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By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
It is hard to be an optimist in the international tax area nowadays.1 However, the Organisation for Economic Cooperation and Development (OECD) gave me a tiny glimmer of hope recently in its modest improvement to new Chapter IX of the OECD Transfer Pricing Guidelines on business restructuring, particularly with regard to respecting the bona fides of a business transaction. I am, as I have said before, an optimistic guy.
For those not up on their OECD pronouncements, these recently released guidelines are the progeny of an initiative launched in 2005, which included a "discussion draft" published in September 2008. In June 2009, a consultation meeting was held on the discussion draft where some fundamental concerns were expressed by business commentators.
This commentator raised his own objections to the OECD discussion draft in this space back in February 2009. In particular, I took issue with two areas of the report: the transfer pricing of the restructuring itself and the discussion of "exceptional circumstances" giving the tax authorities the right to disregard the legal and commercial arrangements regarding the restructuring in applying a transfer pricing analysis. (See "The OECD Restructuring Report: OECD and Judge Learned Hand Agree on Something," 38 Tax Mgmt. Int'l J. 111 (Feb. 2009).)
Fast forward to new Chapter IX, and, in particular, the section on regarding and disregarding of transactions involving related enterprises. Part IV reviews the "exceptional circumstances" when it may be appropriate for tax administrators not to recognize a transaction for transfer pricing purposes.
Apparently to underscore the meaning of the term "exceptional circumstances," the report notes that the OECD is talking about "rare" or "unusual" circumstances. And those are identified as situations where the economic substance of the transaction differs from its form or, alternatively, situations where independent enterprises would not structure the arrangement as did the related parties and arm's-length pricing cannot be reliably determined. The former is a facts and circumstances test. As always, it requires a review of the economic and commercial context of the restructuring, a look at the practical and business reasons for the transaction, and an analysis of the functions, assets, and risks assumed.
But I want to focus on the latter point: the idea that there are situations where arm's-length pricing cannot be reliably determined for the transaction because independent parties behaving in a commercially rational manner would not structure a transaction as did the related parties.
The OECD begins by underscoring that tax administrators should not ordinarily interfere with business decisions, and that determinations that a structure is "not commercially rational" should be made with "great caution." Moreover, only under exceptional circumstances should such a determination lead to nonrecognition of a business structure. All true. In fact, the notion that a national tax administration would be empowered to substitute its judgment for what is "commercially rational" is somewhat frightening to me.
The mere fact that a related-party arrangement is not ordinarily done similarly by independent parties does not mean that the restructuring is not arm's length or commercially rational, according to the OECD. Particularly important, the OECD acknowledges that global groups often enter into centralized supply chain arrangements that are not found among independent parties and that the lack of similar arrangements therefore is not proof of anything nefarious. Instead, the OECD says tax authorities should test whether the "outcome" is similar to what would result with unrelated parties. There's some more acknowledgement here of real life business reality: the OECD stresses that tax authorities generally should not look at a single transaction in isolation, but generally should take into account the broader context of a series of economically related transactions. In other words, look at the entire restructuring as a big picture. I'm still feeling pretty good.
One caveat worth mentioning: the OECD says it is not enough that, from a transfer pricing perspective, the restructuring makes sense from a commercial point of view for the group, but rather the arrangement must be at arm's-length for each individual taxpayer involved in the restructuring. I can live with that, especially given that tax authorities get another warning to respect business realities. According to the OECD, so long as an appropriate transfer price that takes into account comparability can be arrived at, tax authorities should respect the arrangement even if it generally is not found among unrelated businesses "and the tax administration might have doubts as to the commercial rationality of the taxpayer entering into the transaction or arrangement …" It sounds like the OECD is telling tax administrators to let businesses run their affairs as they see fit, so long as appropriate arm's-length pricing can be determined.
One other point worth passing on: the OECD acknowledges that the fact that a business restructuring is motivated by tax benefits does not, in and of itself, result in a conclusion that there is no arm's-length arrangement in place. This was in the discussion draft and obviously its reiteration in the guidelines is welcome. But as I said in my earlier article on the subject, in my experience business restructurings are dictated by commercial concerns and the tax guys come in to accomplish the specific business objective in the most tax-efficient manner. It is nice to see the OECD again concur with Judge Learned Hand, who famously said a taxpayer can arrange his affairs "so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury."
The most positive change in the report is the revision to the first example in the 2008 draft. In that example, a full-fledged distributor is acquired by a multinational. A post-acquisition restructuring transfers — for lump-sum prices — various IP to certain existing, centralized companies to manage. The 2008 draft confirms that the restructuring appears to be commercially rational and appropriate compensation would be expected to result in an arm's-length outcome. But in 2008 the OECD then added that certain countries believe that the sale of "crown jewels" is so detrimental to the seller that it is impossible to arrive at an arm's-length price unless it can be shown that a company has decided to exit a particular business or the seller had no other realistic options available to it. It sounded like the OECD was condoning the possibility that a tax authority would consider that the crown jewels were not transferred at all.
