OECD draft transfer pricing guidelines.

On May 26, 1995, Tax Executives Institute filed the following comments with the Organisation for Economic Cooperation and Development (OECD) on Part II of the OECD's draft Transfer Pricing' Guidelines for Multinational Enterprises and Tax Administrations. The draft guidelines were released earlier this year by the international organization's Committee on Fiscal Affairs. The final report is expected to be issued later this summer TEI filed comments on December 2, 1994, on Part I of the Draft Guidelines (which were reprinted in the January-February 1995 issue of The Tax Executive). TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Philip J. Bergquist of Apple Computer, Inc. Contributing materially to the development of the Institute's submission were Robert Lamm of the Aluminum Corporation of America, James A. McFall of Xerox Corporation, Lisa Norton of Ingersoll-Rand Company, Lisa Peschcke-Koedt of Hewlett-Packard Co., and James Williams of Northern Telecom Inc.

This letter responds to your March 9, 1995, request for comments on the discussion draft entitled, OECD Draft Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Part II: Applications (hereinafter referred to as the "Draft Guidelines" , which was released by the Committee on Fiscal Affairs of the Organisation for Economic Co-operation and Development. TEI filed comments on December 2, 1994, on Part I of the Draft Guidelines and is pleased to have this opportunity to comment on Part II.

The Institute commends the OECD Committee on Fiscal Affairs for its work on the Draft Guidelines. There is a critical need for international uniformity in the transfer pricing area, and the Institute encourages the OECD to take a leadership role in establishing fair and consistent policies, especially in respect of the penalty and contemporaneous documentation rules.

Background

Tax Executives Institute is the principal organization 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 non-profit 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 governments alike. As a professional association, TEI is firmly committed to maintaining tax systems that work - systems that are administrable and with which taxpayers can comply.

A substantial number of TEI members work for multinational companies that engage in international trade, including many non-U.S. owned enterprises. 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. Consequently, TEI members have a special interest in the Draft Guidelines.

Chapter IV: Intangible Property 

A. Definition. Chapter IV of the Draft Guidelines discusses the special considerations arising from transactions between related entities involving intangible property. The term "intangible property" includes rights to use industrial assets such as patents, trademarks, trade names, designs or models, literary and artistic property rights, and intellectual property such as know-how and trade secrets.(1)

TEI recommends that the definition of intangible property be expanded to include computer software. The current language is ambiguous because computer software is normally protected by a copyright, rather than a patent, and in some countries may be considered artistic, rather than industrial, property. In those instances where it is licensed rather than sold, computer software is similar to other industrial intangible property and should be included in the definition.

B. Application of the Arm's-Length Principle. Chapter IV also discusses the application of the arm's-length principle to transactions involving intangible property. The Draft Guidelines recognize that in cases involving high-profit intangibles, "it may be difficult to find transactions between independent enterprises that are sufficiently close in their transactional features to the controlled transaction to achieve adequate comparability for the transaction-based methods." The Draft Guidelines note that "it may be useful as a last resort to take account of evidence provided by profit methods."(2)

As TEI stressed in its December 2 comments, profit-split methods may be especially relevant where the taxpayer or multinational enterprise (MNE) has valuable, unique intangibles. We agree with the Draft Guidelines that transactions between unrelated entities involving a high-profit intangible are "infrequent"(3); indeed, they are almost non-existent. We therefore believe that a comparable uncontrolled price (CUP) approach will generally be unavailable for valuable intangibles and that a profit-split method may be appropriate in such cases.

The final Guidelines should acknowledge that the profit-split method (including a residual profit-split method) is often the only reliable method available where valuable intangibles are involved. In some cases, the use of costs (e.g., in respect of research and development) may be an appropriate way of applying a profit-split method.(4) Of course, taxpayers using a profit-split approach should provide reasonable financial documentation to the tax administration in support of that methodology.

