The Hindu Business Line : Transfer pricing in business restructuring

Business restructurings covered within the scope of the OECD’s discussion draft primarily consist of internal reallocation of functions, assets and risks within a multinational enterprise.

Girish Vanvari
Chirag Shah

Recently, the OECD Committee on Fiscal Affairs (CFA) released for public comments a discussion draft on the transfer pricing aspects of business restructurings.

The discussion draft trails the recent widespread surge in business restructurings by multinationals enterprises and is an outcome of the discussions at the January 2005 OECD Centre for Tax Policy and Administration (CTPA) Roundtable on Business Restr ucturings.

In the past decade, business restructurings have typically consisted of: conversion of full-fledged distributors into limited-risk distributors or commissionaires; conversion of full-fledged manufacturers into contract-manufacturers or toll-manufacturers; rationalisation and/or specialisation of operations (manufacturing sites and/or processes, research and development activities, sales, services); and transfers of intangible property rights to an “IP company” within the group.

The discussions at the roundtable demonstrated that at one end the business reasons for restructuring are the wish to maximise synergies and economies of scale, to streamline the management of business lines and to improve the efficiency of the supply chain, taking advantage of the development of Internet-based technologies that has facilitated the emergence of global organisations.

On the other end, business restructurings also raise difficult transfer pricing and treaty issues for which there is currently insufficient OECD guidance with respect to their treatment under both the OECD Transfer Pricing Guidelines and OECD Model Tax Convention.

To develop guidance on these transfer pricing and treaty issues, the CFA created a Joint Working Group (JWG) of delegates from Working Party No. 1 (responsible for the Model Tax Convention) to work on the PE threshold aspects of business restructurings and delegates from Working Party No. 6 (responsible for the TP Guidelines) to work on transfer pricing aspects of business restructurings.

The recently issued discussion draft has resulted from the work done on the transfer pricing issues. A separate discussion draft would be issued in due course which is intended to consider PE definitional issues in the context of business restructurings.

The CFA generally defines business restructuring as the cross-border redeployment by a multinational enterprise of functions, assets and/or risks. Business restructurings covered within the scope of the OECD’s discussion draft primarily consist of internal reallocation of functions, assets and risks within a multinational enterprise. Specifically, corporate reorganisations such as mergers and acquisitions are not within the scope of OECD’s discussion draft.

Typically, reallocation of profits follows business restructuring among the multinational enterprises group either immediately after the restructuring or over a few years. The discussion draft’s major objective is to discuss the extent to which such a reallocation of profits is consistent with the arm’s length principle and more generally how the arm’s length principle applies to business restructurings.

The discussion draft is based on the existing transfer pricing rules. It starts from the premise that the arm’s length principle and the Transfer Pricing Guidelines should not apply differently to restructurings or post-restructuring transactions than to transactions that were structured as such from the beginning.

However, the scope of the discussion draft does not include: domestic anti-abuse rules and CFC legislation; and domestic tax treatment of an arm’s length payment, including rules regarding the deductibility of such a payment and applicability of domestic capital gains tax provisions to an arm’s length capital payment

VAT and indirect taxes

The discussion draft considers the transfer pricing issues in four Issues Notes. An outline of these has been provided below:

Issues Note 1 — Special Considerations for Risks: The first Issues Note provides general guidance on the allocation of risks between related parties and, in particular, the interpretation and application of paragraphs 1.26 to 1.29 of the TP Guidelines.

Theoretically, the assumption of increased risk must be compensated by an increase in the expected return, although the actual return may or may not increase depending on the degree to which the risks are actually realised.

Risk allocation and risk transfers are significant factors in many business restructurings.

The first Issues Note mentions that an examination of risks starts from an examination of the contractual terms between the parties, as those generally define how risks are to be divided between the parties.

The contractual allocation of risk between associated enterprises, however, is respected only to the extent that it has economic substance. Therefore, the review of contractual terms must be completed by a review of the following:

Whether the related parties conform to the contractual allocation of risks;

Whether the contractual terms provide for an arm’s length allocation of risks;

Whether the risk is economically significant; and

What the transfer pricing consequences of the risk allocation are.

Issues Note 2 — Arm’s Length Compensation for the Restructuring Itself: Business restructurings involve transfers of functions, assets and/or risks with associated profit/loss potential between associated enterprises.

Restructurings can also involve the termination or substantial renegotiation of existing arrangements. The second Issues Note discusses the application of the arm’s length principle and TP Guidelines to the restructuring itself, in particular the circumstances in which at arm’s length the restructured entity would receive compensation for the transfer of functions, assets, and/or risks, and/or indemnification for the termination or substantial renegotiation of the existing arrangements.

It basically covers the following:

Understanding the restructuring, including the changes that have taken place, how they have affected the functional analysis of the parties, what the business reasons for and the anticipated benefits from the restructuring were, and what options would have been realistically available to the parties at arm’s length;

Reallocation of profit/loss potential as a result of a reallocation of risks;

Arm’s length compensation for a transfer of something of value (that is, an asset, including a right to conduct an activity) to a related party as a result of a restructuring; and

Whether there would be compensation at arm’s length for the detriment or loss suffered as a result of a restructuring.

Issues Note 3 — Remuneration of Post- Restructuring Controlled Transactions: This examines the application of the TP Guidelines to post-restructuring arrangements. This Note provides that the general guidance on the selection of transfer pricing methods applies to business restructuring cases. However, business restructurings raise particular issues and hence deserve specific consideration.

Issues Note 4 – Recognition of Actual Transactions Undertaken: This Note discusses important notions regarding the exceptional circumstances in which a tax administration may consider not recognising a transaction or structure adopted by a taxpayer, based on an analysis of the existing guidance at paragraphs 1.36-1.41 of the TP Guidelines and of the relationship between these paragraphs and other parts of the TP Guidelines.

The discussion draft is welcome as it provides additional guidance to the interpretation and application of provisions of OECD Transfer Pricing Guidelines that may be applicable to business restructurings.

(The authors are Executive Director and Manager, respectively, KPMG. blfeedback@thehindu.co.in)

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