Transfer pricing

2nd Annual Centre for Tax Policy and Administration Roundtable: Business Restructuring



On January 26-27, 2005, the Centre for Tax Policy and Administration sponsored its 2nd CTPA Roundtable.  The program was focused the tax implications of cross-border Business Restructuring and was attended by over 100 participants. Government representatives from both OECD Member Countries and Non-OECD Economies were able to engage in a lively dialogue with private sector participants in an attempt to understand the economic and tax issues which are involved in the accelerating changes taking place in the structure of business models. 

Economic and commercial background of business restructuring

The discussion began with a description of the cross border restructuring activities which had taken place in a number of multinational business organizations.  A common pattern clearly emerged with businesses, regardless of their products or sectors,  increasingly reorganizing their structures to provide more centralized control and management of manufacturing, research and distribution functions.  The pressure of competition in a globalized economy, savings from economies of scale, the need for specialization and  the need to increase efficiency and lower costs were all clearly important driving business restructuring. The changes in the business model  typically consisted of “stripping out” functions, intangible assets and risks which were previously integrated in local operations and transferring them to more centralized and specialized regional or global units. In the view of the business representatives,  tax considerations by themselves were generally not the principal motivating factors for the restructurings, though tax considerations clearly played a role in the way in which the details of the revamped operations were set up.  From the perspective of the host country tax administrators, they were generally seeing reduced profits being generated in their jurisdictions as a result of the changes in the business models.  In the light of  this background, the tax issues involved in restructuring transactions were then discussed in more technical detail.

Tax aspects of the transactions undertaken as part of the restructuring

When a restructuring is asserted to have taken place, the first question raised from a tax point of view is whether there have actually been any changes in the functions or activities of the local operations which justify different tax treatment.  There was agreement on all sides that an alleged  restructuring done with “smoke and mirrors” cannot justify any changes in the profit levels of the local operations.  Changes in function, risk and use / ownership of assets must be agreed on and carried out. In some cases, it  may be  difficult to determine which risks and functions have been modified.  For example, a shift of credit risk may be possible by simply changing the legal responsibility for the obligations but in other cases, there will need to be an actual change in ownership of assets and location of personnel. 

Beyond these issues, another difficult question involves the tax implications of the restructuring itself.  In some cases, the local operation will have developed valuable intangibles which are in effect transferred in the restructuring to other members of the group.  This could arguably involve, for example, the switch from a full fledged distributor to a  commissionnaire, where marketing intangibles, goodwill, clientele, and the like are involved (but there is not one single view on this issue).  In the case of a change from full fledged to contract or toll manufacturing, there might be a transfer of process intangibles developed locally.  In addition, initial costs may have been incurred which have not yet been fully recovered.  In these cases, it will be necessary to identify whether in effect an intangible is being transferred and where this is the case what is the transferred value to quantify its appropriate remuneration.  In other cases, however, the change in function  may not in fact involve any value transfer, for example, a change in the purchasing function of readily available raw materials.  As several participants pointed out, the existing Transfer Pricing Guidelines (“TPG”) give general guidance with respect to these issues but there is clearly a need on the part of both business and tax administrations to refine the issues further to come to an agreed position.

Determining the income of the limited function entity

Assuming that there is an effective change in the profile of the local operations, the next tax issue considered was the appropriate compensation for the new, more limited functions.  There the crucial question is the degree to which the activities have been changed.  It was recognized that there is a spectrum of possibilities.  For example, a full fledged distributor could be restructured as a representative office, with all significant activities being carried out by the principal, as a “buy-seller” distributor or as a commissionaire.  Each situation is fact specific and here the application of principles of the TPG can give guidance in determining the appropriate arm’s length charge.  Depending on the assets, risks and functions involved, the usual methods, CUP, cost plus, resale price minus, profit split, TNMM, etc. will be appropriate.

