PricingGuidelines

Page 12

3.Businessrestructuring in

Europe: whereare we now?

Page 16

4.How businessresponses to

sustainability aregenerating transferpricing issues

Page 20

9.Services, intangiblesand exit charges:the evolving viewson inter-companytransfers of services

Page 48

10.Revisiting

procurement:emergingopportunities

Page 54

Transfer pricing

country leaders

Page 60

6.Transfer pricingin China: servicetransactions

Page 32

7.Transfer pricing inuncertain economic

times: embracingopportunities

Page 36

8.Regulation,documentation and

transfer pricing 2014

Page 40

5.Financial transactionsin todays world:

observations froma transfer pricingperspective

Page 24


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The current state of play on substance:a plea to monitor geographically dispersedcorporate brainpower

Transfer Pricing PerspectivesMay 2010

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Substance is not a new topic it has beenlurking in the shadows of international tax

planning for decades. This is less the casein a transfer pricing context and the notiononly seemed to come to the fore when peopletalked about functional analysis. Indeed,there appeared to be a persistent tendency toconsider substance as a necessary evil, whichpresumably justified a minimalistic approach,reducing the exercise to completion of achecklist. Questions such as Do I need a localboard of directors?, Do I need to organisephysical (in-country) board meetings?, Howmany people should I move? or Is it possibleto merely allocate risk? are quite common when

the traditional analysis is done. But the days aregone when such a quantitative approach willdo. Moreover, it has in fact opened doors for taxauthorities and policy-makers around the worldto challenge international tax planning and labelit as (somewhat) artificial.

Recall the comments made by President Obamawhile he was still on the campaign trail withrespect to Ugland House, the infamous officebuilding in the Cayman Islands. This buildinghouses more than 15,000 corporations andPresident Obama said of it that either this isthe largest office building in the world or it is the

largest tax scam in the world. Of course, not allinternational tax planning is organised this way,but his point was probably valid and was pickedup by other political leaders, making the concernof artificial international tax planning a fixed itemon the agenda of the OECD and the meetings ofthe G20 for the past 12 months.

This does not mean that international taxplanning will no longer work. Far from it! Wefeel, however, that companies should step uptheir efforts to address substance in a qualitative

manner. Instead of asking, How many peopledo I need to move? the question should rather

be: What am I trying to achieve? or What kindof management capacity do I need in a certainjurisdiction to achieve my objectives? Thisrequires a more content-based approach, in anendeavour to align tax strategy with corporatebusiness strategy. So, instead of taking theposition that business people should not getinvolved because they risk blocking anythingthat might hamper operational efficiency, theyshould get involved prior to embarking on aproject to ensure a solid business foundationexists for a (sustainable) tax strategy. In theend, goal-congruence reigns, with the aim of

optimising company value for all stakeholders.Taxes are ultimately a cost of doing business,and trying to achieve an acceptable tax rate is anoble objective that merits effort.

It is important to note here the question of howeconomic substance is monitored. When a tax-effective model is implemented, the substancequestion will be addressed at the same time.The next question is who will take ownershipof the monitoring going forward, in years tocome? Who will see to it that a proper substanceremains in place and who will police theeventuality of a challenge because certain rules

might have changed in country X? From talkingto a large number of executives on this topic, it isclear that when something goes wrong and thetax authorities conclude that, say, profits cannotbe allocated to a certain jurisdiction becauseof a lack of economic substance, it is the taxpeople that tend to get the blame.

We therefore feel it is important to have in placea policy on substance and to organise substancereviews on a regular basis.

The current state of play onsubstance: a plea to monitorgeographically dispersedcorporate brainpower

ByAxel Smits(PwC Belgium)and Isabel Verlinden(PwC Belgium)

PricewaterhouseCoopers. Transfer pricing perspectives. 5

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PricewaterhouseCoopers. Transfer pricing perspectives.6

Building blocks forqualitative substance

Put simply in terms of international tax planning where the aim is to achieve an overallacceptable tax rate companies have a twofold goal:

1. to set up one or more entities in tax-efficientjurisdictions; and

2. to allocate a fair amount of profit to

those entities.

One must ensure that the entities it is intendedshould be tax-resident in a certain jurisdictionessentially qualify as such and that theresults allocated to them are fair under arms-length conditions.

For the purposes of the substance analysisrequired, both aspects should be reviewedseparately given the different rules that apply(especially from country to country). In the end,however, they should be merged to assess the

companys overall position.

Figure 1:

Substance: The qualitative approach

Operating models:Transfer pricing

To be considered: a robust

functionalanalysis

significantpeople functions

controllableentrepreneurialrisk

Corporatestructures:Tax residence

To be considered: differences in

domestic rules no clear

solution attreaty level

EUdevelopments(ECJ case law)

Substance:The qualitative approach

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Substance in operating models

Anecdotal evidence on fiscal residence andtransfer pricing

This first illustration constitutes mere anecdotalevidence on the subject of residence andtransfer pricing.

A classic interest-benchmarking study aimedat establishing a range of arms-length,

intercompany interest rates in relation to asyndicated third-party bank proved in the endto have a somewhat uncommon angle. The loanagreement contained a fairly peculiar provisionstating: no member of the group may change itsresidence for tax purposes. You might imaginethis to be a valid issue relating to the residenceof the borrowing entity given its withholding taxrelevance. However, defining the purpose servedin a broader context is harder. The questionis whether any multinational enterprise thatengages in external borrowing would be ableto commit to such a far-reaching obligation in a

loan agreement? Is this a foretaste of what thenew (tax) world might look like? From a transferpricing perspective, reference can be made tothe September 2009 OECD seminar in Paris onTax Treaties and Transfer Pricing Developments,at which Mr Owens, Director of the Centre ofTax Policy and Administration at the OECD,addressed the needs for transparency, integrityand good government in this new world. Onthe other hand, the hard experience is that taxauthorities need money, as the fiscal crunchis not expected to recede in the short term. Anumber of tax authorities are behaving prettyvigilantly. Former OECD Working Party One

chair, Mr Lthi, already mentioned a year earlierat a similar OECD event that tax authoritiesmight get greedy, aggressive and jealous, addinga tax morality aspect to the debate.

Entrepreneurial structures withseconded executives

Entrepreneurial structures are typically usedto accommodate a groups strategic andoperational desire to organise both its upstreamand its downstream relationships in a slimmermanner on a regional, eg, pan-European, basis.Tax efficiency then predominantly stems fromlocating the principal company in a tax-effectivejurisdiction. The sixty-four thousand dollar

question is whether you have the right peoplein terms of skills and numbers to actually run abusiness credibly out of the principal entity.Experience tells us that global mobility issuesrelated to key executives often come intoplay during the location-study phase of theentrepreneur company. As people often feelreluctant to move permanently with theirfamilies to the principal companys jurisdiction,the possibility of pursuing dual employmentstructures is generally raised. It might whenpush comes to shove be tempting to suggestthat, provided proper, robust secondment

agreements are in place, the substancerequirements are adequately met to justifypremium profit residing with the principalcompany. We feel that the principal shouldhave substantial management control of keyexecutives under secondment agreements andbear the entrepreneurial risk of their activities.From an economic perspective, one might havereason to believe that the principal acts as theemployer of the secondees.

