Policy Proposals  Business Law   Comments on the Public Discussion Drafts on BEPS Actions 8, 9, and 10 (Risk, Recharacterisation, and Special Measures)

February 6, 2015

Andrew Hickman
Head of Transfer Pricing Unit, Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development

Comments on the Public Discussion Drafts on BEPS Actions 8, 9, and 10
(Risk, Recharacterisation, and Special Measures)

Keidanren hereby submits its comments on the Public Discussion Draft "BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterisation, and Special Measures)" published by the OECD on December 19, 2014.

1. Basic Stance on Transfer Pricing Taxation

Base erosion and profit shifting ("BEPS") has become an issue in the global community primarily because of some multinational enterprises ("MNEs") having managed to avoid transfer pricing taxation. Given this background, it is understandable why it has been argued that, in the course of the BEPS Project, the transfer pricing tax regime needs to be reviewed as well. Also, matters such as the treatment of intangibles have been long requested to be clarified, whether involving BEPS or not. Keidanren therefore supports the OECD's effort to improve the transfer pricing tax regime.

The countermeasures to be taken, though, need to be reasonable and targeted. In recent years, Japanese companies have faced aggressive transfer pricing tax enforcement in a number of countries. Transfer pricing taxation poses a major obstacle to the international development of businesses, because the resultant amount of reassessed tax tends to be extremely large, requiring enormous efforts and costs to resolve disputes; and, even then, double taxation remains unrelieved in some cases. The BEPS Project should not result in an increase of transfer pricing tax disputes. We strongly hope that the transfer pricing tax regime and its enforcement will be harmonized among OECD countries and non-OECD G20 countries.

The Japanese business community emphasizes the particular importance of the following three points:

The first is a reaffirmation of the significance of transfer pricing documentation pursuant to BEPS Action 13. The recommendations released last September essentially mean that MNEs will be required to prepare master files and country-by-country reports on top of local files. Ideally speaking, risk assessment should be carried out, not by imposing regulations like this, but through cooperative dialogue between taxpayers and tax administrations. Nevertheless, now that the recommendations have been issued, it may be important for MNEs to view them, in spite of compliance costs most certainly rising, in a positive light as an opportunity to reevaluate their global transfer pricing policies, create an information-sharing framework between the parent company and its subsidiaries, and take other proactive measures.

Such efforts on the side of taxpayers must be rewarded. Since the transfer pricing documentation package is expected to be shared, relevant tax administrations in respective countries should not stress more than necessary information asymmetries between themselves and taxpayers. They also should respect, to the maximum extent possible, the judgments made by companies about the content of documentation.

Secondly, emphasis needs to be placed on form rather than on substance. This relates to the first point as well. Recently, OECD's discussions on transfer pricing taxation have the tendency that, although starting with an analysis of form such as legal ownership and contractual terms, the ultimate emphasis seems to be placed on substance, such as the actual conduct of the parties in the transaction. This tendency is seen in last year's interim guidance on intangibles related to Action 8 and in the treatment of risks in the public discussion draft under discussion herein. The approach of treating form with excessive skepticism seems odd to the vast majority of taxpayers who have nothing to do with BEPS.

It is quite rare that ordinary taxpayers artificially separate the place where intangibles are legally owned from the place where value is created. It is also inconceivable for them to allocate risks in a manner inconsistent with the relevant contract. Furthermore, given that each MNE is expected to explain its global transfer pricing policy in the master file, the content of individual contracts concerning controlled transactions will be consistent with the contents explained in the master file. It needs to be recognized that form and substance are approaching each other rather than diverging.

In this circumstance, an approach that makes light of form in the name of making much of substance could lead to subjective interpretation and arbitrary application of the rule, thereby causing uncertainty for taxpayers. Attention should be paid to these points once again when revising Chapters I (The Arm's Length Principle) and VI (Special Considerations for Intangible Property) of the Transfer Pricing Guidelines.

Thirdly, the arm's length principle should be retained. The public discussion draft makes bold proposals on specific revision options. Those proposals, while the reservation being made that a conclusion has yet to be reached, appear to be a harbinger of a paradigm shift in the transfer pricing tax regime. It is true that some point out the limitation of the current regime in the light of such trends as the increasing complexity of MNEs' global supply chains, the greater role of intangibles in international transactions, and the outrageous tax planning of some taxpayers. Nonetheless, the arm's length principle, which the OECD has long maintained and member countries have respected, should not be abandoned easily. We do not consider it appropriate to introduce non-recognition, to adopt special measures, and to allow an unconditional application of the transactional profit split method. Very careful consideration should be given to these matters.

Based on such basic stance, our comments on specific issues are as set out below. We submit comments on the profit split method in a separate document.

