Transfer Pricing - International Tax Revie in association with: Deloitte Korea Gowling WLG Fenwick &...

Published in association with:

Deloitte KoreaGowling WLGFenwick & WestTax Partner AG – Taxand Switzerland

T A X R E F E R E N C E L I B R A R Y N O 1 0 8

Transfer Pricing 18th edition

W W W . I N T E R N A T I O N A L T A X R E V I E W . C O M 1

03 CanadaIP migration strategies – pre and post BEPSBEPS aims to prevent aggressive profit-shifting strategies to better align transfer pricing outcomeswith value creation. In this paper, Dale Hill, a partner at Gowling WLG, examines BEPS’s appli-cation to the transfer pricing aspects of intangibles and the impact on tax-motivated IP migrationstrategies.

10 South KoreaThere is more to BEPS than meets the eyeMuch lies beneath the surface of BEPS. How will BEPS affect Korean multinationals and what doMNEs need to learn? Tae Hyung Kim, partner and senior transfer pricing economist at DeloitteKorea, explains exactly what multinationals must consider and what they should fear.

14 SwitzerlandIntangibles in a post BEPS worldThe framework for analysing intercompany transactions involving intangibles is examined byHendrik Blankenstein and Caterina Colling Russo at Tax Partner AG – Taxand Switzerland.Does the new DEMPE analysis benefit MNEs and tax authorities or simply confuse matters, result-ing in an increase of intangibles-related disputes?

19 USResponding to the changes in the transfer pricing landscapeThe Internal Revenue Service appears to be strengthening its stand on aggregating transactions andapplying economic substance rationales to override related-party contracts. David Forst and LarissaNeumann of Fenwick & West discuss US developments including the IRS and TreasuryDepartment-issued 482 Temporary Regulations.

Transfer Pricing

E D I T O R I A L

2 W W W . I N T E R N A T I O N A L T A X R E V I E W . C O M

8 Bouverie StreetLondon EC4Y 8AX UKTel: +44 20 7779 8308Fax: +44 20 7779 8500

Managing editor, TPWeek.com Caroline [email protected]

Reporter, TPWeek.com Joelle [email protected]

Managing editor Ralph [email protected]

Reporter Joe [email protected]

Reporter Amelia [email protected]

Production editor João [email protected]

Publisher Oliver [email protected]

Associate publisher Andrew [email protected]

Online associate publisher Megan [email protected]

Senior marketing executive Sophie [email protected]

Graduate marketing trainee Anna [email protected]

Subscriptions manager Nick [email protected]

Divisional director Greg Kilminster

© Euromoney Trading Limited, 2016. The copyright of all editorialmatter appearing in this Review is reserved by the publisher. No matter contained herein may be reproduced, duplicated orcopied by any means without the prior consent of the holder of thecopyright, requests for which should be addressed to the publisher.Although Euromoney Trading Limited has made every effort toensure the accuracy of this publication, neither it nor anycontributor can accept any legal responsibility whatsoever forconsequences that may arise from errors or omissions, or anyopinions or advice given. This publication is not a substitute forprofessional advice on specific transactions.

Directors John Botts (Chairman), Andrew Rashbass (CEO),Sir Patrick Sergeant, The Viscount Rothermere, Colin Jones,Martin Morgan, David Pritchard, Andrew Ballingal, Tristan Hillgarth

International Tax Review is published 10 times a year by EuromoneyTrading Limited.

This publication is not included in the CLA license.

Copying without permission of the publisher is prohibitedISSN 0958-7594

Customer services:+44 20 7779 8610

UK subscription hotline:+44 20 7779 8999

US subscription hotline:+1 800 437 9997

T he boldest initiative in transfer pricing history entered the home-stretch in October 2015 with the release of the OECD’s final reporton its base erosion and profit shifting (BEPS) project. The reverbera-

tions are being felt across North America, Europe, Asia and beyond. Multinational enterprises will soon need to provide tax authorities with

details of almost every facet of their business through the master file, localfile and country-by-country reports: key profit drivers, global value chains,transfer pricing policies for major services and intangibles, MNE financialstatements, and more. Is there any doubt about who has the upper hand:taxpayers or tax authorities?

The objective of the OECD’s plan is clear: combat aggressive profit-shifting strategies. BEPS was designed to ensure MNEs reveal profits injurisdictions based on assets, risks and actual functions. It is unsurprisingthen, that BEPS is shaking up countries and companies.

While tax officials and legislators worldwide are moving quickly, manycompanies are moving cautiously. Some are concerned about how author-ities will handle tax data. Others worry about confidentiality breaches orthe risk of audits and double taxation But a sense of urgency is needed,otherwise, MNEs risk penalties, reputational risks and additional taxes.

In his candid assessment of the tension between taxpayers and taxauthorities, Tae Hyung Kim, a partner at Deloitte Korea, explains whatmultinationals must consider and what they should fear.

Hendrik Blankenstein and Caterina Colling Russo of Tax Partner AG– Taxand Switzerland examine whether the newly introduced DEMPEanalysis benefits MNEs and tax authorities, or whether it will just con-fuse matters and result in an increase of intangibles-related transfer pric-ing disputes.

Dale Hill, a partner at Gowling WLG in Canada, considers the applica-tion of BEPS guidelines to the transfer pricing aspects of intangibles andthe impact on tax-motivated IP migration strategies. His insightful analysisencompasses both pre- and post-BEPS strategies.

Finally, questions remain about how much change the US is preparedto implement, but the OECD’s recommendations are without doubt hav-ing an impact. David Forst and Larissa Neumann of Fenwick & West dis-cuss US developments including the IRS and Treasury Department-issued482 temporary regulations.

Caroline ByrneManaging editor, TPWeek.com

BEPS:The endgame

C A N A D A


IP migration strategies –pre-and post-BEPS

BEPS aims to preventaggressive profit-shifting strategies tobetter align transferpricing outcomes withvalue creation. In thispaper, Dale Hill, apartner at GowlingWLG, examinesBEPS’s application tothe transfer pricingaspects of intangiblesand the impact on tax-motivated IP migrationstrategies.

T he largest initiative the transfer pricing world has seen, since the intro-duction of the Organisation for Economic Cooperation andDevelopment’s (OECD) Transfer Pricing Guidelines for

Multinational Enterprises and Tax Administrations (Current TPGuidelines), is in its final stages and will result in material changes in theway the global operations of corporate organisations are structured andinternational transactions are reported. On October 5 2015, the OECD released the final report of its 15-point

Action Plan on Base Erosion and Profit Shifting (BEPS). The BEPS ActionPlan was an ambitious project that addressed a number of concerns relatingto international corporate tax planning. Actions 8 to 10 and Action 13 dealspecifically with transfer pricing concerns and, in addition to the introduc-tion of Country-by-Country Reporting (CBCR), contain significantrevised guidance in the form of amendments to the Current TP Guidelines(Amended TP Guidelines). In brief, the OECD’s BEPS initiative, as it pertains to transfer pricing,

attempts to prevent aggressive profit-shifting strategies by amending theCurrent TP Guidelines to better align transfer pricing outcomes with valuecreation. This is accomplished by placing more emphasis on the allocationof profits to the jurisdiction where substantive functions are performed,including the control functions related to risks assumed and capitalemployed. The Amended TP Guidelines, intended to be clarifying innature and not a departure from the arm’s length principle as enshrined inthe Current TP Guidelines, now provide the tools and support the CanadaRevenue Agency (CRA), and presumably other tax administrations, needto successfully challenge tax-motivated transfer pricing strategies wheresubstantive people functions are not transferred with the intangible prop-erty (IP).This paper examines the OECD BEPS initiative as it applies to the

transfer pricing aspects of intangibles and the impact on tax-motivated IPmigration strategies. It is widely recognised that the primary objective ofan MNE is to maximise profits and, as such, MNEs are constantly evaluat-ing their international operations in an effort to maximise revenues andminimise costs, including tax expenses. Historically, where the commercialopportunity existed, companies often adopted IP migration transfer pric-ing strategies that allocated significant profits to lower-tax jurisdictions. Inthe most extreme cases, no or minimal functionality (i.e. no employees)was transferred with the IP (e.g. cash box companies). Many of thesestrategies, and the tax savings that arose from them, whether rightfully or