The sixty-four thousand dollarquestion is whether you have the right

people in terms of skills and numbersto actually run a business credibly outof the principal entity

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Recent developments in the area of businessrestructurings at the OECD might play a pivotalrole here. The September 2008 discussiondraft emphasises the need to analyse andsubstantiate who it is that actually controlsentrepreneurial risk. This is easier said thandone, as companies value chains are seldomorganised in a linear manner and seniormanagement is often dispersed over variouslegal entities. The OECD could have taken avariety of positions in the discussion draft. First,

it could have proclaimed that a multinationalenterprise cannot allocate risk over its affiliatesand that, consequently, risk cannot be diversifiedat all, so that it automatically lies with the parentcompany. Alternatively, it could have takeneverything the taxpayer says for granted,provided it is documented, ie, placing form oversubstance. Third, it could have made the so-called comparable uncontrolled risk-allocationmethod a default, meaning you should haveto find out and advance what unrelated partieswould have done. The risk would probably be areversion to the first position: there would be no

possibility to diversify risk whatsoever. The fourthoption, and potentially or probably the preferredone could have been to respect what companiessay they do, provided they have the economicand, to a lesser extent, the financial capacity todo so.

The OECD discussion draft simply urgesgroups to make sure that (1) the principal hasthe people with the expertise, ie, the capabilitiesand authority (decision-making power), toactually perform the risk-control function and(2) the principals balance sheet demonstratesthe financial capacity to absorb losses when

things turn sour without endangering its survivalas a going concern. Consequently, you couldexpect control to be seen as the capacity toanalyse the decision to bear a risk, plus probablywhether and how to manage the risk vis--vis the employees or directors. The issue of

secondment is not addressed in the discussiondraft and the message therefore seems to bethat it is fair to strike an equilibrium betweenpure secondments, or dual-employmentstructures, and people exclusively on the payroll(or board). The expectation is that secondmentarrangements risk being subjected to scrutinyby tax authorities. Parameters that might comeinto play in this debate include the essentiallytemporary nature of secondments (within themeaning of the EUs social security regulations,

under which they should not exceed five years).The employees furthermore stay on the payroll ofthe assigning company and thus formally remainunder its uninterrupted authority.

It does not seem advisable to have thedecision-making process governed by aform-over-substance type of analysis. Recentdevelopments at OECD level might offermore ammunition to tax authorities in theirbid to scrutinise true substance in terms ofentrepreneurial risk control and, generally, interms of functionality and risk profile within

the principal company. This debate mighteven show signs though not formally of thenotion of significant people functions drawnfrom the OECD proceedings on permanentestablishments, the very essence of thesignificant people functions notion beingthe ability to assume responsibility over acertain activity.

It does not seemadvisable to have thedecision-making processgoverned by a form-over-substance type of analysis

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New US perspectives on defining intangibles

Our last case illustrates some potentiallyworrying developments, particularly fromthe perspective of a non-US transfer pricingpractitioner, with the growing risk of attendant

double taxation. This concern could bepremature at this stage because the issue stemsfrom proposals from the Obama administration.It boils down to the consequences of apossible codification of mere value drivers asintangibles under US transfer pricing legislationor tax legislation in general. Fundamentally,you might question whether the classificationquestion is at all relevant from a transfer pricingperspective. Indeed, the governing principleshould be whether a third party would bewilling to pay for something. Consequently,characterising an intangible as such seems

to be less relevant from a transfer pricingperspective. Characterisation is pertinent fromthe viewpoint of article 12 of the OECD ModelTax Convention (MTC), informally referred to asthe royalty article. You might infer from this thatintangibles are restricted to intellectual propertyand know-how and, if you look at section 10.1 ofthe Commentary to the OECD MTC, it appearsas if value enhancers are not to be viewed asintangibles. From a transfer pricing perspective,you are ordinarily assumed to conduct a transferpricing analysis based on a functional analysisin which functions, risks and assets take centrestage. One concern is that, if assets are already

identified under US legislation, there is a risk thatthe possibility of taking a zero-based approachfor the functional analysis will be compromised.At the end of the day, there risks being apreponderance of profit potential for the USparticipants in an intercompany arrangement.

It is unclear at present whether an authoritativesource such as the OECD will embark on aproject to align the thinking process withina broader perimeter around extension of theclassification of soft-intangibles. Personally,we feel that any initiative by the US Congress

in that area might ultimately be a short-livedvictory, especially as labour-intensive countriessuch as China and India might welcome the ideaof codifying notions such as workforce in place,going concern value and goodwill.

Concluding thoughts from a transferpricing perspective

The message is to knit things together from atransfer pricing perspective even before theinternational tax side is looked at. Addressingsubstance requires you to look to the OECD

proceedings on business restructuringsand assess who controls entrepreneurialrisks. The OECD proceedings on permanentestablishments are also relevant, and raisethe question what about significant peoplefunctions? Finally, there have also beeninteresting recent developments in the OECDTransfer Pricing Guidelines. Since 1995, mostof their content has not been revised and thenew draft chapters 1 to 3 that were launchedin September 2009 placed emphasis on thequalitative nature of functional analysis. Thisonce again underscores the fact that the daysseem to be gone when you could conduct a

functional analysis and present the outcomebased purely on a spreadsheet grid in whichyou ticked boxes on functions, risks and assets.Taxpayers have an interest in making properefforts to come up with a high-quality narrativeof functionalities and entrepreneurial risks, fullytailored to the operational context.

The message is to knit things together from a transfer pricingperspective even before the international tax side is looked at

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Substance in corporate structures

Even though the main focus of this contributionis on transfer pricing, a substance analysiscannot rule out a review of potential challengesby tax authorities in the area of tax residence.Even if profits are allocated fairly under thearms-length principle, with the right people inthe right places, issues could still arise if thetax residence of the entities concerned weretreated as if located in another (less-favourable)

jurisdiction. Especially in times of governmentbudget pressures, challenging the tax residenceof companies is a fairly soft target for fiscalauthorities in search of additional revenues.

The main concern here stems from thesignificant discrepancies in how differentjurisdictions determine corporate tax residence.

Today, only a limited number of countries stilluse the place of incorporation as the maincriterion, the US probably being the best-knownexample. Although the benefit of the place of

incorporation rule is clear, ie, simplicity, it is alsoeasy to abuse. Even the US now seems to beconsidering proposals by Senator Carl Levin tostep away from the concept as the sole test andintroduce some form of management andcontrol standard.

Most countries already apply a real seat test,but it is a common mistake to assume thatthis just boils down to the place of effectivemanagement. True, it is the concept underarticle 4 of the OECD MTC, but this concepthas (to date) never been clearly defined andis usually interpreted under domestic tax law.

In considering domestic rules, a differencein interpretation can be discerned betweencommon law and civil law countries. The formertend to consider the board of directors as thepinnacle of power and focus predominantlyon where its meetings take place to determinea companys tax residence. The latter, on theother hand, consider a board of directorsas a company body with a supervisory roleand assign more importance to day-to-day

management. Having surveyed more than40 countries for our publication Substance:

Aligning international tax planning with todaysbusiness realities (pwc.com/substance), we canstate that there is, nevertheless, little consistencyin how individual countries apply these principlesin practice.

A recent example can be found in the 2009 caseof Laerstate (Laerstate BV v HRMC) in the UK,in which two comments made by the court areof wider relevance. The first is that, although theUK is a common-law jurisdiction and the boardsrole is considered to be of key importance,the board of directors can only be taken as acriterion for tax residence if it is functioning

properly. The second interesting point is that itis not merely the board decisions that shouldbe looked at, but also the wider course ofbusiness and trading of the company (ie, youshould consider the companys managementthroughout the year and not merely at boardmeetings). It is not enough to document thecompanys decisions as being taken outsidethe UK, but actually run the company fromanother jurisdiction.

