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3.7 Transfer pricing in the EU

 

Transfer pricing in the EU context
Transfer pricing refers to the terms and conditions surrounding transactions within a multi-national company. It concerns the prices charged between associated enterprises established in different countries for their inter-company transactions, i.e. transfer of goods and services. Since the prices are set by non independent associates within the multi-national, it may be the prices do not reflect an independent market price. This is a major concern for tax authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue.

Background
According to international standards individual group members of a multi-national enterprise must be taxed on the basis that they act at arm’s length in their dealings with each other. This arm’s length principle is found in article 9 of the OECD Model Tax Convention:

“[When] conditions are made or imposed between … two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

This principle (the ‘arm’s length’ principle)  is internationally recognised, although not universally applied.

On July 2010, the OECD Council approved the 2010 versions of the OECD Model Tax Convention, the 1995 Transfer Pricing Guidelines and the 2008 Report on the Attribution of Profits to Permanent Establishments.
The updates were the result of several years of work.

Transfer Pricing Guidelines
The OECD’s Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations provide
guidance on the application of the “arm’s length principle”, which is the international consensus on the valuation for tax purposes of cross-border transactions
between associated enterprises. In a global economy, where multinational enterprises (MNEs) play an increasingly prominent role, consistent application
of the arm’s length principle helps to ensure that the taxable profits reported by MNEs in the countries
where they operate reflect the economic activity undertaken there and that taxpayers can avoid the risk of double taxation that may result from a dispute between two countries about the determination of the arm’s length remuneration for their cross border transactions.
The 2010 revision to the Transfer Pricing Guidelines is the first major revision to this document since the guidelines were released in 1995. It contains more detailed guidance on how to perform comparability analysis in practice in order to compare the conditions
of transactions between associated enterprises
with those of transactions between independent enterprises. It also includes new guidance on how to select the most appropriate transfer pricing method to the circumstances of the case and on how to apply in practice two of the OECD-approved transfer pricing
methods, referred to as “transactional profit methods”,
namely the transactional net margin method and the transactional profit split method. This update
also includes a new chapter providing detailed guidance on the transfer pricing aspects of business restructurings.

Despite the OECD guidelines, Member
States, in practice, take different approaches to the application
of these guidelines. Consequently, it is often
necessary for multinational groups to apply various
transfer pricing methods to similar transactions, use
different sets of comparables, compile different sets of
transfer pricing documentation, and take into account
different safe harbour rules.

Comparables is an example of the difficulties in applying the Guidelines. Multinational european and non-european firms are often required to compile different
sets of comparables in different states for their transfer
pricing policy. This can be because, for example, some
countries insist that only local comparable data can be
used and not data for similar transactions elsewhere in
the European Union, even where no comparable is
available locally.

There are occasions when tax authorities use
comparables which are not publicly available and
which they will not disclose – and which are consequently
difficult to refute.

Regarding documentation, if an European group operating in several MS adopts a common
transfer pricing policy throughout Europe, the various
documentation requirements of the Member States (Germany is a good example)
force the group to compile different sets of documentation
for each country in which it operates. These differences
exist both in the statutory approaches taken
by Member States and in the day-to-day practice of the
tax authorities.

Within the European Union (EU), the arm’s length principle and related OECD
guidelines are accepted and applied by all Member States. However, the
interpretation and application of the OECD guidelines can vary between countries.
Differing interpretations can result in uncertainty for taxpayers and could also affect
the proper functioning of the internal market in that the same profits could be taxed
twice — double taxation.

The quick and effective elimination of any double taxation arising from a transfer
pricing adjustment or from differing interpretations of the OECD guidelines is a
major issue within the internal market. Consequently, a multilateral convention ‘on
the elimination of double taxation in connection with the adjustment of profits of
associated enterprises’ (the ‘Arbitration Convention’ or ‘AC2’) was adopted in 1990
by all EU Member States.