C A N A D A


wrongfully, were thought to be legally effective and in linewith the arm’s length principle as described in the Current TPGuidelines. Such tax-motivated IP migration cases have oftencome under careful scrutiny by tax administrations.Notwithstanding such scrutiny, there was a lack of clear guid-ance and policy application by the CRA’s Audit Division,Appeals Directorate and Competent Authority. In many casesthe CRA accepted these structures as they were generallythought to be tax efficient and in line with the arm’s lengthprinciple regardless that significant profits were allocated tothat lower tax jurisdiction. This is about to change

BEPS changes to current TP guidelines in respect tointangibles The OECD’s BEPS Action Plan was an enormous undertak-ing covering many areas of international tax and only time willtell what the collective impact will be as a consequence of allthe final report recommendations. However, what is widelyagreed upon in the international tax community is that themost immediate, and likely most significant, impact from theBEPS project will be in the world of transfer pricing. The newCbCR and the Amended TP Guidelines are reality and arehere to stay.The OECD’s work related to transfer pricing under the

BEPS Action Plan focused on three key areas. Action 8looked at transfer pricing issues related to transactions involv-ing intangibles, Action 9 considered the contractual alloca-tion of risks and the resulting allocation of profits to thoserisks, and Action 10 focused on other high-risk areas includ-ing the possibility of re-characterisations where transactionswere not commercially rational. The Amended TP Guidelinesarising as a consequence of the OECD’s work on Actions 8 to10 are significant and amend several chapters and sections ofthe Current TP Guidelines. The following is a brief summaryof the new guidance dealing with intangibles: • Legal ownership of intangibles by an associated enterprisealone does not determine entitlement to returns from theexploitation of intangibles;

• Associated enterprises performing important value-creat-ing functions related to the development, enhancement,maintenance, protection and exploitation (DEMPE) of theintangibles can expect appropriate remuneration;

• An associated enterprise assuming risk in relation to theDEMPE of the intangibles must exercise control over therisks and have the financial capacity to assume the risksincluding the very specific and meaningful control require-ment;

• Entitlement of any member of the MNE group to profit orloss relating to differences between actual and expectedprofits will depend on which entity or entities assume(s)the risks that caused these differences and whether theentity or entities are performing the important functions inrelation to the DEMPE of the intangibles;

• An associated enterprise providing funding and assumingthe related financial risks, but not performing any func-tions relating to the intangible, could generally only expecta risk-adjusted return on its funding; and

• If the associated enterprise providing funding does notexercise control over the financial risks associated with thefunding, then it is entitled to no more than a risk-freereturn.

An example of the new approachTo see how the allocation of profits from IP transfers differbetween a pre- and post-BEPS world, consider example 17from the Amended TP Guidelines. In the example, the fol-lowing facts/assumptions are assumed: 1. Parent is a large pharmaceutical company.2. Parent conducts its operations in country X.3. Parent regularly retains independent (unrelated) contract

research organisations (CROs) for research and develop-ment (R&D) activities, including designing and conduct-ing clinical trials.

4. CROs are not engaged in the blue sky research to identifynew compounds.

5. When retained, Parent actively participates with CROengaged in clinical research activities.

6. CROs are paid a negotiated fee for services and do nothave an ongoing interest in the profits.

7. Parent transfers patents related to Product to Subsidiaryoperating in country Y.

8. Product is early stage pharmaceutical drug (high risk, lowprobability of commercialisation).

9. Payment based on anticipated future cash flows – expect-ed cash flow discounted by appropriate discount rate.

10. Subsidiary has no technical personnel for ongoingresearch activities.

11. Subsidiary contracts with Parent to carry out researchrelated to Product.

12. Subsidiary funds all Product research, assumes risk, andpays Parent based on cost plus margins earned by similarCROs.The fact pattern given above is the classic example of an

early stage pharmaceutical company wanting to realise futureprofits in a low-tax jurisdiction. In the pre-BEPS world, a sig-nificant portion of the profits would have moved to countryY. It was generally recognised that given the Subsidiary wasthe legal owner, it was entitled to any excess profit or loss afterpaying routine amounts for the R&D activities, even wherethe important value-creating functions of the IP did not takeplace in the Subsidiary’s country. The transfer of the IP wouldhave been done at a low value (although arm’s length) as theprospects of successful commercialisation were very uncertainat the time of the transfer. In regards to future developmentof the intangible property, Parent, as a service provider, wouldhave been entitled to a cost plus mark-up on costs incurred.

C A N A D A


In a post-BEPS world, less emphasis is placed on legalownership and more on economic aspects of substance. Inthe example above, Parent controls functions and managespatent risks owned by Subsidiary and is entitled to compen-sation. The Amended TP Guidelines, including the analysisto example 17, will support that Parent’s compensation isnot appropriately recognised by the profits earned by aCRO. Parent’s transactions with CROs are not comparableto the Subsidiary/Parent arrangement given that the func-tional profiles differ, i.e. parent is in control of function andis the more appropriate party to assume the risks of successor failure. While Subsidiary legally owns the patents it lacksthe capability to control research risks while Parent per-forms key decision making functions and thus should beappropriately compensated. Clearly there has been a fundamental shift in the way we

look at the division of profits due to the introduction ofBEPS. In a pre-BEPS environment, Subsidiary would be bet-ter able to keep profits given it legally owned the intangiblesand paid arm’s length prices for development functions.Post-BEPS, it is clear this will change with an emphasis onfunctions, including control of those functions and risks.

Moving intangible property offshore in a transfer pricingsetting – pre-BEPS & post-BEPSIntangibles are becoming an increasingly valuable componentof a company’s value. Intangibles often account for a largerstake in an enterprise’s value than traditional tangible assets.When you factor in the mobility of these assets, it is not a sur-prise that IP migration strategies have frequently been reliedupon to move profit-generating assets to lower tax jurisdic-tions. However, there are other legitimate reasons for migrat-ing intangibles, including: • Protection of intangible property• Capital funding• Sharing in intangible development risks• Tax credit issuesFrom a tax perspective, during both the pre-BEPS and

post-BEPS era, moving IP from one jurisdiction to another,including lower tax jurisdictions, can be justified and legallytax effective if the corresponding functions, assets and risksare moved with the IP. Historically, the legal owner took all,or a material portion of, the residual profits after routine prof-its were paid to entities that performed functions related tothe DEMPE of the intangibles and the management of therisk. In the post-BEPS environment however, a shift hasoccurred in that people functions, particularly controllingfunctions related to the DEMPE of the intangibles and con-trolling functions regarding the assumption and mitigation ofrisk, have far greater value than legal ownership, direct fund-ing and contractual assumption of risk. The old transfer pricing adage of “functions, assets and

risk” is now misleading as functionality seems to be highly

Dale HillPartner, Tax Services – National Leader,Transfer Pricing & Competent AuthorityGroupGowling WLG

Office: +1 (613) 786 0102Fax: +1 (613) 788 [email protected]

Dale Hill is a partner in Gowling WLG’s Ottawa office and is thenational leader of the Gowling WLG’s Transfer Pricing andCompetent Authority team. Dale works in conjunction with thefirm’s national tax practice group to help organisations optimisetheir global tax position and reduce exposure to unfavourableaudit assessments through proper tax planning and implementa-tion strategies. Dale’s specialty is audit defence and dispute res-olution with many countries around the world.

In addition to Dale’s audit defence work, he also oversees thegroup’s transfer pricing documentation and Advanced PricingAgreement (APA) practice and is actively involved in providing liti-gation advice to the firm clients from a tax perspective. Dale hasworked in a variety of industries including, but not limited to,pharmaceuticals, auto, construction, consumer durables andcomputer software industries.

Dale’s ability to solve contentious issues stems from his vastexperience working at the Canada Revenue Agency (CRA) at asenior level. Prior to joining Gowling WLG in 2005, Dale wasinvolved in international transfer pricing and tax avoidance withthe CRA for 16 years. During his tenure as a senior manager withthe CRA’s International Tax Directorate, he participated in morethan 40 APAs with numerous countries, as well as hundreds ofCompetent Authority requests relating to international transferpricing adjustments involving a vast array of issues. He is alsoexperienced in a number of other international tax areas, includ-ing interest deductibility, guarantee fees, imputed interest, notion-al expenses, penalties and appeals. Dale has been successful inresolving a number of controversial audit issues through negotia-tions with various tax authorities in a number of countriesaround the world.

