Action Plans 8-10: Aligning Transfer Pricing Outcomes with Value Creation

Action Plans 8-10: Aligning Transfer Pricing Outcomes with Value Creation?

Introduction: Actions 8-10 of the Base Erosion and Profit Shifting (BEPS) agenda aim to address misapplications of international transfer pricing rules. These misapplications result in profit allocations not aligned with the economic activities generating them. The traditional arm's length principle, while widely used, has vulnerabilities that can lead to manipulated outcomes. The BEPS project seeks to strengthen and clarify this principle to ensure proper alignment with value creation.?

Key Areas of Focus: Action Plans 8-10 focus on three key areas to align transfer pricing outcomes with value creation:?

• Action 8 - Intangibles:?
• Addresses misallocations of profits from valuable intangibles to low/nil tax jurisdictions.?
• Proposes clarifications to the arm's length principle and revisions to the OECD transfer pricing guidelines to prevent base erosion and profit shifting.?
• Action 9 - Contractual Allocation of Risks:?
• Focuses on the allocation of profits to risks and activities actually carried out.?
• Emphasizes that MNE group members providing funding should be compensated with appropriate interest, not beyond.?
• Action 10 - High-Risk Areas:?
• Targets profit allocations resulting from transactions not commercially rational (re-characterization).?
• Addresses the use of transfer pricing methods to divert profits and neutralizes certain payments within the MNE group.?

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Revised Guidance: The OECD Transfer Pricing Guidelines, 2017, incorporate suggestions from these reports, with two crucial clarifications:?

• Risks:?

• Defines risks as the effect of uncertainty on business objectives.?
• Identifies group members exercising control and having financial capacity to assume risks, preventing abuse through re-allocation.?

• Intangibles:?

• Clarifies that legal ownership alone does not grant exclusive returns.?
• Ensures all contributing group members receive an appropriate return based on functions, risks, and assets.?

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Holistic Approach and Transparency:?

• Supports a holistic approach to combat BEPS, incorporating transparency requirements under Action 13 (country-by-country reporting, master file, and local file).?
• Enables better risk assessment practices by exchanging critical information on global allocation of MNE group’s revenues, profits, taxes, and economic activity.?

Dispute Resolution:?

• Action 14 provides access to the Mutual Agreement Procedure (MAP) process for all transfer pricing cases, ensuring effective dispute resolution.?
• Proposes mandatory arbitration for disputes pending under MAP process beyond a specified period, preventing double taxation.?

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Changes in OECD Transfer Pricing Guidelines 2017 (TPG) - Section D of Chapter I?

Introduction: Actions 9 and 10 of the Base Erosion and Profit Shifting (BEPS) initiative mandate revisions to the OECD Transfer Pricing Guidelines 2017 (TPG). These changes focus on preventing BEPS by addressing the transfer of risks and allocation of excessive capital among group members, as well as tackling transactions that deviate significantly from those between unrelated parties.?

Key Objectives of Actions 9 and 10:?

• Preventing BEPS by Transferring Risks or Allocating Excessive Capital:?

• Adoption of transfer pricing rules or special measures to ensure inappropriate returns do not accrue solely based on assumed risks or provided capital.?
• Alignment of returns with value creation to avoid misallocation of profits.?

• Preventing BEPS by Engaging in Unusual Transactions:?

• Adoption of transfer pricing rules or special measures to clarify circumstances for re-characterizing transactions.?
• Emphasis on identifying actual business transactions reflecting economic reality.?

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Guidance Highlights:?

• Identification of Actual Business Transactions:?

• Transfer pricing must be based on actual business transactions, avoiding reliance on contractual arrangements that do not reflect economic reality.?

• Respect for Contractual Allocations of Risk:?

• Contractual allocations of risk are respected only when supported by actual decision-making processes.?

• Treatment of Capital without Functionality:?

• Capital without functionality generates no more than a risk-free return, preventing premium returns to entities lacking substance (referred to as "cash boxes").?

• Disregarding Transactions under Exceptional Circumstances:?

• Tax administrations may disregard transactions if commercial irrationality is evident, emphasizing the need to consider the conduct of parties beyond contractual terms.?

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Revisions to Section D of Chapter I:?

