Introduction
Base Erosion and Profit Shifting (BEPS) continues to be a challenge for the government of different countries, as the strategies employed by Multinational Enterprises (MNEs) to reduce taxes in a particular jurisdiction may not necessarily be non-compliant with enabling legislation. Often, the BEPS approach is to exploit the loopholes in the host country's local tax laws. The Organization for Economic Cooperation and Development (OECD) has however made efforts by suggesting options open to a tax system in a jurisdiction to amend and coordinate their local tax policies and laws to ensure that MNEs pay appropriate taxes on the profits they earn from their respective jurisdiction. The compendium of various suggestions is collectively known as OECD BEPS project.
One of the 3 key focus areas of the OECD BEPS project is addressing the issue of Substance. The work under Actions 8-10 of the BEPS Action Plans has targeted this issue, to ensure that transfer pricing (TP) outcomes are aligned with value creation. Functional analysis is an integral aspect of transfer pricing which aims at identifying the economically significant activities performed, the assets (tangible and intangible) used or contributed, and the risks that are assumed or undertaken in a controlled or uncontrolled transaction.
This article will take an in-depth look at the importance of functional analysis and how the maxim of "substance over form" relates to functional analysis; it would also attempt to show the impact on the outcome of transfer pricing audits.
Importance of functional analysis
The functional analysis is a requirement for the accurate delineation of transactions that MNEs engage in. The concept behind accurate delineation of a transaction is about assessing how the actual conduct of the parties to a transaction compares with the details of the transaction in the written contract or agreement. Through accurate delineation, transfer pricing can focus on pricing the real deal rather than following through with the pricing terms of a contract that may not reflect the actual contributions of the parties to value creation.
In delineating a transaction, a detailed description of the entities involved in the controlled transaction is provided by pre-determined process owners; the functions performed at each stage and decision-makers identified, the nature and ownership of assets employed, and inherent risks, mitigation measures, and risk bearers that are highlighted. The value-driving activities and critical success factors at each level become clear and transactions that may have been erroneously characterized are recharacterized appropriately.
One of the importance of the functional analysis is to ensure that the entities in the controlled transactions are appropriately compensated for their roles and responsibilities. Each entity should be compensated based on its contributions such that taxes are correctly assessed in the jurisdiction where value was created. The functional analysis will help identify the jurisdiction entitled to the revenue and profits from a controlled transaction, how the profits are allocated, and if accurately done, it prevents profit shifting.
Paragraph 2.2 of the OECD Guidelines, 20221 alludes to another importance of the functional analysis. In the selection of the transfer pricing method to be adopted in testing the arm's length nature of controlled transactions, the appropriateness of the method should be determined through a functional analysis. The arm's length principle is the "objective" standard that helps to reduce the unfair advantage that may exist in trade between associated enterprises.
The tax authorities are also guided by the functional analysis documented in the TP compliance documentation/local file when an entity is selected for a TP audit. The tax authorities will review the functional analysis to gain an in-depth understanding of the functions performed in respect of the controlled transaction. Where the tax authorities are of the opinion that the documented functional analysis does not portray the full picture; it is not uncommon for a separate fact-finding exercise to be scheduled in a bid to determine the jurisdiction of value-creation and the tax revenue of associated enterprises in their jurisdiction. Adjustments are then made to the taxable profits where it is deemed that the arm's length principle is not fully implemented.
Substance vs Form
The maxim "plus valet quod agitur quam quod simulate concipitur" which means that the substance of a transaction is more important than its form, is a common law concept employed around the world empowering the Courts to evaluate the true nature of a contract, agreement or document governing a transaction rather than simply relying on words in print which may disguise the intentions or not truly reflect the actions of the contracting entities.
This principle is applicable in many accounting and tax disputes, including transfer pricing audits. When it is determined that a contract is a smoke screen designed to mislead or conceal actual realities, a deep dive will be made to reveal the real position of parties rather than a mere acceptance of the external appearance of its form. This doctrine states that the substance (economically significant activities) rather than the technical form (policy, agreements, and contracts) governs a transaction.
