PWC TP Perspectives Europe e

Tax & Legal Services Transfer Pricing
Global Transfer Pricing Perspectives*

Europe, Autumn 2007
*connectedthinking
Transfer pricing
Transfer pricing is a multidisciplinary practice that involves close cooperation between subject matter experts in economic analysis, tax law and accounting. Our global network of dedicated transfer pricing professionals assist multi-jurisdictional companies with determining intercompany prices in accordance with the arms length standard. Intercompany pricing is applicable to companies conducting both international and domestic intercompany transactions. PwCs Transfer Pricing services include helping companies understand and assess the tax impact of business operations and transactions in multiple jurisdictions, allocate taxable profits to jurisdictions in accordance with tax jurisdiction regulations, understand the economic substance of the transactions and the arms length standard, and document and defend these positions. PricewaterhouseCoopers (www.pwc.com) provides industry-focused assurance, tax and advisory services to build public trust and enhance value for its clients and their stakeholders. More than 140,000 people in 149 countries work collaboratively using Connected Thinking to develop fresh perspectives and practical advice. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.
A note from Isabel Verlinden
Jean-Baptiste Colbert, French Finance Minister under Louis XIV in the 17th century, stated that the art of taxation consists in so plucking the goose to obtain the largest amount of feathers with the least possible amount of hissing With hindsight, one might think this was a commentary on transfer pricing some two centuries before the actual introduction of the concept known these days as tax authorities Number One Soft Target. One of the most challenging developments in international taxation has been the transformation of multinational companies into globally integrated businesses. The lure is both strong and legitimate to create business centres with pan-European responsibilities to replace the traditional country-by-country approach. But this transformation raises important questions. For example, if a group with a presence in multiple countries acts as a single operating unit, e.g., under clients pressure to deliver under one contract, the question arises how to allocate the overall income of the group to the various legal entities in the different jurisdictions. Is it productive to draw an imaginary borderline in the middle of a truly global supply chain so as to make sure each national jurisdiction gets a fair share of the tax pie? Further, one may wonder if it is worthwhile from a business perspective for tax authorities to look into the past to substantiate transactions that may have occurred years ago. Needless to say, such processes unavoidably lead to conflicts between the way management looks at things and the way their tax affairs are to be handled, when one or more tax authorities start plucking a goose whose existence has gone unnoticed for years. Witness the situation in which a group decides to relocate production capacity to a lower cost jurisdiction and the tax authorities in the transferring state assess a tax for (deemed) goodwill upon migration. Even if no infinitely
assured profit potential is transferred, upcoming German rules, for instance, require a compensation for transfer of a business opportunity. Unlike certain countries like the United States or Brazil, many European countries do not have an aggressive transfer pricing environment, primarily because legislators and administrative authorities are anxious to lure foreign investors. Consequently, a race to lower tax rates and to increase tax breaks has been marking the European tax arena. The flip side of these measures is that, in order to balance government budgets, measures to police transfer pricing are constantly being strengthened to safeguard effective enforcement and prevent artificial tax-base erosion. Such offensive initiatives, which are often accompanied by penalty regimes, are aimed predominantly at counter-attacking measures from overseas (either East or West or a combination of both) that incentivise taxpayers to over-apportion taxable profits to those regions to the detriment of their national budgets so as to avoid harsh audits and penalties. Luckily, the Joint EU Transfer Pricing Forum plays a pivotal role in mitigating the risk that compliance efforts will result in a disproportionate cost compared to possible transfer pricing adjustments and penalties. Milestone achievements by the Forum include not only the code of conduct on pan-European documentation, but also the consensus reached in terms of dispute Resolution initiatives on a pan-European basis, both before transfer prices are subject to the scrutiny of tax authorities (through an efficient advance pricing agreements infrastructure), or after (in the area of the arbitration convention). The business community can welcome the fact that its input has been heavily solicited by policy making bodies at both national and international levels, such as the OECD, e.g., the OECDs ongoing efforts in the area of
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International tax perspectives
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profit attribution to permanent establishments and business restructurings. Another positive development we have seen is that tax authorities are more often recognising the operational realities that mark specific industries, rather than applying merely theoretical transfer pricing enforcement rules. Indeed, both prefiling meetings with APA commissions and pre-audit meetings with field tax inspectors are proving to be helpful in communicating the specific business context in which transfer pricing rules should be assessed. This communication is particularly important in post-deal integration issues, where an effective dialogue between taxpayers and tax authorities is pivotal to ensure that sure transfer pricing audits focus on the essential. This means nothing more than enabling tax authorities to focus their attention on areas of risk that require further scrutiny rather than focusing on irrelevant details that do nothing more than waste valuable management time. There are other broad trends in European transfer pricing as well. For example, it is becoming increasingly complicated to assess whether the arms length principle should come into play. Indeed, many forms of cooperation with parties that are at first glance unrelated, such as when groups embark on open innovation
initiatives or joint development, risk being captured by transfer pricing rules at the end of the day. New EU accession states appear to struggle with this issue more so than mature transfer pricing countries. This phenomenon also arises in strategic supplier markets beyond the EU, such as Kazakhstan. I am confident that the following articles will assist you to step into the breach to safeguard the achievement of a sustainable and effective after-tax profitability to the satisfaction of all stakeholders in an increasingly complex business environment that is also marked by tight governance rules. Such an approach will therefore also balance the need for compliance by tax authorities with the need for businesses to achieve that compliance with reasonable efforts. I take pride in presenting to you in this issue a comprehensive overview of insights from our PwC European Transfer Pricing network, awarded last May for the third consecutive time as the European Transfer Pricing Firm of the Year by International Tax Review. Enjoy the reading! Isabel Verlinden Eurofirms Transfer Pricing Leader
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Table of contents
The EU transfer pricing landscape - a review of the regulatory environment OECD Business advisory group on business restructuring Dispute resolution, including tax audits, APAS, and rulings Dispute resolution in Belgium - the latest developments The APA landscape in Denmark, Finland and Sweden Dispute resolution and double taxation prevention in Germany International rulings in Italy: an opportunity for multinational companies Dispute resolution and double taxation prevention in France European Union transfer pricing documentation - the status of the EUTPD Industry specific Issues Transfer pricing in the automotive industry Pharmaceuticals and transfer pricing: An EU and German perspective Will your intercompany financial transactions withstand a transfer pricing audit? Integrating intellectual property pransfer pricing planning with early stage M&A post transaction activity OECD - Report on the attribution of profits to permanent establishments The European Commission European Court of Justice - the impact of case law on transfer pricing The European Commission - heading towards a common consolidated corporate tax base Central and Easter Europe: transfer pricing comes from behind Contacts Events The global core documentation implementation tool 1 9
17 21 27 31 37 41
47 53 59
65 71
77 83 93 99 101 103
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The EU transfer pricing landscape - a review of the regulatory environment
author
The EU transfer pricing landscape a review of the regulatory environment

The coexistence of 25 different direct taxation regimes is seen by some policy makers as an obstacle to an efficient and competitive single European market. Therefore, efforts are being made to reduce income tax compliance burdens and to alleviate double taxation within Europe. As part of this broader effort, the European Union (EU) Joint Transfer Pricing Forum (JTPF) has already adopted codes of conduct calling for (1) better adherence to the EU arbitration convention in order to assist taxpayers in avoiding double taxation on their intra-group trade within the EU and (2) the standardisation of EU transfer pricing documentation requirements across member states. However, despite the growing efforts being made by the JTPF towards standardisation, member states still adopt widely differing approaches to transfer pricing documentation and enforcement. This article presents a snapshot of the diversity evident in the European transfer pricing environment. Overview of the transfer pricing landscape in Western Europe
The table at the end of this article presents a summary of the transfer pricing environments in Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Portugal, Spain, Sweden, Switzerland1 and the United Kingdom (UK). The table portrays the local legislation, documentation requirements, level of enforcement activity, application of penalties, tax return disclosure requirements, guidelines on selection of comparable firms and each countrys approach towards Advance Pricing Agreements (APAs). As evidenced by the table, most countries in Western Europe have enacted transfer pricing regulations and implemented requirements for documentation. However, the extent of legislation and level of enforcement varies significantly from country to country. Fourteen of the sixteen countries have chosen to enact some form of transfer pricing legislation. The only two countries that have not yet done so are Ireland and Switzerland. Of those countries that have enacted transfer pricing legislation, only Belgium and Norway have not yet implemented documentation requirements. In Belgium, taxpayers are urged to compile documentation based on an Administrative Circular. Norway is expected to introduce documentation requirements as of 2008. Diversity is evident in the level of local enforcement. Tax authorities in Belgium, Denmark, France, Germany, Greece, Italy, the Netherlands, Norway, Sweden and the UK tend to be most active in enforcing transfer pricing rules, with the level of enforcement generally increasing in the remaining countries. While most countries do not require explicit disclosure of intercompany transactions on the corporate tax return, this is explicitly required in seven of the countries surveyed. Transfer pricing penalties vary widely across the sixteen countries, from no specific penalties (eight countries) to up to 200 percent of the underpayment in Italy. Local comparables are generally preferred when conducting benchmarking studies but in practice PanEuropean comparables are widely accepted in line with the EU Joint Transfer Pricing Forum code of conduct on documentation with certain exceptions. The tax authorities in Italy and Portugal only accept PanEuropean comparables under exceptional circumstances while in Norway and Spain such practice will only be accepted if local comparables are not readily available. Consistent with efforts to avoid double taxation, APAs have become accepted in many jurisdictions. However Denmark, Finland, Greece, Ireland, Norway, Portugal and Sweden have not yet formalised APA procedures. The German tax authorities will only accept bilateral APAs (as discussed in the article beginning on page XX).
To explore the diversity within the transfer pricing environment in Europe, seven countries have been selected for a more detailed analysis: Ireland, Finland, Spain, Belgium, France, the UK and Germany. These countries illustrate the various points on the continuum of European transfer pricing regulatory enforcement, from Ireland - which has limited transfer pricing legislation - to Germany, a country in the process of enacting aggressive transfer pricing legislation.
1 January 2007. The Finnish documentation rules conform to the principles established in the Transfer Pricing Guidelines for Multinational Enterprises (MNEs) and Tax Administrations (OECD Guidelines) as well as the Code of Conduct for Transfer Pricing Documentation in the EU. The Finnish rules provide that documentation establishing the arms length nature of transactions undertaken between related parties must be drafted for cross-border transactions. According to the rules, Finnish transfer pricing documentation should include a description of the business, related party relationships and transactions, as well as a functional analysis, comparability analysis, and description of the pricing method chosen and its application. Transfer pricing documentation must be submitted to the tax authorities within 60 days of a request. However, a taxpayer would not be required to submit transfer pricing documentation earlier than six months after the end of the accounting period in question. No contemporaneous documentation is explicitly required. However, the legislation states that a taxpayer should monitor its transfer prices during the tax year, as it is not possible to amend taxable income downward on a tax return in Finland. Relief from the documentation requirements is available for small and medium-sized enterprises. The definition of small and middle-sized enterprises follows the European Commission recommendation. A failure to comply with the documentation requirements could result in a tax penalty being applied. A tax penalty of a maximum of 25,000 euro could be imposed. Finland does not have a formal APA program.
Ireland - still holding out

Unlike the majority of Organisation for Economic CoOperation and Development (OECD) member countries, Ireland has yet to introduce broad-based transfer pricing legislation. Irelands position in this regard is somewhat understandable in the context of favorable tax opportunities available to multinationals doing business in Ireland. Taxation policies in Ireland are commonly regarded as one of the key success factors in attracting foreign direct investment to Ireland. In this context, Ireland has not experienced the pressures on taxation revenue that has led to the introduction of broad-based transfer pricing legislation in many other countries. Given the lack of transfer pricing legislation, few resources are devoted to the issue by Irelands tax authority, the Revenue Commissioners. Further, the corporation tax return form in Ireland does not require taxpayers to make any disclosures in relation to the nature and value of international related party dealings, or make any disclosure on the extent to which transfer pricing documentation has been prepared to support any such dealings. Unsurprisingly, the Irish tax authorities have yet to release guidance on the expected scope and content of transfer pricing documentation. Given the regulatory environment, a decision by a taxpayer in Ireland to prepare transfer pricing documentation would be based more on recommended best practices rather than any specific legislative or tax authority requirement. In these situations, an Irish transfer pricing report is typically prepared by reference to the guidance contained in the OECD transfer pricing guidelines. Comparability studies based on PanEuropean or North American databases are typically sufficient for an Irish transfer pricing report. While no formal APA process exists, a ruling can be formally requested from the Revenue Commissioners in respect of specific tax issues. This process can effectively provide an APA where a reciprocal APA or other ruling from a foreign tax authority is also obtained.
Spain - significantly raising the bar

In late 2006, Spain enacted the Law for Prevention of Tax Fraud. This law, which introduced significant changes to transfer pricing in Spain, applies to all fiscal years beginning on or after 1 January 2007. Although the Law for Prevention of Tax Fraud introduces various changes to the transfer pricing environment in Spain, and applies to fiscal years beginning on or after 30 November 2006, it leaves certain sections of the law to be further developed. As a result, although certain obligations (e.g. documentation requirements), are introduced by the Law for Prevention of Tax Fraud, they will not become binding until the accompanying regulations are published, which is expected to occur at the end of 2007. These documentation requirements will enter into force three months after the publication of the final regulations.
Finland - joining the game

New legislation on transfer pricing documentation rules became effective on 1 January 2007. Documentation rules will apply to accounting periods starting on or after
1 Although Switzerland is not an EU member state and therefore not party to the JTPF and arbitration convention, Switzerland is included here due to its commercial integration with the rest of Europe and its relevance to a discussion of transfer pricing in the region.
The new law shifts the burden of proof of compliance with the arms length principle to the taxpayer, since it explicitly introduces the obligation to value intercompany transactions at arms length. The law also extends the obligation to value at arms length some domestic Spanish intercompany transactions. Under the new law, taxpayers also will be required to prepare documentation justifying their transfer prices with affiliated companies (unless they belong to the same fiscal group as well as with third parties operating in tax havens, and to make the documentation available to the Tax Administration. During an inspection, a taxpayer will have 10-15 days after receipt of notification to present the documentation. In addition, taxpayers will be required to disclose in their tax returns information pertaining to intercompany transactions. A taxpayers documentation should include two documents: group-level documentation and documentation specific to the local taxpayer. These requirements follow very closely the master file and country-specific approach recommended by the JTPF (see article beginning on page XX). The documentation requirements will be less onerous for small companies (with net revenues of less than 8m for the consolidated group in the previous accounting year), and will not apply to the domestic transactions of companies making up a consolidated fiscal group for Spanish tax purposes. In addition, a specific transfer pricing penalty regime has been introduced. Compliance with documentation requirements also allows for the avoidance of the general penalties for not declaring sufficient tax. The new legislation also encompasses the so called secondary adjustment leading to a re-characterisation of any difference between the arms length price and the price applied by related parties. The re-characterisation may mean that a transfer pricing adjustment has tax consequences even in cases where the corresponding adjustment is immediately accepted by the Tax Administration of the counterparty company subject to the primary adjustment, i.e., either by the Tax Administration in Spain (in a domestic transaction) or by the local Tax Administration of the related party (in an international one). The Spanish tax authorities have confirmed that the new legislation and documentation requirements will lead to much greater focus on intercompany transactions and thus lead to an increase in tax audit pressure in relation to transfer pricing. Various tax inspections focusing solely on transfer pricing matters are currently underway. The Tax Administration strongly favors local comparable data (which is available from commercial databases). PanEuropean comparables are acceptable, particularly in the case where insufficient Spanish companies can be identified or when more than one affiliate is being tested. Finally, the new rules extend the validity of APAs so that they may run for four years. It is expected that increased transfer pricing audit activity alongside these changes will see an increase in the take-up of APAs in Spain. Both unilateral and bilateral (or multilateral) APAs are possible.
Belgium - looking both ways

Belgium is becoming more aggressive and more skilled in the field of transfer pricing as it becomes increasingly aware of the active interest in this area (typically) in surrounding countries and the risk of the erosion of Belgiums taxable bases. Until recently, the Belgian Income Tax Code (ITC) did not provide any specific rules on intercompany pricing. This came to an end in mid-2004 with the formal introduction of the arms length principle in Belgian tax law. Article 185 ITC not only introduces the arms length principle in Belgian tax law (and thus allows for upward profit adjustments), but also contains a provision on the basis of which Belgium will refrain from taxing profits that a Belgian company would not have realised if it would not have been part of related party dealings. As such, Article 185, paragraph 2 ITC allows for a unilateral adjustment of the Belgian taxable basis, similar to the corresponding adjustment of Article 9 of the OECD Model Double Taxation Treaty. Belgian tax regulations provide for both bilateral and unilateral APA procedures. Unilateral APAs were introduced in Belgium in 1993 but became widespread after revisions in 2003 and 2005. Bilateral and multilateral APAs are also available, but will be dealt with on a case-by-case basis, according to the relevant competent authority provision as laid down in the tax treaty. In November 2006, the Belgian tax authorities issued a long-awaited practice note on transfer pricing documentation, which provides additional guidance for situations where information requests are issued by the tax authorities. The Practice Note also contains details regarding requests for documentation and how taxpayers should reply to such requests with regard to the crossborder transfer pricing policies of an MNE. Tax inspectors are encouraged to conduct transfer pricing audits in specific cases, for example, when certain red flags are raised. The Practice Note contains a nonexhaustive list of characteristics that may warrant an investigation of a taxpayers transfer prices. Another potentially effective tool, the pre-audit meeting, has been introduced. This consultation takes place before the tax authorities issue their request for transfer pricing documentation. Together with the introduction of a special transfer pricing investigation squad in July 2006, the release of this Practice Note is intended to put some muscle into Belgiums means of enforcing transfer pricing compliance.
France - high levels of enforcement

In France, transfer pricing rules comply with the arms length principle, and OECD Guidelines are consulted by the French Tax Authorities (FTA). No contemporaneous documentation is required in France. However, during a tax audit very short deadlines are imposed to answer the FTAs often very detailed transfer pricing questions.
Therefore, it is highly advisable to have proper documentation ready for presentation to the tax inspectors. Recent regulatory developments and enforcement activity have also emphasised the FTAs interest in transfer pricing issues. See the article beginning on page XX for a more detailed explanation. As indicated in that article, French tax regulations provide for bilateral and unilateral APA procedures. Multilateral APAs are also available, but only with States that have signed a tax treaty with France in line with the OECD model tax treaty. In addition, in 2006, an APA procedure requesting simplified documentation became available for SMEs. Currently, approximately 30 APA procedures are in review by the FTA concerning all sectors of activity (most are bilateral, but there are also some multilateral and unilateral). Approximately 250 MAP cases are currently under review by the FTA, of which 100 concern transfer pricing. A MAP now suspends the collection of taxes in France.
the day on which the tax was originally due. The UK Government has announced changes in the operation of the penalty regime, which are expected to take effect for return periods beginning after 31 March 2008 where the return is filed after 31 March 2009. HMRC has access to its own sources of comparables data and HMRC International uses a commercially available database of UK company results. HMRC generally accepts Pan-European comparables, in line with the EU Masterfile approach; however, the PanEuropean comparables sample must have sufficient coverage of the UK market to the extent it exists, and further UK evidence on comparability may be requested in an audit. The UK has had formal APA procedures since 1999. To date, the APA process has been initiated by a number of companies, and many APAs have been concluded. While HMRC has generally resisted undertaking APAs except for highly complex and material transactions, the recent guidance material published by HMRC suggests a more flexible and open APA regime. In 2006, the UK Government commissioned a review of HMRCs links with large businesses, resulting in a number of proposals that impact transfer pricing in the UK. HMRC published its Litigation and Settlements Strategy document on June 7, 2007, which sets out principles and consistent standards for bringing tax disputes to a conclusion, whether by agreement with the taxpayer or by litigation. On June 20, 2007, two further consultation documents entitled HMRC approach to transfer pricing for large business and Giving certainty to business through rulings and clearances were released. The expected outcome of these documents is a review of documentation and disclosure requirements, a faster examination process, and a risk-based approach to selecting cases for examination. In addition, HMRC proposes to introduce a system of advance rulings and extend existing clearances, including potentially a more accessible APA regime. With the introduction of a more efficient approach to undertaking transfer pricing enquires, the UK is likely to advocate the wider adoption of the principles of its new approach to transfer pricing in the international community.
UK - seeking a more streamlined approach

Her Majestys Revenue and Customs (HMRC) is active in transfer pricing audits, particularly in cases of business restructuring, dealing with related issues such as exit charges and permanent establishment (PE) issues. HMRC takes an active role in the OECDs work on taxation of multinationals and is at the forefront of the OECD work on business restructuring and on comparability and profits methods. The UK transfer pricing rules closely follow the OECD principles and include a requirement that they should be interpreted so as to give the best consistency with the OECD Guidelines. Under current transfer pricing legislation, which was introduced in 1998 and took effect on April 1, 2004, UKto-UK transactions came within the transfer pricing rules, and thin capitalisation rules were brought wholly within the transfer pricing regime. Further changes affecting the financing of companies were effective as of 4 March 2005. These changes were aimed at private equity houses, but have wide-ranging effect beyond private equity structures. Transfer pricing documentation requirements are based on the UKs general rule for self-assessment that requires taxpayers to keep and preserve the records needed to make and deliver a correct and complete return. HMRC has also published guidance on transfer pricing record keeping. In addition, the UK supports the Masterfile concept published by the JTPF (see article beginning on page XX). Similarly, there is no separate penalty regime for transfer pricing, and the general penalty rules apply. Tax-based penalties apply where tax is underpaid because of negligent or fraudulent errors. In a normal case, interest will be charged on tax underpaid and is calculated from
Germany - new concept of transfer package