• Risk Assumption by Group Members:?

• The guidance ensures that transfer pricing risks are appropriately assumed by group members capable of controlling and financially bearing those risks.?

• Treatment of Capital Providing Members:?

• Members providing capital without controlling corresponding investment risks are eligible only for a risk-free return.?

• Focus on Conduct Over Contractual Terms:?

• Emphasis on evaluating the conduct of parties rather than relying solely on contractual terms regarding risk assumption, control, and financial capacity.?

• Disregarding Transactions in Exceptional Circumstances:?

• Reinforcement of the need for tax administrations to disregard transactions in cases of commercial irrationality.?

Commercial Rationality Criteria:?

• Recognition of transactions not occurring between independent parties doesn't mean they should be disregarded.?
• The key question is whether the actual transaction possesses commercial rationality comparable to arrangements between unrelated parties in similar economic circumstances.?

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Additions to OECD Transfer Pricing Guidelines 2017 (TPG) - Chapter II?

Clarifications on Cross-Border Commodity Transactions:?

Background: Cross-border commodity transactions among associated enterprises pose BEPS risks, leading to revisions in Chapter II of the OECD Transfer Pricing Guidelines 2017.?

Clarifications on Comparable Uncontrolled Price (CUP) Method:?

• Applicability of CUP Method:?

• The CUP method for commodity transactions between associated enterprises is deemed appropriate.?

• Use of Quoted Prices:?

• Quoted prices can be utilized for the CUP method, subject to considerations, as a reference to determine the arm's length price for controlled commodity transactions.?

• Comparability Adjustments:?

• Reasonably accurate comparability adjustments should be made, as needed, ensuring that economically relevant characteristics of controlled and uncontrolled transactions are sufficiently comparable.?

Determination of Pricing Date for Commodity Transactions:?

• Taxpayers are prevented from using pricing dates in contracts enabling adoption of the most advantageous quoted price.?
• Tax authorities can impute, under certain conditions, the shipment date (or any other available date) as the pricing date for commodity transactions.?

Relevance of Action 9 & Action 13 (CBC Reporting):?

• The guidance under Action 9 (dealing with risks) and Action 13 (Country-by-Country Reporting) is considered relevant in the context of cross-border commodity transactions.?

Special Agenda on Transactional Profit Split Method (TPSM):?

Background: Action 10 of the BEPS initiative has a special focus on the Transactional Profit Split Method (TPSM) to improve and strengthen guidance in the context of global value chains.?

Appropriate Circumstances for TPSM Application:?

• Guidance is provided on the appropriate circumstances for the application of TPSM.?
• TPSM, while challenging for taxpayers to apply and tax administrations to evaluate, is recognized as a useful method to align profits with value creation under the Arm's Length principle.?

Addressing Methodological Challenges:?

• Acknowledgment that TPSM may be less straightforward compared to other transfer pricing methodologies.?
• Despite complexities, consultation processes confirm that TPSM, when properly applied, has the potential to align profits with value creation in situations where other methodologies pose challenges due to transaction features.?

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Revised OECD Guidance on Transactional Profit Split Method (TPSM) - June 2018?

Introduction: In June 2018, the OECD provided revised guidance on the Transactional Profit Split Method (TPSM), specifying conditions under which it may be deemed the most appropriate method. TPSM is a unique "two-sided" approach, considering contributions from both parties in a transaction. The guidance emphasizes indicators and procedures for applying TPSM, enhancing clarity and applicability.?

Indicators for Applicability of TPSM: The guidance identifies relevant indicators suggesting TPSM applicability:?

• Unique and Valuable Contributions:?

• Each party in the transaction makes unique and valuable contributions.?

• Highly Integrated Business Operations:?

• Business operations are highly integrated, preventing reliable evaluation of contributions in isolation.?

• Shared Assumption of Economically Significant Risks:?

• Parties share or separately assume closely related economically significant risks.?

Consideration of Comparables:?

• A lack of comparables alone is insufficient to warrant TPSM use.?
• Reliable comparables make TPSM less likely to be the most appropriate method.?

Application of TPSM: The revised guidance expands on how TPSM should be applied:?

• Two-Stage Process:?

