February 2020 Issue
The transfer pricing (TP) arena has seen a number of significant developments over the past 12 months. These include the Organisation for Economic Co-operation and Development’s (OECD’s) proposal for a unified approach to taxing rights in a digitalised economy, as well as the ongoing implementation of country-by-country reporting (CbCR) exchanges by tax authorities. While these initiatives represent a coherent and concurrent review of traditional tax rules, they also increase the level of uncertainty associated with any operational tax planning, particularly for multinational enterprises (MNEs).
FW: Could you outline some of the significant developments in the transfer pricing arena over the last 12 to 18 months? In what ways have these developments impacted how organisations go about implementing their tax planning strategies?
Gracia: The main development that must be mentioned is the Organisation for Economic Co-operation and Development’s (OECD’s) proposal for a ‘unified approach’ under Pillar One, which focuses on the allocation of taxing rights in a digitalised economy and seeks to undertake a coherent and concurrent review of the profit allocation and nexus rules but, at the same time, runs the risk of deviating from the arm’s length principle. We have also seen the launch of a new workstream on transfer pricing (TP) on intragroup financial transactions, the ongoing implementation and extension of the geographic coverage of the country-by-country reporting (CbCR) exchanges by the tax authorities and the national implementation of the new obligations in DAC 6 on tax intermediaries which can encompass the obligation to communicate certain TP schemes.
Carden: The most significant TP developments over the course of the past 12-18 months have been those surrounding so-called ‘digital taxes’. This includes both ‘digital services taxes’ that have been proposed or implemented by several European countries, as well as the OECD’s efforts to address the ‘Tax Challenges of Digitalisation’, culminating in the release of a ‘unified approach’ public consultation document in October 2019. At their core, each of these initiatives reflects a significant degree of dissatisfaction with the traditional tax rules, including the application of the arm’s length principle. Countries are increasingly asserting taxing jurisdiction over income that would, under the arm’s length standard, be treated as allocable to other locations. For multinational enterprises (MNEs), this has increased the level of uncertainty associated with any operational tax planning, since determinations regarding the location of functions, assets and risks would not, under these new proposals, produce outcomes consistent with the arm’s length principle.
Gaspar: It would be stating the obvious to cite tax challenges arising from digitalisation of the economy as a material development. While it will be interesting to see how consensus is sought around it, specifically for Brazil the TP landscape has seen more practical challenges. Brazil is not a member of the OECD and does not follow its TP guidelines. In fact, Brazil’s TP methods are largely based on fixed margins, and the country has consistently highlighted its benefits, notably simplicity. The prospect of Brazil acceding to the OECD in recent years brought a different element to discussions around the appropriateness of Brazil’s TP methods. Part of the journey to potentially join the OECD led to a joint project between the OECD and the Brazil Revenue Service (RFB) seeking to harmonise their methods. The amount of attention TP has received in recent years, along with the fact that it has remained a strategic audit item for the RFB, has led companies to not only strive for compliance but also to give careful consideration to their reputation and an audit trail when building their business models.
Odimma: The most significant developments in TP in Africa include an increase in the number of countries implementing TP regulations following an increase in TP audits. Furthermore, the discussion concerning digital tax as an offshoot of the base erosion and profit shifting (BEPS) project has also gained increased significance. More countries in Africa have started adopting African Tax Administration Forum (ATAF) proposals for TP reviews in their domestic legislation. Additionally, most African countries have implemented CbCR with huge penalties for non-compliance. Some MNEs operating in Africa have set up mechanisms for tracking the TP legislation across African countries. There has also been an increased partnership with technical partners in the TP audits of multinationals in Africa.
“At least in the near term we do not foresee more cross-jurisdictional audits because countries are taking varying approaches with respect to the implementation of the revised OECD Transfer Pricing Guidelines.”
FW: How is the OECD’s base erosion and profit shifting (BEPS) initiative set to alter the transfer pricing landscape? How will issues such as disclosure, intangibles, risk and dispute resolution be affected in the long term?
Carden: The BEPS initiative, along with related changes to individual countries’ tax laws, have led many MNEs to update their TP policies to increase the role of functions, particularly so-called development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles functions in determining the allocation of income between affiliates. However, countries’ interpretation of the revised OECD Transfer Pricing Guidelines have varied substantially, particularly with respect to the methods for determining the allocation of intangible-related income. Going forward, it seems likely that there will be an increase in bilateral and multilateral disputes, thus increasing the value of tools, such as advance pricing agreements (APAs).
