Written Comments on the Revised Discussion Draft
Chapter 1, Risk, Recharacterization and Special Measures
February 5, 2015
Re: Risk, Recharacterization and Special Measures Comments
These comments are made by Shaun T. MacIsaac, Q.C., on behalf of the law firm of Pittman MacIsaac & Roy (“PMR Law“), Calgary, Alberta, Canada, with respect to the Revised Discussion Draft (the “RDD”) on Risk, Recharacterization and Special Measures dated December 19, 2014.
This law firm advises multiple clients on transfer pricing disputes and is presenting current cases before the Tax Court of Canada. The firm has been counsel in past legal cases, including the leading decision in AP Circuits v The Queen, 2011 TCC 232, 2011 DTC 1177.
The RDD proposes new commentary regarding risk and recharacterization, and special measures. This presentation will address itself to the issues on page 14 of the RDD regarding risk and recharacterization.
In summary, our firm’s opinion is that:
A. Risk. The increased emphasis on the impact of risk and the added guidance on which party to a controlled transaction has the ability to control the risk is useful, and will further improve the ability of taxpayers to price transactions.
B. Recharacterization. The suggested broader scope for non-recognition in cases where there is a lack of “commercial rationality” and where “the structure adopted … impedes a transfer price” (quotes from paragraph 88 of the RDD) leads transfer pricing into an area where both the nature of the transaction and the pricing of the transaction are in dispute. This dual analysis widens and complicates the issues under discussion, and thus creates more disputes. Any transaction ought to be capable of being priced for transfer pricing purposes, unless it is a sham, or parties are not acting in accordance with their contractual agreements. The guidance should direct itself to look critically at the value of the contributions of the parties to a controlled transaction, and not the nature of the transaction, as the basis for a transfer pricing entitlement.
These comments will direct themselves to answering seven of the eight questions on pages 14 and 15 of the RDD.
1. Introducing The Concept Of Moral Hazard
Question: Under the arm’s length principle, what role, if any, should imputed moral hazard and contractual incentives play with respect to determining the allocation of risks and other conditions between associated enterprises?
In our opinion, moral hazard is a reasonably straightforward concept that can be dealt with by stating that when analyzing risks assumed, it is important to consider not only the terms of a controlled transaction, but also to investigate the degree of control over risk actually exercised by each of the controlled parties to a transaction to arrive at a proper transfer pricing result. This has been expressed very well, especially in paragraphs 48 and 49 of the RDD that express the value of the impact of risk, and is developed in the examples in pargarphs 51 to 53 of the RDD. As many new concepts have recently been introduced by the OECD, such as the “intangible related return” and “aligning transfer pricing outcomes with value creation”, a new label called “moral hazard” to attach to the importance over the degree of control and impact of risks is not necessary, and will result in still more differences of opinion and disputes. The important step is to have identified in the guidance the degree of control over risks and the impact of risks assumed, which has been well done.
The concept of moral hazard is defined on page 14 of the discussion draft to mean the “… lack of incentive to guard against risk when protected from its consequences.” The context suggests that related parties tend not to define financial rewards and specify contractual terms to align the ability to control risk with the degree of control in a controlled transaction. The consequence of this failure is that in a transfer pricing context, the analysis of risk ought to go beyond the terms of written agreements and attach financial reward to the party to the controlled transaction that has the capacity to bear the risks.
Using the example in paragraph 63 of the discussion draft, which is that of a subsidiary company that owns a piece of equipment, and a parent company that provides specifications for the use of the equipment, operates the equipment, provides personnel and markets the equipment, then it is clear that while one party has ownership of an asset, the other party has effective control over whether the parties will succeed in the commercial exploitation of the asset. From the point of view of risks assumed, the parent company should then be entitled to a reward for transfer pricing purposes for its control over risks assumed.
The 2010 Revision of Chapters I-III of the transfer pricing guidelines, Chapter 3, states that an analysis of risks assumed is part of a comparability analysis, which in turn, is part of the nine-step process outlined in paragraph 3.4 thereof. The commentary in Chapter 1 should be amended as proposed to add provisions that increase the importance of control over risk and clarify the impact of risk.
2. Core Competencies
Question: How should the observation in paragraph 67 that unrelated parties may be unwilling to share insights about the core competencies for fear of losing intellectual property or market opportunities affect the analysis of transactions between associated enterprises?
The Guidance should simply note the tendency of taxpayers and unrelated parties to want to protect their intellectual property and intangibles of all kinds from disclosure. Caution must be applied to an analysis of intangibles as the complete facts are not easily determined , but are needed to perform a proper analysis. All parties need to be aware that there is often incomplete information, disclosure and understanding that is justified by the natural tendency of businesses to protect confidential information.
