24 annual health sciences tax conference - united states · 24th annual health sciences tax...

24th Annual Health Sciences Tax Conference

The OECD Base Erosion and Profit Shifting (“BEPS”) Initiative and Transfer Pricing

December 10, 2014


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► Views expressed in this presentation are those of the speakers and do not necessarily represent the views of Ernst & Young LLP.

► This presentation is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s facts and circumstances.

► These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting advice.


Presenters

► John HickeySenior Manager Global Transfer PricingJohnson & JohnsonNew Brunswick, NJ

► Barry O’SullivanExecutive Director International Tax OperationsMerck & Co., Inc.Whitehouse Station, NJ

► Natalia PerezErnst & Young LLPNew York, [email protected]+1 212 773 8154

► Siv SchultzErnst & Young LLPNew York, [email protected]+1 212 773 3818

► Craig SharonErnst & Young LLPWashington, [email protected]+1 202 327 7095


Agenda

► BEPS action plan status► Action 8 - TP aspects of intangibles► Action 13 - TP documentation and CbC reporting

requirements► Controversy in the BEPS environment and managing

risk► Other BEPS actions impacting life sciences companies


BEPS action plan status


BEPS action plan: Status as of 16 September 2014 (last updated)

2014 Deliverables:Action 1: Tax challenges of digital economy – September 2014

Action 2: Hybrid mismatch arrangements –September 2014

Action 5: Harmful tax practices – September 2014/ September 2015/ December 2015

Action 6: Treaty abuse –September 2014

Action 8: TP for intangibles –September 2014/September 2015

Action 13: TP documentation – September 2014

Action 15: Development of a multilateral instrument for amending bilateral tax treaties –September 2014/December 2015

2015 Deliverables:Action 3: Controlled foreign corporation (CFC) rules – September 2015

Action 4: Deductibility of interest and other financial payments – September/December 2015

Action 7: Artificial avoidance of PE status –September 2015

Action 9: TP for risks and capital –September 2015

Action 10: TP for other high-risktransactions – September 2015

Action 11: Development of data on BEPS and actions addressing it – September 2015

Action 12: Disclosure of aggressive tax planning arrangements – September 2015

Action 14: Effectiveness of treaty dispute resolution mechanisms – September 2015


Tax landscape related to OECD BEPS

► OECD’s Action Plan on Addressing Base Erosion and Profit Shifting (“BEPS”) is aimed at government concern about potential for multinational enterprises (“MNEs”) to reduce their tax liabilities through shifting of income to no- or low-tax countries.

► Driven by MNE tax issues that have been in the headlines around the world.

► G8 and G20 governments have endorsed OECD’s work on BEPS and have committed to individual country action.

► Major developing (non-OECD) countries, including China and India, are actively participating in the BEPS project.

► Responsive changes over the next several years will differ across countries in specifics and in timing, reflecting each country’s particular circumstances.

► Companies are focused on preparing for the impact of BEPS-related developments in all countries where they conduct business.

► OECD BEPS agenda is ambitious in both scope and timing, and the issues are complex, but there is a real sense of political imperative and the OECD has met their deadlines to date, indicating commitment and progress.

► The strongest political imperative and sense of urgency is around increased transparency.


Action 8 – TP aspects of intangibles


Changing perceptions of entitlement to profit from intangibles

1980’s 2015 1990’s

Owner

Legal Owner Legal Owner

R&D FunderInvestor

Controller/Functional Contributor

Developer DeveloperRoutine Developer

Developer/Functional Contributor

User UserPure User

Value Contributor

Non-routine (residual claimant)

Routine

Legal Owner

Economic Owner

Developer

User

2000’s


Action 8 – Overview

► On 16 September 2014, the OECD released its draft recommendations on Action 8

► This interim guidance will be finalized in 2015 in connection with the BEPS work on risk, recharacterization, and hard to value intangibles

► The report contains revised standards for the TP of intangibles, including:► Definition of “intangible” and its component parts (e.g., “marketing

intangible”)► Guidance on location savings and other local market characteristics and

assembled work force► Valuation guidance with respect to intangibles► TP of synergies and “group effects”► Ownership of intangibles (moving away from legal to functional)► Role of control over capital, risks and financing with respect to intangibles


Action 8 – Report overview

Main final changes

Chapter I► Clarification of definition of

intangibles ► Discussion of transfer

pricing treatment of location savings, other local market features, assembled workforce and corporate synergies

