New guidance applying transfer pricing concepts to contracts, written by the OECD and approved by the G20 as a part of the base erosion profit shifting (BEPS) project, will have a significant impact on affiliated enterprises operating internationally.
The onus of implementing these new contract law transfer pricing provisions, as set out in the BEPS report on Action 8—10, “Aligning Transfer Pricing Outcomes with Value Creation,” has been placed on international businesses and their advisers, as well as on their governments. While the new contract law provisions are part and parcel of this international process, the process itself is interdisciplinary.
We provide a contract law transfer pricing primer, recognizing that significant complexities will be added by the coming multilateral instrument to implement the tax treaty measures in the OECD/G20 BEPS project.
These contract law transfer pricing provisions will involve many additional mindsets and they require a wide variety of professional inputs.
The rules emanate from governments’ goal of forestalling taxpayer techniques that would shift income from operating governments to tax havens, eroding each country’s tax base. (For background, see Feinschreiber, R., and Kent, M., Transfer Pricing Handbook: Guidance for the OECD Regulations, John Wiley & Sons, Inc. 2012.)
The OECD promulgated the contract transfer pricing rules on October 5, 2015; the G20 finance ministers approved the rules on October 9, 2015. The G20 leaders provided final approval November 15–16, 2015 at their meeting in Turkey. On June 15, 2016, the rules were approved by the OECD council as amendments to Chapter I, Section D of the OECD Transfer Pricing Guidelines. A number of OECD and G20 countries formally enacted the provisions in 2016 and 2017.
Other international institutions, including the International Monetary Fund, the World Bank, and the United Nations, are already on board with OECD and G20 developments, through the Platform for Collaboration on Tax. One implicit goal of these OECD/G20 provisions is to finally preclude the decision by the US Supreme Court in Societe Internationale v. Rogers, 357 U.S. 197, (1958), a case validating bank secrecy schemes.
In the new guidance, the OECD and G20 have given short shrift to local contract law provisions, setting the stage for conflict of law issues. The contract transfer pricing rules themselves might become part of a country’s transfer pricing regime through local laws that automatically incorporate OECD transfer pricing guidelines into law.
Now, an enterprise seeking to undertake and analyze a transfer pricing study or partake in tax audit defense will require inputs from attorneys, accountants, cost accountants, database experts, economists, and international tax professionals.
Attorneys who are, or might become, involved in these contractual transfer pricing issues need to evaluate the applicable standard of care as to these issues.
It is our view that a professional association that addresses contractual transfer pricing issues without the active involvement by an attorney is operating well below the applicable standard of care, leaving the association be open to tax malpractice claims.
However, it is equally true that attorneys, standing alone, who fail to collaborate with other professionals in addressing contractual transfer pricing issues, are operating well below the applicable standard of care, letting themselves become open to tax malpractice claims.
Aligning transfer pricing outcomes with value creation.
In Section 1.42 of the BEPS report, the term “transaction” is defined as the consequence or expression of the commercial or financial relations between the parties.
One party might control another in the transfer pricing sense. The guidance specifies relationships that create controlled transactions.
The suggestion is that written contracts might formalize the controlled transaction relationship. This relationship should reflect the intention of the parties at the time these parties conclude the contract. This contract might typically include the division of responsibilities among the parties, obligations, and rights, the assumption of identified risks, and pricing arrangements.
The guidance addresses situations in which the associated parties have finalized a transaction though their written contractual arrangements. Those arrangements provide these associated parties with the starting point for delineating transactions between them, and specify how the associated parties further delineate the responsibilities, risks, and anticipated outcomes.
The associated parties divide these relationships at the time they enter into the contract. The guidance points out that the associated parties might determine the transaction other than through a written contract. The OECD and G20 address these imputed issues in these contracts.
Beyond what’s written
The BEPS report on aligning transfer pricing outcomes with value creation points out that reliance on written contracts alone is not adequate. Section 1.43 of the report makes it clear that if a party relies on these written contracts alone, the result is unlikely to provide all the information necessary to perform a transfer pricing analysis.
Relying on the contracts alone will provide inadequate information regarding the relevant contractual terms, or will not provide that information in sufficient necessary detail. Attorneys or other professionals will require further information to create accurate evidence of the nature of the commercial or financial relations. Such attorneys or other professional seeking this information are to address four economic considerations, in addition to examining the contractual provisions themselves:
- The functions performed by each of the parties to the transaction, taking into account the assets the enterprise uses and the risks the enterprise assumes.
- The characteristics of property being transferred or the services being provided.
- The economic circumstances of the parties, and of the market in which the parties operate.
- The business strategies of the parties.
Gathering this information together, one must analyze economically relevant characteristics and must provide evidence of the actual categories pertaining to the associated enterprises.
The OECD and G20 suggest that this evidence might clarify aspects of the written contractual arrangements. These arrangements might provide useful and consistent information by taking into account the consistent behavior of the parties.
