Consultative document on modernisation of the transfer pricing legislation.

On December 19, 1997, Tax Executives Institute submitted the following comments on the United Kingdom's transfer pricing policy to Inland Revenue. The submission, which took the form of a letter from TEI President Paul Cherecwich, Jr. to Kevin Hamer of Inland Revenue's International Division, was prepared under the aegis of the Institute's Task Force on US. Members Overseas whose chair is Lisa Poschcke-Koedt of Hewlett-Packard Company. (Ms. Peschcke-Koedt is currently on assignment in Geneva, Switzerland.) Preparation of the comments was coordinated by the International Tax Committee, whom chair is Joseph S. Tann, Jr of Ameritech Corporation. Among the individuals contributing to the submission were Michael Bacon of Griffin House (England), Joseph K. Chen of Levi Strauss Europe (Belgium), Guy Kersch of Monsanto Services International SA (Belgium), Iain Maclean of Digital Equipment Corporation International (Europe) (Switzerland), Susan G. Norton of Unilever (Netherlands), Nancy Perks of Microsoft Ltd. (England), and Peter Randall of Citibank House (England).

This letter responds to the 9 October 1997 Consultative Document entitled Modernisation of the Transfer Pricing Legislation. Tax Executives Institute thank the Government of the United Kingdom for affording us this opportunity to comment on the Consultative Document and commends the Inland Revenue for its work in this area.

Background

Tax Executives Institute (TEI) is the principal organisation of corporate tax professionals in North America. Our approximately 5,000 members represent nearly 3,000 of the leading corporations in the United States and Canada. TEI is a nonprofit organization that represents a cross-section of the business community; it is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and tax administrations alike. As a professional association, TEI is firmly committed to maintaining tax systems that work, systems that are administrable and with winch tax payers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the various tax laws relating to the operation of business enterprises. U.S. and Canadian companies have long been substantial investors in the United Kingdom. Many TEI members work for multinational companies that engage in international trade with the U.K. and through it with other European countries. Some members have substantial UK-based commercial operations. Thus, our member companies engage in significant levels of crossborder transactions involving the U.K.

TEI welcomes the opportunity to provide comments on the Consultative Document which seeks to clarify an area of tax law that has historically depended on relatively dated legislation and unpublished conventions. In an era where international trade and capital flows are growing every year, it is important for governments and taxpayers to ensure that the governing rules are well thought out and fairly applied, and that they strike the right balance between meeting the government's need to raise taxes and its responsibility not to impose too heavy a compliance burden on taxpayers.

The U.K. Government clearly strives for such a balance in the Consultative Document. In particular, TEI commends the Government for the proposed adoption of the arm's-length approach, as embodied in Article 9 of the OECD Model Tax Convention on Income and on Capital.(1) We believe, however, that the proposal could be improved with little risk to tax yield and still remain consistent with the overall approach taken by the Organisation for Economic Cooperation and Development in the final transfer pricing guidelines.(2)

Proposed Legislation

On 2 July 1997, the U.K Government announced its intention to amend the UK's transfer pricing legislation in the Finance Bill following the next Budget. New rules will be introduced requiring taxpayers to apply the arm's-length method in respect of transfer prices for purposes of calculating their taxable income. At the same time, the Government seeks to modernise the legislation.

Measures to improve predictability in the taxation of cross-border intra-group transactions should always be encouraged. No approach -- no matter how comprehensive -- however, can deal with all situations, so the new measures must be flexible. The proposed legislation should be applied reasonably, tempering external benchmarking by reference to an enterprise's own overall profitability. The Consultative Document rightly acknowledges that tax is only one of a multitude of business costs -- indeed, it is a major cost -- and that decisions on transfer pricing are not necessarily tax motivated.

While the legislation's thrust is unassailable, the proposal is unduly complex. We urge that, in drafting the Finance Bill (which will formally propose the legislation required), the writers adopt the simplified approach being used elsewhere in respect of the U.K. tax code. In particular, the legislation should explicitly incorporate Article 9 of the OECD model treaty rather than simply include a cross-reference to it. TEI would be pleased to assist in this effort.

We agree that taxpayers' statutory obligation to file a complete and accurate return should be the same in respect to intercompany transactions as unrelated party transactions. To this end, TEI recommends that a provision for filing amended returns within a defined period be included. The proposed legislation seems to anticipate such adjustments. To ensure clarity, the proposed legislation should explicitly permit the filing of amended returns, perhaps within a three-year period.

In our comments below, TEI questions three aspects of the proposed law: the "one-way street approach" in the adjustment of profits; the expanded definition of the term association"; and the apparent intention to extend the purview of the legislation beyond pricing of transactions to the structure of the transactions themselves.

