tax management transfer pricing report1).pdftax management transfer pricing report (issn 1063-2069)...

H I G H L I G H T S

IRS to Move APA Program to LB&I, Combine with Competent AuthorityThe Internal Revenue Service will relocate its Advance Pricing AgreementProgram to an office in the Large Business and International Division andcombine it with Competent Authority, putting to rest an issue that has doggedthe program since its inception. Lead Report, Page 283

Japan to Require Submission of All MAP Cases Directly to NTAJapan has amended its submission process for mutual agreement procedurecases to require all requests for competent authority relief to be filed directlywith the National Tax Administration. . . . The NTA highlights further transferpricing enforcement efforts in its 2011 annual report. Page 285; Page 285

PwC Report Addresses Transfer Pricing Reform in Four Developing NationsA report by PricewaterhouseCoopers presented to the European Commissionsuggests that Kenya and Vietnam currently are able to pursue comprehensivetransfer pricing reform, while Ghana and Honduras should first work toachieve legal and economic preconditions. Page 289

BNAI Transfer Pricing Forum Examines Treatment of Routine ServicesBNA International’s survey of practitioners from 26 countries finds that 15 taxadministrations generally accept the use of a cost plus method to attributeprofits to a permanent establishment that renders routine services to its localcustomers, while the remaining 11 would not. Page 286

In India, Need for Enforcement, Foreign Investment Seen CompetingIndian government officials and practitioners discuss transfer pricing auditsand tools, mutual agreement procedure cases, method selection, and other is-sues at a conference in Bangalore, with private sector panelists warning thatoverly zealous enforcement of the country’s transfer pricing regime risks driv-ing away foreign investment. Conference Report, Page 301

P R A C T I T I O N E R A N A LY S I S

The New Russian Transfer Pricing Regulations: An OverviewVladimir Starkov of NERA Economic Consulting in Chicago examines thecountry’s new transfer pricing regulations adopting the arm’s-length stan-dard, which also set forth documentation provisions and require taxpayers toalert the tax authorities to related-party transactions. Analysis, Page 305

Valuing Intangible Property: Discount Rate for Routine ReturnsVinay Kapoor of Duff & Phelps LLC in New York challenges the notion thatthe discount rate applied to routine returns should be the corporate bond in-terest rate, saying the variability or risk inherent in routine returns is greaterthan that of interest payments on a corporate bond. Perspective, Page 310

A L S O I N T H E N E W S

UNITED STATES: The CooperCompanies Inc. is protesting a$1.2 million tax bill related toadjustments the IRS made to thecompany’s income for 2005under the anti-deferral provi-sions of Subpart F. Page 295

UNITED STATES: The IRS updatesits set of frequently asked ques-tions and answers surroundingthe recording of a tax reserve onSchedule UTP.Page 292; Text, Page 297

COLOMBIA: Colombia postponesfiling deadlines for transfer pric-ing informative returns by onemonth. Page 293

CHINA, UNITED KINGDOM: Thepending China-U.K. income taxtreaty adopts the services per-manent establishment con-cept and also updates the PEdefinition of constructionproject. Page China

S E C T I O N I N D E X

Lead Report...........................283

Around the World ...................285

In the Courts .........................295

Text .....................................297

Conference Report ..................301

Analysis ................................305

Perspective ...........................310

Journal .................................314

Directory...............................316

VOL. 20, NO. 7 JULY 28, 2011

Copyright � 2011 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN 1063-2069

Tax Management

Transfer Pricing Report™

T O P I C A L S U M M A R Y

AUSTRALIAInteraction between RTP schedule, Schedule 25A

unclear, practitioner says ................................. 294CHINA

Pending China-U.K. treaty adopts services PEconcept ......................................................... 293

COLOMBIAColombian taxpayers given extra month to file

transfer pricing informative returns ................... 293EUROPEAN UNION

PwC report recommends next steps for transferpricing reform in four nations ........................... 289

INDIAAspects of India’s transfer pricing regime debated

in light of need for foreign investment ............... 301JAPAN

As cross-border transactions increase, Japan tostrengthen enforcement, NTA says .................... 285

Japan to require submission of all MAP casesdirectly to NTA .............................................. 285

OECDBNA International Transfer Pricing Forum

examines treatment of routine services .............. 286U.S. safe harbor rules theoretically sound, TEI

tells OECD; services cost method noted .............. 292RUSSIA

Russian president signs legislation adoptingarm’s-length standard, methods ........................ 291

Russia’s new transfer pricing regulations: Anoverview ....................................................... 305

UNITED KINGDOMPending U.K.-China treaty adopts services PE

concept ......................................................... 293UNITED STATES

Contact lens firm says attribution under Subpart Fat odds with Section 482 .................................. 295

IRS guidance on uncertain tax positions clarifiesdefinition of recording a reserve ........................ 292

IRS to combine APA, competent authorityfunctions in LB&I ........................................... 283

Practitioner says applying 2003 rules would notchange outcome in Xilinx ................................ 296

Valuing intangible property: Discount rate forroutine returns ............................................... 310

T E X T

UNITED STATESIRS FAQs, answers on schedule UTP..................... 297

TA B L E O F C A S E S

The Cooper Companies Inc. v. Comr. (T.C.) ............ 295

R E S O U R C E S

JOURNALUpcoming conferences ........................................ 314

DIRECTORYPrivate sector sources ......................................... 316Government sources ........................................... 316

282 (Vol. 20, No. 7)

7-28-11 Copyright � 2011 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069

Tax Management Transfer Pricing Report (ISSN 1063-2069) is published bi-weekly by Tax Management Inc., 1801 S Bell St, Arlington, VA 22202-4501. Editorialinquiries may be directed to the editors at (703) 341-5913. For customer service, call (800) 372-1033. Outside the U.S., call BNA International in London at(+44) 171-559-4821.

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A TAX MANAGEMENT

TRANSFER PRICING REPORTTAX MANAGEMENT INC., 1801 S BELL ST, ARLINGTON, VA 22202-4501 (703) 341-5914

Gregory C. McCaffery Darren McKewenPRESIDENT GROUP PUBLISHER

George R. Farrah, CPA, EXECUTIVE EDITORMolly Moses, MANAGING EDITOR;

Tamu N. Wright, Kevin A. Bell, STAFF WRITERS/EDITORS;Paul Albergo, Michael Triplett, Rita McWilliams, Alison Bennett, CONTRIBUTING EDITORS;

Nicholas Webb, TAX LAW EDITOR; Marji Cohen, Esq., DIRECTOR, INDEXING SERVICES;Robert Creeden, Esq., INDEX EDITOR

InThis Issue

LeadReportIRS to Combine APA, Competent Authority Functions in LB&I

T he Internal Revenue Service will relocate its Ad-vance Pricing Agreement Program to an office inthe Large Business and International Division, the

Service announced July 27, putting to rest an issue thathas dogged the program since its inception.

As part of the move, the program will be combinedwith the IRS’s competent authority function to form the‘‘Advance Pricing and Mutual Agreement program’’and will be under the IRS Transfer Pricing Director, ac-cording to a news release.

The combined offices will be under the direction of asingle executive, and the IRS will increase staffingavailable to the two program areas, the announcementsaid.

New Assistant Deputy CommissionerIn a separate move, the IRS said it will adjust its com-

petent authority and international coordination func-tions under an Assistant Deputy Commissioner (Inter-national), who will:

s coordinate international activities across all IRSoperating divisions;

s oversee the IRS Exchange of Information programand IRS participation in the Joint International TaxShelter Information Centre;

s manage the activities of IRS tax attaches in for-eign locations;

s coordinate IRS participation at OECD and othernongovernmental organizations;

s support Treasury in its negotiations of new taxtreaties and tax information exchange agreements; and

s pursue agreements with treaty partners on issuesother than transfer pricing.

TimingIRS Deputy Commissioner (International) Michael

Danilack said the effective date of the reorganization isnot certain yet, as officials ‘‘have to work through anumber of internal transitional issues first.’’

Asked about the individuals who will take on the twonew positions, he said the assistant deputy commis-sioner ‘‘will likely be named very soon’’ while namingthe director for the new combined Advance Pricing andMutual Agreement program ‘‘is further off.’’ The APMAdirector, he added, will be a Senior Executive Serviceposition—a higher level than the current APA Programdirector position—and ‘‘will be opened to new appli-cants and competed for under our normal recruitmentprocesses.’’

‘A Long Time Coming’Matthew Frank, senior tax counsel for transfer pric-

ing with General Electric Co. in Stamford, Conn., and a

former director of the APA Program, said the move was‘‘a long time coming and no surprise.’’

‘‘The APA program has been struggling to get re-sources as part of Chief Counsel and this has put it inan untenable position for the last two years,’’ Franksaid. ‘‘The hope is it will be better resourced in LB&Iwhile retaining its historical independence.’’

Another, more recently departed former APA direc-tor, Craig Sharon of Bingham McCutchen in Washing-ton, D.C., said he had expressed support for the moveduring his last year in the program. Sharon, who left theIRS in February, noted that resource constraints in theprogram were causing delays of at least six months be-fore work could begin on cases.

Sharon said the timing of the APA move, an idea thathas been raised at various times since the program’s in-ception, is ‘‘fortuitous in that it makes a lot of sense tocombine it with the IRS’s new transfer pricing prac-tice.’’

While the transfer pricing practice was part of theOct. 1, 2010, reorganization that created LB&I, its direc-tor, Samuel Maruca, was hired only last May (20 Trans-fer Pricing Report 4, 5/5/11).

Transfer Pricing PracticeMeanwhile, at a National Association for Business

Economics conference in Arlington, Va., Maruca gavesome indication of the scope of his practice, saying heestimates his group will have involvement in 125 casesunder the umbrella of two or three regional subgroups,each of which would have multiple teams of five or sixexaminers and economists. The level of involvement incases will vary, he said.

The official also said the Service is developing andinternational practice network—an online, real-timeknowledge base—for the transfer pricing practice.

Short-Term MeasuresIn what now appears to be a foreshadowing of the

APA relocation, Danilack announced following theLB&I reorganization that Competent Authority wouldpool resources with the APA Program and that stafffrom both offices would begin negotiating cases in theirentirety (19 Transfer Pricing Report 690, 10/21/10).

The approach was designed to accomplish twothings:

s increase efficiency of APA processing by eliminat-ing the hand-off between APA personnel, who were re-sponsible for working with the taxpayer to develop theinitial position in cases, and Competent Authority ana-lysts, who then took that position and conducted the ne-gotiations with the foreign government; and

s put needed resources into the processing of APAs.

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TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 7-28-11

However, there was some confusion about the au-thority of APA and Competent Authority managers un-der the arrangement, and Sharon, shortly after depart-ing as APA director, said it should be viewed as a short-term, stop-gap measure (19 Transfer Pricing Report840, 12/2/10; 19 Transfer Pricing Report 1093, 3/10/11).

The July 27 announcement, Sharon noted, puts thisuncertainty to rest. ‘‘It’s good that a decision has beenmade,’’ he said.

Independence, Synergy ConcernsFrank, while supportive of the move, noted that the

APA Program initially was promoted as an alternativedispute resolution program, and as such, its placementin Chief Counsel allowed it to be perceived as indepen-dent from the field.

As the program has grown and gained acceptanceover time, however, ‘‘its ADR role has been diluted and

so, perhaps, has the symbolic importance of its place-ment,’’ Frank said.

In addition, he said, the increase in transfer pricingenforcement by foreign tax authorities has changed thedynamics of these disputes. ‘‘Taxpayers increasinglycome into the U.S. program for help with foreign trans-fer pricing disputes rather than to resolve U.S. dis-putes,’’ Frank said. ‘‘In these cases, independence fromthe U.S. field is not a particular concern.’’

Frank also said he hoped the new combined APAand MAP function would retain the close working rela-tionship that has existed between the APA Program andthe IRS Chief Counsel’s office. Coordination betweenthose offices, he said, has helped the APA Program de-velop its cases as well as helping Chief Counsel attor-neys develop guidance. ‘‘The IRS will have to be mind-ful that those synergies are not lost,’’ he said.

BY MOLLY MOSES AND STEVE SCHUSTER

284 (Vol. 20, No. 7) LEAD REPORT


mailto:[email protected]


AroundtheWorldJapan

Japan to Require SubmissionOf All MAP Cases Directly to NTA

T OKYO—Japan has amended its submission pro-cess for mutual agreement procedure cases to re-quire all requests for competent authority relief to

be filed directly with the National Tax Administration,the NTA said in a statement posted to its website July22.

Under the change, effective Oct. 1, taxpayers thatcurrently submit MAP requests with the tax authoritiesof Japan’s treaty partner countries must send those re-quests either by mail or physically to the NTA’s Officeof MAP. MAP requests must be attached with relateddocuments, the NTA said.

An official at the NTA’s Office of MAP was unable toclarify whether the revision, effective Oct. 1, will re-quire taxpayers to submit MAP requests solely to theNTA or whether they also can continue filing themthrough the tax offices of foreign jurisdictions. Cur-rently, MAP requests are being accepted by such localtax offices, and taxpayers must submit requests to boththose offices and the NTA’s Office of MAP.

‘‘I cannot say for sure whether we will accept appli-cations at our office only,’’ the official said. He addedthat for taxpayers that submit MAP requests togetherwith other tax documents without realizing that thechange has been made, the NTA probably will acceptsubmissions through local tax offices.

The MAP official also said the taxpayer must prepareonly one request. He further said the MAP request formwill be revised by Oct. 1 to reflect the change but em-phasized that the entries on the form will remain thesame.

Surge in Foreign Adjustments. A former NTA officialsaid the change to the MAP process likely reflects asurge in the number of double tax cases brought to theNTA by Japanese taxpayers that are subjected to ad-justments by foreign tax authorities.

‘‘Clearly, many of those cases filed—and many andfar more inquiries—are beyond what local tax officescan handle in terms of the number and content,’’ hesaid.

The NTA, meanwhile, is placing fresh emphasis onreinforcing its international tax administration. This isillustrated by the fact—confirmed by NTA officials—that the agency in June created a new post, the MAPSupport Officer, in the Office of MAP, the former NTAofficial said. The post is occupied by an NTA officialwho is roughly 10 years senior to the head of the Officeof MAP, he said.

Separately, the NTA increased the staff of its MAPoffice from 31 to 41 between 2009 and the present, NTAofficials confirmed.

BY TOSHIO ARITAKE

Japan

As Cross-Border Transactions Increase,Japan to Strengthen Enforcement, NTA Says

T OKYO—As the number of cross-border transac-tions continues to grow due to an increasinglyglobalized economy, Japan will focus its enforce-

ment efforts on transfer pricing and other internationaltaxation by clarifying its tax codes and rules, as well asexpanding its cooperation with foreign authorities, theNational Tax Administration said in its 2011 annual re-port.

‘‘Cross-border economic activities of businesses andindividuals are becoming ever more complicated anddiverse,’’ the 60-page report, dated July 13, said.‘‘Double taxation is becoming a serious problem be-cause respective countries’ views regarding the in-comes of taxpayers operating in those countries and Ja-pan are different.’’

An NTA official said an English translation is beingprepared but the publishing date has yet to be decided.

In its annual report for 2010, the NTA said incomeunderreporting by leading Japan-based corporationscontinues to be rampant and noted the number of mu-tual agreement procedure cases swelled tenfold in 10years, with many of the new cases involving advancepricing agreement requests (19 Transfer Pricing Report296, 7/15/10).

Transparency in Enforcement. The NTA in the reportemphasized that ‘‘it is important to publicly disclose[transfer pricing] enforcement policies relating to taxa-tion administration and strive to make them clearer.’’

The NTA said it has revised its administrative guide-lines and circulars relating to tax laws and ordinances,while clarifying items that the agency considers in de-termining transactional prices between Japan and over-seas related companies, as well as items that taxpayersare asked to heed in preparing documents for calculat-ing arms-length prices.

The NTA also is in the midst of improving its inter-nal examination structure for ‘‘adequately performingthe confirmation of facts and the interpretation and en-forcement of [tax] laws and regulations,’’ the reportsaid.

The NTA is among few Japanese government func-tions that still issue administrative circulars and no-tices, which have been called ‘‘moral suasion tools.’’Such tools were the subject of sharp U.S. criticism inthe 1980s as not written in law.

