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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
In my last commentary, I noted that the project of the Organisation for Economic Co-operation and Development (OECD) to revise Chapter VI of the Transfer Pricing Guidelines, entitled "Special Considerations for Intangible Property," had the potential to significantly impact the practices of tax administrations when examining transactions in goods and services which involve (or allegedly involve) the use or transfer of intangible property. The curtain rose on the first act of this drama when Working Party 6 published its Discussion Draft on June 6, 2012.1 In a second act which featured the voices a good-sized chorus, commentators submitted an unprecedented volume of comments to the OECD reacting to the Discussion Draft.2 In the third act, the OECD will hold a public Consultation to address the comments on November 12-14, 2012. The allocation of three days for this public Consultation is unusual in OECD practice; perhaps it signifies the recognition that commentators have much to say about this draft. Interestingly, it has been reported that both NGOs and the press will be invited to this Consultation, which could create a different atmosphere in the discussions. Hopefully, there will be a fourth act, as the OECD takes the comments into account and revises the Discussion Draft appropriately. Beyond that, the number of iterations is hard to predict, but the energy which the OECD is putting behind this project suggests that it will come to a conclusion without delay.
In the meantime, it is interesting to speculate what the effect of the initial version of the Discussion Draft would be on what seems to be a principal target of the Draft, namely, some of the structures described by the Joint Committee on Taxation staff in its report entitled Present Law and Background Related to Possible Income Shifting and Transfer Pricing, submitted to the House Committee on Ways and Means on July 20, 2010, and presented in a subsequent public hearing on July 22, 2010.3 As noted in my last commentary, there is little doubt that many of the substantive provisions of the Discussion Draft are driven by the delegates' concerns regarding cross-border base erosion and profit shifting. The Discussion Draft includes several examples of transactions of interest to the delegates, including some that are of wide interest to many multinational groups, such as the conversion of an acquired company which owns intangible property into a limited risk service provider shortly after the acquisition. It seems clear that a major villain in the piece, at least from the perspective of the delegates, is the intellectual property (IP) holding company. Using a box surrounding the text and a bold font, so that no reader could miss the point, the Discussion Draft stated its fundamental principle: "Working Party No. 6 delegates are uniformly of the view that transfer pricing outcomes in cases involving intangibles should reflect the functions performed, assets used, and risks assumed by the parties. This suggests that neither legal ownership, nor the bearing of costs related to intangible development, taken separately or together, entitles an entity within an MNE group to retain the benefits or returns with respect to intangibles without more."4
One sees in this statement a reference to some of the structures described in the Joint Committee report. Readers may recall that in that report the Joint Committee described six "case studies," which were based on the actual offshore structures established and operated by six U.S. multinational groups. The groups were made anonymous by referring to the companies as "Alpha Company" through "Foxtrot Company." The factual descriptions of the structures contained enough detail about location of operations, commercial flows, and the like, however, that readers by and large were able to reverse engineer the tax planning implemented by the various multinational corporations (MNCs).
As their case studies, the Joint Committee selected structures that all utilized planning techniques involving the check-the-box rules. While the Joint Committee stated in its report that, based on anecdotal evidence, cost sharing was not the predominant method by which intangible property is transferred for use outside the United States, three of the six case studies nevertheless involved a cost sharing structure. In two of the cases, Company Bravo and Company Foxtrot, the group may have included non-U.S. IP holding companies of the type to which the boxed and bolded text in the Discussion Draft referred, although the statements of fact in the Joint Committee report are not detailed enough to determine what "important functions" in fact may or may not have been performed by the IP holding companies.
In the cases of both Company Bravo and Company Foxtrot, the Joint Committee study reported that the groups had entered into cost sharing arrangements under the applicable U.S. Treasury regulations. Apparently, the offshore companies were fully bought in to the original IP rights (or must we now say "PCTed-in," to employ the post-2009 terminology - certainly a way more awkward expression). In both cases, the IP holding companies charged a royalty to an affiliated entity which used the rights to manufacture and sell the group's product. In both cases, the licensee was established in a high-tax jurisdiction, and the Joint Committee report noted the tax rate arbitrage which resulted due to the fact that the base erosion payments resulted in a deduction in a higher rate jurisdiction than the rate on the income side. (The fact that the deduction was taken against foreign taxable income is a significant point for those who would argue that Congress and the U.S. Treasury should have no interest in beating back the efforts of U.S. MNCs to reduce their foreign tax burden.)
