On 22 July the Organisation for Economic Co-operation and Development (OECD) released major revisions of its transfer pricing guidelines. Please read on for brief details of these recent developments.
Introduction:-Chapters I, II and III of the OECD Guidelines (revised TPG) have been re-worked to reflect practical tax administration experience gained over the past 15 years since the guidelines were last issued.
Over time, concerns arose on the hierarchy of methods as contained in the Guidelines and the explicit treatment of profit methods as a “last resort”. Reflecting the business circumstances that are operative today, the revised TPG have now adopted a “most appropriate method” rule similar to what exists in India. Further, the revised TPG include an extensive discussion of comparability analysis based on countries’ practical experience and provide detailed guidance on what can sometimes become a subjective element in a transfer pricing analysis. While the revisions to Chapters I-III will not cause the Indian transfer pricing rules to be out of step with the OECD’s overall approach, they will provide guidance on the subject.
Also, a new Chapter IX has been added that addresses the transfer pricing issues arising from business restructuring. Business restructuring is defined as the cross border redeployment by a multinational enterprise of functions, assets and/or risks. Importantly, this Chapter provides valuable insights to matters that need to be considered when embarking on a business restructuring project or when considering the transfer pricing outcomes from existing structures.
The Arm’s Length Principle (Chapter I)
Revised Chapter I discusses the arm’s length principle and reaffirms its status as the international transfer pricing standard. Significantly, the revised TPG also maintain the OECD’s rejection of global formulary apportionment approaches.
The revised TPG reiterate the significance of a comparability analysis and the meaning of “comparable”. A key change is that the OECD no longer mandates performance of comparability adjustments in all cases to account for differences that would significantly affect the price or return required by independent enterprises.
These revisions are relevant in the context of India’s transfer pricing Rule 10B(2) which states the factors relevant to comparability of a controlled transaction with an uncontrolled transaction. Rule 10B(2) largely aligns with the various comparability factors discussed in the revised TPG, but the tax authorities and taxpayers will benefit from the detailed guidance on the relative importance of these factors as discussed in the revised TPG.
Transfer Pricing Methods (Chapter II)
The OECD’s TP Guidelines have two categories of transfer pricing methods: the traditional transaction methods and the transactional profit methods. Previously, the OECD advised that the transactional profit methods were a method of last resort, to be used only where there were no or insufficient data available to use one of the traditional transaction methods. The revised TPG now state that the selected transfer pricing method should always be the “most appropriate” method for a particular case. Further, the most appropriate method should be selected after considering:
- the strength and weaknesses of each of the recognized methods;
- the nature of the controlled transaction (determined through a functional analysis);
- the availability of reasonably reliable information (particularly on uncontrolled comparables); and
- the degree of comparability of controlled and uncontrolled transactions, including the reliability of
comparability adjustments that may be needed to eliminate differences between them, if any.
- the degree of comparability of controlled and uncontrolled transactions, including the reliability of
The revisions also include very detailed guidance as to the application of the transactional profit methods. The revisions discuss many important aspects of the practical application of the two transactional profit methods, including a discussion on the use of the Berry ratio as a profit level indicator for a return on functions under the transaction net margin method.
Comparability Analysis (Chapter III)
The revised TPG now have a comprehensive discussion on comparability analysis, and address issues such as the process of a comparability analysis, the selection of the tested party, information on the controlled transactions, internal and external comparables and secret comparables, selection/rejection of comparables, an arm’s length range, extreme results or “outliers”, timing issues in comparability and the compliance burden on taxpayers. While the discussion on comparability analysis will be of benefit for taxpayers in India, the approach taken in India’s transfer pricing rules with regard to the use of the arithmetic mean in determining an arm’s length price may be seen as a departure from the OECD’s guidance on the use of an arm’s length range.
