Part 2.1: Arm's length principle (ALP)

Question 1

What can a transfer price relate to? (5)

Answer 1

Intercompany transaction

• Tangible property: Goods, Assets
• Intangible property: royalties, license, Patents (octrooien), Processes, Copyrights, Trademarks (handelsmerken)

=> All intangibles in a multinational group have one or a few legal entities in the group are assigned to be the legal owner, and others are the users of this intangibles.

• Services (intra group services): Low-Value Adding intra group services (not core activity), High-Value Adding Services (c-levels: core activities)
• Financial transactions => Internal financing: Loans (Classical loans, profit participate loans (difficult)), Cash pooling, Guarantees (Explicit or implicit)
• Cost Sharing/Contribution Arrangements (CSA/CCA): Agreement where related group entities organize or do something together. Eg. Research and development.

Question 2

What is the difference between low and high value services? ?

Answer 2

Low added: remunerate low-value adding, small mark up (5%) <=> High value: high mark-up, (25-30%).

Question 3

What is the side effect and benefit of using a Cost sharing agreement?

Answer 3

CSA side effects: 
- Impact on the VAT qualification. 
CSA benefit: 
- Regarding withholding taxes. 
- Does not qualify as a royalty in a lot of countries: no withholding tax due.

Question 4

Why is transfer pricing important?

• MNE
• Tax authorities

Answer 4

• MNE can influence their profits in the different countries, so they have to pay less taxes
• For tax authorities this is bad because it impacts their taxable profits, they want to collect as much taxes as possible.

Question 5

What are the main motives of MNE when setting up a transfer pricing system? (10)

Answer 5

1. Maximalization of (consolidated) profit (after taxes)
2. To cope with differences in tax rates and tax laws
3. Limitations to repatriation of profits and dividends from abroad; once a profit is realized, it is limited to recall these profits.

=> 3 eerste tegengesteld aan Tax authorities

4. Competitive position of foreign subsidiaries: strategic reasons
5. Import duties and customs regulations
6. Limitations to royalties and management fees: some tax authorities do not look at the deductibility of royalties.
7. Maintaining good relationships with local authorities: give part of the profit so they won’t bother
8. Sufficient level of cash in foreign subsidiaries
9. Import limitations imposed abroad
10. Performance analysis of foreign subsidiaries

Question 6

What is the problem with transfer pricing on an international level? how does the OECD try to resolve it?

Answer 6

If countries tackled transfer pricing in isolation huge risk of double taxation. Because not both will be agree on the transfer price (too high or too low). => solution from the OECD: arm’s length principle.

Question 7

What is the OECD? and what is their function?

Answer 7

Organisation for Economic Co-operation and Development.
- Works as a referee between both parties (Tax authorities and tax payers), giving guidelines (framework TP) to make sure that both parties play by the rules.

Question 8

Explain the arm’s length principle.

Answer 8

This principle says that related parties working with transfer prices should match the price that 2 or more unrelated parties have concluded for a similar transaction under similar conditions.

Question 9

In what article is the ALP discussed? and what does it say?

Answer 9

In article 9 of the OECD Model convention
- Paragraph 1: Most double tax treaties include this article. Companies directly or indirectly related, with participation in management, control or capital. If tax authority believes that the ALP guidelines are not respected, a country (the tax authority) are entitled to challenge the price and adjust the tax base.

• Paragraph 2: If one country increases the tax base because the ALP is not respected, the other country should perform a downwards adjustment: decrease tax base for the same amount for so far it agrees with the adjustment made by the other state.

=> When they do not agree, there is a Mutual agreement procedure: come together and work it out (art. 25 OECD MC)

Question 10

Which article in the OECD MC talks about permanent establishments and what does it say?

Answer 10

Article 7 OECD MC : talks about the attribution of Profits to Permanent Establishments (Report 22 July 2010). A permanent establishment (PE) and its parent entity (in a different country) are seen as 1 legal entity. But for tax purpose, we consider a PE as a functionally separate entity.

Two step approach (AOA=Authorised OECD Approach)
- PE = functionally separate entity ~ dealings
- Profits determined by applying ALP ~ functional analysis
=> Transfer prices should be implemented.

Question 11

What does chapter 9 from the guidelines discusses?

Answer 11

Chapter 9: business restructuring (2010)
When business activities move from one country to another country => This has an impact on the tax base. Authorities needed to intervene: chapter 9.

Exit taxation/ goodwill calculation: if valuable assets are being moved then there needs to be a price in return and that price we are going to tax.

Tax authorities are not going to accept all the costs as tax deductible. Because it impacts the tax base of the original country negatively.

Question 12

What does BEPS stand for? explain.

Answer 12

BEPS = Base Erosion Profit Shifting

The tax Base is eroding, this means less income for the tax authorities.

Profit shifting: moving activities from one country to another: moving activities from the old to the new company often from high to low taxed countries. MNE try to reduce profitable taxes.

Question 13

Why was the BEPS introduced? (2)

Answer 13

Because of the growing realization that there is a change in global business models and taxation.
Globalization and digitalization:
- Growth of digital economy (i.e. no taxable presence in country of business)
- Globalization of corporations

Question 14

What are the key pressure areas for the BEPS? (4) In what did this result?

