Business Restructurings –
OECD Discussion Draft

OECD-Entwurf zu Business Restructurings

Marianna Dozsa/Herbert Greinecker^*)

I. Background

The subject of business restructurings is arguably one of the biggest tax issues of the last ten to 15 years. For tax authorities, the transfer of intangible assets and movement of risk are major concerns due to the resulting, and often very significant, reduction of taxable profits in their county. On the other hand, restructurings are very often commercially driven necessities for businesses to adapt to globalisation and to structure their worldwide operations effectively and efficiently.

Realising that restructurings often raise difficult transfer pricing and treaty issues, the OECD started a project to develop guidance on these issues in 2005. On 19 September, 2008, the OECD released its much anticipated Discussion Draft on Transfer Pricing Aspects of Business Restructurings (discussion draft). Comments from the business community were invited by 19 February 2009. The OECD is expected to decide during the coming months the extent of additional work necessary until the guidance representing the consensus view of its thirty member states can be finalised.

The discussion draft reflects the views of the OECD member countries on some of the most fundamental transfer pricing issues, including the treatment of cross-border transfers of risks, business opportunities, and business functions. It is intended to function as an interpretation of portions of the existing transfer pricing guidelines, so that it would be effective immediately upon adoption in final form. The document can be expected to guide competent authorities and many local tax administrations in applying transfer pricing rules to principal company structures, intellectual property migration transactions, and similar issues even before it is finalised.

The Discussion Draft has been widely welcomed by tax professionals and businesses, and many have congratulated the OECD for the work done so far in preparing a balanced and fair analysis of the business restructurings topic. On the other hand, the feedback during the consultation process highlighted many areas where the draft still lacks consensus and clear guidance or where it is feared to significantly expand government authority to challenge business restructuring transactions under the OECD's existing Transfer Pricing Guidelines (TP Guidelines). It is also thought that the logic and interpretations contained in the document are likely to be applied outside the context of business restructurings.

II. Structure of the Discussion Draft

Business restructurings, for the purposes of the discussion draft, include crossborder redeployment of functions, assets and/or risks by a multinational enterprise. In particular, it addresses the issues raised by “typical” reorganisations seen since the mid-90s, such as conversion of fully fledged manufacturers or distributors into limited risk structures, the rationalisation and/or specialisation of operations and transfers of intangible property. The document contains four draft issue notes addressing the following subjects:

• special consideration for risks,
• arm’s length compensation for the restructuring itself,
• remuneration of post-restructuring controlled transactions,
• recognition of the actual transactions undertaken.

The first issue note provides general guidance on the allocation of risks between related parties in the context of Article 9 of the OECD Model Tax Convention and in particular the interpretation and application of the relevant sections of the TP Guidelines.

The second looks at the arm’s length compensation for the restructuring itself, discusses the application of the arm’s length principle and TP Guidelines to the restructuring, in particular the circumstances where at arm’s length the restructured entity would receive compensation for the transfer of functions, assets and/or risks, and/or an indemnification for the termination or substantial renegotiation of the existing arrangements.

The third issue note examines the application of the arm’s length principle and the TP Guidelines to post-restructuring arrangements.

The fourth discusses some important notions in relation to the exceptional circumstances where a tax administration may consider not recognising a transaction or structure adopted by the taxpayer.

In the sections below we examine some of the key principles outlined by the document and the areas that have drawn the most comments from tax professionals and which appear to be the most controversial in the current discussion draft.

III. Acceptance of Business Rationale for Reorganisations and the “Commercially Rational Behaviour” Test

A very important and welcome feature of the discussion draft is the clear declaration that multinational enterprises (MNEs) are free to organise their business operations as they see fit and are free to act in their own best economic interest. According to the document, tax authorities have no right to dictate how an MNE should design its structure, where to locate its business operations, and cannot be forced to maintain any particular business presence in a country. When acting in their best commercial interest, MNEs have a right to consider tax as a factor.