In The Company Tax Study (SEC(2001)), the Commission identified the increasing importance of transfer pricing tax problems as an Internal Market issue: although all Member States apply and recognise the merits of the OECD “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations”, the different interpretations given to these Guidelines often give rise to cross border disputes which are detrimental to the smooth functioning of the Internal Market and which create additional costs both for business and national tax administrations.
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Penalties
The issue of penalties was recognised as an important concern for multinational
enterprises from the begining in the Commission work, including the transfer pricing documentation requirements.  This topic was addressed also when Professor Maisto conducted a study to better assess how penalties were addressed by EU Member States to the Commission.
This work confirmed that EU Member States have rules which aim at enforcing
taxpayers’ compliance with national tax legislation. These rules can vary widely from
one Member State to another. In the area of transfer pricing, penalties are generally
applied in the event of non-compliance with transfer pricing documentation
requirements, uncooperative behaviour by a taxpayer and understatement of profits.

Penalties can take the form of either monetary deterrents, for example a surcharge or
additional tax imposed as a consequence of underpayment of tax in addition to the
amount of underpayment, or other measures, for example, a reversal of the burden of
proof where a taxpayer has not acted in good faith.

Penalties must always be distinguished from interest on late payment of tax, which is
imposed to recompense the time value of money.

As regards penalties linked to transfer pricing documentation, the JTPF felt the issue
was already addressed in the Code of Conduct on transfer pricing documentation,
where the following recommendations are made:
‘Member States should not impose a documentation-related penalty where taxpayers
comply in good faith, in a reasonable manner and within a reasonable time with
standardised and consistent documentation as described in the Annex or with a
Member State’s domestic documentation requirements, and apply their
documentation properly to determine their arm’s length transfer prices.

Txpayers avoid cooperation-related penalties where they have agreed to adopt the
EU TPD approach and provide, upon specific request or during a tax audit, in a
reasonable manner and within a reasonable time, additional information and
documents going beyond the EU TPD referred to in paragraph 18.’

Considering that penalty regimes are a matter of domestic law and recognising that,
generally, EU Member States do not apply separate penalty regimes to transfer
pricing adjustments, transfer pricing specialists observed that the interaction of transfer pricing and
penalties was a matter to be addressed by existing EU Member States penalty
regimes.

Relating to penalties related to transfer pricing adjustments, specialists recognised that
transfer pricing is not an exact science; there will usually be a range of
possibilities for arriving at the arm’s length price. Therefore, it is inappropriate
for tax administrations to impose a penalty automatically, without considering
the facts of the case, merely due to what turns out to be incorrect transfer
pricing.
Transfer pricing specialists also called for the cancellation or mitigation of penalties where the case has been subject
to a Mutual Agreement Procedure (MAP) under a double tax convention or a
procedure under the Arbitration Convention. In practice, penalties are generally
reduced or waived following the downward revision of a settlement originally
made between the taxpayer and the tax administration or following an
agreement between the tax administrations involved in the MAP or AC
procedure to reduce the transfer pricing adjustment.

The topic of serious penalties (Article 8(1) of the AC), whereby access to the AC
may be denied where the taxpayer is liable to a serious penalty, was also discussed
by the JTPF. This article is supplemented by unilateral declarations made by Member
States to explain what they consider to be a serious penalty. Some Member States
now acknowledge that their unilateral declarations do not describe penalties that
should be considered serious. Moreover, since 1995, tax administrations have gained
more experience with transfer pricing disputes and in practice access to the AC has
been denied in very few cases. Consequently,  serious
penalties should only be applied in exceptional cases like fraud and invited Member
States to better reflect this conclusion in their unilateral declarations.

Inter-company service charges
Multinational companies often centralise their
headquarters or certain intra-group service activities
within a single entity in order to deliver, for example,
benefits of scale and consistent corporate policies. The
arm’s length principle requires the provider of the services
to receive remuneration that is comparable to the
remuneration a third party would obtain for the same
services under similar conditions.

However, there are wide variations in practice
across the European Union. Some states allow or require
mark-ups on group services and some do not.
Some insist on a mark-up on charges out of the state
but not on charges in.