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Multinational companies have an interest incarefully considering the type of jurisdictionthey deal with and reviewing the rules that applyunder domestic law (not so much in the countryof incorporation as in the country where the realseat could be deemed to reside). As mentionedabove, no clear definition of the place of effectivemanagement concept is available in article 4 ofthe MTC. In June 2008, the remaining referenceto the board of directors criterion was removedfrom the OECD Commentaries and a formal

option to use a mutual agreement procedure(MAP) introduced. This procedure a part of UStreaties for years is now to be found in, say, thenew double taxation treaty between the UK (acommon-law jurisdiction) and the Netherlands (acivil-law jurisdiction). This trend will only increasethe importance of interpretation under domestictax rules.

Finally, in an EU context, it is worth noting thatan additional defence might be found in thefreedom of establishment concept. Although notabsolute (a rule of reason should be considered),

some guidance can be found in recent ECJ caselaw prohibiting tax authorities from applying

local anti-abuse provisions that are not aimedat preventing wholly artificial arrangements.As long as the appropriate staff, premises andequipment are in place, it should be possible toinvoke the freedom of establishment in the caseof scrutiny by the tax authorities.

Conclusion

With tax authorities around the globe steppingup their efforts to challenge what they might

deem to be artificial tax structures, we feel thattax departments should review their internationalstrategies, including transfer pricing, interms of compliance with various substancerequirements. There will be an increasing needfor tax strategies to align with the businessrealities of multinational company groups.Tax authorities are only likely to prevail overtaxpayers in cases where economic substance isabsent or incomplete. If substance is addressedin a qualitative manner and clear policies areput in place to monitor compliance, there is noreason to assume that effective tax strategies

should not be sustainable for years to come.

There will be anincreasing needfor tax strategiesto align with thebusiness realitiesof multinational

company groups

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Transfer pricing perspectivesMay 2010

Highlights of the proposalsfor updating the OECDsTransfer Pricing Guidelines

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Highlights of the proposals forupdating the OECDs TransferPricing Guidelines

By Garry Stone(PwC US)and Diane Hay(Special advisor to PwC UK)

Over the past few years the OECD has beenworking hard to provide revised and additional

guidance on two major areas of transferpricing: 1) business restructuring and 2) transferpricing methods and comparability. Taxpayersand tax authorities need to be aware of theramifications of these developments as theywill generally guide future country-specifictransfer pricing regulations and will provide thebasis for future competent authority (or MAP)negotiations. In this summary we evaluate someof the highlights.

Business restructurings

In September 2008, the OECD released adiscussion draft outlining the application of thecurrent OECD Transfer Pricing Guidelines to thedifficult issues raised by business restructurings,involving the cross-border redeployment ofassets, functions and risks between associatedenterprises and the consequent effects on theprofit and loss potential in each country. A largenumber of comments were received from variousquarters and significant commentary has beenprovided on the draft. Because of the largenumber of comments, and also because theOECD lacks a clear consensus of its memberson some of the items discussed below, there

will be further refinements and developments ofthese positions.

In our view, there are seven key areas wherethe draft puts forward helpful changes

and explanations.

1. The draft states that tax authorities shouldnormally respect the taxpayers businessoperational changes, and should notimpose reinterpretations of the operationalstructure, so long as the changes meet thetest of commercially rational behaviour,which is linked to the notion of would twounrelated parties have operated in the samemanner? What this means, according tothe draft, is that any attempt to argue thata transaction is not commercially rational

must be made with great caution and only inexceptional circumstances.

2. The draft indicates that for the new structuresto be respected there would need, first of all,to be appropriate intercompany contractsin place that lay out the key relationshipsbetween the parties, in order to effectivelyallow those parties to assume the appropriaterisks that are associated with the newoperational structure.

3. Very importantly, however, the contractualallocation of risk assumed via the contracts

is to be respected only to the extent that ithas economic substance (ie, the risks mustbe allocated to the entity that has the abilityto manage or control those risks and thefinancial capacity to reasonably absorb them).

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4. The draft also looks at the issue of

compensation when assets, functions andrisks are transferred in a restructuring and, asa result, there is a transfer of profit (or loss)potential from one entity to another. It notesthat profit potential is not an asset in andof itself, but is a potential carried by certainassets and, consequently, profit potentialdoes not require its own compensation underthe arms-length principle.

5. If changes occur in the location of assets as aresult of the restructuring, any compensationshould reflect the changes that haveactually taken place and how these affectthe functional analysis and the relativebargaining power of the parties involved inthe change, including the options realisticallyavailable to the parties as a result of therestructuring changes.

6. Finally, the draft makes the important point

that there should be no presumption that,because third parties do not allocate risksin the same way as unrelated parties, theresulting allocation should not be treatedas arms length and that there should be nopresumption that all contract terminationsor major renegotiations would give rise tocompensation at arms length.

7. Taken as a whole, the business restructuringsdraft, together with the comments madeon the draft, move the debate forward in asubstantial way from where the OECD wasseveral years ago. The six key areas provide agood insight into the thinking of the membercountries and should help taxpayers betterorganise their affairs until such time as finalrevisions to the guidelines are issued.

Taken as a whole, the business restructuringsdraft, together with the comments made on thedraft, move the debate forward in a substantialway from where the OECD was several years ago

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Transfer pricing methodsand comparability

The second area of key transfer pricingdevelopments concerns revisions to the firstthree chapters of 1995 OECD Transfer PricingGuidelines. These cover issues around thechoice of transfer pricing methods, with specificreference to profit-based methods, and thewhole area of comparability. There are four keyareas in respect of these proposed revisions

that reflect the comments that PwC has recentlyprovided to OECD.

1. The proposed revisions move away froma hierarchy of methods approach to onebased on the most appropriate method tothe circumstances of the case. This is animportant development because often forpractical reasons the data available wouldwarrant the application of a method such asthe transactional net margin method (TNMM)rather than a traditional transactional method.

2. The current text provides much more detailon the application of TNMM (with explicitrecognition of the applicability of Berryratios) and profit splits. However, the newcomparability standard for TNMM might makethe application of this method more onerousand could give tax authorities a preference forprofit splits.

3. The proposed revisions provide reassurancethat the most appropriate method approachdoes not require taxpayers to test every othermethod in depth and the use of a secondis not compulsory except in difficult cases.

However, there is an expectation that somequalitative information will be provided onthe non-tested party, including a functionalanalysis, in the case of TNMM as well as thetraditional transactional methods.

4. The aim of the proposed new guidance oncomparability is to arrive at the most reliablecomparables. While this might appear tobe setting a standard that will be difficult toreach, the draft also recognises the need tobe pragmatic and provides helpful guidanceon the use of internal and non-domesticcomparables. It also includes a 10-stepprocess for performing a comparabilityanalysis as a guide to good practice.

All the changes and additions to the currentTransfer Pricing Guidelines address many ofthe practical issues found today when usingthe existing guidelines and ought to providetaxpayers and tax authorities with much greaterclarity on how they should conduct their transferpricing affairs in the future.

To read our full response on the proposedrevision of chapters I-III of the OECD TransferPricing Guidelines click here.

