Your Taxes: Multinational firms in the firing line

Intercompany cross-border transactions root of problems; ITA increasing number of transfer-pricing specialists.

By JONATHAN LUBICK, LEON HARRIS
Azrieli (photo credit: Reuters)
Azrieli
(photo credit: Reuters)
From Tel Aviv to California, multinational entities (MNEs) are being accused of unfair play when doing their tax planning. The problem occurs when there are international transactions within a group. Somehow it seems most of the profit seems to end up where there is the least tax.
US experience On Monday, in a memo to the Permanent Subcommittee on Investigations of the US Senate Homeland Security and Government Affairs Committee, US Senators Carl Levin and John McCain wrote: “For example, Apple Inc. established an offshore subsidiary, Apple Operations International, which from 2009 to 2012 reported net income of $30 billion, but declined to declare any tax residence, filed no corporate income tax return, and paid no corporate income taxes to any national government for five years. A second Irish affiliate, Apple Sales International, received $74 billion in sales income over four years, but due in part to its alleged status as a nontax resident, paid taxes on only a tiny fraction of that income.”
Other MNEs have faced similar criticism in the UK and elsewhere.
OECD hits back
On April 30, the Organization for Economic Cooperation and Development, to which Israel became a member in 2010, issued a 40-page handbook guide to educate tax authorities on how to choose which cross-border intercompany transactions to examine.
The contents of this handbook are of concern for any entity operating legitimately with foreign-affiliated companies. While the handbook says fact finding is important, it also says the mere existence of certain types of transactions are worthwhile to assess.
Many tax jurisdictions may already be focusing on the various intercompany-pricing (“transfer pricing”) issues noted in the handbook. That the OECD has published a handbook on “risky” transfer pricing items that should be assessed essentially provides justification for all tax authorities to examiner a multinational’s transfer-pricing policies extemporaneously.
For Israeli multinationals, this is all the more frightening because these audits are not only time consuming, but the OECD’s pronouncements may lead to the Israel Tax Authority (ITA) making unsupportable tax adjustments with insufficient fact finding. The same may be expected in other countries.
Why does transfer pricing matter?
Transfer pricing, informally defined internationally as the cross-border pricing of goods, services, intangibles or financial transactions between related parties, is one of the most controversial areas of tax examination by tax authorities. In addition to the handbook, approximately a month ago, the OECD issued a separate report that addressed MNEs’ “shifting” of profits to lower tax jurisdictions.
Transfer pricing has been deemed in this report to be a leading means by which MNEs shift profits.
Now, with the issuance of the handbook, a means of assessing when and how and what transfer-pricing issues to audit is provided to tax authorities globally.
What the OECD said
The latest OECD handbook does provide a summary of the conditions that need to be assessed prior to engaging in a transfer-pricing audit, though we fear the issues it highlights as higher risk will be pursued by the ITA and other tax authorities without due process to the preconditions noted by the OECD.
The transfer-pricing risk-assessment handbook delineates five topics that a tax authority should assess: (1) what questions should the tax authority seek answers to; (2) how can the tax authority evaluate what are a MNE’s material transfer-pricing risks that justify a detailed audit; (3) where can the tax authority get the information necessary to identify the MNE’s transfer-pricing issues; (4) how can the tax authority organize itself to carry out an effective risk assessment; and (5) how can the tax administration most effectively interact with the taxpayer in assessing transfer-pricing risk.
The high-risk transfer-pricing transactions noted by the handbook include large levels of intercompany transactions, intercompany royalty payments for know-how or other intangibles, intercompany services fees for management activities or any other type of service, intercompany financial transactions such as interest expense, insurance premiums or guarantees, and issues pertaining to the sale or sharing of intangibles.
What does the OECD recommend checking?
The OECD handbook describes in detail the various “risk factors” that need to be assessed, including how to assess them. The details pertaining to the examination of these types of transactions (and others) are alarming. The details cover 13 distinct risk factors.
The first risk factor is “profitability.”
By definition, the OECD is presuming that all tax jurisdictions should expect to see profits, and not losses, regardless of the results of the local company’s business. The handbook suggests that a tax authority should automatically begin to perform its own external profitability benchmarking to assess the profits of the MNE under assessment. This benchmarking is being performed with little specific business information on the local MNE, and it is requiring more than a minimum amount of investment by the tax authority.
The second factor is to compare the local MNE’s profits to that of other entities in the group. The idea behind this comparison is to assess whether there is too little attribution of profits to the local MNE. After mentioning this criterion, the handbook then contradicts itself: “If the group as a whole is making healthy profits and the local affiliate is making minimal profits, it might seem significant that the company’s results are worse than those of the group as a whole.
However, at such a high level, this conclusion may be somewhat simplistic.”
Another of the risk factors noted is a policy often relied on by many Israeli companies. The handbook says: “Marketing or procurement companies located outside market countries or countries where manufacturing takes place” should be assessed.
Many Israeli MNEs, and especially those that are either smaller or run a highly centralized business operations, rely on the use of affiliated marketing entities to help to generate their sales. The sales are recorded by the centralized Israeli entity, and the marketing entities receive an appropriate reimbursement.
The OECD handbook says one of two strategies may be adopted by the MNE: It may seek to accumulate excessive profits in that marketing entity, or alternatively, it may seek to minimize profits in that entity. Either way, this type of structuring and business is being deemed to be a higher- risk issue that should be closely examined by the tax authority. A MNE’s business purpose is not mentioned at all in this section of the risk assessment.
Then what happens?
After providing the 13 risk factors, the OECD handbook addresses the types of company documentation that should be requested and provides a list of sources from which the tax authority can obtain the information. The handbook also mentions that for a tax authority to learn more about the taxpayer under assessment, other sources of information include the Internet, including both external searches and the company’s website.
The handbook specifically mentions that the company’s press releases on its website should be carefully examined to gather facts about it. Other sources include external commercial databases and data from other locally reporting private comparable companies. This is known by tax practitioners as “secret comparables” because it normally involves the tax authority collecting tax information on other potentially comparable companies and using it against the taxpayer, with the restriction that the tax authority cannot provide the information to the taxpayer because it is private and restricted data.
In conclusion
The issues raised by the OECD handbook have been known to transfer-pricing practitioners for many years. However, the formal issuance of an OECD handbook, with perhaps not enough qualifications and with the local knowledge in Israel that the ITA has recently hired more transfer-pricing specialists and has many cases with some of the above issues heading to court, raises a red flag for MNEs.
Likewise, abroad, transfer pricing remains a major tax issue that likely will continue to be a major focus for all tax authorities in the coming years.
As always, consult experienced tax advisers in each country at an early stage in specific cases.
jonathan.lubick@econpartners.com leon@hcat.co Jonathan Lubick is the head of Jonathan Lubick Consulting Ltd., a transfer-pricing specialist firm in association with Economics Partners, LLC.Leon Harris is a certified public accountant and and tax specialist at Harris Consulting & Tax Ltd.