The OECD's Base Erosion and Profit Shifting ("BEPS") initiatives have already altered the international tax landscape dramatically, although the dust is far from settled. Tax planning structures that multinational firms have widely employed may no longer be viable. Firm-specific tax rulings do not provide the legal protections that recipients believed they did. Many countries' international tax regimes will likely be extensively modified as a result of BEPS (or the European Commission's subsequent revisions to the European Union's corporate tax policy and/or its code of conduct on harmful tax practices), although the pace and precise direction of such changes remain unclear. Correspondingly, while disputes over the allocation of multinational firms' taxable income across jurisdictions have traditionally taken place within relatively narrow parameters, the areas of common ground among tax authorities are becoming less clear and more circumscribed.
Many elements of the OECD's Action Plan, published in July 2013, do not relate directly to transfer pricing. However, several important initiatives fall squarely in this conceptual camp, among them those pertaining to the use of profit splits, transfers of intangible assets, and risk, recharacterization and special measures. All of these topics are very important, and all have far-reaching consequences. However, for purposes of this article, I limit my observations to the following "high" points:
- The position taken by US officials on non-recognition and recharacterization in the context of BEPS is inconsistent and conceptually incomplete.
- The moral hazard issue, touched on by the authors of BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter 1 of the Transfer Pricing Guidelines (Including Risk, Recharacterisation and Special Measures), has a direct parallel at governmental and inter-governmental levels, with implications for the European Commission's investigations of illegal state aid.
- The OECD's release of discussion drafts that do not reflect a consensus among member states, and do not invariably reflect carefully considered positions, underscores the wide difference of opinion on key issues among tax authorities and provides a legitimizing platform for countries seeking to justify a more aggressive stance, more than they advance the debate on important tax matters.
- Although many multinational corporations' strong preference for binding arbitration is fully understandable in the current highly uncertain environment, even more far-reaching changes may be worth considering at this critical juncture.
These issues are taken up in turn below.
US Position on Non-Recognition and Recharacterisation
Related parties enter into a greater diversity of arrangements than independent enterprises for many reasons. The fact that related companies are not subject to issues of moral hazard, in circumstances where unrelated parties would be, is one such reason, and a potentially important one.
The issue of moral hazard may not be given the same weight in the OECD's revised draft on Risk, Recharacterisation and Special Measures as it was given in the Discussion Draft released on December 19, 2014. Nonetheless, the more general question of whether one should impute the conditions prevailing between unrelated parties to related party dealings (as the OECD advocated in its consideration of moral hazard) or the reverse is central to the issues of non-recognition and recharacterization, and the interpretation of the the arm's length standard in specific situations more generally.
BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter 1 of the Transfer Pricing Guidelines (Including Risk, Recharacterisation and Special Measures) addresses moral hazard in a thoughtful and considered, if somewhat cursory, fashion. The authors note that moral hazard "...refers to the lack of incentive to guard against risk where one is protected from its consequences... The concept extends to the safeguards or incentives that unrelated parties may incorporate into contracts between them in order that interests are better aligned and moral hazard is reduced or avoided." While recognizing that moral hazard generally does not arise among associated enterprises because their incentives are generally mutually compatible, the authors of the Discussion Draft query whether "imputed" moral hazard should play a role in assessing the allocation of risks among affiliated companies, and, by extension, evaluating whether the recharacterization of certain intercompany transactions is warranted in consequence. As I interpret this discussion, the issue being raised is whether, for purposes of evaluating the arm's length nature of an individual transaction between affiliates or an overarching umbrella arrangement to which they are parties, one should give effect to the fact that the parties' interests would not be perfectly aligned if they were unrelated.
The OECD's discussion of moral hazard references a particular example. In this example, one member of a controlled group owns a valuable trademark that it exploits in the normal course of its business. It relies heavily on the trademark, and enhances its value through extensive marketing activities. This entity sells its trademark for a lump-sum price to an affiliated company in a low-tax jurisdiction, and licenses rights to use the mark, thereby subjecting itself, in principle, to the purchaser's decisions regarding the continued license of the mark, the particular forms and levels of expenditures on marketing on a going-forward basis, etc. The authors of the Discussion Draft conclude that "[t]he transaction lacks the fundamental economic attributes of arrangements between unrelated parties; the arrangement does not enhance or protect the [original trademark owner's] commercial or financial position ..." By implication, presumably, the arrangement should not be recognized and is subject to recharacterization.
Hence, in its Discussion Draft released on December 19, 2014 the OECD was clearly putting forth the position that tax authorities should have the power to disregard and/or restructure transactions when they are fundamentally inconsistent with the arrangements that third parties would willing enter into. (The OECD has since signaled its intent to de-emphasize moral hazard considerations in its revised draft.)
An attorney-advisor in the US Department of Treasury's Office of International Tax Counsel, who is also a US delegate to the BEPS project, recently made the following observations in relation to this issue:
"The implication of these points is really that if unrelated parties would not have entered into this transaction, then related parties should not be able to enter into this transaction....This view of the world potentially renders the arm's length principle useless for a wide range of transactions, because related parties by their nature are able to enter into transactions that might be perfectly appropriate, but unrelated parties might not be able to enter into."
The above quote indicates that, in the view of the US Department of Treasury, transactions between associated enterprises should not be subject to non-recognition and recharacterization merely because third parties would have structured their dealings differently. Hence, it would seem, based on their respective positions on moral hazard and non-recognition and recharacterization, that the OECD and the US Department of Treasury part company on an issue that is fundamental to the arm's length standard and how it is, or will be, implemented.
