Substance – are your transfer pricing actually happening on the ground?

Substance – are your transfer pricing
arrangements still reflective of what is
actually happening on the ground?
In a nutshell
Since the June 2012 G20
leadership meeting, which
focused on the question of base
erosion and profit shifting, the
spotlight has been on transfer
pricing arrangements and the
underlying substance of
multinationals’ activities,
particularly those in favourable
tax jurisdictions.
As there is not one commonly
shared definition of substance
(see Diagram 1 for various
definition of substance) or one
substance based profit allocation
methodology, uncertainty is
increasing in respect of what it
means to have sufficient
substance in order to minimise a
risk of double taxation and
associated transfer pricing
penalties for non- compliance.
Under the OECD Base Erosion
and Profit Shifting project, the
question of ‘recognition of
contractual arrangements versus
substance’ has been raised in
various contexts including
intellectual property planning,
financing planning and
centralised operating models.
Why it matters
Residence
•Central management and control
(common law)
•Place of management (civil law)
Permanent
establishment
•Place of management
•Foreign principal ‘economically’ bound
•Attribution of profit / significant people
functions (SPFs)
Beneficial
ownership
•Recipient has ‘full right to use and enjoy
income unconstrained by a contractual
or legal obligation’
Operating
structures and
transfer pricing
Controlled foreign
companies
Economic
employer
•Re-characterisation /contractual
arrangements
•Control over functions and risks
•Entitlement to IP related returns
•Capacity to bear risks
•Exempt activities tests / substance
requirements
•Significant people functions
•Authority to instruct individual, bears
responsibility for the results of their
work, and conducts performance/pay
review
Diagram 1 – Definition of substance is key for many
areas of international taxation
We can help
Despite a lack of a commonly
shared definition on substance,
there are similarities in
approaches that the tax
authorities take in terms 0f
substance expected in
Entrepreneurs/ Intellectual
property companies.
If the level of substance in the
Entrepreneur company is insufficient,
tax implications can vary from transfer
pricing adjustments, to an imputed
permanent establishment to a change
in residence of the Entrepreneur
How confident are you that what
company – Diagram 2 overleaf gives an actually happens on the ground
overview of the implications.
in day to day business activities
is still consistent with what was
An unexpected tax authority enquiry
understood when transfer
may result in an increased overall tax
pricing policies were put in
cost or double taxation or, as a
place?
minimum, a lengthy dispute.
Given the current environment it
seems that question is not
whether the substance of intragroup transactions will be tested
by the tax authorities but when
and with what degree of rigour.
Given our experience in the
implementation of various
commercial operating models
around the world, and the
agreement of appropriate pricing
policies with relevant tax
authorities , we can work with
you to carry out a proactive
review of your group’s operating
model in relation to the level of
genuine substance and
associated evidence required to
support the economic position of
the model.
Where business activities may
have changed, we can also help
with reassessing the value
drivers and the impact on
pricing.
Where a tax enquiry has already
started, we can provide advice on
an appropriate approach to the
resolution of the dispute.
Centralised operating models assume a certain degree of substance in the Entrepreneur and its
service providers. The transfer pricing methodologies and level of reward for each party are set based
on their respective functional and risk profiles.
If the functional and risk profiles of the parties change, the pricing arrangements need to be amended
to reflect the changes. If the transfer pricing arrangements do not reflect the changes made, the legal
entities will be open to a successful challenge by the tax authorities from the transfer pricing or wider
corporate tax perspective (in case of impact on the corporate residence of the entities) , which may
result in additional tax, late payment interest and potential penalties being payable.
Diagram 2 outlines several different scenarios from ‘sufficient level of substance’ to ‘little or no
substance in the Entrepreneur’ and the likely tax impact.
Worst case
Scenario
All substance
outside
the Entrepreneur
Likely focus of
tax authority
challenge
Residence
challenge
Potential
outcome
All
Entrepreneur’s
profit taxed in
local entities
Best case
Most substance
outside
the Entrepreneur
Some substance
outside
the Entrepreneur
All substance
In Entrepreneur
PE place of
management,
CFC and TP
PEs, CFC, TP
TP
Profit in
Entrepreneur
reduced to
cost + and or
CFC
Some
Entrepreneur
profits taxed
in PEs
elsewhere/
and or CFC
All
Entrepreneur’s
profit taxed in
its jurisdiction
Diagram 2 – degree of tax impact caused by ‘insufficient ‘ substance
Contacts
Ian Dykes, Partner
Value Chain Transformation
[email protected]
+44 (0) 121 265 5968
Annie Devoy, Partner
Transfer Pricing
[email protected]
+44 (0) 207 212 5572
Giovanni Bracco, Partner
Tax Risk Assurance
[email protected]
+44 (0) 207 804 4059
Alenka Turnsek, Director
Value Chain Transformation
[email protected]
+44 (0) 207 213 5045
Claire Blackburn, Partner
Transfer Pricing
[email protected]
+44(0) 207 212 3529
Simon Wilks, Partner
Tax Dispute Resolution Network
[email protected]
+44(0) 207 804 1938