A Guide for Transfer Pricing Issues

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www.pwc.com/internationaltp International Transfer Pricing 2015/16 An easy to use reference guide covering a range of transfer pricing issues in nearly 100 territories worldwide.

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International transfer pricing 2015/16

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All information in this book, unless otherwise stated, is up to date as of 28 April 2015. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. © 2015 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. Please see www.pwc.com/structure for further details.

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Preface Isabel Verlinden It is my pleasure to present the 2015/16 edition of our International Transfer Pricing book. There have continued to be significant changes in the area of transfer pricing since our prior edition, with several new countries implementing either formal or informal transfer pricing documentation requirements and significant regulatory changes in many other countries over the past twelve months. Most significantly, the deliverables released as part of the OECD’s Base Erosion & Profit Shifting (BEPS) Action Plan have resulted in the need for enterprises to reevaluate and reconsider their transfer pricing strategies in light of the proposed new guidance. Part 1 of the book provides a general overview of the global approach to transfer pricing issues. Part 2 is devoted to a summary survey of specific requirements of the key countries with transfer pricing rules. We anticipate that this will be another eventful year during which the subject of transfer pricing will continue to be at the centre of continuing controversy in corridors of power and newspaper editor’s offices around the world. A combination of public debates on the ethics of tax planning, political and economic pressures, and increasingly well trained tax examiners will all contribute to a continuing rise in the number of transfer pricing disputes globally especially as a growing number of tax authorities attempt to enforce their transfer pricing rules more aggressively. It is PwC’s1 view that strategic dispute management (such as through dispute avoidance or alternative resolution techniques) on a global basis will become increasingly crucial in companies’ efforts to sustain their global transfer pricing strategies and to maximise efficiencies enabled by a constructive atmosphere with tax authorities. We look forward to working with you in 2015 and beyond. Isabel Verlinden Global Transfer Pricing Leader PwC Belgium +32 2 710 4422 isabel.verlinden@be.pwc.com View my profile on Linkedin 1  PwC refers to the PwC network and/or one or more of its member firms, each of which is a separate legal entity. www.pwc.com/internationaltp iii

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Preface Nick Raby This book provides you with general guidance on a range of transfer pricing issues. Technical material is updated with each new edition and this book is correct as of 30 April 2015. This 2015 edition is the latest development of a work begun over two decades ago and is now in its 15th iteration. In addition to this reference book, many of you will also require real-time access to current information. Readers wishing to receive e-newsalerts on current transfer pricing can register for our Tax Insights from Transfer Pricing. Given the number of disputes and controversy issues involving transfer pricing matters readers may also be interested in a separate PwC service Tax Insights from Tax Controversy and Dispute Resolution. The challenges facing multinational enterprises in preparing documentation to demonstrate compliance with transfer pricing rules across the globe in accordance with the expectations of each jurisdiction continues to grow. Most countries/territories have now established documentation rules that require companies to state clearly and with supporting evidence why their transfer pricing policies comply with the arm’s‑length standard. iv A large number of jurisdictions have also implemented strict penalty regimes to encourage taxpayers’ compliance with these new procedures. Perhaps the biggest practical difficulty facing taxpayers in their efforts to abide by these requirements, are the subtle differences in transfer pricing documentation expected across the various tax jurisdictions. These conflicting pressures need to be reviewed and managed very carefully, both to meet the burden of compliance and to avoid costly penalties. Many of the world’s major tax jurisdictions have established aggressive audit teams to review compliance with these documentation requirements and are exhibiting a new found willingness to pursue transfer pricing adjustments through administrative appeals procedures and even to litigation. Non‑compliance now comes with a significant risk of being assessed with material adjustments and penalties. For many years, companies accepted nominal adjustments as a small price to be paid to get rid of the tax auditor. In the current environment, however, adjustments have now become potentially so material that companies cannot simply write off assessed adjustments without recourse. These developments are reflected in the increasing use of mutual agreement procedures under bilateral double taxation agreements, or the Arbitration Convention within the European Union, in order to seek relief from double taxation and unsustainable proposed adjustments. This, in turn, necessitates a more controlled and organised approach by companies to handle the audits as they take place, to ensure the process is conducted efficiently and that any areas where the transfer pricing system is deficient are corrected rapidly. International Transfer Pricing 2015/16

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If these challenges were not enough, the subject of transfer pricing has become the centre of a new public controversy on the issue of whether the current rules permit multinational entities to pay less than their ‘fair share’ of the overall tax burden in some of the territories in which they operate. In addition to compliance with a very technical and complex set of statutes, case law, regulations and guidelines, taxpayers may now need to evaluate the potential impact of decisions related to transfer pricing in more subjective areas such as corporate reputation and public perceptionIn this book, my fellow authors and I demonstrate that transfer pricing is a matter that is of fundamental importance to multinational enterprises. It is vital for every company to have a coherent and defensible transfer pricing policy, which is responsive to the very real climate of change in which companies are operating. A sound transfer pricing policy must be developed within a reasonable timescale and be invested in by both company management and professional advisers. It needs to be reexamined regularly to allow for changes in the business, perhaps as the result of acquisitions or divestments of part of the group. Today, a properly coordinated defence strategy is a basic necessity rather than an expensive luxury. We have tried to provide practical advice wherever possible on a subject where the right amount of effort can produce significant returns in the form of a competitive and stable tax burden, coupled with the ability to defend a company against tax auditor examination. Naturally, no work of this nature can substitute for a specialist’s detailed professional advice on the specific facts relevant to a particular transfer pricing issue. However, our hope is that, with the assistance of this book, you, the reader can approach inter-company pricing issues with greater confidence. Nick Raby* PwC US +1 213 356 6592 nick.raby@us.pwc.com View my profile on Linkedin * ick Raby is the principal in charge of transfer pricing services for PwC N in the Western Region of the United States, and has extensive experience in advising on transfer pricing and tax planning for multinational companies. His international experience includes six years in London, and three in Brussels and Amsterdam. The author would like to thank the many transfer pricing specialists from the PwC international network who have contributed to this book. Special thanks also go to the editorial team, Liz Sweigart and Dana Hart. www.pwc.com/internationaltp v

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Table of contents Part 1: Developing defensible transfer pricing policies Introduction.......................................... 3 Categories of inter-company transfer..... 9 The work of the OECD......................... 25 Establishing a transfer pricing policy – practical considerations.................... 47 Specific issues in transfer pricing......... 71 Managing changes to a transfer pricing policy.....................................101 Dealing with an audit of transfer pricing by a tax authority....................115 Financial services...............................121 Transfer pricing and indirect taxes..... 139 Procedures for achieving an offsetting adjustment.........................157 The OECD's BEPS Action Plan.............165 vi Part 2: Country-specific issues ..183 Argentina.......................................... 185 Australia............................................ 203 Austria...............................................219 Azerbaijan......................................... 231 Bahrain............................................. 237 Belgium............................................. 239 Brazil................................................ 259 Bulgaria............................................ 275 Cameroon, Republic of...................... 281 Canada.............................................. 287 Chile................................................. 303 China.................................................313 Colombia........................................... 333 Congo, Democratic Republic of.......... 347 Congo, Republic of............................ 351 Costa Rica......................................... 355 Croatia...............................................361 Czech Republic.................................. 367 Denmark............................................375 Dominican Republic.......................... 389 Ecuador............................................. 395 Egypt................................................. 403 El Salvador........................................ 407 Equatorial Guinea..............................411 Estonia...............................................415 Finland.............................................. 421 France............................................... 433 Georgia..............................................461 Germany........................................... 467 Ghana............................................... 481 Greece............................................... 487 Guatemala......................................... 499 Hong Kong........................................ 503 Hungary.............................................511 International Transfer Pricing 2015/16

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Iceland.............................................. 521 India................................................. 525 Indonesia.......................................... 551 Iraq................................................... 563 Ireland.............................................. 567 Israel................................................. 583 Italy................................................... 589 Ivory Coast (Côte d’Ivoire)..................613 Japan.................................................617 Jordan............................................... 631 Kazakhstan, Republic of.................... 635 Kenya.................................................641 Korea, Republic of............................. 647 Kuwait............................................... 657 Latvia.................................................661 Lebanon.............................................671 Libya..................................................675 Lithuania............................................677 Luxembourg...................................... 683 Madagascar....................................... 689 Malaysia............................................ 695 Mexico.............................................. 709 Moldova............................................ 729 Mongolia........................................... 733 Namibia............................................ 739 Netherlands........................................743 New Zealand......................................761 Nigeria.............................................. 775 Norway............................................. 785 Oman, The Sultanate of......................815 Palestinian Territories........................819 Peru.................................................. 821 Philippines........................................ 833 Poland............................................... 843 Portugal............................................ 853 www.pwc.com/internationaltp Qatar................................................. 863 Romania............................................ 867 Russian Federation............................ 875 Saudi Arabia, Kingdom of.................. 885 Singapore.......................................... 889 Slovak Republic................................. 903 Slovenia............................................ 909 South Africa.......................................915 Spain................................................. 927 Sri Lanka........................................... 939 Sweden............................................. 953 Switzerland........................................961 Taiwan.............................................. 969 Tanzania........................................... 977 Thailand............................................ 985 Turkey............................................... 993 Turkmenistan...................................1007 Uganda............................................1011 Ukraine............................................1015 United Arab Emirates.......................1025 United Kingdom...............................1027 United States....................................1055 Uruguay...........................................1091 Uzbekistan, Republic of....................1107 Venezuela......................................... 1111 Vietnam........................................... 1119 Zambia.............................................1131 Zimbabwe........................................1139 Contacts...........................................1143 vii

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Glossary Advance pricing agreements (APAs): Binding advance agreements between the tax authorities and the taxpayer, which set out the method for determining transfer pricing for intercompany transactions. Arm’s-length principle: The arm’s‑length principle requires that transfer prices charged between related parties are equivalent to those that would have been charged between independent parties in the same circumstances. OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan: A programme introduced by the OECD in July 2013, that established 15 actions related to harmonising and coordinating international tax and transfer pricing rules across jurisdictions. Berry ratio: A ratio sometimes used in transfer pricing analyses, equal to gross margin divided by operating expenses. Comparable profits method (CPM): A transfer pricing method based on the comparison of the operating profit derived from related party transactions with the operating profit earned by third parties undertaking similar business activities. Comparable uncontrolled price (CUP) method: A method of pricing based on the price charged between unrelated entities in respect of a comparable transaction in comparable circumstances. viii Competent authority procedure: A procedure under which different tax authorities may consult each other to reach a mutual agreement on a taxpayer’s position. Cost plus method: A method of pricing based on the costs incurred plus a percentage of those costs. Double taxation treaty: A treaty made between two countries agreeing on the tax treatment of residents of one country under the other country’s tax system. Functional analysis: The analysis of a business by reference to the location of functions, risks and intangible assets. GATT: General Agreement on Trade and Tariffs. Inland Revenue: The UK tax authority. Intangible property: Property that is not tangible, e.g. patents, knowhow, trademarks, brands, goodwill, customer lists. Internal Revenue Service (IRS): The US tax authority. OECD: The Organisation for Economic Cooperation and Development. OECD Guidelines: Report by the OECD on transfer pricing entitled ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’, published in July 1995, with additional chapters subsequently issued. International Transfer Pricing 2015/16

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Patent: Legal protection of a product or process invented or developed by the holder of the patent. Trade name: A name or logo associated with a particular company or group of companies. Permanent establishment (PE): A taxable business unit. Exact definitions vary in different countries and according to different double taxation treaties. Transactional net margin method (TNMM): A transfer pricing method based on an analysis of the operating profit derived by a business from a particular related party transaction or group of transactions. Profit split method (PSM): A method of pricing where the profit or loss of a multinational enterprise is divided in a way that would be expected of independent enterprises in a joint venture relationship. Resale price method (RPM): A method of pricing based on the price at which a product is resold less a percentage of the resale price. Royalty: A payment (often periodic) in respect of property (often intangible), e.g. a sum paid for the use of patented technology. Tangible property: Physical property, e.g. inventory, plant, machinery and factories. Thin capitalisation: A situation in which a company has a high level of borrowing relative to its equity base. The term is usually used when the high levels of debt are derived from related companies. Trademark: A name or logo associated with a particular product. www.pwc.com/internationaltp ix

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x International Transfer Pricing 2015/16

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Part 1: Developing defensible transfer pricing policies www.pwc.com/internationaltp 1

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2 International Transfer Pricing 2015/16

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1. Introduction At the eye of the ‘perfect storm’ Globalisation and the rapid growth of international trade has made inter-company pricing an everyday necessity for the vast majority of businesses. However, the growth of national treasury deficits and the frequent use of the phrase ‘transfer pricing’ in the same sentence as ‘tax shelters’ and ‘tax evasion’ on the business pages of newspapers around the world have left multinational enterprises at the centre of a storm of controversy. Tax authorities have made the regulation and enforcement of the arm’slength standard a top priority (see Chapter 7, Introduction for commentary on the audit approach to pricing matters in a number of countries). A key incentive for challenging taxpayers on their transfer prices is that the authorities see transfer pricing as a soft target with the potential to produce very large increases in tax revenues. Since there is no absolute rule for determining the right transfer price for any kind of international transaction with associated enterprises, whether it involves tangibles, intangibles, services, financing or cost allocation/sharing arrangements, there is huge potential for disagreement as to whether the correct amount of taxable income has been reported in a particular jurisdiction. While the existence of tax treaties between most of the world’s major trading nations might lead the casual observer to conclude that international transfer pricing is a ‘zero sum game’ where an adjustment in one jurisdiction will be matched by the granting of corresponding relief at the other end of the transaction, the reality is that transfer pricing controversies are expensive and time-consuming to manage, not to mention full of pitfalls for the unwary, which frequently result in double taxation of income. The impact of this focus by governments has been to create a very uncertain operating environment for businesses, many of whom are already struggling with increased global competition, escalating operating costs, and the threat of recession. Add to this, accounting rule changes (which often create tension between the economist’s viewpoint that there are many different possible outcomes to any transfer pricing analysis, a number of which may be acceptable and some of which may not), with the accountants need for a single number to include in reported earnings and you have what many commentators have termed the ‘perfect storm’. This perfect storm threatens: • the risk of very large local tax reassessments, • the potential for double taxation because income has already been taxed elsewhere and relief under tax treaties is not available, • significant penalties and interest on overdue tax, • the potential for carry forward of the impact of unfavourable revenue determinations, creating further liabilities in future periods, • secondary tax consequences adding further cost – for example the levy of withholding taxes on adjusted amounts treated as constructive dividends, • uncertainty as to the group’s worldwide tax burden, leading to the risk of earnings restatements and investor lawsuits, • conflicts with customs and indirect tax reporting requirements, www.pwc.com/internationaltp 3

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Introduction • conflicts with regulatory authorities, and • damage to reputation and diminution of brand value as a consequence of the perception of being a bad corporate citizen. The need for adequate planning and documentation of transfer pricing policies and procedures Typically the life cycle of a global transfer pricing policy involves an initial detailed analysis of the underlying facts and economics, evaluation and development of the proposed policy in relation to the groups’ global tax planning objectives, a detailed implementation and monitoring plan, and the adoption of a defensive strategy, given the virtual inevitability that someone, somewhere will want to challenge the result. Probably the biggest challenge inherent in this whole process is the need to balance the conflicting goals of being able to achieve a very high standard of compliance with the numerous rules and regulations that have flourished in the many different jurisdictions in which a multinational may operate, with the need to manage the level of taxes paid on a global basis at a competitive level. In the current hostile environment there is no ‘play safe’ strategy – taxpayers must assume that they will be subject to challenge, no matter how conservative a philosophy they may initially adopt in their transfer pricing policies and procedures. Most of the world’s major trading nations now have detailed requirements for the documentation of transfer pricing matters, but even those that have not yet implemented specific requirements will expect taxpayers to be able to explain and produce support for the positions taken on local tax returns, and to show that they conform to arm’s-length results. One important trend that is emerging is based on the realisation that in such a volatile area, the only clear path to certainty lies in advance discussions with the authorities. Tax rulings and advance pricing agreements (APAs), once thought to be solely the realm of the biggest and most sophisticated taxpayers, are increasingly being seen as an everyday defensive tool. The planning process can also provide an excellent forum for gathering information about the business and identifying tax and commercial opportunities that have until now gone unnoticed. The development of a transfer pricing policy will involve financial, tax and operational personnel and, therefore, provides a useful opportunity for a varied group to communicate their respective positions and assess business priorities. Implementation is also an area that will require cross-functional cooperation within a multinational enterprise since success will ultimately be determined by an ability to ensure that the policies and procedures adopted are fully aligned with the underlying business activities and that the results are reliably reported on the books and records of the entities undertaking the transactions. The importance of keeping policies and procedures up to date A pricing policy cannot be established, set in stone and then ignored. If it is to have any value, the policy must be responsive to an increasingly dynamic and turbulent business environment and must be reviewed on an ongoing basis, at a minimum whenever the group’s business is restructured or new types of transactions are contemplated. This should not be an onerous task if it is performed by appropriate personnel who are well-briefed on the aims of the analysis and any necessary amendments to the policy are implemented quickly. An updating of the transfer pricing policy should form part of the routine process of reviewing the overall business strategy. Regular and as-needed policy updates can help to ensure that the policy continues to cover all inter-company 4 International Transfer Pricing 2015/16

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transactions undertaken by the company, as well as produce arm’s-length results and prevent unwelcome surprises. Theory and practice The theory on which a perfect pricing policy is based has been much discussed in recent years. This book, while recognising the need for theoretical guidelines, focuses on how to establish a successful transfer pricing policy in practice. This is achieved by explaining to the reader the broad principles to be applied in establishing transfer pricing policies that would be acceptable under the generally recognised Organisation for Economic Co-operation and Development (OECD) principles. The book also indicates, through a number of country studies, the areas in which such general practice might need to be amended slightly to meet the requirements of local country law. The degree to which such local amendments will need to be made will undoubtedly change over time and there can be no substitute for current advice from local experts in looking at such matters. In many cases, however, the general principles laid down in this text will satisfy the local law. Transfer pricing is not just about taxation In addition to evaluating the risks of tax controversies in advance, careful advance planning for transfer pricing also allows a multinational enterprise to consider implications beyond taxation. For instance, the effect on corporate restructuring, supply chain, resource allocation, management compensation plans and management of exposure to third-party legal liabilities must also be considered. The implications of transfer pricing policies in the fields of management accounting and organisational behaviour have been the subject of an increasing volume of academic debate; for example, there may be a significant influence on the actions of managers who are remunerated by a bonus linked to local company operating profits. A change in a group transfer pricing policy that fails to recognise the impact that may be felt by individual employees may not bring about the behavioural improvements management wish to achieve. Legal matters that fall under the corporate general counsel’s office should also be taken into account. Matters such as intellectual property protection arising from cost sharing, treasury management issues arising from centralised activities such as cash pooling and areas of logistics and inventory management in co-ordination centre arrangements all require careful consideration. In some cases there may be conflict between the tax planner’s desire to locate certain functions, risks and assets in one jurisdiction and the lawyer’s need to have recourse to the legal system of another. Ultimately, transfer pricing policy should benefit a company from a risk management as well as a business perspective. To this end, building a foundation of internal support by the multinational is imperative in order to enable compliance with tax regulations as well as effective management decision-making. New legislation and regulations The current framework for interpretation of the arm’s‑length principle dates back to the early 1990s when the US broke new ground with detailed regulations on intangibles, tangibles and cost sharing. These regulations evoked widespread reaction among the international community, with the regulations on the application of the ‘commensurate with income’ standard and the need for contemporaneous www.pwc.com/internationaltp 5

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Introduction documentation in order avoid specific transfer pricing penalties proving especially controversial. The OECD responded by publishing new guidelines that covered many of the same issues. Subsequently, many countries around the world introduced their own transfer pricing rules based on the principles set out in the OECD Guidelines, which in some cases include requirements that go beyond the regulations in the US. Based on over a decade of experience in enforcement of these rules and regulations, the last few years have seen renewed legislative activity in a number of jurisdictions. The US has revisited the regulations pertaining to services, intangibles and cost sharing, and has developed new requirements such as the need to include the cost of stock-based compensation in cost sharing charges and charges for inter-company services as well as new transfer pricing methods to respond to perceived issues with the existing regulations pertaining to intangible transfers. In 2010 the OECD issued final revisions to the Guidelines, which included significant changes to the chapters dealing with the arm’s‑length principle, transfer pricing methods and comparability analysis, and also finalised guidance on ‘Transfer Pricing Aspects of Business Restructurings’, which was included as a new chapter. At the time of publication, a further series of revisions to the OECD Guidelines are in progress under the OECD’s Base Erosion and Profit Shifting (BEPS) initiative. (Chapter 11 provides further details). The future Around the world legislative change continues unabated. Transfer pricing rules have recently been introduced or reformed in a number of countries, while many other countries are in the process of reviewing the effectiveness of their existing transfer pricing rules and practices. In parallel, revenue authorities are stepping up the pace of transfer pricing audits, presenting fresh challenges of policy implementation and defence to the taxpayer. Issues that may trigger a transfer pricing investigation may include: • Corporate restructurings, particularly where there is downsizing of operations in a particular jurisdiction. • Significant inter-company transactions with related parties located in tax havens, low tax jurisdictions or entities that benefit from special tax regimes. • Deductions claimed for inter-company payments of royalties and/or service fees, particularly if this results in losses being claimed on the local tax return. • Royalty rates that appear high in relative percentage terms, especially where intellectual property that is not legally registered may be involved. • Inconsistencies between inter-company contracts, transfer pricing policies and detailed transaction documents such as inter-company invoices and/or customs documentation. • Separation of business functions and related risks that are contractually assigned to a different jurisdiction. • Frequent revisions to transfer pricing policies and procedures. • Recurring year-end pricing adjustments, particularly where they may create book/ tax differences. • Failure to adopt a clear defence strategy. • Simply having a low effective tax rate in the published financial statements. 6 International Transfer Pricing 2015/16

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It must be presumed that the pace of change will be maintained, and that it may even increase due to budgetary pressures on governments. A multinational enterprise must maintain continual vigilance to ensure that its transfer pricing policies meet the most up-to-date standards imposed by tax authorities around the world and also continue to meet its own business objectives. The immediate future presents great challenges to both taxpayers and tax authorities. Taxpayers must cope with legislation that is growing by the day across jurisdictions, and which is often not consistent. For instance, safe harbour rules in one jurisdiction may represent a non-controversial alternative and yet could be countered in the other contracting country. Similar difficulties are encountered while dealing with the fundamental definition of arm’s-length range, which continue to have differing legislative meanings and judicial interpretations. The onus is on the taxpayer to establish arm’s-length transfer pricing by way of extensive country-specific documentation. Failure to do so will inevitably result in the realisation of some or all of the threats listed earlier. It is not enough for taxpayers to honestly believe they have the right answer – they will also need to be able to demonstrate that it is. Tax authorities are to some extent in competition with their counterparts from other transacting jurisdictions in order to secure what they perceive to be their fair share of taxable profits of multinational enterprises. This frequently leads to double taxation of the same profits by revenue authorities of two or more transacting countries. Consequently, there is also an increasing trend towards tax authorities favouring the use of bilateral advance pricing agreements where they are available. Another trend being witnessed is the rise in the number of disputes going to the competent authorities for resolution under the mutual agreement procedures of bilateral tax treaties. On the other hand, transfer pricing is also an anti-avoidance issue and to this end, tax authorities have to work together to ensure that the increasing trade and commerce by multinational enterprises and their ability to allocate profits to different jurisdictions by controlling prices in intragroup transactions does not lead to tax evasion, for example through the use of non-arm’s-length prices, the artificial use of tax havens and the use of other types of ‘tax shelters’. Inevitably there will have to be trade-offs between these conflicting considerations. www.pwc.com/internationaltp 7

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Introduction 8 International Transfer Pricing 2015/16

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2. Categories of inter-company transfer Introduction Inter-company transactions take place through transfers of tangible and intangible property, the provision of services, as well as inter-company financing, rental and leasing arrangements, or even an exchange of, for example, property for services or the issue of sweat equity. It is important to note that it is the substance of the situation that always determines whether a transaction has taken place, rather than whether an invoice has been rendered. For instance, management services may be delivered through the medium of a telephone call between executives of a parent company and its subsidiary. In this example, a service has been performed that the provider had to finance in the form of payroll costs, phone charges, overheads, etc. and the service itself is of value to the recipient in the form of the advice received. As a result, a transaction has taken place for transfer pricing purposes even though, at this stage, no charge has been made for the service. Transfer pricing rules typically require related entities to compensate each other appropriately so as to be commensurate with the value of property transferred or services provided whenever an inter-company transaction takes place. The basis for determining proper compensation is, almost universally, the arm’s‑length principle. The arm’s‑length principle Simply stated, the arm’s‑length principle requires that compensation for any intercompany transaction conform to the level that would have applied had the transaction taken place between unrelated parties, all other factors remaining the same. Although the principle can be simply stated, the actual determination of arm’s-length compensation is notoriously difficult. Important factors influencing the determination of arm’s-length compensation include the type of transaction under review as well as the economic circumstances surrounding the transaction. In addition to influencing the amount of the compensation, these factors may also influence the form of the payment. For example, a given value might be structured as a lump-sum payment or a stream of royalty payments made over a predetermined period. This chapter summarises the various types of inter-company transfers and the principles that may be applied to determine the proper arm’s-length compensation for these transactions. The application of the arm’s‑length principle is discussed in detail in Chapters 3 and 4. Sales of tangible property – definition Tangible property refers to all the physical assets of a business. Sales of raw materials, work in progress and finished goods represent a major portion of the transfers that take place between related parties, typically referred to as sales of inventory (see Sales of inventory, below). However, it is important to bear in mind that ‘sales of tangible property’ can include all the machinery and equipment employed by businesses in their day-to-day activities as well as the goods they produce. www.pwc.com/internationaltp 9

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Categories of inter-company transfer Sales of machinery and equipment Machinery and equipment is frequently provided to manufacturing affiliates by the parent company. For example, this may be a means of providing support to an existing subsidiary or it may be in the form of the sale of complete manufacturing lines to a new company in a ‘greenfield’ situation. The equipment may have been purchased from an unrelated company, manufactured by the parent or might be older equipment that the parent (or another manufacturing affiliate) no longer needs. Tax rules generally require that the transferor of this equipment (whether new or used, manufactured or purchased) should receive an arm’s-length consideration for the equipment. This is generally considered to be the fair market value of the equipment at the time of transfer. While the tax treatment of plant and machinery transfers is generally as described above, there can be circumstances where an alternative approach might be adopted. Such circumstances usually arise in connection with general business restructuring or, perhaps, when a previously unincorporated business (or an overseas branch of a company) is transferred into corporate form. A number of countries offer arrangements in their domestic law or under their treaty network to defer the tax charges that might otherwise arise as a result of an outright sale of assets at their fair market value. Another possibility to consider is whether there are any tax implications arising from the transfer of business as a whole, which is to say, the bundling of assets, related liabilities and goodwill or intangibles, as against the transfer of assets such as plant and machinery on a piecemeal basis. Sales of inventory Sales of inventory generally fall into three categories: sales of raw materials, sales of work in progress and sales of finished goods. Goods in each of these categories may be manufactured by the seller or purchased from third parties. Tax rules typically require that arm’s-length prices be used for sales of inventory between affiliates. Ideally, arm’s-length compensation is determined by direct reference to the prices of ‘comparable’ products. Comparable products are very similar, if not identical, products that are sold between unrelated parties under substantially similar economic circumstances (i.e. when the market conditions affecting the transactions are similar and when the functions performed, risks borne and intangible assets developed by the respective unrelated trading parties coincide with those of the related parties). Example Assume that Widgets Inc. (WI), a US company, manufactures and sells in Europe through a UK subsidiary, Widgets Ltd. (WL). WL manufactures one product, Snerfos, using semiconductor chips that are produced by WI, transistors purchased by WI through a worldwide contract and packaging material that WL purchases locally from a third party. In addition, a testing machine, which is proprietary to WI, is supplied by WI. In this situation, there are three inter-company sales of tangible property by WI to WL: 1. Sale of the testing machine. 2. Sale of semiconductor chips. 3. Sale of transistors purchased from unrelated parties. 10 International Transfer Pricing 2015/16

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In each case, an arm’s-length price must be determined, invoices for the sales must be produced and payment on those invoices must be made by WL. An important consideration in the context of determining comparability in the context of transfer of inventory is the level of investment in working capital between the related enterprises and the independent enterprises, which is driven by payment terms and inventory lead times. At arm’s length, an uncontrolled entity expects to earn a market rate of return on that required capital. Accordingly, the effects on profits from investing in different levels of working capital warrant an adjustment to the transfer prices. Transfers of intangible property – definition When the profits of a corporation exceed the level that would otherwise be expected to arise, taking into account market conditions over a long period, the cause is the presence of what economists refer to as a ‘barrier to entry’. Barriers to entry are those factors that prevent or hinder successful entry into a market or, in other words, perpetuate some sort of monopoly control over the marketplace. Sometimes these barriers to entry create an absolute monopoly for the owner or creator of the barrier. For example, Aluminum Company of America (ALCOA) owned the world’s source of bauxite (vital in the production of aluminium) and, until the US courts forced ALCOA to divest itself of some of the supply, had an absolute monopoly in the production of aluminium. In another example, the pharmaceutical company Eli Lilly owned the patent on a drug sold as ‘Darvon’. This patent was so effective that no competitor was able to develop a drug that could compete with Darvon until the patent expired. Barriers to entry are recognised as ‘intangible’ assets in an inter-company pricing context. Examples of intangible assets include goodwill, patents, brands and trademarks, intellectual property, licences, publishing rights, the ability to provide services and many others. In general, intangible assets are non-physical in nature, are capable of producing future economic benefits, can be separately identified and could be protected by a legal right. Those intangibles that produce a monopoly or near-monopoly in their product areas are sometimes referred to as ‘super intangibles’ and are the subject of much current interest in the transfer pricing arena. Ever since the Tax Reform Act of 1986 and the subsequent white paper, the question of the appropriate inter-company royalty rates for ‘super intangibles’ had remained a controversial issue in the US. (See US chapter for a detailed discussion of the current US regulations.) An intangible asset that does not produce a monopoly (i.e. situations where the product to that the intangible relates is sold in very competitive markets) is sometimes referred to as an ‘ordinary’ or ‘routine’ intangible. Types of intangibles In the transfer pricing world, intangible assets are commonly divided into two general categories. The first category consists of manufacturing intangibles, which are created by the manufacturing activities or the research and development (R&D) effort of the producer. Marketing intangibles – the second category – are created by marketing, distribution and after-sales service efforts. www.pwc.com/internationaltp 11

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Categories of inter-company transfer Modes of transfer of intangibles Intangibles can be transferred between related entities in four ways: 1. Outright sale for consideration. 2. Outright transfer for no remuneration (i.e. by way of gift). 3. Licence in exchange for a royalty (lump sum or periodic payment based on a percentage of sales, sum per unit, etc.). 4. Royalty-free licence. As a general rule, transfers without remuneration are not accepted by the tax authorities of any country, except occasionally in the limited context of property owned and exploited from tax havens or business reorganisations that attract special tax reliefs. These exceptions are not considered further in this book. Transfers of intangibles through licences are very common and are the primary method of transfer discussed in this book. Sales of intangibles are generally treated in the same way as sales of tangible property (i.e. the arm’s-length standard requires that the selling price be the fair market value of the property at the time of sale). Some countries’ tax authorities, notably the US, require that an assessment of whether a transaction is arm’s length meet certain requirements. For the transfer of an intangible asset, US tax law requires that the consideration paid be commensurate with the income generated or expected to be generated by the intangible asset. This may require additional support, beyond an assessment of fair market value that by itself does not consider the income potential of the transferred intangible. Manufacturing intangibles Patents and non-patented technical know-how are the primary types of manufacturing intangibles. A patent is a government grant of a right that guarantees the inventor that his/her invention will be protected from use by others for a period of time. This period varies from one country to another and, to a lesser extent, according to the product. Patents can be either very effective barriers to entry or quite ineffective barriers. Very effective barriers create an absolute monopoly for the owner for the life of the patent and are exemplified by product patents. Ineffective barriers are created by patents that can easily be ‘designed around’ or cover only minor aspects of a product, such as process patents. When transferring patents to affiliates, it is vital to understand the degree of monopoly power conveyed by the patent. This is critical to the determination of the arm’s-length compensation due to the transferor because patents that provide more protection to the owner are more valuable than patents that provide less protection. Technical know-how is the accumulated specific knowledge that gives a manufacturer the ability to produce a product. In some industries, technical know-how is worth very little, so that when it is transferred between unrelated parties the royalty rate is extremely low. In other industries, technical know-how is highly valuable. Example Consolidated Wafers Ltd. (CWL) designs and manufactures semiconductors. Its research and development (R&D) department has designed a memory chip that is significantly faster and uses less power than any other chip on the market. CWL has an 12 International Transfer Pricing 2015/16

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absolute monopoly on the production of this chip until a competitor ‘reverse engineers’ the chip and markets a clone. At that time, CWL’s ability to remain successful in the market will be determined by its ability to produce high-quality chips at lower cost (higher yield) than its competitors. Typically, in the semiconductor industry, this process may take less than two years. The manufacturing intangibles cited in this example are of different value at different points during the life of the product. At the outset, the design of the chip explained its success in the marketplace. The design was proprietary but not patented. After the competition began marketing its own version of the chip, the manufacturing intangible of greatest value to CWL was its ability to improve the quality of the product and reduce the cost of manufacturing the product, both critically important factors in this industry. In determining the value of the intangibles in this example, it is important to note the length of time during which the original design created an absolute monopoly for CWL. Intangibles that sustain monopoly positions over long periods are far more valuable than intangibles that create monopoly positions for much shorter periods. The longer the monopoly continues, the more time the owner of the intangible has to exploit the monopoly position and to develop value in the form of technical know-how or selling intangibles such as trademarks, which will protect an imperfectly competitive market position after the expiration of the patent. Furthermore, in this example, the ability to produce a high-quality and low-cost product is extremely valuable in the long run, because without this ability, CWL would not be able to compete in the marketplace. There are countless examples of these types of intangibles in the modern world. Marketing intangibles Marketing intangibles include, but are not limited to, trademarks and trade names, corporate reputation, the existence of a developed sales force and the ability to provide services and training to customers. A trademark is a distinctive identification of a manufactured product in the form of a name, logo, etc. A trade name is the name under which an organisation conducts its business. Trademarks and trade names are frequently treated as identical, although one (trademark) is a product-specific intangible, while the other (trade name) is a company-specific intangible. A product-specific intangible applies to a particular product and has zero value at the time the product is marketed for the first time under that name. Its value is developed by the marketing/sales organisation over the life of the product. This is important for inter-company pricing because trademarks typically have little or no value when a product is first introduced into a new market (even though it may have high value in the markets into which the product is already being sold). A company-specific intangible is one that applies to all products marketed by a company. For example, ‘Xerox’ applies to photocopiers manufactured and sold by the Xerox Corporation. In fact, the very word ‘xerox’ has become a synonym for ‘photocopy’ in many markets. However, the power of the brand name means that this type of intangible includes new, as well as existing, products and has value in most markets at the time the products are introduced into these markets. www.pwc.com/internationaltp 13

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Categories of inter-company transfer Corporate reputation represents the accumulated goodwill of a corporation and is sometimes used as a synonym for trade name. A company with a strong corporate reputation will have a developed sales force. This means that a trained sales force is in place and is familiar with the company, its customers and its products, and can sell products effectively. This in turn involves pre-sales and post-sales activities. Pre-sales services entail generating interest in prospective customers, establishing proof of concept, making effective product demonstrations and thereby leading to closing a sale, which can be critical in industries such as healthcare, insurance and software. Service to customers after a sale and training of customers in the use of a product are extremely important in some other industries. In fact, in some industries, this intangible is the one that keeps the company in business. Example Deutsche Soap, AG (DSAG) is in the business of manufacturing and selling a line of soap products to industrial users. Its products are not patented and the manufacturing process is long-established and well-known. It sells to industrial customers that rely on DSAG for technical assistance and advice regarding difficult cleaning problems. DSAG’s sales force is on 24-hour call to assist customers within 30 minutes of a request. DSAG has developed training programmes and a service manual that it provides to its sales force. DSAG has decided to establish a wholly-owned subsidiary in France. The subsidiary will purchase products manufactured by DSAG (in Germany) and will be responsible for sales and services in the French market. DSAG intends to train the French subsidiary’s sales force and to provide a copy of the service manual for each member of its French sales force. From an inter-company pricing standpoint, the intangible of value is the ability to provide service to the customer. The transfer of this intangible to the French subsidiary should be accompanied by an arm’s-length payment to the German parent. Hybrid intangibles In the modern world, it is difficult to classify every intangible neatly as either a manufacturing or a marketing intangible. Some intangibles can be both. For example, corporate reputation may result from the fact that a company has historically produced high-quality products which were at the ‘leading edge’ in its industry. The reputation that results from this is clearly a manufacturing intangible. In another example, suppose that corporate reputation of a particular company results from its advertising genius, so that customers and potential customers think of the corporation as, for example, ‘The Golden Arches’ (McDonalds) or the company that ‘taught the world to sing’ (Coca-Cola). In this case, corporate reputation is a very powerful marketing intangible. In such cases, a significant portion of the value of the corporation is attributed to the trade name itself, such as BMW. Further complexity arises when software is the product in question. It is not clear whether software is a product to be sold or an intangible to be licensed (and there may well be withholding tax and sourcing of income implications to be considered, in addition to pricing considerations). The transfer of software to customers has elements of both a sale and a licence in most instances. 14 International Transfer Pricing 2015/16

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If software is determined to be an intangible, the question is then whether it is a manufacturing or a marketing intangible. Whatever the answer, the important question for inter-company pricing purposes is: Which legal entity developed the value of the intangible? The developer must receive an arm’s-length remuneration for the use of its property from any user of the intangible. There can be differences of opinion on this issue, stemming from whether a particular product succeeds in a specific, new market because of the technology, giving rise to manufacturing intangibles or the sales efforts, resulting in the creation of marketing intangibles. The recently settled GlaxoSmithKline dispute regarding the drug Zantac is a case in point. The provision of services – definition Services that are provided to related parties range from the relatively commonplace, such as accounting, legal or tax, to complex technical assistance associated with transfers of intangibles. The proper handling of service fees is a difficult inter-company pricing issue (considered more fully in Chapter 5). In general, each country requires that arm’s-length charges be made for any service rendered to an overseas affiliate. In many countries, ‘arm’s length’ is defined as the cost of providing the service, often with the addition of a small margin of profit. Furthermore, only arm’s-length charges for services that are directly beneficial to the affiliate can be deducted by an affiliate in its tax return. (The difficulty in determining whether a service is directly beneficial can be a major issue.) Examples of types of service Five types of service may be provided to related parties: 1. The service can be a routine service, such as accounting or legal services, where no intangible is transferred. In situations such as this, the price charged in arm’slength relationships is invariably based on a cost-plus formula where the ‘plus’ element varies greatly with the value added of the service and the extent of competition within the market. In the inter-company context, many countries allow reimbursement on a cost-plus basis, though with a relatively small and steady uplift for services that are regarded as being low risk and routine. However, a minority do not allow the inclusion of a profit or have restrictive rules. 2. The service can be technical assistance in connection with the transfer of an intangible, either manufacturing or marketing, but usually a manufacturing intangible. Typically, in arm’s-length relationships, a certain amount of technical assistance is provided in connection with a licence agreement (at no extra charge). If services in excess of this level are needed, arm’s-length agreements usually allow for this at an extra charge, typically a per diem amount (itself determined on a costplus basis) plus out-of-pocket expenses. 3. The service can be technical in nature (pertaining to manufacturing, quality control or technical marketing), but not offered in connection with an inter-company transfer of the related intangibles. In this situation, only the services provided are paid for on an arm’s-length basis. 4. When key employees are sent from their home base to manage a new facility, some tax authorities have tried to assert that there is a transfer of intangibles. For example, when a new manufacturing plant is established outside the home country, it is not unusual for a parent company to place a key manufacturing www.pwc.com/internationaltp 15

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Categories of inter-company transfer employee in that plant as plant manager to get it established and to train a local employee to take his/her place. Such a relationship may exist for three to five years. The tax authority may take the position that the knowledge and experience in the head of that employee is an intangible, owned by the parent company, which should therefore be compensated by the subsidiary for the use of the intangible asset. However, in arm’s-length relationships between unrelated parties, such a new manufacturing plant could easily recruit a plant manager from existing companies in the industry. In such a case, the plant manager would be paid a market-determined wage and no royalty would be payable to any party. Therefore, it would appear that no royalty is appropriate in the context of the multinational group, although a service charge might be needed to cover the cost of the assignee. 5. A combination of (1) to (4) above could exist where the offshore affiliate requires the expertise of the parent in order to manage its own affairs, including determining its strategy. In this situation, the substance of the relationship is that the parent company is managing the offshore affiliate with little or no local input. The substance of the relationship is such that the parent company tax authority can easily show that the amount of profit allowed to the offshore affiliate should be minimal in that it is performing a service for the parent (e.g. through a contract manufacturer arrangement or a manufacturer’s representative arrangement). The problem of ‘shareholder’ services From a transfer pricing point of view, activities conducted by a parent company (or perhaps a company that provides coordination of services within a group) are not always such that a charge should be made to the other companies involved. This is because they might be performed for the benefit of the parent company in its role as shareholder, rather than to provide value to the subsidiaries. This category of services has been defined in Chapter VII of the OECD Guidelines as ‘shareholder services’ (a narrower definition than the ‘stewardship’ discussed in the earlier OECD reports). Chapter VII was added to the guidelines in 1996. In reviewing a transfer pricing policy for services, it is very important to examine this issue thoroughly to see whether the services rendered by a parent company can directly benefit one or more recipients, can duplicate services performed by the subsidiaries, or can represent shareholder activities and, if so, whether the subsidiary will succeed in obtaining a tax deduction for the expense if a charge is made. Directly beneficial services are those that provide a benefit to the recipient. For example, if a parent prepares the original books and records for a related company, this accounting service is directly beneficial to the recipient because it allows the recipient to produce its financial statements. Whether an intragroup service has been rendered so as to warrant the payment of an inter-company charge depends on whether the activity provides the related entity with economic or commercial value to enhance its commercial position. This can be determined by considering whether an independent enterprise in similar circumstances would have been willing to pay for the activity if it was performed by a third party or would have performed the activity in-house. In the absence of any of these conditions being met, the activity would not be regarded as an intragroup service. Duplicate services are those that are initially performed by a company and duplicated by an affiliated entity, often the parent company. An example would be a marketing survey of the local market, which is completed by the subsidiary but redone by the 16 International Transfer Pricing 2015/16

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parent (because it did not trust the subsidiary’s work, for example). In cases of this type, the parent cannot bill its costs to the subsidiary for this service. However, if it can be shown that the subsidiary requested the service to ensure that its marketing survey was correct (i.e. that the parent’s input added value to the subsidiary), the position would be different. Shareholder services are those that are incurred to protect the shareholder’s interests in its investment and relate to activities concerning the legal structure of the parent company, reporting requirements of the parent company or costs of capital mobilisation. These services can be distinguished from stewardship services, which is a more broad term, referring to a range of intergroup activities performed, for which a careful evaluation is required to determine if an arm’s-length payment is normally expected. This determination will depend upon whether, under comparable facts and circumstances, an unrelated entity would have been willing to pay for a third party to provide those services or to perform them on their own account. For instance, a service provider may be required to act according to the quality control specifications imposed by its related party customer in an outsourcing contract. To this end, the parent company may depute its employees as stewards to the related subsidiary. Stewardship activities in this case would involve briefing of the service provider personnel to ensure that the output meets requirements of the parent company and monitoring of outsourcing operations. The object is to protect the interests of the service recipient (i.e. the parent company). In such a case, it is evident that the parent company is protecting its own interests rather than rendering services to the related entity. Consequently, a service charge is not required to be paid to the parent company that is in receipt of outsourcing services. Examples of these various types of expenses are included in Table 2.1. Table 2.1 Costs often incurred by a parent company Typical stewardship expenses Typical beneficial expenses The cost of duplicate reviews or performance The cost of preparing the operating plans of a of activities already undertaken by the subsidiary, if it is not a duplicate function subsidiary The cost of periodic visitations to the The cost of reviewing/advising on personnel subsidiary and general review of the management plans and practices of a subsidiary’s performance carried out to subsidiary, if it is not a duplicate function manage the investment The cost of meeting reporting requirements The cost of supervising a subsidiary’s or the legal requirements of the parentcompliance with local tax and legal shareholder, which the subsidiary would not requirements, if it is not a duplicate function incur but for being part of the affiliated The cost of financing or refinancing the The cost of conducting an internal audit of a parent’s ownership of the subsidiary subsidiary if the audit is required by the local laws of the subsidiary’s country and it is not a duplicate review Example Beautiful Unique Bathtubs SA (Bubble) is a French company that manufactures bathtubs in France for resale to related companies throughout Europe. Bubble developed the manufacturing intangibles associated with the production of the www.pwc.com/internationaltp 17

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Categories of inter-company transfer bathtubs and completes the entire manufacturing process in its plants in France and Sweden. The technology involved is unique in that the bathtub produces its own bubbles when the surface is wet. This process has been licensed to an unrelated Canadian company in exchange for a royalty of 5% of sales. Ten workdays of technical assistance are provided to the Canadian company free of charge. A licence agreement to manufacture bathtubs in Sweden has been entered into between the French and Swedish affiliates, wherein the French parent agreed to provide its technology and 10 workdays of consulting regarding the implementation of the technology in return for a royalty of 5% of sales. During the current year, Bubble’s technicians have spent 15 workdays assisting the Swedish subsidiary’s manufacturing employees. In addition, Bubble has developed a unique marketing approach that it allows related parties in the UK, Sweden, Ireland and Italy to use in their selling efforts. This marketing strategy was developed in France and is modified by each sales subsidiary for the local cultural peculiarities existing in each country. Finally, Bubble’s president visits each subsidiary quarterly to review performance. In this example, three types of service are provided by the French company: 1. Technical assistance to the Swedish subsidiary in connection with the utilisation of the manufacturing technology. 2. Marketing assistance to all selling subsidiaries. 3. The president’s quarterly review. The five days of technical assistance over the amount normally provided to third parties should be charged to the Swedish subsidiary, probably on a cost-plus basis. The cost of rendering the marketing assistance must be charged to the selling affiliates on a cost-plus basis. However, before concluding that this is the current approach, it would be necessary to consider whether the marketing strategy developed in France is in fact critically important to the subsidiaries and is therefore an intangible being licensed (for local modification) to each country. This would be more akin to a franchise, in which case it is the value of the licence to the subsidiary which needs to be established and a royalty charged, and the cost of maintaining the strategy in France becomes irrelevant. The president’s quarterly review is not of direct benefit to the subsidiaries and should therefore not be billed to them, because it represents shareholder expenses. Financing transactions The arm’s‑length principle generally applies to financing arrangements between affiliated parties as for other related party transactions. To ensure arm’s-length terms are in place, it is necessary to analyse the various forms of finance that are being provided by one related party (often the parent company) to another. A number of factors are relevant in the context of related party debt: • The rate of interest on the loan (including whether it is fixed or floating). • The capital amount of the loan. • The currency. 18 International Transfer Pricing 2015/16

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• The credit worthiness of this borrower (including whether any guarantees have been provided in connection with the loan). Tax authorities may review whether a third party would charge the rate of interest set between the related parties or whether that rate is too high or low (see Interest on loans, Chapter 5). Furthermore, the tax authority in the borrower’s country may question whether a third party would have been willing to lend the funds at all. In assessing the answer to the latter question, the local revenue authority will have reference to the debt-to-equity ratio of the borrower. If it is considered that the interest rate is too low, the tax authorities in the lender’s country may deem additional interest income to arise and tax this notional income accordingly. If it is considered that too much interest is being paid by the borrower (because the rate is too high and/or because the amount of the debt is too great) the following consequences may ensue: • Tax deductions for interest accrued or paid may be denied, increasing the local tax burden. • Interest paid may be recharacterised as dividends, which may result in additional withholding taxes being due. If it is considered that an entity has related party debt in excess of the amount that a third party would lend, the borrower is said to be thinly capitalised. Many countries, particularly the developed nations, have special thin capitalisation rules or practices. A detailed analysis of these rules, as they apply in each jurisdiction, is beyond the scope of this book (although a number of examples are included in the country commentaries). However, it is crucial to review any specific rules and practices (including any safe harbour debt-to-equity ratios) applicable in the relevant countries before international financing structures are established. Financing short-term capital needs A company’s short-term capital needs are typically greatest when it is first formed or undergoing rapid expansion. A parent company that has established a new subsidiary needing to finance its short-term working capital may use: • • • • inter-company payables and receivables, advances of capital from a related party, extended credit for inventory purchase or sales, and related party guaranteed loans. The long-term, strategic funding of R&D costs is often a very important issue to be considered as groups expand. A possible way of spreading the expenditure to be directly financed by profits earned overseas is cost-sharing. Even where no specific thin capitalisation rules apply, a revenue authority may attempt to challenge interest deductions on related party debt where a very high debt-toequity ratio exists under other general anti-avoidance provisions. There may also be regulatory end-use restrictions preventing the usage of long-term borrowings to finance working capital requirements. www.pwc.com/internationaltp 19

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Categories of inter-company transfer Example TLC Inc. (TLC) is an American company that has recently established a new subsidiary in the UK (TLUK). TLC manufactures a special line of pillows that lull small children to sleep within 10 minutes of lying down. The pillows are successful in the US market but have just been introduced in the UK market and are not currently selling very well. The parent company sells the pillows to TLUK, which is responsible for marketing and distribution. The overhead expenses of the subsidiary are greater than the current sales revenue, and serious cash-flow problems exist in the UK. These problems can be addressed as follows: • Inter-company payables and receivables The parent company may invoice TLUK for the pillows but not collect the receivable until the subsidiary can afford to make the payment. If the period of time involved is short (no longer than the payment terms ordinarily granted to distributors in this industry), this is an acceptable way of financing the receivable. However, in many countries (the US in particular), an inter-company receivable outstanding for a longer period of time than is commercially appropriate is reclassified as a loan and deemed interest accrues on it. • Advance of capital TLC may loan the funds required to finance the short-term needs of the subsidiary and collect interest on that loan. This method is acceptable unless the amount of debt owed by TLUK is sufficiently greater than the equity of the subsidiary, such that the local tax authority can argue that the subsidiary is thinly capitalised. In these situations, the tax authority may recharacterise all or part of the loans as if they were equity. In this case the parent is taxed at the subsidiary level as if it did not receive interest for use of those funds, but rather inter-company dividends in respect of equity capital. This recharacterisation means that no tax relief is obtained by TLUK on the ‘interest’. Furthermore, the tax treatment of interest is often different from dividends with respect to withholding taxes/imputation tax credits, etc. • Parent guaranteed bank loans TLC may guarantee a loan that is granted to the subsidiary by a third party (e.g. a bank). A loan guarantee fee may be required to be paid by the subsidiary to the parent for having provided the guarantee. The loan itself is primarily the responsibility of the subsidiary and must be repaid by the subsidiary. This may potentially cause a thin capitalisation problem for the subsidiary if it could not have obtained the loan without the parent’s guarantee, although in practice the risk of tax authority attack is generally much less than where the loan is made directly from the parent company to the subsidiary. Market penetration payments An alternative to the financing schemes discussed in Financing transactions and Financing short-term capital needs sections, earlier, is to use a market penetration or market maintenance mechanism. In this situation, the manufacturing company treats the related selling company’s market as its own in the sense that the manufacturer wishes to expand its sales into a new market. Because its products have not previously been sold in the new market, it must penetrate the market through marketing (e.g. advertising or through a reduction in price to customers – below the price that is 20 International Transfer Pricing 2015/16

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expected to be charged after achieving the desired level of sales). These costs are the costs of the manufacturer rather than the distributor. Market penetration payments can be made in one of two ways. A lump-sum payment (or a series of periodic subvention payments) can be made to cover the market penetration costs or, alternatively, transfer prices can be reduced for the market penetration period. Effectively, the payment for market penetration or subvention payments converts the selling company into a routine distributor, assuming less-thannormal business risk and leaving it with a normal profit margin. Documentation is a key issue in defending this approach, and great care must be taken to ensure that any lump-sum payment will attract a tax deduction for the payer. A reduction of transfer prices must be viewed as a temporary reduction of prices only; it cannot be allowed to become permanent, because the profits of the subsidiary would eventually become excessive and cause transfer pricing problems in the future. Market maintenance occurs when a company is threatened by competition and must respond, either through reducing prices to customers or by significantly increasing marketing activity, if it is to maintain its market share. The cost of this activity can be funded in the same way as market penetration, that is, either through a lump-sum payment or through a reduction of the transfer price. Cost-sharing Cost-sharing has frequently been used by companies that need to finance a major R&D effort but cannot fund it in the company that must perform the activity. For example, in a group where the parent company houses the R&D department, funding R&D locally may become a problem if domestic profits fall. However, if the group has profit in other locations, it may decide to institute a cost-sharing agreement with its subsidiaries to allow profitable subsidiaries to fund the R&D activity of the group. The establishment of cost-sharing arrangements has a major long-term impact on a group’s profitability and tax strategy, country by country, in that the companies contributing to the research will obtain an interest in the knowledge created and thereby be entitled to a share in profits derived from it. Furthermore, a buy-in payment may be required when companies come into the cost-sharing arrangement. Participating companies wishing to exit from a pre-existing cost-sharing arrangement would correspondingly have to receive a buyout payment representing the value of their share in the intangible developed until date of opting out. Financing long-term capital needs Long-term capital needs can be financed through: • Mortgages. • Lease financing. • Capital stock. • Long-term debt (inter-company or third party). • The issue of equity to shareholders and bonds or other financial instruments in the marketplace (this activity with third parties is not covered further). Mortgages The purchase of land can be accomplished through a lump-sum payment or through a mortgage. Use of a mortgage means that the total cash outlay for the land is spread over a period of years. Usually, the interest rate on mortgages is lower than for www.pwc.com/internationaltp 21

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Categories of inter-company transfer unsecured loans (whether short- or long-term), so that it is cheaper to raise funds through this mechanism than through other types of debt financing. In the event that the mortgage is obtained from a related party, the interest rate and terms should normally be the same as would have been obtained from an unrelated party. Lease financing A subsidiary may lease capital equipment from a related or unrelated party. This means that the subsidiary does not make a lump-sum payment for the asset but spreads its cost over a number of years and may not necessarily take all the risks of ownership. If the lease is obtained from a related party, the interest rate and terms must be the same as would have resulted had the lease been obtained from an unrelated party. One consideration would be structuring the lease as an operating lease (where the substantial risks and rewards relating to the asset remain with the lessor) or a finance lease (where the eventual ownership of the asset transfers to the lessee) and pricing the lease rental accordingly. Capital stock The parent can provide capital to a subsidiary through purchase of capital stock in the subsidiary. This is probably the most straightforward method of financing the longterm needs of a subsidiary but is relatively difficult to adjust quickly to meet changing needs. In particular, many jurisdictions have rules making it difficult for a company to reduce its equity base. The dividend policy between subsidiary and parent is usually the only area of intercompany transactions that does not attract significant interest from tax authorities (although they sometimes challenge inter-company payments to a parent company, such as royalties and interest in circumstances where no dividends are paid on ordinary capital or where they consider the company to be thinly capitalised). From a planning perspective, it can sometimes be preferable to issue shares at a premium rather than issue more shares at the same nominal value. This is because many jurisdictions allow the repayment of share premium, while a reduction of share capital often requires relatively complex and formal legal proceedings or may not be possible at all. The flexibility gained will probably weaken the balance sheet somewhat where such arrangements exist. It is also worthwhile exploring the possibility of issuing redeemable preference shares or similar quasi-equity instruments, which would enable early redemption or other simpler forms of capital reduction or equity repurchase. Preference shares are broadly similar to equity shares in terms of the treatment of dividend payout, but have priority in matters of profit and capital distribution. Long-term inter-company loans A parent company usually has the flexibility to lend funds to subsidiaries directly in the form of loans, whether secured or unsecured. Most parent company jurisdictions require that the parent charge an arm’s-length rate of interest on the loan based on the term of the loan, the currency involved and the credit risk associated with the subsidiary (see Interest on loans, Chapter 5). At the subsidiary level, tax deductions are normally available for interest expense. However, thin capitalisation is increasingly an area that is scrutinised by tax 22 International Transfer Pricing 2015/16

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authorities, so particular attention must be given to the gearing levels acceptable in the borrowing country. Careful attention must also be given to any double taxation agreement in force between the countries involved. Other financing techniques The methods of determining an appropriate price for the financial transactions discussed in sections Financing transactions through Long term intercompany loans, above, apply equally to the more sophisticated financing techniques, such as deep discounted loans, hybrid financing arrangements (where the instrument is taxed on an equity basis in one country and as debt in the other), swaps, etc. In all these situations, the correct remuneration for the parties involved can be determined only by a careful analysis of the various obligations and risks of the parties to the transaction and how these would be compensated in an arm’s-length situation. This analysis is essentially the same as that which a bank does in setting the terms of special arrangements with its customers or the market processes that eventually determine how a quoted financial instrument is valued on a stock exchange. Flexibility in managing capital needs It is important to bear in mind that cash is easily moved from one place to another. A multinational will have opportunities to raise external capital from shareholders or from institutional backers and banks, probably in a number of different countries, and will similarly be generating profits across a wide spread of territories. While the remarks in the sections Financing transactions through Other financing techniques, above generally refer to the financing of subsidiaries by the parent, there may well be opportunities to arrange finance between subsidiaries across the group, perhaps through a special entity taxed on a low basis, such as a Belgian Coordination Centre. Similar principles apply in these circumstances. www.pwc.com/internationaltp 23

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3. The work of the OECD Introduction The Formation of the OECD According to its Convention, the Organisation for Economic Co-operation and Development (OECD) was established in 1961 in order to establish policies within its member countries that would: • achieve the highest maintainable economic growth and employment and a sustained rising standard of living in member countries • result in sound economic expansion, and • contribute to the expansion of world trade on a multilateral, nondiscriminatory basis. A list of the OECD member countries is set out at the end of this chapter. The OECD report and Guidelines on transfer pricing The tax authorities in the United States and a handful of other countries started to pay considerable attention to transfer pricing in the 1960s and 1970s. As part of their general remit, the OECD member countries recognised that it would be helpful to provide some general guidance on transfer pricing in order to avoid the damaging effects that double taxation would have on international trade. The result was the OECD report and Guidelines on transfer pricing which were first issued in 1979 and were subsequently revised and updated in 1995 and again in 2010. The importance of transfer pricing and the need for regulations and/or guidelines intensified in 1990 when an investigation for a US congressional committee found that the Japanese distribution subsidiaries of US groups reported profits of roughly 7% in Japan while the average for US subsidiaries of Japanese groups were -0.2%. The ‘Pickle Hearings’ (named after a member of that committee) attacked foreign (and specifically Japanese) groups alleging tax avoidance using transfer pricing. Following the Pickle Hearings, the IRS promptly challenged US distribution subsidiaries of foreign multinationals that reported losses or lower profits. In those cases where there were losses, the argument the IRS used was, very broadly, that distributors do not make sustained losses – they renegotiate prices with their suppliers, switch to distributing profitable products or go out of business. It was against this background that the United States introduced the comparable profits method (CPM) in proposed regulations in 1992, just as the OECD was engaged in prolonged discussions that resulted in the 1995 update of the OECD Guidelines. On 22 July 2010 the OECD published revised Chapters I – III of the OECD Guidelines covering the arm’s‑length principle, transfer pricing methods and comparability analysis. At the same time, final guidance on the Transfer Pricing Aspects of Business www.pwc.com/internationaltp 25

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The work of the OECD Restructurings was issued, which is now incorporated into the OECD Guidelines as a new Chapter IX. To summarise the main points, the 2010 OECD Guidelines: • Reaffirm the position of OECD member states that the arm’s‑length principle is the fairest and most reliable basis for determining where profits fall to be taxed and reject alternatives such as global formulary apportionment (Chapter I). • Remove the hierarchy of methods contained in earlier versions of the OECD Guidelines which had expressed preference for the use of traditional transactionbased methods in favour of a new ‘most appropriate method rule’ (Chapter II). • Elevate the standing of the transactional net margin method (TNMM) to be on an equal footing with other transfer pricing methods and provide detailed guidance on the use of profit level indicators (PLIs) including return on sales, return on cost,return on capital or assets and the Berry ratio (i.e. mark-up on operating expenses) (Chapter II). • Provide additional guidance on the use of the profit split method (Chapter II). • In addition to the five comparability factors that were added in 1995, place greater emphasis on data analysis and the use of adjustments and statistical methods to draw conclusions, including – for the first time – endorsement of the use of an interquartile range (Chapter III). • Introduce a typical nine-step process for performing a transfer pricing comparability analysis (Chapter III). • Introduce new principles on disregarding or re-characterising certain restructuring transactions, reallocation of risk and compensation for the restructuring itself (Chapter IX). As a result of the changes, taxpayers should expect to see the following from taxing authorities: • Increased challenges on the comparability of data used to support the application of one-sided methods (i.e. the TNMM, the resale price method, and the cost plus method). • Greater focus on the potential use of internal comparables. • Additional pressure to consider the profit split method. • Closer examination of the processes followed to establish or document their transfer prices. • Requests to explain the options realistically available to the parties to a transaction • in the context of a restructuring. • Examination of capability to control risks by the party which has been assigned the risks in the restructuring. • More focus on intangibles. New OECD initiatives Reflecting a much higher level of activity by the OECD, a number of new initiatives have resulted in pronouncements that potentially have significant impact on transfer pricing matters. In December 2006 final versions of Parts I, II and III of the Report on Attribution of Profits to Permanent Establishments (PE Report) dealing with general considerations in relation to the taxation of permanent establishments and application of these principles to banks and in the context of global trading were issued. This was followed on 22 August 2007 by a revised Part IV dealing with insurance. A final version of the combined parts to the PE Report was finally issued on 17 July 2008. The 2008 PE 26 International Transfer Pricing 2015/16

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Report then spawned a project to update Article 7 and the Commentary to that Article, resulting in the revised text of the old Article 7 and associated commentary, as well as a new Article 7 included in the 2010 update to the OECD Model Tax Convention. Also in 2010, an amended and updated version (but not fundamentally altered from 2008) of the PE Report was issued in order to reflect any necessary minor amendments to make the report consistent with the new Article 7. The OECD has recently launched new projects on the transfer pricing aspects of transactions involving intangibles (25 January 2011) and on the administrative aspects of transfer pricing (9 March 2011). Regarding the intangibles project, it aims at a substantial revision and clarification of the current Chapter VI ‘Special Considerations for Intangible Property’ of the OECD Guidelines, as well as a consistency check of Chapters VII ‘Special Considerations for Intra-Group Services’ and VIII ‘Cost Contribution Arrangements’, in order to ensure that the terminology and concepts in all Chapters are applied consistently. The project focuses on issues, such as, definitional aspects of intangibles, valuation and guidance on specific transaction categories involving intangibles (e.g. R&D activities, marketing intangibles and service provision using intangibles). On 6 June 2012, nearly one and a half years ahead of the original timeline, the OECD published the first public Discussion Draft, Revision of Chapter VI of the OECD Guidelines. The early availability of the Discussion Draft underscores the immense progress the OECD has made on the intangibles projects since the kick off meeting help jointly with business commentators in November 2010. The comment period following the release of the Discussion Draft ended 14 September 2012. The arm’s‑length principle Under the arm’s‑length principle, related taxpayers must set transfer prices for any inter-company transaction as if they were unrelated entities but all other aspects of the relationship were unchanged. That is, the transfer price should equal a price determined by reference to the interaction of unrelated firms in the marketplace. This concept is set out definitively in Article 9 of the OECD Model Tax Convention, which forms the basis of many bilateral tax treaties. The OECD Guidelines acknowledge that it is often difficult to obtain sufficient information to verify application of the arm’s‑length principle in practice but state that it is the best theory available to replicate the conditions of the open market. The OECD Guidelines then focus on best practice in determining the equivalent of a market price for intercompany transactions within multinational groups. Guidance for applying the arm’s‑length principle The arm’s‑length principle is usually applied by comparing the ‘conditions’ (e.g. price or margin) of a controlled transaction with those of independent transactions. The OECD Guidelines allow the use of inexact comparables that are ‘similar’ to the controlled transaction but not the use of ‘unadjusted industry average returns’. The factors that should be considered when assessing the comparability of a transaction include: • The specific characteristics of the property or services. • The functions that each enterprise performs, including the assets used and, mostimportantly, the risks undertaken. • The contractual terms. www.pwc.com/internationaltp 27

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The work of the OECD • The economic circumstances of different markets, for example, differences in geographic markets, or differences in the level of the market, such as wholesale vs. retail. • Business strategies, for example, market penetration schemes when a price is temporarily lowered. For instance, if a subsidiary corporation manufactures a sports shirt and then sells that shirt to its foreign parent for distribution, it must establish an inter-company price for the shirt. Under the arm’s-length standard, this inter-company price should be determined by analysing what comparable sports shirt manufacturers receive when they sell shirts to unrelated distributors. Although there are several acceptable methods for determining arm’s-length price, each is based on a comparable transaction. Analysis of transactions The OECD Guidelines set out how transactions should be analysed when determining or reviewing transfer pricing. • The tax authorities should review the actual transaction as structured by the related parties (however, see Recent developments at the OECD, below in relation to business restructuring). • Although the OECD Guidelines prefer a review of transfer pricing on a transactionby-transaction basis, they acknowledge that this is not often practical, and so a combination of transactions may be examined. • It is not always possible to use a single figure, for example, as a price or margin; instead, a range of prices may be more appropriate. • The OECD Guidelines suggest examining data from both the year in question and previous years. Transfer pricing methods The OECD Guidelines comment on various pricing methodologies, with examples of their application, under a number of headings. Prior to the 2010 revision the OECD Guidelines expressed a preference for the use of ‘traditional transaction methods’ as being the most direct price comparisons as compared to more indirect profit based methods. The OECD Guidelines now explicitly require the selection of the most appropriate method, taking into account the strengths and weaknesses of the OECD recognised methods. The selection of the method needs to consider several elements, including the availability of reliable information needed to apply the selected method. Although what is ultimately important is that the most appropriate method is selected, the OECD Guidelines states that if the CUP method and another transfer pricing method can be applied in an equally reliable manner, the CUP method is preferred. The OECD Guidelines (Chapter III) also provide a description of a typical process when performing comparability analysis, which is considered an accepted good practice but is not compulsory. This nine step process is a good illustration of not only the considerations necessary when selecting the most appropriate method, but also understanding the overall comparability analysis. 28 International Transfer Pricing 2015/16

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Comparable uncontrolled price method The comparable uncontrolled price (CUP) method offers the most direct way of determining an arm’s-length price. It compares the price charged for goods or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction. The OECD acknowledges that it may be difficult to determine reasonably accurate adjustments to eliminate the effect on price, but states that this should not routinely preclude the application of the CUP method. The extent of the OECD’s support for the CUP method can be seen from the comment that ‘every effort should be made to adjust the data so that it may be used appropriately in a CUP method’. Using the CUP method for sales to affiliates, potentially comparable sales include sales made by a member of the controlled group to an unrelated party, sales made to a member of the controlled group by an unrelated party, and sales made between parties that are not related to each other. Any of these potential CUPs may provide an arm’s-length price for use in the sale between related parties if the physical property and circumstances involved in the unrelated party sales are identical to the physical property and circumstances involved in the sales between the related companies. Transfer pricing regulations in most countries allow CUPs to be adjusted if differences between the CUP and the related party transaction can be valued and have a reasonably small effect on the price. Examples of adjustments that are commonly allowed include differences in: • the terms of the transaction (for example, credit terms) • the volume of sales, and • the timing of the transaction. Differences in respect of which adjustments are difficult or impossible to make include the: • • • • quality of the products geographic markets level of the market, and amount and type of intangible property involved in the sale. Example Far East Steel Ltd (FES), a Japanese company, manufactures steel ingots in the Far East and ships them to related and unrelated foundry businesses in the UK. The ingots that FES ships to its unrelated and related party customers are identical in every respect. Moreover, the terms and conditions of the sales are also identical, except that the related party customers are given payment terms of 90 days as opposed to only 45 days for unrelated party customers. Based on this information, it is determined that the unrelated party ingot sales represent a CUP for the inter-company transfer price. The difference in payment terms must be taken into account, however, before the actual arm’s-length inter-company price can be determined. Based on prevailing interest rates, it is determined that the difference in payment terms is worth 0.5% of the ingot price. Adjusting the unrelated party price for this difference, it is established that the inter-company price should reflect the unrelated party price plus 0.5%. www.pwc.com/internationaltp 29

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The work of the OECD Example Gluttony Unlimited, a UK company (GUK), manufactures a type of cheese that is calorie and cholesterol-free when eaten while drinking fine French wine. The cheese is sold to related companies in Germany and the United States and to an unrelated company, Guilt Free Parties (GFP), in France. A transfer price is needed for GUK’s sales to its affiliates. GFP is a sponsor of cheese and wine parties in France. Individuals ask GFP to organise and conduct these parties and to provide the cheese, wine and other food and utensils needed to sponsor the event. GUK’s subsidiaries in Germany and the United States are distributors of the cheese to unrelated grocery stores and to wine and cheese party sponsors throughout their respective countries. The price charged to GFP by GUK does not qualify as a CUP in this instance because the ‘level of the market’ is different (i.e. the German and US affiliates sell to a higher level of the distribution chain than does GFP). Typically, these differences cannot be valued and, as a consequence, no CUP exists. Resale price method An arm’s-length price is determined using the resale price method by deducting an appropriate discount for the activities of the reseller from the actual resale price. The appropriate discount is the gross margin, expressed as a percentage of net sales, earned by a reseller on the sale of property that is both purchased and resold in an uncontrolled transaction in the relevant market. Whenever possible, the discount should be derived from unrelated party purchases and sales for the reseller involved in the inter-company transaction. When no such transaction exists, an appropriate discount may be derived from sales by other resellers in the same or a similar market. The OECD Guidelines recognise that there are problems in obtaining comparable data, for example, where there is a considerable period of time between the comparable transaction and the one under review within the group, where movements within the economy (i.e. foreign exchange rate, interest rate, recession or boom) generally would cause possible distortion. As with the CUP method, it is possible to adjust the discount earned by the reseller to account for differences that exist between the related transaction and the comparable unrelated transaction. Example Shirts Unlimited (SU), an Italian company, manufactures and sells sports shirts. Manufacturing takes place at the parent company’s factory in Italy. Subsidiaries in Germany, France and the UK serve as distributors in their respective markets. Through a search of comparable distributors of sports shirts, it is determined that independent distributors earn gross margins of 25%. There is one major difference between the related party distributors and the independent distributors – the independent distributors also design the shirts, whereas the related party distributors do not. Upon further investigation, it is learned from independent distributors that they typically charge a 3% (on sales) royalty for designing shirts. Based on this information, the comparable resale price margin is adjusted for the design function. Therefore, the gross margin to be earned by the related party distributors is reduced from 25% to 22% to account for the absence of a design function. 30 International Transfer Pricing 2015/16

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Cost plus method The cost plus method is one of the methods typically applied in analysing the activities of a contract manufacturer (see Chapter 4, Contract manufacturers and fully fledged manufacturers) or when determining the arm’s-length charge for services. It can also be applied to fully-fledged manufacturers, although the mark-up, as well as the cost base, may be different from that utilised in the case of a contract manufacturer. The cost plus method determines the arm’s-length price by adding an appropriate mark-up to the cost of production. The appropriate mark-up is the percentage earned by the manufacturer on unrelated party sales that are the same or very similar to the inter-company transaction. The cost base for both the comparable company and the one under review must be carefully analysed to ensure that the costs to be marked up are consistently defined. Thus, as with the resale price method which is also premised on using gross margins as the basis for comparison, a careful comparative review of the accounting policies is as important as the determination of the mark-up, particularly with a view to identifying any potential mismatches of expense categorisation between cost of goods sold and administrative expenses when comparing the financial results of the taxpayer and the comparables. When determining the mark-up to be applied in the contract manufacturing case, it is important to note that the goods transferred under the comparable transaction need not be physically similar to the goods transferred under the inter-company transaction. For example, a contract manufacturer should be compensated for the manufacturing service provided rather than for the particular product manufactured. When determining arm’s-length mark-ups for fully-fledged manufacturers (i.e. manufacturers that operate with a greater degree of independence and which carry out more sophisticated activities) the nature of the product that is manufactured will probably be of much greater significance to the analysis. Mark-ups earned by manufacturers could vary considerably from one product to another because of manufacturing intangibles that may have been developed by the fully-fledged manufacturer. As a result, identifying a comparable for the fully-fledged manufacturer may be extremely difficult unless the company manufactures and sells the products in question to unrelated companies at the same level of the market as the affiliates to which the related party sales are made (i.e. an internal comparable exists). Example A UK company, Glass Shapes Ltd (GSL), is a specialist glass manufacturer. The company conducts all of its research and development (R&D) and manufacturing activities in the UK. After the glass has been produced, it is shipped to the manufacturer’s Irish affiliate where it is shaped, utilising a special technical process developed by the UK company. The shaping process is not complex, nor does it require highly skilled labour. When the unfinished glass arrives at the plant, the Irish personnel examine the accompanying work order and immediately begin processing the glass. The Irish affiliate never takes title to the glass; rather, the unfinished glass is consigned to it. In this case, the Irish affiliate is a contract manufacturer. It performs limited manufacturing activities and engages in no production scheduling, materials purchasing, or technical service. Moreover, it bears no raw material or market risk. When the shaping process is complete, the Irish affiliate ships the completed products www.pwc.com/internationaltp 31

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The work of the OECD to the UK parent for sale in the UK market. In addition to this service provided to the UK parent, the Irish affiliate also provides similar services to unrelated companies. Since the UK company uses no other contract manufacturer, a CUP does not exist from the UK standpoint. However, as the Irish affiliate is also performing manufacturing services for unrelated companies, comparable information will be available from these transactions. Specifically, the mark-up the Irish affiliate earns on services provided to unrelated companies can potentially be used to apply a cost plus method to the related party transaction. Cost plus method – capacity adjustments Regardless of whether the manufacturer is a contractor or a fully-fledged manufacturer, several issues must be considered when evaluating a comparable transaction. These issues include capacity, technology owned by the manufacturer, volume and geographic market. In many cases capacity issues are important in determining the appropriate cost base. For example, if a contract manufacturing plant is operating at 50% capacity, the question of whether all the overhead costs should be included in the cost base in determining the fee received by the contract manufacturer is critically important. If those costs are excluded, the contract manufacturer may report negative income; if instead, all overhead costs are included, the fee paid to the contract manufacturer may be so high that the cost base of the product exceeds the market price. The correct answer is determined by the nature of the relationship between the parties. Typically, in arm’s-length relationships between unrelated parties, a contract manufacturer would not devote its entire productive capacity to a single customer, so that capacity utilisation problems are not the responsibility of any single customer. However, if a contractor agrees to maintain a certain productive capacity to be available to a given customer at any moment, that customer should pay for the cost of maintaining that capacity, whether it is used or not. Example As an example, if we take the facts of GSL (see previous Example) but change the assumption such that the Irish affiliate dedicates 100% capacity to GSL through a longterm contract, then the fee for charges to GSL must take account of all the overhead accruing on a long-term basis. As a result, GSL and its Irish affiliate must budget to maintain the subsidiary in an appropriately profitable position. Where there are significant differences in the cost base due to geographic market differences, it will be important to conduct a thorough review of the existence of location savings and which parties to the transaction should be the beneficiary of such savings. Profit split method This method establishes transfer pricing by dividing the profits of a multinational enterprise in a way that would be expected of independent enterprises in a jointventure relationship. It might be appropriate to use this method for highly integrated operations for which a one-sided method would not be appropriate. The profit split method may also be the most appropriate method in cases where both parties to the transaction make unique and valuable contributions to the transaction. The OECD Guidelines state that expected profits should be used rather than actual profits, in 32 International Transfer Pricing 2015/16

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order to avoid the use of hindsight. Many multinational enterprises (MNEs) have responded to this by including a year-end ‘true up’ calculation as part of their intercompany agreements. To compute arm’s-length prices using the profit split method, it is necessary to know how profits would be split between unrelated parties based on the same facts and circumstances as in the related party situation. Because this information is almost never publicly available, a ‘comparable profit split’ derived from formulae used by third parties is rarely possible. More frequently this method relies on the judgment of the user to determine an appropriate profit split formula that reflects the relative contributions of tangible and intangible assets made by each of the parties to the transaction (in the terminology adopted in the US regulations this is known as a residual profit split). For this method, it is necessary to compute the revenues and costs of each legal entity involved in the transaction. For example, if, for a given geographic market, an MNE conducts R&D and manufacturing in one legal entity and marketing and distribution is conducted in a second, the revenues and costs in each entity relevant to the specific geographic market must be computed. This can be extremely difficult, and may lead to extensive disclosure requirements in order to ensure that transfer pricing documentation standards are met. Typically, the profit split analysis is conducted at the operating income level, although sometimes it is applied at the gross profit level. In each instance, the income in question must be solely the income attributable to operations (i.e. non-operating income should be excluded from the analysis). The extent to which a profit split method should be used to test a result achieved by the CUP method or a one-sided method has been subject to significant international debate. Some tax authorities have made attempts to perform a sanity check of a result achieved from a CUP method or a one-sided method using a profit split method. However, the OECD Guidelines’ clear position is that secondary methods are not required, and the application of a profit split method requires both parties to make unique and valuable contributions to the transaction (which would not be present when applying a one-sided method). The 2010 revised OECD Guidelines include a significant amount of new guidance on the practical application of the profit split method, which led to concerns that this reflected a greater endorsement of the profit split method. However, the OECD has indicated that the intention of the working party was that the (2010) revised OECD Guidelines did not represent a greater endorsement of the profit split method. Example Wheels AG (WAG) is a German company that manufactures luggage carriers that are lighter than those sold by its competitors. Key parts are manufactured at the parent company and sold to a subsidiary located in the UK. The UK subsidiary, via its selffunded research and development activities, developed unique and highly valuable technologies which make the luggage even lighter. The UK subsidiary also assembles the finished luggage carriers and markets and distributes the products in the UK market. It has been in existence for 15 years. No comparables are available that would allow the application of the CUP, or one of the one-sided methods; so WAG has decided to utilise a profit split method to determine transfer prices. www.pwc.com/internationaltp 33

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The work of the OECD Table 3.1 Wheels AG’s sales in the UK market (1992) WAG Sales 75 Cost of sales (60) Gross profit 15 Selling 0 General and administrative expenses (1) Operating income 14 WUK 100 (75) 25 (20) (8) (3) Consolidated 100 (60) 40 (20) (9) 11 The first step in the application of the profit split method is to produce basic income statement data for the transaction, as follows: The profit split at the gross profit level is 15/40 or 37.5% for WAG and 25/40 or 62.5% for WUK. The profit split at the operating income level is 127% for WAG and negative 27% for WUK. It is obvious that the transfer prices used here produce an inequitable profit split and are unlikely to be acceptable to the UK tax authority. Transactional net margin method This method was the OECD’s response to the US CPM. The TNMM looks at the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer makes from a controlled transaction. In substance, it is similar to the US CPM, although there has been considerable debate as to the extent to which they are the same in practice. Neither method requires the same level of comparability in product and function as is required for the traditional methods. However, the OECD Guidelines express concern that there should be sufficient comparability in the enterprises being compared so that there is no material effect on the net margins being used or adjustments to be made. It is interesting to note that the debate over the US CPM was an important driver of the revision to the earlier OECD work on transfer pricing. There was some concern outside the US that the CPM would be used in inappropriate circumstances. Under the TNMM, the focus is initially on transactions (rather than business lines or perhaps the operating income of a company) and the argument is that this imposes a greater discipline to look closely at the inter-company transactions and to justify why they may be aggregated together for the purposes of the analysis. Under the US CPM there is a requirement that is similar in effect that requires the taxpayer to consider whether the test is being applied to an appropriate business unit. This is obviously an area in which taxpayers can easily find areas of disagreement if they chose to do so. In practice, by focusing on areas of commonality of approach, it is often possible to establish transfer pricing policies and procedures that satisfy the requirements of both the US CPM and the OECD TNMM. Although before 2010 such profit based methods were described as ‘methods of last resort’ under the OECD Guidelines, in practice they were widely used largely because of the availability of comparable data at the net profit level based on the published financial statements of independent companies. Now, the OECD Guidelines place the application on the TNMM on equal footing as the traditional methods, and furthermore recognise the notion of comparability defects, and that the application of the TNMM should not be excluded solely because of the existence of comparability defects. 34 International Transfer Pricing 2015/16

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Return on assets Return on capital (i.e. equity) is generally the economist’s preferred rate-of-return measure but it is often difficult to use this measure directly in an inter-company pricing framework. This is because the capitalisation of a subsidiary will usually be determined by the parent company in the light of internal group financing requirements and not by the market forces of banks, shareholders and bond holders, who effectively control the capitalisation of a quoted company. The overall capitalisation of a wholly-owned subsidiary is therefore not necessarily arm’s-length. As a substitute for return on equity, return on assets (ROA) is frequently used as a PLI, as is now recognised in the 2010 update of the OECD Guidelines. In the United States, ROA is frequently selected as an appropriate PLI in an analysis that applies the CPM, and in many other countries it has historically been similarly applied as part of a transactional net margin or cost plus method analysis. For example, such analyses are frequently applied to manufacturing activities. When using ROA, the definition of assets utilised in the manufacturing activity can be a potential area of difficulty. Return on the net book value (NBV) of all assets may be used in some situations. In this case, the numerator is the operating income before interest and taxes. The denominator is the NBV of all assets reported on the balance sheet that are utilised in the manufacturing activity, excluding financial and nonoperating assets. In addition, the age of the plant and equipment must be considered when comparing the ROA in a related party with those earned by independent companies. For example, if the manufacturing company within a multinational group has a new plant with very high depreciation expense, its ROA may not represent a valid comparison with independent companies that operate with old, fully depreciated plants (or vice versa), unless the assets are all revalued to a current basis. Example Clipco SA, a Belgian company, manufactures and sells razors. Its R&D activity is conducted at the parent company in Belgium; its manufacturing is done by a subsidiary in Ireland and its distribution is done by a subsidiary in Germany. The Irish manufacturing process is capital intensive. Financial statements are available which allow a typical ROA to be computed for the manufacturing activities. Specifically, financial statements for manufacturing companies that produce razors for sale to unrelated distributors are available. Furthermore, no publicly available information exists which can be used to apply the CUP, resale price or cost plus methods to determine transfer prices between the Irish and German subsidiaries, and the profit split method is not considered appropriate given the nature of activities being performed by the Irish manufacturer. The balance sheets reveal that liquid assets (cash, short-term investments and accounts receivable) for Clipco’s Irish subsidiary represent 40% of total assets while the same assets for the independent manufacturers represent only 10% of total assets – these are excluded from the calculation. Further analysis reveals that the plants (related and independent) are approximately the same age and the accounting principles utilised in constructing the balance sheets are similar. The ROA is calculated and this ratio is used to determine transfer prices for Clipco’s Irish subsidiary’s sales to Clipco-Germany. www.pwc.com/internationaltp 35