C. Periodic Adjustments. The Draft Guidelines discuss the propriety of using periodic adjustments, particularly in years following the year of the transfer. The draft states:

Thus, future adjustments

will be limited to those exceptional

cases in which associated

enterprises have

sold or licensed intangible

property under fixed terms,

for multiple years where

comparable independent enterprises

would have insisted

on bonus payments, a

price adjustment clause, or

would have been able to

achieve a renegotiation of the

contract. In determining

whether independent enterprises

would have maintained

fixed terms for a

transfer, one consideration

that tax administrations may

take into account is whether

actual profit experience has

been inconsistent with that

anticipated by the associated

enterprises in the projections

made at the time of the initial

transfer. The existence of

such an inconsistency would

not by itself be sufficient to

justify an adjustment by the

tax administration. Rather,

the question to be asked is

whether the variation in actual

profit experience is attributable

to factors that

could not reasonably have

[been] anticipated. Where

profit experience has been affected

by such unanticipated

factors, an adjustment to future

consideration would not

generally be appropriate,

since parties at arm's length 

would not have considered

those factors in determining

whether to adopt fixed terms

for the agreement.(6)

TEI agrees with the OECD's approach, but is concerned about the interaction between the Draft Guidelines and the U.S. transfer pricing rules. Section 482 of the Internal Revenue Code requires the income from the transfer of intangible property to be "commensurate with the income" from that property. The U.S. section 482 regulations require periodic adjustments to be made. The regulations also may require a taxpayer to adjust the results in its tax return to reflect an "arm's-length" compensation, even though the actual transactions are final, unrelated parties would have been bound by a contract that precluded further adjustments, and the adjusted return will not reflect the book results.(7)

The final guidelines should state even more forcefully, however, that tax authorities should focus on what was arm's length at the outset of the transaction. TEI members' experience is that, with very few exceptions, unrelated parties do not contract to adjust compensation subsequent to a binding agreement.(8) TEI believes that tax administrations should focus on the information available at the time of the transaction and on whether the taxpayer acted reasonably based on such information. The Draft Guidelines properly look to whether third parties would have agreed to adjust or to renegotiate under the same facts and circumstances. Such third-party information should determine whether adjustments based on subsequent events or conditions and any type of retroactive adjustment based on information or other data occurring after the transfer price was established should be accepted.

We urge the OECD to maintain its position on this critical point and adjure other member countries (including the United States) to follow suit. Specifically, the United States should be encouraged to narrow significantly the circumstances under which periodic adjustments will be required.

D. Examples. TEI endorses the OECD suggestion of incorporating examples in this section. If the United States continues to hold to its views on periodic adjustments, we suggest the inclusion in the final guidelines of an example to address the divergent approaches. The example should emphasize that no adjustment would be made based on data arising after year end.

Chapter V: Intragroup Services

A. Shareholder and Stewardship Activities. Chapter V of the Draft Guidelines discusses issues arising in conjunction with the provision of services by one MNE member for another.(9) The draft distinguishes between (i) "shareholder activities," which are generally performed by another member solely because of its ownership interest in one or more groups members, and (ii) "stewardship activities," which cover a range of activities by a shareholder (including detailed planning services for particular operations, internal audit, or trouble-shooting). The draft concludes that shareholder activities generally do not justify a charge to recipient companies, whereas stewardship activities (that are not duplicative) may.(10) TEI believes the distinction between "shareholder" and "stewardship" activities" is helpful.

B. Arm's-Length Charge. The Draft Guidelines state a preference for a "direct-charge" method (i.e., charging for specific services) of determining an arm's-length charge for services between related entities. The draft notes, however, that a direct-charge method is generally difficult to apply in practice. In such cases, the draft concludes that MNEs may find they have few alternatives but to use cost allocation and apportionment methods (referred to as "indirect-charge methods").(11)

TEI commends the OECD for recognizing the practical difficulties that arise when intra-company services are rendered across international borders. We support the general cost-plus approach to valuing services based on the anticipated benefits where the provider is not in the trade or business of providing such services. In these circumstances, a fair market valuation using comparables is rarely available and cost-plus should provide a fair return to the service provider.