A. Adjustments of Profits. In essence, the legislation places taxpayers on a one-way street: only upward adjustments of profits are permitted. Although Article 9(1) of the OECD model treaty clearly authorizes upward adjustments, it must be read in tandem with paragraph (2), which specifically recognises that an upward of adjustment of profits in one contracting State should prompt a downward adjustment in another:

Where a Contracting State

includes in the profits of an

enterprise of that State -- and

taxes accordingly -- profits

on which an enterprise

of the other Contracting

State has been charged

to tax in that other State and

the profits so included are

profits which would have accrued

to the enterprise of the

first-mentioned. State if the

conditions made between the

two enterprises had been

those which would have been

made between independent

enterprises, then that other

State shall make an appropriate

adjustment to the

amount of tax charged therein

on those profits. In determining

such adjustment, due

regard shall be had to the

other provisions of this Convention

and the competent

authorities of the Contracting

States shall if necessary

consult each other. (Emphasis

added.)

Basing the U.K. rule solely on the first paragraph of Article 9 is too restrictive and could result in double taxation of profits. Taxpayers do not purposefully set miles prices at a level higher than the arms-length price, or their cost of goods at a level below that price. The law should allow for appropriate adjustments to be made in determining whether additional tax is due. The same criteria would be applied in determining whether the price is arm's length, and the Inland Revenue will have the same opportunity for review and adjustment. Such an approach in domestic law will effectively avoid double taxation, similar to the competent authority arrangements embodied in most, if not all, of the U.K.'s tax treaties.

In addition, TEI recommends that Inland Revenue publicly commit to support the position of taxpayers applying to competent authority for relief from an upward adjustment of profits. In such circumstances, taxpayers would obviously be obliged to notify the Inland Revenue formally of such adjustments.

Off-sets extended beyond the year under review should also be permitted. Over a period of time, transactions may occur that are arguably inconsistent with the arm's-length standard, but that average out over a few years to an arm's-length result. These transactions should be netted before any adjustment is made. Any three-year period (including the year under review) seems a reasonable time period during which such offsets could be allowed and would be consistent with the OECD guidelines.

The proposed legislation employs very general language for which there is little judicial precedent in UK tax law, which may expand its scope beyond a review of the pricing to a recharacterization of the underlying transaction itself. Article 9 of the OECD model treaty limits the reach of the rules in two specified circumstances: loans and unlimited transfers of intellectual property The Inland Revenue should confirm that it will disregard the structure of the actual transactions and recharacterize them only in those two instances. (In the case of loans, other remedies are also available under existing legislation.)

B Definition of Association. The proposed legislation contains a series of attribution rules that bring relationships involving certain joint ventures within the scope of the legislation. The legislation adopts a 40-percent control test for companies and provides that the test includes rights and powers that a person is entitled to acquire at a future date or will, at a future date, become entitled to acquire.

TEI objects to the extension of the control test to transactions between parties to a venture where one party has at least 40-percent control. The expansion will only serve to increase incidents of double taxation and make competent authority proceedings more difficult. It especially overreaches to include in the definition of control interests that a party may acquire in the future. In respect of neither the 40-percent test nor the future interest case would the party so associated be in a position to control commercial relationships with his fellow associates. Such transactions should be brought within the scope of the legislation only where the parties are shown to have acted in concert to exercise control in a way that creates a tax advantage in the United Kingdom. In other words, the reality of control should be decisive, not its form.

C. Secondary Adjustments. The Consultative Document announces that the Government does not now propose to require secondary adjustment and solicits comments on this issue. TEA agrees that such adjustments should not be required by law or administrative policy because they add unnecessary complexity and are difficult to deal with in competent authority proceedings. Taxpayers should be permitted to determine whether a secondary adjustment is appropriate.

If no corresponding adjustment were made, the taxpayer's U.K. accounts would effectively reflect an implied dividend or outstanding trade receivable. A constructive dividend approach should not be adopted. The normal penalty provisions provide for an adequate sanction to culpable infractions.

Administrative Issues

In respect of the proposed administrative procedures, TEI is concerned about the management of enquiries, documentation, and penalties. We also offer comments on advance pricing agreements and profit-based methods.

A. Management of Enquiries. TEI is concerned about the management of transfer pricing enquiries by Wand Revenue. No matter how responsive taxpayers may be, it may be years before such enquiries are finally resolved. Changes in Inland Revenue and company personnel and inefficient development of cases at the District level before transfers to Head Office contribute greatly to these delays.

