BEPS action plan 10: Other high-risk transactions

Action Plan 10 of the Base Erosion and Profit Shifting (BEPS) project of the Organisation for Economic Co-operation and Development (OECD) seeks to align transfer pricing (TP) outcomes with value creation by clarifying the conditions under which transactions between related parties can be re-characterized.

It also sheds light on how TP methods, particularly the profit split method, can be applied in the context of the global supply chains and provide protection against common types of base-eroding payments (such as management fees and head office expenses).

This article examines the new rules on commodity transactions as a possible source of base-eroding payments and the ongoing initiative to clarify the rules on the applicability of the TP methods, particularly the profit-split method.

COMMODITY TRANSACTIONS
Chapter II of the OECD’s TP Guidelines has been amended to include new rules on commodity transactions which are intended to provide a framework for an analysis of cross-border commodity transactions, which have been identified as a potential source of base-eroding payments.

“Commodities” encompass physical products for which a quoted price is used as a reference by independent parties in the industry to set prices in uncontrolled transactions.

A “quoted price” refers to the price of the commodity in the relevant period obtained in an international or domestic commodity exchange market. It also includes prices obtained from recognized and transparent price reporting or statistical agencies, or from governmental price-setting agencies, where such indexes are used as reference by unrelated parties to determine prices in transactions between them.

The new rules express preference for the use of the Comparable Uncontrolled Price (CUP) Method for commodity transactions. The CUP method compares the price charged for the commodities transferred in a controlled transaction, with the price charged for commodities transferred in a comparable uncontrolled transaction in comparable circumstances.

In this case, the quoted price can be considered as a “CUP” as it generally reflects the agreement between independent buyers and sellers in the market on the price for a specific type and amount of commodity, traded under specific conditions at a certain point in time. The question on whether the quoted price is appropriate or not will depend on the extent to which the quoted price has been widely used in the industry as the basis of a negotiated price in comparable transactions between independent entities.

Certain comparability factors will have to be considered before a quoted price can be used as the basis of an arm’s length price for commodity transactions. These factors include:

a) Physical features and quality of the commodity; and

b) Contractual terms of the controlled transaction, such as volumes involved, the timing and terms of delivery, transportation, insurance and foreign currency terms.

An important factor to consider in using the quoted price is the “pricing date,” or the specific date or time period selected by the parties to determine the price for commodity transactions. A “pricing date” has to be set since commodity prices fluctuate over time, given the direct correlation between economic conditions and commodity prices. The pricing date is the date agreed upon in the proposals, contracts or other documents setting forth the terms of the transaction, but this has to be consistent with the actual conduct of the parties.

In the absence of reliable evidence of the pricing date, tax administrations may use available evidence to establish the pricing date, such as by checking the shipment date on a bill of lading or equivalent document.

TRANSACTIONAL PROFIT SPLIT METHOD
The OECD TP Guidelines prescribe five methods for determining an arm’s length price. One such method is the Transactional Profit Split Method (TPSM). Under this method, profits from a controlled transaction are identified and divided between related parties involved in the transaction on the basis of the relative value of each enterprise’s contribution.

The TPSM is the most appropriate method for highly integrated operations, such as the global trading of financial instruments, and in transactions where both parties to the transaction make unique and valuable contributions.

In December 2014, the OECD released a discussion draft, which presented scenarios and raised questions regarding the applicability of the TPSM under these scenarios. The draft, and the corresponding consultation process, generated significant interest, which confirmed that the TPSM could provide a useful method to align profits with value creation, particularly in cases where the features of the transaction make the application of other TP methods problematic.

The OECD decided that further work was needed for a revised guidance on the applicability of the TPSM, which was not included in Action Plan 10. The revised guidance will address important questions, such as when the TPSM can be considered the most appropriate method, when significant integration of business operations may lead to the conclusion that the TPSM is the most appropriate method, and what is meant by the term “unique and valuable” contributions. The revised guidance is expected to be finalized in the first half of 2017.

In next week’s article, we will continue our discussions on Action Plan 10, particularly on the elective and simplified approach in charging for low value-adding intra-group services.