Transfer pricing aspects of business restructuring

Introduction

It is highly essential for multinational enterprises to come up with different workable business strategies to compete in today’s economy. One such strategy is business restructuring. Business restructuring is an activity wherein companies significantly modify their financial and operational aspects of a company. This tedious process requires proper documentation and might lead to changes in the Transfer Pricing model of the MNEs. Cross border transfer pricing leads to change in their Transfer pricing models eventually affecting their tax structure. Transfer pricing has become an important tax issues in the current globalized economy, especially for the tax administrators and taxpayers in terms of compliance. This is not only for the apparent tax revenue collection that may be affected but also because transfer pricing in itself is a complex procedure. Business restructuring is one area that can lead to great transfer pricing issues since it involves allocation of taxable profits for multinational enterprises and the countries in which the MNE has its enterprises. In the below article, I have tried to bring out the implications on business restructuring from a transfer pricing perspective.

Business restructuring from a TP perspective

There is no general or legal definition for the term business restructuring. From a transfer pricing perspective, business restructuring maybe said as the cross-border redeployment by a multinational enterprise of functions, assets and/or risks. It can also involve cross-border transfers of valuable intangibles. Business restructuring may also or alternatively involve the termination or substantial renegotiation of existing arrangements. A business restructuring typically leads to a reallocation of profits among the members of the MNE group, either immediately or in the future.  Business restructurings can also be inclusive of the rationalisation, specialisation or de-specialisation of operations including the downsizing or closing of operations. The OECD Transfer Pricing guidelines recognize the following as the methods by which business restructuring can be carried out.

• A controlled transaction that leads to the cross-border reorganisation of the commercial or financial relations between associated enterprises (AE). For instance, the conversion of a full-time manufacturer into a contract manufacturer can be said to be a reorganisation for this matter.
• Amalgamation or merger of two associated enterprises to form a single entity or demerger of a business unit of an enterprise with an associated enterprise;
• A business restructuring for the purpose of transfer pricing could also involve cross-border transfers of something of value, even if it is not always the case,
• Termination or substantial renegotiation of existing arrangements
• Change in pricing policy, for example, change in mark-up on operating cost from 20% to 15% Change in remuneration model.
• Renewal of agreement with alterations in terms and conditions.

In analyzing if the business restructuring activities are relevant from the transfer pricing perspective, the following aspects may be considered by the taxpayer[1]

i. Reallocation of profit potential- upon reallocation of the profit potential, a compensation payment to the entity giving up such potential by means of transferred functions and/or risks may be warranted.

ii. Transfer of something of value- a transfer of something of value maybe a tangible asset, intangible asset and even transfer of rights of such assets

iii. Termination of existing agreements- If agreements are terminated or renegotiated to the harm the restructured party, an assessment whether an indemnification needs to be paid to ensure arm’s length conditions must be effected in this regard. Hence, along with the terms and conditions of agreements between related parties, any change, renegotiation or termination of such contracts should also be carried out under arm’s length conditions.

The OECD Model Convention on business restructuring

Article 9 of the OECD Model Tax Convention deals with adjustments to profits made for tax purposes between associated enterprises on the arm’s length terms[2]. Business restructuring is accompanied by the reallocation of profits among the members of the MNE group either immediately or for a few years. The OECD guidelines insist that the arm’s length principle and the Guidelines do not apply differently to restructuring or post-restructuring transactions than to transactions that were structured as such from the beginning.

The OECD, in its report, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration[3], provides strategies for the application of the arm’s length principle for enterprises in terms of business restructuring. Analsying transfer pricing of business restructuring primarily involves accurately delineating the transactions that account for business restructuring by identifying the financial and commercial relations. This is then followed by looking into  the conditions attaching those relations that lead to a transfer of value among the members of the MNE group. Such business transaction must be carried out according to the arm’s length principle. The arm’s length principle is an important tool for MNE and tax administrations when dealing with international taxation issues within the Transfer Pricing area. The main purpose of applying the arm’s length principle is to find transactions between independent enterprises so called comparable uncontrolled transactions and determining if they differ from the controlled transactions found between associated enterprises. even if there are no comparable transactions, a comparability analysis still needs to be performed in order to determine what independent enterprises would have done if they had been in a similar situation. the arm s length principle does not require compensation for a mere decrease in the expectation of an entity s future profits or for a mere transfer of FAR. The question of an exit charge arises only where there is a transfer of something of value -rights or other assets or a termination or substantial renegotiation that would be compensated between independent enterprises in comparable circumstances.

