Transfer pricing aspects of restructuring

In September 2008, the Organization for Economic Cooperation and Development (OECD) released its much anticipated discussion draft on transfer pricing aspects of business restructurings, which contains comments on the cross-border business reorganizations designed to shift functions, risks and intangibles. The public commentary period on the draft paper ended in February 2009.

The paper is intended to function as an interpretation of the existing OECD transfer pricing guidelines. It is expected to guidemany local tax administrations in examining business restructurings involving tax planning elements such as intellectual property migration, principal structuring, or conversion to a limited risk distributor or a contract manufacturer.

Although the guidelines are not legally binding, they are generally accepted by the Czech tax authorities. The draft paper significantly widens government authority to challenge business restructuring transactions. Specific issues addressed in the draft paper include guidance on the allocation of risks, arm's length compensation for the restructuring (including exit charge), post-restructuring remuneration, and recognition of a transaction or structure.

Current transfer pricing analyses are based on the premise that the assumption of risksmust be compensated by an increase in expected return, and taxpayer's contractual arrangements are typically the first point to determine such risks. The draft paper interpretations allow for recharacterization of individual contractual terms where the economic substance is found to differ from the form (e.g., contractual allocation of risk differs fromthe actual control over those risks such as capacity to make management decisions). Further, the contractual terms can be re-characterized if they are not at arm's length. This is despite the fact that the draft paper reiterates that associated enterprisesmay engage in transactions that independent enterprises would not undertake.

The introduction of amechanismto adjust contractual terms appears to mark a significant departure from the current practice as the OECDModel Treaty rather deals with any such discrepancies via pricing adjustments. This gives rise to higher potential adjustments under different transfer pricing methods.

An exit charge should be imposed at the time of restructuring if valuable intangible assets are in fact transferred. The current draft paper discusses transfers of "profit potential," which is not a concrete asset but rather ameasure of total value being transferred. Themost pertinent consideration is whether the restructuring involves a transfer of rights or assets that carry a valuable potential for future profit.

The draft paper does not address the fundamental question as to what constitutes valuable intangible assets, thus there is a concern that tax authorities will try to impose exit charges in the case of business restructuring even in the absence of a transfer of readily discernable assets.

An important message from the draft paper is that the guidelines and the arm's length principle apply to post-restructured transactions in the same manner as to any transactions structured as such from the beginning. Thus, post-restructuring remuneration would be based on functional and risk analysis and an appropriate transfer pricing method. The post-restructuring remuneration should take into account any foregone compensation for the restructuring itself. Further, the sharing of location savings is dependent upon what independent parties might do in similar circumstances, including considerations for relative bargaining power.

The draft paper acknowledges that if unique functions exist they are unlikely to be benchmarked. That increases the likelihood of the imposition of profit split methodology by tax authorities versus currently used benchmark profitability approach under the Transactional Net Margin Method (TNMM).

The draft paper supports the separate entity hypothesis of the arm's length principle by requiring that transactions are structured in a commercially rational manner-considering whether each of the parties to the restructuring would have found the transaction to be economically justified and evaluating reasonable alternatives. Importantly, it can be commercially rational for amultinational company to restructure in order to obtain tax savings as long as functions, assets and/or risks are actually transferred.

However, if the entire restructuring is commercially rational only at the multinational level, it can be potentially disregarded. Specific examples where the commercialrationality testmay not bemet include transfer of "crown jewel" assets or transfer of intangibles to an "empty" holding company. Further, possible retroactive implementation outlined in the draft paper is certainly intended to give governmentsmore tools to challenge business restructuring arrangements.

With the recent developments in business restructuring in the Czech Republic (e.g., conversions to a limited risk distributor model or shifts of production to lowcost locations), the draft paper and further discussions could have a noticeable impact. The draft paper can raise awareness of the tax authorities on transfer pricing aspects connected with restructuring activities and initiate increased activity of the tax authorities in this respect. The number of tax audits is thus likely to increase and exit charges could be imposed.

The restructuring projects need to be carefully planned to be economically justifiable fromthe local point of view. It is recommended to prepare robust documentation summarizing the economic grounds for the restructuring, collate third party market evidence and benchmarks where possible, and clearly identify the economic ownership of intangibles affected by the restructuring. The contractual terms stated in agreements need to be carefully reviewed against the practice and the arm's length principle. * David Borkovec is director and Natalia Pryhoda is a senior manager at the tax and legal services department of consultancy PwC in the Czech Republic.