Dale’s expertise has been recognised many times by variousinstitutions. In particular, his group was awarded with CanadaTransfer Pricing Firm of the year award by International TaxReview for the years 2011, 2013, and 2015. He acquired his CPAand CFP designations in 1991 and 1995, respectively, and com-pleted the CICA in-depth tax course in 1999.

C A N A D A


relevant in all three of those factors. In other words, if transferpricing is supposed to be based on economic reality, does eco-nomic reality support allocation of residual profits to purelyfunctions (e.g. labor) rather than ownership (e.g. capital)?This is one of the main reasons there is debate in the interna-tional tax community, and particularly in the Canadian taxcommunity, regarding whether the Amended TP Guidelinesare clarifying in nature or whether they constitute a funda-mental change to the arm’s length principle. Unfortunately,this debate is a moot point because the opinion of the OECDand tax administrations, which ultimately prevails over that ofthe taxpayer, is that the revised guidelines are clarifying innature and not a fundamental departure from the arm’slength principle. The CRA has confirmed its view that therevisions are clarifying in nature. In the post-BEPS world, if tax-motivated IP migration

strategies are to be carried out in an acceptable manner, it isimperative that substantive functions be transferred with theintangibles. From the OECD’s perspective, its BEPS initiativesuccessfully eliminates the tax benefits behind cash box compa-nies and other structures that were pushing the envelope withrespect to lack of functionality in the lower tax jurisdiction.

Rectifying pre-BEPS structures that are inconsistent with theamended TP guidelinesMany enterprises are concerned about how taxing authorities,such as the CRA, will treat existing tax structures involving IPmigration that were created before BEPS. As mentionedabove, the Amended TP Guidelines are considered by theOECD and the CRA to be clarifying in nature and are, for allintent and purpose, retroactive in effect. If taxpayers believethat their existing structures are not consistent with theAmended TP Guidelines and make no attempt to rectifythem, they run the risk of being exposed to transfer pricingadjustments should they be audited by the CRA. In the eventtaxpayers decide to rectify the situation on a prospective basisonly (e.g. by amending their transfer pricing documentationto reflect the Amended TP Guidelines for future years), thiscould red flag problems and deficiencies to the CRA withrespect to their filed taxation years. To date, the CRA hasn’t made public statements regard-

ing possible relief for taxpayers trying to rectify existing IPmigration structures that have been reported in a mannerthat is inconsistent with the Amended TP Guidelines. Inthe author’s view, this silence, or lack of concern, is unfor-tunate considering the significance of the changes whichare, arguably, beyond clarifying in nature. What is moretroublesome is the CRA’s position that these changes areclarifying in nature and retroactive in effect despite havingagreed to countless audit, appeal and mutual agreementsettlements over the years on IP migration structures, sup-posedly on a “principled” analysis of the arm’s length prin-ciple, in a manner that is not consistent with the Amended

TP Guidelines. In other words, tax administrations haveroutinely settled transfer pricing cases in a manner that isnot consistent with the Amended TP Guidelines and haveallowed varying degrees of profits to be reported in lower-tax jurisdictions where little functionality has taken place. In the absence of guidance from the CRA on this matter,

taxpayers should proceed with caution before deciding on arectification strategy. Canadian taxpayers can file amendedtax returns for those open taxation years where theirreported transfer prices are inconsistent with the AmendedTP Guidelines. However, if the taxpayer’s pending upwardtransfer pricing adjustments for filed taxation years are sig-nificant and subject to possible penalties, taxpayers mayconsider the CRA’s voluntary disclosure program (VDP).The CRA has little experience in its VDP with respect totransfer pricing cases and the waiver of transfer pricingpenalties, so there is some uncertainty in this avenue ofrecourse. Also, Canada’s VDP has stringent conditions foreligibility that often prohibit taxpayers from applying, par-ticularly those taxpayers who are under constant auditactivity by CRA. Taxpayers could also consider applying foran Advanced Pricing Agreement (APA) which assists tax-payers in determining transfer pricing methodologies forprospective years (generally three to five years). One of thebenefits of the CRA’s APA program is the ability for taxpay-ers to ask to apply the terms and conditions of an APAretroactively to non-statute-barred taxation years (i.e., anAPA rollback). Where APA rollbacks are accepted, the tax-payer will not be subject to transfer pricing penalties.Taxpayers would be well advised to seek tax counsel

before deciding on first, whether self-rectification of unau-dited filed years is advisable and, if so, what specific courseof action to take.

Post-BEPS – is there now more uncertainty?As a consequence of the BEPS project and the resultingAmended TP Guidelines, profits must be aligned with thelocation of value creation. There is no ambiguity in theOECD’s message to the tax community on this issue.However, the guidance from the OECD, including exam-ple 17, does not provide much in the way of how the actualintercompany transfer prices should be documented. In atypical IP migration strategy, there is often only two inter-company transactions taking place: i) the initial transfer ofthe IP to the subsidiary located in the lower tax jurisdic-tion; and ii) the intercompany R&D service contract. Thefinal sale of the IP or the ultimate exploitation of the IP bythe foreign subsidiary will be done with arm’s length par-ties (i.e. customers). In the event the CRA decides not torecharacterise the transaction, the first intercompany trans-action will simply involve valuation issues. With regards tothe second intercompany transaction, the OECD expectsfuture revenues to be properly allocated to the parent

C A N A D A


company for its efforts in contributing to the value of theIP. However, in the absence of guidance from the OECDand tax administrations on how this should be document-ed, taxpayers are left in the dark.From a practical point of view, profits should be set such

that the simpler of the two parties be given a routine returnwhile the more complex party receives the residualprofits/losses if such profits materialise. The profits attrib-utable to each party will depend on the functions per-formed, assets utilised, and risks assumed by each party. Ifthe subsidiary is simply the holder of IP with no correspon-ding functions, it may only be entitled to an unadjustedreturn on capital. If the subsidiary performs routine func-tions in addition to holding the IP, a risk adjustment returnon capital may be warranted. The decision to allocate excess profits/losses to the par-

ent may cause audit controversy for a number of reasons. Itis the author’s experience that governments are risk averseand want to see some level of compensation in the immedi-ate term even though they may only be entitled to largeratypical profits or losses when the intangibles are fullyutilised. Consider the possibility that, in the example above,the IP generated large losses in the initial post transferyears. Will the CRA allow the parent company, performingand controlling key functions and risks, to report the losseseven though it did not own the IP and is simply a serviceprovider according to the intercompany R&D service con-tract? It’s doubtful. Tax authorities such as the CRA may have difficulty

accepting that a service provider should not receive at leasta cost plus mark-up on services it renders (in addition tosome share of the profits if they materialise). It is very likelythat setting intercompany pricing on an intercompany serv-ice agreement such that the parent company serviceprovider incurs losses will trigger an audit. The guidance, inour view, does not shed sufficient light on the mechanics ofprofit allocation and seems to add more confusion to analready uncertain landscape. Example 17 of the AmendedTP Guidelines is a common IP migration structure but it ishighly likely that the annual reporting of the service con-tract during the start-up years where no profits are beingrealised will be treated differently between taxpayers andtax administrations until further guidance is developed. The Amended TP Guidelines will likely result in fewer

companies carrying out IP migration strategies, which wasone of the unwritten goals of the BEPS initiative.Consequently, the OECD and tax authorities may not beoverly concerned about its lack of guidance on reportingissues during the start-up years where the legal ownership ofIP was in fact transferred offshore. This is unfortunatebecause some IP migration strategies involving low-tax juris-dictions may still be carried out, regardless of the AmendedTP Guidelines, without the initial movement of functions.

This could, for example, be an acceptable strategy where astart-up company wants to keep its options open (e.g. relo-cate the appropriate DEMPE functions to the jurisdictionthat holds legal title of the intangibles) once it has a betteridea of the potential value and income earning capacity of theintangible. Even though the Amended TP Guidelines willneed to be considered regarding the lack of functionality inthe low tax jurisdiction in that initial start-up period, therecould be future departure tax savings by transferring owner-ship of the intangibles at the earliest stage possible.

