Worldwide: Transfer Pricing Times: OECD Releases Discussion Draft On Hard-To-Value Intangibles

In this edition: the OECD releases discussion draft on hard-to-value intangibles, Australia issues risk framework for evaluating intercompany loans, recent transfer pricing developments in India, Italy and China revise national regulations to more closely align with the OECD guidelines and related BEPS recommendations, and U.S. tax reform topics.

OECD Releases Discussion Draft on Hard-to-Value Intangibles

On May 23, 2017, the OECD released a public discussion draft addressing certain aspects of transfer pricing for hard-to-value intangibles ("HTVIs").

When taxpayers employ transfer pricing methodologies for intangibles that are informed by expectations, tax administrations necessarily have an interest in ensuring that the projections that are used fully reflect all relevant information available to the taxpayer (and to ensure that taxpayers haven't misstated expectations to gain tax advantage). The HTVI provisions provided as part of the final BEPS report for Action Items 8-10 included provisions that recognized the potential need for tax administrations to be able to use information about ex post outcomes to inform their judgments about the reasonableness of the information used to establish ex ante pricing.

In that guidance, the OECD states that its approach on HTVIs is intended to be consistent with the arm's-length principle and provide tax administrations with a method by which to determine situations in which transfer prices should weigh foreseeable events. The approach allows tax administrations to use ex post data as presumptive evidence to assess the arm's-length nature of ex ante pricing, but also allows taxpayers the ability to rebut the presumption. If an administration ultimately determines an adjustment is warranted, the adjustment can be assessed by creating and quantifying contingent payments and price adjustments, irrespective of how the taxpayer originally structured the transaction (e.g., as a lump sum).

The final BEPS report on Action Items 8-10 mandated the creation of guidance on the implementation of the approach to HTVI outlined in that report. The recently produced discussion draft is intended to present the principles that should underlie the implementation of the HTVI approach, and to provide clarifying examples on how to implement the approach. The three examples provided all relate to the transfer of intangible property associated with a Phase III pharmaceutical program.

These examples demonstrate:

  • The calculation of adjustments using actual outcomes to inform transfer pricing adjustments under examination, illustrating the potential substitution of ex post outcomes for erroneous projections that didn't qualify for the provided exemptions. These calculations are demonstrated both for circumstances in which commercialization occurs earlier than incorporated in the ex ante projections used by the taxpayer and when revenues are substantially higher than those reflected in those ex ante projections;
  • A circumstance where actuals were different than projections, but an adjustment is not made because the price incorporating ex post information is within 20 percent of the price established by the taxpayer;
  • The potential use of a contingent payment form for making adjustments based on ex post outcomes when a tax administration's evaluation of the available evidence indicates that arm's-length parties would have employed some form of contingent payment; and
  • Potential adjustments to a contingent royalty rate based upon ex post evidence (again, stressing that such adjustments might not be necessary if the royalty calculation considering ex post evidence falls within 20 percent of the royalty established by the taxpayer using its ex ante projections).

From a practical perspective, the implementation guidance is aimed at promoting consistency amongst tax administrations and limiting potential double taxation. Comments on the discussion draft are due by June 30, 2017.

Further information on the discussion draft is available here.

Following Major Chevron Decision Australia Issues Risk Framework for Evaluating Intercompany Loans

On May 16th, 2017, shortly after the release of the Chevron decision, the Australian Tax Office ("ATO") issued a draft Practical Compliance Guideline ("Draft Guideline") outlining the ATO's go-forward approach for assessing intercompany financing arrangements. The Draft Guideline provides a risk framework intended to assist taxpayers with understanding how to assess the risk level associated with their intercompany financing arrangements and to further understand the compliance approach the ATO is likely to adopt when reviewing and enforcing such arrangements. The Draft Guideline sets out six risk zones ranging from "White zone - already reviewed and concluded by the ATO" to "Red zone - very high risk". The Draft Guideline notes that loans which receive a low risk score are likely to be subject to fewer ATO resources than loans higher up the scale.

A scoring system is used to determine the risk rating by evaluating several different aspects of the intercompany arrangement including:

  • The interest rate relative to the global group and or third party borrowings;
  • Leverage ratio of the borrower relative to the global group;
  • Interest coverage ratio relative to the global croup;
  • Collateral pledged;
  • Position within the capital structure (i.e., subordinated or mezzanine)
  • Tax rate of the lending entity;
  • Whether the arrangement is in a different currency than the borrower's operating currency;
  • Arrangement is covered by a taxpayer alert;
  • One party is a hybrid entity;
  • Presence of exotic features on the loan; and
  • Sovereign risk of the borrowing entity's jurisdiction.