• Identify overall profits from controlled transactions.?
• Split these profits between associated enterprises on an economically valid basis, reflecting agreements between third parties.?

• Unique Position of TPSM:?

• TPSM is the only two-sided method in the OECD guidelines, considering contributions from both parties.?

Additional Indicators for TPSM Applicability:?

• Presence of "unique and valuable contributions" by each party.?
• Operations being "highly integrated" in the transaction.?
• "Shared assumption of economically significant risks" or "separate assumption of closely related risks" by each party.?

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Structured Guidance Chapters:?

• General:?

• Overview of TPSM and its unique features.?

• When is TPSM Likely Appropriate??

• Discussion on indicators and conditions for TPSM suitability.?

• Guidance for Application - In General:?

• Detailed insights into the application of TPSM.?

• Guidance for Application - Determining Profits to be Split:?

• Procedures for identifying relevant profits for splitting.?

• Splitting the Profits:?

• Methods for dividing profits between associated enterprises.?

• Annex - Examples:?

• Illustrative examples to clarify the application of TPSM.?

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Revisions to Chapter VI of the Transfer Pricing Guidelines (TPG)?

Introduction: Chapter VI of the Transfer Pricing Guidelines has undergone revisions as part of Action 8, addressing Base Erosion and Profit Shifting (BEPS) by preventing the improper movement of intangibles among group members. The revisions aim to ensure a fair allocation of profits associated with intangible transfers based on value creation and to develop rules for hard-to-value intangibles.?

Key Objectives of Revisions:?

• Clear Definition of Intangibles:?

• Adoption of a broad and clearly delineated definition of intangibles.?

• Allocation of Profits in Accordance with Value Creation:?

• Ensuring profits associated with the transfer and use of intangibles are appropriately allocated based on value creation.?

• Rules for Hard-to-Value Intangibles:?

• Development of transfer pricing rules or special measures for transfers of hard-to-value intangibles.?

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Risk Allocation Framework:?

• If an associated enterprise assumes a specific risk but lacks control and financial capacity, the risk is allocated to another MNE group member meeting these conditions.?
• Control of risk and financial capacity are cumulative conditions for allocation.?

Assessment of Control over Outsourced Functions:?

• Control over outsourced functions related to intangible development, enhancement, maintenance, protection, and exploitation is assessed to determine risk allocation.?

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Guidance Highlights:?

• Legal Ownership Not Sole Determinant:?

• Legal ownership alone does not entitle an associated enterprise to returns from intangible exploitation.?

• Remuneration for Value-Creating Functions:?

• Enterprises performing essential value-creating functions related to intangible activities can expect appropriate remuneration.?

• Control and Financial Capacity for Risk Assumption:?

• An associated enterprise assuming risk must exercise control and have the financial capacity, aligned with guidance on risks in Section D.1.2 of the chapter on Applying the Arm’s Length Principle.?

• Entitlement to Profits or Losses:?

• Entitlement to profits or losses depends on which entity assumes the risks causing differences between actual and expected profits and performs crucial functions related to intangibles or contributes to risk control.?

• Funding and Financial Risks:?

• An associated enterprise providing funding without performing intangible-related functions generally expects a risk-adjusted return.?
• If no control over financial risks is exercised, it is entitled to no more than a risk-free return.?

• Expanded Guidance on Valuation Techniques:?

• Expansion of situations where valuation techniques can be appropriately used.?

• Rigorous Transfer Pricing Analysis:?

• Taxpayers must conduct a rigorous transfer pricing analysis to ensure arm's length pricing for transfers of hard-to-value intangibles.?

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Revisions to Chapter VII of Transfer Pricing Guidelines (TPG)?

Introduction: Chapter VII of the Transfer Pricing Guidelines has undergone revisions, addressing the common phenomenon of low-value adding intra-group services, such as management fees and head office expenses. The revisions introduce an elective, simplified approach for such services to balance appropriate allocation according to the arm's length principle and the need to protect the tax base of payer countries.?

Objectives of Revisions:?

• Introduction of Simplified Approach:?

• To address BEPS risks associated with low-value adding intra-group services.?
• Establishing an elective, simplified approach for common services with a limited profit mark-up.?

