Shaun MacIsaac commented on current post- BEPS issues including the new landmark Chevron case …
Shaun T. MacIsaac, Q.C. appeared with a panel of international experts at the Sofitel Hotel, London, UK on November 22, 2017, and provided comments that related to the five following topics:
1. Overview of the current controversy landscape
2. TP audits in an ideal world
3. Practical options and guidance on best practices for resolving disputes
4. What’s next for transfer pricing controversy
5. The Chevron decision, and the wider implications for multinationals
1. Overview of the Current Controversy Landscape
The revised guidelines for transfer pricing resulted from the Base Erosion and Profit Shifting Project “BEPS”, and the response to BEPS by the OECD is in the form of revisions to existing guidelines, which are now known as the “2015 Guidelines” which replaced the “2010 Guidelines”. The basic change is that tax authorities now have greater tools to advocate that the reported pricing of transactions by taxpayers offends new principles as outlined in the 2015 Guidelines.
The basic tools available to the tax authorities are reassessments under domestic law, or negotiations between tax authorities. The OECD countries have extensive tax treaties with each other and other nations. For instance, Canada has 93 tax treaties in force. The UK has many more. The US has less. These treaties provide for dispute resolution. Disputes are of two major types, litigations before the courts by appeals of tax reassessments, and mutual agreement procedures (“MAP”).
A good example of a MAP is the comprehensive treaty between Canada and the United States, and in particular paragraphs 6 and 7 of Article XXVI thereof which have added a feature whereby the Canadian and American competent authorities can agree to binding arbitration to resolve disputes rather than face a disposition that will decide in favor of one side or the other. Like all MAP processes, the procedure involves a negotiation between tax authorities, rather than between a taxpayer and the tax authority. The process has been widely used in the automotive industry to effectively resolve disputes. In practice, it has resulted in increased settlements before the dates of scheduled arbitrations.
Not every dispute is accepted by both tax authorities for MAP dispute resolution. If either country’s competent authority decides a case is not available for MAP, then the procedures are not available in accordance with the MAP processes. By default, you are left with dispute resolution by court proceedings.
The alternative to MAP process are tax appeals that are brought to the domestic courts. Typically, the multinational enterprise (“MNE”) chooses the court where it has a firm belief that its transfer pricing is correct, or where no other process is available. Transfer pricing disputes are expensive.
The nature of the controversy at issue is very relevant to the choice of method of dispute resolution. When the dispute is between a high tax jurisdiction and a low tax jurisdiction, MAP procedures are usually not available to the taxpayer of the high tax jurisdiction. The high tax jurisdiction often declines the invitation to participate in MAP processes with the other jurisdiction. Also, if the dispute relates to controversial issues such as restructuring or intangibles and their value, the case is often not accepted tax authorities into their MAP processes.
Some countries have enacting diverted profits taxes to deal with transfer pricing issues, such as the UK. These laws suggest that the countries of the world and their tax authorities perceive that the “arm’s length principle” that is fundamental to transfer pricing in the 2015 Guidelines and the domestic laws of most countries is not enough of a tool for tax authorities to capture their so-called “fair share” of profits. Domestic laws of the countries of the world differ in form and in substance. The best summary of the distinction in practical terms amongst the domestic laws is the country profiles published by the OECD. As of November 6, 2017, thirty-one countries provided to the OECD summaries of their domestic laws that confirm the implementation of BEPS principles. The concept of state aid is another venture into transfer pricing issues by the EU. Another approach is to draft GAAR like clauses into transfer pricing domestic laws, such as Subsection 247(2) (b) and (d) of Canada’s Income Tax Act which are being relied upon to support more and more adjustments.