All the changes andadditions to the currentTransfer Pricing Guidelinesaddress many of thepractical issues found todaywhen using the existingguidelines and ought toprovide taxpayers and taxauthorities with much greater

clarity on how they shouldconduct their transfer pricingaffairs in the future

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ByIan Dykes (PwC UK)andYvonne Cypher(PwC UK)

Given the number of uncertainties aroundspecific areas of business reorganisation

expressed in the Organisation for Economic Co-operation and Development (OECD) DiscussionDraft, strategic management of engagement withtax authorities and documenting new businessstructures from the foundation and throughoutthe process is critical.

Businesses are subject to competitive pressuresand changing market demand to structure theirworldwide operations effectively and efficiently.In reaction to market forces, a multinationalgroup might only be able to protect its profitmargins by restructuring its business.

Tax authorities generally recognise thatbusinesses are free to reorganise themselves asthey see fit. Nevertheless, they have also madeit clear that companies that engage in businessrestructuring are likely to receive scrutiny, and,indeed, this is what we have observed.

The debate has intensified since the publicationof the Discussion Draft on Transfer PricingAspects of Business Restructurings issued byOECD in September 2008 (the Discussion Draft).

While the Discussion Draft reflected consensus

among OECD member countries across manyissues, it also suggested quite openly theexistence of differences of opinion betweengovernments and businesses on some criticalissues, examples of which include:

the definition of intellectual property; permanent establishment positions;

the occasions on which exit chargeswill arise;

circumstances in which governments maydisregard taxpayer initiated restructuringtransactions in their entirety;

circumstances in which individual terms oftaxpayer contracts may be disregarded orrewritten by taxing administrations;

indemnification of individual participants in arestructuring transaction; and

the location of significant decision makerswhere risk and consequence of risk ultimatelysettles within multinational company (MNC).

The above and other key topics were covered

by the Working Party 6 during their PublicConsultation held in Paris on 9 and 10 June 2009in Paris. These have been summarised in moredepth in the previous edition of Perspectives.

In articulating the foregoing principles, theDiscussion Draft displays common sense,balance, and pragmatism. The concerns that wehave with the Discussion Draft generally involveissues where these key foundational principlescould be undermined to some degree.

Having this in mind, the tax authoritieshave already begun to challenge business

reorganisations by applying arguments basedon the Discussion Draft. In this article we havefocused on showing more practical aspects ofhow MNCs considering restructuring might dealwith the issues raised in the Discussion Draftand prepare themselves in case of potential taxaudits, which are becoming more frequent andbetter informed.

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The optimal approach will be based on astrong theoretical foundation that will inform allaspects of the reorganisation and that shouldinclude economic analysis of actual behaviour,third-party evidence and an analysis of relativebargaining power on the understanding thatchallenges and fundamental disagreementsare likely to arise. It should be determined whatan MNC can practically do to prepare for thechallenges based on the areas raised in theDiscussion Draft in order to ensure a robust and

optimised defence position. It is critical to beprepared to respond affirmatively in the likelyevent of an audit, considering the following likelyareas of tax authorities scrutiny:

Commercial rationaleThe business records that reflect theconsideration of the drivers and commercialrationale for the changes (such as presentations,board minutes, etc) should be retained and itideally would reflect the thinking at both an MNClevel and at a stand-alone entity level. Theserecords would be collateral throughout the

process from early idea conception through tothe final implemented structure.

Transitional considerationsA transition period is usually required toimplement a business restructure. The businessrequirements that drive the timetable should bewell documented to show whether and how theevents that occur during the transition period areattributable to the same business restructure.

Demonstrating the nature of thebusiness changeThe Discussion Draft implies that a

reorganisation equates to a transfer ofa business from one entity to another.Reorganisations are rarely this simple, andusually amount to a transformation of theoperational paradigm. It is important to reflectthis in your support files.

Compensation issuesAssets carrying profit potential that have beenchanged or transferred in the restructuringprocess should be remunerated to the extent

that they have economic value. In this regard itis important to identify and define all rights andassets that exist in the original structure andanalyse the compensation provisions withinthe existing framework of legal contracts, ie,indemnity rights within existing legal framework eg, termination provisions. It is also importantto collate and analyse any third-party evidence inthis respect.

Non-recognition of transactions or

contractual formsThe Discussion Draft recognises that MNCsenter into transactions that independentparties wouldnt (or couldnt), but provide littleguidance on what happens when this occurs.One of the key tests introduced asks whetherthe transactions or contractual form within atransaction would be contemplated or acceptedby third parties. In this regard it will be importantto generate appropriate evidence includingexternal terms, conditions and pricing in thetransactions that are structured similarly withindependent parties.

Economic substanceUnder the approach presented in the DiscussionDraft the legal position will be recognisedonly if it aligns with the underlying economicsubstance. It will be therefore important todocument the fact that the economic substanceis consistent with the legal form of the newoperating structure. In addition to collecting thisevidence at the time of the restructuring reviewit is crucial to document the position periodicallythereafter to ensure continued alignment of legalform and economic substance.

Economic significance of riskIt is imperative to analyse and document thebusiness risks present in the organisation andtheir location before and after a restructure hasoccurred. Moreover, the location of the strategicmanagement (also being a crucial element of theeconomic substance) and control of the risksshould be consistent with the economic result,ie, contractual risk allocation should align witheconomic substance.

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Intangible assetsIdentification of the intangible assets in thebusiness and their legal ownership profile usuallyforms the cornerstone of the transfer pricinganalysis. It is important to reconcile the legal andeconomic ownership position.

Restructuring costsThese will arise as a consequence of thechange in operational structure for exampleredundancy costs and systems costs. It is

necessary to establish who is responsible forbearing these.

Permanent establishmentTypically with a business restructuring, bothduring the transition period and under the newbusiness model, there can be risks of the central,entrepreneurial entity creating a permanentestablishment in the restructured local entitiesterritory. This needs to be evaluated duringthe planning stages of a restructuring whendetermination of the new operating model ismade. It should also be managed and reviewed

on an ongoing basis to ensure the integrity of thenew operating model is retained.

Remuneration of post-restructuringcontrolled transactionsOn determination of the final business modelpost-restructuring, a detailed functional, financialand economic analysis is required to design andsupport the arms-length transfer pricing policiesfor all intra-group transactions.

The analysis should be driven by businessrealities of the industry reorganisation.Businesses should be ready to justify the

profit and loss outcomes in all parts of theirorganisation and should be ready to engage withtax authorities early if necessary and considerinteractions between tax authorities (includingconsideration of unilateral or bilateral AdvancePricing Arrangements for new structures,if appropriate).

The issue of business restructuring will clearlycontinue to be one of intense interest to bothgovernments and taxpayers. Such transactions

must have functional substance and businessmotivation if they are to be respected. Somecritical issues in the Discussion Draft are likely tobe clarified further and some might be removedin order to maintain consensus, but its basicapproach is likely to be preserved and will behighly influential.

It would be unrealistic to say there is a solutionthat guarantees a given reorganisation is wellprotected and safe from challenge by tax

authorities. However, if a good strategic plan isdeveloped and implemented, businesses shouldbe able to maximise their chances of success.

Conclusion

In the current economic climate, governmentsare under pressure to raise revenue and issuessuch as transfer pricing, international tax andpermanent establishment are high valuetargets for enforcement by tax authoritiesworldwide. Also, governments are co-operatingas never before to share taxpayer and

industry information.