The 2010 report generally takes the same example and deletes the wholly unsatisfactory 2008 caveat that some tax administrators would not recognize the post-acquisition IP restructuring transaction. Instead, the latest report simply states it is expected that arm's-length pricing would result in an arm's-length outcome for each of the parties, in which case that the restructuring transaction would be recognized.
So clearer heads have prevailed and the OECD is not going to give credence in their report to the possibility that some tax authorities may try to disregard a transfer of crown jewels. It is gratifying that the OECD is once again defending the arm's-length standard and opposing one-sided government re-characterizations of common global transactions.
But is it really safe to go in the water? The OECD's retraction of the statement that certain countries would nullify sales of IP crown jewels is good news, but it does not mean it will be universally followed in all countries. Some country representatives to the OECD reportedly had argued in favor of the original conclusion and, therefore, could be expected to continue to take this position notwithstanding the OECD report. So, realistically, controversy in this area can be expected to continue.
The OECD is also not sitting on the sidelines. It is in the process of launching its next project in this area to review "intangibles" in the transfer pricing realm. The OECD project is expected to address so-called "soft intangibles," meaning profit potential, workforce in place, and goodwill. According to press reports, OECD officials consider soft intangibles to include unprotected marketing intangibles, workforce in place, commitments to undertake research and contribute to the development of future intangibles, goodwill, profit potential, business opportunities, and value drivers. (See 19 Tax Mgmt. Transfer Pricing Rpt. No. 5 (7/1/10).)
I can only hope that the OECD's Working Party No. 6 will focus on why soft intangibles should not be treated as constituting intangible property rights. Taking any other position will only add another dimension to already contentious transfer pricing controversy. The last thing the OECD should be doing is encouraging governments to require independent compensation for undefined concepts that do not rise to the level of enforceable property rights. This point was well made by my fellow commentator Gary Sprague ("OECD Considers New Transfer Pricing Project on `Intangibles,'" 39 Tax Mgmt. Int'l J. 681 (11/12/10)), and also in a comment letter to the OECD by the Tax Executives Institute. So I'm not the only one hoping for this outcome.
Finally, it's worth noting that the OECD has always shown a certain deference to domestic anti-abuse rules. The recent transfer pricing report on business restructurings unfortunately continues this approach. In two of the three restructuring examples, the OECD report footnotes the possible application of general domestic anti-avoidance rules. This happens even in the context of the third example, in which there is a restructuring involving a transfer of an intangible that is recognized: the footnote caveats, "This does not say anything about the possible application of domestic anti-abuse rules."
My concern is that this broad concession to tax authorities' application of anti-abuse principles will give governments a free pass to attack the transfer pricing outcomes of otherwise acceptable commercial transactions. Those footnotes offer cover for governments seeking to circumvent the arm's-length method. To wit, the Obama Administration's proposal to impose current U.S. tax on "excess returns" associated with transfers of intangibles to a related CFC subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting. Under the Administration's proposal, in such instances, an amount equal to the excess return would be treated as Subpart F income and would be isolated in a separate foreign tax credit basket. (See Tobin, "U.S. Taxation of Intangible Property – Yet Another Stick But Still No Carrots?" 39 Tax Mgmt. Int'l J. 408 (7/9/10).)
If it wasn't already clear, at a July 2010 Ways and Means Committee hearing on business restructuring and transfer pricing, a Treasury official communicated the Administration's interest in moving forward with the excess returns proposal, described as an anti-abuse proposal, without waiting for action on overall international tax reform. The rationale offered for seeking action on this proposal without deliberation on the state of the U.S. international tax regime more broadly and the transfer pricing system in particular was one of urgency. The phrase used was "if not now, when?" Where what's being advocated is the overriding of the arm's-length standard, I have an unequivocal answer to that question.
Thinking about this from the perspective of fair play and good sportsmanship, the Administration's excess returns proposal seems a bit like a mulligan to me. First to argue that a low-tax affiliate's profit is too high under arm's-length rules, but if that argument is a loser, to go ahead and tax it anyway under a new domestic anti-abuse rule.
It would be nice for the OECD to call out domestic anti-abuse rules that are really just overrides of the arm's-length standard. But perhaps I'm being too optimistic.
This commentary also will appear in the December 2010 issue of the Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Culbertson, Durst, and Bailey, 894 T.M., Transfer Pricing: OECD Transfer Pricing Rules and Guidelines, and in Tax Practice Series, see ¶3600, Section 482—Allocations of Income and Deductions Between Related Taxpayers.
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