Recent Developments in EuropeanTransfer Pricing

Regina Zwahlen-Gyarmathy Dr. jur., LLM, Gyarmathy&Partners, Hungary

DFK International - European Members‘ MeetingIstanbul, 22 January 2009

Aim of the of the efforts of the EU in the field of transfer pricing:

• To reduce tax obstacles to cross-border economic activities in the internal market and to harmonize transfer pricing practices of MS.

Three kinds of transfer pricing systems in Member States:

1. Direct implementation of the OECD Transfer Pricing Guidelines, e.g. Holland, Austria, Hungary

2. Comprehensive transfer pricing legislation, deviation from OECD rules, e.g. Germany, the UK, Denmark

3. No transfer pricing legislation, e.g. Ireland, Malta

EU Joint Transfer Pricing Forum - specialized group of experts established in June 2002

• Aim– to produce pragmatic, non-legislative solutions („Communication

of the Commission”) within the framework of the OECD Transfer Pricing Guidelines to the practical problems posed by transfer pricing practices in the EU

• Members– tax administrations of each Member State , experts from business

1. Code of Conduct for the effective implementation of

the "Arbitration Convention" – the rules of international arbitration in the case of EU transfer

pricing disputes (2004)

2. Code of Conduct on transfer pricing documentation for associated enterprises in the EU – a proposal for EU transfer pricing documentation (2006)

3. Guidelines for Advance Pricing Agreements – a proposal for the proceedings for Advance Pricing Agreements

(2007)

Centralised inter-company services – the Forum is now addressing the various transfer pricing issues

concerning inter-company services (2008)

Arbitration Convention • Entered into with the aim to eliminate double taxation in cases where the tax

authorities adjust the taxable income of associated enterprises.

Example: • A multinational enterprise has subsidiaries in country A and B. The company in

country A sells goods to B for 100€. The tax authorities in A are of the opinion that the correct transfer price would be 120€. They therefore increase the tax base of A by 20€. (primary adjustment)

• The taxpayer must now convince the tax administration of B to reduce the tax base of B by 20€. (corresponding adjustment), otherwise: double taxation. If no agreement is reached, taxpayer can initiate arbitration proceedings under the Arbitration Convention.

Arbitration Convention

• The modern form of the arbitration clauses contained in double tax treaties - Art. 25 of the OECD model convention.

• Only applies to transfer pricing cases.• Multilateral treaty, does not constitute EU legislation.

Code of Conduct • Detailed rules of proceedings to make the arbitration procedure more

efficient and transparent.

Problem•Different documentation requirements in Member States caused onerous administrative obligations for multinational enterprises.

Masterfile concept to be adopted by Member States:

•Masterfile: common standardized information relevant for all EU group members of a multinational enterprise such as a general description of the business and business strategy, a general description of the transactions involving associated enterprises in the EU and the enterprise's transfer pricing policy. •Country-specific documentation: a set standardized documentation for each of the specific Member State involved. Contains information relevant to that country only such as amounts of transaction flows within that country, contractual terms and the particular transfer pricing methods used.

Definition

• APAs are agreements between the tax administrations of EU Member States concerned defining how future transactions between related taxpayers established in two or more Member States will be taxed.

Form

• unilateral, bilateral, multilateral

Concept

• APAs result in more consistency in transfer pricing practices within the EU.

• Arbitration Convention: should help to eliminate transfer pricing double taxation in the EU within a time frame of not more than three years. The aim of APAs is the avoidance of such disputes between tax administrations in the first place.

• Prevention of transfer pricing disputes and associated double taxation by laying down how an efficient APA process should work.

• Based on best practices identified in the EU.

APA process in four distinct stages:

• (a) Pre-filing stage/Informal application• (b) Formal application• (c) Evaluation and negotiation of the APA• (d) Formal agreement

The APA process should be completed in 18 months. More complex cases may take longer.

Country Total number of Bilateral and Multilateral APAs at the end of 2006

Total number of Unilateral APAs at the end of 2006

Number of APA request received in 2006

Denmark 5 0 3

Germany 8 0 15

Austria 0 0 0

Bulgaria 0 0 0

Cyprus 0 0 0

Czech Republic 0 0 4

UK 20 13 24

Italy 0 0 0

Netherlands 9 0 8

A large number of procedures launched under the European Arbitration Convention are based on transfer pricing disputes concerning intra-group services.