Gaspar: Brazil is part of the G20 and, as such, has been involved in BEPS discussions for some time. While Brazil has adopted some of the Actions recommendations, to the extent they are compatible with the fixed margins model, including MAP, it is not yet clear whether full alignment will be achieved with the OECD’s guidelines. The way the system is currently designed, which is based on fixed margins, themes like risks and functions are not as relevant as for the OECD framework. Similarly, intangibles are challenging to deal with under a fixed margins approach. Different TP methodology across the countries can materially increase the risk of double taxation. Converging to a single system is desirable and could lead to more countries abiding by the same set of rules, although TP is naturally a subject prone to differences in interpretation between taxpayers and tax authorities, and also among tax authorities in different jurisdictions. Hence, well-functioning dispute resolution processes are key to dealing with this challenge. The joint project with the OECD has culminated in a preliminary recommendation that Brazil would have to relinquish much of its current model in order to align with OECD guidelines, as both would not be able to coexist. This conclusion sparked a strong reaction from some of the most prominent TP scholars in Brazil, who argued for a possible compromise in applying the different methods. The outcome of the joint RFB-OECD assessment was published in December 2019, highlighting efforts toward implementation of a modern, simple and efficient system aligned with the OECD standard. This refreshed system would retain simplicity while allowing a proper taxable basis for the parties concerned and avoid double taxation. To that end, different paths have been identified and explored in detail, from full alignment to partial alignment, although dismissed as a viable option.
Odimma: The OECD’s initiatives have attracted the attention of tax authorities in Africa to the cases of profit shifting by way of TP. This has led to increased audits of all related-party transactions by MNEs with consequent TP adjustments in Africa. In turn, this has elicited increased disclosure and transparency from the MNEs. Review of payment of intangibles from Africa to other countries outside Africa is a key risk assessment criterion for initiating TP audits. Furthermore, based on the ATAF’s recommendation, there is normally a limitation of the amount that can be deducted in respect of royalty and intangible payments. Dispute resolution mechanisms remain a big issue in Africa as some countries do not have detailed tax resolution options for taxpayers.
Gracia: The most relevant impact has been on tax planning activity when it is not substantiated with the right allocation of assets, functions and risks. Increasingly, tax authorities are insisting that they will not abide by the content of relevant intragroup agreements, but instead will look at the facts to draw conclusions about the real interaction between related entities before assessing the arm’s length transactions on the basis of real or otherwise reconstructed transactions. This approach will definitely oblige companies to be consistent when it comes to establishing, for example, an intangibles holding subsidiary in a tax-friendly jurisdiction. By the same token, the new information in the hands of the tax authorities, coupled with their new approach, will no doubt substantially increase TP reassessments, domestic tax litigation and, above all, international mutual assistance and arbitration procedures under the double tax treaties and the EU Arbitration Convention.
“Mutual agreement procedures (MAPs) have recently been brought into force in Brazil, which has been greatly welcomed by scholars. How they will develop in practice, however, remains to be seen.”
FW: Do you foresee tax authorities collaborating more frequently on cross-jurisdictional transfer pricing audits? How does this approach affect participating countries and multinational companies?
Gaspar: Even though Brazil has double taxation treaties with language on TP, especially exchange of information, I have never heard of an actual example where a coordinated cross-jurisdictional audit has taken place. One reason may be the lack of corresponding adjustments. Recent legislation has caused additional challenges, such as RFB pricing guidelines for certain oil & gas transactions that can be potentially misaligned with other TP legislation, including Normative Instruction 1786/18. Further development of the legal framework and collaboration between the relevant tax authorities could reduce double taxation, but we are yet to see this happen.
Gracia: We do not foresee the Spanish Tax Inspectorate participating in joint TP audits in the short term, although it would be desirable in order to ensure the elimination of double taxation. However, the Spanish Tax Inspectorate has been participating in simultaneous TP audits for at least 15 years, always in the frame of the initiatives sponsored by the EU authorities and Member States. They have now joined the International Compliance Assurance Programme (ICAP), sponsored by the OECD in the framework of the collaborative relationships. The Spanish tax authorities consider this kind of initiative instrumental to the wider and broader gathering of information which may then be used in the course of the tax audit run at the level of the taxpayer established in Spain. MNEs will see many more of these simultaneous audits going forward with the risk of more frequent double taxation cases.
Odimma: A number of tax authorities are already collaborating with one another to confirm transactions recorded locally. This is to ensure that tax is duly collected on all income and there are no cases of double non-taxation. Also, the OECD has provided a strong platform for collaboration. Through the ATAF, Africa tax authorities are continuously exchanging ideas on how to properly tax MNEs.