As early as 1983, Germany issued its first detailed transfer pricing regulations (so-called administrative principles), which established general principles of transfer pricing (including the adoption of the arms length standard) as well as the authorities position on the application of transfer pricing methods and on various categories of intercompany transactions. In 1999, the authorities began to revisit the administrative principles and started to issue revised regulations on specific subjects such as:
permanent establishments (1999); cost sharing (1999); cross-border assignments of employees (2001). The legislature then introduced statutory documentation requirements as well as provisions on sanctions for nonfulfillment of the requirements to the German General Tax Code. The documentation requirements apply to fiscal years starting after 31 December 2002; i.e., in most cases from 1 January 2003, whereas the sanctions apply to fiscal years 2004 onwards. The statutory documentation rules were supplemented by an ordinance (2004) as well as very detailed regulations (administrative principles procedure issued in 2005). In line with the increasing regulatory environment, the authorities are expanding and further training their task force for transfer pricing audits. While, in the past, German authorities were very reluctant to enter into APAs, they have recently established a central dedicated task force for APAs and have encouraged taxpayers to apply for bilateral APAs. In order to stress their commitment to this goal, the authorities issued a circular letter in 2006 that outlined detailed rules for an APA procedure including Germany. The central task force will also act as Competent Authority in MAPs. The Enterprise Tax Reform 2008 The Enterprise Tax Reform Bill 2008, which was adopted by the Upper House in July 2007, contains several measures that clearly increase the burden to taxpayers in the area of transfer pricing. The main elements of the new transfer pricing rules are described in the rest of the article. Business restructurings The statute explicitly addresses business restructurings or - in German terminology - the cross-border transfer of functions (Funktionsverlagerungen). The statute applies to cases where operative functions such as production and distribution, will be shifted across the border (typically from a German entity to a foreign entity), or where such functions will be reduced, as in the case of transforming a fully-fledged production entity to a contract manufacturer. In these circumstances, an exit charge will increase the taxable income of the party transferring the function. The new law establishes with respect to the transfer of functions, the concept of a transfer package, which consists of all business changes and risks as well as underlying tangible and intangible property and other advantages relating to the operative functions. A valuation of each function, which will determine the basis of the exit charge, will have to be done based on the transfer package in its entirety. Comparability The new law contains provisions on the use of transfer pricing methods as well as on comparability. With respect to the latter, the statute distinguishes between unconditionally comparable arms lengths values and conditionally comparable arms lengths values. Based on such distinction, it will be required that a transfer pricing range be properly narrowed.
Retroactive adjustments If profits from intangibles that have been subject to an intercompany transaction develop differently than originally envisaged, the statute assumes that independent third parties would have agreed upon price adjustment clauses before concluding the original business transaction. If such an adjustment clause has actually not been agreed upon and the actual profit development determined by the transfer price deviates from the expected profit development, the German tax authorities are entitled to make a one-time price adjustment within ten years of the original business transaction. Other measures The bill contains additional aspects relevant to transfer pricing. Among others, if foreign related parties will not disclose information that is relevant for the transfer prices of the German entity, the transfer price of the German entity can be estimated at the end of the range that is most disadvantageous for the German taxpayer. In addition, the time period for documentation relating to extraordinary business transactions that must be submitted to the authorities is reduced from 60 days to 30 days. Timing and additional provisions The law applies, in general, for the first time to all business years ending in 2008. Accordingly, if a taxpayers business year corresponds to the calendar year, the bill will apply from January 1, 2008 forward. In cases of fiscal years deviating from the calendar year, the new principles will apply for the fiscal year that begins in 2007.
Conclusion
Over the years the German government has introduced a considerable number of measures in the transfer pricing area that should be thoroughly considered by taxpayers. Corresponding to the increasing regulatory complexity, local tax inspectors have been instructed to focus in every tax audit on transfer pricing matters, if the taxpayer engages in cross-border intercompany transactions. In addition, central training programs have commenced for tax inspectors, and specifically-trained transfer pricing staff is also centrally available who will participate in larger audits. Thus, taxpayers will be more than likely to find themselves in the position that they need to defend their transfer pricing policy in their next German tax audit.
Summary
Despite the recent efforts by the EU to standardise aspects of tax policy across member states, including transfer pricing, it is clear that significant diversity in both transfer pricing legislation and enforcement exists throughout Europe. MNEs operating in Europe face a broad spectrum of transfer pricing regimes, and taxpayers must continue to be aware of and address this diversity in designing their overall transfer pricing strategies.
Legislation
Documentation requirements Yes
Enforcement Activity Developing
Penalties
Disclosure requirements No
Local Comparables Preferred
Pan-European Comparables Accepted
APAs
Austria
Yes
No specific TP penalties No specific TP penalties
No
Belgium
Yes
No
Aggressive
No
If available the BTA will tend to rely on local comparables as a sanity check Preferred
Accepted
Yes
Denmark
Yes
Yes
Aggressive
Twice the amount saved + 10% penalty Up to 25.000 euro added tax No specific TP penalties 5-10%
Annual tax return
Accepted
Limited activity but no formal regulations No
Finland
Yes
Yes
Developing
Annual tax return
Preferred
Accepted
France
Yes
Yes
Aggressive
No
Preferred
Accepted
Yes
Germany
Yes
Yes
Aggressive
Upon request
Preferred
In practice often used Possibly
Yes (but only bilateral) No
Greece
Yes
Yes (approval by a special committee required for Management fees/royalties) No
Fairly Aggressive
10% fine on difference plus penalties for inaccurate tax filing
No
Preferred
Ireland
No
Developing
No specific TP penalties Up to 200%
No
No
Accepted
No
Italy
Yes
Yes
Aggressive
Annual tax return
Strongly preferred Preferred
In exceptions
Yes
Netherlands
Yes
Yes
Aggressive
No specific TP penalties No specific TP penalties: up to 60% additional tax (from 2008 lack of documentation may result in loss of right to appeal assessments) No specific TP penalties 15% of adjustment (with minimum) & certain specific documentation penalties General tax penalties apply (20% of 40%) No specific TP penalties Max 100% of the underpaid tax
Annual tax return
Accepted
Yes
Norway
Yes
Yes from 2008
Aggressive
Annual tax return
Preferred
If local comparables not available
No
Portugal
Yes
Yes
Developing
Annual tax return
Strongly preferred Strongly preferred
In exceptions
No
Spain
Yes
Yes
Developing
Annual tax return
If local comparables not available
Yes
Sweden
Yes
Yes
Aggressive
Upon request
Preferred
Accepted
Developing
Switzerland
No
No
Developing
No
No
Accepted
Yes
United Kingdom
Yes
Yes
Aggressive
No
Preferred
Accepted
Yes
OECD business advisory group on business restructuring
Isabel Verlinden, Partner, PricewaterhouseCoopers, Belgium.
OECD business advisory group on business restructuring
Given the vast importance of business restructurings and the relative lack of success of national measures in effectively dealing with the taxation of business restructurings, these issues have begun to have a profound effect on the work of the OECD. One of the strongest features of the current approach of the OECD for dealing with business restructuring issues is that it stresses the importance of good dialogue with business, both through its Business Advisory Group on Business Restructuring (Business Advisory Group), and beyond. The Business Advisory Group was established shortly after the OECD started its work on the model double taxation treaty and on the transfer pricing aspects of business restructurings. The group is an informal group of academics, business representatives, and consultants who work together to obtain technical and factual input from the business community. This contribution has been submitted to the Business Advisory Group by Isabel Verlinden in a personal capacity with the help of the PwC Transfer Pricing Network and was discussed with the relevant OECD working parties.
Basic issues
Transactions that are specific to MNE Groups Paragraph 1.10 of the TP Guidelines recognises that associated enterprises may engage in transactions that independent enterprises would not undertake. The JWG would welcome examples of such transactions that are implemented by MNE groups, but which are not, or are seldom found between third parties and therefore raise difficulties in the application of the arms length principle and comparability analysis. The JWG would also be interested in your views of why third parties would not implement such transactions: if a transaction is beneficial to all the parties involved, why wouldnt independent parties be willing to implement it (given third parties also have the possibility to operate in a coordinated fashion through joint venture agreements, cartels, etc.)? The very essence of a companys existence may be the fact that it minimises the transaction costs of coordinating an economic activity. Indeed, by bringing assets and people in-house, one reduces the cost of negotiating and concluding a separate contract for each exchange transaction. According to Nobel Prize winner Ronald Coase2, companies make sense when the transaction costs associated with buying things on the market exceed the hierarchical costs of maintaining a bureaucracy. The traditional economic theory of the time suggested that, because the market is efficient (that is, those who are best at providing each good or service most cheaply are already doing so), it should always be cheaper to contract out than to hire. Coase noted, however, that there are a number of transaction costs to using the market; the cost of obtaining a good or service via the market is actually more than just the price of the good. Other costs, including search and information costs, bargaining costs, keeping trade secrets, and policing and enforcement costs, can all potentially add to the cost of procuring something with a firm. This suggests that firms will arise when they can arrange to produce what they need internally and somehow avoid these costs. One may therefore safely assume that there are transactions occurring in an open-market context that also tend to exist among entities between which some form of economic solidarity exists. Whether all relevant attributes are sufficiently similar to compare these transactions following the five standards of comparability is less straightforward. Concepts as Organisational Capital3 and/or simply best practices may render internal transactions more efficient. It may though be impossible to price these attributes as they may not be tradable since they may only have value in a specific context and may fade away over time should they be lifted out of that context. Indeed, knowledge is often context-specific; even though one knows how a firm does something, it may be very hard to replicate it
2 3 4
Micklethwait, J., and Woolridge, A., The Company-A Short History of a Revolutionary Idea, Weidenfeld & Nicholson London, 2003, at 10 and 175-176. Aston, A., Brainpower on the Balance Sheet, Business Week, August 26, 2002 at 59. Davenport., T.H., How much knowledge should a business give away?, European Business Forum, Issue 24, Spring 2006, at 21. International tax perspectives PricewaterhouseCoopers
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elsewhere4. Organisational Capital is a term used by Professor B. Lev to describe the qualities that enable GE to boost efficiency and profits at the companies it acquires; organisational processes can thus grow into important value simply because a company is well run. Being well run over time is a necessity to be able to survive in a competitive global marketplace. A constant increase of efficiency and innovative behavior is essential. Examples can be found on centralisation throughout the world. In a transparent market, there would be little or no difference between transactions conducted by MNEs and third parties. There are however differences by nature. If for example several independent companies create a joint procurement center to allow all participants to benefit from the economies of scale and strengthened buying power (such as in the FMCG business), the situation is comparable to a MNE initiating central purchasing for several business units. For a MNE it would be easier to execute such transactions without a lot of time being spent on negotiations, especially when there is also some form of centralised regional or global management. The third parties would first need to reach agreement how their cooperation would be managed and how it benefits each member. Finally, it should also be borne in mind that given the specific dynamics of related and third party dealings, open market references such as joint ventures will often proof to be far less comparable than one might initially have expected. Indeed, joint venture arrangements are normally the result of complex negotiations covering a basket of transactions which on a stand alone basis may not be comparable at all with intra-group transactions. Examples of transactions that are implemented within MNE Groups and which may at first glance appear less obvious in a third party context even though they do exist are: Specific forms of contract manufacturing It appears to us as if contract manufacturing as used in common parlance in transfer pricing jargon may cover different things. Outsourcing the entire manufacturing of a product occurs more often these days in an open-market context as it allows original equipment manufacturers (OEMs) to reduce labor costs, free up capital and improve worker productivity while concentrating themselves on R&D, design and marketing5. Contract manufacturers strengths include location in a low-wage jurisdiction, economies of scale, manufacturing prowess and exposure to the engineering and development processes of products it handles for other OEMs. Consequently, even though launching a brand would not be a trivial undertaking for any contract manufacturer, a brand identity rooted in its production prowess would have immediate credibility. Moreover, a contract manufacturer working for several OEMs has experience in making a wider range of products than do most of its clients permitting it to concentrate on producing the most
profitable ones while not necessarily having to bear the burden of R&D investment. This means that reality shows that it is probably not wise to compare such contract manufacturers to instances where a low risk manufacturer is exclusively linked to one principal. The combination of standardisation and flexible manufacturing lets OEMs replace underachieving or uncooperative contract manufacturers smoothly. The reciprocal nature of these relationships and conversely the ability of either party to withdraw at first sign of a hold-up by its partner make them easy to embrace. Leading OEMs cannot afford to retreat to the safety of vertical integration as the benefits of specialisation are too great6. Franchising (commercial and even more extreme in industrial franchising) Franchising operations are a hybrid form of economic organisation and the term can be employed to label diverse business relationships. A franchising relationship is a continuing relationship with the franchisor providing general advice and support, research and development and marketing assistance. In return, the franchisee usually pays an ongoing royalty or fee, normally based on the level of turnover. Generally speaking, franchising is an arrangement under which the contracting parties agree to enter for their mutual interest into a close link of cooperation, whereby the franchisor would grant its local business units as franchisees, in exchange for direct or indirect financial consideration, the right to exploit its particular business approach. First generation franchising mainly covers the granting of a right or license to a retailer or distributor to sell products or services according to a predetermined marketing method through outlets using a known name or trademark. Such franchising emerged mainly in marketing-intense environments and can be viewed upon as a privileged license, including assistance in organising, training and management. Traditional franchising arrangements can be found in the food or service industry and heavily rely on the use of a marketing or retail concept owned by large institutions. Essential elements in this respect are the use of a well-known trademark, joint advertising and purchasing. Modern franchising can be defined as a business format franchising. It includes a complete package of tried and tested work methods of the franchisor, which transfers a successful system or business concept surpassing the mere marketing level and more focusing on business management in general. Such franchising process for instance also refers to support with respect to manufacturing performance and related IP, whilst the former traditional franchising did not cover manufacturing operations as such. Franchising is in fact based on the premise that it is easier to develop a local business under the guidance of
5 6
X, Incredible shrinking plants -Special Report-Car Manufacturing, the Economist, February, 23rd, 2002, 75-77. Arrunada, B., and Vazquez, X.H., When Your Contract Manufacturer Becomes Your Competitor, Harvard Business Review, September 2006, 135-144.
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an established organisation, rather than by trial and error. The franchisor offers to maintain a continuing interest in the business of its franchisees, particularly in such areas as know-how and training. An implicit feature of a franchise system is indeed the technological transfer and the access it provides to the global learning organisation. It is the responsibility of the franchisor to support the franchisee in all the relevant areas of their business operations. Therefore the franchising concept does not potentially only accommodate both the licensing of the marketing intangibles (such as the trade-mark) and a technology and IP transfer, but it may also cover the provision of the general functional and technical assistance to the business units. In summary, it is very unlikely that unrelated parties would sell their key value drivers though several attributes thereof may be subject of a transaction among unrelated parties. In essence, in a commercial franchising context, the franchisee is spending money to enhance the brand value of the brand owner as the quality of its customer services creates a win-win for both parties. (It is to be noted that also the issue of network effects may come into play here). Risk profile and volatility How would you measure the trade-off between a relatively high profit, possibly subject to volatility, and a relatively low profit with a guarantee clause? How would you take into account historical data on past years actual returns and volatility to determine the appropriate level of low but guaranteed return a party would be willing to accept at arms length? The JWG would welcome factual examples where arms length parties have entered into these transactions or arrangements, as well as comments on the economic/business arguments that could cause two arms length parties to enter into such arrangements. We are aware of a case where a product with an uncertain product life cycle was developed by a closely-held business. The founders of the family business decided at some point to enter into an agreement with a third party equity provider. A steady, though relatively low return was opted for rather than continuously bearing full entrepreneurial risk which would mean undergoing the potential hazards of a premium profit generating though potentially short-lived fully fledged operation. In other words, a constant trade-off between risk and reward also occurs in the open-market. Future profits are not certain to materialise and should therefore be discounted. The discount rate is positively correlated to the rate of return on alternative investments, the riskiness of the project and the country inflation rate. Whether parties operating in an open-market context factor in past years actual returns to determine future profitability is not a given. Indeed, parties may start from functionality & risk profile at a certain point in time to determine corresponding fair returns rather than by looking at what was given up compared to the past. Others might factor in past experiences. I dont believe a clear-cut assessment can be made of what is likely to occur as there are probably as many possibilities as there are deals.
Low risk activities and market risk Do you consider that low risk manufacturers (e.g. toll manufacturers) which work for a related party should be protected against market risk, and in particular that they should be protected against the risk of plant closure? Please indicate whether your response is based on factual evidence of unrelated transactions or on other arguments. Please also indicate how such a protection can be implemented in the relations between the parties. The JWG would welcome detailed examples of toll manufacturers that have only a single arms length client and the arrangements between them, to the extent this information is available. On the topic of protection against plant closure, I refer to the contribution Potential Tax Consequences Upon Relocation Of Production Capacity as posted to the OECD website in the framework of the 2005 Roundtable. Useful inspiration on the protection against market risk can be found related to contract manufacturers in the aforementioned Harvard Business Review article where it says that the duration of the relationship may be dictated by the uniqueness and/or degree of innovativeness, complexity and maturity in the marketplace of the OEMs product. Contract Manufacturers may have devoted considerable time and resources to mastering the manufacturing which renders a long-term contract conditional to making these efforts. This is also beneficial to the OEM as it is then protecting its own investments in the CMs mastering of the production process. It will be difficult to find a replacement for the CM at short notice. A long-term contract will also hinder the CM from abandoning the OEM or extracting prohibitive terms as the price of staying in place. Conversely, if the OEM can easily switch CMs because the product is simple to make or is mature enough to qualify as generic, a contract of shorter duration is called practical as nothing should prevent an OEM from pursuing more attractive value propositions from other CMs. The article mentions the relationship between Daimler Chrysler and Magna Steyr as an example where the latter has assembled the Mercedes-Benz M-class SUV. The first car left the plant within 8 months of the initial venture agreement. A contract of limited duration was considered to be all the parties needed in the case at hand to protect their investments. When BMW entered into an agreement with Magna Steyr on the X3 SUV, a lengthier contract was needed (I recall HBR mentioning over 5.000 pages) as BMW sought for help in four-wheel-drive technology and thus a potential threat of intellectual property leakage needed to be dealt with. In an open-market context numerous forms of manufacturing outsourcing arrangements exist ranging from market agreements (i.e. one-off contracts) over more interdependent to and ongoing pacts (such as framework arrangements, joint ventures, partnerships,) reflecting various levels of bargaining position of the respective parties to the deal. The high-tech arena products may have a short life span. Commodifying products result in OEMs gaining
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wider choices of interchangeable suppliers. PCs were originally built by brand owners. Later on, the assembly was made easier by the routinisation of internal processes and the increasing codification of knowledge so as to enable external suppliers to take on this type of work. Currently, PCs tend to be predominantly generic products whereby a local assembler operates according to the OEMs specifications. The increasing modularisation of components results in automation requiring less judgement from workers so that is is not a prerequisite for CMs to have special skills and knowledge. The above therefore means that in specific circumstances it can be perfectly justifiable for a CM to bear closure or restructuring expenses. Centralisation of risks and of risk management In your experience, what can be the non tax motivations for risk transfers within a MNE Group? What is the benefit for an MNE Group of centralising risk bearing (rather than just the management of decentralised risks)? The level of centralisation/decentralisation will most likely affect the reply to this question: 1. There are instances where (an) affiliate(s) of a MNE Group assumes a number of risks so as to manage in a first instance certain processes more effectively. An example is a factoring arrangement without recourse where the credit control function performance is optimised in the factoring entity while simultaneously the intercompany funding is effectively structured as factoring may in some instances be a suitable financing tool and an alternative to expensive short term/flexible bank loans. 2. There are examples of MNE Group affiliates that have gone bankrupt as a result of having assumed risk (partly) centrally. MNEs may therefore have a strong interest in trading off preservation of commercial reputation versus financial protection (as a going concern). Historical data can be a basis for projecting the future outcome of business operations but it is necessary in our fast changing business environment to consider alternative scenarios of market development. Past experience does not provide a guarantee that the predicted results will be achieved. Where individual companies have to meet one or several shareholder(s) expectations, MNEs usually have to meet stock analyst and global market expectations. Depending on the industry, a risk preferent attitude of an MNE may not be welcomed with applause and thus reflect negatively on the market value of the company as a whole. Centralising risks and the abilities to manage and control the risks are thus quite common. Third parties by nature have less flexibility to share risks. When small companies are risk aggressive they either succeed (and may be taken over by a larger MNE) or fail and go out of business. MNEs cannot afford material failure that may take them out of business as a whole and thus develop different risk management strategies.
Risk transfers Do you think risks can be traded in isolation from the associated assets and functions? Can you provide examples of third parties transferring risk in isolation (i.e. without the assets or the functions associated to the risk and without the transferor retaining part of the risk)? Reference can e.g. be made to the insurance sector (hedging), to derivative financial instruments, options, guarantee fees, Unprotected, local intangibles Do you think there are valuable unprotected intangibles that cannot be transferred in isolation, e.g. because they are intrinsically linked to a (manufacturing or marketing) process operated locally and cannot be transferred without the function? It appears to me that such instances are unlikely to exist. It may be relevant here to underscore that a distinction is to be made between relevant attributes to a process which in common parlance merely qualify as best practices and valuable unprotected intangibles. As mentioned above, best practices may be only of particular value in a specific context and it may very well be that local involvement is relevant for the maintenance and even value enhancement of an intangible (such as trademark, trade name, i.e. registered or not) held elsewhere. Reference can be made to the franchising concept as highlighted above.
Additional points of attention

Indemnification/payment upon conversion In what circumstances is an enterprise likely to have disposed of something of value as a result of a business restructuring for which the arms length principle requires compensation? To what extent (if any) does the arms length principle affect the allocation within a MNE group of termination costs (out of pocket expenses) related to a business restructuring? In what circumstances (if any) would there be at arms length an indemnification for termination of an established contractual relationship/loss of business opportunities? How does the arms length principle apply to determine the remuneration of a transfer of functions, assets, risks?
We refer to the contribution referred to above and already posted to the OECD website in the framework of the 2005 Roundtable. The term have disposed something of value as a result of a business restructuring is not entirely clear to us. Needless to say, if a perpetual right (legally or economically) to an intangible is owned by the
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restructured entity, or one that can be virtually assimilated to it based on barriers to entry, customer loyalty etc., a compensation may be appropriate. We are reluctant to see the merits of the introduction of a loss of business opportunity concept as parties make constant choices between high risk/low risk ventures and any preponderance of one against the other may stem from various elements. In other words, if there is no sufficiently assured profit potential of a certain high return opportunity, a third party would probably not be ready to buy something of value at least not without factoring in an appropriate risk element (beta factor). We feel that the Guidelines already properly address such circumstances such as where the low-risk distributor (acting as a mere agent) is commented versus the distributor with substantial marketing spend so as to create a marketing intangible. As illustrated above on contract manufacturers, a third party contract may simply become at its end without any compensation being due. Contract manufacturers operating in a competitive environment for fairly standardised products are faced with potential losses, especially when it is difficult to find another principal. In other instances, a so-called ever green arrangement may be concluded so as to enable the contract manufacturer to make proper capital investments and be compensated for e.g. undepreciated capital cost when the contract it terminated. Remuneration of a stripped entity How do the principles in the 1995 TP Guidelines for selection and application of the most appropriate arms length pricing method apply in a business restructuring context?
thorough application of the classical standards of comparability is felt less practical. What is the role (if any) of comparisons of profits made before/after a conversion?
We feel that the Guidelines rightfully impose an analysis of functions, risks and intangibles. We do not see the relevance of adding profit comparisons. To what extent is cost stripping acceptable (e.g. cost plus on a limited cost basis)?
The Guidelines do in our view already fairly address the issue so as to limit the need for a profit element to value added cost (see e.g. 6.37). This is probably also in line with how price setting may be dealt with by brokers. Synergies/efficiency gains How to account for synergies and efficiency gains in the theoretical arms length environment? How to deal with situations where expected synergies/efficiency gains are not made?
The Guidelines do in our view apply equally to a stripped entity from the outset as to a converted entity. In many instances, a cost plus type based compensation (such as cost-plus, TNMM with cost as PLI, Berry ratio) is appropriate. What is the role (if any) of transactional profit split methods in a post conversion structure?
The topic of synergies is extensively dealt with in economic doctrine though it appears as if it merely serves to underscore the choice of vertical integration versus transacting with third parties. In other instances, it focuses on expected synergies stemming from mergers. The models are usually DCF-based and built on pre-merger forecasts for the stand-alone merging firms (excluding synergies) and one for the post-merger combined firm including synergies. In our view, the Guidelines already extensively address the difference between a MNE and third party relations in 1.9-1.10. This may equally apply to efficiency gains. An affiliate is according to the Guidelines not be considered to have received a service by the sheer fact of being member of the group as laid down in 7.13. The arms length principle Does the arms length principle apply differently to an arrangement between associated enterprises depending upon whether or not it replaces an existing arrangement ( i.e. conversion situations vs. start-up situations), and if so how? Compliance with the arms length principle should in my view be assessed based on a comparability analysis as laid down in the Guidelines7. Any reference to what can only be traced based on hindsight risks to lack fairness.
We are not sure whether a transactional profit split method should be elevated from its current last resort status to serve the purpose of remunerating a stripped entity post conversion. It may be appropriate in a setup of centers of excellence with corresponding functionality and/or risk profile. However, we grab the occasion to urge for preserving the use of profit-based methods to those situations where both parties own non-routine intangibles rather than to instances where a
A reservation is made here as this contribution was prepared pending the comments we will be posting in response to the May 2006 call for interest on Comparability on behalf of PricewaterhouseCoopers. International tax perspectives PricewaterhouseCoopers
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Dispute resolution in Belgium - the latest developments
Thierry Vanwelkenhuyzen, Partner, PricewaterhouseCoopers, Belgium.
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Dispute resolution in Belgium - the latest developments
Multinational businesses tend to fall into two groups with respect to their transfer pricing policy in Belgium. Some decide to take a proactive stance: when setting up a business in Belgium or when they modify their TP policy, they often request an advance tax ruling from the Belgian Tax Authorities. Other businesses do not request advance rulings. Some may pro-actively develop TP documentation, while others wait until a tax audit takes place. This article discusses what taxpayers may expect from Belgian Tax Authorities with respect to transfer pricing issues.
A new approach to taxpayer disputes

The Belgian Ruling Commission has begun to take a more business-oriented attitude, particularly regarding transfer pricing. The Commission is much more ready to encourage positive decisions. For example, in the past, the Commissioners would listen to a taxpayers comments, then the taxpayer would need to wait for the Commissions decision, but there was no interim dialogue allowed. Now, taxpayers may speak in pre-filing meetings, and can add both additional documents and arguments. In addition, taxpayers can get advance indications of the tentative position of the Commission, and, if that position is negative, taxpayers have the opportunity to add documents or arguments in order to make the decision a positive one.
The creation of a special TP team

Prior to 2005, transfer pricing audit issues were part of general, broader tax audits. However, in 2005, the Belgian Tax Authorities began to conduct transfer pricing audits of multinationals having one or more subsidiaries in Belgium. A specific TP team was officially created in July 2006 with a twofold mission: To build up a TP expertise to the benefit of all field Tax Inspectors and to develop the appropriate procedure to conduct tax audits in this area according to the OECD principles. To carry out itself transfer pricing audits of multinationals being present in Belgium through a subsidiary or a branch.
Which multinationals are being audited in Belgium?