The discussion draft also affirms that the starting point of the transfer pricing analysis of a business restructuring should be the analysis of the taxpayer’s contracts. So long as the contracts accurately reflect the conduct of the parties, the transfer pricing analysis should be limited to determining the arm’s length consideration for the transactions described in those contracts.

The discussion draft, however, leaves the door open for tax administrations to disregard the transactions in certain, albeit exceptional, cases, discussed in Issue Note 4. Such circumstances may arise where the substance of the transaction differs from its form or where the arrangements “differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner …” The introduction of the “commercially rational behaviour” test and its vague definition is one of the areas that caused the most controversy among business professionals, even though the document repeatedly states that such an avenue should only be used in exceptional cases and that the mere fact that a related party arrangement is not seen between independent parties does not in itself mean that it is not arm’s length.

There are two main questions relating to this issue that make it so fundamental for both taxpayers and tax administrations. Firstly, whether there should be any tool other than price adjustment in the hands of tax authorities for challenging a restructuring assuming that it took place for genuine business reasons, and, secondly, whether those business reasons should be looked at on group or individual entity level.

While some individual tax authorities commented that their countries would routinely seek to disregard transactions where the arrangements themselves are not "arm's length", there appears to be a consensus on the side of business commentators that a focus on arm’s length pricing should be sufficient so long as the taxpayer’s restructuring is commercially rational at group level. This leads to the second part of the question, the conflict between group and individual entity perspectives, looming throughout the discussion draft. The arm’s length principle treats the members of an MNE group as separate entities, rather than as inseparable parts of a unified business. On the other hand, a restructuring that is obviously beneficial for an MNE group for business reasons may impact an individual group member in such a way that it would not engage in the transaction were it an independent party. In order to solve this apparent conflict, the discussion draft seems to suggest that so long as legitimate group level business reasons exist, the question at the individual entity level should be that of finding the arm’s length price.

However, at some places the OECD appears to have lost sight of this principle, and sections of the discussion draft can be interpreted in a way that the commercial rationality test should be applied at the individual entity level. In fact, some tax authorities have already hinted at their intention potentially to disregard a group's bona fide, business motivated restructuring where an individual group member would not have entered into the transaction as a commercial matter. Since MNEs operate in an integrated fashion and nearly always restructure for group reasons, requiring an entity level rationale would defeat the purpose of existence as a MNE.

Based on the above, the discussion draft should clearly state as a core principle that any transaction that has a bona fide non-tax business purpose judged at group level should not be judged to fail the commercial rationality test. Moreover, it should be clear that such a business purpose need not be the primary motivation for the transaction, but instead that a bona fide business purpose, together with tax savings objectives, is sufficient to defeat any claim that the restructuring transactions should be disregarded.

IV. Respect for Individual Terms of Taxpayer Contracts Related to Risk

Risks are of critical importance in restructuring transactions where local operations are often converted into low risk operations. According to the general transfer pricing principles, a company bearing a higher portion of risks should have a greater potential to make profits or losses. Issue Note No. 1 examines the allocation of risks between members of an MNE group and addresses the question when individual terms of taxpayer contracts may be disregarded or rewritten by tax administrators, and attempts to establish the criteria for determining whether a risk is economically significant.

As mentioned above, a universally accepted principle expressed in the discussion draft is that taxpayers’ contracts and commercial arrangements should be the starting point for any analysis of a business restructuring transaction. According to the discussion draft, tax authorities may disregard individual terms of a taxpayer agreement if the actual conduct of the parties is different from the terms of the written agreement, or where the party assuming risks under a contract lacks the managerial capacity and financial substance to assume or manage the risk. This second condition is called the “control” criteria and appears to be the subject of almost as much controversy as the issue of the “commercially rational behaviour” test discussed above since publication of the discussion draft.