• Balancing Arm's Length Principle and Tax Base Protection:?

• Ensuring a balance between appropriately allocating charges for intra-group services and protecting the tax base of payer countries.?

Key Features of Simplified Approach:?

• Specifies a wide category of common intra-group services with a limited profit mark-up.?
• Applies a consistent allocation key for all recipients of these services.?
• Provides greater transparency through specific reporting requirements, including documentation showing the determination of the specific cost pool.?

Definition of Low-Value Adding Intra-Group Services:?

• Incorporated in Section D of Chapter VII?
• Characteristics include:?

• Supportive nature.?
• Not part of the core business of the MNE group.?
• No creation of profit-earning or economically significant activities.?
• No use or creation of unique and valuable intangibles.?
• No assumption or control of substantial or significant risk.?

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Illustrative List of Low-Value Adding Services:?

• Accounting and Auditing:?

• Gathering and reviewing financial information.?
• Maintenance of accounting records.?
• Operational and financial audits.?

• Processing and Management of Accounts Receivable and Payable:?

• Compilation of billing information.?
• Credit control checking and processing.?

• Human Resources Activities:?

• Staffing and recruitment.?
• Training and employee development.?
• Remuneration services.?

• Monitoring and Compilation of Data:?

• Health, safety, environmental, and other business-related standards.?

• Information Technology Services:?

• Installing, maintaining, and updating IT systems.?
• Information system support.?
• IT security systems.?

• Internal and External Communications:?

• Public relations support.?
• Excluding specific advertising or marketing activities.?

• Legal Services:?

• General legal services performed by in-house legal counsel.?
• Legal research and administrative work.?

• Activities with Regard to Tax Obligations:?

• Information gathering and tax return preparation.?
• Tax payments and responding to audits.?

• General Administrative or Clerical Services.?

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Section D in Chapter VII: Services not Qualifying for Simplified Approach and Implementation of Simplified Method?

Services Not Qualifying for Simplified Approach:?

• The list outlines services that do not qualify for the simplified approach, emphasizing that the exclusion doesn't imply high returns but rather low value addition.?
• Arm's length charges for these activities should be determined according to guidance provided.?The excluded services include:?

• Core business services of the MNE group.?
• Research and development services.?
• Manufacturing and production services.?
• Purchasing activities related to manufacturing.?
• Sales, marketing, and distribution activities.?
• Financial transactions.?
• Extraction, exploration, or processing of natural resources.?
• Insurance and reinsurance.?
• Services of corporate senior management (except management supervision of qualifying low value-adding intra-group services).?

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Simplified Method for Low Value Adding Intra-Group Services:?

• The revised chapter introduces a simplified method to benchmark low value-adding intra-group services more efficiently.?
• This method provides assurance to taxpayers that tax administrations accepting the simplified approach also accept the price charged for these services.?
• MNE group members adopting this method must provide targeted documentation for efficient review of compliance risks.?
• Application of the simplified method should be consistent group-wide in all countries where the MNE operates.?
• Once adopted and accepted by tax administrations, the simplified method deems the benefit test met for low value-adding intra-group services charged at a recommended profit markup of 5% (Para D.2.4).?

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Documentation Requirements for MNEs Using Simplified Method:?

• Description of Services:?

• Categories of low value-adding intra-group services.?
• Identity of beneficiaries.?
• Reasons justifying services as low value-adding.?
• Rationale for services within the MNE's business context.?
• Description of benefits or expected benefits.?
• Description of selected allocation keys and reasons justifying their use.?
• Confirmation of the applied markup.?

• Written Contracts or Agreements:?

• Contracts for service provision and any modifications.?
• Documents reflecting agreement among group members to follow allocation rules.?

• Documentation and Calculations:?

• Determination of the cost pool and applied markup.?
• Detailed listing of all relevant costs, including those for services provided exclusively to one group member.?
• Calculations demonstrating the application of specified allocation keys.?

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Cost Contribution Arrangements (CCAs) Guidelines (Chapter VIII of OECD TPG):?