It is plausible that a contract might not explicitly or implicitly address characteristics of the transaction that are commercially relevant.
The parties are to take into account the applicable principles of contract interpretation for this purpose when the principles affect activities that are commercially relevant. The parties should then supplement any information the contract fails to provide for transfer pricing purposes by providing evidence that identifies those unaddressed characteristics.
The OECD and G20 provide an example that illustrates the concept that the multinational enterprise can clarify, and thus supplement, the written contractual terms. Section 1.44 of the guidance states that tax professionals should make this determination based on the identification of actual commercial or financial relations.
In this scenario, Company P is the parent company of a multinational group situated in Country P. Company S, situated in Country S, is a wholly-owned subsidiary of Company P. Company S acts an agent for Company P’s branded products in the Country S market.
In the example, the agency contract between Company P and Company S is silent as to marketing and advertising activities in Country S that the parties should perform. The attorneys and other professionals undertake an analysis of the multinational enterprise’s economically relevant characteristics, and in particular, the nature of the functions performed. The attorneys and other professionals conclude that Company S launched an intensive media campaign in Country S to develop brand awareness. The making of this campaign was a significant investment for Company S.
Based on the foregoing facts, the parties to the Company P-Company S arrangement might conclude that the written contract might not reflect the full extent of the commercial and financial relations between the parties.
Accordingly, attorneys and other professionals should not limit their analysis to the terms recorded in the written contract. Instead, they should seek further evidence pertaining to the conduct of the parties. They should adduce evidence demonstrating the basis upon which Company S undertook the media campaign.
Writing vs. behavior
The BEPS report on aligning transfer pricing outcomes with value creation, in Section 1.44, recognizes that the characterization of an economically relevant transaction might be inconsistent with the written contract between associated enterprises. The guidance provides that, in choosing between the written contract and the conduct of the parties, the actual conduct of the party during the transaction prevails for purposes of transfer pricing analysis.
The multinational taxpayer is to make this contractual determination in accordance with the characteristics of the transaction reflected in the conduct of the parties.
Applying contractual relationships
The OECD and G20 place high importance on independent transactions compared with related party transactions because independent parties, by virtue of this independence, have divergent interests, un under Section 1.46 of the BEPS guidance.
The “divergent interests” standard means that:
- Both parties reflect the interests of each party in setting up the contractual terms.
- Each party will ordinarily seek to hold each other accountable to the terms of the contract.
- The parties will ignore or modify contractual terms after the fact only if it is in the interests of both parties to do so.
The OECD and G20 caution that the same divergence of interests might not exist in the case of associated enterprises. Associated enterprises can manage any such divergences by the control relationship, not solely or mainly through contractual commitments.
The guidance suggests that it is particularly important, in considering the commercial or financial relationships between associated enterprises, to examine whether the arrangements reflected in the actual conduct of the parties meets one of more of the following range of results:
- The arrangements substantially conform to any written contract.
- Whether the associated enterprises’ actual conduct indicates that the parties have not followed the contractual terms.
- That the arrangements do not reflect a complete picture of the transactions.
- The enterprises incorrectly characterize or label the arrangements incorrectly.
- The arrangement is a sham.
The guidance cautions that the parties will need to undertake further analysis to identify the actual transaction when the conduct of the parties is not fully consistent with the economically significant terms.
The multinational enterprise should ultimately determine the factual substance of the transaction and accurately delineate the actual transaction where there are material differences between contractual terms and the conduct of the associated enterprises in their relations with one another. Multinational enterprises should take into account the functions they actually perform, the assets they actually use, and the risks they actually assume.
Modifying the arrangement
The BEPS guidelines in Section 1.47, recognize that there might be situations in which the associated enterprises might not agree to the specific nature of the agreement. In that event, the OECD and G20 would have the associated enterprises take into account all relevant evidence from economically relevant characteristics of the transaction.
Here, the guidelines caution that the terms of the transaction between the enterprises might change over time. When such a change of the terms of transaction do take place, the associated enterprises need to examine the circumstances of the change. The modification might suggest that the associated enterprises replaced the original transaction terms with new transactional terms, a description effective from the date of the change.
The associated enterprises need to consider whether this change reflects the intention of the parties in the original transaction. The affiliated enterprises need to exercise care when it appears that knowledge of emerging outcomes from the transaction might trigger these differing outcomes. The associated enterprises need to consider whether a change of the agreement changes the assumption of risks. There might not be an assumption of risk, as there might not be a continuation of risk.
The OECD and G20 established a procedure the affiliated enterprises might use when there are material differences between the contract terms and the conduct of the associated enterprises in their relationships with one another.
In that event, the multinational enterprise should consider the functions that the associated enterprise actually performs, the assets the associated enterprise actually uses, and the risks that associated enterprise actually assumes.
In the context of actual performance, the affiliated enterprise should ultimately determine the factual substance and the accurate delineation of the actual transaction.