The control test becomes an issue in the context of the requirement expressed in the discussion draft for the risk allocation to be “arm’s length” following a restructuring transaction. A contractual risk allocation is automatically deemed to be arm’s length if a similar allocation of risks exists between independent parties. However, accepting that just because a related party arrangement is not seen between independent parties it should not be considered non arm’s length, the OECD had to come up with additional criteria. Where there is no reliable
evidence for similar allocation of risks between independent parties, it is necessary to determine whether the contractual risk allocation in the controlled transactions would have been agreed at arm’s length according to the discussion draft. One of the elements to be taken into account in this context is the issue of control.

The focus on arm’s length allocation of risks, however, potentially opens the road to unproductive hypothetical speculations about what unrelated parties may or may not have done had matters been different than they actually are. In addition to this, control is a relative concept, relative to type of risk and type of organisation. There are plenty of examples between third parties where a party accepts risks without necessarily managing the risk, particularly in the insurance or banking industries. Even in other industries, however, “virtual” management teams or regional and global management structures are becoming increasingly common within MNE groups which makes it very difficult to interpret “control” as “ownership” of the risk. Similarly, cost contribution arrangements not usually require each participant independently to manage part of the risks of, for example, a joint research and development programme. Many commentators agree that the discussion draft understates the importance of financial risk bearing and that it is not possible to separate the consequences of risk realisation from the bearer entity.

Section C of Issue Note No. 1 aims at providing assistance for determining whether a risk is economically significant. The economic significance of a risk is important in the context of business restructurings, since the transfer of an economically insignificant risk cannot generally explain a substantial amount of decrease in the entity’s profit. The discussion draft points to the accounting treatment of risks, i.e. whether or not a risk appears as a contingent liability in the balance sheet, as an important aid in determining if a risk is economically significant. This stance, however, loses sight of the fact that many key risks are not quantifiable enough to appear on the balance sheet as a reserve item. It appears to be important to emphasise that the fact that a risk is not explicitly referred to in agreements or accounts does not necessarily mean that it is not economically significant.

V. Compensation for the Restructuring Itself

Issue Note No. 2 of the discussion draft addresses the question under which circumstances a restructuring itself would give rise to a requirement for compensation. In connection to this, the discussion draft clearly states that profit or loss potential is not an asset in itself and that the arm’s length principle does not require compensation for loss of profit or loss potential per se. Only if actual rights or other assets are transferred in the course of a business restructuring, the question should arise whether these rights or other assets carry profit or loss potential and should be remunerated at arm’s length. Additionally, the discussion draft notes explicitly that “there should be no presumption that all contract terminations or substantial renegotiations should give rise to indemnification at arm’s length”. The clear expression of these principles was generally welcomed by business commentators, particularly in light of the fact that some tax authorities, particularly Germany, have already introduced regulations, or are in practice using potentially much broader criteria for determining when a business restructuring transaction gives rise to compensation and how the compensation should be valued.

The discussion draft itself, however, uses wording and examples at places that can potentially be interpreted in a way that is inconsistent with the above principles. It is for this reason that many commentators focused on Issue Note No. 2 in their analysis. Where profit/loss potential is mentioned as a potential way for valuing actual rights or other assets transferred, the discussion draft can potentially be interpreted as if the shifting of profit potential between related parties could be a taxable event in itself. Business commentators, therefore, expressed the need for the compensation requirements to be clearly limited to transfers of real assets only.

As far as real assets and rights are concerned, a further contested issue is what actually constitutes an asset of value. Particularly in the context of intangible assets, the discussion draft uses very broad examples that include the value of goodwill, while commentators argue that only in the case of protectable intangible assets, such as patents and trademarks, a separate compensation should be justified. This issue leads to the question of potential double standards where different and more burdensome requirements appear to be present in the case of related parties than generally exist between unrelated parties. Individual tax authorities often try to impose or assume such conditions, and the discussion draft now has the potential to support those attempts.