New Chapter IX: Transfer Pricing Aspects of Business Restructuring
Chapter IX is organized in four key parts. The first part provides general guidance on the allocation of risks between related parties when, as a part of a business restructuring, a multinational reallocates risk between various entities. It states that such a reallocation cannot be done without regard to certain principles. First, the contractual allocation of risk between associated enterprises will be respected only to the extent that it has economic substance. The chapter defines and clarifies the concept of “economically significant” risks and further states that a higher risk should be compensated with a higher average return only when the underlying risk is economically significant. Actual conduct should be in sync with the proposed assignment of risk.
The OECD recognizes that business restructuring exercises are often prevalent among multinational entities and accordingly similar reallocation of functions, assets and risks may not be observed between independent entities. Hence, mere lack of independent entities not having undertaken a restructuring will not translate to a rejection of the restructuring to be non arm’s length.
The allocation of risk between two parties will be deemed reasonable (and possibly acceptable) if risk is bestowed on that entity which has greater control over it. “Control” is defined as the capacity to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider. Moreover, the risk bearing entity should have the “financial capacity to assume the risk”. Examples are provided to better explain and clarify the manner by which a conclusion on control and financial capacity to bear the risk can be determined.
Part Two focuses on the application of the arm’s length principle to the restructuring itself, and provides guidance on when an “exit charge” may be warranted when an entity’s operations are scaled down as a part of the restructuring exercise. The concept of “profit potential” is introduced in this context. Profit potential means “expected future profits” (which could include “losses” too) and should not be interpreted as simply the profits/losses that would occur if the pre-restructuring arrangement were to continue indefinitely. The discussion clearly states that no compensation is required for a mere decrease in the expectation of an entity’s future profits or that a transfer of profit potential per se does not warrant any compensation. The estimation of any compensation to the restructured entity is intimately linked to the transfer of the functions, assets and risks and the profit potential that may be embedded in such a transfer. This note also discusses whether the restructured entity is entitled to any indemnification charges as a part of the restructuring exercise.
Part Three discusses the application of the Guidelines to post-restructuring arrangements. It reiterates that the Guidelines do not apply differently to post restructuring transactions than to transactions that were structured as such from the beginning. While this may seem obvious, the subtle implication of this is to account for facts and circumstances that existed prior to the restructuring and how such operations may have an influence on the post restructuring analysis. For example, if a full fledged distributor is converted into a limited risk distributor as a part of a business restructuring exercise, the local presence and relationships should be accounted for while determining the arm’s length compensation for the limited risk distributor.
Of important relevance to India, this part also addresses the issue of location savings and asserts that location savings should be attributed among the parties depending on what independent parties would have agreed, and depends on each party’s functions, assets, and risks and on their respective bargaining powers, and in particular on whether or not the relocated activity that gives rise to the location savings is a highly competitive one.
Part Four discusses important notions regarding exceptional circumstances in which a tax administration may de-recognize a transaction or structure adopted by a taxpayer. It highlights and advocates that non-recognition of transactions by tax authorities should not be the norm, but an exception to the general principle. A tax administration’s examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them, using the methods applied by the taxpayer insofar as they are consistent with the Guidelines. The actual transactions can be disregarded when:
- Economic substance differs from form; or
- Independent enterprises would not have characterized the transaction the same way.
Conclusions
The revised TPG are an important development for India. While the changes in Chapter I bring the approach closer to the most appropriate method rule in India, the changes in Chapter II and III create a divergence from the transfer pricing methods and the comparability analysis as practiced in India.
For example, the revised TPG’s acceptance of the use of the Berry ratio. It is important to be aware of these differences since courts and practitioners rely on the Guidelines in corroborating transfer pricing principles when there is ambiguity in interpretation.
The commentary on business restructuring in Chapter IX is important for Indian based multinationals planning or undertaking business restructuring exercises. Moreover, the views on the “rightful” allocation of risks, the allocation of location savings and the principles governing transfer pricing analysis when an operation undergoes change will have more generic applicability even when there are no business restructuring exercises being undertaken by the taxpayer per se.