This question addresses the difficulties in obtaining from unrelated parties complete insights about core competencies, and obtaining from controlled transactions complete information related to intangibles.
This is certainly an issue when trying to investigate a controlled transaction, as multi-national enterprises (“MNE”) are willing to share intellectual property and market opportunities with controlled entities in ways that would be unlikely between arm’s length companies. In this way, MNEs facilitate the sharing and exploitation of intellectual property to on a wider scale, but also make the challenges of transfer pricing more difficult.
There is no formula or insight that resolves the challenges posed by the fact that controlled transactions are unique, and often cannot easily be compared to uncontrolled transactions.
Transactions are often unique to a controlled party, which means that the transfer pricing analysis of the value drivers of many transactions often are difficult to price by the use of comparables. For this reason, transactions have to be carefully analyzed, and risks assumed are one of many factors that need to be considered.
3. Moral Hazard and Non-recognition of Transactions
Question: In the example at paragraphs 90 and 91 how should moral hazard implications be taken into account under the arm’s length principle?
Any transaction that is the subject of an agreement should be capable of being priced, and should not be the subject of non-recognition. The only exception should be for a sham, which is when the parties to a controlled transaction do not follow their written agreement. Transfer pricing should be about pricing transactions. There is no underlying tax principle worthy of protection that justifies non-recognition of agreements. In the paragraph 90 example, the only issue should be whether the $400 Million paid is enough, and later whether the royalty is properly priced, and not whether a trademark can be transferred to a low tax jurisdiction.
This question brings the issue of moral hazard into the context of determining whether a transaction should not be recognized for transfer pricing purposes. It is difficult to understand the relationship between moral hazard and non-recognition of agreements, but the explanation offered in the guidance at paragraph 88 of the RDD is that even though it is acknowledged that commercial agreements between controlled parties do not have terms that would exist in other contracts, the test is a two-legged one, based on “commercial rationality” and whether “the structure adopted … impedes a transfer price”. Paragraph 90 of the RDD considers an example where a trademark is transferred to a low tax jurisdiction. The example then tells us that the low tax jurisdiction affiliated is functionally challenged, so that all it does is own the asset. The example tells us that the transaction should be ignored in that situation so that the trademark is still left in the jurisdiction that transferred it. The rationale is that a commercially rational businessman acting reasonably would not have transferred its trademark for the price paid or for any price.
In this respect, the example raises fairly the question of the direction of the guidelines when it relates to non-recognition of commercial agreements. If the policies of the OECD are to promote trade, avoid double taxation and provide clear guidance, then the power to say that a transaction should not be recognized should only be used where the parties do not follow the agreements that they have in place. Where they do, notwithstanding the comments in paragraph 88 of the RDD relating to pricing a transaction not being enough in some circumstances, the real issue in cases such as example 90 should only be whether the transaction is properly priced.
4. Transactions that shift risk
Question: Under the arm’s length principle, should transactions between associated enterprises be recognized where the sole effect is to shift risk? What are the examples of such transactions? If they should be recognized, how should they be treated?
To the extent that shifting risk can be isolated as the only purpose for a transaction, then the transfer pricing issue should be to properly reward the party that has control over the risk obligation.
Transactions that have the sole effect of shifting risk are unusual in the sense that most transactions have a business purpose, and thus the real issue in practice is to consider risk amongst a number of other features of a transaction, and give its proper weight. One wonders how often this type of transaction arises in practice.
5. How does transfer of trade mark change risk analysis
Question: In the example at paragraphs 90 and 91, how does the asset transfer alter the risks assumed by the two associated enterprises under the arm’s length principle?
The challenge of dealing with high tax jurisdictions and low tax jurisdictions should not be conflated with the issue of proper pricing. Having paid $400 Million dollars, the low tax jurisdiction party ought to have received an asset of that value for all purposes, including transfer pricing. Generally, a successful transfer pricing policy ought to ensure that countries can protect economic activity in their jurisdiction, and nothing more. In this case, as ownership was sold, the issue should be the value used in the sale transaction, and the value of the ongoing royalty payment.
The example in paragraph 90 does present divergent views on transfer pricing. In the example, a valuable trade mark is transferred for $400 Million dollars from one high tax jurisdiction to a low tax jurisdiction. The policy issue is whether transfer pricing should seek to arrive at an arm’s length price for the transaction, or should there be rules that disregard the transaction.