ConclusionsThe BEPS initiative was designed to ensure multinationalcorporations report profits in jurisdictions based on actualfunctions, assets and risks and to combat aggressive taxplanning structures. The new guidance moves away fromplacing significant emphasis on legal ownership andtowards economic substance and control. The introductionof the Amended TP Guidelines will provide taxing author-ities, such as the CRA, more tools to raise and supporttransfer pricing adjustments. Consequently, taxpayers mustbe aware of this new guidance before carryout out any IPmigration planning.From a Canadian perspective, an unfortunate aspect of the

BEPS project is the lack of guidance provided by CRA withrespect to these new guidelines. In the author’s opinion, nowthat the CRA has endorsed these changes as clarifying innature, having both retroactive and prospective effect, it isinappropriate for the CRA to remain silent on self-rectifica-tion and contemporaneous documentation issues. The jurisprudence is clear that legal form prevails in

Canadian transfer pricing cases. The Supreme Court ofCanada has on many occasions addressed the doctrine ofeconomic substance and significantly limited the CRA’sability to ignore the facts and circumstances, and substituteeconomic fiction. Two recent transfer pricing cases heard by the Tax Court

of Canada (TCC) also comment on the CRA’s discretion tosubstitute legal reality with economic theory. In McKesson(2013 TCC 404)), the TCC concluded that the CRA canonly recharacterise the legal reality under paragraph247(2)(b), a special GAAR-like anti-avoidance rule in theCanadian taxing statute. In the absence of a reassessmentunder this recharacterisation provision, “[a] reassessmentunder [paragraphs] 247(2)(a) and (c) does not permit arecharacterisation of the transactions entered into by non-arm’s length parties, nor can another different transactionentirely be substituted therefore.” In Marzen (2014 TCC194), the TCC agreed with the respondent’s reference tothe Current TP Guidelines in support of respecting legalreality which states “[a] tax administration’s examination ofa controlled transaction ordinarily should be based on thetransaction actually undertaken by the associated enterprises

C A N A D A


as it has been structured by them.” Both these transfer pric-ing cases are consistent with the earlier Supreme Court ofCanada decisions concerning the appropriate use of the doc-trine of economic substance. With Canada’s tax system having such a strong emphasis

on legal form, one might question how a Canadian courtwould view a transfer pricing adjustment made by the CRAto an R&D service contract as per example 17 above, onceCRA has chosen not to recharacterise any of the transac-tions. That is, the OECD’s approach under its AmendedTP Guidelines is to reward the company that forms the

value creating function while ignoring the traditional entre-preneurial principle of rewarding legal ownership with all orat least a portion of residual profits. In other words, theOECD seems to want to treat the company that contributesto the value creation of the IP as the beneficial owner of theIP in cases where they do not feel they have the grounds torecharacterise the transaction. However, issues will arise inthe absence of further guidance on how to properly docu-ment these transactions in those early years where no rev-enues are generated. It will be interesting to see how thesecases will play out in a Canadian court.

S O U T H K O R E A

1 0 W W W . I N T E R N A T I O N A L T A X R E V I E W . C O M

There is more to BEPS thanmeets the eye

Much lies beneath thesurface of BEPS. Howwill BEPS affect Koreanmultinationals and whatdo MNEs need tolearn? Tae Hyung Kim,partner and seniortransfer pricingeconomist at DeloitteKorea, explains exactlywhat multinationalsmust consider and whatthey should fear.

T he Korean National Tax Service (NTS) and the Ministry of Strategyand Finance are gearing up for what’s ahead with BEPS. They aremoving slowly but surely.

The ministry provides the specific guidance for master files and localfiles. The details are stipulated in the Law for Coordination ofInternational Tax Affairs (LCITA) as Enforcement Decree (ED). Theguidance specifies who should submit what and when. In essence, what isstipulated in the ED is literally the same as the Korean translation ofOECD Action 13 Annexes I and II. The LCITA-ED provides Korean tem-plates for the master file (MF) and local file (LF). In both templates, theED itemises each information category and all specific items under eachcategory in Annexes I and II in Korean. Country-by-country reportingrequirements will be put in place certainly, not in fiscal 2016 but in fiscal2017. That’s all that is planned so far for this year.

On the tax administration side, the NTS is moving rather quickly on theresource side. The NTS acknowledges that sufficient resources are neces-sary to perform risk assessments with the files and the information con-tained in the files. The NTS plan to pool the right resources and train themto perform risk assessments. Most of all, the author would like to see theNTS bring in economics professionals to provide the necessary training tothe NTS examiners. The NTS has not recruited nor employed an econo-mist since the inception of the LCITA in 1996, as far as the author isaware.

Overall, the NTS and the ministry have been reactive in paying atten-tion and responding to base erosion and profit shifting (BEPS). They havefollowed developments at the OECD and monitored developments andnews in other jurisdictions around the globe, but until recently there hasnot been much discussion between the government (both the NTS and theministry) and taxpayers. The practitioners have been rather active in com-parison, holding public seminars to discuss and disseminate the OECDfinal deliverables on actions.

In this article, the author intends to focus on what is below the surfaceof BEPS. What does BEPS really mean to Korean MNEs? What do KoreanMNEs in particular need to think about? Why should the top managementcare about BEPS? What’s next?

BEPS is a whole new ball gameThere is little doubt that the tax authorities will have the upper hand withimportant data and information at their fingertips. It was a different story

S O U T H K O R E A

W W W . I N T E R N A T I O N A L T A X R E V I E W . C O M 1 1

in the past. Under the new rules, the information required inthe master file (MF), local file (LF), and country-by-countryreports (CbCR) will cover almost every aspect of an MNE’sbusiness: global value chains and key profit drivers, a list of allintangibles, the way the group is financed, transfer pricingpolicies for major products, services, intangibles, and financialarrangements, ties between the financial data used in transferpricing methods and the MNE’s financial statements, and soon. The list goes on. The tax authorities can request evenmore focused details on the information already supplied tothe extent that it is needed.

A few points are worth mentioning here. The objectivesare clear with transfer pricing documentation in Action 13.What they really mean to MNEs is less clear. The focused andspecific information required under the MF and LF will behanded over to the tax authorities before an audit. And theexact same information will be available to all relevant taxauthorities at the same time.

The author would like to emphasise that a great deal offocused and specific information will be in the hands of taxauthorities. What is clearly different with BEPS is that thetime frame for handing over all of this information to the taxauthorities will be before an audit. The availability of theinformation to the tax authorities changes who’s calling theshots in the ball game. Even before the ball game begins,information will be fully analysed to assess risks for the audit.MNEs should not miss the fact that tax authorities will haveplenty of time. Not a few weeks or months but even a fewyears to the extent that the statute of limitation allows. Putsimply, it is enough time. Not to mention fast-changing dataanalytics technology available everywhere. The informationcan be sliced, diced, and drilled down on to the very bottomof the issue quickly. This is new under the sun. Tax authoritieswill try to put all available resources to full use before they pindown the objects. In addition, MNEs should always remem-ber that the exact same information will be available to virtu-ally all relevant tax authorities at the same time. How will thetax authorities in different jurisdictions respond? What canMNEs do about it?

Prepare for unilateral actionsMNEs may wish that they had a crystal ball. It will not be easyto predict the future. The author’s view is that the exact sameinformation is more likely to be interpreted differently by dif-ferent tax authorities across continents. The differences couldbe a result of various factors: different kinds of priorities andinterests, different ways of approaching issues and resolvingmatters, different educational backgrounds, different levels ofexperiences, different levels of understanding of the informa-tion, and so on. As a result, they could view and respond dif-ferently. All this could contribute to unilateral actions by eachtax authority. The author expects a significant number oflengthy battles between tax authorities and MNEs and also

among competent authorities. In particular, MNEs shouldkeep this point in mind and take it into consideration whenthey engage in disputes with the tax authorities.

Consistency should top the priority listInconsistency matters. MNEs need to pay particular attentionto transfer pricing methods and polices over the past years. Ofcourse, this is the case to the extent that the years fall withinthe statute of limitation. The information contained in theMF, LF, and CbCR can be analysed to assess risks in the pastyears. If proper documentation is not in place for the pastyears, the information provided in the MF, LF, and CbCR forthe fiscal year 2016 could provide benchmark information forthose years. The MNEs should expect that the tax authorities,and in particular the NTS, can always confront the MNEswith any inconsistency that exists between the past years andthe present year. It is worth double checking whether propertransfer pricing policies were coordinated centrally by theheadquarters of the MNEs in the past.

