by Julie Martin
The latest draft of the rewrite of Chapter 1 of the OECD Transfer Pricing Guidelines includes a new framework for analyzing risk that will address cash box companies without resort to any special measures, OECD tax officials said during a July 7 OECD consultation.
Officials also provided a detailed update of other transfer pricing work being developed by Working Party No. 6 of the OECD’s Committee on Fiscal Affairs (WP6) under the base erosion profit shifting (BEPS) plan, discussed plans for post-BEPS transfer pricing projects, and announced progress on transfer pricing dispute resolution.
New framework for risk
The OECD’s Marlies de Ruiter said that WP6 has revised a December draft that proposes to modify to Chapter 1 of the OECD transfer pricing guidelines. WP6 has developed a new framework for analyzing risk which, along with the updated intangibles guidance and BEPS guidance, should ensure that pure cash boxes with no or low functionality will receive only a risk-free rate of return for funding.
“We are now comfortable that, at this stage, no special measures are deemed necessary” in the Chapter 1 guidelines, said de Ruiter, who is head of Tax Treaty, Transfer Pricing, and Financial Transactions at the OECD.
As WP6 has not yet achieved complete agreement on the Chapter 1 revisions, OECD officials opted to describe the current thinking on the revised draft in detail at the consultation rather than supply an updated draft. The final guidance should be released to the public in early October, just before the G20 finance ministers meeting, de Ruiter said.
De Ruiter also noted that the title of the guidance has changed to reflect the changed content. The title now refers to recognition of accurately delineated transactions; all references to nonrecognition have been deleted, she said.
Andrew Hickman, who heads transfer pricing at the OECD Center for Tax Policy and Administration, said the new Chapter 1 guidance provides six steps for analyzing risk and determining which party assumes risk for transfer pricing purposes.
Hickman said the first three steps of the new framework involve a determination of the facts surrounding the risks, namely (1) identifying the “economically significant” risks with specificity, (2) identifying contractual assumption of the specific risk, and (3) conducting a functional analysis to determine what the parties actually do in relation to the risk.
The fourth step asks if the contractual assumption is aligned with the conduct and facts of the case, namely, whether the parties are actually “living” the contract, he said. In this step, one must ask if the party assuming the risk exercises control and also has the financial capacity to assume the risk, Hickman said.
If not, step five of the guidance requires allocation of the risk to the group company having the most control and also having the financial capacity to assume the risk, he said.
The final step of the framework is to price the transaction, taking into account the full functional analysis of the transaction, including the analysis of risk, Hickman said.
De Ruiter added that if, in step four and five, no party has both financial capacity to assume risk and control of the risk, WP6 will likely provide that a facts and circumstances test will determine which entity should be allocated the risk.
She also confirmed that if multiple parties are involved in the decision making process and the party contractually assuming the risk has a meaningful level of control, the contractual allocation will be respected.
Hickman said that new draft provisions discussing control of risk acknowledge that mitigation of risk and preparatory work relating to the actual decision making may be outsourced. If such activities are outsourced, the group company in control of the risk should set the objectives of the outsourced activities, be able to assess whether the objectives are met, and hire or fire the service provider.
The guidance also provides that the parties performing risk mitigation activities and the parties making the decisions that shape the policy environment in which the specific risks in the transaction are assumed do not exercise control over the specific risk in the transaction, Hickman said.
Italy’s delegate explained that guidance is designed to be practical, taking into account “decentralized situations.” He said it is not enough for a central entity to set up the policy for controlling the risk of affiliates if the affiliates then manage the specific risk.
Responding to questions posed by Philippe Penelle of Deloitte, de Ruiter said that while outsourcing through contract R&D and other arrangements would be possible under the new guidance, “it is very important to recognize in that situation that we have stipulated that there are some conditions about control that you need to have over those outsourced activities and the risks that are allocated to you.”
Board minutes
Hickman said that the guidance also clarifies that mere formalization of decision making in board meeting minutes or by signing the documents of a board meeting does not qualify as exercising a decision making function sufficient to demonstrate control over risk.
De Ruiter explained that the guidance looks to the decision making process rather than where decisions are formalized to determine location of control.
“I have heard some people saying that it would be possible to just fly in a couple of directors to a nice low tax location and then have a meeting there and then they fly back. For WP6 delegates, it is explicitly not the intention that that would be covered by the threshold [and] we target that by looking at process instead of looking at formalization of the decisions,” she said.
Cash boxes
De Ruiter said the Chapter 1 guidance does not include a separate section on cash box companies, rather cash boxes are analyzed under the general framework on risk.
If a cash box company does not exercise meaningful control over financial risk associated with the funding provided, the risk will be reallocated to the group entity performing control functions, she said. Pure cash boxes with no or low functionality will get no more than a risk-free rate of return for the funding, she said.