2. TP Audits in an Ideal World
The biggest new development in audits is the wider scope and practice of attack on controlled transactions by tax authorities. It used to be that tax authorities used to accept structures as outlined by the participants, and followed articles 1.64 and 1.65 of the 2010 Guidelines, which stated that “In other than exceptional cases, the tax administration should not disregard the actual transactions or substitute other transactions for them.” The 2015 Guidelines expand the concept to grant the power to ignore transactions if they “… differ from those which would have been adopted by independent enterprises behaving in a commercially reasonable manner.” Please refer to Section D, Chapter I, articles 1.122 and all of section D.2 in the 2015 Guidelines.
In accordance with the 2015 Guidelines, the guiding principle that profits must be aligned with economic activity as stated in the first paragraph of the Executive Summary to the BEPS report has been explained to mean that an entitlement to profits will follow economic activity and not ownership of assets, such as intangibles. The phrase used is that entitlement will follow the value attributed to the development, enhancement, maintenance, protection and exploitation functions (“DEMPE”) as stated in Chapter VI, article. 6.35 of the 2015 Guidelines. The practical result of this 2015 Guidance is that while one tax authority will advocate that most of the employees and staff of an organization are found in their jurisdiction, and thus it is justified in finding that profits should be heavily taxed in that jurisdiction, another tax authority in another jurisdiction will advocate that all of the value of the intangibles that created economic value was developed and enhanced in their jurisdiction, and thus the bulk of the profits should be taxed in their jurisdiction. Both positions find refuge in differing paragraphs of the 2015 Guidance.
In addition, domestic tax authorities have expanded their attacks by not only challenging pricing of transactions as presented, but increasing the nature of the challenges by advocating that transactions as structured ought to be disregarded. Once a contract is disregarded, the issue then is whether a tax authority has a claim to increased profits.
Taxpayers facing transfer pricing compliance issues already deal with pricing a hypothetical transaction. The question used to be what is an arm’s length price for a given transaction based on what would unrelated parties would have agreed on as a price for a transaction. OECD methodologies could be used to establish arm’s length prices for similar transactions. Transactional methods were approved of and preferred to profit based methodologies in cases such as my case called Alberta Printed Circuits Ltd. v. The Queen 2011 TCC 232, 2011 DTC 1177 (TCC) in Canada. The 2015 Guidelines now sanction and legitimize a wider scope for inquiry into the nature of the controlled transactions. In the result, there are two hypothetical questions to be answered. What is the transaction that unrelated parties would have agreed upon in these circumstances, and then how should that transaction be priced? In effect, the added power to disregard transactions creates formidable challenges for the taxpayer that seeks to comply with all applicable laws relating to transfer pricing. These new tools available to the auditor to challenge the transaction and its price have resulted in much greater uncertainty and the risk of double taxation to the MNE.
3. Practical Options and Guidance on Best Practices For Resolving Disputes
On a practical level, when disputes arise, the typical scenario is that after many communications between the MNE and a domestic tax authority, a letter containing proposed adjustments is sent to the company for consideration. At that point, the company needs to conduct an assessment of whether there is merit to the proposed reassessment. Double taxation is a real possibility where the decision is made to opt for objection in the domestic jurisdiction only. Where there is a treaty available, and the dispute is between two high tax jurisdictions, the strategy of choice is generally to try to have the dispute determined under the MAP procedures. The advantage of this choice is that if the dispute results in greater tax in one jurisdiction, there should be a corresponding downward adjustment by the other jurisdiction. This flows naturally from the MAP procedure, but where the dispute is resolved by the courts, the other jurisdiction will often take the view that the corresponding adjustment is not available.
Where the dispute is one where the MAP procedure is unavailable, then by default, the taxpayer has to follow the objection and court procedures. At the initial stage, where the issue relates to typical issues such as valuing an intangible, MAP procedure is unlikely to be available, and, time and the corresponding interest and penalties can be saved by immediate resort to the courts.