Better management is required. More focused training is needed in this specialist area to facilitate the timely conclusion of enquiries. In addition, consideration should be given to adopting a time limit on settling enquiries, effectively restricting the six-year statute of limitations, or establishing a specialist tribunal independent of the General or Special Commissioners to arbitrate disputes that exceed the time limit (while keeping matters open for competent authority claims). Long running enquiries are not in the best interest of either the Inland Revenue or taxpayers, especially in light of the pace of change in the commercial world. We support the development of more detailed proposals to ensure that enquiries are handled speedily, fairly, and with appropriate resources.

An effective review mechanism for submitting cases to Head Office is still required. The draft administrative guidelines to Inspectors represent a good start, and we strongly agree with the proposal to have cases submitted before a notice of closure is issued. We recommend, however, that cases be mandatorily submitted to Head Office in the following circumstances:

* where significant adjustments (say, 10m [pounds sterling] to profits) are claimed or may result;

* where a case remains unsettled after three years; or

* at taxpayer's request where a case has been under review for two years at the District level.

Taxpayers also encounter delays where disputes are referred to the Special Commissioners for determination. By default, jurisdiction should lie with the General Commissioners, who -- with their commercial backgrounds -- are as capable of determining the facts as the Special Commissioners. As in other cases, either party should be permitted to ask the General Commissioners to transfer jurisdiction to the Special Commissioners if there is a material point of law in dispute or the facts are unduly complex.

B. Documentation. We are pleased that the U.K. Government has decided that specific transfer pricing information need not be submitted with the tax return, and that a decision to examine a particular taxpayer's transfer pricing will be taken on the basis of information available to the Inland Revenue.

Certainly, taxpayers must be prepared to provide whatever documentation is reasonably required to discharge their burden of proof and to show that to the best of their knowledge and belief the return is complete and accurate. Current law requires the taxpayer to keep and preserve "all such records as may be required for the purpose of enabling him to make and deliver a correct and complete return." According to the Consultative Document, the Inland Revenue expects documentation to be created and retained in relation to a taxpayer's transfer pricing arrangements in accordance with the same prudent business management principles that would govern the process of evaluating a business decision of a similar level of complexity and importance. Appendix II notes:

Taxpayers am only expected

to prepare or retain such

records if they are indispensable

for a reasonable assessment

of whether the taxpayer's

transfer pricing arrangements

reflected in its tax returns

satisfy the arm's

length principle and can be

prepared or retained by the

taxpayer without a disproportionately

high cost being

incurred. (Emphasis added.)

In the area of transfer pricing, documentation requirements can become very burdensome. We recognise that a reasonable balance must be struck between commercial practice and fiscal obligations, and that the Inland Revenue is trying to achieve such a with the "prudent businessman" test and cost-benefit approach. As currently set forth in Appendix II of the Consultative Document, however, the balance is tilted too much in favour of the Inland Revenue."

In some cases, documents relating to third-party agreements that a prudent businessman would retain may be limited to the final agreement itself, rather than the paperwork leading up to that agreement. In large the paperwork may be widely dispersed, unduly laborious to obtain, and difficult to interpret accurately out of context. It should be sufficient that the taxpayer makes a effort to identify and rereasonable view third-party transactions that might be relevant to the transfer pricing analysis and document that portion of the third-party information.

Further, paragraph 11 of Appendix II states that the taxpayer is not required to consider comparable data from a transaction where the taxpayer was not a party unless such data are "available to them." The term "available" should be clarified. For example, a requirement that the taxpayer search public databases or information about third-party transactions is costly, yet -- if the term is not better defined -- such information could be considered "available" to taxpayers. We believe this result is inappropriate. The expectation that the taxpayer retain data on relevant comparables should be sufficient to meet the Inland Revenue's reasonable review needs. Similarly, the requirement that a record of all budgets or forecasts be prepared may be too broad. Again, an expectation that the taxpayer retain any budgets or forecasts relied upon in setting the transfer pricing should be sufficient.

It is unrealistic to expect that companies can keep such a broad range of documentation for the length of time required by the Inland Revenue. Prudent taxpayers will keep core documentation on a contemporaneous basis where it is relevant to transfer pricing considerations. Rather than specifying what is expected, and what is not, it would be better to follow the approach of the OECD and specify the type of records that could be useful to taxpayers in determining the arm's-length nature of their prices, and then leave taxpayers discretion to decide what to keep and for how long. To the extent taxpayers are unable to produce such documentation on audit, or provide an acceptable explanation of why certain types of record were not prepared or retained, those facts should be taken into account in assessing culpability.

