Business Restructuring and How to
Deal with the Economic Downturn
2009 Asia Pacific Transfer Pricing Conference
10 February 2009, Korea Chamber of Commerce & Industry, Seoul
Baker & McKenzie: Richard Weisman, Marc Levey, Monique van Herksen
Yulchon: Joseph Hong
Business Restructuring and How to Deal with the Economic Downturn
The OECD Report
• Originated due to
concerns over
business restructuring & tax
consequences
• Aims to develop
guidance to apply
transfer pricing
rules to these
issues to avoid
double (non)
taxation
© 2009 All rights reserved. 2
Business Restructuring and How to Deal with the Economic Downturn
Observed Trends
• Risk stripping and reductions of number and
operating mode of manufacturing sites due to a
merger or acquisition are commonly observed.
• Concerns raised by governments:
–
–
–
–
–
creation of permanent establishments
(large) variations in levels of profits
goodwill and transfer of intangible assets
threshold issues for recognition of migration
closing expenditures
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Business Restructuring and How to Deal with the Economic Downturn
Expected
Profit
Rate
+
High
Full-Fledged
Manufacturer
Toll
Manufacturer
Contract
Manufacturer
• R&D
• Regional/global
marketing
• Production scheduling
• Manufacturing
• Business risks
Low
Simple
(Low)
Integrated
(High)
Functions/Risks/
Assets Employed
_
12/02/2009
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Business Restructuring and How to Deal with the Economic Downturn
Expected
Profit
Rate
+
High
Commissionaire
Commission
agent
Stripped buy
sell
distributor
Full-Fledged
Distributor
Low
Simple
(Low)
Integrated
(High)
Functions/Risks/
Assets used
_
12/02/2009
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Business Restructuring and How to Deal with the Economic Downturn
Observed Trends
• Pattern: centralized control and management of
manufacturing, research and distribution
functions; stripping out of functions, intangible
assets and risks which were previously
integrated in local operations
• Reasons cited by business:
–
–
–
–
Competition in globalized economy
Savings from economies of scale
Need for specialization
Need to increase efficiency and lower costs
© 2009 All rights reserved. 6
Business Restructuring and How to Deal with the Economic Downturn
Observed Trends
• Economic downturn may result in re-evaluation
of businesses processes resulting in
restructuring
• Consider intangible property planning
opportunities as projected earnings analysis will
generate lower value in an economic downturn
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Business Restructuring and How to Deal with the Economic Downturn
Tax Issues Raised [ ]
• Have there actually been changes in the
functions or activities of local operations?
• What is an appropriate compensation for the
new, more limited functions?
• Can the activities of a limited function entity be
deemed to be a permanent establishment of the
foreign entity for which it acts?
[2nd Annual Centre for Tax Policy & Administration Roundtable in 2005]
© 2009 All rights reserved. 8
Business Restructuring and How to Deal with the Economic Downturn
The OECD Report
• What is a
Business
Restructuring?
• How does the
arm’s length
principle apply?
• Scope:
– Existing TP rules
– Only related party
transactions
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Business Restructuring and How to Deal with the Economic Downturn
4 Issues Notes
1. Risk allocation in relation to business
restructurings
2. Arm’s length compensation for the
restructuring itself
3. Application of the arm’s length principle and
the TP Guidelines to post-restructuring
controlled transactions
4. Exceptional circumstances where a tax
administration may consider not recognising a
transaction or structure adopted by a taxpayer
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Business Restructuring and How to Deal with the Economic Downturn
I. Special
Consideration of
Risk 1/5
• Restructurings generally
involve transfer of risks
• Related party assuming
risk:
– Bears costs connected to
realization of risk
– Should be compensated
by increase in expected
return
– Bears costs of managing
or mitigating risk
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Business Restructuring and How to Deal with the Economic Downturn
Special Consideration of Risk 2/5
• Analysis starts with contractual terms (those
generally define risk allocation between the
parties)
• Contractual allocation of risk is only respected
to extent of economic substance:
– Do the related parties conform to the contractual
allocation of risk
– Do contractual terms provide for arm’s length
allocation of risks
– Is risk economically significant
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– What are TP consequences of the risk allocation
Business Restructuring and How to Deal with the Economic Downturn
Special Consideration of Risk 3/5
• Who has control? (& financial capacity to bear
the risk)
– Can one transfer risk yet continue day-to-day
operations and administration?
