0 Tax Conference in Istanbul Transfer Pricing Rules in Turkey Ceylan Intercontinental Hotel, 22...

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Tax Conference in Istanbul

Transfer Pricing Rules in Turkey

Ceylan Intercontinental Hotel, 22 November 2006

Application of Methods and Planning

Dr. Gerhard EnglerBDO Deutsche Warentreuhand AGGrüneburgweg 10260323 Frankfurt am Main

Tel. +49 69 / 95 94 1-2 40Fax +49 69 / 95 94 1-2 59E-Mail: [email protected]

BDO Denet

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1 Transfer of tangible assets 1.1 International Tax Planning Objectives 1.2 Use of Contract Manufacturer 1.3 Distributor Models 1.4 Losses of distribution companies

2 Services 2.1 Forms of service charges

2.2 Cost allocation agreements

3 Loans and other financial services 3.1 Adequate interest rates

3.2 Guarantees, hedging services etc.

Application of Methods and Planning – Topics (I)

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4 Transfer of intangible assets 4.1 Intangible property categories 4.2 Forms of transfer 4.3 Licensing 4.4 Contract R&D 4.5 Cost shares 4.6 Acquisition / sale of IP

5 Transfer of functions and risks

5.1 Transfer of distribution 5.2 Transfer of IP 5.3 Transfer of services 5.4 Transfer of production

Application of Methods and Planning – Topics (II)

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To divert, extract and distribute profits out of high tax paying jurisdictions

Minimize global tax liability

Ensure that connecting factors i.e. residence / presence do not arise in high tax paying jurisdiction

Avoid double tax

Avoid capital gains when shifting functions and risks

Avoid withholding taxes

1 Transfer of tangible assets 1.1 International Tax Planning Objectives

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Case 1: Fully fledged manufacturer

A-Corp. B-Corp.

Country Alow tax

Country Bhigh tax

license agreement

license fees

distributor / customers

distributors / customers

salessalesR&D owns

patents, trademarks

B-Corp. takes all manufacturing and market functions, assumes related risks, owns customer list B deserves adequate manufacturing profit

1 Transfer of tangible assets 1.2 Use of contract manufacturer

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Case 2: Contract manufacturer (7.40 OECD-G)

A-Corp. B-Corp.

Country Alow tax

Country Bhigh tax

service fee

contract manufacturing

distributor / customers

distributors / customers

salesRisk takerR&D, owns patents,

trademarks

A-Corp. bears market risk, owns customer list, acquires goods at a pre-determined price based on cost plus arrangements B-Corp. assumes only manufacturing function and little risks


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Correlation between profits and functions / risks

Functions Fully fledged manufacturer Contract manufacturer

R & D Performs R & D, owner of IP alternatively licensee of IP

no R & D; principal grants free use of IP

Production strategy and planning

Full dispositions what products in which place and which quantities are made

no real influence

Manufacturing process All functions and responsibilities All functions assigned by principal, usually except quality control

Purchasing All functions Raw materials often dilivered by principalWarehousing All functions Limited, because usually just-in-time

deliveryTransport All functions not responsible Marketing and Distribution All functions; either sales to (group)

distribution companies or to wholesalers, customers, other manufacturers etc.

not responsible; principal obliged to acquire all goods; price usually agreed on cost plus basis

Administaration All functions insignificant scope


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Correlation between profits and functions / risks

Correlation:

• Less functions are associated with less risks• Less functions and risks imply lower profit potential

Consequence:

• Transfer of functions and risks shifts profit potential

Risks Fully fledged manufacturer Contract ManufacturerR & D failure Full risk noInvestment in machinery Full risk restricted due to long-term CM agreementSupply Full risk limitedMarket Full risk noWarehouse Full risk noTransport Full risk no Warranty, product liability Full risk no


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Distributors sell in their own name and on own account - Full distribution (and marketing) functions / risks or - Limited risk distributor (LRD)Transfer price: CUP or (reduced) RPM (or TNMM)

Commission Agent sells in its own name but on account of principal Transfer price: CUP commission fee

Sales Agent sells in the name and on account of principal Transfer price: CUP commission fee

Sales support, logistic support service providers do not conclude and not procure contracts Transfer price: cost plus service fee

Planning: set-up fully fledged distributor in low tax jurisdiction, whereas other distributor models are preferable in high tax jurisdictions

1 Transfer of tangible assets 1.3 Distributor Models

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Limited risk distributor

Prerequisites for limited risk distributor (LRD) see attachment

Remuneration of LRD- lower gross margin than for marketing distributor or- cost plus compensation e.g. in Anglo-Saxon countries possible

