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By David Ernick, Esq.
PricewaterhouseCoopers LLP, Washington, DC
As part of its high-profile project to address "base erosion and profit shifting" (BEPS), the OECD has been conducting a fundamental re-examination of transfer pricing rules, particularly with respect to intangibles, risks, and capital. One key question has been whether the transfer pricing rules would continue to be based on the arm's-length principle, or whether a new paradigm would be introduced. Although the 2010 revisions to the Transfer Pricing Guidelines (Guidelines) strongly reaffirmed a commitment to the arm's-length principle,1 the 2013 BEPS Action Plan reflected the OECD's willingness to deviate from that concept.2
Along with re-examining the arm's-length principle, the transfer pricing work undertaken as part of the BEPS project also seemed to call into question the principle of respect for separate legal entities, on which the international tax rules generally have been based.3 Although the final transfer pricing revisions formally accept continued reliance on both the arm's-length principle and separate-entity accounting, lingering doubts seem to remain.4 That skepticism appears to have resulted in a broad rewrite of the rule regarding recognition of transactions that is inconsistent with the corresponding rule in the §482 regulations and that may significantly increase uncertainty and controversy.
Under Reg. §1.482-1(d)(3)(ii)(B)(1), contractual terms in a written agreement entered into before the transaction will be respected if they are consistent with the economic substance of the underlying transaction. The contractual terms may be disregarded where they are inconsistent with economic substance.
The 2010 version of the Guidelines similarly focused on the economic substance of a transaction, but also provided a second route for disregarding transactions that were not "commercially rational" and could not be priced. Paragraph 1.65 provided that there were two circumstances in which a tax administration may disregard a controlled transaction:
1. Where the economic substance of a transaction differs from its form; or
2. Where the arrangements made in relation to the transaction, viewed in their totality, differ from those that would have been adopted by independent enterprises behaving in a commercially rational manner, and the actual structure practically impedes the tax administration from determining an appropriate transfer price.5
With respect to the second prong of the 2010 test, there was little guidance on defining when a transaction would not be considered to be "commercially rational." Additionally, it was not clear when an appropriate transfer price could not be determined; the Guidelines seemed to contemplate that any transaction can be priced. Consequently, it was not clear when a transaction could be disregarded under the second prong of the test. As a practical matter, then, the rule in ¶1.65 seemed similar to the rule in Reg. §1.482-1(d)(3)(ii)(B)(1), in that the primary focus was on determining the economic substance of a transaction.
The 2015 revisions to the Guidelines incorporate significant changes to the circumstances in which tax authorities may disregard transactions. Paragraph 1.122 now provides:The transaction as accurately delineated may be disregarded, and if appropriate, replaced by an alternative transaction, where the arrangements made in relation to the transaction, viewed in their totality, differ from those [that] would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction.6
The revision is significant in that it completely eliminates the first prong of the test from the 2010 Guidelines, which focused on examining economic substance. Only the second prong of the test survives, with its focus on whether a transaction is "commercially rational." And, importantly, unlike the 2010 Guidelines, the remaining standard no longer is a conjunctive test, under which a transaction may be disregarded when it is both not commercially rational and cannot be priced. In the 2015 revision, the use of the word "thereby" instead of "and" means that if a transaction is not "commercially rational," that by itself prevents determination of a price.
No definition of "commercially rational" is given, although two examples are provided. Only the first example will be discussed here, as it is at odds with existing guidance in the §482 regulations. In that example, a manufacturing company, S1, owns commercial property situated in an area prone to increasingly frequent flooding. There is no active market for third-party insurers in that area, so a related party, S2, provides insurance to S1. However, the annual insurance premium is 80% of the value of the commercial property in the flood prone area.
