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By James J. Tobin, Esq.1
Ernst & Young LLP, New York, NY
Yet another commentary where I had every intention of not writing about BEPS again and I get excited about something in the OECD reports and get sucked back into the BEPS tangled web. This commentary focuses on the OECD BEPS report on Actions 8-10, specifically on the aspects of that report dealing with risk and intangible property (IP) which would basically attribute IP and risk returns to the related parties responsible for development, enhancement, maintenance, protection, and exploitation (DEMPE) and control of risk functions.
The report presents intended changes to the OECD Transfer Pricing Guidelines (OECD Guidelines). Since many countries subscribe to the OECD Guidelines, it has been said that the conclusions in this report immediately take effect in those countries and thus these changes have a much more accelerated effect (at least in those countries) than the other BEPS Actions. So potentially a lot more worrying than with the other Actions where I am also at odds with some aspects of the conclusions reached.2
We at EY did a survey on the effect of changes to the OECD Guidelines, which can be accessed from our website (ey.com). It was released as an International Tax Alert in August 2015, titled "Country Implementation of BEPS Actions 8-10 and 13." It concludes that of the 34 OECD countries only nine make direct reference in their domestic legislation to the OECD Guidelines and it was felt that even for a majority of these countries a change in legislation or administrative guidance would be required to introduce changes in the OECD Guidelines into domestic law. In 24 of the remaining 25 OECD countries, the OECD Guidelines are considered to have "soft law" status. That is, they are referred to as a source of interpretation of the arm's-length principle by tax authorities or courts but they are not binding and cannot contradict existing legislative rules. Twelve non-OECD countries surveyed report specific reference to the OECD Guidelines and again, in the majority of these countries, it was felt that amendments to local legislation or administrative guidance would be necessary to adopt changes to the OECD Guidelines. In addition, the OECD Guidelines would have soft law status in many non-OECD countries.
Another aspect I find troubling is the effective date of the proposed changes. I think there can be little doubt that the positions in the report are significant changes from the existing OECD Guidelines, yet there is no discussion of the effective date aspects. There are some implicit references in the report which would lead toward the conclusion that these changes are thought to be a clarification of existing rules and I am sure some country tax authorities will try and take that view. (For example, the Swedish tax authority announced this view in December.) However, I know of no country with an articulated rule or interpretation before 2016 that took the position that an IP owner without oversight of DEMPE functions should only earn a risk-free return. So to potentially apply such a rule retroactively must be inappropriate. And I would expect the courts to agree. But how to address transition issues assuming a country adopts this view after the OECD Guidelines are changed?
Moving beyond the precedential aspect of the report, I find many aspects of the report to be either ambiguous or potentially inappropriate, at least for many fact patterns, and doubt a court would be persuaded to follow the rationales for some of the recommendations, but I obviously worry that tax authorities seeking to raise revenue would be more inclined to do so.
The basic premise of the report with respect to risk and intangible property is to ostensibly keep faithful to the arm's-length standard. However, the big change is that the economic return from intangibles and increased return from bearing risk will not merely follow the legal ownership of an intangible or the party contractually assuming risks, but rather the returns should be "appropriately" attributed to/shared between related parties who actually control and manage the risks or intangibles. This premise can be best understood and is best illustrated in the OECD report with respect to so-called "cash-box" companies which have legal ownership of IP but have no substance to actually manage the IP development or exploitation. In such case, the report concludes that the IP returns should instead be allocated to the related parties which do control and manage those functions. The report makes clear that the reallocation of profit is for transfer pricing purposes only and not for the purpose of determining the character of the income or other consequential substantive effects. This is also one of the aspects I worry about.
A multi-step process is provided both with respect to risk and intangibles to enable the determination of how the associated profit should be allocated. The steps will require much more functional analysis of the nature and value of risk and IP inherent in a group's supply chain and of which entities in the group make contributions to that value than I believe is current practice today. Given the required brevity of this commentary, I won't go into detail on the steps. However, I will make a few observations on how the rules seem to work (or potentially not work):
This construct might be relatively easy to understand and apply (not that I completely agree with it) in the context of a parent with all DEMPE functions transferring IP to a low-tax, cash-box subsidiary with no DEMPE functions. The subsidiary would still earn the IP income in the first instance (e.g., recognize royalty or other IP income) and would be required to pay a value fee to the parent so that its net income would reflect a funding return. Some real world complications I could foresee:
As with most of the OECD reports, I am concerned that a disproportionate focus is on U.S. multinationals and they will potentially suffer most in a local country enforcement activity. I was pleased to see that in the 29 examples provided in the report with respect to intangibles there were 12 hypothetical companies named to illustrate the principles of the report. At least 10 of the names were clearly not hypothetical U.S. companies – names included Shuyona, Zhu, Osnovni, Prathamika, etc. Clear evidence that the focus is not on U.S. multinationals so at least something to take some comfort in.
Overall I found the Actions 8-10 report very troubling. By defining the portion of IP return that the company that is the legal owner is not entitled to, but leaving many open questions on which entities are entitled to that return or a portion of that return, the prospect of extended controversy around the world and high risk of double taxation seems a highly likely outcome. Lots of countries seeing a potential revenue prize to pursue. And I'd suggest the issue will be real for virtually all large multinationals and not just for the dwindling few that may have something that resembles a "cash-box." I encourage the OECD to continue its work in this area but with greater input from industry. Meeting the very ambitious timetable for the report could be said to be an achievement. But not when it produces an unworkable answer.
This commentary also appears in the April 2016 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Chip, Culbertson, and Maruca, 6936 T.M., Transfer Pricing: OECD Transfer Pricing Guidelines, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers, ¶7160, U.S. Income Tax Treaties.
It should be pointed out that the report's recommendations have not yet been officially adopted as changes to the OECD Guidelines. (Proposed changes to the OECD Guidelines must be formally submitted to and approved by the OECD Council.)
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