Given the progressing debate around mostcontroversial issues arising from the DiscussionDraft, there is only a very limited possibilitythat any given business reorganisation will notbe subject to tax investigation. Therefore it isadvisable that MNCs who are driving commercialchanges to their operational approach developa fact-specific strategy including audit-readydefence files. Also, it is crucial that theirstakeholders understand the possible exposuresand are aware of mitigation strategy andlikely cost.

Issues such as transferpricing, international tax andpermanent establishmentare high value targetsfor enforcement

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By Duncan Nott(PwC UK)andYvonne Cypher(PwC UK)

Unveiled at the World Economic Forum inDavos, January 2010, PricewaterhouseCoopers

Appetite for Change survey1examinesthe attitudes of the international businesscommunity towards environmental regulation,legislation and taxes. With almost 700 interviewsconducted in 15 countries, it is the mostcomprehensive survey of its kind yet completed,giving an insight into both companiesexpectations and what they are doing now toadapt their businesses to the regulations andrequirements of sustainability.

This report shows that businesses globally arealready tackling the challenges of sustainability.

Many are approaching this centrally, seeingopportunities to improve competitivenessthrough changes to areas such as branding,technology and the business model as a whole.

This survey illustrates that transfer pricingpolicies will need to keep pace withthese sustainability developments withconsiderations including:

the creation of new transaction streams; changes to existing transactions to embrace

changes in functions, assets and risks; potentially complex questions surrounding

the interaction of central and local strategyand execution and the appropriate arms-length attribution of cost and benefitthat results;

the need to keep transfer pricing policy,comparables and documentation current tomeet compliance requirements; and

the ability to identify and secure planningopportunities if transfer pricing is linked intobusiness change early.

The surveys clearest message is that addressingclimate change and sustainability is a currentissue for companies, not just a challenge forthe future. More than half of respondents, inparticular the largest companies, have observeda fairly or very big impact on their businessalready. This rises to 90% who have seen atleast some impact. The majority of companiesare also expecting to change the way theirbusinesses operate in the next two to threeyears as a result of climate change. Weve gone

from being pulled by customers to seeing this asa financial imperative.

This is a global picture, with only small regionalvariations. Multinational companies makeup two-thirds of respondents, and the globalscope of the challenge is frequently found tobe met with a centrally driven response: Wehave a unified global standard in every countrywe operate in, whether or not that country has

1Appetite for change: Global business perspectives on tax and regulation for a low carbon economy www.pwc.com/appetiteforchange

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the legal requirement for that environmentalstandard. The global standard applied bybusinesses often exceeds territories minimumregulatory requirements, especially amongstlarger companies with environmental reportingrequirements: There are many areas where wego beyond the mandatory level of legislation ona voluntary basis we wouldnt do that of courseif we didnt see value in it. This is influenced bya range of factors, including compliance (85%),corporate reputation (74%) and competitive

advantage (67%). How these factors mix,however, was found to be highly specific to thefacts and circumstances of each company.

Achieving this value will give rise to new andchanging provisions or transactions betweengroup companies in multinational businessesthat will need to meet the arms-length standardand be robustly documented to comply withnational transfer pricing rules. This covers a widerange of areas, from the adoption of regulatoryschemes such as emissions trading to reshapinga companys business model. Changes might

also arise in product pricing, the value ofintangibles, services and financing. Transferpricing is therefore at a minimum an urgentcompliance requirement, however potentialplanning opportunities also exist to alignintercompany relationships and business modelsin a tax efficient manner. Transfer pricing policieswill need to adapt to ensure that, for example:

appropriate transactions are recognisedand addressed;

comparables are reviewed for effectiveness,for example where existing ranges reflect acost base that has been superseded by the

environmental model; and documentation remains current and robust.

Where a groups response to sustainabilityrequirements exceeds local minimum standards,the drivers of the additional costs thiscreates must be understood and appropriateremuneration identified. The considerationsrevealed by the survey suggest that spendingin support of brands or to fulfil shareholderrequirements might play a major role, and soshould be considered carefully. The same is truewhere cost savings are achieved.

Major changes to business models presentmore fundamental transfer pricing and taximplications. In our experience, this could involveconsiderations surrounding the ownershipof key assets such as intellectual property,centralisation of procurement functions orrestructuring of group activities to accommodatea reduced mileage distribution network. Howresponses to environmental regulation are builtinto groups existing transfer pricing modelscan also be critical, as activities such asemissions credit trading or administration ofthe EUs regulation on Registration, Evaluation,

Authorisation and Restriction of Chemicals(REACH) programme can alter the risk profileof companies.

The costs and appropriate rewards for researchand development will also need to be addressed,and consideration given to the most appropriatelocation for the resulting intellectual property.Incentives prove popular, and the benefits ofthese should be integrated with how the relatedactivities are structured and rewarded.

Building emissions into supply chain pricing wasidentified as the main single issue concerning

respondents. An emissions trading scheme (ETS)was narrowly favoured over a carbon tax by 68%to 62%, although the 17% already involved in

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such a scheme showed much stronger supportwith 81% in favour. This suggests that an ETS ispotentially the most popular approach, but to theunfamiliar it suffers from a lack of transparencyand, in some regions, the feeling that it couldlead to unfair gains by those who work thesystem best. This view could be picked up bytax authorities and reflected in challenges to howbusinesses price credits are traded betweengroup companies. The existence of differentschemes and variations in value of creditsto different business units, coupled with thefluctuating price of carbon, mean transfer pricing

decisions in this area are not straightforward.Coupled with a lower level of understanding fromtax authorities, this will place heavy demands onboth transfer pricing policy and documentationto establish and support a pricing model. In anuncertain area, the certainty offered by advancepricing agreements might be advantageous formany companies.

A key challenge for tax departments will beto ensure they are linked into their businesssenvironmental strategy. The survey interviewedthe most senior person in the organisationresponsible for setting strategy and managing

environmental impact. Of these, only 37%also have the responsibility for managingenvironmental taxes in the organisation.

This suggests that in many cases, thoseresponsible for transfer pricing will need toreach out to the relevant parts of the business,not only to ensure they are aware of changesto operations, but to bring transfer pricingconsiderations into any business change early toallow for effective planning and compliance.

Conclusion

Businesses have been clear that thesustainability agenda has already broughtchange and this process will intensify. This

is changing how value and cost are createdand distributed within groups, and bothtransfer pricing policies and the tax modelfor the supply chain must keep pace withthis to meet compliance requirements and toidentify planning opportunities. The impactsof sustainability are complex, with a rangeof drivers and little international consistency,and responses are often highly specific tothe business model, facts and circumstancesof each group, which might be in flux. Taxdepartments will need to understand both thechanges and their impacts and take actionto optimise their transfer pricing policy going

forward. In our experience, the earlier transferpricing is considered in this process, the moreeffective and robust the results.

Tax departments will need to understandboth the changes and their impacts, andtake action to optimise their transfer pricingpolicy going forward

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Financial transactions in todaysworld: observations from atransfer pricing perspective

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Risk premiums remain at a relatively high level

Due to the uncertainty surrounding the economiccrisis, various market participants have becomemore risk averse. At the same time, the turmoilwithin financial markets has severely impactedthe real economy, resulting in higher risks ofdefaults. The combination of these factorsresulted in a significant increase in risk premiumsthat continued until the fourth quarter of financialyear 2008.

