Global transfer pricing developments

Andrew Kim and Larissa Neumann of Fenwick & West discuss some of the important transfer pricing developments and US transfer pricing cases from 2017.

The OECD continues its BEPS work through the issuance of several significant discussion drafts addressing hard-to-value intangibles, the attribution of profits to PEs and the application of the profit split method. In the US, the IRS has been aggressive in asserting large transfer pricing adjustments, but has been unsuccessful in defending these adjustments in court.

Hard-to-value intangibles

The OECD released the 'Implementation Guidance on Hard-to-Value Intangibles' discussion draft on May 23 2017. The final BEPS report on Actions 8-10 (Aligning Transfer Pricing Outcomes with Value Creation) mandated the development of guidance on the implementation of the approach to pricing hard-to-value intangibles (HTVI).

The HTVI approach is intended to allow tax administrators to use after-the-fact profit information as presumptive evidence about the appropriateness of the parties' transfer prices. The new rules deviate from the arm's-length standard, and a major concern is how tax administrators will apply these rules. The new approach to HTVIs is not consistent with how unrelated parties handle after-the-fact information. The discussion draft assumes independent enterprises are able to renegotiate agreements if major unforeseen developments occur. However, renegotiations and repricing contracts after-the-fact are not common between unrelated parties.

The OECD transfer pricing guidelines (TPG) state that ex post (after-the-fact) outcomes can provide information to tax administrators about the arm's-length nature of the ex ante (before the transaction) pricing arrangement and the existence of uncertainties at the time of the transaction. If there are differences between the ex ante projections and the ex post results that are not due to unforeseeable developments or events, the differences may give an indication that the pricing arrangement may not have adequately taken into account the relevant developments or events that might have been expected to affect the value of the intangible and the pricing arrangements adopted. Ex post evidence provides presumptive evidence as to the existence of uncertainties at the time of the transaction. This presumptive evidence is subject to rebuttal if it can be demonstrated that it does not affect the accurate determination of the arm's-length price.

The new discussion draft regarding HTVI implementation guidance is helpful in that it states that tax administrators are not to base transfer prices and valuations solely on the ex post income. While it is helpful that the new discussion draft emphasises the limitations on the use of ex post results, the concern is that tax administrators could take this new HTVI guidance and apply ex post outcomes more broadly than the TPGs intend.

The term 'HTVI' itself is not objective. The term 'HTVI' covers intangibles for which (i) no reliable comparables exist, and (ii) the projections of future profit, or the assumptions used in valuing the intangibles, are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer. Defining HTVI by using subjective terms like 'highly uncertain' and 'making it difficult' is problematic. What is considered an HTVI has been heavily debated and many definitional issues are still unresolved. In this regard, it would be helpful to have concrete guidance regarding when an intangible might be considered an HTVI. Even a short list of objective factors would be helpful.

Taxpayers can overcome the presumption of an HTVI ex post approach by preparing a robust valuation that considers various possibilities. Taxpayers can also overcome the presumption by demonstrating the variance was due to an unforeseen circumstance. It would be helpful if there were examples demonstrating how the taxpayer could overcome the presumption by proving either the original valuation property took into account the possibility or the development was unforeseeable.

Profit attribution

The OECD issued a new discussion draft in July 2017 addressing the attribution of profits to permanent establishments (PE). The additional guidance was deemed necessary following significant proposed revisions to the PE rules under BEPS Action 7 (preventing the artificial avoidance of PE status). These revisions are expected to dramatically increase the number of PEs under those treaties that adopt the recommended changes.

The new discussion draft replaces a prior 2016 discussion draft, and provides high-level guidance for the attribution of profits to PEs in the circumstances addressed by BEPS Action 7. In particular, the new discussion draft addresses profit attribution to PEs resulting from the expansion of the dependent agent PE rules in Article 5(5) of the OECD Model Treaty, and the changes to the preparatory/auxiliary and anti-fragmentation rules in Article 5(4).