When conduct and terms differ
The guidance, in Section 1.47, squarely addresses situations in which the conduct of the parties differs from the contractual terms they have enunciated.
An example provided illustrates two concepts: written contractual terms and the conduct of the parties. The OECD and G20 make clear that the actual conduct of the parties predominates, and delineates the transaction.
In the example, the multinational enterprise has a parent company, Company P, and its subsidiary, Company S, with 100 percent ownership. The parties enter into a written contract under which Company P licenses intellectual property to Company S for use in Company S’s business. Company S agrees to pay a royalty under the license to compensate Company P.
The facts demonstrate that Company P and Company S as a group undertake the following actions, taking into account the economically relevant characteristics and the actions that each company performs:
- Company P undertakes negotiations with Company S’s third-party customers to enhance Company S’s sales.
- Company P provides regular technical services support to Company S enabling Company S to deliver contracted sales to its customers.
- Company P regularly provides staff to enable Company S to fulfill its customer contracts.
The facts in the example further demonstrate that a majority of the customers of the multinational enterprise insist on including Company P as a joint contracting party along with Company S.
The fee income under the contract is payable to Company S. 1 The attorney undertakes an analysis of the commercial and financial relations of the parties and determines that Company S is not capable of providing contracted services to customers without Company P providing significant support, and that Company S is not developing its own capability.
Under the contract between Company P and Company S, Company P has given a license to Company S. In fact, Company P controls the Company S’s business risk and output. Company P had not transferred risk and functions in a manner that is consistent with the licensing arrangement. Company P acts as the principal, not as the licensor.
The OECD and G20 would have both Company P and Company S identify the transaction by the conduct of the parties, not solely defined by the terms of the written contract. The actual functions the companies perform, the assets the companies use, and the risks the companies assume are not consisted with the written license agreement.
The OECD and G20 contractual provisions, in Section 1.49, recognize that a multinational enterprise might create an oral contract with a related party. Where no such written terms exist, the attorney would have to deduce the terms of the contract from the actual conduct of the parties involved. The attorney is to identify the economically relevant characteristics of the transaction in making that determination.
The attorney’s obligation is difficult in this context because the multinational enterprise might not identify as a transaction the actual outcomes of commercial relations or financial relations. Nevertheless, the transaction might result in a transfer of material value between affiliated parties. The attorneys have an obligation to deduce this arrangement from the conduct of the parties and reflect this arrangement to the relevant tax administrations.
The guidance states that, for example, an affiliated party might grant technical assistance to another affiliated party, or affiliated parties might create synergies through their deliberate concerted action or provide know-how through the transfer of employees.
The multinational enterprise might not recognize these relationships as part of its formal structure. As a consequence, the related parties might not reflect the pricing of these connected transactions.
The multinational enterprise might not formalize this arrangement in written contracts, and the related parties might not reflect concurrent entries in their accounting systems.
When the multinational enterprise does not formalize the transaction, the attorney would have to deduce the arrangement from the available evidence of the parties. Such evidence would typically include the functions that the affiliated parties perform, the assets the affiliated parties actually utilize, and the risks that each of the parties assume.
Attorney’s contractual role
Section 1.50 of the BEPS guidance on aligning transfer pricing outcomes with value creation views the attorney’s role in an expansive manner when dealing with related-party transactions.
The OECD and G20 expect the attorney to examine the multinational enterprise’s actual transactions, even in situations in which the multinational enterprise has not even acknowledged the existence of these transactions. Gone are the days when an attorney could proceed with clients’ wishes without due diligence. The attorney bears at least a significant portion of the responsibility, along with other professionals, in reviewing the multinational enterprise’s activities including in the income allocation process.
The purpose of the initial inquiry is to ferret out the major activities of the multinational enterprise. The “know your customer” standard comes to mind as the attorney and other professionals should undertake a review of the multinational enterprise’s commercial and financial relations. Such related party relationships typically include, for example, relationships between the parent company and its subsidiary companies.
The new provisions illustrate an example in which the attorney observes that an independent party has engaged with the parent company to pay for services for the benefit of the subsidiaries. The subsidiaries in this example fail to reimburse the parent company for making expenditures, whether direct or indirect. Here, the parties failed to establish services agreements between parent and subsidiaries.
The example illustrates situations in which commercial or financial relationships exist between the parent company and its subsidiaries apart from the ownership structure. The guidance provides that these commercial or financial relationships transfer potential value between the parent companies and their subsidiaries.
The attorney – or someone else duly qualified – would need to ascertain the specifics of this commercial or financial relationship. That person would need to analyze the economically relevant characteristics of the relationship with the goal of determining the terms and conditions of this transaction. Then, and only then, the attorney can develop an agreement that accurately depicts the intended relationship.
–-Robert Feinschreiber and Margaret Kent are international transfer pricing lawyers. See their website, TransferPricingConsortium.com. Their clients include diversified multinational enterprises and governments.