Carden: We believe that there will be increased international cooperation in trying to perform initial risk assessments for MNE groups. For example, the ICAP provides an excellent mechanism for high-level discussions and consensus regarding relatively straightforward and uncontroversial positions. This is very useful and important, since day-to-day transactions make up a significant portion of MNE activity and reducing audit burdens is helpful to both tax authorities and taxpayers. However, at least in the near term we do not foresee more cross-jurisdictional audits because countries are taking varying approaches with respect to the implementation of the revised OECD Transfer Pricing Guidelines. Consequently, we believe that more complex and controversial TP issues will continue to be addressed through bilateral and multilateral competent authority negotiations that follow the completion of local audits.
FW: Has there been a noticeable increase in transfer pricing disputes between companies and tax authorities in recent times? What dispute resolution options are available to parties so that disputes of this nature are resolved as efficiently as possible?
Odimma: There has been increase in TP disputes across Africa, primarily because of a shortage of relevant tax authorities and the shortcomings of those authorities that do exist. The disputes which have emerged often relate to the understanding of the substance of the transactions in question, as well as consensus on comparable use. There have been some instances where the relevant tax authorities have adopted secret comparables in proposed TP adjustments. The above notwithstanding, some countries in Africa have included internal review processes to ensure fairness and to adopt a robust approach to the dispute. However, some countries require companies to pay the full amount before going to a higher stage of dispute resolution. It is common to go for negotiated settlement on TP cases in Africa.
Carden: The US is slowly moving past the disputes over pre-2010 TP positions that were a source of substantial dispute between taxpayers and the Internal Revenue Service (IRS). Going forward, unilateral TP disputes arising from more recent years appear to be on the wane. This is in part due to changes in TP rules in the early 2010s, the implications of which are still being digested on the audit or dispute side. Moreover, comprehensive US tax reform at the end of 2017, which included a so-called ‘transition tax’ imposed on subsidiary earnings, may be reducing the number of disputes because the financial consequences of TP adjustments are somewhat offset by transition tax. Additionally, the reduction in the US corporate income tax rate, along with global changes that have reduced the amount of ‘stateless’ income, have made TP disputes more about ‘which country gets to tax the income’ than ‘will the income be taxed’. Hence, we foresee MNEs getting into an increasing number of disputes that take a long time to resolve, mainly owing to the different approaches to BEPS Actions 8-10 that are being adopted by major treaty countries.
Gracia: We are certainly seeing cash pooling recharacterisations in short-term intercompany loans and a residual cash pooling where spreads must be at arm’s length and the cash pool leader is denied the role of financial entity entitled to earn a profit for its functions. We are also noticing a massive recharacterisation of shareholders loans into equity instruments through reconstruction of the related transactions with somewhat arguable technical support. To the extent that TP reassessments do not carry a serious penalty, or the penalty is annulled by the courts, the best available option for resolving TP disputes is the arbitration procedure set forth by the EU Arbitration Convention, or one of the few bilateral treaties signed by Spain which contemplate it – hopefully more, once the multilateral instrument (MLI) enters into force.
Gaspar: TP disputes, as with all tax disputes in Brazil, are privileged while at the administrative level. It is therefore difficult to track ongoing administrative litigation cases and, when it comes to judicial cases, there are currently very few of these underway. The lack of jurisprudence to guide taxpayers on how to interpret the legislation is an additional source of uncertainty, as either other taxpayers will not know details about TP administrative court decisions, or will find out about them many years later. The above, together with TP being a strategic audit item in which interpretation may vary, likely points to an increase in audits. Mutual agreement procedures (MAPs) have recently been brought into force in Brazil, which has been greatly welcomed by scholars. How they will develop in practice, however, remains to be seen.
“The concept of fairness and what is provided in the tax law is one of the challenges faced by MNEs in trying to manage their tax cost.”
FW: In a scenario in which a company finds itself subject to a tax audit or investigation, how should it respond? What steps should it take from the outset to reduce potential financial and reputational damage?
Carden: In my view, success in audits depends on preparation before any tax authority inquiry starts. This requires developing TP policies that reflect and are consistent with business operations, as well as ensuring consistent implementation and documentation of these policies. It also involves using, but not overly relying upon, technology that records and reports transactions in a manner consistent with intercompany agreements and policies. Consistent and readily available financial information is of particular importance. Once an audit begins, proactive management aimed at open communication and defence of positions, such as through presentations to tax authorities, can be an effective tool for reaching a successful resolution and avoiding an escalation that could lead to financial and reputational damage. Given the increasing level of transparency, as well as the amount of media attention now given to international tax issues, reputational and business concerns can be as important as the underlying tax liability.