The level of mark-up required in some states
exceed what one would expect to see in an arm’s
length situation with the result that a portion of the
mark-up may be disallowed if the other country finds
that the uplift exceeds an arm’s length amount.
For example, in the case of headquarters or centralised services,
certain Member States require that a
cost-plus method is used with a mark-up of 10 percent.
Other Member States require a mark-up of
25 percent for the same type of services.

Justification

On 21 January 2010 the ECJ ruled in the
Société de Gestion Industrielle (SGI) case
that the Belgian cross-border transfer
pricing provision does not infringe the
freedom of establishment (C-311/08).
Belgian Income Tax Code allows benefits
(not being at arm’s length) granted by a
Belgian resident company to a non-
resident related company to be added
back to the grantor’s taxable basis,
whereas benefits granted to a Belgian
related company would normally not be
added back, since they are already
included in the taxable basis of the
Belgian beneficiary.
The ECJ considered that Belgian transfer
pricing rules constitute a restriction on
the freedom of establishment. However it
ruled that this restriction is justified by
the need to ensure a balanced allocation
of the power to tax between Member
States, and to combat tax avoidance and
abusive practices.
The ECJ also considered that Belgian
transfer pricing rules do not go beyond
what is necessary to reach their goals,
since any adjustment is restricted to the
amount exceeding the arm’s length
compensation, and since the burden of
proof lies with the tax authorities
whereas the taxpayer has the right to
demonstrate bona fide reasons.

Various European Countries have transfer pricing
regulations for cross-border activities between related
companies like Belgium and a large number of international tax
experts were of the opinion that such rules are
incompatible with EU law. However, this ECJ judgment makes clear that such an approach of EU
Member States to save their tax base is generally
justified.
Only national regulations which go beyond what is
necessary to reach their goals might be in
contradiction to EU law. This might be the case if the
adjustments are not restricted to an arm’s length
transfer price.

The Arbitration Convention

The EU Arbitration Convention establishes a procedure to resolve disputes where double taxation occurs between enterprises of different Member States as a result of an upward adjustment of profits of an enterprise of one Member State. In other words, the Arbitration Convention gives associated
companies the opportunity to obtain relief from juridical and economic double taxation that occurs within the European Union as a result of an upward adjustment to a transfer price in one Member State without a corresponding adjustment in the other Member State.

Whilst most bilateral double taxation treaties include a provision for a corresponding downward adjustment of profits of the associated enterprise concerned, they do not impose a binding obligation on the Contracting States to eliminate the double taxation.

The Convention provides for the elimination of double taxation by agreement between the contracting states including, if necessary, by reference to the opinion of an independent advisory body. The Convention thus improves the conditions for cross-border activities in the Internal Market.

For clarifications concerning some practical aspects of the Convention, see also the ‘Code of conduct for the effective implementation of the Arbitration Convention’ and the revised Code of Conduct.

Background

The Commission has reported on four occasions on the issue in four
Communications. The first Communication presented a Code of Conduct for the
Arbitration Convention, which sought to ensure that the AC would operate more
efficiently. The second Communication presented a Code of Conduct concerning
documentation requirements for transfer pricing within the EU — the EU Transfer
Pricing Documentation (EU TPD). The EU TPD Code of Conduct sought to ensure a
consistent approach by setting out the type of documentation that Member States
should request and accept for the purposes of their own transfer pricing rules.

The third Communication presented guidelines for Advance Pricing Agreements (APAs)
within the EU. APAs are considered to be an efficient tool for dispute avoidance as
they provide advance certainty concerning the transfer pricing methodology.

The fourth Communication presented a revised Code of Conduct for the Arbitration Convention. As
a result of a monitoring exercise on the application of the existing Code of Conduct,
it was recognised that the three-year target for resolution specified within the Code of
Conduct was difficult to achieve and further work was needed to clarify the process
to facilitate resolution within the three-year time frame. Consequently, some
revisions are proposed to provide the necessary clarification on specific provisions of
the Arbitration Convention.

The origin of the Arbitration Convention was, then, the Commission’s 1976 proposal for a directive to eliminate double taxation in the case of transfers of profits between associated enterprises in different Member States (Official Journal C 301 of 21 December 1976) and the White Paper of 1985 on the completion of the Internal Market.