4. What’s Next for Transfer Pricing Controversy
The implementation of BEPS action item 13 resulted in an amended Chapter V of the 2015 Guidelines that now requires a country-by-country report. This forces the MNE to tell the story in a “master file” as it relates to the nature of its affiliates and a wealth of other information, the focus of which is to give the tax authority some additional direction as far as identifying directions for audit enquiries. The “local file” has more detailed information that identifies related party transactions. As it relates to disputes, the master file information should be of marginal relevance, and therefore not terribly useful as adjustments should relate to specific controlled transactions between related parties. However, the direction of seeking this information suggests that tax authorities want to have at their disposal general information on world-wide income, and the amount of global tax paid by MNEs on a system wide basis. This suggests that the priority of tax authorities is to select for audit companies based on considerations relating to the relative amount of profits being taxed in various jurisdictions.
Transfer pricing disputes should deal with arm’s length pricing of transactions, as these form the basis of Article 9 of the OECD Model Tax Convention on Income and on Capital, as revised July 15, 2014, and the understood bench mark for international transfer pricing. The combination of country by country reports and new powers to disregard transactions suggest that tax authorities may invoke some of their new powers to seek adjustments based on the rationale that the MNE simply does not pay enough tax to the national treasury of a given tax jurisdiction. Taxpayers ought to avoid tax structures and the accumulation of assets and profits in jurisdictions where they have insignificant economic activity.
While much attention is now focused on complying with the master and local file requirements, attention still must be paid to the basics of having your pricing reflected in proper policies. An example of this is the recent case of VSM Group AB from the Swedish Administrative Court of Appeal. In that case, the related parties had a legal agreement that limited the amount of the sales price that an American affiliate of a Swedish company could charge for its services. Evidence was led that a greater share of profits was cearned by a greater range of services provided by the US company. The adjustment directed to the Swedish company was upheld, with the court stating that the contract should have been amended to reflect the true reported transfer price. You have to make sure your agreement and practices are aligned with the transfer prices that you report.
5. The Chevron Decision, and the Wider Implications for Multinationals
The Chevron Australia Holdings Pty Ltd v Commissioner of Taxation 2017 FCAFC 62 decision is of international interest in transfer pricing as it relates to inter-corporate loan transactions. Very simply, the facts involved a loan by an American affiliate to an Australian subsidiary at a 9% interest rate. The Federal Court of Australia upheld assessments and decided that the interest rate charged was far above an arm’s length price, and confirmed substantial adjustments believed to have been resolved for about $1 Billion AUD.
Transfer pricing of loan and guarantee transactions between related companies is a very common transfer pricing issue. The Federal Court of Appeal in Canada decided the case of General Electric Capital Canada Inc. v. R 2010 DTC 1353 TCC, affirmed 2011 DTC 5011 in favour of the taxpayer in 2010. The case involved the amount paid to the US parent of a Canadian subsidiary as a guarantee fee. The judgment went on to say that the concept of “implicit support” meant that a subsidiary of a strong parent would expect to draw on the strength of its parent, and that this fact made the subsidiary stronger, and able to command a better interest rate than if it were not a subsidiary. This was found to be a relevant transfer pricing consideration.
This reasoning was the start of great controversy and criticism by tax commentators. The reasoning of the court was attacked as being unfair in that it tended to lower unfairly the value of guarantees given by affiliates, and lower unfairly the rate of interest that could be charged in loans to affiliates.
The 2015 Guidelines introduced a new emphasis on the relevance of the “group synergy” and “passive association”. In effect, they validated the trend in the Canadian decision of placing an economic value for transfer pricing purposes on the non-arm’s length relationship between affiliated companies in financial transactions.
Chevron has endorsed this wider approach and the approach in the 2015 guidelines by focusing on the significance of the “mutual interdependence” of the Australian company and its affiliates. The court used this concept as the basis to conclude that “in the circumstances there would have been a borrowing cost conformable with Chevron’s AA rating, which, on the evidence, would have been far below 9%”.
As this trend is now supported by the 2015 guidelines and emerging judicial authority, taxpayers must now accept that the economic value of the relationship between a taxpayer and another affiliate will be a relevant factor in determining an arm’s length price.