BEPS Actions 8–10 – Aligning Transfer Pricing Outcomes with Value Creation
Within the BEPS project three actions have been initiated to target concerns around transfer pricing. Increasing globalization of the economy has led to an increase in intra-group trade. To determine the conditions of intra-group trade, including the price, transfer pricing rules have been set up for tax purposes. The impact of these rules has become increasingly important for both taxpayers and tax administrations. In certain circumstances these rules can be misapplied, leading to base erosion and profit shifting. The work under BEPS Actions 8-10 has targeted this issue, to ensure that transfer pricing outcomes are aligned with value creation.
The arm’s length principle is used by countries as the cornerstone of transfer pricing rules. Treaties have embedded this principle and it is integrated in the Model Tax Convention. Moreover, the OECD’s Transfer Pricing Guidelines for Multinational Enterprise and Tax Administrations (the “Transfer Pricing Guidelines”), although these are published as guidelines, is a recognized standard. It was first published in 1979, revised in 1995, further updated in 2010 and as a result of the BEPS project revised in 2017.
The principle is rather straightforward. It requires that transactions between associated enterprises are priced as if the enterprises were independent, operating at arm’s length and engaging in comparable transactions under similar conditions and economic circumstances. However, a weakness in the rules lies in the perceived emphasis on contractual allocations of functions, assets and risks, which makes the guidance vulnerable to manipulation.
The work has focused on three key areas:
- Action 8 looked at transfer pricing issues relating to transactions involving intangibles.
- Action 9 handled the contractual allocation of risks, and the resulting allocation of profits to those risks, which may or may not correspond with the activities actually carried out. Also addressed is the level of returns to funding provided by a capital-rich multinational enterprise group member, where those returns do not correspond to the level of activity undertaken by the funding company.
- Action 10 focused on other perceived high-risk areas, including the scope for addressing profit allocations resulting from transactions which are not commercially rational for the individual enterprises concerned (re-characterization), the scope for targeting the use of transfer pricing methods in a way which results in diverting profits from the most economically important activities of the multinational enterprise group, and neutralizing the use of certain types of payments between members of such a group (such as management fees and head office expenses) to erode the tax base in the absence of alignment with value creation.
The goal of BEPS Actions 8-10 is to see that operational profits are allocated to the economic activities that generate them. In order to do so, the Transfer Pricing Guidelines have been revised as a result of the work under these actions. A delineation of the actual transactions between the associated enterprises is required. This is achieved by analyzing the contractual relations between the parties in combination with the conduct of the parties. The actual conduct will replace or supplement the contractual arrangements if the contracts are incomplete or are not supported by the conduct. This will lead to allocation of profits to the enterprises that conduct the corresponding business activities. It will not allow for paper transactions without underlying business/economic activities. There needs to be activities, or in other words, substance to the transactions. In those situations where the commercial rationale for transactions is absent the guidance continues to authorize the disregarding of such arrangements for transfer pricing purposes.
Risks and intangibles have been further clarified in the revised guidance to allow for a better handling of these two subjects.
Risks are defined as the effect of uncertainty on the objectives of the business. The base line is the consideration that no profit-seeking business takes on risk without expecting a positive return. The higher the risk, the higher the anticipated return. This has lead in some situation to re-allocation of risk without any change in the business operations. These paper based transactions are addressed by determining that if an entity cannot in fact exercise meaningful and specifically defined control over the assumed risks or does not have the financial capacity to assume the risks then those risks will be allocated to the party that in fact does exercise such control and does have the financial capacity to assume the risks.
The guidance further clarifies that for intangibles legal ownership alone does not necessarily generates a right to all or any of the return that is generated by the exploitation of the intangible. Also in this case through delineation of the actual transaction those group companies performing important functions, controlling economically significant risks and contributing assets will be entitled to an appropriate return reflecting the value of their contributions.
Situations where a capital-rich member of the group provides funding but performs few activities is also addressed in the guidance revision. If such an entity does not in fact control the financial risks associated with its funding then it will not be allocated the profits associated with the financial risk and will be entitled to no more than a risk-free return, or less, if the transaction is not commercially rational and therefore the guidance on non-recognition applies. Risk control in this aspect is to apply an assessment of whether the party receiving the money is creditworthy. Credit risk management is the value-adding activity that a funding company at the minimum must undertake to control its financial risks.
The transactional profit split method is being revised and the guidance ensures that pricing methods will allocate profit to the most important economic activities. If synergistic benefits of operating as a group are achieved, then these benefits should only be proportionally allocated to those members of the group that have actually contributed to those benefits. The benefits of a few members can no longer be allocated to all of the members of the group.
The work done under BEPS Actions 8-10 has many connections with other actions of the BEPS project. BEPS Action 4 for example targets interest deductions which may be the income derived by a funding company. Due to the treaty abuse recommendations made in BEPS Action 6 it is difficult to effectively create structures to circumvent withholding taxes. Further a cash box with limited or no economic activity will be targeted by BEPS Action 3 on CFC Rules. To access information relevant to tax administrations on transfer pricing BEPS Action 13 ensures that this transparency is provided. Master and local files together with Country-by-Country reporting will provide information about a multinational group’s revenues, profits, taxes and economic activities.
It may by now be clear that the work under BEPS Actions 8-10, further supported by other actions under the BEPS project, is looking at the underlying transactions of transfer pricing. The transfer pricing itself remains based on the arm’s length principle.
Risk needs to be managed and controlled by the same company that receives the premium for that risk absorbance. The same goes for companies that receive benefits from intangibles. Substantial work needs to be undertaken by that company to manage, support and control those intangibles. In summary, paper based transactions do not qualify as being a transaction under the revised guidelines. Those are being rejected and its earnings, profits are re-allocated back to where management and control is actually taking place.