(Vol. 20, No. 7) 285



Advance Pricing Agreements. The number of APA ap-plications and approvals has been growing steadily,reaching all-time highs of 127 and 75, respectively, in2009, the report said. The numbers compare with 76and 32 in 2006.

In response to increasing cross-border transactions,the NTA has established offices specializing in APAs inits Tokyo and Osaka regional tax bureaus and hasformed other offices to provide prior consultation onAPAs at each regional tax bureau, the report said.

MAP Cases. In recent years, transfer pricing issueshave come to command more than 90 percent of mutualagreement procedure cases with foreign taxauthorities—of which those relating to APAs as a meansof enhancing taxpayers’ tax predictability are growingrapidly, the report said.

In 2009, a total of 183 new MAP cases were receivedby the NTA, of which transfer pricing cases accountedfor 176. Of that 176, APAs accounted for 149 cases, theNTA said.

Compared with 10 years ago, total MAP cases haveincreased threefold and APAs fourfold.

The number of countries with which Japan has mu-tual agreement procedures in place increased to 22 atthe end of June 2010. In 2001, such procedures were inplace with 14 countries, the report said.

Focus on Cross-Border Transactions. The NTA isstrengthening its examination management structurethrough closer interaction with foreign tax authorities,including information exchanges, the report said. Forexample, the NTA has been increasing its internationaltaxation staff and formed divisions specialized in han-dling cross-border tax avoidance transactions, it said.As part of this policy, the agency said it is hiring law-yers and financial specialists.

In 2009, the number of Japanese companies withoverseas operations totaled 18,201, compared with10,416 in 1995, according to statistics from the Ministryof Economy, Trade and Industry. Of those 18,201, theshare of Japanese companies in China accounted forabout one-third, growing from less than one-fifth in1995, while the share of Japanese companies in NorthAmerica shrank to less than one-fifth—although thenumber essentially remained the same—from nearlyone-third in 1995.

The number of foreign-capitalized companies oper-ating in Japan in 2009 totaled 5,800, a 50 percent riseover 2000—though it shrank by 114 from 2008, accord-ing to NTA data. The decrease reflected the impact ofthe strong yen against the U.S. dollar and the euro, anNTA official said.

In 2009, the NTA examined 3,256 companies operat-ing cross-border, down slightly from 3,297 in 2008,while issuing ¥801.4 billion (US$1.2 billion) in incomedeficiency assessments, up sharply from ¥218.7 billion(US$2.8 billion) in 2008. The steep rise reflected the ef-fect of large deficiency assessments, the official said.

Information Exchanges. The NTA is inserting specialprovisions for the exchange of information in its taxtreaties, with such provisions covering 59 countries andregions, the report said.

The number of information exchanges in 2010 to-taled 291,000, compared with 500,000 in 2009, the NTAsaid.

At the same time, the NTA is holding seminars andoffering training in tax administration for Asian na-tions. Japan in 2010 dispatched officers to China, Indo-nesia, Malaysia, and Vietnam, while also keeping per-manent staff in Indonesia, Malaysia, and Vietnam toteach the NTA’s approach to government officials ofthose countries, it said. The NTA also held seminars forMongolia, the Philippines, and Uzbekistan in 2010.

One official said that over the past few years, manyAsian countries have begun to develop international taxpolicies, including transfer pricing and APAs, but stillneed to improve laws, regulations, and administrativestructures for combating tax evasions and avoidances.

At a conference held in Tokyo in March, practitio-ners noted that transfer pricing enforcement and APAsare becoming integral parts of several Southeast Asiancountries’ tax policies and said that foreign taxpayerswho ignore that fact run the risk of audits and steeppenalties (19 Transfer Pricing Report 1153, 3/24/11).

BY TOSHIO ARITAKE

� More information about the NTA Report is avail-able in Japanese at http://www.nta.go.jp/kohyo/katsudou/report/2011.pdf

OECD

BNA International Transfer Pricing ForumExamines Treatment of Routine Services

A survey of practitioners from 26 countries foundthat 15 tax administrations generally accept theuse of a cost plus method to attribute profits to a

permanent establishment that renders routine servicesto its local customers.

The tax administrations of Argentina, Austria, Bel-gium, Canada, France, Germany, Ireland, Italy, theNetherlands, Poland, South Africa, Spain, Switzerland,the United Kingdom, and the United States would ac-cept a cost plus method, at least in principle, for attrib-uting profits to a PE that renders services to local cus-tomers if the PE’s functional, asset, and risk profile isthat of a routine service provider. The remaining 11jurisdictions—Brazil, China, Denmark, Hong Kong, In-dia, Israel, Luxembourg, Mexico, New Zealand, SouthKorea, and Russia—would not.

The July survey by BNA International’s TransferPricing Forum asked leading practitioners in the 26countries whether their tax administrations would ac-cept a cost plus method for attributing profits to a PEthat renders services to local customers if the PE’s func-tional, asset, and risk profile is that of a routine serviceprovider. Alternatively, the survey asked, would the taxauthority attribute to the PE the entire revenue receivedfrom the customer for the rendering of the services?

The Organization for Economic Cooperation and De-velopment’s authorized separate-entity approach fordetermining profits attributable to a PE is now en-shrined in the OECD Model Tax Treaty. Under new Ar-ticle 7(2) of the model, profits attributable to a PE arethose profits that it might be expected to make, in itsdealings with other parts of the enterprise, if it were aseparate and independent enterprise engaged in the

286 (Vol. 20, No. 7) AROUND THE WORLD



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same or similar activities under the same or similar con-ditions ‘‘taking into account the functions performed,assets used and risks assumed’’ by the enterprisethrough the PE and through the other parts of the en-terprise.

In a May survey conducted by the BNAI TransferPricing Forum, practitioners found that 19 out of 27 taxadministrations surveyed in principle apply the OECD’sauthorized separate-entity approach to attribute profitsto PEs (20 Transfer Pricing Report 95, 6/2/11).

Argentina. The Argentine Revenue Service may applythe cost plus method to attribute the profits to a PE thatrenders services to its local customers if the apportion-ment of functions between the foreign head office andthe PE is consistent with the PE undertaking low risksand limited functions coupled with guaranteed profits.

Local Argentine revenue authorities will apply theconcept of significant people functions, under the au-thorized OECD separate-entity approach, in order todetermine the PE’s assets, functions, and risks. In sev-eral audits, the tax authorities have scrutinized thenumber of employees that the foreign entity has, includ-ing their hierarchy, salary levels, and place of resi-dence.

Austria. Practitioners said rendering services in Aus-tria generally does not create a PE given stringent func-tional and timing requirements. In the event a PE is cre-ated, the Austrian tax administration should attributeonly the profit to the PE that corresponds to the func-tions carried out by the PE.

Under Austrian guidance, the supply of services isone of the main fields of application of the cost plusmethod. Therefore, the Austrian tax administrationshould, in principle, not challenge the applicability ofsuch a method. A ruling of the Ministry of Finance saysthe cost plus method may be applied if the predominantpart of the profitable activity can be attributed to the ac-tivity carried out abroad, while the activities carried outin Austria have a merely routine character.

Belgium. Practitioners said that if the profile of theBelgian PE is that of a routine service provider, the Bel-gian tax authorities typically accept a cost plus ap-proach. The Belgian ruling commission typically ac-cepts a markup of between 3 percent and 8 percent forroutine services and has held that administrative, hu-man resources, accounting, and logistics services gen-erally are considered routine activities. The commissionalso has applied a net cost plus of 5 percent to manage-ment support, distribution support, marketing, promo-tion, and sales services.

The application of the cost plus approach based ongross costs also may be possible, to the extent that theoperating profit of the PE is consistent with reasonablycomparable companies providing similar routine ser-vices. In addition, other transfer pricing methods—forexample, the profit split method— may be used if war-ranted by the facts and circumstances.

Brazil. Brazilian transfer pricing rules do not followthe OECD transfer pricing guidelines.

To determine the transfer price of services that areimported by a Brazilian related party, the taxpayer may

use one of three methods. Under the production costplus markup method, a 20 percent margin is applied tothe average direct cost incurred by the foreign relatedcompany for the rendering of services to the PE.

For exports of services, a taxpayer may use the ac-quisition or production cost plus taxes and profitmethod. The export price must be at least the averagepurchase cost, or the average production cost for ex-ported services, increased by a profit margin of 15 per-cent over the total cost plus taxes. A 5 percent deviationis accepted.

Canada. If the relevant Canadian tax treaty conformsto new Article 7 of the OECD Model Tax Treaty, Canadaabides by the authorized OECD approach for profit at-tribution to PEs, including the allowance of certainmarkups and notional expenses. Canadian practitionerssaid the Canada Revenue Agency presumably wouldconsider allowing a cost plus method for attributing in-come to the PE if the facts support this analysis.

If new Article 7 does not apply, it is likely the CRAwill attribute the entire revenue received from the localcustomers to the PE. However, an intercompany royaltymay be appropriate to reflect the use of the parent com-pany’s intellectual properties being used in Canada.

China. Chinese tax authorities usually use the rev-enue basis method to attribute profits to the PE if theservice income for that transaction could be readilyascertained—for example, if a domestic entity pays aservice fee to an overseas entity for consulting services.In the past, the tax authorities have agreed to an on-shore portion of 60 percent and then applied thedeemed profit rate to calculate the corporate incometax. Often in recent cases, the tax authorities have ap-plied the deemed profit rate to the entire revenue andthen calculated the corporate income tax.

Practitioners said as the tax authorities in China be-come more sophisticated they are likely to adopt atransfer pricing approach for ascertaining the profits at-tributable to a PE.

Denmark. Practitioners said the Danish tax authori-ties are likely to attribute the entire revenue receivedfrom the PE’s customers to the PE if the PE’s activitiesare separate from the head office’s activities and all ofthe services to the local customers are performed bythat PE.

A cost plus method, or for that matter any otherarm’s-length method, would not be permitted if the en-tire revenue is ascribed to the service-rendering PE.

France. The French tax administration frequently ap-plies the cost plus method to determine the level ofprofit attributable to the provision of routine services bya PE in France because the method relies on costs datathat may be more readily available than the financialdata of the whole enterprise.

Alternatively, the tax administration, in line with theOECD authorized separate-entity approach, may assessthe amount of revenue that at arm’s-length the PEwould have generated by reference to the revenues gen-erated by the entire foreign enterprise in relation to itsFrench customers. In the case of consulting activities,the tax administration typically would establish arm’s-

AROUND THE WORLD (Vol. 20, No. 7) 287


length hourly rates for the services rendered and evalu-ate the time spent by the employees of the French PE inrendering the services.

Germany. A cost plus method or the transactional netmargin method with an appropriate markup will be ap-plied if the services are purely routine in nature and thePE is the only entity involved in providing the services.

However, services that result in substantial profitsusually will include some degree of nonroutine activi-ties. If the nonroutine activities are provided outside ofthe PE, then a cost plus or TNMM margin for the PEstill might be appropriate, although the size of themarkup will be scrutinized by tax authorities—as willthe routine nature of the activities at the PE itself.

Hong Kong. Under domestic law, service fee incomegenerally is considered to be sourced at the place wherethe services are performed and the Inland Revenue De-partment should accept the attribution of a portion ofprofits to Hong Kong provided that it is a true reflectionof the respective value of the services performed inHong Kong.

If the services are performed solely in Hong Kong,the entire service fee will be taxable in Hong Kong. Onthe other hand, if the services are performed partially inHong Kong and partially outside Hong Kong, the ser-vice fee income should be allocated between the HongKong PE and the overseas head office based on thevalue of the services performed in the respective loca-tions.

India. Practitioners said neither the Indian taxing au-thority nor taxpayers have attained the necessary levelof maturity to characterize PEs as either entrepreneursor routine service providers for the purposes of attribut-ing profits. Currently, the general trend in India is to at-tribute the entire revenue received from customers forrendering services in India to the PE, as if the PE werean entrepreneur.

The proper approach is to apply the OECD transferpricing principles to PEs, and therefore, depending onwhere the significant peoples functions are performed,the PE may be classified as either an entrepreneur or aroutine service provider.

Ireland. The Irish tax authority would not seek to taxthe entire revenue or service fee received from the cus-tomer.

As to the method of calculating the profit of the for-eign service provider that may be taxed in Ireland, thetax authority previously has accepted the cost plusmethod when the functional, asset, and risk profile ofthe PE is that of a routine service provider.

Israel. The tax treaties executed by Israel do not in-clude the concept of a service PE.

Italy. When the Italian PE does not have a profit andloss account, the tax authorities make presumptions re-garding the income attributable to the PE and fre-quently assess a taxable base equal to the PE’s grossrevenues.

However, during settlement procedures, the tax au-thorities often agree to a calculation of the remunera-

tion that the alleged PE should receive based on thefunctions performed and risks assumed. Thus, the tax-payer may demonstrate that the PE is a routine serviceprovider that merely executes the decisions taken at theheadquarters, and the application of the cost plusmethod is appropriate.

Luxembourg. If a PE is created to render services tolocal customers, the entire revenue received from thelocal customers will be attributed to the PE.

However, the PE’s local profit will be reduced by theforeign related-party charges for supporting activitiesso long as the charges are justified under the arm’s-length principle.

Mexico. There have been cases where a Mexicancompany rendering offshore services to Mexico’s state-owned oil company, Petroleos Mexicanos, charters avessel from a nonresident related party. During audit,the tax authority takes the position that the relatedparty is a PE and disallows the deduction of the charterpayments made by the Mexican company to the non-resident due to failure to meet the requirements for taxreceipts applicable to corporations in Mexico.

The tax authority then disallows the deductions forthe group’s Mexican company, and the foreign revenuesource is taxed at a rate approaching 100 percent.

Netherlands. Once the threshold for establishing a PEhas been reached, income allocation for Netherlandscorporate tax purposes is determined using the OECDauthorized separate-entity approach. The PE is treatedas a functionally separate enterprise.

Thus, when the functional, asset, and risk profile ofthe PE is that of a routine service provider, a cost plus-based income allocation may very well be correct andused to allocate an arm’s-length amount of profit to thePE.

New Zealand. Taxpayers often apply the comparableprofits method, based on a markup on the total costsprofit level indicator, to review the arm’s-length natureof consideration paid to a New Zealand PE routine ser-vice provider for activities undertaken.

If the head office has contributed valuable functions,tangible or intangible assets, or assumed risks in rela-tion to the activities of the PE, such as providing globalcustomer relationships, access to databases, know-how,or assuming contractual risks, arguably the entire rev-enue derived should not be apportioned to New Zeal-and.

Poland. Practitioners said the PE should be classifiedas a routine entity or an entrepreneur based on ananalysis of the PE’s function and risk profile. If the onlyrole of the PE is to follow the head office’s instructions,and the head office designs the project and supervisesits execution, the PE should be classified as a routineentity, with a cost plus approach used to estimate theprofits attributable to the PE.

On the other hand, if the most important value-driving functions are performed in Poland and the headoffice activities are limited to back-office functions, thehead office functions should be remunerated through a



notional cost plus service fee, with the residual profitsbeing attributed to the PE.

Russia. In Russia, neither the tax authorities nor tax-payers have yet reached the maturity to characterizePEs as routine service providers or entrepreneurs. In arecent court case, the tax authorities rejected the appli-cation of a cost plus method to attribute profits to a PEeven though the taxpayer argued that the PE was a rou-tine service provider. Instead, the tax authorities taxedthe entire amount of revenue received by the PE fromits customers, less allowable expenses.

With the introduction of the new transfer pricinglaw, presumably effective from January 1, 2012, the ap-proach of the tax authorities to establishing the profit ofPEs may change. Under the new law, the taxable in-come of the PE should be determined taking into ac-count the specific functions performed, risks borne, andassets employed by the PE.

South Africa. The South African Revenue Service ap-plies the OECD transfer pricing guidelines to tax theprofits of PEs.

Therefore, the most appropriate transfer pricingmethod is applied to allocate the profits to the PE,which in the case of a routine service provider, is a costplus method.

South Korea. Generally, the Korean tax administra-tion will accept a cost plus method to attribute profits toa PE that renders services to local customers if the PE’sfunctional, asset, and risk profile is that of a routine ser-vice provider. As long as the functional, asset, and riskprofile of the PE is consistent with that of a routine ser-vice provider, a cost plus method, or a method based ona cost plus profit level indicator, is an acceptablemethod.

