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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The project of the Organization for Economic Co-operation and Development (OECD) to revise Chapter VI ("Special Considerations for Intangible Property") of its Transfer Pricing Guidelines has the potential to significantly impact international tax planning and practice. International tax planners, transfer pricing experts, and even students of international diplomacy should take notice. The discussion draft with respect to Chapter VI (the "Discussion Draft") was published on June 6, 2012.1 September 14, 2012, is the deadline for comments. The public consultation will be held on November 12-14, 2012.
There is much to be said about the Discussion Draft; I expect that the volume of public comments will exceed even those submitted on the OECD's current and high-profile project to clarify certain elements of the "permanent establishment" definition in Article 5 of the OECD Model Tax Convention on Income and on Capital. For this column, I will limit my comments to two topics: an observation on the process; and some observations on the most significant policy and practice proposals contained in the Discussion Draft.
On the process, Working Party No. 6 has produced this draft at warp speed. This is a noteworthy point, as it reflects the importance which the delegates place on this project. Many OECD projects proceed at a measured pace, governed by the periodic meeting cycle of the Working Parties, competition for attention from the many other items on the Working Party agenda, and in many cases the difficulty of the project. It is not uncommon for several years or more to pass between the commencement of a project and the publication of final Commentary or other guidance.
This project commenced with the publication of a "Scoping Paper" on January 25, 2011.2 The OECD held three public consultations on specific topics, including a general consultation with business representatives in November 2011 on those topics specified in the Scoping Paper. The Discussion Draft then appeared a mere seven months later.
Along with the speed of the project so far, another remarkable point is that the OECD expressly notes that the Discussion Draft is still a work in progress. The Discussion Draft states that it is "an interim draft" and that "it is not necessarily a consensus document…. One or another country may not be in full agreement with one or more of its provisions."3
This transparency is to be applauded. The business community had urged the OECD to circulate its draft proposals at the earliest possible opportunity, to allow the most effective input from practitioners and other interested persons. The OECD's willingness to issue this draft, including positions which may still be controversial issues among the delegates and which presumably will be refined through further public and internal discussion, represents a new maturity in the OECD's engagement with the business community on difficult international tax issues.
I expect that the existing momentum will continue to propel this project to a remarkably speedy conclusion, especially for a project of such technical complexity and global significance. Those wishing to participate in the process should do so now, as the comments to be filed during the public comment period ending September 14 will be the best opportunity for the business community to be heard on these issues. As the OECD itself has noted that this is not yet a consensus document, I hope that the OECD will again circulate a draft for discussion if the next version contains any significant changes. While the desire to move quickly certainly is understandable, the higher goal is to allow considered comments from all quarters on any new proposals.
There is a lot to talk about on the substantive points addressed in the Discussion Draft. At the time the Scoping Paper was issued, the project generally was described as one which principally was to address the treatment of so-called "soft intangibles," which the Scoping Paper identified as items such as "workforce in place, a commitment to undertake research and contribute to the development of future intangibles, goodwill, going concern, profit potential, business opportunities, value drivers, first mover advantage," and other items.4 The Discussion Draft has made some useful progress in that area, as it defines an "intangible" for transfer pricing purposes as "something which is not a physical asset or a financial asset, and which is capable of being owned or controlled for use in commercial activities."5 This type of item is contrasted with "market conditions or other circumstances that are not capable of being owned, controlled or transferred by a single enterprise." The Discussion Draft unfortunately does not consider that the nature of an item as "property" is an element of the identification of an "intangible," despite the fact that the title of existing Chapter VI refers to special considerations relating to "Intangible Property." This approach to identifying intangibles still leaves a lot of work to be done on the treatment of goodwill and ongoing concern value, but it at least alleviates fears that other non-property items such as "profit potential" could be elevated to the status of intangible property for transfer pricing purposes.
There is little doubt that the main substantive provisions of the Discussion Draft are driven by reactions of the delegates to the issue of cross-border base erosion. In that sense, the Discussion Draft is the third installment of recent OECD work in this area, work that started in 2010 with the addition of a new Chapter IX to the OECD Transfer Pricing Guidelines dealing with business restructuring, is continuing with the project to clarify certain aspects of the "permanent establishment" definition in Article 5 of the OECD Model, the discussion draft for which was issued on October 12, 2011,6 the public consultation on which is scheduled for September 7, 2012, and now this document. Concerns about cross-border base erosion certainly influenced the OECD's decision to launch projects on business restructurings and the permanent establishment standard. The Discussion Draft seems to have been more influenced by those concerns than even the first two projects.
