Transfer pricing – OECD developments and the future of governance for lessors
By Neil Casey, KPMG in Ireland
The backdrop. The last several decades have seen significant globalisation of businesses and the wider economy generally. World-wide intra-group trade has grown exponentially within this environment and transfer pricing rules had struggled to keep pace.
In short, transfer pricing rules determine the conditions and prices for intra-group transactions that take place between associated members of a multinational group. This includes the prices at which an enterprise within a multinational group transfers physical goods and intangible property, or provides funds or services, to associated enterprises. These prices determine the allocation of profits, for tax purposes, between group companies located in different countries.
The impact of these rules has become more significant for businesses and Tax Administrations around the world as a result of the ever-increasing intra-group cross-border trade.
In 2013, the OECD and G20 embarked upon a major upgrade of the international tax system. The aim was to address weaknesses in the system that created opportunities for tax planning that eroded the tax base of countries and shifted profits across borders. The initiative required some reasonably bold moves by policy makers to try and restore confidence in the international system.
The Base Erosion and Profit Shifting (“BEPS”) Action Plan was published by the OECD in 2013 and identified 15 key action points to combat aggressive tax planning. In particular, the BEPS Action Plan identified that the existing standards for transfer pricing rules could be misapplied so that the allocation of profits was not aligned with the underlying economic activity that produced the profits.
In 2015, the OECD published detailed papers on the 15 key action points and actions 8–10 of the plan focused on upgrading the arm’s-length principle.
The arm’s-length principle has been the cornerstone of transfer pricing for a long time and is embedded in most international tax treaties between countries. The principle essentially 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.
In a leasing context, this might include, for example, the provision of intra-group shareholder debt or the provision of specific day to day services outsourced by aircraft owning companies to service companies. Where the conditions of the intra-group transactions are different to those that occur between third parties under comparable circumstances, then adjustments to allocation of profits may be required for tax purposes.
Over the course of the last number of years the OECD has consulted widely with key stakeholders and published many discussion papers with a view to reaching a consensus-based approach to upgrading the transfer pricing rules. The primary output of this process has been the publication, in July 2017, of revised OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. These new guidelines replace the previous version published by the OECD in 2010.
Key principles emerging from the new OECD transfer pricing rules
The new OECD transfer pricing guidelines sought to enhance, refine and clarify several aspects of the previous version of the guidelines. A number of these key principles relevant to lessors include:
Contractual relations between the parties should be considered in conjunction with the conduct of the parties. There was a perceived emphasis on the contractual allocation of functions, assets and risks in the previous guidelines and this proved to be vulnerable to manipulation from a transfer pricing perspective.
The primary concern was that this was leading to outcomes which did not correspond to the value created through the underlying economic activity carried out by members of a multinational group.
Nevertheless, it remains the case that the contractual obligations between the parties is an important part of the analysis and is a key starting point in establishing the commercial and financial relations between the associated parties involved in the intragroup transaction. However, careful examination of the conduct of the parties is now required, and will supplement or replace the contractual arrangements, if the contracts are incomplete or not supported by the conduct. In a nutshell, allocating risk on paper does not in itself shift profits.
The role of risk and the performance of the control of risk functions. The revised guidelines emphasise the importance of risk to the transfer pricing analysis. In an open market, the assumption of increased risk would typically be compensated by an increase in the expected return.
This made groups pursue strategies based on contractual reallocation of risks, sometimes without any changes in the business operations. It is clear that in a third-party scenario, to the extent that one party assumes risk, that party is highly unlikely to relinquish control of the important decisions that could either lead to the assumption of risk or the materialisation of the outcome associated with the risk.
Therefore, in the case of an intra-group transaction, the transfer pricing rules state that the risk should be allocated to the party that performs the control of risk functions.
Importantly, in order to be in a position to assume the risk, the party controlling the risks must also have the financial capacity to bear those risks. Otherwise, in a third-party situation, that party would not be in a position to enter into the risk bearing opportunity in the first instance and, furthermore, there would not be the same consequences associated with their decision-making activity (as there would be if they were actually bearing the risk).