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The work of the OECD Berry ratio compared to return on sales (ROS) ROS has traditionally been the primary PLI applied to the profitability of distribution operations in order to evaluate the arm’s-length nature of the underlying intercompany pricing arrangements in many countries. In contrast, the Berry ratio focuses on comparing the gross profitability of an activity and operating expenses necessary to carry it out (i.e. gross profit divided by operating expenses). In substance the Berry ratio may thus be seen as a cost plus method applied to selling entities. It has been frequently used as a PLI for the application of the US CPM to certain categories of distribution activities. By way of illustration, consider the case of a parent company that has performed all the R&D required to bring a product to market and has also manufactured the product. A related entity is responsible for arranging the sale of the goods to the end customer and maintains a local sales office for this purpose. The distributor may either directly sell the goods to the customer or may be compensated by way of a sales commission paid by the manufacturer. In this situation, the ‘simple’ entity is the selling entity and the ‘complex’ entity is the manufacturer. To compute the Berry ratio, it is necessary to determine the mark-up that a typical distributor earns on selling, general and administrative (SG&A) expenses which it incurs in the process of providing sales services on behalf of the manufacturer. Specifically, the Berry ratio is calculated as the ratio of gross profit to operating costs and is used to mark-up the SG&A costs of the selling affiliate in the inter-company transaction. All remaining income is attributed to the manufacturing entity. It is noted that in practice a transactional method such as the RPM or cost plus will often have to be applied during the company’s budgeting process in order to insure that the actual invoice pricing of the goods on a day-to-day basis will achieve the desired overall Berry ratio target established for the company’s financial year. The advantages of the use of the Berry ratio include the ease of administration and the lack of concern for the size of the distributors used as comparables. Its use is appropriate when the distribution activity in question consists of a limited range of functions and risks, and may be properly characterised as the provision of a service to the manufacturer. In contrast, distributors that operate with a higher degree of independence, that may own intangible assets, or which conduct value added activities in addition to mere resale of tangible goods may be better evaluated by use of ROS. As in all matters relating to the choice of an appropriate PLI, a comprehensive functional analysis is essential in making these distinctions in functionality, levels of risk taking and assets employed, and insuring that a valid comparison is made with third party comparables that exhibit similar characteristics. Although the OECD Guidelines now makes reference to the use of the Berry ratio as a PLI, the Guidelines also identify specific criteria which should be met in order for the Berry ratio to be considered appropriate. Example US Pills Inc. (USP) is a US pharmaceutical company that has begun to manufacture a new drug in a subsidiary located in Sweden. The parent developed and patented the drug in the United States and has licensed the Swedish subsidiary to manufacture it. The parent purchases the drug from its subsidiary and distributes it in the United 36 International Transfer Pricing 2015/16

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States. The final US sales price for the drug is 2 United States dollars (USD) per tablet. Sales of the drug are expected to be 600 million tablets per year. The distributor’s operating costs are USD 14.4 million per year. To determine the transfer price, the Berry ratio for US distributors is computed and found to be 125%. This means that the operating costs of the distributor are marked up by 25% to determine transfer prices (i.e. the distributor’s gross margin is USD 18 million per year). Using this gross margin, the price of the tablets to the distributor is USD 1.97 per tablet. This analysis implies that the distributor will earn a gross margin equal to 1.5% of sales. The Berry ratio method will be acceptable in this case only if the functional analysis has clearly established that the distribution activity does not involve the use of any locally developed intangible assets, involve any local ‘value added’ functions, or exhibit any other unique characteristics that the tax authorities may consider should attract a higher rate of return. Again, careful analysis of the facts and circumstances is critically important. It is often found that distributors that are members of MNEs perform different functions from independent, entrepreneurial distributors. One area that can be particularly complex to analyse, for example, concerns advertising expenses. It is important to understand how these are dealt with in both the controlled and uncontrolled transactions under review and this may be very difficult to establish from public sources for comparable businesses. The nature of the sale is also important. For instance, it will be important to consider the impact the distributor actually has on the customer in comparison with the customer’s desire to buy the product (from the parent). Stated differently, can it be demonstrated that independent local activities of the distributor can drive a pricing differential in the market? If the answer to this question is ‘yes’, then use of the Berry ratio may not be appropriate. Non-arm’s-length approach: global formulary apportionment A global formulary apportionment allocates the global profits of a multinational group on a consolidated basis among the associated enterprises, using a preset formula. The OECD Guidelines review the argument for this to be a suitable alternative to the arm’s‑length principle. Those arguing in favour asserted that it would provide more administrative convenience and certainty for taxpayers. Whatever the difficulties in applying the arm’s‑length principle in practice, the debate led by the OECD has been unable to produce any justifiable substitute to the arm’s‑length principle which would produce a more manageable and stable fiscal climate for MNEs. The OECD Guidelines identify numerous practical problems associated with the idea of using an inflexible predetermined formula as the basis of setting transfer prices, and consequently member countries rejected global formulary apportionment and confirmed that they should retain the arm’s‑length principle as the best available approach to the analysis of inter-company transfer pricing. www.pwc.com/internationaltp 37

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The work of the OECD OECD commentary on other matters impacting transfer pricing Safe harbours Establishing transfer prices is a fact-intensive, judgmental process. This could be alleviated by establishing a simple set of rules (a safe harbour) under which tax authorities would automatically accept the transfer prices. Safe harbours would reduce the compliance burden and provide certainty both for taxpayers and tax administrations. However, there are some problems that need to be addressed if safe harbours are to be used, including: • A risk of double taxation and mutual agreement procedure difficulties. • Tax planning opportunities for taxpayers. • Potential discrimination and distortion of competition. On balance, the OECD does not recommend the use of safe harbours. However, as mentioned above, this issue, as well as other simplification measures, is currently being revisited by the OECD in the new project on the administrative aspects of transfer pricing. This is also related to the work of the United Nations on transfer pricing in the context of developing nations and the recognition that, often, these countries lack capacity to deal with transfer pricing compliance and administration. Advance pricing agreements (APA) An advance pricing agreement sets out appropriate criteria (e.g. a method, comparables and critical assumptions) for determining transfer pricing over a fixed period. APAs involving the competent authority of a treaty partner should be considered within the scope of the mutual agreement procedure (MAP) under art. 25 of the OECD Model Tax Convention. An APA can help taxpayers by providing certainty through the establishment of the tax treatment of their international transactions. Currently, an increasing number of OECD member countries have adopted APAs in their transfer pricing legislation and the number of APAs has consistently increased. For this reason, the Committee on Fiscal Affairs continues to monitor the use of APAs. APAs are discussed in some detail in Chapter V of the OECD Guidelines, as well as in an annex on APAs, issued by the OECD in 1999. The annex explains that the OECD encourages the use of bilateral APAs achieved through the MAP provisions of tax treaties, and so focuses on such bilateral processes in the annex. The aim of the annex is to encourage consistency between APA procedures by looking at: issues arising from the application process; the scope of APAs; behaviour of the taxpayer and the Competent Authorities (i.e. tax officials who administer the MAP for each state); the content of APA proposals; and implementation issues, such as critical assumptions on which the APA is based and monitoring of the agreement. Documentation The OECD Guidelines provide direction for tax authorities on the development of rules and procedures on documentation. Each taxpayer should try to determine transfer pricing, ‘in accordance with the arm’s‑length principle, based upon information reasonably available at the time of the determination’. The information needed will vary depending upon the facts and circumstances of the case. In fact, as will be seen from the country commentaries later in this book, there are numerous different regulatory approaches to the issue of transfer pricing documentation. Compliance with 38 International Transfer Pricing 2015/16

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the rapidly growing range of requirements is becoming a considerable challenge to international business. The mutual agreement procedure and corresponding adjustments Tax authorities consult with each other in order to resolve disputes about the application of double tax conventions and agree to corresponding adjustments following transfer pricing examinations. The OECD Guidelines note the concerns of taxpayers about these procedures and recommend: • extending domestic time-limits for the purposes of making corresponding adjustments • reducing the time taken for mutual agreement proceedings • increasing taxpayer participation • the publication of domestic rules or procedures, and • the suspension of collection of tax during the procedure. Secondary adjustments In addition to the transfer pricing adjustment, some countries have a second adjustment based upon a constructive transaction for the transfer of the excess profit, for example, constructive dividends. The Committee on Fiscal Affairs has decided to study this issue further in order to develop additional guidance in the future. Authority of the OECD Guidelines The OECD Guidelines, as their name suggests, do not have any direct legal force in the member countries, unless a given country has incorporated them into its domestic legislation. In any event, they do have a major influence on the tax authorities of the OECD countries (and increasingly on non-member countries), particularly those that do not have detailed transfer pricing regulations and, traditionally, have followed the OECD Guidelines. In particular, OECD countries tend to rely on the OECD Guidelines as a basis for resolving matters submitted to the competent authorities under the treaty mutual agreement process. The Council of the OECD, when publishing the OECD Guidelines, recommended that: • Tax administrations follow the OECD Guidelines when determining taxable income. • Tax authorities should encourage taxpayers to follow the OECD Guidelines. • Governments should further develop co-operation between the tax authorities. Increased co-operation between tax authorities One result from the process of agreeing the OECD Guidelines has been the increasing internationalisation of the review of MNE’s transfer pricing. This is because the tax authorities have improved their communication procedures through having more discussions in the forum of the OECD, which in turn has resulted in a significant increase in the use of the exchange of information article included in most bilateral tax treaties. The bilateral co-operation set out in the OECD Model Convention takes a multilateral dimension with the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, created under the auspices of the OECD and the Council of Europe and amended with effect as of 1 June 2011, is particularly relevant in transfer pricing as it provides for a single legal framework for joint tax audits, which are increasingly being pursued by tax authorities. The amended version of the Convention applies to members of the OECD and the Council of Europe and non-members, as www.pwc.com/internationaltp 39

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The work of the OECD a way to foster co-operation with developing countries and create a multilateral approach to exchange of information. In addition, there is, today, a wide network of signed Agreements on Exchange of Information on Tax Matters between OECD and non-OECD countries, based on the Model developed by the OECD Global Forum Working Group on Effective Exchange of Information. The Model grew out of the OECD work on harmful tax practices. These initiatives are applicable to all cross-border tax matters, however, given the particular focus by tax authorities on transfer pricing issues, the increase in co-operation between tax authorities is particularly relevant for transfer pricing. Member countries of the OECD The current OECD member countries are: Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States. Russia is currently engaged in open discussions for membership with the OECD. Additionally, the OECD has enhanced agreements with Brazil, China, India, Indonesia and South Africa. Recent developments at the OECD As noted above, the OECD has recently taken on a number of significant projects which potentially mark a major expansion of the role and influence of the OECD in international tax and transfer pricing matters. New Article 7 (Business Profits) of the OECD Model Tax Convention and Report on Attribution of Profits to Permanent Establishments On 22 July 2010 the OECD released a new Article 7 (Business Profits) of the OECD Model Tax Convention and related commentary changes. Together with the OECD’s issue of the Report on the Attribution of Profits to Permanent Establishments, the intention is to reflect certain changes and clarifications in the interpretation of Article 7. With these changes, the OECD intends to achieve greater consensus in terms of interpretation and application of the guidance on the attribution of profits to PEs in practice among OECD and non-OECD countries. The revised Commentary describes the ‘central directive’ of Article 7 as being the separate entity approach under which the profits attributed to a PE should be those that it would have realised if it had been a separate and distinct enterprise engaged in the same or similar activities under the same or similar conditions and dealings wholly independently from the rest of the enterprise. The Commentary embodies the authorised OECD approach set out in the Report, a two-step approach in which the PE is, first, hypothesised as a functionally separate entity from the rest of the enterprise of which it is a part; and second, the appropriate compensation is determined by applying by analogy the OECD Guidelines’ arm’s‑length principle, including its comparability analysis of dealings between the PE and the rest of the enterprise. In a non-financial services business, risks and assets are allocated between the home office and the PE based on the location of ‘significant people functions’. In a financial services business, the location of ‘key entrepreneurial risk taking functions’ will be determinative. The ‘force of attraction’ principle under 40 International Transfer Pricing 2015/16

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which income arising in the territory may be fully taxable even if it is not attributable to the PE is rejected. The main developments included in the Commentary may be summarised as follows: • The calculation of profits attributable to a dependent agent should be consistent with the two stage approach described above. • The deduction of expenses incurred in the operation of a PE should be allowed. • Recognition of the attribution of an arm’s-length amount of interest to a PE based on attributing an appropriate amount of ‘free’ capital in order to support the functions. • Encouragement of taxpayers to produce contemporaneous documentation in order to reduce the potential for controversies. • Emphasis is placed on arbitration as a means of resolving disputes. Transfer pricing aspects of business restructurings On 4 August 2010 the OECD released a final paper on the Transfer Pricing Aspects of Business Restructurings which is now incorporated into the OECD Guidelines as Chapter IX. Chapter IX combines the four issue notes (which was present in the Discussion Draft) into a single, four-part chapter which is to be read as a whole. This represented a lengthy process of drafting and consultation from the time the Discussion Draft was first released in September 2008, and the final text of Chapter IX has been welcomed as a significant improvement over the original 2008 draft. The OECD acknowledges that there is no legal or universally accepted definition of business restructuring, but in the context of Chapter IX, business restructuring is defined as the cross-border redeployment by a multinational enterprise of functions, assets and/or risks. A business restructuring may involve cross-border transfers of valuable intangibles, or may involve the termination or substantial renegotiation of existing arrangements. The new chapter covers the transfer pricing consequences of internal business reorganisations designed to shift risks, intangible property and income among members of a multinational group of corporations. The following issues are addressed: Part 1 – Special consideration for risks. States that the reallocation of risks should be respected to the extent that it has economic substance. Additionally, an assessment of the economic significance of the risks and the impact on the transferor’s profits should be conducted and arrangements not commonly seen between independent parties should not automatically mean that it is not at arm’s-length. Part 2 – Arm’s-length compensation for the restructuring itself, states that a profit/loss potential is not an asset in itself but a potential that is carried by some rights or assets. This area was subject to significant debate during the consultation and the finalised chapter states that: • An independent enterprise does not necessarily receive compensation when a change in its business arrangements results in a reduction of its profit potential. The arm’s‑length principle does not require compensation for a mere decrease in the expectation of an entity’s future profits. The question is whether there is a transfer of something of value (rights or other assets) or a termination or www.pwc.com/internationaltp 41

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The work of the OECD substantial renegotiation and that would be compensated between independent in comparable circumstances. • If there is a transfer of rights or other assets of a going concern, the profit potential should not be interpreted as that would occur if the pre-restructuring arrangement would continue indefinitely. • There is to be no presumption that a termination should give rise to an indemnification. This depends on rights, other assets and ‘options realistically available’. The guidance clarifies that this concept has primary application in pricing decisions, and considers that the options available at the individual level may be relevant in applying the arm’s‑length principle to a business restructuring. Part 3 deals with the remuneration of post-restructuring controlled transactions, and states that the Transfer Pricing Guidelines should not apply differently to postrestructuring transactions compared to transactions that were structured as such from the beginning. Finally, Part 4 concentrates on the recognition of actual transactions undertaken and again was another area that generated significant interest among taxpayers and practitioners. In response to concerns in the business community the OECD Guidelines are now clear that the circumstances in which transactions may only be disregarded or recharacterised should be ‘rare’ or ‘unusual’ such as when there is a mismatch between substance and form. The mere fact that an associated enterprise arrangement is not seen between independent parties is not evidence that it is not arm’s-length. Nevertheless, the new chapter significantly widens government authority to challenge business restructuring transactions. Other important issues addressed in Chapter IX include changes to the commentary on taxpayer allocation of risk, such that mismatches between the contractual location of risk and the location in which control over risk is exercised are now more likely to be addressed through pricing adjustments rather than through recharacterisation of a transaction. However, a tax administration ‘is entitled to challenge a contractual allocation if it is not consistent with economic substance’. In respect of transfers of profit potential, the OECD Guidelines are clear that a mere decrease in the expectation of future profits does not necessarily create the need for compensation under the arm’s-length standard, but concerns have already been expressed that the use of the term ‘something of value’ in the context of asset transfers is too vague and that there is insufficient guidance on the transfer of a going concern, which is broadly defined as a ‘transfer of assets bundled with the ability to perform certain functions and bear certain risks’. As mentioned above, the OECD has commenced a project on the transfer pricing aspects of intangibles, and it is to be hoped that further clarification will emerge during this process. Perhaps the most controversial aspect of the new chapter is the concept of ‘options realistically available’ which is now prominent in the OECD Guidelines. This should be considered at the individual entity level and implies that the alternatives theoretically available to each party should be taken into account in determining appropriate levels of compensation to be paid. The final version of the OECD Guidelines clarifies that the primary purpose of the concept is in its application to pricing decisions rather than recharacterisation, and that while a realistically available option that is clearly more 42 International Transfer Pricing 2015/16

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attractive should be considered there is no requirement to document all hypothetical options. The use of hindsight is prohibited. Discussion Draft of Chapter VI ‘Special Considerations for Intangible Property’ of the OECD Guidelines Arriving almost a year and a half prior to the anticipated release date, the Discussion Draft of Chapter VI attempts to clearly articulate the thinking of the OECD with respect to the complexities surrounding the inter-company transfers of intangibles. One area of interest for taxpayers is the definitional aspects of intangibles. The Discussion Draft stresses that the corner stone of transfer pricing analyses should be based on how unrelated parties would behave in comparable situations, rather than on certain accounting or legal definitions or those for general tax purposes. Indeed, the Discussion Draft does not differentiate between ‘trade vs. marketing’, ‘soft vs. hard’ and ‘routine vs. non-routine intangibles’. Instead, it presents the view that intangibles are intended to address ‘something which is capable of being owned or controlled for use in commercial activities’. A key break-through in this Discussion Draft is the distinction between intangibles and market conditions or other circumstances that are ‘not capable of being owned, controlled or transferred by a single enterprise’ – such as features of local markets, level of disposable income, size or relative competitiveness of the market and group synergies. Moreover, the Discussion Draft argues that goodwill and going concern value (with certain exceptions) should not be considered separately as intangibles for transfer pricing purposes, but rather taken into account as part of other business assets. Nevertheless, the OECD considers that these factors may affect the determination of prices and should be considered in the comparability analysis or adjustments. The Discussion Draft goes on to clarify that, indeed, not all intangibles are valuable and certainly not all deserve a separate compensation or give rise to premium returns in all circumstances (e.g. non-unique or easily accessible know how). Contractual agreements and legal registrations continue to be seen as a valid and necessary starting point for assessing ownership concepts. However, the actual conduct of the parties and substance of the transactions involved remains the key test in allocating entitlement to intangibles-related returns. Here, the Discussion Draft takes guidance from Chapter IX of the Guidelines to stress the importance of notions such as ‘control over functions (and risks)’. In other words, ownership of intangibles needs to stem from the performance (including having the requisite capability or capacity) and control (and when outsourced to affiliates or third parties, the oversight and management responsibility) of the important functions related to the ‘development, enhancement, maintenance and protection’ of the intangible (and bearing the necessary costs and risks thereof). Conversely, where a party passively bears costs related to the IP but does not control the risks or critical functions related thereto, ownership of the intangibles (and the related returns) should not be attributable to such party. Any determination should be supported by a rigorous comparability analysis as such activity could equally have been outsourced to a third party (that as a matter of principle would not create intangible ownership). As part of such assessment, the Discussion Draft also integrated a form of a ‘bright line test’ where a taxpayer should evaluate whether or not a party has borne costs and risks or performed functions disproportionately as compared to independent parties. The Discussion Draft provides guidance on factors to consider in the characterisation of intra-group intangible transfers. It distinguishes between two broad classes of transactions involving the use of intangibles. In the first type of transaction, intangibles www.pwc.com/internationaltp 43

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The work of the OECD are used by one or both parties to the controlled transaction in connection sales of goods or services but there is no transfer or intangibles. The second type of transaction involves situations in which the rights to intangibles are transferred as part of the controlled transaction. Attention is also drawn to ‘combinations of intangibles’, the (artificial segmentation) thereof and the link with the choice of transfer pricing methodology and tested party. In certain situations, bundled transactions are sufficiently unique that it may not be possible to identify comparable transactions. In some cases, it may be necessary to ‘segregate the various parts of the package of services and intangibles for separate transfer pricing consideration’. In other cases, one or more intangibles and/or services are ‘so closely intertwined that it is difficult to separate the transactions for purposes of a transfer pricing analysis’. Nuances have been highlighted through the use of examples in the consumer products, pharmaceutical and information technology industries. One specific example provided in the Discussion Draft includes the transfer of the business rights including the transfer of both tangible and intangible assets including patents, trademarks and other brand intangibles held by the parent company and developed in a local country, B, to a newly formed subsidiary, Company S. The example emphasises that in determining the amount to be paid ‘for the tangible assets transferred with the licensed right to use the intangibles in country B, the goodwill and going concern value of the business transferred to Company S should be taken into account’. The Discussion Draft confirms the principle that associated enterprises do not necessarily ‘organise their affairs’ in a similar manner to independent parties. Considerable attention has been given to comparability analysis and the two-sided approach, where the Chapter IX ‘Business Restructurings’ test reoccurs – in the form of the notion of ‘options realistically available’. Taking into account the more stringent standards on comparability in the context of transactional comparables, the Discussion Draft then addresses the selection of transfer pricing methodologies (including the use of the transactional profit split method) to evaluate different transactions as well as situations with and without comparables to some detail. However, the OECD cautions against the adoption of a transfer pricing methodology that ‘too readily assumes that all residual profit from transactions after routine returns’ should necessarily accrue to the owner of the intangibles or the party entitled to the returns on the intangibles. Instead, the Discussion Draft calls for, among other things, a thorough understanding of the group’s value chain, business process and the interaction of the two with the intangibles. A clear message to taxpayers from the Discussion Draft is to devote proper time and effort to the functional analysis as part of the comparability assessment. Financial valuation methods continue to be a discussion point. While such valuation methods continue to be available to taxpayers, the OECD noted that certain accounting principles under financial valuation methods may be inconsistent with transfer pricing principles. In particular, ‘valuations of intangibles contained in purchase price allocations performed for accounting purposes are not relevant for transfer pricing analyses’. It further emphasises that the selection of valuation methods will need to be based on robust and consistent underlying assumptions (such as purpose, financial projections and other indices). Industry ‘rules of thumb’ are discouraged. Consistently, the Discussion Draft takes a dim view of cost-based approaches to measure the value or partially or fully developed intangibles as unreliable. 44 International Transfer Pricing 2015/16

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Considerable discussion is also devoted to the application of valuation methods that use discounted cash flows. The Discussion Draft expresses concern about the use of financial projections which extend past the point where a business enterprise can realistically forecast income and expense and questions the accuracy of constant growth assumptions that fail to account for business cycles and other relevant fluctuations to the business of the company or the industry as a whole. Discount rates used in valuation analyses must be tailored to reflect the risks associated with the discounted cash flows and the use of the company’s weighted average cost of capital as the default discount rate is discouraged. Where small changes in discount rates produce significant variations in results, taxpayers are instructed to develop ranges of values based on reasonable variations such as discount rate assumptions. The Discussion Draft clearly recognises that, in most cases, intangible assets have finite lives. It cautions that the lives assumed for purposes of the transfer pricing analysis must also be consistent with lives used for other business purposes. Certain intangibles will contribute to creation of non-routine profits by future intangibles and the valuation analysis of such intangibles must take this into consideration. Importantly, while some intangibles may have indeterminate lives, it does not mean that they are expected to produce non-routine returns indefinitely. Reconciliation of pre-and post-tax cash flows appears to be a point of struggle for the OECD. The Discussion Draft emphasises that ‘prices for transfer pricing purposes must typically be determined on a pre-tax basis’. However, explicit acknowledgment is also made that the ‘specific tax situations of the transferor and transferee’ are relevant to the analysis and that ‘it is important to take into account the perspectives of the parties to the transaction in this regard and to consider how unrelated parties might account for the relative tax advantages or disadvantages faced by the transferee following the transfer’ in determining the arm’s-length price. Moreover, in the subsequent example provided involving the use of an application of the discounted cash flow approach, the analysis is done on an after-tax basis from the perspective of both the transferor (at a tax rate of 30%) and the transferee (at a tax rate of 10%) yielding a range of possible results. As suggested by the business commentators, the OECD has included over 20 examples to provide practical guidance on the appropriate application of the principles contained in the Discussion Draft. The comment period following the release of the Discussion Draft ended 14 September 2012. The OECD has signalled that transfer pricing is a high priority and more follow up to the Discussion Draft is likely in the near term. The OECD and the new United Nations transfer pricing manual On 2 October 2012, the United Nations released its Practical Manual on Transfer Pricing for Developing Countries (UN Manual). While largely similar to the OECD Guidelines, the UN Manual is specifically tailored to address the needs and concerns of developing countries, most of whom are not OECD members. Prior to the UN Manual’s release, at the OECD International Tax Conference sponsored by The United States Council for International Business held in Washington, D.C. in June 2012, some audience members expressed scepticism about the practical guidance regarding transfer pricing being given to developing countries by the UN. Specifically, there was concern that the work of the UN might fuel theories on transfer pricing among developing countries that are www.pwc.com/internationaltp 45

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The work of the OECD at odds with the conventional interpretation of the arm’s-length standard. Speaking for the OECD, Pascal Saint-Amans, the new Director of the OECD’s Centre for Tax Policy and Administration (CTPA), stated that he did not see the UN Manual as a competing set of standards from the OECD Guidelines. Given the newness of the UN Manual, it is premature to speculate as to the impact or acceptance it will have as compared with the prevalence of the OECD Guidelines. 46 International Transfer Pricing 2015/16

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4. Establishing a transfer pricing policy – practical considerations Arm’s-length pricing – market prices By definition, use of the arm’s-length standard to determine inter-company prices demands an examination of the market conditions surrounding both the inter-company and unrelated party transactions. Market prices are driven by the characteristics of the particular transaction. For instance, a product that is sold with a well-known and highly valuable trademark sells at a premium compared with a product that is identical in every respect, except that it is sold with an unknown trademark. In this case, additional profit accrues to the owner/developer of the valuable trademark. The premium for the market leader may well decline over time, provided that the unknown brands can establish reputations for quality and value for money. An example to consider in this area is the way in which prices for personal computers, branded by leading manufacturers such as IBM, Dell and others, have been driven down as the reliability of inexpensive clones has improved. By way of a further example, a distributor that provides marketing and technical support to its customers should be able to earn a higher profit margin than a distributor that does not provide these services. These two examples illustrate the basic principle that prices in third-party situations are determined by the facts and circumstances present in any given situation. Similar factors apply in an inter-company situation. In the latter case, a functional analysis must be performed to identify which party is responsible for manufacturing, research and development (R&D), materials purchasing, logistics, sales, distribution, marketing, after-sales service, etc. Once these facts are known, the entities can be characterised as manufacturing-type companies, sales/distribution-type companies, contract R&D companies, service providers, etc. as appropriate. From the characterisations, the analyst may look to comparable companies operating independently in the open market. The next step is to determine the method to be used for transfer pricing within the group. It is interesting to consider how prices are set in comparable unrelated party situations as, in many jurisdictions, it pays dividends to mimic the mechanism used as far as possible. However, it is not easy to identify how independent companies set their trading prices. Instead, the data usually available concerns the results of these transactions. In such cases, the inter-company transfer price will be based on the most appropriate method in all the circumstances and will try to emulate as clearly as possible financial results observed from the independent trading situation. Obviously, if the facts change, the characterisation of the entities involved in the intercompany transactions will change accordingly and the prices used in the inter-company transactions must be adjusted. Consequently, the first step in establishing a transfer pricing policy must be to gather all the relevant facts and circumstances surrounding a particular inter-company transaction. These facts can be summarised in three categories: functions (see Functions, below), risks (see Risks, below), and intangible and tangible assets (see Intangibles, below). www.pwc.com/internationaltp 47

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Establishing a transfer pricing policy – practical considerations Functional analysis Functional analysis is a method of finding and organising facts about a business in terms of its functions, risks and intangibles in order to identify how these are allocated between the companies involved in the transactions under review. To obtain a comprehensive understanding of the facts surrounding the inter-company transactions, it is necessary to gather information from numerous sources. Firstly, operating employees within the multinational must be interviewed to obtain in-depth information regarding functions, risks and intangibles of each legal entity. These interviews identify further areas for review, including relevant contracts and financial data. Secondly, industry experts and publications about the industry must be consulted to understand standard operating practices within the industry as well as the relative values of the intangibles involved in the transaction. Interviews The analyst obtains much information about the criteria under review through interviews. She/he should draw up a list of key employees who are able to state clearly what functions, risks and intangibles are relevant to the operations for which they are responsible. Personnel from each entity involved in the inter-company transactions should be interviewed. It is important to hear all sides recount the facts. Frequently, human perspectives are different, particularly when the individuals involved are working at corporate headquarters or at a subsidiary. Hearing all sides allows the analyst maximum opportunity to determine the truth of the inter-company relationship and hence the most appropriate transfer pricing policy to fit the circumstances. On-site interviewing is preferable to questionnaires or telephone conferences. Questionnaires are subject to many interpretations, are usually inadequately completed and make it impossible to determine the tone of the response (i.e. the nuances of the relationship). Furthermore, questionnaires make follow-up questions difficult. Another non-tax reason for interviewing all affected parties is that the implementation of new transfer pricing policies can be highly controversial within a company. When all parties feel that they have played a role in the proper determination of a transfer pricing policy, it is usually easier to deal effectively with the political problems, which inevitably arise. As the functional analysis progresses, certain persons may be added to, or deleted from, this list of intended interviewees, as appropriate. Appendix 1 provides a list of questions that may be used as a starting point to design the interviewing process. These questions should not be viewed as covering every area of importance. During the interview process, various questions are discarded and many more added so that a thorough understanding of the facts is obtained. The interviews typically cover the following topics, as they apply to each entity involved in the manufacture and distribution of products as well as performance of inter-company services: • Manufacturing functions: production scheduling, production process, materials purchasing, supplier approval, personnel education and training, quality control procedures, quality control implementation, reporting relationships, process technology and improvement. 48 International Transfer Pricing 2015/16

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• Marketing functions: strategic marketing plans, advertising, trade shows, sales force, the relative autonomy of various entities in marketing the company’s products, forecasts, selling techniques, key marketing personnel, new market penetration, reporting relationships, and training. • Distribution functions: warehousing and distribution, inventory, warranty administration, third-party distributor relationships. • Administrative, management or other inter-company services performed on behalf of other related parties and/or third parties. Other information or documents required In addition to carrying out interviews, analysts should examine documents and other information from the entities. This information includes: organisation charts; existing inter-company pricing policy statements; inter-company agreements such as licences and agreements covering distribution, R&D, cost-sharing, management services, etc.; and product and marketing information. Examples of product and marketing information include product brochures and literature, stock analyst reports, trade press articles, in-house news publications, reports on competitors, advertising literature and information regarding customers. This information aids in understanding the information gathered at interview and the economics of the markets in question. Note that the company itself is not the only source of information to the person conducting the functional analysis. The analyst should also gather information on trade associations, competitors, academics, etc., to learn as much as possible about the company, its industry, its products and the markets it serves. These days, it is also likely that information of relevance is publicly available on the internet (as the internet is accessible worldwide, tax authorities are also making use of the available data in the conduct of their transfer pricing investigations). Functions Functions are defined as the activities that each of the entities engaged in a particular transaction performs as a normal part of its operations. Table 4.1 provides a list of some typical business functions. In general, the more functions that a particular entity performs, the higher the remuneration it should earn, and its prices should reflect this. It is not enough simply to determine which entity has responsibility for a particular function, risk or intangible. The proper development of a transfer pricing policy requires that the transfer pricing analyst also determines the relative importance of each function in that transaction, industry and market. For instance, it is common in many industries for a foreign distribution subsidiary to be responsible for marketing and advertising, as well as distributing the parent’s product. However, marketing and advertising activities may be far more important in the consumer goods market, where products may be differentiated by image and brand name recognition, than in the chemical industry, where the company’s name may be of limited importance compared with the specific chemical properties of the product. Several functions are particularly important in the context of a manufacturing company. The first is the materials purchasing function. For instance, does the parent corporation purchase raw materials on behalf of its manufacturing subsidiary and then consign those materials to its subsidiary, or does the subsidiary purchase its own raw materials? The selection of materials will naturally have a significant impact on the www.pwc.com/internationaltp 49

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Establishing a transfer pricing policy – practical considerations price and quality of the finished goods, the reliability of supply and other areas of the business process. Another major function in manufacturing is production scheduling. Does the parent corporation tell its manufacturing subsidiary what to produce, how much to produce and when to produce it, or does the subsidiary plan its own production schedule? Quality control is also an important area. The analyst must determine which legal entity is responsible for establishing quality control policies, the implementation of those policies and the monitoring of their differences. Does the manufacturing subsidiary have limited control over the policies that it uses, or does it develop and implement its own quality control procedures? Table 4.1 Typical business functions Product research, design and development Purchasing materials, supplies and equipment Controlling stocks of raw materials and finished goods Developing and administering budgets Quality control Production of finished goods Packaging and labelling of products Sales Marketing Shipping of products to customer Facilities engineering Personnel Manufacturing engineering Maintenance: building, grounds and equipment Electronic data processing Public relations Production planning and scheduling Industrial engineering Management and supervision of offshore operations Manufacturing site selection Administrative services Government affairs Finance and control Accounting services Arranging product liability insurance Establishing and controlling pricing policy Technical service Risks A significant portion of the rate of return (ROR) earned by any company reflects the fact that the business is bearing risks of various kinds. Table 4.2 provides a list of some potential business risks. Market risk relates to the potential loss that may be associated with selling in an uncertain marketplace. If a parent company has made arrangements to protect its manufacturing subsidiary so that it does not incur operating losses if it encounters adverse market conditions, then the subsidiary should sell to affiliates at considerably lower prices (and earn lower levels of profit) than if it bears the full risk of market fluctuations. In such a case, the plan will probably have been for the marketing subsidiary to carry the risk of the market. It is particularly important to document this fully and to ensure that the marketing company has sufficient capital resources to support the risk it is taking. This should assist in fending off a tax authority attack on losses contained in the marketing company (tax authorities often tend to assume that such companies do not carry the risk of the market and therefore seek to disallow losses accruing in this way). 50 International Transfer Pricing 2015/16

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Table 4.2 Typical business risks Market risk Inventory risks: raw materials, work in progress and finished goods Defective products and warranty Credit risk Product liability risk Foreign exchange risk Environmental risk There are various ways to judge whether market risk exists. One way is to determine the time in the product development cycle at which manufacturing responsibility for the product was transferred to the subsidiary by the parent company. For example, if the product is first manufactured by the subsidiary immediately after it leaves the group’s pilot manufacturing plant, then the manufacturing subsidiary has considerably more market risk than if the product had been manufactured first by the parent and was firmly established in the marketplace at that time. The extent of market risk depends also on the degree of competition and economic structure in the market. For instance, where the parent has limited competition in a particular industry, the manufacturing subsidiary may face considerably less market risk than if it faced stiff competition from several companies that produce close substitutes for its product. The existence of limited competition within a particular industry or product sector can arise from a number of factors. Barriers to entry by new firms, such as government regulation or the need for an extremely large initial investment (the development and commercialisation of new drugs in the ethical pharmaceutical market is a good example). Even if there is more than one firm in the industry in question, a company can establish a competitive advantage by developing a patent or proprietary know-how that essentially bars or inhibits competition in a particular product or market. If such barriers exist, they can have a material impact on the degree of market risk faced by a particular firm. Market risk can also vary with the sensitivity of the industry to general economic conditions. The performance of some industries, such as the automotive industry, varies dramatically over the business cycle. When the economy is in recession, these industries are in recession, and when the economy is booming, so too are they. Other industries, such as pharmaceutical and medical supplies, may be more immune to the impact of fluctuations in the national or world economy. People fall ill and suffer injury during good and bad times alike. As a consequence, the protection that a parent may provide for its subsidiary against market risk can be significantly more valuable in some industries than in others. It depends on the market structure and the underlying demand profile for the product. Inventory risk is another factor that should be investigated in every transfer pricing study. Both raw materials and finished products inventory risk are particularly important, but work in progress may also be material (for instance, the value of work in progress for a whisky distiller, which needs to age the stock for many years before it can be sold as premium aged Scotch). www.pwc.com/internationaltp 51

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Establishing a transfer pricing policy – practical considerations If a company wishes to maximise profits in a manufacturing subsidiary, it must be prepared to take all write-offs associated with inventory in that subsidiary. This responsibility reduces profits in the year of the write-off; however, that experience can be used to demonstrate to a tax authority that inventory risk lies within the subsidiary. Some manufacturers rarely own any raw materials or finished goods; their inventory risk is minimal or nonexistent. On the other hand, some manufacturers do face inventory risk since they typically purchase raw materials, schedule production and hold a stock of finished goods. In short, inventory risk is a critical component of the risk assumed by parties engaged in an inter-company manufacturing transaction. Other important risks include defective product, warranty and environmental risks. If a product is returned as defective by the final customer, for instance, who bears the cost of that return? Is it the company that distributed the product or the foreign manufacturer? Who bears the warranty costs? If an environmental accident occurred at the manufacturing subsidiary, which party would bear the cost of the clean-up? With increased attention being paid worldwide to environmental problems in virtually every industry, it is becoming increasingly important to develop a clear understanding of which party assumes this risk and how these risks vary across countries. It is also important to consider how contract law might be used to deal with the location of risk in this area. For instance, it might be that a manufacturing operation is obliged by local law to be responsible for all environmental risks associated with its activities. However, its parent company might be able to establish indemnity arrangements to cover this risk, effectively shifting the local, legally imposed risk to another jurisdiction. It is important to recognise that risks can vary markedly across industries and geographic markets. In some businesses, there is no credit risk because customers are required to pay before delivery is made. The retail trade is often operated in this way. By comparison, in other industries it is standard practice to request payment within three to nine months of delivery. Differences in judicial systems across countries can mean that, within a given industry, underlying product liability risk is a much more significant factor in one geographic market than another. Intangibles Table 4.3 provides a list of typical intangible assets. Table 4.3 Typical intangible assets Patents Unpatented technical know-how Formulae Trademarks and brand names Trade names Licences Copyrights Technical data Ability to provide after-sales service Customer list High-calibre personnel, such as a strong sales force Intangibles are ordinarily divided into two categories: manufacturing and marketing. Manufacturing intangibles are characterised as one of two types – patents or nonpatented technical know-how – and arise out of either R&D activity or the production engineering activities of the manufacturing plant. 52 International Transfer Pricing 2015/16

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Marketing intangibles include trademarks, corporate reputation, the distribution network and the ability to provide services to customers before and/or after the sale. This category of intangibles is very broad indeed, and regard must be had to the question of ownership of such assets as well as to their maintenance and development. It is not necessary that the asset appears on the balance sheet for it to have significant value for transfer pricing purposes. The accounting practices that apply to particular categories of asset vary enormously from one country to another and any apparent balance-sheet value may therefore be of little relevance. For instance, goodwill arising on the acquisition of a highly successful business might be written off immediately or carried forward and depreciated over 40 years, depending on the accounting practice adopted in the acquiring country. In both cases, the goodwill might, in reality, be an appreciating asset. It must be determined which intangible assets play a role in the transaction under consideration, as well as their relative values. Specifically, the transfer pricing analyst must determine which type of intangible – manufacturing, marketing, or both – accounts for the success of a particular product. Does the product’s design explain its success? Or is it the company’s ability to deliver the product when promised? Or is it the company’s trade name? In this connection it must be borne in mind that all marketing intangibles are not created equal. A trade name that is well-known and thus valuable in one market may be completely unknown and of no initial value in another market. The return earned by the various entities should vary directly with the importance of the functions performed, the degree of risks undertaken and the value of intangibles provided. Looking at the production intangibles, is it a proprietary manufacturing process that enables the company to produce goods at 20% below the cost of its nearest competitor? Or is it a combination of this and other intangible assets? Companies that have developed valuable proprietary manufacturing know-how may decide not to patent the technology for fear of making the process known to competitors. This know-how can range from design changes made on a standard machine to a more efficient plant layout, to an innovative production process. A particularly pertinent question to ask when visiting a plant is whether there is anything in the plant that the company would not show to a competitor. If the answer is yes, the analyst may have found a valuable manufacturing intangible, though further investigation would be necessary to establish who developed the know-how, its value to the company, etc. Characterisation of businesses Characterisation of the related parties is an important component to a transfer pricing analysis and is typically used as the foundation in developing the economic analysis. Characterisation of businesses means making comparisons of the functions and risks of the related entities under review and comparing those to uncontrolled entities that exist in the same or similar industry. Such characterisation involves using information from the functional analysis and information about the industry. www.pwc.com/internationaltp 53

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Establishing a transfer pricing policy – practical considerations Contract manufacturers and fully fledged manufacturers There are two general characterisations of manufacturing businesses: the contract manufacturer and the fully fledged manufacturer. (A subtype of contract manufacturing is toll manufacturing, whereby the contract manufacturer does not take legal title to the raw material or products manufactured.) Both contract and fully fledged manufacturers are found in almost all industries, an important point because the ROR received by contract manufacturers is generally significantly lower than the ROR received by fully fledged manufacturers (see Table 4.4). Contract manufacturers provide manufacturing services to fully fledged manufacturers. They do not develop their own product lines but offer expertise in performing certain manufacturing functions only. They may or may not perform such functions as materials purchasing and production scheduling or own the inventory (raw materials, work in progress and finished goods). Over the course of a contract, they do not face direct market risk because they have a guaranteed revenue stream from the customer with which they are under contract. They may be remunerated on a fee basis (cost-plus), or on a pre-established price per unit (which will probably have been determined on a cost-plus basis). The contract manufacturer’s intangibles are limited and typically consist of know-how pertaining to the manufacturing processes. Fully fledged manufacturers develop their own product lines and may have substantial R&D budgets or may obtain the technology they require through licences. They perform all manufacturing functions, such as vendor qualification, materials purchasing, production scheduling and quality control procedures. Also, they are typically extensively involved in marketing to the ultimate customers (or end-users) of the product. They bear several types of risk, including inventory risk and market risk. Table 4.4 summarises the critical features that distinguish contract manufacturers from fully fledged manufacturers. As a general rule, manufacturing companies within a multinational group do not fall precisely into one or other category; rather they gravitate towards one end or the other. Identification of the differences between the model and the multinational’s circumstances provides information that can be used in adjusting potential comparables to create a justifiable inter-company price. (Of course, it is possible to determine the risks incurred by a contract manufacturer within a multinational and also to determine the functions it performs. This offers the group considerable flexibility of structure and hence tax-planning opportunities.) Table 4.4 Characterisation of manufacturing entities Contract manufacturer Fully fledged manufacturer Does not own technology Owns technology Little risk Full of risk Purchasing Little discretion in production scheduling Production scheduling Does not totally control equipment Scheduling Select own equipment scheduling Quality control usually dictated Direct control over quality by customer Usually manufacturing high-volume, mature Manufacturing products at all high-volume, products mature products stages of product life cycle 54 International Transfer Pricing 2015/16

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Increasing profit potential Manufacturing profitability Increasing functions, risk and intangibles of sales/distribution company Note that, as shown in the diagram above, greater functions/risks may not only have greater profit potential but may also have greater loss potential. Characterisation of distribution/selling companies The four general characterisations of distribution/selling companies are, in order of increasing functions, manufacturer’s representative (or commission agent), limited distributor, distributor and marketer/distributor. This characterisation is important because the prices paid/profits earned vary, sometimes considerably, between these various types of selling entities, with the manufacturer’s representative earning the least profit of all. A manufacturer’s representative does not take title to the merchandise it sells. It bears neither credit risk nor inventory risk. It does not have any marketing responsibilities and is typically paid a commission based on the sales revenue it generates for the company it represents. A limited distributor takes title to the merchandise. It has limited inventory risk and credit risk. It has limited marketing responsibilities but typically does not bear foreignexchange risk on purchases from its suppliers. A distributor takes title to the merchandise, bears credit risk and inventory risk. It has limited marketing responsibilities, and may or may not have foreign-exchange risk. A marketer/distributor takes title to the merchandise, has credit risk, inventory risk and may have foreign-exchange risk. It has total marketing responsibility for its product lines, including, generally, the determination of marketing strategy for its market. This typically occurs in inter-company situations where the subsidiary is mature or where it is located in a different time zone from the parent company or where, for cultural reasons, the parent is unable to compete effectively in the foreign marketplace. Table 4.5 summarises the salient characteristics of each type of sales entity and indicates their relative profitability. www.pwc.com/internationaltp 55

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Establishing a transfer pricing policy – practical considerations Goals of the multinational corporation A company’s financial goals are important considerations in developing a transfer pricing policy because it is often possible to achieve them through transfer pricing. Financial goals include managing cash flows, supporting R&D, funding capital expansion, paying interest on debt, meeting tax liabilities in accordance with overall group tax strategies and funding dividend payments to shareholders. Satisfying each requires placing income in the legal entity where the funds are ultimately required and transfer pricing can be used to move funds as required, so long as the substance of the relationship between the related entities supports the policy adopted. It may be possible to achieve this result by altering the previous arrangement of functions, risks and intangibles within the group. A company may have overriding business reasons for wanting to place functions, risks and intangibles in certain locations. For example, the goal may be to rationalise global production, or centralise management, financial and marketing functions to improve efficiency and reduce costs, or it may be necessary for a variety of reasons to manufacture the product within the market in which it will be sold. These reasons may include transportation costs, legal requirements that a product be manufactured where it is sold, customs and indirect tax reasons, etc. The realisation of these goals has implications for the transfer pricing policy adopted by the group. A key goal of most multinationals is to minimise the global tax charge. Corporate income tax rates vary across countries and form an important consideration in establishing a transfer pricing policy. Because the arm’s-length standard for transfer pricing requires that pricing, and so profit, be based on the substance of a transaction, corporate restructuring, which places important functions, risks and intangibles in jurisdictions that have lower tax rates, results in a lower overall tax rate for the group, maximising earnings per share. Some examples of these possible restructuring techniques are set out in sections Manufacturing opportunities through Contract marketing. Table 4.5 Characterisation of distribution/selling companies sales/distribution profitability Manufacturer’s Limited Distributor Marketer/ representative distributor Distributor Does not take title Takes title Takes title Takes title No credit risk minimal/ Credit risk Credit risk Credit risk parent controls policy No inventory risk Inventory risk minimal Inventory risk Inventory risk Inventory risk No marketing Marketing Marketing Total marketing responsibilities limited responsibilities responsibilities limited responsibilities No FX risk No FX risk May or may not have May or may not FX risk have FX risk 56 International Transfer Pricing 2015/16

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Increasing profit potential Sales/distribution profitability Increasing functions, risk and intangibles of sales/distribution company Note that, as shown in the diagram above, greater functions/risks may not only have greater profit potential but may also have greater loss potential. Manufacturing opportunities It is self-evident that the more income that can be placed in subsidiaries located in low-tax jurisdictions, the lower will be the multinational corporation’s effective tax rate. In recent years, the effective use of tax havens has become increasingly difficult as tax authorities have found ways of attacking taxpayers’ planning schemes. However, in many instances the use of tax havens continues to be beneficial, if carefully planned. The key to success is to be certain that the low-taxed affiliate is compensated properly in respect of the functions, risks and intangibles for which it is responsible. In this way, offshore profits that are not taxed directly by anti-avoidance laws (such as the US subpart F or the UK controlled foreign companies legislation) may remain offshore, tax-free. Manufacturing in tax havens is desirable only when it makes commercial sense. For example, if a company can serve a certain geographical region from a single manufacturing location (for example, a plant located in Ireland to serve the European market) and the tax haven has the infrastructure, the labour force, etc. needed to support the manufacturing activity, then manufacturing in the tax haven is plausible. To place as much profit opportunity in the tax haven as possible, the manufacturer should be a fully fledged rather than a contract manufacturer (although there is normally a risk of loss as well, depending on the economics of the business). This can be contrasted with the situation where, if manufacturing in a high-tax jurisdiction is necessary for commercial reasons, it may be possible to structure the activity as a contract manufacturer (if established this way at the outset), thereby minimising the income that must be reported in that jurisdiction. Centralised support activities Many multinationals, responding to the globalisation of business, have centralised certain support services in an attempt to minimise costs. In various situations, support activities can be placed in low-tax jurisdictions to reduce the total income subject to tax in higher tax jurisdictions. For example, trading companies can be used to centralise www.pwc.com/internationaltp 57

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Establishing a transfer pricing policy – practical considerations foreign-exchange risk and/or worldwide inventory control. Trading companies can be placed in any country where the requisite substance can be established. Support activities, such as accounting and marketing, can be centralised in a low-tax jurisdiction and affiliates can be charged for the services rendered. Typically, these entities are limited to charging their costs plus a markup. Nevertheless, this is a means of reducing income in higher tax jurisdictions, provided that the service entities do have the substance needed to support the charges made. In practice, the absence of good communications and an appropriately qualified workforce is often a real barrier to shifting important support functions to pure tax havens. Opportunities exist, however, in using low-tax vehicles located in more mainstream countries, such as the Belgian Coordination Centre. However, both in the context of Ecofin Code of Conduct and EU state aid developments, it was decided that the regime will be safeguarded until 2010 and that, in any event, no refund of tax savings would be required. As an alternative regime, many groups are contemplating the use of the Belgian notional interest deduction related to equity funding of Belgian enterprises. This incentive consists of granting business relief for the risk-free component of equity and is available to all Belgian enterprises, so as to avoid any challenges on the deemed selective nature of the measure. Selling companies As a general rule, selling companies are located close to their customers, often in hightax jurisdictions. If the multinational is actively seeking to minimise its worldwide tax rate, it may be possible to reduce the level of income that must be earned by a given selling entity. For example, if the reseller operates as a marketer/distributor, possibly the marketing function could be moved to a central location and thereby remove marketing income and related intangibles from the high-tax jurisdictions. Alternatively, it may be possible, in certain limited circumstances, to set up the marketing activity as ‘contract’ marketing (if done at the outset) so that the marketer is paid on a cost-plus basis for the marketing activity performed. An important consideration is that this arrangement is established before any marketing intangible is generated to ensure that the contract service provider is economically limited to the remuneration that it receives for performing such contract services. In other words, there is no pre-existing marketing intangible that it may have created before entering into a contract service. Contract service providers In addition to contract manufacturers (see Contract manufacturers and fully fledged manufacturers, earlier in this chapter), there are other types of contract service companies – these include contract R&D and contract marketing. Such entities are typically established for commercial reasons and can be structured as service providers to minimise tax or to place ownership of valuable intangibles created by the R&D or marketing activity in a central location. Contract research and development Contract R&D firms provide facilities and personnel to assist their customers (typically a fully fledged manufacturer or a parent company’s R&D activity) in developing intangibles. As long as they honour the terms of the contract, they do not bear the risk that their R&D may not lead to a commercially successful product or application, nor are they entitled to the profits of exploiting viable new ideas or products developed under the contract. (This technique was found to be acceptable in a US tax case – Westreco, Inc. v Comr., 64 TCM (CCH) 849 (1992).) 58 International Transfer Pricing 2015/16

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This construction is useful in the inter-company pricing context when the parent wishes to conduct R&D in several countries, but wishes to retain legal ownership of the intangibles (and therefore the profit created by the R&D) in a single country. Contract R&D places the risk in the country that will ultimately own the technology. Example Militia Inc. is a US corporation that develops, manufactures and markets industrial applications for use in the defence, aerospace and automotive industries in the US and internationally. The company recently established Militia Canada Company, a whollyowned Canadian subsidiary to develop and manufacture certain raw materials that are needed to manufacture Militia Inc.’s products. The original manufacturing process and know-how for these raw materials was developed in the US and was transferred to the Canadian subsidiary. Currently, all of the intellectual property resides in the US regarding the development and manufacture of these raw materials. However, as Militia Canada Company begins operations, the company believes it will be most efficient to have its Canadian subsidiary conduct all the research and development activities for these raw materials. The management of Militia Inc., however, also believes that maintaining legal ownership of all intellectual property in the parent company maximises the company’s ability to protect and defend this property from predators. The decision has therefore been taken to place all economic and legal ownership of intangibles in the parent company. In addition, the parent’s vice president in charge of R&D will be assigned to coordinate and manage the R&D activities of Militia Canada Company. In this situation, a contract R&D arrangement would allow the group to maintain economic ownership of intangibles in the parent company. Militia Inc. will effectively employ Militia Canada Company to perform certain R&D functions under its guidance, paying them on a cost-plus basis and reserving all rights to the intangibles developed under the contract. By ensuring that an executive employed by Militia Inc. is overseeing the R&D operations of Militia Canada Company, the substance needed to defend the use of this technique (i.e. centralised decision-making from the parent) appears to exist. Documentation of this arrangement is critical. Other reasons for establishing contract research and development Contract R&D is a useful technique to employ when a subsidiary has special expertise available to it, which the parent wishes to exploit but where the subsidiary does not have funds available to cover the costs. By setting up a contract R&D arrangement, the parent company can finance the R&D activity that is conducted by the subsidiary. Similar to a contract marketing service provider, an important consideration is that this arrangement is established before any R&D intangible is generated to ensure that the contract service provider is economically limited to the remuneration that it receives for performing such contract services. In other words, there is no pre-existing R&D intangible that it may have created before entering into a contract service. Example Semi-Chips Inc. (a US company) has been manufacturing and selling custom-designed semiconductor equipment for semiconductor original equipment manufacturers (OEMs) in the US for ten years. It recognises that a vast majority of semiconductor www.pwc.com/internationaltp 59

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Establishing a transfer pricing policy – practical considerations OEMs (its direct customers) have moved operations to Asia. As such, the company has determined to establish a subsidiary in Taiwan to be closer to its customers. At the same time, the company has noticed that because of the large amount of semiconductor manufacturing activities in Asia, there exists a great deal of technical expertise in Taiwan. Due to this fact, the company determines that it is more efficient for the Taiwanese subsidiary to also conduct R&D activities for products on its behalf. The new Taiwanese subsidiary is capitalised by Semi-Chips Inc. with 1 million United States dollars (USD) and sets about hiring Taiwanese scientists to conduct the R&D. The subsidiary does not have the cash to pay these scientists; therefore, the parent establishes a contract R&D arrangement and pays the Taiwanese subsidiary its costs plus an arm’s-length markup for its services. Contract maintenance Contract maintenance firms provide a labour force with the skills, instruments and tools needed to maintain or service equipment. These companies typically use special expertise, which is developed by the manufacturer of the product and provided free of charge to the contract maintenance company for use in servicing the manufacturer’s customers. They are usually compensated on a cost-plus basis. The application of this concept in an inter-company pricing context offers one method that may assist in controlling the profitability of a subsidiary responsible for selling products and providing an after-sales service to customers. The sales activities may be characterised as those of a basic distributor, while the service activity is treated as a contract activity and remunerated only on a cost-plus basis. The transfer of ‘expertise’ or the ‘method of providing service’ need not be compensated because the owner of the technology receives the entire service fee except for the return on labour, which is paid to the contract service provider. Great care must be taken in structuring these arrangements, and this technique may not be appropriate where the service activity is a crucial part of the overall sales activity, rather than a routine after-sales obligation. Contract marketing Contract marketers perform marketing activities on a contract basis. This technique is used in inter-company pricing situations to prevent the development of marketing intangibles in the affiliate that conducts the marketing activity. If the arrangement is established at the time marketing activities commence, the affiliate does not bear either the cost or the risk of marketing intangible development and therefore is entitled to none of the marketing intangible income earned in the future. Example Forever Young Inc. (FY), a US company, manufactures and sells cosmetics, body and skincare products and nutritional supplements. The company operates in the direct selling industry, using independent distribution networks to sell their products to endconsumers. After experiencing a tremendous success in the US market, the company decided to enter the international market. The company expects to repeat its success setting up subsidiaries in Germany and France. The company expects to derive a significant amount of revenue in the future from those markets, but would not like to place more income than is necessary in Germany or France for their sales support activities. Under a contract sales support and marketing arrangement, the subsidiaries in Germany and France would implement the marketing strategy, source all marketing materials from the parent and promote the business model in their local countries. 60 International Transfer Pricing 2015/16

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All activities would be approved and supervised by the management of the parent company. The service providers would be compensated on a cost-plus basis for their sales support and marketing activities. As a result, the parent company would arguably retain the economic ownership of the marketing intangibles in the local markets. The evaluation of pricing options This chapter has examined the way in which functional analysis can be used to characterise a business and has looked at some examples of particular ways in which operations might be structured. When evaluating the options available in particular circumstances, the facts may lead directly to a clear choice of pricing method. If this is not tax-efficient, changes need to be made to the functions, risks or intangibles in order to justify an alternative pricing structure. As the decision is being made, it is also necessary to determine how the local tax authority is likely to react so that any exposure can be quantified before opting for a particular structure. In order to do this it is vital to seek local advice to be certain that the structure will not lead to tax problems in any locations. This is especially true for companies that may be deemed to have intangible property. The search for comparables Once a pricing structure is chosen, arm’s-length prices need to be computed. To do this it is necessary to conduct a comparables search, as it is only through comparable transactions that a business can objectively establish a clear basis on which to defend its transfer prices. Chapter 3 discussed the methods of determining transfer prices that are consistent with the OECD Guidelines. The following example illustrates how the process of selecting and evaluating comparables might work. Example Fishy Fish KK (Fishy Fish) is a Japanese company that manufactures, develops and distributes fishing rods, reels and tackle in Japan and internationally. Fishy Fish distributes its products within the US through its US subsidiary, Fishy Corp. (Fishy US). Fishy Fish has to determine whether the transfer price for which it sells its products manufactured in Japan to Fishy US to distribute within the US market is at arm’s length. After a thorough functional analysis has been carried out, it has been determined that Fishy US is a distributor that conducts limited additional marketing activity, similar to what an independent distributor would conduct. Fishy US is also determined to take on certain limited business risks, such as product liability risk, market risk and credit risk, but Fishy Fish is assessed to be the primary entrepreneur of the group, and therefore the primary risk-taker of the operation. Further, it is determined that the fishing products are successful in the US market primarily because of the design and quality of the fishing equipment. Both of these attributes are the responsibility of Fishy Fish, the parent. Fishy Fish now wishes to identify comparables that can be used to determine and support transfer prices between the manufacturing activity in Japan and the distribution activity in the US by Fishy US. The preferred method of determining the price for this transaction is the comparable uncontrolled price (CUP) method. There are three methods of identifying a CUP for this transaction: www.pwc.com/internationaltp 61

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Establishing a transfer pricing policy – practical considerations • The Japanese parent may have sold the same fishing equipment to an unrelated distributor in the US. • The US subsidiary may have purchased the same fishing equipment from an unrelated manufacturer. • An entirely separate operation, Company A, may have manufactured identical fishing equipment and sold it to Company B (unrelated to Company A), which serves as its distributor in the US. Rarely do transactions such as these exist due to the stringent product comparability requirements. However, if it is possible to identify such transactions, it would be necessary to determine whether they could be applied directly or whether adjustments must be made to the CUP to account for elements of the CUP that differ from the related party transactions (see Chapter 3, Resale price method). In the event that a CUP cannot be found, the most likely method that would be used in this example is the resale price method. To apply this method, it is necessary to identify distributors of fishing equipment (or, if these cannot be found, other sporting goods) in the US. These distributors must purchase their sporting goods from unrelated manufacturers. If these types of transactions are identified, income statements for the distributors need to be obtained and the gross margin (sales less cost of sales) for the distributors calculated. Adjustments must be made to the gross margin if there are substantial differences between Fishy Fish’s relationship with its subsidiary and the relationship between the unrelated parties involved in the comparable transaction. It should be recognised that Fishy Fish may sell fishing equipment to unrelated distributors within the US. In this event, it may be possible to use these relationships to determine an arm’s-length discount to apply the resale price method. (While the CUP method would not apply because of differences in market prices across the US, distributor margins are frequently very similar across the US.) In this example, the resale price method would be the next option to be sought. However, there may be difficulties in using what may appear to be an obvious solution. These include the following: • There may be no published accounts for comparable distributors. • If accounts are available, they may not disclose the gross margin. • If gross margin is disclosed in the accounts, it cannot be analysed with sufficient certainty to enable reliable comparisons to be made with Fishy US’s gross margin. When these obstacles to using the resale price method cannot be overcome, as is often the case, the transactional net margin method (TNMM) under the OECD Guidelines or the comparable profits method (CPM) in the US transfer pricing regulations, discussed in Chapter 3, would most likely be applied. When using the CPM/TNMM, the degree of functional comparability between the tested party and the uncontrolled distributors is less than that required under the resale price method to obtain a reliable result. To search for comparables under the CPM/TNMM, a search for external comparable independent distributors with broadly similar functions as the tested party (i.e. Fishy US) using information obtained from the functional analysis, is conducted. Once this set of comparable companies is established, the profitability results of the distribution business of Fishy US are benchmarked against the profitability results of the uncontrolled distributors. If Fishy US profitability results fall within the range 62 International Transfer Pricing 2015/16

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of profitability results established by independent distributors, Fishy Fish should be treated as having reasonably concluded that its transactions with Fishy US were at arm’s length. Identifying appropriate comparables It is crucial to bear in mind the underlying aim in searching for comparative information. A comparable can be used to support the validity of the terms of a transaction if, in commercial terms, it can be shown that third parties at arm’s length have agreed terms similar to those set between the affiliates. A comparables search may be undertaken to identify CUPs, gross profit margins for use in applying the resale price method, cost markups for use in applying the cost-plus method or other information required to apply or support other pricing methods. Comparables may be sought from a variety of sources and, broadly, fall into two categories: those that may be identified internally within the group and those identified from external sources, which reflect transactions not carried out by group companies. Internal comparables It is advisable to perform a thorough analysis of group transactions to ascertain whether any comparable transactions with third parties exist. Internal comparables may be preferable to external comparables for a number of reasons, including: • They are more likely to ‘fit’ the affiliated transaction as they occur within the context of the group’s business. • More information about the comparable situation should be readily available. • One internal comparable may be sufficient to support a defence of the transaction under review, whereas a wider base of support may be required if external comparables are used. A broad perspective is required in reviewing the group’s business for comparative transactions, as their existence may not be immediately obvious, as illustrated in the following example. Example Healthy Life Inc. (HLUS), a US manufacturer of medical devices, must determine transfer prices with its subsidiary in Ireland. The Ireland subsidiary (HLI) is a manufacturer that employs certain specific technologies from its parent company to manufacture its medical devices. HLUS would like to identify comparable agreements that can be used to determine an appropriate royalty rate for the licence of its intangible property to Ireland. After discussions with HLUS management, it was discovered that HLUS licensed similar intangible property (under diverse agreements with third parties) compared to the intangible property used by Ireland in their manufacturing process. The preferred method of determining the price for this transaction is the comparable uncontrolled price (CUP method using internal comparable licensing agreements. As a result, it is possible to construct a range of royalty rates using the internal licensing agreements for similar intangible property. www.pwc.com/internationaltp 63

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Establishing a transfer pricing policy – practical considerations Identification of internal comparables may be made through: • discussions with management of all the entities involved in the transaction, and • review of the management accounts of the entities. External comparables Detailed information regarding transactions carried out by independent entities may not be easy to obtain, and the extent to which useful information is available varies from country to country. The main sources of information regarding third-party comparables are as follows: • Government (e.g. statutory public filing requirements and government trade department publications). • Commercial databases. • Industry associations. • Knowledge of employees. Of the many sources of information for conducting a search for comparable transactions, the most important source may be the operating personnel who know their industry and the characteristics of competitors. These individuals can frequently provide valuable sources of information about competitors and potential comparables. Trade associations are also important because they publish trade journals or other helpful documents. In addition, many trade associations have conducted studies of the market and/or employ experienced industry experts who may provide a wealth of valuable information. Online databases are useful for identifying potential comparables and obtaining financial information about them. Other business research resources may also be consulted, as necessary. Appendix 2 contains a list of some of the currently available resources. To establish whether a comparable transaction is, in fact, appropriate, it may be useful to approach the third-party comparable to ask for help in comparing the relevant aspects of the transaction. Although, when approached for this purpose, third parties may be unwilling to discuss their business, in some instances, very useful information can be obtained. The search for comparables, as well as adjustments that are made to those comparables, is an art rather than a science, for the information collected is rarely wholly complete or perfect; judgements must be made at many points during the process of analysis. For this reason, it is important to test the reasonableness of the results before finally determining appropriate transfer prices. The test of reasonableness should be based on a financial analysis of the projected results on applying the comparative information (see Financial analysis, below). 64 International Transfer Pricing 2015/16

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Functional analysis and comparable information – an overview While the process of completing a functional analysis of a business and identifying useful information on comparables should be detailed, it is imperative always to bear in mind the importance of the basic arm’s‑length principle that underlies the pricing review. For instance, it is easy to become so engrossed in the analysis of functions that this tool of information provision becomes confused with the methods of computing a transfer price. Functional analysis is not an alternative to searching for comparables; it is a way to establish what sort of comparables need to be sought. Example Never Fail Motor Co. (NFM) is a US-based manufacturer of electric motors used in a variety of applications, including the medical, aerospace and military industry. Customers of NFM are manufacturers that purchase NFM products to incorporate in their equipment and systems. As part of its strategic business expansion, NFM acquires shareholding interest in Never Fail Computer Co. (NFC), a manufacturer of computer products, which could use NFM motors to create a new highly reliable computer product. Subsequent to the acquisition, NFM sells its motors to NFC to incorporate in NFC’s new product. NFM charges NFC for the motor at a price comparable to the price of motors sold to its unrelated customers under similar contractual arrangements. The functional analysis establishes that both NFM and NFC are manufacturers that develop and own significant non-routine intangibles and assumes entrepreneurial risks in their operations. The analysis further indicates NFC does not purchase similar products from unrelated parties. As a result, the sale price of products sold by NFM to its unrelated customers should be used as a comparable transaction. However, this transfer pricing policy results in a significantly lower profit on products sold to NFC. While internal comparable transaction seems to exist based on the functional interview, the contradicting operating results is an indication that there are differences in the functions performed by NFM in its uncontrolled and controlled transactions. Further analysis shows that NFM performs additional custom design services for the motors sold to NFC. Such services are not required for products sold to unrelated parties. Therefore, the price of products sold to NFC should reflect these additional design services functions performed by NFM. Documentation Contemporaneous documentation is crucial in order to prove to the tax authorities that a transfer pricing policy is arm’s length. In other words, if a company can show what its policy was, how it interpreted that policy and why the prices chosen satisfy the arm’s-length standard, then the tax authority has little choice but to accept the policy. Companies that have not properly documented their policies are likely to face severe problems in the context of an intensive transfer pricing audit. How to document a policy In the past, little guidance was available on the appropriate level of documentation needed to support a transfer pricing policy. In many countries, the fact that the burden of proof lay largely with the tax authority gave little incentive for work in this area. However, the US provided a lead at the start of the 1990s, culminating in regulations www.pwc.com/internationaltp 65

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Establishing a transfer pricing policy – practical considerations that impose heavy penalties for transfer pricing adjustments unless the taxpayer holds contemporaneous documentary evidence that it was reasonable to believe that the policy was in fact arm’s length. As more tax authorities began to take transfer pricing matters seriously, it was recognised that documentation standards were important and new regulations have now emerged in many countries. The OECD also devoted attention to the matter in Chapter V of the Guidelines, which was part of the work published in 1995. As a general guide, however, a defensible transfer pricing policy requires documentation covering the following areas in order to demonstrate how the policy complies with the arm’s‑length principle: A description of the transfer pricing methodology used to test the arm’s-length nature of the inter-company transactions. • • • • • • Guidelines interpreting the choice of the methodology. Inter-company legal agreements. Functional analysis of the entities involved. Comparables supporting the policy. Financial analyses of the comparables as well as the tested party. Industry evidence required to substantiate the decisions made. Financial analyses Thorough financial analyses and financial segmentations are crucial to the documentation of a transfer pricing decision, because they act as compelling evidence that the prices were set on a reasonable basis. The purpose of this exercise is to produce an income statement that reflects what the company’s results would be if a particular business line were its only business. Construction of transfer pricing financial statements (profit and loss (P&L) accounts and balance sheets) requires certain judgements to be made with respect to allocations and other issues. First, business lines have to be grouped and the statements constructed according to those groupings. Criteria that should be considered in grouping business lines are: • Existing groupings (established based on industry practices, division or department, or for management purposes). • Profitability (business lines that are ‘big winners’ should be analysed separately, as should business lines that are losing money or that are earning significantly lower income than other products). • Materiality (do not form a separate business line grouping if the income/cost profile of the group is immaterial). Once business line groupings have been formed, allocations of sales, general and administrative expenses must be made to each P&L account. This should include an allocation of R&D expenditure if, and to the extent that, such expenditure relates to the given product grouping. The allocations should be based on a reasonable methodology. Such a method will often be in current use, although in different contexts: for example allocations used for financial reporting, tax or management purposes. To the extent possible, the chosen allocation method should first make direct allocations where particular expenses can be definitely and accurately matched to a specific business line. Then, indirect allocations of other expenses may be made on a 66 International Transfer Pricing 2015/16

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reasonable basis. (Examples of allocation bases for this purpose include sales, gross profit, volume and headcount ratios.) The aim of this exercise is to produce an income statement that reflects what the company’s results would be if a particular business line grouping were its only business. (One of the reasons for constructing such a statement is that when comparables are found, the results of one line of business may be compared with the results of independent companies that operate only that line of business.) Similarly, balance-sheet assets should be allocated to correspond to the relevant lines of business. Example Continuing with the example in The search for comparables section, above, income statements for Fishy US are constructed. In 2007, sales to Fishy US are 80. Assume that Fishy US’s sales to its customers during this period are 100. The following income statement reflects these transactions: Net Sales Cost of sales Gross income Gross margin % Selling, general and administrative Expenses Operating income (loss) Operating margin Fishy Fish $80 56 $24 30.0% Fishy US $100 80 $20 20.0% Consolidated $100 56 $44 44.0% 21 $3 3.8% 18 $2 2.0% 39 $5 5.0% Evaluation of financial analyses There are many ways to check the reasonableness of a transfer pricing policy, all of which compare certain financial ratios for the related party transaction with their counterparts in the industry in which the multinational trades. This analysis must be tempered by knowledge of the unique characteristics of the inter-company transaction at issue and should never become mechanical. Financial ratios that are selected are determined by the availability of reliable data as well as the particular facts of the transaction under review. For example, in some situations, a review of gross margins, operating margins and profit splits would be sufficient. In other situations, a review of return on assets (ROA) and operating margins may be appropriate. The decision regarding which ratios to examine must be made on a case-by-case basis, taking into consideration all the relevant facts. Example For Fishy US, it is determined that the appropriate financial ratios for evaluation purposes are gross margin and operating income/sales. The gross margin for the manufacturer is 30% and the gross margin for the distributor is 20%. As previously mentioned, Fishy US is the tested party in our transaction since it is the less complex party and does not possess valuable intangible assets. Comparable www.pwc.com/internationaltp 67

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Establishing a transfer pricing policy – practical considerations manufacturing margins are much harder to judge, primarily because of the return on intangible assets that they reflect. Fishy US’s gross margin is 20% and other comparable distributors of similar products in the US are found to have gross margins that range between 20% and 25%. Based on this data, it is likely that the determination will be made that the gross margin for Fishy US on the purchase of finished products to Fishy Fish is not unreasonable. The operating margin for Fishy US is 2%. This ratio may be compared with the operating margin for comparable distributors of similar products. Transfer pricing policy A transfer pricing policy is a statement that the company is committed to the arm’slength standard for transfer pricing and should be included in the financial policies of the parent company. The statement need not be detailed, but should set out the philosophy upon which the company bases its pricing decisions. Transfer pricing guidelines Transfer pricing guidelines are detailed descriptions of the various inter-company transactions that exist within the group, together with the methods by which transfer prices will be determined for each of those transactions. Generally, guidelines do not include numbers for markups, discounts or royalty rates. Instead, they say the comparables (or whatever other means of computing the prices used) will be identified and prices will be determined annually (or semi-annually, or within whatever time frame is appropriate). The guidelines, therefore, constitute the ‘formulae’ by which transfer prices will be determined, based on the nature of the company’s intercompany transactions. Inter-company agreements Inter-company legal agreements are a method of formalising the relationship between affiliated companies and might include distribution agreements, licence agreements, contract R&D agreements, etc. Each inter-company relationship that gives rise to a transfer price should be documented through a legal agreement. In certain circumstances, these agreements can be disregarded by the tax authorities in certain countries (e.g. the US). In other countries (e.g. Germany), they are inviolable. The agreements enable a company to state, for the record, what it intends the intercompany relationship (characterisation of the entities) to be, and it is difficult in any country for the tax authority to disregard totally such agreements, especially if the functional analysis supports the form that is documented. Documentation of the functional analysis The functional analysis, together with the characterisation of the entities, should be documented so that it can be provided at the time of a tax audit. In addition, memoranda that set out the functional analysis are extremely valuable to a company that is preparing for an audit (to remind the relevant personnel of the facts) or reevaluating its policy. 68 International Transfer Pricing 2015/16

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Documenting the comparables All information gathered about the comparables (e.g. financial statements and functional analyses) should be retained in a useful form so that it can be referred to in presenting explanations to the tax authorities. Updates of financial statements from those comparables should be collected annually to be sure that the prices applied continue to reflect the arm’s-length standard. It is also important to update the search for comparables on a regular basis (as independent companies enter or leave the market) to ensure that the sample used for analysis remains as complete as possible. Income statements The income statements prepared as part of the analysis should be retained and updated at least annually to show the reasonableness of the policy. Industry evidence This category is a potpourri of items that support conclusions reached, adjustments made, etc. Whatever information is needed to be able to explain to the tax authority what was done, why it was done and why it produces an arm’s-length result should be retained and updated periodically. Implementing a transfer pricing policy Implementation is perhaps the hardest part of the determination and defence of a transfer pricing policy. Calculating transfer prices and establishing the controls necessary to be certain that the prices are not changed without prior notification can be time-consuming. The implementation process itself depends upon the nature of the business and the pricing structure. But, in all cases, implementation is more likely to be successfully achieved if employee politics and sensitivities are fully considered. In particular, relocation of functions and adjustments to employee pay or bonus schemes (see Chapter 6, Impact on management/employee bonus schemes) require careful handling. Monitoring the application of the policy The arm’s-length standard requires that inter-company pricing must reflect the substance of transactions. As a business grows, evolves and possibly restructures, the substance of transactions changes. Transfer prices may also have to change to remain arm’s length. Monitoring the application of the policy is important so that the taxpayer knows when facts have changed and no longer support the existing pricing structure. Even in the absence of changes in the substance of the relationship, business cycles can mean that prices change (going up during periods of high inflation and down during recession). Regular re-evaluation of the facts and the prices to determine that they are, and remain, arm’s length, is advisable. Documentation should be prepared to reflect that this process is carried out and that appropriate conclusions are reached and acted upon. The policy should be examined quarterly until it is clear that it is working. After that, semi-annual examinations are usually sufficient, unless the industry is inordinately volatile. The evaluation should include an examination of the financial results realised under the policy. That is, financial ratios and profit splits should be calculated and www.pwc.com/internationaltp 69

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Establishing a transfer pricing policy – practical considerations examined to ensure the policy is producing the anticipated results. If it is not, the reasons for this should be determined and appropriate adjustments made. In addition, the facts should be checked. Has there been a change in the substance of any transactions? Is one entity now performing a function that another entity originally performed? Have risks changed or shifted? Has there been a change or innovation in the industry that affects prices? Finally, the implementation of the policy should be checked. Have the intercompany agreements been put in place? Do appropriate personnel in the various entities understand the policy? Are the inter-company charges reflecting the appropriate pricing? Compensation of management Transfer pricing to achieve tax or financial goals may result in levels of income in the various legal entities that are inconsistent with the way in which management should be compensated on the basis of performance-related pay or bonus schemes. Typically, multinationals establish a separate transfer pricing scheme for managementreporting purposes (not necessarily based on the arm’s-length standard), so that management is encouraged to behave in a particular way in running the business and is properly compensated when it obtains the desired results. 70 International Transfer Pricing 2015/16

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5. Specific issues in transfer pricing Management services Management fees – introduction The term ‘management fee’ is often used to describe any of a variety of inter-company services charges. In this chapter, the term is used to describe charges paid for general administrative, technical services, or payments for commercial services that are provided intragroup from one or more providers to one or more recipients. Chapter 2 considered the types of services that might be provided between related companies. This chapter focuses on specific challenges related to the methods of determining arm’s-length charges for the services and the documentation needed to support the arrangements. The importance of management fees Multinationals have a long-standing practice of providing certain services from a central point to one or more affiliates; in many cases it is appropriate for a charge to be made by the renderer. While the parent company is often the centralised service provider in recent years for the model of one affiliate providing services on a central basis to several other affiliates has become popular. Examples include regional HQs located in Europe to provide centralised marketing, management and accounting assistance to all European entities in a non-European group. In these situations, costcontribution (or shared-service) arrangements can be constructed to charge the costs of the service providers to the affiliates that benefit from the services they provide. As the unique bundle of services provided may vary significantly between taxpayers, it may be difficult to find a comparable price for such services or to evaluate the benefit received. Because of this difficulty, rightly or wrongly, many tax authorities regard the area of management fees as particularly prone to potential abuse and are therefore devoting increasing resources to auditing such transactions. Tax authorities consider these management fees to be ‘low-hanging fruit’ and perceive that taxpayers’ documentation and support for them is often lax. At the same time, the increasingly competitive global marketplace is demanding greater efficiency from multinational businesses. They must take every opportunity to minimise costs, so there is an evergreater need to arrange for the centralisation of business functions where possible. It is important to understand that centralisation does not necessarily mean that the functions are all grouped together in one location. It may be the case that specialised departments are spread throughout the group in what are commonly called ‘Centres of Excellence’, depending on the particular needs of the group and the location of its resources. If the group wishes to avoid serious double taxation problems, it is of paramount importance that it operates a tightly controlled management-fee programme, aiming at the funding of central resources and allocating expenses to the correct companies, ensuring that tax deductions are obtained for these costs. www.pwc.com/internationaltp 71

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Specific issues in transfer pricing The tax treatment of management fees – an overview The world can be divided broadly into two camps regarding the tax treatment of management fees. Many developed nations have adopted laws and regulations dealing with inter-company services, which accept the deductibility of inter-company charges as long as they comply with the general requirements of the national tax code and with the arm’s‑length principle. The rest of the world typically does not recognise these types of inter-company charges and refuses deductibility for tax purposes. Included in this latter category are authorities (e.g. some South American jurisdictions) that offer limited deductions but place restrictions on remittances of funds through foreignexchange controls and withholding taxes. These limitations often create an effective barrier to establishing service arrangements. Management fees in the developed world Before any meaningful structure can be devised for a management-fee arrangement, it is vital to establish the following: • • • • The exact nature of the services that are to be performed. Which entities are to render the services. Which entities are to receive the services. What costs are involved in providing the services. Once these facts are known, consideration can be given to selecting the basis for charging the recipient group companies. The fee structure and the general circumstances of the arrangement should be recorded in documentation evidencing the arrangements between provider and recipient. Often this documentation takes the form of a bilateral or multilateral service arrangement. Such documentation should include, in addition to a written agreement, sufficient evidence of costs involved and services actually rendered. The documentary evidence required by tax authorities varies from territory to territory, and it may be necessary to provide timesheets, detailed invoices and/or other detailed worksheets or evidence of costs incurred. Recently, multinational groups are finding that even having the aforementioned documentation may not be sufficient to ward off a potential adjustment or disallowance of a deduction in the recipient jurisdiction. Often, the recipients are required to prove that benefit is derived from the services received and that such benefits are of a more than just remote or indirect benefit. As a result, depending on the facts and circumstances, it may be imperative for the multinational group to maintain more than just the documentation referenced above, but also documentation of the facts and circumstances of the service arrangement and the benefits received. Dealing with shareholder costs Central services include services provided to: • One or more specific companies (perhaps including the parent company) for the specific purposes of their trading activities (e.g. marketing advice). • A range of companies (perhaps including the parent) for the general benefit of their businesses (e.g. accounting services). • The parent company in its capacity as shareholder of one or more subsidiaries. The costs in this last category are generally known as shareholder costs. They are the responsibility of the ultimate parent company and should not be borne by other group members. If incurred by the parent, the cost should remain with the parent. If incurred elsewhere, the expense should be recharged to the parent, possibly with a markup. 72 International Transfer Pricing 2015/16

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Once costs for shareholder functions have been addressed, it is necessary to consider charging for other services. Recent developments in the US (i.e. the Final Service Regulations issued on 31 July 2009) have put a renewed emphasis on the evaluation of inter-company service transactions dealing with myriad issues in this area. Of the many services considered, these new regulations have redefined or narrowed the definition of ‘shareholder activities’ to those expenses that solely benefit the ultimate shareholder. The focus of the new US regulations were to be more consistent with the OECD Guidelines; however, the new definition in the context of shareholder expenses may prove problematic because of its restrictiveness. This narrowed definition creates a new aspect that multinationals (particularly US-based companies) must consider, as the potential for challenges of deductibility for non-shareholder costs may be initiated by the provider country (see US chapter). Analysing the services The correct allocation of shareholder costs should be the first step in determining intercompany service fees. The next step is to identify the specific additional services that are provided. This process is most easily accomplished through a functional analysis described in Chapter 4. Through interviews with operating personnel, it will be possible to identify specific services that are provided to related parties as well as the companies that provide those services. At the same time, care must be taken to identify the nature of the benefits received by the recipient. Where a direct relationship exists between the rendering of a service and the receipt of benefit, it should normally be possible to charge a fee for the service and obtain a deduction in the paying company. Example EasternMed (EM), a US company, operates a worldwide network of distribution companies that sell alternative nutritional supplements. The nutritional supplements are manufactured in the US by EM (or by vendors for EM) and sold to each non-US location for further resale to the local customer base. EM has operations throughout the Western European countries, Canada, the Australia–Asia region and Bermuda. EM has engaged external advisers to assist in determining inter-company charges for services rendered by the parent company to its subsidiaries. The study on intercompany charges was jointly commissioned by the parent company and the subsidiary to provide assurances regarding appropriate inter-company service fees, which would be deductible to each of the subsidiaries and acceptable from EM’s viewpoint in the US. As a result of the functional analysis performed, the following services were identified: • Accounting assistance to the subsidiaries by the parent with respect to maintaining local accounts. • Management of the group’s internal IT system, which the group members use to track customer accounts. • Marketing assistance in the form of recommendations for advertisements and promotional campaigns. • Provision of marketing assistance in the form of sales brochures that have been localised to the local customer base and used by the foreign affiliates in their distribution operations. www.pwc.com/internationaltp 73