Tax authorities lack and need proper training ineconomicsA great deal of important information will be at the NTS’sfingertips. The NTS will slice and dice the information tomake risk assessments and to determine whether an audit isnecessary. The author expects that tax authorities will contin-ue to make investments in human resources. The resourceswill be put in place to educate and train tax examiners and getthem ready before the rubber hits the road. The authordoubts, however, that the NTS will bring in economics pro-fessionals to train them. That’s what might worry MNEs.Most of the NTS examiners do not have the appropriate levelof capabilities needed in performing economic analysis. TheNTS does not have economists and lacks training in econom-ics and therefore relevant skills. Value creation and profit allo-cation is all about economics from the start and also at theend of the day. Until the tax authorities are equipped with theright analytical capabilities, it will pay off if the MNEs areready to go the extra miles to educate the tax authorities.

MNEs need to reset the mindsetMNEs vary in terms of the depth and breadth of experience,understanding, and skills they have in BEPS-related issues andmatters. In other words, there are MNEs that fully under-stand how BEPS will change the landscape of the global play-ground and know what to do about it. There are MNEs thatdo not have any idea about what it really means to them at all.Advice and recommendations about what the MNEs need todo should vary accordingly as well.

When cost concerns come first, it is hard to manage trans-fer pricing policies. Getting the job done properly is a chal-lenge. For example, to most Korean MNEs, and also for manyother non-Korean MNEs, minimising compliance costs tops

S O U T H K O R E A


the priority list most of time. That mindset is more likely toresult in poorly prepared, low quality documentation. Tothem, BEPS means just another cost or more costs. Theauthor’s view is that they fail to see the woods for the trees.As a result, they don’t have a serious game plan.

The number one challenge, therefore, is to change themindset. Top management at the headquarters of MNEsmust understand BEPS in great detail and what it means tothem. They must know what MNEs need to do. MNEs arerequired to disclose a lot of information that is sensitive andconfidential. For example, they need to describe the overallR&D strategy including ownership and exploitation of intan-gibles, location of principle R&D facilities, and location ofsuch management and provide a list of intangibles transferredcross-border between related parties and a list of importantagreements, and so on. It is not a choice. It is a must.

To the author’s mind, the people at the top management ofmost of the Korean MNEs need a wake-up call. Tax managersand executives should make sure that the top management isfully aware of what is required in BEPS. The level of detail forthe information that needs to be disclosed should be managedproperly in a professional manner. For that to happen, the topmanagement must understand the depth and breadth of thedetails in the information required. Based on prudent businessjudgment, the top management should be able to determinethe appropriate level of detail for the information that needs tobe disclosed. This is one of the most important processes inpreparing for BEPS challenges going forward.

Action 13 emphasises that the disclosed information willbe used only for tax risk assessment and audit purposes. Taxadministrations in all jurisdictions will do the job to protectthe confidentiality from their end. However; the level of legalprotection in each jurisdiction will vary depending on locallaws and enforcement efforts. It will be wise for MNEs tomake every effort to ensure that that remains the case. It isprudent for MNEs to monitor such efforts being madearound the globe. Again, remember that all confidential infor-mation will be accessed and analysed by virtually all relevanttax authorities at the end of the day.

Time to move with a sense of urgencyThere is a prevailing perception in Korea that what MNEs arepaying as taxes is not fair. Nowadays, this perception mayapply to other jurisdictions as well. Whenever there is newsabout tax matters of MNEs, it is bad news. Bad news grabspublic attention quickly. It makes a big impact but in a badway. That is why Korean MNEs should worry about BEPS

and pay attention immediately. The MNEs need to put inplace a strong team capable of handling all aspects of potentialrisks from all angles. This requires new thinking about thepeople with the right skill sets with global experiences.

It is no use locking the stable door after the horse has bolt-ed. If BEPS is not managed properly, there will be the devilto pay. Above all, it could do serious harm to brand and rep-utation, not to mention operations and businesses. Social net-works convey news in the wink of an eye. In particular, badnews travels fast. It is a big deal.

A sense of urgency is needed. There are a few must-dos forKorean MNEs. First and foremost, top management andmanagement executives should grasp the gravity of BEPS assoon as possible. They also need to instill the sense of urgencyin employees to win their buy-in as well. Under the new rulesof the international tax game, noncompliance penalties, addi-tional taxes, reputational risks, and loss of value-enhancing,tax-saving opportunities won’t come in a small package.Being wise after the fact is not wise after all.

Tae Hyung KimPartner & EconomistDeloitte Anjin LLC

Tel: +82 2 6676 [email protected] www.deloitteanjin.co.kr

Tae Hyung Kim is a senior partner and an economist at DeloitteKorea. Kim has represented and advised multinational corporationsin various industries on their global transfer pricing and supplychain management strategies for more than 19 years. In doing so,he has handled and resolved complex transfer pricing disputesand negotiations with both Korean and foreign tax authorities.

Kim has been recognised as a world leading transfer pricingadviser by Euromoney’s Legal Media Group and also as a leaderin tax controversy in Korea by International Tax Review. As acountry panellist, he has been a regular contributor to BNABloomberg’s international transfer pricing forum.

He holds a Ph.D. in economics from the University ofWashington and is also a graduate of the advanced manage-ment programme of Harvard Business School. He graduated fromKorea University with BA in economics.

S W I T Z E R L A N D


Intangibles in a post-BEPSworld

The framework foranalysing intercompanytransactions involvingintangibles is examinedby HendrikBlankenstein andCaterina Colling Russoat Tax Partner AG –Taxand Switzerland.Does the new DEMPEanalysis benefit MNEsand tax authorities orsimply confuse matters,resulting in an increaseof intangibles-relateddisputes?

O n October 5 2015, the OECD delivered a final package of reportsproviding recommendations and guidance in connection with the 15-point action plan to address base erosion and profit shifting (BEPS).

The 186-page final report, which covers BEPS Actions 8-10,Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10Final Report (in this article referred to as the Report) offers guidanceon a multitude of transfer pricing topics, most importantly guidance forapplying the arm’s length principle (focusing on economic substance,risks/control and corresponding rewards) and on intangibles. The Report replaces various sections of the OECD Transfer Pricing

Guidelines for Multinational Enterprises and Tax Administrations, 2010(TPG). For countries that formally subscribe to the TPG, the new guid-ance offered by the Report takes the form of agreed amendments to theTPG. These amendments will become part of the TPG after they haveformally been adopted by the OECD Council. Within the Report a strong emphasis is placed on the accurate delin-

eation of the actual intercompany transaction by making use of pre-determined analytical frameworks (para. 1.60, p. 22 and para. 6.34, p.74) offering taxpayers and tax authorities a stepped approach on how toachieve an accurate delineation of the transaction under review. Paragraph 6.34 of the Report provides a specific analytical framework

for analysing intangibles in controlled transactions. Within the pre-scribed analytical framework, multinational enterprises (MNE) need tofocus on the DEMPE functions (development, enhancement, mainte-nance, protection and exploitation) with a view to determining whichgroup entities in the MNE undertake and more importantly controlthese functions.In this article, we will discuss the framework for analysing intercom-

pany transactions involving intangibles and, in particular, whether thenewly introduced DEMPE analysis benefits the MNEs and tax authori-ties in their analysis or whether it will merely confuse matters resultinginstead in an increase of intangibles-related transfer pricing disputes.

Framework for analysing intercompany transactions involvingintangiblesThe steps of the analytical framework will lead to a DEMPE analysis ofthe transaction aimed at providing the MNE with all the ingredients tocorrectly delineate the transaction before determining the intercompanypricing.



The framework for analysing transactions involving intan-gibles between associated enterprises requires taking the fol-lowing steps:

Step 1: Identify the intangiblesThe MNE has to define the intangibles at stake with specifici-ty, in conjunction with the specific, economically significantrisks associated with the DEMPE of the intangibles. In order to support MNEs in performing this step, the

Report includes a definition of intangibles only for transferpricing purposes. Paragraph 6.6 defines intangibles as “some-thing which is not a physical asset or a financial asset, which iscapable of being owned or controlled for use in commercialactivities, and whose use or transfer would be compensatedhad it occurred between independent parties in comparablecircumstances”. In addition, some guidance is given through examples of

what can and cannot be defined as intangibles. The examples

are, however, only for illustrative purposes and not intendedto be comprehensive. In this context, it is clarified that groupsynergies and market-specific characteristics are elements totake into account in a comparability analysis, but are notintangibles.Intangibles used or transferred in a controlled transac-

tion already under the existing guidelines needed to beidentified with some specificity. What is new is the DEMPEanalysis, i.e. the MNE has to identify which activities it clas-sifies as development, enhancement, maintenance, protec-tion and exploitation in relation to the defined intangibleand analyse the intercompany transactions focusing onthese activities.