For example, consider a situation whereby one party, without authorisation or oversight by another party, negotiated the amount and all the key terms of a material loan facility and then entered into that loan agreement on behalf of that other party. This is highly unlikely to occur in a third-party situation because, at arm’s length, nobody would relinquish that level of control over those important decisions given the risk involved.
Therefore, the new transfer pricing rules allocate the risk to the party making the decisions on the basis that it is the economic reality as opposed to the paper form that should dictate the characterisation of the intra-group transaction.
What does control of risk mean? It is important to understand what constitutes control and how risk should be viewed for transfer pricing purposes.
Risk management encompasses three key activities. Firstly, it involves the decision to take on, lay off, or decline a risk bearing opportunity. Secondly, risk management involves deciding on whether and how to respond to risks associated with the opportunity.
In order to be said to be controlling the risk involved, the individuals making those decisions must possess the capability to make those decisions and must, in practice, be actually be performing that decision-making function. This means that the decision makers in question should possess the competence and experience in the area of the particular risk for which the decision is being made and possess an understanding of the impact of their decision on the business. In short, they must be credible and have the relevant experience and expertise.
They must also have access to the relevant information required to support that decision-making process. This could be achieved by either gathering the information themselves or by exercising authority to specify and obtain the relevant information required.
The third component of risk management involves risk mitigation. The transfer pricing guidelines state that risk mitigation activities may be outsourced, provided that the party that decides to outsource these risk management activities continues to retain control over that other party.
For example, a lessor that decides to mitigate risk, by outsourcing the day-to-day servicing of a portfolio of aircraft to a specialist servicer, would be required to possess the capability to determine the objectives of the outsourced activities, decide to hire the servicer, assess whether objectives are adequately being met and, where necessary, decide to adapt or terminate the contract with that provider.
Alignment of value creation with profit allocation. The new guidelines focus on gaining a thorough understanding of what the key value drivers are across the business and within the industry. A key stated objective of the new transfer pricing guidelines is to align value creation and profit allocation.
For example, it may be the case that two competing third-party lessors are different in terms of how their respective businesses create value. Group A may be highly effective at procurement and sourcing assets, while Group B may have a strong sales and commercial team with important relationships in the market with airlines. In these two contrasting situations, the transfer pricing analysis will not be the same and the profits will be allocated amongst the members of each respective group on a different basis.
In practice, Tax Administrations are now going into great detail to establish where within the business the value is created. A high-level analysis or broad description of the business is no longer sufficient for transfer pricing purposes and is unlikely to be accepted by Tax Administrations.
Enhanced transfer pricing documentation and transparency. Action 13 of the BEPS initiative introduced a three-tiered standardised approach to transfer pricing documentation. The stated objectives of the enhanced documentation requirements are: (i) to ensure taxpayers give appropriate consideration to transfer pricing; and (ii) to provide Tax Administrations with information necessary to conduct an informed transfer pricing risk assessment and thorough audit of the transfer pricing practices in their jurisdiction.
This requires larger taxpayers (generally those with group revenues in excess of €750m) to prepare:
- A master file containing standardised information relevant for all group members. It essentially serves as an executive summary that gives an overview and description of the business, including details of the group supply chain, important drivers of business profit, key risks and service arrangements, high level functional analysis describing the principal contributions to value creation, transfer pricing policies relating to intangibles, how the group is financed and related transfer pricing policies etc.
- A local file specific to each country that sets out the material related party transactions, amounts involved, and the detailed transfer pricing analysis. This is similar to existing transfer pricing documentation requirements.
- A Country-by-Country (“CbyC”) Report to be provided annually to the Tax Administration in the jurisdiction of the arent company of the group. This will show, at each country level in which the group does business, revenues (split between related and unrelated parties), profits, taxes paid and accrued, number of employees, tangible assets, retained earnings and stated capital. It must also disclose the nature of the activities carried on by each entity. The CbyC Report will then be shared by the parent jurisdiction Tax Administration with all Tax Administrations in other countries where the group does business.