After long negotiations in the Council, the Commission proposal was transformed from a Directive into an inter-governmental Convention and it was signed on 23 July 1990 (Convention 90/436/EEC on the elimination of double taxation in connection with the adjustment of profits of associated enterprises, Official Journal L 225 of 20/08/1990, p. 10).

The Arbitration Convention was in force from 1 January 1995 until 31 December 1999 for an initial period of five years. Several months before the expiration of the first five-year application period of the Arbitration Convention, the Council adopted a Protocol to the Arbitration Convention that provides for an automatic extension of the Convention by periods of five years unless a Contracting State opposes.

A case is covered by the AC when
the request is presented within the time period referred to in Article 6 of the AC but
after the date of entry into force of accession by new Member States to the AC, even
if the adjustment applies to earlier fiscal years. Taxpayers in all Member States are now covered by the Arbitration
Convention for future transactions.

The objective of the first Code of Conduct was to ensure a more effective and
uniform application by all EU Member States of the Arbitration Convention and to
establish procedures to enable smooth and timely progression through the various
stages of the Arbitration Convention. The Code of Conduct also contained a
recommendation to EU Member States on the suspension of tax collection during
cross-border dispute resolution procedures.

Given the (relative) lack of a consistent transfer pricing
approach by Member States, double taxation may still
arise as a result of unilateral upward transfer pricing
adjustments. Tax authorities may be reluctant to allow
a corresponding downward adjustment because they
may view the adjustment made by the other tax authority
as inappropriate. When it comes to trying to resolve
this situation, they are not obliged by their tax treaties
to reach an agreement.

Thin capitalisation and the Arbitration Convention

There were doubts about to what extent ‘thin capitalisation’ cases are covered by the
scope of the AC. It was unanimously recognised that adjustments to the rate of
interest on loans between associated enterprises fall within the scope. However,
differing views were expressed by the tax administration members on the specific
issue of whether adjustments to the amount of a loan are also covered, and this in
turn leads to wider issues concerning general borrowing capacity. This is particularly
sensitive if the adjustment of profits related to thin capitalisation are deemed to be
derived from the application of EU Member States’ anti-abuse rules (AAR) rather
than from their general arm’s length rules, as evidenced by the number of
reservations, referring to AAR, expressed on the JTPF recommendation.

A large majority of Member States concluded that the AC covers thin capitalisation
cases as it makes clear reference to ‘conditions … made or imposed between the two
enterprises in their commercial or financial relations’. Consequently, adjustments
related to conditions made or imposed in relation to interest rates, the amount of the
loan and borrowing capacity are all covered by the AC. A significant minority did
not agree with this conclusion, reasoning that AAR and the application of the arm’s
length principle to a financial transaction are different concepts and that adjustments
related to the amount of a loan and borrowing capacity were therefore not within the
scope of the AC.

The Commission’s opinion, based on the text of the AC, is that Article 4(1) is
sufficiently broad to cover all aspects of thin capitalisation rules, whether they
concern the interest rate or the amount of the loan, as these aspects ultimately all
affect the profits of the associated enterprises.

It may be noted that the European Court of Justice (ECJ), in applying the arm’s
length principle, also refers to these different aspects of thin capitalisation rules (see in particular para. 81 of Thin Cap GL case C-524/04 of 13/03/2007). On the specific aspect of adjustments derived in whole or in part from the application of
domestic anti-abuse rules (AAR) in cross-border situations only, the Commission
concludes, based on recent ECJ case law and as already partly developed in its
Communication on anti-abuse measures10, that such adjustments should be restricted
to transactions which, in whole or in part, represent a purely artificial arrangement.
In addition, the rule should only aim to set the right price of the transaction.

Since the AC addresses adjustments related to the application of the arm’s length
principle, there should not be any reason to prevent the application of the AC in the
above circumstances. Therefore the Commission encourages all tax administrations
to accept this interpretation in order to give the widest possible access to the benefits
of the AC process.

