The opinions expressed in this article do not necessarily reflect the views of EY.
Consistency and uniformity sound like a couple of primary goals for a global transfer pricing policy that keeps controversy risks low and a feature that enables reliability of the CbC report, Master file and Local file structure, isn't it?
However, Action 13 of the BEPS Action Plan created a multi-tiered structure that would enable multinational enterprises (MNEs) to have better visibility and control of its transfer pricing reporting and the implementation of transfer pricing policies all along the OECD/G20 countries, but lacks of clarity regarding what to do when a Local file refers to a non-OECD/G20 jurisdiction.
This article intends to give a perspective of the challenges that MNEs may confront when dealing with non-standard documentation, based on the first year experience of the Action 13 implementation in one of the non-OECD/G20 countries.
The Action 13 report, when replaced the Chapter V of the OECD Guidelines created a big opportunity for MNEs, in its aim to consolidate transfer pricing (TP) documentation providers, to achieve consistency in implementing their structures and to review their complete international tax profile.
At the same time, and as a primary goal, BEPS Action 13 enabled tax authorities (TAs) to view business models and operating structures of MNEs not just for their own jurisdictions, but having the whole picture available.
This action compelled companies all around the globe to evaluate the potential BEPS pressure points in their businesses and developing plans so that their models and practices better aligns with the new global tax landscape.
In general, the three-tiered structure is composed by:
- Master File, which contains high-level information of the business, carried by the MNE, along with a description of its TP policies and arrangements with Tax authorities in a single document, which will be available for tax authorities of the countries adopting the Action 13, where the MNE operates.
- Local File, which reports local business and related party transactions in functional and financial terms, along with comparability analyses and benchmarking. This report is delivered to the corresponding Tax authority and will make cross-references to the Master file for simplification purposes.
- CbC report, which details the aggregation of certain financial figures and non financial facts, including profits, revenues, employees and assets, enabling a high-level assessment of the appropriateness of the allocation of the reported variables.
This structure created, at MNEs, an increased need for centralized control over what a company's documentation says and consistency between the CbC report and the master/local files where simplification and efficiency are paramount.
At the same time, TAs of countries whose legislation has not been adapted to follow Action 13 – which included model legislation and model agreements for report exchanging – may be evaluating the feasibility of proposing such modifications on the regulations of its respective countries. For these actors, the trade-off between the independence to request for special interest information and methodologies and the perspective of receiving general information along with a Master file and the ability to exchange CbC reports is, probably, being weighted carefully.
In this regards, it is relevant to understand that, for countries not being part of the OECD/G20, (whose locally based MNEs reaching the €750MM threshold are scarce) it may be more relevant to be keep strict control of the strategies of national companies, which have a smaller footprint, based on multiple local subsidiaries and a few companies abroad.
This substantial difference of interests and needs carries the unavoidable consequence of making formal and methodological decisions and concessions when creating and filing local reports, as they follow rules which vary by country and may include, in the case of Ecuador:
- Domestic transaction reporting, to capture the internal activity of the Economic Group
- Different approach on what makes a transaction relevant for being included on the report
- PLIs requirements different from standard, based on the technical approaches defined by the local TA
- Extensive differences on what constitutes an adequate comparable
- Relevant impacts on the adequate period of financial information to be used as comparable
- A very specific approach and understanding on what constitutes appropriate economic substance evidence for services and intangibles transactions
- The requirement of abundant, additional documentation for cases of tested parties different than the taxpayer
- Specific requirements for industry analyses
- Particular approaches to comparability adjustments
- Lack of a materiality rule for reporting
- Unavailability of a Master file to cross refer the Local file
- In addition to some other methodological preferences revealed by the TA on the relevant regulations
Thus, a careful review of the adaptation procedure that enables a MNE to adequately portrait it operations and efforts to keep the Arm's Length standard when dealing with the operations in Ecuador and other non-OECD/G20 country is compulsory if the primary goals of control and transparency are to be kept.