The special TP team has selected the groups to audit based on the data-mining technique, although the team has been reluctant to disclose their specific criteria for selection. It is known, however, that they select Belgian companies making either losses every year or a significant loss in a specific year. Moreover, when the overall profitability or the operating profit drops dramatically one or two years, the group is also selected through the data mining. Other selection criteria are indicated in a TP circular letter issued on November 14, 2006 by the Tax Authorities, including the use of tax havens, back-to-back agreements, transfer of intellectual property outside Belgium and the payment of invoices for management fees close to the end of the financial year. However, the criteria described in the circular letter are those that the team may use; it is not known to what extent these criteria are actually used in practice.
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How are TP tax audits conducted?

Until recently, the TP Team was sending a standard questionnaire of about 20 questions covering numerous items that we will comment below. In their new circular letter on TP documentation (which is commented by Patrick Boone in this edition), the Belgian Tax Authorities have accepted the guidelines comprised in the European Commissions European Transfer Pricing Documentation (EUTPD) (see article on page XX) , including the concept of master file and local file, but also the principle of the pre-audit meeting. The pre-audit meeting is recommended to the Tax Authorities in order to avoid raising questions which are irrelevant for the group being audited or because they would request an unreasonable amount of work. As of 2007, the TP Team has suggested organising such a pre-audit meeting. Its purpose is indeed to reduce the questions to those which are relevant to the group taking the specific activities of the Belgian companies into account but also the specific facts, like the absence of intangibles in Belgium or the absence of any royalties being paid by the Belgian entities. Other advantages of said meeting is to ask which TP policy is carried out within the group and which kind of TP documentation exists and can be sent at short notice to the Authorities. In the questionnaire sent by the TP Team after the meeting, in the form of an official request for information, the following information will be requested if it has not yet been obtained during the pre-audit meeting: the situation of the Belgian entities in the group; the relationship between the Belgian entities and other companies of the group; the description of the functions carried out and the risks borne by the Belgian entities; specific questions on intangibles (trademarks, patents, know-how); the TP method used by the Belgian entities and other methods used in the group and if changes to the method have occurred; the benchmark study if one has been carried out; details on the contractual relationship between group companies and the Belgian companies regarding goods and services; and whether or not tax rulings have been requested in Belgium or in other countries.
After receiving the completed questionnaire, the Team examines the responses, and then visits the Belgian company for further verifications. For example, they want to be satisfied that a drop in profitability or a cause of losses can be justified and that the arms length principle has been respected by both the group and the Belgian entity. Recently, the special TP Team sent additional questions after the first questionnaire regarding the profitability by line of products or regarding the implementation of some provisions mentioned in agreements concluded by the Belgian company. Indeed, although the approach is standardised, the TP audit becomes specific based on the fact pattern of each group. When the arms length principle has not been respected, the Team adjusts the taxable income of the Belgian entities over a three-year period. This audit can lead to economic double taxation if the same additional profit has already been taxed in another group company. Companies will need to undertake relief procedures (whether internal or through the Arbitration Convention or the double tax treaty) to remedy this situation. In Belgium, no interest for late payment is due on the adjustment unless if it concerns withholding taxes. It is possible to conclude an agreement with the Team on the application of transfer pricing for future years. It is our experience that the Team is reasonable, provided the group has good arguments to sustain its position.
Be pro-active
As a result of the changes begun in 2005 and the creation of the TP Team in 2006, multinational groups should expect specific TP tax audits in the future in Belgium. At present, only groups with losses or significant drops in profitability have been selected but this was an earlier priority of the Tax Authorities. Now, groups without losses or drops in profitability can expect to be selected as well. In view of this situation, multinational groups should pro-actively prepare their TP documentation, preferably along the lines of the EUTPD. This will save a significant time when the special TP Team starts its tax audit. Another trend being observed is the initiative taken by field Tax Inspectors to start a TP tax audit or to raise specific TP questions in the framework of the standard tax audit of multinational companies. The Belgian entity should be in possession of the relevant documentation in order to answer those questions. This is another reason to have its TP documentation readily available, even if Belgian tax law does not yet require this documentation to be kept available at all time.
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The APA landscape in Denmark, Finland and Sweden
Hans Chr. Jeppesen, PricewaterhouseCoopers Copenhagen, Denmark. Jrme Monsenego, PricewaterhouseCoopers Stockholm, Sweden. Veli-Matti Talaand, PricewaterhouseCoopers Helsinki, Finland.
PricewaterhouseCoopers International tax perspectives 21
The APA landscape in Denmark, Finland and Sweden
Although tax authorities in a number of countries have created formal Advance Pricing Agreements (APAs) for transfer pricing methodologies, no formal APA procedures currently exist in Sweden, Denmark, or Finland. However, each of these counties is considering formal programmes. This article describes the progress in each country towards the establishment of APAs, and, in the absence of APAs, what taxpayers can expect in terms of advance rulings.
An overview
These three Nordic countries show a strong interest in APAs, and formal APA programmes are expected to be available in the near future. Sweden has explicitly included on its agenda the implementation of an APA programme, which should be launched before 2010. Denmark expects a formalised APA procedure in 2007 through administrative guidelines. Finnish authorities are investigating the possibility of enacting an APA programme, but no timetable has yet been decided. The Communication of the European Commission relating to Guidelines for APAs in the European Union8 is likely to accelerate the process in the European Union as well as provide for a valuable blueprint. Even in the absence of formal APA programmes, advance tax rulings have been used in Denmark and Finland for transfer pricing purposes. However, Swedish advance rulings have so far had limited usefulness in this fieldtaxpayers in Sweden may apply for an advance ruling, but are likely to receive a negative answer. Practice shows that a few MAP (Mutual Agreement Procedure) APAs have been concluded by Sweden and Denmark, based on unilateral APAs issued by foreign competent authorities. That possibility is available as long as the relevant tax treaty includes a MAP similar to the one provided at article 25(3) of the OECD Model Convention.
The Swedish APA landscape

Although Sweden does not currently have a formalised APA programme, taxpayers may apply for advance tax rulings at the Board for Advance Tax Rulings (Skatterttsnmnden). Historically, this procedure has seldom been applicable to transfer pricing. However, given the new regulations on transfer pricing documentation and increased focus on transfer pricing, it is likely that more companies will apply for advance tax rulings on transfer pricing issues. In practice, the Swedish competent authorities may accept foreign unilateral APAs that thus become bilateral, based on the MAP included in the relevant tax treaty. Indeed, an APA can be concluded on the sole basis of the MAP included in the relevant tax treaty, provided it is similar to article 25(3) of the OECD Model Convention9. It is difficult to assess the number of and circumstances surrounding MAP APAs, since this information is not made public. As far as we know, it has occurred in probably less than five cases. USA and France seem to be countries with which the Swedish authorities have extended unilateral APAs to bilateral ones.
Communication from the Commission to the Council, the European Parliament and the European Economic and Social Committee on the work of the EU Joint Transfer Pricing Forum in the field of dispute avoidance and resolution procedures and on Guidelines for Advance Pricing Agreements within Europe, COM (2007) 71, 26 February 2007. OECD Guidelines, 4.140 International tax perspectives PricewaterhouseCoopers
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Due to the advantages provided by APAs, the Swedish Ministry of Finance has asked the Swedish Tax Agency to investigate the possibilities of launching an APA programme in Sweden. This assignment includes looking at other countries practice and recommendations at the OECD level. Although it is encouraging that Swedish authorities show willingness to adopt an APA programme, there are several possible weaknesses in the current approach. First, the assignment encourages the Swedish Tax Agency to look at practice in other countries and at the OECD level. However, nothing is said about taking into consideration the EC Guidelines for APAs in the European Union. These guidelines are meant to provide for a blueprint for APAs, and the European Commission encourages member states to quickly implement them. However, Swedish authorities are usually open to European initiatives, e.g., they explicitly accept transfer pricing documentation prepared according to the EUTPD approach. As a result, they are likely to take into consideration the Guidelines for APAs in the European Union. Second, the assignment does not include a simplified APA procedure for SMEs (Small and Medium-Sized Enterprises), although several countries do offer such a possibility. Sweden, however, adopted lighter transfer pricing documentation requirements for minor transactions. Finally, the assignment does not include the possibility of concluding unilateral APAs and views are divergent as to whether unilateral APAs are good solutions. Based on our discussions with the Swedish tax authorities, our understanding is that they are not eager to adopt unilateral APAs because of the absence of binding effect on foreign authorities. The legislative proposal is expected by 31 December 2007, and the APA programme should be launched by no later than 2010.
Due to the absence of a formal APA programme, there are no guidelines for how to formulate an application. However, following EC Commissions guidelines, it is likely that an application including the information in Annexes A and B will be accepted. This information relates to (1) historical information - which might already exist in some format but will need to be compiled for the APA; and (2) information that may need to be created specifically for the APA. The figure below illustrates the current APA procedures in Denmark.
APA
Bilateral OECD procedure MAP APA
Unilateral APA Binding response Appeal to national tax tribunal Appeal to lower court appeal to high court Appeal to supreme court
No deduction of expenses but reimbursement of expenses - 50% or 100% depending on the outcome of the case
Depending on the nature of expenses some are reimbursed
The publication of statistical information on the status of APAs by the member states is encouraged by the EU Joint Transfer Pricing Forum (EU JTPF). Yet, the DTA does not make such information available on a regular basis. Nevertheless, the Danish Minister of Taxation, in an answer to the Tax Committee of the Danish Parliament, stated that in 2006 that there were three ongoing APA negotiations and that the number of APA negotiations is expected to increase. The table below provides for information on the number of APAs for previous years. Year 2002 2003 2004 2005 Concluded APAs 1 1 1 2
The Danish APA landscape

Currently there is no formalised APA programme in Denmark. However, it is possible to benefit from a MAP APA with countries with which Denmark has concluded double taxation treaties10. Danish law does not require the DTA (Danish Tax Authorities) to enter into APA negotiations, and negotiations are usually initiated upon an application from a taxpayer. Yet, it is our experience that the DTA on a case-by-case basis are willing to enter into informal APA negotiations.
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As of May 2007 Denmark has concluded 97 double taxation treaties.
This will typically include requests for binding responses from large companies that are assessed by the DTAs unit for large companies, i.e. applications for binding responses concerning controlled transactions will always be evaluated by the DTAC.
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Binding responses For many years Danish taxpayers have been able to obtain binding responses for direct taxation issues (including transfer pricing), either prior or after any actions taken. A binding response will give the taxpayer an answer on how the DTA will treat a certain transaction. The answer is binding for the DTA and is provided within one month. If the question affects several taxpayers, concerns large economic values, interpretation of new legislation, EU law, or can attract the attention of the public, the DTA must as of 1 January 2007 present the application to the Danish Tax Assessment Committee (DTAC). In this case an answer will be provided within three months. If the documentation provided with the request is insufficient or if the request is particularly complex, the DTA or DTAC may extend its time limits. Furthermore, a request for a binding response must be formulated in a way that the DTA (or when relevant the DTAC) can answer the question by yes or no. Within the first seven months after restructuring of the DTA in 2005 and updating the binding response procedure to include indirect tax matters, the DTA received more than 4.000 requests for binding responses. Anticipated developments At the end of May 2007, the DTA informed us that they intend to publish guidelines on the APA procedure during 2007. It is expected that these guidelines will concern both unilateral and bilateral APAs, and that the APA procedure will be similar to the one applicable to binding responses.
Taxpayers are entitled to submit requests for advance rulings either to the Central Tax Board or to a local tax office. The main distinction between these procedures is that the ruling of the tax office is final (i.e. it is binding and there is no appeal possibility), whereas it is possible for a taxpayer to make an appeal on a ruling from the Central Tax Board directly to the Supreme Administrative Court (SAC), the highest court to deal with tax issues in Finland. Therefore it is quite natural that advance rulings in matters containing questions of principal character - and thus having general interpretative or precedent values - are usually requested from the Central Tax Board. Although there are different routes available for appealing an advance ruling, in practice, requests concerning ordinary transfer pricing issues seem to be directed mainly to the local tax offices. In recent years, advance rulings on transfer pricing issues have been given mainly by two local tax offices: the Tax Office for Major Corporations (TOMC) and the Uusimaa Corporate Tax Office. There have been between two and four transfer pricing advance rulings per year. The Finnish advance ruling system does not provide all possible benefits of APAs to a taxpayer. For example, advance rulings normally deal with acceptability of one single intra group transaction, and it is not usual to deliver an advance ruling on all of a taxpayers international transactions for a given period of time. Additionally, local tax offices and the Central Tax Board are handling advance rulings quite independently and thus there is no involvement from the Competent Authoritys side on the cases. Therefore there is no dialogue between the Finnish and the foreign tax authorities and no confirmation on the acceptability of the final result. The Finnish Competent Authority function is divided between the Ministry of Finance and the National Board of Taxes. Although there are no public statistics on APAs or MAP APAs, our understanding is that the Finnish Competent Authorities have never been in a situation that another treaty partner would have suggested the broadening of a foreign unilateral APA to a bilateral APA. Finnish authorities have recently started investigating the possibility of launching a formalised APA programme. However, it is currently too early to estimate any date for its implementation.
The Finnish APA landscape

Finland has not implemented any formal APA programme. However, Finnish taxpayers have a possibility to utilise two different kinds of advance rulings in order to get a binding solution on a tax issue in advance. This possibility has been used also in the area of transfer pricing. These two procedures have slightly different features, and the choice of the procedure is up to the taxpayer.
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Dispute resolution and double taxation prevention in Germany
Lorenz Bernhardt, Partner, PricewaterhouseCoopers, Germany.
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Dispute resolution and double taxation prevention in Germany
Transfer pricing environment Over the years, the transfer pricing environment in Germany has become increasingly complex, if not aggressive. In 2003, documentation rules (including a penalty regime) were enacted, and, for fiscal years ending in 2008 and later, comprehensive statutory transfer pricing rules (including rules on business restructurings) will apply. In addition, the tax authorities have issued administrative guidelines on various topics, including, among others, cost contribution agreements (1999), and documentation and transfer pricing methodologies (2005). The increasing regulatory activities with respect to transfer pricing are mirrored by reactions of the tax administration both in the area of tax audits and the area of dispute resolution.
TP tax audits: approach of the German tax authorities

One principle of the German tax audit approach is that, in general, every corporate taxpayer should regularly be the subject of tax audits, and that eventually every year in a companys life will be audited by the German tax authorities. Accordingly, tax authorities do not select individual companies to be audited based on a catalogue of criteria, such as loss makers, certain industries, membership in an international group. There is also no random selection. In contrast, after German companies prepare and file their tax returns, they are routinely subject to a desktop review by the tax authorities before the returns are processed. Typically, the desktop reviews result in assessment notices which reflect the tax payers positions as entered in the tax return. However, within three to five years, the tax filings and the tax assessment notices issued by the authorities after their limited review are the subject of an in-detail examination by a tax field auditor who has authority to do a comprehensive review and to fully amend the assessments. Typically, the tax auditor will be a staff member of the local tax office. However, in more and more instances, teams of several auditors will perform a tax audit, and one member of the team will typically be a specialist in international taxes if the company has cross-border transactions. Very large companies, predominantly German MNCs, are subject to continuous audits, i.e., one audit will immediately follow another such that there may always be auditors at a companys premises. Corresponding to the increasing regulatory complexity in transfer pricing matters, German tax authorities have announced that they will focus on transfer pricing in every audit in which a tax payer has cross-border transactions with related parties. In addition, central training programs have commenced in order to train local tax auditors in international taxation, including transfer pricing. Lastly, central - and specifically trained - transfer pricing staff are available at the Central Federal Tax Office (Bundeszentralamt fr Steuern) and who will participate in larger audits.
Dispute resolution - advance pricing agreements (APAs)

In 2006, the German Tax Authorities issued a comprehensive circular letter on advanced pricing agreements (APAs). The circular letter outlines, among other things:
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general principles governing an APA procedure involving Germany ; preconditions for commencing an APA procedure; required content for the application as well as further information and documents to be submitted by the taxpayer with the application; regular term of an APA; implementation of an APA under national law; further aspects (including rollbacks, extensions, simplifications for small enterprises). In the past, the German tax authorities had been reluctant to enter into APAs. They had expressed doubts that APAs would bring further efficiencies in tax audits and no personal resources had been available to administer APAs. By issuing the circular letter, the authorities confirm, which they had recently stated on other occasions, that they are now willing to issue APAs on a regular basis. This willingness is stressed by the fact that a central team of officials has been installed at the level of the Federal Tax Office (Bundeszentralamt fr Steuern) which is fully dedicated to APAs and will act as competent authority. Practical experience in recent months shows that the authorities are indeed dedicated to the new program. A considerable number of APA applications under the new program have been filed, and they have been processed by the authorities within reasonable time. In general, the authorities expect, and are willing to grant, the holding of a prefiling meeting before the formal application for the APA will be filed. The prefiling meeting allows the tax payer to state his case and to obtain a preliminary response from the authorities whether they will accept the application and, if so, what their positions on the substantive issues are likely to be. Thus, tax payers can avoid the (costly) process of filing an application that will later be declined by the authorities, and can draft an application that already takes into account the feedback received from the authorities in the prefiling meeting. In specific cases, the authorities have accepted prefiling meetings even on a no-name basis, i.e., where tax advisors present cases for clients without disclosing the clients name. Typically, the APA procedure following the prefiling meeting will include the following steps:
filing of the formal APA application; consultations between federal and state (local) representatives; consultations with the other country; conclusion of the APA with other country; approval by applicant and waiver of future appeals; issuance of binding ruling by local tax office reflecting the content of the APA; issuance of tax assessment notices reflecting the APA; ongoing obligations during the duration of the APA, including annual filings of compliance reports. These steps reflect facts specific to the German legal and administrative system, namely the involvement of both federal and state representatives in the procedures (as federal representatives must be in charge of the negotiations with foreign countries, whereas only state representatives make decisions with respect to individual tax payers), as well as the need to issue a binding ruling after the conclusion of the APA (as, under German lax, a tax payer will not be party of the APA and in order to have the APA become binding for the tax payer, a formal binding ruling under national rules needs to be issued directly to him by his local tax office). The German parliament has also enacted provisions on fees payable by a tax payer for an APA. Under the new law, fees are 20.000 euro for an APA, 15.000 euro for the extension of an existing APA and 10.000 euro in case an APA application will be amended by the tax payer after filing. Lower fees apply to small and medium sized business as well as in particular cases. It is important to note that these rules cover bilateral APAs only. Germany will, as a matter of principle, in general not issue unilateral APAs on transfer pricing matters.
Mutual agreement procedures (MAPs)

In 2006, the German authorities also issued a leaflet with respect to international agreements and arbitration procedures. This, too, stresses the increased focus of the authorities on transfer pricing matters, and on their willingness to handle such matters.
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International rulings in Italy - an opportunity for multinational companies
Gianni Colucci, Partner, PricewaterhouseCoopers. Marco Meulepas, Director, PricewaterhouseCoopers.