In the context of transfer pricing, this means that the mere terms of inter-company agreements, contracts, and documentation of a controlled transaction cannot be solely relied upon; as written contracts alone are not likely to provide all the information necessary to perform a transfer pricing analysis, or to provide information regarding the relevant contractual terms in sufficient detail. The economic realities of a transaction must be observed and if adjudged to be different from the terms, the economic realities would be upheld. For example, a contract between associated enterprises may seem to be legal and in agreement with the arm's length principle, but the law allows the tax administration to "unveil the transaction" and it may then be determined that one of the entities is a shell corporation incapable of performing the functions assigned to it. If such disparity is recognized, appropriate adjustments are made, and taxes are assessed accordingly.
It is important to note that this principle does not imply that all transactions that seemingly present a tax benefit would be scrutinized. Any transaction no matter how complex, that would be reasonably entered into or carried out in a manner common for bona fide business operations, having commercial substance, and with terms that "genuinely" depict the latent purpose of the parties would not be deemed as a sham transaction.
Why Substance may differ from Form
The reasons for the difference between substance and form are not always nefarious. Business decisions or arrangements by taxpayers may not necessarily be for the sole purpose of obtaining tax benefits or shifting profits. Attention must be given to some key reasons why substance may differ from form.
Simplification of Contract – Sometimes, contracts are usually simplified for the purpose of time and cost savings. It is not uncommon to find an agreement which has been loosely put together, just to satisfy the requirement of having a supporting legal document for a transaction. In such instances, the contracts may not fully capture the actual conduct of the parties. Also, given that contracts are prepared in advance, significant regulatory, political, and socio-economic changes during the contract execution may not be fully anticipated and documented. A case in point may be the unprecedented effects of the COVID-19 pandemic on the structure of controlled transactions involving supply-chain, where procurement or logistics functions and risks borne by the different parties in ensuring business continuity, may have differed from the terms of written agreements.
Business Restructuring - Business restructuring refers to the cross-border reorganisation of the commercial or financial relations between associated enterprises, including the termination or substantial renegotiation of existing arrangements. For example, the conversion of a full-fledged distributor into a limited risk distributor, concentration of functions in a regional or central entity, with a corresponding reduction in scope or scale of functions carried out locally, such as procurement, sales support, supply chain logistics etc. The impact of a restructuring on the allocation of functions, assets and risks in a contract may not have been duly considered by the parties and this could result in a mismatch of the form of the transaction with the new profiles of the parties.
Complicated Business Arrangements – Beyond the contracting parties to a transaction, a broader assessment of the business arrangement within which the transaction has occurred can provide useful information to the tax authorities, on the intent of the contracting parties. An example is the appointment of a third-party contract manufacturer who is mandated to purchase its major raw materials from an affiliate of its principal. Where it can be established that the contract manufacturer does not own significant tangible and intangible assets or bear any significant risks relating to the manufacturing process, the entire arrangement could be deemed as a controlled arrangement, with the third party being a passive player, despite the fact that there was no direct intercompany transaction between the principal and its affiliate ab initio. Also, business arrangements involving a holding company in a tax haven, a company with no employee, and dividend payments have the potential for the substance of the transactions to be different from the form, as they beg the question of what, where, and how value is being created.
Addressing the gap
MNEs must be proactive in dealing with the potential issues that may arise due to differences in the legal form and substance of transactions between associated enterprises. An important action point is to regularly evaluate the Group's TP policies (the form), especially its value chain in a bid to recognize inconsistencies in the jurisdiction of value creation and to review the actions of the group entities (the substance), rather than merely regurgitating the status quo of prior years' intra-group transactions.
The international tax landscape continues to evolve, with some developments and updates to how certain transactions e.g., financial transactions should be evaluated. MNEs should revisit such transactions in light of new regulations and guidelines. For example, controlled transactions involving intangibles must now consider the effect of the Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) concept on the returns attributable to the associated enterprises involved. If the legal owner of an intangible performs no DEMPE function but simply acts as a holding entity of the intangible; it would no longer be entitled to the receipt of any returns generated from the enhancement or exploitation of the intangible. This is distinctly different from what was previously obtainable, and the contract should be revised to reflect such changes.
Another practical step is to ensure that agreements or contracts are not overly simplified, rather they should comprehensively outline the functions to be performed and responsibility of the contracting parties. The potential risks identified should be allocated and the obligations of associated enterprises in such circumstances be stated clearly.