In the fourth quarter of 2008, for example, thecredit spreads for long-term BBB (investmentgrade) quoted bonds were more than five timeshigher than the credit spreads at the beginningof 2007. It is only as of the second quarter of2009 that significant reductions in risk premiumshave been recorded.

Figures 4 and 5 present an overview of theevolution of credit spreads on quoted bonds forboth BBB and B credit ratings between January

2007 and December 2009.

0.25

01 Jan 07

0.5 1 2 3 4 5 8 9 107

4.5

4

3.5

3

2.5

2

1.5

1

0.5

0

Creditmargininpercentage(%)

Time to maturity

01 Jul 08 28 Nov 08 31 Dec 09

0.25 0.5 1 2 3 4 5 8 9 107

12

10

8

6

4

2

0

01 Jan 07

Creditmargininpercentage(%)

Time to maturity

01 Jul 08 28 Nov 08 31 Dec 09

Figure 4:

BBB credit rating - 31 December 09

Figure 5:

B credit rating - 31 December 09

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More stringent conditions to obtainexternal funding

Despite the efforts of various governments toinstigate a recovery of financial markets and toencourage confidence, financial institutions arestill facing a mix of challenges. While they haveto restore their capital buffers, the default riskof their clients has increased. Consequently,financial institutions remain cautious whengranting funding. Therefore, borrowers nowtypically have to pass more rigorous screeningprocesses and are faced with much morestringent terms and conditions (ie, formalguarantees and covenants that impose moresevere earnings before interest and taxes EBIT or debt-equity conditions, etc).

Unique market conditions triggerdifferent transfer pricing questions

Establishing the credit rating of anintercompany borrower

Various tax authorities around the world arecurrently struggling with the questionShould intercompany financing reflect fundingconditions at a group level and, as such, mirrorthe risk profile of the group as a whole, or,

should the individual risk profile of theborrowing entity be considered?

If we consider the tax authorities that adhereto an individual risk profile (separate entity or

stand-alone) approach, different methodologiescan be observed when determining an entitysindividual risk profile. These alternativeapproaches could result in significantly differentoutcomes. As the risk profile of an entity is oneof the most important factors when establishingan arms-length interest rate, one can imaginethat these discussions are not merely academic.The theoretical arguments in favour or againstthe various possible approaches should notbe influenced by the current crisis. However,given the increased risk premiums, the financialimpact of these discussions has become much

more important.

The General Electric Tax Court Case (TCC) inCanada dated 4 December 2009, regardingthe payment of guarantee fees, contains aninteresting debate on how to determine thecredit risk profile of a subsidiary. This caserelates to the level of guarantee fee payableby a Canadian subsidiary in return for a formalguarantee granted by its AAA rated US parent.The Canadian tax authorities fully disallowedthe payment of the guarantee fee based on theassertion that the Canadian subsidiary did notreceive any benefit from this guarantee. The

Canadian tax authorities further defended theirposition by arguing that the Canadian subsidiary

Should intercompany financing reflect funding conditionsat a group level and, as such, mirror the risk profile of thegroup as a whole, or, should the individual risk profile of theborrowing entity be considered?

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would benefit from the groups rating solelyby virtue of affiliation (an implicit guarantee orpassive association). The tax payers positionwas that a subsidiarys rating should beassessed on a stand-alone basis and, as such,affiliation should be disregarded. In the case athand, the tax payer estimated the stand-alonerating of the subsidiary to be BB-/B+.

In its decision, the TCC disagreed with the taxauthoritys position that the subsidiarys rating

should be equal to the parents rating sincethe Canadian subsidiary benefited from betterfinancing conditions thanks to the explicitguarantee. As such, the guarantee fee wasdetermined to be priced in accordance withthe arms-length principle. However, the TCCdid also recognise that, to a certain extent, thesubsidiary would have benefited from implicitgroup support even in the absence of a formalguarantee. Such implicit support is based onthe fact that multinational groups might beincentivised to support their subsidiaries dueto reputational risk, for example. For the case

at hand, implicit group support resulted in anuplift of three notches on the stand-alone creditrating of the subsidiary. Implicit group supportis the result of what the OECD defines aspassive association.

Before the crisis, the discussion of subsidiarycredit ratings was mostly based on hypotheticalarguments. Due to the current crisis, some real-life cases now exist on groups behaviour. Thereare examples where groups have intervened toavoid the bankruptcy of a subsidiary, however,in other cases, sub-groups or subsidiaries havebeen allowed to fail.

Arms-length terms and conditions

Traditionally, a transfer pricing analysis ofintercompany loans was typically limited toan analysis of the level of the interest ratesapplied. However, tax authorities are increasinglyquestioning whether the other terms andconditions of an intercompany loan reflectarmss-length behaviour. This might especiallybe the case where tax authorities adhere toa substance-over-form approach. Recent

examples of relevant questions relate to whereentities have financed long-term needs via short-term facilities and where guarantees have beenprovided that do not provide a real economicbenefit. As a high level test to understandwhether a transaction might reflect arms-lengthdealings, it could be worth asking whether thetransaction makes sense for all parties involvedfrom an economic perspective and also whetherunrelated parties enter into this transaction oncomparable terms and conditions.

Recently, there has been extensive press

coverage with respect to banks imposing morestringent and comprehensive covenants for newfunding. Moreover, while in the past, banks rarelyenforced covenants, nowadays, more and morebanks are withdrawing or renegotiating existingcredit facilities if these covenants are not met.One may argue that for intragroup funding,such covenants are less important as onecould reasonably assume that a group wouldprotect the financial health and interests of itssubsidiaries. Consequently, such covenantswould have a rather theoretical impact. At thesame time, as covenants are applied in third-party funding, tax authorities could argue that

comparable terms and conditions should alsobe reflected in intercompany loan agreements.Even if such covenants are not included withinintercompany contracts, it is recommendedthat groups maintain an awareness of thefinancial health of their subsidiaries. Thismight be particularly relevant should asubsidiarys activities be reorganised resultingin, for example, significantly different debtcoverage ratios.

Moreover, while in the past,banks rarely enforced covenants,nowadays, more and more banksare withdrawing or renegotiatingexisting credit facilities if thesecovenants are not met.

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Capital structure

Various countries have thin capitalisation rulesbased on simple financial tests, for example,debt to equity ratios. Recently, some countries,including Germany and Italy, have tightenedtheir thin capitalisation rules, for instance byintroducing limits specifically addressing thelevel of (intercompany) interest that can bededucted (not only focusing on the level of debt).

When looking at third-party dealings, banks havebecome much stricter when it comes to grantingfunding. This fact, combined with higher interestrates, might result in groups having to reduce theamount of third-party debt that they hold.When scrutinising intercompany financingtransactions, in addition to questioning interestrates and terms and conditions, some taxauthorities are also interested in whether anintercompany borrower would have been able toattract the same volume of external funding. Inother words, this comes down to the questionof whether the decision to grant or accept an

intercompany loan is an arms-length decision.If not, the loan might, from a tax perspective, bere-qualified as non-interest bearing equity forexample. In other words, thin capitalisation ismore and more being considered to be a transferpricing issue. According to paragraph 1.37 of theOECD Transfer Pricing Guidelines this indeedseems to be the case.