2. Risk (Sections D.1 and D.2 of Chapter I)

Part I of this public discussion draft proposes revisions to Chapter I (The Arm's Length Principle) of the Transfer Pricing Guidelines. In particular, revised Sections D.1 "Identifying the commercial or financial relations" and D.2 "Identifying risks in commercial or financial relations" go into greater detail on risks, including risk analysis frameworks and risk categorization. As these may help increase transparency in transfer pricing taxation, the overall direction seems appropriate. On the other hand, more detailed guidelines and more complex tax compliance can be said to be two sides of the same coin. In the course of finalizing revisions to the Guidelines, consideration should be given to ordinary taxpayers.

For instance, paragraph 5 of Section D.1 reads, "It should not be automatically assumed that the contracts accurately or comprehensively capture the actual commercial or financial relations between the parties." As we pointed out earlier, it is not advisable to take the approach of making light of contracts from the start, given that the vast majority of taxpayers take compliance very seriously.

As to Section D.2, we are concerned about the statements in paragraph 46 that "assumption of core risks is likely to be rooted in a MNE group's operational functions, and is not always limited to the party in which the outcome of the risk materializes," and in paragraph 49 that "blanket statements that one or another party performing commercial activities is insulated from all commercial risk ... should be carefully scrutinized." These statements are true, but excessive if they are designed to require MNEs to undertake a detailed risk analysis of all the controlled transactions, regardless of importance. We also fear that the relevant countries may have different views as to where risk exists and where it is managed and controlled, causing new disputes between them.

Both tax administrations and taxpayers have only limited resources. Revisions to the Guidelines should be made in a manner that, at least, prevents the revised Guidelines from resulting in more rigorous investigations into ordinary taxpayers, a heavier administrative burden, and a greater number of disputes.

We find that in many parts of Sections D1. and D2., the discussion of risk is too general to apply to the insurance sector including reinsurance, where assumption and transfer of risk are the core of the business. We believe that the insurance sector should be distinguished from other sectors. Paragraph 78 reads, "A party which does not control risk will not be allocated the risk and therefore will not be entitled to unanticipated profits (or required to bear unanticipated losses)". However, in the insurance context, while an insurer generally does not control the risk sufficiently, it assumes risk in return for collecting a premium which is priced depending on the level of the risk assumed. Risk assumption is the core business of the insurance industry, and as such, the insurer would therefore be entitled to unanticipated profits or required to prepare for unanticipated losses.

Due attention needs to be paid to issues specific to the insurance sector, whose operation is regulated and supervised in each jurisdiction, such as the relationship between risk and capital.

3. Non-recognition (Sections D.3 and D.4 of Chapter I)

Even after a transaction has been carefully examined through the process pursuant to Sections D.1 and D.2 of Chapter I, the provisions of Sections D.3 and D.4 require the possible non-recognition of the transaction to be considered on the grounds that "in exceptional circumstances the transaction as accurately delineated may be interpreted as lacking the fundamental economic attributes of arrangements between unrelated parties, with the result that the transaction is not recognized for transfer pricing purposes" as set out in paragraph 82.

Paragraph 89 defines an arrangement exhibiting fundamental economic attributes as one that "would offer each of the parties a reasonable expectation to enhance or protect their commercial or financial positions on a risk-adjusted ... basis, compared to other opportunities realistically available to them at the time the arrangement was entered into." The paragraph continues, "If the actual arrangement, viewed in its entirety, would not afford such an opportunity to each of the parties, or would afford it to only one of them, then the transaction would not be recognized for transfer pricing purposes." With regard to consequences of non-recognition, paragraph 93 reads, "The structure that replaces the taxpayer's structure for transfer pricing purposes should be determined by the alternative transaction that affords the parties the opportunity to enhance or protect their commercial or financial position. The replacement structure should be guided by the fundamental economic attributes of arrangements between unrelated parties and comport as closely as possible with the commercial reality of independent parties in similar circumstances."

The notion of "fundamental economic attributes" is explained to replace the commercial rationality test hitherto used (paragraph 88). However, the conditions triggering non-recognition are still unclear, which could lead to subjective interpretation and arbitrary application of the rule by tax administrations. This notion, simply put, means that transactions that economically do not make sense are not recognized for transfer pricing purposes, and has the effect of forcing enterprises to adjust the behavior itself, rather than the price, of controlled transactions. We cannot support the provisions of non-recognition that lacks clarity. It is necessary, at the very least, to clarify that replacing the term "recharacterisation" used in the existing Guidelines with the term "non-recognition" proposed in the public discussion draft will not cause cases of non-recognition to increase, in other words, that Sections D.3 and D.4 will never apply to ordinary taxpayers. Detailed guidance on the difference between "fundamental economic attributes" and "commercial rationality", and outcome of the consequences of non-recognition (D.4) would be helpful.

4. Special Measures

Part II of the public discussion draft states that "the main aim of the Transfer Pricing Actions (8-10) is to assure that transfer pricing outcomes are in line with value creation" in paragraph 1, and that "the proposed revisions set out in Part I ... are intended to make significant contributions to achieving this aim" in paragraph 2. Then, paragraph 3 reads, "However ... certain BEPS risks may remain. These residual risks mainly relate to information asymmetries between taxpayers and tax administrations and the relative ease with which MNE groups can allocate capital to lowly taxed minimal functional entities (MFEs). This capital can then be invested in assets used within the MNE group, creating base eroding payments to these MFEs." Based on these views, Part II proposes five potential special measures.