Gracia: In our view, a company should get a good tax lawyer, preferably one independent from the TP adviser, although a good degree of collaboration between both is essential to set the strategy of defence from the outset and make available to the tax administration the required TP documentation. In Spain, it is compulsory to make available to the Spanish tax authorities the master file, the local file and from 1 January 2016, the CbCR for groups with a consolidated net turnover of at least €750m in 2015. With some notable exceptions, courts are generally siding with the tax authorities’ approach when the discussion deals with the methodology in a TP controversy, even if the proposal of the tax authorities is somewhat flawed, due to the little knowledge of economic concepts by courts and their current bias toward tax authorities’ stances on the national and international context of the fight against international tax-aggressive practices.
Gaspar: When it comes to an audit, it is ideal for the taxpayer to have prepared in advance. Having a strong internal process to analyse transactions, doing thorough work to fit the chosen method to adequate legal grounds, and keeping documentation up to date and organised, are key to a smooth process. It is worth emphasising the need for a thorough internal process within the organisation, with clear responsibility and accountability between areas, to ensure a proper audit trail on costs, documentation and so on. Also, in-house TP experts can prove fruitful to the extent that regulation has to be taken into account when designing business models and transactions to ensure compliance. On the reputation side, being transparent about tax affairs has grown from being ‘nice to have’ to imperative, to maintain a social licence to operate.
Odimma: MNEs in Africa are first encouraged to ensure they have the relevant TP documentation in place as the penalties for non-compliance can be significant. Secondly, the company should ensure transactions occur in practice as documented in the TP files. Thirdly, it is always helpful to engage a local tax adviser to help navigate local legislation and nuances. It is also helpful to make a presentation of the company’s business during the start of the audit to ensure that all aspects of the business are clearly explained to the tax authorities. Furthermore, transparency from the outset of the audit helps to create mutual trust. Companies must understand the TP audit process from the field stage to the dispute stage. It is also important to leverage alternative dispute resolution (ADR) mechanisms wherever possible. This will ensure key issues are clarified before escalation to the courts.
FW: Could you outline the challenges that face multinationals as they try to maximise their tax efficiencies while staying within the bounds of transfer pricing regulations? Is it becoming tougher to balance the drive for efficiency with compliance requirements?
Odimma: The concept of fairness and what is provided in the tax law is one of the challenges faced by MNEs in trying to manage their tax cost. Undoubtedly, it is becoming tougher to balance the drive for efficiency with compliance requirements. Implementing responsible tax is important to ensuring companies are accountable and transparent while trying to manage tax efficiencies. This will ensure all stakeholders understand taxpayers’ legitimate desire to manage tax efficiencies with respect to the law and the communities in which they operate.
Gaspar: The first TP challenge multinationals may encounter in Brazil is the gap between local TP regulation and the OECD’s guidelines. Lack of certainty when applying local methods can also add difficulty due to the limited jurisprudence arising from rulings issued by the RFB and courts. Most multinationals today aim to be compliant, however challenging. Designing transactions and business models with TP in mind from the start can prove effective, and should help companies to maximise compliance while sustaining a good reputation.
Gracia: We want to highlight that those companies focused on the digital economy and consumer-facing business must be aware of the OECD works for a ‘unified approach’ under Pillar One, according to which a new nexus, not dependent on physical presence but largely based on sales, and a new profit allocation rule, are created. However, it is important to bear in mind that further work must be carried out on the scope of such companies. It must also be mentioned that the US government is pushing back on the OECD’s proposal for a ‘unified approach’ and that unilateral country reactions are also proliferating as evidence of the need to have a consistent and coordinated global approach.
Carden: The most significant challenge facing companies now is the high degree of variation between countries’ implementation of function-based TP principles. These differences can lead to significant double taxation risks and lengthy international dispute resolution procedures, meaning that decisions that are believed to be tax efficient, or at least not tax-inefficient, when made can produce unexpected results. Managing this uncertainty in the near term will be very difficult, but I believe that many companies can benefit from APAs – preferably supported by simpler TP methods that can be easily implemented by the relevant tax authorities. Historically, double tax risk was best managed by carefully considering the key value-driving functions and assets within a company’s lines of business and aligning TP accordingly. However, with countries increasingly moving away from the arm’s length principle, even this approach may be insufficient to avoid double taxation.
