Harmony or discord?

By Sean Kruger
Illustration: Gary Clement

Global transfer pricing is a major issue for MNEs, but at times there seems to be more discord than harmony

Transfer pricing continues to be the No. 1 international tax issue of interest to multinational enterprises (MNEs), according to Ernst & Young’s global transfer-pricing surveys. This should come as no surprise when one considers that the number of countries with effective transfer-pricing documentation rules increased to more than 38 in 2007 from five in 1997.

While there is a high level of agreement between countries on the broader transfer-pricing concepts, such as the applicability of the arm’s-length standard, it is in the application of such concepts in the unique political and legal environment of a particular jurisdiction that the divergence in the approach of the various authorities becomes clear. The reality for MNEs is that it is becoming ever more difficult to determine and use transfer-pricing policies that are acceptable in all the jurisdictions within which the MNE has operations. The difficulty of achieving harmonization is also experienced by the transfer-pricing advisers who attempt to document the MNE’s transfer-pricing policy in the most expedient and expeditious manner.

The impact of such trends as well as the increased documentation requirements of many countries have prompted various authorities and interest groups to seek ways to minimize the negative impact on MNEs. Given that most countries in broad terms accept the arm’s-length standard, there have been a number of attempts by governments, including those of the US and Canada, to minimize the compliance burden and the risk of controversy.

In addition to country-specific efforts, the Organisation for Economic Co-operation and Development (OECD) has issued guidance in the form of various discussion documents relating to the attribution of profits to a permanent establishment; the approaches to the analysis of comparable companies and data; the use of profit-based methods to demonstrate compliance with the arm’s-length standard; and the transfer-pricing implications of business restructuring.

In order to provide a greater level of harmonization of transfer-pricing principles, the US and Canadian governments entered into a memorandum of understanding (MOU) in 2006 regarding the Mutual Agreement Procedure (MAP) provided for in the US-Canada double tax convention (DTC) for solving disputes. The MOU was intended to provide greater clarity as to the specific approach to be adopted in resolving matters under the MAP. However, in practice the MOU was not successful in resolving Canada/US disputes or providing greater clarity. Subsequent to the MOU in 2006, the Fifth Protocol to the US-Canada DTC was executed on September 21, 2007.

In broad terms, the relevant provisions in the Fifth Protocol stipulate that the governments of the US and Canada have agreed to submit to mandatory and binding arbitration, matters that have not been completely resolved. Cases will, unless otherwise agreed between the authorities, not be submitted for arbitration until two years after commencement of the case. It is at this stage unclear as to how effective this process will be, given that the parties may well be reluctant to submit to arbitration due to the uncertainty of an outcome under this process.

Other efforts to improve harmonization include those by the members of the Pacific Association of Tax Administrators (PATA), including Australia, Canada, Japan and the US, to compile a transfer-pricing documentation package that, if complied with, should satisfy the documentation requirements of the member states. Despite the original optimism surrounding the introduction of the PATA provisions in 2004, in practice, the PATA provisions have not been widely embraced by MNEs or advisers due to the fact that compliance with the principles of the PATA documentation package will not prevent a PATA member from making a transfer-pricing adjustment if necessary. As such, the PATA process should not be confused with an advance-pricing agreement.

Notwithstanding the above harmonization efforts, the differences in legislation, regulations, practices and administration continue to expose MNEs to multijurisdictional transfer-pricing challenges. The situation is expected to be exacerbated by the current economic downturn and the need of most tax jurisdictions to fund their domestic administrations in an era where raising tax rates would be politically unacceptable.

Current, specific examples that are likely to give rise to disputes for US taxpayers and their Canadian subsidiaries arise from recent developments in the US relating to charges for certain services and their approach to cost-sharing arrangements.

With respect to charges for services rendered by US headquartered MNEs to their subsidiaries resident outside of the US, the three issues that are likely to create the greatest controversy are: the amendments to the criteria in terms of which services can be charged on a cost-only basis; the treatment of shareholder activities; and the need to factor in stock-based compensation.

On July 31, 2009, the Internal Revenue Service (IRS) and the US Treasury Department issued final regulations relating to taxable income in connection with controlled services transactions.

The final regulations make it clear that in order to continue to charge for services on a cost-only basis, four requirements must be met. Specifically:

the service must be a covered and hence a qualifying service (the white list); or qualify as a low margin covered service;
the service activity cannot be one that is specifically excluded by the regulations (the black list);
the service must be judged by taxpayers under a “business judgment rule” not to be fundamental to the success or failure of the business; related to the company’s core competencies; or part of the company’s competitive advantage; and
adequate books and records must be maintained.