In practice, however, the tax authorities have astrong inclination to attribute the entire revenue to thePE if an analysis of the functions performed, risksborne, and assets employed in rendering services inquestion is deemed not properly performed.

Spain. The Spanish tax administration will accept acost plus method if the local PE has a low-risk profileand undertakes only routine functions.

In order to determine the functions performed andrisks borne, the local tax authority will apply the con-cept of significant people functions under the autho-rized OECD separate-entity approach. During audits,the local tax authority will scrutinize the role of the em-ployees assigned to the PE, based on questionnaires torelevant employees and information obtained fromthird parties—for example, customers.

Switzerland. The Swiss tax authorities will accept thecost plus method if the profile of the PE is a routine ser-vice provider.

However, if, after a functional and risk profile, thePE is characterized as an entrepreneur—with key deci-sions and negotiation and signing of contracts takingplace in Switzerland—it is likely that the Swiss tax au-thorities will attribute the entire amount of revenue re-ceived from the customers for rendering the services tothe PE.

United Kingdom. U.K. practitioners said H.M. Rev-enue and Customs is wary of using the cost plus methodto determine the arm’s-length price for the provision ofservices. HMRC guidance says a cost plus methodsometimes is appropriate when the activities are of rela-tively low importance to the multinational enterprise asa whole, but it also is important to look at how the re-cipient benefits from the services. If the services carriedout by the PE could be contracted out to an independentthird party, then a cost plus method may produce anarm’s-length reward to be attributed to the PE.

However, the use of a cost plus method would be in-appropriate if the type of functions being carried outare vital to the overall trade of the nonresident com-pany. If HMRC rejects a cost plus method of profit allo-cation, then a functionally separate enterprise analysismust be carried out and the arm’s-length terms thatwould have been agreed by such hypothesized separateenterprise established.

United States. When significant functions and risksregarding a project are carried out at the foreign com-pany’s headquarters and the PE in United States merelyexecutes the decisions or orders taken at the headquar-ters level, the PE most likely will be classified as a rou-tine service provider, with a cost plus remunerationmodel. Notional service fees receivable from the head-quarters under a cost plus model with respect to the in-ternal dealings between the headquarters and the PE inthe United States would be recorded as income in thebooks of account of the PE.

However, if the functions and risks of the U.S. PE aremore entrepreneurial in nature, the PE likely will becharacterized as an entrepreneur, with the revenue re-ceived from the customer attributed to the profit andloss account of the PE. Necessary expenditures relatedto the PE, whether incurred in the United States orabroad, then will be allowed as deductions in comput-ing the profits of the PE, subject to the overall restric-tions generally contained in the tax treaties signed bythe United States.

BY KEVIN A. BELL

� For a free trial of the new BNA InternationalTransfer Pricing Forum, go to http://www.bna.com/products/tax/tpforum.htm.

European Union

PwC Report Recommends Next StepsFor Transfer Pricing Reform in Four Nations

A report presented to the European CommissionJuly 15 making specific recommendations for im-proving the transfer pricing regimes for four de-

veloping countries suggested that Kenya and Vietnamcurrently are able to pursue comprehensive transferpricing reform, while Ghana and Honduras should fo-cus on achieving certain legal and economic precondi-tions before undertaking major changes.

PricewaterhouseCoopers, which authored the report,welcomed the EC’s initiative because ‘‘it has the poten-tial to promote a uniform set of practices which are ad-hered to globally.’’




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The report, commissioned by the EC as part of its taxand development policy agenda, has been criticized bya group of NGOs, which expressed concern about theobjectivity of a document written to assist developingnations that is authored by a provider of tax planningservices to multinational corporations.

The report was compiled through conducting localinterviews with revenue authorities, donor organiza-tions, civil society groups, academics, and business rep-resentatives from different industries.

Universal Recommendations. The PwC report said thatwhile Kenya and Vietnam have some specific transferpricing legislation in place, Honduras will be adoptingtransfer pricing legislation shortly and Ghana currentlyhas no transfer pricing specific framework in place be-yond requiring that intercompany transactions adhereto the arm’s-length standard.

Referring to all four countries, the report said thatthe definition of ‘‘related party’’ in the transfer pricingrules is ‘‘significantly broader’’ than is outlined in theOECD guidelines. The report cautioned that ‘‘defining‘related parties’ very broadly may increase the adminis-trative burden for both tax administrations and taxpay-ers and thereby hamper investment and growth.’’

The report also said that all four countries should:s broaden treaty networks and gain practice in their

application;s identify and pool local comparables;s build transfer pricing expertise, competitive work-

ing conditions, and adequate control mechanisms; ands develop risk-based transfer pricing audit proce-

dures.

Transfer Pricing Pitfalls. PwC stressed that interna-tional consistency in transfer pricing ensures proper ap-plication of the arm’s-length principle, noting that boththe Organization for Economic Cooperation and Devel-opment and the United Nations’ tax committee supportthe arm’s-length standard.

However, the report noted that the UN committeealso has stressed that ‘‘it is ultimately for each countryto adopt an approach that works in its domestic legaland administrative framework’’ (20 Transfer PricingReport 223, 6/30/11).

PwC pointed out that ‘‘application of the arm’s-length principle to the domestic realities of developingcountries’’ can be difficult in practice, especially withrespect to proper comparability.

Treaty Issues. The report observed that many devel-oping countries have not signed tax treaties with theirmost important trading partners, saying doing so ‘‘iscrucial in order to provide taxpayers with a legalmechanism to question double taxation and to put inplace the legal foundations for the exchange of infor-mation.’’

Noting that while some developing countries haveidentified the need to sign treaties and consciously aimat expanding their treaty networks, many developingcountries still lag behind in this important aspect. Thereport said that in this context, ‘‘developed countriesshould contribute their fair share by demonstrating thatthey are in principle prepared to enter into such nego-tiations’’ and noted that while sometimes treaties areregarded as potential obstacles to foreign direct invest-

ment, the evidence suggests that treaties ‘‘provide in-vestors with security and stability and are seen as acommitment to stable, correct treatment of foreign in-vestors in terms of taxation.’’

Several participants in a June meeting of the UN taxcommittee noted the huge cost to developing countriesthat creating a treaty network would pose and ques-tioned whether concluding tax treaties currently is inthe best interests of many developing nations. DavidRosenbloom of Caplin & Drysdale in Washington, D.C.,suggested that the United Nations could assist coun-tries in adopting an arbitration process that still pro-vides adequate dispute resolution despite the lack of atreaty (20 Transfer Pricing Report 221, 6/30/11).

Recommendations: Kenya. The report said Kenyashould be offered assistance in revising its existingtransfer pricing legislation and to ensure it is ad-equately structured. It added that technical assistancealso could be targeted at familiarizing the local tax ad-ministration with the possibility of creating an advancepricing agreement program and providing help in draft-ing the rules.

The report included additional recommendations forthe use of funds received from various donor institu-tions that could be provided in the short, medium andlong term. In the short term, it recommended:

s facilitation of secondment and the employment ofexperienced transfer pricing officials from more experi-enced tax administrations to the Kenyan revenue au-thorities;

s development of structured training programs andassistance in the selection of appropriate resource per-sons; and

s provision of detailed, practical reference materialssuch as transfer pricing manuals and guides.

Over the medium or long term, the report recom-mended obtaining technical assistance in scrutinizingexisting legislation prior to enacting reforms.

Recommendations: Ghana The report next endorsed alist of the assistance needed in order of importance, cre-ated by local tax authorities in Ghana:

s technical support in the development and testingof transfer pricing legislation;

s training of tax officials and possible secondmentsof transfer pricing experts to the Ghana Revenue Au-thority in order to provide additional support;

s assessment of the effectiveness of the transferpricing legislation once implemented; and

s the required funding to undertake the actionslisted above.

The PwC report stressed that special attentionshould be given to the introduction of additional disclo-sure requirements for multinational enterprises, whichwill provide some of the information required for trans-fer pricing purposes.

The report noted that Ghana has signed up to the Ex-tractives Industry Transparency Initiative—a globalcoalition of governments, companies, civil societygroups, investors, and international organizations thataims to increase transparency in financial transactionsbetween governments and companies within the extrac-tive industries through the publication of company pay-ments and government revenues from oil, gas, and min-ing.



PwC said Ghana’s involvement the EITI and similarinitiatives also will contribute towards successful imple-mentation of transfer pricing legislation.

In identifying other areas of future donor support,the report recommended:

s investing in technical training for a significantnumber of local tax officials;

s secondment programs that would send GhanaRevenue Authority officials to participate in to tax agen-cies in countries more transfer pricing experience; and

s computerization of tax offices, stating with thelarge taxpayer units.

Recommendations: Honduras. The report said Hondu-ras ‘‘is making considerable progress in the area of im-proving its policies and action’’ in the area of transferpricing. However, it said that continuing assistance isnecessary as transfer pricing enforcement and taxpayerbehavior increase in complexity.

Noting that the country is on the verge of introduc-ing binding transfer pricing legislation, the report basedits recommendations on interviews with government of-ficials, international organizations, and members of theHonduran business community. Those entities re-quested:

s assistance in scheduling and establishing a train-ing period for transfer pricing legislation, whereby thelegislation will enter into force after a fixed period oftime in order to ensure a smooth transition;

s development of a phased approach to increase thecompliance requirements for taxpayers when the trans-fer pricing legislation comes into effect;

s assistance in drafting informational bulletins orhosting training and question and answer sessions fortaxpayers;

s assistance in revising the initial transfer pricinglegislation and evaluation of whether all provisions in-cluded in the first draft are sound with regard to admin-istrative burden and budgetary effects; and

s making use of external auditors responsible forreviewing intercompany transactions reported by tax-payers.

Recommendations: Vietnam. Vietnam has received asubstantial amount of donor support during the last fewyears, including direct support for transfer pricing. Aswith most other developing countries, there is thereforestill a demand for support in improving the implemen-tation of transfer pricing legislation in the form of:

s assistance with legislative changes to introducecomprehensive transfer pricing legislation as well as as-sistance on APAs, simplified compliance procedures,and mutual agreement procedures;

s building transfer pricing expertise by developingstructured training programs for all tax officials, includ-ing on issues such as joint audits and treaties; and

s information technology infrastructure and sup-port.

NGOs’ Concerns. The European Network on Debt andDevelopment (EURODAD) criticized the report in aJuly 20 statement, first expressing concern that it wasprepared by PwC. Eurodad said the report ‘‘reflects astrong conflict of interest of the authors in their doublerole of advisors to [multinational corporations] on taxplanning, and advisors to the EC on how to curb aggres-sive tax planning practices’’ and added that the authors

of the report ‘‘sorely lack’’ strong development exper-tise.

Eurodad said that the report ‘‘misses some importantelements highlighted by the [European] Commission’’in a 2010 communication that has since been reiteratedby the European Parliament.

The communication proposed that the Commissionsupport developing countries in fighting tax evasionand other ‘‘harmful tax practices’’ by, among otherthings, implementing the OECD’s transfer pricingguidelines and country-by-country reporting in devel-oping nations.

Eurodad, a network of 54 nongovernmental organi-zations from 19 European countries working on issuesrelated to debt, development finance, and poverty re-duction, recently criticized the EU Joint Transfer Pric-ing Forum’s naming of a chair and 16 members becauseall were from the private sector (20 Transfer Pricing Re-port 42, 5/19/11).

BY TAMU N. WRIGHT

Russia

Russian President Signs LegislationAdopting Arm’s-Length Standard, Methods

M OSCOW—Russian President Dmitry MedvedevJuly 18 signed legislation setting forth the arm’s-length standard and stipulating that current pro-

visions dealing with related parties and methods applyonly to transactions that took place before Jan. 1, 2012.

The Russian presidential press service said July 20that Federal Law No. 227-FZ amends provisions of theRussian Tax Code including Articles 38, 45, and 102.Under the new law, Articles 20 and 40 of the Code,which deal with related parties and methods for deter-mining market prices, respectively, do not apply fortransactions taking place in 2012 and later years.

Instead, the new law introduces new Chapters 141-146 of the Tax Code, including Articles 1051-10529. Inaddition to setting forth the arm’s-length principle, un-der which prices should be the same as they would havebeen had the parties to the transaction not been relatedto each other, the new provisions introduce more meth-ods for determining market prices, expand the list of re-lated parties, reduce the number of transactions inwhich the tax authorities can control prices, and ex-pand the number of information sources for determin-ing market prices (20 Transfer Pricing Report 257,7/14/11).

Separately, the Russian Federal Tax Service earlierthis month said it created a new department dealingwith transfer pricing matters. The department wouldanalyze international experience and practices and co-operate with foreign tax services and international or-ganizations, according to a July 12 statement.

Definitions, Methods. New provisions of Chapter 141

define related parties as companies in which one holdsa direct or indirect interest of more than 25 percent inanother, or all companies in a vertical chain in whicheach company owns more than a 50 percent interest insubsequent companies.

Chapter 142 includes general provisions on marketand regulated prices for tax purposes. Notably, Article



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1053 stipulates that prices of goods, work, and servicesused by parties involved in transactions should bedeemed market prices for tax purposes in the absenceof proof that different treatment should apply.

For determining whether prices of controlled trans-actions may be viewed as market prices, Chapter 143

sets forth methods including the comparable uncon-trolled price, resale price, cost plus, profit split, andtransactional net margin methods, as stipulated by Ar-ticles 1057-10513.

Reporting Requirements. Chapter 144 regulates con-trolled transactions. Article 10514 requires taxpayers toreport controlled transactions to the tax authorities an-nually if these deals total more than 1 billion rubles(US$35.6 million) per year from Jan. 1, 2014. From Jan.1, 2012 the limit is set at 3 billion rubles, and from 2013at 2 billion rubles.

Section 3 of Article 10514 also requires reporting ofcontrolled transactions if one party is:

s a payer of Russia’s extraction tax;s exempt from Russia’s profit tax; ors a resident of the country’s special economic zone

and the deals total more than 60 million rubles (US$2.1million) per year from Jan. 1, 2014.

The requirement also applies to parties using Rus-sia’s preferential taxation schemes granted to agricul-tural producers and small businesses if transactions to-tal more than 100 million rubles (US$3.6 million) ayear. According to Section 7, Article 10514, the require-ment also applies to foreign trade transactions involv-ing exchange-traded commodities, and if one of the par-ties involved is based in jurisdictions included in the listapproved by the Russian Finance Ministry in accor-dance with Subsection 1, Section 3, Article 284 of thisCode, if these transactions total more than 60 millionrubles (US$2.2 million) per year. From Jan. 1, 2012 thelimit is set at 100 million rubles, and in 2013 at 80 mil-lion rubles (US$2.9 million).

Chapter 145 sets forth regulations on tax control oftransactions between related parties. Chapter 146 regu-lates price agreements for tax purposes.

Articles 1293 and 1294 stipulate that failure to reportcontrolled transactions to the tax authorities will entailfine of 5,000 rubles (US$178), while incomplete pay-ment of applicable taxes will entail fine of 40 percent ofthe due taxes but no less than 30,000 rubles (US$1,070).

The new legislation, adopted July 8 by the StateDuma, the lower house of parliament, and on July 13 bythe Federation Council, the upper house of parliament,becomes effective Jan. 1, 2012.

BY SERGEI BLAGOV

OECD

U.S. Safe Harbor Rules Theoretically Sound,TEI Tells OECD; Services Cost Method Noted

T he Tax Executives Institute July 15 asked the Orga-nization for Economic Cooperation and Develop-ment to encourage countries to adopt transfer pric-

ing rules similar to the U.S. safe harbor rules for theservices cost method.

TEI International President Paul O’Connor in his let-ter to the OECD said the U.S. safe harbor rules are theo-retically sound.

O’Connor said while taxpayers’ experience with theadministration of the safe harbor rules ‘‘has not beenwholly satisfactory,’’ most large multinational compa-nies employ the rules to their benefit.

TEI pointed out that transactions covered by the U.S.rules for low-margin services—found at Regs. §1.482-9(b) of the final services provisions—include servicesthat:

s have a median comparable markup of 7 percent orless or are listed in Rev. Proc. 2007-13;

s are not listed as excluded activities;s do not contribute significantly to key competitive

advantages, core capabilities, or fundamental risks ofsuccess or failure; and

s for which certain documentation requirements aresatisfied.