Chapter VI: Cost Contribution Arrangements

A. Valuation. The Draft Guidelines raise the question whether costs of a capital nature should be allocated based on the relative use of the capital asset in the activity using either fair market value or book depreciated value as the measure of the total cost.(12) TEI believes that, based on the administrative ease of application, the allocation should be based on book depreciated value. Like any tax issue using fair market value, attempting to use fair-market-based depreciation would introduce a highly contentious element to the cost-sharing arena that can only lead to more, rather than fewer, disputes between countries.

B. Net Costs. The Draft Guidelines observe that generally only net costs may be subject to allocation. The second, bracketed sentence of Paragraph 106 states: "This means for instance that any license receipts or receipts from an ancillary sale of research assets should be deducted from the amount to be allocated among the participants."

In some instances - e.g., where the allocation formula is based on sales of, and royalties received from the license of, developed property - such license receipts should be included in the allocation formula, rather than deducted from sharable costs. Licensing developed property is simply another method of commercially exploiting the property and the resulting license receipts/royalties should be treated the same as outright sales of the developed property. In addition, adding license receipts/ royalties to sales in the allocation formula is used in actual cost-sharing arrangements. Thus, TEI suggests that the second sentence be modified by replacing 'should" with "may." In addition, the OECD should clarify that it is also appropriate for such licensing receipts to be included in the allocation formula with sales, rather than deducted from the sharable costs.

C. Government Subsidies, Incentives, and Tax Credits. The Draft Guidelines state that "[i]t would ordinarily not be expected that the [cost-sharing] arrangement would take into account any subsidies or tax incentives (including tax credits on investments) that a particular participant may be granted by a government in allocating costs..." An exception is made, however, "where the subsidies accrue because of the activity undertaken by the cost contribution group."(13)

TEI agrees that, as a general matter, government subsidies, incentives, and tax credits should not enter into the allocation formula, though we acknowledge that the cost allocation should be reduced by the amount of any direct government subsidies, such as grants or the provision of services or goods. The Draft Guidelines seem to distinguish between such government subsidies and tax credits - and properly so. We recommend that the exception be clarified to confirm this distinction.

D. Use of Non-Financial Indicators. Chapter VI of the Draft Guidelines discusses the use of cost contribution arrangements, i.e., where members of an MNE group acting in concert jointly produce or provide goods, intangible property, or services, or jointly acquire goods, intangible property, or services from a third party.(14) The draft recognizes that, in allocating costs, non-financial indicators - such as number of employees, production capacity, and staff time - may be appropriate.(15) TEI supports this approach.

E. Buy-Ins/Buy-Outs. The Draft Guidelines acknowledge that, while payment may be appropriate in some cases, the entrance or withdrawal of a participant may not produce a benefit or detriment to the other participants "so that there would be no transfer for which compensation was required."(16)

TEI applauds this practical approach. Requiring the remaining members to make a buy-out payment to an abandoning member would impose an unjustified hardship to the remaining members, particularly if no benefit (in the form of a useable intangible or more expansive rights to exploit the intangible) is conferred on the continuing member. In addition, it may be inequitable to apply a buy-in rule to basic research costs that precede the formation of a cost-sharing group or the entry of a new participant. Buy-ins and buy-outs should

Chapter VII: Administrative Approaches

A. Penalties. The Draft Guidelines recognize that appropriate penalties may play a role in addressing compliance concerns. The draft cautions, however, that the administration of a penalty system as applied in such cases must be fair and not unduly onerous for taxpayers.(17)

Operating in an environment where one country imposes stringent rules that other countries do not accept places the taxpayer in an untenable position of complying with the rules in the most stringent jurisdiction (often to the detriment of other countries), accepting the exposure to double taxation, or both. TEI strongly encourages the OECD to press for consistency between the U.S. approach to penalties (especially in respect of documentation and post-year end compensating adjustments) and that of other OECD members. Moreover, competent authorities should be given the power to relieve taxpayers from penalties in appropriate cases. Without such authority, taxpayers will still be subject to a form of double taxation.