International rulings in Italy - an opportunity for multinational companies

In 2003, the Italian government introduced a procedure by which taxpayers involved in international business could request advance rulings in connection with transfer pricing as well as interest, dividend and royalty income. The introduction of the international ruling procedure was initially seen as an interesting opportunity by the business environment; however, although as yet the provision has seen limited use. In the following paragraphs, we will briefly describe the new international ruling procedure and highlight the main differences between it and the APA procedure recommended by the OECD. We will also discuss, based on our experience, the main pros and cons of this provision in the Italian tax environment. Description of the international ruling
Article 8 of the Law Decree No. 269, dated 30 September 2003, introduced a tax ruling procedure (international ruling) for companies involved in international business. The ruling may involve tax issues in connection with transfer pricing, interest, dividend, and royalty flows. Article 8 did not provide a detailed regulation concerning the procedure to be followed but gave only general guidelines. Subsequently, on 23 July 2004, Italian tax authorities issued the detailed procedure, including terms and formalities to be observed when applying for an international ruling. Depending on the company or the permanent establishments tax residence, the application must be submitted to either the Milan or Rome office of the International Ruling Office Central Management. The application must include the following information: general information concerning the applicant company, such as the name, its registered office, its tax and VAT identification number, and other details; documentation proving that the applicant meets the eligibility requirements for the procedure; the scope of the application and the purpose of the ruling request; and the signatures of the legal representative(s). Applications submitted with incomplete information may not be accepted. Within 30 days from the receipt of the application or from the completion of the inquiry, the empowered local office of the Italian Revenue Agency notifies the taxpayer to appear in front of the competent Tax Office to verify the accuracy of the information provided, and to define terms and conditions of the negotiation proceeding to be followed. The procedure, according to the law provision, should be completed within 180 days from the filing of the request (although a longer period may be effectively required). The procedure should be concluded by an agreement between the taxpayer and the Tax Office. The concluded agreement will remain into force for three fiscal years (the fiscal year in which the agreement is concluded and the two following years). The agreement must be communicated to the competent Tax authorities of the foreign company, on the basis of the residence of the foreign companies involved in the international transactions.
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Within 90 days before the expiration of the agreements terms, the taxpayer may ask for a renewal. The competent Tax Office must give its approval or refusal to the renewal, at least 15 days before the agreements expiration.
Differences between the international ruling and OECD APAs

The international ruling is a unilateral ruling: the decision is made by the Italian tax authorities and it is simply communicated to the foreign Tax Authority, which does not have to commit itself on the matter, nor it is involved in the discussion. However, it is important to bear in mind that OECD Guidelines recommend that the foreign competent Tax Authorities should be informed about the procedure as soon as possible. The OECD Transfer Pricing Guidelines12 state the preference for bilateral/multilateral APAs rather than unilateral APAs: Wherever possible, an APA should be concluded on a bilateral or multilateral basis between competent authorities through the mutual agreement procedure of the relevant treaty. The reasons for this preference are clearly listed13 in the OECD Guidelines. Difficulties cited with respect to unilateral APAs include: Significant problems that may be created for tax administrations; for example, problems may arise if foreign administrations disagree with the APAs conclusions; Problems that may be created for taxpayers; for example, the unilateral APA may not provide a high level of certainty, and it may not reduce the risk of economic or juridical double taxation for the group. The unilateral nature of the procedure creates the risk of challenge by the foreign Authorities, as well as the ongoing risk of consequent double taxation.
have preferred to enter an APA/ruling in other jurisdictions, where taxpayers can rely on long-term experience and where the procedure has a bilateral/multilateral nature. Taxpayers can then eventually leverage a successful ruling in such jurisdictions into a defense perspective in front of the Italian tax authorities in case of audit. Another possible downside of the ruling procedure is that, because it is a relatively new procedure, there is inadequate experience by both taxpayers and the Italian tax authorities, which may result in long delays in resolving issues and the outcome may be uncertain. Moreover, because there have been few rulings concluded to date, there is not yet a database listing all the cases filed. This type of database, which exists in many foreign countries, would allow taxpayers to understand the approach followed by the Italian tax authorities in similar cases and to know in more detail what documentation must be presented in order to reach an agreement. The existence of consolidated experiences would permit also to the operators to forecast (within certain limits) the outcome of the request, while now a feeling of uncertainty dominates. Given these difficulties, why should a taxpayer consider using the international ruling procedure? It is worth considering that Italian tax authorities are taking an increasingly aggressive position in making assessments based on permanent establishment and transfer pricing issues, and that the Italian penalty system is extremely severe. In case of assessment, penalties may range from 100% to 200% of the tax increase (reduced to one fourth in case of subsequent agreement with the tax authorities). There are no specific penalty protection provisions, even if the taxpayer prepared proper transfer pricing documentation. It is also important to note that there are relatively low thresholds for the imposition of criminal penalties. If no tax return was filed, the threshold for criminal penalties is an assessed tax increase of 77.468,53 euro (the typical case when a permanent establishment is successfully assessed). In the case of an untrue tax return, the criminal penalty threshold is an assessed tax increase of 103.291,38 euro, provided also that the positive nondeclared elements of income (e.g., revenues) exceed either 10% of the positive elements of income declared or 2.065.927,60 euro. Given the tax increase, sanctions, and related potential criminal consequences that may result from a transfer pricing assessment or a permanent establishment assessment, the benefits of a ruling with Italian tax authorities should not be underestimated. In particular, in our opinion, a ruling may be particularly advisable in the following circumstances:
Pros and cons of the Italian international ruling procedure

To date, the international ruling procedure has been rarely utilised by taxpayers. One reason may be that the law does not provide for any safeguards in case an agreement is not reached. This is a valid concern for taxpayers, who could spontaneously disclose much information to the Tax Authorities, who, in the absence of an agreement, could use that information against the taxpayer. As a result, both Italian and non-Italian multinational groups are reluctant to use the procedure. Instead, multinational groups with operations in several countries
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OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 1995, Chapter IV, paragraph F, v), c, n. 4.163. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 1995, Chapter IV, paragraph F, iv), n. 4.148.
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start-up of a new business in Italy, or significant reorganisation of the business model adopted; adoption of a new transfer pricing policy; or following a settlement of a transfer pricing assessment with the tax authorities.
Conclusions
Taxpayers have been insofar reluctant to utilise the International ruling procedure, mainly due to its (relative) newness and to its unilateral nature. Certainly, some changes in the procedure would be desirable; such as the introduction of bilateral ruling or introduction of increased protection for taxpayers. In addition, an increase in actual use of the procedure could create a virtual circuit, reducing taxpayers concerns. In spite of these concerns, taxpayers should evaluate whether or not they may benefit by applying for an international ruling, including a consideration of the benefits of the protection and the certainty granted by a ruling.
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Dispute resolution and double taxation prevention in France
Laurence Delorme, Partner, PricewaterhouseCoopers/Landwell, France. Pierre Escaut, Partner, PricewaterhouseCoopers/Landwell, France.
Dispute resolution and double taxation prevention in France
Transfer pricing environment

In France, transfer pricing rules comply with the arms length principle, and OECD transfer pricing guidelines are in practice adhered to by the French tax authorities (FTA). France is thus not unique in its transfer pricing rules, but rather in the approach of the FTA, which is particularly active in the transfer pricing field; audited companies are frequently subject to significant reassessments. The FTA has shown its strong interest in transfer pricing issues through several recent developments, including an administrative regulation relating to mutual agreement procedures (MAPs) issued in February 2006, a transfer pricing guide for small and medium enterprises (SMEs) released in November 2006, and the introduction in 2005 of a specific unilateral APA procedure in addition to the bilateral one introduced in 1999.
Currently, approximately 30 APA applications are in the process of being negotiated before the FTA, concerning all sectors of activity; approximately 60 have already been signed. Most of them are bilateral, but there are also some multilateral and unilateral ones. They concern mainly European countries (in particular Switzerland, the Netherlands, the UK), and also the United States and Japan. The average duration of APA negotiations is 18/20 months. Bilateral APAs. Bilateral APAs can be initiated only with States which have signed a Tax Treaty with France in line with the OECD model tax treaty. The process can be launched in France or abroad and the duration of the APA will be from three to five years (generally five years). The APA cannot in principle have a retroactive effect; however, it is possible in practice to request a roll back over years open to audit, that may be accepted by the FTA on a case by case basis. Unilateral APAs. Unilateral APAs were introduced in France in 2005 and are only granted in limited cases: where there is no APA procedure in the other considered State; where the transactions involve a significant number of countries (e.g. a French manufacturing company with many foreign distribution companies); for simple but frequent issues such as those relating to management fees (e.g. validation of an allocation key); or for small and medium enterprises. Small and medium enterprises (SMEs): simplified APA procedure. A simplified APA procedure for SMEs has been available since November 2006. The simplified procedure proposed by the FTA includes fewer transfer pricing documentation requirements, and the FTA may assist in the preparation of an economic analysis; further, only a simplified annual APA compliance report is requested.
TP tax audits: approach of the FTA

As a whole, the FTA has been developing a more sophisticated/economic approach towards transfer pricing, and may also be assisted by valuation experts and IT specialists who focus on auditing computerised accounting systems. In addition, audit teams are specialised by sectors, and their level of industry specific knowledge is therefore high. Tax inspectors are now systematically looking at transfer prices, which are scrutinised within general field tax audits. The tax inspector in charge of the audit may be assisted by a transfer pricing specialist (who is a member of a specialised unit). In addition, a computer specialist may request specific computer treatments extracted from the accounting systems, such as margins analysis by product or segmented P&L data by activity. TP verifications usually take time, and can include very detailed information requests in the form of written questionnaires. Major multinational enterprises (MNEs) are audited on a regular basis-every three to four years. Currently, almost all sectors are audited, however, companies in the pharmaceutical, IT, chemical, and luxury sectors are more likely to be targeted, and also, more recently, the banking sector.
Mutual agreement procedures (MAPs)

In February 2006, the FTA issued a regulation regarding MAPs. This regulation provides guidance related to the scope and implementation of MAPs in France. It may be noted that a MAP now suspends the collection of taxes (at no cost to the taxpayer) until the MAP process is concluded. Approximately 250 MAP cases are currently pending before the FTA, of which 100 concern transfer pricing.
Dispute resolution
Advance Pricing Agreements (APAs). French tax regulations provide for both bilateral and unilateral APA procedures. In addition, since 2006, an APA procedure requesting simplified documentation is now available for small and medium enterprises.
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European Union transfer pricing documentation the status of the EUTPD
Caroline Goemaere, Manager, PricewaterhouseCoopers, Belgium/US. Patrick Boone, Director, PricewaterhouseCoopers, Belgium.
European Union transfer pricing documentation - the status of the EUTPD

To prevent groups having to take a country-bycountry documentation approach, with all its inherent downsides, the EU Council14 adopted, in June 2006, a Code of Conduct for transfer pricing documentation for associated enterprises in the European Union (EUTPD). The aim of the Code of Conduct is to simplify transfer pricing for cross-border activities within the EU by providing direction for taxpayers in the implementation of standardised and partially centralised transfer pricing documentation for cross-border activities. The Code of Conduct is a political commitment made by EU member states that it would not impose a documentation-related penalty when taxpayers provide specific documentation in good faith, in a reasonable manner and within a reasonable time. This article provides an overview of the EUTPD provisions as well as the two main required elements of the documentation, the Masterfile and Country-Specific Files. Background
In its 2001 communication called Towards an Internal Market without Tax Obstacles, the EU Commission decided that the tax problems for cross-border economic activity across member states have increased over the past years and are still growing. The problems consist primarily of high compliance costs and potential double taxation for intra-group transactions. In order to tackle those problems, the EU Commission decided in 2001 to establish a Joint Forum on transfer pricing comprising representatives of tax authorities and business to allow conflicting perspectives of the two sides to be reconciled. According to the aforementioned communication, tax administrations view transfer pricing as a common vehicle for tax avoidance or evasion by companies and as a source of harmful tax competition between member states, while businesses feel that tax authorities are imposing disproportionate compliance costs. In June 2002, the EU joint transfer pricing forum was established. On June 27, 2006, the EU Council adopted a code of conduct on transfer pricing documentation for associated enterprises in the European Union (EUTPD) that was developed on the basis of work in the EU joint transfer pricing forum.
General principles and application

The code of conduct15 is a political commitment made by EU member states to refrain from imposing documentation related penalties where taxpayers comply in good faith, in a reasonable time with standardised and consistent documentation as described below and apply their documentation properly to determine their arms length transfer prices. In order to have legal effect, the code of conduct must be adopted by the various EU member states in their local tax legislation before taking effect. Many tax administrations within the EU have already formally adopted or provided administrative guidelines referring to the code of conduct. The code of conduct explicitly states that EU member states should (1) not impose unreasonable costs or administrative burden on enterprises in requesting documentation to be created or obtained; (2) not request documentation that has no bearing on transactions under review; and (3) ensure that there is no public disclosure of confidential information contained in documentation. The use of the EUTPD is optional for groups. However, a group that opts for the EUTPD should generally apply this approach collectively to all associated enterprises
14 The Council of the European Union brings together the heads of state or government of the European Union and the president of the Commission. It defines the general political guidelines of the European Union. 15
A Code of Conduct is often referred to as soft law. It is a political commitment made by EU member state. Another example of a Code of Conduct is the Code of Conduct on business taxation (more known under harmful tax competition), which has been fully implemented. A result of this political commitment is the phase-out of various tax schemes existing within the EU member states which were considered by the EU Commission as harmful tax measures. International tax perspectives PricewaterhouseCoopers
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engaged in controlled transactions involving enterprises in the EU to which transfer pricing rules apply. Each company of the group should inform relevant tax administrations of its decision to opt for the EUTPD.
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and risks compared to the previous tax year, e.g. change from a fully fledged distributor to a commissionaire; the ownership of intangibles (patents, trademarks, brand names, know-how, etc.) and royalties paid or received; the MNE groups inter-company transfer pricing policy or a description of the groups transfer pricing system that explains the arms length nature of the companys transfer prices; a list of cost contribution agreements, Advance Pricing Agreements and rulings covering transfer pricing aspects as far as group members in the EU are affected; and an undertaking by each domestic taxpayer to provide supplementary information upon request and within a reasonable time frame in accordance with national rules.
Content
The EUTPD should contain enough details to allow the tax administration to make a risk assessment for case selection purposes or at the beginning of a tax audit. The EUTPD covers all group entities resident in the EU, including controlled transactions between enterprises resident outside the EU and group entities resident in the EU. It should contain all of items listed below, and should be completed taking into account the complexity of the enterprise and the transactions. A multinational enterprise (MNE) groups standardised and consistent EUTPD consists of two main parts, the Masterfile and country-specific documentation. Masterfile The masterfile consists of one set of documentation containing common standardised information relevant for all EU group members. The masterfile should follow the economic reality of the business and provide a blueprint of the group and its transfer pricing system that would be relevant and available to all EU member states concerned. The masterfile should contain the following items:
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As noted above, the code explicitly states that member states should not request documentation that has no bearing on transactions under review. The masterfile should be drawn up in a commonly understood language in the member states concerned. Country-specific documentation The country-specific documentation comprises several sets of standardised documentation, each containing country-specific information. The content of the country-specific documentation supplements the masterfile. Together the two constitute the documentation file for a relevant EU member state. The country-specific documentation would be available to those tax administrations with a legitimate interest in the appropriate tax treatment of the transactions covered by the documentation. The country-specific documentation should be prepared in a language prescribed by the member state concerned. Country-specific documentation should contain, in addition to the content of the masterfile, the following items: a detailed description of the business and business strategy, including changes in the business strategy compared to the previous tax year; information, i.e., description and explanation, on country-specific controlled transactions, including (1) flows of transactions (tangible and intangible assets, services, financial), (2) invoice flows, and (3) amounts of transaction flows;
a general description of the business and business strategy, including changes in the business strategy compared to the previous tax year; a general description of the MNE groups organisational, legal and operational structure (including an organisation chart, a list of group members and a description of the participation of the parent company in the subsidiaries); the general identification of the associated enterprises engaged in controlled transactions involving enterprises in the EU; a general description of the controlled transactions involving associated enterprises in the EU, i.e. a general description of (1) the flows of transactions (tangible and intangible assets, services, financial), (2) the invoice flows, and (3) the amounts of transaction flows; a general description of functions performed, risks assumed and a description of changes in functions
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a comparability analysis, i.e.: (1) characteristics of property and services, (2) functional analysis (functions performed, assets used, risks assumed), (3) contractual terms, (4) economic circumstances, and (5) specific business strategies; an explanation of the selection and application of the transfer pricing method(s), i.e. why a specific transfer pricing method was selected and how it was applied; relevant information on internal and/or external comparables if available; and a description of the implementation and application of the groups inter-company transfer pricing policy. The documentation necessary for a company that is a subsidiary in a group may be different from that needed by a parent company. For example, a subsidiary would not need to produce information about all of the cross-border relationships and transactions between associated enterprises within the group but only about the relationships and transactions relevant to the subsidiary in question.
easily and rapidly tailored as a first line of defense in case of a tax audit. The best practice approach towards EUTPD is always to follow the masterfile concept and to determine the need to prepare local operation based on the groups documentation strategy. This strategy can range from (1) obtaining penalty protection to (2) being able to file the relevant tax returns or (3) increasing the level of comfort of local and/or group management. If the groups strategy is to obtain penalty protection, country-specific files for all European operations should be made in line with local documentation rules for which the functionality was not covered in the masterfile. If the groups strategy is to increase the comfort level, it is sufficient to prepare local files for material companies and transactions.
Conclusion
EUTPD is an excellent way to provide for an intermediary level of documentation between global centralised and localcountry documentation as it allows capturing the market and functional similarities that may exist at an integrated European level. All multinational groups need to develop a documentation strategy and in a number of circumstances, and the EUTPD may be a valuable framework for doing so. In other circumstances, i.e., in cases where groups do not want to go the full length of preparing local documentation, the concept of centralising documentation could be used as a source of inspiration without formally applying the code of conduct. Given the fact that the EU code of conduct is only a political commitment, one can only hope that governments will endorse the principle objective of obtaining cost savings in how groups deal with transfer pricing.
A best practice approach to EUTPD

The EUTPD concept allows groups to streamline its documentation process on a European group level. Preparing EUTPD is an easy way to identify potential transfer pricing pitfalls and planning opportunities. Once it has been produced, efficient centralised updates can be made. The EUTPD concept allows company to efficiently respond to enquiry letters from local tax authorities. Even when groups decide to start with a masterfile, it provides a blue-print of the groups transfer pricing on a European level which can be
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Transfer pricing in the automotive industry
Loek de Preter, Partner, PricewaterhouseCoopers, Germany.
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Transfer pricing in the automotive industry
The automotive industry is undergoing significant change in an expanding global borderless economy. A wide variety of complex relationships have been established through partnerships and joint ventures, including capital participation (contribution), technological tie-up, collaborative development and manufacturing, and sales cooperation. Over the last several years, a number of divestments have occurred as alliances failed to yield the synergies and benefits anticipated. Such changes have provided the entire industry with choices in manufacturing bases, parts sources, and expanded sales regions. As a result of these changes, industrial activity, employment, and industrial technology are moving at an unprecedented rate to countries around the world. In addition, manufacturers are reducing surplus production through restructuring. They are addressing cost reduction as well, by implementing economies of scale through platform integration and the resulting standardisation of parts and modularisation that are directed towards increased sales and profit, including global harmonised (hybrid) strategies for automotive engines. Environmental discussions on CO2 reduction and EU environmental regulations are increasing the pressure on automotive companies to provide technological solutions and to reduce development costs, and manufacturers are coordinating development efforts. In todays market, one thing is clear: the entire value chain in the automotive industry is changing and the roles of all parties in the value chain will also change. Multinational businesses must identify whether their existing transfer pricing model can deal with these changes. This article will discuss trends in the automotive industry and how these trends affect transfer pricing considerations.
A changing market
The key issues driving growth in the automotive industry are: global capacity management, with high levels of excess capacity in the industry; cost reduction pressures which have led to the exploitation of lower cost markets for manufacturing; and sales expansion into emerging markets. From the start of the 1990s, suppliers have led the charge into Central Europe, often moving before automakers, and sometimes instead of them. Now they are repeating the trend with investment in East Europe and beyond. Having made significant investments in Central Europe, many suppliers are looking at East Europe as the next phase of their expansion plans. Early movers have been lower-tech and commodity-based industries like tires. But increasingly more complex components are shifting east. This raises questions. Will capacity begin to shift from Central to East Europe? Will suppliers increase their R&D spending in Central Europe? Due to the changing market, all players in the automotive industry are facing supply chain restructuring issues. Troubled suppliers can cause a breakdown in the chain and a forward-thinking corrective plan can be essential for the party that needs to secure the availability of components. It can be expected that there will be fewer global players with a better holistic understanding of strategic portfolio management. Supply chain restructuring issues can include: many suppliers face little to no margin for error; overexposure to weaker OEMs leads to vulnerabilities; higher raw material costs acting as last straw pushing several suppliers past viability threshold (including ones that dont know it yet); low-cost sourcing trend pressurises suppliers with new global price standards; strategic/trade buyers face low cash flow positions & cost pressures limit activity. Successful suppliers will be those able to consistently: claim larger share of value chain margin; sufficiently conduct and fund appropriate R&D; control (or at least influence) sourcing; diversify customer base but among winning OEMs.
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Multinational businesses must identify whether their existing transfer pricing model can deal with these changes or whether they need to consider adjustments to the model and the resulting inter company pricing arrangements. Transfer pricing issues can involve (1) general cross-border issues and (2) transactions involving business restructurings.
General transfer pricing considerations

The current fundamental rule for transfer pricing is the arms length principle. The basic tests for comparing related party arrangements with those of unrelated parties can be met if there any comparable uncontrolled prices (CUPs). In practice, it can be quite difficult to find exactly matching comparables and judgment is required to decide how much adjustment is practical or defendable to bring external prices to an acceptable comparability level. When looking at comparability, some considerations include: is the price of an in-house produced petrol engine comparable with a bought-in diesel engine? unrelated contract manufacturers in the industry versus group manufacturing/assembly sites; impact of R&D and development costs (difficult to adjust results to make them comparable); and relative value of brand and reputation etc. to the overall value of the car. In designing a transfer pricing policy and reward model for the different parties in the value chain, one is often tempted to look at the entities performing the least complex functions first. To justify an at arms length profit level range for these entities, a benchmark study is frequently used. Based on the risk and function profile of the least complex entities, the benchmark study will most likely show that a modest but positive income should be earned. This strategy may not do justice to the overall profitability of the multinational enterprise and may be in sharp contrast with the more complex entities to which the residual profit will be allocated and creates pressure if the overall result of the group is negative. The OECD guidelines recommend a detailed functional analysis that includes an industry and market analysis. A more sophisticated transfer pricing methodology should more adequately take into consideration the specific industry pressures for the automotive industry.
situations. The arms length principle requires taxpayers to determine if compensation must be paid for transfers of tangible and intangible assets, business opportunities, risks, or functions. Although the EU recommended in December 2006 that member states should not apply exit charges for business restructurings within the EU, it remains to be seen whether member states will follow this recommendation. For example, Germany has introduced a new tax law, effective January 2008, which will more aggressively tax the cross border business restructuring if location savings do not flow back to Germany and if the transaction will reduce the German taxable basis going forward. However, the closing facility may not have the decision power, since production capacity management (PCM) is decided centrally and consequently it may not be entitled to those savings. Tax authorities are generally taking a transactional approach when reviewing the tax and transfer pricing aspects of a business restructuring: when valuable (in)tangible assets and income streams are leaving the country and no compensation is paid by the recipient, the arms length principle gives the tax auditor the justification to re-characterise the transaction and increase the taxable income. Treatment of intangibles. When, as part of capacity management, production moves east, the downsising or closing facility may transfer intangibles to other companies within the group. In this situation, an appropriate payment for those intangibles will need to be determined, and the valuation many not be straightforward. For example, if production related intangible property is transferred to the new entity, the business must consider how much profit these intangibles will generate over the long term. The new facility may start its own research and development to be able to release upgrades and new IP that will gradually replace the existing IP. Rather than paying a lump sum for the acquisition of existing IP, a declining royalty may be paid for several years to reward the donating entity for the usage rights of the existing IP. If the new facility starts to sell its production output the question is whether there needs to be a payment for the transfer of a customer list. In the automotive industry however, there is only a limited number of players and the value of a mere customer list might be immaterial as it would be not that difficult to put such a list together. It would be fair to say that it is the customer contracts and the capabilities to continue to conclude new contracts, together with the know how to continue to create innovative products that create value. The robustness of TP models is increasingly linked with the location of key people. The allocation of profits to the respective parties in the value chain needs to consider the function and risk profile. Where the location of key IP assets and associated functions and risks, as spelled out in the intercompany agreements, is not in line with the physical location of the individuals who have the skills to
Transfer pricing considerations in business restructurings

As indicated earlier, the automotive industry continues to see many cross-border movements. It is key to determine whether any taxable effects (exit charges) arise in these
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manage and control these assets, functions, and risks on a day to day basis, authorities will seek to re-characterise them. The issue of significant people functions is a key theme of the US service regulations, of the UK HMRC (Her Majestys revenue and customs) international manual, and of OECD working parties. Other considerations. In addition to the transfer of IP, employees from the closing facility may provide services engineering or management - to the new facilities. If so, the older facility should be paid for those services provided plus an element of profit. Cash flow issues should not be underestimated. The sale of property, plant and equipment may generate cash to (partially) pay for the other shut down costs such as severance payments. Tax authorities may argue that a payment for goodwill resulting in a taxable gain needs to be recognised if profit generating capacity is transferred. However, the profit earning capacity of the older facility will most likely not be sustainable, as the PCM is driven by cost saving objectives that are only achievable in more cost efficient locations. Also, failing to ensure compliance with VAT and customs regulations may cause unnecessary cash outflow. Cash repatriation will be impacted by the availability of deductions and imposition of withholding tax for management charges, financing, royalties, dividends etc.
margin in a central legal entity without the significant people functions, as mentioned before. In addition, as indicated earlier, global capacity management has become a critical issue in the automotive industry. PCM is required to ensure that the costs of production enhance the affordability of products. PCM occurs whenever a new plant opens, or an existing plant expands, contracts, or closes. While PCM begins in operations or strategy departments, finance organisations probably have the most to offer when evaluating the benefits of PCM. Applying the principles of transfer pricing economics, financial organisation can enhance the success of production capacity management by: evaluating and establishing operational infrastructure; developing new plant metrics; and tax considerations and other costs. Properly applied, it lays out the entire value chain of a corporation on a location by location basis, in order to assess the most equitable possible arrangements between disparate entities within a corporation. Then it compares the circumstances of each entity and assigns target profits to each location based on its particular activities, assets, and risks. Transfer pricing economics not only establishes an arms length amount of profits available to a new operation, but it also uncovers hidden opportunities and options within existing global operational and tax parameters that maximise the value of the manufacturing as well as the sourcing activities. Some companies have estimated that by better managing their sourcing operations, hundreds of millions of Euros can be saved. At the extreme, one major global automaker has recently targeted $1 billion in net material cost savings. Whether these savings will have to be reported by several locations that source the products, or whether they can be allocated to a single tax-efficient location, requires strategic PCM considerations that transfer pricing economics can help answer. The choice of a central sourcing team with appropriate decision authority versus a decentralised sourcing team will impact the savings allocation. Transfer pricing can and must be seen in a commercial context. Market developments in the automotive industry have an impact on the value chain that requires companies to make transfer pricing an issue. Transfer pricing can be as much an opportunity as a risk for global tax rate management. Upfront planning and the consideration of transfer pricing issues at the design stage of changes to the operational business model can allow you to avoid unnecessary pain on audit, when it may too late become clear that the transfer pricing model is no longer in line with changed dynamics within the business and the profit allocation is no longer at arms length. Flexibility in the system will ensure you can adapt your pricing in an evolving business.
New business models, new transfer pricing models

