A Busy First Quarter
There was a lot of transfer pricing activity this first quarter of 2017. This lengthy quarterly newsletter doesn't even mention any of the growing list of countries that are releasing guidance, legislation, forms and regulations regarding Country-by-Country reporting to focus on these other significant developments. Australia has been busy this quarter, we have had three large volumes released on application of transfer pricing principles, and the Amazon transfer pricing case was decided.
Simplified Transfer Pricing Record Keeping
Australia: The Australian Taxation Office (ATO) has issued the Practical Compliance Guideline ("PCG 2017/2") (pdf) that provides guidance on the administrative approach for the simplified transfer pricing record keeping option. This option allows certain taxpayers that meet the criteria to minimize the recording keeping cost. A recent blog from the Australian Boutique transfer pricing firm Transfer Pricing Solutions provides a nice summary and also provides a reminder that any company that chooses this simplified option must inform the ATO and must document how it satisfies ALL of the eligibility criteria.
Transfer Pricing Guidance Volumes
The first quarter has had three significant releases for guidance on specialized topics of practical transfer pricing practices.
A Toolkit for Addressing Difficulties in Accessing Comparable Data for Transfer Pricing Analyses: (130 page pdf)
This draft addresses the uncertainties and difficulties in conducting comparability analysis. Early in the paper the following principle is highlighted:
The selection of the most appropriate transfer pricing method, based on a detailed factual analysis, is central to the application of the arm's length principle, and in many cases, is likely to have a greater impact on the outcome than the accuracy of the data used in the method's application.
The overriding concern addressed in the paper is the scarcity of data in many circumstances. One option that the paper asks for comment is to have less rigid independence requirements in limited circumstance to use data that is presently being discarded as incomparable. That is, are there some instances where potential comparables may be useful, such as when independent minority shareholders may effectively mitigate risks of non-arm's length practices among related entities, or when certain entities have disclosed no related party transactions in their audited financial accounts.
The paper presents details on a typical process for performing a comparability analysis as well as details on typical search processes using a commercial database. A further toolkit on Transfer Pricing Documentation will be developed by this same group later in 2017.
Transfer Pricing and Developing Economies: A Handbook for Policy Makers and Practitioners
This handbook covers an extensive level of detail of transfer pricing concepts. At 391 pages, the handbook contains several flowcharts, check lists, examples, and links to additional resources. This handbook would be handy as a reference when searching for detail on a specific aspect of transfer pricing, be it the pricing of guarantees or other financial transactions, what to consider when pricing administrative support services, or considerations when selecting the tested party.
The handbook provides examples of comparability adjustments including employee stock-based compensation, working capital adjustments, and country-specific risk adjustments. This handbook, combined with the draft toolkit Addressing Difficulties in Accessing Comparable Data for Transfer Pricing Analyses as described above provides a framework to consider when and if adjustments to comparables are reasonable.
Transfer Pricing in Mining with a Focus on Africa: A Reference Guide for Practitioners (321 page pdf)
It has been estimated by the African Natural Resources Center that around 30% of the world's known mineral reserves, together with significant levels of remaining global oil and gas reserves are in Africa. Many jurisdictions in Africa have identified effective transfer pricing regimes as a frontline tool to ensure they receive their 'fair share' of global tax revenues on the profits associated with the extraction and sale of mineral commodities by multinational enterprises.
The guide recognizes that the administration of transfer pricing legislation and ensurance of compliance with the arm's-length principle pose a significant challenge for developing countries in assessing whether the transfer prices used, that is to say the price inputted to goods and services transferred in transactions between related-parties, are in line with those that would have been agreed to by independent parties under comparable circumstances.
The guide identifies that in some cases, fragmentation of the supply chain has resulted in the mining subsidiary in the source country performing mostly routine functions utilizing primarily tangible assets, operating as 'contract miners' do. Many of the specialized services are provided to the miner through cross-border transactions with related parties based on transfer pricing that are difficult to verify and audit and, therefore, open to interpretation and possible manipulation. As a result, the guide provides a detailed narrative of the transfer pricing considerations and issues that arise in the mining industry. A special focus is placed on the assumption and allocation of risk; organizational structures that are common in the resource sector; and intra-group financing. The use and application of the value chain for this industry is prevalent throughout the guide. If you are involved with transfer pricing in the mining industry or are interested in how the value chain is applied when aligning profit outcomes with the true economic contribution by entities in a given tax jurisdiction, then consider this guide to be of great value.
Does the IRS Cost Cutting Mean Less Transfer Pricing Audits?
Not according to a recent Wall Street Journal story. Previously, when a company scored high on the IRS risk exposure algorithm, the entire return was examined. Now the approach is modified to focus on this risk areas instead of the entire return. There are 13 specific areas identified where the IRS will concentrate their reduced resources. Some of these include offshore earnings, transfer pricing, insurance contracts and the insurance industry.
Australia now has its own Google Tax
The Diverted Profits Tax (DPT) has now been passed into law, as Australia joins the UK in implementing a unilateral anti-avoidance tax. This tax, like the UK's DTP is frowned upon by the OECD for departing from their recommendations. The DPT has a high risk of causing disagreements with the revenue authority in the countering jurisdiction.
Essentially, the Australian Taxation Office (ATO) will assess a 40 percent tax on an amount that was determined to be the tax benefit. The DPT is payable within 21 days, clearly placing the onus on the taxpayer to defend the assessment. The tax benefit is the amount that the ATO considers to have been a diversion of profits offshore through contrived arrangements.