1 Transfer of tangible assets 1.3 Distributor Models

Functions Marketing and distribution company

Distributor Stripped buy and sell distributor

Commission Agent

Sales Agent Sales Support Service

Provider*

Logistic Support Service Provider

Sales in own name and on own account + + + - - - -Sales in own name and on account of the principal - - - + - - -Sales in the name and on the account of the principal - - - - + - -

Acquisition of customers + + + + + - -Order management + + + + + - +Warehousing + + +/- - - - +Distribution + + +/- - - - +Pricing policy + +/- +/- - - -Client service + + +/- +/- +/- - -Collection + + + +/- - - -Market research + +/- - - - +/- -Marketing (strategy, implementation) + - - - - +/- -Advertising + + + + + +/- -Selection of local sales agents + + - - - - -

Risks Marketing and distribution company


Commission Agent


Provider*


Warehousing risk + + - - - - +/-Warranty risk + + - - - - -Credit risk + + +/- +/- - - -Exchange rate risk +/- +/- +/- - - - -Utilisation risk + + +/- + + - -Risk of failing business strategies + +/- - - - - -

Applicable transfer pricing methods Marketing and distribution company


Commission Agent


Provider*


Compareable uncontrolled price method (comparable prices for products)

+ + + - - - -

Compareable uncontrolled price method (provision fees)

- - - + + - -

Resale price method + + + - - - -Cost plus method - - (+)/- - - + +* In cross boarder situations usually set up as representative office only with cost reimbursement without mark-up.

Distributor models Agent models

Agent models

Service Providers

Service Providers

Distributor models Agent models Service Providers

Distributor models

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Different situations

Start-up losses

Launching of new products

1 Transfer of tangible assets 1.4 Losses of distribution companies

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Start-up losses (1):

German tax court’s and tax administration’s opinion

German Federal tax court and tax administration accept losses up to 3 years

Exceeding loss periods require extraordinary business reasons

In general, losses must be recovered within a “foreseeable future”, i.e. within further 3 years

Market defense or market penetration cost (e.g. lower sales prices) require support from manufacturer

Note: Similar restrictions exist in other jurisdictions


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Start-up losses (2):

Arguments against restrictions

OECD-Guidelines fix no particular time limit (1.52 OECD-G)

Length of start-up period depends on industry branch (1.54 OECD-G)

Strong competition or weak economy may require longer start-up phase (say even 7 years or longer)

Generally, experience shows that the period to balance losses usually exceeds the start-up period

Later reimbursement of support payments to manufacturer will defer the distributor’s losses

Within the EU discrimination of importing distributors?

Set-offs must be considered (1.60 OECD-G)


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Launching of new products

Tax court’s and tax administration’s opinion

Losses accepted up to 3 years

Overall profit within 6 years

Market support payment from manufacturer (should be recovered later)

Arguments against restrictions

Same as for start-up losses

Losses for some products acceptable if overall profit is generated (1.53 OECD-G)


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2 Services2.1 Forms of service charges

Forms of service charges

Non-chargeable services

based on service agreement

Chargeable services

based on pool agreement

Direct methods: charge for individual services

Indirect methods: Charge for bundle of services to various

recipientsPooling of costs

Cost allocation without profit mark-up

Cost allocation within mark-up

Standard Methods CUP or cost plus

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Distinction of non-chargeable and chargeable services

„Benefit Test“

Services

in the primary interest of the parent

(shareholder activity)

non-chargeable chargeable

in the primary interest of the recipient

2 Services2.2 Cost allocation agreements

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Distinction of non-chargeable and chargeable services

Examples:

Non-chargeable services

Use of group name

Control activities of board members or supervisory board

Group planning and organization

Group controlling

Consolidation

Group budget

Chargeable services

Accounting

IT support

Financing

Marketing

Training of personnel

Technical support


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Cost allocation agreement

if same / similar services for various recipients

Allocation keys

Distribution of cost based on allocation keys reflecting proportionate benefit of recipients

Marketing turnover

Human Resources headcount

Technical support turnover

IT services number of PC users

Consulting time spent

Profit mark-up

Cost Allocation Agreement: yes

Pool agreement: no


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Pool agreement

Compulsory conditions

Cooperation of group companies

Common interest

All pool members expect benefits (incl. service provider)

Only ancillary nature of services

Written pool agreement

Cost allocation without profit mark-up


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Interest-bearing or non-interest-bearing loan?