The onset delineating the transactions comprising the business restructuring  between the MNEs is when the conditions of the business restructuring have been formally agreed in writing by the MNEs. The terms in the contract may describe the roles, responsibilities and rights of the restructured entity under the pre restructuring arrangement including the relevant situations that existing under contract and commercial law and the extent and manner to which those rights and obligations change due to the business restructuring that is carried out. However, where there is no written terms, or where the facts of the case and the conduct of the parties differ substantially from the terms agreed between them, the actual transactions comprising the business restructuring must be inferred from the facts as established, including the conduct of the parties. The focal point is what the parties actually do, their capabilities, and the type and nature of assets used or contributed by the parties in a pre-restructuring and post-restructuring situations[4].

What does the UN Model Tax Convention say?

The UN Practical Manual on Transfer Pricing (2021) is in line with the OECD Transfer Pricing Guidelines. The application of Article 9 of the UN Model Double Taxation Convention to business restructurings establishes that the arm’s length consideration for any kind of transaction be it a supply or acquisition or transfer of property is that which might reasonably be anticipated to be made between independent parties under an agreement dealing at arm’s length. Business restructurings predominantly affect developing countries. Recently, a number of large MNEs have either

(i) transferred their manufacturing facilities into low-cost countries, e.g. where the cost of labour of a skilled workforce is lower and/or

(ii) similarly moved certain distribution functions and/or

(iii) similarly moved valuable intangibles out of the jurisdiction where they were acquired, developed or exploited.

What is the Indian law on transfer pricing of business restructuring?

Business restructuring are within the scope of regulations primarily consist of internal reallocation of functions, assets and risks within a Multinational Enterprise, even though relationships with third parties may also be a cause for the business restructuring and/or be affected by it. According to section 92B of the Indian Income Tax Act, 1961 an international transaction is “a transaction between two (or more) associated enterprises involving the sale, purchase or lease of tangible or intangible property; provision of services; cost-sharing arrangements; lending/borrowing of money; or any other transaction having a bearing on the profits, income, losses or assets of such enterprises”[5]. Finance Act 2012 inserted an explanation to this section with retrospective effect from April 1, 2002 that has an inclusive list of transactions specifically to include business restructuring.

ICAI updated Guidance note report in transfer pricing certificate in Form 3CEB that restructuring could take place in the form of operational change in functional, asset and risk profile of the entity. It can also take place as an organizational change in ownership structure or management of the entity and also include a change in the nature  and/or scope of transactions among the controlled entities, a change in responsibility for specific functions or commencement or termination of a relationship, a shift in the allocation of risks, etc. The taxpayer has to comply with these laws along with pre and post functional analysis and arm’s length pricing.

Conclusion

Multinational Enterprises are entitled to organize their activities as they feel right. Business restructuring as long as they are in line with the transfer pricing conditions. The applicability of the arm’s length principle may not sound that complicated but finding a comparable transaction can in many cases be very hard to accomplish. For business restructurings of intangibles with an uncertain value at the time of the restructuring, it can be deemed very difficult to find a comparable uncontrolled transaction. A key feature in understanding the underlying commercial rationale of a business restructuring is identifying the economic benefits expected from the restructuring. Businesses should plan their  transfer pricing policy in advance i.e., even before implementing the transactions. Only  then that businesses can adopt strategies to achieve the most effective tax planning. The MNEs must prepare a detailed and exhaustive transfer pricing documentation making it easier to find out the validity of such business restructuring in terms of transfer pricing

[1] Anonymous, Business restructuring from a TP Perspecive- fundamentals, Taxguru,  , https://taxguru.in/income-tax/business-restructuring-tp-perspective-fundamentals.html (26^th April 2022, 7:53 pm)

[2] Confirming amendments to Chapter IX of the Transfer Pricing Guidelines, Base Erosion and Profit Shifting (BEPS), https://www.oecd.org/tax/transfer-pricing/conforming-amendments-chapter-ix-transfer-pricing-guidelines.pdf (25^th April, 2022, 8:52pm)

[3] OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en. (23^rd April 2022)

[4] Mehta Darpan, Parekh, Mohit, Transfer Pricing aspects of business restructuring- Navigating uncharted territory!, Taxsutra, https://www.taxsutra.com/tp/experts-corner/transfer-pricing-aspects-business-restructuring-navigating-uncharted-territory (20th April, 2022, 9:00pm)

[5] Section 92B of the Income Tax Act 1961