With respect to the changes to Article 5(5), the new discussion draft notes that once it is determined that a PE exists under Article 5(5), the rights and obligations resulting from the contracts to which that provision refers should be allocated to the PE. This does not necessarily mean that the entire profit resulting from the performance of these contracts should be attributed to the PE. The determination of the profits attributable to the PE are governed by the rules of Article 7. Under Article 7, the only profits attributable to the PE are those that it would have derived if it were a separate and independent enterprise performing the activities that the dependent agent performs on behalf of the non-resident enterprise. Per the discussion draft, this principle applies regardless of whether a tax administration adopts the authorised OECD approach contained in Article 7 of the 2010 version of the OECD Model Treaty.

The discussion draft notes that both Article 7 (PEs) and Article 9 (associated enterprises) will apply where the PE results from the activities of a related party, and that the functions performed by the related party can qualify both as a significant people function for the attribution of a specific risk to the PE under Article 7, and as risk control functions for the allocation of a risk under Article 9. In these situations, it is important to ensure that the risk to which those functions relate is not simultaneously allocated to the intermediary and attributed to the PE. Otherwise, double income could result. Although the discussion draft does not provide an ordering rule for the application of Article 7 and Article 9, the report states that the order in which Article 7 and Article 9 are applied should not impact the overall amount of profit over which a source country has taxing rights as a result of the activities of a related party on behalf of its associated non-resident enterprise in the source country.

The discussion draft notes that the net amount of profits attributable to a PE may be either positive, nil or negative (i.e., a loss). In particular, when the accurate delineation of the transaction in the case indicates that the intermediary is assuming the risks of the transaction of the non-resident enterprise, the profits attributable to the PE could be minimal or even zero. This is consistent with comments by US Treasury Department officials, who have stated that the identification of additional PEs under the changes to Article 5 should not be expected to result in significant additional profits being allocated to the PE where the nonresident entity and local affiliate have transacted on an arm's-length basis.

The new discussion draft includes several examples that are intended to be illustrative and provide a conceptual framework based on the principles discussed in the discussion draft. Specifically, the discussion draft includes examples that address PEs resulting from the revisions to Article 5(5) of the OECD Model Treaty for a commissionaire structure for the sale of goods, an online advertising sales structure, and a procurement structure. The discussion draft also provides an example of the attribution of profits to PEs arising from the new anti-fragmentation rule in Article 5(4).

Each of the examples illustrating the attribution of profits to PEs under Article 5(5) provide that the PE should be attributed ownership of the assets of the nonresident entity that are related to the functions performed by the PE, and the assumption of the risks related to such functions. This attribution of ownership and risks to the PE raises important legal questions concerning a tax administrator's authority to restructure the actual transaction between the nonresident entity and its local affiliate. Further, as noted above, it is questionable whether such attribution to the PE will be necessary in most cases if the underlying activities which are performed by the local affiliate are properly compensated for in accordance with Article 9 of the OECD Model Treaty.

The OECD intends to hold a public consultation on the new discussion draft in November 2017 at the OCED Conference Centre in Paris.

Profit split guidance

The OECD issued a new discussion draft to clarify rules applicable to the transactional profit-split method by identifying indicators for use in determining the most appropriate transfer pricing method and providing additional guidance on determining the profits to be split and how to split them. The new discussion draft addresses situations in which profit splits of anticipated profits or actual profits are appropriate.

Earlier profit-split discussion drafts left a lot to be desired. The initial draft seemed more like a discussion draft on the subject of formulary apportionment. The second version was an improvement but still had significant problems.

The transactional profit-split method seeks to establish arm's-length outcomes by determining the division of profits that independent enterprises would have expected to realise from engaging in a comparable transaction. The method first identifies the profits to be split and then splits them on an economically valid basis that approximates the division of profits that would have been agreed to at arm's length.

The draft report states that the profit-split method can offer a solution for cases where both parties to a transaction make unique and valuable contributions to the transaction. According to the report, since those contributions are unique and valuable, there will be no reliable comparable information that could be used to price the entirety of the transaction in a more reliable way.

