New OECD BEPS Guidelines Become Final
Intercompany transactions affected by multinational enterprises (MNEs) will likely face increased scrutiny in the near future. The Organization for Economic Co-operation and Development (OECD) has recently released its final package of measures under its Base Erosion and Profit Shifting (BEPS) initiative. G20 finance ministers endorsed the plan last week at their meeting in Lima, Peru. A major goal of the initiative is to curb supposed tax avoidance and profit shifting by MNEs. The package, separated into 15 Action Items, tackles various challenging topics, including taxation in the digital economy and preventing artificial avoidance of Permanent Establishment (PE) status. The initiative is likely to increase MNEs’ global compliance burden and to impact the significance of intercompany contractual agreements and other formal legal arrangements.
Transfer Pricing Specific Portions of OECD BEPS
Action 8 - Intangibles
Several of the Actions in the final package are dedicated to Transfer Pricing. Since the OECD believes intangibles are responsible for most base erosion profit shifting, Action 8 focuses on transactions involving intangibles and stresses the importance of aligning profits with value creation. According to the guidance, legal ownership and contractual relationships simply serve as a reference point when determining the appropriate compensation of a controlled group member. Instead, allocation of profit should reflect the entity or entities that bore the costs, investments and other burdens associated with developing and/or maintaining the intangibles. Action 8 provides direction on how to make these determinations as well as illustrative examples.
Action 9 – Risk and Capital
Action 9 centers on the contractual allocations of risk and how they correspond with the activities actually performed. The guidance defines risk as the effect of uncertainty on the objectives of a business. Particular emphasis is to be placed on the entity or entities which carry out risk mitigation functions, suffer any consequences associated with the risk outcomes and have the financial capacity or ability to assume the risk. Ultimately, determining the economic significance of risk and how that risk impacts the pricing of a transaction is an integral part of the functional analysis and helps determine comparability. Any risks explicitly assigned between parties through a contract or other mechanism must match the economic realities of the parties and should be representative of what might occur in unrelated party transactions.
Action 10 – Other High-Risk Transactions
Action 10 addresses controlled transactions which do not appear to be commercially rational. For example, an entity providing capital that does not control the financial risks (provides funding only when told and does not assess the creditworthiness of borrower) should receive no more than a risk-free rate of return. This section also addresses the proper allocation of profits to the most economically important activities and the proper allocation of synergistic benefits of operating as a group. A mandate is included for further analysis and guidance on the transactional profit split method to be carried out during 2016 and finalized in 2017.
Action 13 – Transfer Pricing Documentation
Action 13 intends to enhance transparency for tax administrators around the globe. It outlines a three-tiered approach to transfer pricing documentation for MNEs with annual gross revenues exceeding €750 million (approximately $845 million). These MNEs are to produce: (1) a master file containing a written description of standardized information relevant for all members of the group; (2) a local file referring specifically to material transactions of the in-country taxpayer; and (3) a Country-by-Country (CbC) report containing information relating to the allocation, in each country, of certain financial attributes to be shared with other countries. These attributes include income, earnings, taxes paid and certain other measures of economic activity. A requirement to share this report with other countries will likely emerge. This level of reporting is unprecedented and is sure to produce challenges and raise privacy concerns.
U.S. Treasury officials have indicated they welcome the BEPS initiative. It seems likely the Treasury Department will embrace certain principles in the initiative including the CbC report. Requirements under the CbC report will likely include automatic information exchange of the CbC template with OECD treaty partners. However, U.S. congressional leaders have been critical of the OECD process and have raised concerns that BEPS could reduce the size of the U.S. labor force. It is unclear how much of the BEPS initiative will be included in the U.S. legal framework. Even if specific Actions are not formally adopted, it is likely the Internal Revenue Service will use BEPS as principled guidance and interpretive support.
How to Prepare
MNEs engaging in intercompany transactions should carefully evaluate any related party transactions. Attention should be given to formulaic transfers of money between related parties where there is no in-depth analysis of a transaction’s economic realities. Legal ownership and contractual agreements could become less significant while detailed exploration of a party’s functions, risks and assets will become even more important.
MNEs with greater than €750 million (approximately $845 million) in annual gross revenue should contemplate the burden of complying with the new reporting requirements. We recommend MNEs consider a “CbC Diagnostic” to ensure the necessary information can be accurately captured through existing technology/information systems and to help facilitate compliance by the first filing deadline (Dec. 31, 2017).