The Draft Guidelines' also suggest that in certain cases it may be appropriate for both competent authorities either to agree not to assess interest from the taxpayer or to pay interest to the taxpayer in connection an adjustment.(18) TEI wholeheartedly agrees.

B. Mutual Agreement Procedures and Corresponding Adjustments. The Draft Guidelines discuss Articles 25 and 9(2) of the OECD Model Tax Convention, which deal, respectively, with the mutual agreement procedure and corresponding adjustments.(19)

Because of the complexity of multinational business, more than two parties in the MNE may be affected by any transfer pricing adjustment. For example, assume a factory in country X sells to a reinvoicing center in country Y that sells to a sales affiliate in country Z, and the factory bears the economic burden of any costs or risks incurred by the entities downstream. In that case, a transfer pricing adjustment between the sales affiliate and the reinvoicing center undeniably affects the factory. The OECD guidelines should recognize this reality by encouraging the involvement of the competent authorities of the other affected jurisdiction(s). Thus, in this example, the affected party in country X, and its competent authority, should be included in the settlement discussions.

Moreover, to ensure that the treaty network operates to minimize double taxation, OECD member countries should explore possibilities for managing and concluding cases that involve more than two treaty partners. Specifically, TEI recommends that the OECD establish procedures for multi-jurisdictional cases, including opportunities for taxpayer involvement to enable the respective governments to, be more efficient in information gathering.

C. Safe Harbors. The Draft Guidelines express concern that safe harbors may open up avenues for improper tax planning.(20) The draft states that safe harbors are "generally not compatible with the enforcement of transfer prices consistent with the arm's length standard."(21) The draft concludes that the use of safe harbors is not recommended.(22)

TEI is disappointed in the Committee's draft recommendation concerning the use of safe harbors. We believe that safe harbors promote certainty and ease of administration in an area fraught with complex factual determinations. Indeed, the benefit of certainty often outweighs the income tax detriment taxpayers may incur in following a safe harbor. Moreover, taxpayer adherence to safe harbors will preserve limited government resources to focus on abusive transfers. Many situations are meritorious for safe harbor consideration, including (i) joint ventures where an unrelated party owns a significant interest, and (ii) long standing pricing methodologies that have been examined and accepted by tax administrations. We urge the OECD to reconsider its recommendation.

D. Advance Pricing Agreements. The Draft Guidelines discuss the use of Advance Pricing Agreements (APAs) and conclude that the "success of the APA program will depend on the care taken in determining the proper degree of specificity for the arrangement, based on critical assumptions, the proper administration of the program, and the presence of adequate safeguards to avoid ... pitfalls ... in addition to the flexibility and openness with which all parties approach the process."(23)

TEI supports a broader and more accessible APA program. The costs of establishing the program are generally outweighed by the significant benefits to both taxpayers and tax administrations. Even for taxpayers with a history of voluntary compliance, the availability of a bilateral or multilateral APA is important. The Draft Guidelines express concern that audit resources and expertise may be diverted to negotiating an APA with a taxpayer with a "good voluntary compliance history."(24) We agree that the concern is a legitimate one, but given the size and complexity of most MNE operations, tax administrations already expend considerable resources in auditing such "good" taxpayers. This expenditure could be reduced significantly if an APA were executed. TEI urges the OECD to support the APA program and the allocation of sufficient tax administration resources to the process.

The Draft Guidelines also state that the first taxpayer in an industry reaching an APA may set a standard for its competitors, noting that this should be avoided.(25) TEI agrees. Tax administrations should not apply the data or results of one APA to other unrelated taxpayers. Other taxpayers would not have access to any confidential facts or data, end thus would be unable to analyze or defend against an inappropriate adjustment based on that information. Consequently, TEI recommends that the OECD guidelines explicitly state that the information or results under an APA with one taxpayer should not be used in auditing an unrelated taxpayer.

