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By James J. Tobin, Esq. Ernst & Young LLP, New York, NY
In a well-known 1934 opinion, U.S. Court of Appeals Judge Learned Hand famously wrote, “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury.” This is my favorite quote except for anything by Yogi Berra.
In its long-awaited discussion draft addressing how the OECD Transfer Pricing Guidelines and the corresponding treaty rules should apply to a business restructuring, the OECD similarly recognized the fact that multinational corporate taxpayers should generally be free to organize their business operations as they see fit.
Subject, of course, to the arm's-length standard.
In his opinion, Judge Hand went on to add, “There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
While the OECD doesn't say that there's some sort of global patriotic duty for major corporations to pay more than the law demands, their draft report makes it clear that OECD member governments will continue, and likely accelerate, their review of how companies have arranged their affairs, with a goal of making sure that all elements of what the law demands are fully met.
The draft report, which addresses transactions between related parties in the context of Article 9 of the OECD Model Tax Convention, was prepared after input was obtained from businesses, academics, and consultants, as well as the tax authorities of the OECD members. However, the OECD has requested comments from taxpayers. Here are mine.
The draft addresses “the cross-border redeployment by a multinational enterprise of functions, assets, and/or risks [among related parties] with consequent effects on the profit and loss potential in each country.” It notes, “Business restructurings are typically accompanied by a reallocation of profits among the members of the MNE group, either immediately after the restructuring or over a few years. One major objective of this project in relation to Article 9 is to discuss the extent to which such a reallocation of profits is consistent with the arm's length principle and more generally how the arm's length principle applies to business restructurings.”
When I think about business restructurings, I tend to think about the business reality that multinational companies are running their businesses on a global or regional basis, rather than a national one and, consequently, have been and are continuing to look for ways to make their supply chain more efficient. Given current economic conditions, this will certainly continue and no doubt accelerate. This will involve business changes in areas such as centralization of procurement, rationalization of manufacturing capacity - both internal and outsourced - centralized brand management and brand rationalization, and increased use of low-cost shared service centers. It's interesting that the OECD report states that this type of change is “typically accompanied by a reallocation of profits…”. It's hard to conjure up an “untypical” restructuring, one in which no change in the allocation of profits would result.
It's also interesting, and a key part of the challenge, that likely the only people who care about that intra-group reallocation of profits as between legal entities is the tax department (and their advisors!) and, of course, the tax authorities. Invariably, management reporting ignores national borders or legal entity results to focus on global, divisional, or brand profitability or, in cases of functional groups in the organization, to focus on metrics other than the bottom line, such as sales growth, gross margin, cost controls, etc. Likewise, customers, suppliers, service providers, and other third parties certainly have little if any reason to care about the identity of which local entity of a multinational group they contract with, except, perhaps, for their own tax-related issues in areas such as VAT or customs duties.
The context of the OECD report is a bit more of a narrow focus than I might have expected, and refers specifically to changes in status from full-risk manufacturing to contract manufacturing or from full-risk distribution to limited-risk distribution or to changes with respect to the sale/transfer of intangible property. In my view, the tone and focus of the report would have benefited from a broader view and fuller business context.
The OECD's business restructuring draft is comprised of four “issues notes,” addressing: (1) the allocation of risks between related parties in an Article 9 context; (2) application of the arm's-length principle and transfer pricing guidelines to the restructuring transaction itself; (3) application of the arm's-length principle and transfer pricing guidelines to post-restructuring arrangements; and (4) “exceptional circumstances” under which a tax administration may disregard the parties' transaction results and/or re-characterize the transaction in accordance with its substance.
Article 9 of the OECD Model Treaty, for those of you who may not recall, addresses “associated enterprises” and basically provides that when conditions are made or imposed between two such enterprises in their commercial or financial relations that differ from those that would be made between independent enterprises, any profits that would, but for those conditions, have accrued to one of the enterprises, but have not, may be included in the profits of that enterprise and taxed accordingly. Article 9 goes on to provide that when such an income inclusion is made by one of the Contracting States, the other state will make appropriate adjustment to the other party's income, through the Competent Authority process if necessary.
With that in mind, the draft states that a business restructuring will not be a taxable transaction per se. So far, so good. However, it notes that tax authorities usually will carefully examine business restructurings to determine if rights to intangible property or other valuable rights are being transferred and, if so, whether these were transferred for an arm's-length consideration. True, and not unreasonable.
Also reasonable is the fact that the draft places considerable emphasis on whether the parties' conduct is changed after reallocation of functions and risks, plus whether the entity assigned risks has managerial control over that risk and the financial ability to bear those risks. This is a strong reminder that “paper only” structures won't fly; rather, the taxpayer truly has to “live the structure.”