Step 2: Identify the full contractual arrangementIt is recommended that the MNE maintains the documentsnecessary to derive the legal basis of their cross-border inter-company transactions involving intangibles, as these documents

Caterina Colling RussoTax Partner AG, Zurich

Tel: +41 44 215 77 [email protected]

Caterina Colling Russo, a senior adviser with Tax Partner, hasmore than 10 years’ full-time experience in transfer pricing con-sulting. Caterina has previously held specialist transfer pricingpositions within global international tax and transfer pricing firms.She has worked in Amsterdam, London and Rome.

Caterina has extensive experience in tax planning/restructuringprojects and has performed transfer pricing studies for clients ina wide variety of industries including apparel, banking, luxurygoods, oil and gas, commodities, fast-moving consumer goodsand pharmaceutical. Caterina has provided assistance to clientsdeveloping strategies for the conclusion of APAs as well as taxaudit defence in multiple European countries. Her technical skillsinclude valuation of intangibles, and transfer pricing aspects ofbusiness restructuring. Moreover, she provides advice relating tointer-company financial transactions, ranging from guarantee feeand interest rate projects (transfer pricing policy and benchmark-ing) to providing transfer pricing solutions for intermediatefinance companies as well as for captive insurance companies.

Hendrik BlankensteinTax Partner AG, Zurich

Tel: +41 44 215 77 [email protected]

Hendrik Blankenstein is a partner of Tax Partner AG and leads itstransfer pricing team. From 1989 to 1995, Hendrik was an inter-national tax consultant at Big 4 firms in both the US and theNetherlands, from 1996-2004 he worked as an in-house interna-tional tax and transfer pricing counsel at Nestlé’s HQ inSwitzerland, and from 2005 to 2015 as a Swiss based partner inglobally operating transfer pricing boutique consultancy firms.

Hendrik has been providing transfer pricing advice to Swissand foreign multinational clients in a variety of industries, cover-ing design of transfer pricing systems, preparation ofmasterfile/local file documentation, negotiation and conclusion ofunilateral/bilateral APAs, successful management of complextransfer pricing audits and setting up transfer pricing risk man-agement frameworks.

Tax Partner AG, which currently comprises 12 partners and 26tax professionals, has become a leading Swiss tax boutique firm,focusing on providing tax services such as international andnational corporate tax, individual tax and VAT. Each of the 12partners has their area of specialisation. With regard to relatedservices such as legal, audit and accounting services, Tax Partnertypically cooperates with local firms. For further informationabout Tax Partner, please refer to www.taxpartner.ch.



form the starting point for any transfer pricing analysis. Theterms of a transaction may be found in written contracts, publicrecords such as patent or trademark registrations, or in corre-spondence and/or other communication among the parties. Asmentioned in the Report at para. 6.35, contracts may describethe roles, responsibilities and rights of associated enterpriseswith respect to intangibles.

Step 3: Identify the parties performing functions, using assetsand managing risks related to intangibles in relation toDEMPEThe MNE has, by means of the functional analysis, to reviewthe conduct of the parties under a DEMPE analysis. In otherwords, MNEs have to clarify which group entities:• perform the DEMPE functions; • use the assets related to the DEMPE functions; and • control the economically significant risks related to theDEMPE functions.This analysis does not differ from the already well-known

and widely applied concept of functional analysis, however,now from a DEMPE perspective. Therefore, MNEs are nowrequired to identify specific activities for each DEMPE func-tion and ascertain the relative importance of each DEMPEfunction. Such detailed analysis may be required not onlyinvolving group entities, which are currently involved inDEMPE activities, but also entities which performedDEMPE activities in the past. The Report fails to define the DEMPE functions in much

detail. It is clear that DEMPE may have a different meaningdepending on the industry. In pharma, the several stages ofR&D (and the importance of hard-to-value intangibles) mayassume great relevance whereas in consumer goods, the focusmay be more on brand value and the role of marketing andadvertising. However, even in the same industry, MNEs maycategorise activities – which are similar in nature – in a differ-ent way.

Step 4: Review the consistency between contractualarrangements and conduct of the parties through functionalanalysis (DEMPE) Once the contractual arrangements and the conduct of theparty/-ies have been reviewed within the DEMPE analysiscontext, the MNE has to confirm that there is consistencybetween legal and economic reality while determiningwhether the party assuming economically significant risks aris-ing out of the DEMPE functions also controls these risks andhas the financial capacity to assume them.The conduct of the parties is leading. Only where the con-

duct of the parties and the legal reality of a transaction matchwill a transfer pricing effect be produced: being the legalowner of the intangible does not confer any right ultimatelyto retain returns, even though such returns may initiallyaccrue to the legal owner as a result of legal rights.

The new guidance reaffirms and reinforces the necessityfor alignment between the legal reality and the economic real-ity already present in the 2010 TPG and more importantlythe prevalence of the economic reality, i.e. the conduct of theparties, over the legal reality (terms of the transaction). Werefer in particular to paragraph 1.48 of the 2010 TPG “inrelation to contractual terms, it may be considered whether apurported allocation of risk is consistent with the economicsubstance of the transaction. In this regard, the parties’ con-duct should generally be taken as the best evidence concern-ing the true allocation of risk.” Or paragraph 1.53 of the2010 TPG: “The same divergence of interests may not existin the case of associated enterprises, and it is therefore impor-tant to examine whether the conduct of the parties conformsto the terms of the contract or whether the parties’ conductindicates that the contractual terms have not been followed orare a sham. In such cases, further analysis is required to deter-mine the true terms of the transaction.” The DEMPE analysis should be considered when draft-

ing or reviewing intra-group agreements, specifically howthe allocation of roles, responsibilities and risks are provid-ed for.

Step 5: Delineate the actual controlled transactions related tothe DEMPE of intangiblesThis step is the key outcome of the analytical framework. Inthis step, the MNE has, on the basis of the steps performedso far, access to all the key elements to accurately delineate theactual controlled transaction(s) related to the DEMPE ofintangibles, hence offering the required basis for determiningan arm’s length pricing of the delineated intercompany trans-action (see next step).

Step 6: Pricing of the delineated transactions The MNE, where possible, has to determine the arm’s lengthprices for the transactions under review consistent with eachparty’s contributions of functions performed, assets used andrisks assumed.Assuming a BEPS-proof DEMPE analysis has been con-

ducted, a further and likely more far-reaching challenge willbe to determine the pricing of the delineated transaction con-sistent with the respective contribution(s) of the group com-panies to each of the DEMPE functions. The Report addresses the extreme, however not rare, cases

of so-called “cash boxes”, in which an associated enterpriseprovides funding without either performing any functionsrelating to intangibles or control over the financial risk. Forthese cases, the cash box would only be entitled to a risk-freereturn, whereas in the presence of control over the financialrisk it can expect a risk-adjusted return on its funding.More challenging however, and still lacking clear guid-

ance, are all those intercompany transactions where, oftenfor operational reasons, the DEMPE activities are highly



fragmented amongst associated companies. The compensa-tion for each party’s contribution might not be easy todetermine, especially in cases where the industry does notoffer good availability of comparable transactions undertak-en by independent parties. The authors expect that cases likethese will probably lead to detailed price adjustment proce-dures and probably in some more frequent cases to theadoption of a profit split methodology.