When considering transfer pricing models it is key to determine the risk profile, the resources, and the capabilities of the accounting system and what fits the commercial model. The transfer pricing model should consider the effect on bonuses and stock options and ideally the model integrates key performance indicators that are already measured by the business. Insufficient group-wide transfer pricing design, especially following mergers, may increase the exposure to tax authority attacks. Particularly (1) if group IP is not sufficiently well rewarded; (2) production capacity risks are not reflected in the pricing policy; (3) policies are not flexible enough to deal with movement of business to emerging markets. A changing business model can be a catalyst for global profit management. Including tax considerations during the design stage of a revised operational business model is preferable to the alignment of the transfer pricing model years later. Forward thinking puts a company in a better position to capture the profit margins resulting form location saving tax efficiently right from the start. For example, a centralisation of business processes can be managed by a virtual team with members based across Europe. That will, however, cause pressure to report the resulting increase in profit
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Pharmaceuticals and transfer pricing: an EU and German perspective
Loek de Preter, Partner, PricewaterhouseCoopers, Germany. Oliver Wanger, Senior Manager, PricewaterhouseCoopers, Germany.
Pharmaceuticals and transfer pricing: an EU and German perspective

The European pharmaceutical industry is caught in a push-pull of growth and challenge, both of which create issues for transfer pricing. This article provides an overview of recent macro trends in the EU pharmaceutical market and discusses the impact of these trends on transfer pricing issues both in the EU generally and in Germany. Trends in the pharmaceutical market
Despite tough years in 2005 and 2006 in terms of the regulatory environment and public opinion, a number of leading pharmaceutical companies continued to drive impressive growth, with biotech companies leading the market with double-digit growth percentages. This result is due in large part to increasing demand for pharmaceutical products by an aging population. The population of those over 65, who consume about 2/3 of all pharmaceutical products, grows more than two percent a year. In spite of these pockets of strength, however, the European pharmaceutical market faces an increasingly challenging operating environment. Companies are facing declining productivity in their R&D and sales functions, along with increasingly cost-conscious customers, governments, and third party payers. As a result, companies are turning to a range of strategies both to improve sales and contain costs. Major pharmaceutical companies have achieved growth through acquisitions, cooperation agreements, co-marketing agreements and in-licensing agreements. Such moves allow branded pharmaceutical companies to expand their geographical presence, while enhancing the strength and breadth or their pipelines. This strategy led the big M&A deals in 2006, such as Bayers acquisition of Schering for $21,6 billion, Merck KGaAs acquisition of Serono for $13,3 billion and Tevas completion of its $7,4 billion acquisition of IVAX. However, the broadest-reaching trend in the pharmaceutical and biotech industry is the continued emphasis on cost containment. This includes changes to the pricing and reimbursement environment (e.g. price cuts and reference pricing), together with changes in the governmental policy or legislation that helps healthcare providers save money (e.g., governmental support of generics and parallel importation, plus the launch of biosimilars). A number of political/legislative events continue to significantly impact the healthcare industry, such as introduction of Spains 2006 healthcare reform, the implementation of Germanys Economic optimisation of pharmaceutical care act and the introduction of the Mdecin Traitant schme in France. For at least two decades, blockbuster drugs have played a central role in driving the strong growth in the pharmaceutical market. However, the blockbuster model is facing increasing challenges and it is thought to be contributing to the low R&D productivity facing the industry. As a result, the industry is turning away from exclusively favoring the sales and marketing focused blockbuster model and moving towards trying to recapture greater R&D productivity through other strategies. This is also required since numerous patents of big pharmaceutical
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companies will expire in the next years and nearly $13 billion of drug sales across the seven major markets will be subject to expiry in 2007, with a total of $85 billion at risk for the next five years. The profit margin of the big pharmaceutical companies will be reduced respectively, since after two years of generic competition sales volumes at an average are subject to 45 percent erosion. Further, in the German reference pricing market, generic prices declined by as much as 18 percent within the first two years of generic competition. While pharmaceutical companies are developing strategies to manage the changing environment, it may not be evident at first sight to consider at the same time transfer pricing aspects. The pressure on the effectiveness of R&D and the Governmental regulations will impact the overall profitability. The transfer pricing system would need to ensure that the changes in the business strategy do not have a negative impact to the effective tax rate which has the tendency to go up if not carefully monitored.
an initial project success, migrate the existing IP to a low tax country or a country which offers favorable incentives. Such can be tax incentives with reduced or zero tax rates or R&D incentives, such as tax deduction of more than 100 percent of actual R&D expenses. Under the new German rules, taxpayers no longer determine the value of individual (in-)tangible assets, but rather, a transfer should be evaluated as a package, including functions, risks and profit potential. It is expected that the new rules make it easier for the German tax authorities to recognise a taxable compensation when functions are transferred cross border.
Parallel trade
Parallel trade in the pharmaceutical industry refers to the process where pharmaceutical products that are available in one European country are exported and resold in another European country for a higher price by an intermediary. In Europe, unlike in the U.S., it is legal for companies to parallel trade pharmaceutical goods between European companies, as part of the EUs objective of integrating Europe into a single market. The standard route for parallel traded drugs in Europe involves a parallel trader or distributor purchasing drugs from one wholesaler and then reselling them to a wholesaler in another country. Normally, prices of products are driven by market forces, but the pharmaceutical industry is distinct in that drug prices in most countries are regulated by governments and authorities. As a result of this price differential, the flow of parallel traded pharmaceutical products in Europe has tended to be from lower-price markets, like Spain and Greece, to the higher-priced markets, such as UK and Germany. Accordingly, the price differential of drugs between two countries, minus overhead costs such as transportation and repackaging (if necessary), provides a commercial opportunity for a parallel distributor to make a profit by purchasing the drug in the country where it is cheaper and then reselling it in another country at a higher price. Especially when companies within a group are affected from parallel imports, companies must ensure and carefully document that marketing expenses are properly allocated among the group companies that are benefiting from the parallel imports.
Outsourcing and offshoring - major impacts on transfer pricing

With the globalisation of the pharmaceutical and biotech markets, manufacturers are increasingly outsourcing and offshoring numerous stages of drug development to emerging markets. This trend is set out to continue throughout 2007 and beyond, as it offers significant cost savings for many Western companies, which is crucial in order to offset the ever increasing cost of drug R&D in developed markets. Emerging markets such as India and China provide Western pharmaceutical and biotech companies provide ideal locations for outsourcing and offshoring drug development and manufacturing. In addition, these countries are continuing to experience rapid economic expansion, increasing healthcare expenditure, and an improved IP environment. Combined with their huge populations, these growing markets have become key targets for Western companies aiming to expand their global pharmaceutical revenues. The benefits resulting from outsourcing and offshoring drug development and manufacturing to emerging markets may not flow back to the transferring Western company, which may transfer and lose markets, customers, economic functions and risks. The group as a whole will capture the benefits and if the profit (and loss) potential of the transferring taxable entity is significantly reduced, the at arms length principle may require a compensation to be paid. In light of increased outsourcing and offshoring, new German transfer transfer pricing rules, effective from 2008 onwards address the transfer of functions abroad. This is relevant especially for pharmaceutical and biotech companies which start their R&D activities and, then, after
Focusing on the arms length principle

The interpretation of the at arms length principle has become increasingly important in the transfer pricing arena for pharmaceutical companies, as illustrated by the Glaxo case. The IRS had alleged that Glaxos UK-based parent company, GlaxoSmithKline Plc, UK, had not followed the at arms length principle and allotted too little of its profits from worldwide drug sales to its US subsidiary to reward the US marketing and distribution
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organisation. The Glaxo case began with an IRS audit in the early 1990s and ended with a dispute litigated in the U.S. Tax Court, a settlement of tax claims paid by Glaxo of $3,4 billion, plus an abandonment of a tax claim by Glaxo in an amount of $1,8 billion. For pharmaceutical companies, key elements of the transfer pricing documentation will be the description of the value chain and the value drivers as a well a function and risk analysis to support the arms length character of the profitability earned. As the Glaxo case shows, marketing intangibles also seems to be a hot topic. For example, the revised German legislation will, as of 2008, not just require that the arms length principle is adhered to, but will demand that this be measured on the basis of the comparable uncontrolled price if available. If not, indirect comparisons should be extrapolated from whatever semi-comparables can be found, using one of the recognised transfer pricing methods. The thinking in the finance ministry is to exclude the upper and lower quartiles from the statistics assembled. If the taxpayers price lies within the remaining range, it will be accepted; if it does not, the income adjustment is to the median. This adjustment runs counter to the rulings of the Supreme Tax Court, which has consistently held that it is sufficient to adjust to the most favorable limit of an acceptable range. If there are no comparables at all, the taxpayer should make a hypothetical comparison between the maximum price an informed, but independent, buyer would pay and the minimum price a seller would accept. The correct transfer price is the mean between the two. An explanatory decree is expected shortly.
Areas of focus
Best practice shows us that there are, particularly, five areas where companies can focus efforts to improve internal infrastructure to better segregate and prioritise important functionalities and improve communication within the company: improvement of vertical integration of pricing and reimbursement teams within their businesses; restructuring and prioritising R&D activities to better capture in-house R&D innovation; improve the sales force infrastructure; determine which functionalities to outsource; improvements to supply chain and distribution. It is essential to ensure that the changes in the business model and the role and functions of the respective taxable entities, are captured by the transfer pricing model in an at arms length fashion. Because transfer pricing is not an exact science and disagreements with tax authorities may have a material financial impact, an advance pricing agreement (APA) can, in some cases, provide certainty that the arrangements are at arms length.
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Will your intercompany financial transactions withstand a transfer pricing audit?
Michel van der Breggen, Senior Manager, PricewaterhouseCoopers, Netherlands. Jobst Wilmanns, Partner, PricewaterhouseCoopers, Germany. Irina Diakonova, Senior Manager, PricewaterhouseCoopers, Switzerland.
Will your intercompany financial transactions withstand a transfer pricing audit?

Intercompany financial transactions, such as loans, credit guarantees and other financial arrangements may be among a taxpayers most significant intercompany transactions. To establish arms length terms for these transactions, many taxpayers have historically relied on rules of thumb or indicative quotes from bankers, without having specific documentation in place. However, the transfer pricing environment has changed, and such transfer pricing practices are no longer adequate. In recent years, many taxation authorities have developed audit expertise in this field and have increased their focus on intercompany financial transactions. For example, some taxation authorities have noticed a significant increase in the amount of intercompany debt relative to the overall growth of corporate debt in their economies, which has led to an increased focus on the capital structure of taxpayers. Tax authorities are focusing on interest rates as well as the volume of loans. In particular, the use of unusually low interest rates (at the extreme, interest-free loans) or unusually high rates has raised taxation authorities interest. Moreover, the current activity of private equity funds - which typically use high yield loans as part of their financing structure to fund an acquisition - is likely to further increase this attention. The question of whether an inter-company loan is at arms length is twofold and may be viewed from the perspective of whether the terms and conditions, including pricing, of the loan reflect market terms (e.g., is the interest rate at arms length?), and on the other hand whether the size of the transaction is at arms length, in light of the borrowers capacity to repay (i.e., is the quantum of the debt at arms length or is the company thinly capitalised?). While the taxation regime in a given country may define the ways to evaluate both of these factors, from an economic perspective, they are interrelated. The size and the terms and conditions of a loan are bound to impact its interest rate as the credit quality of the borrower generally decreases as the size of the loan increases, and therefore the interest rate applied to a loan impacts the taxpayers ability to repay. In this article we provide an overview of the core transfer pricing issues that arise in relation to intercompany financial transactions, focusing on intercompany debt and credit guarantees.
Intercompany loans and thin capitalisation

In structuring intercompany loans, taxpayers will want to minimise the risk that tax authorities will reclassify an intercompany loan as equity. Specific provisions in the OECD Guidelines16 refer to conditions under which intercompany loans may be re-qualified into equity. Paragraph 1.37 of the OECD Guidelines states that: an investment in an associated enterprise in the form of interest-bearing debt when, at arms length, having regard to the economic circumstances of the borrowing company, the investment would not be expected to be structured in this way. In this case it might be appropriate for a tax administration to characterise the investment in accordance with its economic substance with the result that the loan may be treated as a subscription of capital .... Moreover, many countries have specific rules and/or practices that restrict the level of related party debt. It is therefore crucial to review these issues before adopting any intercompany financing structure for a multinational group, especially since many of these countries are taking action to reinforce their legislation directed towards intercompany financing transactions. For example, France further specified its thin capitalisation rules as of 1 January 2007, prescribing that taxpayers must demonstrate that the interest rate applied on intercompany loans must be higher than the average annual interest rate applied by credit institutions to companies for medium-term variable rate loans. This provision is likely to shift the burden of proof to the taxpayer, since French taxation authorities will, in practice, probably seek to apply the average annual interest rate as a benchmark. Having passed this interest rate test, French taxpayers would subsequently need to pass a second test: the debt-ratio test of thin capitalisation. Germany significantly changed its thin capitalisation rules in 2003 after a ruling of the European Court of Justice in the Lankhorst-Hohorst case17. The revised legislation is applicable for both resident and non resident companies. In general, the revised Corporate Tax Act limited the
16 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (1995). The OECD Guidelines provide guidance on the application of the arms length principle. They are (directly or indirectly) applicable in many of the OECD member states.
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deduction of interest payments as business expenses and, instead, deemed them as a hidden profit distribution if the safe harbor was exceeded and the taxpayer could not prove that a third party would have agreed upon the same conditions. In July 2007, the German State Council agreed to the 2008 corporate tax reform bill. This Bill inter alia includes a new concept to prevent the reduction of taxable income in Germany through extensive debt financing by limiting the deductibility of interest expenses (Zinsschranke). Under the new concept, net interest expenses, i.e., interest expenses in excess of interest income received, will be disallowed to the extend they exceed 30% of EBITDA. The non deductible interest expenses can be carried forward for deduction in future years18. Under the UK thin capitalisation rules (which, on 1 April 2004, were brought wholly within the transfer pricing regime), companies are required to report that their intercompany funding arrangements reflect arms length conditions for corporation tax purposes. To assist local inspectors of tax in dealing with thin capitalisation enquiries, HM Revenue & Customs (HMRC) has published a number of chapters in its International Manual that set out the processes that inspectors are expected to follow and that provide guidance on how to deal with issues that often arise in the context of intercompany loans19. HMRC issued a number of guidance updates that became effective 10 January 2007. While none of these changes represent a dramatic change in HMRCs general approach to thin capitalisation, they do highlight certain key implications for companies either seeking to increase debt in their UK operations or to defend the thin capitalisation position of UK group companies that already have high levels of debt. As in the case of the substantiation of the arms length nature of interest rates, taxation authorities no longer accept high-level analyses such as banks offers to defend a taxpayers capital structure20. Therefore, in light of the above, it is increasingly important for taxpayers to prepare sufficient documentation, including a business rationale, to substantiate their intercompany financing structure.
interest rate charged between related parties is at arms length if it is the rate that would be charged between unrelated parties under similar facts and circumstances at the time when the indebtedness arose. In determining the interest rate, the following facts and circumstances should therefore be taken into consideration: the credit risk of the debtor; volatility of the business, track record of an affiliate and general market conditions; currency of a loan and location of exchange risk; the repayment terms, i.e. tenor, of the loan (short-term vs. long-term); covenants; collateralisation; guarantees; open lines of credit, trading accounts, etc. Based on the above, a best practice approach to establishing an arms length interest rate consists of three fundamental steps, which can be depicted as follows:
Step 1. Determine the level of risk for the borrower (credit rating on a stand-alone basis)
Step 2. Adjust the risk for specific debt characteristics (e.g., term of loan, currency, rate base (fixed/ flexible), convertibility, options (call/ pre-pay), collateral, debt risk rating)
Step 3. Determine interest rate based on market sources (Comparable Uncontrolled Price (CUP) analysis/ benchmarking )
Arms length pricing of intercompany loans

The rate of interest paid on an intercompany loan must be at arms length. Although the application of the arms length principle by the taxation authorities or national courts in each country can vary significantly, the fundamental principle is uniform and implies that the
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Establishing the credit rating of the borrower is crucial in the process of determining arms length interest rates, as it is arguably impossible to arrive at an arms length interest rate for an intercompany loan without considering (implicitly or explicitly) the credit quality of the borrower. According to the OECD, the creditworthiness of an enterprise is a significant factor in determining the lenders perception of credit risk involved in making a loan to that enterprise, a perception that translates into the interest rate charged21. However, many taxpayers neglect to consider the impact of credit quality when evaluating any potential internal and/or external comparables. Unlike many of the other key factors that impact the
European Court of Justice, 12 December 2002, Rs. C-324/00. There are certain exceptions to the 30% clause: - The net interest expenses are less then 1 million (threshold); - The company is not part of a group and interest paid to shareholders of more than 25% does not exceed 10% of the net interest expenses; - The equity percentage of the company under review is not more than 1 % worse than that the one of the consolidated group and the company does not pay more than 10% of their net interest expenses to a shareholder of more than 25%.
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The HMRC International Manual is available at http://www.hmrc.gov.uk/manuals/intmanual/index.htm and provides a useful indicator of HMRCs approach to thin capitalisation. This is based on the perception that bank letters often represent an offer from friendly banks, and as long as they have not been approved by a credit committee of the bank and are not actually accepted by the taxpayer, they do not constitute an actual, comparable transaction, which is required for transfer pricing purposes. International tax perspectives 61
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appropriateness of a comparable, the credit quality of a subsidiary of a multinational group may not be directly observable, unless the subsidiary was able to obtain external debt without a related-party credit guarantee or a stand alone credit rating, which is not often the case. Numerous methods for estimating the credit quality of a non-rated borrower have emerged over the past ten years. Nowadays, companies conceivably have the option of obtaining a full, formal rating for a subsidiary from a major rating agency, such as Standard & Poors, Moodys Investors Service or Fitch. On the other hand, rating agencies regularly publish details of how they evaluate specific sectors of the economy and types of borrowers, which may be used as a basis for a credit analysis22. At the same time, credit scoring tools, such as Moodys KMV RiskCalc and Standard & Poors CreditModel, provide a means of estimating the probability of default of a private borrower based upon quantitative criteria. Although published guidance from credit rating agencies and quantitative credit scoring tools have simplified the task of estimating the credit quality of a related-party borrower, the credit estimation process still remains the fundamental and most challenging part of a loan pricing exercise.
For instance, a longer term to maturity23 or subordination to the other creditors will generally lead to a higher interest rate for the debtor, while Euro-denominated loans currently carry a lower interest than USD-denominated loans. The use of prepayment clauses24 or credit facilities with commitment fees may affect the interest rate as well. From the perspective of the group, terms and conditions of intercompany loans should be optimally set in a way to achieve the best possible results, making allowance for the tax climate and the tax position of the related group companies involved. Taxpayers should note, however, that taxation authorities - including those in Belgium, France, the UK, Germany, Switzerland and the Netherlands - have intensified their focus on loan pricing, including the arms length nature of the terms and conditions used. They are rapidly gaining experience and becoming sophisticated in this area, and some tax authorities now have access to various databases used by the banking industry for benchmarking interest rates on loans.
Credit guarantees
Taxation authorities are also increasingly taking the position that providing a credit guarantee for the benefit of a group company constitutes an intercompany transaction whereby an arms length fee should be charged. According to the OECD, a guarantee is a commitment by a [guarantor] to reimburse a lender if a borrower fails to repay a loan. Guarantees shift some of the risk from the counterparty to the guarantor. However, the guaranteed party does not experience a reduction in risk, but should get more favorable terms on the transaction from the counterparty as a result of the guarantee. The terms and degrees of legal enforceability of credit guarantees differ and these differences can have a significant impact on their pricing25. Examples of different type of guarantees are formal guarantees, keepwell agreements, and the implicit parent guarantees. An arms length fee should be determined in accordance with the fee that would be charged for such a guarantee between two unrelated taxpayers under similar circumstances. Since guarantees between unrelated parties are not common (leaving aside credit default swaps), the perfect comparable may be hard to find. One way to approach the issue is to estimate the value of the reduction in the interest rate charged to the borrower as result of the guarantee. This interest rate reduction may be used as a good measure of the value of the guarantee. However, there are various complexities which need to be considered in determining a guarantee fee, one of which is the implicit parent guarantee. According to paragraph 7.13 of the OECD Guidelines no service has been procured, for instance, when an associated enterprise, merely based on its association, has a higher credit rating
Arms length terms and conditions of intercompany loans

It is not just the interest rate which must reflect the arms length principle; the terms and conditions of an intercompany loan must also be set on an at arms length basis. However, as long as these terms and conditions reflect economic reality and as long as the debt fulfills thin capitalisation requirements, there appears to be some flexibility in determining the terms and conditions of an intercompany loan. This flexibility, resulting from the range of financing and interest rate pricing options that are available, can be used for optimising the cash-flows and after-tax earnings within a multinational group. The following chart illustrates the potential impact of the different debt characteristics (i.e., terms and conditions) of a loan on its interest rate:
Debt Characteristics Long Term / Fixed Rate Subordination (+ Preference Shares) Multi-currency Facilities Convertibility (Embedded Derivatives Seniority/Collateral/Guarantees Interest Rate
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OECD Report on the Attribution of Profits to Permanent Establishments dated December 2006, par. 80. For example, Standard & Poors provides an overview of its rating process for industrial firms in its annual Corporate Ratings Criteria publication. This does not apply during flat or even inverse interest rate curves. The prepayment option on a fixed-term loan. International tax perspectives PricewaterhouseCoopers
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than it would have had without any association .... This paragraph suggests that any benefit derived from the fact that a company is part of a group and that a third party merely for this reason is willing to provide more favorable terms on a loan, cannot be charged for. If and to what extent a third party considered this implicit parent guarantee (in the context of a credit guarantee), and what value it would have attributed to it (if any) needs to be analysed (and documented) on a case by case basis. Another question is if and to what extent the interest rate reduction (i.e. benefit) resulting from an explicit guarantee should be shared between the lender and the guarantor. OECD Guidelines do not provide an answer to this issue, which suggests that taxation authorities can (and actually do) take different views regarding this point. Other considerations which need to be carefully addressed when establishing guarantee fees include: a guarantee/pledge provided by a subsidiary for the benefit of the parent: what is the probability that the subsidiary will be able to fulfill its obligation once the parent defaults? cross guarantees: which party(ies) are providing/receiving a benefit? How should the cross guarantee be priced? how should one account for small guarantors and large guaranteed entities?
denomination of the group loans to - for instance - USD, EUR and GBP, a matrix of credit spreads can be prepared to facilitate setting the interest on intercompany loans. The credit spreads in the matrix must be regularly updated to reflect the current markets situation. Alternatively, the credit spreads can be established and documented on a case by case basis. As needed, and to the extent possible, the policy should also reflect jurisdiction-specific requirements, especially in relation to thin capitalisation. Where credit guarantees are provided for the benefit of group companies, taxpayers can also consider including a separate chapter within the policy on how the fee for guarantees will be established. Finally, in addition to the loan pricing policy, robust loan documentation needs to be maintained for each specific transaction (including loan agreements).
Conclusion
With tax authorities gaining further sophistication and being reluctant to accept references to bank quotes as substantiation for the interest rate on intercompany loans, it is critical for taxpayers to consider the arms length nature of their intercompany financial transactions. The merits of each intercompany loan must be reviewed based on the arms length principle and the interest rate must be substantiated, referring to similar transactions that have been conducted in the market and making allowance for the debtors own (stand-alone) credit rating. In addition, thin capitalisation requirements if included in local legislation deserve special attention, since tax authorities increasingly challenge the economic rationale of the intercompany loans or specific terms of the loan on this basis. As tax authorities press further into this area, it is important for companies to mitigate the risks associated with their intercompany financial transactions and to meet local transfer pricing documentation requirements by preparing a loan pricing policy. A loan pricing policy can provide for a consistent and practical approach towards implementing intercompany loans and credit guarantees and at the same time provide for procedures to monitor the loans and guarantees throughout their lifetime.
Developing a loan pricing policy