Also somewhat positive is the fact that the OECD recognizes that business restructurings can be considered “commercially rational” even if a purpose of restructuring the enterprise is to obtain tax savings, provided that the parties' conduct is consistent with the reallocation of risks and functions and that the associated transactions are priced using arm's-length principles. That's good news and a bit like the Learned Hand quote above. However, I would have put it a bit differently. In my experience, a business restructuring is dictated and decided upon by management for commercial reasons and the tax department contributes to the value creation by analyzing the best opportunities to implement the business restructuring in the most tax-efficient manner. So, for example, if a centralized supply chain structure is being implemented for business reasons, tax will recommend the most tax-favorable jurisdictions in which to locate that structure in order to operate it tax efficiently and avoid risks of double taxation.
There are two areas of the report that do give me cause for concern, though. The first relates to the transfer pricing analysis of the restructuring itself. The second concerns what constitutes “exceptional circumstances” giving the tax authorities the ability to disregard the legal and commercial arrangements with respect to the restructuring in doing their transfer pricing analysis.
As to the first concern, the general principle of the draft is that analyzing expected benefits and realistically-available options will likely involve sophisticated bargaining theory economic analysis with the need to additionally closely analyze existing legal rights of the related parties and take advice on local law rights and protections available to unrelated parties in similar structures. While I can't disagree with the sound transfer pricing theory behind this approach, I am concerned about its application and the costs and internal burdens of compliance (even though we advisors are likely among the primary beneficiaries of this burden). Legal contracts between a “captive” distributor or manufacturer are rarely prepared in the same rigorous manner as third-party contracts, just as the local country profit results referred to above are rarely relevant to anyone in management except the tax department. And bargaining theory in the context of a captive group situation is purely theoretical and has a high potential to become a source of debate and controversy. It is also likely to be applied inconsistently from country to country.
Do I have a better answer? No, at least not one that I can defend as pure in a theoretical sense. However, I do think as a practical matter the OECD should better emphasize the transfer pricing analysis of ongoing arrangements and lean toward a view that a significant income realization event from a restructuring itself would be a more limited occurrence, such as where there are clearly identifiable intangibles that are being transferred or cost-shared.
I am even more concerned about the discussion of “exceptional circumstances” that could justify a tax authority's disregarding legally-binding commercial terms resulting from the restructuring. Fortunately, the draft emphasizes that this should be done only with “great caution” and where the structure is not commercially rational and where it may not be possible to arrive at an appropriate transfer price based on the terms resulting from the restructuring. But I suspect taxpayers' ideas about great caution and what is commercially rational will differ from those of various tax authorities. Indeed, consider the first example in this section of the draft involving a post-acquisition restructuring where the stated facts were that group companies transferred -- for lump-sum, arm's-length prices -- various IP to certain existing, centralized entities to manage. The draft acknowledges that this would generally be commercially rational, but caveats that some countries believe that the sale of “crown jewels,” such as valuable trade names, is so detrimental to the seller that it would be impossible to arrive at an appropriate price and that accordingly it would be unlikely to occur at arm's length, unless it could be demonstrated that a company had decided to exit a particular business or the seller had no option realistically available to it. These countries believe that if the company continues in the business, there is no commercial logic to this divestment, which is represented as being driven by the group policy.
To me, it sounds like the draft is condoning the possibility that those countries might consider the crown jewels not to have been transferred at all. Such a one-sided recharacterization would play havoc with any potential for Competent Authority relief, characterization for CFC or foreign tax credit calculations in other affected related entities, tax basis calculations, the need to recharacterize initial and ongoing cash flows from the arrangements, and so on. In my view, a lot more caution is needed than is implied by this example!
So, what we have here in my view is a good start and a quite workable framework for evaluating business restructurings. Yogi Berra once famously said, “If you come to a fork in the road, take it,” and the OECD generally seems to be following the right paths with the draft report. Thus, for example, what some commentators consider the more aggressive positions in Germany's “transfer package” rules and the originally-proposed U.K. CFC rules' imputing all IP value to the U.K. head office seem to be implicitly rebuffed by the draft. On the other hand, I really feel that the OECD needs to give a good deal more thought to the practical aspects of some of their positions. Greater recognition of just how real-world-business-driven restructurings are typically created and that things like the application of sophisticated bargaining theory and the analysis of local legal requirements are likely to lead tax authorities and taxpayers to endless controversy would be welcome.
Of course, the document is a draft and the OECD has requested comments, so, as Yogi also said, “It ain't over 'til it's over.”
This commentary also will appear in the February 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and Regulations, and in Tax Practice Series, see ¶3600, Transfer Pricing.
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