ConclusionsIn practice, the authors have observed that tax authorities havestarted to require the taxpayer in tax audits, in litigation,Advance Pricing Agreement (APA) and Mutual AgreementProcedures (MAP) to substantiate their position using theapproaches laid down in BEPS Actions 8-10. Consequentially,MNEs can expect having to demonstrate through the pre-scribed frameworks, leading to a more detailed functional, riskand DEMPE analysis, that the intercompany transactions aredelineated accurately and priced correctly.Most steps in the framework for analysing intercompany

transactions involving intangibles are not new. What is new isthat – for intangibles-related transactions – MNEs need to focuson the DEMPE functions with a view to determining who in theMNE group undertakes and more importantly controls thesefunctions. Whilst the concept of identifying value-adding func-tions and attributing returns based on the respective value addedis understood, the new OECD guidance fails to define theDEMPE functions. The lack of definition of key terms of thenew guidance will undoubtedly lead to increased uncertainty asthe interpretation of a) which activities constitute whichDEMPE function and b) what relative importance should beattributed to each function will likely lead to an increasing num-ber of disputes between MNEs and tax authorities. MNEs are required to ascertain the relative importance of

each DEMPE function in their respective industry and valuechain and identify specific activities for each DEMPE function inorder to be able to undertake the detailed analysis, as required.

MNEs’ burden of proof is expected to increase, and MNEsshould not miss the opportunity to explain the necessarycompany and industry background underlying their transferpricing policies as part of their transfer pricing documenta-tion. This includes a detailed description of the group supplyand value chain in the context of the intangibles-related trans-actions. This is key to support the taxpayer in performing asatisfactory DEMPE analysis. In line with the refreshed concept of a transfer pricing mas-

ter file, as contained in Annex I to Chapter V of the TransferPricing Documentation and Country-by-Country Reporting– Action 13: Final Report – MNEs are now offered theopportunity to present their supply chain as well as all the rel-evant information needed to provide a blueprint of the groupand ultimately to support and justify the selected transfer pric-ing policy.Pricing intercompany transactions in light of a DEMPE

analysis in some industries will favour the use of a profit splitmethodology, however guidance on profit split is still underreview within the BEPS project.The DEMPE analysis will put some pressure on defining

the correct intercompany pricing and identifying comparableuncontrolled prices, especially for those intercompany trans-actions where, often for operational reasons, the DEMPEactivities are highly fragmented amongst associated compa-nies. In these cases, would the taxpayer be able to find com-parable independent parties that have allocated the DEMPEfunctions in a comparable way? Again some industries willoffer good availability of comparable deals undertaken amongindependent parties, where such comparables will not beavailable, assuming the transaction has been correctly delin-eated, this would certainly lead to detailed price adjustmentsprocedures and probably in some more frequent cases to theadoption of a profit split methodology. Additional guidanceon the use of the profit split method, hopefully includingpractical commercial examples for both businesses and taxauthorities, is expected to be provided by the OECD in 2017.

U S


Responding to the changes inthe transfer pricing landscape

The Internal RevenueService appears to bestrengthening its standon aggregatingtransactions andapplying economicsubstance rationales tooverride related-partycontracts. David Forstand Larissa Neumann ofFenwick & West discussUS developmentsincluding the IRS andTreasury Department-issued 482 TemporaryRegulations.

T here have been a number of recent important developments on theUS transfer pricing front. The Internal Revenue Service (IRS) issuednew § 482 regulations in what seems to be an effort to strengthen its

positions on aggregating transactions and applying economic substancerationales to override related-party contracts. In a recent Notice, the IRS stated that regulations will be issued apply-

ing the transfer pricing methods in the cost-sharing rules to transfers ofintangibles to controlled partnerships. In the Guidant LLC v. Commissioner, 146 T.C. No. 5 (2016) motion

for partial summary judgment, the Tax Court ruled in favor of the IRS ona question of aggregation in a transfer pricing adjustment.

New 482 Temporary RegulationsThe Treasury Department and the IRS issued new Temporary Regulationsunder § 482 that are effective to taxable years ending on or afterSeptember 14 2015. The stated purpose is to coordinate § 482 with otherCode provisions. However, the changes to the 482 regulations appear tobe more aggressive than simple coordination rules and clarifying changes. The preamble states that controlled transactions always remain subject

to Section 482 even if other Code provisions apply. In the preamble, theIRS states that it has encountered taxpayer positions involving incompleteassessments of the relevant functions, resources, and risks, and an inappro-priately narrow analysis of the scope of the transfer pricing rules. It certain-ly will benefit the taxpayer to have prepared thorough and well-drafteddocumentation.The new provision in Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(A) pro-

vides that arm’s length compensation must be consistent with, and mustaccount for all of, the value, without regard to the form or character of thetransaction. The regulation states it is necessary to consider the entirearrangement as determined by the contractual terms, whether written orimputed in accordance with the economic substance, in light of the actualconduct of the parties. The IRS will likely attempt to use this regulation tomore aggressively assert that controlled parties’ contractual arrangementsshould be ignored in favor of some broader economic substance argument. Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(B) states that transactions may

be considered together, and taken as a whole, if they are so interrelatedthat an aggregate analysis provides the most reliable measure of an arm’slength result. Prior rules provided for aggregation only in the case of con-trolled transactions involving related products or services. The preamble

U S


calls this a clarification, but the Obama administration pro-posed a change in the statute to permit this type of aggrega-tion, but that proposal was never enacted. The Temp. Treas. Reg. § 1.482-1T(f)(2)(i)(C) provision

provides that overall value (including any synergies) must betaken into account. The preamble and regulations repeatedlyrefer to “synergies”. It is not clear what these “synergies” are.“Synergies” are not an intangible listed in § 936(h)(3)(B), andparties operating at arm’s length do not license “synergies”.The Temporary Regulation contains 11 examples.

Examples 1 through 4 are materially the same as prior regula-tions. The remaining examples are new. Example 5 deals with aggregation. Parent owns 10 individ-

ual patents that together can be used to manufacture and sella successful product. Parent anticipates that it can earn $25from the patents as a bundle. Parent licenses all 10 patents toa foreign subsidiary to be exploited as a bundle. Comparabledata indicates that each license is worth $1, implying a totalvalue of $10. The example states that it would not be appro-priate to use the $1 dollar comparables because it does notreasonably reflect the enhancement to value resulting fromthe interrelatedness of the 10 patents exploited as a bundle. In Example 6, parent and its foreign subsidiary have a cost

sharing agreement, but the parent continues to perform sup-port for the foreign subsidiary. The example states that theIRS may impute agreements or even another platform contri-bution transaction (PCT) for the support services. This exam-ple implies that the IRS’s assertion of economic substanceoverrides the actual contractual terms. Examples 8 and 9 alsoinvolve cost sharing agreements where the IRS can ignore thecontracts.In Example 10, parent provides R&D services building on

the product platform. The example states the parent is provid-ing an embedded value to the foreign subsidiary and the for-eign subsidiary must compensate the US parent for this value.The example states that parent takes the position that theknow-how does not have substantial value independent of theservices of any individual on the R&D Team. This is the posi-tion the taxpayer took in Veritas and won.

Transfers of IP to Controlled PartnershipsIn Notice 2015-54 Treasury and the Service state that theyintend to issue regulations similar to the Treas. Reg. § 1.482-7 cost-sharing regulations to controlled transactions involvingpartnerships. Specifically, the Notice states that regulationswill be issued applying the methods specified in Treas. Reg.§ 1.482-7(g), as adjusted to take into account the differencesbetween partnerships and cost sharing arrangements.Additionally, the Notice states that the regulations will pro-vide periodic adjustment rules that are based on the principlesof Treas. Reg. § 1.482-7(i)(6) so that in the event of a triggerbased on a significant divergence of actual returns from pro-jected returns, the IRS may make periodic adjustments under

a method based on Treas. Reg. § 1.482-7(i)(6)(v), as well asany necessary corresponding adjustments to section 704(b) orsection 704(c) allocations. The Notice states in its Reasons For Exercising Regulatory

