In a recent landmark case involving basic transfer pricing principles, Canada v. Cameco Corporation, 2020 FCA 112, the Canadian Federal Court of Appeal sided with the taxpayer. The Court rejected an argument by the Crown that would have applied “realistic alternatives”-like principles to effectively disregard and recharacterize certain related party purchase and sales transactions. For international observers, the case is worth studying, if for no other reason than to understand the government’s aggressive arguments. In light of the codification of the realistic alternatives principle in IRC § 482, the IRS might now be emboldened to make similar arguments in the US.
COVID-19 has placed unforeseen stress on the distribution structures of Multinational Enterprises (“MNE”) due to catastrophic losses and costs from supply chain interruptions and plummeting demand. Existing intercompany agreements most likely do not cover the allocation of catastrophic costs or losses and several questions may need to be addressed. For example, should catastrophic costs be shared among group members, and if the answer is yes, then how?
In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions.
According to the OECD, before attempting to apply the pricing guidelines that are the primary topic of the Guidance, it may be necessary to determine whether a purported loan should be regarded as a loan, since the balance of debt and equity funding of a borrowing entity that is part of an Multinational Enterprise (“MNE”) group may differ from that which would exist if it were an independent entity operating under similar circumstances. In accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances: the presence or absence of a fixed maturity date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the loan is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement. The accurate delineation of financial transactions may require an analysis of the factors affecting the performance of businesses in the industry sector in which the MNE group operates. The contractual arrangements between independent enterprises may not always provide information in sufficient detail, and it may therefore be necessary to look to other documents and the actual conduct of the parties to define the relationship. Accurate delineation of the transaction may include an identification of the economically relevant characteristics of the transaction, including the functions performed; assets used and risks assumed; the characteristics of the financial instruments; the economic circumstances of the parties and of the market; and the business strategies pursued by the parties.
This week is a busy week for the digital industry. The EU Court of Justice is closing two cases involving digital-economy giants. At the same time, the EU Commission released its new Tax Package covering three separate but related initiatives: a Tax Action Plan (25 distinct actions) to make taxation “simpler, fairer and better attuned to the modern economy over the coming years,” a proposal on administrative cooperation (“DAC 7”) extending EU tax transparency rules to digital platforms, and a Communication on tax good governance proposing a reform of the Code of Conduct, which addresses tax competition and tackles harmful tax practices within the EU. DAC 7 and the new transparency rules will directly impact the digital industry.
In May, the IRS asserted $340 million in transfer pricing penalties in Western Digital Corporation v. Commissioner. If the IRS prevails, these would appear to be the largest transfer pricing penalties sustained in US Tax Court history.
The penalties are notable not only for their amount, but also for the way the IRS raised them. The IRS did not apply penalties in its notices of deficiency or in its initial Tax Court pleadings. Instead, the IRS asserted the penalties in amended pleadings over a year after the case began. Continue Reading IRS Asserts Big-Ticket Transfer Pricing Penalties in Western Digital
In the context of a Cost Sharing Arrangement (“CSA”), Treas. Reg. §1.482-7(c)(1) defines a platform contribution (“PCT”) to be “any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles.” Treas. Reg. §1.482-7(g)(2)(viii) defines subsequent PCTs as those whose date occurs subsequent to the inception of the CSA. Treas. Reg. §1.482-7(g)(1) explains that “a value for the compensation obligation of each PCT Payor” has to be “consistent with the product of the combined pre-tax value to all controlled participants of the platform contribution that is the subject of the PCT and the PCT Payor’s RAB share.” Treas. Reg. §1.482-7(e)(1)(i) notes further that “RAB shares must be updated to account for changes in economic conditions, the business operations and practices of the participants, and the ongoing development of intangibles under the CSA.”
While requiring that the RAB shares be updated, the regulations provide little guidance as to how this is to be accomplished. In particular, the regulations do not specify whether the Payors’ obligations with regard to the prior PCT and the subsequent PCT should be calculated on a combined basis, or whether separate RAB shares, and separate PCT obligations, are appropriate. Whether a combined or separate RAB share will be more appropriate after any subsequent PCT will therefore depend on facts and circumstances of the specific PCTs contributed to the CSA over the life of the CSA.
The IRS recently released informal guidance in the form of “Frequently Asked Questions” discussing its “observations of best practices and common mistakes in preparing transfer pricing documentation” under section 6662. Particularly right now, as many taxpayers find themselves in the throes of drafting and updating annual transfer pricing documentation reports, a review of these FAQs can provide critical insights into the IRS’s thinking that may improve the efficiency of future audits.
Many multinational enterprises (“MNEs”) are providing new forms of financial, technical, or other support to group members facing COVID-19-related business issues such as plant (temporary) closures or supply chain disruptions. This support may in some cases give rise to a transfer of value, such as the knowhow of a seconded employee. It may also involve a transfer of assets coupled with the ability to perform certain functions and assume certain risks. Such transfers could be viewed as a “business restructuring” as defined by the Chapter IX of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2017) (the “OECD Guidelines”) and may trigger transfer pricing and tax consequences.
Responding to the potential disruption created by COVID-19 for transfer pricing arrangements, the Advance Pricing & Mutual Agreement (“APMA”) Program on May 11, 2020, issued informal guidance related to the pandemic. The guidance makes clear that APMA will consider the impact of COVID-19 on both pending requests and completed agreements. It also reveals that APMA is already discussing COVID-19 issues with treaty partners.
COVID-19 has made force majeure a hot topic in transfer pricing. The idea is that the pandemic was an unexpected development of such power, like a natural disaster, that transfer pricing agreements can be changed to reflect the changed economics of a changed world.
But is there any case authority to support this approach? In fact there is, from one of the largest US transfer pricing cases of the 1990s.