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December 4, 2014

2014-Issue 48In September of this year, the Organization for Economic Co-operation and Development (OECD) released drafts of several so-called action items under its Base Erosion Profit Shifting (BEPS) initiative. Two of these items have significant implications for transfer pricing planning and documentation for all multinationals — regardless of U.S. government action or inaction. These items — covering intangibles and documentation — are the focus of this edition of Tax Advisor Weekly.

Big Changes Ahead

The two action items published this September include potentially monumental changes to the practice of transfer pricing. Action 13, “Guidance on Transfer Pricing Documentation and Country-by-Country Reporting” — which has already begun to influence international documentation rules in the United Kingdom and Germany — may present the biggest change to documentation requirements for multinational taxpayers since the publication of the U.S. documentation rules 20 years ago. Meanwhile, the draft of Action 8, “Guidance on Transfer Pricing Aspects of Intangibles,” provides greatly expanded guidance on the treatment of intangibles, including additional guidance on hard-to-value intangibles and dozens of pages of examples — some potentially controversial.

The target audience of this guidance is taxing authorities worldwide (beyond just OECD members); the OECD guidance itself does not carry the authority of law. Rather, the goal of the OECD is to build consensus in the international community and provide a template so that local countries worldwide can harmonize their approaches and build an effective system of international taxation through complementary policy. While it remains to be seen how much consensus there will be at the end of this process, adoption of the OECD template in even a handful of countries will have implications for transfer pricing planning and documentation globally.

Action 13: Documentation and Country-by-Country Reporting — A Three-Tiered Approach

The new guidance in Action 13 will not only greatly expand the scope and reach of documentation requirements in countries where implemented, it will also significantly affect multinationals elsewhere. The proposed documentation requirements are designed to give taxing authorities increased visibility into the global operations of multinationals — beyond the local tax-paying entities engaging in the tested transactions — and into the larger group as a whole. The guidance proposes a new three-tiered approach to documentation with both familiar and new components. The three components are the master file, the local file, and the country-by-country file, with only certain components of the master file and the local file consistent with current U.S. documentation requirements. Many components of the newly proposed documentation template — especially the country-by-country file — present new reporting requirements for multinationals doing business in countries implementing it. Below we describe each tier of documentation and the potential effect on taxpayers.

Country-by-Country Reporting

Country-by-country reporting is perhaps the farthest reaching and most expansive documentation initiative in transfer pricing history. Where implemented, it will require each member of a multinational group to disclose significant amounts of financial data — and even workforce data — related to all group members in most countries in which the group has presence. The country-by-country report takes the form of a spreadsheet that includes the following items:

  1. Related party and unrelated third-party revenue;
  2. Profit/loss before income tax;
  3. Income tax paid (on cash basis);
  4. Income tax accrued — current year;
  5. Stated capital;
  6. Accumulated earnings;
  7. Number of employees;
  8. Tangible assets other than cash and cash equivalents;
  9. Constituent entities resident in the tax jurisdiction;
  10. Tax jurisdiction of organization or incorporation if different from tax jurisdiction of residence; and
  11. Main business activity (options range from “R&D” to “Sales” to “Dormant”).

This information is designed to give local country tax authorities around the world insight that will allow them to evaluate taxpayers for transfer pricing and other BEPS-related risks — through visibility into global operations that currently doesn’t exist for many jurisdictions.

But there are big concerns with country-by-country reporting among multinational taxpayers and even among some taxing authorities. Many businesses and jurisdictions — including the United States — are hesitant to endorse a system of information collection that could risk the leaking of commercially sensitive information. And the United States is seeking guarantees that country-by-country reporting will not be used to implement formulary apportionment with the corresponding erosion of the arm’s length standard. To address these concerns, the United States is proposing that the country-by-country report should be filed first with the parent company’s home jurisdiction, and then shared with other jurisdictions only through the existing treaty process. However, if the IRS is given this information-sharing responsibility, it would put a massive burden on its current Large Business and International Division’s information-sharing system — meaning new resources may need to be mobilized to meet the new demands.

The Master File

The new guidance also promotes the requirement of a master file and a local file. The master file will contain standardized information on transfer pricing policies for all multinational group members, while the local file will contain information specific to material transactions in a specific country — similar to a transfer pricing documentation study. The master file contains five categories of information relevant for all multinational group members:

  1. The multinational group’s organizational structure;
  2. A description of the multinational’s business or businesses;
  3. The multinational’s intangibles;
  4. The multinational’s intercompany financing arrangements; and
  5. The multinational’s consolidated financials and information on certain tax agreements and rulings.

The master file expands upon current U.S. documentation requirements with additional categories of information and expanded detail in previously existing categories. For example, if (and when) the United States or other jurisdictions implement master file requirements, multinational taxpayers will have the added requirement of providing details on intercompany financing, including overviews and details on arrangements with third parties, information on the central financing function, and transfer pricing policies related to intercompany financing. The sharing of financial and tax positions is also new and will include the sharing of annual consolidated financial statements as well as a list and brief description of the group’s existing tax agreements (including APAs).

