BEPS Implementation and Transfer Pricing - …

1 12/2/20161 beps Implementation and Transfer PricingGWU IRS 29thAnnual Institute on Current Issues in International TaxationDecember 15, 2016 Washington, DC1 Chris Bello, Chief, Branch 6, ACC(I), IRS John Hughes, Acting Director, APMA, IRS Michael McDonald, Financial Economist, Treasury Dept. Rocco Femia, Member, Miller & Chevalier Barbara Rollinson, Managing Director, Horst Frisch Bill Sample, Vice President Tax, Microsoft Attribution of Profits to PEs Profit Splits Post beps Local Country Developments Legal developments Administration and enforcement Other Pending Items Hard to value intangibles Low value services 3 Attribution of Profits412/2/20163 Introduction Report on beps Action 7 (Preventing the Artificial Avoidance of PE Standard)

2 Recommended lowering of PE standard Expansion of dependent agent PE concept Narrowing of specific activity exceptions Anti fragmentation rule Report also concluded that additional guidance was needed as to the application of the Article 7 attribution of profits rules to PEs resulting from changes in the Report Discussion Draft issued for public comment on July 4, 2016 Public Consultations held October 11, 2016 5 Attribution of Profits In General 2010 Authorized OECD Approach Memorialized in 2010 OECD Model Treaty and Commentaries Included in relatively few treaties in force (2008 AOA is more common, even new treaties)

3 Rejected by certain countries and UN Model Basic principles of 2010 AOA Hypothesize the PE as distinct and separate functional entity Allocate to the PE assets, obligations, and risks related to its significant people functions Identify and characterize dealings between the PE and the rest of the enterprise Characterization of dealings helps define the PE s business ( , distributor, contract R&D provider, contract manufacturer, etc.) and enable identification of potential comparable Dealings may include notional licenses of IP or advances of capital Price dealings with reference to Transfer Pricing principles Areas of disagreement or tension Deduction for notional royalties Whether to perform Transfer Pricing analysis at the hypothesized entity level (making comparablesavailable) or based on significant people functions 612/2/20164 Discussion Draft General Approach Guidance with respect to Dependent Agent PEs (DAPEs)

4 Examples 1 4 Guidance with respect to PE arising from activities not covered by specific active exceptions Example 5 Questions related to coordination of Article 7 and Article 97 Example 1 Facts Prima manufactures goods in A, its country of residence Prima engages Sellco, an affiliate, as its sales agent in B Sellcoidentifies customers and places customer orders with Prima. It provides local marketing services. Prima sets marketing strategy, reimburses Sellcofor advertising. It is responsible for inventory management. It holds title to inventory, and bears credit risk with respect to receivables.

5 It approves ACountry B812/2/20165 Example 1 Article 9 Analysis Based on functional analysis, Prima is legal owner of inventory, marketing IP, and receivables; it controls and assumes risks with respect to those assets Sellcocontrols operational risk of performing services Sellcois owed a commission of 10, resulting in an operating profit of 2 PrimaCustomer200 Sellco10 Country ACountry B10 Commission(8) Opex2 Op Profit200 Sales(40) COGS160 Gross Profit(10) Commission(20) Other Opex130 Op Profit9 Example 1 Article 7 Analysis Assume activities of Sellcogive rise to DAPE of Prima Based on functional analysis, DAPE is not attributed assets/risks of Prima because no significant people functions are performed by Sellcoon behalf of Prima in Country B DAPE must compensate Sellcofor its services, and must compensate Prima shead office for the goods Because the DAPE has no assets or risks, it is attributed no profitsPrima HO200 Sellco10 Country ACountry B200 Sales(190) COGS (to Prima HO)10 Gross Profit(10)