It is not unusual for multinational companies to have a large number of separate intercompany loans. In order to ensure that the interest on these intercompany loans is determined in an efficient and consistent manner, these companies may want to consider establishing a loan pricing policy. A loan pricing policy determines how, within the group, interest rates are set for each intercompany loan. In such a policy, regard is given to the credit rating of the group companies, for instance by classifying them annually into credit categories based on their financial ratios. By using only a limited number of terms to maturity (e.g., shorter than one year, three years and five years) and by restricting the currency
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There can be situations in which it can be argued that providing a guarantee is an ownership function and therefore should not be charged for. For example, under a net worth guarantee, the guarantor agrees to maintain the fiscal integrity of a company by providing additional capital if the companys net worth should decrease below a specified amount. This kind of guarantee may be provided for a group to remain highly rated, which in turn creates a strong image and attracts superior clients to the group as a whole.
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Integrating intellectual property transfer pricing planning with early stage M&A post transaction activity
Pr Magnus Wisen, Senior Manager, PricewaterhouseCoopers, Sweden.
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Integrating intellectual property transfer pricing planning with early stage M&A post transaction activity
In an increasingly integrated global economy, many multinational enterprises seek out mergers and acquisitions in order to acquire new and unique intellectual property (IP) to maintain their competitive edge or to provide synergies through IP. One way to achieve such synergies is by leveraging product sales or brand reputation by integrating newly-acquired technology into existing products or product ranges. Other companies achieve synergies through IP by integrating the research and development departments of the respective companies in order to save costs, bring new products faster to the market, or develop more advanced products. Of course, not all mergers and acquisitions are for the purpose of acquiring IP. However, even in such cases, both parties will also bring their respective intellectual property to the table. The purpose of this article is to highlight the importance of a thoughtful treatment of IP issues early in the post-merger integration process and to provide insight as to the manner in which this important issue can be handled. Transfer pricing and IP
In the context of transfer pricing, IP refers not only to legally registered and enforceable rights, such as brand names, patents or design, but also to factors such as product know-how, unique packaging, etc. Transfer pricing is generally referred to as the pricing of goods and services sold between two related companies in two different jurisdictions. However, in practice, transfer pricing relates to the manner in which externally generated profits are to be allocated between the various companies and jurisdictions involved in the same value chain. Each company in the value chain is entitled not only to its share of the profits in relation to its specific functions and assets, but also in relation to the risks borne and/or IP owned or controlled. In handling post-merger IP transfer pricing issues, companies must not consider only the legal ownership of IP. Equally, or often more important, is the economic ownership of IP, defined as the entity which has borne the ultimate costs and risks associated with the development of a certain IP. The economic owner can be the legally registered owner or a different legal entity. To add to the complexity, the economic ownership right can be assigned between various legal entities.
Integration of research and development

When the research and development departments of two companies are integrated with the intent to bring a single product portfolio to the market, such a portfolio is likely to contain newly-developed IP as well as existing IP which has been developed by one or both of the two merged companies. For example, a newly-introduced tool may involve an updated design and/or a new feature, with the majority of the software codes and/or processor designs taken from one company and the mechanical parts of the other company. Each individual product can have varying degrees of both new jointly-developed IP and pre-existing IP. And, each individual IP contributes a varying and individual degree of economic value to each specific product. Moreover, these issues are multiplied by the fact that many companies introduce numerous new products each year. As a result, it is a challenge for the post-merger business to ensure that each company is properly remunerated for their IP, and that a correct royalty is paid on sales of each product to its rightful owner. An example of two merging companies with only two new products is presented below. The numbers illustrate the individual shares of economically valueadding IP for each product.
Old IP Company 1 20% 20% Product 1
New developed IP
Old IP Company 2 70%
10%
50%
30% Product 2
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One can clearly imagine the problems that can arise from a transfer pricing perspective if the transfer pricing policies of two merging companies are not aligned, updated, and adjusted to reflect the combined use and development of IP. A few years post-merger, numerous new products are likely to have been jointly introduced to the market and it can be virtually impossible for either party to verify with their local tax authority that they have been properly compensated for their share of the jointly owned IP. The remainder of this article will provide an overview of two alternative routes for a newly merged company to avoid future problems with the integration of research and development and ownership of IP. In the first example, the ownership of the IP within the group is assigned to one single legal entity, while in the second alternative two or more legal entities are assigned a shared ownership of the IP.
In both alternatives, Company 2 will take over the costs and responsibility for all continuous development of the IP. It is important that the license remains in effect until the existing IP at the time of the transfer generates no further economic benefit. As long as the license agreement continues, there will be economic joint ownership of IP between Company 1 and Company 2 which will require a license payment to be paid from Company 2 to Company 1. When the license expires, Company 2 will be eligible for all income attributable to the IP, since Company 2 will then economically own and control the IP. It is important to consider all issues before determining the best method for the IP transfer. If the IP already has already been introduced to the market place, one important issue to consider is the identification of the IP that is unique to the different individual companies. One may also have to determine the importance of the IP as a value driver and the potential time period until the commercialisation of the IP occurs, in order to correct assign ownership rights to IP which is unique to only one on the companies. In complex situations, certain IP rights are assigned on the basis of a license while other IP rights can be sold. Such a transfer can include trade intangibles (such as patents, designs and know-how) and/or marketing intangibles (such as trade name, distribution channels and unique packaging). Depending on whether all of the IP-, or only the trade intangibles-are assigned, Company 1 will either continue to operate as a service provider to Company 2, or as a license manufacturer. Transferring non-routine intangibles26 through a sale From a transfer pricing tax point of view, it is important that the transfer of IP is made at fair market value and that it is properly documented. Certain countries have introduced hindsight rules to discourage the use of an excessively conservative prognosis in the valuation, while other countries have hired their own valuation experts to audit valuations or to make their own assumptions or amendments. As a consequence, IP transfers have emerged as an area in which double taxation issues are likely to arise. To limit this exposure, it is important to structure the transfer of IP from certain countries so that the local hindsight rules are avoided, and to structure the purchase price accordingly, instead of incurring retrospective adjustments by the local tax authorities. The fair market value should preferably be established using a residual income approach27 (also referred to as excess earnings or incremental income), since the fair market price usually aligns very well with the transfer pricing of other services and goods impacting the taxable income of the companies in question. When only certain portions of the IP (such as a trade name or patents) are
Alternative 1 - sale or other transfer of IP

Background In this alternative, which is relatively common when a major company (Company 2) acquires a smaller company (Company 1) primarily to include its superior technology in a certain niche within its own product portfolio, Company 2 is likely to be the future Entrepreneur and the company which commercialises the IP in the form of new products being introduced to the marketplace. Company 1 is likely to continue to perform research and development within its specific niche on a contract basis for Company 2, which integrates the IP from Company 1 into its own research and product development. Company 2 in this case will be the legal and economic owner of all new IP being developed in the group. The key in this scenario is to, at an early stage after Company 2s acquisition of Company 1, make a valuation of the IP of Company 1 and transfer this to Company 2.
Company 1
Transfer of IP
Company 2
Depending on the circumstances, there are various methods of assigning the IP from Company 1 to Company 2. Two common methods are to undertake the transfer on the basis of a time-limited license (phase-out) or via an out-right sale. The primary difference between the two methods is that in a sale, all IP related profits are transferred at once, while in the phase-out, Company 1 will retain part of the IP generated profit for a certain period of time through the time-limited license agreement.
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Non-routine intangibles refer to intangibles which are not commonly known and/or are used by all market participants.
The residual income approach can be described as valuing the IP by adding all future net present cash flow from operations arising during the future lifespan of the IP less applicable market returns for performed functions.
28 The relief from royalty method values the subject IP by reference to the assumption of the annual cost of licensing a similar trade or marketing intangible from a third party. As this methodology does not take any specific value drivers in the trade or marketing intangible into account, it is not as precise as the residual income approach and assumes that the intangibles, rather than the functions, are general in kind and can easily be outsourced.
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transferred, a relief from royalty method28 may be recommended. However, for the transfer of all IP relating to a conversion of a fully fledged manufacturer (one who owns and controls all IP relating to the sale of finished goods and who controls its own trade and marketing IP) a relief from royalty method should be avoided as it does not fully take into account the specific earnings situation and potential of the IP in question. Many countries disallow the use of a cost based valuation for the transfer of IP. Therefore, a cost based valuation should be used only as the last resort when transferring very early stage development projects with highly uncertain market acceptance. It is important to remember that IP valued in purchase price allocation valuations made for accounting purposes are generally not suitable for tax transfer pricing purposes, as such a valuation may not segment out the total value of the IP from a correct tax point of view.
been made, each Company has received its ownership right not only of its previously controlled IP, but has also acquired the right to utilise the IP of the other Company. Going forward, it is important that each of Companies 1 and 2 contributes to the development of the IP-pool. Each Companys contribution should be based upon the economic benefit of the IP to each of the Companies. This usually requires an annual payment from one of the Companies to the other Company. From a transfer pricing point of view, it is important that comprehensive transfer pricing documentation be prepared for the set-up structure, the buy-in payment, as well as the on-going annual payments.
Other planning considerations

From an IP perspective, a post deal environment does not create only tax risks; it also presents opportunities. If carefully handled, the majority of post deal environments present unique one-off opportunities to create additional value from a transfer pricing tax structuring point of view. Two common ways to benefit from the post deal restructuring process include (1) utilising the value of the IP to transfer tax losses carried forward from one jurisdiction29 into another jurisdiction where they might be of more value to the group, and (2) transferring IP to a more tax favorable jurisdiction in order to benefit from long term tax arbitrage possibilities.
Alternative 2 - joint contribution of IP

Background In many merger situations, IP will be used by both companies. In this scenario, a common structure is to have both Company 1 and 2 contribute the rights of their respective IP into a pool of economically and jointly owned IP which is to be used by both companies, for example:
Contribution of IP Company 1 Pool of economically jointly owned IP
Contribution of IP
Conclusion
Company 2
In practice, this is typically referred to as a Cost Sharing Arrangement. Sometimes the right to commercialise the IP can be assigned to the companies for utilisation in the manufacture of various types of products or in the sale of the same or similar products, but in different geographic markets. Utilising a cost sharing agreement When entering into a cost sharing arrangement, it is important that the IP of both Company 1 and 2 is valued. If, subsequently, one of these values changes the future overall economic benefit of the respective impacts on the IP-pool, then the company whose valuation results in less of an impact is required to make a lump sum buy-in payment to the other company. Once such payment has
While the development and control of commercially valuable IP is key to the profitability and competitiveness of many companies, tax authorities usually view IP as the single most important factor in determining whether a correct transfer price has been applied for a given product or set of services. As a consequence, the correct handling of IP and related income and costs has emerged as a key issue for tax authorities when conducting transfer pricing audits. A key element in these audits is to understand changes in the organisational structure, such as mergers and acquisitions activity, as well as the correct remuneration for economically owned IP when commercial integration occurs and/or production is shifted from one entity to another. By failing to address the integration of IP from a tax perspective early in the integration process, companies either realise that tax considerations can prove to be an unexpected barrier or, at least, a delay in the implementation strategy, or the companies become exposed to an unexpected tax risk due to a careless implementation strategy.
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Either due to the fact that the tax losses might be difficult to utilise due to time restrictions or due to the fact that the tax losses are of such a high value that they are not likely to be utilised by normal operating profits in the foreseeable future. International tax perspectives PricewaterhouseCoopers
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OECD - Report on the attribution of profits to permanent establishments
Richard Collier, Partner, PricewaterhouseCoopers, UK. Norbert Raschle, Partner, PricewaterhouseCoopers, Switzerland. Aamer Rafiq, Partner, PricewaterhouseCoopers, UK. Irina Diakonova, Senior Manager, PricewaterhouseCoopers, Switzerland.
OECD - Report on the attribution of profits to permanent establishments

On 21 December 2006, the Organisation for Economic Co-Operation and Development (OECD) Committee on Fiscal Affairs published the new versions of Parts I, II and II of its Report on the Attribution of Profits to Permanent Establishments30. The primary aim of this project has been to achieve a greater consensus on the manner of attributing profits to permanent establishments (PEs) under Article 7 (Business Profits) of the OECD Model Tax Convention and to avoid double taxation. These final versions replace all previous drafts, which should no longer be considered to reflect the views of the OECD. The OECD did not seek any public comment on these versions. It was also announced that work on Part IV (Insurance), published in discussion draft in 2005 is ongoing and that the intention was to publish a new version of Part IV as soon as possible. Subsequently, on 22 August 2007, the OECD issued a revised public discussion draft of its Report on the Attribution of Profits to Permanent Establishments Part IV (Insurance), the last part of the Report. The revised draft replaces the original draft of Part IV released in June 2005. At the time of this writing, comments could be submitted to the OECD by31 October 2007, and a consultation meeting with interested parties was expected to take place on 26 November 2007. This article briefly summarises the main changes and impact of Parts I-III for multinational companies. Revised version of part I on general considerations
Part I of the report is intended to set out the general principles for attributing profits to a PE. Two key steps are detailed in the authorised OECD approach, resting on the fundamental basis that the PE is hypothesised as a distinct and separate enterprise:
Determining the profits of an enterprise: authorised OECD approach (AOA)
Step 1 Determining the activities and conditions of the PE
Step 2 Determining the profits of the PE
The functionality separate entity approach
Functions performed Assets used Risks assumed Capital & funding attribution Recognition of dealings
Applying transfer pricing methods to attribute profit Comparability analysis
Step 1 involves a full functional and factual analysis. The economic ownership of financial assets is attributed to the part of the enterprise which performs either the significant people functions (SPFs) or key entrepreneurial risk taking (KERT) functions. The PE should be considered as assuming any related risks created by, or inherent in, those functions performed by the PE. KERT functions are, broadly, those which require active decisions making with regard to the assumption or management of risks, whether on an individual or portfolio basis. The location performing those KERT functions (the economic owner) will be assigned the income and expenses associated with holding the financial instruments or lending them out or selling them to third parties. Step 2 requires the profits of the PE to be determined by applying the OECD Transfer Pricing Guidelines (Guidelines) to the PE as a distinct and separate enterprise progressing the assets and risks and engaging in the dealing identified in step one31. Comparability factors relevant under the Guidelines are to be applied directly or by analogy in light of the particular factual circumstances of the PE. It is also necessary to apply by analogy one the Guidelines traditional or transactional profit methods to arrive at an arms length compensation for the dealings between the PE and the rest of the enterprise, taking into account the functions performed by and the assets and risks attributed to the PE.
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Released on 21 December 2006, and available for download at http://www.oecd.org/dataoecd/55/14/37861293.pdf. Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators (1995). International tax perspectives PricewaterhouseCoopers
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Financial sector companies should be aware that Part I is equally relevant to them as non-financial sector businesses. Of note are the following issues which will have relevance: Tangible assets
Non-KERT functions The revised text does recognise that there are other functions which are not necessarily low value functions and could involve a whole spectrum of reward level. Asset/risk transfer
The approach to identifying which part of the enterprise should be considered the economic owner is determined solely by Part I. Under this revised approach the general rule is that the place of use of the tangible asset will determine its economic ownership, unless there are circumstances that warrant a different view. Economic ownership of tangible assets may now be located at a place different from the place of performance of significant people functions related to the acquisition and management of those assets. Intangible assets The report does not wish to be overly prescriptive on this matter, but proposes to focus on the relevant SPFs in determining the situs of intangible property as between PE and home office. The breadth of types of intangible property and the potential subjectivity of any analysis will likely take tax payers and tax authorities into uncharted waters with this issue. Documentation The OECD considers that a greater degree of scrutiny will be likely on dealings between a PE and home office and as such encourages taxpayers to prepare relevant documentation as a useful starting point for the purposes of attributing profit. It is stated that tax administrations will give effect to such documentation although there does seem to be some ambiguity about what documentation will encompass. SPFs/KERTs In Part I, the term KERT has been replaced with SPF. This is explained on the basis that these people functions in the financial sector relating to both the ownership of assets and the assumption/ management of risks are very likely to be the same (hence the KERT terminology is retained in parts II-IV). In any event, there is little practical difference in what is denoted by the KERT or SPF label.
Various comments clarify that where assets and risks are transferred, the required capital to support the business in such a situation will also be reduced. This applies equally to direct asset transfers as well as other risk transfers, e.g. by derivatives. Head office and support costs The new approach requires a profit element to be applied to all service provision and not merely allocating costs. It is an open item as to how taxing authorities will accept head office costs charged on an uplifted basis.
Revised version of part III - global trading of financial instruments

Although there are no fundamental approach changes, a number of significant changes have been made to the previous draft. Scope of part III Clarification is provided that the term global trading may now refer to the dealing or brokering of financial instruments in customer transactions where some part of the business takes place in more than one jurisdiction, consistent with the definition in the US Proposed Global Dealing Reg. Section 1.482-8(a)(2). To be considered global dealing, the operation need only perform one of the enumerated functions in more than one tax jurisdiction. Parameter setting A new commentary of parameter setting arrangements rejects the idea that such activities can qualify as KERTS on the basis that the setting of such overall limits is done on an infrequent basis. Further, the OECD states that where senior management activity is confined merely to setting the parameters which define the potential for assumption of risk, there is likely to be a separate trading function which assumes and manages the risk. The discussion queries whether the parameter setting function should be rewarded at all, and refers to the 1995 Transfer Pricing Guidelines to determine whether a chargeable service has been provided. Dependent agent PEs On the topic of dependent agent PEs and the rule of Art 5(5), the Report emphasises heavily that it is neither
Revised version of part II - traditional banking activities

Other than the encouragement to tax payers to prepare documentation relating to branch dealing, Part II is the least affected by revisions with only relatively minor changes to the text as discussed below.
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concerned with nor addresses the point as to whether a PE exists in respect of a particular global trading activity through a dependent agent. The report states it does not discuss the PE threshold under Art 5(5) but merely provides guidance on how to attribute profits where a PE is found to exist under the existing rules and interpretations of Art 5(5) and (6). KERT functions are to play no role whatsoever in the dependent agent analysis under Art 5. Non-recognition of dependent agent PE and the use of transfer pricing The report clarifies that recognition of a dependent agent PE leads to taxation of the dependent agent enterprise not only on the profits attributable to the people functions it performs on behalf of the non-resident enterprise (and on its own assets and risks assumed), but also on the reward for the free capital which is properly attributable to the PE of the non-resident enterprise. However, there is no automatic symmetrical relief mechanism in place. Hedge fund as a comparable A new section on the applicability of the hedge fund model for the purposes of rewarding capital is included. In general, the discussion seems more open to the use of the hedge fund comparables in appropriate circumstances than in the earlier drafts, although it seems to indicate that the use of hedge fund models is more appropriate for proprietary trading activities than for market making activities. The comments in the OECD paper, however, do not address the dependent agent issues which were a previous limiting factor of the applicability of this model. The treatment of capital in profit splits The report expressively emphasises that in profit splits involving associated enterprises the reward for capital only goes to the enterprise(s) that have the capital. However, this has various associated practical issues which may well lead to multiple dependent agent PEs being created.
I, II and II but only to the extent that such additional guidance does not conflict with the existing article 7. Track 2 Prepare a new version of article 7 and a new commentary in order to fully implement the new conclusions reflected in parts I, II and III in a way that removes any uncertainty as to what is the correct interpretation of the provisions of the article. A first draft of the proposed additions to the existing Commentary was released by OECD for public comment in early April 2007. It is expected that the second part of the implementation package (i.e. a new version of Article 7 with accompanying new commentary) will be released as a subsequent discussion draft by the end of 2007.
Conclusions
The OECD is clearly determined to draw the long running work on this project to a close as soon as possible. With regard to (1) the various issues on which complete consensus of OECD member countries has not been achieved, (2) the open issues relating to implementation, and (3) how the package will be applied in practice, it is not self evident that the goal of the project to achieve a greater consensus with a view to reducing the incidence of double taxation will be achieved. The key issues now relate to the two-track implementation approach, including, for example, how the various issues are allocated and dealt with under either track. It remains to be seen to what extent the full package of all measures which follow logically from the hypothesising of the PE as a separate and distinct enterprise (and which are to be encapsulated in the revised article 7 and commentary; i.e., the track two approach) will be adopted in tax treaties by states, whether OECD members or not. Guidance to such issues as allocation of intangible assets, allocation of capital, dependent agent PEs as set forth in the report can potentially result in multiple outcomes under the OECD proposed approach, which may lead to increased controversy and double taxation. Finally, the OECD report emphasised the importance of documentation to address uncertainties and as a means of managing controversy on a global basis. These final versions of the OECDs report on the attribution of profits to permanent establishments and the subsequent implementation package will have a great impact on all multinational companies.
Work in progress - implementing the conclusions of the report

The working group adopted a two track strategy: Track 1 To supplement the existing commentary to article 7 dealing with the attribution of profits to permanent establishments with additional guidance reflected in parts
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European Court of Justice - the impact of case law on transfer pricing
Caroline Goemaere, Manager, PricewaterhouseCoopers, Belgium/US.
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European Court of Justice - the impact of case law on transfer pricing