– If so, does that also apply in case the transferee
cannot assess the performance of the transferor?
• Is the risk allocation one parties would have
agreed to at arm’s length?
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Business Restructuring and How to Deal with the Economic Downturn
Special Consideration of Risk 4/5
• When is risk economically significant?
• Example requiring review of
–
–
–
–
Transfer of inventory risk
History of stock obsolescence
Cost of insuring stock
History of loss in transit
• Who bears the cost
– Of managing risk
– If risk materializes
– Must get the related increase in return
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Business Restructuring and How to Deal with the Economic Downturn
Special Consideration of Risk
Conclusions 5/5
• Issue Note 1 introduces a new burden of proof
or definitely increases it
• Many business decisions are made by unrelated
parties without perfect information on applicable
risk
• Issue Note 1 has broader scope than just
business restructuring and will be applied
generally, also to pre-OECD Discussion draft
cases
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Business Restructuring and How to Deal with the Economic Downturn
II. Arm’s Length Compensation 1/10
• Under what circumstances would restructured entity receive
compensation for:
– transfer and/or
– indemnification for
termination or
– substantial
renegotiation
of existing
arrangements?
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 2/10
• Factors to consider:
– Understanding the restructuring itself
• Functions, assets and risks before and after the BR
• Business reasons for BR
• Options realistically available to restructured entity
– Reallocation of profit/loss potential as a result of BR
• TP consequences of re-allocation of profit/loss potential
• Compensation as a result of business restructuring
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 3/10
• Factors to consider:
– Transfer of something of value (an asset or an
ongoing concern)
•
•
•
•
Tangible assets
Intangible assets
Transfer of activity
Outsourcing
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 4/10
• Factors to consider:
– Indemnification of the restructured entity for the
detriments suffered as a consequence of the
restructuring
• Is terminated or substantially renegotiated arrangement
formalized in writing with an indemnification clause?
• Are terms of arrangement and (absence of) indemnification
arm’s length?
• Are indemnification rights provided by commercial
legislation/case law?
• Would one party have been willing at arm’s length to provide
© 2009 All rights reserved. 19
indemnification?
Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 5/10
• Whether compensation is needed must be
based on:
– Identification of functions, risks and assets before
and after the restructuring
– Identification of transactions between restructured
entity and other group entities
– Evaluation of rights and obligations of restructured
entity under earlier arrangement (considering
contract and commercial law) and the manner/extent
to which those rights/obligations change
– Rights and obligations should be based on© 2009economic
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principles
Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 6/10
• Arm’s Length Principle does not require
compensation for loss of profit/loss potential per
se: only transfer of rights/other assets that carry
profit/loss potential require compensation
• What is the definition of rights/other assets?
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 7/10
• Whether transfer of profit/loss potential must be
compensated depends on 3 factors
– Realistically available options based on rights/other
assets
– Expected return after restructuring
– Potential compensation required for transfer of profit
potential linked to transfer of rights/other assets
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 8/10
• Transfer of something of value: BR may involve
transfers of:
– Tangible assets
– Intangible assets; or
– Activities (ongoing concern): taking account of
goodwill
• Use common transfer pricing for valuing these
transfers.
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Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation 9/10
• Whether restructured entity is entitled to
indemnification:
– No presumption that indemnification is needed
– Requires analysis of following factors:
• Whether existing arrangement is formalised in writing and
provides for a termination clause
• Are arrangement and existence/lack of termination clause
arm’s length?
• Do commercial legislation and/or case law call for
indemnification?
• Would another party be willing to indemnify the one that
© 2009 All rights reserved. 24
suffers from termination or re-negotiation?
Business Restructuring and How to Deal with the Economic Downturn
Arm’s Length Compensation
Conclusions 10/10
• Transfer of rights/other assets that carry
profit/loss potential may require compensation.
But what is the definition of rights/other assets?
• Heavy emphasis (analysis required) on options
realistically available. This puts related parties
in a theoretical position they are not really in.