Now let's assume that the OECD, after due consideration of all the comments, written and oral, submitted by business, academics, and professional organizations, issues the final revised Chapter VI of the Guidelines without changing a word of the Discussion Draft. Let's also assume that the IP holding companies described in the Company Bravo and Company Foxtrot case studies in fact did not employ any personnel which could "physically perform … the important functions relating to the development, enhancement, maintenance and protection of the intangibles" as currently described in the Discussion Draft as a prerequisite for claiming intangible related returns (IRR). The OECD guidance would then seem to say that the IP holding companies embedded in the Company Bravo and Company Foxtrot structures are not entitled to any IRR. So what happens then?
First, we look at the U.S. side. The hypothesized new Chapter VI will not have any effect on the fact that the offshore entities in question had already acquired their territorial exploitation rights under their existing cost sharing arrangements. Furthermore, for U.S. income tax purposes, the IP holding companies as embedded in the Company Bravo and Company Foxtrot structures are not that bereft of employees performing important functions. In both cases, the Joint Committee study describes how those IP holding companies are combined in a single U.S. tax reporting person with several other operating entities through check-the-box elections. Accordingly, from a U.S. perspective, those IP holding companies indeed perform through their "own employees" functions of the sort described in the Discussion Draft as necessary to attract some or all of the IRR, in addition to holding the legal exploitation rights and bearing the financial risk of development. Finally, on the U.S. side there is the interesting jurisprudential issue of how much weight a U.S. court would give to the OECD Transfer Pricing Guidelines to interpret U.S. law on this subject, given the extensive U.S. Treasury regulations under §482 and the many decades of U.S. jurisprudence on transfer pricing matters, including on the transfer of rights for the use of intangible property. The new Chapter VI, of course, could be expected to have greater weight in disputes where a tax treaty applies to the transaction.
On the other hand, jurisdictions outside the United States indeed will see those IP holding companies as separately regarded persons for tax purposes, which fall foursquare within the Discussion Draft's admonition that entities that may hold legally protected rights and bear development costs, but which don't perform the "more," are not entitled to any IRR. What might their approach be?
If the Discussion Draft mandates that the IP holding company is entitled to no IRR (or at least no all of the IRR), then that IRR must go somewhere else. It seems highly unlikely that foreign jurisdictions will volunteer that the IRR must be allocated to the U.S. parent in consideration of U.S. management's strategic vision or other contributions to the success of the business. So the only place left in the system for it to come to rest would be in the entities located elsewhere in the supply or distribution chains.
The Discussion Draft emphasizes that the entities that are entitled to the IRR are those that "either perform the functions related to the development, enhancement, maintenance and protection of the intangible, or arrange to have such functions performed under its control by independent enterprises or associated enterprises dealing on an arm's length basis."5 Perhaps Company Bravo includes an Indian R&D affiliate in its group. The Indian tax authorities probably will not hesitate to compare the activities performed by the Indian R&D affiliate against those performed by the IP holding company to argue that some part of the IRR should be allocated to the Indian entity. Similarly, the Joint Committee report noted that the Foxtrot group includes local country sales entities, some of which take on entrepreneurial risk and responsibilities, and some of which serve as limited risk distributors. In either event, the tax administrations in the various jurisdictions in which Company Foxtrot operates sales entities may argue that the work involved in building the brand intangible has generated profits coming to rest in the IP holding company, and compare the functions in the sales entities to those performed by the IP holding company's employees in an effort to reallocate some of the IRR to the distribution entities.
How should the United States respond? The issue of how the transfer pricing rules apply to IP transfers by U.S. multinationals should be a matter to be decided by the application of U.S. principles under §482 as interpreted by U.S. courts, subject to treaty provisions, if applicable. Undoubtedly, there will be more jurisprudence in the future on this point, as cases continue to work their way through the pipeline. But the scope of the OECD Discussion Draft is broad, touching on all transactions that involve the use of or transfer of intangibles, which is a vastly wider array of transactions than the transfer of IP rights addressed under the U.S. cost sharing regulations. It seems clear that many jurisdictions outside the United States are looking to this OECD project as an important exercise to give them the tools to attract more taxable income to their jurisdictions. From the U.S. perspective, it should be a priority to allow U.S. MNCs to continue to build their defenses against unwarranted allocations of intangible-related profit to development, distribution, manufacturing, and service operations, when those entities did not bear the economic risk of developing the relevant intangibles. In that light, it would seem that a major U.S. interest would be to preserve the ability of U.S. MNCs to assert the application of the TNMM and similar methods to limit the return to be earned by risk-limited foreign entities.
The curtain goes up on the next act in November 2012 at the public Consultation. Readers interested in this topic undoubtedly have something to look forward to as this project takes its final form.
This commentary also will appear in the November 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).
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