In view of landing on the Transfer Pricing track in its work to curb Base Erosion and Profit Shifting (BEPS Actions 8-10) the OECD published two new reports on 21 June 2018:
- Guidance for tax administrations on the application of the approach to hard-to-value intangibles; and
- Revised guidance on the application of the profit split method.
The OECD acknowledges that the increasing integration of national economies and markets puts a strain on international tax rules which were designed over a century ago. Its guidance aims to ensure that profits are taxed where economic activities take place and value is created.
Hard-to-value intangibles
Chapter VI of the OECD Transfer Pricing Guidelines (TPG) contains a separate section on so-called “hard-to-value intangibles”, i.e. intangibles for which either no comparables exist or where the elements used in valuing the intangibles at the time of the transaction are highly uncertain.
The newly published report follows up on the revised Chapter VI TPG and is intended to assist tax administrations to address the alleged lack of information they face with regard to transactions involving intangibles. The approach allows under certain conditions that intangibles related returns pertaining to periods after the transaction can be used as presumptive evidence to consider whether the price set at the time of the transaction was appropriate. The guidance explains certain principles that underpin the application of this approach which is illustrated also by way of two examples in the pharmaceutical industry. Further, some attention is given to dispute prevention and resolution in relation to the approach, in particular through the use of bilateral advance pricing arrangements and through allowing access to the mutual agreement procedure in case double taxation arises.
Profit split method
The report represents a full revision of the current guidance on the use of profit splits. It contains non-prescriptive guidance in an attempt to clarify and expand on when the profit split method is the most appropriate method and how it can be applied. The use of the profit split method may be relevant in case the parties to the transactions make unique and valuable contributions, in case of highly integrated business operations, or when the parties share risks or separately assume closely related risks. The report allots quite some weight on the Masterfile as it mentions that the Masterfile may serve as a useful source of information relevant to the determination of appropriate profit splitting factors.
Particularly noteworthy is that the report states that a lack of comparables in itself is insufficient to warrant the use of the profit split method.
This being said, the use of the profit split method is illustrated by 16 examples in which increased empathy with the method glimmers through. Relevant indicators remain the instance that each party makes unique and valuable contributions, or highly integrated business operations or sharing of economically relevant risks or separate assumption of closely related risks.
Key take aways
It is helpful that the OECD stresses the importance of limiting the risk of economic double taxation. In the absence of a major overhaul of international tax rules, the OECD cannot be expected to come up with silver bullet remedies given the complexity of pricing the pursuit and realisation of commercial opportunities stemming from a mix of innovation, cognitive insight, creativity, and advanced analytics by internationally active groups.
There remains a persistent assumption that taxpayers have more information available at the time they set intercompany prices than tax authorities have. This so-called “information asymmetry” makes it vital for taxpayers to be able to demonstrate that proper diligence was put in place at the time of the transaction to capture “what if” scenarios on commercial viability of in process intangibles. This will mitigate the risk that upon field audits potentially subjective adjustments are put forward speculating on what unrelated parties would, should or could have done under similar circumstances.
A best practice approach for companies is to gain a deep understanding of industry dynamics and the components creating economic rent throughout the entire value chain as a starting point for intangibles evaluation or as a refreshment of existing structures. This can serve as a robust foundation to funnel the analysis to an OECD compliant approach. OECD compliant arm’s length pricing touches on how functions, assets and risks prevail in a country-specific and transactional context. Translation of such principles in a context of matrix organizations and integrated supply chains necessitates the taxpayer to master the balancing act between the use of traditional mainstream principles on comparability and the adoption of case-specific up-or downward adjustments warranted by the case-specific circumstances.
A health check on current methodologies in place would probably be a worthwhile exercise to undertake.
Finally, it may be a good idea to take a fresh look at the Masterfile as tax authorities seem to be given relatively broad powers to use data in the Masterfile for the application of the profit split method. Despite it being firmy reiterated that profit split should only be put forward provided it is the most appropriate method, it could be a good idea to address elements around value creation in the Masterfile in a convincing way should they lead to the conclusion that one-sided method should prevail in the case at hand.
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