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Business Restructuring and How to Deal with the Economic Downturn
III. Remunerating Post-Restructuring
Transactions 1/6
• Based on existing
guidance: Ch. I-III
OECD Guidelines
• Consider OECD
discussion draft
on Transactional
Profit Methods
01/08
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Business Restructuring and How to Deal with the Economic Downturn
Remunerating Post-Restructuring
Transactions 2/6
• Arm’s length principle/OECD Guidelines apply
similarly to post-restructuring transactions and
transactions structured from the start, yet factual
differences may affect comparability analysis
• Selection/application of most apprpriate TP
method must be based on
–
–
–
–
Strength/weakness of each method
Appropriateness
Availability of information
Degree of comparability
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Business Restructuring and How to Deal with the Economic Downturn
Remunerating Post-Restructuring
Transactions 3/6
• Comparability analysis: actual changes must be
documented
• Factual differences may affect Business
Restructuring options realistically available
(§135-141)
• Selection of method for post restructuring
requires comparability analysis of both parties
(§142-148)
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Business Restructuring and How to Deal with the Economic Downturn
Remunerating Post-Restructuring
Transactions 4/6
• Result is that more Transactional Profit Split
methods may be proposed, and the profit split is
also proposed as sanity check method
• Note the term: “Non-benchmarkable” (§161165)
• Profit level indicator must be selected based on
– Main value driver
– That it is not affected by the transaction
– Ability to reasonably measure and compare
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Business Restructuring and How to Deal with the Economic Downturn
Remunerating Post-Restructuring
Transactions 5/6
• Assumption that a relationship is possible
between compensation for the BR itself and
post restructuring transactions (contingent
payment notion)
• Comparing pre and post restructuring profits
can serve as sanity check
• Location savings and synergies to be
considered
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Business Restructuring and How to Deal with the Economic Downturn
Remunerating Post-Restructuring
Transactions Conclusions 6/6
• Issue Note 3 appears to go far beyond business
restructuring situations
• Concept of non-benchmarkable functions
• Emphasis on profit split although traditional
methods are reaffirmed as superior, so what is
the “best” method?
• High burden of documentation
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Business Restructuring and How to Deal with the Economic Downturn
IV. Recognizing Actual Transactions 1/4
• When can tax
inspector disregard actual
transactions?
• Issues Note 4
elaborates on
Paragraphs 1.361.41 of OECD
Guidelines
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Business Restructuring and How to Deal with the Economic Downturn
Recognizing Actual Transactions 2/4
• Non-recognition is an exception to general principle of
application of arm’s length principle to actual
transactions undertaken
• TP adjustments not be regarded as non-recognition of a
controlled transaction (is preferred way to correct)
• Tax authorities can disregard transactions if:
– Economic substance differs from form
– If actual structure impedes tax inspector from determining
transfer price AND the transaction would not have been adopted
by unrelated parties behaving in a commercial rational manner
• Application of arm’s length principle must start with
actual transactions undertaken – contracts are important
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Business Restructuring and How to Deal with the Economic Downturn
Recognizing Actual Transactions 3/4
• Non arm’s length behaviour should be dealt with through
pricing adjustments rather than non-recognition
• Assessing whether arrangement is commercially rational
for a MNE:
– Mere fact that related party arrangement is not found between 3rd
parties does not make it non-arm’s length
– Consider realistically options available
– Functions, risks and/or assets should be actually transferred
– Group-level business reasons to restructure does not eliminate
need for arm’s length treatment of each group member
© 2009 All rights reserved. 34
Business Restructuring and How to Deal with the Economic Downturn
Recognizing Actual Transactions
Conclusions 4/4
• Will we go beyond the economic substance
analysis?
• Greater level of subjectivity allowed?
– How exceptional is exceptional?
– Subjectivity factors:
• Commercial sense determination by tax inspector
• Realistically available options
• Example A: even where conduct follows form,
unable to arrive at appropriate price for crown
jewels?