However, as we pointed out earlier, now that MNEs are expected to share their master files and country-by-country reports with relevant tax administrations, continuing to stress information asymmetries faced by tax administrations is not balanced. Moreover, as non-recognition provided for in revised Section D.4 of Chapter I of the Transfer Pricing Guidelines is likely to function as a kind of special measure, there is no need to add other special measures that would overlap with it. While tax avoidance cases these special measures are intended to address are considered to include the assignment of a trademark to an entity in a low-tax country described in paragraphs 90 and 91 of Part I of the public discussion draft, we suppose that only a handful of enterprises undertake such extreme tax planning. Countries should not subject ordinary taxpayers to unstable taxation by focusing too much on deterring abusive schemes.

Paragraph 6 of the public discussion draft states to the effect that it is not critical to determine whether a potential special measure is within or beyond the arm's length principle because the aim is to consider the effectiveness of the measure. Still, if a special measure were to go beyond the arm's length principle, questions would arise as to its consistency with Article 9 (Associated Enterprises), as well as with Article 25 (Mutual Agreement Procedure) in the event of it causing double taxation, of the OECD's Model Convention.

In the current situation where translating other BEPS Actions into concrete rules alone is expected to increase disputes, the introduction of special measures would drive that trend further. In view of this, the Japanese business community consider special measures unnecessary, and strongly requests that, in the event of special measures having to be adopted, any double taxation resulting from their application be eliminated.

Our comments on individual options are as follows:

Option 1: Hard-to-value intangibles

Based on the so-called commensurate with income standard, the option permits an ex-ante price adjustment on the grounds of a rise in value within a certain period of time after the transaction, thereby seriously undermining taxpayers' predictability. There is a gap between the information available to tax administrations for reassessment and the information available to taxpayers at the time of transactions. It is extremely dangerous for the OECD to recommend that the member countries use such a taxation tool that enables hindsight adjustments.

The public discussion draft states that a taxpayer may be able to rebut the tax administration's presumption under certain conditions. However, it should be tax administrations that bear the burden of proving the inconsistency of taxpayers' pricing with the arm's length principle. Also, the use of the phrase "contemporaneously document" is unreasonable in that it imposes a burden on taxpayers.

Negative impact on ordinary taxpayers needs to be minimized because we understand that the main purpose of introducing special measures is to address BEPS. Although it seems that the current proposal aims to deal with all transfers of intangibles, the following elements should be taken into account as additional conditions to trigger the application of the measure.

  • A transferee of an intangible is located in low tax jurisdiction
  • A transfer of an intangible in question occurred in the period pre-determined by the local legislation (e.g. a few /several years)

Options 2 and 3: Inappropriate returns for providing capital

What these options are intended to achieve is understandable only in the context of the example in paragraphs 90 and 91 of Part I, which we assume is the kind of case the options are designed to address. Yet, the options entail a practical issue as to whether it is possible to define "adequate capitalization" in the first place, along with the issue of consistency with Action 4 (Interest Deductions).

We also fear that these options may go beyond addressing those cases to establish a rule whereby thick capitalization itself is deemed problematic. If such a situation were to materialize, it would be deemed problematic that a manufacturer wishing to set up new overseas facilities simply establishes a subsidiary and takes an equity stake in it. Holding companies, regional or otherwise, might be subject to this special measure, too, on account of thick capitalization. Consideration should also be given to an impact on regulated financial services businesses.

Option 4: Minimal functional entity

The term "fundamental economic attributes" defined in Part I is used here once again. Clarity is needed as to the difference between this option and non-recognition.

Furthermore, while a mandatory profit split based on a predetermined factor is proposed as a way of reallocating profits of a minimal functional entity, we are not supportive of this method because it may lead to formulary apportionment. Applicability to collective investment vehicles is also questionable.

Option 5: Ensuring appropriate taxation of excess returns

This option entails the application of a controlled foreign corporation ("CFC") rule to entities located in low-tax countries. Whereas unrelated to transfer pricing taxation, this option, generally speaking, may be instituted as a means of preventing tax avoidance if properly designed, such as by establishing exemption criteria applied to proactive business activities and by simplifying the calculation related to the threshold.

The problem, in our opinion, is that countries with strict CFC rules already in place will hardly be motivated to additionally introduce this option. Utmost consideration should be given to the compliance burdens of taxpayers.

5. Closing

In the area of transfer pricing taxation, by around this spring, public discussion drafts are due to be released that deal with the treatment of cost sharing agreements and hard-to-value intangibles. The Japanese business community is strongly interested in what a revised transfer pricing tax regime will be like as a result of the BEPS Project. While we are fully aware of the necessity to prevent double non-taxation, what we taxpayers need are, simply, clear rules, transparency in enforcement, and the elimination of double taxation. We will continue to be constructively involved in discussions at the OECD.


Subcommittee on Taxation