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Specific issues in transfer pricing After discussions with each of the subsidiaries, it was determined that: • Bermuda is a tax haven, and the Bermudan government does not care how much the parent extracts from the Bermudan subsidiary in the form of management fees; in contrast, the tax authorities dealing with other EM subsidiaries require satisfaction that any service charges are computed on an arm’s-length basis • all subsidiaries agreed that the accounting assistance was extremely helpful in establishing an accounting framework for their businesses. The cost of the accounting assistance can therefore be charged to all affiliates • no subsidiary located outside the US uses any aspect of the advertising and promotion information provided by EM because it applies only to the US market, which is significantly different from the markets in the rest of the world. None of the costs of the advertising and promotion information can therefore be charged • the costs associated with the sales brochures are actually used by each subsidiary in its sales efforts and therefore a charge is appropriate for these costs, and • the cost of the transfer pricing study can be spread between the affiliates as part of the cost base of the services covered by the management fee. The remaining matters to be considered are whether a markup can be applied and whether it makes sense to make a charge to Bermuda, given that no effective tax relief will be obtained. The preferred method for the determination of inter-company charges is generally the CUP method. In other words, if the provider of the service is in the business of providing similar services to unrelated parties, or if the service is also obtained from third parties, then the arm’s-length charge is that which the third party would pay/ charge. Typically, a CUP is not available in respect of management services because of the unique nature of the services provided within a group. The reports of the OECD (see Chapter 3) state that there may be circumstances in which comparable data may be available, for example where a multinational establishes its own banking, insurance, legal or financial services operations. Even here, however, great care is needed in comparing group activity with third-party businesses. Third parties face the challenge of the real market, whereas group companies are often forced to buy the internal services when available. A group insurance company deals with the risks of one business only, rather than a multitude of different customers. These examples merely illustrate that comparables are hard to find for group service activities, even where similar services appear to be offered by third parties. The cost base for service charges Where services are rendered for which no fee can be established under the CUP method, the cost-plus method is typically applied to arrive at an arm’s-length service fee. This method requires an analysis of the costs incurred in providing the services. Since the services are rendered to several companies in the group, the costs involved must be charged to the various beneficiaries on a pro rata basis. Therefore, the aggregate amount of costs that the service unit incurs in providing the services must be allocated to the recipient companies in accordance with an acceptable allocation key. Costs of a central personnel department may be allocated, for example, by the time spent on assisting each subsidiary. When the central services are more general in nature, allocation by reference to a relative headcount of each company may be appropriate. One of most frequent reasons that management fees are challenged by 74 International Transfer Pricing 2015/16

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tax authorities is on the basis that the allocation methodology was insufficient to establish that the entity receiving the charge was the true beneficiary of the underlying costs incurred. Allocation keys need to be responsive to the nature of the costs to be divided; other keys that may be appropriate are relative capital employed, turnover and number of users (in the context of IT systems). The cost-accounting method The costs actually incurred in providing the services are ascertained by using an acceptable cost-accounting system. National tax laws and regulations do not generally prescribe a particular cost-accounting method, but leave it to the individual group of companies to determine which cost-accounting method is most suitable for them in the specific circumstances, provided that the chosen cost-accounting method is generally acceptable and consistently applied. The computation on a full-cost basis Since the charge determined under the cost-plus method ought to reflect all relevant costs, the aggregate amount of service costs must include direct and indirect costs. It is not acceptable, under generally accepted practice, for costs to be computed on the basis of incremental cost only. Direct costs to be considered are those identifiable with the particular service, including for example, costs attributable to employees directly engaged in performing such services and expenses for material and supplies directly consumed in rendering such services. Indirect costs are defined as those that cannot be identified as incurred in relation to a particular activity but which, nevertheless, are related to the direct costs. As a result, indirect costs include expenses incurred to provide heating, lighting, telephones, etc. to defray the expenses of occupancy and those of supervisory and clerical activities as well as other overhead burdens of the department incurring the direct costs. Although it may often be difficult in practice to determine the indirect costs actually related to a particular service, the supplier of the service is normally expected to charge the full cost. Therefore, an apportionment of the total indirect costs of the supplier on some reasonable basis would be accepted in most countries. The US Temporary and Proposed Service Regulations effective for tax years commencing after 31 December 2006 and the subsequent Final Regulations applicable for tax years beginning after 31 July 2009, require the inclusion of stock-based compensation in the costs associated with a particular service. This change has proven controversial, as third-party dealings typically do not include such costs in their service cost base nor does stock-based compensation ever enter into consideration in third-party negotiations. Nevertheless, the inclusion of stock-based compensation is part of the new regulations and hence companies should consider the impact of these regulations on their inter-company service transactions. There will undoubtedly be controversy related to this issue in the recipient jurisdictions as US multinationals are forced to comply with these new rules, especially in those jurisdictions where stockbased compensation is nondeductible, or if deductible, subject to stringent policies in non-US jurisdictions (see US chapter). www.pwc.com/internationaltp 75

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Specific issues in transfer pricing When should a profit margin be added to cost? The question arises as to whether a profit markup should be added to the costs in calculating a service charge. Nearly all tax authorities expect a group service company to render charges to affiliated enterprises in accordance with the cost-plus method and therefore to add a profit markup to the allocable cost. On the other hand, double taxation is avoided only if the tax authorities of the country in which the recipient company is resident allow a deduction, and not all countries accept the markup element of the charge as deductible. In an arm’s-length situation, an independent enterprise would normally charge for its services to third parties in such a way as to recover not only its costs but also an element of profit. Consequently, any enterprise that is engaged solely in the business of providing such services should seek to make a profit. This scenario is particularly true in the following three situations: • Where the service company’s only business activity is rendering services. • Where service costs are a material element in the cost structure of the service provider. • Where the service costs represent a material part of the cost structure of the service recipient. Most tax authorities in developed countries accept these conditions as relevant in reviewing the application of a markup to service costs. However, a more formalised approach is taken in certain instances, particularly in the US. As noted in the US chapter, the revised US regulations on services require the addition of profit margin to the intragroup charge for services rendered where the services provided are not considered low-margin services or the median arm’s-length markup for such services exceeds 7%. A further issue directly addressed in the new US regulations relates to ‘pass through’ costs. The underlying principle is that only those costs regarded as value added costs incurred by the service provider in conducting its own business should be included in the pool of costs to be marked up. For example, if the service provider incurs thirdparty expense (for instance arranging for advertising space to be made available for its client), then it may well be correct to evaluate the advertising costs as an expense reimbursement (covering disbursements, financing and handling charges). It will invoice for the service of arranging it (labour, phone, office costs, etc.) on a cost-plus basis. The total costs recharged would be the same, but the profit recognised in the service provider would differ significantly. When it is appropriate to include a profit element on service charges, arm’s-length markups are determined by reference to comparables where possible. Once the service is identified, the cost of providing the service is determined and comparables are sought to determine the arm’s-length markup for those costs. In practice, many tax authorities expect to see certain levels of profit margin as the norm, typically between 5% and 10% of costs for most support services. However, as global competition gears up, companies should take care to ensure that the higher historical norms are not allowed to prevail in inappropriate circumstances, or the internal service provider may prove to be a cost-creating mechanism rather than a vehicle to enhance efficiency. 76 International Transfer Pricing 2015/16

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The determination of an arm’s-length service charge The following example sets out how an arm’s-length service charge might be determined. Example Continuing the example above, it has been determined that three services have been provided for, which it is appropriate to make inter-company charges: • Assistance with the determination of arm’s-length service fees. • Provision of marketing assistance in the form of sales brochures. • Accounting assistance. The next step is to determine the fully loaded cost of providing those services. The costs of providing transfer pricing assistance consist of the external adviser’s fee plus the costs of the company’s tax department personnel involved in the study. The cost of providing tax personnel and the accounting assistance can be determined by reference to the amount of time the relevant individuals have spent in providing the services and the departmental costs in terms of salaries and overhead expenses. Once the time devoted to the pricing study has been identified, this amount can be expressed as a percentage of the total resources used by the relevant department during the year. Looking at the accounting support, for example, suppose one person was involved and spent 50% of the year on the project. There are three people in the accounting department. Therefore, the cost of providing the service is one-half of the affected person’s salary and benefits plus one-sixth of the overhead expenses of the accounting department. If we assume that a markup is deductible in each of the countries to which charges should be made, comparables must be identified for tax consulting (for the service fee project) and for accounting assistance. An obvious comparable is the markup the external adviser earned on the project. However, this information may not be publicly available, so other benchmarks must be used. Likewise, for accounting assistance, companies that provide accounting services and for which publicly available financial information exists may be identified. Once this markup is known, the inter-company charge can be determined. In practice this process may not be necessary, as many tax authorities accept that a margin of 5% to 10% on cost is prima facie acceptable. Nevertheless, a properly recorded and documented margin always offers a stronger position. For charges relating to the creation and printing of the sales brochures, one could allocate the departmental costs involved in the developing the brochures as well as any external printing costs. The charges could be allocated on the relative basis of brochures shipped or other allocation keys deemed more appropriate. Documentation Documentation in the area of management fees is every bit as important as in the case of the sale of inventory or the transfer of intangibles. At a minimum, it is necessary to provide documentation regarding the services that are provided, the costs of rendering those services and support for the appropriateness of any markup. It is imperative to have an inter-company agreement that sets out the circumstances under which services will be provided as well as the charges that will be made. www.pwc.com/internationaltp 77

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Specific issues in transfer pricing The support that might be needed to document each of these types of items could include the following: • A written description of the different services provided, summarising the type (specialist skills, seniority, etc.) and number of employees involved, any reports or other end products of the services, and a statement of the aims of the services (to save costs, increase sales, etc.). • A full analysis of the cost base, including explanations of allocation formulae, how they apply and why they are appropriate; a detailed list of the expenses to be allocated (salaries, overhead expenses, etc.); and invoices from other entities where they substantiate expenses suffered. • A detailed computation of the amount of each invoice submitted to the recipient entities – it should be possible for a computer to produce this calculation relatively easily once the cost base and allocation formulae have been established. • A justification of the markup applied referring to comparables or market practice. In a Canadian case, the court gave detailed consideration to the subject of documentation of management fees and concluded that the following items of evidence would be of key significance: • Evidence of bargaining between the parties in respect of the amount to refute any inference that the taxpayer ‘passively acquiesced’ to the charge. • Working papers supporting the expenses charged. • Details explaining how the charges were calculated, including support for the apportionment of employee work performed or other expenses such as allocations of rental costs. • A written agreement for the management charge. • Evidence that the expenses relate to the period of charge rather than a prior period. The above comments are based on a 1991 case that predates the detailed OECD Guidelines chapter on Intra-Group Services. Today, most tax authorities’ expectations are likely to mirror the OECD Guidelines. Contract services and shared service centres Multinationals are increasingly looking for ways to improve their competitive position in the global marketplace through increased efficiency of operations. The traditional model for expansion, whereby the parent sets up one or more new companies for each new country of operation, has been successful in a number of ways. However, it has also encouraged bureaucratic and territorial approaches to business, which carries with it significant hidden costs. For instance, does each company really need its own personnel director, marketing director, finance department, inventory warehouse and buffer stocks, etc. or can these functions be fulfilled from a central point? With respect to strategic approaches to the market, the parent will want to encourage a global market view, while the old ‘country company’ model tends to narrow horizons to a very local level. All these pressures and others are driving the creation of shared service centres which fulfil a wide variety of support functions for companies in many countries. Another way in which multinationals are seeking to improve is through building on best-in-class techniques. If one of their operations appears to be particularly skilful in performing an activity, perhaps this entity should provide this service to others, rather than allow the latter to continue to operate at less than optimal standards. 78 International Transfer Pricing 2015/16

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Finally, the search for access to the best resources for a task at the lowest price is leading to the creation of contract research and development (R&D) centres and contract manufacturing activities. The idea here is that the multinational can tap into what it requires without impacting its strategy for managing intellectual property or manufacturing, while tightly controlling the costs. The best-known example of contract R&D comes from the US case, Westreco, in which the Swiss group Nestlé was involved. Nestlé wanted to conduct research into the US market in order to design successful products for that market. If this research had been financed by its US operation, any intangibles created would have belonged in the US and subsequent profits derived would have been taxable there. Instead, Nestlé established a contract research operation that sold its services to the Swiss operation, which thereby owned the resultant intangibles. Subsequent exploitation by way of licence was therefore possible. The key to the establishment of a successful contract R&D activity (or contract manufacturing operation, which is a similar concept) is to draw up a service agreement that sets out clearly the activities required to be performed, service quality standard, timelines, etc. The service provider’s remuneration should be set by reference to appropriate comparables and is typically a cost-plus approach. Capital risk is a particularly important area to monitor, however. If the service provider needs to make significant investment in order to fulfil the contract, will the purchaser cover the financing costs and risk of disposal at this end of the contract? This question can be answered in many ways, but the answer will materially affect the profit, which it will be appropriate for the service provider to earn. As usual, risk should be compensated by the prospect of future reward. Transfer of intangible property Transfer of intangibles – introduction Generally, intangible assets can be transferred between related parties in three ways: contribution to capital, sale or licence. In addition, the parties may have agreed to share the costs and risks of the development of an intangible through a cost-sharing arrangement or otherwise referred to in the OECD Guidelines as a costcontribution arrangement. Sale for consideration When intangibles are sold, tax laws in most countries require that the developer/owner receive the fair market value of the intangible at the time of transfer. The geographic rights to the property that is sold can be broad or narrow. For example, the developer may sell the North American rights to the property. Alternatively, the developer may sell the worldwide rights for uses other than for the use that it wishes to keep for itself. For example, in the pharmaceutical industry, the developer may keep the rights for human use while selling the rights for animal use. Once the sale has taken place, the party that purchased the intangible is the legal owner of the property and is entitled to receive any third-party or related-party royalties that accrue to the property. The owner also has the right to sublicence or dispose of the property. Licence The typical method of transferring intangible rights between related parties is through the use of an exclusive or a non-exclusive licence agreement. When a licence is used, the developer continues to own the property and can dispose of it as she/he see fit. www.pwc.com/internationaltp 79

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Specific issues in transfer pricing The rights given to the licensee may vary. In general, the licence is evidenced by a document specifying the terms of the licence. The key terms of a licence are likely to include the following: • • • • The geographic rights the licensee is granted. The length of time for which the licensee may use the property. The uses to which the licensee may put the property. The exclusivity of the licence (i.e. exclusive or non-exclusive and the basis of exclusivity). • The amount and type of technical assistance that the licensee may receive from the licensor (together with fees for assistance above that which is provided as part of the licence). • The royalty rate, method of computing the royalties and the timing of payments. • Whether the licensee has sublicensing rights. It is important that licence arrangements be committed to writing. It should also be noted that several of the points listed above play a significant role in the determination of the royalty rate. For example, an exclusive licence typically carries a royalty rate significantly higher than a non-exclusive licence. Broader geographic rights may result in a higher royalty rate, although this result is not always the case. Determination of arm’s-length royalty rates Determining the proper compensation due to the developer/owner of intangible property can be difficult. In setting an arm’s-length royalty rate it is important to distinguish, as precisely as possible, what property is to be licensed. Once the property is identified, the rights granted to the licensee and their relative value is determined. The property may be an ordinary intangible in that it provides some, though not complete, protection from competitors (this type of intangible is sometimes referred to as a typical or a routine intangible). Alternatively, it may constitute a super-intangible, which effectively gives the licensee a monopoly or near-monopoly over the market in question. However, there is no difference in the approach to setting an arm’s-length royalty. The concept of super-intangibles is mentioned here for completeness only. It arose following the 1986 Tax Reform Act in the US. One of the key issues included was a requirement that the licence income to be enjoyed by a licensor in the US from an overseas affiliate should be ‘commensurate with the income’ associated with the intangible. There was concern that insufficient royalty income was being derived from US intangibles that proved to be valuable after being licensed overseas. There was considerable concern outside the US that excessive use has to be made of hindsight in this area. The optimal method for determining an arm’s-length royalty is to refer to licences between unrelated parties under which identical property has been transferred. Such licences can be identified where the developer has licensed a third party to use the technology under terms identical or similar to those granted to the related party, or where the inter-company licensor has received the technology from a third party. If such a licence agreement is identified, adjustments can be made for differences in terms in order to determine an inter-company, arm’s-length royalty rate. 80 International Transfer Pricing 2015/16

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Example Abbra Cadabbra AG (ACAG), a German company, has developed a method of removing grass stains from clothing, which does not also remove the colour from the cloth. It has obtained a patent on its invention and is manufacturing the product for sale in the German market. It has recently decided to establish a manufacturing affiliate in Ireland, where it will benefit from a favourable low-tax regime for the earnings of the Irish subsidiary. The Irish subsidiary will manufacture the product for resale throughout Europe. ACAG wishes to maximise the income that it places in Ireland. Therefore, it is taking all steps necessary to ensure that the Irish subsidiary is a full-fledged manufacturer. To this end, it has decided to licence the patent and related technical know-how to the Irish subsidiary. ACAG will grant the Irish subsidiary an exclusive licence to make, use and sell the product in all European markets. A written agreement is drawn up containing all the relevant terms. The remaining issue is to determine an arm’s-length royalty. Assume that ACAG licensed ZapAway Inc., an independent US company, to make, use and sell the product in North America. The technology provided to ZapAway is identical to the technology licensed to ACAG’s Irish subsidiary. Both licences are granted for the life of the patent and both provide for 20 workdays of technical assistance in implementing the technology. The only significant difference between the two licence agreements is that the third-party licence gives the licensee the rights within North America and the related-party licence grants the licensee the rights to European markets. The question that must be addressed is whether the North American and European markets are economically similar so that the royalty rate applied to the North American licence would be expected to be the same as the royalty rate for the European licence. The economics of the two markets must be examined in order to answer this question. In general, if the differences are small, then the third-party licence should form the basis for the related-party royalty rate. If significant differences exist, adjustments can be made to account for them so long as they can be valued. The underlying question here, of course, is whether both licensor and licensee, at arm’s length, give thought to the profit potential of the intangible when arguing a royalty rate. If markets are different from one another, potential investment returns will also differ and hence the acceptable royalty rate. Determining an arm’s-length royalty rate in the absence of perfect comparables If a perfect comparable does not exist (a common occurrence), then licence agreements between unrelated parties for economically similar technology may be used to determine the appropriate inter-company royalty rate. Typically, this determination is made by reference to third-party licences within the industry. Example Assume that the ZapAway agreement (see Determination of arm’s‑length royalty, above) does not exist (i.e. ACAG does not licence the property to any third party). However, another competitor licences a similar product (another grass stain remover) to a third party. This licence agreement is subjected to the same analysis discussed above in www.pwc.com/internationaltp 81

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Specific issues in transfer pricing the Determination of arm’s‑length royalty section. If the differences do not affect the royalty rate or can be valued, then this third-party licence arrangement can be used as a basis for the determination of the arm’s-length royalty between ACAG and its Irish subsidiary. In a situation where no comparables exist, it is possible to impute a royalty rate by reference to the factors that unrelated parties would consider in negotiating royalty rates. For example: • • • • • • The expected profits attributable to the technology. The cost of developing the technology. The degree of protection provided under the terms of the licence as well as the length of time the protection is expected to exist. The terms of the transfer, including limitations on geographic area covered. The uniqueness of the property. Super-intangibles Super-intangibles are those that give the owner a monopoly or a near-monopoly in its product class for a significant period of time. It is unlikely that, due to their nature, close comparables exist for these intangibles. However, occasionally a developer may not wish to market the product resulting from an invention (or does not have the capital required to exploit the invention) and chooses to licence it to a third party. Even in the case of super-intangibles, a comparables search should be completed to ascertain whether comparables exist. Valuation of royalty rates for super-intangibles In the absence of comparables, the determination of arm’s-length royalty rates is extremely difficult. Chapter VI of the OECD report reviews the important issues on intangibles, but recognises the great difficulty in determining arm’s-length pricing for an intangible transaction when the valuation is very uncertain, as is usually the case at the outset of a business venture. The OECD urges companies and tax authorities to give careful attention to what might have happened at arm’s length, all the other circumstances being the same. Consequently, parties might opt for relatively shortterm licence arrangements or variable licence rates depending on success, where future benefits cannot be determined at the start. This commentary is essentially highlighting the dilemma shared by companies and tax authorities in this area; neither can foresee the future. Companies wish to take a decision and move forward, while tax authorities usually must consider, in arrears, whether such decisions represent arm’s-length arrangements. Tax authorities should not use hindsight. Equally, it is often difficult for companies to demonstrate that they devoted as much effort in trying to look forward when setting the royalty rate, as they might have done at arm’s length. Where particularly valuable intangibles are involved, or tax havens are in the structure, a residual income approach may be adopted by the tax auditor in the absence of other evidence. This approach avoids a direct valuation of the royalty but determines the value of the other elements of a transaction (e.g. the manufacturing of the product) and calculates a royalty based on the total income accruing as a result of the transaction less the cost of these other elements, so that the residue of income falls to be remitted as a royalty. Example Clipco Inc. (CI), a US company, is a manufacturer of shaving equipment. It has recently developed a new razor that is guaranteed never to cut, nick or scrape the skin of its 82 International Transfer Pricing 2015/16

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users. Its success is tied to a microprocessor, contained in the blade, which signals the blade to cut or not cut, depending on whether the substance it senses is hair or skin. Clipco has been granted a patent on this device and is currently marketing the razor in the US where it has obtained a 90% market share. Clipco has established an Irish subsidiary to manufacture the razors for the European market. Clipco (Ireland) (CIre) will manufacture the razors and sell to third-party distributors, which the parent company is currently supplying. The issue is the proper royalty rate to be set for the use of the patented technology and related technical know-how that the parent company provides to CIre. The functional analysis is summarised in Table 5.1. Table 5.1 Functional analysis US PARENT Functions Risks Intangibles Research and development Foreign exchange (on royalty) Patent Marketing (on royalty) Trademark Unpatented know-how Technical assistance IRISH SUBSIDIARY Functions Manufacturing Risks Warranty Obsolete products Intangibles None In this simplified example, the Irish subsidiary is a manufacturer, nothing more (perhaps a contract manufacturer, although the risk pattern is inconsistent with that conclusion). The US method of determining the royalty rate in these circumstances may be to find comparables for the value of the manufacturing activity (usually on a cost-plus basis). All remaining income, after compensating the Irish subsidiary for its manufacturing activity, is as a royalty for the use of the technology. This method usually overstates the return on the base technology by including all intangible income except for the intangible income that is specifically allowed to the manufacturing company. Hence, this valuation method is one that the typical company will seek to avoid when its manufacturing operations are located in a low-tax jurisdiction. However, it may be useful when manufacturing in high-tax jurisdictions. Cost-sharing In 1979, the OECD published a paper on transfer pricing and multinational enterprises. This document included a discussion of the experience of multinational enterprises in establishing and operating cost-contribution arrangements for R&D expenditure. The OECD summarised its knowledge of these arrangements and the experiences multinational companies have undergone in handling cost-sharing arrangements (which are referred to as cost-contribution arrangements (CCAs)) with tax authorities around the world. The OECD commentary has been widely regarded as best practice by many tax authorities and the comments in that paper, to a large extent, remain valid today. However, there are differences beginning to develop in practice, particularly in the US, as tax authorities obtain more experience of the operation of cost-sharing arrangements and become more sophisticated in dealing with multinational www.pwc.com/internationaltp 83

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Specific issues in transfer pricing corporations. For its part, the OECD issued Chapter VIII of its Transfer Pricing Guidelines, which governs the tax treatment and other transfer pricing issues related to CCAs entered into by controlled taxpayers. The guidelines set out in Chapter VIII are essentially the same as draft guidelines the OECD originally proposed in 1994. The primary principle surrounding the OECD’s determination of whether a cost allocation under a CCA is consistent with the arm’s‑length principle is whether the allocation of costs among the CCA participants is consistent with the parties’ proportionate share of the overall expected benefits to be received under the CCA. Cost-sharing is based on the idea that a group of companies may gather together and share the expenditure involved in researching and developing new technologies or know-how. By sharing the costs, each participant in the arrangement obtains rights to all the R&D, although it funds only a small part of the expense. As soon as a viable commercial opportunity arises from the R&D, all contributors to the cost-sharing arrangement are free to exploit it as they see fit, subject to any constraints laid down by the agreement (see Cost-sharing arrangements and Cost-sharing agreements, below). Such constraints typically include territorial restrictions on each participant regarding sales to customers. Cost-sharing is an inherently simple concept, enabling R&D expenditure to be funded on an equitable basis by a range of participants. However, there are many complex issues, both in accounting and tax terms, which arise in practice from the establishment of a cost-sharing arrangement between companies under common control. Advantages of cost-sharing Cost-sharing may offer several advantages to the licensing of intangible property. First, it may obviate the need to determine an arm’s-length royalty rate. If the parties have participated in the development of an intangible, they own it for the purpose of earning the income generated by it, and no royalties need be paid if the intangible is exploited under the terms of the CCA. Such cost-sharing arrangements eliminate the necessity of a royalty payment for the use of intangible property that would otherwise be owned by another party. Second, cost-sharing is a means of financing the R&D effort of a corporation. For example, assume that the R&D activity has historically been carried out by the parent company and it is anticipated that this scenario will continue. Further, assume that the parent company is losing money in its home market but the group is profitable in other locations. This fact pattern implies that the parent may find it difficult to fund the R&D activity solely from the cash generated by its own business. Cost-sharing is a means of using the subsidiaries’ funds to finance the R&D activity. The corollary of this theory is that ownership of intangibles will be shared with the subsidiaries rather than the parent company alone. Cost-sharing arrangements A valid cost-sharing arrangement between members of a group of companies involves a mutual written agreement, signed in advance of the commencement of the research in question, to share the costs and the risks of R&D to be undertaken under mutual direction and for mutual benefit. Each participant bears an agreed share of the costs and risks and is entitled, in return, to an appropriate share of any resulting future benefits. 84 International Transfer Pricing 2015/16

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Cost-sharing arrangements of this nature are not unknown between companies that are not related, and in many respects resemble joint venture activities or partnerships. As a result, there is a prima facie indication that they are likely to be acceptable in principle to the majority of tax authorities. All participants in a cost-sharing arrangement must be involved in the decisionmaking process regarding the levels of expenditure to be incurred in R&D, the nature of the R&D to be conducted and the action to be taken in the event that proves abortive. Members also need to be involved in determining the action to be taken to exploit successful R&D. Their prima facie right to benefit from the R&D activity can be exploited through their own commercialisation of products or through selling or licensing the R&D results to third parties within their specified rights (typically territories) under the terms of the CCA. Typically, any income received from thirdparty arrangements would be deducted from the R&D costs before allocation of the net R&D costs among the signatories to the cost-sharing agreements. Cost-sharing agreements Because cost-sharing is a method of sharing the costs and risks of the development of intangibles, the key to cost-sharing is that the agreement exists prior to the development of the intangibles so that all parties share the risk of development (i.e. cost-sharing is a method of funding the development process). Each participant in the cost-sharing arrangement must bear its share of the costs and risks, and in return will own whatever results from the arrangement. For a description of cost-sharing after the development of the intangible has already begun, (see Establishing cost-sharing arrangements in mid-stream, below). Allocation of costs among participants The strongest theoretical basis for allocating R&D expense among members of a cost-sharing arrangement is by reference to the actual benefits they derive from that arrangement. However, not all R&D expenditure gives rise to successful products for exploitation, and there must be a mechanism to deal with abortive expenditure as well as successful expenditure. Because of this fact, arrangements usually try to allocate expenditure by reference to the expected benefits to be derived from the R&D. Such a method of allocation is necessarily complicated to devise and, in practice, considerable regard is given to the relative sales of each participant. Hybrid arrangements are also used from time to time, whereby current sales or other relevant business ratios are used for determining the expense allocation and hindsight adjustments are made where the original allocation proves to be inequitable. Whenever R&D gives rise to intangible property that can be patented, all members of the cost-sharing arrangements have rights to it. The fact that it may be registered with one member of the cost-sharing arrangement does not give any priority to that member in the exploitation of the intellectual property. In effect, the registered holder is acting in a trustee capacity for the benefit of the cost-sharers as a group. Although most tax authorities prefer to follow the general tests previously propounded by the OECD and now embodied in Chapter VIII of the OECD Guidelines, some tax authorities have special rules for dealing with cost-sharing arrangements. The National People’s Congress of China recently passed the Corporate Income Tax (CIT) Law which will become effective 1 January 2008, and under Article 41 includes legal framework supporting CCAs and provides clarification for a number of issues. In March 2006, Japan for the first time released guidelines on CCAs that provide a definition and www.pwc.com/internationaltp 85

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Specific issues in transfer pricing guidance on the administration of CCAs, the treatment of pre-existing intangibles and appropriate documentation. Also, Australia issued Taxation Ruling 2004/1, which accepts and builds upon the views in Chapter VIII of the OECD Guidelines in the context of the relevant provisions of the Australian income tax law. The most notable exception from following the OECD Guidelines is the US. The US issued final cost-sharing regulations in 1995 (the 1995 US final cost-sharing regulations), proposed regulations in 2005 (the 2005 US proposed cost-sharing regulations), and most recently in 2008 (the 2008 US temporary cost-sharing regulations). Where authorities do have rules, such as the US rules on cost-sharing arrangements, there is a growing tendency for the rules to be complex and restrictive. Furthermore, prior to the issue of Chapter VIII of the OECD Guidelines, there was some variation between different taxing authorities as to whether profit margins are acceptable within cost-sharing arrangements. As noted above, Chapter VIII of the Guidelines now focuses upon whether the allocation of costs among the participants reflects the relative benefits inuring to the parties. This point can be illustrated by considering a cost-sharing arrangement. Example A, B and C decide to work together and spend up to an agreed amount in trying to design the world’s greatest mousetrap. If successful, A will have rights to the intangibles in the Americas, B in Europe and C in the rest of the world. In practice, C is prepared to do most of the work involved, charging A and B their allocations of the amounts to be cost-shared. In this situation, there is no joint sharing of cost, risk and benefit, and therefore no cost-sharing arrangement (or, technically, a CCA) under Chapter VIII of the Guidelines. Rather, C will incur most of the costs and risks, and hence, the benefits. Under Chapter VIII of the Guidelines, in order to satisfy the arm’s-length standard, the allocation of costs to A and B would have to be consistent with their interests in the arrangement (i.e. their expected benefits) and the results of the activity. Under these facts, the arrangement with C for the provision of services would be evaluated for transfer pricing purposes from the standpoint that C will incur most of the costs, risk and benefits. Additionally, C would be the developer for purposes of the intangible property provisions of the Guidelines. Deductibility of cost-sharing payments As noted in the Cost sharing arrangements section above, cost-sharing arrangements may be entered into by third parties, and it follows, therefore, that similar arrangements should be regarded as, prima facie arm’s length where entered into by related companies. However, a key issue as far as each taxation authority is concerned, is whether the net costs borne by the entity under their jurisdiction are deductible for tax purposes on a revenue basis. To determine the deductibility of these costs, there will need to be reference to the tax treatment of specific types of expenditure under local law and practice. As a result, it will be decided whether the costs incurred qualify as a revenue deduction or whether they should, for example, be treated as capital (in whole or part) and therefore subject to different rules. The more fundamental question, however, is whether the proportion of cost allocated to the company under review is reasonable. This scenario necessarily requires a review of the total cost-sharing arrangement. It is not uncommon for a tax authority to require a detailed examination of the cost-sharing arrangement at group level and not just 86 International Transfer Pricing 2015/16

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at the level of the company they are looking at. Consequently, they will need to see the cost-sharing agreement in writing and be convinced that it was entered into in advance and that the basis on which costs are allocated is reasonable. They will require convincing that the costs being accumulated are in accordance with the agreement and do not include costs not covered by the agreement. They will wish to see that the company they are auditing has a reasonable expectation that proportionate benefits will accrue from the cost-sharing payments. It is clear, therefore, that a multinational enterprise must expect to make a considerable level of disclosure on a wide geographical basis if it proposes to enter into and successfully defend a cost-sharing arrangement. Hence, it is of crucial importance that any cost-sharing policy be fully documented and its implementation and operation carefully managed and controlled. The greatest problems with tax authorities are experience, in practice, where R&D is relatively long-term in nature or where there are significant levels of abortive expenditure. The tax authorities always have the benefit of working with hindsight and long development times, or abortive expenditure makes it more difficult to demonstrate the expectation of benefits at the time the contributions to the costsharing arrangement were made. Examining the nature of costs to be included and allocated under a cost-sharing arrangement, the OECD argues that indirect costs of R&D should be shared by the participating companies in addition to the direct costs. Indirect costs would be those that were not directly involved with R&D, but which nevertheless are intrinsically related to the direct cost elements and, typically, would include all the general overhead expenses of running a research business. Since such an allocation will necessarily involve approximations, the tax authorities are likely to scrutinise it closely. Local country laws vary as to whether any particular item of expenditure is deductible. If the amount being charged under the cost-sharing arrangement is the proportionate share of assets of a capital nature, such as machines, buildings, etc., questions may arise as to whether the cost will be treated as revenue or capital for accounting purposes and tax purposes. For instance, it may be necessary to look through the total allocated expense and analyse it into its constituent parts, consisting of, for example, R&D expenditure or depreciation on buildings. To the extent that national practices on the tax relief given for capital expenditure vary considerably, timing and absolute differences may emerge. Any kind of subsidy received for R&D purposes (whether through government grants, third-party royalty income earned from exploiting technology derived from the costsharing facility, etc.) should be deducted before determining the net amount of costs to be allocated under the terms of the cost-sharing arrangement. Particular care must be taken to demonstrate that the companies involved in the costsharing arrangement are not paying twice for the costs of the same R&D. For instance, no part of the R&D expenses dealt with under cost-sharing should be reflected in the transfer price of goods to be acquired by a cost-sharer. www.pwc.com/internationaltp 87

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Specific issues in transfer pricing Looking at the question of whether a profit margin should be added to the pool of costs allocated among the sharers, an earlier report of the OECD concluded that it would normally be appropriate for some kind of profit element to be included, but that it should relate only to the organisation and management of R&D and not the general investment risk of undertaking it, as that risk is being borne by the participants. As noted above, however, Chapter VIII of the OECD Guidelines now focuses upon whether the allocation of costs among the participants reflects the relative benefits inuring to the parties. A profit element is thus no longer to be allocated among the participants in the cost-sharing arrangements. Payments under cost-sharing schemes are not generally regarded as royalties for tax purposes and therefore are typically not subject to withholding taxes. Cost-sharing adjustments By their nature, most cost-sharing arrangements are long-term. The allocation of costs to participants by reference to their relative anticipated benefits is also an inexact science and can be tested for reasonableness only over an extended period. Chapter VIII of the OECD Guidelines recognises these difficulties and provides that adjustments should not therefore be proposed in respect of just one fiscal year’s apparent imbalance between cost-sharers. It also provides that tax authorities should challenge an allocation of costs under a cost-sharing arrangement when the tax authority determines that the projection of anticipated benefits would not have been used by unrelated parties in comparable circumstances, taking into account all developments that were reasonably foreseeable by the parties at the time the projections were established and without the use of hindsight. Consequently, the tax authority would have to conclude that the cost-sharing arrangement was not entered into in good faith and was not properly documented when implemented. If a tax authority does successfully contend that a correction is required, the position can become complex. In essence, an imputed charge to the other cost-sharers will be imposed. This charge imposes considerable difficulties with respect to obtaining relief for the additional costs in the other cost-sharers. In the absence of multilateral tax agreements, the group will need to begin simultaneous requests for relief under a number of separate double tax agreements, which is likely to prove a lengthy task. Cost-sharing and risk Cost-sharing arrangements can be implemented only prospectively. Becoming a cost-sharer represents a change in the nature of business for the paying company. By implication, it becomes involved in the high-risk activity of R&D and agrees to carry the business risk of significant future expenditure. While the offsetting income that it hopes to generate in the future is of value, this income may not accrue for quite some time. Overall, risk is therefore increased and the participants expect eventually to see a corresponding increase in general levels of profitability. However, before the future income stream starts to arise, it is likely that overall expenses will increase in the contributing companies. Therefore, during this transitional phase, there may be a dramatic reduction in profitability taking place at the same time as an increase in business risk. This result will increase the chance of a review of inter-company transactions by the local tax authorities. Lost or delayed income tax deductions and possible limitations on the deduction of start-up losses might also arise during the transitional phase. These items might magnify unprofitable operations and increase business risk. 88 International Transfer Pricing 2015/16

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Cost-sharing arrangements also attract the authorities’ attention because they typically appear as a new category of expense in company accounts and tax returns where, historically, cost-sharing has not been practised. Change is always an occasion when tax authorities might identify an area as worthwhile for investigation. Once implemented, the cost-sharing arrangement must be actively monitored by all involved parties. Care should be taken to ensure that the legal form of the costsharing agreement reflects its substance. In addition, the documentation of the active involvement of the members in policy setting, monitoring and controlling the costsharing agreement on a current basis is indispensable. The participants Cost-sharing is generally performed among manufacturing, distribution or standalone R&D companies. While cost-sharing arrangements have traditionally been most popular between manufacturing companies, distribution and standalone R&D companies are increasingly becoming participants. This change is in part due to the increasing use of third-party contract manufacturers. In a cost-sharing arrangement among manufacturing companies, the manufacturers produce goods that are sold at a price that reflects the R&D costs incurred. Any associated distribution companies are remunerated only for their distribution functions and risks. A cost-sharing arrangement involving a distribution company may fundamentally change the functions and risks typically performed by each participant and greatly increase the complexity of the group’s transactions. The distribution company effectively assumes the functions and risks of a research company and distributes goods that are sold at a price that reflects the R&D costs incurred. In this type of cost-sharing arrangement, the manufacturing company assumes the functions and risks of a contract manufacturer that produces goods sold to the distributor (that owns the intellectual property) for a price that reflects the contract manufacturing costs incurred. To the extent that most of the R&D is concentrated in one company in physical terms, cost-sharing at the distribution company level represents a purely fiscal decision, since the substantive activities of the distribution company do not directly utilise the fruits of the R&D expenditure. While cost-sharing may be achieved in legal and financial terms through the use of contracts, it remains true that arrangements that are purely fiscal in nature are coming under increasing attack by tax authorities around the world. Establishing cost-sharing arrangements in mid-stream If a company has historically conducted and funded R&D in one legal entity and wishes to establish a cost-sharing arrangement in the future, the company must carefully consider two issues: • Buy-in payments. • The business issue regarding the location of ownership of intangible property (i.e. which entities are characterised as the developer of the intangible – under the OECD Guidelines, the developer is the entity that acquires legal and economic ownership of the intangible property). www.pwc.com/internationaltp 89

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Specific issues in transfer pricing Buy-in arrangements When a group decides to form a cost-sharing arrangement to fund the development phase, as opposed to the research phase of R&D, an important issue arises: whether a payment should be made by a company entering into a cost-sharing arrangement with the owner of existing technology. This concept, known as ‘buy-in’, has been under debate for some time but came under widespread review following the publication of a white paper by the IRS in the US in 1988. This white paper interpreted the transfer pricing proposals contained in the Tax Reform Act of 1986 in the US, which obtained widespread publicity. Most tax authorities are now aware of the concept of buy-in and are in the process of considering the issues raised by this concept. The concept of buy-in is based on the view that when a new member joins a costsharing arrangement, the benefits emerging from research typically not only build on current R&D costs but also capitalise on past experience, know-how and the prior investment of those involved in the earlier cost-sharing arrangement. Consequently, the new member receives benefits from the historical expenditure of the earlier participants, although it did not contribute to those costs. In the international context, the US has made the point very strongly that it is inappropriate for a new member to receive these benefits free of charge. While the need for a buy-in payment is well-established, the required computation may be controversial. The IRS has advocated that a valuation be carried out to determine an amount that would be appropriate to be paid to the original cost-sharers by the new member, reflecting the fact that the latter has obtained access to know-how and other valuable intangible property, which it will not be paying for through its proportionate share of future R&D expenditure. The 1988 white paper indicated that the buy-in valuation should encompass all preexisting, partially developed intangibles, which would become subject to the new cost-sharing arrangements, all basic R&D not directly associated with any existing product, and the going-concern value of the R&D department, the costs of which are to be shared. The 1995 US final cost-sharing regulations provide that buy-in payment is the arm’s-length consideration that would be paid if the transfer of the intangible was to, or from, an unrelated party. The arm’s-length charge is determined under the pertinent part of the US regulations, multiplied by the controlled participant’s share of reasonable anticipated benefits. The 2008 US temporary cost-sharing regulations refer to buy-in payments as platform contribution transactions (PCTs) and expand the definition of intangible property subject to a PCT payment as any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost-shared intangibles. Under this new definition, the contribution of an experienced research team in place would require adequate consideration in the PCT payment. Such a team would represent a PCT for which a payment is required over and above the team’s costs included in the cost-sharing pool. The 2008 US temporary cost-sharing regulations also make an important change to the requirements under which reasonably anticipated benefit ratios are calculated for PCTs 90 International Transfer Pricing 2015/16

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and cost-sharing arrangements. There is now an explicit requirement that reasonably anticipated benefit ratios be computed using the entire period of exploitation of the cost-shared intangibles. Furthermore, the 2008 US temporary cost-sharing regulations reiterate that the rights required to be transferred in order to eliminate a perceived abuse where the transfer of limited rights could result in lower PCT payments. Therefore, under these 2008 US temporary cost-sharing regulations, the PCT payment must account for the transfer of exclusive, non-overlapping, perpetual and territorial rights to the intangible property. The 2008 US temporary cost-sharing regulations also consider other divisional bases in addition to territorial basis, including field of use. Similar to the 2005 US proposed cost-sharing regulations, the 2008 US temporary cost-sharing regulations do not allow a reduction in the PCT for the transfer of existing ‘make or sell’ rights by any participant that has already paid for these rights. Another significant change in the 2008 US temporary cost-sharing regulations is the so-called ‘periodic adjustment’ rule, which allows the IRS (but not the taxpayer) to adjust the payment for the PCT, based on actual results. Unlike the ‘commensurate with income’ rules, the temporary regulations provide a cap on the licensee’s profits (calculated before cost-sharing or PCT payments) equal to 1.5 times its ‘investment’. (For this purpose, both the profits and ‘investment’ are calculated on a present value basis.) Notably, this periodic adjustment is waived if the taxpayer concludes an APA with the IRS on the PCT payment. There is also an exception for ‘grandfathered’ CSAs, whereby the periodic adjustment rule is applied only to PCTs occurring on or after the date of a ‘material change’ in scope of the intangible development area. The 2008 US temporary regulations also provide exceptions to the periodic adjustment rule in cases where the PCT is valued under a CUT method involving the same intangible and in situations where results exceed the periodic adjustment cap due to extraordinary events beyond control of the parties. In addition, the 2005 US proposed cost-sharing regulations introduced the ‘investor model’ approach, which provides that the amount charged in a PCT must be consistent with the assumption that, as of the date of the PCT, each controlled participants’ aggregate net investment in developing cost-shared intangibles pursuant to a CCA, attributable to external contributions and cost contributions, is reasonably anticipated to earn a rate of return, equal to the appropriate discount rate. The 2008 US temporary cost-sharing regulations significantly change the application of the investor model. This model indicates that the present value of the income attributable to the CSA for both the licensor and licensee must not exceed the present value of income associated with the best realistic alternative to the CSA. In the case of a CSA, the 2008 US temporary cost-sharing regulations indicate that such an alternative is likely to be a licensing arrangement with appropriate adjustments for the different levels of risk assumed in such arrangements. The 2008 US temporary cost-sharing regulations also recognise that discount rates used in the present value calculation of PCTs can vary among different types of transactions and forms of payment. These new proposed rules are discussed in more detail in the US chapter. Furthermore, the requirements under the Temporary Regulations for application of the Residual Profit Split Method will likely restrict the use of this method to certain cases where the licensee brings pre-existing intangibles to the CSA. In cases where the licensee does not possess pre-existing intangibles, the Income Method, Market Capitalisation Method and Acquisition Price Method are likely to predominate. www.pwc.com/internationaltp 91

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Specific issues in transfer pricing Chapter VIII of the OECD Guidelines supports the use of buy-in payments as the incoming entity becomes entitled to a beneficial interest in intangibles (regardless of whether fully developed), which it had no rights in before. As such, the buy-in would represent the purchase of a bundle of intangibles and would need to be valued in that way (i.e. by applying the provisions of the Guidelines for determining an arm’s-length consideration for the transfers of intangible property). Note that the terminology employed in Chapter VIII of the Guidelines, the 1995 US final cost-sharing regulations and the 2008 US temporary cost-sharing regulations with respect to this concept is somewhat different. Under Chapter VIII, a buy-in is limited to a payment made by a new entrant to an existing cost-sharing arrangement for acquiring an interest in the results of prior activities of the cost-sharing arrangement. Similarly, a buyout refers only to a payment made to a departing member of an existing cost-sharing arrangement. Chapter VIII refers to any payment that does not qualify as a buy-in or a buyout payment (e.g. a payment made to adjust participants’ proportionate shares of contributions in an existing cost-sharing arrangement) as a ‘balancing payment’. In contrast, the 1995 US final cost-sharing regulations use the terms more broadly. Buy-in and buyout payments refer to payments made in the context of new as well as existing cost-sharing arrangements under these regulations. There is no such thing as a balancing payment in the 1995 US final cost-sharing regulations. In further contrast, the 2008 US temporary cost-sharing regulations refer to buy-in payments as PCTs for which the controlled participants compensate one another for their external contributions to the CCA. In addition, post-formation acquisitions (PFAs) occur after the formation of a CCA and include external contributions representing resources or capabilities acquired by a controlled participant in an uncontrolled transaction. If payments are to be made to another participant in the cost-sharing arrangement (regardless of whether the payment is characterised a buy-in, a buyout or a balancing payment), consideration must be given to the tax deductibility of such payments made by the paying entity and their accounting treatment. Unless there is symmetry between their treatment as income in the recipient country and deductible expenditure in paying countries, a related group might well face significant double taxation as a result of the buy-in payment. The buy-in payment issue must be addressed on each occasion a new company becomes involved in the cost-sharing arrangement. Ownership of intangibles Since cost-sharers own the technology developed through the cost-sharing arrangements, when technology is partially developed prior to the commencement of the arrangement and then modified or further developed as part of the arrangement, an issue arises concerning the ownership of the resulting technology. This area is murky and may lead to significant business problems if defence of the property rights becomes necessary. Example Bozos Unlimited (BU), a US company, manufactures toy clowns sold to children worldwide through wholly-owned subsidiaries located in Canada, Germany, France and the UK. Its manufacturing activities are conducted in the US and in a whollyowned subsidiary in Ireland. Currently, the Irish subsidiary pays a 3% royalty to the parent for the technology that it uses and all R&D has, to date, been conducted in the US and paid for by BU. 92 International Transfer Pricing 2015/16

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To meet child safety requirements throughout the world, as well as to reduce manufacturing costs so that its product remains competitive, BU has decided to embark on a major R&D effort. The cost will be significant, and BU realises that it will need the financial resources of the Irish subsidiary to help fund this project. It has decided that neither dividends nor an inter-company loan are desirable, and a cost-sharing arrangement is therefore selected. To implement the cost-sharing arrangement, BU must address the following issues: • The need for a buy-in payment. • The amount of the cost-sharing payment to be made by the Irish subsidiary. • The rights which will be given to the Irish subsidiary. Because the Irish subsidiary has been paying for the pre-existing technology through the licence agreement, it is determined that this arm’s-length royalty rate is sufficient under Chapter VIII of the OECD Guidelines to compensate BU for the existing technology. However, under the 1995 US final cost-sharing regulations, the buy-in payment is required to be the arm’s-length charge for the use of the intangible under the pertinent provisions of the US transfer pricing regulations, multiplied by the Irish subsidiary’s anticipated share of reasonably anticipated benefits. The prior royalty payments will likely be insufficient, and the Irish subsidiary will have to pay a buy-in payment to the parent to the extent that the royalty payments made are less than the required buy-in payment amount. In further contrast, under the 2008 US temporary cost-sharing regulations, the prior royalty payments would be considered ‘make or sell’ rights, which cannot reduce the amount of the buy-in for the existing technology. Under Chapter VIII of the OECD Guidelines, the cost of the R&D is calculated by aggregating the direct and indirect costs of the R&D activities; this expense is divided between BU and its Irish subsidiary, based on the relative sales of both entities. Under the 1995 US final cost-sharing regulations and 2008 US temporary cost-sharing regulations, the cost of the R&D is calculated by aggregating certain operating expenses other than depreciation or amortisation charges (i.e. expenses other than cost of goods sold, such as advertising, promotion, sales administration), charges for the use of any tangible property (to the extent such charges are not already included in operating expenses) plus charges for use of tangible property made available by a controlled party. Costs do not include consideration for the use of any intangible property made available to the cost-sharing arrangement. Under the 1995 US final cost-sharing regulations, 2008 US temporary cost-sharing regulations and Chapter VIII of the OECD Guidelines, these costs are allocated between BU and its Irish subsidiary in proportion to their shares of reasonable anticipated benefits from the developed R&D. However, the 2008 US temporary cost-sharing regulations specify the reasonable anticipated benefits shares be computed using the entire period of exploitation of the cost-shared intangibles. The rights that will be granted to the Irish subsidiary under the agreement are the use of the technology in respect of sales outside North America. Under the 2008 US temporary cost-sharing regulations, the rights granted to the Irish subsidiary must be the exclusive and perpetual use of the technology in respect of sales outside North America. www.pwc.com/internationaltp 93

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Specific issues in transfer pricing Other types of cost-sharing agreements Costs other than those involving R&D can also be shared through a cost-sharing arrangement. For example, common costs such as accounting, management and marketing can be the subject of a cost-sharing agreement among the affiliates that benefit from the services offered. (See Management services section, earlier for further discussion of this type of cost-sharing arrangement.) Foreign exchange and finance Foreign exchange risk – introduction Unexpected foreign exchange-rate fluctuations pose one of the most difficult commercial challenges to an effective inter-company pricing policy. On several occasions over the past 20 years, the value of currencies such as the US dollar and UK pound sterling have moved by up to 40% over a relatively short time, only to rebound by a similar amount. Exchange-rate fluctuations affect the competitiveness of a multinational firm’s various worldwide operations. A depreciating US dollar, for instance, tends to improve the export competitiveness of US-based manufacturers. If a multinational firm’s transfer prices do not respond to changing competitive pressures, the composition of the firm’s worldwide profit profile will be distorted. These distortions can disrupt a multinational firm’s production, financial and tax planning. The arm’s-length standard The arm’s-length standard requires related parties to set their inter-company pricing policies as if they were unrelated parties dealing with one another in the open market. It follows that this principle requires a multinational firm’s transfer pricing policy to include an exchange-rate adjustment mechanism similar to that which would be employed by unrelated parties in similar circumstances. Unfortunately, firms across different industries, and even within the same industry, respond to exchange-rate changes differently. Sometimes, the manufacturer bears the exchange risk, sometimes the distributor bears it, and sometimes the two share it. The choice of which party will bear the exchange risk depends on the multinational firm’s unique set of facts and circumstances. If, for instance, the manufacturing arm of the firm sells to many different related distributors in many countries, it may make most sense for it to centralise foreign-exchange risk. The profits of the company bearing the exchange risk will fluctuate with the relevant exchange rates. When these fluctuations are unusually large, they are likely to draw the attention of the domestic or foreign tax authorities. Types of exchange-rate exposure The exchange-rate exposures of a multinational enterprise can be categorised as translation (see Translation exposure, below), transaction (see Transaction exposure, below) and economic (see Economic exposure, below) exposure. Translation exposure Translation exposure, often referred to as accounting exposure, relates to the multinational firm’s need to translate foreign currency denominated balance sheets into its domestic currency, so that the multinational firm can create a consolidated balance sheet. It measures the change in the consolidated net worth of the entity, which reflects changes in the relevant exchange rate. 94 International Transfer Pricing 2015/16

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Transaction exposure Transaction exposure concerns the impact of unexpected exchange-rate changes on cash flows over a short time, such as the length of existing contracts or the current financial planning period. It measures the gains or losses arising from the settlement of financial obligations, the terms of which are stated in a foreign currency. If the currency of denomination of a transaction is the domestic currency – for instance, if the invoices are stated in terms of the domestic currency – the domestic firm could still bear transaction exposure if the domestic currency price varies with the exchange rate. For example, assume that a contract between a Japanese manufacturer and a Belgian distributor states the price of goods in Euros. It would appear that the Belgian company bears no exchange risk. However, if the euro price is adjusted to keep the Japanese company’s yen revenues constant when the yen/euro exchange rate changes, then the Belgian company is exposed to exchange risk. Consequently, transaction exposure depends not on the currency of denomination of a contract or transaction but on the currency that ultimately determines the value of that transaction. Economic exposure Economic exposure measures the change in the value of the business resulting from changes in future operating cash flows caused by unexpected exchange-rate fluctuations. The ultimate change in the firm’s value depends on the effect of the exchange-rate movement on future volumes, prices and costs. Economic exposure consequently looks at the effects once the market has fully adjusted to the exchangerate change. Factors that determine the degree of economic exposure include the following: • • • • Market structure. Nature of competition. General business conditions. Government policies. Example USM, a US-based manufacturer of auto parts, exports its product to UKD, its UK-based distribution subsidiary. UKD sells parts to unrelated retailers throughout the UK. USM denominates the transfer price in pounds and converts its pound receipts into dollars. USM has adopted a resale price approach to set its transfer price for goods sold to UKD. The resale price method calculates the transfer price by deducting an arm’s-length markup percentage for UKD’s distribution activities from the resale price. Given this pricing method, USM bears all the foreign-exchange transaction exposure. When the value of the dollar appreciates, USM reaps unexpected exchange-rate gains on its dollar receipts; when the value of the dollar depreciates, USM incurs unexpected exchange-rate losses. Planning opportunities The presence of foreign exchange risk in inter-company transactions provides some potentially valuable planning opportunities to multinational firms. These opportunities relate to the strategic placement of foreign-exchange risk. The more risk that a particular entity bears, the higher the compensation it should earn, and a multinational can place foreign-exchange risk in one entity or another by the way that it sets its transfer prices. www.pwc.com/internationaltp 95

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Specific issues in transfer pricing Example A large automotive company manufactures auto parts in many countries, operates final assembly plants in several other countries, and then sells products in virtually every country around the world. This firm’s inter-company transactions generate enormous exchange-rate exposures. For example, each assembly plant purchases parts from its affiliates located in as many as 15 countries and then sells finished automobiles in over 50 countries. The firm has a number of choices to make concerning the management of its foreign exchange risk. Each of the plants incurs expenses denominated in local currency, such as wages, rent, interest and taxes. In an effort to help smooth out the cash flow of these local companies so they can pay local expenses with a minimum of concern about exchange rate fluctuations, corporate management may wish to insulate them from exchange rate exposure. The company could, for instance, establish a trading company that would buy and sell raw materials, parts and finished products from and to each of the local operating companies in the company’s local currency. The trading company would, in these circumstances, bear all of the firm’s foreign exchange risk. Because all goods sold inter-company would pass through the trading company, this company could also centralise and coordinate the purchasing of supplies for the firm’s worldwide operations. By acting as the central agent, the trading company could ensure that supplies were always procured from the suppliers offering the lowest prices, and could capitalise on volume discounts where available. Clearly, in order to be tax effective, the creation of the trading company would need to be supported by a well-established business plan that significantly altered the operations of existing entities and placed real business functions and risks in the trading company. Furthermore, the trading company’s employees must have a level of expertise and be sufficient in number to conduct its business. For instance, if it reinvoices and manages foreign-exchange risk, it needs accountants to handle the invoicing and the collection activity plus foreign-exchange managers to deal with hedging. As with all inter-company transactions, it is necessary to apply an arm’s-length pricing policy between the trading company and its affiliates. The more functions and risks transferred to the trading company, the higher the return that the trading company should earn. Instead of centralising foreign-exchange risk in a trading company, the automotive firm could decide to place all foreign-exchange risk in the local operating companies. In this way, it would force the local managers to control and minimise all of the risks generated by their operations. The return earned by each of the operating companies would then have to be adjusted upwards by enough to compensate them for the additional foreign-exchange exposure. Loans and advances The financial structure is important when considering a range of planning moves with a multinational group, such as: • starting a business in another country • financing expansion 96 International Transfer Pricing 2015/16

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• underwriting losses of troubled subsidiaries, and • determining or establishing a trading account between two affiliates. The use of debt frequently aids in the movement of earnings from one country to another in a tax-efficient manner. The financial structure may also be important in establishing commercial viability in another country. Various types of credit may be involved, including: • • • • • Demand loans. Term loans. Temporary advances. Open trading accounts. Cross-border guarantees or other collateralisation of an affiliate’s outstanding debt. Characterisation of loans For tax purposes, the issue of the characterisation of funds placed with a subsidiary as debt or equity was considered in Financing transactions in Chapter 2. In summary, many countries have specific rules or practices that restrict the permissible level of related-party debt, and it is crucial to review these before adopting any amendments to the group’s international financial structure. Interest on loans The arm’s‑length principle is applicable to the rate of interest paid on inter-company debt. Developed countries have rules that embody the arm’s‑length principle. However, application of the principle by the tax authorities in each country and by each country’s courts varies significantly. The basic principle is that the interest rate to be charged between related parties is the market rate of interest that would be charged at the time the indebtedness arose between unrelated parties, assuming similar facts and circumstances. The facts and circumstances that should be taken into consideration include: • • • • • • • • • • • • • • Repayment terms (i.e. demand, short-term, long-term). Covenants. Collateralisation. Guarantees. Informal and temporary advances. Open lines of credit. Leasing arrangements that are not bona fide leases. Trading accounts. Credit risk of the debtor (i.e. debt-to-equity ratio). Volatility of the business. Reliance on R&D or other high-risk investments such as oil and gas exploration. Track record of affiliate. Location of exchange risk. The market – differences may exist among the markets of various countries, the regional market such as the European market or the Eurodollar market. This general principle is used in most countries, but some provide a ‘safe harbour’. Consequently, although a provision is made for arm’s-length interest rates, if an interest rate falls within a specified range, other factors of comparability will be ignored. For instance, in Switzerland, the tax authorities have issued required minimum and www.pwc.com/internationaltp 97

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Specific issues in transfer pricing maximum rates based on the Swiss market. However, deviations from the rate may be made when the debt is in foreign currency or the difference is modest and the rationale is reasonable. The US also has an extensive system of safe harbours. Loan guarantees Generally, the tax authorities are silent on the treatment of guarantees of indebtedness provided by related parties. Presumably, such guarantees should require an arm’slength fee for the guarantee. The fee would be determined by the fee that would be charged for such a guarantee between two unrelated taxpayers under similar circumstances. Since such guarantees are infrequent, the arm’s‑length principle may be difficult to apply. However, when the interest rate between the borrower and the lender is reduced by virtue of the guarantee, the interest rate reduction can be used as a measure of the value of the guarantee. This concept has recently attracted significant attention from the OECD in its working papers on global dealings as well as in the US. As such, one can expect to see more activities in the examination of these types of arrangements in the near future. Bona fide leases Leasing as a form of loan financing is discussed in Chapter 2 under Lease financing. The use of a bona fide lease as a means of securing the use of tangible property without bearing the risk of ownership is another type of financing. In this context the transfer pricing rules relating to interest rates are not appropriate. However, rules prescribed by the tax authorities on arm’s-length rental rates are minimal. The OECD does not provide guidelines, and most countries do not address the subject, even in a general manner. It is thought that cross-border leasing of equipment (using bona fide leases) is not common practice (being focused mainly on individual, high-value transactions requiring individual treatment), probably because cross-border leasing is commercially complex and raises myriad business and tax issues. For instance, owning equipment located in some countries may create a permanent establishment problem for the foreign-based lessor. In addition, there may be withholding taxes on rentals payable under certain jurisdictions. Establishing an arm’s-length rental rate Most countries accept proof of an arm’s-length rental rate based on one of the following methods: • • • • A comparable uncontrolled price. Pricing based on economic depreciation of the leased asset. Pricing based on interest and a profit markup for risk. Pricing based on any other method for establishing a reasonable rent. E-business Introduction There are no transfer pricing rules specific to e-business and none are currently being proposed. However, this situation has not prevented a great deal of discussion taking place about the impact of e-business and new business models on the application of traditional transfer pricing concepts. Instantaneous transactions across international boundaries – which are quicker, more frequent, often highly automated and involve the greater integration of functions within a multinational group – potentially make it harder to perform a traditional 98 International Transfer Pricing 2015/16

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analysis of functions, assets and risks. What is it that creates value, for instance, where huge costs may be taken out of the supply chain by the use of a software platform that links the entire chain from raw materials supplier to ultimate customer? Can one readily ascertain which party performs which specific function, and where? Given that current tax regimes work within international boundaries, and transfer pricing rules require one to attribute value to location, has it become even more difficult to establish where profit is made? And if one can successfully identify the transaction and its essential attributes, is there a readily available comparable transaction given the unique factual circumstances which, for now, may relate to certain e-business activities? Transfer pricing issues for the business community If one looks at the new business models emerging, one begins to realise that there are opportunities to reduce the tax burden. Let us start with electronic marketplaces. These are the online exchanges and networked business communities, usually involving established businesses, which allow these businesses to buy and sell products and services. These exchanges are often multi-member joint ventures with geographically diverse investors and newly hired management and staff. They are lean operations with high potential value and no loyalty to any particular geographical or business location. Despite the deflation of the dot.com bubble, interest in such business models continues, with some caution over the measure of benefits expected. The playing field is by no means level and the right choice of location can have a great positive impact on the rates of return for investors. Tax is a significant factor in choosing where to set up a new business and, despite what some may say, competition in this area is alive and well. There is also the issue of how established businesses are starting to transform themselves. The new technology has allowed new businesses finally to integrate changes that took place in the 1990s – in particular, restructuring and business process standardisation and a focus on core skills. These changes have brought the emergence of brand owners, or entrepreneurs, who outsource non-core physical activities across the supply and demand chains. They may even move out of manufacturing entirely and simply have finished products shipped from external suppliers. Bring tax and transfer pricing into this process and the who, what and where of what a business does has a crucial impact on the earnings that a business generates. Whether a website or server has a taxable presence in another country into which the business is selling pales in importance beside the priority of ensuring that the value in this streamlined and more mobile business is created in the most friendly tax jurisdiction. The change in business model has afforded the established business an ideal opportunity to revisit the tax efficiency of how and from where they operate. Issues for tax authorities Tax authorities have been concerned about the perceived difficulty of identifying, tracing, quantifying and valuing web-enabled cross-border transactions. A number of countries including Australia, Canada, Ireland, New Zealand, the UK and the US, issued reports on the tax implications of e-business, which included discussions about the impact of e-business on existing transfer pricing rules and practices. However, there has been a general recognition that the response, if needed, has to be international and has to be coordinated. Consequently, tax authorities within and outside the OECD www.pwc.com/internationaltp 99

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Specific issues in transfer pricing have used the OECD as the forum to address the issues and produce appropriate international guidance. This debate at the OECD has produced some conclusions which have been incorporated in the latest version of the OECD Model Tax Convention on income and on capital, which was released in January 2003. For instance, it has been concluded by most OECD countries that a website by itself does not constitute a permanent establishment, as it is not tangible property and so cannot be a fixed place of business. However, if the enterprise that carries on business through the website also owns or leases the server on which the website is located, then the enterprise could have a permanent establishment in the place where the server is located, depending on the nature and extent of the activities carried on through the server and the website. Other issues, such as the attribution of profit to a server permanent establishment remain to be resolved and the work of the OECD on the taxation of e-commerce continues. 100 International Transfer Pricing 2015/16

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6. Managing changes to a transfer pricing policy Introduction From time to time, it will become necessary to change a group’s transfer pricing policy, and these amendments themselves can give rise to a considerable range of problems. In addition to deciding exactly what changes to make, the group must address the challenges involved in communicating the changes to all those involved, ensuring that the new procedures are implemented smoothly, and monitoring the effects of the changes on the profitability of the legal entities involved. Additionally, several strategic questions must be dealt with concerning, in particular, the timing of the changes and the evaluation of their possible effect on the perception of the group’s operations, both by the users of the group’s accounts and the tax authorities that deal with the affairs of the group in various countries. The purpose of this chapter is to guide the reader through these difficult areas and to highlight the critical points that require attention. Transfer pricing committee To guarantee the smooth operation of a transfer pricing policy, all aspects of the transfer pricing process need to be carefully monitored on an ongoing basis. The functional analysis must be kept up to date, as must information on industrystandard operating practices, comparables and the financial performance of each legal entity within the group. In particular, it is necessary to consider alterations to the transfer pricing policy, which may be required to allow for changes in the business, such as acquisitions, major new product lines, new geographic markets and competitors. For any group with significant inter-company transactions, this can be a mammoth undertaking. A helpful approach is to establish a committee to assist in the management of pricing policy. The committee should consist of individuals with a clear understanding of each of the major commercial departments within the company, including R&D, manufacturing, marketing and distribution, logistics, and after-sales service. The interests of each division or business unit should be represented so that the transfer pricing policy clearly reflects business reality and meets the needs of the group as a whole. On the financial side, the committee should include representatives from accounting, finance, tax and treasury. The responsibility of the committee is to advise on whether the arm’s-length transfer pricing policy that the group has adopted is properly and efficiently implemented and continues to work effectively. It must recommend that appropriate transfer pricing policies are implemented for new products, new geographic markets, etc. The committee’s brief will be to monitor changes in the business, whether they be major restructurings made for operational reasons, intended acquisitions, new product lines or changes in operations, and to determine whether the policy is effective or recommend changes that need to be made to correct any deficiencies. www.pwc.com/internationaltp 101

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Managing changes to a transfer pricing policy The transfer pricing committee will therefore have a wide brief to look at the group’s operations as a whole and review how the pricing policy operates. Its members must be prepared to take a broad view of the business, and the committee must be given authority to obtain the information they need and to make recommendations from an independent viewpoint. The chairperson of the committee should therefore be chosen with care as he or she will, from time to time, have to make recommendations for change, which will invariably be unpopular somewhere in the organisation. The final choice of a chairperson will naturally depend on the individuals available within the group, but it would be preferable for someone with the broadest overview of the group to take this role. In general, the chairperson should not be a tax person for the pragmatic reason that this would give the wrong message to the group’s personnel as well as to the tax authorities as to the nature of the committee’s activities. The choice of chairperson might be more or less controversial in different jurisdictions (for instance, in the US a tax person as chairperson would certainly be inappropriate), but it must be borne in mind that the committee is not a tax-planning device but a key tool in the effective financial management of the company. It would be inappropriate for other executives or the tax authorities to reach the conclusion that the committee exists purely for tax purposes. The transfer pricing committee is responsible for policy but may delegate various detailed activities to finance personnel, sales managers and plant managers. The committee should meet when major operating changes are envisaged, but otherwise a regular quarterly meeting is advisable. Setting the group’s initial pricing policy The first occasion on which a group begins to carry on part of its business on a crossborder basis is the point at which it must establish a defensible transfer pricing policy. Needless to say, this is often seen as the least important consideration for those involved (if they consider it at all), who will be far more interested in operational business issues and ensuring that the new operation is a commercial success. At this initial stage, the sums involved may be small and people may be unwilling to invest the necessary effort in establishing the policy. However, whether a company is expanding overseas for the first time or an existing group is adding a new line of business to its multinational operations, ‘getting it right first time’ must be the objective of those who are responsible for the group’s pricing policies. Any more limited objective will inevitably give rise to difficulties in resolving the group’s tax liabilities in the countries concerned and, in the medium- to long-term, necessitate making changes to the policy that could have associated tax costs and adverse fiscal implications. Active planning of the global tax charge It is not unusual for a group to begin its international operations with a transfer pricing policy that is not efficient from an effective tax rate perspective. Apart from the difficulty in devoting sufficient resources to pricing and planning when developing new markets, it is difficult to predict accurately how the overseas operations will progress in terms of sales and expenses. If the pricing policy is still less than optimal when these transactions become a material portion of the total business of the group, there will be correspondingly serious tax problems to be addressed. 102 International Transfer Pricing 2015/16

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The group should undertake a review to consider the possible courses of action that may be pursued to rectify the policy. This analysis may conclude that only fine-tuning is needed to achieve an arm’s-length result. The substance of the operations of a given legal entity determines the amount of profit that should accrue to that entity. Therefore, the only effective way of managing the worldwide tax rate, when the existing policy is arm’s length, is to change the manner in which the group conducts its operations. As a result, the group will make substantive changes in its operations to reduce income in high-tax jurisdictions and increase income in low-tax jurisdictions. However, the impact of a major change in operations of a group should not be underestimated. What appears attractive from a tax management perspective may have adverse commercial results. It is also not for the short-term – tax rates may change rapidly, but it is not easy or cheap to decommission a factory. Having said that, it may be easier to ‘move’ some of the business risks around the group rather than the functions. For example, exchange risk can be moved by changing the currency in which transactions are denominated, and risks of delivery and usage could be transferred by a subcontracting arrangement. One must also consider the tax consequences of transferring substantial functions and risk from a particular jurisdiction. Tax jurisdictions are well aware of these functional and risk moves and are legislating, or clarifying, their existing statutes to address the deemed notion of transfers of business or goodwill upon restructure of the operations, which potentially may attract significant tax consequences. Change in the operating structure of the company If the group does decide to alter its operations through rationalisation of manufacturing plants, centralisation of certain support services, etc., pricing policy changes can often be handled fairly easily. It is generally the case that a new transfer pricing mechanism will be necessary to achieve an arm’s-length result. If it can be demonstrated that both the present and previous transfer pricing policy adhered to arm’s-length standards, then the only issue should be to ensure careful contemporaneous documentation of the changes in the business which necessitated the change in policy. The change in policy should be implemented at the same time as the change in the business (or as soon thereafter as possible). Parent company pressure Transfer pricing policy amendments are sometimes made solely to meet the needs of particular problems within the group not directly related to tax law or commercial law and not necessarily in accordance with arm’s-length rules. For instance, a parent company seeking to pay significant dividends to its shareholders requires not only profits available for distribution but also cash. Where profits and cash are locked up in subsidiaries outside the home country, there will always be a choice between paying dividends to the parent or effecting remittances to the parent in some other form, for example through the mechanism of a management fee, payment of royalty or technology transfer fees, interest on borrowings from the parent, or perhaps through increasing transfer prices for goods sold from the parent to the subsidiary for onward distribution. One should navigate cautiously when executing these strategies because, in addition to the income-tax implications, if these policies are deemed inconsistent with the arm’s‑length principle by a taxing authority, indirect tax issues may crop up. www.pwc.com/internationaltp 103

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Managing changes to a transfer pricing policy The problem created by policies of this sort is the risk of tax audit when the policy is clearly not arm’s length. It is a fact of life that such problems crop up, but a successfully managed group will resist submitting to such pressures unless the changes proposed can be accommodated within a fully arm’s-length pricing policy. Tax audit settlements When resolving disputes with a tax authority, it is good practice, where possible, to ensure that the methodology agreed between the company and the authority for settling the current year’s tax position is also determined as acceptable for some period into the future. This may necessitate an amendment to the existing transfer pricing policy. It is important to consider both sides of the transaction. In settling a tax audit, a competent authority claim (see Chapter 10) may be necessary to involve the authorities of the other state. In going through this claim with these authorities, it is important to address proposals for the future at the same time, if possible. If both countries agree on the approach to be adopted, a change to the transfer pricing policy should be uncontroversial. However, where different positions are adopted, great care will need to be exercised. In circumstances such as these, the company may wish to consider alternate measures to address the forward-looking issues by means of an advance pricing agreement (see Chapter 10). When assessing the full cost of any settlement, it is important to take account of any late payment interest or penalty charges that may apply. Such charges are, in some jurisdictions, themselves not deductible for tax purposes. These liabilities may sometimes be open to negotiation. For further discussion of tax audits, see Chapter 7. Problems with current policy A group may often find that an existing inter-company pricing policy no longer provides the results it requires. This is usually caused by one or more of the following factors: • Changes in business conditions (e.g. recession or inflation) which cause changes in prices or volumes of third-party sales. • Market-penetration activities that are designed to increase market share • by reductions in market prices or by substantially increased marketing and promotional expenses. This could also be brought about due to breakthrough technology advances that force companies to re-engineer their pricing. • Market-maintenance activities that are designed to protect market share in the face of intense competition. This can be accomplished through pricing policies or through marketing/promotion expenses. • Where a group acquires a business with a different transfer pricing policy from that used elsewhere, the policy for the new expanded group should be reviewed. Even if, initially, there will be little cross-trading, over time it is inevitable that there will be transactions between the two groups. If pricing policies are not in line, there may be problems with local tax authorities, which will see similar intragroup transactions taking place in a single company. • Where there are regulatory changes that affect pricing, which typically takes place in the pharmaceutical industry due to drugs going off-patent or due to the prices of drugs being agreed upon with the regulators. 104 International Transfer Pricing 2015/16

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Making corrections through fine-tuning In this paragraph, it is assumed that the change needed to rectify the situation is fairly limited and represents fine-tuning. The situation where the current transfer pricing policy must be changed in a material way is dealt with in the next section (see Massive change: alteration to business reality). Transfer pricing policies should be reviewed frequently. If the policy is monitored periodically (e.g. quarterly), it will be immediately apparent if it is not working properly. In this case, changes to transfer prices can be made for the subsequent quarter and the error in the result of the transfer pricing policy at the end of the year will generally be fairly small and, over a long period of time, the results of each company within the group will reflect the correct operation of the policy. There may be cut-off errors between one period and another, but they will even out over time, and dealing with corrections on a prospective basis is a more defensible position than retroactive changes, which third parties rarely make except where serious disputes are involved. It is important to be aware of pressures in some countries to bring transfer prices up to date on as regular a basis as possible. For instance, while minor cut-off errors are likely to be fitted into the acceptable arm’s-length range of transfer prices for US purposes, errors that mean that US profits cease to meet the arm’s-length test will require adjustment for that year. Transfer pricing policies should be managed within a range rather than on the basis of an exact formula, as it is impossible to maintain a precise transfer pricing result. An arm’s-length range of acceptable results should be determined, with management within that range as the group’s objective. So long as prices (and profitability) remain within the range, no changes should be necessary. Once prices move outside the range (or are predicted to move outside it), adjustments should be made. If the policy is monitored regularly, changes can be made prospectively without the need to be overly concerned about past mistakes or aberrations. Massive change: alteration to business reality A transfer pricing policy must address significant changes in the business environment. If a manufacturing company sells finished goods to a related distribution company using a resale price method, then changes in the market price of the product automatically vary the transfer price. These ‘flow-through’ price changes merely keep the arm’s-length policy in place. If a reduction occurs in prices in this market and the discount that is used to apply the resale price method has to be increased from, say, 25% to 26% in order for the distributor to trade profitably, then this should be viewed as ‘fine-tuning’ and should not create significant problems if it is properly documented. However, assume that a massive recession occurs so that the market price of the goods and the volume sold declines precipitously. In addition, the discount earned by independent distributors declines from the previous norm of 25%–15%. Without a change in the transfer pricing policy, these factors could easily produce losses in the distribution company (because volume has significantly decreased without a corresponding change in overheads) or in the manufacturing company (same reason). Such a situation is not unusual in some industries and provides a very difficult problem for transfer pricing as well as for the business generally. www.pwc.com/internationaltp 105

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Managing changes to a transfer pricing policy It is important in these situations to realise that transfer pricing changes cannot solve the business problem (i.e. the market has collapsed and losses arise on a consolidated basis). All that a transfer pricing policy can do is to allocate the losses to the appropriate legal entities on an arm’s-length basis. Changes in law If a group has established an arm’s-length transfer pricing policy that is working well in all the countries in which it operates, how should it deal with the situation when a new law in one of its territories means that existing policies are no longer acceptable in that particular country? All cross-border transactions have an impact on the accounts of at least two separate legal entities, and if a policy is changed to meet the requirements of one country’s laws, will the new policy be acceptable to the country affected on the other side of the transaction? While the arm’s‑length principle is widely recognised, individual countries have different views of exactly what this means. There is, therefore, always a risk of asymmetric treatment of transactions for tax purposes in different jurisdictions, resulting in double taxation. A group’s reaction to the different legal requirements, country by country, will necessarily be driven by its evaluation of the tax risks involved. If it seems inevitable that one particular country will apply its laws aggressively, resulting in double taxation if the group’s policy for that country is not altered, then it may be necessary to amend the policy to produce the lowest tax result for the group as a whole. In these cases, monitoring the position in other countries will be of crucial importance. Example Cool EC (Cool) is a group of companies engaged in the manufacture of refrigerators operating entirely within the European Union (EU). Cool’s engineering department is located in the UK company (Cool UK) and has for many years provided technical assistance to the group’s sales companies throughout the EU. The services have been provided under the terms of a formal agreement, and charges are made for the engineers’ time and expense in exactly the same way as charges are invoiced to thirdparty customers for the same services. This arrangement has been accepted by all the EU tax authorities, with the result that the service income is taxed only in the UK and tax deductions for the same amount are taken in the paying companies. Cool has recently secured a large order for its machines from the biggest distributor of domestic electrical goods on the African continent. New subsidiaries will be established to service this market and to deal with customer services. However, as with the EU operations, Cool UK’s engineers will also be required to provide their services from time to time. Unfortunately, Cool UK has found that it is likely to suffer extensive taxes if it seeks to charge for the engineers’ services in the same way as in the EU countries. The position varies in detail from country to country, but the range of problems include the difficulties in arranging foreign exchange clearances to obtain currency, withholding taxes, local sales taxes and, in certain cases, direct local taxation of the full service charge on the basis that the services represent a permanent establishment of Cool. Cool UK has calculated that the effective tax rate on the service fees could exceed 80% in certain circumstances, in addition to causing cash-flow problems. How then, should Cool UK react to this significant problem? There are three main options: 106 International Transfer Pricing 2015/16

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• The group could pursue a policy consistent with the present arrangements in Europe, which would be supported by the third-party comparables. • The group could decide that no charge be made, on the basis that the tax rate effectively wipes out any benefit. • The group could find an entirely new way of dealing with the problem. The first option is unacceptable due to the resulting high tax rate. The second option will probably give rise to transfer pricing questions in the UK. The Inland Revenue will not accept that free services should be provided over an extended period to overseas affiliates and are likely to assess a deemed amount of income to UK tax. There is also the possibility that the other EU authorities could challenge the charges made to them if Cool’s UK operation sought to increase the inter-company service charges to its European affiliates to offset the loss-making African service. After lengthy negotiations, Cool UK finds that the African authorities are prepared to give full foreign-exchange clearances for payments for the refrigerators, and no other African withholding taxes would be applied to these payments. If the transfer price of the refrigerators can be increased to cover the expected cost of service by the UK engineers, then the UK authorities are unlikely to complain. Careful documentation will be needed to support the pricing. In particular, it will be helpful to monitor what the normal charge for the engineers’ time on African affairs would have been and how this compares with the recovery made through the transfer price. It will also be relevant to consider if the increased transfer price would cover the estimated cost of maintenance services over the warranty period alone or would also cover after-sales service, which may be normally paid for by the end-customers. Consideration must also be given to the cost of spares, which would have to be imported for the service. One possibility is to increase the price of spares to cover the service component. Finally, it must be borne in mind that increasing the transfer price will increase the base on which African customs duties will be calculated. This hidden tax must also be evaluated in making the final decision on how to proceed. Input from Cool’s transfer pricing committee will be helpful in smoothing over management difficulties, which might otherwise arise. In particular, in this example, the head of the engineering department had been concerned that one result of recovering the value of engineering services through the transfer price of products would be that the apparent profitability of his division would decrease while the sales department’s income would go up by a corresponding amount. As both managers receive bonuses calculated on divisional profits, there is an apparent conflict between their personal interests and those of the business. One solution may be for the bonus scheme to make adjustments for the African business. Alternatively, the engineering department could render an internal invoice to the sales department. Dealing with major changes Occasionally, a transfer pricing policy will not be arm’s length and will require major changes. For example, it is not unusual for a parent company to establish transfer prices from its own manufacturing plant to related parties in high-tax jurisdictions using a cost-plus approach. Often, the cost base is standard manufacturing cost. The ‘plus’ is frequently quite low (e.g. 5% or 10%). If the result of a policy such as this is to produce recurring losses in the manufacturing entity, after deducting overheads and general and administrative expenses, while the sales affiliate is making large profits, it is clear that the transfer pricing policy is not arm’s length; no independent www.pwc.com/internationaltp 107

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Managing changes to a transfer pricing policy manufacturer would tolerate manufacturing at a loss in this way. If such a policy has been in operation for a number of years and has not created problems with the tax authorities in the manufacturer’s country, changing the policy is problematic – particularly because the need for change usually emerges as a result of a crisis. For example, a manufacturing company may experience recurring losses and consequent cash-flow problems. When this happens, the result is a critical need to change the policy to rectify the problem. The issue that must then be addressed is the reaction of the tax authorities involved. When large changes are made to existing transfer pricing policies, the reaction of the tax authority in the country in which higher taxes will be paid is likely to be to investigate the reasons why the change was not made in prior years; it may be that opportunities exist to assess further taxes for years before the change came into effect. In contrast, the reaction in the country that loses revenue is likely to be exactly the opposite. Sometimes the group must simply accept this risk because the crisis requires the immediate imposition of the new policy. However, it may be possible to make changes in the substance of the business (e.g. shift risks between countries) to provide a basis for an argument that the business has been restructured and the new pricing policy reflects these changes. Before the imposition of a new policy, it is necessary to evaluate the need for the change, relative to the tax audit exposure caused by the change. The attitude of the tax authorities involved must be considered along with the extent to which other matters may need to be negotiated with them. In some countries (e.g. the US) it is possible to protect subsequent years by arguing that the policy was wrong in the past. Careful management of prior years’ audits will mitigate the risk in these situations. Year-end adjustment Towards the end of the fiscal year, a group usually examines the forecasted final income statements of the various legal entities within the group. For companies that have failed to plan their transfer pricing policies carefully, the results of this examination may not be acceptable. The reaction in these groups is often to process a lump-sum payment at the end of the year to ‘make things right’. Determining the amount to put on these invoices is generally not difficult. It is deciding what to call the payment and how to justify it that is problematic. If it is described as a retroactive price change, it has the implications discussed in next section (see Retroactive price changes). If it is termed a royalty, it is necessary to show what intangible property has been provided to the licensee and why this was not recognised and formalised in a licence agreement at the beginning of the year. If it is called a management fee, the problem is how to demonstrate what services were provided, their cost and why the services were not formalised in a management service agreement at the beginning of the year. In short, end-of-year adjustments are difficult to defend because there is no easy way to explain what the payment is for. Furthermore, it is usually impossible to find thirdparty comparables supporting major changes to the pricing of ‘done deals’. This, and other points made in this chapter, point to the need to plan transfer pricing policies in advance so that these problems do not occur. If such changes are unavoidable, their risks must be recognised and such documentation as can be assembled should be produced to defend the position taken. 108 International Transfer Pricing 2015/16