Principle:Loan interest-bearing

Exemption:Trade receivables within a customary payment deadline

Requirements to be met:Agreement has to be concluded before transaction takes place

Before implementation check possible shareholder debt restrictions, namely debt to equity ratios

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Determination of interest rateCUP, i.e. in practice bank interest rates take priority

Influencing factors to determine interest rate, e.g. Refinancing costs Currency Duration Rating Securities Exchange rate risks and costs related to hedging Asset portfolio


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Some countries prescribe minimum or maximum interest rates

In principle at least refinancing cost must be recovered

If lendor grants loan out of capital: Range between lending/borrowing rate

low end: borrowing rate high end: lending rate


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Loan, current account credit,

long-term supplier credit

Guarantee

silent partnership, jouissance right

Hedging of exchange rate risks, interest risk

Netting of receivables, placement

of loans or capital investments

remuneration for services

Type of Financial Service Transfer Price

commission on bank guarantee(exception if lack of capital)

interest

profit share

3 Loans and other financial services 3.2 Guarantees, hedging services etc.

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4 Transfer of intangible assets 4.1 Intangible property categories

OECD-categories of Intangible property

Trade Intangibles (OECD-Guidelines para. 6.3.)

patents know-how designs models used for the production of

a good or the provision of a service

copyright (incl. software)

Marketing Intangibles (OECD-Guidelines para. 6.4.)

trademarks trade names (e.g. Calvin Klein,

Yves St. Laurent, Donna Karan) customer lists distribution channels unique names, symbols and

pictures that have an important promotional value for the product concerned

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Licensing of IP

Contract R&D

Cost contribution (cost sharing) agreements

Acquisition / sale of IP

4 Transfer of intangible assets 4.2 Forms of transfer

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Licensing

R&D-GmbH bears all chances and risks; provides R&D results (for example as patents) against royalty payments

R&D-GmbH (AT)

UK-Ltd.

D-GmbH

NL-B.V.

F-SA

license rights

royalty payments

4 Transfer of intangible assets 4.3 Licensing

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Possible royalty payments:

- percentage of sales (agreed in 90% of all cases)- fixed amount per pieces produced- profit-oriented- minimum (upfront) or maximum royalty- one time payment

- Combined (bundled) versus individual license- one royalty rate, e.g. 5% covers use of more

than one intangible like patent and trademark - unbundle for TP analysis


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Tax planning before conclusion of license agreement:

low taxes for royalty income? withholding taxes? range of acceptable royalty rates for specific IP alternatives, e.g. R & D cost sharing incentives or subsidies for R & D? consequences of possible income adjustments

Tax defence aspects contemporaneous documentation regular review of agreements, adjustments if necessary

Caution! Database research necessary for all royalty rates→ see transfer pricing methods


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Transfer pricing methods for royalties

Comparable uncontrolled price method (CUP, OECD Guidelines, par. 6.23)= Comparable uncontrolled transaction method (CUT, 1.482 – 4(c) US-Regs.)

• Internal CUP (CUT)- same or similar license to (or from) third party- sub-license to third party

• External CUP (CUT)- same or similar license between third parties (rarely found)- license in same/similar industry (usually database research e.g.

www.RoyaltySource.com or www.Royaltystat.com) - merchandising?- recognition of rates in other country?

Pepsi

Coca ColaCoca Cola


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Range of royalty rates for various undefined intangibles(displayed on the website of Royaltystat database)


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Transactional profit methods for Royaltiessubsidiary to traditional transaction methods (OECD Guidelines, par. 3.1)

• Transactional net margin method (TNMM)(OECD Guidelines, par. 3.26-3.56, 6.26;in US: Comparable profits method, CPM)Profit margins of comparable transactions (OECD) / enterprises (US)(functional analysis important)

- Return on sales (ROS)- Operating margin (OM)- EBIT margin- Return on operating assets (ROA)- Return on investment (ROI)

• Basic idea: profit within arm’s length range implies that royalty paid meets arm’s length standard

• Profit split method (difficult to apply)


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Contract R&D services

R&D-GmbH provides R&D services on behalf of one group company

Compensation for the contract research: costs plus profit mark-up

R&D-GmbH (AT)

UK-Ltd.

D-GmbH

NL-B.V.