C. Penalties. Because U.K. law does not currently incorporate the OECD standard for use of the arm's-length standard, non-arm's-length pricing structures are not subject to penalties. The proposed legislation requires taxpayers to adhere to the international norm and subjects deviations from the arms-length standard to the general penalty provisions for incorrect returns, accounts, or claim The Government does not propose, however, to introduce specific penalties for failure to comply with the standard.

TEI agrees that the ordinary penalty rules should be sufficient to deter noncompliance. Where culpability is established, the normal consequences should follow This makes for a level playing field. In such a subjective area as transfer pricing, however, the question of culpability is often difficult to determine. It has been said that transfer pricing is an art, rather than a science. There is normally no single arm's-length price, but rather a range of acceptable prices that may apply. Where taxpayers have taken reasonable steps on a contemporaneous basis to document their transfer pricing policy, it should automatically satisfy the "reasonable attempt" test if the pricing is subsequently found incorrect by the Inland Revenue or the Commissioners. Additionally, a material difference between the tax liability computed by the taxpayer and that asserted by the Inland Revenue should not be considered neglect if the taxpayer has acted reasonably in documenting the transfer pricing policy. The use of penalties should be especially tempered in transfer pricing cases, where the law and facts are often unclear.

Further, minor deviations from the range of acceptable arm's-length prices should not be considered negligence. Although we believe that the tolerance-range approach (where the amount of the penalty varies according to the amount of the deviation from the norm) established in the United States may be too restrictive, the United Kingdom may wish to consider imposing penalties based on the relative size and gravity of the infraction. One factor to be considered is be the size of the adjustment in relation to the number or volume of a taxpayer's cross-border transactions.

The Consultative Document provides that penalties may be mitigated where the taxpayer has disclosed any irregularities and otherwise cooperates with Inland Revenue's enquiries. TEI commends the Government for its reasonable approach, but suggests that staunch defence of the taxpayer's pricing policy or the use of the mutual agreement procedure should not be viewed by itself as uncooperative. Finally, the threat of penalties should never be used as a bargaining tool. Penalties should be used to punish culpable behaviour, not to force taxpayers to concede inappropriate adjustments to their tax liabilities.

D. Advance Pricing Agreements. TEI strongly supports a broad, accessible, responsive, and flexible advance pricing agreement (APA) programme, which permits taxpayers to obtain more stability and certainty in their international business transactions. AFAs allow multinational enterprises and tax administrations to resolve fact-intensive transfer pricing issues in a practical and arm's-length manner in a less adversarial and more cost-effective environment.

Although the United Kingdom will entertain APAs under the Mutual Agreement procedure of bilateral tax treaties, this technical framework may be too restrictive. It does not permit unilateral or multilateral APAs and provides no flexibility to handle future or proposed transactions. In addition, an APA under the Mutual Agreement procedure may have to follow the strict flow of the transactions rather than the economic and practical substance of the taxpayer's business structure. A unilateral agreement may well prove useful, giving taxpayers comfort that Inland Revenue will support their pricing methodology if the matter were ever disputed by other competent authorities.

TEI recommends that the Wand Revenue develop formal procedures to facilitate APAs, whether on a unilateral, bilateral, or multilateral basis. Public comments should be requested and the programme should be easily accessible to large and small enterprises. A formal APA procedure provides a framework for more flexible negotiations than under today's informal conventions. We recognise that at least initially such a programme may require the dedication of qualified resources, and perhaps even a "rationing" of availability to material and important cases. With goodwill on both sides, the procedures should set a goal for reaching a positive conclusion to APA discussions within six months.

E. Profit-Based Methods. Although the OECD transfer pricing guidelines permit use of certain profit-based methods, tax administrations are often reluctant to go beyond the traditional transaction-based methods. In today's complex international business environment, however, it is not uncommon for taxpayers to rely on such methods for intercompany transactions. TEI recommends that the Inland Revenue affirm that these types of methods will be acceptable where the taxpayer demonstrates the method produces a reasonable arm's-length result.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the Consultative Document. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEIs International Tax Committee, at 1-312-750-5074, Lisa Peschcke-Koedt, chair of the TEI Task Force on Members Overseas, at 41-22-780-8586, or Mary L. Fahey of the Institute's professional staff at 1202-638-5601.

(1) As a rule, profits derived by an enterprise are taxable only by the country in which the enterprise resides. Article 9(1) of the OECD model treaty permits a country to depart from this general rule by adjusting the profits accruing to a domestic enterprise that is associated with a foreign enterprise, to the extent the business profits are affected by terms and conditions differing firm those customary between independent entities. The profits may be reallocated only according to the arm's-length principle.

(2) Organisation for Economic Cooperation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (1995).