Taken together, these three documents require taxpayers to articulate consistent transfer pricing positions and will provide Tax Administrations with useful information to assess transfer pricing risk and determine how best to effectively allocate audit resources.
Risk-free and risk-adjusted return. The new guidelines also set out the distinction between financial risks, linked to the funding provided for the investment, and the operational risks linked to the operational activities for which the funding is used. For example, if a lessor aircraft owning company cannot show that it controls the key operational risks, under these new guidelines it might only expect to receive a risk-adjusted return on the funding provided to acquire the aircraft.
Furthermore, if the contribution of the asset owning company is limited to providing financing equating to the cost of the asset, and it has no capability and authority to control the risk of investing in a financial asset, the asset owning company may be entitled to no more than a risk-free return. This would be an unusual outcome, but we have already seen Tax Administrations putting forward these arguments in practice.
It is important to note that a risk-fee or risk-adjusted return to the asset owning company could result in the residual profit no longer being allocated to the asset owning company, but rather to where the decision makers are located. To the extent that those decision makers are located in a higher tax jurisdiction, the tax impact could be significant.
What is happening in practice?
In practice, there has been widespread adoption internationally of the new transfer pricing guidelines and, over the last number of years, almost 100 countries have introduced new or enhanced transfer pricing rules.
In a leasing context, Ireland signalled that it will enhance its transfer pricing regime towards the end of 2019 and both Hong Kong and Singapore introduced new transfer pricing rules in 2018. This is an acknowledgment by countries around the world that they are prepared to invest time and resources in shaping how they intend to approach transfer pricing for multinationals into the future.
This changing landscape has led to a number of developments in the area of transfer pricing that is bringing the subject into the spotlight:
Transfer pricing disputes. The number of transfer pricing audits initiated by Tax Administrations around the world has increased notably and this trend is expected to continue. In practice, both taxpayers and Tax Administrations are interpreting certain aspects of the revised transfer pricing guidelines differently and this is leading to more instances of double taxation. The mechanism that seeks to resolve instances of double taxation between countries is referred to as the Mutual Agreement Procedure (“MAP”). The OECD recently reported statistics on the MAP procedure that shows a sharp increase in the number of transfer pricing cases during 2017.
Increased resources and wide sharing of information between Tax Administrations. Governments are allocating resources to Tax Administrations to invest in capability and expertise to tackle transfer pricing matters. We are seeing increases in the budgets allocated to Tax Administrations who are hiring more transfer pricing experts and economists and engaging experts in specialist areas e.g. to prepare in-depth functional or industry analysis and to appear as expert witnesses during disputes and litigation. Tax Administrations are also investing in technology to improve their ability to employ data analytics.
In the media and on the political agenda
Transfer pricing is featuring regularly in mainstream media and it is on the political agenda. There is an ever-increasing list of major multinationals embroiled in protracted and contentious disputes around the world, often carried out on a public stage. This has led to senior executives being called in front of government and public accounts committees to explain their position on transfer pricing and articulate how and why profits are allocated between countries. It is clear that this focus on transfer pricing is having wider implications for businesses, in terms of managing public relations and brand, as well political and policy related considerations.
Impacting shareholder value. Transfer pricing adjustments raised by Tax Administrations can be significant and, invariably, are not expected. This is impacting after-tax profits and cash flows and, ultimately, shareholder value. There are recently reported transfer pricing cases that evidence material recoveries in share price following successful conclusions of court cases in favour of the taxpayer.
Discussion at Board level. Transfer pricing is high on the agenda, not only for senior management in finance and tax, but beyond that and up to Board level. Transfer pricing is also surfacing regularly at audit committee level and is much more prevalent and to the forefront during the statutory audit process than it has been in the past.