F-SA

service

compensation

4 Transfer of intangible assets 4.4 Contract R&D

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Contract R&D services

Functions and Risks Principal determines scope of R&D R&D Co. performs R&D services Principal bears risk of failure Principal reimburses all cost plus profit mark-up Principal becomes owner of IP Principal bears risk of IP exploitation

Mark-up within arm‘s length range for similar R&D services (database research)

4 Transfer of intangible assets 4.4 Contract R&D

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Cost contribution (cost sharing) agreement - Pool concept(in the US: Qualified Cost Sharing Agreement)

R&D-GmbH performs R&D in collaborative interestAll costs are allocated without a profit markupAllocation key: expected proportion of benefit

UK-Ltd.

D-GmbH(D)

F-SA

costsF+E-GmbH (AT) NL-BVCost pool

pro-ratacosts

pro-ratacosts

pro-ratacosts

pro-ratacosts

4 Transfer of intangible assets 4.5 Cost shares

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Cost contribution (cost sharing) agreement (1)

Functions and Risks All parties are members of cost pool One or more members perform R&D Members share all costs according to expected benefits from resulting IP Benefit may be proportion of turnover or operating profit from products based on

IP All risks and chances are shared


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Cost contribution (cost sharing) agreement (2)

Frequent fax issues determination of R & D costs (US include employees’ vested stock options) determination of anticipated benefits and share of cost contributions exclusive rights in certain territory valuation of buy-in payments and buy-out payments US “investor model” concept: CSA participant would not invest in a CSA if

anticipant return is less that from alternative investment


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Acquisition/sale of intangibles – Valuation methods

Ascertainable business benefit= net present value of future cash flows that IP is expected to generate

Net present value of potential license fees= future sales x royalty rate x discount rate

- present value of patents; minus risk deduction- price alignment clause, if necessary

Concept of replacement = cost of replacement with an equally desirable substitute

Estimation of the invention value= acquisition price when buying from a competitor

usually inappropriate method: former R&D costs

4 Transfer of intangible assets 4.6 Acquisition / sale of IP

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Transfer of distribution

Transfer of research & development of (R & D) or intellectual property (IP)

Transfer of services

Transfer of production


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Reasons for transfer

Improvement of competitiveness

Lower costs, namely for raw materials, wages and salaries

Low tax rates, tax reliefs, accelerated depreciation

Subsidies, cash grants

Avoidance or mitigation of custom duties or trade restrictions

New additional markets

Optimisation of transfer pricing

Others


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Case 1: Removing distribution functions

Functions, risks and profit potential for Eastern Europe move from D to P German tax administration assumes transfer of IP (customer base)

→ compensation payment requested Similar tax consequences if original distributor was domiciled in other countries Similar if C-Inc. had no EU subsidiary and later sets up EU subsidiary

tax rate 38 %

C-IncCanada

D-GmbHGermany

P-z.o.oPoland

New distributor Eastern Europe

Distributor for Europe gives up Eastern Europe tax rate 19 %

Manufacturer

100 %100 %

5 Transfer of functions and risks5.1 Transfer of distribution

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Case 2: Transformation of distributor

Swiss parent converts existing German distribution subsidiary into a commission agent

Transfer of functions and risks• Sells in its own name but on account of parent• Removal of warehousing, logistic and market strategy functions• Removal of inventory, warranty, credit risk

Tax consequences • Transfer of IP, e.g. customer base, market or profit chance? unclear whether compensation payment

-- customers remain-- no benefit transfer if attraction by trademark-- possibly transfer of profit chance

• No permanent establishment• Commission fee must be at arm’s length

5 Transfer of functions and risks5.1 Transfer of distribution

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Case 3: Formation of IP administration company

C-Inc sets up Swiss IP administration and R & D company (CH-AG)

• Transfer of patents, designs, know-how, trademarks, copyright etc. to CH-AG• CH-AG invoices royalties to users of IP• CH-AG- performs future R & D

Tax consequences • Transfer of existing IP

capital gain based on market value less book value (if any)• CH-AG must charge at arm’s length royalties for acquired and future IP to

users of IP

5 Transfer of functions and risks5.2 Transfer of IP

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Case 4: Transfer of IP avoiding royalties or buy-in payments

Several group companies own IP of equal value and want to use synergies form current and future IP

Owners of IP conclude R & D cost sharing agreement (CSA) and contribute existing IP → no capital gain!

Sharing of R & D costs and use of common IP without royalty payments

Future R & D cost shares qualify as business expenses

Participants of CSA have exclusive rights for certain territories

5 Transfer of functions and risks5.2 Transfer of IP

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Case 5: C-Inc. transfers service functions, e.g. marketing research, accounting and purchasing services to Indian subsidiary

Transfer of IP?• If termination like for third party service provider → does the transfer

qualify as transfer of profit chance (goodwill) or customer base?