A more difficult conceptual issue is the relation between the profitability of the “stripped” entity and the prior profitability of the “full fledged” operation.  Assuming that all of the identified functions of the limited function entity have been adequately compensated, what has happened to any “excess” profit which was previously earned by the full fledged entity?  In part, this may have to be accounted for by focusing on any intangibles transfers which took place at the time of the restructuring.  Beyond this, however, what may in fact be involved is some kind of sharing in the economic rent generated by the prior participation in the overall activities of the group which is now not available to the limited function entity. How to account for this “industrial organization” intangible is not clear and is an issue which must be considered further as it has important implications for all of the transfer pricing work.

Permanent establishment issues

A further question was raised as to whether and in what circumstances the activities of a limited function entity can deem a permanent establishment to exist   for  the foreign related party for which the entity is acting.  The technical issues discussed included the circumstances in which the separately organized limited function entity could be considered “independent” and thus not trigger the application of the deemed  permanent establishment rule of  the existing treaty definition.  In determining independence, one important factor is the extent to which the entity’s business activities are restricted to transactions on behalf of the related party.

If the agent is dependent and thus potentially a permanent establishment, there is also a question of whether it is carrying on activities sufficient to qualify it as a permanent establishment.  In particular, an issue was raised  under para. 5 of Article 5 of the Model Convention.  That paragraph requires that, in order to find the existence of a permanent establishment,  the agent must have the “authority to conclude contracts” in the name of the principal.

A particular problem arises in the case of the civil law institution of the commissionnaire.  There the local commissionnaire is typically acting in its own name.  As a private law matter, the commissionnaire’s actions do not bind the principal contractually, even though the principal may have responsibility for the delivery of the goods and their quality.  (This situation is to be contrasted with the most analogous common law institution, an agent acting for an undisclosed principal, where the principal is contractually bound by the agent’s actions). While some private sector representatives took the position that a commissionaire could never in theory create a dependent agent PE under Article 5(5) on the grounds that a commissionaire, acting as such, does not exercise an authority to conclude contracts in the name of its principal, some government representatives were of the view that the substance of  the commissionaire’s activities gave it sufficient authority to bind the principal’s participation in the host country and thus justified taxation of amounts beyond the income allocated to the commissionaire for its own activities.

Assuming that the activities of the limited function entity constitute a permanent establishment, there is the additional issue of the appropriate attribution of profits to the deemed permanent establishment.

Here the recently published discussion draft on the attribution of profits gives useful guidance in determining the quantum of profit. In many cases, even if a permanent establishment is present, there will be relatively little profit attribution given the limited activities of the local entity.

Several business sector participants raised the procedural issues which occur where a permanent establishment is found subsequently to exist because of the activities of the limited function entity.  Typically, no tax return will have been filed by the principal in its own name and there will be no separate books and records relating to the deemed permanent establishment.  There was general agreement that it would be useful to do further work in clarifying and perhaps reexamining the role of the dependent agent definition in the light of the issues raised at the Roundtable.

VAT aspects

Changes in supply chain structure have important implications for VAT as well as for direct taxation. Since 29 of the thirty OECD countries have a VAT, cross border VAT issues are of increasing importance to both business and government. This is an area in which the European Union has been active and the Centre work on business restructuring needs to take those developments into account. The “standard” treatment of taxing imports and zero rating of exports is difficult to apply to the more complicated distribution arrangements which have been developed as part of business restructuring. Under the new distribution framework, manufacturing, ordering and invoicing are now all separately structured and the “chain” of supply is more complex.  Another important issue is the relation between the permanent establishment concept in direct taxation and the “fixed” establishment requirement when VAT is involved.  There were a variety of views on whether it would be desirable to try to develop a unified concept to cover both situations.  However, the predominant view was that while this would bring about a degree of simplification, it would also raise some problems as the functions of the two definitions is different.

Follow-up on business restructuring issues

Selected papers presented at the Roundtable are available on an Internet site dedicated to the Roundtable.  A Joint Working Group of governmental experts in treaty and transfer pricing issues has been established to examine further some of the treaty and transfer pricing issues raised at the Roundtable and will report on its work in due course.  The Centre encourages  communications from interested parties concerning the topics raised here. Selected contributions will be posted on the Roundtable Internet site where a discussion of these issues can go forward.

Coming events

The next CTPA Roundtable is scheduled for January, 2006.






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