Twenty-one taxpayer representatives in commentletters posted on the OECD’s website July 8 unani-mously urged the organization to update its guidanceon safe harbors in order to expand their use for low-value intercompany services (20 Transfer Pricing Re-port 254, 7/14/11).

Low-Cost Services. O’Connor in his July 15 letter alsoasked the OECD to delete the statement, at paragraph4.121 of the organization’s transfer pricing guidelines,that safe harbors ‘‘are generally not compatible with theenforcement of transfer prices consistent with the arm’slength principle.’’

Australia, Austria, and New Zealand have safe har-bor pricing rules for non-core services, TEI said, butthey differ from the U.S. rules, and although othercountries also provide safe harbors for services theserules impose limits on the value of the services that willqualify for the relief. ‘‘Hence, they may be beneficialonly for small associated companies within large multi-national enterprises,’’ O’Connor said.

TEI said taxpayers’ documentation burdens under atransfer pricing safe harbor should be no morerigorous—and preferably should be less rigorous—thanthose required in the absence of the safe harbor.

Thus, TEI said taxpayers and tax authorities wouldgreatly benefit from a coordinated, consistent approachof using the cost of providing low-margin services as asafe harbor proxy for the arm’s-length price.

BY KEVIN A. BELL

� The July 15 TEI letter may be found at http://www.oecd.org/dataoecd/26/38/48405443.pdf.

United States

IRS Guidance on Uncertain Tax PositionsClarifies Definition of Recording a Reserve

T he Internal Revenue Service offered more guid-ance July 19 to taxpayers about reporting their un-certain tax positions to the government, address-

ing key questions surrounding the recording of a tax re-serve.

The updated set of frequently asked questions andanswers (FAQ) comes as the deadline approaches for





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the first wave of taxpayers to file the Schedule UTP,Statement of Uncertain Tax Position. The guidanceadds eight new questions to the FAQ first unveiled inMarch (57 Daily Tax Report G-7, 3/24/11) and updatesone existing question on whether interest and penaltiesshould be included when taxpayers are ‘‘ranking’’ theirpositions on the new schedule.

An Internal Revenue Service official in June dis-cussed how the Service will look at the interplay be-tween Schedule UTP and transfer pricing documenta-tion requirements as well as the reporting of reserveson companies’ financial statements. Cyndi Lafuente, se-nior advisor to the deputy commissioner (International)in the IRS’s Large Business & International division,said that listing a transfer pricing issue on ScheduleUTP does not automatically negate the protection thatdocumentation offers from accuracy-related penalties,and also said that taxpayers should not be concernedabout the differences that will result from periodicchanges in reserve amounts on financial statements re-ported to the Securities and Exchange Commission (20Transfer Pricing Report 156, 6/16/11).

The updated FAQs and answers appear in the Textsection of this issue.

Recording a Reserve Defined. In general, under the IRSinitiative, taxpayers are required to report uncertain po-sitions for which they have recorded a reserve, butmany have said there is uncertainty about what thatterm means. In Question 6, the agency clarified that areserve is recorded when an uncertain tax position or aliability under Financial Accounting Standards BoardInterpretation 48 (FIN 48) is stated anywhere in the fi-nancial statements and footnotes of a corporation or re-lated party.

The IRS said that some types of financial statemententries that, alone or in tandem, indicate the recordingof a reserve include:

s an increase in a current or non-current liability forincome taxes, interest, or penalties payable, or a reduc-tion of a current or non-current receivable for incometaxes and/or interest with respect to a tax position; or

s a reduction in a deferred tax asset or an increasein a deferred tax liability with respect to the tax posi-tion.

Other Issues Addressed. The IRS also said in broadterms that:

s taxpayers should not file blank Schedules UTP ifthey have no 2010 tax positions for which reserves havebeen recorded;

s taxpayers who reconsider their tax positions dur-ing the course of an audit and record a reserve in a lateryear must report those positions on a Schedule UTP inthat later year, even if IRS is already aware of the posi-tion;

s taxpayers must report a position either if theyrecord a reserve, or if they do not record a reserve be-cause they expect to litigate, even if that decision torecord or not record occurs because of a change in cir-cumstances in a later year;

s taxpayers are not required to report accruals of in-terest on a tax reserve recorded with respect to a tax po-sition taken on a pre-2010 tax return; and

s taxpayers do not have to include interest and pen-alties in ranking the size of a tax position, or in comput-ing whether a position is a major position, unless they

are separately identified in the books and records asso-ciated with that position.

BY ALISON BENNETT

Colombia

Colombian Taxpayers Given Extra MonthTo File Transfer Pricing Informative Returns

F iling deadlines for transfer pricing informative re-turns in Colombia have been postponed by onemonth, an official confirmed July 18.

Diego Gonzalez-Bendiksen, head of the Colombiantax authority’s international audit unit, said that underDecree 2350 of July 1, filing deadlines for the returnsthat originally fell between July 8 and July 22 depend-ing on the taxpayer’s identification number now will fallbetween Aug. 9 and Aug. 23.

Gonzalez-Bendiksen drew a distinction between theinformative transfer pricing returns and contemporane-ous documentation, or transfer pricing reports, whichunder Article 260-4 of Colombia’s tax code must be pre-pared by June 30. Unlike the informative returns, trans-fer pricing reports must be filed only if requested by thetax office, he said. Gonzalez-Bendiksen noted that thetax office has asked taxpayers to file transfer pricing re-ports in each of the taxable years 2008, 2009, and 2010.

New Deadlines. The new deadlines apply dependingon the last digit of a taxpayer’s identification number,the official said. Taxpayers with an ID number endingin 1 must file their transfer pricing informative returnsby Aug. 9; those with ID numbers ending in 2 must filethe returns by Aug. 10, and so on, with ID numbers end-ing in 0 representing the last category of returns dueAug. 23. No returns are due Aug. 15, which is a holiday,Gonzalez-Bendiksen said.

In Colombia, taxpayers must prepare documentationif their equity or net revenue—or their intercompanytransactions with related parties abroad—exceed spe-cific thresholds. Any transaction that exceedsUS$137,000 should be analyzed in a transfer pricing re-port, and a company having US$1.3 million in gross eq-uity or having US$800,000 in gross revenues is subjectto transfer pricing obligations (20 Transfer Pricing Re-port 158, 163; 6/16/11).

BY MOLLY MOSES

China, United Kingdom

Pending China-U.K. TreatyAdopts Services PE Concept

T he pending China-U.K. income tax treaty hasadopted the services permanent establishmentconcept and also updates the PE definition of con-

struction project.The treaty, signed in London June 27, will enter into

force when both countries have completed their ratifi-cation procedures.

Revised Article 5 of the pending treaty states that thefurnishing of services, including consultancy services,by an enterprise through employees or other personnel





engaged by the enterprise for such purpose will consti-tute a PE. The PE’s activities must continue—for thesame or a connected project—for an aggregate periodof more than 183 days in a 12-month period.

The pending treaty also provides that a PE will ariseif a building, construction, assembly, or installationproject—or ‘‘supervisory activities in connectiontherewith’’—lasts for more than 12 months. The currenttax treaty provides for a six-month period.

Business Profits. Revised Article 7 of the pendingtreaty would change how profits are attributed to a PE.

Under revised Article 7, a contracting state may de-termine the profits to be attributed to a PE on the basisof an apportionment of the total profits of the enterpriseto its various parts. ‘‘The method of apportionmentadopted shall, however, be such that the result shall bein accordance with the principles contained in this Ar-ticle,’’ the treaty said.

The current treaty does not permit the PE, when cal-culating its profit, to take into account managementfees that the PE has paid to its head office.

BY KEVIN A. BELL

� The June 27 tax treaty may be found at http://www.hmrc.gov.uk/international/uk-china-dta2011.pdf.

Australia

Interaction Between RTP Schedule,Schedule 25A Unclear, Practitioner Says

T he interaction between the Australian Taxation Of-fice’s new ‘‘reportable tax positions’’ schedule andSchedule 25A, covering international transactions,

is not yet clear, a Sydney practitioner said July 21.

Paul McNab of PricewaterhouseCoopers told BNATax Management that early discussions with the ATOsuggest ‘‘the new RTP schedule will be for issues otherthan transfer pricing.’’

The ATO July 6 revised its draft RTP schedule to re-quire taxpayers to disclose their reportable tax posi-tions on the new schedule even if they have otherwisedisclosed the tax positions to the ATO (20 Transfer Pric-ing Report 255, 7/14/11).

Schedule 25A, similar to U.S. Form 5471, is the formon which Australian taxpayers are required to discloserelated-party transactions.

New Schedule. The ATO has said it intends to ask spe-cific taxpayers—according to McNab, ‘‘Quadrant 1’’and ‘‘Quadrant 2’’ taxpayers, the 45 to 50 economicgroups representing 60 of the top 100 corporatetaxpayers—to complete the new RTP schedule for the2012 financial year.

The practitioner said the new schedule ‘‘is certainlynot just limited to the banking sector, although mostmajor banks are likely to be included.’’

The ATO has said it will review the program later inthe year and decide whether to extend it to other tax-payers, McNab said, and the ATO has said in principlethat most corporate taxpayers would be expected to fillout the schedule.

BY KEVIN A. BELL




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IntheCourtsUnited States

Contact Lens Co. Says AttributionUnder Subpart F at Odds with §482

T he Cooper Companies Inc. is protesting a $1.2 mil-lion tax bill related to adjustments the InternalRevenue Service made to the company’s income

for 2005 under the anti-deferral provisions of Subpart F,according to documents filed in the U.S. Tax Court. [TheCooper Companies Inc. v. Comr., T.C., No. 14816-11, peti-tion filed 6/23/11]

The Pleasanton, Calif.-headquartered contact lensmanufacturer maintained that the Service improperlyincreased its income by $52.8 million by characterizingis Barbados office as a branch of CooperVision Interna-tional Holding Company LP (CVIHCo)—a company in-corporated in the United Kingdom and registered inBarbados as an external company.

The IRS concluded that the activities of CVIHCo, ascarried on through its Barbados branch, ‘‘has substan-tially the same effect as if the Barbados branch were awholly owned subsidiary corporation deriving such in-come . . . such income constitutes foreign base sales in-come . . . of [CVIHCo].’’

In protesting the adjustment, Cooper argued that the‘‘sales branch rule’’ of Regs. §1.954-3(b)(1)(i) does notapply and that the 5 percent markup on services pro-vided by the three administrative staffers in the Barba-dos office constituted an arm’s-length return under theSection 482 regulations.

Disregarded Entities. The petition contended that Coo-per U.S. affiliates Coopervision Inc. and TCC Acquisi-tion Corp., as the limited partners and sole sharehold-ers of CVIHCo, elected for CVIHCo to be treated as acorporation for U.S. federal income tax purposes underRegs. §301.7701-3. CVIHCo is a controlled foreign cor-poration under Section 957.

Coopervision and CVIHCo develop, market, andmanufacture contact lens products, and all of the salesincome of CVIHCo is from the sale of contact lens prod-ucts to resellers and distributors.

In 2005, CVIHCo’s Barbados office elected underRegs. §301.7701-3 that certain of its non-Barbadoswholly owned entities’ selling and marketing contactlens products were to be disregarded as separate fromCVIHCo for U.S. federal income tax purposes. Thoseentities were located in 10 countries in Europe as wellas South Africa and Singapore. The products sold bythe non-Barbados offices were manufactured in CVIH-Co’s facilities in Australia, Puerto Rico, the UnitedKingdom, and the United States.

The income from the sale of contact lens productsmanufactured at CVIHCo’s Puerto Rican facility is notincluded in the amount determined by the IRS to beforeign-based company sales income, Cooper noted.

Purchasing, Selling Activities. Cooper said the IRS im-properly applied Regs. §1.954-3(b)(1)(i)’s sales branchrule in determining that income attributable to the ac-tivities of the Barbados office is treated as income de-rived by a wholly owned subsidiary of CVIHCo. Accord-ing to Cooper, the sales branch rule does not apply be-cause the activities of the Barbados office cannot beconsidered ‘‘purchasing or selling activities,’’ as is re-quired under the regulations.

Cooper noted that its non-Barbados offices employedbetween 2,300 and 4,000 personnel and its Barbados of-fice employed three secretaries.

Cooper said that the non-Barbados employees wereresponsible for the sales, product demonstrations, mar-keting, and related product activities, while the Barba-dos employees performed limited clerical and adminis-trative tasks necessary to maintain the office, filed localtax returns, and ensured compliance with other local le-gal requirements.

Transfer Pricing Study. According to Cooper, CVIHCofiled a Barbados tax return reporting only its Barbados-sourced income—$31,764—for 2005. The income in-cluded a 5 percent markup on the costs of the Barbadosoffice to compensate it for the functions it performed.

A transfer pricing study conducted by CRA Interna-tional on behalf of Cooper confirmed that the 5 percentmarkup was comparable to the rate of return earned byother North American companies performing compa-rable functions and within the interquartile range of to-tal returns on costs experienced by the comparables.

The company added that the 5 percent markup onthe Barbados office’s activities was in accordance withRegs. §1.482-1’s arm’s-length standard.

Cooper argued in the alternative that even if certainactivities of the Barbados office were treated as pur-chasing or selling activities under Regs. §1.954-3(b), theamounts that the IRS treats as attributable to such ac-tivities exceeds the amounts that would be attributableunder Regs. §1.482-1 and Barbados law.

TCC Settlement. The IRS settled with Cooper subsid-iary TCC Acquisition Corp. in 2005, agreeing that thecompany was not subject to Section 482 adjustmentsfor transactions between itself and its controlled foreigncorporation, Precision Lens Manufacturing & Technol-ogy Inc., for 1999-2001.

TCC originally protested $99.7 million in Section 482allocations in two petitions for 1999-2001 for goods itbought and sold to affiliates in Barbados, Puerto Rico,and the United Kingdom (14 Transfer Pricing Report183, 7/6/05).

BY TAMU N. WRIGHT

(Vol. 20, No. 7) 295



United States

Practitioner Says Applying 2003 RulesWould Not Change Outcome in Xilinx Case

T he U.S. Court of Appeals for the Ninth Circuit’s de-cision last year in Xilinx Inc. v. Comr. declaringthat Section 482’s regulations did not require the

company to share stock option costs under its joint ven-ture with an Irish affiliate wuld remain unchanged evenunder 2003 Treasury regulations explicitly requiringthat options be shared, a practitioner said July 26.

John Magee of Bingham McCutchen LLP in Wash-ington, D.C., agreed with the Ninth Circuit’s ruling inXilinx Inc. v. Comr., 125 T.C. 37 (2005), aff’d 598 F.3d1191 (9th Cir. 2010), that the provisions of Regs.§1.482-1 embodying the arm’s-length standard conflictwith, but should ultimately prevail over, the require-ments in Regs. §1.482-7 that all costs in the pool ofcosts in a qualified cost sharing agreement are to beshared (19 Transfer Pricing Report 179, 6/17/10).

Magee said that even though the IRS included an ex-plicit rule requiring the sharing of stock options in a2003 revision to the cost sharing regulations, ‘‘in myview, there’s still a conflict and I don’t see why the caseshould come out differently.’’

Rocco Femia of Miller & Chevalier in Washington,D.C., pointed out that while the IRS still may be able tomake solid arguments in favor of the validity of the2003 regulations on including employee stock optionsas a cost, any taxpayer challenging the validity of aTreasury regulation will have ‘‘an uphill climb no mat-ter how unreasonable one views the regulation.’’

Irving Plotkin of PricewaterhouseCoopers in Boston,speaking on the panel with Femia and Magee, agreed,noting that taxpayer difficulty in invalidating a Treasuryregulations is even ‘‘more so after Mayo.’’

In Mayo Foundation for Medical Education and Re-search v. U.S., No. 09-837, the U.S. Supreme Courtunanimously held that the Treasury Department actedreasonably in promulgating a rule that says medicalresidents are not exempt from paying employmenttaxes under the Federal Insurance Contributions Act(17 Daily Tax Report K-3, 1/26/11).

Practitioners have said that Mayo ‘‘unquestionablyraises the bar for a frontal assault on Treasury regula-tions,’’ making it harder for tax litigants to prevail in theface of a contrary regulation and strengthens the gov-ernment’s ability to use the regulatory process to pro-spectively avert the impact of adverse court decisions(19 Transfer Pricing Report 1076, 2/24/11).