• yes, if total service company was transferred (capital gain based on capitalized profit expectation – DCF method)

• unclear, where only some special service functions are transferred

• providing use of individual IP to new service company, like software → royalty

Service charges after transfer• CUP or cost plus charges to recipient of services

5 Transfer of functions and risks5.3 Transfer of services

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Alternatives:

Set up of new production site (case 6)

Complete transfer of production (case 7)

Limited transfer of production to contract manufacturer (case 8)

5 Transfer of functions and risks5.4 Transfer of production

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Case 6: C-Inc. forms a new subsidiary (New Co) in Asia which – apart form existing group manufacturers - provides for new capacities or new production lines

Functions and Risks of New Co:

New Co operates as fully fledged manufacturer New Co penetrates new markets Existing production plant of C-Inc. continues business at a full capacity

No capital gain on “transfer”

Capital gain only if transfer of tangibles or intangibles No transfer of customers or other intangibles Normally royalties become due for use of patents, trademarks, know-how, etc.

which are owned by C-Inc.


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Case 7: C-Inc. transfers its (partial) production to Asian subsidiary and (partly) closes down its owns production

Transfer of full production to NewCo

• Whole business or partial business (product line)• Transfer of tangibles / intangibles• Old business (partly) closed

Capital gain on transfer

• Market value of the (partial) business• Valuation based on profit expectations (e.g. DCF method)• Possible disallowance of closing costs (e.g. severance payments to

employees and workers)

NewCo generates all future profits / Losses


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Case 8: C-Inc. transfers its production to a new subsidiary (NewCo) in Turkey which acts as Contract Manufacturer (C.M.)

Functions and risks of New Co.:

• New Co assumes limited functions and risks • Product Manager (P.C.) keeps intangibles, product development, market

risk, customers, etc. • P.M. obliged to take over all goods for an agreed price

No transfer of intangibles

If tangibles and intangibles are used by C.M., no rent or royalty necessary

Cost Plus Method applicable for transfer price


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Cost Fully fledged Manufacturer

Contract Manufacturer

Principal

Alt. 1 Alt. 2 Alt. 1 Alt. 2 Material 400 200 200Personnel 400 200 200

Other 200 100 100

Subtotal (manuf. cost) 1000 500 500

Location savings (50%) 250

Total 750

Profit mark-up 200 50 75

Sales price 1200 1200 1200

Transfer price 550 825 -550 -825

Profit 650 375

Transfer (Outsourcing) to Contract Manufacturer


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Imputed Costs and location savings

Cost Fully fledged Manufacturer

Contract Manufacturer

Principal

Alt. 1 Alt. 2 Alt. 1 Alt. 2 Material 400 200 200Personnel 400 200 200

Other 200 100 100

Subtotal (manuf. cost) 1000 500 500

Location savings (50%) 250

Imputed Costs (depreciation and interest),

Total

50

800

Profit mark-up 200 50 80

Sales price 1200 1200 1200

Transfer price 550 880 -550 -880Profit 50 380 650 320


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Dr. Gerhard Engler

Dr. Gerhard Engler

Lawyer, Tax Advisor

Partner

BDO Deutsche Warentreuhand AG International Tax Services

Grüneburgweg 10260323 Frankfurt am Main

Tel.: 069 – 95 941 - 240Fax.: 069 – 95 941 - 259

E-Mail: [email protected]

PositionPartnerHead of BDO’s German International Tax Competence Center International tax coordinator of BDO Germany

Experience and areas of specialisationGerhard Engler has over 25 years of practical tax consulting experience for medium-sized and big multinational clients, particularly in the area of international taxation. His area of specialization is in tax planning and consultancy for restructuring of international companies, particularly with respect to transfer pricing, corporate mergers and acquisitions. He is a frequent speaker in transfer pricing seminars and co-author of the leading German transfer pricing commentary “Handbuch der Verrechnungspreise” published by C.H. Beck-Verlag.Gerhard Engler became attorney-at-law in 1978 and tax consultant in 1983.He joined BDO in 1996, after several years of working as a consultant for Big Four accounting firms and in a multinational corporation.

EducationStudied law at the University of Frankfurt am Main; Doctor of Laws.

Professional AffiliationsMember of Frankfurt Chamber of Lawyers (Rechtsanwaltskammer Frankfurt)Member of Hessen Chamber of Tax Consultants (Steuerberaterkammer Hessen)

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