Year end review of 2010 European Transfer Pricing developments and a look forward to 2011

2010 represented a landmark year for international transfer pricing, with the OECD undertaking a fundamental overhaul of its Transfer Pricing Guidelines as well as initiating a major review of the transfer pricing of intangibles, an area which has been highlighted as a primary concern for taxpayers and authorities alike. In the UK and across the EU a number of welcome developments in practical application and administration of transfer pricing have resulted in clearer guidance for UK taxpayers in relation to APAs, thin capitalization issues and inter-company services.

Five key developments during that year affecting transfer pricing were as follows:

1. 2010 update to OECD Transfer Pricing Guidelines

In July 2010 the OECD released a long-awaited update to Transfer Pricing Guidelines for Multinational Enterprises (MNEs), incorporating major revisions to Chapters I to III and a new Chapter IX ‘Transfer Pricing Aspects of Business Restructurings’. This represents the most significant wholesale modification to the Guidelines since their introduction in 1995. Draft clauses for the 2011 Finance Bill issued by HMRC confirm that these guidelines will be the new reference basis for UK multinationals for accounting periods beginning on or after 1 April 2011.

Why it matters: This definitive guide to international transfer pricing now contains a number of updates to reflect changing audit and business practices worldwide. Most notably the strict hierarchy of selection of pricing methods has been substantially revised – previously use of the Comparable Uncontrolled Price method was preferred, followed by traditional transaction methods such as resale price and cost plus, and with profit-based methods such as profit split and transactional net margin relegated to use in only exceptional circumstances. The guidelines now direct taxpayers to use the most appropriate method with regard to the specific circumstances of the transaction being priced, ranking profit methods equally with the other options. As multinationals have increasingly adopted profit methods as the most practical means of pricing convoluted cross-border transactions involving, say, diverse ownership of intangibles, this change in approach offers some welcome support.

Transfer pricing on business restructuring is now analysed in detail in Chapter IX of the Guidelines, covering a topic that has been subject to consultation and analysis since 2005 and is of practical interest to many multinationals. Four constituent elements are discussed, analysing control and management of risk, compensation for the restructuring exercise itself, remuneration post-restructuring, and recognition of transactions undertaken. Of specific interest is the emphasis that, as long as substance follows form, any restructuring undertaken by an MNE primarily for tax planning purposes should be considered a commercially viable exercise, whether at a group or legal entity level, and that the documentation of transfer pricing and commercial elements before, during and after the restructuring can make or break the tax treatment. Various worked examples and suggested tax authority treatment of pricing and structuring scenarios provide a useful basis for initial internal analysis of restructuring projects and the associated transactions.

2. HMRC Thin Capitalisation Manual updated

In March 2010 HMRC released a substantial revision of its International Tax Manual Thin Capitalisation: Practical Guidance (INTM570000), which provides guidelines and analysis for review of thin cap issues by the UK tax authorities.

Why it matters: Detailing practical and commercial standpoints that tax inspectors are expected to adopt in relation to the frequently complex issues surrounding thin capitalisation, the update to this manual now represents a contemporaneous analysis of debt structuring, in many instances adopting a clearer, more pragmatic basis for examination than has been seen previously. Although some concerns still arise in relation to consistent application of the arm’s-length standard for comparables and associated benchmarking, the expanded guidance is useful in anticipating HMRC’s standpoint in debate over thin capitalisation concerns. Of particular note is additional analysis discussing cover and gearing ratios, property lending, private equity business, and credit ratings.

3. HMRC’s revised statement of practice on APAs

A Statement of Practice (SP) was issued in September 2010 by HMRC, updating Advance Pricing Agreement (APA) procedures originally implemented in 1999. Following consultation with practitioners and UK companies a finalised version is expected shortly.

Why it matters: Although the SP contains limited revisions to the procedures adopted by HMRC, it is indicative of changes in attitude towards the use of APAs in practice. To date a continuing concern of taxpayers has been the convoluted, expensive and lengthy process of applying for and negotiating an APA. With uncertain and fluctuating economic conditions in many business sectors, the usefulness of an agreement that may cover a three- to five-year period may also be in question where there is the increased possibility of breaching the APA terms.

Bearing this in mind, an important element of the SP is the potential for informal, pre-filing discussion with HMRC, giving taxpayers the opportunity to address potential show-stoppers to an APA before committing to significant time and expense. Similarly, HMRC’s increased flexibility in addressing the particular circumstances of any given APA application both in terms of complexity and potential unilateral adoption should ease what has often proved to be a particularly cost and time-intensive process.

4. EU low value adding intra-group services guidelines drafted

Issued in February 2010 by the EU Joint Transfer Pricing Forum (JTPF), ‘Guidelines on Low Value Adding Intra-Group Services’ represents an extended review of typical services provided between members of an MNE, and seeks to establish a framework for a standardised approach to recharges and documentation for transfer pricing purposes.

Why it matters: Expanding on Chapter VII of the OECD Transfer Pricing Guidelines, this report offers a detailed analysis of low-risk routine service activities that may take place within a multinational, and provides a practical reference for establishing whether a service has actually been provided, costing the service, allocating those costs to the parties concerned, and determining an appropriate arm’s-length charge. The document includes a useful list of typical intra-group services which, although far from exhaustive and subject to the caveat of overriding OECD principles, is a positive step towards encouraging consistency in treatment of service recharges by EU tax authorities.

5. OECD initiates review of transfer pricing aspects of intangibles

Following the release of the 2010 update to its Transfer Pricing Guidelines for Multinational Enterprises, in July 2010 the OECD started a consultation process to scope a project on the transfer pricing of intangibles, carrying out discussions with companies and practitioners throughout the course of the year.

Why it matters: In recent years the pricing of intangibles has become one of the most challenging aspects of transfer pricing, with significant variances in theoretical and practical approaches by tax authorities resulting in both the number and size of disputes escalating rapidly. With no consistent definition of intangibles for legal, accounting and tax purposes, and a variety of different approaches in treatment of unique, routine and ‘soft’ intangibles, multinationals are at significant risk of material tax adjustments at audit. At present the OECD guidelines in Chapters VI and VIII fall short in providing clear practical analysis, particularly regarding the complexities of valuing and pricing intangible assets in accordance with the arm’s-length principle, and the focussed attention to the issue and expected adaptation of the existing guidelines should prove of significant interest.

What’s ahead for 2011?

The OECD work on intangibles will continue with a further briefing by Working Party 6 on the scope of the project in early 2011, followed by a meeting of the Special Session on the Transfer Pricing Aspects of Intangibles in March 2011. With the continuing development of local transfer pricing regulations and guidelines by tax authorities, particularly across Europe, adoption of consistent, practical multijurisdictional transfer pricing approaches and methodologies is critical, and we can look forward to renewed work by the OECD and JTPF to establish clear transfer pricing frameworks that can be readily implemented.