The most significant proposals contained in the Discussion Draft are those which identify the parties "entitled to intangible related returns" in a transaction. The Discussion Draft expresses the purpose of the transfer pricing review as to determine whether "the conduct of the parties is in alignment with the terms of the legal registrations and contracts or whether the parties' conduct indicates that the legal forms and contractual terms have not been followed."7
To implement that purpose, the Discussion Draft pushes transfer pricing guidance into new territory. The point of the arm's-length standard is to figure out what unrelated parties would have done in similar circumstances, and apply that external reference to police the pricing of the transactions taking place between related parties. A proper application of transfer pricing principles therefore normally simply takes the transaction as it exists, and endeavors to find the right price.
Instead of referring to unrelated-party practice, the Discussion Draft prescribes substance requirements for the party claiming the intangible related returns. In particular, the Discussion Draft states as follows:It is not essential that the party claiming entitlement to intangible related returns physically performs all of the functions related to the development, enhancement, maintenance and protection of intangibles through its own employees. … It is expected, however, that where functions are in alignment with claims to intangible related returns in contracts and registrations, the entity claiming entitlement to intangible related returns will physically perform, through its own employees, the important functions related to the development, enhancement, maintenance and protection of the intangibles. Depending on the facts and circumstances, these functions would generally include, among others, design and control of research and marketing programmes, management and control of budgets, control over strategic decisions regarding intangible development programmes, important decisions regarding defense and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible.8
Where a related party is retained to perform functions related to the development, enhancement, maintenance, or protection of intangibles, the Discussion Draft expresses the expectation that "the party or parties claiming contractual entitlement to intangible related returns will exercise control over the performance of those functions and the associated risks" as well as provide arm's-length compensation.9 In order to determine whether the member of the group claiming entitlement to intangible related returns has exercised the requisite "control" over the performance of the relevant functions, the Discussion Draft refers to the provisions defining control over risk contained in the new Business Restructuring chapter of the Transfer Pricing Guidelines.10 "Control" is defined there in a way that emphasizes the actions of personnel in assessing and managing risk: " `control' should be understood as the capacity to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider. This would require the company to have people - employees or directors - who have the authority to, and effectively do, perform these control functions."11
Finally, the Discussion Draft states quite plainly that "bearing costs related to the development, enhancement, maintenance and protection of intangibles does not, in and of itself, create an entitlement to intangible related returns."12
It is hard to predict, of course, where these principles will push tax planning and transfer pricing practice. Certainly, there will be controversies over what constitutes the requisite control, and what happens if, in the view of the tax administration, such control does not exist. Tax administrations will find additional encouragement to contest the use of the transactional net margin/comparable profits method in favor of profit split methods whenever they detect some local activity that arguably gives rise to nonroutine profits. In any event, this project represents a significant, concerted effort by the tax administrations of the OECD Member States to modify taxpayer behavior, or at least the location of aggregate reported corporate income tax, in many common international structures.
This commentary also will appear in the September 2012 issue of the Tax Management International Journal. For more information, in the 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.
1 Discussion Draft -- Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions (http://www.oecd.org/document/41/0,3746,en_2649_33753_50509929_1_1_1_1,00.html).
2 Transfer Pricing and Intangibles: Scope of the OECD Project (http://www.oecd.org/document/44/0,3746,en_2649_33753_46988012_1_1_1_1,00.html).
3 Discussion Draft, page 3.
4 Scoping Paper, p. 5.
5 Discussion Draft, ¶ 5.
6 Interpretation and Application of Article 5 (Permanent Establishment) of the OECD Model Tax Convention (http://www.oecd.org/document/51/0,3746,en_2649_37427_48836787_1_1_1_37427,00.html).
7 Discussion Draft, ¶ 37.
8 Discussion Draft, ¶ 40.
9 Discussion Draft, ¶ 41.
10 Discussion Draft, ¶ 41.
11 Transfer Pricing Guidelines, Chapter IX, ¶ 23.
12 Discussion Draft, ¶ 47.
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