“We envisage a genuine revolution derived from the OECD’s ‘unified approach’ under Pillar One.”
FW: How do you envisage the transfer pricing environment unfolding over the coming months and years? What trends and developments are likely to shape the way companies roll out their transfer pricing policies going forward?
Gaspar: The next couple of years are poised to be hugely exciting in the TP space. From the outcome of tax challenges arising from digitalisation of the economy, to the potential overhaul of TP in Brazil, practitioners will not have a dull moment. Still, those are two ambitious goals and whether – and when – they will materialise remains to be seen. International tax principles as we know them may change and, likely, we will all need to adapt.
Gracia: We envisage a genuine revolution derived from the OECD’s ‘unified approach’ under Pillar One and from overcoming the traditional concept of permanent establishment based on physical presence and the new profit allocation rule going beyond the arm’s length principle. As a result of this new scenario, many doubts will have to be resolved but undoubtedly controversies will also arise; hopefully many of them will be agreed between the competent authorities under the ADR mechanisms which are starting to proliferate. In addition, we expect to see continuous monitoring in the area of TP over the coming years, as it becomes an increasingly important issue for MNEs. Particularly in a post-BEPS world, it is foreseeable that we will see greater scrutiny by national tax authorities on where the added value is generated in the value chain within multinational groups in order to avoid profit shifting through the TP policy.
Carden: If 2019 suggests any trend, it is that the most significant changes to TP in the coming years will involve departures from the arm’s length standard and the use of functions, assets and risks – two cornerstones of TP for most of the last century. The European Union (EU), the UK and the OECD all seem to have reached the conclusion that, as a result of the mobility created by the globalisation and digitalisation of the world economy, the allocation of taxing rights over business income based on the activities and assets of the organisations that earn that income is no longer a viable, or at least sufficient, approach to taxation. Whether the US follows suit is less clear, but certainly the US has expressed some willingness to participate in international processes that will substitute other, more formulaic bases for allocating income into the place of the arm’s length standard. As a result, the future of TP that follows the traditional OECD guidelines and the arm’s length standard is thus very much unclear. Consequently, until the relevant rules regarding customer and market-based taxation rights become clear, we would advise MNEs to build as much flexibility into their TP policies and systems as possible. Additionally, it is prudent to seek bilateral, or even multilateral, agreements that at least cover the next several years as the new rules are developed, refined and implemented.
Odimma: Companies should expect the unexpected with respect to TP audits. The coming months will likely bring an avalanche of TP audits as more Africa tax authorities improve their ability to conduct TP reviews. The ATAF has been working hard in collaboration with technical partners to build capacity among Africa tax authorities, which will be reflected in the growing number of tax audits undertaken. It is also possible that the ATAF will release additional proposals on other aspects of TP audits, especially on the taxation of digital business. Joint tax audits across Africa have also been mentioned in some ATAF meetings.
Eduardo Gracia advises a wide range of Spanish and international corporates, funds and financial institutions on the tax planning and structuring of inbound investment into Spain relating to project finance, M&A, real estate and distressed asset deals. He has also advised on outbound investments advising on the corporate and operational restructuring of multinationals. He specialises in Spanish, European Union (EU) and international taxation of companies, VAT and other indirect taxation, as well as tax dispute resolution matters. He can be contacted on +34 91 364 9854 or by email: eduardo.gracia@ashurst.com.
Sebastine Odimma is responsible for tax dispute and resolution for Maersk companies within Africa. Until recently, he was responsible for the tax affairs of more than 40 Maersk companies within 20 countries in West and Central Africa. In his role, he supervises tax compliance, strategy, optimisation and transfer pricing risk assessments of related-party transactions, as well as tax advisory on any inbound investment into West and Central Africa. He can be contacted on +23 48 18793 9272 or by email: sebastine.odimma@maersk.com.
Fabio Gaspar is a tax lawyer with over 10 years’ professional experience. Mr Gaspar specialises in tax planning and consulting on Brazilian and international taxation, with a background in tax litigation and corporate law. He has authored a number of books and lectured on tax subjects in distinguished publications and forums worldwide.
Nathaniel Carden focuses on both planning and controversies arising in connection with transfer pricing and related international tax issues. Building on several years of experience as a management consultant with McKinsey & Co, Mr Carden specifically concentrates on the tax aspects of ongoing business operations. He works with corporate and other clients across many industries, with a particular focus on life science, healthcare and technology companies. He can be contacted on +1 (312) 407 0905 or by email: nate.carden@skadden.com.
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