Related parties implement structures to minimize their worldwide effective tax rates. They have a fiduciary duty to their shareholders to do so, notwithstanding tax authorities' views that they should pay their "fair share" of taxes. They have certain means at their disposal to minimize tax burdens, by virtue of their affiliated status and common interest and control, from which unrelated parties do not and cannot benefit. This has always been the conundrum underlying the arm's length standard. One is inevitably comparing like with unlike, apples with oranges. It does not render the arm's length standard useless. Rather, it necessitates a clear statement of principle: Is one taking as given the circumstances prevailing between related companies (e.g., the compatibility of their incentives, the symmetric and full information that each party possesses about other Group members, etc.) and modeling how unrelated companies would behave if they were similarly situated, or the reverse?
It should also be noted that the US Department of Treasury has enthusiastically embraced the concepts of non-recognition and recharacterization, and the Internal Revenue Service has actively engaged in such recharacterizations on audit, most notably in relation to intercompany cost-sharing arrangements. Moreover, the preamble to the cost-sharing regulations (in proposed form) makes clear that such recharacterization is justified precisely because third parties would not enter into comparable arrangements.
The Income Method, widely used by the Internal Revenue Service to compute the value of "platform contributions" (pre-existing intangible assets contributed by US parent companies to cost-sharing arrangements involving non-US affiliates), is a recharacterization writ large. The Income Method effectively restructures cost-sharing arrangements as de facto perpetual licensing arrangements, albeit with non-contingent, lump-sum payments up front. Through this "analytical" device, the US Department of Treasury and the Internal Revenue Service have attempted to reconcile the Congressional requirement that bona fide intercompany cost-sharing arrangements be respected as such with their conviction that there are "...fundamental differences in cost-sharing arrangements between related parties as compared with any superficially similar arrangements that are entered into between unrelated parties."
In short, the ability to recharacterize transactions that are fundamentally at odds with the ways in which third parties structure their transactions, far from being inconsistent with the arm's length standard, is an integral part of the standard, as the US Department of Treasury and the Internal Revenue Service have long recognized, in principle and in practice.
Absent explicit agreement on this point among tax authorities, it will be difficult to make meaningful progress in (a) developing a uniform set of criteria that will applied to determine whether a particular transaction or structure is sufficiently incompatible with arm's length practices to warrant restructuring, and (b) establishing certain guidelines as to how such transactions will be restructured.
Moral Hazard at the Governmental Level
As has been widely reported, the European Commission has challenged firm-specific concessionary tax rulings granted by a number of European governments on the grounds that these concessions violate the EU's anti-competition policies and state aid rules. Where the European Commission finds that such rulings are illegal, the companies that have benefited have been, and will be, required to repay the monetary value of these tax benefits.
Decisions to grant tax concessions to individual multinational firms are made by governments, and governments (as well as firms) benefit therefrom in a variety of ways. If governments do not bear the associated risks and contingent costs---in the form of payments equal in magnitude to the concessions granted if their rulings are challenged by the European Commission---this creates a moral hazard problem, and does not adequately safeguard against continued transgressions. As such, as a policy matter, it would make more sense to have governments, rather than firms, bear these costs.
Wisdom of Releasing Public Discussion Drafts that are Preliminary in Nature
Certain of the Public Discussion Drafts that the OECD has released to date set forth positions that (a) are very preliminary in nature, (b) expressly do not reflect a consensus view, and (c) are highly controversial. This observation applies most notably to BEPS Action Plan 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains.
While the opportunity to provide comments on the OECD's work-in-progress is certainly welcome and helpful, there is a notable downside: Certain Discussion Drafts have served as a lightning rod with regard to debates about important international tax and transfer pricing issues, widening existing differences of opinion rather than advancing the debate through dialog. Moreover, a certain legitimacy attaches to the positions expressed in documents issued by the OECD, Discussion Drafts or otherwise. For example, the Discussion Draft on BEPS Action Plan 10 will likely serve as a legitimizing platform for countries that are strong advocates of the profit split method.
It would be preferable, for these reasons, for the OECD to release a set of questions to which commentators can respond, without appearing to take a position on profit splits or other controversial issues. While the horse is out of the barn with respect to many BEPS Actions, this observation applies to Actions published in the form of "interim drafts" and those with deadlines of September or December 2015.
Dispute Avoidance in Lieu of Dispute Resolution
As public officials and practitioners alike recognize, the lack of consensus around fundamental international tax and transfer pricing issues will lead inexorably to more disputes and a higher incidence of double taxation, absent the introduction of mandatory arbitration, other approaches to streamlined dispute resolution, or, in the alternative, a far more significant departure from the status quo.
At present, individual multinational corporations apply the tax laws and regulations in place in the countries in which they operate. Tax authorities audit these results some years after the fact, and determine whether the laws and regulations have been applied properly. If not, individual tax authorities propose adjustments. Multinational firms subject to these adjustments must then attempt to reconcile potentially overlapping allocations of their consolidated income (and, consequently, potential double taxation) through the Mutual Agreement Procedure ("MAP"), where this avenue is available to them. The MAP process is already extremely overburdened, and likely to become vastly more so as the OECD moves forward with BEPS.
As an alternative, one could, in principle, envision a system in which tax authorities coordinate among themselves, and jointly determine, through coordinated audits (a) how the arm's length standard should be applied in particular circumstances, and (b) the consequent tax liability of individual multinational firms in each jurisdiction. (This is already taking place on a small scale.) While multinational firms should have the ability to dispute such allocations in neutral forums, this synchronization and reordering of the audit process would force tax authorities to come to a meeting of minds, rather than taking unilateral action and thereby potentially subjecting multinational firms to double-taxation on a large scale with limited (and very laborious and costly) recourse.
While the OECD has taken care, in implementing its BEPS Action Plan, to stress that "countries retain their sovereignty over tax matters and measures may be implemented in different countries in different ways", the luxury of "pure" sovereignty may come at too high a cost in the current climate.