The Local File

The local file is comparable to existing transfer pricing documentation requirements (requiring a functional analysis, an economic analysis, and the selection of the most appropriate method), but with expanded detail in certain areas. Some additional items included in the local file not currently seen in U.S. transfer pricing reports are as follows: a description of the management structure, key competitors, and policies and amounts paid for intragroup services. Thus, the local file represents a slightly expanded version of the current U.S. documentation requirements.

Taxpayer Challenges

For multinational taxpayers, there are potentially two big challenges that may result from three-tiered reporting: added compliance burden and increased exposure (or scrutiny). The increased compliance burden will be a clear result of requiring the preparation of numerous additional files. The country-by-country report will be especially time-consuming, requiring the filing of numerous new categories of data every year, and for multiple jurisdictions. Increased exposure — or at least increased scrutiny — is potentially another big consequence of the advent of three-tiered reporting. The master file and the high-level detail in the country-by-country report will give taxing authorities new visibility into a multinational taxpayer’s global activities, allowing the comparison of returns across entities at a level of detail where the explanation for discrepancies may not be self-evident. This will require taxpayers to be more prepared to answer larger questions about functions and risks in entities beyond the locally scrutinized entity.

As a result of these changes, taxpayers will no longer be able to view documentation as a local, separable issue. Instead, multinationals must begin to address documentation globally with a consistent approach not only to transfer pricing policy but to the new support and documentation requirements of trail-blazing jurisdictions. This new approach to documentation will require more planning and coordination among operations worldwide — even if all countries do not eventually implement the requirements. Importantly, it only takes one jurisdiction implementing the new requirements for a multinational taxpayer to be saddled with the extra responsibility of three-tiered reporting.

Action 8: Transfer Pricing Aspects of Intangibles

For many years, the OECD has been attempting to build consensus on the treatment of intangibles for transfer pricing purposes, yet differences of opinion remain, often between developed and emerging economies. One particular area of international contention is the role of intangibles in value creation. Issues of value creation play a large role in the BEPS initiative, with countries such as China and India pushing for increased recognition of their workforces’ contributions. Both countries have been vocal in advocating for increased remuneration for a new class of value-driving intangibles referred to as “location specific advantages,” such as location savings and overall market scale.

The draft of Action 8 is intended to replace chapter six of the OECD Transfer Pricing Guidelines — which is only 13 pages long — with over 130 pages of guidance and examples. A few dozen of these pages are greyed out to show they remain in draft form and are still under discussion. (Final guidance is scheduled to be issued in 2015.) Notably, the new guidance does include a section that describes several “location specific advantages” — such as location savings, assembled workforce and various other local market features — that can either affect the arm’s length price or give rise to comparability concerns.

Also, many “soft intangibles” (or hard-to-define intangibles) that were largely ignored in the 2010 transfer pricing guidelines are given more detailed treatment — and specific examples — in Action 8. Among the intangibles now described are goodwill and going concern value, which the guidance says “should be taken into account when establishing arm’s length prices.” The guidance recognizes that a precise definition of goodwill is not necessary for transfer pricing purposes, but says: “when the reputational value sometimes referred to by the term goodwill is transferred to or shared with an associated enterprise in connection with a transfer or license of a trademark or other intangible that reputational value should be taken into account in determining appropriate compensation.” Finally, the guidance reinforces the idea that for transfer pricing purposes, the accounting or tax definition of goodwill is not relevant, as the inherent value will be computed when making the arm’s length determination.

As noted above, large sections of Action 8 remain in draft form. This is partly because the guidance is still under discussion, and partly because other actions — including Action 5 on Harmful Tax Practices, Action 9 on Transfer Pricing and Risk, and Action 10 on High-Risk Transactions — still have forthcoming guidance that may affect Action 8. Further, some of the guidance and examples in Action 8 are somewhat controversial and therefore likely to change. For illustration, one draft example would treat entities that solely fund intangible development as pure lenders and limit their returns to the rate a lender might receive.

Alvarez & Marsal Taxand Says:

Actions 8 and 13 of the BEPS initiative present some major overhauls to transfer pricing guidance — especially in the areas of documentation standards and concepts of value creation. This new guidance presents a challenging landscape for forward-looking taxpayers responsible for mitigating tax risk. OECD guidance itself does not carry the force of law, yet it represents an international consensus on tax policy and provides a roadmap and template for individual nations’ lawmakers to move forward — in this case with broad changes to the current transfer pricing framework. Implementation at the level of the individual nation — including the United States — becomes less important than the general direction in which nations are moving. Consider the recommendations for three-tiered documentation: as the first few major nations begin implementing requirements for the extra documentation files (the master file and country-by-country reporting), the cost of compliance for all multinationals doing business in those jurisdictions increases — whether or not the multinational’s home country adopts the template.

In the United States, the Treasury likely has sufficient existing authority to implement at least country-by-country reporting, but it is unclear when and to what extent the U.S. will move to implement major BEPS guidance. Nonetheless, it is wise to begin looking forward and preparing for the changes as updates begin to occur in major jurisdictions. The BEPS initiative creates enhanced visibility for tax authorities into global operations, and taxpayers will need to respond by taking a more holistic view of their transfer pricing policies and documentation — which means taking more care to view transactions from both sides of the equation. We have left the age of one-sided documentation. Whether or not the United States moves to adopt OECD guidelines, are you ready for a global shift in transfer pricing practices?

Written by Laurie Dicker
Marc Alms contributed to this article



The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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