Femia asserted that recent cases in which the tax-payer’s position has been upheld—Xilinx and VeritasSoftware Corp. v. Comr., 133 T.C. 297—‘‘are not aber-rations.’’ To the contrary, he said that ‘‘when we look atthe case law in the area rather than the regulations, wefind that courts often rely on CUTs and CUPs’’ even ifthey are not perfect. He added that the courts have re-jected efforts by the IRS to recast transactions and torely on broad principles rather than the facts at issue.

The panelists spoke on a panel about U.S. transferpricing jurisprudence at a conference sponsored by theNational Association for Business Economics in Arling-ton, Va.

BY TAMU N. WRIGHT

296 (Vol. 20, No. 7) IN THE COURTS



TextIRS FAQs, Answers on Schedule UTP, Updated 7/19/11

Frequently Asked Questions on Schedule UTPBeginning January 1, 2010, certain corporate taxpay-

ers are required to file Schedule UTP with the Form1120. Instructions for completing the schedule andother information related to the filing of Schedule UTPcan be found at the UTP web page.

These frequently asked questions supplement the in-formation contained in the 2010 instructions and in the

other guidance issued on Schedule UTP, and previouslyissued frequently asked questions can be found at theweb address set out above. The 2011 Schedule UTP in-structions will incorporate the guidance in these ques-tions and answers.

(July 19, 2011: Question 4 and its answer have beenrevised, and questions 5 - 12 are new.)

Reporting on Schedule UTP

# Question Answer

1. The instructions state that corporations need not report The instructions explain that the schedule seeks the reporting of tax positions

tax positions for which no reserve is recorded because consistent with the reserve decisions made by the corporation for audited

it was ‘‘sufficiently certain so that no reserve was financial statement purposes under applicable accounting standards. For a

required.’’ For a corporation subject to FIN 48, is a tax corporation subject to FIN 48, a tax position is considered ‘‘sufficiently certain

position that is ‘‘highly certain’’ within the meaning of so that no reserve was required,’’ and therefore need not be reported on

FIN 48 the same as a tax position that is ‘‘sufficiently Schedule UTP, if the position is ‘‘highly certain’’ within the meaning of FIN 48.

certain so that no reserve was required’’ under the

instructions?

2. A corporation records a reserve in an audited financial Yes, if the interim financial statement is unaudited. If the corporation

statement for a tax position it expects to take in its reconsiders whether a reserve is required for a tax position and eliminates the

2010 tax return but later eliminates the reserve in a reserve in an interim audited financial statement issued before the tax position

subsequent interim financial statement issued before is taken in a return, the corporation need not report the tax position to which

the filing of the 2010 return. Must the tax position be the reserve relates on the Schedule UTP.

reported on Schedule UTP?

3. If a corporation uses in a 2010 or later year return a net No. The use of an NOL or credit carryover in a post-2009 return is a tax

operating loss (NOL) or credit carryforward and the position that should not be reported if the portion of the NOL or the credit

NOL or credit carryforward that is used includes a pre- carryforward that is used includes a tax position taken in a pre-2010 return for

2010 tax position for which a reserve has been which a reserve has been recorded. This FAQ does not otherwise affect the

recorded, must the corporation report that tax position? requirement to report a tax position claimed on a post-2009 return for which a

reserve has been recorded that is included in an NOL or credit carryover for

potential use in a later year. Additional guidance will be forthcoming regarding

reporting requirements for the use of NOLs and credit carryovers.

4. Must interest and penalties be included in determining The size of a tax position is the amount of the reserve recorded for that

the size and ranking of a tax position in column (f) on position. If an amount of interest or penalties relating to a tax position is not

Schedule UTP, as well as the computation of major tax separately identified in the books and records as associated with that position,

position in column (e)? then that amount of interest and penalties is not included in the size of a tax

position used to rank that position or compute whether the position is a major

tax position.

5. If a taxpayer has no 2010 tax positions for which No. The Schedule UTP Instructions require taxpayers to file a Schedule UTP

reserves have been recorded, should the taxpayer file only if all of the four conditions set forth in the instructions under Who Must

a blank Schedule UTP with its 2010 tax return? File are satisfied. One of these conditions is that the corporation has one or

more tax positions that must be reported on Schedule UTP. If, under the

Schedule UTP Instructions, a taxpayer has no tax positions that must be

reported on the current year Schedule UTP, the taxpayer should not file a

blank Schedule UTP for that year.

6. The term reserve is not a defined accounting term. A reserve is recorded when an uncertain tax position or a FIN 48 liability is

When is a reserve recorded in an audited financial stated anywhere in a corporation’s or related party’s financial statements,

statement? including footnotes and any other disclosures, and may be indicated by any of

several types of accounting journal entries. Some of the types of entries that,

(Vol. 20, No. 7) 297


entered alone or in tandem, indicate the recording of a reserve are: (1) an

increase in a current or non-current liability for income taxes, interest or

penalties payable, or a reduction of a current or non-current receivable for

income taxes and/or interest with respect to the tax position, or (2) a reduction

in a deferred tax asset or an increase in a deferred tax liability with respect to

the tax position.

7. A corporation claims a deduction in 2011 and Yes. The corporation has taken a tax position in its 2011 tax return and

determines under applicable accounting standards that recorded a reserve with respect to that tax position. The corporation must

it can recognize the full benefit of the position. In 2013 report that position on Part II of the Schedule UTP filed with its 2013 tax

the IRS begins an examination of the 2011 tax return return. The requirement to report the tax position exists even if the IRS

and decides to examine whether the deduction is identifies the tax position for examination prior to the recording of the reserve.

proper. The corporation subsequently reevaluates the

tax position and records a reserve for that position in

2013. Must the corporation report the tax position on

Schedule UTP filed with its 2013 tax return even

though the IRS is aware of the tax position?

8. A corporation takes a tax position on its 2011 tax return Yes. The corporation must report that position either if it records a reserve or

for which no reserve is recorded because the if it does not record a reserve because it expects to litigate, even if that

corporation determines the tax position is correct. decision to record or not record occurs because of a change in circumstances

Circumstances change, and in 2013 the corporation in a later year. Therefore, assuming the other requirements of the Instructions

determines that the tax position is uncertain, but does for Schedule UTP are satisfied, a corporation must report a tax position for

not record a reserve because of its expectation to which it initially decides not to record a reserve if circumstances change such

litigate the position. That is, the corporation or a that in a later year the corporation expects to litigate that position. Under

related party determines the probability of settling with these facts, the tax position will be required to be reported on Part II of the

the IRS to be less than 50% and, under applicable Schedule UTP filed with the 2013 tax return.

accounting standards, no reserve was recorded

because the corporation intends to litigate the tax

position and has determined that it is more likely than

not to prevail on the merits in the litigation. Must the

corporation report the tax position on the Schedule

UTP filed with its 2013 tax return?

9. Corporation A merges into Corporation B in 2011, and The answer depends on when Corporation B records its reserve. As a result

Corporation B survives. Corporation B records a of the merger, Corporation B is liable under applicable law for all of

reserve with respect to a tax position taken on the final Corporation A’s federal income taxes. In addition, Corporation B is the

return of Corporation A. Should the tax position be surviving corporation and, as the surviving corporation, should be treated as a

reported on the Schedule UTP filed with Corporation continuation of the merged corporation. Because it recorded a reserve and is

A’s final 2011 tax return? the successor in interest to Corporate A, Corporation B is the appropriate

party to report a tax position on the Schedule UTP filed with the final tax

return for Corporation A. If Corporation B records a reserve with respect to

Corporation A’s tax position before the final return is filed, the tax position

should be reported on the Schedule UTP filed with Corporation A’s final tax

return even though the return was filed by Corporation B and the reserve was

recorded by Corporation B. Corporation B should not report the tax position

on the Schedule UTP filed with its 2011 tax return because Corporation A’s

final return is a prior year tax return on which the tax position was reported.

If Corporation B records the reserve for the tax position after filing Corporation

A’s final tax return, Corporation B must report the tax position on the Schedule

UTP filed with its 2011 tax return.

10. A corporation claims an item of deduction, loss, or A corporation must report a tax position taken on its 2010 tax return on

credit on its 2010 tax return and that tax return contains Schedule UTP if a reserve is recorded in an audited financial statement with

an NOL or a credit. The NOL or credit cannot be used respect to the tax position. As stated in example 9 of the Schedule UTP

in 2010 and is carried forward. The corporation Instructions, claiming an item of deduction, loss, or credit is a tax position.

records a reserve with respect to the tax position that is Since the corporation recorded a reserve for that tax position in 2010, the

reflected on an audited financial statement in 2010. corporation should report that tax position on the Schedule UTP filed with its

The NOL carryforward or credit carryforward is used to 2010 tax return.

reduce the tax liability reported on the 2012 tax return.

The corporation records a reserve with respect to the This reporting in 2010 is the only reporting required. We recognize that

tax position that is reflected on an audited financial example 9 caused confusion with respect to this issue. Even though the

statement in 2012. How should that item be reported future use of the NOL or credit carryforward is a tax position for which the

on Schedule UTP? corporation recorded a reserve, the IRS will not require reporting with respect

to the future use of NOLs or credit carryforwards. The corporation therefore

298 (Vol. 20, No. 7) TEXT


should not report the use of the NOL or credit carryforward on the Schedule

UTP filed with its 2012 tax return.

11. Under the transition rule in the Instructions for No. The corporation is not required to report accruals of interest on a tax

Schedule UTP a corporation is not required to report on reserve recorded with respect to a tax position taken on a pre-2010 tax return.

Schedule UTP a tax position taken on a pre-2010 tax

return. Must the corporation report accruals of interest

on that tax position that are part of the reserve

recorded for that tax position?

12. A corporation records a reserve for a tax position that Yes. Assuming all other requirements in the Schedule UTP Instructions are

would result in an adjustment to a line item on a satisfied, a corporation must report a tax position for which it has recorded a

schedule or form attached to the corporation’s 2010 reserve or did not record a reserve because it expected to litigate the position

Form 1120 (for example, the tax position would result that would result in an adjustment to a line item on any schedule or form

in an adjustment to a balance sheet item on the attached to the corporation’s filed Form 1120.

corporation’s Schedule L that is filed with the

corporation’s 2010 Form 1120), if that position was not

sustained. Must the tax position be reported on

Schedule UTP filed with the 2010 return?

Policy of Restraint

1. Do the changes to the policy of restraint announced in Yes. It would be very unusual for Appeals to conduct any substantive fact-

Announcement 2010-76 apply to documents requested finding during its case consideration. Nevertheless, the changes to the policy

by Appeals? of restraint apply to any request for documents during the administrative

process of determining the correct tax liability, which includes Appeals’

consideration of proposed audit adjustments.

2. Do the changes to the policy of restraint announced in In general, Counsel attorneys will not issue discovery requests for documents

Announcement 2010-76 apply to documents requested or information that the IRS would not seek under its policy of restraint. The

by Counsel after the filing of a Tax Court petition? application of the policy of restraint to actions taken by Counsel in Tax Court

litigation will be addressed in a revision to the Chief Counsel Directives

Manual.

3. What is the effective date of the changes to the policy The changes announced in Announcement 2010-76 apply to any request for

of restraint announced in Announcement 2010-76? documents outstanding on or made after September 24, 2010, in any open

examination.

Page Last Reviewed or Updated: July 19, 2011

TEXT (Vol. 20, No. 7) 299


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300 (Vol. 20, No. 7)


ConferenceReportAspects of India’s Transfer Pricing RegimeDebated in Light of Need for Foreign Investment

B ANGALORE, India—At a July transfer pricingconference in the south Indian city of Bangalore,Milind Kothari of the Bombay accounting firm

MZS & Associates posed a question that has puzzledpractitioners: Why, despite the experience the countryhas gained with transfer pricing in the last severalyears, do so many disputes remain unresolved?

In the decade since transfer pricing has been on thestatute books, Indian income tax officials have becomemore experienced, better prepared, and better in-formed. Courts have issued a variety of rulings on arange of transfer pricing issues.

‘‘Why then, despite all this activity and progress, is itthat tax demands are still cripplingly high?’’ Kothari de-manded. ‘‘Why are the same issues being debated end-lessly by multiple government agencies? And why dowe still have so much litigation lasting eight to 10years?’’

At the July 8 conference, organized by the Associ-ated Chambers of Commerce and Industry of India,Kothari and other practitioners questioned tax officialsabout a wide range of transfer pricing issues, including:

s the volume of transfer pricing audits conducted—now exceeding 10,400—and various audit tools at thegovernment’s disposal;

s the country’s dispute resolution panels;s settlement of mutual agreement procedure cases,

including the group resolution of 140 U.S. cases;s the transfer pricing analysis, including selection of

the method and comparables; ands issues faced by startup companies.

Overlaying the discussion was the broader concern,voiced by practitioners, that the country cannot affordto be overly zealous in enforcing its transfer pricing re-gime because it risks driving away foreign investment.

Kothari pointed out that the large amounts at stakein audits are of no use while they remain in disputerather than in the government’s coffers. He also de-scribed the general experience with the country’s dis-pute resolution panels, introduced in 2009 to help stemthe tide of litigation, as ‘‘sub-optimal.’’

Apart from the actual cost of litigating cases, ‘‘an-other cost for India is the impression we are giving for-eign investors that India is a litigious country. If you in-vest here, you’d better get ready to handle litigation.Some companies are choosing to invest in other coun-tries because of this,’’ Kothari told the conference.

Outflow of RevenueR.N. Dash, Director General of Income Tax and In-

ternational Taxation in New Delhi, however, said it isimportant for India to tighten the transfer pricing re-gime to stop the illegal outflow of money. Dash asserted

that 77 percent of this outflow is ‘‘essentially due to mis-pricing.’’

While he acknowledged that ‘‘mispricing is not al-ways transfer pricing,’’ Dash said tax officials ‘‘are verysensitive to transfer pricing’’ as they attempt to arrestthe flow of money out of India. ‘‘The money that goesnever comes back, so we need to be vigilant,’’ he added.

However, Kothari asserted that the 77 percent figureis essentially speculative. India’s transfer pricing ruleswere introduced in 2001, but money has been flowingillegally from the country for much longer than 10years, he said. ‘‘How can you measure what was lostwhen you never had it?’’ he demanded.

Aggressive or More Efficient?Dash, taking issue with the notion that the tax au-

thorities are being aggressive on audit, said his depart-ment is interested in the quality, rather than the vol-ume, of transfer pricing adjustments.

Speaking to allegations of an order from the top to‘‘come down hard’’ in audits of multinational compa-nies, the official said, ‘‘I have given no such order. Ihave said to tax officers to give relief where you can.’’Further, he said, a review in the last month of tax offi-cials’ work ‘‘found that their functioning is severaltimes better than last year and I expect it to get evenbetter in the next few years.’’

Dash said that just as military officers have protectedIndia’s physical borders, so have tax officials protectedthe country’s economic borders from being ‘‘eroded bypowerful multinationals.’’

Rakesh Bhaskar, Director of Income Tax in Hyder-abad, said India is not interested in short-term invest-ment or ‘‘investors who just want to make money andrun.’’

The government, Bhaskar said, has been ‘‘very le-nient in the past and lost out on revenue.’’ He also drewa distinction between auditors’ being aggressive and be-ing unreasonable.

‘‘Our method may be aggressive but it does not resultin injustice,’’ Bhaskar said. ‘‘In any case, honest inves-tors will never be deterred by these things.’’

Tax Adjustments—StatisticsDash said India, now in its seventh year of transfer

pricing audits, so far has examined 10,400 cases. ‘‘Thisis not a large figure given the size of our country andthe size of business here. Only in 3,752 cases out of10,400 did we make tax adjustments,’’ he said. Dashsaid transfer pricing manpower has increased by be-tween 10 percent and 20 percent and that most of thestaff have undergone training to improve their skills.

(Vol. 20, No. 7) 301


Kothari disagreed with Dash’s characterization ofthe number of adjustments—which, at 3,752 of 10,400audited cases, comes to 36 percent—as small. Accord-ing to the practitioner, this is a ‘‘huge’’ number by anystandard, but particularly for a developing country.‘‘You don’t get this kind of figure in the U.S. or Eu-rope,’’ he said.

