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CPD technical article
This article was first published in the June 2011 edition of Accounting and Business magazine.
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In July 2010 the OECD introduced significant changes to the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and also updated its position on the attribution of profits to permanent establishments (‘PEs’ or branches).
As the UK tax system largely adopts the OECD principles for taxing cross-border intercompany transactions and for attributing profits to PEs, these changes will be important for many corporate taxpayers: they set the new standard against which compliance will be measured. Recent UK initiatives, such as the overseas-branch exemption, will also need to be analysed in the context of the revised OECD framework.
Changes to the OECD guidelines
The guidelines, which apply the arm’s-length principle for tax purposes to cross-border intercompany transactions, are not automatically binding on tax authorities.
However, the guidelines are applied by the many tax authorities of OECD member countries (they are referred to directly in the UK’s transfer pricing legislation) and increasingly by non-member countries. They are also increasingly considered and quoted by judges hearing transfer pricing cases around the globe. And finally, they are the relevant standard if a transfer pricing adjustment is subject to a mutual agreement procedure claim requiring negotiation between the respective tax authorities.
Comparability and methods
The OECD update provides detailed guidance on the critical steps necessary for establishing whether evidence is sufficiently comparable. There is more extensive discussion on the selection of the most appropriate transfer pricing method (the hierarchy of methods has been removed) and on the application of profit-split methods. A nine-step process for performing comparability analysis is introduced, although this is not compulsory provided that the search process used identifies the most reliable comparables.
Business restructurings
One of the more controversial areas in international tax has been the treatment of business reorganisations that are accompanied by a reduction of profits in one country and an increase of profits in another country – often one that has a lower tax rate. Some countries, particularly Germany, seek to impute a taxable gain when there is such a reduction in profits. The OECD refers to this area as ‘business restructurings’ and its guidelines provide an analytical framework for tackling a number of the transfer pricing issues.
The transfer pricing guidelines deal with the extent to which the allocation of risks in a group should be recognised, and focus on economic substance and the ability to bear risk. Compensation for the restructuring itself is discussed and the view stated that a profit/loss potential is not an asset in itself. The application of the arm’s-length principle after the restructuring is also considered. Importantly, the guidelines deal with the recognition of the actual transactions undertaken (the default position) and the exceptional circumstances when they should be disregarded.
Interaction with domestic rules
The current UK transfer pricing legislation is contained in part 4 of the Taxation (International and Other Provisions) Act 2010. As these rules followed the principles prevailing in the 1995 guidelines, the 2011 Finance Bill includes a modification of the rules to align them to the revised OECD guidelines with effect from 1 April 2011. For earlier periods taxpayers may nevertheless find that inspectors use parts of the 2010 guidelines as an informal audit manual.
Profit attribution to PEs
The OECD completed its review of the attribution of profits to PEs with the publication last year of a new Article 7 (and accompanying commentary) of the OECD Model Tax Convention on Income and Capital (MTC) and the final report on attribution of profits to PEs. This area is complex and with this review the OECD intends to reduce the degree of uncertainty as to how profits should be attributed.
The OECD position sets out a two-step process. The first step is to hypothesise the PE as a separate entity (the company’s assets, liabilities, capital and risks are attributed to the PE, based on key people activities) and ‘dealings’ (notional transactions) between the PE and head office or with other PEs are identified. In the second step, profits to the PE are attributed by applying the transfer pricing approach in the guidelines.
The main clarifications relate to management expenses, notional interest and royalties from head office to the PE. The revised position is that, depending on circumstances, an arm’s-length charge from head office to the PE may be applied.
Comparability is a critical part of any transfer pricing review. The new standard will increase compliance costs for taxpayers wishing to protect themselves from challenge and possible penalties. More focused tax authority challenges are expected as a result of the new guidelines.
The update to the OECD work on PE profit attribution will eventually result in more consistency in the treatment of PEs. However, in the short and mid term, the differences in the versions of Article 7 (and its commentary) that countries apply will result in more complexities and uncertainty, and potentially double taxation.
The new branch exemption regime will attract interest, but determining whether the election is worthwhile will require significant analysis.
*Interaction with UK rule
The UK rules for attributing profits to permanent establishments are contained in the Corporation Tax Act 2009 and are based on Article 7 of an earlier version of the Model Tax Convention and its accompanying commentary.
The latest OECD position introduces differences as to how countries may interpret existing treaties, which may lead to disputes and potentially double taxation. For example, the UK legislation in its current form explicitly prohibits deductions for nominal royalties, but if other countries follow the most recent OECD interpretation, then double taxation may arise.
Although HMRC has not so far expressed its intention of falling into line with the OECD position on profit attribution, change is likely sooner or later for the sake of consistency.
Profit attribution under the new branch exemption rules
Until now UK-resident companies have been subject to UK tax on worldwide profits. The current Finance Bill includes an irrevocable election for the exemption of profits and losses of overseas PEs. Profits arising from all current and future overseas branches would be permanently exempt from UK tax and branches’ losses could not be offset against the profits of the UK company. Unlike the rules for UK PE profit attribution, the profits/losses excluded from UK tax would be calculated by reference to Article 7 in the 2010 MTC.
The flexibility and cost efficiencies (fewer administrative and local compliance costs) of operating through branches rather than subsidiaries will tempt many groups. For groups with intragroup debt financing, a branch structure would allow the branches to share the credit rating of the UK company without having to assess their own credit rating on a standalone basis.
However, the apparent simplicity and effectiveness of the tax-efficient ways of running an international business should not mask the complexity and effort required to apply the authorised OECD approach to PE profit attribution.
John Sheer is a transfer pricing tax partner and Claudia Del Toro Reyes a financial services transfer pricing tax manager at PwC
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