E. Arbitration. The Draft Guidelines state that it "seems appropriate to analyze again and in more detail whether the introduction of a tax arbitration procedure would be an appropriate addition to international tax relations."(26)

TEI believes that arbitration procedures - such as those specified in the U.S.-Germany Tax Convention and the U.S.-Mexico Treaty - represent a positive development in tax administration. We recommend that the OECD provide for mandatory arbitration where the competent authorities are unable to agree within a specified time period (say, two years). We suggest an appropriate model for the arbitration mechanism is the European Economic Community Model. See Convention on the Elimination of Double Taxation in Connection with the Adjustments of Profits of Associated Enterprises 90/463/EC (as agreed by the EEC members on July 23, 1990).

Chapter VIII: Documentation

Chapter VIII of the Draft Guidelines provides general guidance for tax administrations to take into account in developing rules and procedures on documentation.(27) The draft states that a taxpayer ordinarily should give consideration to whether its transfer pricing is appropriate for tax purposes before the pricing is established.(28) The draft suggests that the taxpayer's process of setting its transfer pricing should be determined in accordance with "the same prudent management principles that would govern the process of evaluating a business decision of a similar level of complexity and importance."(29) The taxpayer should not be expected to incur disproportionately high costs and burdens to obtain documents from foreign associated enterprises or to engage in an exhaustive search for comparable data from uncontrolled transactions, based on a reasonable belief that no such data exists or the costs of retrieval would be disproportionately high relative to the amounts at issue.(30) The draft also suggests that the amount of information required at the tax return filing stage should be limited to data sufficient to allow the tax administration to determine approximately which enterprises need further examination.

TEI generally endorses the OECD's approach to documentation. The OECD should emphasize the critical nature of uniform requirements concerning the scope and substance of the required documentation, including whether documentation must be prepared at the time of filing a return or only for audit, whether information is required that is not available at the time transfer prices were set, and what is a reasonable burden to impose on MNEs in this context. TEI also suggests that the OECD undertake further study in this area and, in particular, strive toward reaching a consensus among the member countries.

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on Part II of the Draft Transfer Pricing Guidelines. If you have any questions, please do not hesitate to call Philip J. Bergquist, chair of TEI's International Tax Committee, at [phone], or Mary L. Fahey of the Institute's professional staff at [phone].

(1) Draft Guidelines [paragraph] 2. (2) Draft Guidelines [paragraph] 25. (3) Id. (4) Draft Guidelines [paragraph] 26 ("the costs incurred in developing or maintaining the intangible property might be examined as an aid to determining comparability or possibly relative value, particularly where a profit split method is used" . (5) Draft Guidelines [paragraphs] 9 33-41. (6) Draft Guidelines [paragraph] 40 (emphasis added). (7) Treas. Reg. [sections] 1.482-4(f)(2). (8) As we noted in our December 2 comments, third parties generally set prices based on expected costs, volume, profitability, etc. In some cases third parties may also agree to compensate an entity based on actual costs or results or to renegotiate or reset prices, even retroactively, if significant changes occur. (9) Draft Guidelines [paragraphs] 47-92. (10) Draft Guidelines [paragraphs] 55, 57. (11) Draft Guidelines [paragraphs] 65, 67, and 68. (12) Draft Guidelines [paragraph] 105. (13) Draft Guidelines [paragraph] 106. (14) Draft Guidelines [paragraph] 93. (15) Draft Guidelines [paragraph] 108. (16) Draft Guidelines [paragraph] 120. not be automatically required, but rather be evaluated on a case-by-case basis. (17) Draft Guidelines [paragraph] 140. (18) Draft Guidelines [paragraph] 39a. (19) Draft Guidelines [paragraphs] 145-157. (20) Draft Guidelines [paragraphs] 226-229. (21) Draft Guidelines [paragraph] 231. (22) Draft Guidelines [paragraph] 233. (23) Draft Guidelines [paragraph] 271. (24) Draft Guidelines [paragraph] 263. (25) Draft Guidelines [paragraph] 269. (26) Draft Guidelines [paragraph] 281. (27) Draft Guidelines [paragraphs] 282-310. (28) Draft Guidelines [paragraph] 284. (29) Draft Guidelines [paragraph] 285. (30) Draft Guidelines [paragraph] 287. (31) Draft Guidelines [paragraph] 296.