Existing loans

Existing loans that were concluded prior tothe financial crisis should reflect the marketconditions (and information reasonably available)

at the time that the transaction (and loanagreement) was established. Changing marketconditions do not automatically impact existingloans. Nevertheless, for these transactions, itshould be considered whether any of the partiesare entitled to renegotiate existing loans and ifso, whether that party would have an interestin doing so. Particular attention should be paid

to the economics of each transaction to assesswhether the parties are behaving in an arms-length manner. Potential areas for considerationinclude contracts with lender or borrower calland put options, contracts that are automaticallyextended or penalty clauses where the cost ofthe penalty does not outweigh the advantage ofearly termination, etc.

Particular care should be taken when makingamendments to existing transactions, especially

at a time when tax authorities are becomingincreasing sophisticated in their approach to thetransfer pricing of financial transactions.

Safe harbour rules

Several countries have adopted domestic safe-harbour rules. In certain cases, if pre-determinedinterest rate thresholds are respected, interestexpenses are, in such cases, deemed to beat arms length. However, most of these safeharbour regimes allow for the applicationof higher interest rates if the tax payer can

demonstrate that the higher rates satisfy thearms-length principle. Such safe harbourrules appear to be a cost-effective way toavoid transfer pricing scrutiny. A well-knownexample is the US safe harbour rules, wherebysafe harbour interest rates are determined byreference to the Applicable Federal Rates.The latter is determined on the basis of USTreasury rates.

Most of these safe harbour rules are based onlocal reference rates, which are updated fromtime to time. However, these reference rates areoften low risk rates derived from government

bonds for example. Consequently, given the factthat low risk rates are at historically low levels,the safe harbour rates are typically also ratherlow. At the same time, credit margins are higherthan they were in recent years. This means thatthere are an increasing number of cases whereconflict arises between safe harbour rules andarms-length interest rates.

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Cash pooling

As a result of the financial crisis, companies inneed of cash increasingly rely on their internalcash pool(s) for the management of the cashavailable within the company. Taxpayers needto address specific transfer pricing issues thatarise from cash pool arrangements, such ashow the appropriate debit and credit interestrates to be applied to intragroup balancesare set; how the underlying (cross) guarantee

structure is priced; and how the cash pool leaderis remunerated. With the increased usage ofcash pools and the volumes handled by thesecash pools, the attention of taxation authoritieson these types of transfer pricing issues hasincreased significantly.

Recent examples of discussions with taxauthorities include that, in practice, positionsin a cash pool often end up in being long-termpositions, on which given the nature of a cashpool short-term debit and credit interest ratesare applied. Furthermore, traditionally the benefit

for the group of using a cash pool (ie, the cashpool advantage) ends up being allocated to thecash pool leader, which might actually be a thinlycapitalised company that cannot substantiatethe return on equity that it earns. At the sametime, the depositing participants, who in manycases are effectively incurring the credit riskassociated with the cash pool, might receiveonly a credit interest rate similar to what theywould have received if they had made a depositat a major commercial bank, with a much lowerrisk profile.

Intercompany guarantees

Many local subsidiaries that attract funding fromthird-parties are increasingly confronted withthe fact that financial institutions are requestingadditional collateral in the form of guaranteesfrom parent companies. This raises the question;if and to what extent guarantee fees should becharged by those parent companies.

Charging a guarantee fee can be contentious in

some countries, but is a requirement in others.Where a benefit is conferred, the taxpayer shouldconsider charging for this benefit. However, careshould be taken when establishing whether aguarantee fee is due. From a transfer pricingperspective, there are certain circumstanceswhere a guarantee fee is not due on the basisthat the provision of a guarantee is a shareholderservice. This might be the case if the subsidiarycould not have secured funding of any kindwithout a parental guarantee. On the other hand,if a subsidiary could have secured funding, but abetter rate or better conditions were achieved by

virtue of a parental guarantee, a guarantee feemight be due.

The different approaches taken by varioustax authorities should be considered whenestablishing whether a guarantee fee is due, andwhat an arms-length guarantee fee is.

As the GE case demonstrates, discussions onhow to assess a subsidiarys credit rating mightimpact the benefit derived from an intercompanyguarantee and thus, the level of guarantee fee due.

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The importance of having a loanpricing policy

Following the above, it might appear that thetransfer pricing requirements to substantiateand document each and every inter-companyfinancial transaction can be quite cumbersomeand inflexible, especially in todays world.However, in practice this does not necessarilyneed to be the case. In our experience,the starting point to address these transfer

pricing requirements can be to develop a loanpricing policy that sets out which processesand tools are being used to substantiate andprice intercompany financial transactions.In developing such a policy, theoreticalrequirements versus practical needs can bebalanced in a way that best suits the needs andthe transfer pricing risk profile of the company.

A loan pricing policy can include a specificmethodology to substantiate and documentthe arms-length nature of each type ofintercompany financial transaction taking

place within the group. It can also specifywhich departments are involved in the processof implementing and monitoring financialtransactions (ie, treasury, tax, legal), whichspecific financial information systems are beingused and where and how documentation is keptto support specific transactions. The policy canbe tailored towards the information systemsused within your organisation and, as such, itcan accommodate the day-to-day operationswhile at the same time, as much as possible,addressing the transfer pricing requirements thatmust be satisfied.

In principle, a loan pricing policy should becapable of being rolled out to all finance andtreasury centres within the company. Togetherwith robust, written agreements addressingall the key terms and conditions third partieswould also address, it can help companies tosignificantly increase their level of documentationand strengthen their line of defence towardstax authorities.

All doom and gloom?

The current financial and economic environmentpresents many challenges for most taxpayers.Transfer pricing of intercompany financialtransactions might be one of those challenges,with policies having to be fine-tuned and longestablished intercompany practices having to bechanged or updated. However, current marketconditions could also create opportunities thatcan be realised by the pro-active taxpayerwith the right planning, implementation andmonitoring processes.

Once financial markets stabilise, governmentsmight reduce or withdraw their marketintervention and stimulus packages. Suchfuture changes are likely to change drasticallythe dynamics of open-market pricing. Theincreased attention tax authorities are giving tointercompany financial transactions is unlikelyto change in the near future and, as a result,transfer pricing should continuously mirror themarket and transactions between third partiesand group transfer pricing practitioners shouldremain vigilant and avoid rigid rules whenupdating their intercompany financing policies.

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By Cecilia Lee(PwC China)and Thomas To(PwC China)

Until recently, the majority of foreign investmentin China was in the form of manufacturing

activities. Cross-border intercompany servicesconsisted mainly of support or auxiliary servicesto the manufacturing companies and, to alesser extent, of certain services outsourcedto China. To the Chinese tax authorities, theirtransfer pricing focus has, in the past, been onthe sale and purchase of tangible goods. Today,with Chinas opening market economy, thereis an increasing number and variety of cross-border intercompany services. Likewise, thetax authorities are becoming more and moreinterested in transfer pricing matters related tocross-border services.

Challenges in China

To many multinational corporations, dealingwith cross-border intercompany services withChina could be a challenge. While China is nota member of the OECD, its transfer pricing lawand regulations are generally consistent with theOECD principles. What makes China challengingis the way in which the law and regulationsare implemented by the different levels ofthe tax authorities State Administration ofTaxation (SAT), provincial, municipal, district,etc. It is important to note that most transfer

pricing audits are initiated and conducted bytax bureaus at the municipal level. Although

they are supervised by the SAT and theirrespective provincial tax authorities, the level

of technical knowledge and experience acrossdifferent localities varies significantly, often withdifferences in interpretation of law and regulationand local practices. While the SAT is stepping upits transfer pricing enforcement and is strivingto improve the technical competency of itstax officials across the country, it will still takesome time before consistent practices can beachieved. This is particularly true with respect tointercompany services, a somewhat newer areaof transfer pricing compared with tangible goodstransactions. Therefore, while the view of theSAT and new developments on Chinas bilateral

cases are critical, it is of equal importancefor taxpayers to consider the local views andpractices when implementing cross-borderservices transactions.