Rather than simply proposing a pricing adjustment to the insurance premium, the example concludes that the transaction is "commercially irrational" – since there is no market for insurance and either relocation or not insuring may be more attractive realistic alternatives – and that therefore it cannot be priced. The problem with that conclusion is that it would allow tax authorities to jump to disregarding or recharacterizing a transaction whenever arm's-length pricing has not been achieved. It also is inconsistent with the §482 regulations, which clearly provide that mispricing, by itself, is not enough to disregard a taxpayer's transaction. Instead, a simple adjustment to conform to arm's-length pricing is the preferred alternative.7
The consequences of rewriting the rule for when transactions can be disregarded in a subjective, open-ended manner are that the rule will lead to greater uncertainty in planning, as well as the possible second-guessing of legitimate business transactions by tax authorities whenever arm's-length pricing has not been achieved. As noted, no definition of "commercially rational" is provided, meaning that there is a risk that tax authorities may seek to disregard business transactions between related parties whenever similar transactions between unrelated parties are not available to serve as comparables.
Such an approach also creates doubt as to what alternative transaction will be imputed by a tax authority. For example, if the transfer of an asset between related parties has legal effect but is disregarded for tax purposes, what transaction will be imputed in its place? A range of alternatives could be possible; the revised Guidelines provide little guidance as to what alternative transaction should be imputed. From an administrative perspective, the approach in the §482 regulations is more practical, with its recognition of transactions having economic substance and its preference for pricing adjustments over recharacterization of transactions.
This commentary also appears in the February 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.
A move away from the arm's length principle would abandon the sound theoretical basis described above and threaten the international consensus, thereby substantially increasing the risk of double taxation.….OECD member countries continue to support strongly the arm's length principle. In fact, no legitimate or realistic alternative to the arm's length principle has emerged. Global formulary apportionment, sometimes mentioned as a possible alternative, would not be acceptable in theory, implementation, or practice.
[S]pecial measures, either within or beyond the arm's length principle, may be required with respect to intangible assets, risk and over-capitalisation to address these flaws.
3 See, e.g., BEPS Action 1: Address the Tax Challenges of the Digital Economy, Mar. 24, 2014, available at http://www.oecd.org/ctp/tax-challenges-digital-economy-discussion-draft-march-2014.pdf, at ¶166:
Corporate legal structures and individual legal entities became less important and MNE groups moved closer to the economist's conception of a single firm operating in a coordinated fashion to maximise opportunities in a global economy. Attention should therefore be devoted to the implications of this increased integration in MNEs and evaluate [sic] the need for greater reliance on value chain analyses and profit split methods.
4 See, e.g., Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10, 2015 Final Reports, at p. 9, available at http://www.oecd.org/ctp/aligning-transfer-pricing-outcomes-with-value-creation-actions-8-10-2015-final-reports-9789264241244-en.htm:
However, with its perceived emphasis on contractual allocations of functions, assets and risks, the existing guidance on the application of the principle has also proven vulnerable to manipulation….For intangibles, the guidance clarifies that legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible. [Emphasis added.]
7 The Preamble to the final services regulations makes it clear that recharacterization is not warranted when a transfer pricing adjustment will suffice: When the 2003 proposed regulations were issued, commentators expressed concerns with the rule for imputing contingent payment terms to the extent that it permits the IRS to recast arrangements if there is a disagreement about the pricing of a service. The temporary regulations responded to this concern by providing a new Example 5 in §1.482–1T(d)(3)(ii)(C) to illustrate that if a taxpayer's pricing is outside of the arm's length range, that fact alone would not support imputation of additional contractual terms based on economic substance grounds. Commentators responded, however, that the last sentence of Example 5 perpetuated the same problem of allowing the IRS to recast arrangements if there were pricing disputes between a taxpayer and the IRS. The Treasury Department and the IRS agree that the last sentence of Example 5 in §1.482–1T(d)(3)(ii)(C) did not clearly convey its intended meaning, which is that a transfer pricing method and the price derived from the application of that method do not inform the terms of the transaction or the risks borne by the entities. Rather, the selection and application of a transfer pricing method should be based on a comparability analysis of the transaction, which must consider the risks borne by each entity in the transaction.
T.D. 9456, 74 Fed. Reg. 38,829, 38,836 (Aug. 4, 2009).
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