“The level of control that will need to be exercised is very dependent on the facts and circumstances of the case – it depends on the kind of funding, the riskiness of funding, the amount of money at stake, the investment you are making,” she said.
US delegate and WP6 co-chair Michael McDonald agreed with a business representative that if it turns out that the cash box is not actually controlling the risk, the arrangement could be viewed as being similar to a loan from the cash box to the entity that has ability to control the investment risk, with the latter entity being entitled to the premium returns.
According to de Ruiter, while WP6 believes that the new guidance, coupled with other BEPS guidance and the guidance on intangibles, will stop cash boxes from drawing excessive profits without the need for any special measures, WP6 intends to monitor whether the guidance actually works and revisit the guidance if it does not.
Financial capacity to assume risk
Hickman said that in determining the financial capacity to assume risk, equity levels are not the only factor. The relevant test relates to access to funding on the basis that the associated enterprise is operating as an independent enterprise in the same circumstances as the associated enterprise, he said.
“We take account of the available income-generating assets [and] options realistically available to accesses additional liquidity,” Hickman said.
Dispute resolution, ongoing and post-BEPS projects
Turning to other projects, De Ruiter noted that the OECD is developing a set of minimum standards for dispute resolution as a part of the BEPS project. One such standard will be the requirement that access to the mutual agreement procedure (MAP) be provided in all transfer pricing cases, even if a treaty does not contain article 9 (2) of the OECD convention, she announced.
She also said the OECD plans to take up several new transfer pricing projects following completion of work under the BEPS plan. Work commencing in 2016 and 2017 will include guidance on attribution of profits to permanent establishments, financial transactions, profit splits, and implementation of guidance on hard-to-value intangibles, she said.
De Ruiter said that the work on profit attribution to PEs will target issues under action 7 of the BEPS plan on commissionaire arrangements and the specific activity exemptions. She said the work needs to be complete by 2016 so it is ready before the planned signing of the BEPS multilateral instrument.
WP6 guidance on financial transactions will include discussion of the level of remuneration in non-cash box situations, namely, where there is both funding and functionality, she said. The project was put on hold pending the outcome of BEPS work under action 4 concerning interest deductibility and the new guidance on risk, she said.
WP6 will also take up a project that seeks to prevent double taxation and mismatches arising from the new hard-to-value intangibles guidance, de Ruiter said.
Hickman said that the guidance on profit splits will not “throw away the most appropriate method rule,” as some have worried. Rather, the guidance will unlock the potential of profit splits as an appropriate method, he said.
De Ruiter said there is broad agreement in WP6 to finalize the draft guidance on low-value-adding services released last November with one change to address concerns that implementation will lead to excessive deductions. She said the revised guidance will include a threshold amount of deductions which, if exceeded, will allow countries to conduct a full transfer pricing analysis. A very broad group of countries is willing to implement the guidance, she said.
Hickman said WP6 has agreed on guidance specifying the arm’s length price for commodities transactions. The approach follows the December 16 discussion draft, bringing elements of commodity pricing into the CUP method under Chapter 2 of the guidelines, he said. The approach also allows pricing to be determined by reference to a commodity’s quoted prices, includes a deemed pricing date for commodity transactions, and mentions the need to have access to MAP, he said.
WP6 will also combine the three separate papers on transfer pricing documentation into one report and intends to seek formal CFA approval in “short notice,” de Ruiter said.
September 2014 guidance on transfer pricing aspects of intangibles and guidance on hard-to-value intangibles will also be combined into one document, she said. No fundamental changes will be made to the intangibles guidance except to align it with Chapter 1 changes, she said.
De Ruiter also said WP6 will be assisting the United Nations and others in the development of toolkits to implement BEPS action items in developing countries. The work will include guidance on how to deal with a lack of transfer pricing comparables, base eroding payments, and transfer pricing documentation, she said. De Ruiter appealed to business representatives for more assistance on this project.
NGO frustration
Sol Picciotto of the BEPS Monitoring Group expressed his group’s dissatisfaction with the OECD’s BEPS plan output on transfer pricing. Picciotto said that NGO comments have been ignored by the OECD, particularly their call for radical change through adoption of formula apportionment. The OECD guidance will not result in the demise of the tax planning industry; rather, it is more likely that tax planning will increase as a result of the guidance, he said.
Picciotto said the OECD is writing the tax rules only with insider input and, while the OECD has done its best to include non-OECD counties in the process, “inevitably they are there as junior partners,” he said.
De Ruiter responded it is not the case that NGO comments have been ignored even though their suggestions have not been adopted. She said that many of businesses’ recommendations have not been adopted either.
The OECD takes comments by all parties seriously, de Ruiter said, adding that the OECD’s engagement with developing countries has gone beyond its engagement with NGOs.
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