6 Commission to Sellco0 Op ProfitDAPE1901012/2/20166 Example 1 AlternativeArticle 7 Analysis Analysis implicitly assumes that dealings between Prima HO and DAPE consist of Transfer of goods (DAPE is characterized as a distributor) Alternative: DAPE provides services to Prima HO. Because DAPE performs no functions, is attributed no assets/risks, service fee = 0 2ndAlternative DAPE is conduit for Sellcoservices Query whether it is appropriate to deem a PE to existPrima HOCustomer200 Sellco10 Country ACountry BDAPE0?11 Example 2 Facts Same facts as Example 1, except Sellcois responsible for inventory management Sellcosets parameters for extending credit to customers, approves sales, and handles collection of receivables PrimaCustomerGoodsSellcoServicesCountry ACountry B1212/2/20167 Allocation of Risk OECD TPG Final Reports on Actions 8 10 provide significant guidance on Article 9 allocation of risk for purposes of allocating non routine returns to risk Analysis applies to operational and non operational risk Entitlement to non routine returns from assumption of operational risk requires.

7 Assumption of risk Financial capacity to bear risks Control of risks Control of risks Must have in location capacity to identify risk, manage risk (including by choosing to face risk), and respond to changing risk conditions Must actually perform these functions13 Example 2 Article 9 Analysis Based on functional analysis, and application of post beps guidance on risk, inventory and credit risk, as well as associated costs, are allocated to Sellco Sellcois owed a higher gross commission of 30, but bears bad debt and inventory losses, and warehousing costs, of 13 Prima is owed funding return related to its legal ownership of inventoryPrimaCustomer200 Sellco15 (net)Country ACountry B30 Commission(4) Bad Debt Losses(3) Inventory Losses(6) Warehousing(8)

8 Other Opex9 Op Profit(2) Funding return to Prima200 Sales(40) COGS160 Gross Profit(30) Commission(7) Other Opex123Op Profit2 Funding Return1412/2/20168 Example 2 Article 7 Analysis Assume activities of Sellcogive rise to DAPE of Prima Based on functional analysis, DAPE is attributed ownership of inventory/receivables, and inventory/credit risks, due to significant people functions performed by Sellco(DAPE is implicitly characterized as a distributor) Profits related to these risks have already been allocated to Sellco(other than funding return related to inventory)Prima HO200 Sellco30 Country ACountry B200 Sales(170) COGS (to Prima HO)30 Gross Profit(30) Commission to Sellco0 Op Profit2 Funding return from SellcoDAPE17015 Example 2 AlternativeArticle 9 / Article 7 Analysis Article 9 analysis assumes inventory/credit assets and risks are allocated to Sellco, but continues to treat Sellcoas an agent Alternative.

9 Treat Sellcoas a full risk buy sell distributor in accordance with its risk management and control functions Accordingly, Sellcoperforms functions for its own account, not on behalf of Prima Because DAPE performs no functions, and is attributed no assets/risks, service fee = 0 (alternatively, the combined profits of Sellcoand DAPE should reflect functions, assets, and risks that have been attributed to Sellcounder Article 9)Prima HO200 Sellco170 Country ACountry BDAPE0?200 Sales170 COGS to Prima30 Gross Profit(4) Bad Debt Losses(3) Inventory Losses(6) Warehousing(8) Opex9 Op Profit(2)

10 Funding return to Prima1612/2/20169 Example 4 Facts Same facts as Example 2, except Sellcoand Prima share responsibility for credit risk and where recovery problems arise, it may not be possible to determine whether the customer was evaluated/reviewed by Sellcoor Prima Assume that arm s length return for credit risk is 5% of receivables, and arm s length fee for credit risk management is cost plus 10% Prima and Sellcohave a contractual incentive fee arrangement providing fee to Sellcoequal to 40% of the difference between the value of the credit risk and the bad debt write off (assumed to be arm s length)PrimaCustomerGoodsSellcoServicesC ountry ACountry B17 Example 4 Credit Risk Profit Split Arrangement Discussion draft provides two tables illustrating operation of incentive fee arrangement to compensate Sellcofor credit risk management services, one showing risk return in excess of bad debts (income)