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Retroactive price changes At the end of the fiscal year, companies sometimes discover that their transfer pricing policies have not produced the desired result. The temptation is to change transfer prices retroactively to correct the error. This behaviour is particularly likely if one of the related entities faces urgent cash or profitability needs. These types of changes should be resisted at all costs, if they affect years for which financial statements have been audited and published and tax returns have been filed. It is difficult to conceive of third-party situations where such a change would be justifiable, except perhaps on very long-term contracts. Furthermore, it is hardly likely to be in the group’s best interests to withdraw their accounts and tax returns. Concern from banks, shareholders and tax authorities regarding the implications of such a move is bound to be highly unwelcome. When the change affects only the current fiscal year, the picture is somewhat murkier. While the income-tax authority audits the result of a transfer pricing policy, rather than the method used, there is a ‘smoking gun’ aura surrounding retroactive price changes that undermines the credibility of the taxpayer’s claim that an arm’s-length transfer pricing policy is in place. Having said this, the direct tax authorities tend to review accounts rather than invoices, and if the overall effect is to produce a fair result they may not be able to identify the late timing of events. Companies should not be complacent, however, even where it is unlikely that the direct tax authorities will be able to identify a year-end adjustment. The interest of indirect tax authorities must also be considered, as there will probably be duty and valueadded/consumption tax implications of a retroactive price change. The best approach must be to refrain from retroactive price changes unless the business situation is so desperate that the inherent tax risks are overwhelmed by commercial necessity. Defensible late adjustments The question of whether a charge can be made retroactively without creating significant tax problems can usually be answered by considering comparable transactions between parties at arm’s length. For instance, in most forms of professional advice that companies seek, it is normal for the consultant to charge his client in arrears for work they undertake at their request. However, such an arrangement will have been agreed in advance between the consultant and the client. It will typically be evidenced in a contract between them describing the basis upon which they will work together. Consequently, the rendering of an invoice some time after the work has been done (and possibly indeed in a different financial year) will not affect the reasonableness or validity of the charge. However, an invoice rendered for work carried out without prior authorisation of that work by the client will often result in a dispute and possibly non-payment for the consultant. To take the example even further, a consultant who gratuitously provides a company with information that could be of value to that company might do so as a speculative activity, hoping to win the company as a client. However, it seems unlikely that the consultant would be in a position to demand payment for such advice, even if successful in winning the business. The initial work is an investment for the future. If we take these examples in the context of a group of companies where the parent company is taking a decision to charge all the subsidiaries a management fee, it will www.pwc.com/internationaltp 109

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Managing changes to a transfer pricing policy usually be evident from the facts whether a charge made on the last day of the year to cover the whole of the previous 365 days will be acceptable. The questions to be asked are whether the subsidiary requested the service and whether the subsidiary benefited from the service. It is not good enough merely for the parent to have incurred expenses in carrying out work that might or might not have been for the benefit of, or at the request of, the subsidiaries. Typically, the purchase and sale of goods is a fairly simple process. Two parties enter into a contract for the supply of a product. The contract provides that the purchaser takes title to the goods subject to certain conditions (perhaps, for instance, full payment of the invoice) and the purchaser usually takes the goods under some kind of warranty from the seller as to their general condition and their fitness for their intended purpose. The contract also specifies the price at which the sale is to take place. As a result, most sales between parties at arm’s length happen once and once only, and any subsequent transactions relating to the same goods concern warranty costs where the purchaser has found a difficulty with the items purchased. It would be most unusual in a third-party situation for the seller of a product to demand more payment for what has already been sold, sometime after the original transaction has taken place. Despite this, many groups seek to do just this when they realise at year-end that the profits of the group have not arisen in the different subsidiaries quite as expected. In certain industries, such as electronic components and semiconductors, distributors are typically afforded price protection by the manufacturer. In these situations, the distributor may receive credit notes by means of a retroactive discount on goods that it cannot move, due to market conditions or discounts on future purchases to affect the credit. However, these circumstances are limited to particular industry practices and should not be blindly applied. A group should tread cautiously in applying these adjustments and have documentation of third-party arrangements to support its positions. If the change is necessary to bring the group’s position into line with an arm’s-length standard, then the timing is not as important as the need to make the change itself. Failure to make the change at that time will merely perpetuate a situation that is known to be incorrect and is therefore inadvisable. A technique that may assist in reducing these tensions is to include limited rights to vary certain transactions as part of the overall policy applying between the group companies (i.e. create a situation where invoices are issued on an interim basis and may be adjusted for certain predetermined and mutually agreed factors). Such contracts are not unknown between third parties, as they can offer a mechanism to share risks, such as foreign exchange, particularly on long-term contracts, but care must be taken to ensure that indirect taxes and customs duties are handled appropriately. Timing of changes The timing of a change in transfer pricing policy, particularly if it corrects an error in a prior policy, is crucial. If an income-tax audit is ongoing at the time the policy change is made, the tax authority might become aware of the change, and it could be alleged that the prior policy was incorrect. This type of evidence is not helpful in settling the audit favourably. It is, therefore, imperative to plan carefully the timing of the implementation of a policy change to minimise the impact on the tax liability for 110 International Transfer Pricing 2015/16

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previous years. This involves weighing the risks for prior years against the potential cost to the company of inaction, in the form of possibly higher tax rates in the future or possible penalties. This analysis is detailed and must be done on a case-by-case basis to arrive at a defensible answer. ‘Big bang’ or gradual Where a change in an existing transfer pricing policy is to be made for the future, the decision must be made to phase in the change gradually or to make the change in one ‘big bang’. Assume, for example, that the change desired is to double transfer prices. This may be implemented through a doubling of the prices on 1 January of the next year (the big bang) or by phasing the price change in through incremental changes over the next three years (the gradual approach). Which of these options should be selected is largely determined by the reaction of the local tax authority of the country that is to pay the higher prices and vice versa in the source country of the price increases. In some countries, the big bang works so long as it can be clearly demonstrated that the new prices are arm’s length and the risk of audit on prior, open years is controlled. In other countries (e.g. Italy), phase-in is the only way to deal with the potential objections of the tax authority. Knowledge of the size of the change and the reaction of the tax authority that will lose revenue on the transaction is essential to this decision. Communicating the changes to the tax authorities For certain changes in transfer pricing policies, it may be important to obtain local government approval. In some countries (e.g. Korea and China), for instance, royalty payments must be approved by foreign-exchange control authorities. This is especially true when dealing with the developing countries in general and countries that are heavy importers of technology of all kinds. Tax authority clearances may also be required to avoid withholding taxes or to benefit from the lower rates offered by a double tax treaty. In other situations, it may be useful to approach the authority concerned for a ruling on the policy under review. Such an advance pricing agreement offers certainty to the multinational, albeit at the price of higher levels of disclosure than might otherwise be the case (see Chapter 7, Advance rulings). Sometimes, in the course of a previous year’s transfer pricing audit, the tax authorities may also seek the financial statements of the succeeding years. A change in transfer pricing policy would then come to light earlier than expected and hence the taxpayer should be prepared to explain the rationale for the variance in advance. Tax return disclosure Unless the change in policy has been agreed in advance with the relevant tax authority, the mode of its reflection in the tax return should be carefully considered. It is generally important (to avoid penalties for fraudulent or negligent non-disclosure) to ensure that reasonable disclosure is made, while avoiding drawing unnecessary attention to the change of policy. For example, it would generally not be sufficient to include a significant new management fee under a profit and loss account category such as ‘miscellaneous expenses’, but it might be described as ‘technical fees’ if it mainly related to technical support provided to the company. Accounting disclosure In some countries, the extent and form of accounting disclosure of a change in certain transfer pricing policies may be prescribed by statute or accepted best practice. However, there is generally some discretion as to the wording in the accounts, which www.pwc.com/internationaltp 111

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Managing changes to a transfer pricing policy should be considered carefully because the accounts are likely to be reviewed, certainly by the domestic tax authorities, and possibly by foreign revenue authorities. Impact on banks and other users of the financial statements Legal entities within a corporate group may publish separate company financial statements that are provided to third parties, most frequently banks. In addition, groups are continually changing through acquisition, merger or perhaps by spinning off a subsidiary into a public company. When this is the case, the transfer pricing policy takes on special importance and it is essential that the policy is arm’s length so that the financial statements are fairly presented. In these situations, when the group wishes to change its transfer pricing policy, the risks of such a change are magnified. All the problems and cautions referred to in this chapter apply; the burden of explaining the change is critically important for the successful implementation of the new policy. As a practical matter, it may be impossible to make the changes in this situation. There may also be other, more subtle, points to consider. For instance, the subsidiary company may have entered into arrangements with its banks that require it to meet certain profitability levels in order for them to maintain certain levels of overdraft facilities. Would the reduced profitability of the company concerned (as a result of pricing policy changes) give rise to problems in its relationship with the banks (e.g. trigger a default of a debt covenant)? Will new guarantee arrangements be needed from the parent company in order to give the banks the level of comfort they require for the banking facilities needed by the subsidiary? These and other matters require careful handling as part of the pricing policy changes. Communicating the changes to employees Changes to the transfer pricing policy of a multinational will have an impact on numerous people and organisations. There will be an immediate effect on the employees involved in the transactions, for there may be completely new procedures for them to follow and they need to be directed exactly how to proceed. The reasons underlying the change and the technical justification for it need to be recorded as part of the group’s overall documentation of its transfer pricing policy. It may be useful, however, to communicate the key reasons for the change to employees and to explain what has happened and why. This will help make employees more supportive of the change and may well be of value in future years when those same employees may be questioned by tax authorities on the reasons why changes were made. For example, in the area of management services rendered by a parent company to its subsidiaries, the parent company executives may be quite clear about the nature of the services they carry out for subsidiaries and will also have ideas about the value to the subsidiary of their work. However, executives at the subsidiary company may feel overawed by the parent company or, alternatively, feel that the parent company does not understand their position. Their view of the benefit of the services they receive will therefore be a different one, and in such circumstances it would be enormously helpful for both sides to be clear about what is being provided and why and how the services will be priced. The work involved in documenting these points would follow the course of an ordinary negotiation between parties at arm’s length and, if followed, should produce a result that will be fully justifiable and properly understood by all those involved. At the same time, it is not always appropriate to let too many employees know about tax planning initiatives that the parent company is using to manage the worldwide tax burden of the group. Loose lips sink ships’ is an old adage that applies 112 International Transfer Pricing 2015/16

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in this area. There are numerous examples of disgruntled former employees who knew only enough about a transfer pricing policy to suggest to the tax authority that a fraud might exist. In such cases, the employee is rarely in a position to know the whole story and, consequently, to understand that no fraud existed at all. The end result can be an awkward situation for the group in dealing with the tax authority. Subject to compliance with local laws that may govern disclosures to employees or trade unions, employees should be told only what they need to know to do their jobs properly and to support policies that directly affect them. Impact on management/employee bonus schemes Some of the most contentious situations faced by any transfer pricing analyst occur when employee compensation decisions or bonuses are tied to the profitability of the legal entity that is affected by pricing changes. In such situations, a transfer pricing policy change increases the income of some employees and reduces the income of others. Clearly, this creates significant problems within the group, as focus is shifted away from running the business into a discussion of transfer prices. Groups with significant cross-border transactions should consider establishing a method of compensating employees, which is not related to the vicissitudes of tax law. This is normally achieved by maintaining a mirror management accounting system independent of statutory and legal books of accounts and can measure employee contributions differently. Accounting systems All changes to a group’s transfer pricing policies will affect the way in which transactions are accounted for, if only to the extent of their value. There may, however, be more significant implications. For instance, where a management services agreement is established for the first time, there will be an entirely new set of transactions to be dealt with, both in the company rendering the service and in the company receiving it and paying the fees. It may necessitate new account codes and possibly new procedures for authorising such payments. Furthermore, in order to render a charge for the management services, the price of those services has to be determined. Very often this involves an evaluation of the time spent by the executives performing the services, plus an analysis of the direct expenses incurred in providing them. The analysis of the charging company accounts in order to produce the basic information necessary to calculate the management fee can be time-consuming, and new accounting procedures may be necessary to ensure that these invoices can be produced quickly and efficiently. New computer reports and procedures are likely to be required and the information systems department of the group would therefore need to be involved in the implementation of any changes to transfer pricing procedures. Training would also need to be imparted to the employees recording transactions so that the cutover to the new policy is error-free and transaction reversals and rectification entries are minimised. The audit trail Tax authorities are requiring ever-greater amounts of information during their audits. As discussed in Chapter 7, tax authorities (particularly in the US) routinely ask for income statement data by product line and by legal entity to aid in evaluating the appropriateness of transfer pricing policies. This information is also of importance to the group in monitoring and developing its pricing policies, but the level of detail available will vary from company to company. It is particularly important to ensure that data is not lost when policy changes are made, that the transition from old to new www.pwc.com/internationaltp 113

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Managing changes to a transfer pricing policy systems is smooth and a full audit trail is preserved. It is also important that companies assess the degree to which accounting data that is not routinely prepared for business purposes may be required by a tax authority in a country in which they do business. In some countries, severe penalties are imposed for failure to provide the data that the tax authority requires. As in many areas of transfer pricing law and practice, the US is by far the most demanding authority in this regard. However, the US approach is gaining increasing credence in other countries, and most companies do not have the accounting systems required to develop these detailed income statements easily. Care must be taken, where possible, to ensure that accounting system enhancement programmes are designed with these criteria in mind. Having these processes built into a company’s internal control process is typically best practice. Documenting the changes The documentation of the group’s pricing policy forms an important part of the evidence supporting the values shown on invoices and eventually the profits reflected in the financial statements. In most countries, company directors have an obligation to conduct themselves and the company’s activities in a businesslike way and to act in the company’s best interests at all times. Proper documentation of the pricing policy and changes to it are therefore important parts of the audit trail supporting the actions of the directors. It is also important to document the reasons for the change so that it is clear to all tax authorities involved that the change produces an arm’s-length result. In some countries, notably the US, contemporaneous evidence is required by law. Even where it is not, papers prepared at the time of the relevant transactions, clearly written and supported by appropriate evidence, will always be of great value. 114 International Transfer Pricing 2015/16

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7. Dealing with an audit of transfer pricing by a tax authority Introduction Transfer pricing is an area in which tax authorities increasingly choose to focus when auditing the tax returns of businesses that have transactions with foreign affiliated entities. A number of reasons for this can be identified, including the following: • Companies are becoming more international in their operations and therefore there are ever-growing numbers of cross-border transactions between affiliates. • Tax planning increasingly focuses on the optimisation of the effective worldwide tax rate and on its stabilisation at the lowest possible level – a defensible transfer pricing policy is fundamental to the attainment of these objectives. • Tax authorities are increasingly recognising that commercial relations between affiliates may fail to reflect the arm’s‑length principle. • More and more jurisdictions are legislating, or codifying interpretations, on transfer pricing matters into their tax statutes. • As tax authorities gain experience in transfer pricing audits, they are becoming more sophisticated and aggressive in their approach and more skilled in selecting cases that they believe are worth detailed investigation. The approach of tax authorities in different jurisdictions to transfer pricing audits varies enormously. In some developing economies in particular, transfer pricing has not yet been identified as a key target for serious reviews; revenue controls are maintained through foreign-exchange control and withholding taxes. This trend has dramatically changed in recent years, even in these emerging economies, as new legislations are enacted and these economies have become more sophisticated in transfer pricing as a result of cross-training from revenue authorities of other jurisdictions. In others, a pricing audit is likely to consist of a fairly basic review of the company’s intragroup transactions by a local tax inspector. Then there are jurisdictions where, due to the relative inexperience of the revenue authorities and the taxpayer and owing to recent legislation, transfer pricing arrangements are regularly taken up for audit and subjected to scrutiny, regardless of their acceptance in previous years. In these circumstances, if the local company and its tax inspector cannot agree on appropriate transfer prices, the matter may need to be resolved before the appropriate revenue commission and ultimately in court. Such appellate proceedings would normally be based on facts and relative perceived merits of the positions adopted by the taxpayer and the revenue authorities rather than on the pure technical merits of the case alone. Under other jurisdictions (notably the US) a complex framework of extensive resources and procedures has been established to deal with transfer pricing investigations and disputes. In some countries, it has been suggested that the natural inclination of the local tax authority and government would be to apply fairly relaxed transfer pricing principles, only mounting a concerted transfer pricing attack where the prices concerned fall outside a reasonable range. However, the aggressive US approach to transfer pricing has apparently caused these countries (Japan, Korea and Germany are www.pwc.com/internationaltp 115

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Dealing with an audit of transfer pricing by a tax authority notable examples) to seek to match the extensive resources devoted to transfer pricing in countries such as the US, UK and Australia, and to legislate to introduce clearer rules on the subject to protect its tax base from predatory tax authorities around the world. Transfer pricing audits are as likely as other areas of taxation to be subject to legislative and procedural changes over time. This chapter, therefore, deals generally with those factors that should be addressed when dealing with any transfer pricing audit. The audit processes are covered specifically in the country sections and demonstrate the diversity of approach around the world. Perhaps the most important point to note is that all the tax authorities reviewed (as well as others) are continually building up their resources and experience in the transfer pricing area. Correspondingly, the increased attention paid by the tax authorities also leads to questioning by less experienced revenue agents. The taxpayer has to consider whether to adopt a policy of responding in a passive manner to questions that seem to be leading nowhere or whether to take a proactive approach, which assumes that ultimately a defence of its transfer pricing policies will be required. Establishing control of the audit process It is crucial that the taxpayer establishes and maintains control of the audit process. Companies in the throes of a transfer pricing audit often ask how much information the local tax authority will require and how long the process will take. Unfortunately, unless the company is proactive in controlling the audit, the answer to this question tends to be ‘How much information do you have’? For the company to take control of the audit process, it must be able to take a firm stance. All too often, a tax audit highlights the lack of knowledge a group has about its own pricing policies and their implications. If the company finds itself in this position, it will need to take stock very rapidly and reach some broad conclusions about its intercompany arrangements. For instance: • What functions, risks and intangibles exist in the legal entities between which the relevant transactions have occurred? • What interpretation should be placed on this functional analysis (e.g. is the local company a contract rather than a full-fledged operating entity)? (See Chapter 4.) • What is the information available to support the group’s position? • What very broad conclusions can be reached about the risks inherent in the tax audit – on balance, will the company win or lose if all the relevant information is examined by the tax authority? Control of the audit process can be established and maintained only if the taxpayer devotes appropriate resources to this endeavour. Therefore, it is necessary to ensure that: • Management support is obtained for the endeavour. • A team of appropriate and highly competent individuals, consisting of tax and operational staff, are assigned to manage the audit process (this team should include non-local personnel and external advisors as appropriate) and are allowed to devote a sufficient time to the task. • All the information required by the team is made available to it on a timely basis. 116 International Transfer Pricing 2015/16

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• A careful plan is established that sets out protocols on how the audit should progress and how liaison with the local tax authority (and overseas authorities) should be handled. If the taxpayer’s audit team is operating in the context of a well-planned and executed worldwide transfer pricing policy, its job will naturally be substantially easier than if prices within the international group have been set on an ad hoc basis, as a result of administrative convenience or tax imperatives existing in different locations. Minimising the exposure Tax exposure can be limited in a number of ways in the context of an imminent or ongoing transfer pricing audit. For example: • Tax returns for prior years, which are not under audit, should be finalised and agreed with the local tax authorities as quickly as possible. • If it is envisaged that additional tax will be payable as a result of the audit, action should be taken to limit interest on overdue tax and penalties if possible, perhaps by interim payments of tax. However, an additional tax payment might be regarded as an admission of guilt and the tactics of payment as well as the financial implications will require careful consideration. • Depending on the circumstances, it may be advisable to plan to reach a negotiated settlement with the local tax authority in relation to prior years and agree arm’slength terms to apply in future periods – in such circumstances, one should also consider the impact of such settlement on overseas tax liabilities. Settling the matter – negotiation, litigation and arbitration Negotiation with the local tax authority representatives on transfer pricing issues is a critical element of the audit process in many jurisdictions. Successful negotiation requires, at least, the following: • • • • A capable, confident negotiating team. Full and up-to-date information on the issues under discussion. An understanding of local statutes, case law and practice. A well-laid-out strategy concerning the issues at hand, identifying what positions could be compromised and others on which the company would not budge. • Experience of the general attitude of the local tax authority towards the type of issues under consideration. • A clear view of the financial risks of reaching or not reaching agreement. The old saying ‘know thine enemy’ is of crucial importance in pursuing a favourable outcome to a transfer pricing dispute. At all stages of the audit, the company will need to consider the nature and experience of the tax authority team. For example, is it dealing with a local tax inspector, a revenue commissioner in transfer pricing, a trained economist or a professional revenue attorney? The implication of not reaching an agreement is, of course, ultimately, litigation in the local jurisdiction. The company needs to consider the implications of local litigation on transfer pricing issues very carefully, as the chances of success in the courts may vary widely in different countries. Again, the extent to which transfer pricing issues, being substantially questions of fact, can be escalated in the legal system would have to be borne in mind relative to other available administrative relief measures. The burden of www.pwc.com/internationaltp 117

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Dealing with an audit of transfer pricing by a tax authority proof is different from jurisdiction to jurisdiction, and at various times local courts may reflect public concern that foreigners are shifting taxable income out of the country rather than the pure technical integrity of the matter. In these instances, the taxpayer may feel that it should not pursue its case through the local judicial system. The implication of a transfer pricing adjustment resulting in a liability is the payment of the tax demand. This presents a cash flow situation for the taxpayer, regardless of whether the company decides to pursue litigation or alternative dispute-resolution avenues. Furthermore, the company must consider the implications of the transfer pricing assessments and the dispute-resolution measures to be taken and how these matters should be disclosed on its publicly released financial statements. This is becoming evermore a critical matter in today’s environment, where transparency of a company’s accounting policies is required by public markets. When negotiation or litigation has resulted in a tax adjustment, the company must consider whether an offsetting adjustment can be made in the other country involved. This may be through the mutual agreement procedures of the relevant income-tax convention or, alternatively, a special-purpose arbitration vehicle such as the European Arbitration Convention for countries that are part of the European Union (see Chapter 10). Considering all the avenues that are available to a taxpayer, it is critical to consider the appropriate timing of when to invoke one avenue versus the another (i.e. should the taxpayer pursue a mutual agreement procedure process if negotiations with the local inspectors fail, should litigation be pursued instead, or should both processes be initiated at the same time). The decision on these matters hinges on where the taxpayer believes it will be able to reach the best solution given the factors previously discussed. Preparation Negotiation, litigation and arbitration are all procedures that demand extensive preparation if the company is to protect its best interests. It should be borne in mind that individuals other than those directly involved in managing the audit process may be required to answer questions or give evidence and they must be adequately briefed to ensure that they can deal with the questions addressed to them. The taxpayer’s audit team must research the powers of the local tax authority and plan to meet its likely requirements. For example, the local tax authority may have the power to require the provision of substantial amounts of information about the group’s transactions within a short time frame. Further, in view of protracted revenue audit or litigation proceedings, which may take place long after the transactions in question have occurred, the importance of documentation at every step (by way of work papers, notices, hearing memos, submissions and rejoinders) cannot be overemphasised. • Any information that is to be provided to the local tax authority (verbal or documented) must be carefully reviewed by the audit team to ensure the following: • All of the information is correct. • All of the information is consistent with the tax returns and accounts of the relevant entities and other information which may be available to the local tax authority. The positive or negative implications of the information have been fully considered (i.e. does it support the existing pricing structure, and the functional analysis of the relevant entities’ activities or does it identify a tax exposure?). 118 International Transfer Pricing 2015/16

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Proper consideration has been given to the possibility that the information will be made available to other tax authorities and that the local tax authority may have sought information of other authorities under the exchange of information procedure in income tax conventions. Dealing with adjustments to existing pricing arrangements If an adjustment to the existing transfer pricing arrangement is agreed with the tax authority, it is necessary to consider what impact this has or will have on the commercial and tax positions of the relevant entities in past and future periods. The discussion in Chapter 6 (see Tax audit settlements, Year-end adjustment, Retroactive price changes and Defensible late adjustments) is relevant here. In respect of past periods, the company must decide whether it can or should reflect the tax adjustment in commercial terms by raising appropriate invoices (although commercially desirable, this may not be possible in practice, demanding recourse to the dispute-retention procedures in bilateral tax treaties to seek to achieve relief – see also Chapter 10 for notes on the arbitration procedure in the EU). Similarly, with regard to the future, it must decide whether to amend the transfer pricing arrangement to take the tax adjustment into account. A key factor in each of these decisions is the attitude of the tax authority in the country where the other affiliate is located – double taxation is a risk that most taxpayers are anxious to avoid. In addition to the direct tax issues, the company must consider whether the adjustments need to be reflected in tax returns for indirect taxes and customs duties. This may be the case where the transfer pricing adjustments are related directly to particular shipments of goods. Further, accounting and regulatory considerations must also be taken note of. If the tax authority that would bear the cost of any simple adjustment refuses to accept its validity, it may be necessary to invoke competent authority procedures under a tax treaty or some other form of resolution (e.g. the European Union arbitration procedure – see Chapter 10, European Union Arbitration Convention section) in order to reach a satisfactory conclusion. Such processes are unfortunately very lengthy, but some form of negotiation or arbitration may be the only way to ensure the agreement of all the relevant tax authorities to the pricing policy on an ongoing basis. Advance rulings It may be possible to request an advance ruling on an acceptable pricing structure (an APA) from a tax authority. If mutual agreement is reached, this option provides relative certainty for the future by setting a precedent, which may be very attractive to the taxpayer. Countries vary in their willingness to provide advance comfort that a particular pricing arrangement or structure will not be disputed. This is a rapidly developing area because, as more countries become used to the process, it becomes more attractive for them to put resources into advance agreements, recognising that it is often significantly quicker and cheaper for the tax authority than ex post facto dispute resolution. As a general rule, the greater degree of comfort provided, the more likely it is that a significant amount of detailed information will be required by the local tax authority to enable it to make such a ruling. This robust disclosure may be costly and timeconsuming from an administrative point of view and may weaken the company’s negotiating position in the future or on other issues that may arise. www.pwc.com/internationaltp 119

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Dealing with an audit of transfer pricing by a tax authority In some instances, two or more tax authorities may be willing to work together to give a mutually agreed solution for the future. However, some authorities consider that they do not have sufficient resources to pursue many such projects. Any APA or ruling is valid only as long as the fact pattern on which it is based remains in place. Therefore, if functions, risks or intangibles are, to a substantial extent, moved to different entities, a new agreement or ruling must be sought. Even during the tenor of the APA, it would be essential to maintain documentation establishing that the transfer pricing arrangements adhere to the terms of the agreement. 120 International Transfer Pricing 2015/16

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8. Financial services Introduction Over the last several years and particularly since the 2008 global financial crisis transfer pricing issues within the financial services industry have been a major concern of tax authorities around the world. Recent developments in the regulatory environment along with the unrelenting fiscal pressure imposed by governments across the globe and the complexity of the issues at stake in the industry hint at the fact that such scrutiny will prevail in the foreseeable future. The industry covers numerous business activities within which, and across which, many complex transfer pricing issues have been identified. Exploring their depth is not possible in a single chapter and as such, this chapter covers only the main issues and approaches to common types of transactions associated with banking and capital markets, insurance and investment management activities.1 Some of the features of the financial services industry which, in part, contribute to its complexity from a transfer pricing perspective are explored below. Perhaps one feature that, while not wholly restricted to the financial services industry, is more prevalent in this industry, is the impact that regulation, global integration and the other factors mentioned below tend to have commercially, and the limits that they place on businesses and their ability to structure their operations to deal with pricing challenges. Other developments include the impact that the global financial crisis has had on credit markets, the recent court case decisions (i.e., General Electric Canada) regarding the treatment and pricing of intercompany guarantees, and the Euro crisis, all of which have contributed to the intense scrutiny the transfer pricing issues associated with funding transactions and structuring of such funding both in and out the financial services industry have gathered. Regulatory environment Most parts of the financial services industry are subject to significant levels of governmental regulations to protect the integrity of the global financial system as well as consumers. Historically, the regulation has involved myriad rules and regulators at the local country level, although more recently there has been a move towards more consistency at the international level through the development of, for example, the Basel measures2 by the Bank for International Settlements (BIS) and within the European Union (EU). The US 2010 Dodd-Frank Wall Street Reform Act has imposed a series of restrictions on banks, and to a lesser extent, insurance companies to limit their abilities to engage in risky behaviour. In the wake of the 2008 financial crisis, the OECD, the European Union (EU) and the International Monetary Fund (IMF) concluded that solutions to ensure that the financial sector made ‘fair and substantial contributions’ to the macro-economy introduced the pathway for ‘bank tax levies’ that have been adopted and implemented by many European countries over the past 1 2 For further analyses please refer to PwC’s April 2012 ‘Clarifying the rules; Sustainable transfer pricing in the financial services sector’ for additional details. The ‘Basel’ measures are made up of the ‘Basel I’, ‘Basel II’, ‘Basel 2.5’ and ‘Basel III’ reform measures designed to strengthen the regulation, supervision and risk management within the banking sector. www.pwc.com/internationaltp 121

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Financial services two years.3 Such levies raise transfer pricing issues that need to be addressed from a holistic perspective as levy bases are not uniform and tax rates vary significantly across different jurisdictions. The impacts of these regulations materialise, among other things, into the corporate and operating structures that financial institutions have been employing over the past few years.4 Any transfer pricing analysis should therefore be mindful of such restrictions. Conversely, operating structures accepted by the regulators may provide evidence that the arrangements should also be accepted for transfer pricing purposes. Global integration Like other industry sectors, the financial services industry has been witnessing a trend towards more globally and regionally integrated business units, with less focus on the results of individual countries and greater focus on the aggregate business unit results. This, in turn, increases the challenges of identifying and monitoring the pricing of cross-border transactions and reduces the inherent comfort that businesses have the internal checks to ensure that each country has been appropriately remunerated. While these observations are true for many other industries, the challenges are greater for a sector such as the financial services sector where capital is fungible, not dependent on major plant or factories and does not involve the flow of tangible products. Complexity and speed Certain sectors of the financial services industry are highly innovative in their development and use of new and complex products and also in the speed (i.e., statistical arbitrage trading) with which they have exploited and come to rely on new technology. One of the key features of the industry is its concentration: a relatively small number of individual firms based in a few countries across the globe may be largely responsible for managing substantial assets and risks with increasingly complex interactions with other teams, products and countries. Any analysis of the transfer pricing position should reflect an understanding of not only the products involved but also the overall businesses and the systems used to manage them so as to adequately allocate their embedded expenses. Capital The availability and velocity of capital at the macroeconomic level is critical to the success of all businesses. It allows key investments to be made and ensures cash is available when needed to keep growing existing businesses and starting up new ones. Within the financial services industry capital plays a more fundamental role inasmuch as its level might be regulated and therefore shape the business’s operations and structures. As exemplified by certain of the so-called Basel requirements, the nature and level of capital held affects both the extent and the prices at which businesses are willing and able to transact with one another. In this context, the remuneration of capital is to be carefully examine and the preferences of local authorities taken into account when establishing such remuneration. 3 4 The objectives of the bank levies were to cover the fiscal cost of the direct public support to financial institutions and help reduce excessive risk taking. The divestiture of risky financial assets of certain banking institutions’ balance sheets over the past two years and their subsequent focus on their core banking activity is a prime illustration of such impact. 122 International Transfer Pricing 2015/16

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Branch profit allocation While transfer pricing has traditionally concerned itself with cross-border transactions between separate legal entities, the financial services industry, particularly in the banking and insurance sectors, has historically operated through branches in an attempt, among other things, to alleviate the regulatory constraint requirements on capital. Attributing the profits or losses of branches raises issues similar to those in traditional transfer pricing. The OECD reviewed how profits and losses of branches should be determined and the extent to which branches should be treated as if they were separate legal entities dealing with one another. In July 2010, the OECD published final reports (Parts I, II, III, and IV) on the attribution of profits to permanent establishments which provide guidance with respect to such profits and losses allocations. The branch profit allocation topic and its concomitant permanent establishment threshold determination have, more than ever, continued to be at the forefront of transfer pricing policy design considerations both at the business and tax authorities levels around the world. Head-office services5 Regardless of whether parties are related, when a service is rendered, it is expected that the recipient will remunerate the service provider for the activities performed at arm’s length. In a transfer pricing context, Shared services refers to the provision of a service by one part of an organisation or group where that service had previously been provided by more than one part of the organisation or group. Shared services are designed to create convergence and streamline an organisation’s functions such as certain back-office or administrative functions, human resources, finance, and certain functions within middle or front offices to enable organisations to take advantage of economies of scale and creation of synergies. Thus from a transfer pricing perspective, the pricing of multiple intercompany transactions need to be determined and documented. With the growing speed of global integration, many organisations within the financial services sector have already established shared service centres performing centralised services. In the financial services world, the shared services can be broadly broken down into two types of services: management and product-related services. Management services are typically associated with the back office or administrative support. Product services vary depending on the specific financial sector in which the organisation is classified (i.e. banking, investment management, or insurance). Within the banking industry, for example, functions such as loan processing, data validation, and treasury/capital management are often centralised in shared service locations. For most tax authorities, these services are an easy and understandable target when analysing transfer pricing within a financial institution. They have transposed into the financial services sector the experience with intra-group service charges they gained and honed in the non-financial service sectors. As such, a shared service is often the first transaction that is queried during a transfer pricing audit. To hedge against undesirable outcomes during a transfer pricing audit, as highlighted in the OECD Guidelines,6 the transfer pricing documentation of intercompany shared 5 6 Please refer to PwC’s April 2012 Financial Services ‘Clarifying the rules; Sustainable transfer pricing in the financial services sector’ for additional details. OECD Guidelines, Chapter VII, B(i), Paragraph 7.6. for additional guidance. www.pwc.com/internationaltp 123

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Financial services services transactions should clearly demonstrate (i) whether services have in fact been rendered and a benefit has been conferred,7 and (ii) that the intra-group charge for such services is in accordance with the arm’s‑length principle.8 Additionally, shareholders activities (i.e., activities considered not beneficial to the recipient) should clearly be identified as they cannot be charged out. Given the subjective nature of the pricing process and the relative ease in understanding the underlying transactions (compared with other more complex financial services transactions), it can be expected that tax authorities will focus on, from both the recipient and provider perspectives, the issues of what constitutes a service and what is the proper arm’s-length return for the provision of such a service. As a result, many organisations have employed systematic approaches to identify and document the nature of a service and the ultimate beneficiaries. The OECD Guidelines provide a framework to develop a policy; however, thought needs to be given to local rules in various jurisdictions to ensure compliance. Given this, the transfer pricing policy needs to be evaluated for implementation factors and establishment of a robust defence during a tax authority challenge. IT services9 Transfer pricing issues arising from the use of technology are common to all financial institutions. Technology often represents one of their most significant costs, has connection and usage in the front-, middle-, and back-office operations and spawns the whole globe making IT services a perfect target for tax authorities. In general, transfer pricing policies for technology-related services differ based on a variety of relative factors, such as customisation of the technology and its purpose and use within the front-, middle- and back-office functions of the institution. Technology activities can generally be categorised as follows: technology infrastructure, applications, and other ancillary activities. The infrastructure and related network elements refer to the ‘pipes’ and hardware that transmit information within and between the financial institution, its various affiliates, and/or external sources. The applications refer to the software applications – proprietary software and/ or customisation of third-party-developed software – used within a financial institution and their ongoing management and maintenance. The ancillary services relate to the adaptation for ‘local’ use, the data entry (including data conversion), the installation and training services. All else being equal, front-office technology is perceived by tax authorities to have higher relative value versus middle- or back-office technology due to its direct tie to revenue generation and the related importance of ensuring performance and controls. However, the 2008 financial crisis has increased the focus on risk assessment and has therefore raised the stature of middle-office applications. In addition, the reach and 7 8 9 In general, an activity is considered to provide a benefit to the recipient if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position or that may reasonably be anticipated to do so. On the other hand, for an indirect or remote benefit, the service is not considered to provide a benefit to the recipient. The OECD Guidelines identify two arrangements by which organisations seek to charge for intra-group services: the Direct Cost Method and the Indirect Cost Method. Please refer to PwC’s April 2012 ‘Clarifying the rules; Sustainable transfer pricing in the financial services sector’, for additional details. 124 International Transfer Pricing 2015/16

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life of the technology will most likely become contentious points of discussion under a transfer pricing audit. To ensure compliance with local transfer pricing regulations, financial institutions have relied on licensing, cost sharing, and contract research and development (R&D) transfer pricing policies. Numerous considerations such the distinction of legal and economic ownerships, the availability of third party data, the reliability of projections need to be accounted for in the transfer pricing policy design process. From a planning perspective, the diversity of models and the multiple activities involved provide useful opportunities to align tax objectives with the broader operational objectives of the technology function. From a compliance and support perspective, it is important for the tax department to consider the implications of the internally determined model of technology development and support in terms of the anticipated distribution of returns or costs among relevant affiliates. Funding considerations10 The recent developments in the financial services industry architecture partially triggered by the changes in the regulatory environment has led many non-financial services companies to seek alternative funding channels as terms and conditions extended by credit providers have been substantially more conservative in recent years. As a result, multinational enterprises have devoted significant resources developing treasury business models that promote a higher degree of self-funding. Consequently, sources of cheaper funding for capital market actors have depleted revitalising the transfer pricing issues surrounding the pricing of liquidity premia and their allocations. A comprehensive transfer pricing analysis in the context of a global banking business would therefore need to address these considerations. Going forward Planning and management of intercompany transactions in the financial services industry from a transfer pricing perspective is an exceptionally challenging task given the inconsistency of transfer pricing rules and practice across territories. There are however some common practices that can be identified to lighten some of the compliance burden. For instance, developing transfer pricing planning policies addressing the main intercompany transactions in an organisation resting on the common best practices identified in the industry. In addition, in light of the recent trends observed in the resources devoted by governments towards facilitating access to programs such as the US Advanced Pricing and Mutual Agreement, financial institutions should consider such alternatives for their most sophisticated intercompany transactions. Banking and capital markets Introduction From the traditional lending of funds and financing of trade flows, banks’ activities have extended to retail deposit-taking, lending, credit cards and mortgages to private client wealth management, commercial loans, asset-backed financing and financial risk management products, and into capital markets’ activities including equity brokerage, bond dealing, corporate finance advisory services and the underwriting of securities. 10 Please refer to PwC’s April 2012 ‘Clarifying the rules; Sustainable transfer pricing in the financial services sector’, part V for additional details. www.pwc.com/internationaltp 125

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Financial services Over the last century, banks and capital markets’ groups have expanded across the globe, in part to service their internationally active commercial clients and in part to track the flow of capital from developed countries to newer markets in search of higher returns. The traditional lending activity involves a bank borrowing funds from various investors, such as depositors, and earning a spread by lending to borrowers at a higher interest rate based on the bank’s credit assessment of the borrower. However, due to enhanced competition, over the years, the spread earned by banks has reduced considerably. Consequently, banks have made an increasing percentage of their total income from non-lending activities, by leveraging off their infrastructure and network in the financial markets to provide value-added services from straightforward foreign currency trades to more complex structured products. As the 2008 financial crisis unfolded and the banking sector became the focus of attention of governments all over the world, additional layers of regulations, on an already heavily regulated sector, were designed and have been implemented ever since in an attempt to rein in the systemic risks attributable to these non-traditional lending activities. The ripple effects of these new regulations have started to permeate the banking sector both from an organisational and operational point of views granting a careful re-examination of current transfer pricing policies in place for the major actors in the industry. This section considers the main types of cross-border transactions and activities in traditional banking and capital markets groups. Global trading From a transfer pricing perspective, both the US Treasury department and the OECD guidelines have provided guidance regarding the definition of global trading operations along with the transfer pricing methods available in such context.11,12 Under both sets of guidelines, a global trading operation involves the execution of customer transactions in financial products where part of the business takes place in more than one jurisdiction and/or the operation is conducted on a 24-hour basis. A simple example would be where a salesperson in one country introduces a customer to the trader located in another country who is responsible for trading the relevant financial product followed by the execution of the customer transaction by the trader. Because of the inherent complexity of the transactions at stake that typically involve a mix of technology, sophisticated trading skills and unfold across multiple tax jurisdictions, the design and documentation of transfer pricing policies continue to be extremely complex and challenging in this context. Historically, given the large amounts at stake, many multinational banks have resorted to advance pricing agreements/advanced pricing and mutual agreements (APAs/ APMAs) as a way of addressing the uncertainty resulting from pricing this type of activity. Adopting an APA/APMA approach has its own risks, including the potential mismatch between the speed with which global trading businesses develop and the length of time an overall APA process might take. It is also a time-consuming and 11 Treasury Regulations ‘Allocation and Sourcing of Income and Deductions Among Taxpayers Engaged in a Global Dealing Operation’, March 1998. 12 OECD Reports Part III, July 2010. 126 International Transfer Pricing 2015/16

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resource intensive exercise and the practical difficulty of negotiating APAs across more than a few jurisdictions might appear particularly daunting at times. Recent developments from fiscal authorities in the US and Europe indicate that taxpayers’ concerns over the difficulties of the APA process have been acknowledged and attempts to respond in a pragmatic fashion have been implemented. Fee-based businesses Fee-based businesses range from relatively high-volume, low-fee-based businesses such as equity brokerage to the relatively low-volume, high-fee-based businesses such as corporate finance advisory activities and the management, underwriting and distribution of new issues of securities for clients. Even within such well-established businesses as equity brokerage, there can be a wide range of operating structures within a group and a significant variety of products and services provided to clients. Substantial differences may also exist between the products, markets and exchanges of different countries, including not only in the volatility and liquidity of products but also, for example, in the settlement risks and costs involved. Difficulties can also arise in extrapolating from data on relatively small trading volumes to potentially much larger volumes handled within a group. The relatively low-volume, high-fee-based businesses can be particularly challenging from a transfer pricing perspective, particularly as many of the transactions are unique. Several years may have been spent investing in a client relationship before a structured transaction emerges and when it does, specialists from several countries with different expertise may be involved in the final transaction. Treasury and funding The funding of a bank, both on a short-term basis, for example to meet withdrawals by depositors and to fund new loans, and on a longer term basis as part of the overall management of the capital of a bank, is an intrinsic part of the activities of a bank. Although many of the transfer pricing issues surrounding financing transactions apply equally to intragroup funding within banking groups, the nature, amount and term of internal funding has been significantly affected by the latest changes in the regulatory environment along with the available liquidity in the marketplace post the 2008 financial crisis. For banks operating in the US, the advent of the Volcker Rule, a section of the Dodd-Frank Act which prohibits banks from engaging in proprietary trading and from owning and investing in a hedge fund or private equity fund, has triggered funding reallocations across banks’ businesses lines impacting the operating structures for raising and managing funds. Given the sensitivity of tax authorities towards funding transactions, even straightforward money market transactions or repurchase transactions must be carefully examined to ensure that each party to the transaction is remunerated according to the arm’s-length standard. Cross-border services As alluded to above, banking and capital markets groups generally undertake many centralised activities (i.e. management services), including inter alia the provision of central human resources, legal, accounting, internal communications and public relations’ activities. The past few years have witnessed an increase in the number and quality of the tax administrations’ audits related to the allocations, across business participants, of such expenses. A number of Asia-Pacific, European and US tax authorities have recently devoted a significant amount of resources auditing such www.pwc.com/internationaltp 127

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Financial services transactions and paid a particular attention to the characterisation of the services provided, the identification of the benefits conferred, the costs associated with the provision of the services and the profit elements attributable to the service providers. In response to the financial crisis, actors in the banking sector have increasingly centralised their credit and market risk management activities along with their regulatory compliance and reporting ones. In addition, banks are also often heavily reliant on partially developed IT systems, communication links and external data feeds leading to challenging transfer pricing issues revolving around the pricing of the technology used and the allocation of its costs. Other issues in banking and capital markets The above comments are by no means exhaustive. Other important but difficult issues include the transfer pricing treatment of relationship managers. Developments in the banking sector have resulted in an increasing focus on trading and fee-based activities leading to corresponding changes in the perception of the role of general banking relationship managers. This in turn leads to a more difficult question of whether the relationship management function remains an originator of wealth or has perhaps become merely a consumer of cost. Similarly, research has historically been treated as an overall cost to a business. Developments since the late 1990s suggest that the role of research may need to be reassessed as the market for research becomes increasingly sophisticated and independent from the multinational group, leading in some cases perhaps to a potential comparable uncontrolled price (CUP) approach. Credit derivatives is another area where there have been significant developments recently, not only in the trading area where customers have been increasingly willing to purchase protection and lower their credit exposure but also in the use of credit derivatives internally by banking groups, for example as part of the centralised management of credit risks associated with loan portfolios. Insurance Introduction An insurance policy is a contract that binds an insurer to indemnify an insured against a specified loss in exchange for a set payment, or premium. An insurance company is a financial entity that sells these policies. Insurance policies cover a wide range of risks. Broadly, these can be classified as: • general insurance (motor, weather, nuclear, credit), and • life insurance (pension, term). The major operations of an insurance company are underwriting, the determination of which risks the insurer can take on and rate-making, the decisions regarding necessary prices for such risks, claims management and appropriate investment of the sizeable assets that an insurer holds. By investing premium payments in a wide range of revenue-producing projects, insurance companies have become major suppliers of capital, and they rank among the largest institutional investors. 128 International Transfer Pricing 2015/16

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Reinsurance Reinsurance is insurance purchased by insurers. Under a reinsurance arrangement, the reinsurer agrees to indemnify an insurer (known as the cedant under a reinsurance contract) against part or all of the liabilities assumed by the cedant under one or more insurance or reinsurance contracts. In consideration for reinsuring risks, the ceding insurance company pays a premium to the reinsurer. Although reinsurance does not legally discharge the primary insurer from its liability for the coverage provided by its policies, it does make the reinsurer liable to the primary insurer with respect to losses sustained under the policy or policies issued by the primary insurer that are covered by the reinsurance transaction. Reinsurance is generally purchased to enhance the risk diversification of the insurers’ portfolio, to stabilise their annual results, and to increase efficiently their premiumwriting capacity.13 It may also be used to facilitate the growth of an insurer’s new products or aid its entry into new lines of business. The two methods by which risk is ceded through reinsurance contracts are: • Treaty reinsurance – A contractual arrangement that provides for the automatic placement of a specific type or category of risk underwritten by the primary insurer. • Facultative reinsurance – The reinsurance of individual risks whereby the insurer separately rates and underwrites each risk. Facultative reinsurance is typically purchased by primary insurers for individual risks not covered by their reinsurance treaties, for excess losses on risks covered by their reinsurance treaties and for ‘unusual’ risks. The two major forms of reinsurance are proportional reinsurance and excess-of-loss reinsurance. Premiums received from treaty and facultative reinsurance agreements vary according to, among other things, whether the reinsurance is on an excess-of-loss or on a proportional basis. • Proportional reinsurance – The two types of proportional insurance are: • Quota share – The risk is shared according to pre-agreed percentages. • Surplus share agreement – The primary insurer selects the amount of liability it wishes to retain on the policy and then cedes multiples, known as ‘lines’, of its retention to the insurer. Losses and premiums are divided between the company and the reinsurer proportionally with respect to the portion of risk undertaken. • Excess-of-loss reinsurance – The reinsurer indemnifies the primary insurer for all covered losses incurred on underlying insurance policies in excess of a specified retention. Premiums that the primary insurer pays to the reinsurer for excess of-loss coverage are not directly proportional to the premiums that the primary insurer receives, because the reinsurer does not assume a proportional risk. Furthermore, the reinsurer generally does not pay any ceding commissions to the primary insurer in connection with excess-of-loss reinsurance. 13 An insurer’s gross underwriting capacity (i.e. its ability to write business) is limited by law or regulation based on the amount of its statutory surplus. The greater the ratio of premiums written or liabilities to such surplus (i.e. its leverage ratio), the less likely it is that the regulator will consider the surplus to be sufficient to withstand adverse claims experience on business written. Through reinsurance, an insurer can increase its gross volume of business written, while maintaining a healthy ratio between risk retained and surplus. www.pwc.com/internationaltp 129

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Financial services A company that provides reinsurance can, in its turn, engage in an activity known as ‘retrocession’. Retrocession is defined as a transaction in which a reinsurer cedes to another reinsurer all or part of the reinsurance it has previously assumed. The ceding reinsurer in a retrocession is known as the ‘retrocedent’, while the assuming reinsurer is known as the ‘retrocessionaire’. Intragroup reinsurance arrangements are typically the most material transfer pricing transactions for most insurance groups and therefore a focal point for governments and tax authorities around the globe. Over the past few years, the transfer pricing environment surrounding insurance and reinsurance transactions has evolved such that, when conducting a transfer pricing analysis, special care should be taken to ensure that (i) capital requirements are being met by the insurers and (ii) the substance of the transactions is carefully documented. In 2009, the European Union enacted the Solvency II directive thereby introducing economic risk based solvency requirements which have led to an increased consolidation within the industry to take advantage of the synergies and economies of scale and an increase appetite for companies to operate through branches. This in turn raises significant transfer pricing challenges in light of the July 2010 OECD Part IV publication on the attribution of profits to permanent establishments of insurance companies. In the US, the 2011 Neal Bill (a revised version of the so-called 2009 Neal Bill) was introduced with the intent of eliminating the deductions for reinsurance premiums paid by a US insurance company to its off-shore non-taxed related affiliates. As a consequence, although many group reinsurance companies still reside in jurisdictions with benign tax and regulatory regimes, such as Bermuda, an increasing number of those have now chosen to establish their operations in treaty countries. As described above, reinsurance transactions are generally complex in nature and many contracts are bespoke to address the particular requirements of both the reinsured and the reinsurer. Transfer pricing support typically comprises a combination of the following approaches: Commercial rationale: The first requirement in support of a reinsurance arrangement is to demonstrate the commercial rationale behind the transaction. Tax authorities can seek to re-characterise the transaction if it would clearly not have been entered into with a third party. This is particularly critical given the OECD members’ current focus on an anti-avoidance agenda in respect of reinsurance transactions and business restructuring. Internal CUPs: In some cases, a group reinsures portions of the same business to related and unrelated parties, which may provide a strong CUP. In other cases, a group may have previously reinsured with an external reinsurer before establishing a group reinsurer. Care needs to be taken to demonstrate that the contracts are comparable, taking into account the mix of business, layers of risk, volume, expected loss ratios, reinsurance capacity, etc. Pricing process: For complex non-proportional reinsurance, the most appropriate transfer pricing support may often be derived from being able to demonstrate that the pricing process for internal reinsurance contracts is exactly the same as that for external reinsurance. This involves due diligence on the actuarial modelling and 130 International Transfer Pricing 2015/16

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underlying assumptions, as well as the underwriting decision, which evidences the process of negotiation, challenge and agreement on the final price. The use of this approach has been strengthened by the US services regulations, which expanded the indirect evidence rule by reference to an insurance-specific example. Cost of capital: Many large proportional reinsurance contracts are difficult to price using either of the above methods, as they often involve multiple classes of business that are not commonly found in the marketplace. In such cases, it is often necessary to return to first principles and address the capital requirements and appropriate return on capital based on the expected volatility and loss ratios of the portfolio of business, as well as the cost of acquiring and supporting the business, thereby addressing the pricing from both the cedant’s and reinsurer’s perspectives. Additionally, ratings agencies may provide guidance and support for the pricing process through the benefits in the sources and uses ratio due to capital relief obtained through reinsurance transactions. Centralisation Insurance groups generally undertake many centralised activities (i.e. management services), including inter alia the provision of central human resources, legal, accounting, internal communications and public relations’ activities. The past few years have witnessed an increase in the number and quality of the tax administrations’ audits related to the allocations, across business participants, of such expenses. European and US tax authorities have recently devoted a significant amount of resources auditing such transactions and paid a particular attention to the characterisation of the services provided, the identification of the benefits conferred, the costs associated with the provision of the services and the profit elements attributable to the service providers. Specific centralisation issues can also arise when global insurance policies are sold to multinationals where negotiation, agreement and management of risk occur at the global or regional head-office level. In such cases, even where the local insurance company/branch is required to book the premium, the reality may be that the local entity is bearing little or no risk. Alternatively, where risk is shared among the participants, consideration needs to be given to how the central costs of negotiation should be shared. Investment and asset management The return earned from investing the premium collected contributes to the ability of insurance companies to meet their claims obligations. To the extent that such investment and asset management capabilities are concentrated in certain parts of the overall group, a charge is made for the services provided to other members of the group. Specific factors that may influence the pricing of such services include the type of assets managed, level of activities carried out, risk involved, volume of transactions, expected returns and expenses of providing such services. The specific issues to be considered are described in more detail in the Investment Management section below. However, it is worth noting here that, as insurance groups often have very large sums to manage and the level of funds under management represents a key business factor in pricing investment management services, comparables used in the broader investment management sector may need to be adjusted for the sale of invested assets before being applied within an insurance group. www.pwc.com/internationaltp 131

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Financial services Financing and financial guarantees As with banking, many of the issues surrounding financing transactions apply equally to intragroup financing within insurance institutions. These include intragroup loans and loan guarantees. However, certain financing issues are specific to the insurance sector. The provision of financial guarantees is an important aspect of insurance transfer pricing. Such guarantees can include claims guarantees, net worth maintenance agreements and keep-well arrangements. Pertinent factors that need to be considered include the type of security or collateral involved, the differential credit ratings between guarantee providers and recipients, market conditions, and type and timing of the guarantee. Brokerage and agency activities With the increasing internationalisation and consolidation in the insurance sector, insurance brokers and agents are becoming increasingly integrated. As such, brokerage/commission sharing becomes increasingly complicated, resulting increasingly in the use of profit split as a primary or secondary supporting method to adequately represent each participant’s contributions. Other issues in insurance Insurance companies are increasingly expanding into new areas of business, with a view to diversifying the risks associated with the modern insurance industry. As a result, we are seeing insurance groups undertake many of the activities that have traditionally been associated with the banking and capital markets industry. The resurgence of insurance derivatives is part of the general trend of using capital markets solutions to solve insurance industry problems. Transfer pricing associated with the trading of insurance derivatives often raises similar issues described above for global trading within banks, as discussed above. One specific issue that arises reflects the history of insurance groups. As insurance groups have grown, typically through acquisition, complicated group structures and non-standard transactions have arisen as a result of regulatory restrictions and historical accident. Understanding the history behind such transactions often plays an important part in explaining how the transfer pricing approach must be evaluated within an appropriate commercial context. Investment management Introduction Investment management activities permeate the entire financial services industry. Insurance companies have a core need to manage their funds, and banks, following the enactment of the Volcker Rule, have been searching for new investment channels to manage the capital they used to devote towards their own proprietary trading desks. Although many investment management businesses are still part of a wider banking or insurance operation, there is also a significant number of independent investment management firms whose sole business it is to manage assets on behalf of their clients. In all cases, assets are reinvested on a segregated basis or, more commonly, on a pooled basis through the medium of a notional or legally distinct investment fund. 132 International Transfer Pricing 2015/16

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The diverse and global nature of the investment management industry gives rise to a huge variety of investment fund types. Fund types include securities or bond funds, hedge funds, property funds, private equity funds, futures and options funds, trading funds, guaranteed funds, warrant funds and fund of funds. These funds can be further subdivided into different share or unit classes incorporating different charges, rights and currency classes. Within each type of fund are different strategies of asset management. Investors select funds based on performance and their aversion to risk. Funds can either passively track an index or be actively managed. Indexed funds or trackers are benchmarked to a defined market index. The fund managers are passive insofar as they do not attempt to outperform the index through stock selection. This contrasts with the actively managed fund where the managers select assets with the aim of outperforming the market or the benchmark. As a result of these strategies, different remuneration schemes for the investment managers have been devised to adequately reflect their contributions to the overall performance of the funds. Factors such as the increasing mobility of capital and technical advances in the field of communications have contributed to the large number of jurisdictions with thriving investment management industries. In many cases, investment managers offer services from offshore domiciles to investors in selected target countries for certain legal, regulatory or tax requirements. Investment advisory, marketing and fund-accounting services are often then delegated to onshore subsidiaries, which benefit from better access to a skilled workforce. Fees for managing assets are typically charged on an ad valorem basis (i.e. as a percentage of assets under management) and have recently decreased due to the increasing competition in the industry. However, charges and charging structures still vary depending on the nature of the funds in which the investment is made, the investment profile of the fund, the investment objectives themselves, and the brand name recognition surrounding the investment manager. Private equity and venture capital vehicles may charge investors based on the committed capital pledged to the investment vehicle over time. Investment funds can give rise to a number of different charges for investors, including: Front-end loads: A charge made on the monies committed by an individual investor on entering the fund and paid by the investor. This is common in retail funds where an independent financial advisor (IFA) brings clients’ monies to the fund and, in return, expects a proportion of the load. Management fees: A charge (usually a fixed percentage) made on the net asset value of the fund and paid directly by the fund to the fund manager. Trailer fees: A fee payable to distributors (e.g. IFAs) by the fund manager from the gross management fee for the referral of clients’ monies. The fee is normally calculated as a proportion of the net assets referred by the distributor and is usually payable by the fund manager until the investor withdraws their monies. Performance fees: Fees typically paid in addition to a base management fee by niche market funds (e.g. hedge funds and private equity funds) as well as for the www.pwc.com/internationaltp 133

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Financial services management of large segregated funds. The industry recognises three broad classes of investors: institutional, retail and private client. Below, the main investment management sub-industry categories involving significant cross-border flows of products and services are considered in more detail. Asset management Asset management typically comprises overall asset allocation and the asset research, selection and management of individual securities, with a view to meeting the objectives of the portfolio or fund. It is common for these functions to be segregated to take advantage of local/specialist knowledge and expertise (commonly referred to as subadvisors). Investment management groups may have potential internal comparables relating to institutional mandates. In addition, there is some publicly available information in respect to both investment management and subadvisory fees. These should be used carefully, since specific factors influence the pricing of such services, including the type of assets managed, scope of activities carried out, risk involved, volume of transactions, expected returns and expenses of providing such services. Marketing, distribution and client servicing In considering appropriate arm’s-length fees for marketing, distribution and client servicing, one of the most important considerations is the type of customer. For example, fees are usually higher for retail investors than for institutional investors. This reflects both the additional costs associated with attracting funds for retail investors and also the greater bargaining power of institutional investors, due to their larger size of investment. Again, owing to the different business models applicable to different types of customer, funds and investment strategy, great care needs to be taken in attempting to make use of potential comparables – internal and external. Industry intelligence and anecdotal evidence should be accounted for in the comparable analysis as financial arrangements for distribution and capital-raising services are often highly discrete or depend on the type of client and asset class managed. Administration and other centralised activities As for banking and insurance groups, investment management groups or subgroups generally undertake many of the same types of centralised activities (i.e. management services), including inter alia the provision of central human resources, legal, accounting, internal communications and public relations’ activities. The considerations highlighted in the context of the banking and insurance industries relating to the identification of the services provided, the entities providing the services, the entities receiving the services, the costs involved and the application of a markup apply equally here. Consideration needs also to be given to the development of bespoke investment technologies, which act to enhance investment performance or to centralise risk and decision-making. In addition, the track record and skills of the portfolio managers are highly important in the investment management business, while the ownership and development of brand and other intangible assets needs to feature prominently in any transfer pricing analysis. 134 International Transfer Pricing 2015/16

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In 2011 and 2012, the alternative investment industry performance rebounded significantly from the post 2008 financial crisis era and is expected to keep growing at a superior pace in the foreseeable future. Despite the recent performance trend, investors have maintained a significant amount of pressure on fees they are willing to pay to fund managers. As in the case of the insurance industry, the major factors currently affecting the industry are globalisation, structural changes, and changes in the capital market regulatory environment. With new regulations in place (i.e. the 2010 Dodd-Frank Act, BASEL III) to prevent future credit crisis and market collapses, certain types of business activities have been restricted affecting the future profit, revenue, and assets of management of the industry. More stringent capital and liquidity standards have been proposed, which will hamper risk-taking or liquidity in the capital markets and increase compliance costs in the banking industry leading investors to turn to less regulated environments. Further, the Volcker Rule, scheduled to go into effect in July 2014, by prohibiting banking entities from (i) investing in or sponsoring private equity funds, venture capital funds or hedge funds or from (ii) conducting proprietary trading is likely to increase the industry’s assets under management as investors seeking high returns will go to hedge funds and private equity firms once they become the only source of relatively unrestricted capital left in the market. Additional regulations aimed at regulating the alternative investment industry (i.e. the European Alternative Investment Fund Managers Directive) will likely increase the compliance burden of European investment funds while decreasing the number of non-European investment managers operating in Europe and therefore the overall competitiveness of the European market. As these ongoing changes unfold, tax authorities have recently increased their number of transfer pricing audits mainly in relation to the remuneration of offshore managers. Additional considerations such as the value-added tax impacts, when relevant and possible, should be weaved into the transfer pricing policies as these represent expenses for the investment managers. Real estate In the wake of the 2008 financial crisis, institutional investors have increased their allocations into the real asset market as sales of distressed real estate assets by banks have boosted the availability of prime properties in key locations. However, given the recent market events, investors are now requiring more frequent reporting on the assets they invest in and also request higher transparency. The coming years will continue to witness significant major regulatory changes as regulators keep on focusing on investor protection and harnessing systemic risks. To cope with these challenges, constraints and increasing costs pressure, real estate fund managers have been rethinking their business models and organisational structures. The concomitance of these trends has enhanced the visibility of the industry in the eyes of tax authorities around the world in general and in the US, in particular where an investment vehicle, the real estate investment trust (REIT) has risen to prominence due to its preferential tax treatment. A REIT is a ‘pass-through’ entity that can avoid most entity-level federal tax by complying with detailed restrictions on its ownership structure and operations. As such, its shareholders are taxed on dividends received from the REIT but the entity itself is generally not subject to taxes as it generally redistributes all of its income in the form of dividends. A taxable REIT subsidiary (a TRS) provides a REIT with the ability www.pwc.com/internationaltp 135

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Financial services to carry on certain business activities that could disqualify it if engaged in directly by the REIT. Transactions between a REIT and its TRS are analysed under the section 482, transfer pricing regulations and subject to the arm’s-length standards. Such transactions include providing services to tenants, sharing resources, leasing transactions and financing transactions. In developing these investment structures, the challenges are (i) to determine the right mix of debt and equity and setting the appropriate interest rate on the debt component, and (ii) to ensure that the ancillary services performed by the TRS are appropriately remunerated as available third party comparables are typically difficult to obtain. Sovereign wealth funds (SWF)14 Over the last decade as nations become richer and increasingly wiser about financial planning, the number and the wealth of the SWFs have dramatically increased. From an international tax standpoint, there is no conventional definition of an SWF. Generally, the term refers to a state-owned fund invested into a variety of financial assets (stocks, bonds, real estate, commodities, and other financial instruments). Conceptually, the SWF is only one of the types of investment vehicles used by sovereign states to invest their accumulated wealth, along with public pension funds, stateowned enterprises or sovereign wealth corporations. An understanding of the functional profile of the sovereign wealth funds is fundamental to the understanding of transfer pricing matters for SWFs. Generally, in the asset management market, SWFs are unique in that they are established, funded by, and managed under mandates designed by a sole shareholder, the sovereign state. Each fund has its own unique reasons for creation, source of funds, and objectives. Depending upon the tax laws of the home country or the structure of the investments, some SWFs may be tax exempt. Given state ownership, many SWFs do not publically report investment activity. Sovereign investment corporations have certain unique features that make them different from non-sovereign investment houses – they are established, funded by, and managed under mandates designed by a sole shareholder (the sovereign state), have large pools of assets under management, and may receive special tax treatment. They also have features that make them similar to non-sovereign investment managers – they operate as independently managed commercial investment companies, are managed on commercial principles to create and maximise long-term value to their shareholders, and are subject to the same competitive market pressures as any other player. They also operate through affiliates established around the world, as relevant to their mission, to enhance their visibility into the opportunities offered by the regional markets and to facilitate their investments. From a business operational standpoint, the relationships between affiliates and the parent sovereign investment companies are structured in the same way as the intercompany relationships of any other multinational. These transactions may consist of one or a combination of business management services, business support services, market research services, investment advisory services, loan origination services, 14 Please refer to PwC’s April 2012 ‘Clarifying the rules; Sustainable transfer pricing in the financial services sector’, part III for additional details. 136 International Transfer Pricing 2015/16

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licensing of intellectual property, inter-company financing, and other types of intercompany transactions. Although the transfer pricing method and concepts are the same as those available for the analysis of mainstream investment managers, because of the unique structure of SWFs, the challenge is often the selection and use of the pricing data available in the public domain, assuming the CUP method is the best/most appropriate method, and how to determine the necessary adjustments. However, various public databases provide industry-specific data for separate accounts and fund of funds to construct robust benchmark ranges of advisory fees, and to appropriately adjust these ranges (if such adjustments are possible) to reflect primarily the substance of the inter-company advisory functions for a single sovereign investor. www.pwc.com/internationaltp 137

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9. Transfer pricing and indirect taxes Customs duty implications Goods moved across international borders and imported from one customs’ jurisdiction into another are potentially subject to customs duties and, in some cases, to other duties and taxes such as value added tax (VAT) (which are beyond the scope of this book). In determining the transfer price for such goods, consideration must be given not only to the corporate income-tax repercussions but also to the customs duty implications and, in certain circumstances, there may be an apparent conflict between the treatment of a transaction for the purposes of the two regimes. Careful planning is then necessary to achieve a price that satisfies the requirements of the tax and customs authorities without incurring excessive liabilities. WTO Valuation Agreement Most countries levy ad valorem duties and have complex regulations governing the determination of the value of imported goods for customs’ purposes. All references in this book to customs’ valuation (unless otherwise stated) are to the World Trade Organisation (WTO) Agreement on implementation of Article VII of the General Agreement on Tariffs and Trade 1994 (the WTO Valuation Agreement), formerly known as the GATT Customs Valuation Code. Under the Uruguay Round Agreement, all members of the WTO were required to adopt the WTO Valuation Agreement within a specified period; however, some developing countries have not done so. Nevertheless, the laws of most trading countries are now based on the WTO Valuation Agreement. The basic principle of the WTO Valuation Agreement is that, wherever possible, valuation should be based on the ‘transaction value’ – the price paid or payable for the goods when sold for export to the country of importation, subject to certain prescribed conditions and adjustments. The most significant condition for acceptance of the transaction value by the customs authorities is that the price has not been influenced by any relationship between the parties. While different countries have widely varying standards to determine whether companies are ‘related’ for direct tax purposes, the WTO Valuation Agreement offers a worldwide standard for customs’ purposes, which is more narrowly defined than many direct tax laws. Persons, whether natural or legal, are deemed to be related for customs’ purposes under the WTO Valuation Agreement if: • • • • • • • • 1 they are officers or directors of one another’s businesses they are legally recognised partners in business they are employer and employee there is any person who directly or indirectly owns, controls or holds 5% or more of the outstanding voting stock or shares of both of them one of them directly or indirectly controls the other1 both of them are directly or indirectly controlled by a third person together they directly or indirectly control a third person, and they are members of the same family. Control for this purpose means that one person is legally or operationally in a position to exercise restraint or direction over the other. www.pwc.com/internationaltp 139

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Transfer pricing and indirect taxes Relationship between customs and tax rules Although the customs valuation rules are broadly similar to the OECD transfer pricing rules discussed elsewhere in this book, there are some significant differences and it cannot be assumed that a price that is acceptable to the revenue authorities will necessarily also conform to the customs’ value rules. At a basic level, a tax authority focuses on the accuracy of a transfer price as reflected on a tax return (annual basis aggregated across the entire business). Conversely, a customs’ authority applies duties against the value of the merchandise at the time of entry into a customs’ territory (at a transactional level, product type by product type). Consequently, an immediate potential conflict arises. In addition to this inherent difference, the two governmental authorities (tax and customs) are working at cross-purposes. On the one hand, a low value for customs’ purposes results in lower duties, while, on the other hand, this same low value results in a higher income/profit in the country of importation and results in higher taxes. Although variations on the same theme, value for transfer pricing and for customs’ purposes share a common founding principle: the price established for goods traded between related parties must be consistent with the price that would have been realised if the parties were unrelated and the transaction occurred under the same circumstances. This principle is colloquially known as the arm’s‑length principle. Intangibles Import duty is not normally applied to the cross-border movement of intangible property. However, the value of intangibles may form part of the customs’ value of imported goods if they both relate to, and are supplied as, a condition of the sale of those goods. Consequently, some commissions, certain royalties and licence fees, contributions to research and development (R&D), design, engineering and tooling costs, and other payments made by the buyer of the imported goods to the seller may be subject to duty if certain conditions are fulfilled. Conversely, certain costs and payments that may be included in the price of imported goods are deductible in arriving at the customs’ value or can be excluded if they are invoiced and/or declared separately from the goods themselves. The Brussels’ definition of value Those few countries that do not subscribe to the WTO Valuation Agreement (typically developing countries such as Côte d’Ivoire and Montserrat) continue to rely upon an older international code – the Brussels’ definition of value (BDV) – which is based on the principle of an entirely notional ‘normal’ value. Under the BDV, there need be no connection between the customs’ value and the price paid for the goods, so that the customs implications of importing goods into these countries have little or no significance for transfer pricing. Specific duties and fixed values Not all products are assessed a duty based on their value. Some products are assessed specific duties (e.g. a fixed amount per gallon/litre). In addition, some countries (e.g. Lebanon and Sri Lanka) levy specific duties on certain categories of imported good so that the actual price paid for them does not impact the duty owed. It is important to note, however, that many countries require the value declared to be ‘correct’, regardless of whether it impacts the amounts of duty paid, and have penalty provisions 140 International Transfer Pricing 2015/16

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for ‘non-revenue loss’ violations. Similarly, some countries apply fixed or official minimum values for certain goods, which also makes the transfer price irrelevant as a method of determining the value of imported goods for customs’ purposes. However, these latter practices are gradually disappearing as the countries concerned adopt the WTO Valuation Agreement. Sales taxes, value added taxes and excise duties Generally, the value of imported goods for the purposes of other ad valorem duties and taxes tend to follow the value for customs’ purposes. There are, however, special rules in many countries and, while a detailed discussion of these is outside the scope of this book, these rules must be taken into account when planning a transfer pricing and business policy. Antidumping duties/countervailing duties Anti-dumping duties are levied when, as the result of a formal investigation, it is determined that domestic producers have been or may be damaged because imported goods are sold in the country in question at less than a fair value, having regard to the price at which the same goods are sold in the country of export or, in certain cases, in a third country. In theory, it may appear that, if goods are sold at a dumped price, that price will not be acceptable to the revenue authority in the country of export, although the revenue authority in the country of import would presumably have no problem with it. In practice, however, because dumping is a product of differentials between prices in two markets, it is possible for a transfer price to offend the antidumping regulations while being acceptable to the revenue authorities or vice versa. Although, the need for the aggrieved industry to make its case and the administration to be satisfied that the dumping is causing injury mean that dumped prices do not necessarily result in the imposition of anti-dumping duties. Whereas anti-dumping duties are assessed against companies for their business practices, countervailing duties are assessed based on government subsidies or assistance. These cases target the actions of all trading entities in a particular industry, which are receiving some kind of export-generating assistance from the government of the exporting country. As with anti-dumping duties, the government subsidies can impact the transfer price of goods by removing some of the costs from the price of the exported goods. Accordingly, the transfer price would then be artificially low. However, and as is the case with anti-dumping duties, the aggrieved industry must bring forth the case to the importing country’s government. The complainants must show that they have been harmed or will be harmed by the abnormally strong trading position of the entities that received the government subsidies. Establishing a transfer pricing policy – technical considerations Where the proposed transfer pricing policy relates to international movements of goods that attract customs duties or other taxes on imports, it is necessary to determine whether the policy will: • meet the requirements of the customs authority in the country of importation, and • create opportunities for tax and customs’ planning to reduce the values for customs purposes without prejudice to the transfer pricing policy. www.pwc.com/internationaltp 141

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Transfer pricing and indirect taxes When traders use the transfer price as the value for customs’ purposes, they exercise an option that is both convenient and rife with pitfalls. The parties to the transaction must be able to demonstrate that, at the time the customs’ value was reported, supporting documentation was available to demonstrate that the transfer price was determined using acceptable valuation methods and applicable data. In essence, the customs’ value reported by related entities must mimic that which would have been established in an arm’s-length transaction according to customs’ rules. It is interesting to note that several customs’ authorities have issued written guidance specifically stating that a transfer pricing study, in and of itself, is not sufficient to support customs’ value requirements. Adjustments Before attempting to validate the transfer price for customs’ purposes, it may be necessary to make certain adjustments to deduct those items that can be excluded from the customs’ value of the goods, even though they are included in the price, and to add those items that must be included in the customs’ value, even though they are excluded from the price. • Costs and payments that may be excluded from the transfer price of goods when included in such price include the following: • Costs of freight, insurance and handling that are excluded by the regulations of the country of importation (these costs are not always excludable). • Costs that relate to such activities undertaken after the goods have left the country of export. • Import duties and other taxes (including sales and value added taxes and excise duties) that are levied on importation of the goods into the country of import. • Charges for construction, erection, assembly, maintenance or technical assistance undertaken after importation on goods, such as industrial plant, machinery or equipment if separately itemised. • Charges for the right to reproduce the imported goods in the country of importation. • Buying commissions. Certain costs may be excluded from the customs’ value if they are separated from the price of the goods. The method of excluding these costs and payments – known as price unbundling – is explained later. It is important to note that there may also be other costs and payments that must be included in the customs’ value (added to the price) of the goods when not included in the transfer price. The costs and payments that must be added to the transfer price for customs’ purposes (if they are not already included) are as follows: • Commissions (other than buying commissions). • Freight, insurance and handling charges up to the point designated in the rules of the country of import (this can vary by country). • Royalties, if they both relate to the imported goods and the underlying rights were sold as a condition of the sale of the goods by the supplier (this also can vary by country). • Assists (i.e. the value of goods and services provided free of charge or at a reduced cost by the buyer to the seller for use in connection with the production or sale of the goods). 142 International Transfer Pricing 2015/16

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• Any quantifiable part of the proceeds of resale of the goods by the buyer that accrue to the seller (other than dividends paid out of the net profits of the buyer’s overall business). • The value, if quantifiable, of any condition or consideration to which the transfer • price is subject as per the rules of the country of import. • Any additional payments for the goods, which are made directly or indirectly by the buyer to the seller, including any such payments that are made to a third party to satisfy an obligation of the seller. • The cost of containers treated as one with the imported goods. • The cost of labour and materials in packing the goods. Validation of the transfer price for customs purposes The WTO Valuation Agreement provides quantitative and qualitative criteria for validating a price of goods. The quantitative criteria defined below are, however, dependent upon the existence of values for identical or similar goods that have already been accepted by the customs’ authority in question (or, in the case of the EU, by a customs’ authority in another member state). In practice, therefore, unless there are parallel imports into the same customs’ territory by buyers not related to the seller, these criteria are not applicable. The quantitative criteria are: • The price paid approximates closely to a transaction value in a sale between a seller and unrelated buyer at or about the same time. • The price paid approximates closely to the customs’ value of identical or similar goods imported into the same customs’ territory at or about the same time. The qualitative criteria are not specifically defined, although the explanatory notes to the WTO Valuation Agreement do provide some examples. Essentially, the customs’ authority must be satisfied that the overseas’ supplier and the importer trade with each other as if the two parties were not related. Any reasonable evidence to this effect should be sufficient, but the following circumstances, in particular, should lead the customs’ authority to conclude that the price has not been influenced by the relationship: • • • • The price is calculated on a basis consistent with industry pricing practices. The price is the same as would be charged to an unrelated customer. The price is sufficient for the seller to recover all costs and make a reasonable profit. The use of an alternative method of valuation (e.g. deductive or resale-minus method) produces the same customs’ value. If the application of any of the above criteria confirms that the proposed transfer pricing policy yields transaction values that are acceptable values for customs’ purposes, no further action is necessary other than to determine whether any adjustments need to be made to the price and whether prior application should be made to customs for a ruling. Since the objective of the tax and customs’ rules is to arrive at a price that is not influenced by the relationship between the parties, there should be no substantial difference between a transfer price that meets the requirements of both tax authorities and one that constitutes an acceptable transaction value for customs’ purposes. However, given the degree of flexibility inherent in both sets of rules, some variation is inevitable and, in certain cases where this flexibility has been exploited for commercial www.pwc.com/internationaltp 143

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Transfer pricing and indirect taxes or income-tax purposes, the difference may be sufficient to result in a transfer price that is unacceptable to the customs’ authority or results in an excessive liability to customs’ duty. Transfer prices below the acceptable customs value If none of the methods described above enables the transfer prices to be validated for customs’ valuation purposes, because they are lower than the acceptable value, the taxpayer has the following options: • Modify the transfer pricing policy. • Submit valuation for customs’ purposes on the basis of an alternative method of determining value. The choice between these two options depends upon the circumstances in each case, but the following factors need to be considered: • The interest of the customs’ authority in the country of import is, in principle, the same as that of the revenue authority in the country of export: both are concerned that the transfer price may be too low. A transfer pricing policy that produces prices unacceptable for customs’ purposes, may, therefore, not be acceptable to the exporting country’s revenue authority. • The methods of validating a transfer price are based, for the most part, on the application of the alternative methods of valuation to determine whether their use will yield a customs’ value that is significantly different than the actual transfer price. The results of the validation exercise will therefore indicate the customs’ values likely to be acceptable to the customs’ authority under each method. The alternative methods must be applied in strict hierarchical order, except that the importer has the option of choosing the computed (i.e. cost plus) or deductive (i.e. resale-minus) method of valuation and is free to choose the method that yields the lower customs’ value. Transfer price exceeds acceptable customs value If the application of the validation methods demonstrates that the transfer price is higher than the value that could be justified for customs’ purposes, the taxpayer has the following options: • Consider the scope for unbundling the transfer prices. • Modify the transfer pricing policy. • Submit valuation on the basis of an alternative method. The transfer price may exceed the acceptable customs’ value of the imported goods because it includes elements of cost and payments that need not be included in the customs’ value. An exercise to ‘unbundle’ the transfer price and to separate those elements may result in a customs’ value that is significantly less than the transfer price. Most jurisdictions have no legislative requirement to reconcile the value of imported goods for customs’ purposes with the inventory value of those goods for corporate income-tax’ purposes. Where such a requirement does exist, however – notably in the US – due account can be taken of those elements that form part of the inventory value but are not required to be included in the value for customs’ purposes. If the unbundled transfer price still exceeds the acceptable customs’ value, the taxpayer should consider 144 International Transfer Pricing 2015/16

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whether the transfer price does in fact meet the requirements of the revenue authority in the country of importation. Corporate income tax is levied only on the profits of a transaction, whereas customs’ duties are paid on its full value, irrespective of whether a profit or loss is made. In certain circumstances, notably where there are losses, a high transfer price – even if it is acceptable to the revenue authorities – may result in a net increase, rather than a reduction, in the overall tax burden when the increased duty liability is taken into account. Customs’ authorities do not normally entertain the argument that a transaction value is unacceptable solely because it has been inflated as a result of the relationship between the buyer and seller of the goods. It may be, however, that the circumstances surrounding the transactions between the buyer and seller are such as to preclude valuation on the basis of the transfer price, namely: • The price is subject to some condition or consideration that cannot be quantified (e.g. the goods are supplied on consignment and the transfer price is dependent upon when, to whom and in what quantity the goods are resold). • An unquantified part of the proceeds of the resale of the goods by the buyer accrues to the seller (other than in the form of dividends paid out of the net profits of the buyer’s total business). • The seller has imposed upon the buyer a restriction that affects the value of the goods in question (e.g. they can be resold only to a certain class of purchaser). • The goods are supplied on hire or lease or on some other terms that do not constitute a sale of the goods (e.g. on a contingency basis). Alternative methods of valuation Once it is established that the imported goods cannot be valued for customs’ purposes on the basis of the transaction value, the link between the transfer price for commercial and income-tax’ purposes and the value of the goods for customs’ purposes is broken. The taxpayer is then free to determine a transfer price without regard to the customs’ implications, irrespective of whether the price so determined is higher or lower than the value of the goods for customs’ purposes, except for countries like the US where the inventory value for tax purposes cannot exceed the customs’ value. Several transfer pricing methods (TPMs) are available, many of which are sufficiently flexible to apply to a variety of transaction types. Traditional TPMs are the CUP method, the cost-plus method, and the resale price method. Other methods are the profit split and the transactional net margin methods. The alternative methods of customs’ valuation are similar to some of the methods used to validate transfer prices for income-tax’ purposes, but the WTO Valuation Agreement requires that they be applied, with one exception, in strict hierarchical order as set out below: 1. Value of identical goods. The transaction value of identical merchandise sold for export to the same country of importation and exported at or about the same time as the goods being valued. The value of the identical merchandise must be a previously accepted customs’ value, and the transaction must include identical goods in a sale at the same commercial level and in substantially the same quantity as the goods being valued. www.pwc.com/internationaltp 145

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Transfer pricing and indirect taxes 2. Value of similar goods. As in (1) except that the goods need not be identical to those being valued, although they must be commercially interchangeable. 3. Deductive value. A notional import value deduced from the price at which the goods are first resold after importation to an unrelated buyer. In arriving at the deductive value, the importer may deduct specific costs – such as duty and freight in the country of importation and either his/her commission or the profit and general expenses normally earned by importers in the country in question – of goods of the same class or kind. 4. Computed value. A notional import value computed by adding to the total cost of producing the imported goods, the profit and general expenses usually added by manufacturers in the same country of goods of the same class or kind. Note that, as an exception to the hierarchical rule and at the option of the importer, the computed valuation method can be used in preference to the deductive valuation method. The valuation of identical or similar merchandise is similar to the CUP method. The CUP method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. While simple on its face, the method is difficult to apply. The fact that any minor change in the circumstances of trade (e.g. billing period, amount of goods traded, marking/ branding) may have a significant effect on the price makes it exceedingly difficult to find a transaction that is sufficiently comparable. The deductive value method is similar to the resale price (RP) method. The RP method determines price by working backwards from transactions taking place at the next stage in the supply chain, and is determined by subtracting an appropriate gross markup from the sale price to an unrelated third party, with the appropriate gross margin being determined by examining the conditions under which the goods/ services are sold, and comparing the said transaction to other third-party transactions. Consequently, depending on the data available, either the cost-plus (CP) or the RP method will be most the appropriate method to apply. The computed value method is similar to the cost plus (CP method. The CP method is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the parties to the transaction. Amounts may be added for the cost of materials, labour, manufacturing, transportation, etc. Given the variables required for the proper application of this method, it is most appropriately used for the valuation of finished goods. As a matter of practice, some customs administrations do not accept the use of this method by importers given that the accounting for costs occurs in the country of export, which makes verification by local authorities difficult. If it proves impossible to find a value under any of the above methods, a value must be found using any reasonable method that is compatible with the WTO Valuation Agreement and is not specifically proscribed. In practice, customs authorities often adopt a flexible application of the transaction value rules or one of the alternative methods in order to arrive at an acceptable value. 146 International Transfer Pricing 2015/16