Over the last decade, the European Court of Justice (ECJ) has had a great impact on harmonisation in the field of direct taxation. ECJ case law has established the following two principles: (1) EU member states may not impose discriminatory tax measures on nationals of other member states, and (2) EU member states may not impose tax measures which constitute a barrier to exercise of the EC Treaty freedoms or which make the exercise of those freedoms less attractive. Moreover, in ECJ cases to date, over 90% of the 140 judgments relating to direct taxes have been in favor of the taxpayer. Although none of those 140 ECJ judgments related directly to transfer pricing, the principles laid down in the judgments have an indirect impact on transfer pricing legislation within the EU This indirect impact can especially be found in three areas where transfer pricing comes into play: migration, business restructurings and internal country transactions. Background
The EC Treaty makes no provision for direct taxes. The EU member states retain their national powers in direct tax matters. Their competence is nevertheless subject to the requirement that: Although, as Community law stands at present, direct taxation does not fall within the purview of the Community, the powers retained by the member states must nevertheless be exercised consistently with Community law and therefore avoid any overt or covert discrimination on grounds of nationality. Each of the Treaty freedoms is directly applicable in the EU member states and takes precedence over domestic legislation to the extent of any inconsistency. The onus of proving that a case is in breach of one of the Treaty freedoms is a very low hurdle to surmount compared to the enormous hurdle that the EU member states have to get over to prove that the barrier or discrimination is justifiable. The five key Treaty freedoms are: free movement of goods (articles 23 to 31 of the EC Treaty), free movement of workers (article 39 of the EC Treaty), freedom of establishment (articles 43 and 48 of the EC Treaty), freedom to provide services (article 49 of the EC Treaty) and free movement of capital (article 56 of the EC Treaty). The last three freedoms are, in a sense, the freedoms applicable to companies, i.e., corporate freedoms. As indicated, all legislation in place within the European Union cannot be contrary to or cannot impose a barrier to exercise the key Treaty freedoms. The current legislation of EU member states on migration, business restructuring and transfer pricing legislation as such can potentially impose a barrier to exercise the Treaty freedoms based on the principles as laid down in the existing ECJ judgement on direct taxes.
Migration
In March 2004, the ECJ held that the French provision which immediately taxed Hughes de Lasteyrie du Saillant32 on the unrealised increase in value of his shares held in a French company upon his move from France to Belgium, was likely to restrict the exercise the Freedom of Establishment. This decision created significant opportunities for companies considering whether to move their seat of management from one EU member state to another.
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Case C-9/02, Hughes de Lasteyrie du Saillant v. Ministre de lconomie, des Finances et de lIndustrie, OJ C 94, 17.04.2004, p. 5. Case C-470/04, N v. Inspecteur van de Belastingdienst Oost/kantoor Almelo, OJ C267 of 28.10.2006, p. 2.
Communication from the Commission to the Council, the European Parliament and the European Economic and Social Committee, Exit Taxation and the need for co-ordination of member states policies, COM(2006) 825 final.
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The ECJ held that the French provision in question was likely to restrict the exercise of the freedom of establishment, having at the very least a dissuasive effect on taxpayers wishing to establish themselves in another EU member state, because they were subjected in the exit country, by the mere fact of transferring their tax residence outside France, to tax on a form of income that had not yet been realised, and thus to disadvantageous treatment by comparison with a person maintaining his residence in France. In a similar case, the N-Case33, the ECJ stated that although a tax declaration demanded at the time of transfer of residence that was necessary in order to calculate the tax on income at a later stage is an administrative burden, it cannot be regarded as a breach of the freedom of establishment, taking into account its legitimate objective of allocating the power of taxation. Such allocation of the power of taxation cannot, however, give rise to an immediate tax charge and no further conditions attached to the deferral of the tax payment (e.g. imposition of guarantees). In a Communication34, the Commission clearly indicated that it is of the opinion that the interpretation of the freedom of establishment given by the ECJ in de Lasteyrie in respect of exit tax rules on individuals also has direct implications for EU member states exit tax rules on companies. A first implication for companies can be found in the transfer of the registered office of a European Company35 from one EU member state to another. Under the Merger Directive36, such a transfer will not result in immediate taxation of unrealised gains on assets remaining effectively connected to a permanent establishment in the member state from which the office is transferred. The Merger Directive does not indicate the consequences on the assets which do not remain connected to a permanent establishment in the member state from which the registered office is transferred. In its Communication, the EU Commission clearly states that it considers that the principles of de Lasteyrie apply to such transferred assets. The EU Commission states that an EU member state wishing to exercise its taxing rights on the difference between the book value and the market value of the asset at the moment of transfer, may establish the amount of income on which it wishes to preserve its tax jurisdiction, provided this does not give rise to an immediate charge to tax and that there are no further conditions attached to the deferral. In its Communication, the EU Commission provides various
proposals for the practical implementation of such deferral of tax upon realisation including on mismatches of legislation between EU member states. A second implication for companies can be found when a company transfers the seat of management from one EU member state to another. Most EU member states have provisions in their tax legislation that treat a locally resident company transferring its seat of management abroad as having disposed of all its assets at market value for tax purposes. This is arguably contrary to the freedom of establishment37 .
Business restructurings
Another important case with a potential impact on transfer pricing is the Cadbury Schweppes Case38, relating to UK CFC provisions. On 12 September 2006, the ECJ decided that UK CFC legislation was a breach of the Freedom of Establishment. Under the UK CFC provisions, even undistributed profits of a foreign company controlled by UK-resident companies located in a low-tax jurisdiction are profits attributable to the UK-resident company holding at least 25% of the shares in the foreign company. The ECJ concluded, first, that the fact a Community national, whether national or a legal person, sought to profit from tax advantages in force in a member state other than his State of residence cannot in itself deprive him of the right to rely on the provisions of the Treaty. Secondly, it concluded that the UK CFC legislation constitutes a restriction on the Freedom of Establishment which can only be justified by overriding reasons of public interest. The ECJ stated that, in order for a restriction on the freedom to be justified on the ground of prevention of abusive practices, the specific objective of such restriction must be to prevent conduct involving the creation of wholly artificial arrangements which do not reflect economic reality, with a view of escaping the tax normally due on the profits generated by activities carried out on national territory. The conclusion that there is a wholly artificial arrangement intended solely to escape tax should be analysed based on objective factors which are ascertainable by third parties with regard, in particular, to the extent to which the company physically exists in terms of premises, staff, and equipment. If the analysis of these factors leads to the finding that the company is a
35 The European Company Statute which can be created since 8 October 2004. The SE (Societas Europaea) gives companies operating in more than one member state the option of being established as a single company under Community law and so able to operate throughout the EU with one set of rules and a unified management and reporting system rather than all the different national laws of each member state where they have subsidiaries. A company organised in the form of an SE (Societas Europaea) is able to transfer its registered office to another MS, without this resulting in the winding up of the company or the creation of a new legal person. 36 36 37
90/434/EEC. Regard should be given in this respect to the Daily Mail and General Trust Cases. C-194/04, Cadburry Schweppes plc v. Commissioners of Inland Revenue.
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fictitious establishment not carrying out any genuine economic activity in the territory of the member state, the creation of that company must be regarded as having the characteristics of a wholly artificial arrangement. The ECJ refers in this respect to letterbox or front subsidiaries.
Denmark also apply to domestic transactions. Other EU member states will likely follow in the coming years to avoid having their legislation will be challenged; preliminary questions in this respect will be referred by local country courts to the ECJ.
Transfer pricing legislation

Based on the principles established by the ECJ and as outlined above, any transfer pricing legislation that is only applicable to transactions between residents and non-residents is most likely to be in breach of the Freedom of Establishment. Most EU member states transfer pricing legislation, especially on documentation, is likely to be an infringement. Some EU member states have already amended their transfer pricing provisions by extending them to domestic transactions, in order to be in line with the basic Treaty freedoms. For example, transfer pricing documentation requirements in both the UK and
Conclusion
The ECJ has already made a significant impact on the harmonisation of direct taxation. Although no actual transfer pricing case has yet been ruled in front of the ECJ, multinational companies should be aware of, and take into account, ECJ case law and its impact, especially in case of migration and business restructurings. They should also be aware that it can reasonably expected that EU member states will expand the application of their transfer pricing legislation to domestic transactions in order to avoid having their legislation will be challenged and questions in this respect will be referred to the ECJ.
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The European Commission heading towards a common consolidated corporate tax base
Monica Erasmus-Koen, Senior Manager, PricewaterhouseCoopers, Netherlands.
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The European Commission - heading towards a common consolidated corporate tax base
Globalisation raises the question of how international tax bases should be allocated given the lack of a higher, international authority. This question is one of the biggest obstacles to streamlined business taxation in the European Union: How should a company with cross-border activities within the EU report its profits among member states? For several years, the European Commission (EC) has been working on proposals to streamline EU taxation. In 2001, the EC published its communication Towards an Internal Market without Tax Obstacles with various proposals to tackle identified tax obstacles. The key tax obstacles identified were: a multiplicity of tax laws, conventions and practices which entail substantial compliance costs as a result of 25 different company tax systems; not being able to off set losses incurred in one member state against profits earned and taxed in another member state; profits have to be allocated on an arms length basis based on separate accounting (SA). Practice has shown that this gives rise to numerous problems on the fiscal treatment of intra-group pricing, notably in the form of high compliance cost and potential double taxation; companies may find it difficult to reorganise their European operations or expand by cross-border acquisitions, without incurring substantial additional tax costs as a result of capital gains taxes and transfer taxes. In conjunction with this publication, the EC launched a twin-track strategy for removing tax obstacles in the internal market. The first part of the strategy comprises targeted short-term measures such as directives that address specific problems to eliminate the worst of the obstacles. The second prong of the strategy is a comprehensive solution for the long-term, the Common Consolidated Approach (CCA), aimed at eliminating simultaneously most of the tax obstacles faced by the EU firms when operating in the internal market. The short-term measures aim to not only address the immediate internal market needs, but also to provide longer term benefit for those companies which will not be able to take advantage of the CCA. The EC has explored different CCA techniques, but has expressed a preference for a Common Consolidated Corporate Tax Base (CCCTB) approach as basis for taxation within the EU. This article will explore the background and progress of the CCCTB proposal and explain what taxpayers might expect to happen next.
Difficulties with the arms length principle

As far back as 1933, developed countries attempted to address the problem of cross-border taxation by creating the fiction of the separate entity approach, enforced via the arms length principle. The arms length principle aims to allocate international income produced by related entities across multiple tax jurisdictions in accordance with comparable third-party scenarios. But this principle has proved problematic. Among its shortcomings, the arms length principle does not take into consideration the economic synergies resulting from working as a fully economically integrated group. Party dealings (and therefore prices) will never include similar economic synergies. The question for transfer pricing practitioners is whether reliable pricing adjustments to a third-party comparable price are needed and could be made to reflect the effect of group economic synergies. Second, a principle instead of a rule is only workable if the legal system provides meaning and certainty ex post38. The enforcement of the arms length principle has turned out to be problematic because little case law has resulted since 1933 to clarify this principle, given that most transfer pricing cases are settled outside court. In addition, the inherent confidential nature of advanced pricing agreements does not contribute to information that can be used as public goods. This struggle in applying the arms length principle is emphasised by the fact that the OECD only released guidelines to the possible interpretation of the arms length principle in 1995, 57 years after the concept was introduced. Further evidence of the struggle comes from businesses themselves: transfer pricing, which in principle implies the application of the arms length principle, has been reflected as the biggest challenge in more than 20 per cent of cases39 in a number of tax surveys of companies in the EU.
38
Key norms of the OECD Model do not have precise (legal) meaning before the taxpayer acts; rather their precise (legal) meaning is provided after the taxpayer acts through judgement or decision by the (local) court. International tax perspectives PricewaterhouseCoopers
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Two options for a consolidated approachCCCTB or Home State Taxation?

The European Commission believes that the separate entity approach and arms length principle should be replaced by a CCA which would tax income based on a single tax base shared across member states by means of formulary apportionment. In 2004, the EC established the Common Consolidated Corporate Tax Base Working Group (CCCTB WG) to explore options for CCAs. Among options explored by the CCCTB WG are the CCCTB and Home State Taxation (HST). In its simplest it can be said that both approaches would provide businesses in member states with: a consolidated corporate tax base for their EU-wide activities; an appropriate sharing mechanism which can be agreed by all participants; the autonomy to determine applicable national corporate tax rates40. HST suggests that the tax system of the Home State of the parent company of the group is used to compute the profits of the group. For example, a Dutch head office company would use the Dutch tax system to calculate the profits of all its branches and subsidiaries established in participating member states, as if all activities were conducted in the Netherlands41. HST can have the disadvantage that competing enterprises in other MS are subject to different taxation rules. For example, under HST three competing retail shops in Germany would compute their tax base under Belgian, French and German rules according to whether the home state of the group to which they belonged was Belgium, France and Germany42. CCCTB differs in the sense that it would provide companies with establishments in at least two member states with the possibility to compute their group taxable income according to one set of rules, those of the new EU tax base43. The EC has expressed a preference for a CCCTB, and, as explained in more detail below, expects to present a Community legislative measure for the CCCTB in 2008. Issues under consideration include establishing common rules to determine the tax base, international aspects, administrative problems, as well as establishing definitions for consolidated groups and taxable income, the workings of consolidation, x and y and z. Each issue is addressed separately below.
What starting point for the tax base?

The Commission stressed that the development and evolution of the CCCTB would be primarily driven by tax and not accounting needs44. IFRS as such cannot form the basis for the tax consolidation for a number of reasons: the definition of the consolidated group for accounting purposes is broader than the envisaged 75% voting right threshold, many consolidated statutory accounts would also include the results of non-EU subsidiaries, the general principles of materiality and substance over form of IFRS are clearly not entirely in keeping with exiting tax principles, and adjustments would be required in order to arrive at the tax base. In addition, where fair value accounting applies, these unrealised gains should not be subject to taxation and thus further adjustment would be required. Finally, a large number of companies will not use IFRS for accounting, but local GAAP45. In earlier communications the Commission stated that it believes that local GAAP will converge to IFRS, and therefore, it would be sensible to use IAS/IFRS as starting point to establish a common language and some common definitions46. Language in later communications suggests that the EC is diverging from this position towards an independent set of definitions and rules. In the last communication of the CCCTB WG, in May 2007, IAS/IFRS was not even mentioned.
Defining the consolidation group

Although CCCTB would be optional, once a group has opted for the CCCTB, they would be obliged to consolidate the results of the various members of the group which meet the conditions for consolidation. This would prevent potential cherry-picking of which associates should be included in the consolidation group for CCCTB purposes47. Member states would be free to extend the implementation of CCCTB by deciding not to have domestic rules any longer and make CCCTB compulsory for all companies48. The first question to ask is how the definition of group should be determined; legally or economically. The EC has indicated a preference for a legal criterion as used in tax law. A legal definition has the advantage of being objective, certain and easy to administer. There are, however, two weaknesses in such an approach: there could be a misattribution of income as affiliated but economically unrelated entities (because they are active in different industries) would apportion income which they might not have contributed to; a legal criterion could lead to manipulation by adjustment of the ownership percentage.
39 40 41 42 43 44 45 46 47 48
E&Y 2006 Tax Survey. COM (2001) 582 final, p15. S. Lodin and M. Gammie (2001), p2. COM (2001) 582 final, p46. Commission Non-Paper (2004), p1. Commission Non-Paper (2004), p2, p.10. COM (2003)726 final, p17-22. Commission of the European Communities (2006) p7. European Commission CCCTB WG (2006) p11. European Commission CCCTB\WP\053 p2.
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The CCCTB WG suggested a threshold for consolidation of 75% ownership based on voting rights49, whereas the member states believes the threshold should be higher. This implies that anti-abuse provisions should be introduced to avoid ownership-manipulations, for example, sales or acquisitions of shares for a few days in order to include or exclude a company from the group. A four or five year duration of the options was regarded as a sensible rule, which implies that the entity opting for CCCTB would not be allowed to opt out during this period50. Theoretically, an economic criterion might be more correct based on the understanding that if two commonly owned entities have no economic relationship other than ownership, there is no justification for why these should apportion their income between them. Criteria like functional integration, centralisation of management, and economies of scale as indicia of unitary business, are used in the US for state tax purposes. On the other hand, determining the extent of economic integration is a factual exercise and therefore quite subjective and could lead to inconsistent treatment, implying more complexity and uncertainty, similar to the application of the arms length principle51. A complicating factor would also be the treatment of holding and finance companies in a consolidation based on economic criterion. In principle, holding and finance companies could provide services to a number of economic units within one legal group, making it questionable how these type of companies are treated for consolidation purposes; should these companies be allocated to one specific economic unit or should the income of the holding or finance company be divided over the different economic units. Although the CCCTB WG believes the CCCTB should be made available to the largest possible number of entities, the general view of the experts is that transparent entities should not be included in the personal scope of the CCCTB52. The qualification of the transparent entity itself clearly suggests complications and implies the need for a common definition of a transparent entity, as well as to distinguish between entities not in the scope and entities in the scope but transparent53.
There is currently no consensus on how to treat the consolidated group in the situation when the EU ownership chain is broken by a non-EU entity, the fragmentation into two or more separate CCCTB groups within one single group of companies would introduce complexity and could trigger tax planning opportunities54.
Defining taxable income and consolidation

The definition of taxable income will determine the size of the tax base to be divided between both corporations countries. There exists no international agreement on the computation of profit. The EC has decided that intragroup transactions between participating EU affiliates should, in principle, be excluded and only transactions made to third parties should be included. Intra-group transactions must be understood as transactions between companies belonging to the same CCCTB group and at the time when they belong to the same CCCTB group. There would be no need to require companies to price intra-group transactions at arms length prices as the intra-group profits and losses must be eliminated. Thus, groups would be able to price the internal transactions as they wish. This approach results in a complicating factor being the recapture rules where an intra-group profits or losses have been eliminated on assets sold intra-group, but the company which received the asset or liability leaves the group55. The size of the tax base is influenced by the choice whether only income from EU sources or worldwide income should be included in the income definition. The Commission stated that only income from EU sources (the so called waters edge56) should be apportioned and not the worldwide income of EU multinational companies. This approach simplifies potential technical issues around, amongst others, international differences in accounting standards, the need to convert documents prepared in other languages, as well as the need to renegotiate tax treaties with non-member states which are based on SA and the arms length principle. Logic also dictates that it would be difficult to perform tax audits to confirm the EU attributed profits. As regard to pre-exiting losses (i.e. losses incurred by companies before entering a CCCTB group), the prevailing idea is to ring-fence such losses which could be offset against the share of the common tax base that the company in each member state would get after apportionment. With regard to ongoing losses of the consolidated group as a whole, the suggested approach is to carry forward such loss at the group level and only allocated the consolidated profit to the group when the group itself becomes profitable57. The treatment of losses carry forward should be considered in combination with the decision on whether passive income should be included or excluded from the CCCTB, otherwise losses can get stranded at CCCTB group level, whereas member states are in taxable positions due to receipts of passive income58.
49 50 51 52 53 54 55 56
European Commission CCCTB WG (2006) p11. European Commission CCCTB\WP\053 p3-4. Bogerd (2006), p22. European Commission CCCTB WG (2006) p9-10. European Commission CCCTB\WP\053 p5. European Commission CCCTB\WP\053 p4. European Commission CCCTB\WP\053 p7.
COM (2003)726 final, p23 and European Commission CCCTB WG (2006) p.7. European Commission CCCTB\WP\053 p6. European Commission CCCTB WG (2006) p11-12. S. Lodin and M. Gammie (2001), p9.
57 58 59
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Third county income and the application of tax treaties

The inclusion of third country income within the system and existing treaty relationships raise difficult issues in terms of providing double taxation relief59. The basic idea of formulary apportionment implies that the location of the factors creates the jurisdiction to tax. There are two relevant situations where the boundaries of formulary apportionment results in uncertain situations with respect to third country treaties: 1. EU sourced income of non-EU based affiliates; 2. Non-EU sourced income of EU based affiliates. One important question is how to deal with the difference between the results of the two allocation methods which would result from an EU permanent establishment of a foreign tax head office. The remuneration between the foreign head office and the EU permanent establishment would be based on the arms length principle, but the amount actually attributed to the relevant permanent establishment member state would be based on the CCCTB (the CCCTB would include the EU permanent establishment arms length profit, but this would consequently be apportioned according to the CCCTB sharing mechanism)60. The second scenario asks if the foreign passive income (e.g. interest, dividends and capital gains) received from the non-EU sources should be included in the tax bases and apportioned over the number of EU participating countries. If the third country income is included, further discussions are needed on a sharing mechanism to apply double tax relief for withholding taxes paid in the source country, e.g. the sharing of relating withholding tax amongst the member states61. Another example is that if we suppose that the US tax authorities decide to increase the transfer price of a product delivered from an affiliate in the US to its parent company in France. The affiliates taxable profit in the US will then increase and if we assume that the French tax authorities is willing to adjust the taxable profit downward in France, all the other participating CCCTB countries would be affected by the adjustment62.
Although the waters edge approach is easier to coordinate, the detriment is that the EU will have to master two parallel approaches due to the fact that CCCTB would be optional. Nevertheless, this seems to be the only possibility as tax treaties concluded with the 3rd countries are based on SA with the arms length principle.
The sharing mechanism

For any transfer pricing specialist, the heart of the discussion on the CCCTB is the concept of the sharing mechanism: Some fundamental problems associated with sharing mechanisms are63: it does not determine the precise origin of the income and the result can sometimes be arbitrary; it assumes that all factors earn the same rate of return; there is no theoretical basis for why profits are a fraction of payroll, property and, especially, sales. There are two mechanisms to share profits within the CCCTB group; a macro- or micro-economic approach. The first method takes into account factors aggregated at member state level (macro-factors) such as GDP, national VAT bases, etc. The fundamental drawback of a macrolevel approach is that it disconnects the real economic activity performed by a company in a country with its tax liability in that country, which conflicts with the very idea of a fair distribution of the tax base. This is due to the fact that the EU would not seek enterprise specific company data, but instead it would seek economic data at the level of the member state. In addition, if apportionment was to take place between all member states and not only between member states in which the group operates, member states where a group has no presence would also receive profits associated with the group. Whether this could be considered compatible with international law seems less likely, given the basis for levying income tax is on the ground of a company having economic nexus in the jurisdiction64. The shared view by the Commission and the expert from member states is that a pure macrofactor method cannot guarantee the basic requirement of fair treatment of individual corporate income taxpayers65 66. The second approach focuses on factors calculated at individual company level (micro-factors), such as the value added or the formulary apportionment (FA). The value added would assign the groups tax base on the basis of the ratio value added by a group member-to-all value added of the group, while the formulary apportionment would assign the groups tax base on the basis of a predetermined formula whose elements represent the factors that are deemed to generate the group income (such as property, payroll and/or sale)67.
60 61 62 63 64 65 66 67 68 69 70 71
European Commission CCCTB WG (2006) p8. European Commission CCCTB WG (2006) p7-8. A. Butt (2004), p36. A. Butt (2004), p11 and H Bogerd (2006), p18. A. Butt (2004), p31. European Commission CCCTB WG (2006) p18. European Commission CCCTB\WP\052 p2. European Commission CCCTB WG (2006) p18. European Commission CCCTB\WP\052 p4-5. European Commission (2006), Working paper 9/2006, p.5. European Commission CCCTB WG (2006) p18. COM (2003)726 final, p23.
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Adjusted VAT basis

The countries that apply apportionment formulas; e.g. the US and Canada do not use the value-added method as a basis for FA. Although the value added is a common concept and VAT data is recorded and collected extensively in the EU, value added tax (VAT) returns are consumption-type-destination based. The value added method considered for the CCCTB would most likely be income-type-origin based. Under the origin based approach, goods and services are taxed where they are produced. Thus, using VAT returns as the basis to calculate value added would be complex and involve a lot of calculations for companies68. Additionally, the greatest problems associated with the origin based VAT is that reintroduces the need to value all inter-company transactions and, secondly, it places a heavy tax burden on labor, which represents about two thirds of the value added in the EU economy69. For these reasons the current view of the Commission is that the value added method is not preferable70.
The payroll factor

The payroll factor reflects the labor compensation to employees and it includes employee compensation such as wages, salaries, commissions, bonuses and other forms of remuneration. How third party outsourced labor would be treated is still unclear. With respect to outsourced labor and seconded employees between group companies the question is how the costs should be shared between the service provider and the recipient country. As mentioned labor as a factor for apportionment transforms the corporate tax on a tax on labor, which implies that groups would have the incentive to reallocate labor force to low tax jurisdictions. This is especially of importance if the relevant employees are employed by a group company in a low tax jurisdiction and perform their services for the benefit of the companies in high tax jurisdictions. Further discussions still have to be made with respect to outsourced and seconded labor72. In the view of the CCCTB WG, the location of the factor is where the employee works and if the employee works in more than one country, the compensation is attributed to the employees base of operation. If an employee has no base of operation, the country assigns the payments to the residence state of the employee73. How these adjustments would be made in the basis of the allocation, in practice, has not yet been discussed. The views around the treatment of differences in labor costs and labor productivity across member states are quite diverse. The payroll factor would tend to allocate profits to high-cost countries, which might be perceived as unfair if compensation rates were not really the result of higher productivity74. Other experts believe that in the long term differences in wage levels will tend to disappear across the EU and that there is a self-adjustment effect through the other factors in the equation. The CCCTB WG suggested using the number of employees, instead of or together with payroll as basis. The CCCTB WG will seek the opinion of the private sector on these matters75.
Formulary apportionment
One basic premise of the CCCTB approach is formulary apportionment of a single taxable base. A problem that undisputedly arises when designing a formula is the trade-off between accuracy and simplicity. The Commission has expressed that the factors must reflect the source of income. The Commission is of the view that the three traditional factors: sales, property/capital and labor are vulnerable to manipulation and may not always be the right formula, but they do reflect how income is generated and recognises the contributions made by the manufacturing and marketing activities71. Worth noting is that it is unclear how to deal with a group who is active in several industries since the importance and value of factor would differ from industry to industry, for example the services industry compared to a capitalintense industry. Using only one standard weight formula approach could distort business decisions since the weight of factors would differ from industry. In practice the use of firm specific factors transforms the corporate income tax to direct tax on the chosen factors. The question is therefore to what extent taxpayers would be able to mitigate or defer their tax liability by manipulating these factors.
Apportionment - the property factor

