The shifting sands of transfer pricing
December 2023 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
December 2023 Issue
Transfer pricing (TP) continues to be an area of major focus for tax administrations and multinational corporations (MNC). Rules, compliance requirements and case law are in a constant state of evolution. This year, 2023, has brought changes in several major markets as well as the ongoing negotiation of a potential global overhaul of one of the most common analyses in TP, distribution activities, as part of Pillar One, Amount B. This article provides an overview of significant developments in 2023 in Brazil, the US, Germany, the UK, and a preview of changes that might be globally applicable as early as 2024.
Brazil. Brazil has long been an outlier in the world of TP as the jurisdiction’s rules did not adhere to the arm’s length principle. This frequently resulted in double taxation when the counterparty to the controlled transaction was in the US or a jurisdiction that follows the Organisation for Economic Co-operation and Development’s (OECD’s) ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’. Earlier this year, the US Tax Court found in favour of the Internal Revenue Service (IRS) in 3M Company and Subsidiaries v. Commissioner of Internal Revenue and required the US taxpayer to include in income the arm’s length royalty amount from a Brazilian subsidiary rather than the lower royalties permitted under Brazilian law.
However, the new Brazilian law (Law No. 14,596) allows taxpayers to depart from the application of the prior pre-approved fixed margin concept and aligns the Brazilian TP system with the arm’s length principle. This includes the ability to use frequently used methods described by the OECD Guidelines, like the ‘cost plus method’ and the ‘transactional net margin method’ (TNMM) which rely on comparable company results as profitability reference points to determine arm’s length pricing. The rules are effective as of 1 January 2024 and provide MNCs with the option to adopt for 2023.
Guidance released by Brazilian authorities indicates a preference for domestic companies to be used as benchmarks. Based on our experience, a limited pool of local companies exists but may not be sufficient to generate a statistically meaningful result for many common transaction types.
US. While historically the focus has been on international transactions, US states are increasingly focused on TP. The State Intercompany Transactions Advisory Service (SITAS) Committee of the Multistate Tax Commission resumed regular meetings in 2021 after a long pause, and has adopted a new charter and an Information Exchange Agreement for its members. SITAS was originally named the Arm’s Length Adjustment Service, and provides support to states seeking to address tax base erosion of income-based taxes due to intercompany transactions.
In addition, following several state decisions in favour of taxpayers in Indiana and Utah, the Wisconsin Tax Appeals Commission issued a decision in favour of the Wisconsin Department of Revenue in February 2023 in a case involving Sketchers USA, Inc. At issue in this case was the existence of a nontax business purpose for the creation of a subsidiary which owned intellectual property (IP), and the economic substance of related licensing transactions.
Germany. The German Federal Ministry of Finance released updated TP administrative guidelines on 6 June 2023 which are binding on the German tax authorities even for open audits and open years. Major changes include detailed guidance on valuing the transfer package of relocated functions and a recognition that unsecured loans can be arm’s length if the risk is appropriately compensated. A differentiator of the German TP regime continues to be the emphasis on the price-setting approach.
UK. The UK’s Finance (No. 2) Act 2023 came into effect on 9 August 2023 adopting for the first time the TP documentation requirements incorporated in the OECD Guidelines comprising a local file and a master file. The regulations are applicable to corporate tax returns for accounting periods beginning on or after 1 April 2023.
Global – Pillar One, Amount B
The sale of goods from one jurisdiction to another within MNCs accounts for two-thirds of global trade and is therefore subject to TP rules. The approach to apply the arm’s length principle to one of the most common contractual arrangements for the cross-border sale of tangible goods may change in 2024. In parallel with other multilateral international tax initiatives (for example the 15 percent global minimum tax) the Inclusive Framework of more than 130 jurisdictions has been working with the OECD Secretariat to streamline the application of the arm’s length principle to marketing and distribution activities. The stated goal of this initiative is to increase tax certainty and reduce resources by MNCs and tax administrations, especially for low-capacity jurisdictions. This is referred to as Amount B.
On 17 July 2023, the OECD released ‘Public Consultation Document Pillar One – Amount B’ (July PCD) on Amount B which showed significant progress toward reaching a consensus within the Inclusive Framework jurisdictions regarding the scope and quantification of Amount B. In essence, for certain common transactions, the selected TP method, profit level indicator and comparable companies are replaced by Amount B, which is a sliding scale of routine wholesale distribution target returns based on the type of product and size of operations.
As drafted in the July PCD, Amount B will apply to legal entities within an MNC acting as a limited risk distributor, sales agent or commissionaire (LRD/SA/C) that sells tangible goods, with the exception of commodities. LRD/SA/Cs that sell services, including digital services, are not in scope of Amount B. There are quantitative thresholds to be considered on an entity by entity basis relating to operating expense, retail sales or multifunction entities. However, there are no revenue or profitability thresholds at the MNC or entity level. Accordingly, Amount B may be applicable to MNCs of any size. There are no specific industry exemptions in the July PCD. In addition, the sale of commodities is excluded, careful evaluation is required for regulated industries and there is no consensus regarding digital goods. The intercompany sale of tangible goods that is most reliably tested via the ‘comparable uncontrolled price’ (CUP) method using internal data is exempt from Amount B.
The pricing matrices incorporated in the July PCD presuppose that the TNMM is the most appropriate method, and the operating margin (OM) is the most reliable net profit indicator.
The pricing matrices can only be applied after calculating the following ratios for each LRD/SA/C: (i) operating expense-to-sales ratio; and (ii) operating asset-to-sales ratio. The pricing matrices assign higher OMs to LRD/SA/Cs deploying higher levels of operating assets.
If adopted, the pricing matrices will be valid for five years (unless there is a material change in market conditions). That said, the pricing matrices are not constant across each jurisdiction as there are geographical adjustments that could be applied to increase the target OMs. One such adjustment applies to in-scope LRD/SA/Cs that operate in jurisdictions with sovereign credit ratings of BBB or lower. Moreover, the adjustment factor for affected jurisdictions will change each year based on the entity-specific inputs to the calibration calculation. Finally, there is a ‘cap and collar’ test based on a minimum and maximum gross profit to operating expense ratio at the entity level. As a result of applying these steps, many MNCs will have a unique set of adjusted target OMs for their LRD/SA/Cs.
As there might be impacts on the TP policies of MNCs commencing 2024, we recommend that MNCs conduct a detailed scoping exercise to determine which LRD/SA/Cs are potentially in scope. The target OM for the in-scope LRD/SA/Cs can then be computed and the impact on the company’s effective tax rate (ETR) can be estimated. This exercise may include segmenting the balance sheet for multi-function entities, which is likely a new exercise.
From a practical perspective, the Amount B framework does not reduce complexities for MNCs, such as aligning TP and customs requirements and making year-end adjustments. Amount B could potentially be effective as early as 1 January 2024 via the release of the 2024 OECD Guidelines which incorporate Amount B.
Anna Soubbotina and Robin Hart are principals at Charles River Associates. Ms Soubbotina can be contacted on +1 (212) 294 8896 or by email: asoubbotina@crai.com. Mr Hart can be contacted on +1 (510) 595 2890 or by email: rhart@crai.com.
© Financier Worldwide
BY
Anna Soubbotina and Robin Hart
Charles River Associates
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The shifting sands of transfer pricing
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Taxation of carried interest: a view from the UK
Corporate tax: the dawn of a new tax era in the UAE
Expanding scope of the Australian general anti-avoidance rule