Ahead of our European Branch’s Amsterdam Conference next week, Tim Sarson looks at recent changes in transfer pricing (TP).
BEPS has been bedding in for some time now. How has it changed the world of transfer pricing?
Transfer pricing was the ‘Profit Shifting’ poster child of the BEPS project. three of the 15 actions specifically addressed it and most tax authorities have embraced the new global lexicon of DEMPE, control of risk, and the alignment of profit outcomes with value creation. So have multinationals. But the revolution has been patchy. For large parts of the world the old ways persist.
(Almost) everyone understood where working group 6 at the OECD were coming from when they launched actions eight, nine and 10 on the world: TP outcomes should be aligned with business reality; substance was king; the contractual allocation of risk was no longer enough. In much of Europe this was, frankly, a more articulate restatement of how taxpayers and authorities had been operating for many years.
Unlike other BEPS actions there has been little hanging about. The OECD TP guidelines were rapidly updated, countries have been quick to incorporate them into domestic legislation. Doing so in most places takes a few sentences in a finance bill. No need for the MLI; no detailed new tax code. This means we already have a year or more of practical experience to reflect on: how have tax authority approaches to TP changed, and how have MNCs themselves adapted?
I will start with the UK experience. Since the guidelines changed HMRC have overhauled their internal governance structure, any TP considered at all “BEPSy” is referred to a diverted profits group in Bristol, and in theory the approach to IP and risk / capital structures is more coordinated and fair than before. In practice this is partly true: my clients are seeing standardised letters and questions couched in a language that reflects the way they think about and document their businesses. In particular Value Chain Analysis (VCA) is now an established means through which to explain global TP models, with language both sides understand.
But in the UK as elsewhere, unilateral actions are muddying the waters. Diverted Profits Tax (DPT) is a heavily TP focused tax, but its remit is wider. Unlike the OECD guidelines it probes the motives and intentions of the taxpayer. Every APA and TP enquiry now comes with DPT questions attached, and companies are being asked to explain why transactions were untaken many years into the past. In some cases as far back as the 1980s.
Elsewhere we are seeing similar trends in tax authority approaches albeit with less of the governance overlay and more variation. However, approaches still vary. Take a profitable IP-owning manufacturer that no longer controls or manages the DEMPE functions supporting its business: do local tax inspectors accept economic value has moved over time to another location? Very rarely. Groups continue to face eye watering exit charge assessments whenever they try to adjust the TP of high margin, low substance subsidiaries. Meanwhile the headquarters carries on making unrecovered losses.
Developing world: a patchwork
Arguably the BEPS TP actions do not really help developing countries. They shift profit from one rich nation to another. It is not surprising that take-up is patchy and cherry picking is an issue. In many cases, particularly in the commodities industries, the domestic laws on deductions or, for example, VAT recovery by non-established entities are effective blunt instruments that do away with the need for actions eight to 10. If you can limit deductions for service fees to a percentage of revenue, why bother worrying about value creation and substance?
For this reason most groups with significant activity in Latin America and Africa in particular are faced with managing two parallel approaches to TP: specific local rules or practices in their subsidiaries and a BEPS-aligned emphasis on value creation in their European headquarters. Double taxation continues to be a problem, and I expect it to increase.
China and India seem to be taking a different approach. Chinese subsidiaries must now produce VCAs in their local TP files, and DEMPE and other BEPS terms are being employed by the tax authorities aggressively, but in a very different way from Europe. We have seen APAs where both sides use the same language but differ hugely on how and where value is created. TP in China is difficult. The experience of our clients in India is similar: BEPS terminology is everywhere, but only when it suits the tax authority.
USA: what’s this BEPS thing?
Meanwhile across the Atlantic it is becoming clear that little has really changed. The officials at the OECD may have said the right things but on the ground the contractual allocation of risk still rules, DEMPE means little, and s.482 of the US code remains a formalistic, prescriptive outlier in the TP world. To some extent Japan remains similar: the old ways (identify the entrepreneur and the tested party, do some benchmarking) still rule in most cases.
For the enterprising or cheeky this potentially means arbitrage: a simple example would be valuable ‘management service’ activities in the US earning a cost-plus fee, and residual profits resting somewhere low tax with little ability for other tax authorities to challenge them. For the more conservative it means confusion: how to come up with a coherent global approach to profit allocation when a major market operates in such a different way.
So has BEPS been good or bad for TP?
For tax authorities BEPS has certainly provided new weaponry, coupled with local additions like DPT or ATAD. For taxpayers the new OECD guidelines themselves provide helpful clarity in most cases, and without doubt the whole project has led to a change in mentality in European MNCs. The positives are greater engagement between the tax function and the business, more sustainable tax planning, and in many cases a better mutual understanding of value chains between the tax inspector and taxpayer.
But all revolutions are messy, and that is the problem. The other big legacy of the TP actions is greater workload, including the new documentation and CbCR requirements, and yet more complexity. Double taxation may increase just as double non-taxation declines. It is a mixed picture.
Tim Sarson, Partner at KPMG LLP (UK), will be speaking on TP at the conference
(The views in this blog are his own personal views and do not necessarily reflect the view of CIOT).