Introduction: Cost Contribution Arrangements (CCAs) are contractual agreements among group enterprises aimed at sharing contributions and risks related to joint development, production, or acquisition of intangibles, tangible assets, or services. The goal is to ensure fair distribution of benefits among participants based on their individual contributions. Any manipulation or distortion in this process can lead to profit shifting away from the location where value is created through economic activities.?

Principles of CCAs Guidelines:?

• Equal Treatment for Similar Economic Characteristics:?

• Parties with similar economic characteristics under different contractual arrangements should receive similar expected returns, regardless of whether it is termed a CCA.?

• Prevention of Circumvention:?

• CCAs cannot be used to circumvent the new guidance on the arm's length principle, especially in transactions involving the assumption of risks or intangibles.?

• Application of Analytical Framework:?

• CCAs are subject to the same analytical framework for delineating actual transactions and allocating risks as other contractual arrangements.?

• Valuation and Pricing Consistency:?

• The same guidance for valuing and pricing intangibles, including hard-to-value intangibles, applies to CCAs as to other types of contractual arrangements.?

• Reality-Based Analysis:?

• Analysis of CCAs is based on the actual arrangements and conduct of associated enterprises, not just on contractual terms that may not reflect economic reality.?

• Conditions for Participation:?

• An associated enterprise can participate in a CCA only if there is a reasonable expectation of benefiting from the activity, exercises control over assumed risks, and has the financial capacity for those risks.?

• Measurement of Contributions:?

• Contributions to CCAs, especially for intangibles, should not be measured at cost if this is unlikely to provide a reliable basis for determining the value of relative contributions, as it may lead to non-arm's length results.?

Critical Elements Emphasized:?

• Expected Benefits Commensurate with Contributions:?

• The revised chapter emphasizes the critical need to align the expected benefits from CCAs with the respective contributions of each participant.?

• Primacy of Actual Conduct over Contractual Terms:?

• The actual conduct of the parties within the group is deemed more critical than the contractual terms of the CCA.?

• Systematic Valuation of Contributions:?

• Valuation of each participant's contribution should follow a systematic approach as detailed in .?

• Application of Arm's Length Principle:?

• The arm's length principle must be applied primarily to CCAs, focusing on the conduct of the parties, especially when it deviates from contractual terms.?

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OECD Transfer Pricing Guidelines 2022 (TPG):?

Cost Contribution Arrangements (CCAs):?

• CCAs are contractual arrangements among group enterprises for sharing contributions and risks in joint projects.?
• The guidelines ensure consistency with the arm's length principle, valuing and pricing of intangibles, and preventing circumvention.?
• Actual conduct holds precedence over contractual terms, and benefits must align with contributions.?

Hard to Value Intangibles (HTVI):?

• HTVI refers to intangibles with no reliable comparables and high uncertainty in future cash flows or valuation assumptions at the time of transfer.?
• OECD TPG provides guidance on applying HTVI adjustments, aiming for consistency and reducing economic double taxation.?
• Principles, examples, and the interaction with the mutual agreement procedure under tax treaties are addressed.?

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TPG 2022 - Transactional Profit Split Method (TPSM):?

• TPSM guidance was developed under BEPS Action 10, incorporated into TPG 2017, and fine-tuned in TPG 2022.?
• Clarifications on when TPSM is most appropriate, application details, computation of relevant profits, and profit-splitting factors are provided.?
• Examples illustrate the principles discussed.?

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Guidance on Hard-to-Value Intangibles (HTVI) in TPG 2022:?

• Builds on TPG 2017, addressing the asymmetry of information regarding HTVI between taxpayers and tax administrations.?
• New guidance proposes a common approach for tax authorities in adjusting HTVI transactions to mitigate the risk of economic double taxation.?
• Components include principles, illustrative examples, and specifics on the interaction between HTVI and the Mutual Agreement Procedure (MAP).?

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Transfer Pricing Guidance on Financial Transactions:?

• Originating from the 2020 report on BEPS Action 4 and Actions 8-10, the guidance is incorporated into TPG 2022 as a new chapter X.?
• Provides guidance on the accurate delineation of financial transactions, including treasury functions, intra-group loans, cash pooling, hedging, guarantees, and captive insurance.?
• Addresses the determination of risk-free rates of return and risk-adjusted rates of return in line with guidance from Chapter I and Chapter VI of the TPG.?