•Common centralised services:

– Management services– Support services and administrative functions– Research and development

The main issues that generally arise are

• Classification of re-chargeable costs - differentiation from shareholder expenses, stewardship expenses

• Sanity check: who has an economic interest in the service? • Direct charge vs. indirect charge• Transfer pricing method to be used• Allocation keys for sharing costs between associated enterprises• Supporting evidence and documentation

• I. Identification of all central costs• II. Deduction of shareholder/stewardship expenses• III. Determination of allocations key(s)• IV. Determination of the mark-up• V. Supporting documentation• VI. Other

• Allocation to group members based on “benefit test”: costs need to be real and inherent to the professional activity of the party that incurred the cost.

• Definition of „benefit” pursuant to OECD Guidelines (§7.6): economic value to enhance the commercial position of the group member.

• No allocation should occur if the probable benefit to the related member is so indirect or remote that unrelated parties would not have paid for the same services.

• Open-market concept of the “willingness to pay” lacks pragmatism.

OECD Guidelines (§7.10): three examples of shareholder activities:

• Activities relating to the juridical structure of the parent company, such as shareholder meetings, issuing shares of parent company stock, and activities of the supervisory board.

• Activities relating to fulfilling reporting requirements of the parent.• Raising funds for the acquisition of the parent’s participations.

The OECD Guidelines offer little guidance in defining “stewardship activity.” This may be distinguishable as a broader term than “shareholder activity”.

• Sales are easy to manage as allocation keys, yet there are deeply refined approaches with a multiple of allocation keys.

• Other keys: headcount, assets, number of transactions, invoices processed, regulatory filings handled, number of user IDs. These would cover many service centre type functions in HR, accounting, legal and suchlike departments.

• A question may be raised on the level of sophistication of allocation keys used.

• Concerning the mark-up there are no specific rules in any EU countries. • As a matter of principle, the “added value” needs to be assessed so as

to determine a fair mark-up.• “Safe harbours” are rejected. In practice though, some 3-10% appears

to be an acceptable margin for typical HQ services; • OECD Guidelines allow for charge at cost. • Non-OECD countries outside the EU do not necessarily agree with a

range of 3-10%. • Rule of thumb : some countries tend to put forward a lower mark-up

on inbound charges versus outbound charges.

Aim:

• To update the OECD Transfer Pricing Guidelines (dated: 1979, revised: 1995) and their official interpretation to reflect the current trends of world economy such as globalization and the standardization of the operational forms of businesses.

Main issues:

1. The frequent practical use of profit based transfer pricing methods such as the TNM and the Profit Split Method along with commercial databases. Concept of old OECD Guidelines: „methods of last resort.”

– Issue notes on comparability and transactional profit methods (2006-2008) – proposes amendments to the OECD Guidelines!

2. Profits attributed to permanent establishments

• Hypothesis of PE in transfer pricing: „distinct and separate enterprise”.

• Focus on: banks, global trading, insurances.

– Report on the attribution of profits to permanent establishments (2008)

3. The global mobility of businesses involving international

restructurings

– Issue notes on transfer pricing aspects of business restructurings (2008-2009)

OECD Guidelines give preference to „traditional transaction methods”:

•Comparable Uncontrolled Price Method (CUP) •Cost Plus Method (CPM)•Resale Price Method (RPM)

Transactional profit methods are

1. Profit Split Method (PSM)2. Transactional Net Margin Method (TNMM)

Transactional profit methods

1. examine the profits that arise from transactions,2. to be used only exceptionally as methods of last resort.

• Notion of the “most appropriate method” in proposed

amendments to the OECD Guidelines:– „...the selection of a transfer pricing method always aims at finding

the most appropriate method for a particular case...” (new § 3.49)

• If two methods „can be applied in an equally reliable manner”– the traditional transaction method is preferable to the

transactional profit method ,– the comparable uncontrolled price method (CUP) is preferred to

another transfer pricing method. (new § 3.49)

Identifying comparable transactions in 10 steps • Step 1: Broad based analysis (e.g. industry analysis, etc). • Step 2 : Determination of years to be covered. • Step 3 : Review of the controlled transaction(s) (e.g. functional analysis, etc.).• Step 4 : Review of existing internal comparables if any. • Step 5: Determination if external comparables are available.• Step 6: Choice of the relevant transfer pricing method(s). • Step 7: Identification and analysis of comparables.• Step 8: Making comparability adjustments if necessary. • Step 9: Interpretation of data collected, determination of the arm’s length remuneration. • Step 10: Review processes for material changes and documentation.