The Base Erosion Profit Shifting (BEPS) reform has some serious punch. The true extent to which BEPS will reduce aggressive as well as abusive tax planning schemes only becomes clear when looking at the fundamental changes of transfer pricing regulations on the level of individual transactions. This article discusses the impact of BEPS on intercompany transactions involving intangibles as well as financial transactions, illustrating that there is no need for additional anti-abuse policies (“beyond BEPS”). It will also be discussed that most of the anti-abuse policies currently on the agenda of policymakers are not targeted at limiting tax avoidance, but rather aim to maximize tax revenues by high tax governments.
In my previous contribution to CFR (3Q/2018, Issue 52), I have pointed out that the reforms resulting from the BEPS project will have a su bstantial impact on transfer pricing and tax structures in the years to come. I further stressed that there cannot be any doubt that the BEPS project will largely succeed in facilitating a closer alignment between the place where value is created and where taxes are paid. I have primarily made these comments to criticize the EU for continuing to conceive and implement new and increasingly suffocating tax reforms that go far beyond the OECD BEPS reforms – notably, tax-grabbing policy proposals such as the Common Consolidated Corporate Tax Base (CCCTB) and the new approach to digital taxation, which are pet projects of the EU bureaucracy and some high tax governments who are committed to eliminate tax competition.
The most recent discussions on the level of the OECD provide a good opportunity to further substantiate my previous comments by illustrating how far reaching the impact of the BEPS project is already. To be sure, interpreting discussions involves a fair deal of speculation when anticipating policy outcomes. Still, as the implementation of BEPS reforms now enters the nitty-gritty stage of hammering out the new or modified regulations for specific types of intercompany transactions, it does no longer require a crystal ball to clearly recognize the challenges ahead. In the following, I will focus on illustrating the impact of BEPS on transactions involving intangibles as well as on financial transactions. Two things shall become clear:
- BEPS will seriously curtail any abusive transfer pricing practices, with the burden of proof for arm’s length compliant pricing gradually being shifted to the taxpayer.
- Policymakers should take a deep breath and start recognizing that, provided curbing aggressive tax structuring is their honest aim rather than pushing ahead a blatantly tax grabbing agenda, there really is really no need to introduce any additional anti-abuse policy proposals beyond BEPS at this time.
Intangibles – the fight over the economic interpretation of ‘value creation’ is not about limiting tax avoidance
Intangibles have been a focal point of the BEPS project. Specifically, the OECD was determined to enshrine the emphasis on economic value added as the basis for an arm’s length profit allocation (opposed to legal ownership) into the transfer pricing guidelines. As pointed out in a recent contribution to Tax Notes International (Vol. 91, No.8, pp. 797 – 800) respective modifications can be observed most clearly in the introduction of the so-called DEMPE concept, which is designed to identify the value contributions of each party to a transaction involving intangibles by analyzing the functions of Development, Enhancement, Maintenance, Protection and Exploitation. The extent to which each of these functions contribute to the total value-added will obviously depend on the idiosyncratic value-chain of the taxpayer, which can be reflected in the analysis by assigning differing weights to individual functions. Introducing the DEMPE concept will thus ensure that profits, specifically the residual profits resulting from the exploitation of intangibles, are closer aligned with value creation. In the pre-BEPS world, the legal ownership of an intangible was basically enough for allocating the bulk of residual profits to an entity with minimal substance located in a low tax jurisdiction. The introduction of BEPS effectively renders one of the core mechanisms underlying aggressive transfer pricing schemes unfeasible for the future.
What is noteworthy in this context, is that the OECD coupled the introduction of the DEMPE concept with issuing new guidance for tax administrations on the application of the approach to hard-to-value-intangibles (the HTVI approach), which is important when determining a selling price for intangibles that are transferred between related parties. The somewhat nasty aspect of the HTVI approach is that it essentially permits tax authorities to use ex-post financial results as presumptive evidence that the ex-ante price-setting was not consistent with the arm’s length principle. This implies that the value of an intangible that was sold between related entities for $20 million in 2018 (i.e., with the transfer price being based on a DCF analysis) would be subjected to challenges in future tax audits based on actual future value.
As the valuation of intangibles invariably involves dealing with substantial uncertainties, it will often only be feasible to determine a price within a range of feasible values. Now, if market developments or other unforeseeable developments will impact the value of the intangible, i.e., imagine an update of the DCF analysis conducted on data available in 2022 yielding a value of $50 million, the HTVI approach would (in this highly simplified example) essentially allow tax authorities to make a transfer pricing adjustment based on the $50 million (i.e., a price adjustment of $30 million) and to retroactively levy tax of the adjusted price.
Unsurprisingly, there was quite some discontent in the transfer pricing community during the public consultation procedure, but to no avail, as the OECD insisted on keeping this harsh anti-avoidance mechanism on the agenda.
As far as transfer pricing regulations go, the introduction of the DEMPE concept could be interpreted as being sensible, as it reflects an adequate tradeoff between reducing aggressive transfer pricing schemes and sustaining the international consensus on the arm’s length principle. With introducing the HTVI approach, however, the OECD provided tax authorities with an unnecessarily harsh anti-avoidance tool that is bound to create many conflicts in future tax audits. Irrespective of how one evaluates the quality of the new regulations, it seems hard to argue that BEPS is a toothless placebo-type of reform.
The fact that the EU is still not content with anti-abuse measures facilitated by BEPS must thus be seen in the fact that they are not so much concerned with minimizing aggressive tax structures (tax avoidance) but are rather determined to generate as much tax as possible in their respective jurisdictions.