If an MNE transfers an asset for fair market value, the transaction ought not to be challenged. Once the asset is owned by a low tax jurisdiction controlled party, then the analysis should be as to whether or not payments such as royalties reflect an arm’s length price. While the proposed guidance suggests a widening of the group of transactions that should not be recognized, we disagree with this in principle on the basis that the objective of transfer pricing should be to properly price transactions.
To those that argue that these transactions result in BEPS, we say that the jurisdiction that sold the valuable trademark received value which it is entitled to tax as profit. The unfairness of non-recognition is that it results in double taxation, a result that is objectionable on a principled basis.
6. What is the importance of risk return to transfer of trade mark
Question: In the example at paragraphs 90 and 91, how should risk-return trade-off implications be taken into account under the arm’s length principle?
For transfer pricing purposes, the existing comparability analysis of companies operating in a similar business should be enough to be able to deal with these challenges. The fact that, in controlled transactions, parties fail to identify risks that will be controlled by one or the other party simply means that the factual issues are complex. The guidance should be useful in noting that the identification of risk should include an analysis of the contracts, and the underlying performance of the obligations to determine the conduct of the parties, and the control over the risks. All need to be considered and balanced in a reasonable fashion.
Risk return is a concept that simply notes that the higher the risk taken, the higher the expected profit should be. The rationale is quite simple: a reasonable businessman will take more risks if a greater reward is possible, and fewer risks if a smaller reward can be obtained.
This concept is also straightforward in the sense that it is part of the identification of the transaction between the controlled party and its related party. For instance, in drilling oil wells, there are the risks of the well blowing up, but also the risks of not finding hydrocarbons. In order to induce a party to participate in a transaction, high rewards must be available.
7. Does risk return relate to transfer of risk
Question: Under the arm’s length principle, does the risk-return trade-off apply in general to transactions involving as part of their aspect the shifting of risk? If so:
a) Are there limits to the extent that the risk-return trade-off should be applied? For example, can the risk-return trade-off be applied opportunistically in practice to support transactions that result in BEPS (for example by manipulating the discount rates to “prove” that the transaction is economically rational)?
b) Are there measures that can be taken in relation to the risk-return trade-off issue to ensure appropriate policy outcomes (including the avoidance of BEPS) within the arm’s length principle, or falling outside the arm’s length principle?
In the two questions set forth above, the threshold issue is the absence of an understandable definition of the concept of commercial rationality. The additional problem is that the guidance is equally unclear as to what the consequences are of non-recognition, while noting in paragraph 84 of the RDD that double taxation will occur. We recommend that the transaction be considered as it exists, and that transfer pricing principles assign weight and value to relevant terms and conditions of agreements, and to other economic circumstances, including control over risk. Then the only remaining challenge is to price the actual transaction. All of the tax policy considerations that result from deciding when to apply non-recognition are simply avoided by fairly pricing what was done. This solution may seem simplistic, but it is much more likely to be accepted by the countries of the world as a whole, and by compliant taxpayers that seek clarity and understandable rules for transfers of intangibles. A cornerstone of world trade is that any asset ought to be capable of being transferred in an open market.
The first part of the question provides an example that shows the risk-return trade-off can be applied opportunistically by the manipulation of discount rates to prove that a transaction is economically rational. The second part of the question raises the question of whether the solution to the problem lies within or outside the arm’s length principle.
The assumption behind both questions is that it is proper policy to attack a transaction as not being commercially rational. While this is part of the non-recognition analysis guidance in proposed paragraph 88 of the RDD, this problem really arises from the desire to recharacterize. Transactions that are a sham have been recognized by the courts as such, where parties do not act in accordance with their contractual agreements. No other policy argument but a sham or a failure to follow an agreement justifies the extreme remedy of recharacterization. An approach that would allow contractual terms that conflict with legitimate expectations to be given less weight, according to useful guidance is the preferred direction. In the law of contracts generally, courts of the world distinguish amongst:
conditions that are fundamental to a contract;
terms and warranties that are significant, but when breached do not invalidate the contract; and
mere puffery, which are statements that are not contractually significant.
It is unfortunate that non-recognition seeks to invalidate contracts, when a much simpler process would be to disregard certain terms of a contract when they conflict with principles such as control over risk. In this way, weight could be given to contractual terms on a principled basis.
BEPS Initiative Policies Regarding Risk and Recharacterization.
The BEPS initiative does seek to avoid base erosion. The best defence against base erosion is a clear understandable set of rules that provide guidance that is easily applied.
The fundamental challenge posed by non-recognition is that the tax payer is left with double taxation as the penalty for engaging in international commerce. While some may not approve of low tax jurisdictions, double taxation is an even greater impediment to world trade. The area of compromise is to apply rigour and principled vigilance in scrutinizing controlled transactions between high tax and low tax jurisdictions.