Answer 14

1. Increased transparency on effective tax rates
2. Insight in Transfer pricing, monitoring risks and intangibles
3. Stopping harmful preferential regimes
4. Tax treatment of related-party financing, insurance, and other intra-group financial transactions General anti-avoidance rules, anti-avoidance measures

=> Resulted in the BEPS action plan (July 2013) with 15 action points

Question 15

What are the three basic principles that are the foundation for the BEPS actions? (3)

Answer 15

1. Coherence: coherence between the different countries to close loopholes
2. Substance: taxing multinationals where they have substance (factories, people, activities)
3. Transparency: MNE need to be transparent about their taxes.

Question 16

What are the 15 action points of the BEPS action plan?

Answer 16

1. Digital economy: clarify the application of international tax principles to the digital economy
2. Hybrid mismatch arrangements: develop treaty provisions and recommendations to neutralize the effects of hybrid mismatch arrangements
3. CFC rules: Develop stricter rules for CFCs
4. Erosion of the tax base through interest deductions and other financial expenses: guidelines for best practices to prevent base erosion
5. Countering harmful tax practices: Emphasis on transparency and substance in the analysis of harmful tax practices.
6. Prevent treaty abuse: Develop guidelines to deny treaty benefits in inappropriate circumstances.
7. Avoidance of PE status: change definition of PE to avoid artificial avoidance of PE status
8. Transfer pricing: intangibles, develop guidelines to ensure profits associated with intangibles are allocated in accordance with value creation
9. Transfer pricing: risks and capital, develop guidelines to avoid the inappropriate transfer of risks, or allocation of excessive capital, among group companies
10. Transfer pricing: other high risk transactions, develop guidelines to identify transactions that would not (or only rarely) occur between third parties.
11. Data collection on BEPS: Analysis of the effectiveness of the BEPS approach
12. Disclosure of aggressive tax planning arrangements: Design mandatory disclosure rules for aggressive/abusive arrangements
13. Transfer pricing: enhance transparency of TP documentation
14. Make dispute resolution mechanisms more effective: develop solutions to obstacles to mutual agreement procedure and arbitration
15. Multilateral instruments: development of multilateral instruments to facilitate the quick implementation of the BEPS measures between different countries

Question 17

Which of the BEPS actions fall under coherence?

Answer 17

2. Hybrid mismatch arrangements
3. CFC rules: controlled foreign corporations
4. Interest deductions
5. Harmful tax practices

Question 18

Which of the BEPS actions fall under substance?

Answer 18

7. Avoidance of PE status

8. Transfer pricing: intangibles

Question 19

Which of the BEPS actions fall under transparency?

Answer 19

12. Disclosure of aggressive tax planning arrangements
13. Transfer pricing: enhance transparency of TP documentation
14. Make dispute resolution mechanisms more effective

Question 20

What are the key elements of the BEPS action plan?

Answer 20

• Recognition of the accurately delineated (afgebakende) traction
• Allocation of risk (see later)
• Location savings and other local market features. (4 step analysis)
• MNE group synergies. (incidental or deliberated group synergy)
• How to value intangibles (HTVI) : Hard to define or the degree of success lays in the future. Legalized hindsight for tax authorities (‘they can look in the future’)
• Low value adding intra-group services

Question 21

How can MNE optimize their location savings?

Answer 21

Distribution side: Enter growing market eg. China

Production side: local cost such as labor, energy, environmental, …

Question 22

What are the six steps in the analytical framework on risk?

Answer 22

Risk allocation and bearing risk has always been very important but it has become more important nowadays.
=> The six-step approach:
1. Identify economically significant risks

2. Identify contractual risk allocation
3. Functional analysis. control functions and risk mitigation functions.
4. If discrepancy between the contractual assumed risk and the capabilities (people skills, financial capacity)
   => changes need to be made to the transfer pricing taking into account the conduct and capabilities of the parties.
   - First test: You cannot allocate a risk on paper if the group entity does not dispose the right capabilities.
   - Second test: financial capability to bear the risk: having sufficient equity or having the possibility to get loans on the market (internal or external).
5. If organizations does not have the right capabilities (management, people,… & financial wise), allocate the risk to the group company having most control and having the financial capacity to assume the risk.
6. Price the accurately delineated transaction taking into account the financial and other consequences of risk assumptions, as appropriately allowed.

Question 23

What are the three elements of risk management?

Answer 23

i. Capability for and actual performance of decision-making functions i.e. taking on or declining risk-bearing opportunity
ii. Capability for and actual performance of decision-making functions i.e. responding to risk-bearing opportunity
iii. Capability for and actual performance of risk mitigation functions
=> control over risk

Question 24

Which are other players that can play a role on transfer pricing issues? (3)

Answer 24

• United Nations
• Economic climate
• Public opinion

Question 25

What program is used to stimulate cooperation between tax authorities? explain.

Answer 25

JITSIC-program: training at OECD level. Where tax authorities exchange ideas.

Question 26

What is horizontal monitoring?

Answer 26

MNE and SME’s have one spokesperson, that keeps the tax authorities informes. Under a few conditions, the company won’t be audited. Tax authority and MNE work together!

Question 27

What is the Form 10-K?

Answer 27

FIN 48/ Form 10-K: annual report required by the U.S. Securities and Exchange Commission (SEC), that gives a comprehensive summary of a company’s financial performance.
=> CFO needs to tell if the company is in line with the “arms-length principle”.