Chapter VI► New guidance on

comparability in transactions involving intangibles

► New guidance on transfer pricing methods and use of valuation techniques

Interim guidance

Provided on the allocation of returns derived from intangibles► Legal ownership and

contractual arrangements are starting point in transfer pricing analysis of intangibles

► Financing return to be attributable to entities that finance development / acquisition of intangibles and that have legal ownership

► DEMPE functions – arm’s length return to entities developing, enhancing, maintaining, protecting and exploiting intangibles

Recommendations

To be issued in final form in 2015 following consideration of several controversial points:► Excessive

capitalization► “Cash box” intangible

owners ► Contractual

assignment of risks► Hard to value

intangibles


Action 8 – Main final changes, Chapter I

► Definition of Intangible: ► “Something which is not a physical asset or a financial asset, and

which is capable of being owned or controlled for use in commercial activities and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.”

► Definition of Marketing Intangible:► “An intangible (within the meaning of paragraph 6.6) that relates to

marketing activities, aids in the commercial exploitation of a product or service, and/or has an important promotional value for the product concerned. Depending on the context, marketing intangibles may include, for example, trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers.””


Action 8 – Main final changes, Chapter I

► Comparability of local market features, location savings, assembled workforce and group synergies should be taken into account

► Local market features are not intangibles and should be distinguished from contractual rights or government licenses that limit market entry, and may be intangibles► Marketing authorization could constitute an intangible

► Transfer or secondment of employees may result in the transfer of valuable know-how


Action 8 – Main final changes, Chapter VI

► Intangible transaction comparability: ► Transfer pricing analysis of intangible transactions (use or transfer)

rooted in understanding of MNE’s global business and intangibles used to create value

► Comparability and functional analysis require understanding the intangible intercompany transaction and its contribution to value creation

► Ownership of an intangible does not always lead to a non-routine return

► Not all R&D expenses or marketing activities result in the creation or enhancement of an intangible



► TP methods and use of valuation techniques► Two-sided analysis – consider options realistically available to each party

to the transaction

► One-sided methods used only to value intangibles indirectly (estimate value of intangible as a residual)

► Most useful methods to analyze intercompany transactions involving intangibles are the Comparable Uncontrolled Price Method (“CUP”) and the transactional profit split method

► Uniqueness of the intangible determines need to adjust CUP or to rely on profit split methods or valuation methods► CUP – requires strong comparability of intangibles between transactions

► Profit split method desirable if both parties make unique and valuable contributions to the transaction



► TP methods and use of valuation techniques► Valuation techniques may be used and should be applied in a manner

consistent with arm’s length standard► Consider options realistically available to both sides, attribution of risk

and aggregation of transactions► Volatility of valuation results based on application of valuation methods

require careful look at assumptions► Thorough understanding of assumptions (e.g., discount rate, useful life, growth

rates) and motivations underlying financial projections

► Preference for business projections relied upon for operational decision making

► Selection of payment form (royalties v. lump sum) to be consistent with facts and circumstances including parties ability to manage payment risks► Converting lump sum into royalty stream should be done at a higher discount

rate to reflect increased risk to owner of intangible


Action 8 – Interim guidanceEntities entitled to the return for intangibles

► Which of the entities in an MNE group should be entitled to retain the economic profits from exploitation of intangibles?► The legal ownership of an intangible by itself does not confer any

right to retain the return from exploiting an intangible.

► Legal ownership and funding of the development of an intangible do not lead, in isolation, to an entitlement to the returns derived from the exploitation of such intangible ► Bearing funding risk would entitle funder to a risk-adjusted rate of

return on its funding

► Entities performing functions related to development, enhancement, maintenance, protection and exploitation (“DEMPE”) of the intangibles are entitled to a share of the intangibles returns


Action 8 – Interim guidanceEx ante v. ex post returns

► Should profits/losses be shared among entities that have contributed DEMPE associated functions (ex post returns)? If so, how to split?► If outcome truly unanticipated and pricing of all intercompany

transactions relating to the intangible (including remuneration for DEMPE functions) is at arm’s length then ex post returns also at arm’s length (no sharing)


Action 8 – Recommendations

► Cash box► Separation of ownership, assumption of risk and/or funding of

investments in the intangible from important functions and control over risk may seen as source of BEPS

► If intangible is rarely/never shared with third parties, intercompany transactions involving intangible) could be re-characterized by tax authorities

► TP analysis that strips income out of the cash box► Company that funds R&D should earn a lower return than one that funds and

controls R&D

► Bearing a funding risk entitles to a risk-adjusted rate of return on funding, but not more


Action 8 – Recommendations

► Hard to value intangibles► How to determine the arm’s length price of an intangible when the level of

uncertainty is very high?