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Implementation of the customs’ pricing policy The procedures for declaring the value of imported goods to customs’ authorities vary from country to country. In most cases, however, some form of declaration as to the value of the goods is required at importation and the importer may be required to state whether the seller of the goods is a related party and, if so, whether the relationship has influenced the price. In some cases – such as where identical goods are sold to an independent buyer in the same country of importation at the same price – the importer can declare the transfer price with any necessary adjustments as the value for customs’ purposes. In most cases, however, the position is less clear and, where the local rules permit, the importer is strongly advised to seek a definitive ruling in advance from the customs’ authority or, at least, to obtain the authority’s opinion as to the validity of the values that it intends to declare. Strictly speaking, the WTO Valuation Agreement places the onus on the customs’ authority to prove that a price has been influenced by a relationship between the parties. In practice, however, the importer would be well advised – even if it is not intended to seek an advance ruling or opinion – to validate transfer prices for customs purposes and to maintain the necessary records, calculations and documentation for use in the event of a customs’ audit or enquiry. Transfers of intangibles Intangibles per se are not subject to import duty, but when supplied as part of a package of goods and services, the value of intangibles may constitute part of the customs’ value of the imports. When a package of goods and services is supplied for a single, bundled price, customs’ duty is paid on that price in full, unless it contains any elements of cost that can be separately quantified and is permitted to be deducted from the price. As explained previously, it is up to the importer and the foreign supplier to unbundle the price so as to separately quantify and invoice the value of those costs that do not have to be added to the customs’ value of imported goods if they are not already included. However, the following categories of intangibles are, subject to certain conditions, required to be included in the customs’ value of imported goods: • Payments by the importer, in the form of royalties or licence fees, for the use of trademarks, designs, patents, technology and similar rights, provided that the rights in question relate to the imported goods and that the payment therefore is a condition of the sale of the goods by the seller to the buyer. • Intangible ‘assists’, except where the work is undertaken in the country of importation. • Payments for computer software (subject to the options described in the GATT decision of 24 September1984). • Payments for the right to resell or distribute imported goods (but excluding a voluntary payment by the buyer to acquire an exclusive right to resell or distribute the imported goods in a particular territory). • Design, development, engineering and similar costs that represent part of the cost of manufacturing or producing the imported goods. www.pwc.com/internationaltp 147

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Transfer pricing and indirect taxes Royalties and licence fees This is the most complex area of customs’ valuation and each case has to be examined carefully to determine whether a liability to import duty arises. The following guidelines are helpful: 1. The key consideration in determining whether a royalty or licence fee is dutiable is the nature of the rights for which the payment is made. The basis on which the payment is calculated is usually not relevant. 2. Generally, if the imported goods are resold in the same state in which they are imported, any royalties or licence fees payable as a condition of the importation of those goods are likely to be dutiable. For example, if imported goods are resold under the manufacturer’s trademark – whether it is affixed to the goods before or after importation – the corresponding royalty payment is dutiable, even if the payment is based on income from sale of the goods in the country of importation. 3. However, where goods are subjected, after importation, to substantial processing or are incorporated into other goods, such that the resulting product does not have the characteristics of the imported goods, it is likely that the royalty or licence fee is not considered to relate to the imported goods, provided that the rights in question relate to the finished product. An example of this would be where the rights conferred on the buyer enable him to manufacture a product using the seller’s technology, patents or know-how or to sell that product under the seller’s trademark. In such circumstances, it is unlikely that the royalty payments would be regarded as part of the customs’ value of raw materials or components imported by the buyer from the seller for incorporation in the finished product. It may be necessary, however, to include at least part of the royalty in the customs’ value of the imported components if those components contain the essential characteristics of the finished product (see point [4] below). 4. Difficulties frequently arise where the imported materials or components are considered by the customs’ authority to contain the essential characteristics of the finished product. For example, the buyer may be paying a royalty for technology that supposedly relates to the manufacture of the finished product in the country of importation. However, if the process of manufacture is, in reality, no more than a simple assembly operation, customs may take the view that the technology is incorporated in the imported components rather than the manufacturing operation and deem the royalty to be dutiable. Another example is where the seller’s particular expertise or specialty is clearly incorporated in one key component, which is imported. As a result, royalties paid for a company’s unique technology which is incorporated in a single imported semiconductor device could be deemed dutiable even if the whole of the rest of the system is manufactured in the country of importation from locally sourced parts. 5. In circumstances where an importer is manufacturing some products locally using the affiliate’s designs, know-how and materials or components, while importing others as finished items from the same or another affiliate, care must be taken to distinguish the rights and royalties applicable to each. In such cases, it would normally be expected that the seller would recover all its research, development and design costs in the price of the products that it manufactures and exports to the buyer; it is inappropriate therefore to charge royalties for those products. 6. The decision of whether royalty and licence fees are dutiable may be subject to varying interpretations in different countries. Some countries, for example, may consider periodic lump-sum licensing fees to be non-dutiable charges, provided that payments are not directly related to specific importations. 148 International Transfer Pricing 2015/16

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7. Cost-sharing agreements (i.e. for R&D) can prove problematic if adequate documentation is not maintained, establishing what portion of development costs relates to the import of products. In such instances, the local import authorities may take the position that all such costs in a general pooling of costs are considered dutiable. In the case of the products manufactured in the country of importation, however, a royalty or licence fee is the only way in which the owner of the intangible can recover its costs. However, if a royalty refers to ‘the right to manufacture and distribute the company’s products in the territory’, it will be deemed to relate to the imported products as well as those manufactured in the country of export. Alternative wording – “the right to manufacture the company’s products in country A and to sell such products as it manufactures in the territory” – may avoid unnecessary liability to duty. Payments for the right to reproduce imported goods in the country of importation are specifically excluded from the customs’ value of imported goods. Intangible assists Intangible assists consist of designs, specifications and engineering information supplied by the buyer of the imported goods to the seller free of charge or at reduced cost. If the work is undertaken within the country of importation, such assists are not dutiable, but if the work is undertaken in the country in which the goods are manufactured or in any other country, the assists are deemed to be part of the customs’ value of the imported goods. There are different interpretations of what is meant by the word ‘undertaken’. Some customs authorities accept, for example, that work undertaken by the buyer’s designers who are based in the country of importation but who actually designed the product in the country of manufacture would not result in a dutiable assist; others, however, would take the opposite view. However, even if work is performed in the country of importation but paid for by the foreign seller and recharged to the importer, it may constitute a dutiable cost as representing part of the price paid or payable for the imported product. The value of an assist is the cost to the buyer of producing or acquiring it, and it is not necessary to add a markup or handling fee. Interest Interest incurred by the manufacturer of imported goods is deemed to be part of the cost of producing the goods and should therefore be included in the price. However, where the importer pays interest – to the seller or a third party – under a financing agreement related to the purchase of the imported goods, that interest need not be included in or added to the customs’ value of imported goods, provided that: • The financing agreement is in writing (although this need only be a clause in the agreement for the sale of the goods). • The rate of interest is consistent with contemporary commercial rates of interest for such transactions in the country in which the agreement is made. • The buyer has a genuine option to pay for the goods promptly and thereby avoid incurring the interest charge. • The interest is separately invoiced or shown as a separate amount on the invoice for the goods. • In some countries, such as the US, the interest must be treated as an interest expense on the books and records of the importer. www.pwc.com/internationaltp 149

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Transfer pricing and indirect taxes Computer software Contracting parties to the WTO Valuation Agreement may value software for use with data processing equipment on one of two alternative bases, namely: 1. The full value of the software, including the carrier medium (disk, tape, etc.) and the program data or instructions recorded thereon. 2. The value of the carrier medium only. The second option applies only to software in the form of magnetic tapes, disks and similar media. Software on the hard disk within a computer or embedded in semiconductor devices (firmware) is dutiable on the full value. Similarly, this option does not extend to software that includes audio or visual material. Although this exclusion was originally intended to cover leisure products, such as computer games, movies and music, more and more serious software now incorporates audio and visual material and, in some jurisdictions, may be subject to duty on the full value. The terms of the present valuation options on software dated from 1985 have been overtaken by advances in technology and commercial practice in the data processing industry. Furthermore, the Information Technology Agreement (ITA) has resulted in most movements of computer software becoming subject to a zero rate of duty. It is inevitable therefore that importers will face anomalies and uncertainties in the valuation of software unless or until the WTO Valuation Agreement is updated to reflect these developments. However, it is worth noting that software and other goods transmitted electronically do not attract customs duty even if, in their physical manifestation, they would be dutiable (e.g. music CDs, videos). Design, development, engineering and similar charges The costs of these activities are normally expected to be included in the price paid for the imported goods. However, there are circumstances in which companies may wish to recover these costs from their affiliates by way of a separate charge. Furthermore, the affiliate may be supplied not with finished products but only with components on which it is not normal to seek to recover such costs. Generally speaking, any payment for design and similar expenses that relates to imported goods is regarded as part of the customs’ value of those goods and an appropriate apportionment will be made and added to the price of the goods. Costs for research, if properly documented as such, are not subject to duty. Where components are supplied to the buyer and a separate charge is made relating to the design of the finished product that is manufactured in the country of importation, some difficulty may arise. If the components are purchased by the seller from thirdparty suppliers, the costs of design are likely to be included in the supplier’s price and no further action is necessary. However, where some or all of the components are produced by the seller and design costs have not been included in the price, it will be necessary to attempt to allocate an appropriate proportion of the total charge for design to the components in question. The impact of transfer pricing policy changes Where the basis of customs’ valuation is the transaction value – the price actually paid or to be paid for the imported goods – any change in the method of determining the transfer price may affect the validity of that price for customs’ purposes. It may also 150 International Transfer Pricing 2015/16

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trigger a requirement to notify the customs authority if the buyer holds a ruling that is subject to cancellation or review in the event of a change in commercial circumstances. If the proposed change in pricing arrangements is significant, the validation exercise described previously must be repeated to determine whether the new policy produces an acceptable value for duty purposes. Examples of significant changes are: • A shift in the allocation of profit from one entity to another. • A shift of responsibility for certain functions from one entity to another. • A change in the transaction structure, such as the interposition or removal of an export company, a foreign sales corporation or a reinvoicing centre. • Any changes in pricing levels that exceed normal commercial margins of fluctuation. Provided that the changes represent realistic responses to changes in commercial circumstances, there should be no difficulty in validating the new prices for customs’ valuation purposes. However, where no such justification for the changes exists – and particularly where the price change is substantial – it may be difficult to explain satisfactorily why the prices now being proposed have not previously been charged since the commercial circumstances are substantially unchanged. If the proposal is to increase prices, the customs authority may take the view that the values previously declared, based on the current transfer pricing policy, were too low and, depending upon local regulations, they may be able to recover substantial arrears of duty and to impose penalties. Conversely, even if the customs authority accepts that the current transfer prices are higher than commercial circumstances justify, there will probably be no basis for claiming repayment of duties overpaid, even if the seller credits the buyer with the difference between the existing and proposed prices on a historical basis. The impact of retrospective transfer price adjustments The WTO Valuation Agreement contains no specific provisions for dealing with adjustments to transaction values and, therefore, the rules and practice in each country determine how customs authorities respond if a price already paid is subject to subsequent adjustment for commercial or corporation tax’ purposes. The transaction value principle states that the price for the goods ‘when sold for export to the country of importation’ should represent the customs’ value of those goods. Provided, therefore, that the price paid or agreed to be paid at that time was not in any way provisional or subject to review or adjustment in the light of future events, specified or otherwise, that price must be the customs’ value of the goods. If, subsequently, that price is adjusted as a result of circumstances that were not foreseen at the time of the sale for export – or that, if they had been foreseen, were not expected or intended to lead to a price adjustment – there appears to be no provision under the WTO Valuation Agreement that would either: • in the event of a downward adjustment, allow the importer to recover duty overpaid, or • in the event of an upward adjustment, allow the customs authority to recover duty underpaid. www.pwc.com/internationaltp 151

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Transfer pricing and indirect taxes However, it is likely that, so far as customs authorities are concerned, the above is true only of occasional and non-recurring adjustments. If, for example, a company were to make a practice of reviewing its results at the end of each fiscal year and decided to reallocate profit between itself and its affiliates, it is probable that customs would take the view that such adjustments were effectively part of the company’s transfer pricing policy, even if no reference to it appeared in any written description of that policy. In those circumstances, subject to any statute of limitations, they would be likely to seek arrears of duty and possibly also penalties for all previous years in which upward adjustments had been made. While some customs jurisdictions may give credit for any downward adjustments in assessing the amount of duty due, it is unlikely that they would accept a claim for repayment where a net overdeclaration of value could be substantial. Where a company’s transfer pricing policy specifically provides for periodic review and retrospective price adjustment – for example, to meet the requirements of the IRS and other revenue authorities – customs will certainly regard any adjustments as directly applicable to the values declared at the time of importation. Any upward adjustments will therefore have to be declared and the additional duty paid. Downward adjustment, in some countries, may be considered post-importation rebates and consequently claims for overpaid duties will not be accepted. However, in the US, importers may take advantage of the Custom’s Reconciliation Program, which provides the opportunity to routinely adjust the value of imported goods and either collect or pay duties. In addition, in the US, a specific IRS provision (1059A) requires that the inventory basis for tax purposes does not exceed the customs’ value (plus certain allowable adjustments). Therefore, the possibility exists that the IRS authorities could disallow any upward price adjustment in the event it causes the inventory taxable basis to exceed the customs’ value. To avoid penalties for failing to declare the full value of imported goods and to ensure that duty can be recovered in the event of price reductions, it is recommended that any transfer pricing policy that involves retrospective price adjustments should be notified to customs in advance. Some authorities are amenable to arrangements whereby provisional values are declared at the time of importation and subsequent adjustments are reported on a periodic basis, provided they are accompanied by the appropriate additional duties or claims for repayment. As an alternative to the above, it may in some cases be in the importer’s interests to take the position that, at the time of importation, there is no transaction value because the eventual price for the goods cannot then be determined. In that event, the importer could seek valuation under one of the alternative methods described above. The impact of international structure The structure of a transaction chain that involves at least one cross-border movement between different customs’ jurisdictions can have a significant impact on duty liabilities. Transaction values exist only where there is a price for imported goods between two separate legal entities in a sale whereby ownership of the goods and the attendant risks pass from the seller to the buyer. In the absence of such a sales price between the exporter and importer, the customs’ value must be based on another sales’ transaction, if there is one, or on one of the alternative methods of valuation described above. The following examples illustrate the impact of various structures on the value of imported goods for duty purposes: 152 International Transfer Pricing 2015/16

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• Where an exporter uses a subsidiary company in the country of importation as its distributor, and the latter buys imported goods as a principal and resells them to end-customers, the price between the two companies is, in principle, acceptable for customs’ purposes. However, this is not the case where the distributor is merely a branch of the exporter and part of the same legal entity. In that event, unless there is another transaction value, duty is payable on the selling price to the endcustomer, including the gross margin of the branch. • Similarly, there is no transaction value if the subsidiary merely acts as a selling agent or commissionaire for the exporter and does not own the imported goods. Again, duty is payable on the selling price to the end-customer, including, in this case, the subsidiary’s commission. • Transactions involving reinvoicing operations that merely issue a new invoice in a different currency and do not take title or risk in respect of the imported goods are ignored for customs’ purposes, as are those involving foreign sales corporations (FSCs), which are remunerated by way of commission. However, transactions involving FSCs that act as principals may provide a basis of valuation. The customs laws of the EU and the US (but not, at present, any other jurisdiction) recognise a transaction value, based on a sale for export to the country of import even when there are subsequent sales in the supply chain (successive or first sale concept). This means, for example, that if a manufacturer in the US sells goods for 80 United States Dollars (USD) to a US exporter who, in turn, sells them to an importer in the EU for USD 100, the latter can declare a value of USD 80 for duty purposes, even though USD 100 was paid for the goods. Acceptance of the price in the earlier sale is conditional upon the following factors: • The goods being clearly intended for export to the country of importation at the time of the earlier sale. • The price being the total consideration for the goods in the earlier sale and not being influenced by any relationship between the buyer and seller. • The goods being in the same physical condition at the time of the earlier sale and at importation. Apart from allowing duty legitimately to be paid on what is, in most cases, a lower value, the ‘successive sales’ concept in the EU and ‘first sale’ approach in the US also have the benefit of decoupling the value of imported goods for duty purposes from the values of those goods for the purposes of determining the taxable profits of the importer and exporter. Japan also provides for duty reduction based on a principle very similar to that which underlies the ‘first sale’ programmes in the US and EU, albeit in a more complex manner. Dealing with an audit of pricing by an indirect tax authority For similar reasons to those advanced by the tax authorities, customs authorities are taking an increasing interest in the validity of values declared by importers on the basis of transfer prices between related parties. The principal areas on which they focus their inquiries are: • Whether the transfer price allows full recovery of all relevant costs, including general and administrative overheads and relevant R&D. • Whether the addition for profit occurs on an arm’s-length basis. • Whether all appropriate additions have been made for royalties, R&D payments and assists. www.pwc.com/internationaltp 153

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Transfer pricing and indirect taxes Traditionally, customs authorities have tended to operate in a vacuum, with no consideration for the commercial or tax environments within which transfer pricing policies are developed and implemented. This has led to considerable frustration as companies have tried to defend to customs’ officers prices that are not only commercially justifiable but have already been accepted by the revenue authorities. However, this situation is changing in some jurisdictions where customs authorities are making efforts to understand the OECD Guidelines and are increasingly interfacing and cooperating with their direct-tax revenue colleagues. It is unlikely that greater knowledge and understanding will lead to fewer customs valuation audits – indeed, the opposite is more likely to be the case – but it should mean that they are less troublesome for importers. As for tax purposes, the availability of documentation that describes the company’s overall transfer pricing policy and demonstrates how individual transaction values have been calculated is essential. In addition, a similar approach to customs’ value documentation should also be undertaken. This can start with the transfer pricing documentation and include the appropriate additional analysis required by customs. In addition, where the position is complex and there is likely to be any contention as to the correct values, it is strongly recommended that the facts and legal arguments be presented to the customs authority before the relevant imports commence and, as advisable, a formal ruling or opinion obtained. Although these will not preclude subsequent audit, the latter should then be confined to verification of the relevant facts rather than involve arguments about issues of principle. Strategy based on balance and leverage A prudent company will take the same care and documentation approach for customs as it does for transfer pricing. Considering the above, it can be argued that an importer’s sole reliance on a transfer pricing analysis would likely not be sufficient to support the proper appraisement of merchandise for customs’ valuation purposes. To believe and act otherwise runs the risk of being subjected to fines, penalties or a mandated application of an alternative customs’ valuation method that may be difficult and costly to implement and sustain. Indeed, the belief that if a taxpayer has done a transfer pricing study then its customs’ value must be correct has been proven wrong time and time again. Still, a transfer pricing analysis and related documentation can be leveraged to provide a basis from which a customs’ value may be derived and supported. This assumes, of course, that all required statutory adjustments are applied and other relevant considerations are factored in. The potential benefits to global traders from finding an appropriate balance in the transfer pricing and customs’ valuation nexus are many and include the following: • A foundation for establishing inter-company pricing policies for customs’ purposes that help to decrease accounting issues that are created by gaps, lack of coverage, or contradictions among inter-company pricing initiatives. • The ability to significantly reduce the potential of a customs’ audit as well as the financial exposure related to penalties associated with non-compliance of customs’ regulations. • A global (or at least multijurisdictional), long-term coordinated inter-company customs’ valuation documentation compliance solution that considers products/ product line, market conditions, and other key economic factors. 154 International Transfer Pricing 2015/16

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• A basis for proactively managing value adjustments to achieve arm’s-length results required under tax and customs’ regulations. • A foundation for pursuit of advanced pricing agreements that may also be considered by customs authorities as evidence of an appropriate arm’slength result. • The ability to identify planning opportunities related to the valuation of merchandise and intangibles (e.g. royalties, licence fees, research and development, warranties, marketing and advertising, cost-sharing arrangement) via alternative methods of appraisement. • The development of limits to customs authorities’ ability to interpret Art. 1.2(a) and (b) of the WTO Customs Valuation Agreement relating to the acceptability of using the transfer price as an initial basis for the customs’ value of imported merchandise. • Enhanced financial reporting compliance related to inter-company cross-border transactions to satisfy obligations under Sarbanes-Oxley reporting requirements. www.pwc.com/internationaltp 155

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10. Procedures for achieving an offsetting adjustment Introduction Early consideration should be given to the procedures that might be followed to obtain compensating adjustments in other jurisdictions should a transfer pricing audit lead to additional tax liabilities in a particular jurisdiction. The attitudes of revenue authorities vary and will depend upon the overall circumstances (such as whether they consider that the taxpayer has deliberately sought to reduce their taxes by what they perceive to be ‘abusive’ transfer pricing). Generally, no scope is available with which to make adjustments in the absence of a double tax treaty or multi-country convention. However, it might be possible to render further invoices in later years reflecting pricing adjustments, although these types of adjustments are frowned upon and attract scrutiny from the tax authority of the receiving jurisdiction. Very careful attention needs to be paid to the legal position of the company accepting retroactive charges and to other possible consequences, particularly to indirect taxes. Nevertheless, in a few cases this may afford relief. The ability to seek relief under the mutual agreement procedure process and, more particularly, under the European Union Convention, which is discussed in this chapter, is sometimes cited by taxpayers as if it is an easy solution to transfer pricing problems. This is not the case and should certainly not be viewed as allowing taxpayers to avoid paying careful attention to the implementation of a coherent transfer pricing policy and to its defence on audit. Competent authority Competent authority procedures for the relief of double taxation are typically established in bilateral tax treaties and must always be considered when a tax authority proposes an adjustment to prices. For instance, where a US subsidiary accepts that the price of each widget sold to it by its UK parent should be reduced by, say, 10 British pounds (GBP), to satisfy the US Internal Revenue Service, will the UK Inland Revenue accept a corresponding reduction in UK taxable income? This type of question involves consultation with the competent authorities. Virtually all double tax treaties contain provisions similar to those set out in Article 25 of the OECD Model. These provide that a taxpayer may petition the competent authority of the state in which he/she is resident where the actions of one or both of the treaty partners “… result or will result for him/her in taxation not in accordance with the provisions of [the double tax treaty]”. In the course of an audit, a taxpayer needs to consider whether reference should be made to the competent authority procedures and at what stage. It is necessary to pay attention to the required procedures and, more particularly, to the statute of limitations under each treaty. Adjustments may not be possible after a tax liability has become final, and only if the other revenue authority is prepared to give relief will double taxation then be avoided. While in general, revenue authorities consider that their enquiry should have been concluded before they begin discussions with the other www.pwc.com/internationaltp 157

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Procedures for achieving an offsetting adjustment revenue authority, they may be prepared to delay the finalisation of any assessment and, in particularly complex cases, may be willing to operate the procedure in parallel with the conduct of their audit. However lengthy or uncertain they are, the competent authority procedures remain the main process through which a taxpayer can hope to avoid double taxation after paying tax in respect of a transfer pricing adjustment. It is significant to note that the Mutual Agreement Procedure under a double tax treaty ordinarily provides an alternative process of dispute resolution and is an option available to the taxpayer in addition to and concurrently with the prevailing appellate procedures under domestic law. The reference to the competent authority is to be made by the aggrieved party impacted by taxation not in accordance with the treaty. Consequently, the reference would be made by the taxpayer, which has or may suffer double taxation arising from the adjustment to the transfer price of an associated enterprise, rather than the enterprise itself. Further, it is important to recognise that the charter of the mutual agreement procedure process is to mitigate taxation not in accordance with the treaty and not a means of eliminating the tax impact of a proposed transfer pricing adjustment. The mutual agreement procedure is a negotiation process between the competent authorities and ordinarily involves a compromise on both sides, by way of reaching a consensus on the acceptable transfer prices. During the mutual agreement procedure process, it is advisable for the taxpayer and its associated enterprise to provide inputs to respective competent authorities on an ongoing basis so that an effective and acceptable settlement is expeditiously reached. The taxpayer is at liberty to accept the agreement reached by the competent authorities or decline the arrangement (and by consequence revert to remedies under domestic law). The taxpayer may also withdraw its reference to the competent authorities during the negotiation process. European Union arbitration convention Background On 23 July 1990, the representatives of Belgium, Denmark, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Portugal and the UK jointly approved a convention on the elimination of double taxation in connection with the adjustment of profits of associated enterprises (Convention 90/436). This multilateral convention represented a unique attempt to solve some of the difficulties faced by multinational enterprises in the transfer pricing area. There were a number of procedural difficulties that made its use difficult, due to the modifications required to ratify the original treaty, to reflect the accession of Finland, Sweden and Austria, and also to the ratifications needed to extend the life of the original treaty beyond 31 December 1999. These procedural difficulties have now been overcome, thanks to the work of the EU Joint Transfer Pricing Forum. In November 2006, the Council Convention was amended with the accession of the Czech Republic, Estonia, Cyprus, Latvia, Lithuania, Hungary, Malta, Poland, Slovenia and the Slovak Republic in the European Union and entered into force on 1 November 2006. The scope of the Convention The Convention is designed to apply in all situations in which profits subject to tax in one Member State are also subject to tax in another as a result of an adjustment to correct non-arm’s-length pricing arrangements. The Convention also provides that relief is available under its terms where there is a risk of losses being doubly 158 International Transfer Pricing 2015/16

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disallowed. However, the Convention is not applicable in any circumstance in which the authorities consider that the double taxation arises through deliberate manipulation of transfer prices. Such a situation arises in any instance where a revenue authority is permitted to levy a ‘serious penalty’ on the business concerned. This is considered in more detail below (see The advisory commission). The businesses that can benefit from the Convention are those that constitute ‘an enterprise of a contracting state’; this specifically includes permanent establishments of any enterprise of a contracting state. No further definition of these terms is included in the Convention, although it is stipulated that, unless the context otherwise requires, the meanings follow those laid down under the double taxation conventions between the states concerned. The intention was undoubtedly that all businesses of any description which have their home base within the European Union (EU) should receive the protection of the Convention, regardless of their legal form. Consequently, a French branch of a German company selling goods to an Italian affiliate would be covered. However, a French branch of a US company selling goods to an Italian affiliate would not be covered. It is important to note that the Convention is drawn up in terms that recognise not just corporations but also other forms of business, subject to tax on profits. The required level of control In drafting the Convention on transfer pricing, the European Commission recognised that Member States use widely varying definitions of the level of control required between affiliated businesses before anti-avoidance law on transfer pricing can apply. The Convention’s definition of control for these purposes is accordingly very widely drawn indeed. It merely requires that one Member State enterprise “participates directly or indirectly in the management, control or capital of an enterprise of another contracting state” and that conditions are made or imposed between the two enterprises concerned such that their commercial and financial relationships differ from those that would have been made between independent enterprises. A similar definition deals with the situation where two or more Member State businesses are controlled by the same person. Regarding the profits to be attributed to a permanent establishment, the Convention follows the OECD Model Treaty, requiring that the permanent establishment be taxed on profits that it might be expected to make if it were a distinct and separate enterprise, engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. Adjustments to profits The Convention makes no attempt to interfere with the processes by which the tax authorities of any one Member State seek to make adjustments to the profits declared by a business operating in their country. However, where a contracting Member State does intend to make an adjustment on transfer pricing grounds, it is required to notify the company of its intended actions in order that the other party to the transaction can give notice to the other contracting state. Unfortunately, there is no barrier to the tax adjustment being made at that stage. As a result, Member State businesses still face the cash-flow problems associated with double taxation until such time as the authorities agree to make offsetting adjustments. If this double taxation cannot be eliminated by agreement between the two countries concerned, then the remaining provisions www.pwc.com/internationaltp 159

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Procedures for achieving an offsetting adjustment of the Convention may be used to gain relief. To address these issues, the Council of the European Union adopted a Code of Conduct for the effective implementation of the Convention wherein it has recommended Member States to take all necessary measures to ensure that tax collection is suspended during the cross-border dispute resolution procedures under the Arbitration Convention. As of September 2006, 16 Member States had allowed the suspension of tax collection during the dispute resolution procedure and other states were preparing revised texts granting this possibility. Mutual agreement and arbitration procedures The Convention provides for an additional level of protection to Member State businesses over and above anything available under the domestic laws of the states concerned or through the existing bilateral treaties. The protection available begins with the presentation of a case to the competent authority of the contracting state involved. This presentation must take place within three years of the first notification of the possible double taxation. The procedures require that all the relevant competent authorities are notified without delay and the process is then underway to resolve the problem, regardless of any statutory time limits prescribed by domestic laws. If the competent authorities are unable to reach an agreement within two years of the case first being referred to them, they are obliged to establish an advisory commission to examine the issue. The Convention provides that existing national procedures for judicial proceedings can continue at the same time as the advisory committee meets, and that if there is any conflict between the procedures of the arbitration committee and the judicial procedures in any particular Member State, then the Convention procedures apply only after all the others have failed. Serious penalty proceedings There is no obligation on Member States to establish an arbitration commission to consider pricing disputes if “legal and administrative proceedings have resulted in a final ruling that by actions giving rise to an adjustment of transfers of profits … one of the enterprises concerned is liable to a serious penalty”. Where any proceedings are currently underway, which might give rise to serious penalties, the normal due date for the establishment of the arbitration committee is deferred until the other proceedings are settled. The term ‘serious penalty’ is somewhat subjective and has different meanings from one country to another. However, the Member States have included, as part of the treaty, unilateral declarations on their view of the meaning of ‘serious penalty’ for these purposes. The advisory commission When an advisory commission is needed, it is established under the chairmanship of an individual possessing the qualifications required for the highest judicial offices of his/her country. The other members of the commission include a maximum of two individuals from each of the competent authorities involved and an even number of independent persons of standing, to be selected from a list of such people drawn up for the purpose by each contracting state. The task of the advisory commission is to determine, within six months, whether there has been a manipulation of profits, and, if so, by how much. The commission makes its decisions by simple majority of its members, although the competent authorities concerned can agree together to set up 160 International Transfer Pricing 2015/16

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the particular detailed rules of procedure for any one commission. The costs of the advisory commission procedure are to be divided equally between all the contracting states involved. In reaching its decision, the advisory commission may use any information, evidence or documents received from the associated enterprises concerned in the transactions. The commission can also ask the competent authorities of the contracting states involved to provide it with anything else it requires, but there is no obligation on the contracting states to do anything that is at variance with domestic law or normal administrative practice. Furthermore, there is no obligation on them to supply information that would disclose any trade secret, etc. which might be contrary to public policy. There are full rights of representation for the associated enterprises involved to speak before the advisory commission. Resolution of the problem Once the advisory commission has reported, the competent authorities involved must take steps to eliminate the double taxation within six months. They retain the discretion to resolve matters as they see fit, but if they cannot agree on the necessary steps to be taken, they must abide by the decision of the advisory commission. Term of the convention The Convention came into force on 1 January 1995 for an initial period of five years. However, it was agreed in May 1998 that the Convention would be extended for at least a further five-year period. During this time Austria, Finland and Sweden joined the EU and became parties to the Convention. The original protocol for accession of new Member States required that all parties had to satisfy each accession, and consequently extensions to membership required lengthy procedures to ensure the continued life of the Convention. As a result of the work with the EU Joint Transfer Pricing Forum, it is anticipated that as new countries join the EU they will accede to the Arbitration Convention by a simpler process. Interaction with non-member states The Convention recognises that countries other than the Member States of the EU may be involved in transfer pricing disputes with EU businesses. The Convention simply notes that Member States may be under wider obligations than those listed in the Convention and that the Convention in no way restricts these obligations. There is no comment on the way in which third-country disputes might be resolved. Experience of the Convention While the Convention is already perceived by the EU members as being a major step forward in the development of worldwide tax policies designed to resolve pricing issues, there is little practical experience of its use (the first ever advisory commission set up under the Convention only met on 26 November 2002 to begin looking at a Franco–Italian matter). It is understood that there is now a backlog of more than 100 cases that might go to arbitration, following the resolution of the procedural problems faced by the Arbitration Convention. The EU Joint Transfer Pricing Forum will monitor the work to make sure matters are followed through on a timely basis. www.pwc.com/internationaltp 161

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Procedures for achieving an offsetting adjustment Further EU developments in transfer pricing Within Europe, the EU Commission struggled for many years to attain agreement on a common tax base for European businesses or common tax rates across the EU states. This is politically highly difficult to achieve and there remains little likelihood of substantial agreement in this area in the foreseeable future. However, the Commission convinced Member States that there was no political logic in favour of continuing the problems experienced by multinationals when they faced double taxation as a result of transfer pricing adjustments being made by tax authorities. The Arbitration Convention represents the statement that, from a purely pragmatic point of view, it must be reasonable to eliminate such double taxation of profits. The European Commission would like to go much further. Instead of rectifying double taxation after it has occurred, the Commission would like to see a mechanism for preventing it in the first place. A number of Commission officials have stated their wish to see possible transfer pricing adjustments being discussed among the competent authorities before they are made, such that any offsetting adjustment could be processed at the same time as the originating adjustment. Some Commission officials want to go even further than this and create a regime for multilateral advance pricing agreements on pricing issues within the EU. It is clear that the European authorities firmly support the use of the arm’s‑length principle in transfer pricing. They are on record, via the Convention, as stating that they do not approve of double taxation. Most of the Member State tax authorities have privately expressed the view that, however desirable, advance pricing agreements represent an unacceptably high administrative burden. Information on the use of the Convention within Europe has been lacking. However, this was remedied in October 2001 when a Commission working paper published a summary for 1995 to 1999. During this period, 127 intra-EU transfer pricing cases were referred to the Arbitration Convention or to a bilateral treaty mutual agreement procedure (it is interesting to note the total number of cases rises to 413 when non-EU country counterparties are brought in). The paper estimated that 85% of the cases had been satisfactorily resolved, removing double taxation in an average timescale of 20 months. In its recent communication in February 2007, the European Commission revealed that none of the 24 cases for which the taxpayer had made the request for mutual agreement procedure prior to January 2000 was sent to arbitration commission. Recognising that considerable numbers of transfer pricing cases are never referred to competent authorities for resolution, the Commission identified transfer pricing as a major concern for cross-border business. To review the tax position on transfer pricing in the EU and to consider pragmatic ways in which the burden on business could be relieved, in early 2002 the Commission proposed the establishment of the EU Joint Transfer Pricing Forum. This was a radical step, in that membership would include both government personnel and representatives from business. In addition to the chairperson, the forum now includes 25 Member State representatives and 10 business representatives (the author is one of the 10) together with Commission membership and observers from the OECD and EU accession states. The forum’s work resulted in two formal reports. The first was published on 27 April 2004 and was adopted by the ECOFIN Council on 7 December 2004. The material is available on the Commission websites and contains detailed guidance on the operation of the Arbitration Convention, including practical matters relevant to time limits 162 International Transfer Pricing 2015/16

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and the mutual agreement procedures. The Council adopted the Code of Conduct recommend by the EU Joint Transfer Pricing Forum in full. The second report of the EU Joint Transfer Pricing Forum was completed in mid-2005 and set out a proposal for documentation standards across all Member States. The Commission adopted the proposal on 10 November 2005. In June 2006, the Council of the European Union adopted a Code of Conduct on transfer pricing documentation for associated enterprises in the European Union. This Code of Conduct standardises the documentation that multinationals must provide to tax authorities on their pricing of cross-border, intragroup transactions. Considering the recent achievements within the EU and the need to ensure a monitoring of implementation of codes of conduct and guidelines and the examination of several issues, the EU Joint Transfer Pricing Forum has been renewed for a new mandate of two years. The Commission has endorsed the Joint Transfer Pricing Forum’s suggestions and conclusion on advance pricing agreements and on this basis released guidelines for advance pricing agreements in the EU. Going forward, the Joint Transfer Pricing Forum will continue to examine penalties and interest related to transfer pricing adjustments and focus on the important area of dispute avoidance and resolution. International updates in cross-border dispute resolution Taking a cue from the EU Arbitration Convention, OECD countries have agreed to broaden the mechanisms available to taxpayers involved in cross-border disputes over taxation matters by introducing the possibility of arbitration if other methods to resolve disagreements fail. The background for this initiative goes back to February 2006, when the OECD released a public discussion draft entitled ‘Proposals for improving mechanisms for resolution of tax treaty disputes’. This public discussion draft essentially dealt with the addition of an arbitration process to solve disagreements arising in the course of a mutual agreement procedure and the development of a proposed online manual for an effective mutual agreement procedure. The OECD received numerous comments on the public discussion draft and followed it up with a public consultation meeting in March 2006. As a result of these comments and meeting, the Committee of Fiscal Affairs of the OECD approved a proposal to add to the OECD Model Convention an arbitration process to deal with unresolved issues that prevent competent authorities from reaching a mutual agreement. The proposed new paragraph to the Mutual Agreement Procedure Article of the OECD Model Convention (paragraph 5 of article 25) provides that in the event the competent authorities are not able to reach agreement in relation to a case presented to the competent authority for resolution within a period of two years from the presentation of the case, it may be submitted to arbitration at the request of the taxpayer. It is left to the discretion of the member countries as to whether the open items may be submitted for arbitration if a decision on these issues is already rendered under domestic law. Issues of treaty interpretation would be decided by arbitrators in the light of principles incorporated in the Vienna Convention on the Law of Treaties, whereas the OECD Guidelines would apply in respect of transfer pricing matters. www.pwc.com/internationaltp 163

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Procedures for achieving an offsetting adjustment Finally, the OECD has recently developed a Manual on Effective Mutual Agreement Procedure explaining the various stages of the mutual agreement procedure, discussing various issues related to that procedure and, where appropriate, bringing out certain best practices. 164 International Transfer Pricing 2015/16

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11. The OECD's BEPS Action Plan Overview With the concern over perceived tax avoidance and double non-taxation having reached the highest levels of governments, and with growing attention from the media and the public on international tax planning practices of high-profile multinationals, the Organisation for Economic Co-operation and Development (OECD), in conjunction with the G20 and developing nations around the world, has taken up the matter of Base Erosion and Profit Shifting (BEPS). The OECD’s Action Plan on BEPS was published in July 2013 with a view to addressing perceived flaws in international tax rules. The BEPS Action Plan, which was developed pursuant to a directive by the G20 nations, identified 15 key areas to be addressed by 2015; with seven deliverables delivered in September 2014. The 40 page Action Plan, which was negotiated and drafted with the active participation of its member states, contains these 15 separate action points or work streams organised by areas of perceived gaps in the international tax system some of which are further split into specific sub-actions or outputs. The Plan is squarely focused on addressing these issues in a coordinated, comprehensive manner, and was endorsed by G20 leaders and finance ministers at their summit in St. Petersburg in September 2013. The work under the Action Plan has resulted in discussion drafts or final reports on all of the 15 workstreams. While seven deliverables were agreed and approved by the G20 finance ministers in September 2014, most of the proposed measures are not yet finalised, as they may be impacted by further deliverables. However, the guidelines implementing Transfer Pricing Documentation and Country-by-Country (CbC) Reporting are substantially completed, as are the recommendations on Hybrids, the study on the digital economy, and the mandate for a multilateral tax treaty. Completion of most of the work for the 15 actions is scheduled to take place by December 2015, though the OECD announced in July 2015 that certain work including Use of Profit Split Methods, Financial Transactions, Profit Attribution to Permanent Establishments, and Implementation of Hard to Value Intangibles may not be finalised until 2016. While it may take longer for the impact of these changes to be fully applied in practice, the BEPS project and related developments are already leading to the need for business to take action (in some cases, urgent action) both to comply with new requirements and to consider the ways in which they do business in different countries. To the extent that the changes relate to the OECD’s Model Tax Convention and Transfer Pricing Guidelines, their implementation is assured and should follow fairly quickly. The speed with which they are then implemented in existing bilateral tax treaties will be heavily linked with the success of the OECD’s proposed ‘multilateral instrument’, which the OECD has reported can be applied without any obvious technical barriers (though practical issues may be of more concern). The proposed OECD rule changes that involve amendments being made by individual territories to domestic tax rules are likely to be widely but not universally adopted, though consistency and timing is uncertain. www.pwc.com/internationaltp 165

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The OECD's BEPS Action Plan Governments, revenue authorities and business will all have a material role to play over coming months if the proposed changes are to be effective. Action 1: The digital economy ‘Solving’ the digital issue – specifically identifying appropriate tax rules to deal with digital business – has been designated the number-one action in the BEPS Action Plan. While the final version of the report issued 16 September 2014 does not introduce any conclusions that the initial draft left unaddressed, it does bring greater clarity to issues that have given rise to the need for the digital economy workstream. The report also explains the role of the Digital Economy Task Force (DETF) for the remainder of the BEPS project. The primary conclusion remains that the digital economy is so widespread that it pervades the global economy as a whole. In consequence, it is not possible to isolate it for purposes of creating separate tax rules. Nonetheless, it is clear that, if the other BEPS workstreams do not address the specific concerns and challenges identified, the DETF has the remit to propose its own solutions. Indeed, in referring to the continual developments of how technological innovation affects business, the DETF implies that its work may need to survive the end of the BEPS process to deal with a recurrence of the issues which it identifies. It also notes issues which may come from but are currently unidentified: the Internet of Things1; virtual currencies; advanced robotics and 3D printing; the sharing economy; access to government data; and reinforced protection of personal data. The report focuses on the fragmentation of international business models, aided by developments in technology, as being the key tax area to address, identifying the specific remedies to be considered by the other BEPS workstreams – specifically, controlled foreign company (CFC) rules; artificial avoidance of permanent establishment (PE); and transfer pricing measures. A new suggestion in the report (which picks up on a request in the public consultation) is that Working party No. 1 of the Committee on Fiscal Affairs should consider the characterisation of various payments arising in the new information and communication technology-enabled world (a couple of examples are given in the report, namely Cloud computing and 3D printing). Draft input to the International VAT/GST Guidelines, prompted in substantial part by the need to clarify VAT/GST application to digital transactions, was published in December 2014 in two parts providing: • guidance on the place of taxation for B2C supplies of services and intangibles, and • supporting provisions to facilitate proper and consistent implementation of the Guidelines’ principles in national legislation, including consistent interpretation by tax administrations. 1 “The Internet of Things refers to the internet-enabled network of physical objects that can connect and interact with one another. Sensors, networks, objects, and even humans can produce data that is picked up by connected devices and converted into one or more of a diverse range of actions and impulses.” http://www.worldinbeta.com/blog/internet-ofthings-world-in-beta 166 International Transfer Pricing 2015/16

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Action 2: Hybrid mismatch arrangements The OECD’s second action point in the BEPS Action Plan is to “neutralise the effects of hybrid mismatch arrangements.” On 19 March 2014, the OECD released two draft reports calling for the introduction of both domestic rules and amendments to the OECD Model Tax Convention. The draft reports describe ‘hybrid mismatch arrangements’ as being the result of a difference in the characterisation of an entity or arrangement under the laws of two or more tax jurisdictions that result in a mismatch in tax outcomes. On 24 September 2014, the OECD issued a comprehensive set of recommendations regarding domestic rules and treaty provisions to address the cross-border tax effects of hybrid entities, instruments, and transactions. The domestic law recommendations are identified and categorised within three types of hybrid mismatch arrangements, identified according to their tax effects. The two main types of mismatches identified are payments that (i) are deductible under the rules of the payer and not included in the income of the recipient (deduction/ no inclusion or ‘D/NI’ outcomes) and (ii) give rise to duplicate deductions from the same expenditure (double deduction or ‘DD’ outcomes). The third type of mismatch is where non-hybrid payments from a third country can be set off against hybrid mismatch arrangement deductions and thus are not included in the income of the recipient (indirect deduction/no inclusion or ‘indirect D/NI’ outcomes). Within these three categories of hybrid mismatch arrangements are the different types of hybrid transactions and entities specifically addressed by the deliverable. D/NI outcomes include (i) hybrid financial instruments (including transfers), covering deductible payments made under a financial instrument that is not taxed as ordinary income in the payee’s jurisdiction; (ii) disregarded hybrid entity payments, covering deductible payments that are not taxed as ordinary income in the payee’s jurisdiction; and (iii) payments made to reverse hybrids, covering payments made by an intermediary payee where differences in characterisation of the intermediary entity by its own jurisdiction and its investor’s jurisdiction results in payments being excluded from ordinary income in both jurisdictions. DD outcomes include deductible hybrid entity payments, covering deductible payments made by a hybrid entity that could trigger a duplicate deduction in the parent jurisdiction; and deductible payments made by a dual resident company, involving payments made by a company treated as a resident by more than one jurisdiction. Indirect D/NI outcomes apply only to imported mismatch arrangements, covering arrangements where the intermediary jurisdiction is party to a separate hybrid mismatch arrangement, and the payment from another jurisdiction to the intermediary jurisdiction under a non-hybrid arrangement is set off against a deduction arising under the hybrid mismatch arrangement to which the intermediary is a party. The deliverable provides recommendations with a common format and succinct language. The format generally includes a Primary Rule for each country to adopt, a Defensive Rule (for another jurisdiction to apply where the Primary Rule is not in place), specifications for the types of entities and payments subject to the rule, and the scope of situations to which the rule applies. The recommendations only apply to payments that result in a hybrid mismatch. In general, the recommendations focus on denying deductions where there is a duplicate deduction or no income inclusion, with income inclusions as a backstop. www.pwc.com/internationaltp 167

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The OECD's BEPS Action Plan The proposed rules would apply mechanically, with no motive or purpose test. Hybrid payments are broadly defined and could include royalties or even payments for goods, but would not include deemed payments, such as notional interest deductions. A bottom-up approach is taken to scope and in several areas is restricted to related parties (with a 25% common ownership threshold), structured arrangements or controlled groups. Rules against deductible dividends and double deduction situations are proposed to have no scope restriction. While the recommendations are nominally final, the report notes that deliverables from other workstreams to be subsequently delivered could impact the recommendations, and thus influence countries’ law changes in this area. Also, further work remains to be done in 2015 on certain aspects of the report, such as potential restrictions on the scope of the imported mismatch rule, interaction with CFC rules and application of the recommendations to repo transactions, regulatory capital, and collective investment vehicles. The OECD and G20 will consider the coordination of the timing of the implementation of these rules. It is possible that this may not be until after a Commentary and guidance have been produced, foreseen by September 2015. Action 3: Strengthening controlled foreign corporation regimes The OECD’s Action 3 is to develop recommendations regarding the design of CFC rules. The OECD issued a discussion draft on CFC rules in March 2015. CFC rules tax certain income of controlled foreign subsidiaries in the hands of shareholders resident in the country of the ultimate parent. Policy objectives for CFC regimes vary. Some countries with worldwide tax systems focus on long-term base erosion rather than profit-shifting. Other countries with more territorial tax systems do not currently have CFC rules or have more limited CFC regimes. The suggestion in this discussion draft is that CFC rules should address base erosion but also seek to prevent profit-shifting from third territories (with a particular focus on developing countries). The main target of many CFC regimes is passive income. For example, both intellectual property (IP) royalties and interest income would generally be characterised as passive income and therefore included in the CFC income attributable to the parent. Although most OECD Member States apply CFC regimes, the OECD has done little work on this area in the past, and the rules vary greatly by jurisdiction. The taxation of foreign income, derived directly or via a foreign subsidiary, is a key aspect of the fiscal policy of national governments to encourage economic growth, competitiveness and foreign investment. Before issuance of the OECD draft, it was considered unlikely that a common position on CFC rules could be achieved, because different jurisdictions have chosen a variety of different ways to approach taxing foreign income. The discussion draft does not change that view. The preliminary proposals offered by the CFC discussion draft are complex and, in practice, the difficulties are likely to be worsened by the degree of latitude accorded to states in applying or varying the proposed approach. 168 International Transfer Pricing 2015/16

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The OECD suggests that existing CFC rules do not always counter BEPS in a comprehensive manner. Stronger CFC rules will, in principle, lead to inclusion of more income in the residence country of the ultimate parent. Some countries have proposed that, in addition to ‘primary rule’ CFC measures, countries could introduce a ‘secondary rule.’ It would apply to income earned by CFCs that does not give rise to sufficient CFC taxation in the parent jurisdiction. This secondary form of taxation would apply in another jurisdiction (for example the source country of the income earned by the CFC), and it will add further complexity if ultimately recommended by the OECD. The CFC discussion draft considers all the constituent elements of a CFC regime and breaks them down into the building blocks necessary for effective CFC rules. The recommendations are made with reference to each building block, and most of them include alternative options for jurisdictions that prefer a different approach consistent with existing domestic tax laws. The building blocks are: The definition of a CFC • The primary recommendation is to include more than just corporate entities. Threshold requirements • The primary recommendation is to have a low-tax threshold. The definition of control • The primary recommendation is to determine control using both legal and economic criteria – like vote and value tests under US law – with a 50% minimum control level. The definition of CFC income • There is no primary recommendation, just options offered, generally involving criteria based on substance of the entity. Rules for computing income • The recommendation is to use the parent jurisdiction’s rules to calculate a CFC’s income, but that jurisdiction should have a specific rule limiting the offset of CFC losses. Rules for attributing income • The attribution threshold should be tied to the minimum control threshold when possible. • The amount of income attributed to each shareholder or controlling person should reflect both proportion of ownership and actual period of ownership or influence. • Jurisdictions should be free to decide when and how income inclusions should occur. • The tax rate of the parent jurisdiction should generally apply. Rules to prevent or eliminate double taxation • The recommendation is to allow a credit for foreign taxes actually paid (including CFC tax assessed on intermediate companies) and to exempt dividends and gains on disposition of CFC shares if the CFC’s income has previously been subject to CFC taxation. www.pwc.com/internationaltp 169

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The OECD's BEPS Action Plan One proposal that has not achieved consensus yet but merits particular attention is an ‘excess profits’ approach under which income attributable under the CFC rules would be the profits in excess of a ‘normal return’, being a specific rate of return on the equity properly to be regarded as utilised in the business of the CFC. This approach echoes a proposal previously included in Obama Administration budgets. In general, the CFC discussion draft reflects little consensus and seems unlikely to result in more uniform application of CFC regimes. Action 4: Financial payments In Action 4 of its BEPS Action Plan, the OECD seeks to target a broad range of what it describes as ‘excessive’ interest and other financial payments. The aim of Action 4 is to produce best practice rules to address BEPS through the use of interest expense. The discussion draft issued in December 2014 examines various current rules and their relative level of success, concluding that such rules do not generally address the underlying BEPS concerns. The draft then looks at a number of different approaches and design features for rules designed to address BEPS through interest deductions, including group-wide rules, fixed financial ratio rules, targeted rules and combinations of these approaches. In addition to BEPS concerns, the paper also acknowledges other policy considerations, including minimising distortions to competition and investment, promoting economic stability, providing certainty, avoiding double taxation, and reducing administrative and compliance costs. In addition, there is acknowledgment of the need to consider a different approach to specific sectors, the importance of addressing EU law, and the interaction with other BEPS action items. The Action 4 discussion draft does not reach firm conclusions, but it does identify two broadly-defined potential best practice rules: • A group-wide interest allocation or ratio approach (group-wide tests). This would either limit an entity’s net interest deductions to a proportion of the group’s actual net third party interest expense, based on a measure of economic activity such as earnings or asset value (interest allocation), or limit interest deductions based on comparing a financial ratio for the entity with the equivalent group-wide ratio (such as net interest as a proportion of earnings). The interest allocation approach is broadly similar to a US budget proposal, and also has similarities to existing debt rules in the UK and other countries. • A fixed ratio test operating to restrict interest expense to a specified proportion of earnings, assets or equity of a company. This type of approach is already widely used by a number of countries, for example the restriction of interest deductions based in Germany (using taxable EBITDA) or based in the United States (using adjusted taxable income). The paper acknowledges the difficulty in setting an appropriate benchmark ratio that is low enough to address BEPS concerns without giving rise to significant double taxation risk. The recommendation is to set the rate ‘deliberately low,’ and the OECD seems to believe that current ratios are all too high to deal effectively with BEPS risks. The paper also considers a combination of fixed ratio and group-wide ratio tests, including using one to be a backstop for the other. In all cases, the paper would exclude assets generating tax exempt or deferred income. The discussion draft also recommends that allocations or ratios be based on interest rather than debt, to deal more directly with BEPS concerns. 170 International Transfer Pricing 2015/16

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The discussion draft raises significant questions regarding impacts on investment choices and potential for double taxation, which may be addressed more effectively in a final report. Action 5: Harmful tax practices It is understandable that the OECD would wish to put the topic of harmful tax practices on the agenda of its BEPS Action Plan. ‘Substantial activity’ is the touchstone in the G20-approved report on harmful tax practices as it is throughout the BEPS Action Plan. The focus on aligning taxation with the ‘substance’ of transactions seems to be defined as determining where people are located, and where the performance of ‘significant people functions’ takes place. Nonetheless, determining the location of substantial activity is inevitably a subjective determination, making objective criteria difficult. The report also voices concerns with regimes that apply to mobile activities and that unfairly erode the tax bases of other countries, potentially distorting the location of capital and services. There is some overlap of this work with that in the transfer pricing space relating to intangibles and risk and capital, as well as similar issues being addressed in the report on the tax challenges of the digital economy. Criteria to assess whether preferential treatment regimes for intellectual property (patent boxes) are harmful have subsequently been agreed in principle. A solution proposed by Germany and the UK on how to assess whether there is substantial activity in an intellectual property regime has been endorsed and further formalised. The proposal, based around a ‘nexus approach’, allows a taxpayer to receive benefits on intellectual property income in line with the expenditures linked to generating the income. Transitional provisions for existing regimes, including a limit on accepting new entrants after June 2016, have been agreed, and work on implementation is ongoing. Proposals for improving transparency through compulsory spontaneous exchange on taxpayer-specific rulings related to preferential regimes contribute to the third pillar of the BEPS project, which is to ensure transparency while promoting increased certainty and predictability. It should also be noted that the word ‘compulsory’ is understood to introduce an obligation to spontaneously exchange information wherever the relevant conditions are met, meaning this is a further step in moving more generally from exchange of information upon request to automatic exchange of information. The work continues with consideration of the regimes of non-OECD members before then revising as required the existing harmful tax framework. Action 6: Treaty abuse According to the OECD, inefficiencies in tax treaties have triggered double nontaxation in a number of situations. In September 2014, the OECD proposed three alternative approaches that countries could take to curb treaty shopping and other treaty abuses: (1) a limitation of benefits (LOB) provision accompanied by a principal purpose test (PPT), (2) an LOB accompanied by a narrower anti-abuse rule, or (3) a stand-alone PPT. www.pwc.com/internationaltp 171

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The OECD's BEPS Action Plan In revised proposals published in May 2015, two versions of the LOB were put forward. One version responds to the suggestion made by many respondents of limiting the LOB recommendations to a simplified version setting forth general standards and relying on the PPT to cover cases not caught by the LOB tests (the Simplified LOB). Another version includes a PPT within it and is combined with proposed Commentary addressing the possible addition to the LOB article of targeted provisions that were the source of both debate within the Working Group and criticism by stakeholders, questioning both the practicality and policy underpinnings of some of the proposed restrictions. The Simplified LOB includes a basic version of most of the common LOB tests: individuals, governments, publicly traded entities, entities more than 50% owned by qualified persons, active trades or businesses, and discretionary grant of benefits. In addition, it includes a derivative benefits test for residents more than 75% owned by equivalent beneficiaries. The Simplified LOB lacks a rule to qualify pensions, charities, and collective investment vehicles; the main LOB includes a placeholder for such a rule. The anti-conduit provisions to accompany a detailed LOB could, the OECD proposes, take the form of domestic anti-abuse rules or judicial doctrines that would achieve a similar result. Examples of transactions that should and should not be considered to be conduit arrangements for this purpose are largely drawn from an exchange of letters with respect to the US-UK tax treaty. Specific anti-abuse rules applicable to the detailed but not the simplified LOB include base erosion tests, substantial presence requirements, or disproportionate share rules. Other proposals currently under consideration include: • A restriction on intermediate owners being resident to prevent the interposition of a company in a tax haven to which base-eroding payments could be made, but this could often result in ineligibility for treaty benefits where no treaty shopping is present. • A denial of treaty benefits if the income is beneficially owned by a person subject to a special tax regime that provides a preferential effective rate of tax or if one of the treaty partners starts to exempt the income. • A disallowance in the active trade or business test in considering the local activities of a connected person if the resident claiming treaty benefits (1) is subject to a special tax regime; or (2) is not engaged in the same or a similar line of business. • A denial of treaty benefits with respect to income attributable to a permanent establishment (PE) effectively taxed at less than 60% of the general rate of company tax in the residence state, unless an active trade or business exception is satisfied. On the PPT, obtaining benefits under a tax treaty need not be the sole or dominant purpose for the establishment, acquisition, or maintenance of the person and the conduct of its operations; rather, it is sufficient that at least one of the principal purposes was to obtain treaty benefits. Examples provide that it would not be reasonable to deny benefits where: • A company acquires another business owned by a holding company and decides to retain that holding company because of treaty benefits. 172 International Transfer Pricing 2015/16

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• A company establishes an intra-group service provider in a jurisdiction based on that jurisdiction’s skilled labour force, reliable legal system, business-friendly environment, political stability, membership in a regional grouping, sophisticated banking industry, and comprehensive double tax treaty network. • A company invests in a contracting state through a subsidiary based in the other contracting state where the latter subsidiary carries on diverse business activities as part of an active trade or business. • Two companies enter into cross-licensing arrangements to ensure that withholding tax is collected at the correct treaty rate on cross-licensing royalties without the need for a broad population of individuals each to apply for a refund on small payments. • The revised proposals also address issues with respect to publicly traded companies, the timely availability of discretionary relief, the residency tie-breaker rule, and the application of domestic anti-abuse rules to claims of treaty benefits. Action 7: Artificial avoidance of PE status More countries have recently been challenging overseas companies on the presence in their jurisdiction of a PE – so it is no surprise that the OECD would choose to pursue this area in its BEPS Action Plan. Although one of the shortest papers so far released, various options proposed in the 3 November 2014 discussion draft included fundamental changes to the existing PE rules, with a potentially wide impact on many structures currently in use by MNEs. Revised proposals, published in May 2015, replaced the alternative approaches to a number of significant PE issues with a set of definitive proposals. They include widening the dependent agent provisions and narrowing both the independent agent exemptions and the specific activity (e.g., warehouses, etc.) exemptions, and go beyond the PE areas identified for review under Action 7 in the original BEPS Action Plan. Separate areas in which the OECD is proposing change include: • commissionaire arrangements and similar strategies (broadening the current recognition of the conclusion of contracts on behalf of an enterprise to include negotiating the material elements of contracts that are in the name of that enterprise, or that, broadly, relate to property of that enterprise or which are for the provision of services by that enterprise, with exclusions for independent agents only where they act for a wider group of people) • insofar as the OECD wishes to restrict the existing specific activity exemptions which allow certain activities to take place in a state without triggering the threshold PE rule, it is proposed to restrict all of those exemptions to activities that are of a ‘preparatory or auxiliary’ character with additional Commentary to clarify their scope; the ability of companies to fragment activities is also restricted where the combined business activities represent “complementary functions that are part of a cohesive business operation” • rules to counter the splitting up of contracts aim to prevent the circumvention of the 12 month ‘construction site’ PE rule (which also covers installation projects) • PE profit attribution issues (the OECD seems to proceed largely on the basis of an expectation of an increase in profits to such PEs but the precise reasoning is not included). www.pwc.com/internationaltp 173

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The OECD's BEPS Action Plan It is inevitable that the proposed changes would lead to a material shift towards sourcebased taxing rights. There would also be a material increase in uncertainty given the greater use of subjective tests in what is proposed. The existing strained dispute resolution system would come under increasing pressure and alternative means of preventing and resolving disputes and audits should be given a high priority. Action 8: Transfer pricing and intangibles The OECD has published final and interim revisions in relation to Chapters I, II, VI and VIII of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. These revisions have been developed in connection with Action 8 of the Action Plan on BEPS that is focused on ensuring that transfer pricing outcomes with respect to intangibles are in line with value creation activities. The revisions to the guidelines addressing the transfer pricing aspects of intangibles show the direction in which the OECD had been thinking on key issues related to identification and valuation of intangibles, a topic that had been debated among governments before the BEPS Action Plan was published. In several discussion drafts associated with work streams related to intangibles, the OECD has emphasised that the starting point to this analysis begins with an evaluation of a group’s global value chain to show how intangibles interact with other functions, risks and assets. However, the emphasis is on the importance of accurately delineating the actual transaction and the possibility of recharacterisation or non-recognition of transactions has been highlighted (see Action 9). There are proposals on the arm’s-length pricing of intangibles when valuation is highly uncertain at the time of the transaction or the intangibles are hard to value. The OECD proposed that a tax authority may impute adjustment or renegotiation clauses in related-party contracts if it determines that independent parties would have used such mechanisms, but announced in its July 2015 public consultation that this position is to be reconsidered based on the real terms of the transaction and the parties’ behaviour pursuant to the contract. Further, under the current draft paper, ex-post information should be used for a new category of ‘hard-to-value intangibles’, defined as those for which – at the time of their transfer in a transaction between associated enterprises: • no sufficiently reliable comparable exists, • there is a lack of reliable projections of future cash flows or income expected to be derived from the transferred intangible, or • the assumptions used in valuing the intangible are highly uncertain. Combined with special measures, to be further developed in 2015, the revised guidelines aim to prevent an MNE group member that merely assumes funding risk related to an intangibles transacti0n, without performing and controlling certain identified ‘important functions’, providing all assets and bearing and controlling all risks in relation to the development, enhancement, maintenance, protection and exploitation of the intangibles from earning more than a risk-adjusted rate of anticipated return on its funding. Modified guidelines are proposed where intangibles are developed under cost contribution arrangements (CCAs). These apply with respect to measuring the value of contributions to CCAs, the effect of government subsidies or tax incentives, and the tax characterisation of contributions, balancing payments and buy-in/buy-out 174 International Transfer Pricing 2015/16

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payments. The main aim is to ensure that contributions are commensurate with the benefits received under a CCA. However, a requirement for any participant in a CCA to have the “capability and authority to control the risks associated with the riskbearing opportunity” would unnecessarily impair the usefulness of CCAs. The need to measure contributions based on value rather than costs is inappropriate except in the case of development CCAs (or possibly also service CCAs when the services cannot be qualified as low value-added). On the revised definition of intangibles, Chapter VI will state the importance of distinguishing between intangibles and market conditions or local market circumstances, which are not capable of being owned or controlled. A key theme of the discussion drafts addressing intangibles is that the extent to which a member of an MNE possesses control over risks, assets, or outcomes is material to evaluating whether intangible-related returns generated from the transaction should be allocated to the MNE member entity. Regarding location savings or local market features, the most reliable approach is stated to be local market comparables and only if they don’t exist to consider advantages and disadvantages and whether they are passed on to customers. The benefits of an assembled and experienced workforce may affect the arm’s-length price. In general, the transfer of such people within an MNE should not be separately compensated but reflected to the extent that there are time and costs savings (except where there is a transfer of know-how or other intangibles). In certain limited instances, the transfer or secondment of individual employees could be a transfer of know-how or related intangibles. Group synergies should result in arm’s-length remuneration only if they arise from deliberate concerted group actions that provide a member of an MNE group with material burdens or advantages not typically available to comparable independent entities. The revised guidelines contemplate that such an analysis can only be determined through a functional and comparability analysis. Action 9: Transfer pricing and risks/capital One key aspect of the Action Plan is its indication that in some instances, special measures, either within or beyond the arm’s‑length principle, may be required to address the perceived flaws in the international tax system with respect to intangibles. This point remains a substantial topic of debate and is especially apparent in the controversial OECD discussion draft addressing risk, recharacterisation and special measures as part of Action 9 of the OECD BEPS Action Plan. Action 9 of the OECD BEPS Action Plan is designed to develop rules to prevent base erosion and profit shifting through the transfer of risks among – or the allocation of excessive capital to – group members. On 19 December 2014, the OECD released a transfer pricing discussion draft within Actions 8-10 covering risk and situations calling for recharacterisaton or ‘special measures’. Based on the extensive comments received from the business community, it is likely that many of the more controversial elements of this discussion draft will be modified in the OECD’s next release expected in October 2015, as announced by the OECD during the July 2015 public consultation. . However, the proposals emphasise the importance of accurately delineating the actual transactions, and include guidance on the relevance and allocation of risk, www.pwc.com/internationaltp 175

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The OECD's BEPS Action Plan determining the economically relevant characteristics of the controlled transaction, and on recharacterisation or non-recognition of transactions. One basic theme of the modifications is that, while contractual allocations of risk may be a starting point, such contractual allocations are subject to a substantive analysis of the economic behaviour of the parties in the context of the entire value chain of the MNE, the substance of the risk-bearing entity, and the parties’ behaviour pursuant to the contract terms. Action 10: Transfer pricing and other high-risk transactions The objective of action 10 in the OECD’s BEPS Action Plan is to develop rules to prevent abusive transactions which would not, or would only very rarely, occur between unrelated parties. The OECD’s work in this area includes drafts published on Transfer Pricing for Low Value-Adding Services, Use of Profit Split Methods in the Context of Global Value Chains, and Transfer Pricing Aspects of Cross-border Commodities Transactions. Proposed modifications to Chapter VII of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations for management fees and other low value-adding services do not yet represent a consensus view and are intended to provide stakeholders with substantive proposals for analysis and comment. The Working Party seems to have taken a step in the right direction to achieve a balance between appropriate charges and protecting the tax base, but the draft fails to substantially address how the additional guidance will be impacted by the other BEPS work. These proposals mainly consist of an elective, simplified alternative approach to the usual transfer pricing exercise. There is a definition of what constitutes the low value-adding services that would be covered and a number of examples of things which the OECD doesn’t consider as qualifying. The single mark-up to be utilised for all these services would function as a safe-harbour and thus not require to be supported by a benchmarking study and would be between 2 percent and 5 percent of the relevant cost base. Action 10: Transfer pricing aspects of cross-border commodity transactions The OECD discussion draft on transfer pricing for commodity transactions seeks to reconcile developments in taxing commodity transactions with existing transfer pricing guidance. The draft focuses on the broadly-defined ‘Sixth Method.’ The Sixth Method is the established method for the purposes of commodity-specific taxation in many developed countries (e.g., petroleum revenue tax in the UK or Norway). This method has also recently increased in popularity for other commodities in developing countries. The draft takes the position that the Sixth Method in all its versions is essentially a variation of the Comparable Uncontrolled Price (CUP) method. Thus, the draft concludes that the Sixth Method, if properly applied, can be reconciled with OECD transfer pricing principles. 176 International Transfer Pricing 2015/16

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The discussion draft suggests wording for the OECD Transfer Pricing Guidelines that would effectively create a framework for tax authorities and taxpayers to apply Sixth Method within existing transfer pricing systems. This would operate particularly with respect to comparability adjustments to quoted prices, which the draft acknowledges would be needed in applying the CUP method to account for physical differences, different specifications, freight, etc. The discussion draft acknowledges that tax authorities in developing countries may have limited expertise and resources for verifying the pricing date used. Pricing in the commodities industry is complex, with many variations, so setting a single rule for pricing dates may be challenging. In fact, it may not be possible to price certain commodities (e.g., power) at delivery. Other activities, such as pricing of optionality around delivery dates, may need to be accounted for by means other than pricing dates (e.g., by comparability adjustments). The discussion draft specifies that the BEPS project will provide additional guidance relevant to commodity-related transactions under Actions 9 (on risk and capital), 10 (especially on recharacterisation and low value-adding services) and 13 (transfer pricing documentation and CbC reporting). Many commodity-dependent developing countries are not members of the OECD and may not adopt all aspects of the OECD transfer pricing guidance. It would be helpful if the final recommendations encourage consistency on a global basis. The alternative could be new countries introducing different variations of the Sixth Method as an application of the CUP method. The OECD is expected to finalise this paper by October 2015. Action 10: Profit splits A Discussion Draft deals specifically with the Use of profit splits in the context of global value chains. This is part of the wider item 10 of the BEPS Action Plan dealing with assuring that transfer pricing outcomes are in line with value creation. According to paragraph seven of the Discussion Draft, “where there is significant integration involving parties to a specific transaction or transactions within that value chain, for example in the effective sharing of key functions and risks, the reliability of one-sided methods may be reduced”. The Discussion Draft recommends transactional profit splits may be more reliable than one-sided methods where there is pooling of entrepreneurial functions and risks and the success of the business depends on integration of related parties. The Discussion Draft notes that transactional profit splits may be appropriate where an MNE’s business is highly integrated and strategic risks may be jointly managed and controlled by more than one entity. Such an analysis therefore requires an appropriate consideration of strategic risk, further confirming the OECD’s continued reliance on detailed functional analyses. Many MNEs split functions within a value chain whereby certain entities undertake only limited, specific functions (e.g., logistics, marketing etc.). Due to fragmentation, the Discussion Draft argues that comparables that are similarly limited to comparable specific and discrete functions may be difficult to identify. As such, it may be preferable to undertake a transactional profit split approach as a corroborative method identifying comparable companies that combine multiple functions and utilising the principles of a contribution analysis to divide the benchmarked profit. www.pwc.com/internationaltp 177

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The OECD's BEPS Action Plan Such an analysis appears aligned with a reliability analysis in determining the best comparables in the marketplace to be used as benchmarks. The Discussion Draft’s reliance on the use of transactional profit split as a corroborative method raises a level of concern that a one-sided analysis may, because of a default preference to profit split based on the overarching language in the draft, be eschewed when it is otherwise appropriate and reliable. In scenarios where one-sided methods are appropriate and reliable based on a thorough functional analysis, corroborative profit split methods may be a precursor to formulary apportionment, as they may improperly suggest higher returns to entities performing routine functions that can be reliably benchmarked. The OECD announced at the July 2015 public consultation that the revised paper will be more in line with the arm’s‑length principle and selection of the most appropriate method, and that a final paper will likely not be completed until 2016. Action 11: Data and methodologies Action 11 reflects the OECD’s apparent goal of establishing methodologies to collect and analyse data on BEPS and to focus on actions to address the analytical findings. There are some firm conclusions about indicators of BEPS in the discussion draft published on 16 April 2015 but there is also recognition that assessing the extent of BEPS is ‘severely constrained’ and no attempt is made in the draft to ascertain an overall figure for total BEPS. In fact, many of the existing attempts to do so are fairly heavily criticised. Much of the draft deals with broad indicators of BEPS: • • • • Relative concentration of net foreign direct investment (FDI) to GDP. High profit rates of low-taxed affiliates of top global MNEs. High profit rates of MNE affiliates in lower tax countries. Profit rates compared to effective tax rates (ETRs) for MNE domestic and foreign operations. • ETRs of MNEs compared to comparable domestic firms. • Relative concentration of royalty payments relative to R&D expenditures. • Interest expense to income ratios of top global MNE affiliates in high statutory tax rate countries. Two approaches are put forward as alternative ways of seeking to measure BEPS: • extrapolating from studies assessing the impact of tax rate differentials on the movement of profit from one location to another, and • adding the amounts identified for each separate BEPS channel (per the Action Plan) with an adjustment for interactions between them. Existing data sources are considered but questions remain as to whether there are other sources and whether the data will be adequate to perform reliable analyses. 178 International Transfer Pricing 2015/16

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The discussion draft does not discuss new tools to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS, or new types of data that might be useful in helping to analyse BEPS in the future. However, it is potentially a concern for MNEs that the draft suggests confidential data could be used or more data might be necessary. No recommendation is made as to whether business should be asked to provide that data. Action 12: Disclosure of aggressive tax planning The OECD is aiming to require taxpayers to disclose aggressive tax planning arrangements. Action 12 of the BEPS Action Plan targets this objective. A new discussion draft of 31 March 2015 deals primarily with the first two elements of this part of the BEPS package: • design of mandatory disclosure rules or a mandatory disclosure regime (MDR), and • a focus on international tax schemes. The other elements: • coordination with work on cooperative compliance, and • enhanced models of information sharing between tax administrations will be addressed in due course, partly under BEPS and partly in other initiatives. There is a need to identify mass marketed pre-packaged schemes or those which rely on limited or no disclosure and which aim to provide absolute tax benefits or cash flow advantages from delays in paying the tax due. However, the challenge will be to target such schemes without creating an enormous compliance burden for the vast majority of MNEs and intermediaries whose commercial affairs happen to need crossborder advice. In keeping with the intention to adopt a modular approach, the discussion draft sets out a number of features of existing MDRs. It is not clear whether the OECD recommends countries implement MDRs including, in particular, when they have other ways in which they satisfy their perceived information requirements. Significant work may be needed to confirm whether a disclosure has to be made following the introduction or extension of a specific regime as put forward in this discussion draft. In many cases, the outcome will be that no disclosure is needed. Changes in international tax standards and other promised increases in cooperation between jurisdictions and alternative methods for addressing avoidance activity also suggest a serious review of the costs and potential benefits is needed before the recommendation of any new disclosure regime for international tax arrangements. Action 13: Transfer pricing documentation Action 13 of the OECD’s BEPS Action Plan is aimed at re-examining transfer pricing documentation requirements – and in particular providing for more information from taxpayers. www.pwc.com/internationaltp 179

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The OECD's BEPS Action Plan The proposals now agreed by the G20 on the transfer pricing documentation master file and local file are broadly in line with what has already been announced while on CbC reporting. The report now confirms that the data points that will be required to be reported for each country will be the following: • • • • • • • • Revenues (from both related and unrelated-party transactions) Profit before income tax Income tax paid (cash basis) Current year income tax accrual Stated Capital Accumulated earnings Number of employees Tangible assets (excluding cash and equivalents) The clear implication is that the template is designed to highlight those low-tax jurisdictions where a significant amount of income is allocated without some ‘proportionate’ presence of employees. What this means in practice is that there will be pressure to assure that profit allocations to a particular jurisdiction are supported by the location in that State of sufficient, appropriately qualified employees who are able to make a ‘substantial contribution’ to the creation and development of intangibles. Concerns regarding confidentiality of this data and the potential for adjustments by tax administrations based on a formulary apportionment approach leading to many more transfer pricing controversies have already been noted. The OECD has also noted that some countries (for example Brazil, China, India, and other emerging economies) would like to add further data points to the template regarding interest, royalty and related-party service fees. Those data points will not be included in the template in this report, but the compromise is that the OECD has agreed that they will review the implementation of this new reporting and, before 2020 at the latest, decide whether there should be reporting of additional or different data. The OECD finalised its arrangements for the sharing of master file and CbC information in February 2015, including protections that would preserve the confidentiality of the country-by-country report (CbCR) to an extent at least equivalent to the protections that would apply if such information were delivered to the country under the provisions of the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, a TIEA or a tax treaty. The OECD proposals would require tax administrations to ensure multinationals with a turnover above EUR 750 million in their countries of residence start using the reporting template for fiscal years beginning on or after 1 January 2016 with tax administrations beginning to exchange the first CbCRs in 2017. A “Country-by-Country Reporting Implementation Package” published on 12 June 2015 includes model legislation the OECD suggests could be used by countries to mandate filing of CbCRs and model competent authority agreements that could be used by each country to effect the information exchange. Neither the model legislation nor any of the model competent authority agreements contains additional guidance regarding the particular data that multinational enterprises (MNEs) need to provide in the CbCRs. 180 International Transfer Pricing 2015/16

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Action 14: Make dispute resolution mechanisms more effective On 18 December 2014, the OECD released its discussion draft on Action 14. During the last decade, the OECD has issued guidance to improve dispute resolution mechanisms, including the Manual on Effective Mutual Agreement Procedures (MEMAP) in 2007. Today’s global tax controversy environment, however, calls for a more focused effort to improve the effectiveness of the Mutual Agreement Procedures (MAP) in resolving treaty-related disputes. The discussion draft acknowledges that it does not present a consensus view of the Committee on Fiscal Affairs and the discussion only provides proposals and options to arrive at measures that will constitute a minimum standard to which participating countries will commit. Further, the discussion draft acknowledges that a universal adoption of mandatory binding arbitration would be difficult, if not impossible, in the immediate term to achieve, and therefore suggests the need for complementary solutions that are practical and impactful. The discussion draft specifically focuses on obstacles that prevent resolving disputes and identifies corresponding measures and options to address such obstacles. Taking a holistic view, the draft should be read in the context of a three-pronged approach that would improve resolution of disputes through MAP. This three-pronged approach would: (i) consist of political commitments to effectively eliminate taxation not in accordance with the tax convention; (ii) provide new measures to improve access to MAP and improved procedures; and (iii) establish a monitoring mechanism to check the proper implementation of the political commitment. The political commitment and the measures to improve MAP are grounded in four principles that form the basis of the OECD’s recommendations. These four principles are the framework of the discussion draft: • Ensuring that treaty obligations related to MAP are fully implemented in good faith. • Ensuring that administrative processes promote the prevention and resolution of treaty-related disputes. • Ensuring that taxpayers can access MAP when eligible. • Ensuring that cases are resolved once they are in MAP. Specific measures that will implement the political commitment will be determined as part of future work on Action 14. Such measures will likely be supplemented by a monitoring process that will evaluate the functionality of MAP and include an overall assessment as to the commitment made by individual countries. This monitoring process, while not described in the discussion draft, is expected to be performed by a select forum of competent authorities. Action 15: Creation of a multilateral instrument The final action of the BEPS Action Plan is the development of a multilateral instrument that countries can use to implement various treaty-related measures developed in the course of the work. Released 24 September 2014, the Action 15 OECD paper confirmed that a multilateral instrument is both desirable and, from a tax and public international law perspective, technically feasible. www.pwc.com/internationaltp 181

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The OECD's BEPS Action Plan On 6 February 2015, OECD and G20 countries agreed a mandate for negotiations for the agreement of a multilateral convention with an aim to conclude discussions by 31 December 2016. It was clarified that the purpose would be restricted to the updating of bilateral treaties, and not be extended to other things, such as to ‘express commitments’ to implement certain domestic law measures or provide the basis for exchange of the CbC template, discussed above. Work on the development of the Multilateral Instrument began on 27 May 2015 in Paris. As per the mandate, the ad hoc Group that will complete the work under Action 15 has been established, with over 80 countries participating (the US being a notable absentee at this stage). At the meeting, members of the Group appointed Mr. Mike Williams of the UK as Chair, and Mr. Liao Tizhong of the People’s Republic of China, Mr. Mohammed Amine Baina of Morocco and Mrs. Kim S. Jacinto-Henares of the Philippines as Vice-Chairs. Participants also agreed on a number of procedural issues so that the substantive work can begin at an Inaugural Meeting which will take place on 5-6 November 2015 (back-to-back with the 20th Annual Tax Treaty Meeting for government officials which will take place on 3-4 November 2015). A number of international organisations will also be invited to participate in the work as Observers. To keep up to date with the latest BEPS and tax policy developments, sign up for our newsletters www.pwc.com/taxsubscriptions 182 International Transfer Pricing 2015/16

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Part 2: Country-specific issues

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12. Argentina A PwC contact Juan Carlos Ferreiro Pricewaterhouse & Co. Asesores de Empresas S.R.L. Bouchard 557, 10° (C1106ABG) Ciudad de Buenos Aires Argentina Tel: +54 11 4850 4651 Email: juan.carlos.ferreiro@ar.pwc.com Overview The Argentine Federal Tax Authority (AFIP) on 19 December 2013 released resolutions 3572/13 and 3573/13, which create registries and information regimes for affiliated parties and joint ventures, and other non-corporate entities involved in domestic and international transactions. Argentinian resident corporations, partnerships, trusts in general, and trusts in which the settlor and the beneficiary are the same person (the obligors) must register with the registry of affiliated parties if they are affiliated to any other party incorporated, domiciled, or situated in Argentina or abroad. Additionally, the obligors must act as information agents for domestic transactions performed with affiliated parties (as described in Annex I of Resolution 3572/13) that are incorporated, domiciled, or situated in Argentina. That requirement is in addition to the transfer pricing (TP) information obligations for cross-border transactions. Regarding the audit environment, local tax authorities have continued with a strong audit programme, and sometimes, focus on certain industries (pharmaceutical, commodities, exporters); while in other cases the analysis is oriented on certain types of transactions (management fees, technical assistance, financial transactions). Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border intercompany transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? www.pwc.com/internationaltp Argentina No Yes No Yes No Yes 185

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Argentina Country TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Must TP documentation be prepared in the official/ local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? Argentina Yes During the eighth month following the end of the FY Yes Yes Yes Yes In the event that the taxpayer’s conduct is considered an omission, a fine must be paid that varies between one and four times the unpaid tax. Also, there are fixed penalties for formal infringements. Introduction Argentinian TP regulations have existed, in some form, since 1932. Prior to 1998, the rules focused on the export and import of goods through application of the wholesale price method, comparing the price of imports and exports with the wholesale price of comparable products in the markets of origin or destination. This methodology was applied unless the parties to the transaction could demonstrate that they were not related parties (Article 8 of the Income Tax Law [ITL]). Article 14 of the ITL reflected the need for all transactions to comply with the arm’slength standard: “Transactions between a local enterprise of foreign capital and the individual or legal entity domiciled abroad that either directly or indirectly control such enterprise shall, for all purposes, be deemed to have been entered into by independent parties, provided that the terms and conditions of such transactions are consistent with normal market practices between independent entities, with limits to loans and technical assistance.” However, the rules did not include any methodologies for supporting inter-company transactions, or outline any documentation requirements. On 30 December 1998, pursuant to Law 25,063, Argentina adopted general guidelines and standards set forth by the Organisation for Economic Co-operation and Development (OECD) including the arm’s-length standard, and applied it to tax years ending on, or after, 31 December 1998. With the adoption of the OECD standards, the computation of a taxpayer’s income-tax liability including provisions governing the selection of appropriate TP methodologies for transactions between related parties, could be impacted. On 31 December 1999, Law 25,063 was updated with Law 25,239, which introduced the special tax return and documentation requirements in relation to inter-company transactions. Under the TP reform process, the old wholesale price method was 186 International Transfer Pricing 2015/16

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only applicable to transactions involving imports or exports of goods between unrelated parties. A On 22 October 2003, Law 25,784 introduced certain amendments to the ITL which affected TP regulations. One of the amendments related to one of the points of an antievasion programme, with one of its objectives being to control evasion and avoidance in international operations resulting from globalisation. On the one hand, Law 25,784 replaces regulations on the import and export of goods with related and unrelated parties (replacement of Article 8 of the ITL), eliminating the concept of wholesale price at the point of destination or origin as a parameter for comparison. Now, in the case of imports or exports of goods with international prices known through commonly traded markets, stock exchanges, or similar markets, the new parameter establishes that those prices will be used to determine net income. On the other hand, a new TP method is introduced for the analysis of exports of commodities (amendments to Article 15 of the ITL). Taxpayers currently have two important TP-related obligations: to prepare, maintain and file transfer pricing documentation; and to file three information returns (special tax returns) on transactions with non-resident-related parties. In addition, taxpayers are required to maintain some documentation on import or export of goods between unrelated parties and to fill information returns on such transactions. On 14 November 2003, Law 25,795 was published in the official gazette (modifying Procedural Law 11,683), establishing significant penalties for failure to comply with TP requirements. It is important to note that the tax authorities are currently conducting an aggressive audit programme including a number of TP audits that are under way. Legislation and guidance Statutory rules Effective 31 December 1998, Argentinian taxpayers must be able to demonstrate that their transactions with related parties outside of Argentina are conducted at arm’s length. Transfer pricing rules are applicable to all types of transactions (covering, among others, transfers of tangible and intangible property, services, financial transactions, and licensing of intangible property). Under Argentinian legislation, there is no materiality factor applicable, and all transactions must be supported and documented. Transfer pricing rules apply to: • Taxpayers who carry out transactions with related parties organised, domiciled, located, or placed abroad and who are encompassed by the provisions of Article 69 of the ITL, 1997 revised text, as amended (mainly local corporations and local branches, other types of companies, associations, or partnerships), or the addendum to Clause D of Article 49 of the ITL (trusts or similar entities). • Taxpayers who carry out transactions with individuals, or legal entities domiciled, organised, or located in countries with low or no taxation, whether related or not (On 7 January 2014, the Argentinian Government issued Decree 589/2013, which eliminated the list of no- or low-tax jurisdictions from the income tax regulations (the so-called ‘black list’) and empowered AFIP to establish a new ‘white list’ of www.pwc.com/internationaltp 187