As a consequence, it is likely that some services that were historically charged out on a cost-only basis will now require a margin to be added to the cost base. This approach is likely to face some resistance in Canada in particular, as the Canada Revenue Agency (CRA) appears to prefer that many of these services are charged at cost on the basis of the OECD concept that the underlying services are routine in nature and not high- value-added services.

The final regulations have further expanded the definition of the term “services” to include any activity provided by a member of a controlled group that results in a benefit to one or more members of that group. A recipient would be considered to receive a benefit where:

the activity increases the commercial value of the recipient or enhances the recipient’s commercial position;
the recipient would be willing to pay for the same or similar activity or would have performed the activity for itself; or
the activity increases the value of the recipient’s intangible assets.

Of particular interest is the treatment of shareholder services that were, until now, not charged to recipients of the service. Going forward, an activity will only be regarded as a shareholder service if the sole effect of the activity is to protect the capital of a member, or is for legal or regulatory compliance. This sole-effect requirement significantly reduces the number of activities that will not require a charge by the shareholder to the recipient of the service.

The implications of this change are far-reaching. Failure by a US-based shareholder to comply with this regulation will result in audit challenges in the US. However, compliance with this rule is likely to result in additional charges to the non-US-based subsidiaries, Canada included. Foreign authorities are aware of the changes in the US regulations and are likely to monitor the related party charges very closely. It is anticipated that this could result in an increased risk of double taxation and a greater incidence of requests under the MAP. A single change in approach by a US shareholder could result in disputes in every country where the group has subsidiaries. The possible tax and economic costs associated with this approach should not be underestimated.

Further controversy is likely to arise over the mandatory inclusion of stock-based compensation expenses in the total service costs applied in any cost-based or profit-based method. Cost allocations should, in the view of the IRS, include direct and indirect service costs, including stock-based compensation. However, stock-based compensation charges will continue to be rejected in many foreign jurisdictions, including Canada, resulting in potential double taxation.

The stock-based compensation issue is also a major factor in applying the US temporary cost-sharing arrangement (CSA) regulations released with an effective date of Jan. 5, 2009. Under these regulations, stock-based compensation must be included in the pool of costs that are to be borne by the participants of the CSA, in proportion to their expected benefits from the CSA. Once again, the reluctance of foreign governments to accept that stock-based compensation should form part of the cost pool is likely to create major obstacles to achieving the benefits typically associated with a CSA.

The IRS is understood to retain the view that pricing methods for CSA buy-in payments that do not accord with the outcome of the IRS’ preferred approaches (for example, the investor model and the income method) should be viewed with circumspection. This position, which arguably does not adequately address the particular risk profile of a CSA, again places pressure on participants to follow approaches that may not be readily accepted in other jurisdictions. This again increases the potential for double tax, conflict and controversy.

Apart from these more recent changes, the continued existence of fundamental differences in the approaches followed by the IRS and the CRA, such as the appropriate way to identify comparable company datasets, will continue to create uncertainty, disputes and increased costs of compliance.

Taxpayers should carefully consider the ramifications of the above trends and uncertainties, for the purposes of financial statement disclosure having regard to Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in In-come Taxes (FIN 48), and similar regulations.

While harmony is desired, in practice this is proving very difficult to achieve and at times there appears to be more discord than harmony.

All is not lost, however. Taxpayers can reduce their exposure by an increased awareness of the changing trends in legislation, practice and administration in the countries in which they operate. This will enable taxpayers to identify potential exposure areas in a timely manner, providing an opportunity to mitigate these or at the very least, ensure that they are properly accounted for. Preparing robust transfer-pricing documentation continues to be the starting point for reducing transfer-pricing risk. A thorough review of historic approaches to dealing with service charges and CSAs is considered to be a necessity, in addition to regular revaluation of the functional and risk profiles of the various entities within a multinational group. Lastly, taxpayers are encouraged to explore the benefits of using advance-pricing agreements and of adopting a strategic approach to managing controversy in audit activity within the various jurisdictions to increase certainty in these uncertain times.

Sean Kruger is a partner in the transfer-pricing practice with Ernst & Young in Toronto. He can be reached at Sean.Kruger@ca.ey.com

Technical editor: Trent Henry, tax managing partner, Ernst & Young