Kothari also told BNA after the conference that taxofficials are armed with a carefully designed strategy tomake multinationals pay more.

‘‘They are deliberately out to create tax issues, tocatch multinationals on the wrong foot,’’ Kothari said.‘‘These days they are latching onto intangibles, claim-ing taxes have not been paid on them. In the process,taxpayers suffer, particularly as the tax adjustments areoften made years after the audit.’’

Audit Targets, Lack of Transparency AssertedThe fundamental issue between multinationals and

India’s transfer pricing regime, Kothari said, is not thatthe tax authorities are being aggressive, but ‘‘that thereis no transparency or openness about how tax officialsare going to interpret the rules and regulations. Theyshould regularly issue advance guidelines to taxpayerson what their position is likely to be, on how they intendto apply the rules and what their view is going to be.That’s the only way to prevent disputes. Then you won’teven need a dispute resolution panel,’’ he said.

The other main problem, Kothari said, is that tax of-ficers are given ‘‘astronomical targets’’ for tax collec-tion. While he said setting targets as a way to measureperformance is not intrinsically wrong, the attorney dis-agreed with the way these targets are being imple-mented.

‘‘You have officers trying to create tax demandswhich are not sustainable and which can amount to ha-rassment. When you set such high targets, then it isopen to abuse,’’ he told BNA.

Dispute Resolution Panels, APAsDash agreed with Kothari’s criticism of the DRPs’

performance in the last year as less than optimal. Hespoke of various administrative measures he has takento ensure that this year, the panels do a better job.

‘‘You have to remember that [their] only job is to dopeer reviews of the assessing officers and see if theyhave made any errors,’’ Dash said. ‘‘It is not an appel-late body. Nonetheless, I have insisted that all the mem-bers of the DRP upgrade their skills and give taxpayersan opportunity to be heard.’’

Other officials in the New Delhi Income Tax Officealso told BNA that the DRPs will be more responsiveand sensitive to the views of taxpayers than they wereearlier.

Some companies have complained about the failureof DRPs to give ‘‘speaking orders’’ explaining the ratio-nale for decisions. ‘‘Now most DRPs will give a speak-ing order, whether the decision has gone in favor of theassessee or the assessing officer,’’ an official said.

Dash, meanwhile, said provisions for advance pric-ing agreements—another alternative to litigation—willbe part of the proposed new tax law, the Direct TaxesCode, to be introduced next year. He said his depart-ment already has trained its staff so that they will beready to accept applications the moment APAs are in-troduced.

Taxpayers Asked to ‘Meet Us Halfway’Dash said that Indian Finance Minister Pranab

Mukherjee had met him recently to convey his dismayat the ‘‘multiple layers of litigation’’ in transfer pricingcases and had asked him to find ways to reduce thelevel of litigation.

‘‘His exact words to me were, ‘You reduce the litiga-tion and turn the litigation into revenue.’ But litigationis not just one way,’’ Dash contended. ‘‘If we can reduceit by meeting taxpayers halfway, taxpayers also need tomeet us halfway.’’

Giving an example of a cooperative approach, Dashcited a recent settlement of 140 cases—all of which in-volved the same issue—that occurred when a group ofU.S. taxpayers met with him and his colleagues. ‘‘Wedon’t have a statutory system of mediation other than[the mutual agreement procedure] but I’m sure that awillingness to reduce litigation by tax officials andtaxpayers—without transgressing the law—can im-prove affairs,’’ he said.

Mutual Agreement Procedure CasesAddressing mutual agreement procedure cases as a

whole, Dash said the government is in a position to en-ter into more now than ever before. Roughly 100 MAPcases were concluded last year, he said, ‘‘and we havelearned roughly what to expect in different industries,particularly through talking to our counterparts in othercountries.’’

Dash also said MAP proceedings have been fast-tracked.

‘‘Earlier, getting information from the field used totake ages. Now it doesn’t take more than three weeks.That’s why we have achieved a larger volume of MAPsand want to increase it further because it is the surestway of decreasing litigation,’’ he said.

Comparables SelectionDash said his department follows a transparent

method in selecting comparables. ‘‘I have asked officersto give speaking orders after giving adequate opportu-nities to taxpayers. We need to narrow down the differ-ences between the two parties to make them converge,’’he said.

Dash said he has heard of tax officers rejecting loss-making companies as comparables in favor of thosewith high profit margins. The official said he has told of-ficers to adopt a judicious approach and select compa-rables on merit, which involves using both profit- andloss-making companies.

‘‘It all depends on the nature of the enterprise, whichis more important. Our view is that loss or profit mar-gins do not decide comparability. Other criteria need toconverge.’’ Following this principle, Dash said that insome cases he has told his officers to accept loss-making companies and exclude those with high profits.

One Year of DataBhaskar noted that in India, generally data of only

the relevant financial year in which the relevant inter-national transactions took place should be considered.In other words, contemporaneous data alone must beused.

302 (Vol. 20, No. 7) CONFERENCE REPORT


While he said that in some cases, data from twoyears before the year of the transaction can be referredto, this is permitted only if the data reveals facts thatcould have influenced the company’s transfer pricing.

The lack of availability of data at the time of thetransfer pricing study may be a good reason for notconsidering such data at the time of the study, but thiscannot prevent use of such data subsequently by thetransfer pricing officer if it is available to the TPO,Bhaskar said.

Safe Harbor RulesDash said that initially, a proposal to introduce safe

harbor rules was intended purely for the informationtechnology industry. The matter is under study, and hisdepartment’s proposal is now back with the FinanceMinistry.

‘‘We must know the limitations of safe harbor rules,’’he said, pointing out that such rules currently exist inonly six countries. Nevertheless, Dash said India iscommitted to implementing a safe harbor for IT ser-vices, which are particularly important in Bangalore,‘‘the IT capital of the country.’’

Meanwhile, a U.S. taxpayer advocacy group, Tax Ex-ecutives Institute Inc., has asked the Organization forEconomic Cooperation and Development to encouragecountries to adopt safe harbor rules similar to those inU.S. regulations on intercompany services for low-margin services. (See the related article in this issue.)

Powers to Survey PremisesWhile he said these powers so far have not been

used, Dash noted that income tax officials have, fromlate 2010, been given the authority to survey a compa-ny’s premises to check for discrepancies between thedocuments in the office and those that were submittedfor tax scrutiny.

‘‘I have told them to use these powers sparingly ornot at all. Intrusion becomes necessary only when I can-not manage a situation sitting at my desk,’’ the officialsaid. ‘‘So far, these survey powers have not been usedand I will be happy if they are never used. But taxpay-ers must submit correct documentation to avoid a visit,’’he said.

Concerns from U.S. PractitionerBhaskar relayed the concern of one U.S. practitioner

that multinationals face substantive problems in tryingto deal with numerous jurisdictions that interpret andapply similar transfer pricing guidelines in a differentmanner. Among the issues raised by the practitioner,according to the Hyderabad official, are that:

s the tax authorities often want the local legal entityto be treated as the tested party regardless of the riskand function profiles of the parties;

s the tax authorities may try to force the use of localcomparables when in reality none exist; and

s it often is difficult to convince tax auditors thatcertain adjustments to comparable data are necessary.

Bhaskar, responding to these concerns, referred tothe ruling in a case involving Global Vantage. In thecase, the Delhi Income Tax Appellate Tribunal ob-served that while the least complex entity normally isselected as the tested party in a transfer pricing analy-sis, an overseas entity may not be appropriate because

it is difficult to obtain all the relevant facts and data re-quired for a proper analysis of functions, assets andrisks (18 Transfer Pricing Report 1010, 1/28/10).

Noting that the Indian entity is used as the testedparty in the majority of transfer pricing cases in India,Bhaskar said this treatment ‘‘is not arbitrary—it is be-cause these entities are least complex.’’ He added,‘‘Amongst the associated enterprises, it is the entitysituated in other tax jurisdictions that is generally morecomplicated, being the repository of intangible proper-ties.’’

Further, Bhaskar said, ‘‘the very good economicgrowth of India and the availability of a large databasefor more than 25,000 companies are helpful in identify-ing the uncontrolled comparables in the same geo-graphical region, and thus reducing the need of makingadjustments in the comparable data.’’

Method SelectionSpeaking to the selection of methods, Bhaskar

pointed to a decision by the Pune ITAT, which foundthat where revenue authorities seek to disturb the tax-payer’s chosen method, they must demonstrate that aparticular method will be more appropriate. Thisgreater level of appropriateness must be shown in rela-tion to the following factors set out in Income Tax Rule10C(2):

s the nature and class of the international transac-tion;

s the class or classes of associated enterprises en-tering into transactions and the functions performed bythem, taking into account assets employed or to be em-ployed and risks assumed;

s the availability, coverage, and reliability of datanecessary for application of the method; and

s the extent to which reliable and accurate adjust-ments can be made to account for differences, if any.

In a 2009 case involving MSS India Private Ltd., thePune ITAT said that when a taxpayer has followed oneof the standard methods of determining the arm’s-length price—in this case, comparable uncontrolledprice—the method cannot be discarded in favor of atransactional profit method unless the taxing authoritydemonstrates the fallacies in the application of the stan-dard method. ‘‘Any preference of one method over theother method must be justified by the [transfer pricingofficer] on basis of cogent material and sound reason-ing,’’ the court said (18 Transfer Pricing Report 244,7/23/09).

Comparables SelectionNoting the OECD mandate that comparables selec-

tion should be based on a functional analysis that iden-tifies economically significant activities and that properfilters should be applied to identify those activities,Bhaskar gave the example of software services and out-sourcing, a sector that has witnessed tremendousgrowth not only in terms of revenues but also in termsof profit margins.

Service providers in the United States normally com-mand markups ranging from 5 percent to 10 percent oftheir service cost, the official said, but in India markupsof 25 percent or more are common. Indian service pro-viders provide offshore as well as onshore services, andonshore services result in higher revenue receipts butlower profit margins.

CONFERENCE REPORT (Vol. 20, No. 7) 303


‘‘Therefore, the Income Tax Department has appliedseveral filters to identify uncontrolled comparablesbased on economically significant activities such as,percentage of onshore revenues [and] persistent loss-making companies,’’ Bhaskar said.

He noted that taxpayers have objected to the inclu-sion of companies making ‘‘super profits,’’ such as soft-ware concerns Infosys and Wipro. On this issue, hesaid, the Mumbai ITAT in a recent case involving ExxonMobil held that, in principle, neither loss-making unitsnor those making high profits can be eliminated fromthe comparables unless there are specific reasons fordoing so—other than the general reason that a compa-rable has incurred loss or has made abnormal profits.

Mean Versus MedianThe Indian tax authorities use the arithmetical aver-

age of more than one price to determine arm’s-lengthpricing. This is different from U.S. and OECD guide-lines, which prescribe the use of the median to deter-mine the arm’s-length price.

Hardev Singh of PricewaterhouseCoopers in Benga-luru told the conference that his firm has been trying topersuade the tax authorities to use the median ratherthan the arithmetical mean. ‘‘We think it’s fairer to lookat the central trend and that means excluding the bigprofit-makers and big loss-makers that you find at ei-ther extreme and instead take the majority of the com-panies and see how they are faring and come to the ar-ithmetical median on the basis of this,’’ he said.

Scrutiny of Smaller CasesPwC’s Singh cited a poll showing that of five Asian

countries featured in a list of the 10 toughest authoritiesfor transfer pricing, India was second—after Japan butbefore China. He warned that the country could beviewed even less favorably by outside investors if thetaxing authorities, as has been rumored, begin subject-ing tax cases involving transactions of less than 150 mil-lion rupees (US$3.4 million) to scrutiny. So far, Singhsaid, any amounts below this figure have not been re-viewed, mainly because there are simply not enough taxofficers to deal with the higher volume of work thatwould ensue.

Officials in the New Delhi Income Tax Departmentconfirmed to BNA that while the basic guideline is toavoid scrutinizing amounts of less than 150 million ru-pees, if a case warrants the attention of the tax officers,it could be examined. ‘‘In fact, there are already somecases where this is happening,’’ an official told BNA.

StartupsSingh said tax officials must pay particular attention

to the special issues faced by startups. These include:s determining when a project had started

operations—something difficult to pinpoint in a projectwith a long gestation period;

s the issue of paying a royalty when the startup ismaking losses; and

s the need for adjustment when performing anyform of comparability in matters such as idle capacity,working capital, or extraordinary circumstances (suchas the tsunami in Japan, which disrupted the supplychain) because the two entities could be working in to-tally different risk environments.

‘‘Tax officials are clear-cut on things like the date ofthe commencement of operations—they go by the dateof the legal agreement or contract. But there are timeswhen the decisions in the subsidiary are dependent onthe decisions of the parent company in India, and thesecould delay the start in operations,’’ Singh said.

Singh cited two relevant rulings: the HyderabadITAT in a case involving Convergys, and the Delhi ITATin a case involving Haworth.

In Convergys, he said, the court found that a subsid-iary’s operating expenses incurred after entering intothe agreement with the group company should be con-sidered for a 10 percent markup, as no third-party cus-tomer would pay a markup before entering into a le-gally binding agreement.

In Haworth, Singh said, the tribunal held that theonus is on the taxpayer to demonstrate that expensesincurred before the commencement of the business op-erations do not relate to the international transactions.If the taxpayer is unable to show the expenses were in-curred before the start of the business operations, thenthe expenses should not be excluded while calculatingthe taxpayer’s operating margin.

Thus, he urged taxpayers to:s maintain robust documentation with a sound

analysis of the functions and risks and a well-developedeconomic analysis;

s document the facts on a contemporaneous basis;s adequately document the company’s risk profile

versus that of the comparables;s describe in detail reasons for making adjustments

and provide detailed computations for carrying out ad-justments; and

s maintain adequate backup documents, such as an-nual reports of comparables and reports of any extraor-dinary activities, to support the computation of adjust-ments.

BY AMRIT DHILLON

304 (Vol. 20, No. 7) CONFERENCE REPORT



AnalysisThe New Russian Transfer Pricing Regulations: An Overview

The author examines in detail new transfer pricing regulations designed to bring Russia

more in line with Organization for Economic Cooperation and Development guidelines,

noting provisions including the requirement to alert the tax authorities to related-party

transactions that will increase the compliance effort required by taxpayers.

BY VLADIMIR STARKOV, NERA ECONOMIC

CONSULTING

R ussian President Dmitry Medvedev July 18 signedlegislation amending the Tax Code that signifi-cantly alters the country’s transfer pricing land-

scape. Beginning Jan. 1, 2012, the effective date of thechange, the safe harbor of 20 percent around the mar-ket price of comparable goods will no longer be suffi-cient to demonstrate compliance with the arm’s-lengthstandard. Instead, new amendments to the Tax Code in-troduce full-scope transfer pricing regulations that con-stitute a significant step toward adapting the frameworkestablished by the Organization for Economic Coopera-tion and Development transfer pricing guidelines, al-though practitioners will find that the regulations con-tain many idiosyncratic features.1 Proper transfer pric-ing compliance in Russia will therefore require athorough understanding of the newly adopted regula-tions.

Some of the regulations’ features likely will increasethe compliance effort for taxpayers with Russian opera-tions. Among them:

s the requirement to report controlled transactionsto tax authorities on an annual basis coupled with arelatively low threshold for the volume of transactionssubject to reporting requirements;

s the necessity to prepare transfer pricing documen-tation to avoid penalties for underpayment of taxes;

s limits on powers granted to tax authorities con-ducting transfer pricing audits to make only income ad-justments that increase the Russian income taxes;

s the lack of a clearly defined mechanism for corre-sponding income adjustments between the Russian andforeign taxpayers; and

s limited availability of advance pricing agreements.This summary of the new Russian transfer pricing

regulations is an attempt to chart a ‘‘navigation map’’through the document and does not necessarily provideexhaustive coverage of every detail.

Definition of Related PartiesThe regulations stipulate that, for transfer pricing

purposes, interdependence between parties is formedvia capital participation or other relationships that al-low one party to influence decisions of the other party,either directly or through other dependent parties. Theregulations list the following circumstances as givingrise to such interdependent relationships:

s The proportion of one party’s participation in thecapital of another party is 25 percent or more. The par-ticipation may be either direct or indirect—that is,through other related parties. The capital participationis measured by either a proportion of voting shares or aproportion of shareholder equity.

s Two or more companies for which the same share-holder holds directly or indirectly 25 percent or morecapital in each company.

s A party that can control appointment or electionof a chief executive or at least 50 percent of the mem-bers of the board of directors in another company isconsidered related to that company.

s Companies that share more than 50 percent of theboard of directors’ personnel or the same chief execu-tive are considered related.

s Companies controlled by people related throughthe chain of hierarchy and companies controlled byrelatives are considered related.