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Argentina countries, territories and tax regimes that are considered to be ‘cooperative’ with respect to tax transparency. Cooperative countries are those that have signed either double tax treaties (DTTs) with broad exchange of information clauses or tax information exchange agreements (TIEAs) with Argentina, or that are in the process of negotiating a DTT or TIEA). • Taxpayers resident in Argentina, who carry out transactions with permanent establishments (PEs) abroad that they own. • Taxpayers resident in Argentina who are owners of PEs located abroad, for transactions carried out by the latter with related parties domiciled, organised, or located abroad, under the provisions of Articles 129 and 130 of the ITL. Related parties The definition of related party under Argentinian TP rules is rather broad. The following forms of economic relationship are covered: • One party that owns all or a majority of the capital of another. • Two or more parties that share: (i) one common party that possesses all or a majority of the capital of each; (ii) one common party that possesses all or a majority of the capital of one or more parties and possesses significant influence over the other or others; and (iii) one common party that possesses significant influence over the other parties. • One party that possesses the votes necessary to control another. • One or more parties that maintain common directors, officers, or managers/ administrators. • One party that enjoys exclusivity as agent, distributor, or licensee with respect to the purchase and sale of goods, services and intangible rights of another. • One party that provides the technological/intangible property, or technical knowhow that constitutes the primary basis of another party’s business. • One party that participates with another in associations without a separate legal existence pursuant to which such party maintains significant influence over the determination of prices. • One party that agrees to preferential contractual terms with another that differs from those that would have been agreed to between third parties in similar circumstances including (but not limited to) volume discounts, financing terms and consignment delivery. • One party that participates significantly in the establishment of the policies of another relating to general business activities, raw materials acquisition and production/marketing of products. • One party that develops an activity of importance solely in relationship to another party, or the existence of which is justified solely in relationship to such other party (e.g. sole supplier or customer). • One party that provides a substantial portion of the financing necessary for the development of the commercial activities of another including the granting of guarantees of whatever type in the case of third-party financing. • One party that assumes responsibility for the losses or expenses of another. • The directors, officers, or managers/administrators of one party who receive instructions from, or act in the interest of another party. • The management of a company is granted to a subject (via contract, circumstances, or situations), which maintains a minority interest in the capital of such company. 188 International Transfer Pricing 2015/16

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Methodology For the export and import of goods between unrelated parties, the international price is applicable. In the event that the international price cannot be determined, or is not available, the taxpayer (the exporter or importer of the goods) must provide the tax authorities with any information available to confirm whether such transactions between unrelated entities have been carried out, applying reasonable market prices (Article 8 of the ITL). For related-party transactions, both transactional and profit-based methods are acceptable in Argentina. Article 15 of the ITL specifies five TP methods (an additional method has been established, dealing with specific transactions): 1. 2. 3. 4. 5. 6. Comparable uncontrolled price method (CUP). Resale price method (RPM). Cost-plus method (CP). Profit split method (PSM). Transactional net margin method (TNMM). Specific method for export transactions involving grain, oilseed and other crops, petroleum and their derivatives and, in general, goods with a known price in transparent markets (sixth method). This last method will only be applied when: (i) the export is made to a related party; (ii) the goods are publicly quoted on transparent markets; and (iii) there is participation by an international intermediary that is not the actual receiver of the goods being sold. It should be noted that this method will not be applicable when the international intermediary complies with all the following conditions: • Actual existence in the place of domicile (possessing a commercial establishment where its business is administered, complying with legal requirements for incorporation and registration, as well as for the filing of financial statements). • Its main activity should not consist of the obtaining of passive incomes, or acting as an intermediary in the sale of goods to, and from, Argentina, or other members of its economic group. • Its foreign trade transactions with other members of the group must not exceed 30% of the annual total of its international trading transactions. The method consists of the application of the market price for the goods being exported on the date the goods are loaded. This applies, regardless of the type of transport used for the transaction and the price that may have been agreed with the intermediary, unless the price agreed with the latter were to be higher than that determined to be the known price for the goods on the date of loading. In such a case, the higher of the two prices should be used to determine the profit of the Argentinian source. Under the above-mentioned circumstances, the Argentinian tax authorities disregard the date of transaction for these types of operations and consider the date of loading, assuming the date of the transactions could be manipulated by the related parties. In addition, they apply the same methodology, even when the foreign intermediary was an unrelated party. www.pwc.com/internationaltp 189 A

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Argentina Best method rule There is no specific priority of methods, except for the sixth method. Instead, each transaction or group of transactions must be analysed separately to ascertain the most appropriate of the five methods to be applied (i.e. the best method must be selected in each case). The TP regulations provide that in determining the best method to apply in a given circumstance, consideration will be given to: • the method that is most compatible with the business and commercial structure of the taxpayer • the method that relies upon the best quality/quantity of information available • the method that relies upon the highest level of comparability between related and unrelated-party transactions, and • the method that requires the least level of adjustments in order to eliminate differences existing between the transaction at issue and comparable transactions. Tested party The regulations established by the tax authority have stated that the analysis of the comparability and justification of prices – when applying the methods of Article 15 – must be made, based on the situation of the local taxpayer. Penalties If the Argentinian tax authorities are not in agreement with a taxpayer’s transfer prices, any tax difference should be paid, together with restatement and interest (which is not based on a specific public interest rate). In the event that the taxpayer’s conduct is considered an omission, a fine must be paid that varies between one and four times the unpaid tax. In cases where the tax authorities determine that the taxpayer has deliberately manipulated the amounts, fines could be assessed for up to ten times the evaded tax liability, notwithstanding the penalties stipulated in the Criminal Tax Act (Law 24,769). The tax authorities have the discretion to analyse the TP arrangement(s) by consideration of any relevant facts and application of any methodology they deem suitable. Penalties for non-compliance with respect to international transactions are as follows: • Failure to submit an informative tax return on imports and exports between independent entities is penalised with a fine of 1,500 Argentine pesos (ARS) which is raised to ARS 9,000 when an entity belongs to a foreign subject. • Failure to submit a tax return for all other import and export transactions with foreign related subjects is penalised with a fine of ARS 10,000, which is raised to ARS 20,000 when the entity belongs to a foreign subject. • Failure to provide correct tax address, information regarding international transactions, or supporting documentation for transfer prices, as well as obstructing an inspection, is penalised with amounts between ARS 150 and ARS 45,000. • Failure to comply with the requirements of the AFIP regarding the submission of informative tax returns for transactions with foreign-related entities, and regarding the submission of proprietary or third-party information, is penalised with fines between ARS 500 and ARS 45,000. Following three non-compliances the fine will be raised to between ARS 90,000 and ARS 450,000 for taxpayers whose income is equivalent to, or above, ARS 10 million. 190 International Transfer Pricing 2015/16

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It is important to mention that on 15 March 2013, the Tax Court confirmed the penalty of ARS 20,000 imposed by the Argentine tax authorities to the company Petersen Thiele y Cruz S.A. de Construcciones y Mandatos for omitting filing the informative tax return. Documentation The Argentinian income-tax law requires that the AFIP promulgate regulations requiring the documentation of the arm’s-length nature of transactions entered into with related parties outside of Argentina. In this regard, the TP regulations require that taxpayers prepare and file special tax returns detailing their transactions with related parties. These returns must be filed along with the taxpayer’s corporate income tax return. Information returns Import and export transactions between unrelated parties: • Requirements have been established for information and documentation regarding import and export of goods between unrelated parties (Article 8 of the ITL) covering international prices known through commonly traded markets, stock exchanges, or similar markets, which will be used to determine the net income. A semi-annual tax return must be filed in each half of the fiscal year (Form 741). • In the case of import and export transactions of goods between unrelated parties for which there is no known internationally quoted price, the tax authorities shall be able to request the information held in relation to cost allocation, profit margins and other similar data to enable them to control such transactions, if they, altogether and for the fiscal year under analysis, exceed the amount of ARS 1 million. A yearly tax return must be filed for those import and export of goods between unrelated parties for which there is no known internationally quoted price (Form 867). • In cases of transactions with parties located in countries with low or no taxation, the methods established in Article 15 of the law must be used, and it will be necessary to comply with the documentation requirements described for the transactions covered by TP rules. The obligation to document and preserve the vouchers and elements that justify the prices agreed with independent parties is laid down, and minimum documentation requirements are established. Compliance requirements for transactions with related parties: • Six-month tax return, for the first half of each fiscal period (Form 742). • Annual tax return covering the entire fiscal year (Form 969). • Complementary annual tax return, also covering the entire fiscal year (Form 743), which includes information about the TP methodology included in the report and the TP adjustment in case it is applicable. • Transfer Pricing documentation (certificated by the corresponding professional body) must be submitted to the tax authorities between the third and seventh day of the eighth month after the fiscal year-end. www.pwc.com/internationaltp 191 A

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Argentina The report must contain the information detailed below: • Activities and functions performed by the taxpayer. • Risks borne and assets used by the taxpayer in carrying out such activities and functions. • Detail of elements, documentation, circumstances and events taken into account for the analysis, or transfer price study. • Detail and quantification of transactions performed and covered by this general resolution. • Identification of the foreign parties with which the transactions being declared are carried out. • Method used to justify transfer prices indicating the reasons and grounds for considering them to be the best method for the transaction involved. • Identification of each of the comparables selected for the justification of the transfer prices. • Identification of the sources of information used to obtain such comparables. • Detail of the comparables selected that were discarded, with an indication of the reasons considered. • Detail, quantification and methodology used for any necessary adjustments to the selected comparables. • Determination of the median and the interquartile range. • Transcription of the income statement of the comparable parties corresponding to the fiscal years necessary for the comparability analysis, with an indication as to the source of the information. • Description of the business activity and features of the business of comparable companies. • Conclusions reached. Nevertheless, if a TP adjustment was applicable, it must be included in the annual tax return for which filing is due on the fifth month after the fiscal year-end. From fiscal years ending 31 December 2012, the TP report must be filed electronically (through the Form 4501). The Argentinian tax authority on 19 December 2013 released resolutions 3572/13 and 3573/13, which created registries and information regimes for affiliated parties and joint ventures, and other non-corporate entities involved in domestic and international transactions. Argentinian resident corporations, partnerships, trusts in general, and trusts in which the settlor and the beneficiary are the same person (the obligors) must register with the registry of affiliated parties if they are affiliated to any other party incorporated, domiciled, or situated in Argentina or abroad. Additionally, the obligors must act as information agents on a monthly basis for domestic transactions performed with affiliated parties (as described in Annex I of the Resolution 3572/13) that are incorporated, domiciled, or situated in Argentina. This requirement is in addition to the TP information obligations for crossborder transactions. 192 International Transfer Pricing 2015/16

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General due dates: Form 741 741 867 Period First six months of fiscal year Second six months of fiscal year Full fiscal year 742 969 First six months of fiscal year Full fiscal year 743 4501 Full fiscal year Full fiscal year (TP report) A Due date Fifth month following the end of the half-year General due date for filing income tax return Seventh month following the end of the fiscal year Fifth month following the end of the half-year Fifteen days immediately after the due date for filing the income tax return Eighth month following the end of the fiscal year Eighth month following the end of the fiscal year Transfer pricing controversy and dispute resolution The AFIP has a specialised group that performs TP examinations. This group is part of the División de Grandes Contribuyentes, a division of the AFIP that deals with the largest taxpayers. At present, the Argentinian tax authorities investigate TP issues under four main categories: • In the course of a normal tax audit. • Companies that undertake transactions with companies located in tax havens. • Companies that registered any technical assistance agreement, or trademark, or brand name licence agreement with the National Industrial Property Institute. • Specific industrial sectors such as the automotive, grain traders, oil and pharmaceutical industries. Controversial issues include, among others, the use of multiple-year averages for comparables or, for the tested party, the application of extraordinary economic adjustments according to the present situation of the country (e.g. extraordinary excess capacity, extraordinary discounts and accounting recognition of extraordinary bad debts). The audit procedure The audit procedure must follow the general tax procedure governed by Law 11,683. Transfer pricing may be reviewed or investigated using regular procedures such as onsite examination or written requests. Written requests are the most likely form of audit. During the examination, the tax authorities may request information and must be allowed access to the company’s accounting records. All findings must be documented in writing and witnesses might be required. In the course of the examination, the taxpayer is entitled to request information and the audit may not be completed without providing the taxpayer a written statement of findings. Upon receipt of this document, the taxpayer is entitled to furnish proof and reasoning that must be taken into account for the final determination. Reassessments and the appeals’ procedure Additional assessments or penalties applied by the Dirección General Impositiva (DGI) may be appealed by the taxpayer within 15 working days of receipt of the notification of assessment. The appeal may be made to either the DGI or the tax tribunal. An www.pwc.com/internationaltp 193

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Argentina unsuccessful appeal before one of these bodies cannot be followed by an appeal before the other, but an appeal before the competent courts of justice may be filed against the findings of either. If an appeal is made before the DGI or the tax tribunal, neither the amount of tax nor the penalty appealed against need be paid unless, and until, an adverse award is given. For an appeal to be made before the courts of justice, the amount of tax must first be paid (although not the penalties under appeal). Overpayments of tax through mistakes of fact or law in regular tax returns filed by the taxpayer may be reclaimed through submission of a corrected return within five years of the year in which the original return was due. If repayment is contested by the DGI, the taxpayer may seek redress through either the tax tribunal, or the courts of justice, but not both. Overpayments of tax arising from assessments determined by the DGI may be reclaimed only by action before the tax tribunal or the courts of justice. Upon claim for overpayments of tax, interest is accrued from the time when the claim is filed. Legal cases Since the tax reform introduced in 1998, several cases have been and are currently being discussed before the courts. It is expected that the tax courts will address several issues related to TP in the coming years. Following are summaries of some of the TP court cases. S.A. SIA The Supreme Court applied Article 8 for the first time in the S.A. SIA case, decided on 6 September 1967. The taxpayer, a corporation resident in Argentina, had exported horses to Peru, Venezuela and the United States. It was stated in the corporation’s tax return that these transactions had generated losses because the selling price had been lower than the costs. The tax authority decided to monitor such transactions under the export and import clause, according to the wholesale price at the place of destination. The tax authority concluded that, contrary to what had been argued by the taxpayer, such transactions should generate profits. It based this statement on foreign magazines on the horse business, which explicitly referred to the horses of the taxpayer and the transactions involved in this case. The Supreme Court maintained that because the evidence on which the tax authority based its argument was not disproved by the taxpayer, it deemed that the tax authority correctly reflected the wholesale price of the horses. As a result, the adjustment was considered valid. Eduardo Loussinian S.A. Loussinian S.A. was a company, resident in Argentina, which was engaged in importing and distributing rubber and latex. It concluded a supply contract with a non-resident subsidiary of a foreign multinational. Under this contract, the parent of the multinational group, ACLI International Incorporated (ACLI), would provide Loussinian such goods from early January 1974 up to the end of 1975. After the contract was agreed, the international market price of rubber and latex fell substantially. However, Loussinian kept importing the goods from ACLI despite the losses. The tax authority argued that there was overcharging under the contract and that Article 8 should be applied in this case. As a result, it considered that the difference between the wholesale price of the goods at the place of origin and the price 194 International Transfer Pricing 2015/16

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agreed on the contract was income sourced in Argentina which Loussinian should have withheld when it made the payments to ACLI. Both the tax court and the court of appeals upheld the tax authority decision. The Supreme Court said that despite the fact that the purchasing price was higher than the wholesale price, the latter could not be applied to this case to determine the income sourced in Argentina. This was because it considered that Loussinian had rebutted the presumption under which both parties had to be deemed associated, due to this gap between prices. Laboratorios Bagó S.A. On 16 November 2006, the members of Panel B of the National Fiscal Court (NFC) issued a ruling in the case Laboratorios Bagó S.A. on appeal – Income Tax. The matter under appeal was the taxpayer’s position to an official assessment of the income tax for the fiscal years 1997 and 1998. Even though the current TP legislation was not in force during those periods (wholesale price method was applicable in 1997 and 1998), the case was closely related to that legislation. Specifically, the ruling addressed issues such as (i) comparability of selected companies, (ii) the use of secret comparables (non-public information) for the assessment of the taxpayer’s obligation, and (iii) the supporting evidence prepared by the tax authorities. Laboratorios Bagó S.A., a pharmaceutical company based in Argentina, exported finished and semi-finished manufactured products to foreign subsidiaries. The tax audit was focused on the differences in prices between the markets involved, both international and domestic. In this case, the taxpayer argued that, with regard to its export transactions, it only performed ‘contract manufacturer’ activities, focusing its efforts only on manufacturing. Foreign affiliates performed research and development, advertising, sales and marketing activities, among others. The tax authorities first confirmed the lack of publicly known wholesale prices in the country of destination. Afterwards, they conducted a survey of other similar companies in Argentina, requesting segmented financial information on export transactions. The main purpose of that request was to obtain the profitability achieved by independent companies in the same industry. Because the taxpayer’s results were below the profitability average of independent companies, the tax authority adjusted the taxable basis for income-tax purposes. The ruling focused on four specific issues: • • • • Validity of the information obtained by the tax authority. Use of the so-called secret comparables. Nature of the adjustment performed by the tax authority. Evidence presented by the parties. Matters such as comparability adjustments, the application of statistical measures like the interquartile range, and especially the definition of functions, assets and risks, were mentioned in the ruling but were not material to the decision. www.pwc.com/internationaltp 195 A

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Argentina The analysis conducted by the tax authority contained conceptual mistakes that affected the comparability of the transactions (e.g. differences in volume of net sales as well as of export sales, verification of economic relationship or otherwise between the selected companies and their importers, unification of criterion for the different selected companies’ allocation of financial information, among others). It is also remarkable that in this case, the Tax Court accepted the use of secret comparables, being understood as information obtained by the tax authority through audits or other information-gathering procedures. The taxpayer presented several scenarios and other related evidence that supported its current position. Eventually, it was the evidence presented by the parties that allowed for the ruling in this case to be favourable to the taxpayer. Specifically, the Tax Court held in this case that under domestic law, the tax authority has a significant burden of proof when adjusting transfer prices. Because the tax authority did not offer enough evidence to support its position, the Tax Court ruled in favour to the taxpayer. DaimlerChrysler Argentina The case dealt with export transactions for the fiscal period 1998 (i.e. under the old TP methodology). The members of the Argentinian Tax Court unanimously decided that section 11 of the regulatory decree establishes a ‘different’ presumption where ‘once the business relationship has been proved’; the tax authorities may apply the wholesale price of the country of seller. However, the Tax Court clearly stated that it is not entitled to issue an opinion on the constitutionality of laws unless the Argentinian Supreme Court of Justice had already issued an opinion. Additionally, from the decision of the Tax Court, we understand that there are elements to consider that the comparability standard is not the most appropriate standard for this case. Based on that interpretation, the crucial element to be determined is whether the business relationship criteria applies to transactions between Mercedes Benz do Brasil, Mercedes Benz Argentina and Daimler Benz AG. Quoting traditional case law and considering the economic reality principle, the Tax Court ruled that wholesale prices effective in Argentina should be applied. In terms of the price used in the assessment by the tax authorities, the discounts and rebates granted to local car dealers were important elements. The Court adopted a formal approach in this case because it stated that the regulatory decree sets forth that the tax authorities can apply the wholesale price without taking into consideration the impact of the domestic market expenses. As a result, the tax court has not considered that prices in the domestic and foreign market can only be compared if an adjustment is made on the differences in the contractual terms, the business circumstances, functions, and assets and risks in either case. In this situation, the Tax Court has applied a price to a substantially different operation (and therefore non-comparable). Volkswagen Argentina SA (Fiscal Year 1998) The case was conceptually similar to DaimlerChrysler Argentina, with the exception that an independent third party acquired products of the local company (VWA), and then sold them, once imported, to Volkswagen do Brasil (VWB). 196 International Transfer Pricing 2015/16

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The court’s analysis is based on the export contract executed between VWA and the third party. The court considered that certain clauses evidenced the control that VWA and VWB exerted on the third party (i.e. purchase commitments, audit of the costs and expenses of the intermediary, assistance in the import process, among others). As such, the Tax Court concluded that the operations should be considered as having been conducted between related parties, even when the relationship was not economic, based on the principle of economic reality, according to which substance prevails over form. The Tax Court believes that the Administrative Court ignored Article 8 and applied section 11 of the regulatory decree without giving any reason for not applying the wholesale prices in the country of destination (Brazil) and applying that of the country of seller (Argentina). The procedure followed by the tax authorities would have been appropriate if it had proved why prices informed by the Brazilian tax authorities were not valid, or if it had applied the provisions of Article 8 (i.e. the determination of the factors of results obtained by third parties conducting activities similar or identical to those of the taxpayer). Volkswagen Argentina (fiscal year 1999)/Aventis Pharma (fiscal year 2000) Even when the companies belong to different industries, there is a common issue related to the burden of proof when discussing TP issues. The National Tax Court stated that both parties (taxpayer and the tax authorities) shall support their statements on the process and that the quality of the proof is relevant to both parties. The Court considers that the tax authority has not proved its own position, which basically consists of discrediting comparability adjustments carried out by the taxpayers in the TP study. For example, in case of a selected comparable company with operating losses, the impugnation made by the tax authority is rejected, due to lack of a systematic investigation work, so that disqualification has something to be based on. As a conclusion, the decision points out the importance of preparing and submitting the TP study because once the taxpayer has met the documentation requirements, the tax authorities shall demonstrate that the analysis performed by the taxpayer is incorrect. Nobleza Piccardo In this case, local tax authorities applied the CUP method to analyse the exports of manufactured products using what the tax authorities considered internal comparables (local sales to unrelated customers in a free trade zone). The taxpayer considered that those transactions were not comparable and applied a TNMM. Again, in this case, the National Tax Court considered that proof was a fundamental element to the final decision because the majority of the judges decided that no comparability was observed in the transactions used by the tax authorities as internal comparables. Alfred C. Toepfer Internacional This decision, favourable to the tax authorities, indicates the importance of the ‘certain date’ of the transactions when dealing with products with publicly known prices (commodities). In this case, as the taxpayer was not able to prove the certain date of the transaction, the tax authorities disregarded the prices applied by the taxpayer and www.pwc.com/internationaltp 197 A

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Argentina compared the price of the exported products with the price at the moment of shipping the goods. It is important to mention that the ITL was modified in 2003 to include the position adopted by the tax authorities, but the transactions under discussions referred to the fiscal year before the law amendment. Boeringher Ingelheim The Boehringer Ingelheim case, the most elaborated TP decision in Argentina so far, concerns a pharmaceutical company that manufactured and exported medicines as well as imported and distributed finished products. The Tax Court ruled about many aspects, such as the selection of the most appropriate profit level indicator, the preparation of a functional segmentation analysis, the appropriateness of performing country risk adjustments for comparability purposes, the rejection of comparable companies that had transactions with related parties, the burden of the proof, among others. Regarding the functional segmentation of the financial information of the taxpayer, the Tax Court upheld the AFIP´s criterion that the taxpayer should have used a functionally segmented TP analysis, so that the results reached and the comparables used for the manufacturing function do not get aggregated with those of the distributing function. In addition, the Tax Court admitted the usage of averaged financial information of the last three years for the tested party. This decision was based on the fact that: (i) local rules do not provide any guidance on this regard, (ii) the tax authorities had accepted the average of financial information of three years for the comparable companies, and (iii) according to the Tax Court, the tax authorities did not provide appropriate arguments to support their position. Akapol The National Tax Court rejected the position of the federal tax agency (AFIP) and held that an economic relationship did not exist between two companies that had entered into an exclusive distribution agreement and, as a result, the Argentinian TP rules did not apply to their transactions. In Argentina, the concept of economic relationship is established by the section added after section 15 of the ITL. The application of that law is determined by the AFIP General Resolution 1122/01 (GR 1122), which provides in Schedule III a list of assumptions that would imply economic relationship. During a tax audit, the AFIP characterised Akapol S.A.C.I.F.I.A. and a third-party exclusive distributor located in Uruguay (Distributor) as related parties for tax purposes using the list of assumptions from Schedule III and applied a TP adjustment for fiscal year 2001. The Court rejected the economic relationship presumed by AFIP, holding that the exclusive distribution agreement alone does not provide Akapol with the decisionmaking power to control the activities of Distributor, a condition that the ITL requires for an economic relationship to exist and so for the TP rules to apply. Toyota Argentina On 2 September 2014, Argentina’s Supreme Court for the first time passed judgment on a TP controversy related to OECD type regulations. The Supreme Court noted 198 International Transfer Pricing 2015/16

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the strict adherence to the legal principle in TP matters. The material elements of the TP regulations must be established by law and it could not be based on administrative regulations. A It is also implied by the Supreme Court’s decision that if the taxpayer properly documents its transfer prices, the burden of proof reverts to the tax authorities. According to the Supreme Court ruling, the tax authorities should provide enough evidence to support its cases in court. It is not enough that it refute the proof provided by the taxpayer, but it must properly back its position as well. Burden of proof The general rule is that the taxpayer has the burden of proof, as it is obligated to file a report with certain information related to TP regulations, together with the income tax return. If the taxpayer has submitted proper documentation, the AFIP must demonstrate why the taxpayer’s transfer prices are not arm’s length and propose an amount of TP adjustment in order to challenge the transfer prices of a taxpayer. Once the AFIP has proposed an alternative TP method and adjustment, it is up to the taxpayer to defend the arm’s-length nature of its transfer prices. Use and availability of comparable information Availability of comparables Comparable information is required to determine arm’s-length prices and should be included in the taxpayer’s transfer pricing documentation. Argentinian companies are required to make their annual accounts publicly available by filing a copy with the local authority (e.g. Inspección General de Justicia in Buenos Aires). However, the accounts would not necessarily provide much information on potentially comparable transactions, or operations because they do not contain much detailed or segmented financial information. Therefore, reliance is often placed on foreign comparables. The tax authorities have the power to use third parties’ confidential information. Use of comparables To date, there have been several cases where the tax authorities have attempted to reject a taxpayer’s selection or use of comparables. Any discussion in this context is focused on the comparability of independent companies, or its condition as independent. In this connection, the tax authority has requested additional information related to the final set of comparables. Limitation of double taxation and competent authority procedure Most of the tax treaties for the avoidance of double taxation concluded by Argentina include provisions for a mutual agreement procedure (MAP). In Argentina, a request to initiate the MAP should be filed with the Argentine Ministry of Economy. There are no specific provisions on the method or format for such a request. No information is available on the number of requests made to the Ministry of Economy. It is understood that the competent authority procedure is not well used in Argentina, as there is no certainty for the taxpayer that the relevant authorities will reach an agreement. www.pwc.com/internationaltp 199

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Argentina Advance pricing agreements (APAs) There are no provisions enabling taxpayers to agree on APAs with the tax authorities. There is a binding consultation process available, but it is not commonly used to obtain certainty on TP issues. Practice The tax authorities are expected to become more aggressive and more skilled in the area of TP. Transfer pricing knowledge of the ‘average’ tax inspector is expected to increase significantly, as training improves and inspectors gain experience in TP audits. As the number of audits increases, some of the main areas being examined include inter-company debt, technical services’ fees, commission payments, royalty payments, transfers of intangible property, and management fees. Liaison with customs’ authorities The DGI and the customs’ authority (Dirección General de Aduanas, or DGA) are both within the authority of the AFIP. Recent experience suggests that exchange of information between DGI and DGA does occur. The Argentine government issued Decree 2103/2014 establishing a new foreign trade regulatory agency, the ‘Monitoring and Tracking of Foreign Trade Transactions Unit’ (the Unit), which will monitor and verify the increasing amount of complex foreign trade transactions taking place in and out Argentina. The Unit will allow more direct participation as well as access to information to other Argentine regulatory agencies (i.e. AFIP, Central Bank and Secretary of Commerce are among the members of the Unit). Nevertheless, there is no prescribed approach for the use of certain information of one area in another area (e.g. TP analysis for customs’ purposes). The information that must be provided to the DGA, in relation with foreign trade, is now required in an electronic form. As a result, the DGI could have better and easier access to that information. Also, the DGI has direct access to the customs information of other countries, like Brazil. Joint investigations Even though there have been some requests for information from other tax authorities (e.g. Brazil) for specific transactions or companies, there is no regular procedure for joint investigations. Comparison with OECD Guidelines Argentina is not a member of the OECD. The tax authorities have generally adopted the arm’s‑length principle and use as guidance the methodologies endorsed by the OECD Guidelines for TP which give effect to the arm’s-length standard. The Argentinean TP methods are consistent with the OECD Guidelines, with the addition of a specific method for analysing exports of commodities carried out through an international agent. There is no specific priority of methods, except for the method cited for exports of commodities. The most reliable method must be selected and applied. Similarly, the reasons considered for discarding the use of the other methods must be justified. Regional comparable companies are accepted; however, local comparable companies are preferred. 200 International Transfer Pricing 2015/16

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Argentinean legislation establishes the requirement to use interquartile ranges. When the application of any of the specific methods determines the existence of two or more comparable transactions, the median and the interquartile range should be established for prices, amounts of consideration and profit margins. Taxpayers are advised to update comparable company sets annually, in accordance with the expectations of the tax authorities. Regarding the Tested Party selection, regulations established by the AFIP have stated that the comparability analysis and justification of prices must be made on the basis of the situation of the local taxpayer. In this sense, the local taxpayer must be selected as the tested party in the application of a TNMM. Finally, it is important to mention that some recent jurisprudence of the National Tax Court established that the role of the OECD Guidelines is to fill in gaps of Argentinian law to make TP regulations as clear as possible. www.pwc.com/internationaltp 201 A

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13. Australia A PwC contact Pete Calleja PricewaterhouseCoopers 201 Sussex St Sydney NSW 2000 Australia Tel: +61 2 8266 8837 Email: pete.calleja@au.pwc.com Overview Australia’s transfer pricing (TP) laws were comprehensively rewritten in 2013, with a new self-assessment based regime taking effect for income years beginning on, or after, 29 June 2013. The new rules continue to be based upon the arm’s‑length principle. The law contains specific provisions that require transactions to be disregarded and ‘reconstructed’ in accordance with hypothetical arm’s-length transactions in certain circumstances. The law prescribes the 2010 Organisation for Economic Co-operation and Development (OECD) Guidelines as relevant guidance materials that must be considered by taxpayers when self-assessing whether they have complied with the rules. Transfer pricing documentation is not mandatory, but it is a necessary prerequisite for establishing a ‘reasonably arguable position’ (RAP) on any TP matter. Establishing a RAP reduces the penalty rates that may apply if the Commissioner of Taxation (the Commissioner) issues an amended assessment. The Australian Taxation Office (ATO) actively enforces Australia’s TP rules through reviews and audits. The ATO is increasingly focusing on adopting a ‘whole of code’ approach when considering TP matters, rather than considering TP in isolation, particularly in light of the global focus on base erosion and profit shifting (BEPS). This means that TP issues are often examined in combination with related-international tax issues. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border intercompany transactions? Does TP legislation apply to domestic intercompany transactions? Does TP legislation adhere to the arm’s‑length principle? www.pwc.com/internationaltp Australia Yes Yes (but not mandatory) Yes Yes No Yes 203

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Australia Country Australia TP documentation Can TP documentation provide penalty protection? Yes When must TP documentation be prepared? Prior to filing income tax return Must TP documentation be prepared in the official/local Yes language? Are related-party transactions required to be disclosed on the Yes tax return? Penalties Are there fines for not complying with TP documentation No requirements? Do penalties or fines or both apply to branches of foreign No companies? How are penalties calculated? Percentage of tax shortfall Introduction Australia has had TP legislation in force for several decades. Substantial changes to this legislation were enacted in 2012 and 2013, with a new regime taking effect for income years beginning on, or after, 29 June 2013. The Australian TP rules are based upon the arm’s‑length principle and are largely consistent with the OECD Guidelines. The ATO is vigilant in policing taxpayers’ compliance with Australia’s TP rules and works closely with tax authorities in other jurisdictions and international bodies (such as the OECD) to reduce double taxation, resolve TP disputes and share information. Australia has a broad network of double tax agreements (DTAs) and tax information exchange agreements. An advance pricing arrangement (APA) programme is available for taxpayers to apply for unilateral, bilateral or multilateral APAs. Legislation and guidance Current legislation: Income Tax Assessment Act 1997 (ITAA 1997) and Taxation Administration Act 1953 (TAA 1953) The current Australian TP rules are contained within Subdivisions 815-B, 815C and 815-D of the ITAA 1997. Subdivision 815-B applies to dealings between separate entities, Subdivision 815-C applies to permanent establishments (PEs), and Subdivision 815-D applies to partnerships and trusts. Record-keeping requirements are contained in Subdivision 284-E of Schedule 1 of TAA 1953. Under Subdivision 815-B, a taxpayer must self-assess whether it has obtained a ‘transfer pricing benefit’, and if so, it must make an adjustment to negate that benefit. In effect, this means the TP rules can only be applied to increase taxable income in Australia. A taxpayer obtains a ‘transfer pricing benefit’ from ‘conditions’ operating between it and another entity (which need not be a related party) in connection with their commercial and financial relations, if the following are satisfied: • The ‘actual conditions’ differ from the ‘arm’s-length conditions’, defined as the conditions that might be expected to operate between independent entities dealing wholly independently with one another in comparable circumstances. 204 International Transfer Pricing 2015/16

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• The actual conditions satisfy the ‘cross border test’. • Had the arm’s-length conditions operated instead of the actual conditions, the amount of the taxpayer’s taxable income (or withholding tax [WHT]) would be greater or taxable loss (or tax offsets) would be less. A The law notes that conditions include, but are not limited to, such things as price, gross margin, net profit and the division of profit between the entities. In identifying the arm’s-length conditions, it is necessary to use the TP method (or methods) that is ‘most appropriate and reliable’, having regard to: • the respective strengths and weaknesses of the possible methods in their potential application to the actual conditions • the circumstances including the functions performed, assets used and risks borne by the entities • the availability of reliable information required to apply a particular method, and • the degree of comparability between the actual circumstances and the comparable circumstances including the reliability of any adjustments to eliminate the effect of any material differences. This comparability assessment requires a consideration of five comparability factors (which are consistent with the OECD Guidelines), namely the: • • • • • functions performed, assets used and risks borne by the entities characteristics of any property or services transferred terms of any relevant contracts between the entities economic circumstances, and business strategies of the entities. Under Subdivision 815-B, in some circumstances, taxpayers must disregard actual transactions and reconstruct them in accordance with hypothetical arm’s-length transactions. Specifically, s815-130 requires taxpayers to consider whether the arm’slength conditions should be identified under a ‘basic rule’ or one of three exceptions to the basic rule. The basic rule requires the arm’s-length conditions to be identified, based on the actual commercial and financial relations (having regard to both the form and substance of the arrangements). The three exceptions in s815-130 are: Exception 1: In identifying the arm’s-length conditions the form of the commercial and financial relation is to be disregarded to the extent that it is inconsistent with the substance of those relations. Exception 2: If independent entities would not have entered into the actual commercial and financial relations, but instead would have entered into other commercial or financial relations (which differ in substance from the actual relations), the arm’slength conditions are to be based on the commercial or financial relations that independent parties would have entered into. Exception 3: If independent parties would not have entered into commercial and financial relations at all, the identification of arm’s-length conditions is to be based on the absence of commercial and financial relations (i.e. the actual transaction must be disregarded entirely). www.pwc.com/internationaltp 205

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Australia In addition to these core rules, other key features of the TP rules are: • The arm’s-length conditions must be identified in a way so as best to achieve consistency with prescribed guidance materials. The guidance materials currently prescribed for Subdivision 815-B are the 2010 OECD Guidelines. • Subdivision 815-C requires profits to be attributed to PEs, based on the ‘relevant business activity’ approach. This permits actual income and expenses to be attributed to a PE, but does not permit the recognition of notional dealings between a PE and its head office. The OECD Model Tax Convention and commentaries are prescribed as guidance materials that must be followed when applying Subdivision 815-C, but only as they read prior to the 2010 version of Article 7. The law enables the Government to make regulations to prescribe additional guidance materials in the future. • A specific rule addresses the interaction of Australia’s TP and thin capitalisation rules (see the thin capitalisation section below). Subdivision 284-E of the TAA 1953 contains optional TP record-keeping requirements. Taxpayers are not able to establish a RAP on TP positions unless they prepare documentation meeting the requirements at, or prior to, the lodgment of their tax return. Therefore, while the preparation of TP documentation is not mandatory, there are penalty implications if contemporaneous documentation is not prepared and the Commissioner makes a TP adjustment (see Penalties, below, for more detail). In order to counteract this compliance burden, the Commissioner has outlined a number of simplification measures for taxpayers and transactions considered low-risk (see Documentation, below, for more detail). Previous legislation: Income Tax Assessment Act 1936 (ITAA 1936) and Subdivision 815-A of ITAA 1997 Division 13 The former TP rules were contained in Division 13 of ITAA 1936. While Division 13 has been repealed, it still applies to financial years commencing before 29 June 2013. Transfer pricing matters in years covered by Division 13 remain open for amendment indefinitely. Division 13 applies only at the discretion of the Commissioner and only to increase the tax liability of a taxpayer. Division 13 dealt with circumstances in which a taxpayer has supplied or acquired ‘property’ (which is defined very broadly, including for example, services and rights to use intangible property) under an international agreement with another party. As with the current rules, there was no requirement for these parties to be related. In summary, the Commissioner could determine the transfer price in accordance with the arm’s‑length principle in circumstances where there had been: • supplies of property for less than arm’s-length consideration • supplies of property for no consideration, and • acquisition of property for excessive consideration. Section 136AE addressed international dealings between different parts of the same entity (e.g. dealings between a PE and its head office, or between two PEs of the same entity). The Commissioner was authorised to reallocate income and expenditure between the parties and thereby determine the source of income and the allocation of related expenses. 206 International Transfer Pricing 2015/16

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Subdivision 815-A Subdivision 815-A of the ITAA 1997 was enacted in September 2012 with retrospective application to income years beginning on, or after, 1 July 2004. Subdivision 815-A ceased to operate for income years beginning on, or after, 29 June 2013. Subdivision 815-A applied to dealings between Australian resident taxpayers and related parties in DTA countries and to Australian PEs of foreign residents of DTA countries. The Commissioner was permitted to make a determination under Subdivision 815-A when an Australian taxpayer received a ‘transfer pricing benefit’ in relation to dealings with a related party in a DTA country. A ‘transfer pricing benefit’ under Subdivision 815-A was defined by reference to the relevant Associated Enterprises or Business Profits Article of the relevant DTA. These Articles typically refer to the profits that have accrued to the parties, so a ‘transfer pricing benefit’ for the purposes of Subdivision 815-A will arise where the Australian taxpayer’s actual profits are less than the profits it would have accrued if it had been dealing wholly independently. The Commissioner was required to have regard to relevant OECD guidance (including the TP Guidelines and Model Tax Convention) when assessing whether a TP benefit has arisen. Similar to Subdivision 815-B, Subdivision 815-A also contained a specific provision on the interaction of Australia’s TP and thin capitalisation rules. Thin capitalisation Australia has thin capitalisation rules which apply where an entity’s total debt deductions are greater than 2 million Australian dollars (AUD) in an income year. Under Australia’s thin capitalisation regime, taxpayers are not permitted to deduct debt related expenses where the debt exceeds certain statutory limits. These rules were tightened for financial years commencing on or after 1 July 2014. Under the new rules, the maximum allowable debt in an income year is the greatest of the following amounts: • The safe harbour debt amount, i.e. 60% of assets (i.e. a debt to equity ratio of 1.5 to 1), a decrease from 75%. • The worldwide gearing debt amount, i.e. 100% of the gearing of the entity’s worldwide group, a decrease from 120%. • The arm’s-length debt amount, the calculation of which is guided by Taxation Ruling (TR) 2003/1. The TP laws contain a specific provision (section 815-140) that deals with the interaction of the TP and thin capitalisation rules. Based on this provision, the TP provisions are to be applied first to determine an arm’s-length interest rate. The arm’s-length rate is then applied to the actual amount of the loan (with interest deductions permitted to the extent the amount of debt is allowable under the thin capitalisation provisions). Other regulations Taxation rulings In addition to the statutory rules referred to above, the ATO has issued various public rulings (in both draft and final form) concerning TP. These both provide the Commissioner’s interpretation of the application of the statutory rules and provide guidance on other issues not specifically covered by statute. While final taxation rulings are binding on the Commissioner, they are not binding on taxpayers; however, taxpayers may rely on draft or final taxation rulings for penalty protection. www.pwc.com/internationaltp 207 A

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Australia Two taxation rulings have been issued providing guidance on the interpretation of the new TP rules: • TR 2014/6 – Application of section 815-130 (i.e. the ‘reconstruction’ provisions). • TR 2014/8 – TP documentation requirements. Practice statements The ATO provides practice statements to ATO staff on the approaches to be taken in performing their duties. These instructions may outline, for example, procedures for identifying and resolving significant issues, and work practices to be followed in the practical application and administration of the tax laws. These instructions, known as law administration practice statements (or PS LAs), do not express a precedential ATO view. While taxpayers that rely on a PS LA will remain liable for any tax, they are not liable for any interest or penalties in the event the PS LA is incorrect and the taxpayer makes a mistake as a result. Three PS LAs have been issued providing guidance on the application of the new TP rules: • PS LA 2014/2 – Administration of TP penalties. • PS LA 2014/3 – TP documentation simplification measures. • PS LA 2015/3 – Process for the application of section 815-130 (i.e. the reconstruction provisions). Taxation determinations Taxation determinations are generally shorter than rulings and deal with one specific issue rather than a comprehensive analysis of the overall operation of taxation provisions. Final taxation determinations may be relied upon by taxpayers. Determinations relevant to TP include Taxation Determination TD 2008/20, which provides specific guidance in relation to the interaction of Australia’s TP and debt/ equity provisions, and Taxation Determination TD 2014/14, which considers the deductibility of ‘capital support payments’ from an Australian parent company to a subsidiary. Taxation rulings and practice statements issued under the old law In addition to the above, there are a number of older taxation rulings, practice statements and taxation determinations that remain applicable for interpretation of the old law. These documents may also have some relevance in interpreting the new law to the extent that they provide coverage of topics that are not addressed in newer ATO guidance and do not conflict with the new law or OECD Guidelines. It is expected that many of these will be revised by the Commissioner in the short-to-medium term as the Commissioner expands upon the range of guidance available for interpretation of the new law. The taxation rulings, practice statements and taxation determinations that continue to operate are: • TR 92/11 – Loan arrangements and credit balances. • TR 94/14 – Basic concepts underlying the operation of the old TP law. • TR 97/20 – Arm’s-length TP methods. 208 International Transfer Pricing 2015/16

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• TR 98/11 – TP documentation and practical issues associated with setting and reviewing transfer prices. • TR 98/16 – Penalty tax guidelines. • TR 1999/1 – Intragroup services. • TRs 2000/16 and 2000/16A – TP and profit reallocation adjustments, relief from double taxation and mutual agreement procedure (MAP). • TR 2001/11 – Operation of Australia’s PE attribution rules. • TR 2001/13 – Interpreting Australia’s DTAs. • TR 2002/2 – Meaning of ‘arm’s length’ for the purpose of dividend deeming provisions. • TR 2003/1 – Thin capitalisation and applying the arm’s-length debt test. • TR 2004/1 – Cost contribution arrangements. • TR 2005/11 – Branch funding for multinational banks. • TR 2007/1 – Effects of determinations, including consequential adjustments. • PS LA 2007/8 Treatment of non-resident captive insurance arrangements. • TR 2010/7 – Interaction of the thin capitalisation provisions and the TP provisions. • TR 2011/1 – Application of the TP provisions to business restructuring. • PS LA 2011/1 – Advance pricing arrangement programme. It is expected that this PS LA will be updated within the next 12 months to reflect recent changes to the APA programme such as the introduction of a ‘triage’ process at the beginning of the APA process (see Advance pricing arrangements, below, for more detail). Penalties In PS LA 2014/2, the Commissioner sets out his views on how the ATO will issue penalties when it issues an amended assessment in relation to a TP matter. The penalty regime in the event of an amended assessment is outlined below. • If an entity has a sole or dominant purpose of obtaining a TP benefit and does not have a RAP, the penalty is equal to 50% of the tax shortfall. This is reduced to 25% if the entity can establish that it has a RAP. • If an entity does not have a sole or dominant purpose of obtaining a TP benefit and does not have a RAP, the penalty is equal to 25% of the tax shortfall. This is reduced to 10% if the entity can establish that it has a RAP. • The Commissioner has the discretion to remit all or part of a TP penalty. In ordinary circumstances, the Commissioner is likely to exercise discretion where the taxpayer has genuinely made a reasonable attempt in good faith to comply with the law, has made its best efforts to have a documented TP treatment and can satisfy that it did not have a tax avoidance purpose. In determining whether a position is ‘reasonably arguable’, it is necessary to determine whether the position is ‘about as likely as not, or more likely than not’ to be correct. The preparation of contemporaneous TP documentation is a legislated prerequisite for establishing a RAP. In addition to penalties, which are not deductible, the taxpayer is liable to pay a shortfall interest charge (SIC) on the value of any increase in the tax assessment arising from an ATO adjustment. This interest is deductible. The SIC annual rate is calculated by using the Reserve Bank of Australia’s 90-day Bank Accepted Bill rate, plus an uplift factor of 3%. The SIC annual rate was 5.36% for the quarter April – June 2015. www.pwc.com/internationaltp 209 A

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Australia Documentation Legislative requirements Transfer pricing documentation is not mandatory; however, as noted previously, taxpayers who do not prepare documentation meeting the requirements of Subdivision 284-E are precluded from establishing a RAP on any TP matter. To meet the requirements, the documentation must: • • • • • be in the possession of, or freely accessible to, the Australian be prepared by the time of lodging the tax return be in English (or readily convertible to English) explain the way in which the taxpayer has applied the Australian TP laws explain why the taxpayer’s application of the law achieves consistency with the prescribed guidance materials • allow the following to be readily ascertained: • the arm’s-length conditions relevant to the matter(s) • the method(s) used and comparable circumstances relied upon to identify the arm’s-length conditions • the result of applying the law in that way (i.e. whether a TP benefit has arisen) • for Subdivision 815-B, the actual conditions relevant to the matter(s), and • for Subdivision 815-C: • the actual profits attributed to the PE and the arm’s-length profits attributable to the PE, and • the activities and circumstances of the PE (including the functions, assets and risks attributed to the PE). ATO guidance The ATO has issued guidance in TR 2014/8 elaborating on the documentation requirements. In this draft guidance, the ATO clarifies that it expects taxpayers to explicitly consider the ‘reconstruction’ rules in their documentation. The draft guidance also clarifies that the Australian taxpayer must have ready access to the documentation, i.e. it is insufficient for the documentation to be held offshore and available upon request. TR 2014/8 provides a suggested framework in accordance with which taxpayers should prepare their TP documentation. The framework suggests entities consider five key questions when documenting their transfer pricing: • Question 1: What are the actual conditions that are relevant to the matter(s)? • Question 2: What are the comparable circumstances relevant to identifying the arm’s-length conditions? • Question 3: What are the particulars of the methods used to identify the arm’slength conditions? • Question 4: What are the arm’s-length conditions and is/was the TP treatment appropriate? • Question 5: Have any material changes and updates been identified and documented? ATO documentation simplification measures The Commissioner has acknowledged that, while the preparation of documentation is important to demonstrate that taxpayers have self-assessed their compliance with Australia’s TP laws, such preparation can be costly for smaller businesses 210 International Transfer Pricing 2015/16

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and unnecessarily onerous for low-risk transactions. Therefore, in PS LA 2014/3 (and associated online guidance Simplifying Transfer Pricing Record Keeping), the Commissioner has outlined the circumstances in which taxpayers may rely upon simplified documentation. If a taxpayer is eligible for one of these simplification measures, the Commissioner will not allocate compliance resources or take other compliance action to examine its TP records (beyond reviewing its compliance with the simplification criteria). The circumstances in which the preparation of ‘complete’ TP documentation is not necessary are set out below. To apply the small taxpayer simplification measure, the Australian economic group must: • not have more than AUD 25 million turnover • not have related‑party dealings involving royalties, licence fees or research and development arrangements • not have specified service (i.e. any strategic activity contributing significantly to the creation, enhancement or maintenance of value in the group, such as software development and the development of various forms of intellectual property and know-how) related party‑dealings exceeding 15% of turnover, and • not be a distributor. To apply the distributor simplification measure, the Australian economic group must: • not have more than AUD 50 million turnover • not have related-party dealings involving royalties, licence fees or research and development arrangements, and • not have a three-year weighted average profit before tax to sales ratio less than 3%. To apply the intragroup services simplification measure, the intragroup services must: • be no more than AUD 1 million or, if greater than AUD 1 million, intragroup services revenue must comprise no more than 15% of total revenue and intragroup services expense must comprise no more than 15% of total expenses • not have specified service related‑party dealings, and • not have a mark-up on costs greater than 7.5% for intragroup services expense or less than 7.5% for intragroup services revenue. To apply the low-level loans simplification measure, the Australian economic group must: • not have total cross-border loan balances exceeding AUD 50 million during the financial year • not have an interest rate on the inbound intercompany loan exceeding the Reserve Bank of Australia indicator lending rate for ‘small business; variable; residentialsecured; term’ (which was 6.85% as at March 2015) • have received the loan in Australian dollars, and • have paid all associated expenses (e.g. interest expense) in Australian dollars. In addition, if any of the following conditions are broken in relation to any of the above simplification measures, the taxpayer will be ineligible to use it: www.pwc.com/internationaltp 211 A

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Australia • The taxpayer must not have derived three or more consecutive years of tax losses. • The taxpayer must not have entered into related-party dealings with entities in ‘specified countries’ (i.e. jurisdictions considered by the Commissioner to be high risk, such as the British Virgin Islands, Cayman Islands and Jersey). • The taxpayer must not have undergone a restructure within the financial year. • The taxpayer must have assessed its compliance with the TP rules. At a minimum, this requires the preparation of a memorandum by a taxpayer outlining its compliance with these criteria. A functional analysis and benchmarking, for example, is not required. The simplification measures have been introduced for a trial period of three years. The ATO will monitor the results of the simplification measures over this period and will then make a decision on whether to continue, modify, or expand the simplification measures. Tax return disclosures Every taxpayer that engages in international transactions with related parties which total more than AUD 2 million (including loan balances) is required to submit an International Dealings Schedule (IDS) with its income tax return. In Section A of the IDS, details must be provided regarding the nature and dollar value of transactions, the locations of counterparties, the extent to which each type of transaction is covered by TP documentation, the pricing methods applied to each type of transaction, details of any cross-border business restructures involving related parties, and various other questions. The other sections of the IDS require disclosures on other international tax matters including thin capitalisation and controlled foreign companies (CFCs). The ATO uses information from the IDS to assess a taxpayer’s TP risk and to identify candidates for review. Transfer pricing controversy and dispute resolution Risk differentiation framework The ATO uses a risk-differentiation framework (RDF) to assess tax risk and determine an appropriate risk management response. In using this framework, the ATO considers the likelihood of non-compliance (i.e. having a tax outcome that the ATO doesn’t agree with) and the consequences of that non-compliance (e.g. in terms of dollars, precedent). Large taxpayers are subject to continuous monitoring by the ATO, for example in the form of pre-lodgement compliance reviews, which require the taxpayer to meet the ATO and disclose material tax issues prior to lodgement of an income tax return. Conversely, smaller taxpayers who are rated lower risk by the ATO may only be monitored periodically. Risk reviews The ATO typically uses an approach known as a client risk review (CRR) when undertaking a risk assessment of potential material tax issues including TP. The ATO will examine information such as the taxpayer’s IDS, compliance history, latest tax collections, news or media articles and other publicly available information to select candidates for CRRs. A CRR is a review of one or more historical income years for which a tax return has been lodged. The ATO’s CRRs have become increasingly intensive in recent years, with more detailed questionnaires and more thorough 212 International Transfer Pricing 2015/16

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analyses in order to equip the ATO with the necessary information to determine whether it should proceed to audit. A Taxpayers receive a risk rating for each of the issues reviewed by the ATO at the completion of the risk review. The ATO may issue an overall TP risk rating or a risk rating for a particular TP issue (or issues). A higher risk rating does not necessarily mean that the company will be selected for audit, but with such a risk rating, the taxpayer is likely, at a minimum, to be placed on a watching brief. International structuring and profit shifting project The ATO received specific government funding in the 2013–14 federal budget to conduct a four-year compliance programme focused on BEPS. The programme, known as the international structuring and profit shifting (ISAPS) project, is targeting high-risk areas including CFCs, funding, taxation of financial arrangements (TOFA), thin capitalisation, TP and valuations. The programme has a target of generating approximately AUD 4 billion of tax revenue over the four years. Audits An ATO audit is more comprehensive than a risk review. In an audit, the ATO conducts extensive investigations to identify relevant facts and evidence. The ATO has wide-reaching information gathering powers, which provide the Commissioner, or any duly authorised taxation officer, full and free access to all buildings, places, books, documents and other papers for the purposes of ITAA 1936 or ITAA 1997. The Commissioner might also require any person to attend and give evidence or produce any documents or other evidence relating to a taxpayer’s assessment. The law also empowers the Commissioner to require a person to produce documents held outside Australia. Compliance with this latter requirement is not mandatory, but where a taxpayer fails to comply with such a request, the taxpayer may not rely on those documents in the event it wishes to challenge the Commissioner’s assessment. After the ATO has gathered the information it requires, it will develop its position on the matter and will issue a position paper to the taxpayer. The position paper will set out the ATO’s views on the characterisation of the taxpayer and related-party dealings, the most appropriate TP method and an economic analysis to apply that method using arm’s-length comparable data. The position paper will state the ATO’s conclusion on whether it believes an amended assessment should be issued. The taxpayer is usually offered an opportunity to respond in writing to the ATO’s position paper, which would involve correcting any factual errors made by the ATO and, where available, to provide additional information and arguments to counter the ATO’s position. After a review of the taxpayer’s response, the ATO will issue its final position paper followed by determinations and notices of assessment or amended assessments giving effect to the determinations. The notices of assessment or amended assessment will state when any tax, interest and penalties are ‘due and payable’. Usually the due date for payment will be 21 days from the date of the notice, but the Commissioner has the discretion to defer or bring forward the payment time. Any delay in paying the assessments incurs additional interest costs. Joint investigations The ATO is actively working with other tax authorities to conduct joint audits of a number of multinationals covering tax issues across multiple jurisdictions. www.pwc.com/internationaltp 213

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Australia Statute of limitations For income years beginning on, or after, 29 June 2013, there is a seven-year time limit for the Commissioner to issue amended assessments. There was no statute of limitations under Division 13, so income years commencing prior to 29 June 2013 remain open to amendment indefinitely. Revised assessments and the appeals procedure Australia has a comprehensive objection and appeals’ procedure for disputing an amended assessment raised by the Commissioner. Under these provisions, the taxpayer may object to an amended assessment issued by the Commissioner. A taxpayer who is dissatisfied with such an assessment has the later of four years from the date of the original assessment (which, under the self-assessment regime, is usually the date of filing the relevant income tax return) or 60 days from receiving the notice of amended assessment to lodge an objection in writing, setting out the grounds relied upon in support of the claim. In practice, most TP audits are not completed until more than four years after the original assessment, so in most cases taxpayers are required to object within 60 days of receiving an amended assessment. The Commissioner is required to consider the objection and may either allow it in full, in part, or disallow it. The Commissioner is then required to give notice to the taxpayer of the decision on the objection. A taxpayer dissatisfied with such a decision may either refer it to the Administrative Appeals Tribunal (AAT) for review or refer the matter to the Federal Court of Australia. Where the notice of assessment includes additional tax for incorrect returns, it is generally prudent to remit the matter to the AAT, which has the discretion to reconsider the level of additional tax imposed and may substitute its own decision for that of the Commissioner. In contrast, on appeal to the Federal Court, that court can only decide whether the Commissioner has made an error in law in imposing the additional tax. If no error of law has occurred, then the penalties will remain unadjusted. Decisions of the AAT may be appealed to the Federal Court, but only on a question of law. Burden of proof Under Australian law, the burden of proof in a dispute lies with the taxpayer. Legal cases To date, there have only been two completed cases involving the substantive operation of Australia’s TP laws. Both of these cases, however, were considered in the context of former Division 13 (i.e. Australia’s old TP laws). The details of these two cases are summarised below. Roche Products Pty Ltd v Commissioner of Taxation (2008) The case concerned the transfer price of goods acquired by Roche Products (an Australian company) from its Swiss parent. The AAT found that the transfer prices paid by the Australian taxpayer for ethical pharmaceutical products were excessive and made adjustments accordingly. No adjustments were made to the transfer prices of the other product lines. 214 International Transfer Pricing 2015/16

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In its judgment, the AAT made a number of comments that provided an insight into the interpretation of Division 13. They included: • Transfer pricing methodologies – Although the ruling acknowledged the difficulty in finding available comparable data, and used a uniform gross margin to price the transfers of all pharmaceutical products, the AAT expressed a preference for transactional methods over profit methods in the application of Division 13, such as the profit-based transactional net margin method (TNMM). • Loss-making companies – In noting the weaknesses of profit methods, the AAT pointed out their tendency to attribute any losses to incorrect TP. The AAT rejected this inference. The ruling accepted the taxpayer’s commercial reasons for the losses within one division, despite their occurring over a number of years, and did not order a TP adjustment for that division. • Annual test – The ruling clearly stated that the Australian income tax law requires that arm’s-length prices be determined for each separate year under consideration, rather than a multiple-year average. Commissioner of Taxation v SNF (Australia) Pty Ltd (2011) The proceedings concerned an Australian distributor (SNF Australia) purchasing from offshore related parties. For 13 years SNF Australia had no income-tax liability and made trading losses in all years bar two. The Commissioner argued that an arm’slength purchaser would never agree to the prices paid, given the sustained period of losses. In a significant win for the taxpayer, the Federal Court and the Full Federal Court both held that SNF Australia had successfully discharged its burden to satisfy the court that the prices paid to offshore related parties did not exceed arm’s-length prices. SNF Australia did this through the application of a comparable uncontrolled price (CUP) method. The ramifications (for the interpretation of Division 13) of SNF Australia’s win in the Full Federal Court included: • The mere existence of losses, even over a lengthy period, will not necessarily mean that the price paid for products is not arm’s length. • The courts found that the CUP method is the most appropriate method for the application of Division 13 where direct transactional data is available. The courts were willing to accept imperfect comparable data, indicating that the ATO cannot set the bar for comparability ‘at an unattainable height’. The Commissioner’s loss in the Full Federal Court provided impetus for the federal government to introduce the new legislation. Chevron Australia Holdings Pty Ltd v Commissioner of Taxation As at the date of writing, the Federal Court has heard evidence on another substantive TP matter in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation, but has not yet reached a decision. The matter relates to the pricing of intercompany debt. Other Australian cases Most of the other Australian cases have been administrative in character. Summaries of these cases are outlined below: • San Remo Macaroni Company Pty Ltd v Commissioner of Taxation (1999) – allegations that the Commissioner had made TP assessments in bad faith. www.pwc.com/internationaltp 215 A

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Australia • Daihatsu Australia Pty Ltd v Commissioner of Taxation (2001) – challenging TP adjustments on the basis that the Commissioner did not exercise his power on a bona fide basis. • Syngenta Crop Protection Pty Ltd v Commissioner of Taxation (2005) – request for the Commissioner to provide details of the TP assessments. • WR Carpenter Holdings Pty Ltd v Commissioner of Taxation (2008) – request for the Commissioner to provide particulars of matters taken into account in making TP determinations. To date, there have not been any cases finalised involving the application of Subdivisions 815-A or 815-B. The Chevron case (which has not yet been decided) will consider Subdivision 815-A. Limitation of double taxation and competent authority proceedings In the event that a TP audit results in an adjustment, a taxpayer may suffer double taxation. There are, however, mechanisms available to taxpayers, which may be able to limit the double taxation. Resident taxpayers An Australian taxpayer may obtain relief from double taxation; however, the mechanism available depends on whether or not there is a DTA. Where there is a DTA, a resident taxpayer may present their case to the Australian competent authority. The MAP Article in each of Australia’s DTAs enables competent authorities of the relevant countries to meet and consult with each other with a view to seeking to resolve potential double-taxation issues. The MAP does not compel an agreement to be reached and does not relieve the Australian taxpayers from penalties or interest charged by the ATO. Taxation Rulings TR 2000/16 and TR 2000/16A outline the procedures for seeking relief from double tax. If a foreign tax authority makes a TP adjustment and Australia does not have a DTA with that country, there is generally no mechanism to obtain relief from double taxation. However, the resident taxpayer may pursue domestic relief through the Australian appeals’ process. Non-resident taxpayers A non-resident party to certain transactions may be able to obtain relief from double taxation under Australia’s domestic legislation. Advance pricing arrangements A formal APA process is available in Australia. Detailed guidance on the ATO’s APA programme is contained in PS LA 2011/1. Matters covered in this guidance include: • Categorising APAs according to their complexity into simplified, standard and complex APAs. • ATO APA procedures and processes including the ATO Case Leader role and a detailed project management framework for all APAs. • The availability of a circuit breaker mechanism in some cases. 216 International Transfer Pricing 2015/16

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Reform While PS LA 2011/1 remains effective, it is currently being reviewed and modified by the Commissioner and is expected to be substantially revised within the next 12 months. The stated aims of the revisions are to: A • Improve taxpayer experience and better support willing participation. • Improve bilateral and multilateral engagement. • Increase efficiency and effectiveness. The Commissioner is seeking to do this by revising PS LA 2011/1 to reduce ‘red tape’, streamline processes and practices to improve timeliness and reflect a ‘principles-based’ approach. Although the revised practice statement is yet to be released, a number of changes – deviating from the process described in PS LA 2011/1 – have already been implemented. The most significant change has been the introduction of a ‘triage’ process for all APA/ MAP applications. To enable the ATO to review potential APA applications and allocate appropriate resources during the triage process, taxpayers need to provide certain information to the ATO before pre-lodgement discussions can begin. Another change has been that, with the broadening of the skillset of officers involved on APA cases, there has been a much greater emphasis placed by the ATO on identifying and addressing collateral issues before allowing a taxpayer to enter into the APA programme. These issues are more rigorously investigated by the ATO and may include issues such as the characterisation of the related‑party dealings (to determine if withholding tax should apply), the potential applicability of controlled foreign company legislation, the potential application of the general anti-avoidance provisions and dealing with ATO reviews or audits (not in relation to TP) already taking place. Comparison with OECD Guidelines The Australian rules are generally consistent with OECD Guidelines. In particular, the comparability factors in the OECD Guidelines are incorporated into the Australian legislation and must be considered by taxpayers in self-assessing their compliance with the TP rules. Further, the 2010 OECD Guidelines are prescribed as guidance materials that taxpayers must consider when selecting the most appropriate and reliable TP method and in preparing documentation meeting the Australian requirements. Future updates to the OECD Guidelines are not automatically incorporated into the Australian rules; however, the government is able to make regulations to prescribe additional guidance materials. The Australian rules differ from the OECD Guidelines in the following respects: • The ‘reconstruction’ provisions in s815-130 arguably apply more widely than the ‘exceptional circumstances’ contemplated in the OECD Guidelines, and are required to be applied by taxpayers on a self-assessment basis (whereas the OECD Guidelines only contemplate disregarding of actual dealings by a tax authority). • The provision modifying the TP rules where the thin capitalisation rules also apply has been included to clarify the interaction of the Australian TP and thin capitalisation regimes. In contrast, the OECD Guidelines contemplate that some domestic regimes may not include specific thin capitalisation rules (and therefore the TP rules in those regimes may operate to determine the maximum amount of debt allowable). www.pwc.com/internationaltp 217

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Australia • Australia has not endorsed the Authorised OECD Approach for PE profit attribution. The attribution of profits to PEs must therefore be based on attribution of actual income and expenses. 218 International Transfer Pricing 2015/16

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14. Austria A PwC contact Herbert Greinecker PwC Österreich GmbH Erdbergstraße 200 1030 Wien Austria Tel: +43 1 501 88 3300 Email: herbert.greinecker@at.pwc.com Overview The Austrian transfer pricing (TP) environment has been influenced by the recent developments in international tax law where TP continues to be a focus area, in particular, in light of the work of the Organisation for Economic Co-operation and Development (OECD) concerning the base erosion and profit shifting project (BEPS Project). The initiative of the BEPS project as such has effected the Austrian TP environment, for instance, in the form of increased scrutiny of TP-related issues in the course of Austrian tax audits and an extended discussion on the importance of a thorough value-chain analysis. In addition, the BEPS project requests increased documentation requirements (country-by-country reporting) in order to enhance transparency for tax administrations. It is expected that the BEPS discussion will also impact the regulatory environment in Austria. One measure that has already been introduced in Austria with reference to BEPS is a limitation of the deduction of interest and royalty expenses, if the recipient’s respective income is not taxed or is low taxed (for more information, please see ‘Legislation and guidance’). The Austrian Transfer Pricing Guidelines (ATPG 2010) introduced by the Austrian Ministry of Finance (MoF) in 2010 aim to facilitate and ensure the application of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) to allow for a dynamic interpretation, i.e. to consider further developments by the OECD. Hence, it is recommendable for companies and permanent establishments (PEs) situated in Austria to review their TP set-up in light of the Austrian provisions stipulated in the ATPG 2010 and from a BEPS’s point of view. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? www.pwc.com/internationaltp Austria Yes Yes Yes Yes Yes Yes N/A 219

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Austria Country When must TP documentation be prepared? Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? Austria Contemporaneously, however, at the latest when the tax returns are filed. No No No N/A N/A Introduction As a member of the OECD, Austria subscribes to the principles contained in the OECD Guidelines. In addition, the Austrian MoF published the ATPG 2010 in November 2010 with the intention to facilitate the implementation of the OECD Guidelines in Austria. The publication of the ATPG 2010 had been widely anticipated since they harmonise the tax authorities’ approach regarding the assessment of TP cases. Transfer pricing is becoming increasingly important, and this is reflected by the increasing number of tax inspectors specialising in international transactions. Austria has a broad treaty network with approximately 90 double tax agreements (DTAs) on income in place. In addition to the advance pricing agreements (APAs) in line with the DTA, there is a formal procedure for obtaining unilateral APAs in Austria (for more information, please see ‘Transfer pricing controversy and dispute resolution’). Legislation and guidance Statutory rules Austria has general statutory rules that aim at dealing with TP. Consequently, the statutory authority for addressing TP issues is found in the application of general legal concepts, such as substance over form and anti-avoidance regulations, as well as the application of other regulations to deal with issues such as fictitious transactions, hidden capital contributions and constructive dividends. The requirements to apply the arm’s‑length principle on inter-company dealings and for adequate documentation of transfer prices are constituted in Article 6 Item 6 Income Tax Act and Articles 124, 131 and 138 Federal Fiscal Code, respectively. Austrian transfer pricing guidelines The OECD Guidelines were published in Austria as administrative decrees. Although an administrative decree does not have the force of law, this is nevertheless an important indication of the acceptance of the principles contained in the OECD Guidelines and the approach to TP that the Austrian authorities are likely to adopt. The ATPG 2010 has been published for the general public; however, they primarily aim at providing guidance to tax inspectors on how to handle TP cases by interpretation of the OECD Guidelines. As a result, the ATPG 2010 does not represent comprehensive guidelines on the determination and documentation of transfer prices, but refers back in many aspects to formerly published opinions of the MoF in connection with specific questions of international tax issues, the so-called Express Answer Services (EAS). 220 International Transfer Pricing 2015/16

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No other binding regulations concerning TP have been published. If, however, guidance is required on a particular TP problem, then a taxpayer may submit the facts of that problem to the Austrian MoF to obtain comment on its legal aspects (an EAS inquiry and EAS reply, respectively). It should be noted that, although the reply of the Ministry is not legally binding, these replies are published in professional journals and are referred to in practice. The ATPG 2010 consists of five chapters that discuss various issues in connection with TP. In the first chapter, ‘Multinational group structures’, the legal basis of income allocation, the arm’s‑length principle and the TP methods on the basis of the OECD Guidelines are set out. Moreover, examples of types of inter-company transactions (e.g. manufacturing, sales, services, various financial transactions) are elaborated on. The second chapter, ‘Multinational structures involving permanent establishments’, discusses TP issues surrounding PEs. This chapter is strongly influenced by the OECD’s Report on the Attribution of Profits to Permanent Establishments (also referred to as the ‘Authorised OECD Approach’ – AOA). The third chapter, ‘Documentation requirements’, deals with basic principles of TP documentation, and requirements for the documentation of benchmarking studies are explained. The fourth part, ‘Transfer pricing audits’, discusses TP adjustments imposed by the tax authorities and possible solutions for solving disputes. The fifth chapter, ‘Tax structures involving intermediate companies’, represents the Austrian tax authorities’ focus on combating tax avoidance and tax evasion. Transfer pricing methods The acceptable TP methods are consistent with the TP methods presented in the OECD Guidelines: • Comparable uncontrolled price method (CUP method) – this method evaluates the arm’s-length nature of a transaction by direct comparison with the price charged in comparable uncontrolled transactions. • Resale price method (RPM) – this method evaluates the arm’s-length nature of a transaction by reference to the gross profit margin realised in comparable uncontrolled transactions. • Cost-plus method (CPM) – this method evaluates the arm’s-length nature of a controlled transaction by reference to the mark-up realised in comparable uncontrolled transactions. • Transactional net margin method (TNMM) – this method examines the net profit margin realised on a controlled transaction and compares this with the net profit margin earned by independent entities undertaking comparable transactions. The TNMM operates in a similar manner to the CPM and RPM, and ideally should be applied with reference to the net margin that the tested party earns in comparable uncontrolled transactions. • Profit split method (PSM) – where transactions are very interrelated, it might be that they cannot be evaluated on a separate basis; under such circumstances, independent enterprises sometimes agree to a form of profit split. The ATPG 2010 states that the method is to be chosen that leads to the most reliable arm’s-length result. www.pwc.com/internationaltp 221 A

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Austria Inter-company services In line with the OECD Guidelines, the ATPG 2010 stipulates that transfer prices for inter-company services are usually determined by applying the CPM in case a CUP method is not applicable. The ATPG 2010 provides an indicative range of mark-ups between 5% and 15% for routine services. This range shall, however, not be considered as safe harbour rule within which the pricing would not be challenged. For example, in case high value services are provided, ATPG 2010 does not consider a mark-up of 5% as adequate. Although ATPG 2010 explicitly states that the suggested mark-up range is for guidance only, there is a risk that tax auditors will insist on mark-ups within the abovementioned range and apply this range without further evaluation of the individual circumstances of the case in question. Management services Where the amount of a management charge has been calculated on an arm’s-length basis, the management fee would normally be tax-deductible. The following issues should, however, also be considered where management services agreements are being concluded: • A detailed contract should be drawn up. • The terms of the agreement should not take effect retroactively. • Documentary evidence to substantiate the provision of services and its benefits to the recipient should be maintained. Further, the ATPG 2010 includes a list of intragroup activities that are regarded as shareholder activities, and are therefore non-deductible. These comprise, for example, costs of the management board, costs that concern the legal organisation of the affiliated group and incidental benefits. In contrast, the ATPG 2010 also states a number of management services that generally may be charged, e.g. consulting services concerning the economic and legal affairs of the group company, training and education of the personnel on behalf of the group company and costs for a continuous audit as long as these release the subsidiary from its audit expenses. The following comments of the Austrian Federal Fiscal Court (Bundesfinanzgericht) provided in its recent decision (GZ RV/7101486/2012, 11.07.2014) involving the charging of management fees within a group might be helpful to consider when making intercompany charges: • The arm’s-length nature of inter-company transactions should be tested by the Austrian tax authorities in two steps: (i) reviewing the method applied, and (ii) analysing comparable evidence. • The selection of the most appropriate method is to be based on an appropriate entity characterisation resulting from the functional and risk analysis. • In order to consider a service as actually rendered, it is not necessary that the service is provided on-site. • In case of potential overlap of services provided by two related entities based on contractual provisions, double charge of the services cannot be assumed by the Austrian tax authorities without appropriate investigation (i.e. review of time sheets of the relevant employees). 222 International Transfer Pricing 2015/16

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Inter-company financing The ATPG 2010 states that the CUP method is the preferred method when testing the arm’s-length nature of financial transactions. However, the ATPG 2010 also indicates that a direct comparability of bank terms and conditions will not be given in most cases, as there are fundamental discrepancies between the entrepreneurial objectives of inter-company lending and bank lending. The ATPG 2010 does not offer clear guidance on how the interest rate is to be determined. The arm’s-length nature of inter-company interest rates is generally assessed in accordance with international practice with reference to market interest rates, taking into account the creditworthiness of the borrower, term of the loan, existence of guarantees and other relevant comparability factors. As mentioned, the ATPG 2010 does not consider banks comparable to group financing companies from a strategic perspective. With respect to cash pooling, the TP methodologies generally accepted in Austria are the same as the TP methodologies generally accepted in establishing the arm’s-length interest rates on inter-company loans. The service rendered by the cash pool provider can be remunerated, based on the CPM. If the cash pool provider undertakes additional functions and bears risk, this should be considered in the remuneration. According to the ATPG 2010, the synergies resulting from the cash pool need to be allocated among all participating companies. Therefore, in general, no residual profit should be left at the master company. The ATPG 2010 sets out that guarantee fees need to be charged when a guarantee was provided, based on economic reasons. If, however, the guarantee fee is provided to establish the creditworthiness of a group company, it needs to be assessed whether the group company was equipped with sufficient equity; if the group company is poorly capitalised, then it needs to be evaluated if it is appropriate to charge a guarantee fee at all. The ATPG 2010 clearly states that group affiliation is relevant in relation to the borrower’s creditworthiness, but do not give a clear understanding in how far this should be integrated in the borrower’s rating. Notwithstanding, the arm’s-length guarantee fee should be established on a ‘separate entity’ basis (i.e. borrower and its subsidiaries) and based on the ATPG 2010, bank guarantee fees may be used as comparables, where appropriate. The relevant provisions of the ATPG 2010 are somewhat unclear and in practice, tax auditors apply different interpretations of the ATPG 2010’s provisions. Therefore, the pricing of inter-company loans and guarantees should be given careful consideration. Thin capitalisation There are no statutory rules on permissible debt to equity (D/E) ratios. As a rule of thumb, D/E ratios of 3:1 would in principle not be challenged by the tax authorities, provided the terms of the debt are otherwise at arm’s length. A decision of the Tax Appeals Board (Unabhängiger Finanzsenat; now Federal Fiscal Court – Bundesfinanzgericht) indicates that even a much higher D/E ratio could be permissible, provided that the ability of the company to pay the interest rates and to repay the loan principal at maturity date are supported by a business plan that is based on realistic assumptions. However, it is not clear whether the Administrative High Court (Verwaltungsgerichtshof) will confirm this position. Where, e.g. the interest rate is higher than an arm’s-length rate, the consequences are that a deduction would be www.pwc.com/internationaltp 223 A

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Austria denied for the excessive interest, that corresponding amount would be qualified as a constructive dividend and withholding tax (WHT) would also be payable (there is normally no WHT on interest payments to foreign lenders, whether related or unrelated, unless the loan is secured by real estate). Inter-company licences In general, the ATPG 2010 requires arm’s-length compensation in case intangible assets, both registered and not registered, are provided to a related party. Regarding the definition of intangible assets, it refers to chapter VI of the OECD Guidelines. The ATPG 2010 considers two factors as important in determining a lower and upper limit of the potential royalty charge. The lower limit of arm’s-length royalty charges is represented by the costs incurred by the licensor. It is interesting that the ATPG 2010 implicitly accepts the licensor’s costs as an indication of the intangible asset’s value. It remains to be seen if they rely on this ‘lower limit’ in both inbound and outbound licensing transactions. As an upper limit, the licence fee cannot reduce the result the licensee would earn without using the intangible asset under the licence. If there is a lack of comparables, the PSM could be considered, particularly where both parties own valuable intangibles, in line with the OECD Guidelines. Interestingly, the ATPG 2010 notes that if comparables for royalty charges are not available, controlled intangible transactions within the group that had already been audited by foreign tax authorities can be considered as guidance. Restriction of interest and royalty deduction With effect from 1 March 2014, Austrian tax relief is no longer granted for intercompany royalty expenses where the recipient is based in a low-tax jurisdiction or is subject to a special tax regime. Royalty payments are not tax-deductible for an Austrian company if either the nominal corporate income tax rate in the recipient’s state is below 10%, or if the income derived from inter-company royalty payments is subject to an effective tax rate lower than 10% in the recipient’s state, due to a special tax regime. Furthermore, the restriction of royalty deductions applies if the recipient is subject to a general, or an individual, tax exemption. If the recipient is not the beneficial owner of the royalty payment, then the beneficial owner is to be regarded. Cost contribution arrangements (CCAs) Cost contribution arrangements are, in general, acceptable according to the ATPG 2010. However, the ATPG 2010 sets out specific documentation requirements for such arrangements. Business restructurings The chapter in the ATPG 2010 dealing with business restructurings prescribes certain documentation requirements and discusses cases when compensation payments need to be made. The ATPG 2010 contains a non-exhaustive list of questions that should be considered and documented when a business restructuring takes place. The extended documentation requirements list stipulates, for instance, that a pre- and postrestructuring functional analysis of the transformed entity should be prepared. 224 International Transfer Pricing 2015/16

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Permanent establishments (PEs) Under Austrian tax law, a PE is defined as a fixed place of business where a business is carried out. In particular: • a place where the management is carried out • branches, plants, warehouses, purchase and sales’ establishments, and other establishments where an entrepreneur or one’s permanent representative carries out one’s business, or • construction sites lasting for more than six months. In general, the Austrian definition of a PE largely corresponds to the definitions as set out in the OECD Model Convention. However, the definition of a PE may differ in individual DTAs. Although the AOA is not implemented in Austrian law, the ATPG 2010 stipulates that the AOA may serve as an interpretation of the application of DTAs as far as it does not contradict Article 7 of the applicable DTA. Hence, the separate entity approach for PEs has been implemented with some restrictions: Until Article 7 of the version of the OECD Model Convention issued in 2010 is implemented in a DTA, no notional interests, licence fees and lending rates are accepted. Moreover, if an activity of a PE is not part of its main activity, no profit mark-up should be used. In addition, the indirect profit allocation methods are still accepted. As mentioned, the APTG 2010 covers the subject of PE on the basis of the AOA. In order to create a dependant agent, PE dependency and acting on behalf of the principal is required. The criterion of dependency is satisfied inter alia if the agent’s activities are performed for merely one principal over a longer period of time. According to the ATPG 2010, a confirmation of independency by the parent company does not disprove the agent’s dependency. Regarding the second criterion, a dependant agent PE is created if duties arise for the principal through the agent’s conclusion of contracts, even if they are concluded in the agent’s name. A formal authority to conclude contracts on behalf of the principal is not required. Therefore, subsidiaries acting solely for one related company, particularly commissionaires, may create a dependant agent PE in Austria. This is especially crucial after conversions from fully fledged distributors to commissionaires. The ATPG 2010 points out that such conversions will especially be scrutinised if the downsized entity’s profit decreases significantly, or if it continues to carry out valuable functions on a service basis. Penalties There are no specific TP penalties stipulated in the ATPG 2010. However, TP adjustments have a direct effect on the corporate income-tax base and late payment interest may also be assessed if corporate taxes are not paid by the statutory deadline. If, however, the tax liability relating to past years is increased as a result of a tax audit, interest will be charged on the difference between the tax paid and the final tax assessed. The period for which interest is levied starts from October following the assessment year and lasts for 48 months at a maximum. The interest rate amounts to 2% above the base interest rate. If tax is paid late, a late payment surcharge will be imposed, amounting to 2% of the unpaid amount. An additional surcharge of 1% would be levied if tax is not paid within three months as of the date it has become due, www.pwc.com/internationaltp 225 A

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Austria and an additional 1% in case of late payment of the second surcharge. This surcharge is not tax-deductible, and no supplementary interest will be charged. In addition, with the amendment of the Tax Offences Act 2010, the regulations for infringement of tax law covering fines and imprisonment have been tightened. According to the Tax Offences Act 2010, fines and imprisonment charges may be assessed in cases of tax evasion and tax fraud. Moreover, fines are assessed on negligent and minor tax offences. Further, a tax offence is not only committed by the perpetrator, but also by anyone who incites another person to commit an offence. Documentation According to the ATPG 2010 the taxpayer has to prepare reasoned documentary evidence of the issues that were considered when determining the transfer prices. This documentation should be prepared before any transactions occur using those transfer prices, i.e. documentation is required at the time a transaction takes place. According to information obtained from the Austrian MoF the TP documentation has to be readily available at the point of time of filing the tax return. The TP documentation has to be presented to the tax auditors within a short period of time upon request at the latest. The two-tier approach to TP documentation (master file/local file) is accepted in Austria. Thereby, the local market conditions should be reflected and special documentation requirements set out in the ATPG 2010 – e.g. on business restructurings – need to be considered. In addition, the ATPG 2010 includes an exemplary list of issues that are to be addressed in the documentation of the functional and risk profile, comprising, for instance, the group structure, production processes, as well as competition and market conditions. The Austrian tax authorities have gained much experience lately by increasing the number of TP audits. They have formed a strict view on what constitutes a reasonably reliable process for using databases to provide comparable data on arm’s-length margins or profits. Critical elements of the search strategy are independence criterion (25% preferred), start-ups, loss-makers, geographic region (EU (27) plus Switzerland, Norway and Ireland are generally accepted), size, consolidated data and intangibles. In line with the increased focus on comparability in the OECD Guidelines’ updated chapters I–III, the ATPG 2010 stipulates that each of the five comparability factors needs to be considered in detail. Although the ATPG 2010 does not refer to the ninestep process introduced in the update of the OECD Guidelines, this process is generally considered, required, for preparing benchmarking studies from 2010 onwards. Similarly to the revised OECD Guidelines, the ATPG 2010 states that the application of interquartile ranges to narrow the range of transfer prices is an internationally accepted approach. By contrast, however, the ATPG 2010 provides for an adjustment to the median if a taxpayer’s transfer prices deviate from the acceptable range of transfer prices. One more recent decision of the Austrian Independent Fiscal Senate (UFSW, GZ RV/2515-W/09) deals with the determination of the arm’s-length distribution margin. The Senate reached the following conclusions, which may be extended to benchmarking studies in general: 226 International Transfer Pricing 2015/16