Authority that an example it is concerned about is where adomestic partner receives a fixed preferred interest inexchange for the contribution of an intangible that is assigneda value that is inappropriately low, while a related foreignpartner is specially allocated a greater share of the incomefrom the intangible. The Notice appears to take the position that a taxpayer

who contributes intangible property and elects the GainDeferral Method, and therefore the application of the reme-dial allocation method, could still be subject to further adjust-ments in excess of its Built-in Gain amount. The Notice statesthat when intangible property is contributed to a partnership,the IRS may consider making periodic adjustments underTreas. Reg. § 1.482-4(f)(2) in years subsequent to the contri-bution, without regard to whether the taxable year of theoriginal transfer remains open for statute of limitations pur-poses. It states that the IRS may do so regardless of whether§ 721(a) applies to the initial contribution of intangible prop-erty to the partnership. Therefore, in the IRS’s view, even if ataxpayer elects the Gain Deferral Method, it still would besubject to adjustments under § 482 even though § 721(a)applies. Of course, any new rules that the IRS writes in this regard

would need to be consistent with the arm’s length standard,which underlies all of § 482. See, e.g., Treas. Reg. § 1.482-1(b); Xilinx v. Commissioner, 598 F. 3d 1191 (9th Cir. 2010).The Notice reiterates the application of § 482 to con-

trolled transactions involving partnerships under existing law.See Treas. Reg. §§ 1.704-1(b)(1)(iii), -1(b)(5), Example 28in this regard. The Notice states that examples of the applica-tion of § 482 under current law include adjustments to theamounts of contributions to, and distributions from, a part-nership; partnership allocations, including allocations under§ 704(c), and the relative magnitudes of the partners’ part-nership interests in light of their respective contributions andthe related controlled transactions. The Notice also states that the IRS can impute terms to a

partnership agreement that are consistent with the substanceof a transaction, for example, when a partner provides servicesto the partnership but neither the partnership agreement norany other agreement reflects the provision of such services.Further, according to the Notice, the IRS can apply an aggre-gate analysis under Treas. Reg. § 1.482-1(f)(2)(i) to theextent that controlled transactions involving a partnership,including contributions of tangible and intangible propertyand the provision of services by the controlled partners ortheir affiliates, are interrelated if the aggregate analysis pro-vides the most reliable means of determining the arm’s lengthresults for the controlled transactions.

U S


David ForstFenwick & West

Tel: +1 650 335 7254Fax: +1 650 938 [email protected]

David Forst is the practice group leader of the tax group ofFenwick & West. He is included in Euromoney’s Guide to theWorld’s Leading Tax Advisers. He is also included in Law andBusiness Research’s International Who’s Who of Corporate TaxLawyers (for the last six years). David was named one of the toptax advisers in the western US by International Tax Review, islisted in Chambers USA America’s Leading Lawyers for Business(2011-2014), and has been named a Northern California SuperLawyer in Tax by San Francisco Magazine.

David’s practice focuses on international corporate and part-nership taxation. He is a lecturer at Stanford Law School oninternational taxation. He is an editor of and regular contributorto the Journal of Taxation, where his publications have includedarticles on international joint ventures, international tax aspectsof M&A, the dual consolidated loss regulations, and foreign cur-rency issues. He is a regular contributor to the Journal ofPassthrough Entities, where he writes a column on internationalissues. David is a frequent chair and speaker at tax conferences,including the NYU Tax Institute, the Tax Executives Institute, andthe International Fiscal Association.

David graduated with an AB, cum laude, Phi Beta Kappa, fromPrinceton University’s Woodrow Wilson School of Public andInternational Affairs, and received his JD, with distinction, fromStanford Law School.

Larissa NeumannPartner, Tax GroupFenwick & West

Tel: +1 650 335 [email protected]

Larissa Neumann focuses her practice on US tax planning and taxcontroversy with an emphasis on international transactions. She hasbroad experience advising clients on acquisitions, restructurings andtransfer pricing issues. She has successfully represented clients infederal tax controversies at the audit level, in appeals and in court.

Larissa appears in International Tax Review’s “World’s TaxControversy Leaders” and in Euromoney’s World’s Leading TaxAdvisers. Euromoney selected Larissa for inclusion in the AmericasWomen in Business Law Awards shortlist for Best in Tax DisputeResolution in 2014 and she was named the 2015 Rising Star: Tax.She was also named to the Silicon Valley Business Journal’s 40 Under40. In 2016, Larissa was named a Rising Star in tax by Law360.

Larissa frequently speaks at conferences for professional taxgroups, including TEI, IFA, Pacific Rim Tax Institute, Bloomberg,and the ABA. She is the ABA International Law Tax Liaison.

Larissa has published several articles, including recently: • US Tax Overview, Euromoney’s LMG Rising Stars 2015• US transfer pricing litigation update , International Tax Review

(March 2015)• Areas of TP Scrutiny in a pre- and post-BEPS World,

International Tax Review (February 2015)• U.S. International Tax Developments, The Euromoney Corporate

Tax Handbook 2015• U.S. Transfer Pricing Developments, International Tax Review (2014)• U.S. Tax Developments, International Tax Review

(December/January 2013)• Character and Source of Income from Internet Business

Activities, The Contemporary Tax Journal (July 2011)• The Application of the Branch Rule to Partnerships,

International Tax Journal (July – August 2010)Fenwick has one of the World’s Top Tax Planning and Tax

Transactional Practices, according to International Tax Review, and isfirst tier in tax, according to World Tax. International Tax Review gaveFenwick its San Francisco Tax Firm Award a total of seven times andits US Tax Litigation Firm Award a total of three times. International TaxReview has also named Fenwick Americas M&A Tax Firm of the Year.

Larissa is a leader on Fenwick’s Pro Bono Review Committeeand regularly provides pro bono services to various nonprofitorganisations. Fenwick was recognised by The National LawJournal Pro Bono Hot List (2014) and Larissa’s nonprofit work ispointed to as exemplary in the profile.

U S


Finally, the Notice also states that Treasury and the IRSare considering issuing regulations under Treas. Reg.§ 1.6662-6(d) to require additional documentation for cer-tain controlled transactions involving partnerships. Theseregulations may require, for example, documentation of pro-jected returns for property contributed to a partnership (aswell as attributable to related controlled transactions) and ofprojected partnership allocations, including projected reme-dial allocations covered, for a specified number of years.

Guidant Guidant involves a group of US corporations that filed con-solidated federal income tax returns (collectively, the “taxpay-er”). During the years in issue, the taxpayer consummatedtransactions with its foreign affiliates including the licensingof intangibles, the purchase and sale of manufactured proper-ty, and the provision of services. The IRS utilised § 482 to adjust the reported prices of the

different transactions. The IRS asserted an adjustment to thetaxpayer’s income without making specific adjustments to anyof the subsidiaries’ separate taxable incomes. The IRS also didnot make specific adjustments for each separate transaction,but rather asserted an aggregated transfer pricing adjustment. The taxpayer filed a motion for partial summary judgment

asserting that the IRS adjustments were arbitrary, capricious,and unreasonable as a matter of law since the IRS did notdetermine “true taxable income” of each controlled taxpayeras required under Treas. Reg. § 1.482-1(f)(iv) and did notmake specific adjustments with respect to each transaction. The court denied the taxpayer’s motion stating that nei-

ther § 482 nor the regulations thereunder requires the IRS todetermine the true taxable income of each separate controlled

taxpayer within a consolidated group contemporaneouslywith the making of a § 482 adjustment. The court also heldthat the IRS is permitted to aggregate one or more relatedtransactions instead of making specific adjustments withrespect to each type of transaction. While the court stated that Treas. Reg. § 1.482-1(f)(1)(iv)

requires the IRS to determine both consolidated taxableincome and separate taxable income when making a § 482adjustment with respect to income reported on a consolidatedreturn, the court held that as a matter of law the IRS canassert a § 482 adjustment before it determines the separatetaxable income. The court stated that the regulation does notpreclude the IRS from deferring making the separate taxableincome determinations for each member until the time whensuch a determination is actually required.The court stated that whether the IRS’s decision to delay

the separate-company taxable income computations consti-tutes an abuse of discretion under these circumstances is stillin dispute and remains to be determined on the basis of thefull record as developed at trial. Thus, the court did not con-clusively hold that the IRS’s § 482 adjustments were not arbi-trary, capricious or unreasonable as a matter of fact. It onlyheld that the IRS’s § 482 adjustments were not arbitrary,capricious, or unreasonable as a matter of law.The taxpayer also argued that the IRS’s § 482 adjustments

were arbitrary, capricious and unreasonable because the serv-ice did not make separate adjustments for each transfer ofintangible property, transfer of tangible property and provi-sion of services. The applicable regulations in determining thearm’s length consideration aggregation is permitted if itserves as the most reliable means of determining the arm’slength consideration for the transactions.

Transfer Pricing - International Tax Revie in association with: Deloitte Korea Gowling WLG Fenwick &...

Documents

Transcript of Transfer Pricing - International Tax Revie in association with: Deloitte Korea Gowling WLG Fenwick &...