What we can observe in the context of the proposed digital taxation is that the EU will increasingly advance the thesis that the “value of things” largely depends on how (where) people use them. Based on this thesis, they will aim to design international tax rules that allocate the profits based on concepts such as “user innovation” rather than on money and other resources devoted develop intangibles (including high-profile patent generating R&D).
This new interpretation of value creation is quite different from the interpretation implied in the DEMPE concept and will be heavily relied on by the EU and other advocates of higher taxes in advancing their centralist and tax grabbing agenda. Further long-term policy implications of such an interpretation could be the introduction of limitations of Patent Box regimes and other R&D incentives.
The vital nature of the fight about the interpretation of value creation was recently discussed by Mindy Herzfeld (Tax Notes International Vol. 91, No.8, pp. 773-777). The support voiced by Mrs. Herzfeld for the user innovation thesis is based on critiquing the OECD for failing to clarify what creates value and for failing to provide guidance for determining where value is created. Naturally, the DEMPE concept is not perfect at this stage but it certainly provides sufficient guidance for determining an arm’s length allocation of profits. Again, if regulators would be really concerned with minimizing tax avoidance, they would devote their attention towards optimizing the DEMPE concept instead of going beyond BEPS and creating additional (interim) taxes on revenues instead of profits, i.e., for online advertising.
Financial transactions: MNEs face increased scrutiny and difficulties defending interest rates applied in intergroup financing
In its recent public discussion draft, the OECD addressed transfer pricing specific issues of intergroup financial transactions, such as treasury functions, intra-group loans and cash pooling. Alongside intangibles, intragroup financing activities have received a lot of attention throughout the BEPS project. Like intangibles, financial transactions (interest rates) provide an attractive lever for aggressive transfer pricing structures. Obviously, charging comparatively high interest rates to operating entities in high tax jurisdictions potentially enables MNEs to funnel profits to financing entities (often holding companies) located in a low tax jurisdiction. Hence, tax authorities were notoriously suspect when seeing interest rates applied for intercompany transactions that exceed rates that are observed in day-to-day transfer pricing transactions. For financial transactions, the price-setting is often based on interest rates observed in the financial markets for similar transactions, with one of the most important factors to consider in a comparability analysis being the creditworthiness (credit rating) of the borrower. The arm’s length analysis for defending the appropriateness of the interest rate is often based on a benchmark analysis. In case that taxpayers could substantiate that a low credit rating (and thus high interest rate) is justified for a specific transaction, it was usually in a good position to defend the arm’s length nature of the applied transfer prices – with the burden of proof falling on the tax authorities.
Now, in a nutshell (and without addressing technical details), the Leitmotiv of the OECD discussion draft seems to be that intercompany financing activities are – by default – to be viewed as mere (routine) or support functions – i.e., not contributing substantial value (again, note how crucial the interpretation of value creation is for transfer pricing). The immediate consequences are that the OECD suggests that the interest rate charged to a related entity (subsidiary) should be based on the group rating. Specifically, the OECD suggests introducing a “rebuttable presumption that tax administrations may consider to use the credit rating of the MNE group as the starting point, from which appropriate adjustments are made, to determine the credit rating of the borrower ….”
If indeed implemented this would factually amount to a reversal of the burden of proof and MNEs, obviously including those never having adopted aggressive tax structures. MNEs having thus far based their intercompany loan agreements on the stand-alone rating of a local borrower, will face substantially increased difficulties in justifying the arm’s length nature of the applied interest rate.
For cash pooling agreements, the OECD formulated the default assumption of the low value-added nature of treasury functions even more explicitly; i.e., “In general, a cash pool leader performs no more than a co-ordination or agency function with the master account being a centralized point for a series of book entries to meet the pre-determined target balances for the pool members. Given such a low level of functionality, the cash pool leader’s remuneration as a service provider will generally be similarly limited.”
In other words, it will no longer be feasible, without compiling comprehensive analysis and justification, to allocate synergies realized from cash pooling at the level of a financial holding located in a low tax jurisdiction.
To be sure, the guidelines on financial transactions may only be in the discussion stage at this time. Many commentators have provided detailed and very sound arguments to the OECD (comments amounted to more than 800 pages), outlining that the proposed guidelines reflect an unduly negative view on the reliability of ensuring arm’s length pricing based on available market data and that there exist too many circumstances in which the simplified assumptions and the proposed rebuttable presumptions will not valid (for a summary of the relevant technical aspects, I recommend reading the comments submitted by NERA Economic Consulting, Public Comments – Part III, pp. 62ff.).
Looking back at the public discussion procedure on intangibles, however, one should not be too surprised if the OECD sticks rather close to its initial proposals when publishing the final guidelines. In any case, the discussion of the financial transactions further illustrates that BEPS is anything but a paper tiger and will have a tangible impact on the way MNEs structure their financial activities and the business operations.
There is a strong case to be made that BEPS will ultimately prove to be somewhat successful – measured by the goals set by the OECD in the beginning of the project. When viewed a little magnanimous, BEPS is reflecting an appropriate modernization of the arm’s length principle, as well as a targeted reform that effectively limits tax avoidance.
There is some good and some bad, but overall BEPS is at least no major calamity. On a technical level, there remain many unresolved issues and the OECD at times (the HTVI approach and rebuttable presumption for financial transactions) tends to be overzealous.
What I really do not see currently, however, is the need for any additional reforms or policies to counter tax avoidance. Resolving the unresolved technical issues will be more than enough. My impression is that advocates of going beyond BEPS, notably the EU, merely utilize the fight against tax avoidance as a fig leaf for their tax grabbing agenda. It is time to tear away this fig leaf and expose these advocates of higher taxes and anti-business policies for what they are.