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• Benchmarking analyses, where quantitative screenings are used and an independence rate of only 50% is given, can be applied as a plausibility check, but cannot be relied upon for the determination of transfer prices. • All financial data on the available and accessible comparables, available at the time of the analysis, should be considered in the benchmarking study. • The use of the full or the interquartile range of results depends on the quantity and the level of comparability of the potential comparables. A small sample (six companies in the case of the decision) does not meet the requirement of there being a sufficient number of observations for statistical analysis; hence, the full range of results can be used. Transfer pricing controversy and dispute resolution Burden of proof As a matter of principle, the tax authorities carry the burden of proof. If the tax authorities challenge a tax return, the taxpayer does not have to prove the accuracy of the return; rather, the tax authorities would have to prove the contrary. However, based on the fact that tax authorities are entitled to ask for the documentation of TP, if an accurate documentation is not provided, the burden of proof switches to the taxpayer. In addition, in international tax cases, the taxpayer bears a special liability of cooperation (see ‘Tax audit procedures’). Tax audit procedures In Austria, it is not usual for the tax authorities to carry out an audit specifically in respect of transfer prices alone. However, recent experience shows that already at the beginning of a tax audit, inspectors request a description of the TP system in place. Typically, transfer prices represent one major part of a tax audit. If TP or benchmarking studies exist, they have to be provided to the tax auditors. The tax authorities have dedicated experts who are retracing and reviewing the correctness and comparability of such studies. Selection of companies for audit The tax authorities aim at auditing companies exceeding certain size thresholds on a three- to five-year basis. For smaller companies, there are three possible ways for a company to be selected for a tax audit: • Time – Those companies that have not been audited for an extended period are likely to be selected. • Industry group selection – Tax authorities might focus on certain industries from time to time. • Individual selection – Some companies are selected individually, based on ‘professional judgement’ or exceptional fluctuations in key ratios. The provision of information and duty of the taxpayer to cooperate with the tax authorities The taxpayer has a general duty to cooperate with the tax authorities, although decisions of the Administrative High Court (Verwaltungsgerichtshof) indicate that there is a limit to this duty, insofar as the tax authorities cannot demand impossible, unreasonable, or unnecessary information from the taxpayer. www.pwc.com/internationaltp 227 A

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Austria There also is an increased duty to cooperate where transactions with foreign countries are involved. Under this increased duty to cooperate, the taxpayer has a duty to obtain evidence and submit this to the tax authorities. The possibility of administrative assistance from other (foreign) tax authorities does not suspend the duty of the taxpayer to cooperate with the Austrian authorities. At the same time, in addition to the taxpayer’s duty to cooperate with the tax authorities, in its recent transfer pricing court decision (GZ RV/7101486/2012, 11.07.2014) the Austrian Federal Fiscal Court considered the tax authorities’ duty to investigate during a tax audit. The case involved the charging of management fees where the court did not accept the tax authority’s approach, which relied on mere assumptions for the assessment of tax without thorough investigation of the facts. This decision shows that the tax authorities are constrained by their duty to investigate the evidence relevant in the context of the transfer pricing method applied by the taxpayer in challenging the inter-company arrangements. The relevant evidence, in this context, should be included in the transfer pricing documentation (see Documentation section). The audit procedure There is no special procedure for TP investigations, which are seen as part of a normal tax audit. In this procedure, the tax auditors visit the company’s premises, interview the relevant company personnel and inspect the company’s books and records. As far as TP is concerned, tax inspectors increasingly request a summary of the TP system applied, and ask for the TP documentation. It should be noted that the conduct of the taxpayer during the tax audit can significantly affect both the outcome of the inquiry and the amount of any adjustment. If the taxpayer is able to maintain an objective approach and can provide good documentary evidence to support the TP scheme in place, they will have a much better chance of defending it against any adjustments proposed by the tax authorities. Revised assessments and the appeals’ procedure After the end of a tax audit, the tax inspector usually issues a ‘list of findings’, which is discussed with the company and/or the tax adviser. If the company agrees to the findings, the list forms the basis for the revised assessments covering the audited years. If, however, agreement could not be reached on any particular issues, then the tax office would still issue revised assessments in accordance with the inspector’s findings, but the company could file an appeal against the assessments. If an appeal is filed by the company, it will be heard by the Federal Fiscal Court (Bundesfinanzgericht, prior to 2014: Tax Appeals Board). The company may file a further appeal against a decision of the Federal Fiscal Court with the Administrative High Court. If a DTA exists that contains provisions for mutual agreement procedures (MAPs), it is very likely that these procedures would be used to avoid double taxation. According to information obtained from the MoF, there are only a few cases where such an agreement between the tax authorities involved could not be reached. In such cases or where there is no DTA, settlement could be achieved under the Arbitration Convention (the Convention re-entered into force retroactively as of 1 January 2000). Currently, the Arbitration Convention is applicable between Austria and all other European Union Member States except Croatia. Otherwise, Article 48 of the Austrian Fiscal Code and a decree of the MoF provide unilateral measures to avoid double taxation where no 228 International Transfer Pricing 2015/16

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DTA is applicable. Taxpayers subject to taxation on Austrian-sourced income may file an application for a double taxation relief to the MoF, and it may be granted at the Ministry’s discretion. The competent authority procedure may be initiated by the taxpayer, too. In case no competent authority procedure clause is given under the respective DTA, double taxation may be avoided by administrative assistance proceedings (EC Administrative Assistance Directive and EC Administrative Assistance Act) carried out by the tax authorities. Advance pricing agreements (APAs) There has been a formal procedure for obtaining unilateral APAs in Austria since 1 January 2011. The Ministry issued a law that enables taxpayers to ask for binding APAs regarding certain issues in taxation, such as TP. These regulations allow taxpayers for the first time to apply for binding, unilateral APAs in Austria. Bilateral agreements remain possible under the MAP clause of the applicable DTA. Besides applying for binding rulings regarding transfer prices, such applications are also possible for reorganisations and group taxation. Taxpayers wanting to have a binding ruling must submit a written application, which includes the relevant facts, the critical assumptions as well as a legal assessment of the facts. Administrative fees between 1,500 euros (EUR) and EUR 20,000 will be charged for the processing of the application of such APAs, depending on the company’s size. As a reaction to the initiatives of the OECD and the European Commission to fight aggressive tax planning, the MoF issued a procedural document on approaching the taxpayers’ requests for binding APAs in December 2014. The document formalises the existing procedures with respect to the APA applications submitted by multinational companies and contains specific criteria based on which such applications are analysed and reviewed in order to prevent aggressive tax planning: Indications (evidence) of unacceptable tax planning structures (e.g. unusually high remuneration [inter-company payments], intermediary group companies without value-added contributions, low-functional entities in a low-tax countries/‘tax havens’, nontransparent shareholding structure). The Ministry of Finance will also consider the economic substance of the activities performed in Austria and may liaise with other countries where relevant. Although the above-mentioned document represents rather a formalisation of the existing APA practice, it also reduces the room for potential negotiation with the tax authorities during the application process that might have been the case in the past. Comparison with OECD Guidelines Austria is a member of the OECD. In our experience, the Austrian MoF is very inclined to follow the positions of the OECD as expressed in the Model Commentary and the various OECD reports (e.g. partnership report, report on the attribution of profits to a PE). The ATPG 2010’s stated objective is to facilitate and ensure the application of the OECD Guidelines and to allow for a dynamic interpretation, i.e. to consider further developments by the OECD. www.pwc.com/internationaltp 229 A

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Austria In practical terms, there are certain areas where the Austrian tax authority’s interpretation of the OECD Guidelines seems to be stricter and/or more extensive than that of the majority of other countries applying the OECD Guidelines. It is therefore recommendable that special regard be paid to the potential TP implications in Austria in the following areas: • • • • 230 Inter-company financing. Business restructurings. PEs. Benchmarking studies. International Transfer Pricing 2015/16

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15. Azerbaijan A PwC contact Movlan Pashayev PricewaterhouseCoopers Central Asia & Caucasus B.V. Azerbaijan Branch Nizami 90A Street, 12th floor Landmark Office Plaza III AZ1010 Baku Azerbaijan Tel: +994 12 497 25 15 Email: movlan.pashayev@az.pwc.com Overview There are no changes in transfer pricing (TP) legislation over the past year. The TP concept is relatively new to Azeri tax law, although in the pre-tax code legislation there were some limited TP regulations focused principally on circumstances where goods, work, or services were sold at, or below, cost or bartered/transferred without charge. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? www.pwc.com/internationaltp Azerbaijan No No No Yes Yes Yes No N/A – No such requirement N/A No No (general financial sanctions may apply N/A N/A 231

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Azerbaijan Introduction The current TP rules were introduced in the current tax code, effective from 1 January 2001 and have been amended several times since then. These rules mainly focus on the determination of prices on the sale of goods, work, or services, and establish the principle of arm’s-length pricing for transactions between related parties and, in certain instances, the approach for making adjustments to transfer prices. In practice, the tax authorities have limited experience in dealing with TP, mainly making adjustments to taxpayers’ profits by disallowing certain deductible costs or challenging interest rates or the markup on services that were not, in their opinion, incurred or charged on an arm’s-length basis. Legislation and guidance Scope Under the tax code, ‘market price’ is defined as the price for goods, works, or services, based on the relationship of demand and supply. A contractual price should be deemed the market price between counterparties for tax purposes, unless the contract or transaction falls under one of the exceptions below. Under the tax code, the tax authorities may apply market price adjustments majorly in the following cases: • • • • Barter transactions. Import and export operations. Transactions between related persons. Transactions in which the prices within 30 days deviate by more than 30% either way from the prices set by the taxpayer for identical or homogeneous goods, works, or services. • Insurance of a property of an entity for the amount exceeding net book value of such property. • In certain cases monthly rent fee of an immovable property for tax purposes. Related parties Persons are considered ‘related’ in the following cases: • If one person holds, directly or indirectly, 20% or more of the value, or number of shares or voting rights in the other entity, or in an entity that actually controls both entities. • If one individual is subordinate to the other regarding official position. • If persons are under the direct or indirect control of a third person. • If persons have a direct or indirect control over a third person. Pricing methods The tax code lists the following methods for determining the ‘market price’: • Comparable uncontrolled price (CUP) method. • Resale price method (RPM). • Cost-plus (CP) method. 232 International Transfer Pricing 2015/16

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The tax code establishes the priority of pricing methods to be used by the tax authorities to determine market prices, according to which, the CUP method should be used first, before all other methods. If the determination of the market price is not possible under any of the methods above, the market price should be determined by an ‘expert’. Comparability factors In determining the market price, the tax authorities are required to take into account usual discounts from, or markups to, prices. In particular, the tax code gives specific circumstances of how the discounts or markups can be caused, such as deterioration of the quality of goods, or the expiry of a product’s life. In addition, the tax code sets out the commonly accepted principle that, for the purposes of determining the market price, only transactions carried out under comparable conditions should be taken into account. In particular, the following factors should be evaluated: • • • • • Quantity (volume) of supply. Quality level of goods and other consumption indicators. Period within which liabilities should be fulfilled. Terms of payment. Change of demand for goods (works, services) and supply (including seasonal fluctuations of consumer demand). • Country of origin of goods and place of purchase or procurement, etc. In the Profits Tax section of the tax code, there is a separate list of comparability factors which should be looked at to identify borrowings that can be treated as taking place under comparable circumstances. In particular, borrowings should take place in the same currency and be under the same terms and conditions. Resources available to the tax authorities Although the arm’s‑length principle has existed in the tax legislation since 2001, the enforcement of this principle is not common practice. Absence of statistical information for benchmarking purposes and the lack of modern information systems hamper the effective application of TP regulations in Azerbaijan. Use and availability of comparable information The tax code provides that comparables for the determination of market prices are to be taken only from ‘official and open’ information sources. The tax code does not define or specify what sources are considered official and open, but gives examples of such possible sources – databases of authorities in the specific market, information submitted by taxpayers to tax authorities, or advertisements. In practice, in the majority of tax audits where TP issues have been raised, the tax authorities have relied on information they collect from other similar taxpayers, or directly from alternative producers or sellers of similar goods in the local market (primarily, state-owned concerns). Information published by the State Statistics Committee has not been commonly used. www.pwc.com/internationaltp 233 A

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Azerbaijan Occasionally, the Azeri tax authorities undertake extensive data-gathering involving comparables to obtain an in-depth knowledge of specific industry practices and pricing policies. The data obtained from comparables have been used in some cases to make TP adjustments on a single-transaction basis, without regard to overall company profitability or multiple-year data. In that situation, taxpayers have been faced with considerable difficulty in challenging the position, as no specific data is provided on the comparables to allow verification and submission of counter-arguments. Risk transactions or industries The types of transactions typically scrutinised by the Azeri tax authorities in tax audits include: • Sale/purchase of goods, where the supplier is an overseas entity, even unrelated to the taxpayer. • Provision of centralised head-office services, and technical/management fees. • Import transactions and recovery of related input value-added tax (VAT). • Interest rates on inter-company loans. All industries are subject to the TP regulations in Azerbaijan. Penalties There is no separate penalty regime for the violation of TP rules; however, TP adjustments made by the tax authority in the course of a tax audit that would increase the taxable revenue of the taxpayer (e.g. by disallowing the deduction of the costs in relation to excessive pricing levels), may lead to the underpayment of tax. In case of a successful challenge by the authorities, a penalty of 50% of the underestimated tax may be imposed on the taxpayer. In addition, an interest payment of 0.1% per day also would accrue until the tax is paid in full. Documentation There is no statutory requirement in Azeri law that requires TP documentation to be prepared, apart from a general requirement for taxpayers to maintain and retain accounting and tax records, and documents. It is however clear those taxpayers that do not take steps to prepare documentation for their TP systems, in general or for specific transactions, will face an increased risk of being subject to an in-depth TP audit. Transfer pricing controversy and dispute resolution Currently, the tax authorities do not have specific procedures in the tax code for conducting separate TP audits. Control over prices is primarily made in the course of tax audits. Under the tax code, the burden of proof rests with the tax authorities to demonstrate that the price charged by a taxpayer significantly fluctuates from the market price. Unless otherwise proved, prices set by taxpayers are deemed to be the market prices. However, if the documentation requested by the tax authorities is inappropriate or unavailable, then the tax authorities can determine the adequate pricing levels, whereby the burden of proof would be shifted to the taxpayer. Taxpayers have the right to appeal to higher level tax authorities or to court. So far very few court cases have been related to TP in Azerbaijan. 234 International Transfer Pricing 2015/16

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Currently, there are no procedures in Azerbaijan for obtaining an advance pricing agreements. However, it is possible to obtain a written opinion from the tax authorities on TP issues. Such opinions are not binding. Currently, there are 42 effective double tax treaties with Azerbaijan. However, there is no experience with the application of the TP provision in those treaties. Comparison with OECD Guidelines The Ministry of Taxes has started consultations with the Organisation for Economic Cooperation and Development (OECD) on adopting new, more detailed TP regulations. The general expectation is that the OECD-type guidelines and models will be adopted in Azerbaijan at some point in the future, but the Government has not yet indicated a target date. www.pwc.com/internationaltp 235 A

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16. Bahrain B PwC contact Mohamed Serokh PwC UAE Emaar Square, Building 4, Level 8 PO Box 11987 Dubai United Arab Emirates Tel: +971 (0) 4 304 3956 Email: mohamed.serokh@ae.pwc.com Overview Bahrain does not currently have specific transfer pricing (TP) guidelines, although it does prescribe the use of the arm’s‑length principle. Bahrain does not impose corporate tax except on oil companies that face a corporate tax rate of 46%. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? www.pwc.com/internationaltp Bahrain No No No No No No No Documentation is not mandatory No No No No No specific guidance 237

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Bahrain Introduction There is currently no specific legislation regarding TP in Bahrain. Bahrain has double tax treaties (DTTs) in force with various countries including Algeria, Austria, Belarus, Brunei, Bulgaria, China, Egypt, France, Iran, Ireland, Isle of Man, Jordan, Lebanon, Luxembourg, Malaysia, Malta, Mexico, Morocco, the Netherlands, Pakistan, Philippines, Singapore, Sudan, Syria, Thailand, Turkey, the United States, Uzbekistan and Yemen. Legislation and guidance There are no taxes in Bahrain on income, sales, capital gains, or estates, with the exception, in limited circumstances, of businesses (local and foreign) that operate in the oil and gas sector or derive profits from the extraction or refinement of fossil fuels (defined as hydrocarbons) in Bahrain. For such companies, a tax rate of 46% is levied on net profits for each tax accounting period, irrespective of residence of the taxpayer. There are no specific restrictions in the income-tax law pertaining to payments made to foreign affiliates. There is currently no specific legislation regarding TP in Bahrain. Penalties The law is silent on the due date for filing of the final income tax statement. However, an estimated income tax statement must be submitted on or before the 15th day of the third month of the taxable year. Where applicable, a taxpayer may also be required to file an amended estimated income tax statement quarterly thereafter, unless a final income tax statement has been provided. There is no specific guidance on penalty calculation in the Bahrain income tax law. Documentation Bahrain income tax law does not contain a specific documentation requirement. Transfer pricing controversy and dispute resolution Given the absence of TP guidelines with specific TP provisions (including delineation of specified TP methods), there are no specific rules regarding burden of proof. Comparison with OECD Guidelines Although Bahrain is not an Organisation for Economic Co-operation and Development (OECD) member, it acknowledges the importance of the OECD Guidelines as the international best practice. 238 International Transfer Pricing 2015/16

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17. Belgium B PwC contact Patrick Boone PwC Tax Consultants bcvba/sccrl Woluwe Garden, Woluwedal 18, 1932 Sint-Stevens-Woluwe Brussels – Belgium Tel: +32 2 7104366 Email: patrick.boone@be.pwc.com Xavier Van Vlem PwC Tax Consultants bcvba/sccrl Sluisweg 1, 9000, Gent Belgium Tel: +32 9 2688311 Email: xavier.van.vlem@be.pwc.com Gaspar Ndabi PwC Tax Consultants bcvba/sccrl Woluwe Garden, Woluwedal 18, 1932 Sint-Stevens-Woluwe Brussels – Belgium Tel: +32 2 7109129 Email: gaspar.ndabi@be.pwc.com Overview The Belgian tax authorities turned their attention towards transfer pricing (TP) in the early 1990s. Belgium has become more aggressive in the field of TP as it has become increasingly aware of the active interest adopted (typically) in the surrounding countries and the risk of seeing Belgium’s taxable basis eroded. This focus on TP resulted in the issuing of a Dutch/French translation of the 1995 Organisation for Economic Co-operation and Development (OECD) Guidelines (and the 1996, 1997 and 1998 additions thereto) and of a revenue document that comments on the 1995 OECD Guidelines and serves as an instruction to tax auditors. As of 1 January 2003, the Belgian Government also introduced a new broadened ruling practice aimed at providing foreign investors upfront certainty regarding their ultimate tax bill. In 2004, further changes to the ruling procedure were made to enhance a flexible cooperation between taxpayers and the Ruling Commission. A specialist TP team has been established and, in 2006, the Belgian tax authorities also installed a special TP investigation squad. Finally, during 2006, the Belgian Government issued a second TP practice note, endorsing the European Union (EU) Code of Conduct on transfer pricing documentation. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? www.pwc.com/internationaltp Belgium Yes No Yes Yes Yes 239

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Belgium Country Belgium Does TP legislation adhere to the arm’s‑length principle? Yes TP documentation Can TP documentation provide penalty protection? No When must TP documentation be prepared? Upon request Must TP documentation be prepared in the official/local language? No Are related-party transactions required to be disclosed on the tax return? No Penalties Are there fines for not complying with TP documentation requirements? No Do penalties or fines or both apply to branches of foreign companies? Yes How are penalties calculated? Adjustment penalties as a percentage between 10%–200% Introduction The Belgian Income Tax Code (ITC) did not provide specific rules on inter-company pricing until mid-2004, with the formal introduction of the arm’s‑length principle in a second paragraph to Article 185 of the ITC. In addition, the authorities can make use of other more general provisions in the ITC to challenge transfer prices. For example, in some cases where the Belgian tax authorities raise the issue of TP, the general rules on the deductibility of business expenses are invoked. Furthermore, the ITC contains provisions that tackle artificial inbound or outbound profit shifting. These are the so-called provisions on abnormal or gratuitous benefits. Legislation and guidance Arm’s-length principle In 2004, Article 185 of the ITC was expanded to include the arm’s‑length principle in Belgian tax law for the first time. Article 185, paragraph 2 of the ITC allows for a unilateral adjustment to the Belgian tax basis, similar to the corresponding adjustment of Article 9 of the OECD Model Tax Convention. Deductibility of expenses General rules The general rule concerning the deductibility of expenses is contained in Article 49 of the ITC. This Article stipulates that a taxpayer enjoys the presumption of deductibility. The tax authority presumes that the expenditure is incurred for the benefit of the taxpayer and is connected with the taxpayer’s business activity. However, the taxpayer has to provide proof of the authenticity and amount of the expenditure. In addition Article 53 (10) demands that the amount of that expenditure must not exceed business needs to an unreasonable extent. Excessive expenses As a matter of principle, the tax authorities and courts may not test whether a business decision was expedient. Although the company bears the burden of proof that expenses are necessarily linked with its operations or functions, the authorities have no right to question whether the expenses are useful or appropriate. However, Article 53 (10) of the ITC provides that relief may be denied for any excessive expenses incurred, and this 240 International Transfer Pricing 2015/16

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will be the case if the expense is not reasonable in light of the activities carried out. No case law exists on the application of this article in the context of TP. Interest payments Article 55 of the ITC provides that interest paid is a tax-deductible business expense, provided that the rate of interest does not exceed normal rates after taking into account the specific risks of the operation. (See also section on thin capitalisation.) Article 54 of the ITC contains a special rule to the general rule of Article 49 of the ITC. It states that interests and other similar rights, or payments for supplies and services (such as fees for granting use of patents and manufacturing processes) are not considered tax-deductible business expenses if they are made or attributed to taxpayers, resident or having a permanent establishment (PE) in a country whereby they are not subjected to tax or are subjected to a tax regime that is appreciably more advantageous than the applicable tax regime in Belgium. However, the taxpayer can bring proof that the transactions are real and genuine and do not exceed normal boundaries. In a judgment by the European Court of Justice (ECJ), it was determined that this rule breaches the free movement of capital, written down in Article 49 of the TFEU. The ECJ found that the lack of presumption of deductibility, which is included in the general rule of Article 49 of the ITC, the substantive requirements, which are stricter in Article 54, and the lack of a clear definition of which countries are targeted, make it liable to restrict the free movement of capital. Even though the Article could be justified by reasons of prevention of tax evasion and preservation of the effectiveness of fiscal supervision and balanced allocation, it was not proportionate. The scope could not be determined with sufficient precision and its application remained uncertain, which made it impossible for the taxpayers to provide evidence of any commercial justification. In subsequent Belgian cases, the position of the ECJ has been followed, the most recent of which was by the Court of Appeal of Liège on 23 October 2013. The Court followed the ECJ and stated that the prohibition of interest deduction does not stand. The fact that there is a relationship of mutual dependence between payor and payee or that the interest is effectively not taxed or at a much lower rate, does not have an impact on the case. Abnormal or gratuitous benefits Article 26 of the ITC provides authority for the taxable profits of enterprises in Belgium to be increased where the authorities can demonstrate that any profit transfers were ‘abnormal or gratuitous benefits’ granted to individuals or companies established in Belgium or abroad. This does not apply if the benefits transferred are subject to (Belgian) tax in the hands of the recipient(s). Although this Article seems to have become obsolete because of the formal introduction of the arm’s‑length principle in Belgian tax law by Article 185, paragraph 2 of the ITC, this is not true for situations where the latter Article does not apply. This may, for example, be the case for pure Belgian transactions where the recipient of the benefit is not subject to taxation on the said advantage. The Belgian ITC does not define ‘abnormal or gratuitous benefits’ and, consequently, the issue has been subject to review in the courts. Case law suggests that ‘abnormal’ www.pwc.com/internationaltp 241 B

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Belgium refers to ‘that which is not consistent with common practice’, while ‘gratuitous’ refers to the fact that a benefit is not granted in the course of the execution of a contractual obligation, or is granted where there is no equivalent consideration (Court of Cassation, 22 September 2011, Belgian Government/Aquaflam NV, F.10.0087.N; Pas. 2011, afl. 9, 2028). The Belgian legislature inserted in Article 26 paragraph 1 of the ITC the following wording: ‘notwithstanding the application of Article 49’. This means that, in case of an internal Belgian situation, the application of Article 26 of the ITC does not exclude the application of Article 49 of the ITC. In other words, even if the abnormal or gratuitous benefit is taken into account for determining the taxable basis of the beneficiary, the tax deductibility of the related expenses can still be denied in the hands of the grantor. This could result in economic double taxation. This provision has come into play as from tax year 2008 and has been ruled to be in line with the Belgian equality principle (Constitutional Court nr 149/2013, 7 November 2013; BS 10 March 2014). Article 207 of the ITC provides that a Belgian company that receives (directly or indirectly) abnormal or gratuitous benefits from a company upon which it is directly or indirectly dependent, may not use any current year losses or losses carried forward, nor may it apply the participation exemption, investment deduction or notional interest deduction against the taxable income arising from the benefit. In an answer to a parliamentary question (L. Van Campenhout, 2 April 2004), the Belgian Minister of Finance has given a very broad interpretation to this provision by declaring that in the case of received abnormal or gratuitous benefits, the minimum taxable basis of the receiving company equals at least the amount of the benefit. There has, however, been controversial case law which denies the recognition of a minimum taxable basis in those cases where the taxable profit is smaller than the tax losses for a given year (Antwerp Court of Appeal, 6 November 2012; Antwerp Court of first instance 14 January 2014). The previous administrative tolerance under which abnormal or gratuitous benefits received from abroad were not tackled has been abolished as from tax year 2004. Anti-abuse regulation Under the Programme Act of 29 March 2012, a general anti-abuse provision was introduced in Belgian tax law, applicable as from tax year 2013 – income year 2012 (with some exceptions). The revised Article 344, §1, of the ITC contains this general anti-avoidance provision. Under the previously applicable general anti-abuse provision, the Belgian tax authorities could reclassify a legal deed (transaction) into a different transaction, provided that both transactions had the same/similar legal consequences. Due to the latter condition, the old rule in most cases proved to be inadequate to recharacterise transactions on the basis that they did not make commercial sense (commercially rational). The wording of Article 344 §1 ITC now clearly provides that a transaction (in other words a legal action [or a chain of legal actions]) is not opposable towards the tax authorities if the tax authorities can demonstrate that there is tax abuse. For the purpose of the anti-abuse rule, ‘tax abuse’ is defined as: • a transaction in which the taxpayer places himself – in violation with the purpose of a provision of the ITC – outside the scope of this provision of the ITC and whereby the tax advantage is the essential goal of the transaction, and 242 International Transfer Pricing 2015/16

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• a transaction that gives rise to a tax advantage provided by a provision of the ITC, whereby getting this tax advantage would be in violation with the purpose of this provision of the ITC and whereby getting the tax advantage is the essential goal of the transaction. In case the tax authorities uphold that a transaction can be considered as tax abuse, it is up to the taxpayer to prove that the choice for the legal action or the whole of legal actions is motivated by other reasons than tax avoidance (reversal of burden of proof). In case the taxpayer cannot demonstrate this, the administration can reclassify the transaction, or the whole of transactions into another transaction. The transaction will be subject to taxation in line with the purpose of the ITC, as if the abuse did not take place. Please note that the extent of this anti-abuse rule is still uncertain. Notwithstanding the fact that the Belgian tax authorities published administrative commentaries on 4 May 2012 (Circular letter Ci.RH.81/616.207) on this anti-abuse rule, no clear examples have been given in this respect. However, in the parliamentary works (DOC 53 2081/016) with respect to this anti-abuse rule, the Belgian Minister of Finance stated that taxpayers will still be free to choose the structure with the lowest tax burden, provided that there is no tax abuse (i.e. provided that there is a commercial rationale for the transaction). Notional interest deduction On 22 June 2005, the Belgian tax law on the notional interest deduction was passed. These rules are intended first to ensure equal treatment of debt and equity funding. Companies liable to Belgian corporation tax (including Belgian branches of foreign companies) are granted a notional interest deduction equal to the 10-year state bond rate on the equity shown in the company’s individual Belgian financial statement. The equity requires slight alteration (e.g. holdings in subsidiary companies [inter alia] are to be trimmed off in assessing the relevant equity figure).Initially the notional interest deduction could be carried forward for a period of seven years in cases where there was no direct tax effect (e.g. in loss situations). However, on 20 July 2012, the Council of Ministers approved the limitation of the carry forward of excess notional interest deduction (NID). According to this law, carrying forward excess NID is no longer possible. As from tax year 2013 (financial years closing between 31 December 2012 and 30 December 2013, both dates inclusive) the existing NID carried forward (as per 31 December 2012) can still be utilised but within certain limitations. The NID rate is capped at a maximum of 3% (3.5% for small and medium-sized enterprises [SMEs]). For tax year 2015 (accounting years ending between 31 December 2014 and 30 December 2015, both dates inclusive) the NID equals 2.63% (3.13% for SMEs). For tax year 2016 (accounting years ending between 31 December 2015 and 30 December 2016, both dates inclusive) the NID equals 1.63% (2.13% for SMEs). On 4 July 2013, the ECJ rendered its judgment in the Argenta Spaarbank NV case (C350/11). The ECJ ruled that the NID rules and, in particular, the refusal to apply the NID to a foreign PE’s net assets violates the freedom of establishment. www.pwc.com/internationaltp 243 B

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Belgium The Act of 21 December 2013 provides an amendment to the NID legislation in such a way that as of assessment year 2014 (accounting years ending 31 December 2013 or later): • foreign PEs (located in a treaty country) no longer result in a correction of the NID calculation basis • the correction occurs at a later stage as the NID calculated on the higher calculation basis must be reduced with: • the lower amount of (i) the result of the foreign PE or real estate and (ii) the net asset value (cfr. the definition included in the Act) of the PE or real estate multiplied by the NID rate, if it concerns a PE located in the European Economic Area (EEA) • the net asset value of the PE or real estate is multiplied by the NID rate if it concerns a PE or real estate located in a treaty country outside of the EEA. Confirmed by the Parliamentary draft documents, this would imply that a Belgian company with a loss-making PE no longer loses the benefit of the NID, calculated on the net asset value of the PE based in the EEA. As concerns the past, the Belgian tax administration confirmed that all pending disputes or new requests will be treated according to the new legislation (Circular letter 16 May 2014). Recent case law, however, stated that the new legislation can only be applied as of assessment year 2016, so that for (older) pending cases no correction for the net assets of a foreign PE or real estate has to be applied (Bruges Court of first instance 9 April 2014; Antwerp Court of first instance 13 February 2015). Example A Belgian company realises Belgian profits of 120, the NID related to the Belgian assets amounts to 25. There is an EEA PE with a profit of 50 and net assets resulting in NID of 40. In this case, the total NID would amount to 65. In a second step, the NID would be reduced with 40 resulting ultimately in a Belgian taxable basis of 120 and a NID of 25. If the NID related to the PE’s net assets would amount to 60, the total NID would amount to 85, but would only be reduced with 50 (the branch result). In such a case, the Belgian taxable basis would amount to 120 and the NID to 35. Entry into force: This proposed rule is applicable as from tax year 2014. Patent income deduction On 27 April 2007, the Belgian parliament approved the law introducing a tax deduction for new patent income (PID) amounting to 80% of the income, thereby resulting in effective taxation of the income at the maximum rate of 6.8%. To benefit from the PID, the Belgian company or branch can exploit the patents owned by it, or licensed to it, in different ways. A first option available to the Belgian company or branch is to license the patents or extended patent certificates to related and unrelated parties. Alternatively, the Belgian company or branch can exploit the patents by manufacturing, or having manufactured by a contract manufacturer, products in which 244 International Transfer Pricing 2015/16

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the patents are used and supply the products to related or unrelated customers. It may also use the patents in the rendering of services. For patents licensed by the Belgian company or branch to any related or unrelated party, the PID amounts to 80% of the gross licence income derived from the patents and patent certificates, to the extent the gross income does not exceed an arm’s-length income. The PID applies to variable and fixed patent licence fees as well as other patent income, such as milestone payments. For patents used by the Belgian company or branch for the manufacture of patented products – manufactured by itself or by a contract manufacturer on its behalf – the PID amounts to 80% of the patent remuneration embedded in the sales price of patented products. In the case of services, the PID amounts to 80% of the patent remuneration embedded in the service fees. This tax measure is aimed at encouraging Belgian companies and establishments to play an active role in patent research and development, as well as patent ownership. The tax deduction is to apply to new patent income and has come into force as from financial years ending on or after 31 December 2007. The Act of 17 June 2013 introduced a new rule regarding PID. The rule now states that SMEs can also benefit from the patent income deduction, even if the patents are not developed or improved within a research centre, which forms a branch of activity as mentioned in section 46 § 1, 1, 2° of the Belgian Income Tax Code. Finally, one should monitor how the OECD’s revised nexus approach may impact the existing regulation. Withholding tax The law concerning Tax and Financial Measures, dated 13 December 2012 has amended article 228, §3 of the ITC as from the 1 January 2013. Pursuant to a Royal Decree of 4 March 2013, the enactment relating to the professional withholding tax (WHT) obligation on qualifying payments has been delayed to fees paid or made payable as from 1 March 2013. In brief, as a result of this change, a WHT will apply in Belgium on certain payments made by Belgian residents (or a Belgian establishment of non-Belgian residents, as defined for domestic tax purposes) for services provided in Belgium or abroad. Three conditions have to be met for this so-called ‘catch all’ provision to apply to a Belgian resident company. First of all there needs to be a cost borne by a Belgian resident company. In a note to debtors of payroll, dating from the 23 July 2014, the tax administration clarified that, in contrast with the text of the law, the obligation only targets payments for services. Secondly, the cost needs to relate to income that is considered as taxable income under Belgian domestic law. Lastly, there needs to be an income tax treaty based on which Belgium is allowed to tax or, in the absence of an income tax treaty, the non-resident cannot demonstrate that the income is effectively taxed in its own residence state. The tax administration has provided a template, which could be used by the non-resident to obtain certification by www.pwc.com/internationaltp 245 B

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Belgium the tax authorities of its own residence state, confirming that the income is, or will be, effectively taxed. The tax administration also determined that no tax should be retained on the first sum of 38,000 euros (EUR) per non-resident, per year and per Belgian debtor. Administrative guidelines Initial guidelines On 28 June 1999, administrative guidelines were issued relating to TP. The guidelines are broadly based on the OECD Guidelines. The reason for issuing the guidelines is of a purely ‘offensive’ nature. The guidelines stipulate that Belgium risks being forced to make corresponding downward profit adjustments if no adequate measures are taken to counterattack aggressive revenue action in other countries. Although no specific penalty rules are imposed, the guidelines urge tax inspectors to carry out in-depth TP audits where the taxpayer fails to show ‘documentary evidence’ that efforts have been made to fix arm’s-length inter-company prices. Consequently, taxpayers may benefit from preparing a defence file upfront, substantiating their TP methodology. In addition, the guidelines underscore the importance of conducting a proper functional analysis and refer to a list of generic functional analysis questions. Guidelines on Arbitration Convention On 7 July 2000, the Belgian tax authorities issued administrative guidelines on the technicalities of applying the Arbitration Convention. The guidelines offer guidance to taxation officers and tax practitioners into how the tax authorities will apply the Convention. It is also an acknowledgement by the Belgian tax authorities of the need to develop an efficient practice to resolve issues of international double taxation. Guidelines on transfer pricing audits and documentation Introduction The Belgian tax authorities published, in November 2006, administrative guidelines on TP audits and documentation. In light of certain developments, such as the formal set-up of a specialist TP investigation squad and the approved EU Code of Conduct on Transfer Pricing Documentation, the need had obviously arisen in Belgium for an update of the previous TP administrative guidelines and for new guidance, particularly on TP audits and documentation requirements. The 2006 administrative guidelines fill this need and, at the same time, confirm the integration in Belgian tax practice of the EU Code of Conduct on Transfer Pricing Documentation. The Code of Conduct is added as an appendix to the administrative guidelines. Cases with a higher risk of prompting an audit The administrative guidelines contain a list of cases (which is not exhaustive) where ‘it may be advisable’ to check the TP practices. Among the situations listed in the administrative guidelines are transactions with tax havens and low-tax jurisdictions, back-to-back operations, and so-called complex and circular arrangements, as well as situations that are much more frequent (i.e. entities that suffer structural losses, business restructurings or delocalisation and the charge-out of management fees). 246 International Transfer Pricing 2015/16

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Pre-audit meeting The administrative guidelines acknowledge the fact that an investigation into the TP dealings of a business and the related documentation form a complex whole and are significantly affected by widely diverse company-specific factors. To this end, the administrative guidelines suggest the possibility of holding a ‘pre-audit meeting’. The purpose of this pre-audit meeting is to explore, in consultation with the taxpayer, what should be the appropriate scope of the tax audit, what documentation is relevant to the TP investigation, if there is any readily available documentation, etc. Concept of ‘prudent business manager’ As to the question of what proactive effort is required when putting together transfer pricing documentation, the administrative guidelines refer to the concept of a ‘prudent business manager’ (i.e. given the nature of the transactions that take place between related companies, it is only normal, as a ‘prudent business manager’, to maintain written documentation that underpins the arm’s-length character of the TP applied). The administrative guidelines list the information that can be prepared to this end. Flexibility as to the language of the documentation The administrative guidelines acknowledge the reality that a large part of the transfer pricing documentation may not be available in one of the official languages of Belgium (i.e. Dutch, French, or German). Reasons for this include the multinational character of business, the growing tendency of organising TP studies at a pan-European or global level, or the need to ask a foreign-related company for information. Inspectors are urged to apply the flexibility they feel ‘in conscience’ to be necessary when they evaluate the reasons given by the taxpayer for submitting documentation in a foreign language. This applies particularly to pan-European or worldwide TP studies, group TP policies and contracts with foreign entities. Code of conduct on transfer pricing The administrative guidelines ratify the standardised and partly centralised approach to TP documentation that is recommended in the Code of Conduct. This also means that concepts such as the ‘master-file’ and ‘country-specific documentation’ are now officially introduced into a Belgian context. The resolution of the EU Council on this Code of Conduct is added to the administrative guidelines as an appendix. The Belgian government is currently looking at the introduction of mandatory TP documentation following Base Erosion and Profit Shifting (BEPS) action 13 and the revised chapter 5 of the OECD Guidelines. As loyal adherent to the OECD Guidelines, Belgium will most likely largely follow the revised chapter 5 of the OECD Guidelines. Pan-European benchmarks The administrative guidelines confirm the current practice whereby the use of panEuropean data cannot per se be rejected in the context of a benchmark analysis. This may be interpreted more strictly going forward in view of the changed wording in chapter 5 of the OECD Guidelines. The use of pan-European analyses finds its justification not only in the often-existing lack of sufficient points of reference on the Belgian market, but also in the fact that many multinational businesses prefer to spread the cost of investing in a benchmark analysis over various countries. www.pwc.com/internationaltp 247 B

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Belgium Treatment of tax havens As of 1 January 2010, Belgian companies and Belgian PEs of foreign companies are required to report in their annual tax returns all payments, direct and indirect, to tax havens totalling EUR 100,000 or more. Within the context of this new provision, tax havens are considered to be: • countries that have been identified by the OECD as not sufficiently cooperative in the domain of international exchange of information, and • countries that appear on a list of countries with no or low (less than 10%) taxes. Payments made, directly or indirectly, to such tax havens and which have not been reported accordingly are not accepted as deductible business expenses. The same applies for payments that have been appropriately reported, but for which the taxpayer concerned has not provided sufficient proof that the payments have been made in the context of real and sincere transactions with persons other than artificial constructions. The latter proof can be provided by all means of evidence as defined in the Belgian ITC. Accounting guidelines The Belgian Commission for Accounting Standards (BCAS) has caused some discussion in the accounting and tax field by issuing advice that deviates from current accounting practice. As Belgian tax law, in principle, follows accounting law (unless it explicitly deviates hereof), these evolutions may also impact the TP field. Broadly speaking, the discussion relates to the acquisition of assets for free or below-market value. Until now, Belgian accounting law basically referred to the historical cost to determine the acquisition value of assets, provided the principle of fair image of the balance sheet is not impaired. For those cases where the acquisition price is below the fair value the BCAS argued that the difference between the fair value and the acquisition value should be treated as an exceptional profit at the level of the acquiring company. The European Court of Justice however ruled that no exceptional profit should be recognised in the situation where the acquisition occurred below market value (HvJ C-322/12, GIMLE, Pb. C. 2013, Afl. 344, 34). The advice issued by the BCAS was consequently also removed after this decision. There is however still uncertainties for those cases where no consideration is given by the receiving company as this is not expressly dealt with in the GIMLE case. Furthermore, in 2009 a Royal Decree introduced additional reporting requirements in statutory and consolidated accounts made under Belgian generally accepted accounting principles (GAAP). The additional reporting requirements cover (i) information on non-arm’s-length inter-company transactions and (ii) information on the off-balance-sheet operations that could have an impact on the balance sheet. By ratifying this Royal Decree, the Belgian legislature complied with the content of the European Directive 2006/46/EC of the European Parliament and of the Council of 14 June 2006. These accounting rules introduced new burden of proof on the arm’slength character of inter-company transactions. More specifically, since the board of directors and the statutory auditor have to approve and sign these accounts, sufficient evidence should be available to draw conclusions on the arm’s-length nature of intercompany transactions. Henceforth, for transactions covered by these accounting rules, TP documentation may prove to be extremely useful or even required to comply with accounting law and to manage directors’ liability. 248 International Transfer Pricing 2015/16

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Transfer pricing controversy and dispute resolution Legal cases Belgian authorities did not significantly turn their attention to TP until the beginning of the 1990s. Consequently, relatively few important TP cases have taken place in Belgium. In the first line of cases the tax authority was relatively mild. Although the Court of Cassation determined on 23 February 1995 that the benefit of losses carried forward in a loss-making company is denied where there has been an abnormal transfer of profit from a profitable company to that loss-making entity. It did state that the benefit can only be denied if the transaction was done with the sole intent of avoiding taxation. The tax administration has to consider if there are any other economic justification before denying the benefit. An example of such an economic justification is the striving for a global group balance. The Court of Appeal of Ghent declared, in a case of 29 April 1999, that quality discounts given to an affiliated company did not constitute an abnormal or gratuitous benefit, since the Belgian company only granted the discounts to compensate the losses suffered by the related company that originated from the buy of spoiled products of the Belgian company. According to the Court the same compensation would have been given between unrelated companies and that the companies were striving for a global group balance. Another example is a court case by the Court of Appeal of Mons of 3 November 1989. The Court accepted the granting of interest-free loans to a loss-making daughter, as otherwise the group might have faced adverse financial circumstances. In this case the Court also ruled in favour of analysing in detail why certain related-party transactions take place under terms and conditions that might at first glance breach the arm’slength standard. The objective of protecting enterprises in financial distress is still considered a valid justification in recent years. In a number of cases, different courts have accepted that the conditional waiver of a debt by a parent company to one of its subsidiaries does not constitute an abnormal or gratuitous advantage (after proving and fulfilling all the conditions and requirements). Moreover, it is also worthwhile mentioning that Belgium changed its legislation in 2009 with respect to waiver of debts to protect enterprises in financial distress (see section on ‘Debt waiver’). However, on 31 January 2012, the Ghent Court of Appeal decided that the waiver of a debt by a Belgian parent company to its Italian subsidiary is to be considered a gratuitous advantage as it was not demonstrated that the Italian subsidiary was confronted with imminent bankruptcy at the time of the waiver. As such, according to the Court the waiver of debt by the Belgian company was not required or necessary. On 21 May 1997, the Liege Court of Appeal rendered a favourable decision recognising the acceptability of a set-off between advantages of transactions of related parties. In the case at hand, a Belgian distribution entity acquired the contractual rights (from a group affiliate) to distribute certain high-value branded products in the Benelux countries. However, this was subject to the Belgian entity contracting out the distribution of certain dutiable brands to a Swiss affiliate. The Belgian authorities stipulated that the Belgian–Swiss transaction granted abnormal or gratuitous benefits to the Swiss entity. However, it was demonstrated that the transfer of profit potential to a foreign-related party subsequently generated an inbound transfer of profit from www.pwc.com/internationaltp 249 B

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Belgium another foreign-related party. The court based its decision on the economic reality in a group context, and the fact that different companies were involved (and so an indirect set-off was made) did not jeopardise the possibility to net the advantages against each other. The Court of First Instance in Ghent stated on 14 November 2002 that there is a presumption that the accounts give a faithful view of the financial situation of the company; however this presumption can be refuted. Concretely, the case dealt with a situation whereby a Belgian company acquired shares at the book value, which was lower than the market value, thereby creating an advantage for the Belgian company. The tax authority determined that the financial statements did not reflect the reality and that the Belgian company may be tax liable on the basis of Article 24 of the ITC. In the more recent cases concerning TP, the motto of the Belgian courts has been ‘substance over form’. For example, on 10 June 2010, the Court of Cassation issued a decision where it stressed the importance of substance. In its decision, the Court confirmed that management fees paid to a company having neither tangible or intangible assets, nor operational expenses to perform any management services were deemed to be paid to another company, i.e. the effective provider of the management services. Another example is a case of 27 October 2010, where the Antwerp Court of first instance confirmed the priority of the substance principle by rejecting the deduction of certain business expenses related to a seat of management for lack of justification of personnel, offices, central bookkeeping, or archives of the company. However, if the Court cannot adequately check the substance of the transactions, it could see it as an abnormal or gratuitous benefit. In a case of 12 December 2012, the Namur Court of First Instance rejected the deduction of costs based on invoices, because they were too vague to check the substance of the presentations. Accordingly, the amount of the invoices was added to the taxable profit. Another example that shows the importance of adequate proof is a court case of 15 May, 2012 by the Ghent Court of Appeal. The case concerned a Belgian company granting interest-free loans to a Polish daughter, stating that they are dependent on the survival of the daughter, which was in difficulty. Normally, this would be an adequate reason; however, the fact that there was no proof stating that the transaction was meant to bring a balance in the group and there was insufficient information to control the sale transactions led the court to determine that the arm’s-length balance was not upheld. Furthermore, on 22 December 2010 the Supreme Court of Belgium published a preliminary ruling based on the request from the Ghent Court of Appeal of 5 October 2010 in the case of NV Vergo Technics v Belgian State (No. 5042), which confirmed that the current version of the corporate income tax code that may in some situations still trigger double taxation does not breach the equality principle laid down in the constitution. The Supreme Court recently repeated this case law in a new case of 7 November 2012. As a member of the European Union, Belgium also has to abide by the case law of the ECJ. On 21 January 2010, in the case SGI v the Belgian state, the ECJ delivered a judgment that clarifies the position of TP rules within the framework of European law. The relevant provision of the Belgian ITC that was considered was Article 26, which 250 International Transfer Pricing 2015/16

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allowed for adjustments in the cases of ‘abnormal or gratuitous benefits’ granted to a foreign affiliate, but not in a domestic context. The ECJ found that (a) there was, in principle, a breach of the EU freedom of establishment, but (b) the Belgian legislation was justified as being within the public interest, provided (c) it was proportional. Proportionality in this context means that (i) the expenses disallowed (or income-imputed) are limited to the excess (shortfall) over the arm’s-length amount, and (ii) there is a defence of commercial justification. The Court remitted the case back to the Belgian courts to consider whether the way in which the national legislation was applied met the two tests of proportionality. Tax audit As noted above, Belgian tax authorities have issued administrative guidelines on TP audits and documentation. Although these guidelines are not legally binding, they play a pivotal role in current (and future) TP audits. In carrying out the audits, the tax authority in Belgium uses a data mining technique in order to determine a risk profile of a taxpayer. The technique sets a number of parameters that are used in assessing the risk profile of a taxpayer. In the course of 2013, 2014 and 2015 there has been a large wave of TP audits conducted to various companies in Belgium. Burden of proof In theory, taxpayers must demonstrate that business expenses qualify as deductible expenses in accordance with Article 49 of the ITC, while the tax authorities must demonstrate that profit transfers to an affiliate are ‘abnormal or gratuitous benefits’. In practice, however, the tax authorities have actually requested on several occasions that taxpayers demonstrate that the TP methodology adopted is on an arm’s-length basis (see below). Since 1997, the tax authorities have scrutinised the deductibility of management service fees in a more stringent way. The taxpayer is required to demonstrate that any services provided are both necessary to the business of the recipient and charged at market value. Selection of companies for audit The administrative guidelines published in November 2006 contain a list of cases where it may be advisable to check the TP practices (see Administrative guidelines section, above). Transfer pricing enquiries may also arise in the course of a ‘routine’ tax audit. The audit procedure During the course of an audit, the inspector would normally visit the company’s premises. The 1999 administrative guidelines urge tax inspectors to interview as many people as possible including staff with an operational responsibility, to get a fair idea of the functions, assets and risks involved. The tax audit normally begins with a written request for information. The taxpayer must provide the data requested within (in principle) one month. However, the 2006 administrative guidelines preach flexibility as to this one-month period. Any documentary evidence considered relevant to the audit can be requested and reviewed by the authorities. As to the issue of obtaining information from foreign companies, the approach of the administrative guidelines seems to be more demanding than the OECD www.pwc.com/internationaltp 251 B

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Belgium Guidelines. Indeed, the fact that a Belgian subsidiary argues that it did not receive any information from its foreign parent on its TP policy can be deemed to reflect a lack of cooperation. The 2006 administrative guidelines stimulate companies to have a pre-audit meeting with the authorities to (i) discuss the TP policy carried out with the group, (ii) discuss the level of TP documentation already available, and (iii) avoid having irrelevant questions raised which ask the taxpayer to prepare an unreasonable amount of documents. This focused approach should save a lot of time for the taxpayer as well as the tax authorities. Revised assessments and the appeals procedure Since assessment year 1999, new revised assessment and appeal procedures have been introduced. The main features can be summarised as follows: Once the tax inspector has completed the analysis, any adjustment is proposed in a notification of amendment outlining the reasons for the proposed amendment. The company has one month to agree or to express disagreement. The tax inspector then makes an assessment for the amount of tax which they believe is due (taking into account any relevant comments of the company with which the inspector agrees). Thereafter, the company has six months within which to lodge an appeal with the Regional Director of Taxes. The decision of the Regional Director of Taxes may be appealed and litigated. In a number of circumstances, the intervention of the courts can be sought, prior to receiving the decision of the Regional Director of Taxes. Additional tax and penalties Tax increases in the range of 10% to 200% of the increased tax can be imposed. In practice, discussion has arisen as to whether penalties or increases of tax can be levied in the context of abnormal or gratuitous benefits granted by a Belgian taxpayer. Although conflicting case law exists (e.g. Antwerp Court of Appeal, 17 January 1989), the Antwerp Court of Appeal ruled on 15 April 1993 that by its mere nature, abnormal and gratuitous benefits are always elements that are not spontaneously declared in the company’s tax return and can therefore not give rise to an additional tax penalty. It is unlikely that this reasoning can be upheld in cases where Article 185, section 2 of the ITC is applicable. Resources available to the tax authorities Within the Central Tax Administration, several attempts have been made to improve the quality of TP audits and the search for comparable information. To this end, a specialist transfer pricing team (STPT) was established to ensure coherent application of the TP rules by the tax authorities, with a view to achieving consistency in the application of tax policies. In short, the mission statement of the STPT is to: • act as the central point of contact for all tax authorities facing TP matters • maintain contacts with the private sector and governmental bodies in the area of TP • formulate proposals and render advice with respect to TP 252 International Transfer Pricing 2015/16

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• take initiatives and collaborate in the area of learning and education, with a view to a better sharing of TP knowledge within the tax authorities, and • take initiatives and collaborate with respect to publications that the tax authorities have to issue with respect to TP. In addition to creating the STPT, in 2006, the Belgian tax authorities also installed an experienced special TP investigation squad (special TP team) with a twofold mission: • Build up TP expertise to the benefit of all field tax inspectors and develop the appropriate procedure to conduct tax audits in this area according to the OECD Guidelines. • Carry out TP audits of multinationals present in Belgium through a subsidiary or branch. This special TP team has recently been supplemented with more audit teams focusing on TP and hence significantly expanding the reach of TP audits. Use and availability of comparable information Use As indicated above, Belgium, in its capacity as an OECD member, has adopted the OECD Guidelines. Comparable information could, therefore, be used in defending a pricing policy in accordance with the terms of the OECD Guidelines. On 22 July 2010, the OECD approved and published revisions of Chapter I-III of the OECD Transfer Pricing Guidelines. One of the most significant changes in this respect was the removal of the hierarchy between traditional methods and profit-based methods in favour of the ‘most appropriate method’ rule. This means that in principle, all the authorised OECD methods now rank equally. In addition, higher standards of comparability are advocated. It is expected that the Belgian tax authorities will be using these new guidelines in evaluating taxpayers’ transactions upon tax audits. Availability The search for comparables relies primarily upon databases that provide financial data on the major Belgian companies. These databases provide comprehensive annual financial data, historical information and information on business activities, all of which is largely extracted and compiled from statutory accounts. In addition, the Belgian National Bank maintains a database that contains all statutory accounts. Entries are classified according to NACE (the Statistical Classification of Economic Activities in the European Community) industry code (i.e. by type of economic activity in which the company is engaged). Information on comparable financial instruments (such as cash-pooling, factoring, etc.) can be obtained from banks. This information (e.g. market interest rates) can then be used to support or defend a TP policy. The 1999 administrative guidelines acknowledge that Belgium is a small country, so sufficient comparable Belgian data may be difficult to obtain. Consequently, the use of foreign comparables is accepted, provided proper explanation can be provided as to the validity of using surrogate markets. The 2006 administrative guidelines reconfirm that pan-European data cannot per se be rejected in the context of a benchmark analysis. www.pwc.com/internationaltp 253 B

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Belgium This may be interpreted more strictly going forward in view of the changed wording in Chapter 5 of the OECD Guidelines. Risk transactions or industries Generally, there are no industry sectors which are more likely to be challenged than any other, and, since there are no excluded transactions, all transactions between related companies may be under scrutiny. Debt waivers According to Article 207 of the ITC, in some circumstances a Belgian company receiving abnormal or gratuitous benefits, whether directly or indirectly, is not allowed to offset among others, current year losses or losses carried forward against these benefits. The circumstances in which this applies are those where the company receiving the benefits is directly or indirectly related to the company granting such benefits. This rule is being used stringently in cases where a loss-making company benefits from a debt waiver. In these circumstances, the waiver could be treated as an abnormal or gratuitous benefit, although certain court cases (and also rulings) confirm the acceptability of intragroup debt waivers under particular circumstances. In the beginning of 2009, however, the Belgian administration introduced a Continuity Act, which assists companies with judicial restructuring in a court of law. The Act provides, among other things, a tax relief for a waiver of debt on both the creditor and debtor side. If a creditor waives debts according to the judicial restructuring procedure, the debtor’s profit resulting from the debt reduction granted by the creditor should remain tax-exempt and the creditor’s expenses resulting from waiving the debt will remain tax-deductible within Belgium. In this respect, the Act modified section 48 of the ITC, which now explicitly states that, following approval by the court, expenses incurred due to a waiver of debt will qualify as tax-deductible. Similarly, (exceptional) profits are tax-exempt for the company receiving the waiver. Permanent establishments – transactions with head office The tax rules and administrative practices can be summarised as follows. It is acceptable that, for tax purposes, a ‘contractual’ relationship exists between a head office and its permanent establishment (PE). Hence, the arm’s‑length principle applies to most transactions between the head office and the PE, such as the transfer of goods and the provision of services based on the separate entity approach. It is accepted that ‘notional profits’ can arise from internal transfers and that, in accordance with this treatment, these might be subject to taxation before any profit is actually realised by the enterprise as a whole. Services During a tax audit, particular attention would be paid to payments such as management fees or technical support fees to establish whether these payments should actually have taken the form of dividends. Advance Pricing Agreements (APAs) Unilateral As of 1 January 2003, the Belgian Government introduced a new ruling practice that seeks to increase upfront legal certainty for investors, while taking into account national and international tax standards. 254 International Transfer Pricing 2015/16

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Under the new regime, a ruling is defined as an ‘upfront agreement’, which is a legal act by the Federal Public Service of Finance in conformity with the rules in force with respect to the application of law to a specific situation or operation that has not yet produced a tax effect. Previously, a taxpayer could apply for a ruling only in a limited number of cases. Under the revised rules, a taxpayer may apply for a ruling in all cases, unless there is a specific exclusion. Although the Ministry of Finance acknowledges that it is impossible to provide a comprehensive list of all excluded topics, the new ruling practice nevertheless explicitly excludes some ruling categories to demonstrate the open nature of the ruling system. To this end, a specific Royal Decree confirming the exclusions was published in January 2003. A taxpayer may not apply for a ruling involving tax rates, computations, returns and audits; evidence, statutes of limitation and professional secrecy; matters governed by a specific approval procedure; issues requiring liaison between the Ministry of Finance and other authorities, whereby the former cannot rule unilaterally; matters governed by diplomatic rules; penalty provisions and tax increases; systems of notional taxation as for instance used in the agricultural sector; and tax exemptions. In 2004, further changes to the ruling procedure were made to enhance a flexible cooperation between taxpayers and the Ruling Commission. At the same time, the ruling procedure itself has been rendered more efficient. These changes took effect 1 January 2005. The provisions of double taxation treaties fall within the scope of the new ruling practice and, therefore, the Belgian competent authority is involved in the preparatory phase of making the ruling decision to ensure consistency of the decisions of the Ruling Commission in this respect. Summaries of the rulings are published anonymously in the form of individual or collective summaries. The rulings are published at the Government’s website, unless a foreign taxpayer is involved and the treaty partner has rules preventing publication. In such cases, approval to publish the ruling is requested. Under the revised ruling practice, the use of prefiling meetings is encouraged. A request for an advance ruling can be filed by (registered) mail, fax, or email. The Ruling Commission must confirm receipt of a request within five working days. Subsequently, a meeting is organised allowing the Ruling Commission to raise questions and the applicant to support its request. Recent experiences have demonstrated the effectiveness of the Commission and its willingness to accommodate, within the borders of the national and international legal framework, the search by the taxpayer for upfront certainty. Although there is no legally binding term to issue a ruling, it is the Ruling Commission’s intention to issue its decision within three months (counting as from the submission of the formal ruling application). In most cases, this three-month period is adhered to. Bilateral/multilateral Under the new ruling practice, taxpayers may be invited to open multilateral discussions with other competent authorities. These issues are dealt with, case by case, according to the relevant competent authority provision as stipulated in the tax treaty. www.pwc.com/internationaltp 255 B

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Belgium Recent experience shows that the Belgian tax authorities are also promoting bilateral or multilateral agreements and that they take a cooperative position for realising such agreements. Competent authorities On 27 November 2006 the United States and Belgium signed a new income tax treaty and protocol to replace the 1970 income tax treaty. This new treaty and protocol entered into force on 28 December 2007. The new treaty introduces an innovative binding arbitration procedure in the context of the mutual agreement procedure. Indeed, when the competent authorities are unable to reach an agreement, the case shall be resolved through arbitration within six months from referral. In this type of arbitration, each of the tax authorities proposes only one figure for settlement, and the arbitrator must select one of the figures (‘baseball arbitration’). Anticipated developments in law and practice Practice has shown a significant increase in TP audits in Belgium as well as in the number of people carrying out TP audits. This trend is expected to continue. Within that framework, the importance of having available upfront TP documentation will only increase. Careful attention needs to be given to the reports issued within the framework of the BEPS Action Plan and how these will be adopted in the international and Belgian tax practice. Liaison with customs authorities Although it is possible for an exchange of information to take place between the income tax and customs’ authorities, this rarely happens in practice. Joint investigations A facility exists for the Belgian tax authorities to exchange information with the tax authorities of another country. According to Belgian law, such an exchange must be organised through the Central Tax Administration. A large number of bilateral treaties have been concluded to facilitate this process. The 1999 administrative guidelines also consider the possibility of conducting joint investigations with foreign tax authorities. Belgium has already been involved in several of these multilateral audits. Thin capitalisation The arm’s‑length principle applies to financing arrangements between affiliated parties. Article 55 of the ITC provides that interest paid is a tax-deductible business expense, provided that the rate of interest does not exceed normal rates, taking into account the specific risks of the operation (e.g. the financial status of the debtor and the duration of the loan). In addition, note that related-party loans from shareholders or directors of a Belgian borrowing company are subject to specific restrictions. 256 International Transfer Pricing 2015/16

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In the past, Belgian tax law did not have a general thin-cap rule. A special thin-cap rule only existed for interest payments or attributions to (real) beneficiaries taxed at low rates on that interest. This was the so-called 7/1 debt-equity (D/E) ratio. The Programme Acts of 20 March and 22 June 2012 replace the 7/1 rule with a new rule introducing a (general) 5/1 D/E ratio. For the purposes of the thin-cap rule, equity is defined as the sum of the taxed reserves at the beginning of the taxable period and the paid-up capital at the end of the taxable period. For the purposes of this new rule, certain non-taxed reserves are deemed to be taxed reserves. It regards inter alia certain tax-free reserves created upon a merger/division (including as a result of merger goodwill). The below loans are captured by the thin cap rule: • All loans, whereby the beneficial owner is not subject to income taxes, or, with regard to the interest income, is subject to a tax regime that is substantially more advantageous than the Belgian tax regime • All intra-group loans (whereby ‘group’ should be interpreted in accordance with section 11 of the Companies Code). Bonds and other publicly issued securities are excluded, as are loans granted by financial institutions. The new thin-cap rule is not applicable to loans contracted by (movable) leasing companies (as defined by section 2 of Royal Decree no. 55 of 10 November 1967), to companies whose main activity consists of factoring or immovable leasing within the financial sector and to the extent the funds are effectively used for leasing and factoring activities, and to loans contracted by companies primarily active in the field of public-private cooperation. The new Programme Act of 22 June 2012 has made some amendments to the thincap rule in order to safeguard companies that have a centralised treasury function in Belgium. The amendments introduce netting for thin-cap purposes for companies responsible for the centralised treasury management of the group. These companies are allowed to net all interest paid to group companies with all interest received from group companies, insofar the interest is paid/received within the context of a framework agreement for centralised treasury management. In cases where the 5/1 D/E ratio has been exceeded, only net interest payments (of the higher amount) will be regarded as non-tax-deductible business expenses. Centralised treasury management is defined as management of daily treasury transactions, or treasury management on a short-term basis (e.g. cash pools) or, exceptionally, longer term treasury management. In addition, in order to qualify for the exemption, the treasury company should set up a framework agreement under which the group companies clarify the treasury activities and the financing model applicable to their group. www.pwc.com/internationaltp 257 B

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18. Brazil B PwC contact Cristina Medeiros PricewaterhouseCoopers Contadores Públicos Ltda. Av.Francisco Matarazzo, 1440 – Torre Torino São Paulo – SP 05001-100 Brazil Tel: + 5511 3674 2276 Email: cristina.medeiros@br.pwc.com Overview As is widely known, Brazil’s transfer pricing (TP) rules do not adopt the internationally accepted arm’s-length standard. Instead, Brazil’s TP regulations provide the use of statutory fixed margins to derive a benchmark ceiling price for inter-company import and minimum gross income floors for inter-company export transactions. While incorporating these transaction-based methods, Brazilian TP rules excluded profitbased methods, such as transactional net margin method (TNMM) or profit split method (PSM). In addition, there are many controversial legal issues that have been disputed by taxpayers and tax authorities, and as a result the tax authorities have been imposing tax assessments against many taxpayers. Brazilian taxpayers endeavour to prepare TP documentation that is acceptable under Brazilian TP rules, while testing transactions performed at prices determined within the context of TP policies prepared with observance of international standards. Within this context, it has been a challenge for the entities operating in Brazil to comply with local rules and at the same time avoid double taxation issues. Therefore, while the definition of the best approach to deal with TP issues in Brazil is key in order to mitigate potential double taxation issues, the implementation of the defined strategy requires as much care in order to avoid unexpected results. In view of the substantial double taxation and documentation burdens, several international chambers of commerce and multinational companies have lobbied for changes to the current regulatory framework, in order to align Brazil’s TP rules with international standards including the adoption of the arm’s‑length principle. This effort has so far been unsuccessful. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? www.pwc.com/internationaltp Brazil No No No Yes 259

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Brazil Country Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? Brazil No No No Usually June 30 Yes Yes No Yes Based on deemed tax deficiencies Introduction From the outset, Brazil’s TP rules, which took effect on 1 January 1997, have been very controversial. Contrary to the Organisation for Economic Co-operation and Development (OECD) Guidelines, US TP regulations, and the TP rules introduced by some of Brazil’s key Latin American trading partners such as Mexico and Argentina, Brazil’s TP rules do not adopt the internationally accepted arm’s‑length principle. Instead, Brazil’s TP rules define maximum price ceilings for deductible expenses on inter-company import transactions and minimum gross income floors for intercompany export transactions. The rules address imports and exports of products, services and rights charged between related parties. The rules also cover inter-company loans, and all import and export transactions between Brazilian residents (individual or legal entity) and residents in either low-tax jurisdictions (as defined in the Brazilian legislation) or jurisdictions with internal legislation that call for secrecy relating to corporate ownership, regardless of any relation. Through the provision of safe harbours and exemptions, the rules were designed to facilitate the monitoring of inter-company transactions by the Brazilian tax authorities. Since the Brazilian rules do not adopt the arm’s‑length principle, multinational companies with Brazilian operations have to evaluate their potential tax exposure and develop a special TP plan to defend and optimise their overall international tax burden. From the outset, planning to avoid potential double taxation has been especially important. Legislation and guidance Rules regarding imports of goods, services or rights Deductible import prices relating to the acquisition of property, services and rights from foreign-related parties should be determined under one of the following Brazilian methods: Comparable independent price method (PIC) This Brazilian equivalent to the comparable uncontrolled price (CUP) method is defined as the weighted average price for the year of identical or similar property, 260 International Transfer Pricing 2015/16

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services, or rights obtained either in Brazil or abroad in buy/sell transactions using similar payment terms. For this purpose, only buy/sell transactions conducted by unrelated parties may be used. The use of the taxpayer’s own transactions with third parties for purposes of applying this method will be acceptable only to the extent the comparable transactions are equivalent to at least 5% of the tested transactions; if necessary, transactions carried out in the previous year can be considered to reach this percentage. Resale price less profit method (PRL) The Brazilian equivalent to the resale price method (RPM) is defined as the weighted average price for the year of the resale of property, services or rights minus unconditional discounts, taxes and contributions on sales, commissions and a gross profit margin determined in the tax legislation. As of 1 January 2013, a 20% gross profit margin is required for industries/sectors in general, calculated based on the percentage of the value imported over the final resale price. For the following industries/sectors a different mark-up is required: Sectors where a 40% profit margin is required: • • • • • pharma chemicals and pharmaceutical products tobacco products optical, photographic and cinematographic equipment and instruments machines, apparatus and equipment for dental, medical and hospital use, and extraction of oil and natural gas, and oil derivative products. Sectors where a 30% profit margin is required: • • • • chemical products glass and glass products pulp, paper and paper products, and metallurgy. These margins are applied in the same way for imports of products for resale or for inputs to be used in a manufacturing process. In applying the PRL, a Brazilian taxpayer may use their own prices (wholesale or retail), established with unrelated parties in the domestic market. Until 31 December 2012, the PRL method was calculated considering a margin of 20% applicable to products for resale, and if value was added before resale the profit margin was increased to 60%, calculated based on the percentage of the value imported over the final sales price. Production cost plus profit method (CPL) This Brazilian equivalent of the cost plus (CP) method is defined as the weighted average cost incurred for the year to produce identical or similar property, services, or rights in the country where they were originally produced, increased for taxes and duties imposed by that country on exportation plus a gross profit margin of 20%, and calculated based on the obtained cost. Production costs for application of the CPL are limited to costs of goods, services, or rights sold. Operating expenses, such as research and development (R&D), selling and www.pwc.com/internationaltp 261 B

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Brazil administrative expenses, may not be included in the production costs of goods sold to Brazil. Quotation price on imports method (PCI) This new Brazilian method, introduced by Law 12715/12, must be applied to test imports of commodities that have a quote in a commodities’ exchange, as of 2013. Based on this method, taxpayers shall compare the transaction value with the average quote of the respective commodity involved, adjusted by an average market premium, in the date of the transaction. In the case of transactions involving commodities that do not have a quote in a commodities’ exchange, taxpayers may choose to test the prices in import transactions, based on information obtained from independent sources, provided by internationally recognised institutes involved in researches of specific sectors. In the event that more than one method is used, except when the use of the PCI method is mandatory, the method that provides the highest value for imported products will be considered by the Brazilian tax authorities as the maximum deductible import price. This is intended to provide taxpayers with the flexibility to choose the method most suitable to them. The Brazilian rules require that each import transaction be tested by the parameter price determined using one of the three methods, as applicable to the type of transaction (this also applies to export transactions). If the import sales price of a specific inter-company transaction is equal to, or less than, the parameter price determined by one of the methods, no adjustment is required. Alternatively, if the import sales’ price exceeds the determined parameter price, the taxpayer is required to adjust the calculation basis of income tax and social contribution. The aforementioned excess must be accounted for in the retained earnings account (debit) against the asset account or against the corresponding cost or expense if the good, service or right has already been charged to the income statement. Until 2012 one of the most controversial issues raised with regard to import transactions was the treatment of freight and insurance costs, as well as Brazilian import duty costs, for purposes of applying the Brazilian TP rules. Before the changes introduced for 2013 onwards, the TP law considered freight and insurance costs and the Brazilian import duty costs borne by the Brazilian taxpayer as an integral part of import costs (i.e. the tested import price). According to the regulatory norms published in November 2002, taxpayers could compare a parameter price calculated under the CPL or PIC methods with an actual transfer price that included or excluded freight and insurance costs as well as Brazilian import duty costs borne by the Brazilian taxpayer. Meanwhile, for testing under the PRL, freight and insurance costs and Brazilian import duty costs borne by the Brazilian taxpayer should be added to the actual transfer price. As of 2013, taxpayers are no longer required to include customs’ duty in the tested price as well as freight and insurance contracted with third parties, provided such third parties are not located in low-tax jurisdictions or benefit from privilege tax regimes. Rules regarding exports of goods, services and rights In the case of export sales, the regulations provide a safe harbour whereby a taxpayer will be deemed to have an appropriate transfer price with respect to export sales when the average export sales’ price is at least 90% of the average domestic sales’ price of 262 International Transfer Pricing 2015/16

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the same property, services, or intangible rights in the Brazilian market during the same period under similar payment terms. When a company does not conduct sales’ transactions in the Brazilian market, the determination of the average price is based on data obtained from other companies that sell identical or similar property, services, or intangible rights in the Brazilian market. When it is not possible to demonstrate that the export sales’ price is at least 90% of the average sales’ price in the Brazilian market, the Brazilian company is required to substantiate its export transfer prices, based on the parameter obtained using one of the following Brazilian methods: Export sales price method (PVEx) This Brazilian equivalent of the CUP method is defined as the weighted average of the export sales’ price charged by the company to other customers or other national exporters of identical or similar property, services, or rights during the same tax year using similar payment terms. Resale price methods The Brazilian versions of the RPM for export transactions are defined as the weighted average price of identical or similar property, services, or rights in the country of destination under similar payment terms reduced by the taxes included in the price imposed by that country and one of the following: • A profit margin of 15%, calculated by reference to the wholesale price in the country of destination (wholesale price in country of destination less profit method, or PVA). • A profit margin of 30%, calculated by reference to the retail price in the country of destination (retail price in country of destination less profit method, or PVV). Purchase or production cost-plus taxes and profit method (CAP) This Brazilian equivalent of the CP method is defined as the weighted average cost of an acquisition or production of exported property, services, or rights increased for taxes and duties imposed by Brazil, plus a profit margin of 15%, calculated based on the sum of the costs, taxes and duties. Quotation price on exports’ method (PECEX) This new Brazilian method, introduced by Law 12715/12, must be applied to test exports of commodities that have a quote in a commodities’ exchange, as of 2013. Based on this method, taxpayers shall compare the transaction value with the average quote of the respective commodity involved, adjusted by an average market premium, in the date of the transaction. In the case of transactions involving commodities that do not have a quote in a commodities’ exchange, taxpayers may choose to test the prices in export transactions based on information obtained from independent sources, provided by internationally recognised institutes involved in researches of specific sectors as well as by Brazilian regulatory agencies. Taxpayers must apply this method to test commodities quoted in the exchange market, even if their average export sales’ price are at least 90% of the average domestic sales’ price of the same goods. In the event that the export sales’ price of a specific inter-company transaction is equal to, or more than, the transfer price determined by one of these methods, no adjustment is required. On the other hand, if the export sales’ price of a specific inter-company export transaction is less than the determined transfer price, the taxpayer is required to make an adjustment to the calculation bases of income tax and social contribution. www.pwc.com/internationaltp 263 B

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Brazil Relief of proof rule for inter-company export transactions In addition to the statutory 90% safe harbour rule for inter-company export transactions, there is a secondary compliance rule (herein referred to as the ‘relief of proof rule’) whereby a taxpayer may be relieved of the obligation to substantiate the export sales’ price to foreign-related persons using one of the statutory methods if it can demonstrate either of the following: Net income derived from inter-company export sales, taking into account the average for the calculation period and the two preceding years, excluding companies in low-tax jurisdictions and transactions for which the taxpayer is permitted to use different fixed margins, is at least 10% of the revenue from such sales, provided the exports to related parties do not exceed 20% of the total exports. Net revenues from exports do not exceed 5% of the taxpayer’s total net revenues in the corresponding fiscal year. If a taxpayer can satisfy the relief of proof rule, the taxpayer may prove that the export sales’ prices charged to related foreign persons are adequate for Brazilian tax purposes using only the export documents related to those transactions. The relief of proof rules do not apply to export transactions carried out with companies located in low-tax jurisdictions or beneficiaries of a privileged tax regime, and they do not apply to exports subject to the mandatory adoption of the PCEX method. Exchange adjustment In an attempt to minimise the effect of the appreciation of local currency vis-à-vis the US dollar and the euro, the Brazilian authorities issued ordinances and normative instructions at the end of 2005, 2006, 2007, 2008, 2010 and 2011, which amended the Brazilian TP legislation for export transactions only. Per these amendments, Brazilian exporting companies were allowed to increase their export revenues for calendar years 2005, 2006, 2007, 2008, 2010 and 2011 (for TP calculation purposes only), using the ratio of 1.35, 1.29, 1.28, 1.20, 1.09 and 1.11, respectively. For 2009, 2012 and 2013, no exchange adjustment was allowed. This exceptional measure only applied for those years, and for the statutory 90% safe harbour, the net income relief of proof and CAP method. Divergence margin For inter-company import and export transactions, even if the actually practised transfer price is above the determined transfer price (for import transactions) or below the determined transfer price (for export transactions), no adjustment will be required as long as the actual import transfer price does not exceed the determined transfer price by more than 5% (i.e. as long as the actual export transfer price is not below the calculated transfer price by more than 5%). The divergence margin accepted between the parameter price obtained through the use of PCI and PECEX methods and the tested price is 3%. Rules regarding interest on debt paid to a foreign-related person Rules applicable until 31 December 2012 The statutory rules provide that interest on related-party loans that were duly registered with the Brazilian Central Bank before 31 December 2012 is not to be subject to TP adjustments. However, interest paid on a loan issued to a related person that was 264 International Transfer Pricing 2015/16

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not registered with the Brazilian Central Bank will be deductible, only to the extent that the interest rate does not exceed the LIBOR (London interbank offered rate) dollar rate for six-month loans plus 3% per year (adjusted to the contract period). The actual amount of the interest paid on the loan in excess of this limitation will not be deductible for income tax and social contribution purposes. The rules do not provide a reallocation rule, which would treat the foreign lender as having received less interest income for withholding tax (WHT) purposes. Because the foreign lender actually received the full amount of the interest in cash, the foreign lender will still be required to pay WHT at the rate of 15% on the full amount paid including the excess interest. Similarly, loans extended by a Brazilian company to a foreign-related party, which were not registered with the Brazilian Central Bank must charge interest at least equal to the LIBOR dollar rate for six-month loans plus 3%. In the case of renewal or renegotiation of the loan terms after 1 January 2013, the respective interest will be subject to the TP rules applicable as of this date, as described below. Rules applicable as of 1 January 2013 As of 1 January 2013, interest on related-party loans, even if resulting from agreements duly registered with the Brazilian Central Bank, will be deductible only up to the amount that does not exceed the rate determined based on the following rules, plus a spread determined by the Ministry of Finance: • In case of transaction in US dollars subject to fixed interest rate: rate of Brazilian sovereign bonds issued in US dollars in foreign markets. • In case of transaction in Brazilian reais subject to fixed interest rate: rate of Brazilian sovereign bonds issued in Brazilian reais in foreign markets. • In all other cases: London interbank offered rate – LIBOR for the period of six months. In the case of transactions in Brazilian reais, subject to floating interest rate, the Ministry of Finance can determine a different base rate. For transactions covered in item III above in currencies for which there is no specific LIBOR rate disclosed, the LIBOR for US dollar deposits must be considered. The Brazilian Ministry of Finance established that the interest deduction will be limited to the interest determined considering a spread of 3.5% on top of the maximum interest rate applicable to the case, according to the Law. Interest expenses in excess to such limit will not be deductible. On the other hand, the minimum interest income to be recognised for tax purposes as of 3 August2013 on loans granted abroad is determined considering the spread of 2.5% on top of the minimum interest rate applicable to the case according to the Law. The deductibility limit must be verified on the contract date, and it will apply during the full contract term. For this purpose, the renewal and the renegotiation of contracts will be treated as the signing of a new contract. www.pwc.com/internationaltp 265 B

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Brazil Rules regarding royalties and technical assistance The statutory rules expressly exclude royalties and technical, scientific, administrative or similar assistance remittances from the scope of the TP legislation. Accordingly, provisions of the Brazilian income-tax law established before the Brazilian TP rules went into effect still regulate the remittances and deductibility of inter-company payments for royalties and technical assistance fees. According to this preceding legislation, royalties for the use of patents, trademarks and know-how, as well as remuneration for technical, scientific, administrative or other assistance paid by a Brazilian entity to a foreign-related party are only deductible up to a fixed percentage limit set by the Brazilian Ministry of Finance. The percentage limit depends on the type of underlying royalty, product or industry involved (the maximum is 5% of related revenues, 1% in the case of trademarks). Additionally, royalties and technical assistance fees are only deductible if the underlying contracts signed between the related parties have been approved by the National Institute of Industrial Property (INPI) and registered with the Brazilian Central Bank after 31 December 1991. Royalty payments that do not comply with these regulations and restrictions are not deductible for income tax. Consequently, while royalty and technical assistance payments are not subject to TP rules, they are subject to rules that impose fixed parameters that are not in accordance with the arm’s‑length principle, except for royalties for the use of a copyright (e.g. software licences), which are not subject to the rate limitations mentioned above and, in most cases, are paid at much higher rates. Such remittances are subject to Brazil’s TP rules for import transactions. The Brazilian TP regulations make no mention of royalty and technical assistance payments received by a Brazilian taxpayer from a foreign-related party. Hence, such foreign-source revenues should be subject to Brazil’s TP rules for export transactions. Cost-contribution arrangements No statutory or other regulations on cost-contribution arrangements have been enacted at this point. Accordingly, deductibility of expenses deriving from costcontribution arrangements is subject to Brazil’s general rules on deductibility, which require deductible expenses to be (1) actually incurred, (2) ordinary and necessary for the transactions or business activities of the Brazilian entity, and (3) properly documented. Based on our experience, Brazilian tax authorities will assume that related charges merely represent an allocation of costs made by the foreign company. Consequently, they will disallow deductibility for income tax and social contribution on net income unless the Brazilian taxpayer can prove that it actually received an identifiable benefit from each of the charged services specified in any corresponding contracts. Sufficient support documentation is crucial to substantiate any claims that expenses are ordinary and necessary, especially in the case of international inter-company costcontribution arrangements. In past decisions, the Brazilian tax authorities and local courts have repeatedly ruled against the deductibility of expenses deriving from cost-contribution arrangements, due to the lack of proof that services and related benefits had actually been received by the Brazilian entity. In addition, in past decisions Brazilian tax authorities have 266 International Transfer Pricing 2015/16

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ruled against the deductibility of R&D expenses incurred by a foreign-related party and allocated as part of the production cost base in the calculation of the CPL for intercompany import transactions. With the exception of cost-contribution arrangements involving technical and scientific assistance with a transfer of technology, which are treated the same as royalties (please see above), resulting inter-company charges will have to comply with Brazil’s TP regulations, in order to be fully deductible. Due to the nature of the transaction, the CPL is the most commonly adopted method. Back-to-back transactions Back-to-back transactions are subject to TP rules. For this purpose, back-to-back transactions should be considered as those in which the product is purchased from a foreign party and sold to another foreign party – and at least one of them is treated as a related party for Brazilian TP purposes – without the transit of goods in Brazil. Penalties Assessments and penalties In making an assessment if taxpayers are not able to present a new calculation and its support documentation in 30 days after the first one has been disqualified, the tax inspector is not required to use the most favourable method available. Consequently, the inspector will most likely use the method that is most easily applied under the circumstances and assess income tax and social contribution at the maximum combined rate of 34%. The objective of an assessment would not necessarily result in the true arm’s-length result, but would be based on an objective price determined by the regulations. In the case of exports, tax inspectors would most likely use the CAP, because they could rely on the Brazilian cost accounting information of the taxpayer. In the case of imports, the tax inspector may have independent data collected from customs’ authorities, using import prices set by other importers for comparable products, based on the customs’ valuation rules, or use the PRL. If the Brazilian tax authorities were to conclude that there is a deficiency and make an income adjustment, penalties may be imposed at the rate of 75% of the assessed tax deficiency. The rate may be reduced by 50% of the penalty imposed if the taxpayer agrees to pay the assessed tax deficiency within 30 days without contesting the assessment. In some cases, when the taxpayer fails to provide the required information the penalty rate may be increased to 112.5% of the tax liability. In addition, interest would be imposed on the amount of the tax deficiency from the date the tax would have been due if it had been properly recognised. In this instance, the interest rate used is the federal rate established by the Brazilian Central Bank, known as SELIC. Resources available to the tax authorities The Brazilian tax authorities have created a group of agents specialised in TP audits. In addition, all tax agencies have a special area dedicated to the investigation and development of audits that conduct studies and form databases that can be used to compare prices and profit margins across industries and to identify questionable companies for audit. The electronic contemporaneous documentation filing requirements (DIPJ, recently replaced by ECF – Tax Accounting Recording) for TP purposes facilitate the creation of such comprehensive databases. Since taxpayers are www.pwc.com/internationaltp 267 B