The transactional profit-split method can also provide a solution for highly integrated operations in cases for which a one-sided method would not be appropriate.

A weakness of the profit-split method relates to the difficulties in its application. Initially, the transactional profit-split method may appear readily accessible by both taxpayers and tax administrators because it tends to rely less on information about independent enterprises. However, associated enterprises and tax administrators alike may have difficulty accessing information from foreign affiliates. In addition, it may be difficult to measure the relevant revenue and costs for all the associated enterprises which could require stating books and records on a common basis and making adjustments in accounting practices and currencies.

Further, when a transactional profit-split method is applied to operating profit, it may be difficult to identify the appropriate operating expenses associated with the transactions and to allocate costs between the transactions and associated enterprises' other activities. Identifying the appropriate profit-splitting factors can also be challenging.

These weaknesses can present serious problems regarding the reliability of profit-split results.

The discussion draft states that it is sometimes argued that a transactional profit-split method is rarely used among independent enterprises (this is true; otherwise the result likely would be a partnership), and that its application in controlled transactions should similarly be rare.

In general, the presence of factors indicating that a transactional profit-split is the most appropriate method will correspond to an absence of factors indicating that an alternative method of pricing – one that relies entirely on comparables – is the most appropriate method.

Country-by-country reporting

One of the most significant and immediate impacts from the OECD's BEPS work is the new transfer pricing reporting that is required for large multinational enterprises under the three-tier reporting system set forth in the BEPS Action 13 report. Many countries were quick to adopt the country-by-country reporting (CbCR) requirement under Action 13, which requires large multinational enterprises to report on an annual basis the aggregate tax jurisdiction-wide information relating to the global allocation of income, taxes paid, and certain indicators of the location of economic activity among the tax jurisdictions in which the multinational group operates.

CbCR information is generally to be filed by the parent entity of a multinational group, and then exchanged among the relevant jurisdictions in which a multination group operates. As of June 22 2017, 64 countries have signed on to the OECD's Multilateral Competent Authority Agreement providing for the automatic exchange of CbCR. The US is a notable exception, having chosen to exchange the reports filed by US parent entities with the US's treaty and information exchange partners via bilateral competent authority and information exchange agreements.

As multinational groups expend significant time and resources to comply with the CbCR rules, important questions and concerns remain regarding the confidentiality and limitations on use of information contained in CbCR. Under Action 13, CbCR is intended to assist taxing authorities in the performance of high-level transfer pricing risk identification and assessment, and not used as a substitute for an appropriate transfer pricing determination based on a detailed and thorough review. However, most observers expect that CbCR will lead to additional transfer pricing audits and controversies based on the information contained in the reports. Another significant concern is the protection of information contained in CbC reports from improper disclosure. Although the confidentiality of CbCR was expressly incorporated in the Action 13 documents and was part of the negotiations between stakeholders, there continues to be a significant push for the public disclosure of CbC information, particularly within the EU. The potential public reporting of CbC information raises significant concerns for taxpayers, and also threatens the information exchange mechanisms. For example, the US has explicitly stated that it will not share CbC information with another jurisdiction unless that jurisdiction properly ensures the confidentiality and restrictions on use of the CbC information.

Eaton's tax court victory

The Tax Court ruled that the IRS abused its discretion by canceling two advance pricing agreements (APAs) that Eaton and the IRS entered into to establish a transfer pricing methodology for covered transactions between Eaton and its subsidiaries. Eaton Corp. v. Commissioner, T.C. Memo 2017-147. In an earlier 2013 summary judgment decision, the Tax Court initially ruled for the IRS and rejected Eaton's argument that the APAs were enforceable contracts. Eaton Corp. v. Commissioner, 140 T.C. No. 18 (2013).

The IRS had cancelled the APAs retroactively, claiming that Eaton did not comply in good faith with the terms and conditions of the two APAs and failed to satisfy the APA annual reporting requirements. The two APAs involved the sale of products from manufacturing operations in Puerto Rico and the Dominican Republic to the US.

