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by Kenneth J. Krupsky, Esq.
These days, multinational enterprises and their global tax advisers devote considerable resources to internal “business restructurings.” These restructurings result in the cross-border redeployment of functions, assets, and risks between and among a multinational's commonly-controlled subsidiaries, with significant intended effects on the taxable profit and loss in each country. Restructurings may involve transfers of valuable intangibles, the conversion of full-fledged distributors to limited-risk distributors or commissionaires, the conversion of full-fledged manufacturers to contract manufacturers or toll manufacturers, and the asserted, and sometimes actual, rationalization and specialization of operations.
These restructurings raise difficult issues for taxpayers and tax agencies, including the application of transfer pricing rules on and after a restructuring, the determination of the existence of and attribution of profits to permanent establishments, and, sometimes, the recognition or non-recognition of transactions for tax purposes.
In 2005, the OECD's Committee on Fiscal Affairs decided there was insufficient guidance on these issues under both the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and the OECD Model Tax Convention on Income and on Capital. So, the Committee created a Joint Working Group, and on September 19, 2008, the OECD issued a Discussion Draft for Public Comment, “Transfer Pricing Aspects of Business Restructurings.” Comments are requested before February 18, 2009.
The OECD and its pronouncements are authoritative in many countries. Not so in the United States. Although the U.S. Treasury and IRS consider that §482 of the Code and the regulations are “wholly consistent” with U.S. treaty obligations and the OECD Transfer Pricing Guidelines, nevertheless the IRS Examination and Appeals divisions have been instructed to enforce compliance with §482 “without reference” to the OECD Guidelines, except in a Competent Authority process. See Associate Chief Counsel (International), Advisory Memorandum on Taxpayer Use of Section 482 and the Commensurate With Income Standard, AM 2007-007 (Mar. 15, 2007).
The OECD Draft is composed of four “Issues Notes” that provide general guidelines and comments on four aspects of business restructurings: (1) risk allocation between related parties; (2) application of the transfer pricing guidelines to the business restructuring itself, in particular as to compensation for the transfer of functions, assets, or risks, or indemnification for the termination or substantial renegotiation of existing arrangements (the “buy-in”); (3) application of the transfer pricing guidelines to post-restructuring intercompany arrangements; and (4) “exceptional circumstances” when a tax agency may consider not recognizing a transaction or structure adopted by a taxpayer.
The Draft is generally consistent with the OECD Guidelines, but contains remarkable and important statements of principle and nuance. On a non-statistical gut-check basis (who's counting?), the key statements are approximately evenly balanced between those usable by tax agencies to support tax adjustments and those helpful to taxpayers in combating such claims (perhaps even in the United States). For example, in determining when the taxpayer's contractual allocation of risk between related companies is consistent with what independent parties might have done, the Draft cites as one factor the issue of which party has control over the risk. “The term ‘control’ in this context means the capacity to make decisions to take on the risk by placing capital at risk and decisions on whether and how to manage the risk, internally or through an external provider.” So far, so good. But the Draft also says that the relevant control “requires the exercise of control by individuals (that is, employees or directors) who have the authority to, and effectively do, perform these control functions. When one party bears a risk, that it hires another party to administer and monitor the risk on a day-to-day basis is not sufficient to transfer the risk to that other party.” This statement reflects the continuing OECD view that real live professional people — and employees, not independent contractors — are critical.
The focus on live employees (or directors) is especially apparent in Issue Note No. 4 on not recognizing the actual transactions undertaken. Very helpfully, the Draft says that non-recognition of a transaction is not the “norm,” but an exception to the general principle that a tax agency's examination of a controlled transaction “ordinarily” should be based on the transaction as structured and undertaken by the taxpayer. Apparent non-arm's-length behavior should “as much as possible” be dealt with by pricing adjustments rather than non-recognition.
Assuming first that the taxpayer's actual behavior is consistent with the structure and intercompany contracts it has put in place, the Draft then identifies the difficult question as whether the arrangements are consistent with what would have been done by independent enterprises “behaving in a commercially rational manner.” The Draft declares that an independent party would not enter into a restructuring that is expected to be detrimental to it, if it has the option realistically available to it not to do so. Further, the Draft says it can be commercially rational for a group to restructure to obtain tax savings, provided that appropriate transfer pricing makes it arm's-length for each individual company as well. Does this suggest that the group's tax savings must be shared among participating companies on an arm's-length basis?
Two examples of non-recognition focus on the importance of real people. (A third example involves the conversion of a full-fledged distributor to a risk-less distributor.) Example B considers the transfer of valuable brand names from an affiliate in one country to a new affiliate in another (with a lower tax rate) for a lump-sum payment. After the restructuring, the transferor is paid on a cost-plus basis for the services (legal, tax, etc.) it performs for the transferee and the rest of the group. The products are contract manufactured and distributed by other affiliates under arrangements with the transferor.
There are no uncontrolled comparable transactions. The new brand company is managed by a local trust company. It does not have people (employees or directors) to control the risks of future brand development, nor the financial or economic capacity to bear these risks. Instead, 125 brand development employees remain at the transferor company, and officials from the transferor fly to the transferee's country once a year to formally validate in that location the strategic decisions they have already made in the transferor's country.
It is hardly surprising that for this extreme (hopefully fanciful) example “most OECD countries indicate that they would consider not recognizing the arrangement as structured.” (One wonders who the dissenters are.) Notably, the Draft does not tell us what “not recognizing” exactly means. Presumably, it means that taxation should be applied — by both affected countries — as if the restructuring had never occurred.
Example C assumes the same facts, except that 30 of the 125 original employees are dismissed by the transferor, another 30 are moved to the new branding company, and the new company makes 15 new hires. Thus, the new company through its own 45 employees actively carries on the development, maintenance, and execution of the worldwide marketing strategy. What a difference a few employees makes! We are told, “The vast majority of OECD countries consider that in this case the transaction should be recognized for transfer pricing purposes as it has economic substance.”
Examples B and C seem correct. And yet. What if instead of brands, the new company is funded entirely with cash, it has no employees of its own, and it contracts with an independent money manager in another country to invest its funds? The manager has authority to make all investment decisions on a day-to-day basis, although the risk of loss remains with the investor. Thus, the investor controls its risks through three essential decisions: the amount of funds it puts at risk; the extent of the authority and investment objectives it gives the manager; and whether to fire the manager and hire another. These decisions are presumably made by the company's board of directors, which one thinks could (would) be located in another country (except perhaps for annual board meetings).
This example in fact is found in Issue Note No. 1 on risks. There is no indication that the transaction should not be recognized. Instead, the Draft says this example illustrates the principle that an investor who gives to another the authority to make all day-to-day decisions does not necessarily transfer the risk to that other person. Is this “fund” example inconsistent with the two “brand” examples? And if so, what principle is being applied? Why are brands different than cash? Further comment by the public, and reflection by the OECD, are needed.
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