Specifically, on thin capitalisation disputes, the Commission is of the opinion that as the AC
refers to profits arising from commercial and financial relations without seeking to
differentiate between different types of profit, all aspects of thin capitalisation
adjustments are covered by the AC. Whilst the Commission recognises the value of
the agreement that interest rates are covered by the AC, different interpretations on
whether — or not — loan amounts come under the AC leads to uncertainty,
increased compliance burden and potential double taxation. Member States are
therefore invited to consider permitting access to the Arbitration Convention on the
above aspects of thin capitalisation disputes with a view to the elimination of double
taxation.

Triangular cases

A triangular case is a case where two Member States in a MAP cannot fully resolve
any double taxation arising in a transfer pricing case when applying the arm’s
length principle because an associated enterprise — as defined in the Arbitration
Convention — situated in a third Member State and identified by both EU competent
authorities (evidence based on a comparability analysis including a functional
analysis and other related factual elements) had a significant influence in
contributing to a non-arm’s length result in a chain of relevant transactions or
commercial/financial relations and is recognised as such by the taxpayer suffering
the double taxation and requesting the MAP.

Transfer pricing disputes in triangular cases involving only EU
competent authorities were covered by the scope of the Arbitration Convention.
Considering the recommendation in the first Code of Conduct to suspend tax
collection during the Mutual Agreement Procedure, there is a possibility to suspend interest charges during the procedure. All tax administrations
could agree that a taxpayer should not be adversely affected by the existence of
different approaches to interest charges and refunds during the time it takes to
complete the MAP process. Therefore,  Member States
should apply one of the following approaches: 1) tax to be released for collection and
repaid without attracting any interest; 2) tax to be released for collection and repaid
with interest; 3) each case to be dealt with on its merits in terms of charging or
repaying interest (possibly during the MAP process). The competent authorities, by
discussing and adopting the most appropriate approach based on the three options,
have an opportunity to prevent the taxpayer being adversely affected by differing
approaches to interest charges during the MAP negotiations. The Commission
encourages the adoption of the above process.

Final remarks

Member States have reported on the implementation of the recommendation on
the suspension of tax collection included in the Code of Conduct adopted in 2004. All Member States had confirmed that suspension is possible
or will become available. 

A issue which needs further discussion is  the interaction between the Arbitration Convention and
Article 25.5 of the OECD Model Tax Convention.

Some problems still remains. Despite the OECD guidelines, Member
States, in practice, take different approaches to the application
of these guidelines. Consequently, it is often
necessary for multinational groups to apply various
transfer pricing methods to similar transactions, use
different sets of comparables, compile different sets of
transfer pricing documentation, and take into account
different safe harbour rules.

If a company operating widelly in the European Union adopts a common
transfer pricing policy throughout Europe, the various
documentation requirements of the Member States
force the group to compile different sets of documentation
for each country in which it operates. These differences
exist both in the statutory approaches taken
by Member States and in the day-to-day practice of the
tax authorities. For example, the existence of strict documentation rules for
cost-sharing agreements in Germany compared with other countries.

Regarding inter-company service charges, multinational groups often centralise their
headquarters or certain intra-group service activities
within a single entity in order to deliver, for example,
benefits of scale and consistent corporate policies. The
arm’s length principle requires the provider of the services
to receive remuneration that is comparable to the
remuneration a third party would obtain for the same
services under similar conditions. However, there are wide variations in practice
across the European Union. Some states allow or require
mark-ups on group services and some do not.
Some insist on a mark-up on charges out of the state
but not on charges in.

The level of mark-up required in some states
may exceeds an arm’s length amount. For example, for headquarters or centralised services,
certain Member States require that a
cost-plus method is used with a mark-up of 10 percent.
Other Member States require a mark-up of
25 percent for the same type of services.

In the case of comparables, Groups are often required to compile different
sets of comparables in different states for their transfer
pricing policy. This can be because, for example, some
countries insist that only local comparable data can be
used and not data for similar transactions elsewhere in
the European Union, even where no comparable is
available locally. There are occasions when tax authorities use
comparables which are not publicly available and
which they will not disclose – and which are consequently
difficult to refute.

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