Furthermore, taxpayers can choose to declare them-selves to be related parties, and companies can be de-clared related parties by court decision. On the otherhand, participation of government organizations incommercial companies does not by itself make suchcompanies related.

Definition of Controlled TransactionsThe following types of transactions are considered

controlled:

1 The amendments would add Articles 1051-10525 underChapters 141-146, as well as other provisions.

Vladimir Starkov is a senior consultant atNERA Economic Consulting in Chicago. Theauthor wishes to thank Harlow Higinbothamfor his thorough review and helpful com-ments. The views expressed in this article arethose of the author and do not necessarilyrepresent those of NERA.

(Vol. 20, No. 7) 305


s those between related parties, as defined above;s transfers facilitated by unrelated parties acting as

intermediaries among related parties when the unre-lated parties do not bear significant risks or performsignificant functions;2

s export sales of goods subject to international tradein mercantile exchanges (for example, crude oil and pe-troleum products, ferrous and non-ferrous metals, fer-tilizers, gems, and precious stones); and

s transactions in which at least one of the parties isa company registered, residing, or paying taxes in oneof the tax havens listed under Russian law (or transac-tions in which a Russian company effectively forms apermanent establishment in such tax haven).

Transactions among Russian taxpayers with a totalvolume exceeding 1 billion rubles (US$36 million)3 aresubject to transfer pricing audits unless all of such com-panies operate and pay taxes in the same administrativeregion of the Russian Federation and none of thesecompanies have operating losses, including past periodloss carryovers.

Additionally, if the total volume of the followingtransactions exceeds 60 million rubles per year (US$2.1million), such transactions among the Russian taxpay-ers also are subject to transfer pricing regulationswhen:

s at least one of the parties is a payer of a mineralextraction tax and the controlled transaction involvesthe mineral subject to this tax;

s one of the parties is a non-taxable entity whileother parties are subject to income tax; or

s one of the parties operates in an economic zonewith a special income tax regime while other parties donot have any special tax treatment.4

Transactions among Russian taxpayers with a mini-mum volume of 100 million rubles (US$3.6 million)where at least one of the parties is a payer of the agri-cultural tax or is subject to tax on imputed income aresubject to transfer pricing regulations as well.

On the other hand, transactions within the same con-solidated group of taxpayers are not considered con-trolled (the legislation on the consolidated group of tax-payers is yet to be adopted by the parliament and en-acted by the president).

Transactions can be deemed controlled under othercircumstances—for example, by a court ruling that sev-eral transactions in the aggregate meet the criteria forcontrolled transaction even though each individualtransaction does not.

Notification of Tax AuthoritiesRussian taxpayers will have to report to the local tax

authorities all transactions defined as controlled trans-actions using special paper or electronic forms to be de-veloped for such reporting. These transactions must bereported no later than May 20 of the year following thecalendar year of the transaction. Taxpayers will have aright to self-correct the notifications. The penalty for

failure to file such notifications or erroneous notifica-tion is 5,000 rubles (US$180).

During the initial implementation period of the newtransfer pricing regulations, disclosure of the related-party transactions is subject to the minimum thresholds(computed as annual totals of prices or costs of allrelated-party transactions of similar type) as follows:100 million rubles (US$3.6 million) in 2012 and 80 mil-lion rubles (US$2.9 million) in 2013. In later years,there will be no minimum threshold for reporting con-trolled transactions other than the thresholds that applyto the Russian taxpayers, as discussed above.

The information subject to disclosure includes:s the calendar year of the transactions;s the subject matter of the transactions (including a

description of goods and services);s information about the parties to the controlled

transactions, including the full name of the organiza-tion and taxpayer code (or full name of the individualentrepreneur and his or her taxpayer identificationnumber);

s the gross volume of sales or costs for the con-trolled transactions, including separately stated volumeand costs for transactions whose prices are separatelyregulated under Russian law.

Local tax authorities are required to forward the in-formation about the controlled transactions to the fed-eral tax authorities within 10 days of receipt.

Transfer Pricing AuditsAlthough conduct of transfer pricing audits is del-

egated exclusively to the federal tax authorities, the lo-cal tax authorities will have the right to notify the fed-eral authorities about the controlled transactions theydiscover during the course of their audits.

The federal tax authorities are authorized to verifythe arm’s-length nature of transfer pricing and proposeany income adjustments. The federal tax authoritiesmay initiate the transfer pricing audit with respect toany taxpayer no later than two years after receiving thenotification about the controlled transactions. Thetransfer pricing auditors may review controlled transac-tions for the period of at most three years before theyear in which the audit has begun.5

Federal transfer pricing audits are required to beconcluded within six months or, in exceptional cases,within 12 months. When the audit involves requestinginformation from foreign tax authorities or when an ad-ditional expert analysis or document translation are re-quired, the audit period may be extended by an addi-tional six months. If the foreign tax authorities do notprovide responses within six months, an additionalthree months may be added to the audit.

If the taxpayer applies one of the transfer pricingmethods specified in the regulations (as described be-low), the federal tax authorities must apply the samemethod unless they determine that the method used bythe taxpayer is not reliable. The federal tax authoritiescannot apply methods not listed in the regulations.

In conducting a transfer pricing audit, the federal taxauthorities can request the transfer pricing documenta-tion, the content of which is discussed below. The docu-mentation must be provided within 30 days of request.

2 For a select group of taxpayers, such as payers of an agri-cultural tax and the tax on imputed income, enforcement ofthis clause will begin as of Jan. 1, 2014.

3 The minimum threshold for these types of transactions is3 billion rubles for 2012 and 2 billion rubles for 2013.

4 This provision will be enforced beginning Jan. 1, 2014. 5 This provision will be applied starting Jan. 1, 2014.

306 (Vol. 20, No. 7) ANALYSIS


If the federal tax authorities conclude that a tax ad-justment is necessary, they must notify the taxpayerformally within two months of the end of the transferpricing audit. The taxpayer has 20 days from the receiptof the notice to appeal it. The appeal may be accompa-nied by additional supporting evidence, and the timeframe for submitting the supporting documents may beextended beyond the 20 days if the tax authorities agreeto it.

Correction of Taxable IncomeThere is a presumption that the transfer prices used

by the taxpayer are arm’s-length unless proven other-wise. Self-correction of transfer prices by taxpayers isallowed, including the corresponding correction of thetax declarations. The correction of the tax declarationmust be made within the time limit set for paying thegeneral income tax. Self-correction, if needed, must beperformed on an annual, as opposed to quarterly, basis.

When a transfer pricing audit is conducted by thefederal tax authorities, they are authorized to proposeonly pricing adjustments that do not reduce the Russianincome tax liability.

Corresponding Income AdjustmentsCorresponding income adjustments can be made

among the Russian taxpayers only when one of themhas received an official notification of a tax adjustment(that increases its tax liability) and has, in fact, paid theadditional tax. The corresponding income adjustmentscan be recorded in contemporaneous tax declarationsof the affected parties.

Given that the regulations do not allow for corre-sponding adjustments between the Russian and foreigntaxpayers, the only feasible option to implement the in-come adjustment between the Russian and non-Russiantaxpayers outside of an APA seems to be through theuse of bilateral treaties on the avoidance of double taxa-tion (although the competent authority proceedings arenot spelled out in the law).

DocumentationIf the federal tax authorities have initiated a transfer

pricing audit, the taxpayer may be asked to providedocumentation. The documentation can be requestedon or after June 1 of the year following the year beingaudited. Documentation needs to be presented within30 days of a request. The tax authorities have the rightto request documentation and other information aboutcontrolled transactions not only from the taxpayer be-ing audited but from other parties to the transactions aswell.

The regulations do not provide a specific format fortransfer pricing documentation, although they state thatthe complexity of such documentation should be com-mensurate with the complexity of the transaction. Theinformation contained in the documentation is requiredto include:

s a description of the taxpayer’s business;s a list of related parties, including their countries of

residence;s a description of the controlled transactions and

their terms, including the transfer pricing method ormethods used (if any), payment terms, and other rel-evant conditions;

s a functional analysis of controlled parties, includ-ing risks taken and assets used by each of those parties;

s a description of the method or methods used totest the arm’s-length nature of transfer prices, includingdiscussion of why a particular method was selected;

s a description of the information sources used (adiscussion of the information sources listed in the regu-lations is provided below);

s a calculation of the arm’s-length range includingthe description of the selection of the comparable trans-actions;

s the tested party’s profit and loss statement;s the profit of the tested party associated with the

use of valuable intangibles obtained in a controlledtransaction;

s other relevant information, such as market strat-egy;

s adjustments to the reported tax liability made bythe taxpayer, if any; and

s any other information confirming the arm’s-lengthnature of transactions that the taxpayer considers rel-evant.

The following transactions are exempt from thedocumentation requirements:

s transactions subject to APAs;s transactions with prices regulated by government

organizations;s transactions that involve widely traded financial

instruments; ands those that do not involve related parties.Timely submission of transfer pricing documentation

allows the taxpayer to avoid a penalty if the tax under-payment is alleged by the tax authorities. Such penaltyis calculated as the greater of 40 percent of the under-paid tax or 30,000 rubles (US$1,000).6

Advance Pricing AgreementsAPAs are permitted only for the largest taxpayers (as

defined elsewhere in the tax law). APAs are concludedbetween Russian taxpayers and the federal govern-ment. Bilateral APAs are allowed with countries thathave double tax avoidance treaties with Russia (thisprocedure is to be approved by the Russian Ministry ofFinance). A single Russian taxpayer may act on behalfof a group of related Russian taxpayers in the APA pro-cess under a power of attorney provided to it by the re-lated taxpayers.

APA terms are limited to three years with a possibleextension for another two years upon a taxpayer’s re-quest. The request for extension will be considered ifthe taxpayer has abided by the terms of the existingAPA. The APA period also may cover the time elapsedbetween the taxpayer’s application for the APA and theAPA’s approval.

The taxpayer’s APA application should be consid-ered within six months, or, in exceptional circum-stances, within nine months. A taxpayer has a right torecall its APA application. By the end of the consider-

6 Income adjustments for controlled transactions conductedin 2012-13 are not subject to an additional penalty. Controlledtransactions conducted during 2014-16 are subject to the re-duced penalty of 20 percent of the additional tax assessment,and controlled transactions in 2017 and thereafter are subjectto the full penalty of 40 percent of the additional tax assess-ment.

ANALYSIS (Vol. 20, No. 7) 307


ation period, the tax authorities can either accept theapplication, ask for additional materials, or deny the ap-plication with formal explanations of the reasons forsuch denial. One of the reasons for denial may be theprojected reduction of income taxes payable in Russia.Denial of an APA application can be appealed in court.

Control over APA execution is delegated to the fed-eral tax authorities. If the taxpayer abides by the APAconditions, the federal tax authorities cannot make up-ward income adjustments for transactions covered bythe APA.

An APA that has gone into effect can be terminatedby the federal tax authorities if they conclude that thetaxpayer has paid lower taxes than agreed upon underthe APA.

An APA can be modified based on a court decision,by mutual agreement of the parties, or to reflectchanges in the tax or customs laws other than the lawthat regulates the APA process itself.

Comparability AnalysisThe regulations present an extensive list of factors

that should be used to consider comparability betweencontrolled and uncontrolled transactions. These factorsinclude:

s the characteristics of goods or services;s the functions performed, risks assumed, assets

(including intangible and financial) used, and responsi-bilities of the controlled parties;

s contract terms, volume of transactions, paymentterms, exchange rates, and assignment of rights amongparties;

s economic conditions;s market characteristics (for example, geographic

location, competitive situation, relative market power ofbuyers and sellers, government regulations);

s market strategies (such as new market penetra-tion, and product updates);

For financial transactions, additional comparabilityfactors such as credit history of the recipient of a loanor a loan guarantee, the term of the loan (guarantee),the currency of transaction, and formulas for interestrate adjustments can be used.

Sources of InformationThe federal tax authorities are authorized to use only

the sources of information listed in the regulationswhen conducting transfer pricing audits. The tax au-thorities cannot use any non-public information not re-lated to the taxpayer being audited in the course of thetransfer pricing audit. Taxpayers can use any public in-formation sources to support their transfer prices andprepare transfer pricing documentation.

The regulations list the following primary sources ofinformation that can be relied on by the federal tax au-thorities:

s prices and pricing quotes of the Russian and for-eign mercantile and stock exchanges, including thoseofficially published by the Russian and foreign govern-ments and commercial organizations;

s customs statistics of the Russian Federation;s pricing databases; ands prices applied in the taxpayer’s own transactions.If sufficient information cannot be obtained from the

primary sources listed above, the tax authorities mayconsider the following additional sources:

s prices and pricing quotes reported in other pub-licly available databases;

s financial and statistical reports of companies ob-tained from publicly available databases or companies’websites;7 and

s valuation reports prepared according to Russianor foreign valuation standards.

If, during the transfer pricing audit, tax authoritiesdetermine that the taxpayer was engaged in transac-tions with unrelated parties that are comparable to thecontrolled transactions of the same taxpayer, then thetax authorities must use the prices of these uncon-trolled transactions to establish the prices of the con-trolled transactions.

Arm’s-Length RangeThe interval of arm’s-length prices is calculated us-

ing the interquartile range. The interquartile range isdetermined in the same way as described in the U.S.Treasury regulations under Section 482. Specifically,the lower end of the range is found as the lowest resultderived from the range of uncontrolled prices arrangedin the increasing order such that at least 25 percent ofthe results are at or below the value of that result. If ex-actly 25 percent of the results are at or below a result,then the 25th percentile is equal to the average of thatresult and the next higher result derived from the rangeof uncontrolled prices. The upper end of the range isdetermined analogously using the 75th percentile.

Pricing MethodsThe transfer pricing methods that can be used to es-

tablish the arm’s-length price are the comparable un-controlled price (CUP), resale price, cost plus, compa-rable profits (CPM), and profit split methods. The defi-nitions of those methods in the Russian regulations arebroadly consistent with those used in the OECD guide-lines and the U.S. transfer pricing regulations, althoughthe Russian regulations differ in some details with re-spect to implementation of these methods.

A taxpayer can use a combination of two or moremethods to establish the arm’s-length price. A group ofsimilar transactions may be combined for the purposesof a transfer pricing analysis.

There is a hierarchy of methods, with CUP being thepriority method for all transactions and the resale pricemethod preferred for transactions involving purchasesof goods from related parties and resale to unrelatedparties without substantial transformation in caseswhen the reseller does not own valuable intangibles.Other methods can be applied when CUP or resale pricedo not produce reliable results.

Resale price and cost plus can be used only if finan-cial statements of the tested party and the comparablecompanies apply the same accounting methods to cal-culate relevant costs and income, or if reliable adjust-ments can be made to correct for any such differences.When reliable adjustments cannot be made, CPM or theprofit split method should be used. CPM and profit split

7 Financial data of foreign companies can be used only if fi-nancial reports of the Russian companies engaged in compa-rable transactions are insufficient for purposes of determiningthe arm’s-length pricing range. Details on calculation of thisrange are discussed below.

308 (Vol. 20, No. 7) ANALYSIS


do not require calculation of arm’s-length prices foreach tested transaction.

If a transaction between related parties is an isolatedtransaction that involves transfer of goods or servicesthat are not the core business of the tested party, thearm’s-length price can be established using a valuationanalysis.

Taxpayers are not required to use the methods speci-fied in the regulations to establish intercompany prices.The specified methods are to be used only for purposesof establishing compliance with the transfer pricingregulations.

Profit Level IndicatorsThe following profit level indicators can be used in

all of the transfer pricing methods described above ex-cept CUP:

s the ratio of gross profit to sales (gross margin);s ratio of gross profit to cost of goods sold;s ratio of gross profit to operating expenses; ands ratio of gross profit to total assets.Additionally, in the application of CPM, operating

profit may be used instead of the gross profit in thesame ratios. Other profitability ratios that reflect the re-lationship between the functions performed, assetsused, risks taken, and profits may be used as well.