In addition, besides all the technical transfer pricing specific implications already explained, we must not lose sight of the fact that TP reports are not just a compliance requirement, but also a declaration that the company makes on a vast array of matters. This formalization might be quite irrelevant as long as the companies are not subject to audits and transfer pricing assessments, but, when these events occur – and they will – every decision on the information included and method applications will be as relevant as then can be.
That is why, when dealing with tax controversies and its risk management, Corporations are usually aware of the fact that they will not happen just at the center, but mostly, on the foreign, local level.
These controversies will show that, in non-OECD/G20 countries, as in any other jurisdiction, tax authorities and tax courts will enforce and judge on the base of very strict in application of the letter of the law, which, in these cases, will not be what Action 13 proposes.
In the specific case of Ecuador, there are, in every tax matter, complex formal requirements and specifications that information filed by the taxpayers must comply. Transfer pricing reports are not the exemption; in fact, the content and framework of such reports are micro-regulated in detail in order to be lawful.
Consequently, a centralized model report has a lot of elements (or the lack of them) that pose a risk to not comply with all the complexities duly established in the local Tax law which are enforceable for transfer pricing reports (i.e. technical guidelines sheet).
Therefore, when a report that has not been fully "tropicalized" becomes part of a tax controversy, this uncompliant status represent a first obstacle in case of a transfer pricing controversy related to the validity of the aforesaid report as a full proof.
Based on our experience during TP controversies in Ecuador, we believe it will be relevant to consider, when deciding on the way to deploy the centralized model required by Action 13, the answers that the MNE gives to the following questions:
1. Who and how is going to monitor effectively all the transfer pricing information, besides what is included in the standard model?In case of a controversy, it is unquestionable that tax administration and judges will require all the transfer pricing information of the companies, especially the one related to the demonstration of substance of the transactions. The support documentation for this purpose in our experience is vast, intense and vital in Ecuador and it is part of the documentation that has to be attached to the transfer pricing reports. As it is not part of the Action 13 model, there is the need to track it and have it available for the time it may be required.
2. Who, and with which information is going to defend the model before the tax courts? The defense of any tax case, demands fully understanding the tax environment of the country as well as the local tax policies and legislation. It will not be enough to have the knowledge of the technical aspects included in the model but to understand how to focus such explanations within an administrative claim or litigation, in concoction with a more than acceptable understanding of the local taxation environment.
3. How the defense strategy could be carried considering the approach that the administrative or judicial authorities can have in regards the information included in the standard local file?The approach of the administrative authorities or judges to local laws can change dramatically the understanding of the companies' taxable activities and may influence the analysis of their functions, risks and assets. This situation can lead to undesirable scenarios where double taxation may occur as well as collateral controversies involving assessments on indirect taxes.
In this point, also a political approach based on the concept of sovereign tax authorities could also guide the decisions and unleash tax controversies with tax administrations of other countries.
4. Who is going to defend the report as the expert before the tax Courts?The procedural tax system demands that any expert´s report should be exposed and submitted to the interrogatory of the parties before the Judges in the Proof Hearing phase within a trial. The expert should be available at all time during this phase.The Judicial Administrative Authority must also qualify the expert as such; this qualification is granted once passed rigorous evaluations, so it must be someone who understands the local regulations on procedural tax law and the transfer pricing regulations in order to be effective for the defense of the TP position of a company.
Consistency of TP information based on Action 13 is, of course, a good idea and one of the most relevant advancements in fiscal transparency derived from the BEPS Action Plan: it gives TAs and MNEs plenty of benefits that will show its developments on the next few years.
Over-centralization, on the other hand, is never such a good idea. It may carry as downsides the risks of failing to fully comply methodological requirements, along with the aggregated risk of not adequately reporting transactions as the local TAs require (increased by the frequency of changes in Tax Law in emerging countries). Finally, most of all, MNEs must weigh the real possibility of being seriously challenged by a Tax Court without having certainty of the effectiveness of its Local file within a tax controversy.