► Unrelated parties may adopt shorter-term agreements or include price adjustment clauses to address ex post results: e.g., varying royalty rate according to product sales volume► EXAMPLE: Pharma1 licenses compound to Pharma2 at an early stage. At

time of transaction, compound expected to achieve high volume of sales. Competitor introduces alternative low-cost therapy. Pharma2 may decide to stop manufacturing the product, in which case Pharma1 and Pharma2 might renegotiate terms of agreement


Action 8 – Impact on Life Sciences companies► Typically intangibles are a key focus in life sciences planning strategies

► Intercompany licenses, cost sharing, R&D funding, etc.► Another closely linked element of planning is the allocation of risk

► Definition of intangible property► Intangible definition in draft guidelines generally consistent with life sciences

concepts, such as patents, technology/know-how or regulatory approval/government licenses

► However, the revised guidelines provide more focus on a broader category of intangible that may be transferred only in combination with other assets, such as goodwill

► How does the clarification on marketing intangibles affect the return to LRDs?► Role of functions and risk

► More emphasis on controlling risk, may impact the entities that:► Bear product liability, ► Pay for R&D, or► Responsible for quality control

► Potential challenges to late stage licenses and licensee’s management of product commercialization


Action 8 – Impact on Life Sciences companies

► Impact of revised guidelines on pricing methodologies► CUP method – Continues as a viable method with increased focus on comparability► Profit split – Subject to further work, more discussion on the reliability of projections► Valuation techniques – Brings in US cost-sharing concepts

► Effect on supply chain operations► More need for substance and control in principal location

► Can you demonstrate that key value drivers are controlled by the licensee and its IP licensor?

► Will the greater focus on “value contributors” translate to more returns to R&D service providers?

► Do you have inter-company transactions where one or both parties uses intangibles in connection with the sale of goods or provision of services?


Action 13 – TP documentation and CbC reporting requirements


Action 13 – Overview

► On 16 September 2014, the OECD released its recommendations on Action 13 - TP documentation and country-by-country reporting -under its Action Plan on BEPS

► The report on Action 13 contains revised standards for TP documentation and a template for CbC reporting for MNEs, both of which will be included in the OECD TP Guidelines

► The report indicates that the standards will be revisited by the OECD and G20 countries no later than the end of 2020

► Implementation issues will be addressed by early 2015


Action 13 – TP documentation and CbC reporting requirements

Master FileOverview of the MNE group business, its overall TP policies

and its global allocation of income (e.g., agreements with tax authorities) in a single document, including cross-

references to other existing documents and copies of the relevant documents.1 Include MNE’s consolidated financial

statement for the year under review.

CbC ReportInformation on jurisdictional

allocation of profits, revenues, employees and assets for use in the high-level transfer pricing risk

assessment purposes. Include activities performed by constituent entity2 within each tax jurisdiction.

Local FileDetailed information on the MNE’s local business, including related party payments and receipts for products, services, royalties, interest, etc. Include annual local entity financial

accounts and schedule tying TP financials to annual financial statement.

1. The draft report on Action 13 states that the information is considered important for inclusion in the master file if its omission would affect the reliability of the transfer pricing outcomes. The report does not provide more detailed guidance, such as materiality thresholds, on what is considered important.2. Any separate business unit of the MNE group that is included in the consolidated group for financial reporting purposes.


Action 13 – Master File - Information Required

Organizational Structure Business description Intangibles Intercompany

financial activitiesFinancial and tax positions

Structure chart: ► Legal

ownership ► Geographic

location

Important drivers of business profit Overall strategy description

Financing arrangements for the group (related and unrelated lenders)

Annual consolidated financial statements

Supply chain of: ► 5 largest products/services by

turnover ► Products/services generating

more than 5% of turnover

List of important intangibles and legal owners

Identification of financing entities

List and description of existing unilateral APAs and other tax rulings

Main geographic markets of above products

List of important intangible agreements

Details of financial TP policies

List and brief description of important service arrangements

R&D and intangible TP policies

Functional analysis of principal contributions to value creation by individual entities

Details of important transfers

Business restructuring/ acquisitions/ divestitures during fiscal year


Action 13 – Local File - Information Required

Local Entity Controlled transactions Financial information

► Management structure

► Local organization chart

► Details on individuals to whom local management reports

► Description of material controlled transactions and context in which they take place

► Copies of all material intercompany agreements► Identification of associated enterprises party to

controlled transactions and relationship ► Functional analysis ► Transfer pricing methods used ► Comparables and details of methodology

Local entity financial statements

Description of business and business strategy pursued

Amounts of intra-group payments and receipts for controlled transactions (i.e. products, services, royalties, interest, etc.)