TP audit cases impacted by the functional analysis
Denmark vs NetApp Denmark ApS and TDC A/S2
The issue for determination was whether the companies i.e., NetApp Denmark ApS and TDC A/S were obliged to withhold dividend tax on distributions to foreign parent companies.
NetApp Denmark ApS in 2005 and 2006 made dividend payments to an intermediate parent company in Cyprus and then on to NetApp Bermuda while TDC A/S distributed dividends in 2011 to an intermediate parent company in Luxembourg – and then on to owner companies in the Cayman Islands.
The Danish tax authorities took the view that the intermediate parent companies were "flow-through companies" disguising as the recipients of the dividends whereas, the real recipients (beneficial owners) were residents in countries not covered by the EU Parent-Subsidiary Directive (Bermuda and Cayman respectively). Therefore, withholding taxes should have been paid by the Danish companies on the distributions.
The Supreme Court ruled in favour of the Danish tax authorities and upheld the assessment of an additional withholding tax of 28 percent on a total amount inclusive of a substantial amount of interest on late payments.
This ruling clearly exemplifies the application of the common law principle explained above and the Danish Supreme Court unveiled the dividend payments between associated enterprises and exposed the true nature of the transaction which was simply to gain relief on taxes.
Germany Vs. Turbine Owner "GmbH"3
A German partnership (KG) ran a wind farm with five wind turbines. Each of the turbines are treated as a separate asset that is to be depreciated individually. The KG assigned a GmbH with the turnkey construction of the turbines and the terms of the purchase was "payable in installments". The GmbH then engaged another company with the delivery and installation of the wind turbines and take them into operation.
According to the contract, the risk of accidental destruction and accidental deterioration of the turbines should not pass before installation was completed. However, the turbines were first put to use in November 2004 and the wind turbines were inspected and accepted by the GmbH in September 2005. The KG expressed its wish to depreciate the turbines from its date of use but the German tax office objected and insisted that depreciation commenced from September 2005.
The German Supreme Tax Court clarified that tax depreciation for turbines presupposes economic ownership of the asset which occurs when risks are transferred to the purchaser/customer. The mere possession of the turbines from November 2004 did not negate the underlying insurance contract that stipulated that the risk of accidental destruction and accidental deterioration coverage does not commence until the acceptance of the wind turbines.
The court further, explained that should technical problems have occurred during the trial run of the wind turbines, the supplier of the asset still had to bear the risks until final acceptance. The Court ruled in favour of the tax office.
The TP audit cases summarized above indicates that the Courts are inclined to uphold the assessments of the tax authorities where it can be demonstrated that the substance of a transaction should result in additional taxes in its jurisdiction. The functional analysis was relied upon to clearly delineate the participating and benefitting entities as well as the management and control of risks associated with the transactions.
Recommendations and conclusions
Functional analysis is the starting point in determining the substance of controlled transactions. Updates should be made to the FAR analysis when there are significant changes that may affect the pricing of controlled transactions.
For example, changes may be required in cases of a business restructuring that would result in new reporting lines, expansion or alteration in activities performed by an entity or changes in tax jurisdictions.
In extreme cases, there is a possibility that tax authorities may seek to restructure controlled transactions arbitrarily, simply to create an inflated "revenue tax base". However, one of the most appropriate defense against such aggressive approach is for the terms of the contract, including the transfer price, to align with the actual conduct of the associated enterprises and documented in the functional analysis.
With the digitalization of the global economy, MNEs and tax authorities will continue to pay attention to the substance of controlled transactions. Taxpayers should have a resolve to create legal agreements setting out the terms and conditions of a controlled transaction and to make sure formal controls are in place to ensure adherence to the documented processes in the functional analysis.
Footnotes
1. OECD (2022), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, OECD Publishing, Paris, https://doi.org/10.1787/0e655865-en.
2. Denmark vs. NetApp Denmark ApS and TDC A/S. (2023). Supreme Court, Cases 69/2021, 79/2021, and 70/2021.
3. Germany vs "Turbine Owner Gmbh", September 2016, Supreme Tax Court IV R 1 14
https://tpcases.com/germany-vs-corp-september-2016-supreme-tax-court-iv-r-1-14/
The opinion expressed in this article is solely personal and does not represent the views of any organization or association to which the authors belong.