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Brazil required to report in the DIPJ or ECF the average annual transfer prices for the 199 largest inter-company import and export transactions, the Brazilian tax authorities will be able to test these prices using the prices of similar products traded by other companies. In addition, as mentioned earlier, the tax inspector may also use data collected from the customs authorities’ electronic Integrated System for International Trade (Sistema Integrado de Comércio Exterior, or SISCOMEX), as well as from the Integrated System of Foreign Service Trade (Sistema Integrado de Comércio Exterior de Serviços, Intangíveis e outras operações que produzam variações no patrimônio, or SISCOSERV). Liaison with customs’ authorities In principle, it should not be possible to have different import values for customs and TP purposes. However, in determining import sales’ prices, the TP rules and customs’ valuation rules are not the same. It is quite common to find that the customs and TP rules result in different import prices. In practice, many multinational companies find themselves having to use an import sales price for customs’ purposes, which is higher than the price determined by the TP rules. As a result, these companies pay higher customs’ duties and, at the same time, make a downward adjustment to the price for TP purposes. Limitation of double taxation and competent authority proceedings Should the Brazilian tax authorities adjust transfer prices, it is possible that the same income could be taxed twice, once in Brazil and once in the foreign country. Multinational companies conducting transactions with their Brazilian affiliates through countries that do not have double-tax agreements (DTAs) with Brazil, such as the US and the UK, cannot pursue competent authority relief as a means of preventing double taxation arising from an income adjustment. Conversely, multinational companies conducting transactions with their Brazilian affiliates through countries that have DTAs with Brazil may appeal for relief under the competent authority provisions of Brazil’s tax treaties. However, few taxpayers have tested this recourse, and none successfully. This is because Brazilian TP rules were enacted after the various tax treaties had been signed, so the reasons for evoking competent authority relief on TP grounds did not yet exist. Documentation Contemporaneous documentation requirements Many taxpayers initially failed to appreciate the complexities created by the Brazilian TP rules and their practical application to particular circumstances. The general impression held by many companies was that the fixed-income margins established by the Brazilian rules made it easier to comply with the rules and eliminated the need for detailed economic studies and supporting documentation. In practice, however, the application of the rules has shown that they are more complicated than they might appear. The amount of information necessary to comply with the rules was underestimated because the regulations did not provide any contemporaneous documentation requirements. This changed in August 1999, when the Brazilian tax authorities issued information requirements concerning TP as part of the manual for filing the annual income-tax return (Declaração de Informações Econômico-Fiscais da Pessoa Jurídica, or DIPJ, recently replaced by ECF). These documentation requirements, which include five 268 International Transfer Pricing 2015/16

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information forms (Fichas) in the tax return for disclosure of transactions conducted with foreign-related parties, greatly increased the TP compliance burden. These forms oblige taxpayers filing their annual tax returns to provide detailed disclosure regarding their inter-company import and export transactions, the method applied to test the inter- company price for the 199 largest import and export transactions, and the amount of any adjustments to income resulting from the application of the method to a specific transaction during the fiscal year in question. For most companies, the elements needed to comply with the information requirements imposed by the information returns and a possible TP audit should be available through analytical information or the accounting system. However, many companies have yet to develop the systems that can provide the information needed to comply with these requirements as well as for purposes of determining the best TP methodology. Transfer pricing controversy and dispute resolution Burden of proof The taxpayer is obliged to satisfy the burden of proof that it has complied with the TP regulations as of the date the annual corporate income-tax return is filed. However, the fact that the Brazilian rules allow taxpayers to choose from several methods for each type of transaction provides properly prepared taxpayers an advantage over the tax authorities. Proper and timely preparation enables taxpayers to collect the necessary information and choose the most appropriate method in advance. The rules also state that the tax authorities can disregard information when considered unsuitable or inconsistent. Assuming the methodology is applied and documented correctly, taxpayers can satisfy the burden of proof and push the burden back to the tax authorities. This also applies when a taxpayer can satisfy the relief of proof rule for inter-company export transactions. Tax audit procedures Audits are the Brazilian tax authorities’ main enforcement tool with regard to TP. Transfer pricing may be reviewed as part of a comprehensive tax audit or through a specific TP audit. The audit procedure The audit procedure occurs annually, except in some cases such as suspicion of fraud. As part of the audit process, the regulations require a Brazilian taxpayer to provide the TP calculation used to test inter-company transactions conducted with foreignrelated parties, along with supporting documentation. Since the taxpayer is obliged to satisfy the burden of proof that it has complied with the TP regulations as of the date the tax return is filed, it is important for taxpayers to have their support and calculations prepared at that time. If the taxpayer fails to provide complete information regarding the methodologies and the supporting documentation, the regulations grant the tax inspector the authority to make a TP adjustment based on available financial information by applying one of the applicable methods. As from calendar year 2012, taxpayers can only change the method adopted before the start of the audit procedure, unless the tax authorities disqualify the existing documentation; in this case, taxpayers will have 30 days to present a new calculation based on another method and the corresponding support documentation. www.pwc.com/internationaltp 269 B

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Brazil As part of the audit process, the tax inspectors typically request that the methods used by the taxpayer be reconciled with the accounting books and records. The tax inspector also requests any significant accounting information used to independently confirm the calculations performed by the company. The information requested by the tax inspector may be quite burdensome and may require the company to provide confidential data regarding the production cost per product, the prices charged in the domestic market, and the prices charged to foreign-related and independent parties. As previously mentioned, companies need to develop the necessary informationreporting systems and controls that can provide reliable accounting information regarding all transactions conducted with foreign-related parties in advance to properly defend on audit. Legal cases A significant issue under dispute between taxpayers and the tax authorities relates to the mechanics for calculating the PRL 60%. Normative Instruction (IN) 243 issued in 2002, introduced significant changes to the calculation of the PRL method, creating a controversy regarding whether it expanded the scope beyond what the law intended. As a result of this controversy, most companies ignored the IN 243 provisions related to the PRL 60% calculation, which would yield much higher taxable income than the mechanics of the previous regulations. The Brazilian tax authorities have begun issuing large tax assessments based on IN 243. The Taxpayers’ Council decided in several cases against the taxpayers, and recently there were a few decisions in favour of taxpayers. Also, a Federal Regional Court (that it is not yet a final instance of this legal dispute) decided against a taxpayer, in an overturn of the same Court’s position from a few months back. In any event, the final decision on this dispute will only be known when it reaches the Superior Courts. As of 2013 the mechanics for calculating PRL 60% according to IN 243 provisions was included in Law 12715, but with profit margins of 20%, 30% or 40%, according to each industry/sector (see comments above). This change in the tax law will end the dispute regarding this matter as of calendar year 2013. Comparison with OECD Guidelines The rules require that a Brazilian company substantiate its inter-company import and export prices on an annual basis by comparing the actual transfer price with a parameter price determined under any one of the Brazilian equivalents of the OECD’s comparable uncontrolled price method (CUP method), resale price method (RPM) or cost plus method (CP method). Taxpayers are required to apply the same method, which they elect, for each product or type of transaction consistently throughout the respective fiscal year. However, taxpayers are not required to apply the same method for different products and services. While incorporating these transaction-based methods, the drafters of the Brazilian TP rules excluded profit-based methods, such as the TNMM or PSM. This is contrary to the OECD Guidelines and the US TP regulations, as well as the TP regulations introduced in Mexico and Argentina. Other material differences from internationally adopted TP regimes include the Brazilian TP legislation’s exclusion of a best method or most appropriate method rule; accordingly, a taxpayer may choose the respective pricing method. In addition, 270 International Transfer Pricing 2015/16

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the Brazilian TP rules explicitly exclude inter-company royalties and technical, scientific, administrative or similar assistance fees, which remain subject to previously established deductibility limits and other specific regulations. OECD issues As with many other countries, Brazil is still in the early stages of developing its TP policies. Brazil’s TP regime has been criticised abroad for its failure to abide by international TP principles. The Brazilian TP rules focus not on the identification of the true arm’s-length price or profit but on objective methods for determining what the ‘appropriate’ transfer price should be for Brazilian tax purposes. The regulations themselves do not mention the arm’s‑length principle, and the rules do not expressly require that related parties conduct their operations in the same manner as independent parties. Brazil is not an OECD member country. However, in the preamble to the tax bill that introduced the TP rules, the Brazilian government stated that the new rules conformed to the rules adopted by OECD member countries. In a ruling, the Brazilian tax authorities reaffirmed their opinion that Brazil’s TP regulations are in line with the arm’s‑length principle as established in Article 9 of the OECD Model Tax Convention. Although these pronouncements appear to be an endorsement of the arm’s‑length principle as the norm for evaluating the results achieved by multinational enterprises in their international inter-company transactions, the regulations do not provide the same level of explicit guidance and flexibility provided by the OECD Guidelines. The fixed percentage margin rules, which have the appearance of safe harbours, are designed to facilitate administration and compliance, and not necessarily to foster a fair and flexible system seeking maximum compatibility with the arm’s‑length principle. The Brazilian rules prescribe methodologies for computing arm’s-length prices that are different from the methodologies approved by the US regulations and the OECD Guidelines, and apply to transactions between certain unrelated parties. In other areas, such as technology transfers and cost-contribution arrangements, Brazil has failed altogether to establish TP rules. The question is whether non-Brazilian OECD-compliant methods may be applied by taxpayers in valid situations when the three Brazilian transaction-based methods cannot be applied for practical reasons (for example, lack of applicability in general or lack of reliable information). In the case of transactions conducted with related parties in treaty countries, there is a strong basis supporting the conclusion that the treaties, which are based on the OECD model treaty and supersede Brazilian domestic laws, should allow a Brazilian company to apply profit-based methods accepted by the OECD. In practice, however, the Brazilian tax authorities have demonstrated that they clearly do not agree with this interpretation, especially when it comes to methodologies not provided in the Brazilian TP regulations. In TP audits, the Brazilian tax authorities have repeatedly rejected economic studies prepared in line with the arm’s‑length principle under observance of the OECD Guidelines as acceptable documentation. It can be assumed that the Brazilian tax authorities do not want to set a precedent that would allow multinational companies to bypass the rigid Brazilian documentation methods in favour of more flexible OECD approaches. Defending the use of OECD methodologies may eventually be resolved in the courts, although such a resolution would involve a lengthy and costly legal process. www.pwc.com/internationaltp 271 B

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Brazil Definition of related persons Brazil’s TP rules provide a much broader definition of related parties than do internationally accepted TP principles. As described in the following section, the regulations go so far as to characterise foreign persons as being related when they are located in low-tax jurisdictions, whether or not a relationship exists between them and the Brazilian entity. The statutory list of related persons illustrates that the TP regulations clearly target foreign-related parties since none of the listed relationships would result in a Brazilian company being considered as related to another Brazilian company. Consequently, the TP rules do not apply to two Brazilian sister companies. Inter-company transactions in a purely domestic context are covered by the disguised dividend distribution rules described below, which are less rigorous. Under the statutory rules, a foreign company and a Brazilian company may be considered to be related if the foreign company owns as little as 10% of the Brazilian company, or when the same person owns at least 10% of the capital of each. Additionally, regardless of any underlying relationship, the Brazilian definition of related parties considers a foreign person to be related to a Brazilian company if, in the case of export transactions, the foreign person operates as an exclusive agent of the Brazilian company or, in the case of import transactions, the Brazilian company operates as an exclusive agent of the foreign person. This broad definition was specifically designed to control potential price manipulations between third parties in an exclusive commercial relationship. For these purposes, exclusivity is evidenced by a formal written contract, or in the absence of one, by the practice of commercial operations relating to a specific product, service or right that are carried out exclusively between the two companies or exclusively via the intermediation of one of them. An exclusive distributor or dealer is considered to be the individual or legal entity with exclusive rights in one region or throughout the entire country. Companies located in low-tax jurisdictions or beneficiaries of privileged tax regime Under the regulations, the TP rules apply to transactions conducted with a foreign resident, even if unrelated, that is domiciled in a country that does not tax income or that taxes income at a rate of less than 20%, or in a jurisdiction with internal legislation allowing secrecy in regard to corporate ownership. For these purposes, the tax legislation of the referred country applicable to individuals or legal entities will be considered, depending on the nature of the party with which the operation was carried out. The TP provisions also apply to transactions performed in a privileged tax regime, between individuals or legal entities resident or domiciled in Brazil and any individuals or legal entities, even if not related, resident or domiciled abroad. These rules create some practical compliance issues because they require Brazilian companies to apply the Brazilian TP rules with respect to transactions conducted with companies in tax havens even though the parties are completely unrelated. In an effort to facilitate compliance by taxpayers, the Brazilian tax authorities have issued a list of jurisdictions that they consider to be tax havens or without disclosure of corporate ownership. This list currently includes the following jurisdictions: American Samoa, Andorra, Anguilla, Antigua and Barbuda, Dutch Antilles, Aruba, Ascension Island, Bahamas, Bahrain, Barbados, Belize, Bermuda, Brunei, Campione D’Italia, Singapore, Cyprus, Costa Rica, Djibouti, Dominica, French Polynesia, Gibraltar, Granada, Cayman Islands, Cook Islands, Island of Madeira (Portugal), Isle of Man, Pitcairn Islands, Qeshm Island, Channel Islands (Jersey, Guernsey, Alderney, 272 International Transfer Pricing 2015/16

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Sark), Hong Kong, Kiribati, Marshall Islands, Samoa Islands, Solomon Islands, Saint Helena Island, Turks and Caicos Islands, British Virgin Islands, US Virgin Islands, Labuan, Lebanon, Liberia, Liechtenstein, Macau, Maldives, Mauritius, Monaco, Montserrat, Nauru, Niue Island, Norfolk Island, Oman, Panama, Saint Kitts and Nevis, Saint Lucia, Saint Pierre and Miquelon, Saint Vincent and Grenadines, San Marino, Seychelles, Swaziland, Tonga, Tristan da Cunha, Vanuatu and United Arab Emirates. The list of privileged tax regimes includes: Sociedad Anonima Financiera de Inversion (SAFI) incorporated under Uruguayan law until December 2010, holding companies incorporated under Danish law and under Dutch law which do not have substantial economic activity, international trading companies (ITC) incorporated under Icelandic law, limited liability companies (LLCs) incorporated under US state law (in which the equity interest is held by non-residents and which are not subject to US federal income tax), ITCs and international holding companies (IHC) incorporated under Maltese law, and Swiss holding companies, domiciliary companies, auxiliary companies, mixed companies or administrative companies which combined income tax rate is less than 20%. Currently, the inclusion of Dutch holding companies and Spanish companies incorporated as ‘Entidades de Valores Extranjeros’ or ‘ETVEs’ is suspended as a result of a request made to the Brazilian government by those countries, until their inclusion is further evaluated by the Brazilian authorities. Advance pricing agreements (APAs) While Brazil’s TP rules do not expressly refer to the institution of APAs, the statutory rules offer some leeway for the negotiation of an advance ruling from the tax authorities, stating that a taxpayer’s transfer prices are appropriate, even though they do not meet the fixed profit margins contained in the statute. The regulations specifically state that taxpayers may file ruling requests to alter the fixed profit margins for either industry sectors or individual taxpayers. Careful planning and substantial documentation will be necessary to justify lower margins to the Brazilian tax authorities. To date, however, the few companies that filed ruling requests with the Brazilian tax authorities have not succeeded in obtaining different margins. Disguised dividend distributions Brazil’s income tax law lists seven types of related-party transactions (domestic and international) that are deemed to give rise to disguised distributions of dividends. In summary, such disguised distributions of dividends encompass all transactions between a Brazilian legal entity and its individual or corporate administrator(s) and/ or controlling partner(s) or shareholder(s), which are negotiated at terms more favourable than fair market value. In the concrete case of related-party financing transactions, these rules have a certain analogy to thin capitalisation rules or practices. Amounts characterised as disguised dividends are added to the taxable income of the legal entity deemed to have performed such a disguised distribution. This rule does not apply when the taxpayer can substantiate that the terms of the related-party transactions were at fair market value. However, as previously mentioned, compliance with these disguised dividend distribution rules is less rigorously enforced than compliance with the TP rules, which focus exclusively on international inter-company transactions. www.pwc.com/internationaltp 273 B

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19. Bulgaria B PwC contact Irina Tsvetkova PricewaterhouseCoopers Bulgaria EOOD 9-11 Maria Louisa Blvd., 8th Floor 1000 Sofia, Bulgaria Tel: +359 2 91 003 Email: irina.tsvetkova@bg.pwc.com Overview Transfer pricing (TP) rules were issued by the Minister of Finance on 29 August 2006. Bulgarian TP rules generally follow the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Bulgaria No No Yes, generally Yes Yes Yes N/A No explicit TP documentation requirements, but is required upon request during audit Must TP documentation be prepared in the official/local language? No Are related-party transactions required to be disclosed on the tax return? Yes Penalties Are there fines for not complying with TP documentation requirements? N/A Do penalties or fines or both apply to branches of foreign companies? No How are penalties calculated? Penalties are calculated as a percentage of any TP adjustment www.pwc.com/internationaltp 275

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Bulgaria Introduction The Bulgarian tax legislation requires that taxpayers determine their taxable profits and income by applying the arm’s‑length principle to the prices for which they exchange goods, services and intangibles with related parties (i.e. transfer prices). Interest on loans provided by related parties should be consistent with market conditions at the time the loan agreement is concluded. The TP rules apply for transactions between resident persons, as well as for transactions between resident persons and non-residents. Legislation and guidance Statutory rules Bulgarian TP rules are provided in the Corporate Income Tax Act (CITA), the Tax and Social Security Procedures code, as well as in Ordinance № H-9 for implementation of the TP methods, issued by the Minister of Finance on 29 August 2006. The CITA sets the arm’s‑length principle and explicitly determines cases where the prices are deemed not to comply with the principle (e.g. in cases of receiving or granting loans that carry an interest rate that differs from the market interest rate effective at the time the loan agreement is concluded). The Tax and Social Security Procedures code includes a definition of related parties and stipulates the method to be used when determining prices on transactions between related parties. Definition of related parties For tax purposes, related parties are: • Spouses, relatives of the direct descent without restrictions and relatives of the collateral descent up to the third degree included, and in-law lineage, up to and including the second degree. • Employer and employee. • Persons, one of whom participates in the management of the other or of its subsidiary. • Partners. • Persons in whose management or supervisory bodies one and the same legal or natural person participates, including when the natural person represents another person. • A company and a person who own more than 5% of the voting shares of the company. • Persons whose activity is controlled, directly or indirectly, by a third party or by its subsidiary. • Persons who control together, directly or indirectly, a third party or its subsidiary. • Persons, one of whom is an agent of the other. • Persons, one of whom has made a donation to the other. • Persons who participate, directly or indirectly, in the management, control or capital of another person or persons where conditions different from the usual may be negotiated between them. • Persons, one of whom controls the other. 276 International Transfer Pricing 2015/16

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In addition, according to specific provisions in the Tax and Social Security Procedures Code, if a party to a transaction is a non-resident person, the revenue authorities may deem that the parties are related if: • the non-resident entity is incorporated in a country, which is not a European Union (EU) Member and in which the profit or the corporate tax due on the income, which the non-resident has realised or would realise from the transactions, is below 40% of the tax due in Bulgaria, except if there is evidence that the non-resident person is subject to preferential tax treatment, or that the non-resident has sold the goods or services on the domestic market, and • the country in which the non-resident is incorporated, denies or is not able to provide information regarding the effected transactions or the relations, when there is an applicable double-tax treaty (DTT) with this country. Methods for determining market prices For the purposes of TP rules, market prices are determined by: • • • • • the comparable uncontrolled price (CUP) method the resale price method (RPM) the cost plus (CP) method the transactional net margin method (TNMM), and the profit split method (PSM). Ordinance № H-9 for implementation of the TP methods stipulates the methods to be used when determining prices on related-party transactions, the application of each method, as well as the approach of the tax authorities in case the taxpayer has TP documentation in place. Other regulations The Bulgarian National Revenue Agency published internal TP guidelines on 8 February 2010. Generally, the guidelines contain information on recommended documentation that the revenue authorities should request during tax procedures, the TP methods, as well as some procedural rules for the avoidance of double taxation. The guidelines will be used by the revenue authorities when auditing related-party transactions and are not obligatory for taxpayers. Thin capitalisation According to the Bulgarian thin capitalisation rules, the interest expenses incurred by a resident company may not be fully deductible if the average debt-to-equity (D/E) ratio of the company exceeds 3:1 in the respective year. However, even if the D/E test is not met, the thin capitalisation restrictions may not apply if the company has sufficient profits before interest to cover its interest expenses. Interest under bank loans or financial leases are not restricted by the thin capitalisation rules unless the transaction is between related parties or the respective loan or lease is guaranteed by a related party. The Bulgarian thin capitalisation rules also do not apply to interest disallowed on other grounds (e.g. for TP purposes) and interest and other loan-related expenses capitalised in the value of an asset in accordance with the applicable accounting standards. Even if some interest expenses are disallowed under thin capitalisation rules, they may be reversed during the following five consecutive years if there are sufficient profits. www.pwc.com/internationaltp 277 B

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Bulgaria Management services The Bulgarian TP rules do not contain specific tax regulations regarding management services. Resources available to the tax authorities Bulgarian revenue authorities do not have special teams dealing with TP issues. The relevant investigations are performed as a part of the general tax audit procedures. Use and availability of comparable information The taxpayers may use all relevant sources of comparable information in order to support the arm’s-length compliance of the transfer prices with the relevant market conditions. If the tax authorities challenge the transfer prices, they may use various sources such as statistical information, stock market data and other specialised price information. The tax authorities should duly quote the source of its information. In Bulgaria there are no databases containing information on unrelatedparty transactions. The financial statements of the local companies are publicly available, but are not collected in a single database that can be used for TP studies. Risk transactions or industries No transactions or industries can be considered exposed to TP investigations at a higher risk. Penalties Additional tax and penalties Apart from an adverse tax assessment in respect of additional tax liabilities, the taxpayer may be subject to certain penalties. If the taxpayer does not determine their tax obligations correctly and files a tax return declaring lower tax liabilities than as per strictly applying the TP provisions, a penalty between 250 euros (EUR) and EUR 1,500 may be imposed. The difference between the agreed transfer prices and the market price may be considered as a hidden profit distribution, which will be associated with a penalty equal to 20% of the respective difference. If the taxpayer does not provide evidence that the prices agreed with the related parties are market-based, a penalty between EUR 125 and EUR 250 may be levied. Documentation Documentation requirements According to Bulgarian legislation, the taxable person is obliged to hold evidence that its relations with related parties are in line with the arm’s‑length principle. The tax provisions do not contain specific requirements regarding the filing of transfer pricing documentation (TPD) with revenue authorities. 278 International Transfer Pricing 2015/16

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The internal TP guidelines of the National Revenue Agency, however, contain indications as to the types of documents that the revenue authorities may request from taxpayers during tax procedures (e.g. during tax audits, procedures for DTT application, etc.). Although the guidelines do not introduce obligatory TPD requirements for taxpayers, they do specify the approach the revenue authorities should follow when examining intragroup transactions. B According to Ordinance № H-9 for implementation of the TP methods, if companies have available TPD, the revenue authorities are obliged to start their analyses of the intragroup prices, based on the method chosen by the taxpayer. Transfer pricing controversy and dispute resolution Legal cases To date, there have been few court cases related to TP issues, and all of them occurred prior to the implementation of Ordinance № H-9. Most of them set the general principle for determination of the prices on related-party transactions by referring to the TP methods stipulated in the tax legislation. Burden of proof Taxpayers should be able to prove that the transfer prices are market-based. If the taxpayer does not provide evidence that the transfer prices are market-based, the revenue authorities may estimate the market prices. In such a case, the burden of proof shifts to the revenue/tax authorities and they should back up their findings with sufficient evidence. Tax audit procedures Transfer pricing may be examined during a regular tax audit, as there are no separate procedures for TP investigations. During a tax audit, the revenue authorities may request additional information in order to make an assessment related to TP. The term for provision of information by the taxpayer will be determined in the tax authority’s request (however, the term cannot be less than seven days). Revised assessments and the appeals’ procedure If the transfer prices are not market-based, the revenue authorities may adjust the taxable result of the entity, and assess additional tax liabilities. Any tax assessments can be appealed at an administrative level. If the appeal fails, the assessments may be challenged in the court. The statute of limitations (i.e. the period within which state authorities are entitled to collect the tax liabilities and other related mandatory payments) is five years from the end of the year in which the tax liabilities become payable. However, this period could be extended in certain cases (e.g. a tax audit). However, the maximum period of the statute of limitation is ten years. Limitation of double taxation and competent authority proceedings The DTTs concluded by Bulgaria provide taxpayers the opportunity to initiate a mutual agreement procedure (MAP) for the purposes of eliminating double taxation. www.pwc.com/internationaltp 279

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Bulgaria Regulations with respect to the MAP and the exchange of information with EU Member States have been introduced in the Bulgarian Tax and Social Security Procedures Code as of 1 January 2007. The EU Arbitration Convention is applicable to Bulgaria per the European Parliament resolution of 17 June 2008. There is no publicly available information on the competent authority proceedings undergone in Bulgaria. Advance pricing agreements (APAs) There is no possibility of obtaining APAs, pursuant to the local legislation. However, it is possible to obtain a written opinion from the revenue authorities on a case-by-case basis. Such opinions are not binding, but they may provide protection from assessment of interest for late payment and penalties. Anticipated developments in law and practice Although certain TP rules have been present in the Bulgarian tax legislation for a long time, there are no developed TP practices. However, in view of the recent amendments to the legislation, we expect revenue authorities will begin to pay greater attention to this area. Liaison with customs’ authorities Pursuant to the customs’ legislation, the base on which the customs’ duties are calculated may be amended when the parties in the transaction are related. There are rules for determining the arm’s-length price for customs’ duties purposes using available data on comparable transactions. Joint investigations We are currently unaware of any simultaneous TP audits performed by the Bulgarian tax authorities and those of other countries. Comparison with OECD Guidelines Bulgaria is not a member of the OECD. However, the general principles of the OECD Guidelines are implemented in the Bulgarian TP rules and followed by the Bulgarian tax authorities. 280 International Transfer Pricing 2015/16

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20. Cameroon, Republic of C PwC contact Nadine Tinen Tchangoum PricewaterhouseCoopers Tax & Legal, Sarl Immeuble PwC, Rue Christian Tobie Kouoh BP: 5689 – Douala – Bonanjo Republic of Cameroon Tel: +237 233 43 24 43/44/44 Email: Nadine.tinen@cm.pwc.com Overview In Cameroon, transfer pricing (TP) is the new area of focus for the Tax Administration. The TP legislation and guidance complies with the Organisation for Economic Cooperation and Development (OECD) Guidelines 2010. We believe that for in the coming fiscal year, the Tax Administration will strengthen the legislation and the audits on TP. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? www.pwc.com/internationaltp Cameroon No Yes Yes Yes Yes Yes Yes Before the filing of the annual tax return with the tax administration, no later than 15th March for companies of the Large Taxpayers Unit (LTU). Yes Yes Yes Yes As a percentage of any tax payment. 281

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Cameroon, Republic of Introduction In order to fight against illicit transfers of profits, the Cameroonian General Tax Code (GTC) has provided rules implementing TP provisions in its section 19. These rules follow the TP regime developed by the OECD. According to said rules, the companies and multinational groups should determine the price of their internal transactions according to the arm’s‑length principle. It is up to the tax administration to examine the overall relationship between the related entities to determine whether their results are consistent with this principle. The circular N°0004/MINFI/DGI/LC/L applying the provisions of the finance law for fiscal year 2007 completes section 19 of the General Tax Code by establishing the terms and conditions for implementation of the request by the tax authorities for information relating to the determination of TP. For this purpose, the circular states that the request for information on TP should occur only in the context of general or partial tax audit. Also, the tax administration should have gathered evidences suggesting that an enterprise has made a transfer of profits within the meaning of section 19 of the General Tax Code, demonstrating, firstly, that there are dependencies between the companies concerned, and secondly, whether the transaction was carried out under abnormal conditions. In the same way, the Finance Law for 2012 reinforces the provision of article L 19 by establishing the obligation of automatic production of TP documentation by certain taxpayers of the Large Taxpayers Unit (LTU) during tax audits. Likewise, the Finance Law for 2014 provides specific returns filing obligations for taxpayers of the LTU. Finally, the tax administration accepts the procedure of advance pricing agreements (APA) in the application of OECD principles. Legislation and guidance The general context: Section 19 of General Tax Code provides that: “For the assessment of the company tax payable by companies which are controlled by, or which control an undertaking established outside Cameroon, the profits indirectly transferred to the latter by increasing or reducing the purchase or selling price, or by any other means, shall be incorporated in the results shown by their accounts. The same shall apply to undertakings which are controlled by an under-taking or group likewise in control of undertakings established outside Cameroon”. The specific context: The implementation of Cameroon legal provisions on TP is clarified by circular N°0004/MINFI/DGI/LC/L applying the provisions of the finance law for fiscal year 2007 and circular N°001/MINFI/DGI/LC/L of 30 January 2012 applying the provisions of finance law for the fiscal year 2012, as regards section L19bis of the Cameroon tax procedures code. However, the Cameroon regulations on TP do not specify which criteria should be taken into account in order to select and appropriate TP method. 282 International Transfer Pricing 2015/16

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The above-mentioned circular of 2007 regarding the justification by the company of the TP method used, merely states that any method invoked by the enterprise can be considered acceptable, provided that it is justified by the following documents: • Contracts or internal memos describing the methods. • Extracts of the general or analytical accounts. • Economic analyses, notably on the markets, the functions fulfilled, the risks assumed, the comparable retained. C Therefore, what matters in practice is: • the fact that a definite method has been applied consistently, and • the results achieved through the retained method, and the way such results may be defended on the basis of comparables (internal, i.e. transactions between a group company and a third party, or external, i.e. transactions between companies not belonging to the group of the considered taxpayer). To determine the price of normal operations, it is certainly possible to use methods based on profits. These include the division of profits, the transactional net margin method. However, it should focus on the following methods, which are based on arm’slength price and appear best suited to the Cameroonian environment: • The comparable uncontrolled price (CUP) method. • The resale price method (RPM). • The cost plus (CP) method. Section M 19a of the circular of Finance Law for 2012 establishes a new requirement which provides for the automatic production of certain TP documents by certain taxpayers during tax audits. These taxpayers are henceforth required to submit to the tax administration, from the date of commencement of the tax audit carried on by tax administration, documentation that justifies the TP policy applied in transactions of any nature realised with legal entities established or incorporated outside Cameroon, and which are dependent or have control of businesses located in Cameroon. The same applies to transactions with companies located in Cameroon and which are under the control of a company or group also having control over companies located outside Cameroon. Companies liable to this automatic documentary obligation are those in the LTU, which meet one of the following conditions: • At the close of the financial year, more than 25% of the capital or voting rights of a legal entity domiciled in Cameroon is owned directly or indirectly by an entity established or incorporated outside Cameroon. • At the close of the financial year, more than 25% of the capital or voting rights of a legal entity domiciled outside Cameroon is owned directly or indirectly by an entity established or incorporated in Cameroon. www.pwc.com/internationaltp 283

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Cameroon, Republic of It should be noted that in case of partial or total failure of the taxpayer, a warning to provide or complete the documentation within thirty (30) days must be served to the taxpayer. This warning must recall the sanctions for failure to answer, notably adjustments based on information available to the Administration. In this case, the onus of proof rests with the company. The documents concerned are listed in appendix 3 of the circular of Finances Law for 2012. Also, circular No 001/MINFI/DGI/LC/L, applying the provisions of the finance law for fiscal year 2014, provides that companies of the (LTU) are now required to automatically transmit the following information to the tax authorities no later than 15 March of each year. • A statement of their shareholdings in other companies if the holdings exceed 25% of their share capital. • A detailed statement of intergroup transactions. 1) With regards to the statement of their shareholdings in other companies if the holdings exceed 25% of their share capital It should be noted that this requirement equally applies to affiliated or associated companies included in the scope of consolidation of the parent company as defined by the provisions of Article 78 of the OHADA Uniform Act on the Organisation and Harmonisation of Business Accounting. The statement of shareholdings should be accompanied by the following items: • A general description of activities deployed including all changes in securities which occurred over the past two years. • A general description of the legal and operational structures of the associated group of companies including an identification of the associated companies with the group engaged in transactions with the company filing the tax return. • A general description of the functions performed and risks assumed by the associates, in the manner in which they impact the company filing the tax return. • A list of key intangible assets including patents, trademarks, business names and know-how related to the company filing the tax return. 2) With regards to the detailed statement of related party or intergroup transactions The following information must be submitted before 15 of March yearly: • A description of the transactions carried out with related companies including the nature and the amount of cash flow including royalties. • A list of cost-sharing agreements and, if applicable, a copy of APAs and advance tax rulings relating to the determination of transfer prices, affecting the results of the company filing the tax return. • A presentation of the TP determination method(s) with respect to the arm’s‑length principle including an analysis of the functions performed, assets used and risks assumed with an explanation on the selection and application of the method(s) used. • When the chosen method requires an analysis of comparables considered relevant by the company. 284 International Transfer Pricing 2015/16

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Taxpayers who fail to meet the aforementioned filing requirements shall be summoned to do so within thirty (30) days. The summons would refer to the penalties due including potential tax adjustments in case of failure to reply. Penalties C For TP, we apply the general penalties on income tax adjustments. The penalties are calculated as a percentage of any tax payment. However, where the correction of errors in filing of returns or payment of taxes is carried out voluntarily by the taxpayer, no penalties shall be applied. As from 1 January 2015, companies which have the obligation to submit their TP documentation no later than 15 March 2015, and which fail to file it within this set deadlines, shall pay the fine of 1 million Communauté Financière Africaine francs (XAF) per month after sending of a formal notice. Documentation Until 31 December 2011, section M19a of the GTC rendered it compulsory for companies to provide certain documents at the request of the administration, when in the course of an audit, elements showing an indirect transfer of profits, in accordance with Section 19 of the GTC, were discovered. However, the amended version of this section induces new obligations (section M19a of the circular of Finances Law for 2012), different from those mentioned above, to companies that meet certain conditions (for more details see the above paragraph on legislation and guidance). Following appendix 3 of the circular of Finances Law for 2012, the TP documentation must include: • General information about the group of associated companies: • A general description of the legal and operational structures of the related entities including an identification of those related entities involved in the transactions being audited. • A general description of the functions performed and risks undertaken by related companies, where these affect the company being audited. • A list of key intangible assets held including patents, trademarks, trade names and technical knowledge, with regard to the company under audit. • A general description of the TP policy of the group. • Specific information regarding the company under audit: • A description of the work done including changes in the audited financial year. • A description of transactions with other associates including the nature and amount of flow including royalties. • A list of cost-sharing arrangements and, where applicable, a copy of the prior agreements with respect to TP and relating to the determination of transfer prices affecting the results of the company audited. • Or a presentation of the methods for determining transfer prices in compliance with the arm’s‑length principle including an analysis of functions performed, assets used and risks assumed, and an explanation concerning the selection and application of the method(s) used. www.pwc.com/internationaltp 285

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Cameroon, Republic of • When required by the method chosen, an analysis of comparative elements considered relevant by the company. Article 18-3 of Finances Law for 2014 requires that the taxpayers under LTU must submit their TP documentation for fiscal year 2013 no later than March 15, 2014. Transfer pricing controversy and dispute resolution When the tax authority makes an adjustment for the price of a transaction, the burden of proof rests with administration (Art. L 23, General Tax Code). However, in case of partial or failure to submit the TP documentation, the burden of proof rests with the company (Art. L 19bis, General Tax Code). During the tax audit, the administration focuses on the application of the TP method. Some companies have already been the subject of control in such matters. Therefore, in order to agree on the best method to adopt, the tax authorities accept the application of the Unilateral APA, which is adapted for Cameroonian environment for the moment. Through this APA submission, Cameroon Entities requests that the Cameroonian Tax Administration (CTA) agrees on the appropriate TP methodology to establish arm’slength results for the covered transactions during a certain period. Comparison with OECD Guidelines In Cameroon, the TP legislation is applied in respect to application of the OECD principles (OECD Transfer Pricing Guidelines 2010). 286 International Transfer Pricing 2015/16

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21. Canada C PwC contact Gord Jans PricewaterhouseCoopers LLP PwC Tower 18 York Street, Suite 2600 Toronto ON M5J 0B2 Canada Tel: +1 416 815 5198 Email: gordon.r.jans@ca.pwc.com Overview There were significant changes to the global transfer pricing (TP) landscape in 2014, which in turn influenced the Canadian TP environment. The Organisaton for Economic Co-operation and Development’s (OECD) mandate around base erosion and profit shifting (BEPS) continued to drive change and discussion of worldwide tax policies, as its first set of reports and recommendations to address seven of the actions in the Action Plan were released in September 2014. Canadian taxpayers are continuing to assess the impact of BEPS on their current structures and inter-company transactions, while at the same time dealing with aggressive audits by the Canada Revenue Agency (CRA) not just on TP issues but also on the procedural and timing aspects of audits. Overall, the changes in 2014 and expected future changes should make taxpayers actively assess risk and manage their TP positions. Country Canada OECD member? Yes TP legislation Are there statutory TP documentation requirements in Yes place? Does TP legislation adopt the OECD Guidelines? Yes Does TP legislation apply to cross-border inter-company Yes transactions? Does TP legislation apply to domestic inter-company No transactions? Does TP legislation adhere to the arm’s‑length principle? Yes TP Documentation Can TP documentation provide penalty protection? Yes When must TP documentation be prepared? On or before the tax return filing date for the tax year to provide penalty protection in the event of a transfer pricing adjustment. Must TP documentation be prepared in the official/local Yes language? www.pwc.com/internationaltp 287

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Canada Country Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? Canada Yes No, but TP documentation can be used to avoid TP penalties Yes 10% of the net upward transfer pricing adjustments if the adjustment exceeds the penalty threshold, which is the lesser of Canadian dollars (CAD) 5 million or 10% of gross revenues. Introduction Canadian TP legislation and administrative guidelines are generally consistent with the OECD Guidelines and endorse the arm’s‑length principle, i.e., transactions between related parties must occur under arm’s-length terms and conditions. Penalties may be imposed where adjustments exceed a threshold amount and contemporaneous documentation requirements are not met. To date there have only been a handful of major TP cases litigated in Canada, and the number of cases is expected to increase as the TP-related audit activity of the CRA continues to intensify under ongoing mandates from the federal government. Legislation and guidance Legislation and guidance related to transfer pricing Canadian TP legislation is set out in section 247 of the Income Tax Act (ITA) and embodies the arm’s‑length principle: • Related-party transactions may be adjusted if the CRA determines that they are not on arm’s-length terms (subsection 247(2)). Note that a general anti-avoidance rule (GAAR) (section 245 of the ITA) can apply to any transaction considered to be an avoidance transaction, and may be applied in TP situations if subsection 247(2) does not apply. • Transfer pricing adjustments that result in a net increase in income or a net decrease in a loss may be subject to a non-deductible 10% penalty (subsection 247(3)). • Set-offs may reduce the amount of the adjustment subject to penalty where supporting documentation for the transaction that relates to the favourable adjustment is available (subsection 247(3)) and the adjustment is approved by the Minister of National Revenue (the Minister) (subsection 247(10)). • Penalties may not apply to a transaction where reasonable efforts were made to determine and use arm’s-length transfer prices. Contemporaneous documentation standards are legislated for that purpose (subsection 247(4)). • ‘Transfer price’ is broadly defined to cover the consideration paid in all relatedparty transactions. Transactions between related parties will be adjusted where the terms and conditions differ from those that would have been established between arm’s-length parties. That is, the nature of the transaction can be adjusted (or recharacterised) in circumstances 288 International Transfer Pricing 2015/16

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where it is reasonable to consider that the primary purpose of the transaction is to obtain a tax benefit. A reduction, avoidance or deferral of tax (or increase in a refund of tax) will be viewed to be a ‘tax benefit’. The legislation does not include specific guidelines or safe harbours to measure arm’s length; rather, it leaves scope for the application of judgment. The best protection against a tax authority adjustment and penalties is the maintenance of contemporaneous documentation. The nature of the documentation required to avoid penalties is described in the legislation. The CRA also releases information explaining its interpretation of various taxation matters through the following publications: • Information circulars (ICs), which deal with administrative and procedural matters. • Transfer pricing memoranda (TPMs), which provide guidance on specific TP issues. • Interpretation bulletins, which outline the CRA’s interpretation of specific law. • Advance tax rulings, which summarise certain advance tax rulings given by the CRA. These publications describe departmental practice and do not have the authority of legislation. However, courts have found that these publications can be persuasive where there is doubt about the meaning of the legislation. News releases are another source of information that communicate changes in, and confirm the position of, the CRA on income tax issues. The TP ICs and TPMs issued by the CRA are set out below: Information circulars (ICs) • IC 87-2R, regarding guidance on the application of the TP rules as amended in 1998 to conform to the 1995 OECD Guidelines. • IC 94-4R regarding advance pricing arrangements. • IC 71-17R5 regarding competent authority assistance under Canada’s tax conventions. • IC 94-4RSR (Special Release) regarding advance pricing arrangements for small businesses. Transfer pricing memoranda (TPMs) • TPM-01 – Referrals to the Transfer Pricing Review Committee: This document has been replaced by TPM-07. • TPM-02 – Repatriation of Funds by Non-Residents – Part XIII Assessments: This document explains the CRA’s policy on the repatriation of funds following a TP adjustment under subsection 247(2) of the ITA (as this memo has not been updated since the date of issue, some information may no longer be valid). • TPM-03 – Downward Transfer Pricing Adjustments under subsection 247(2): This document provides guidance on dealing with downward TP adjustments that may result from an audit or a taxpayer-requested adjustment. • TPM 04 – Third-Party Information: This document provides guidelines on the use of confidential third-party information in the context of TP audits by CRA auditors. • TPM-05R – Requests for Contemporaneous Documentation: This document cancels and replaces TPM-05 and clarifies that directive with respect to the process that must be followed by CRA auditors when requesting contemporaneous documentation pursuant to subsection 247(4) of the ITA. www.pwc.com/internationaltp 289 C

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Canada • TPM-06 – Bundled Transactions: This document explains the circumstances in which the CRA will accept bundled transactions. • TPM-07 – Referrals to the Transfer Pricing Review Committee: This document has been replaced by TPM 13. • TPM-08 – The Dudney Decision – Effects on Fixed Base or Permanent Establishment Audits and Regulation 105 Treaty-Based Waiver Guidelines: This document provides guidelines and a general framework for permanent establishment (PE) determinations. • TPM-09 – Reasonable Efforts under section 247 of the Income Tax Act: This document provides guidance as to what constitutes reasonable efforts to determine and use arm’s-length transfer prices or arm’s-length allocations; it also provides examples of situations where taxpayers are at greater risk for a TP penalty. • TPM-10– Advance Pricing Arrangement (APA) Rollback: This document has been replaced by TPM-11. • TPM-11 – Advance Pricing Arrangement (APA) Rollback: This document cancels and replaces TPM-10 with respect to APA rollbacks and clarifies CRA policy regarding an APA request to cover prior tax years, sometimes referred to as an APA ‘rollback’. • TPM-12 – Accelerated Competent Authority Procedure (ACAP): This document provides guidance on ACAP, which provides for the resolution of a mutual agreement procedure (MAP) case to be applied to subsequent years. • TPM-13 – Referrals to the Transfer Pricing Review Committee: This document replaces TPM-07 and provides guidelines for referrals by CRA auditors to the International Tax Directorate and the Transfer Pricing Review Committee (TPRC) regarding the possible application of the penalty under subsection 247(3) of the ITA or the possible recharacterisation of a transaction pursuant to paragraph 247(2)(b). The revised TPM seeks to ensure a more open dialogue with taxpayers for consistent and fair application of the TP penalties. • TPM-14 – 2010 Update of the OECD Transfer Pricing Guidelines: This document provides an overview of the significant changes made in the 2010 version of the OECD Guidelines and the CRA’s position regarding these changes. • TPM-15 – Intra-group services and section 247 of the Income Tax Act: This document clarifies the CRA’s audit policy on several audit and tax issues commonly encountered during an international audit of intra-group services. • TPM-16 – Role of Multiple Year Data in Transfer Pricing Analyses: This document confirms the CRA’s position of examining transfer prices on a year-by-year basis and distinguishes between using multiple year data for comparability purposes versus using it to substantiate a transfer price. The CRA’s guidance on ‘range issues’ as they arise in testing a taxpayer’s (or its affiliate’s) profitability was published in an article presented at the Canadian Tax Foundation 2002 Tax Conference by Ronald I. Simkover, Chief Economist, International Tax Directorate, CRA. Secondary adjustments For transactions occurring after 28 March 2012, TP adjustments are deemed to be a dividend paid to the related non-resident, regardless of whether the non-resident has an ownership interest in the Canadian company, pursuant to subsection 247(12) of the ITA. As a deemed dividend, the amount is subject to withholding tax (WHT) as high as 25%, which could be reduced under the relevant treaty. The amount of the deemed dividend and associated WHT can be reduced, at the Minister’s discretion if the amount of the primary adjustment is repatriated to the Canadian taxpayer. In effect, subsection 290 International Transfer Pricing 2015/16

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247(12) combines a number of other ITA provisions that were previously relied on by the CRA to effect secondary adjustments (i.e. subsections 15(1), 56(2), 212(2) and paragraph 214(3)(a)). Reporting requirements relating to transfer pricing Subsection 231.6 – Foreign-based information or documentation The CRA may formally serve notice requiring a person resident or carrying on business in Canada to provide foreign-based information or documentation where this is relevant to the administration or enforcement of the ITA. Such notices must set out the time frame for production, a reasonable period of not less than 90 days. Supporting documents for inter-company charges and TP are prime examples of the types of information likely to be formally required. Information or documentation not produced following the delivery of the notice may not be used as a defence against a later reassessment. Taxpayers can bring an application to have the requirement varied by a judge. Failure to provide the information or documentation may lead to possible fines or possible imprisonment as discussed in subsection 238(1). In a 2003 decision, the Tax Court of Canada (TCC) prohibited GlaxoSmithKline Inc. from submitting foreignbased documents as evidence at trial because the documents had not been provided to the CRA when it served notice. In a 2005 decision, the TCC upheld the CRA’s right to request such documentation from Saipem Luxembourg, S.A. (See also the Soft-Moc decision, below, where the Federal Court of Canada dismissed the taxpayer’s application for a judicial review of the CRA’s request for f0reign-based documentation.) Section 233.1 – Annual information return: non-arm’s-length transactions with nonresident persons Persons carrying on business in Canada are required to file Form T106, Information Return of Non-Arm’s-length Transactions with Non-Residents, to report transactions with related non-residents. For every type of transaction it is necessary to identify the TP methodology used. The form also asks for the North American Industrial Classification System (NAICS) codes for the transactions reported, whether any income or deductions are affected by requests for competent authority assistance or by assessment by foreign tax administrations, and whether an APA in either country governs the TP methodology. A separate Form T106 is required for each related non-resident that has reportable transactions with the Canadian taxpayer. Each asks if contemporaneous documentation has been prepared for transactions with that related non-resident. The CRA imposes late-filing, failure to file and false statement or omission penalties with respect to these forms. A de minimis exception removes the filing requirement where the total market value of reportable transactions with all related non-residents does not exceed CAD 1 million. Foreign reporting requirements Canadian residents are required to report their holdings in foreign properties and certain transactions with foreign trusts and non-resident corporations. Significant penalties are assessed for failure to comply with these rules. www.pwc.com/internationaltp 291 C

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Canada Section 233.2 – Information returns relating to transfers or loans to a nonresident trust Generally, amounts transferred or loaned by a Canadian resident to a non-resident trust or to a company controlled by such a trust must be reported annually on Form T1141. The filing deadline generally depends on whether the Canadian resident is an individual, corporation, trust or partnership. Section 233.6 – Information return relating to distributions from, and indebtedness to, a non-resident trust A Canadian resident that is a beneficiary of a non-resident trust and is either indebted to, or receives a distribution from, such trust must report such transactions on Form T1142. Section 233.3 – Information return relating to foreign property Form T1135 should be filed where the cost of the Canadian resident taxpayer’s total specified foreign property exceeds CAD 100,000 at any time in the year. The foreign property definition is comprehensive. Specific exclusions from the definition include personal assets (e.g. condominiums), property used exclusively in an active business and assets in a pension fund trust. Section 233.4 – Information return relating to foreign affiliates Where a person (including a corporation) or a partnership resident in Canada has an interest in a corporation or trust that is a foreign affiliate or a controlled foreign affiliate, the person or partnership is required to file an information return (Form T1134A or T1134B) for each such corporation or trust. Financial statements of the corporation or trust must also be submitted. The filing deadline for these information returns is 15 months after the tax year-end of the person or partnership. Treaty-based disclosure Any non-resident corporation carrying on business in Canada that claims a treatybased exemption from Canadian tax must file a Canadian income tax return together with Schedules 91 and 97. This filing will identify those non-resident companies that are carrying on business in Canada without a PE. Other rules and regulations Intragroup services (management fees) For intragroup service fees to be tax-deductible in Canada, a specific expense must be incurred and the expense must be reasonable in the circumstances. There should also be documentary evidence to support the amount of the charge, such as a written agreement to provide the services and working papers evidencing the expense charged. Intragroup service charges are governed by section 247 of the ITA; there is no specific TP legislation for intragroup service fees, though the CRA’s position on this issue is addressed in IC 87-2R and TPM-15. The WHT legislation in section 212 of the ITA provides insight into what constitutes intragroup services. Qualifying cost-contribution arrangements Qualifying cost-contribution arrangements provide a vehicle to share the costs and risks of producing, developing or acquiring any property, or acquiring or performing any services. The costs and risks should be shared in proportion to the benefits that each participant is reasonably expected to derive from the property or services as a 292 International Transfer Pricing 2015/16

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result of the arrangement. Where a participant’s contribution is not consistent with its share of expected benefits, a balancing payment may be appropriate. Penalties Transfer pricing penalty provisions may apply where the CRA has made TP adjustments, which can result from the following circumstances: C • A net increase in income or a net decrease in loss. • A reduction in the taxpayer’s tax cost of non-depreciable and depreciable capital property and eligible capital property. These TP adjustments are liable to a 10% penalty, subject to the following exceptions: • Where the net TP adjustment does not exceed the lesser of 10% of the taxpayer’s gross revenue and CAD 5 million. • Where the taxpayer has made reasonable efforts to determine that its prices are arm’s length, to use those prices, and to document such on or before the date its tax return is due for the taxation year. Taxpayers must be able to provide this documentation to the Minister within three months of a request. The legislation allows favourable adjustments to reduce unfavourable adjustments when determining the amount subject to penalty. However, to obtain a set-off, taxpayers must have documentation supporting the transaction to which the favourable adjustment relates and the Minister’s approval of the favourable adjustment; taxpayers without contemporaneous documentation cannot benefit from set-offs. TPM-09 provides additional guidance on what constitutes reasonable efforts to determine and use arm’s-length transfer prices. According to TPM-09, a reasonable effort is defined as ‘the degree of effort that an independent and competent person engaged in the same line of business or endeavour would exercise under similar circumstances’. Further, the CRA considers a taxpayer to have made reasonable efforts when it has ‘taken all reasonable steps to ensure that [its] transfer prices or allocations conform to the arm’s‑length principle’. Canada’s penalties are based on the amount of the TP adjustment and can apply when the taxpayer is in a loss position, such that no increased taxes are payable as a result of the adjustment. In the event of capital transactions, the penalty applies to the taxable portion of any gain. Each case where a penalty may apply is referred to the TPRC, which makes a determination as to whether reasonable efforts were made. Interest (at rates prescribed by the CRA) is charged on the underpayment of incometax liabilities and WHT. This interest is not deductible for income-tax purposes. Interest is not charged on TP penalties unless the penalty is not paid within the required time frame. Risk transactions or industries Although the CRA may not be targeting any particular industry for TP audits, it continues to develop an industry-based audit approach by developing tax service offices (TSOs) that have expertise in specific industries including pharmaceutical (TSO in Laval, Quebec), automotive (Windsor, Ontario), banking (Toronto, Ontario) and oil www.pwc.com/internationaltp 293

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Canada and gas (Calgary, Alberta). It is not yet known whether this approach will be extended to other industries. Over time, the CRA is expected to become more consistent in its approach to TP audits in these industries and to develop national industry-specific audit procedures. The CRA also has a team of specialists in Ottawa that are focused on the TP analysis of related-party financial transactions. Specific transactions scrutinised by the CRA include intragroup services, intercompany debt, interest charges, guarantee fees, royalty payments, intellectual property (IP) migration, contract manufacturing arrangements and restructuring and plant closures. The CRA continues to pay close attention to transactions involving IP, which are routinely referred to the CRA’s specialist teams in Ottawa for review. The CRA is active in reviewing head-office charges made to subsidiaries, both outbound by Canadian parent companies and inbound to Canadian subsidiaries. Controversy on the calculation of an arm’s-length price for services can arise from the definition of shareholder costs, the inclusion (or not) of stock-based compensation expense in the service cost base, and the treatment of government incentives in computing the service cost base. The CRA has an aggressive international tax planning (AITP) division, which is part of the International and Large Business Directorate. The AITP initiative is aimed at identifying and responding to international transactions that may be designed to avoid paying income tax in Canada. Documentation The CRA continues to pursue a relatively aggressive programme of TP enforcement. Any TP adjustment may be subjected to a 10% penalty, with some de minimis exceptions, unless the taxpayer has made reasonable efforts to determine and use arm’s-length prices. This requires contemporaneous documentation to be on hand when the tax returns for the year are due (i.e. six months after the end of the taxation year for corporations) and submitted to the CRA within three months of a written request. As a minimum, the taxpayer should have a complete and accurate description of the following: • The property or services to which the transaction relates. • The terms and conditions of the transaction and their relationship, if any, to the terms and conditions of each other transaction entered into between the participants in the transaction. • The identity of the participants in the transaction and their relationship to each other at the time the transaction was entered into. • The functions performed, property used or contributed and the risks assumed in respect of the transaction by the participants in the transaction. • The data and methods considered and the analysis performed to determine the transfer prices or the allocations of profits or losses or contributions to costs, as the case may be, in respect of the transaction. • The assumptions, strategies and policies, if any, that influenced the determination of the transfer prices or the allocation of profits or losses or contributions to costs, as the case may be, in respect of the transaction. 294 International Transfer Pricing 2015/16

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Where contemporaneous documentation has been prepared for a prior year, the ITA provides that only those items that pertain to a material change in respect of a TP transaction must be addressed. Statute of limitations The statute of limitations for most taxpayers is four years. However, transactions with related-non-resident persons can be subject to audit for up to seven years after the tax year is initially assessed. In the rare situation where an audit may take longer, the CRA can ask the taxpayer to sign a waiver to extend beyond the seven years, which must be signed within the seven-year period. The CRA has stated that it is committed to timely reviews and audits. The appropriate tax treaty should be consulted, as treaties often include a provision whereby a taxpayer must be reassessed or the competent authority of the other state notified (the US and the UK) within a specified period in order to preserve its right to request competent authority assistance in the event of double taxation. Such a reassessment can be raised regardless of whether the audit is completed. Transfer pricing controversy and dispute resolution Tax audit procedures Selection of companies for audit The CRA has changed the way it selects files for audit with the introduction of a risk-assessment approach that targets taxpayers considered to have the highest risk of non-compliance. This model focuses not only on corporations but on partnerships and trusts as well. There are three categories: ‘High’ (will be audited), ‘Medium’ (may dictate a restricted audit related to specific concerns) and ‘Low’ (unlikely to be audited pending future evaluations). Sources of information used to determine which category a taxpayer falls into include (but are not limited to) the following: • The taxpayer’s history of compliance. • Data gathered from internal databases created from information required to be filed by law. • Information received from tax treaties and tax information exchange agreements signed with other countries and provinces. Provision of information and duty to cooperate with tax authorities Sections 231.1 to 231.5 of the ITA provide guidance on the authority of a person authorised by the Minister in regard to an audit. Basically, the rights of an auditor are far-reaching and taxpayers are expected to cooperate. As discussed earlier, section 231.2 authorises an auditor to issue a requirement for information that the taxpayer has not readily provided. As discussed earlier, section 231.6 of the ITA requires that foreign information or documents that are available or located outside Canada be provided to the CRA if relevant to the administration or enforcement of the ITA. Transfer pricing audit procedure The risk-assessment approach also applies to TP audits, which can be initiated in two ways: as part of a regular corporate audit (where TP may be included in the audit at the discretion of the audit case manager) or when a local international tax auditor screens a file solely for a TP audit, primarily using Form T106. www.pwc.com/internationaltp 295 C

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Canada CRA auditors are required to provide a taxpayer with a written request for contemporaneous documentation at the initial contact stage of a TP audit. The documentation must be provided within three months of the date of service of the request. Canada’s TP legislation offers no opportunity to negotiate an extension of the three-month deadline; the time frame is specified in the ITA and is not discretionary. If the deadline is not met, the taxpayer will be deemed not to have made reasonable efforts to determine and use arm’s-length transfer prices and may be subject to penalty if any resulting adjustment exceeds the legislated penalty threshold. After the CRA has received the contemporaneous documentation, the auditor usually visits the taxpayer’s premises (and in some cases the premises of the non-residentrelated party) to confirm the information provided. In some circumstances, the auditor may determine that the taxpayer is low risk and not proceed further. Throughout the audit process, the auditor can refer the case to the CRA’s head office to obtain technical assistance from economists. Head-office referrals are mandatory for royalties and cost-sharing arrangements. Reassessments and the appeals procedure Many TP issues can be resolved with the field auditor or the auditor’s supervisor based on information provided and discussions held during the audit. If an issue cannot be resolved, the CRA issues a Notice of Reassessment for tax owing, based on its audit findings. At this stage, a taxpayer may have two options. The first is to pursue the issue through the CRA’s appeals’ division and possibly the Canadian tax courts. The second is to request relief from double taxation through the competent authority process (available only if the TP reassessment involves a related entity in a country that has a tax treaty with Canada). In either case, the taxpayer should file a Notice of Objection. This Notice must be filed within 90 days of the date of mailing of the Notice of Reassessment and can either initiate the appeal process (if that is the desired option), or be held in abeyance (at the taxpayer’s request) while the taxpayer pursues relief through the competent authority process. If the taxpayer pursues the appeal process and is not satisfied with the result, it may seek a resolution in court. If the taxpayer pursues relief through the competent authority process, the Notice of Objection will protect the taxpayer’s rights of appeal in the event that the issue is not resolved through this process. A taxpayer can request competent authority assistance after it has proceeded through the appeal process and/or obtained a decision from a court. However, in its dealings with the foreign competent authority the Canadian competent authority is bound by any settlement with the CRA’s appeals division or a court decision. Whether relief from double taxation is provided is at the sole discretion of the foreign competent authority. A large corporation (as defined under the ITA) is required to remit 50% of any amounts owing to the federal government as a result of the reassessment (tax, interest and penalties) while appealing the Notice of Reassessment. In the case of WHTs and provincial taxes, the full amount must be remitted. 296 International Transfer Pricing 2015/16

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Burden of proof Under the Canadian taxation system, the taxpayer makes a self-assessment of tax that is then assessed by the CRA (either with or without an audit). In the event of an audit, the onus is on the taxpayer to satisfy the tax authorities that transfer prices are arm’s length. The TP legislation also requires that the taxpayer show that it has made reasonable efforts to determine and use arm’s-length transfer prices in order to exclude any related adjustments from penalty. Case law McKesson Canada Corporation (2013) The primary issue in this case was a TP adjustment made by the CRA to McKesson Canada Corporation’s (MCC’s) income, related to trade receivables factoring transactions involving MCC and its immediate parent MIH, a company resident in Luxembourg, pursuant to a receivables sales agreement (RSA) in which the latter agreed to purchase certain of MCC’s receivables at a discount of 2.206% from the face amount. The Court accepted the legal structure of the RSA but disagreed that the terms and conditions that affected the discount rate were arm’s length; it found that the discount rate was too high and agreed with the CRA’s adjustments. After considering each component of the discount rate and making various adjustments, the Court concluded that the appropriate discount rate was between 0.959% and 1.17%. As the discount rate under the RSA exceeded this range and CRA’s rate of 1.013% was within it, the Court rejected the taxpayer’s position. Also of note, the Court made a number of comments related to TP that did not bear on the decision but that are of general interest to taxpayers including the relevance of the OECD Guidelines in court proceedings; the relevance of the series of transactions that relate to the transaction; and the requirement of the taxpayer to consider all options available to it in setting its TP. The taxpayer is appealing the decision. Soft-Moc (2013) At issue in Soft-Moc was whether the taxpayer had to provide a number of documents requested by the CRA during a TP audit including those involving related parties the taxpayer did not transact with, as well as other documents the taxpayer claimed were irrelevant, confidential or inaccessible. The Federal Court of Canada found for the Minister and the CRA, holding that all documents requested were necessary for the audit, noting that while such requests “need to be both relevant and reasonable….the threshold is low and the powers of the Minister are wide-ranging.” GlaxoSmithKline (2012) This case was the first TP case to be heard by the Supreme Court of Canada (SCC). At issue was whether the price paid by a pharmaceutical manufacturer to a related party for an ingredient used in a top selling drug was too high, even though it could be sold using a licensed brand. In its decision, the Court held that when determining transfer prices, significant factors that arm’s-length parties would likely consider, such as the licence agreement in this case, must be taken into account. The SCC referred the case back to the Tax Court of Canada (TCC) for retrial, with each party permitted to provide new evidence with respect to pricing. The case was settled before the retrial. www.pwc.com/internationaltp 297 C

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Canada Alberta Printed Circuits Ltd. (2011) In this case the TCC found in favour of the taxpayer, Alberta Printed Circuits, Ltd. (APCI Canada), in respect of the application of the comparable uncontrolled price (CUP) method to determine arm’s-length set-up service fees paid to a related company in Barbados (APCI Barbados). However, despite the TCC’s rejection of the CRA’s analysis supporting its reassessments, it substantially disallowed the fees paid by APCI Canada to APCI Barbados for other services. While the TCC found that there was an absence of any compelling evidence to show the arm’s-length nature of the charge for these other services, it nonetheless computed a charge for the services that left a significant portion of the CRA’s reassessments in place. General Electric Capital Canada (2010) This case involved the deductibility of guarantee fees paid by a subsidiary to its parent. General Electric Capital Canada Inc. (GECC) deducted millions in guarantee fees it paid to its US-based parent company for explicitly provided financial guarantees, which were disallowed on the basis that the fees provided no value to the taxpayer. The TCC found for the taxpayer, holding that the 1% guarantee fee paid was equal to or below an arm’s-length price and that the implicit support derived from GECC being a member of the GE family was a relevant factor that should be considered as part of the circumstances surrounding the transaction. On appeal, the Court discussed the objective of TP legislation, ‘which is to prevent the avoidance of tax resulting from price distortions which arise in the context of non-arm’s-length relationships,’ and stated that ‘the elimination of these distortions by reference to objective benchmarks is all that is required to achieve the statutory objective’. In this case, because implicit support is a factor that an arm’s-length person would find relevant in pricing a guarantee, Canada’s Federal Court of Appeal (FCA) held that it had to be considered, and that ignoring it would be turning ‘a blind eye on a relevant fact and deprive the TP provisions of their intended effect.’ Double taxation and competent authority proceedings Two articles in Canada’s income-tax treaties are relevant to TP. • The Associated Enterprises article (Article 9) provides a definition of related parties for the purpose of the treaty and provides that each State can make adjustments to related-party transactions based on the arm’s‑length principle. Certain treaties may stipulate a time limit to make application for assistance under this article. In the absence of a timeline, the time provided under domestic legislation prevails. • The MAP article (Article 25) states that the competent authorities shall endeavour to resolve any taxation (e.g. double taxation) that is not in accordance with the treaty. A taxpayer does not need to wait for the issuance of a Notice of Reassessment before filing a request for competent authority assistance. However, the competent authority will not act on the request until a reassessment has been issued. The competent authority process for a Canadian taxpayer that has been reassessed can be summarised as follows. The non-resident-related party must file a request for competent authority assistance (complete submission) in its country of residence within the time frame provided in the treaty. A similar request is normally filed simultaneously with the Canadian competent authority by the Canadian resident. The foreign competent authority informs the Canadian competent authority that it 298 International Transfer Pricing 2015/16

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has received the request and requests a position paper outlining the details of the reassessment. The Canadian competent authority obtains the auditor’s working papers (including additional information provided by the Canadian taxpayer), reviews the case and, if unable to unilaterally resolve the double taxation, provides the position paper to the foreign tax administration, after which negotiations between the competent authorities take place to resolve the double taxation. Once the competent authorities reach agreement, they advise the taxpayers in their respective countries of the proposed settlement. Once the taxpayers have accepted the proposed settlement, the necessary adjustments are processed in each country. As the timing for filing a competent authority request varies by treaty, it is important to consult the MAP article of the relevant treaty. Generally, the competent authority submission must be filed within two years of the date of the Notice of Reassessment. Canada currently has two treaties in which the Associated Enterprises article requires that the other competent authority be notified of potential double taxation within six years of the end of the taxation year under audit. Once notification is provided, the MAP articles in those treaties do not impose a time frame within which the competent authority submission must be filed. If a request for competent authority assistance with a submission or notification is not filed on time, a taxpayer may be denied relief by the competent authority of the nonresident-related party. The CRA’s Competent Authority Services Division is responsible for the competent authority function as it pertains to the MAP and Exchange of Information articles in the treaties. Case officers in this division meet quarterly with their US counterparts and occasionally with governments of other foreign jurisdictions to discuss specific cases. An amendment to the Canada-US treaty providing for binding arbitration in MAP cases was ratified on 15 December 2008, and a memorandum of understanding (MoU) regarding the conduct of these arbitration proceedings was released on 26 November 2010. The MoU establishes the procedures for arbitration cases and indicates that the two countries have resolved their differences regarding the scope of the treaty’s arbitration provision, the types of cases eligible for arbitration and the manner in which issues will be resolved in arbitration proceedings. The process is described as ‘baseball’ arbitration, i.e. the arbitration board (comprising three members) selects one of the proposed resolutions provided by the competent authorities as its determination. Arbitration may be invoked by the taxpayers only on filing the required non-disclosure agreements. Generally, such agreements can be filed two years after the competent authorities have agreed they have received a complete submission to resolve the case. TPM-12, Accelerated Competent Authority Procedure, provides guidance on this process, which provides that the issues that gave rise to a MAP case may be addressed by the competent authorities in subsequent years at the taxpayer’s request. www.pwc.com/internationaltp 299 C

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Canada The CRA’s MAP programme report for 2014 includes the following highlights: • A total of 2,952 new cases were accepted during the year, with 2,923 completed. • Of new cases accepted, 127 were categorised as ‘negotiable’ (i.e. involving another tax administration). • Of the 2,923 cases in inventory that were completed, 105 were negotiable. • The average time to complete the Canadian-initiated cases was 23 months, while the foreign-initiated completed cases took an average of 31 months. • Full relief was granted in 98% of the negotiable cases, partial relief was granted in no cases and no relief was granted in 2% of the cases. Advance pricing arrangements (APAs) The APA programme is intended to assist Canadian taxpayers in determining acceptable TP methodology and provide certainty on covered transactions. An APA is intended to consider proposed pricing arrangements or methodologies that have prospective application and is designed to seek agreement on an appropriate TP methodology for a specified cross-border transaction between related parties. The service is offered in addition to competent authority assistance on the appropriateness of historic transactions that have been challenged by one or both jurisdictions involved. APAs can be unilateral, bilateral or multilateral. At the conclusion of the procedure, there is a binding agreement between the taxpayer and the CRA and, in the case of bilateral or multilateral APAs, between the CRA and the other tax authorities involved. Procedures and guidelines for obtaining APAs in Canada are outlined in IC 94-4R. The CRA has established the following policies regarding the rollback of TP methodologies agreed upon through the APA process: • A rollback will be considered if a request for contemporaneous documentation has not been issued by the CRA, the facts and circumstances are the same, and both the foreign tax administration and the CRA agree to accept the APA rollback request. • A waiver must be filed for each year in question in accordance with the ITA. • Once an APA is in force, transactions occurring in tax years covered by the APA and the rollback period are not subject to a TP penalty. • The CRA will not issue a request for contemporaneous documentation for transactions in a year that a taxpayer has requested to be covered by an APA rollback at a pre-filing meeting. • An APA rollback will not be permitted when a taxpayer requests a unilateral APA. The first year of a unilateral APA will be the first taxation year for which a tax return has not been filed that includes the agreed-to TP methodology. Due to ongoing staffing shortages in the competent authority division, the CRA has implemented the following changes to the APA programme: • CRA case officers must present a business case to the competent authority with respect to the necessity of site visits. • There is reluctance to accept requests for a unilateral APA. • The CRA is relying increasingly on the taxpayer to provide analyses the CRA would normally undertake. • The pre-filing package must be submitted to the CRA and deemed complete by the CRA before a pre-filing meeting is scheduled. 300 International Transfer Pricing 2015/16

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• At the pre-filing meeting, there is increased scrutiny concerning the viability of a taxpayer to enter the APA programme. Additional information may be requested by the CRA before and/or after the pre-filing meeting. The 2014 annual report on the APA programme published by the CRA reports the following: C • Thirty-nine cases were accepted into the programme. • The active case inventory was 99 cases. • Twenty-five cases were completed, of which 23 were bilateral/multilateral and two were unilateral. • Of the completed cases, bilateral APAs took an average of 47.8 months to complete, while unilateral APAs took an average of 46.2 months to complete. • The transactional net margin method (TNMM) continues to be the predominant methodology used in APAs (50% of completed and in-progress cases), followed by the profit split (PSM) (18% of completed and in-progress cases) and the cost plus (CP) method, at 13%. • When the TNMM is used, the most common profit level indicator used is the operating margin (used 61% of the time), followed by total cost plus (27% of the time) and the Berry ratio and return on assets (combined, 12% of the time). Joint audits Most tax treaties have exchange-of-information provisions including a provision for joint audits. Canada and the US have an agreement in place for joint audits. Both groups of auditors on complex audits initiate these reviews to minimise the time and effort. Comparison with OECD Guidelines Canada is a member of the OECD and its TP legislation conforms with the OECD Guidelines. As noted above, the CRA’s TPM-14 specifically endorses the revised OECD Guidelines issued on 22 July 2010, which address a number of issues concerning comparability as well as business restructuring. Further, on 26 June 2012, the governments of the US and Canada entered into an agreement to follow the Authorized OECD Approach for determining the amount of profit to attribute to a PE, which allows profits to be established for a PE regardless of whether the enterprise as a whole shows a profit or loss. www.pwc.com/internationaltp 301

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22. Chile C PwC contact Roberto Carlos Rivas PricewaterhouseCoopers Consultores, Auditores y Compañía Limitada Av. Andrés Bello 2711 Piso 4, Las Condes Santiago de Chile Chile Tel: +56 2 29400151 Email: roberto.carlos.rivas@cl.pwc.com Overview Over the last couple of years, Chile has been experiencing significant changes regarding transfer pricing (TP), which have been changing the way local taxpayers view their inter-company transactions. Even though Chilean TP legislation was introduced in 1997, being among the first in the region, Article 38 of the Chilean Income Tax Law seemed to be insufficient, since it did not include relevant technical matters, such as detailed description of the TP methods, nor did it incorporate internationally accepted practices on this matter. Taking into consideration this background in the Chilean TP legislation, and facing the need for greater funding of public education – a topic that had caused social unrest – on 30 April 2012, President Sebastian Piñera sent to the Parliament a comprehensive bill that introduces major changes to the Chilean tax system. On 27 September 2012, the new Article 41 E of the Income Tax Law entered into force, introducing significant changes in Chilean TP legislation. The main changes introduced by the new TP legislation are the following: • Introduction of the Organisation for Economic Co-operation and Development (OECD) TP methods. • Requirement to file an annual informative return regarding inter-company transactions and penalties for non-compliance. • Introduction of an advance pricing agreement (APA) programme. • Possibility to request corresponding adjustments. Additionally, the Chilean Internal Revenue Service (Chilean IRS) issued Resolution No. 14, which establishes the obligation to file an annual TP informative return, and Circular No. 29 of 2013, which extends certain concepts in this matter. Moreover, on 29 October 2012, the Chilean IRS, issued resolution No. 115, which states that taxpayers who celebrate derivative contracts with related parties, must have a technical memo, at the disposal of the Chilean IRS, containing the necessary elements to demonstrate that such contracts have been agreed under arm’s-length conditions. The rule is applicable to all those derivative contracts agreed with related parties since www.pwc.com/internationaltp 303

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Chile commercial year 2012 or that have otherwise been modified during commercial year 2012 or the applicable year post-2012. Over the last couple of years, the Chilean IRS has actively performed TP audits to a significant number of taxpayers. Currently, there are several TP audit programmes being implemented by the Chilean IRS. There is evidence of TP audits to mining companies, retailer companies, the fruit industry and pharmaceuticals groups, among others. Finally, Chile has entered a path of no return regarding TP, which will imply that Chilean taxpayers will have to be more careful when performing inter-company transactions, in order to avoid possible risks on this relevant tax area. Country OECD member? TP legislation Are there statutory TP documentation requirements in place? Does TP legislation adopt the OECD Guidelines? Does TP legislation apply to cross-border inter-company transactions? Does TP legislation apply to domestic inter-company transactions? Does TP legislation adhere to the arm’s‑length principle? TP documentation Can TP documentation provide penalty protection? When must TP documentation be prepared? (*) Must TP documentation be prepared in the official/local language? Are related-party transactions required to be disclosed on the tax return? Penalties Are there fines for not complying with TP documentation requirements? 304 Chile Yes Yes (*) No Yes No Yes Yes Even though TP studies are not required to be filed on an annual basis before the local IRS, such documentation must be prepared and ready to be presented to the authorities in the context of a TP audit, in order for the local taxpayer to demonstrate and prove the fulfilment of the arm´slength principle for the inter-company transactions under review. Such requirement would make TP documentation necessary to be prepared on a contemporaneous basis, since the taxpayer will only have 30 days to prepare such TP documentation once requested by Chilean IRS. No, although it is recommended to prepare it in Spanish. Yes, an annual TP return must be filed by June every year. Yes. There are also fines for not filing correctly the annual informative return. International Transfer Pricing 2015/16

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Country Do penalties or fines or both apply to branches of foreign companies? How are penalties calculated? Chile Yes If the Chilean IRS performs a TP adjustment in the context of a TP audit, the difference determined will be affected in the applicable year, with the Sole Tax mentioned in the first paragraph of Article 21 of the Income Tax Law (sole tax of 35%), plus interests and readjustments that apply. Furthermore, it is feasible to apply a penalty equal to 5% of the amount of that adjustment in particular cases. The Law establishes the application of penalties for not filing the annual informative return, for filing it out of date or with incorrect/incomplete information. These penalties could range from 10 up to 50 annual tax units (between 10,000 and 50,000 United States dollars [USD] approximately). Introduction Article 22 of Law 19,506, published in the Official Gazette on 30 July 1997, introduced four paragraphs to Article 38 for the Income Tax Law, which used to contain the Chilean TP rules. A minor amendment to these regulations was introduced by Law 19,840, published in the Official Gazette on 23 November 2002. These paragraphs had the basic TP regulations in Chile. A minor amendment of these regulations was introduced by Law 19,840, published in the Official Gazette on 23 November 2002. In addition, the Chilean IRS, the Chilean Tax Authority, issued circulars N°3 and N°57 in 1998 and N°72 in 2002. These circulars contain guidelines for the implementation of regulations by the tax inspectors. On 30 April 2012, the President of the Republic of Chile sent to the Parliament a tax bill that includes Article 41 E to the Income Tax Law. The said article introduces specific TP legislation. On 27 September 2012, the new Article 41 E of the Income Tax Law entered into force, introducing significant changes in Chilean TP legislation. The main changes introduced by the new TP legislation are the introduction of the OECD TP methods, requirement to file an annual informative return regarding inter-company transactions and penalties for non-compliance, introduction of an APA programme and the possibility to perform corresponding adjustments. Additionally, the Chilean IRS issued the Resolution No. 14, which establishes the obligation to file an annual TP informative return, and the Circular No. 29 of 2013 which extends certain concepts in this matter. www.pwc.com/internationaltp 305 C

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Chile Legislation and guidance The Chilean transfer pricing regulations Scope of rules The new TP Article 41 E of the Income Tax Law adheres, in general, to the OECD TP Guidelines. The new TP legislation allows the Chilean tax authority to challenge prices, values or profitability on transactions under the following circumstances: • Transactions with foreign-related parties. • Transactions derived from business restructurings and reorganisations that imply the shift of goods or activities able to generate taxable income to tax havens or preferential tax regimes. • Transactions carried out with entities resident in countries included in a list of tax havens, or preferential tax regimes with whom Chile has not entered into an exchange of information agreement. Considering the Chilean legislation, it is important to bear in mind that even though the TP legislation is conceived for cross-border transactions, Article 64 of the Chilean Tax Code gives the Chilean IRS the faculty to assess the price or value of local transactions between related parties. The concept of related entity For the purposes of section 41 E, the parties are considered related if: • One of them participates directly or indirectly in the management, control, profits or revenues of the other entity. • A person or persons participate directly or indirectly in the management, control, capital, profits and revenues of the other party. • A person or persons participate directly or indirectly in the management, control, capital, profits and revenues of both parties, meaning all interrelated. • The agency, branch or any other form of permanent establishment (PE) with: i) its headquarters, ii) with other PEs of the same parent, iii) related parties of the headquarters, and iv) PEs of the headquarters. • It will be considered that there is a relationship between the participants when a party conducts one or more transactions with a third party who, in turn, carries out, directly or indirectly, similar or identical transactions with parties related to the latter. Also, related parties are considered when the transactions are carried out with entities’ residents, domiciled, established or incorporated in countries or territories considered tax havens or harmful preferential tax regimes included in the list referred to in No.2 of the Article 41-D, unless that country or territory has signed an agreement with Chile allowing the exchange of information. Methods Although current Chilean TP legislation does not explicitly refer to the OECD Guidelines, the methods included in the new TP regulations are in line with the methods described in such Guidelines. The law also adopts the most appropriate method rule and allows the use of other unspecified methods when the methods described in the Income Tax Law are not considered appropriate for determining the arm’s‑length principle in inter-company transactions. 306 International Transfer Pricing 2015/16

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The methods included in the Chilean TP legislation are the following: • • • • • • Comparable uncontrolled price method Resale price method Cost plus method Profit split method Transactional net margin method Residual methods C Formal requirements: Documentation and informative transfer pricing return Pursuant to Chilean Income Tax Law, taxpayers are required to keep all the information that supports the application of a TP method allowed by the Chilean Income Tax Law. Transfer pricing documentation must be contemporaneous with the tested transactions, since it should be available to the Chilean tax authority within 30 days of being requested. Additionally, the taxpayers are required to file an annual informative return regarding cross-border inter-company transactions. Deadline The deadline for filing the informative return is the last working day of June each year. Taxpayers obliged Taxpayers listed below must submit to the Chilean IRS, Form No. 1907 – ‘Transfer Pricing Annual Informative Return’: • Taxpayers that belong to the segments of medium or large companies and that carried out cross-border inter-company transactions during the applicable year. • Taxpayers, other than those classified by the Chilean IRS as medium or large companies, which during the applicable year carried out transactions with persons domiciled or resident in countries or territories considered tax havens or preferential tax regimes. • Taxpayers, other than medium and large companies, which during the applicable year carried out transactions with foreign-related parties for amounts exceeding 500,000,000 Chilean pesos (CLP) (approx. USD 1,000,000), or its equivalent, according to the foreign currency. Penalties Among other relevant penalties that can be triggered under certain circumstances, failure to file the TP Annual Informative Return in the time and manner established by the Chilean IRS will be sanctioned with a penalty of between USD 10,000 and USD 50,000. Content Besides reporting specific information, the TP Annual Informative Return requires detailed information per type of transaction: tangible transactions, financing transactions, operations arising from the use of intangible assets, rendering of services or commissions, and commercial accounts. Additionally, information about the TP method applied by local taxpayers in validating the arm’s-length value for each type of transaction will be required. www.pwc.com/internationaltp 307

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Chile Finally, it is noteworthy that this ruling incorporates relevant aspects of TP to be considered in light of the circumstances of each taxpayer involved. Corresponding adjustments Under the new TP provisions, taxpayers have the ability to perform TP corresponding adjustments, but they have to be authorised by the Chilean IRS and can only be allowed in cases that involve a country with which Chile has a double tax treaty (DTT) in force. The tax authority can agree to the corresponding adjustments only when the filing date of administrative or litigation procedures has not expired. Moreover, the adjustment must be based on the application of one of the TP methods allowed in the Income Tax Law, among other requirements. Advance pricing agreement (APA) programme Article 41E of the Chilean Income Tax Law includes the possibility to enter into APAs (unilateral or multilateral) with local and foreign tax authorities. The Chilean tax authority can reject, totally or partially, the request and such decision would not be subject to an administrative appealing procedure. APAs would be valid for three years and are subject to renewal or extension. Tax authorities can nullify APAs when the request of the taxpayer is based on false statements or when there is a significant change in the facts and circumstances under which the APA was granted. Additionally, the Chilean IRS issued Resolution No. 68, which establishes the background to be accompanied with the APA request, the content of the TP report and processing time of the request, among other issues. The Chilean derivative contracts regulations On 29 October 2012, the Chilean IRS issued resolution No. 115, which states that taxpayers who celebrate derivative contracts with related parties must have a technical memo at the disposal of the Chilean IRS, containing the necessary elements to demonstrate that such contracts have been agreed under arm’s-length conditions. The rule is applicable to all those derivative contracts agreed with related parties since commercial year 2012, or that have otherwise been modified during commercial year 2012 or the applicable year post-2012. For purposes of this obligation, the definition of related parties is quite broad and this refers to Article 100 of the Securities Market Law, which might not coincide with the definition of related parties for the purposes of TP regulations included in our Income Tax Law. The technical memo requested by the Chilean IRS must contain, at least, the following: • A detailed description of the derivative operation, pointing out, among other things, the type of contract, the parameters used to determine its price or value, duration of the contract and the subjacent asset/liability that it is covering for as the case may be. • The economic circumstances that gave place to the celebration of the contract. • An analysis of comparable transactions, as well as the methodology used for selecting the comparables. Likewise, it shall indicate the price or value that the taxpayer believes to be arm’s length for a given contract. 308 International Transfer Pricing 2015/16

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If the information contained in the technical memo is found insufficient by the Chilean IRS (i.e. the IRS considers that it does not support the arm’s-length conditions of a given operation), adverse tax consequences will be triggered to the local taxpayer. Finally, is important to note that on 29 October 2012, the Chilean IRS issued resolution No. 114, which established three new sworn affidavits (DJ 1820, 1829 and 1839) that will indeed serve as base information for assessing derivative operations and the fulfillment of the tax law in general. Penalties If the Chilean IRS performs a TP adjustment in the context of a TP audit, the difference determined will be affected in the applicable year, with the sole tax mentioned in the first paragraph of Article 21 of the Income Tax Law (sole tax of 35%), plus interest and readjustments that apply.