It is important to note that the Draft Guideline and the above criteria are not an interpretation of the transfer pricing rules in Australia. Instead, these criteria are meant to assist taxpayers with understanding which features the ATO deems risky. In fact, it could be argued that the above categories alone do not provide an indication of the existence of bona fide arm's-length debt. For example, the lender's tax rate gives no indication of an arm's-length result nor does the amount of collateral pledged given that unsecured debt is commonplace in arm's-length capital markets.

Taxpayers wishing to avoid scrutiny and possible litigation with the ATO may choose to restructure their intercompany arrangements in order to qualify as low-risk under this Draft Guideline. Alternatively, taxpayers which are deemed riskier under this framework may choose not to restructure if they believe their dealings meet the arm's-length standard and are appropriately documented.

Further information on the ATO's Draft Guideline is available here.

Recent India Transfer Pricing Developments - Release of APA Annual Report

On May 1, 2017, India's Central Board of Direct Taxes ("CBDT"), which is an administrative body of India's Income Tax Department, published its first annual report on the Advance Pricing Agreements ("APA") program in India.

The report includes:

  • Information on the history, structure, and operation of the APA program in India;
  • Statistical data on APAs filed, executed, pending, and withdrawn; and
  • Further detail on the APAs executed, such as industry of the applicant, transaction types, transfer pricing methods used, and counterparties to the APAs.

Effective July 1, 2012, the APA program in India gave legal backing for the CBDT to enter into APAs with taxpayers for a maximum period of five years, including roll-back period of up to four years in certain cases. The report discloses that over the last five years, more than 800 APA applications have been filed in India, including both unilateral and bilateral applications. Unilateral APA applications made up 85 percent of the total, which the CBDT attributes in large part to the U.S. Competent Authority's position, reversed in 2016, to not engage in bilateral APAs with India.

As of March 31, 2017, when the latest data were made available for the report, India had signed 141 unilateral APAs and 11 bilateral APAs (6 with the U.K. and 5 with Japan). As the program has matured over its five-year history, the number of APAs signed has increased significantly, from a total of nine between 2013 and 2015, to 143 between 2015-2017. This is largely due to the time it takes for an APA application to proceed to final agreement; the CBDT report cites an average of 29 months for a unilateral APA, with some taking up to 48 months. This is similar the recent average reported by the U.S. Competent Authority of 34 months.

Not surprisingly for India, the largest industry sector participating in the APA program is information technology (29% of signed unilateral APAs), followed by banking and finance (21%), industrial/commercial goods manufacture (11%), and pharmaceuticals (7%) – with the remainder distributed among 13 other industry classifications. Software services and information technology services were the most common intercompany transaction types to be included in an APA. Finally, with respect to the transfer pricing methods being applied, the Transactional Net Margin Method was by far the most commonly employed, followed by "Other Methods", and then by the Comparable Uncontrolled Price method.

Further information on India's first APA annual report is available here.

Both Italy and China Revise National Regulations to More Closely Align with the OECD Guidelines and Related BEPS Recommendations


On April 24, 2017, the Italian government approved Decree No. 50. This measure, effective immediately, includes revisions to the Italian transfer pricing rules that tailor the rules to more closely align with the OECD Guidelines.

Specifically, the new rules:

  • Replace the Italian concept of "normal value" with specific reference to the OECD concept of the arm's-length principle;
  • Expand the range of options that can result in a downward adjustment of the Italian taxable income base beyond those arising from MAPs (e.g., at the conclusion of tax audits performed under international cooperation procedures; through a specific application), thereby simplifying corresponding adjustments and reducing the risk of double taxation; and
  • More closely align the definition of eligible intangibles under the Italian patent box regime with the definition outlined in the OECD's Final Report on BEPS Action 5 by excluding trademarks in applications filed on or after December 31, 2016 (although no change was made to the current inclusion of know-how, which is limited under BEPS Action 5).


On March 17, 2017, China's State Administration of Taxation ("SAT") published Bulletin Gonggao [2017] No. 6 ("Bulletin No. 6"), which brings Chinese transfer pricing rules more in line with the OECD's BEPS reforms.

