News and Resources
| Transfer Pricing Times: Volume VII Issue 1 |
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Nortel Goes Retro on Advance Pricing Agreements Nortel Networks Inc. (NNI), a U.S. Nortel subsidiary, and Nortel Networks Limited (NNL), the principal Canadian Nortel operating subsidiary, are to enter into advance pricing agreements (APAs) to resolve certain Transfer Pricing issues, on a retrospective basis, for the 2001 through 2005 tax years. The APAs are a condition to the December 23, 2009 Final Canadian Funding and Settlement Agreement (“the Canadian Agreement”), which is related to the Nortel entities’ filing for creditor protection in early 2009. Another condition to this agreement is the U.S. Internal Revenue Service (IRS) settlement of NNI transfer pricing issues for the years 1998 through 2008. In return for a settlement payment of US$37.5 million, the IRS has agreed to release its claims of approximately US$3 billion. However, the Canadian Agreement includes a pre-filing claim of US$2.1 billion by NNL in favor of NNI, which will not be subject to any offset. In addition, the APAs will likely result in a tax readjustment by way of an increase in NNI’s taxable income and a decrease in NNL’s taxable income. Typically APAs are oriented towards the future; however, retroactive APAs on years that have been audited can be viewed as a hybrid between a competent authority proceeding (to resolve double taxation) and a simultaneous audit. Rolling an ongoing audit into an APA is often a successful strategy for companies that are in contentious audit situations. The Nortel situation, whereby an APA is entered into for years that have already been audited, and reassessed, could potentially be a new strategy for taxpayers that find themselves in a difficult position. Transfer Pricing in a Tough Economy: Implications for Comparability Considerations The current recession has impacted the way transfer pricing is treated by taxpayers and taxing authorities alike. Some ramifications are to be expected; for example, as taxable income of companies decreases worldwide, taxing authorities are increasing enforcement by mounting more thorough and exhaustive transfer pricing audits. Concurrently, taxpayers are focusing more effort into preparing their transfer pricing analyses as existing policies can become more difficult to justify. A whole host of practical issues can arise; below we discuss two which may not be obvious. One of the most significant challenges for taxpayers when updating their transfer pricing documentation will be increased volatility in sets of comparable companies used under Comparable Profits Method (CPM) and Transactional Net Margin Method (TNMM) analyses. Historically, an economic downturn has led to industry consolidation, temporary losses, and even companies going out of business. These situations can lead to counterintuitive results when updating comparable sets. While it might be expected that an economic downturn could shrink the pool of viable comparables, a less obvious effect may be that removing loss companies actually drives the arm’s length profit range artificially upward. In this situation, the companies that may have been most functionally comparable and reflective of the current economic conditions faced by the tested party are rejected, possibly leaving only the companies with higher margins (which may or may not be most comparable), thereby inflating the range as economic activity slows! Thus, the reliability of comparables ranges under the CPM and TNMM as indicators of true arm’s length pricing may be somewhat compromised. One solution might be to not automatically remove loss companies from the list of comparables. While in ‘normal’ times companies that suffered losses over a multi-year period would automatically be rejected as not reflecting a company’s steady-state operations, these companies should now be examined more closely to see if the losses are in fact driven by negative general economic conditions also faced by the tested party. Another area in which the current economic conditions need to be considered is the application of the Comparable Uncontrolled Transaction (CUT) method to intangible property transactions. A primary comparability factor for this method is the profit potential of the IP being licensed. However, while the taxpayer entering into a licensing transaction today will consider current economic conditions and the impact on the profit potential of the licensed IP, the available comparable agreements for benchmarking the transaction may have been entered into under very different economic conditions. An identified third-party agreement may be comparable in all other aspects, but its pricing relative to the tested transaction could be impacted by differences in the perceived profit potential of the relevant intangible assets due solely to the dates at which the two transactions were executed. One way to combat this disparity is to make adjustments to the pricing of the comparable agreements based on their profit potential relative to the tested transaction. This adjustment could provide a more reliable indication of arm’s length pricing in a down economy, likely leading to a reduction in pricing vs. unadjusted benchmarks. (Another approach would be to limit the CUT analysis to only those agreements that were entered into during similar economic conditions. However, this may significantly limit the number of potential agreements available for analysis.) Hong Kong Implements Transfer Pricing Framework For the first time, Hong Kong’s Inland Revenue Department (IRD) has articulated its position on the application of transfer pricing principles and methodologies within the region’s tax structure. Details can be found in the December 4 release of Departmental Interpretation and Practice Note No. 46, Transfer Pricing Guidelines—Methodologies and Related Issues (DIPN 46). Although DIPN 46 does not represent the implementation of a comprehensive transfer pricing regulatory scheme, it provides a detailed framework to guide the tax administration in evaluating intercompany transactions. In determining arm’s length pricing, the IRD will, by and large, follow the transfer pricing guidelines of the Organization for Economic Cooperation and Development (OECD Guidelines), except when these guidelines are in conflict with express provisions of Hong Kong’s existing tax legislation. The IRD’s integration of DIPN 46 with the region’s current tax ordinances suggests that the note will have retroactive significance as well as current and future implications. Although the OECD Guidelines currently prefer traditional transaction methods to transactional profit methods, DIPN 46 favors the use of the most appropriate and reliable method.1 The decision against a hierarchical approach to method selection is accompanied by the acceptance of methods not articulated in the OECD guidelines. In addition to establishing the framework for the use of transfer pricing methods and the arm’s length principle, DIPN 46 elaborates on transfer pricing documentation (although not required), comparability, abusive tax schemes, double tax relief, corresponding adjustments, associated enterprises, and intercompany services transactions (requiring taxpayers to earn profit margins when providing services). The IRD’s release of DIPN 46 is generally welcomed by practitioners and taxpayers alike for the guidance it does provide for setting transfer prices. However, with more specific transfer pricing regulations in place, it is expected that Hong Kong’s tax administration will escalate their investigation into, and challenges of, the pricing of intercompany transactions. In response to the increased likelihood of transfer pricing audits, taxpayers should evaluate their transfer pricing policies involving Hong Kong and prepare documentation as warranted by their potential exposure. 1. Proposed revisions to the OECD Transfer Pricing Guidelines may replace the current preference for traditional transactional methods with deference to the most appropriate method based on the context of the transaction. |
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