The discussion draft, for example, envisions several circumstances where compensation may be due for the termination of a contract even if it did not have an indemnification clause. It seems to disregard the fact that long-term supply contracts often end between third parties without the disadvantaged party having any ability to seek compensation, for example where manufacturing operations are discontinued in a country adversely affecting the suppliers. Similarly, the existence of long-term relationships does not mean that the parties can expect the same level of profits to continue indefinitely or that such relationships cannot be discontinued between independent parties simply by observing the notice period given in the termination clause. The existence of a long-term contract with enforceable rights seems to be the key in determining whether the restructuring of a “long established” distributor or manufacturer should give rise to compensation in the restructuring itself, for anything other than the transfer of raw material or finished products. Based on the above, many commentators expressed the need to make it very clear that no rights, obligations, or intangible assets are construed in the context of a business restructuring that would not exist between parties dealing at arm’s length.

VI. Remuneration of Post-Restructuring Controlled Transactions

The statement that the arm’s length standard and the TP Guidelines do not and should not apply differently to post-restructuring transactions as opposed to transactions that were structured as such from the beginning is a very important fundamental principle appearing in Issue Note No. 3 of the discussion draft. In its discussion of the choice of transfer pricing method for evaluating a postrestructuring transactions, the discussion draft reiterates the general guidance contained in the TP Guidance and draws on the results of its ongoing review of the role of profit methods.¹ The direction of the OECD’s current thinking on transfer pricing methods is to remove the exceptionality of the profit methods from the hierarchical consideration of available methods and to put a greater emphasis on the relative strengths and weaknesses of each method.

The discussion of methods in the discussion draft, therefore, does not contain many surprises and has generally been subject to fewer comments than the other parts of the document. There are two areas, however, that have been mentioned by some analysts as having the potential significantly to increase the burden on taxpayers in supporting their post-restructuring structure. The first of these issues is the question when the use of the transactional profit split analysis might be justified. Even though the discussion draft points out that the performance of valuable functions, the existence of some intangibles or risks do not necessarily justify the application of a profit split analysis, it makes the statement that in some cases the transactional profit split method may be used as a “sanity check”. This suggestion in itself, according to some commentators, is likely to encourage tax authorities to apply this method, significantly increasing the burden on MNEs. The second point is that what is intended to be a clarification of the difference between a one-sided method (i.e. any method other than the profit split) and a one-sided analysis (i.e. the issue of the level of information required on the non-tested party) in the discussion draft will likely be interpreted by tax authorities as a licence to seek excessive information on the foreign, non-tested participant of the post-restructuring transactions.

The most contested area in Issue Note No. 3 is the discussion about the relevance and validity of before and after restructuring profit comparisons. Many tax authorities often seek to reconcile pre- and post-restructuring profits and seek to place the burden on the taxpayer to justify the change by reference to changes in the allocation of functions, assets, and risks. While the discussion draft makes it clear that such an analysis can by no means rely on in itself, it considers before and after comparisons as a potentially useful tool that may provide “valuable indications” which “could play a role” in understanding the restructuring. The view expressed in the discussion draft, however, completely misses the point that restructurings very often happen in practice as a result of an incremental business change over a period of years involving increasing centralisation. In such cases, the transfer pricing structure often cannot keep up with the reality on the field, resulting in a higher than arm’s length remuneration for the restructured entity in the period before the restructuring.

VII. Documentation and Other Increased Burdens on Taxpayers

Commentators seem to agree that the discussion draft in its current form would substantially increase the already significant burden of transfer pricing documentation on taxpayers.

Issue Note No. 1, for example, expects related parties to document in writing their decision to allocate or transfer risks in advance. Whether compensation may be due for the restructuring itself, discussed in Issue Note No. 2, is determined partly by taking into account the options realistically available to both parties. Although a reasonable requirement in itself, it is not difficult to foresee some tax authorities expecting comprehensive documentation including assumptions regarding financial outcomes of theoretical options that have never been explored in practice. Issue Note No. 3, discussing pre- and postrestructuring pricing arrangements, may necessitate complex before and after comparisons, while Issue Note No. 4 assumes detailed documentation of the business rationale.

While many of these items express realistic expectations in some circumstances, all commentators have asked that the OECD moderate the documentation requirements and possibly determine a “minimum” list of documents that have to be produced in the case of a business restructuring.