The Tax Court held that the cancellation of an APA is a rare occurrence and should be done only when there are valid reasons. A misrepresentation must be false or misleading, usually with the intent to deceive, and relate to the terms of the APA. The Tax Court stated that a different viewpoint is not the same as a misrepresentation and is not grounds for terminating an APA. The Tax Court stated that the negotiation process for these APAs was long and thorough and either party could have walked away at any time.

The Tax Court held that based on all the evidence presented, no additional material facts, mistakes of material facts, or misrepresentations existed that would have resulted in a significantly different APA or no APA at all. The IRS had enough material to decide not to agree to the APAs or to reject Eaton's proposed transfer pricing method and suggest another APA at the time the APAs were negotiated. The Tax Court concluded that it was an abuse of discretion for the IRS to cancel the APAs.

The Eaton case bears some similarities to Medtronic and Eli Lilly v. Commissioner, 856 F.3d 855 (7th Cir. 1988), in that each of these cases involved § 482, a prior transfer pricing agreement between the taxpayer and the IRS, and the IRS going against the prior agreement and asserting large tax deficiencies. All three cases were lost by the IRS. In all three cases, the courts effectively adjusted the transfer pricing to conform to the IRS and taxpayer's previous agreement, with minor changes.


The Tax Court decision in Inc. v. Commissioner, 148 T.C. No. 8 (2017), is another transfer pricing taxpayer victory. Judge Lauber rejected the IRS's attempt to relitigate the same cost sharing transfer pricing issues the IRS lost on in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009).

The IRS claimed that Amazon undervalued the buy-in intangibles contributed to Amazon's Luxembourg subsidiary by more than $3 billion when Amazon entered into a cost share arrangement (CSA) with the Luxembourg subsidiary.

The Tax Court stated that by definition, compensation for subsequently developed intangible property is not covered by the buy-in payment. Rather, it is covered by future cost sharing payments, whereby each participant pays its ratable share of ongoing intangible development costs (IDCs). The Tax Court held that the foreign subsidiary, by making cost sharing payments, became a genuine co-owner of the subsequently developed intangibles that the IDCs financed.

The Tax Court stated that the useful life of the trademarks, brand names, and other marketing intangibles in Veritas was determined to be seven years. It is unreasonable, the Tax Court concluded, to determine the buy-in payment by assuming that a third party, acting at arm's length, would pay royalties in perpetuity for the use of short-lived assets.

The Tax Court held that an enterprise valuation of a business includes many items of value that are not intangibles. These include workforce in place, going concern value, goodwill, growth options and corporate resources or opportunities. The Tax Court stated these items cannot be bought and sold independently; they are an inseparable component of an enterprise's residual business value. These items often do not have substantial value independent of the services of any individual and do not derive their value from their intellectual content or other intangible properties. Thus, the Tax Court stated that as concluded in Veritas, there was no explicit authorisation in the cost sharing regulations for the inclusion of workforce in place, goodwill, or going-concern value in determining the buy-in payment for pre-existing intangibles.

The Tax Court held that because the going-forward value of the marketing intangibles would increasingly be attributable to marketing investments by the foreign subsidiary, an unrelated party in its position would not agree to pay royalties forever. A trademark is, at any specific moment, the product of investments of the past. Future investments can replace those made in the past, and therefore the value of a trademark built by investments of the past will diminish. If consumers were dissatisfied with their shopping experience, Amazon's marketing intangibles would rapidly decline in value. The Tax Court found that the marketing intangibles had a useful life of 20 years.

The Tax Court also found unpersuasive the IRS contention that Amazon US was the true equitable owner of any marketing intangibles legally owned by the European subsidiaries. Because of differing cultural preferences, retail traditions, and national regulations, the details of these operations often varied from country to country. Local teams were thus integral to Amazon's success in Europe. The Tax Court held that the European subsidiaries were not mere agents of Amazon US.