Tangible assets Tangible assets are viewed by some economics as probably the most reliable factor for apportionment since it represents, in essence, a return on capital. The factor is easy to locate and it is furthermore easy to quantity76. There are, however, some problems related to the property factor, which cannot be overlooked:
72 73 74 75 76 77 78 79 80 81
European Commission CCCTB\WP\052 p4-5. European Commission (2006), Working paper 9/2006, p.48. European Commission (2006), Working paper 9/2006, p.48. European Commission CCCTB\WP\052 p7. European Commission (2006), Working paper 9/2006, p.49. A. Butt (2004), p34, 35. European Commission CCCTB\WP\052 p8. European Commission CCCTB\WP\052 p8. European Commission CCCTB\WP\052 p8. European Commission (2006), Working paper 9/2006, p.53.
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it is inappropriate to ignore intangible assets because intangibles are the crown jewels of the corporation and represents the most valuable property in any group; the historic cost of assets provides a poor approximation of the value and the user cost of capital; the contribution of old assets is understated during an inflationary period77. With respect to rented or leased assets, the suggestion by the experts was that the company entitled to depreciate the assets (be it the legal or economic owner) should also take account of the assets for the sharing mechanism78. Intangible assets The problems related to intangible assets, for example know how, patents, marketing intangibles, are that the assets are often difficult to value and locate. Using the cost bases of these intangibles assets could be relatively simple to establish, but there is usually no link between the value and the cost and secondly, historic cost can be difficult to apply since intangibles may be created over a period of time and not necessarily over a year. There is also not a shared view on which company should account for the intangibles, the company using it or the company receiving the royalty payment for granting the use of it. Intangibles still remains one of the main problems of any FA system and omitting intangibles from the formula, similar to the US method, seems highly unsatisfactory and result in a misattribution of the group tax base. For this reason the CCCTB WG and experts have suggested to do more research on this matter79. During a May 2007 conference in Berlin organised by the German Federal Ministry of Finance on the concept and necessity of the CCCTB, the US representative confirmed that the most problems with the allocation of assets under the US apportionment rules arise not with tangibles but intangibles. Financial assets The current line of thinking is that financial assets should not be taken into account for the purpose of apportioning the tax base, mainly due to their mobility (although an exception could be envisaged for financial institutions)80.
Apportionment - the sales factor

The most controversial factor seems to be the sales factor. The main problems are that sales by origin is superfluous because it just replicates the distribution already covered by payroll and capital and sales by destination has a great potential of manipulation (e.g. in low tax jurisdictions), and would duplicate the effect of VAT in the EU. The growing role of E-Commerce in the sales process would also complicate establishing the location of the sales factor81. The elimination of intra-group sales will result in an substantial change from the current at arms length approach, since a manufacturing- and marketing company (separate to the sales company) will not be attributed any profits resulting from the sales factor. The fallacy of this approach is that the marketing assets are reflected in the sales factor by increased sales, but will not be remunerated based on the sales factor for its efforts. In order to reduce the possibility of tax evasion/planning for a destination approach, the CCCTB WG and experts is considering a combination between a macro- and micro level, for example by using industry averages like sales by country for the whole industry and not just the specific group. As mentioned earlier, the weakness of such a macro economic approach (using industry averages) is that the apportionment of income would be based on the activities of others in the industry instead of the activities of the specific taxpayer (group). A small taxpayer located primarily in a low tax jurisdiction could potentially pay most of its tax in a high tax jurisdiction where it has few activities and enjoys few public services. This result would be produced because its competitors would be larger and primarily located in the high tax jurisdiction.
Administrative and legal framework

The Commission has the ambition of a sort of one-stopshop, which would mean that a CCCTB group would file a single tax return to only one tax authority for the entire group of related enterprises. MS would then exchange the information to perform checks and audit on the basis of existing tools (the mutual assistance directive and the recovery directive). Formal procedures for tax audits, as well as who is competent to deliver interpretation on CCCTB legislation also needs further consideration82.
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European Commission CCCTB WG (2006) p15-16. Speech Lszl Kovcs (2007). G. Meussen (2006), p.451-452, P. Farmer (2007), p45 and L. Cerioni (2006). L. Cerioni (2006) and COM(2005) 532 final, p.5. E.g. Cyprus, Estonia, Ireland, Slovakia, Czech Republic, Lithuania and UK. A. Butt (2004), p28.
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What to expect in 2007 and beyond

The following ambitious timeline has been set by the Commission: Discussions on the international aspects and on group taxation should be broadly completed by fall 2007; Work on the administrative and legal framework should be completed by the end of 2007; Start discussion on tax incentives, anti-avoidance and the mechanism for sharing the common consolidated tax base during 2007 with aimed completion in 2008; Revisiting the elements already discussed around (financial) assets and depreciation, reserves, provisions and liabilities and issue final recommendations in 2008. The Commissions intention is to present a Community legislative measure for the CCCTB in 200883 and European Commissioner Kovcs insists that CCA measures will be drafted by the end of 2008, though one may wonder if the process is mature enough for such an important step. A number of scholars, amongst Meussen, Framer and Cerioni84, although supporters of the CCCTB initiative, are doubtful if the member states have the political will to commit to the CCCTB. The Commission has clarified that, in the event of persisting opposition by some member states, CCCBT could be introduced by way of enhanced cooperation under Art 43(f) of the EU Treaty amongst those member states accepting the CCCTB. The Commission hopes that the CCCTB, even if introduced through enhanced cooperation, would be considered attractive by business enterprises and that the tax competition effect could eventually induce the nonparticipating member state to align their rules with those of the CCCTB or join as participating countries85. Although the work on the CCCTB has accelerated since 2004, the number of technical difficulties is increasing; for example, defining the consolidation group, taxable income, dealing with third-country income and tax treaty application, establishing a fair sharing mechanism, etc. Just from a process perspective one may question the sensibleness of pushing for legislative measures in 2008 when considering the still early stages of development of the different subgroup discussions, as well as the lack of buy-in into the CCCTB by a number of member states 86. The plot is further complicated by the fact that the CCCTB would be optional, resulting in parallel systems. The arms length principle would apply in relationships with non-EU affiliates. Affiliates in member states which have optioned not to participate in the CCCTB and EUaffiliates excluded from the group definition. It has still to be seen how cumbersome such an approach would be.
Is the CCCTB approach the right answer?

The CCCTB, though not yet finalised, seems a foregone conclusion. But is it the best solution? As mentioned above, there are shortcomings with the arms length principle: it does not take into consideration the economic synergies resulting from working as a fully economically integrated group, and there is a lack of consistent rule-based presumptions. On the other hand, formulary apportionment has its own serious shortcomings: it does not determine the precise origin of an income; the formula implies that each unit of a factor earns the same rate of return; there is no theoretical reason for profits to be a fraction of payroll, property and sales. The separate entity accounting with the arms length principle, aims to decide the precise origin of income. In general, a CCA, in combination with a mechanism to share the common consolidated tax base, makes the most sense in situations where the precise origin cannot be reasonably established87. On its surface, the CCCTB looks simple, but, as indicated earlier, as the CCCTB WG work continues, increasing technical difficulties are surfacing. In addition, by discarding the separate-entity, arms length approach, the EC discards with it many years of experience and guidance. The benefit of the separate entity approach is still that real economic activities performed by a company in a country are more purely connected with its tax liability in that country. The latter would result in a far more fair distribution of profit, than currently envisaged under the sharing mechanism under the CCCTB. This approach seems to suggest a better balance between efficiency and equity compared to the CCCTB. One cannot believe that member states would be willing to trade-in fairness for simplicity, thus the technical issues around establishing a fair allocation method seem to get entangled in the same economic issues which result in the complexity of applying the SA method. The arms length principle is a global issue, and the OECD works on the level of international consensus. Their work in the area of the treatment of tax disputes may eventually generate more case law relating to the arms length principle by forcing taxpayers to resolve issues. In January 2007, the OECD Committee on Fiscal Affairs approved the publication of the final OECD report on Improving the Resolution of Tax Treaty Disputes. This report brings to a conclusion a multi-year OECD
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COM (2001) 582 final, p30.
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exercise to upgrade the operation of the competent authority process. One of the most important elements in this report is the approval of including language in the OECD Model Treaty and commentary to provide for binding arbitration of unresolved tax disputes (most of which most relate to transfer pricing). According to the final report, taxpayers are allowed to initiate the binding arbitration of issues in competent authority disputes that have gone unresolved for a period of two years. It goes without saying that the model treaty provisions and the commentary are not self-executing. Countries must agree through treaty negotiations or through mutual agreement proceedings to establish an arbitration option. This approach would most likely result in countries aligning interpretation and approaches, amongst other things the application of the arms length
principle, over a number of years. Such a mechanism may provide more certainty in the long-term for taxpayers doing business in the EU. There is no such thing as a perfect mechanism. No system achieves a perfect balance between equity and efficiency. In the words of the Commission; taxation ultimately involves a political choice and may entail a trade-off between pure economic efficiency and other legitimate national policy goals and preferences88. Efficiency must be weighed against concerns of member states over losing their sovereignty with regard to direct taxes, as well as budgetary problems due to possible substantial loss of tax revenue. The EC has many sensitive political choices to make; the next several years will reveal exactly which are made.
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Central and Eastern Europe: transfer pricing comes from behind
Ionut Simion, Partner, Adrian Luca, Manager. Daniela Dinu, Senior Consultant, PricewaterhouseCoopers, Romania.
Central and Eastern Europe: transfer pricing comes from behind
A global CEO survey performed by the Economist Intelligence Unit in 2006 revealed that the most important force shaping global business is the demand originating from emerging markets. Various corporate strategies have been developed to address opportunities in emerging markets, such as the so-called Go where the growth is. This new corporate strategy leads to a constant search for the best foreign direct investment locations, new acquisition targets, and evaluation of offshoring opportunities and new R&D locations. Global companies are recognising that the Central and Eastern
Europe (CEE) region, currently the second fastest-growing emerging market region in the world, should be a central part of their strategy. Nevertheless, careful market prioritisation is not enough to address opportunities in emerging markets. Knowledge and understanding of the tax systems and potential changes to those systems (including the transfer pricing environment) are crucial for the success of a multinational group investing in the CEE region (see Figure 1). The aim of this article is to review the current stage of development of transfer pricing legislation and practice in the CEE region.
Figure 1: The CEE Region
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Transfer pricing legislation in the CEE

The CEE region is a diverse region in terms of TP legislation, level of sophistication and the practice of the tax authorities. The CEE countries that have made the transition to a market economy and that have became part of the trading business community have witnessed an accelerated pace of development of their TP legislative framework and practice. Their attempt to attract foreign investors and their new EU status have led to the introduction in the local legislation of the global standards regarding inter-company transactions. Consequently, numerous countries in the region (mainly the CEE EU member states) have implemented transfer pricing documentation requirements often modeled on the regulations of more developed nations (i.e., Poland in 2001, Hungary in 2003, Lithuania in 2004, Slovenia in 2005, Czech Republic in 2006, Romania in 2006, Croatia in 2006, Estonia in 2007). The countries in the region can be divided into two main categories with respect to transfer pricing. The first group
comprises countries where TP is (or is becoming) a priority and which have more or less an OECD-type legislation and practice. These countries include Poland, Hungary, Slovenia, Lithuania, Czech Republic, Romania, Latvia, and Estonia. Other countries in the region, mainly ex-Soviet states, have only adopted certain elements from the Guidelines (e.g., the application of traditional transactional methods). For example, Kazakhstan tax authorities investigate any transaction with a foreign party, either related or not, with a perceived deviation from the market price of more than 10%. The transactions with entities in foreign states with preferential tax regimes are also investigated. The second group includes countries where TP is not yet a priority (e.g., Albania, Bosnia-Herzegovina, Kyrgyzstan, Macedonia, Moldova, Serbia, Uzbekistan, etc.), but which are contemplating the enforcement and application of the arms length principle. The table below presents a summary of the TP legislative framework of specific countries in the CEE region.
Table 1: CEE/CIS - Summary of TP legislative framework

Legislation Bulgaria Croatia Czech Republic Estonia Hungary Latvia Lithuania Macedonia Poland Yes Yes Yes Yes Yes Yes Yes Yes Yes Documentation Requirements No Yes No No (expected from 2007) Yes No Yes No Yes Enforcement Activity Developing Developing Significantly increasing Developing Developing Aggressive Developing Developing Aggressive Local Comparables Not much practice exists Preferred Preferred Preferred Preferred Preferred Preferred Accept Preferred Pan-Europe Comparables N/A N/A Accepted N/A N/A Accepted Accepted Accept Accepted Penalties No specific TP penalties. No specific TP penalties. Max. 100% of the unpaid tax. No specific TP penalties. 7.500 euro + tax penalties. 100% of unpaid tax. No specific TP penalties. No specific TP penalties. Penalty of 50% tax rate; personal penalties for not submitting the documentation - approx. 360.000 euro and for submitting false data 720.000 euro. No specific TP penalties. No specific TP penalties. No specific TP penalties. 1.700 - 25.000 euro for not having documentation: up to 60% of underpaid tax for entity and up to 2.400 euro for responsible person. No specific TP penalties. Disclosure Requirements Annual tax return and financial statements. Upon request. No Annual financial statements. No Annual tax report. Annual tax report. Annual tax return. Annual tax report, documentation disclosed upon request. Annual tax report. No No Yes with tax return.
Romania Serbia and Montenegro Slovakia Slovenia
Yes Yes Yes Yes
Yes No Yes Yes
Developing Developing Fairly aggressive Fairly aggressive
Preferred N/A Preferred Preferred
N/A N/A N/A N/A
Ukraine
Yes
No
Developing
Preferred
Depends on type of transaction (eg. cross-border or local)
No
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Advance Pricing Arrangements (APAs)

Recent years have also witnessed the emergence of APA regulations in the CEE region. Currently, APA legislation exists in four countries in the region: the Czech Republic, Hungary, Poland and Romania. The APA regulations in these four countries are more or less similar, but with specific differences in terms of duration for which they are granted and issuance fees. The table below provides an overview of the APA legislation in these countries.
Table 2: CEE/CIS - Summary of APAs legislative framework

How long does it take? No deadline (1 year) 120 - 240 days + Unilateral 6 months, Bi/Multilateral 12-18 months Unilateral 12 months, Bi/Multilateral 18 months 5 years or more Yes
Duration? Can it be renewed?
3 years No (new application) Not officially (possible practically) No
3-5 years Yes, once for 3 years
5 years or more Yes, once for 5 years
Pre-filing meetings possible?
Yes
Yes
Yes
Tax office performing audit before? Annual reporting requirement? APA covers: method, comparables, adjustments, critical assumptions, profits?
Yes
Possible but unlikely
No
No Method, comparables, range, critical assumptions. 2006
No Method, critical assumptions, if possible also the range
Yes Method, critical assumptions
Yes Methodology, critical assumptions
When was the APA legislation introduced? Unilateral, bilateral or multilateral? Competent authority? Fee payable?
2007
2006
2007
All
All
All
All
Tax Office 50,000 CZK (1.800 euro)
Tax Office 1% of transaction value, but: unilateral min. HUF 5 mil (20.000 euro); bilateral min. HUF 10 mil (40.000 euro); multilateral min. HUF 15 mil (60.000 euro); in any case maximum HUF 50 mil (200.000 euro)
Ministry of Finance 1% of transaction value but: unilateral domestic entities min. PLN 5,000 - max 50,000 (1.300 - 13.000 euro); (unilateral domestic/foreign entities min. PLN 20,000 - max. 200,000, (5.200 - 26.000 euro) bi/multilateral min. PLN 50,000 - max 200,000 (13.000 - 52.000 euro)
Tax Office Major taxpayers, transactions > 4 mil euro - 20.000 euro; Other taxpayers 10.000 euro
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Transfer Pricing Practice

Looking at the practice of the tax authorities in the CEE region, one could link the level of development of the transfer pricing legislative framework in a country to the level of the tax authorities expertise in investigating TP issues. Enforcement of TP regulations in domestic legislation first requires tax inspectors to gain familiarity and training in this area. Tax authorities have become more aware and sophisticated particularly in the CEE countries that pioneered the introduction of TP legislation, such as Poland and Hungary. On the other hand, investors in other countries in the CEE region continue to face inexperienced tax inspectors in the TP field. Figure 2 is an attempt to present the correlation between the level of the TP legislation and the tax authorities activity in various countries across CEE.
Figure 2: CEE - TP legislation vs. tax office TP activity

TP Legislation
Hungary Croatia Slovenia Lituania Estonia Romania Czech Republic
Poland
Latvia, Ukraine, Slovakia
Russia, Kazakhstan
Bulgaria, Serbia Bosnia
Azerbaijan
Albania, Moldova
TAX OFFICEs TP Activity
Conclusion
As CEE countries have transitioned to a market economy, TP legislation and practices in these countries have tended to follow suit, usually reflecting the regulations in more developed EU countries. Tax authorities interest in the area of transfer pricing has increased in recent years as well, and we expect that they will intensify their audit activity in the TP field, especially for cross-border inter-company transactions. Investing in the CEE region represents a business opportunity that is increasingly part of the corporate strategy of multinational groups. However, among other issues to be considered when investing in CEE region, multinational companies should also take into account the current and prospective TP legislation in such countries and be ready to build a consistent TP strategy. Careful consideration of TP legislation in the CEE region and close monitoring of its future development is essential for making a successful investment and it will enhance the chances for multinational groups to benefit from an optimum resource allocation in the region.
Bibliography 1. CEE / CIS Business Strategy, Corporate Network, Economist Intelligence Unit, The Economist, Prague, May 31st 2007. 2. Practical Transfer Pricing Experience in Other CEE Countries, Janos Kelemen, PwC Transfer Pricing Conference, Bucharest, Romania, April 26 2007. 3. Documentation Best Practices, 2006 Global Transfer Pricing Conference, 24-26 October 2006, Patrick Boone, China. 4. Transfer Pricing in Central & Eastern Europe and Commonwealth or Independent States brochure, Third Edition, February 2007. 5. PKN Stop Press - The Council endorses European Union Transfer Pricing Documentation approach on 27 June 2006, PricewaterhouseCoopers Pricing Knowledge Network, June 26 2006. PricewaterhouseCoopers International tax perspectives 97
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Contacts
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Events
Please save the dates for future PwC Transfer Pricing events hosted by our global network:
Transfer Pricing Masters Series for Financial Services Professionals Singapore - March 2008 New York - May 2008 Amsterdam - May 2008
Transfer Pricing Global Conference 2008 Vancouver, British Columbia, Canada - October 2008
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Global core documentation implementation tool
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NEW ZEALAND
HONG KONG
PHILIPPINES
SINGAPORE
ARGENTINA
AUSTRALIA
INDONESIA
COLOMBIA
MALAYSIA
ECUADOR
THAILAND
CANADA
KEY ( ) = YES / BLANK = No
ASIA-PACIFIC
AMERICAS
Transfer Pricing Rules, In General Q1 Q2 Are there formal transfer pricing rules? Are there transfer pricing-specic penalties in place?
Transfer Pricing Documentation, in General Q3 Is the existence of transfer pricing documentation required by tax authorities to mitigate the imposition of transfer pricingspecic penalties? Is there a formal transfer pricing documentation requirement? Is there an informal transfer pricing documentation requirement?
Q4 Q5

[Q7] [Q9] [Q13] TPSA:
Elements of Transfer Pricing Documentation Q6 Q7 Q8 Must certain transfer pricing-related information be provided as part of (or attached to) your tax return? Is a written functional analysis a required element of transfer pricing documentation? Is a written justication of the transfer pricing method (e.g., CUP, cost plus, etc.) selected and/or not selected a required element of transfer pricing documentation? Is a written arms length analysis a required element of transfer pricing documentation?
Q9
Q10 Are there other required elements of transfer pricing documentation? Timing of Transfer Pricing Documentation Q11 Are there requirements that transfer pricing documentation must be in existence at the time the transaction occurs in order for the documentation to either support the transaction and/or mitigate transfer pricing-specic penalties? Q12 Are there requirements that transfer pricing documentation must be in existence no later than the time the tax return is led in order for the documentation to mitigate transfer pricing-specic penalties? Q13 Is it sufcient for the mitigation of transfer pricing-specic penalties for transfer pricing documentation merely to be presented upon request by the tax authorities? Overall Tranfer Pricing Sophistication Assessment (TPSA) Low Moderate High
Notes: Further information related to the questions above and TPSA are provided below. [Q1] [Q2] [Q4] [Q5] [Q6] Formal rules include tax legislation, government proclamations, etc.
Transfer pricing-specic penalties refer to those other than general tax-related penalties and may include penalties for non-compliance with transfer pricing documentation rules and/or underpayments of tax that are attributable to valuation misstatements related to transfer pricing. Answer Yes if transfer pricing documentation is required by law, decree, etc. Answer No if transfer pricing documentation is not formally required but is expected to be provided during a tax audit. Answer Yes if transfer pricing documentation is not formally required (i.e., by law) but is expected to be provided during a tax audit to support the arms length nature of the intercompany transactions. Such transfer pricing-related information may include (i) nancial statements, intercompany transaction amounts and/or other information of afliated companies; (ii) identication of the pricing method(s) used for each type of transactions; etc.
The term functional analysis refers to the fol performed, risks assumed, and assets utilized
The term arms length analysis is intended to Answer Yes if there is no requirement in you
[Q11-13] It may be appropriate to answer yes to more
The TPSA is a tier ranking system that evalu per country on the questions above. This rank countries based on the complexity of transfer
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MEXICO
TAIWAN
BRAZIL
KOREA
JAPAN
CHINA
Global Core Documentation Implementation Tool
CHILE
INDIA
UNITED STATES
SOUTH AFRICA
NETHERLANDS
PORTUGAL
SLOVENIA
SWITZERLAND
VENEZUELA
LITHUANIA
GERMANY
DENMARK
CZECH REPUBLIC
SLOVAK REPUBLIC
HUNGARY
EUROPE
UKRAINE
SWEDEN
POLAND
RUSSIA
lowing types of information: business overview; description of taxpayers organizational structure; identication of functions by each legal entity; description of the intercompany transactions; etc.
o mean a description of the comparables used, the economic analysis performed, etc.
e than one of these questions.
r country for transfer pricing documentation to be prepared prior to inquiry from the tax authorities.
uates each countrys transfer pricing requirements based on current local legislation. The basis for TPSA are the responses king system is a quantitative approach that equally weights each positive response and allows ordering all participant pricing regulations.
UNITED KINGDOM
ROMANIA
BELGIUM
NORWAY
AUSTRIA
FINLAND
IRELAND
GREECE
FRANCE
TURKEY
ISRAEL
LATVIA
SPAIN
PERU
ITALY
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