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) 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)

2 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) 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.

3 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. 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)

4 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.

5 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) 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.

6 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) 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)

7 PrimaCustomerGoodsSellcoServicesCountry 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), and one showing dad debts in excess of risk return (loss) In each case, Sellcois allocated 40% of the difference between the risk return and the bad debts, notwithstanding the fact that: Sellcoincurs only 25% of the credit management functional costs Sellco scosts are reimbursed through a cost plus fee Although example assumes incentive fee is arm s length, it appears to result in an over allocation to Sellco, and the arrangement seems artificial given the relatively routine functions performed by Sellco1812/2/201610 Example 4 Article 7 Analysis Article 7 analysis is provided to divide Prima profit/loss from credit risk between Prima HO and DAPE Discussion draft assumes that it is appropriate to split the profit/losses and Prima credit management functional costs in the following manner.

8 25% to Prima HO, 75% to DAPE Allocation of 75% to DAPE appears based on where decision to conclude sale is initiated ( , Sellco) But, Sellcohas been reimbursed for its credit management costs AND has received an incentive fee that is assumed to be arm s length As a matter of principle, in light of post beps Transfer Pricing guidance that addresses risk, is it appropriate to attribute more profits to Country B under an Article 7 analysis on the basis of the risk management functions performed by Sellco? As a practical matter, could the results in Example 4 be defended? Because Sellco scosts are reimbursed at a cost plus, the source country is allocated 60%+ of the profits while bearing only 25% of the costs. 19 Attribution of Profits Concluding Observations Examples raise questions regarding scope of DAPE rules, particularly as new Transfer Pricing guidance is implemented to ensure appropriate compensation of source country entities Sequencing of Article 9 and Article 7 analyses can be significant Examples would benefit from: a better articulation of the dealings between the PE and the home office an explicit characterization of the hypothesized separate entity ( , as a distributor, contract R&D service provider, etc.)

9 To enable the application of Transfer Pricing principles based on comparables Guidance does not account for limited adoption to date of 2010 AOA Administrative safe harbors should be considered to reduce costs of administration and compliance Tax on profits of DAPE (if any) should be collected from local country dependent agent enterprise2012/2/201611 Profit Splits21 OECD Document Trail:Transactional Profit Splits 1994 Transfer Pricing Guidelines Specified Other Method 2010 Transfer Pricing Guidelines Specified Method with expanded guidance 2015 Aligning Transfer Pricing Outcomes with Value Creation beps Actions 8 10 Expanded discussion of Functional Analysis, especially analysis of risk, applicable to all methods Outline revised guidance to be supplied on Transactional profit splits July 2016 Discussion Draft beps Actions 8 10 Revised Guidance on Profit Splits 2212/2/201612 Topics Addressed in Discussion Draft Most Appropriate Method discussion for profit splits involves consideration of the risk discussion in Chapter 1 of the 2015 guidance Profit Split based on Anticipated vs Actual Profits23 Most Appropriate Method2010 Guidelines Paragraph : Goal is to find the most appropriate method for a particular case.

10 Consider strengths and weaknesses of the OECD recognisedmethods. In short, even though the focus of our discussion is the revised guidance on profit splits, we are not intending to imply that profit splits have more weight than other Aligning Transfer Pricing Outcomes with Value Creation Discussion of Risk Para. : Risk management comprises three elements: (i) the capability to make decisions to take on, lay off, or decline a risk bearing opportunity, together with the actual performance of that decision making function, (ii) the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision making function, and (iii) the capability to mitigate risk, that is the capability to take measures that affect risk outcomes, together with the actual performance of such risk mitigation. Para. : Risk management is not the same as assuming a risk. Risk assumption means taking on the upside and downside consequences of the risk with the result that the party assuming a risk will also bear the financial and other consequences if the risk materialises.