Practical considerations

With the increased transfer pricing enforcementby the Chinese tax authorities, it will beimportant for taxpayers to implementintercompany services transactions in the mostdefensible arms-length manner. To supportservice charges from overseas headquarters oraffiliates, taxpayers are strongly recommended

to develop documentaton that demonstrates thebenefits the Chinese affiliates receive, including

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providing tangible evidence on how thoseservices are received. It is also important toprovide evidence that such services are indeedperformed by the overseas affiliates and thatthe charging method and allocation bases arearms length. Any globally adopted methodologythat supports a consistent transfer pricing policywould be very helpful evidence.

Transfer pricing contemporaneousdocumentation requirements have been in

place in China since 1 January 2008. Thethreshold of RMB 40 million applies collectivelyto intercompany services, royalties and interest.Compliance with the documentation rules grantsthe taxpayer the exemption from the penaltyinterest rate of 5%, which would otherwisebe added to the base interest rate. Transferpricing documentation in China should be kepton file for 10 years, which is also the statuteof limitation for transfer pricing audits. Whenpreparing TP documentation for intercompanyservices, information disclosure might becomean issue, particularly if the overseas affiliate is

to be chosen as the tested party. Excessivedisclosure of overseas affiliates servicesinformation could attract the attention of thetax authorities and raise alarm in areas such aspermanent establishment and individual incometax matters.

Often, the provision of intercompany servicesin China involves more than just setting thearms-length transfer price. A successfullyimplemented intercompany services structureshould address all of the following:

Income tax deductibility- particularly forinbound service charges from overseasaffiliates, this could be a greater issue thantransfer pricing remuneration itself. For thelocal tax authorities, disallowing a servicefee deduction might, from both a technicaland administrative perspective, be easierthan arguing the merits of the arms-lengthnature of the transaction. Characterisationof the deduction is also critical. In China,any payment termed management fee is

automatically disallowed as a deduction. Itis crucial to have service agreements with aproper description of the services performed,and support to show that the fee relates toactual services performed.

Foreign exchange controls remittance ofservice fees to overseas affiliates requires taxclearance and proper documentation. Thisis not always a straight forward process, theresults of which often are dependent uponthe treatment by the local office of StateAdministration of Foreign Exchange.

Permanent establishment (PE) the payerof a service fee often needs to prove that theforeign payee does not have a PE in China.

Withholding income tax- while nottechnically correct for service payments,withholding taxes have been imposed bysome local tax authorities in the past.

Business tax please refer to the followingfor further elaboration.

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Business tax and cost-sharingarrangements

Apart from corporate income tax, China has aturnover tax on services business tax (BT).This tax is levied on both inbound and outboundservices, generally being 5% on the fee amount.For outbound service fees, BT is payable asa withholding tax even if the overseas serviceprovider performs all the services outside China.BT is deductible for corporate income tax, but

BT is not an income tax item itself and thereforeis not covered by tax treaties. Hence foreign taxcredit relief is not available for BT. This couldresult in a significant tax cost, usually non-recoverable, for many companies that performservice transactions with China. In most areas inChina, corporate income tax is administered bythe State Tax Bureau, while BT is administeredby the Local Tax Bureau, a separate body fromthe State Tax Bureau. Taxpayers could thereforebe challenged on the same intercompany servicetransaction by the different tax authorities.With the introduction of cost-sharing

arrangements (CSA) provisions in the newcorporate income tax law effective 1 January2008, certain types of services might qualifyto be covered by CSA, including groupprocurement and group marketing strategies.It is yet to be seen whether such CSAs arerequired to address the shared development ofintangibles related to these services, or whetherthis could potentially be an opportunity toavoid the associated BT altogether. It would beimportant to keep abreast of any progress onthis issue.

Conclusion

As tax authorities around the world increaseenforcement of tax regimes, China has followedsuit and toughened its tax laws, particularlyin transfer pricing regulations. Transferpricing of service transactions is an area inwhich the Chinese tax authorities are gainingincreased interest. As a result, companies withintercompany services operating in China willneed to:

understand the trends and practice oftax authorities at both the state and locallevels in transfer pricing enforcement andother issues;

assess the costs and risk level of their currentoperational model;

implement and maintain robustdocumentation; and

evaluate their risks and where needed take

appropriate actions

China has followed suitand toughened its taxlaws, particularly intransfer pricing regulations

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Transfer pricing in uncertaineconomic times:embracing opportunities

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Transfer pricing inuncertain economic times:embracing opportunities

ByAnthony Curtis(PwC US),J. Bradford Anwyll(PwC US),Henry An(PwC Korea),Lorenz Bernhardt(PwC Germany) andBrandee Sanders(PwC US)

With continued pressure on the global economycomes the pressure on global governments to

fill their tax coffers. Although many economiesare beginning what is likely to be slow progresstowards recovery, tax authorities aroundthe world are focusing on transfer pricingenforcement as a source of additional revenue.Globally, there has been a proliferation oflegislation and regulation intended to limit themovement of income out of tax jurisdictions.In addition, tax authorities have increasedtheir capacity to enforce compliance with suchlegislation as each jurisdiction looks for ways tocollect its perceived fair share of taxes.

But it is not all gloom and doom. Focus ontransfer pricing in todays economic environmentalso offers opportunities for companies to betterposition themselves in the present and for whenthe recovery finally arrives. Transfer pricingpolicies that embed flexibility, align with businessneeds, and improve cash flow can be achievedwith the proper planning and documentation.

Supporting losses/reduced profits

In the current economic climate, manymultinational companies are experiencing lossesor reduced profitability within the group or in

particular group entities. Juxtaposed with thecurrent transfer pricing audit environment, it iscritical for companies to develop supportingdocumentation explaining the underlying reasonsfor their reduced returns and the interplay withtransfer pricing policies.

Successfully defending losses or reducedprofitability of companies engaged inintercompany transactions will be dependent ondemonstrating that unrelated parties engaged

in similar transactions have incurred or wouldincur similar fates under the same or similar

conditions. That is, having compared andcross-referenced the terms of the intercompanyrelationship, such as the functions performedand risks assumed, with the terms of similarrelationships between unrelated parties, itmight be shown that a downward pressure onprofits is reasonable and expected. In certaincircumstances such as in the case of a limitedrisk related party where it is more difficult tolocate comparable companies for which thereis public data available economic modellingto apply adjustments to the economic returns ofcomparable companies should be employed.

Surely, demonstrating the cause of a taxpayerspoor returns as independent from transferpricing could be more complicated in thecontext of a widespread economic downturn(compared with a single isolated event such as anatural disaster that cripples a companys supplychain and ability to serve its market). Thus,considerations should be given to identifyingand documenting the following potential externalissues that might be impacting profits:

the negative impact on sales resultingfrom the current credit crunchs impact on

the taxpayers ability to provide ample oraffordable credit to its customers;

customer demands for price concessions inorder to conclude sales;

lower sales volumes and values as customerssubstitute cheaper goods for more expensivegoods;

excess capacity in manufacturing locations; increased inventory holdings and

related costs; and foreign exchange losses as the relative

pwc tp perspectives challenging times

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