Business Restructuring and How to Deal with the Economic Downturn
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 © 2009 All rights reserved. 3 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 © 2009 All rights reserved. 4 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 © 2009 All rights reserved. 5 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 © 2009 All rights reserved. 7 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 © 2009 All rights reserved. 9 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 © 2009 All rights reserved. 10 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 © 2009 All rights reserved. 11 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 © 2009 All rights reserved. 12 – 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? © 2009 All rights reserved. 13 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 © 2009 All rights reserved. 14 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 © 2009 All rights reserved. 15 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? © 2009 All rights reserved. 16 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 © 2009 All rights reserved. 17 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 © 2009 All rights reserved. 18 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 All rights reserved. 20 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? © 2009 All rights reserved. 21 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 © 2009 All rights reserved. 22 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. © 2009 All rights reserved. 23 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. © 2009 All rights reserved. 25 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 © 2009 All rights reserved. 26 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 © 2009 All rights reserved. 27 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) © 2009 All rights reserved. 28 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 © 2009 All rights reserved. 29 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 © 2009 All rights reserved. 30 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 © 2009 All rights reserved. 31 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 © 2009 All rights reserved. 32 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 © 2009 All rights reserved. 33 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? © 2009 All rights reserved. 35 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 © 2009 All rights reserved. 38 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 © 2009 All rights reserved. 40 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)? © 2009 All rights reserved. 42 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
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