Archive for November 2014

The Most Aggressive Tax Authorities in the World?

Earlier this week there was a court ruling in India related to transfer pricing. As reported by Business Standard:

3087367_sThe Bombay High Court on Tuesday ruled in favour of Shell in a transfer-pricing order that sought to tax the energy giant’s 2009 investment in its Indian subsidiary. The order will have an impact on other multinationals fighting the tax department on similar grounds.

The income-tax department had sought to add Rs 15,220 crore to Shell India’s taxable income after Shell Gas invested in its local arm at Rs 10 a share. The tax department valued Shell India’s shares at Rs 180 apiece in January 2013 and charged it with undervaluing those to evade tax… The court rejected the tax department’s argument that the Shell case was distinguishable from Vodafone’s case, which won a similar reprieve in October.

In a narrow technical sense this verdict matters simply because it means that the tax authorities in India can no longer try to apply Indian transfer pricing regulations to capital transactions such as the issuance of new shares. This will make life a bit simpler for many companies in India (including some of my clients) that have recently felt obliged to prepare transfer pricing documentation to support balance sheet transactions.

But the broader implications are more interesting. To my knowledge, India was the only country in the world that even attempted to apply transfer pricing rules to capital transactions. And that is just one of many ways in which the Indian tax authorities have very aggressively interpreted and applied transfer pricing rules to multinationals doing business in India. In transfer pricing circles, India has a reputation. This ruling is the latest in a string of court decisions that indicate that the Indian judicial system thinks that the Indian tax authorities have been overstepping their bounds.

This is a good illustration of how subjective transfer pricing can be. The fundamental principle behind every transfer pricing analysis – whether conducted on behalf of a company or a tax authority – is clear enough: transactions must be consistent with the arm’s length standard, meaning that the prices applied to intra-group transactions should be the same as market (or arm’s length) prices. But in practice, it’s often impossible to determine exactly what prices or rates of compensation would be agreed upon between unrelated parties, because such transactions are never actually observed in the real world.

As a result, there’s frequently no obviously correct arm’s length price to apply, and multinationals as well as tax authorities often have substantial latitude in how they interpret and apply the arm’s length standard to intra-group transactions. And just as some multinationals are particularly aggressive in how they approach transfer pricing, so are certain tax authorities, like those in India.

What effect does the behavior of the Indian tax authorities have on the business climate in India? Many companies (as well as some politicians in India) would argue that they effectively view the Indian tax authorities’ harshly aggressive transfer pricing enforcement as an extra tax that companies must pay to do business in India. Many are willing to pay that tax in order to reap the advantages that they get from being in India, but it is a real effect nonetheless, as it probably does dissuade some firms at the margin from undertaking certain economic activity in India.

And I find that very interesting. As a student of economics one learns a lot about how to analyze the effect of explicit taxes on behavior. Some students even learn about the importance of institutions and organizations in facilitating or hindering economic transactions (though generally I think such subjects are woefully under-taught in most economics programs).  But relatively little emphasis is paid to qualitative, subjective phenomena such as differential enforcement of transfer pricing regulations from country to county, or the broader category of “business climate”. To me this serves as a useful reminder that even such hard-to-measure economic forces or behaviors can have very real economic effects.

Attacking the Cash Box

A colleague of mine yesterday highlighted comments made recently by Robert Stack, deputy assistant secretary for international tax affairs at the US Treasury Department: “We are determined to put a big dent in the ‘cash box’ because countries cannot afford large piles of untaxed income.”

4871276_sBut what is a “cash box”, anyway?  The concept is pretty simple: it’s a company within a multinational group located in a low-tax jurisdiction that owns some sort of valuable asset. That company may not even have any employees, but since it owns the asset it is legally entitled to the profits that are generated by the asset, thereby ensuring that a portion of the multinational group’s income gets taxed at a very low tax rate.

But for tax authorities, restricting the use of such arrangements is trickier than it might seem. Let’s use an example to illustrate. Imagine there’s a company called SuperTech USA that develops a fantastic new product. SuperTech USA sets up a subsidiary on a lovely tropical island that happens to have a corporate tax rate of zero, and then has SuperTech Island Co purchase the designs and technology underlying that product. SuperTech Island Co hires a contract manufacturing company in China to make the product, and contracts other SuperTech affiliates around the world, possibly including SuperTech USA, to essentially act as local sales agents.  From that time onward, whenever SuperTech products are sold to consumers the local sales affiliates get some sort of arm’s length compensation for their services (maybe a sales commission), but SuperTech Island Co gets the rest of the revenue. If it’s really a good product with fat profit margins then it’s likely that the bulk of the group’s profits will actually belong to SuperTech Island Co and be subject to zero corporate income tax.

If you are interested in stopping this type of arrangement, how would you go about it? Perhaps you might consider blocking the initial purchase of the asset by SuperTech Island Co. But companies buy and sell assets all the time for perfectly reasonable business reasons, so any sort of simple rule prohibiting that won’t work. What about requiring all of SuperTech’s sales revenue to belong to the local sales affiliates rather than to SuperTech Island Co?  Allowing the owner of an asset to claim the income generated by that asset is a basic element of our notion of property rights, so we can’t easily tamper with that.