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Business Restructuring and How to Deal with the Economic Downturn
Overall Suggestions
• Consider desired outcome of restructuring before taking
action. Document business reasons, behavior of your
industry and competitors. Determine how restructuring will
reduce exposure to losses and costs
• Clearly describe functions and risks, determine substance
and capability to manage functions and risks before and
after restructuring
• Well-drafted contracts are a MUST
• Consider implementing indemnification/exit charge
clauses (and trigger criteria) in intercompany contracts
• Consider advance approval/ruling to avoid double taxation
© 2009 All rights reserved. 36
Business Restructuring and How to Deal with the Economic Downturn
German Exit Tax – New Rules
• As of 2008, also profit potentials and business
opportunities migrating cross border are taxable
• Documentation and valuation are key
• Foreign location savings and international group
synergies may be taxed
• Commensurate with income adjustment may be
made once in ten years after the transfer
• Overriding principle: if unrelated parties do not
pay, no exit tax
© 2009 All rights reserved. 37
Business Restructuring and How to Deal with the Economic Downturn
The Economic Downturn
• Incurring losses:
who in the group
gets allocated the
losses?
• How do we
address
comparability?
• Planning
opportunities
• Be prepared for
audit questions
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Business Restructuring and How to Deal with the Economic Downturn
Who Gets Allocated the Losses?
• Contract manufacturers/stripped distributors have no risk,
and should not be allocated less than their arm’s length
return. Residual profit and loss goes to the entrepreneur.
• Will losses resulting from central management decisions
to close divisions be accepted in the countries where the
closed divisions are?
• Arguments for local allocation:
– Cost of laying-off personnel and complying with works council and
unions requirements, are typically local costs, that originate from
domestic laws more than anything
– Cost of closing a division and dismissing personnel can best be
managed at the level of the entity that is directly affected. This is
the entity with most control over the dismissal process.
© 2009 All rights reserved. 39
Business Restructuring and How to Deal with the Economic Downturn
Comparability Challenges
• Database data used always have a 1-2 year lag
• Data batches usually consist of several years (3
or 4-year data)
• Benchmarking conventions usually exclude loss
making comparables
• Suggestions:
– Switch to CUP if possible
– Use 1-year data if possible/get short term rulings only
– Include loss making comps where possible
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Business Restructuring and How to Deal with the Economic Downturn
Planning Opportunities
• Consider intangible property planning opportunities as
projected earnings analysis will generate lower value in an
economic downturn
• Intellectual property right protection remains key if the IP
serves to generate income, so not jurisdictions make
sense for IP migration!
• Substance/people functions are closely monitored
• Consider advance approval for valuation methods
• Consider mismatches in asset book value and market
value
© 2009 All rights reserved. 41
Business Restructuring and How to Deal with the Economic Downturn
Be Prepared for Audit Questions
1. Document your transfer pricing policy before and after
2. Document what the industry and competitors are doing
3. Determine what cost savings are expected as a result of
closing a division; what are the (consecutive) projected
earnings if the divisions were not closed or business was
not transferred?
4. Where will the business be transferred to/who will be
catering to remaining customers?
5. What will the applicable labor law considerations be (in
the home country and in the jurisdiction to which the
activities, if any, are transferred)?
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Business Restructuring and How to Deal with the Economic Downturn
Be Prepared for Audit Questions
6. Collect the economic relevant facts and arguments that
support the economic rationale of restructuring (to tackle
potential denial of deductibility of expenses).
7. Do existing intercompany agreements have termination
clauses and are the terms provided in these contracts
actually observed?
8. The activities to be transferred should be supported with
proper intercompany contracts as well
© 2009 All rights reserved. 43
Business Restructuring and How to Deal with the Economic Downturn
Be Prepared for Audit Questions
9. Consider applicable direct and indirect tax considerations
of the new structure: will services be rendered by other
related companies way of outsourcing to a related party? If
so, it should be verified whether those demand an arm’s
length fee and may be subject to VAT (and customs duties
if importation of products is envisaged as well);
10. Can advance rulings/pricing agreements be obtained and
does the process (and do the cost) of getting such a
determination make sense in light of the size of the
envisaged business restructuring?
© 2009 All rights reserved. 44
Business Restructuring and How to Deal with the Economic Downturn
Feel Free to Contact Us on These Issues!
• Please contact the
panelists or the
Baker & McKenzie
partner you work with
if you have any
questions
• We appreciate
listening to your
questions and
concerns and strive
to be of service
© 2009 All rights reserved. 45
Business Restructuring and How to
Deal with the Economic Downturn
2009 Asia Pacific Transfer Pricing Conference
10 February 2009, Korea Chambers of Commerce & Industry, Seoul
Baker & McKenzie: Richard Weisman, Marc Levey, Monique van Herksen
Yulchon: Joseph Hong