The DPT are applicable to Australian companies that are part of a global group with annual income of AU$1 billion or more and where the Australian entity would, reasonably, have income over AU$25 million. The DPT applies when a taxpayer has obtained such a benefit from a scheme, the principal purpose of the scheme is to obtain an Australian tax benefit, and has failed the sufficient foreign tax test and the sufficient economic substance test. More information is generously provided by the ATO here.
Amazon Wins: IRS Continues their Losing Streak
The US Tax Court ruled in Amazon's favour on March 23rd, 2017 on Amazon's Luxembourg subsidiary's 2005 purchase of pre-existing intangibles and the associated cost sharing payments that maintain these intangibles.
The differences in the actual payment and the amount argued by the IRS were miles apart.
- Amazon Luxembourg (Amazon Europe Holding Technologies SCS or AEHT) paid $254.5 million for the intangibles whereas the IRS argued it should have been $3.468 billion.
- The cost sharing payments were calculated by Amazon to include 50% of a significant cost pool associated with technology and content. The IRS argued that 100% should have been allocated. This would increase the cost sharing payments by $23 million in 2005 and $109.9 million in 2006.
- The cost sharing arrangement also included stock based compensation from US Amazon employees in the cost pool. The arrangement contained a clawback provision in event the Commissioner of Internal Revenue's position of including stock-based compensation was ruled to be an invalid regulation. The court also accepted the activation of Amazon's clawback provision.
The IRS Expert's report noted that the buy-in calculation and Amazon's own financial projections provided AEHT an expected rate of return of 128% on its intellectual property payments. Arguably, this rate of return is inconsistent with the arm's length standard. Also, the projections for AEHT gave them a large share of the expected profits. Also, arguably not an arm's length business transaction. The expert report also noted that in 2004, Amazon was the world's largest global Internet retailer, with worldwide sales of $6.9 billion that was three times as much as its closest competitor. At the time, the brand was internationally recognized and was associated with convenience, low prices, and a wide array of product choices. In addition, the transfer pricing documentation report prepared for Amazon for the buy-in transaction used a non-specified method that was akin to a profit split method. The documentation method contained numerous deficiencies that made it impossible to demonstrate the buy-in followed arm's length terms and conditions. So how did Amazon win?
The buy-in Transaction:
The IRS relied on a discounted cash flow method that it positioned to be different than the discounted cash flow method the IRS used when it lost in Veritas Software Corp. v. Commissioner. Unfortunately to the IRS, the court stated:
One does not need a Ph. D. in economics to appreciate the essential similarity between the discounted cash flow methodology that Dr. Hatch employed in Veritas and the discounted cash flow method that Dr. Frisch employed here.
The court rejected the discounted cash flow method since it valued the entire business instead of just the intellectual property, and that the IRS's assumption that the existing intellectual property had an indefinite life was shown to be invalid. The credibility of the IRS weakened when it made a calculation error when determining the value of Amazon's stock 'beta' value and subsequently mispriced the discount rate used in the discounted cash flow, causing a significant variance of the calculated intangible value.
Amazon, wisely used a different method to justify the buy-in amount than the profit-split method they used in their 2005 transfer pricing report. Amazon used the Comparable Uncontrolled Transaction method to value three different bundles of intellectual property part of the buy-in. The IRS also provided their analysis using the Comparable Uncontrolled Transaction method in event their discounted cash flow method was not accepted. However, the IRS's selection of the higher valued comparable uncontrolled transactions as well as their insistence that the intangibles in question had an indefinite life failed to convince the court the validity of their analysis.
The cost sharing payments:
Amazon presented a highly-detailed presentation of how the 50% allocation of the Technology and Content cost pool was determined. The robust, fact-based analysis was very difficult for the IRS to counter and the 50% allocation to the pool was accepted by the court. The acceptance of the cost pool cost adjustment of the stock based compensation was simply the court following the recent Altera Corp. V. Commissioner decision.
Did the IRS fumble in their arguments?
In addition to the mispriced beta, the IRS's position also incorrectly included revenues attributed to giftwrap, shipping, and miscellaneous services on the base for the royalty when third parties did not. And an IRS's expert used information prepared in October 2013 as a source for revenue projections instead of relying on ex ante sources, as best practices would dictate. These errors would not have provided the court confidence in the IRS's argument.
At one point in time in the Judge's decision, it was noted that the IRS views AEHT as a cashbox. However, Amazon successfully demonstrated the six-year history of Amazon in Europe prior to the 2005 intellectual property transfer by illustrating the tangible and intangible assets and skilled workforce that existed in the European operations of Amazon.
However, the IRS did have significant challenges to overcome. Amazon's change of transfer pricing method to justify the buy-in from the profit-split type approach to the comparable uncontrolled transaction analysis was key to their success. In addition, the evidence provided by Amazon related to the Technology and Content cost pool illustrates the asymmetry of information Amazon has over the IRS. This asymmetry also aided Amazon to demonstrate the substance and history of Amazon Europe to obliviate the assertion by the IRS that Amazon Luxembourg only served as a cash box.
TP Compass Opinion:
It is likely that AEHT paid a below arm's length price for the intellectual property acquired. But the argument the IRS put forward was materially over and above that arm's length price. The IRS used essentially the same approach that they lost with Veritas. The IRS may have had better luck if they had taken a moderate approach and accepts that intangible value does not last indefinitely; but that maintaining this intangible value of a company that is the 'leader of the pack' is far easier than what Amazon had positioned.
To view the court decision, click here. (207 page pdf)
For more reading about the Amazon case, an excellent blog post by Professor William Brynes can be found here at the Kluwer International Tax Blog.