Reconciliation to show how financial data used in applying the TP method ties to the financial statements

Details of business restructurings and/or intangibles transfers

Unilateral and bilateral/multilateral APAs and other tax rulings related to the controlled transactions

Summary of relevant financial data for comparables and sources from which data was obtained

Key competitors


Action 13 – CbC Template

► The CbC reporting template, an entirely new reporting requirement, requires MNEs to report information (see following slides) annually on a jurisdiction by jurisdiction.


Action 13 – CbC Template – Main Reporting Table – Country Aggregated Data

Notes: ► Aggregated rather than consolidated data.► Flexibility in data sources allowed.► Entity data aggregated on the basis of tax residence.► Revenue defined to include turnover, royalties, property and interest income.► Revenue specifically excludes intercompany dividends.► Profit/loss before income tax includes extraordinary items.► Cash tax paid includes tax withheld by other parties on payments to the constituent entity.► Current year tax accrual is tax on current year operations only.► Number of employees may include external contractors.


Action 13 – CbC Template – Table 2 – Entity Details

If “Other” is selected in the “Main business activity(ies)” column, further brief information or explanation supporting the compulsory information provided in the CbC report will need to be included in Table 3 - Additional Information.

Notes: ► Constituent entities rather than legal entities.► Multiple activities may be chosen.


Controversy in the BEPS environment and managing risk


BEPS, transparency, substance

94% of the largest companies having an opinion on the matter think that global disclosure and transparency requirements will continue to grow in the next two years.

74% of the largest companies say they feel that tax administrators are now challenging existing structures due to changes in the law or changes in their enforcement approach.

Of the largest companies expressing an opinion, 51% said that in the last two years they have experienced an increased focus by the tax authorities in their headquarters country on the economic and operational substance of foreign entities in their company’s group.


Data analysisThe growth of exchange of information requests

► According to an OECD sample of 23 jurisdictions for which comparable data are available, the number of exchange of information (EOI) requests received has increased by 81% from 2009 to 2012

► This figure is even more pronounced for those jurisdictions with smaller volumes of requests – jurisdictions with fewer than 100 requests in the first year of the OECD’s Peer Review process saw average increase of almost 267% over the three years (sample of 16 jurisdictions)


BEPS enforcement

Countries are beginning to enforce BEPS before rules are finalized► Several issues are being legislated or enforced in

advance of BEPS action items’ finalization► Limitations on benefits► General anti-avoidance rules (GAAR)► Corporate responsibility/anti-base erosion initiatives► Permanent establishments► Treaty benefits► Deductibility of expenses► Withholding


What you can do now?

Strategic planning review► Factors to consider

► Transparency increasing► Alignment of substance► Increased sophistication of risk assessment and planning risk

management► Rebalance value chain vs. capital structure approaches► Consider options/develop measured response► Keep in mind current landscape

► Settle legacy controversy issues► Proactive shift to greater transparency► Consider unilateral and bilateral APAs, MAP relief


Other BEPS actions impacting Life Sciences companies


Action 5 – Harmful tax practices

► Work on review of IP regimes continues with regard to substantial activities requirement

► Momentum behind ‘nexus’ approach to determining whether activity is substantial enough – closely links to location of R&D activity

► Outsourcing of R&D to related parties could materially impact quantum of benefits under revised proposals

► Outsourcing to third parties (e.g., CROs) could be less problematic► Significant grandfathering expected until June 2021 for IP already in a

regime as at June 2016► Significant work still required to reach consensus, particularly in

relation to tracking and tracing of R&D and transition of IP from current to new regime


Action 7 – Artificial avoidance of PE

► Discussion Draft focuses in part on concept of agency► General principle that concept of PE should be extended to include:

► circumstances where an intermediary carries out activities in a country that are intended to result in the regular provision of goods or services by a foreign enterprise

► unless the intermediary is performing these activities in the course of an independent business

► Various options including:► Conclusion of contracts that are on the account and risk of the enterprise► Conclusion of contracts that results in the provision of property or services by the

foreign enterprise

► Limited risk distributors are in danger of falling into PE definition if risks are too limited


Questions?

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