Specifically, per Bulletin No. 6:

  • DEMPE (development, enhancement, maintenance, protection, exploitation) functions for determining the value of intangibles are referenced. The SAT also includes a sixth element – "promotion."
  • Intercompany service fees are allowed if the service(s) bring indirect or direct economic benefit to the service recipient(s) and if independent parties would pay for or perform such service(s).
  • The same five transfer pricing methods that are identified by the OECD are identified and endorsed. The Value contribution allocation method, a unique and controversial method previously proposed by the SAT, is no longer mentioned. The cost method, the market method, and the income method are listed as other allowable methods.

Other notable amendments to China's transfer pricing rules per Bulletin No. 6 include:

  • The SAT will review related party transactions, transfer pricing documentation, and profit to identify companies that are at risk for a transfer pricing adjustment. These companies will receive a "Notice of Taxation Matters" and can choose to voluntarily adjust their transfer pricing based on the SAT's recommendation. However, the SAT reserves the right to initiate a full audit in the future.
  • Location-specific advantages, such as cost savings and a market premium should be considered if the proposed comparables and the tested party are in different economic environments.
  • The SAT can choose among arithmetic means, weighted averages and interquartile ranges when performing transfer pricing examinations. Furthermore, when using interquartile ranges to compare profitability levels, if a taxpayer's profit level falls below the median, the SAT can adjust it to the median.
  • The SAT will prioritize the use of publicly available information, but is also allowed to use non-public information when conducting the comparability analysis.

Further information on the full text of Decree No. 50 is available here.

Further information on the full text of Bulletin No. 6 is available here.

U.S. Tax Reform Topics: Eliminating Interest Deductibility in Exchange for Full Expensing

As the legislative debate in Congress on tax reform heats up, we at the Transfer Pricing Times have been working to provide our readers with content that tracks how tax reform may or may not impact the transfer pricing landscape. While it is impossible to predict what the outcome of the debate in Congress will be, our hope is to help our readers make sense of the proposals being discussed. For this piece, we tackle the debate on the deductibility of interest expense and the treatment of capital investments, a key facet of Speaker Paul Ryan's "Better Way" proposal also referred to as the "Blueprint".

A central tenant of the U.S., and most other major industrialized tax codes, is the idea that interest payments on debt financing are deductible from taxable income regardless of whether the lender is a third-party or related entity. This practice has become so engrained in modern corporate taxation that many practitioners would not have thought to question it. Enter the Blueprint, which proposes eliminating the deductibility of interest payments resulting in equal tax treatment for debt and equity financing. Such a change would force companies to reassess their capital structures, as the debt "tax shield" (meaning, the ability to use debt financing to lower taxable income) would cease to exist. This proposal would also deny companies the ability to use interest payments on intercompany debt financing to shift profits from the U.S. to lower tax jurisdictions; a key focus of the previous administration as demonstrated by the finalization of the 385 Regulations in October of last year. The proposal does leave open the possibility for exceptions to be granted for firms in the financial services industry which rely more heavily on interest income and expense in day-to-day operations.

The elimination of interest deductions is expected to significantly increase the U.S. tax base, but would likely face significant resistance from corporate stakeholders across the board without an offsetting tax break. The Blueprint provides this supposed offset by fundamentally altering another central tenant of modern corporate taxation: the depreciation of capital investments. Under current tax rules, the cost of a capital investment is spread over its useful life (i.e., depreciated), reducing taxable income over future periods. The Blueprint fundamentally alters this concept by allowing for deducting the entirety of a capital investment in the period in which the investment is made. Because the entire deduction can be taken upfront, the value of the deduction increases significantly on a net present value basis.

Supporters of the Blueprint argue that these policy shifts will largely offset one another in terms of taxable income, and realign businesses' incentives in a way that creates economic value for the U.S. Supporters argue the elimination of interest deductibility will lead to a healthier economy, as firms will be no longer have tax-driven reasons to increase debt levels beyond what would otherwise be considered optimal. Supporters also expect that the immediate expensing of capital investments will give firms incentive to make capital investments in the U.S. It remains to be seen whether these expectations would come to fruition.

Like many proposals in the Blueprint, economists' views on this specific proposal show a great deal of variation. Some research, for instance, suggests that the tax treatment of debt may have no impact on overall debt levels in the economy. Furthermore, forecasts of how these proposals will affect capital investment and taxable income in the medium and long term are also mixed.

Further information on the Blueprint is available here.

Further information on President Trump's tax plan is available here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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