The OECD seems inclined to address the issue in a different way: require SuperTech Island Co to pay much more compensation to SuperTech’s local sales affiliates. That’s a transfer pricing issue, and would depend on making the argument that SuperTech Island Co is paying its sales affiliates less than what it would have to pay to unrelated sales agents. Given the abundance of sales people in this world eager to have a good product to sell, it seems likely that would be a difficult argument to make. Trying to tweak existing transfer pricing rules to address this particular situation would likely open an entirely new can of worms.

Instead, Stack indicated that the US government thinks a better approach would be for an international agreement to allow countries to tax income earned by companies domiciled outside their jurisdiction. In other words, Treasury would like to get other countries to agree to allow the US to tax the profits of SuperTech Island Co even though that company is not located in the US. Needless to say, however, reaching such an international agreement could be extremely difficult.

But the economist in me wonders if the root cause of this sort of arrangement is really something else: incorrect initial valuations of the asset.  If the price that SuperTech Island Co had to pay to acquire ownership of the asset fully reflected the future stream of income that could be expected from that asset, then it seems likely that there would not be much of an incentive to move the asset in the first place. With the transaction described above SuperTech USA would record a large amount of income in the year of the asset sale – on which it would pay US tax rates – in exchange for a stream of tax savings in future years.  It strikes me that a correct initial valuation of the asset should take this into account. And if it did, then perhaps the cash box problem would not be so much of a problem after all.

Simplifying the Rules. A Bit.

Last week the OECD released a discussion draft about how “low value-adding intra-group services” should be treated for transfer pricing purposes (pdf). This document is part of the OECD’s ongoing BEPS project, and represents a substantial piece of output by the group working on action item #10 (out of 15 total): “high risk transactions”.

8161291_sBy way of background, it’s important to understand what is meant by the term “intra-group services”. Nearly all multinational groups have entities that perform services that benefit entities in other countries. Perhaps the group has an R&D center in a country that helps to develop new products for the entire company. Or maybe a local affiliate helps to develop marketing materials for a parent company. Even the performance of order processing, call center, logistics, or other “back-office” type functions by an entity in one country to assist a related entity in another country count as intra-group services. Given the complex web of functions distributed around the world in today’s typical multinational, the scale and scope of such intra-group services are enormous.

Since such transactions are between related parties, they are subject to transfer pricing rules. That means that every time a company or facility in one country performs a function that benefits a member of the corporate group in another country, the service must be paid for in a manner consistent with the arm’s length standard – i.e. as if the transaction had happened between two unrelated companies.  The associated administrative burden to calculate and substantiate that can be substantial.

That’s where the OECD’s latest draft document comes in.  While the primary aim of the BEPS project is to make it harder for multinationals to shift their worldwide income to low-tax jurisdictions and thus reduce their tax bills in ways that are perceived as being unfair, this document actually takes a step toward making life a tiny bit easier for multinationals to meet their transfer pricing regulatory requirements.  The document proposes that there be a simplified way for multinationals to calculate the correct prices to apply to certain intra-group service transactions.

The proposed simplified approach will be very familiar to transfer pricing practitioners in the US, as it is substantially the same as the Services Cost Method (“SCM”) that has been a part of US transfer pricing regulations for several years. The essence of both the SCM and the OECD’s proposed simplified method is to pool the cost of the center providing services, allocate those costs in a reasonable way among the various entities that benefit from the provision of those services, and then possibly add a small markup (in the case of the OECD proposal) or no markup at all (in the case of the US’s SCM).  Importantly, this simplified method is only applicable to services that are considered “routine” and not central to the company’s business.

From my perspective, this makes all kinds of sense. I don’t see any reason for companies to waste time and resources to perform extensive economic analyses supporting their transfer pricing on routine services.  Transfer pricing practitioners have seen so many of these intra-group services (after all, pretty much every multinational company has them) that we can usually tell you exactly what transfer prices the economic research will support even before we’ve crunched the first number.

But this also touches on a couple of larger interesting issues.  First, I think that this marks another step on the path of simplifying transfer pricing by focusing more on outcomes rather than individual transactions. In other words, to me this seems consistent with the continued ascendancy of profits-based approaches over transaction-based approaches to verifying that a company is adhering to the arm’s length standard.

Second, it puts renewed attention where it really should be: on the role and treatment of intangible assets (including their creation, maintenance, and management) when it comes to tax strategies employed by multinational companies.  After all, when you think about today’s most profitable companies, what is the ultimate source of their profitability?  It usually lies with their IP. Most other intra-group transactions are little more than a sideshow and distraction by comparison.

Finally, it’s interesting to note that this may be yet another way in which the US’s transfer pricing rules appear to have foreshadowed developments around the world. The US was one of the first adopters of formal transfer pricing regulations. The US began emphasizing profits-based approaches over transaction-based approaches before most other countries. And now the US’s simplified approach toward low-value intra-group transactions seems to be earning wide-spread acceptance as well.

I think this is simply a reflection of the fact that the US started regulating transfer pricing before most other countries. As a result, the US has had over 20 years to slowly build up a cadre of transfer pricing professionals and a body of institutional knowledge among the IRS, taxpayers, and consulting firms. And with that has come a gradual improvement in our understanding of what works and what doesn’t from a practical point of view.  So it’s worth thinking about how this latest product from the BEPS project may be another small but positive step in the gradual convergence of transfer pricing rules around the world… and to consider that the end result may end up looking more like the US’s transfer pricing rules than one might have expected.