Transfer pricing methodologies. More specifically, we are seeing service fees based on the OECD cost plus mark-up methodology coming under more scrutiny. We are also seeing a particular focus on sales origination and marketing activities, where a commission based return or targeted operating profit margin is typically asserted by Tax Administrations.
Tax Administrations are also investigating key decision-making and performance of risk control functions for lessors. The new transfer pricing rules contain prescriptive guidance around the meaning of control of risk, and that is facilitating tax authorities in challenging transfer pricing policies in structures where there is less robust governance in place.
In leasing it is often a small subset of senior people performing the risk control functions and, to the extent that those people are dispersed across different countries or perhaps the focal point changes from one place to another over time (be that through succession, appointment of new senior management, acquisitions etc.), that can have a significant bearing on the outcome for transfer pricing purposes.
To the extent that Tax Administrations feel that high value functions and risk control functions are split, or not in the one location, they are seeking to apply the OECD profit split methodology. In practice, this is less commonly observed, but it is occurring and it can lead to starkly different outcomes in terms of the allocation of profits between countries.
Impact for lessors and governance measures to mitigate risk
These changes have resulted in much uncertainty for taxpayers. There are a number of practical matters that lessors can consider in order to manage this transfer pricing risk:
Examine intra-group service contracts. This should be done to ensure they are robust from a commercial perspective and are grounded in economic reality.
The contractual arrangement remains the starting point for transfer pricing analysis. Consider whether there are terms in the intra-group agreements that support and evidence that the asset owning company is controlling the key risks? For example, are there terms in the contract that require the service provider to provide written reports quarterly to the asset owning company to keep them informed and provide them with access to the information they require to make informed decisions? Are there termination clauses that are reasonable from the perspective of both parties? Careful thought is required to ensure that the asset owning company is capturing all of the important matters that evidence it is controlling the key financial and operational risks.
Understand the governance process and procedures. Is your decision-making process clearly articulated? Is there an established stage-gate process? How are important decisions escalated and to who? Are there operating guidelines and parameters for decision making? Are there any informal decision-making processes or fora that exist?
The transfer pricing analysis will investigate this in detail. If decision making is occurring elsewhere, it must be clear that the asset owning company is aware of it and took the decision to delegate that responsibility to the other party. The asset owning company must continue to perform the control functions to be in a position to evidence the point that, despite delegating a certain level of responsibility, it continues to exercise control.
Document and evidence the key decision-making processes. Tax audits typically happen retrospectively and it can be particularly frustrating when the governance and underlying facts are roust from a transfer pricing perspective, but simply have not been recorded in a manner that is consistent and in accordance with the requirements set out in the OECD transfer pricing guidelines. Document your decision-making processes and procedures so that they are clearly understood and you can evidence how the asset owning companies ultimately exercises control. The benefit of doing this prospectively should not be underestimated. The process of doing so often unearths unknown issues or wrinkles that can be rectified if identified in a timely manner.
Communicate to key stakeholders. Key stakeholders should be made aware of the existence of this new environment and educated in terms of what is expected from a governance perspective. It is important that the business and the key decision makers are aware of this new environment in which they must operate. If they do not understand it, or are not aware of it, then it will be incredibly difficult to get good practices and governance in place to manage this risk.
Transfer pricing is becoming more grounded in the economic reality of the intra-group transaction and a key objective of the newly published transfer pricing guidelines is to ensure that value creation and profits are aligned. Therefore, Tax Administrations are seeking to gain a deeper understanding of the business and are now more focused on “people based” functions, as opposed to only intra-group contractual arrangements.
Lessors should consider whether there is appropriate governance in place to comprehensively demonstrate that the companies that attract the residual profit are controlling the key risks for the business and have the capability (across the wider functions of the business) to perform this role. Absent this, Tax Administrations, armed with the new transfer pricing guidelines, may seek to challenge the position and the cross-border adjustments to taxable income can be significant.
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