The use of gross margin and the ratio of gross profitto operating expenses is recommended for transactionsinvolving resale activities, while the ratio of gross profitto cost of goods is recommended for manufacturing ac-tivities and the provision of services. The ratio of grossprofit to total assets is recommended for capital-intensive manufacturing activities.

ComparablesThe selection of comparable companies is required

to meet the following criteria:

s Comparables must perform functions similar tothose of the tested party (the comparability is estab-lished by examining the relevant industry codes).

s Comparables must have positive net assets.s Comparables cannot have more than one year of

operating losses in the multi-year analysis period.s The comparable companies cannot be more than

25 percent owned by other companies or control morethan 25 percent of other companies’ capital (either di-rectly or indirectly). If application of the 25 percent con-trol criterion reduces the number of comparables to lessthan four, then the control threshold may be increasedfrom 25 percent to 50 percent.

The comparable companies’ profits can be measuredusing either the year of the tested transaction or threepreceding years, if the latest year’s data are not avail-able. The year end for the latest comparables’ data can-not be later than the year end of the tested party.

The measurement of the comparables’ profitabilityratios is required to be made according to Russian gen-eraly accepted accounting principles. If the financialdata of comparables is stated using foreign GAAP, thedata must be adjusted to reflect Russian GAAP. Profit-ability data can be adjusted to reflect differences in in-ventory holdings, payables, and receivables betweenthe comparables and the tested party.

ConclusionTaxpayers with Russian operations should take pro-

active steps to ensure compliance with the new law.This includes taking an inventory of all controlledtransactions, aligning intercompany prices using avail-able benchmarking information on arm’s-length prices,and preparing transfer pricing documentation.

Transfer pricing practitioners analyzing Russian-related transactions also will need to develop a good un-derstanding of the information sources that providepricing data and financials for Russian companies anddevelop comparables screening and adjustment proce-dures consistent with the regulations.

ANALYSIS (Vol. 20, No. 7) 309


PerspectiveValuing Intangible Property: Discount Rate for Routine Returns

The author challenges the notion that the discount rate applied to routine returns should

be the corporate bond interest rate, asserting that the variability or risk inherent in routine

returns is greater than that of interest payments on a corporate bond. In fact, he says, the

routine return discount rate should be determined using the discount rate of the selected

routine comparables themselves.

BY VINAY KAPOOR, DUFF & PHELPS LLC

A number of transfer pricing methods used to valueintangible property involve accounting for andvaluing the arm’s-length profit attributable to rou-

tine functions such as distribution or contract manufac-turing.1 Examples of these methods include the incomemethod using the comparable profits approach and theresidual profit split method as outlined in the U.S. tem-porary cost sharing regulations. The discount rate usedto estimate the present value of the profits attributableto routine functions (that is, the routine returns) associ-ated with the exploitation of intangible property is a keydeterminant in applying these transfer pricing methodsand determining the arm’s-length value of the intan-gible property under review.2

For example, under a CPM-based application of theincome method,3 the arm’s-length value of the intan-gible property to be transferred intercompany is com-puted by subtracting the present value of underlying

routine returns determined using CPM from the presentvalue of the business operating profits.4

Consistent with finance theory, the temporary regu-lations acknowledge that different streams of cashflows may require different discount rates, dependingon the correlation between these cash flows and a diver-sified market portfolio.5 Therefore, in applying the in-come method or some of the other transfer pricingmethods prescribed in the temporary regulations, thepractitioner must make a judgment about whether thepresent value of the routine returns should be calcu-lated using a different discount rate than that used tocalculate the present value of the overall business oper-ating profits.6

It is not uncommon for transfer pricing practitionersto argue that the discount rate applied to the routine re-turns should be lower than that applied to the overallbusiness profits. The argument advanced is that theroutine returns are ‘‘guaranteed,’’ or not as variable asthe overall business cash flows; for example, the arm’s-length routine return for distribution functions may bebenchmarked to be a consistent 5 percent of sales. Inparticular, some practitioners consider routine returnsakin to interest payments on corporate bonds and sug-

1 The arm’s-length profit attributable to the routine func-tions, or the arm’s-length routine return, is intended to providea market return for those routine functions and assets thatsupport the intangible property being valued.

2 Specifically, the routine return in each year is discountedto the present using the selected discount rate. The discountedroutine returns in each future year are summed to give thepresent value of the projected routine returns.

3 Using CPM, independent companies that perform func-tions comparable to those of the tested party (that is, the com-pany exploiting the intangible property under review) areidentified and used to benchmark the return for the tested par-ty’s routine functions.

4 If the financial projections are for the worldwide businessbut only certain territorial rights to the intangible property areto be transferred, one would multiply the resultant arm’s-length value of the intangible property by the reasonably an-ticipated benefits (RAB) share attributable to the territorialrights to be transferred.

The temporary regulations describe the income method us-ing the CPM approach in a slightly more complicated fashion,but the end result is the same. That is, under this method thearm’s-length value of the intangible property is equal to thepresent value of the operating profits for the business that ex-ploits the intangible property minus the present value for theroutine functions underlying the business.

5 See Regs. §1.482-7T(g)(2)(v)(A).6 As a point of note, one also could express the income

method using the CPM approach as the present value of theannual residual profits where residual profit in each year isequal to business operating profit minus routine returns. Inthis expression, one would require only a single discountrate—that is, a rate of return appropriate for the market-correlated risk of the residual profit stream.

Vinay Kapoor, Ph.D., is a managing directorin Duff & Phelps’ transfer pricing practice.The opinions expressed in this article are hisown and do not represent the position of Duff& Phelps or its clients.

310 (Vol. 20, No. 7)


gest using a corporate bond interest rate as the discountrate in estimating the present value of routine returns.

This article will illustrate why the variability or riskinherent in routine returns is greater than that of inter-est payments on a corporate bond. It also will discusswhy using a corporate bond interest rate to discountroutine returns is not consistent with finance theory orprinciples. Finally, it will explain why it is more appro-priate to determine the discount rate for routine returnsby reference to the same comparable companies used tobenchmark the routine returns.

ExampleAssume the company XYZ has issued a corporate

bond with a face value of $1,000, and that the marketyield or annual market interest rate on the bond is 10percent. For simplicity of discussion, further assumethat the corporate bond has an infinite life. The 10 per-cent interest rate on the bond will be lower than the dis-count rate (of say 15 percent) that would be used to dis-count XYZ’s overall profit streams because barring de-fault, the bondholders will receive a fixed interestpayment of $100 (that is, 10 percent interest × $1,000face value) each year into perpetuity while the corpora-tion’s profit would be expected to vary year to year. Thepresent value of the stream of interest payments is thesum of the annual interest payments discounted usingthe market interest rate of 10 percent, or $1,000.7

Now assume that XYZ has annual revenues of$1,000. XYZ decides to migrate all of its valuable andnonroutine intangible property to a subsidiary overseas.It applies the income method using a CPM approach tovalue the intangible property, which for simplicity ofdiscussion is assumed to have an infinite life. The onlyroutine functions are distribution. Using CPM, the rou-tine distribution return is benchmarked to be 10 percentof sales. Assuming XYZ’s projected annual revenuesare expected to be $1,000 in perpetuity (that is, assum-ing no growth), the expected routine distribution returnwill be 10 percent of $1,000, or $100 annually in perpe-tuity.8 What discount rate should be applied to deter-mine the present value of the routine returns?

Under the argument advanced by some practitioners,both the interest payments and the routine returns havea ‘‘fixed’’ annual cash flow of $100 and both should bediscounted using the same discount rate. That is, a dis-count rate of 10 percent should be used in determiningthe present value of both the interest payments and theroutine returns.

Barring default, XYZ’s bondholders will indeed get afixed cash flow of $100 annually. On the other hand,XYZ’s revenues will fluctuate year to year depending onthe economic environment it faces. That is, while theprofit margin used in calculating the routine distribu-tion returns stays constant at 10 percent of sales, theabsolute amount of the routine returns will vary basedon XYZ’s realized revenues. For example, if revenuesfall to $800, the absolute amount of the routine returns

will be only $80—that is, 10 percent × $ 800. In otherwords, the annual routine return cash flows will bemore volatile or riskier than the annual interest pay-ments on the corporate bond and hence deserving of ahigher discount rate.9

The IssueDiscount rates are used to convert future expected

nominal cash flows into present values by accountingfor the time value of money and the risk inherent in thefuture cash flows. The risk inherent in the future cashflows is the risk that they would be lower or higher thanexpected; specifically, it is cash flow variability risk thatcannot be diversified away by holding a diversified port-folio of all assets (that is, the market portfolio).10

Finance theory and principles inform us that inevaluating two otherwise comparable cash flowstreams, the cash flow stream with higher variabilityrelative to the market portfolio should be discounted us-ing a higher rate. In simpler terms, the cash flow streamwhere realized results are more likely to differ from ex-pected results11 should be discounted using a higherrate.

In calculating routine returns for a given business ortested party there are two components:

s a profit margin benchmarked using independentroutine comparable companies; and

s the base of the tested party—the business trans-ferring the intangible property—to which the bench-marked profit margin is applied.

For example, using independent comparable compa-nies, the return for routine distribution functions (thatis, the routine distribution return) may be benchmarkedto be equal to 10 percent of sales. The 10 percent is theprofit margin benchmarked using the comparables,while the sales is the tested party’s base to which thebenchmarked profit margin is applied.

Even if the benchmarked profit margin is a constant,the tested party’s base (such as sales or costs) to whichthe margin is applied generally will vary depending onthe business environment. As a result the routine re-turn, which is the product of the benchmarked profitmargin and the base to which the margin is applied, willvary too. This variability or risk inherent in the routinereturn is unlikely, except in some rare cases of coinci-dence, to be comparable to that of interest payments ona corporate bond.

The market yield or market interest rate on a corpo-rate bond reflects a premium on the risk-free rate to ac-count for the risk that a corporation’s profits may notcover interest or loan principal payments, and that thecorporation therefore may default on the bond. Whenthe corporation’s profits are sufficient to cover interestand principal payments, such payments will stay con-stant.

7 The present value of a constant annual cash flow streamis calculated as the annual cash flow divided by the discountrate.

8 Note that it is assumed for purposes of exposition, andwithout loss of generality, that the intangible property underreview has an infinite life. As such, the routine functions thatsupport the intangible property also will last into perpetuity.

9 Technically, the discount rate for a particular expectedcash flow stream is a function of the covariance of the ex-pected cash flows with that of a diversified portfolio of assets(that is, the market portfolio). Taking this into account wouldonly complicate the discussion but would not change the na-ture of the discussion or conclusions reached. Therefore, with-out loss of generality, the remainder of this paper abstractsaway from this complication.

10 Ibid.11 Ibid.

PERSPECTIVE (Vol. 20, No. 7) 311


At the same time, while the interest and principalpayments may be a constant, the corporation’s rev-enues and costs can be expected to vary as a result ofthe business environment. As such, as discussed earlier,the routine returns too can be expected to vary (notethe routine return is the product of the benchmarkedprofit margin and the tested party’s sales or costs). Fi-nance theory and principles inform us that investorswould attach a lower risk—that is, a lower discountrate—to the ‘‘steady’’ interest and principal paymentsthan they would to the ‘‘variable’’ routine returns.12

Furthermore, interest payments on debt usually have apriority claim to a corporation’s cash flows, which fur-ther reduces the risk of debt and the discount rate asso-ciated with interest payments relative to routine re-turns.

Said differently, in considering routine returns tohave risk comparable to interest payments on corporatebonds and thereby using the corporate bond interestrate to discount routine returns, one is confusing hav-ing a constant benchmarked profit margin with havinga constant or unvarying routine return (note that theroutine return is the product of the benchmarked profitmargin and the tested party’s sales or costs).

The SolutionFor purposes of discussion, assume that the profit-

ability of comparable independent companies is used tobenchmark a tested party’s routine distribution returnto be 10 percent of sales. In determining the presentvalue of the tested party’s routine distribution returns,this benchmarked profit margin of 10 percent generallywill be taken to be invariant—that is, it is assumed toremain constant into the future. This interpretation of aconstant profit margin for routine functions, however,is not consistent with either the transfer pricing regula-tions or finance theory.

The selected comparable companies used to bench-mark the tested party’s routine distribution return willhave varying realized financial results and hence profit-ability over time depending on the economic environ-ment. If the comparables’ profit results are expected tovary over time, then the benchmarked profit marginused to estimate arm’s-length routine returns too will beexpected to vary.13 In other words, while the profit mar-gin of the comparables might be expected to be 10 per-cent based on information available today, their actualfuture profit margin results will vary from what is ex-pected.

Therefore, a more appropriate interpretation of us-ing the same or constant benchmarked profit margin toestimate the tested party’s routine returns in each fu-ture year is that the benchmarked profit margin is theexpected profit margin based on information availabletoday. That is, the benchmarked 10 percent profit mar-gin is likely to vary over time but its expected valuebased on the information existing today is 10 percent.This expected profit margin is applied to the expectedrevenue base of the tested party (that is, the businesstransferring the intangible property intercompany).That is, both components used to calculate the routinedistribution return are expected values only, and eachmay vary depending on actual future outcomes.

The variability or risk in the benchmarked expectedprofit margin and in the tested party’s expected revenuebase is what determines the discount rate that shouldbe applied in calculating the present value of the testedparty’s routine distribution returns.14

The variability or risk inherent in the benchmarkedexpected profit margin and in the tested party’s ex-pected base (for example, revenues, costs) to which theprofit margin is applied to determine routine returns, isbest approximated by reference to the risk inherent inthe selected routine distribution comparables’ expectedprofit streams. That is, the discount rate that should beapplied to determine the present value of the routine re-turns (that is, benchmarked profit margin × base) ismost reliably determined by reference to the discountrates of the selected distribution comparables. Why?

The benchmarked profit margin used to calculateroutine returns for distribution is determined by refer-ence to the profitability of the selected distribution com-parables. As such, variability or risk in the expectedprofitability of the selected comparables will be posi-tively correlated with variability or risk in the bench-marked expected profit margin. Furthermore, the se-lected distribution comparables are supposed to becomparable to the tested party’s routine activities inboth functions and risks borne, including market risks.That is, variability and risk in the selected comparables’profit streams should be a reliable indicator of variabil-ity and risk in the tested party’s routine returns.

Since the risks (or more accurately, the market-correlated risks) of the selected routine comparablecompanies is similar to that of the tested party’s routineactivities, the discount rates of the routine comparablecompanies should be reliable indicators of the discountrate to use in valuing the tested party’s routine returns.

It is not unreasonable to argue that the tested party’sexpected revenue or cost base, to which the bench-marked expected profit margin is applied, is less vari-able or risky than the expected profit stream of the se-lected comparables. After all, it is straightforward toshow that revenues are less variable than profits. How-ever, there is usually a lack of reliable information withwhich to precisely compute the market-correlated risk

12 In some cases, such as where a corporation’s credit rat-ing is extremely low as a result of there being a high likelihoodof default on issued bonds, the variability and risk inherent inthe interest payments may be comparable to that inherent inthe corporation’s overall financial results and routine returns.In other cases where the routine return is a markup on costs,and the corporation has very high fixed costs, there may belimited variability or risk in the routine returns comparable tothat of interest payments on a bond.

13 A word of caution is appropriate here. While the realizedabsolute profit of the comparables may vary from that ex-pected, the comparables’ profitability (that is, profit as a per-centage of sales or some other metric) used to benchmark theprofit margin component of the routine return may not vary asmuch. However, in light of the fact that most costs are invari-ant, at least in the short run, one would expect a change in ab-solute profit to correlate to a change in profitability.

14 As mentioned earlier, the discount rate for a particularexpected cash flow stream is a function of the covariance ofthe expected cash flows with that of a diversified portfolio ofassets (market portfolio). That is, technically, the discount rateshould be a function of the covariance of expected profit mar-gin multiplied by expected revenue with that of the marketportfolio. However, including a discussion of covariance withthe market portfolio would only complicate matters withoutchanging the nature of the discussion or conclusions reached.

312 (Vol. 20, No. 7) PERSPECTIVE


of revenues or costs. One approach to account for thiswould be to determine an interquartile range of dis-count rates using the selected routine comparables andto use the lower end of that range to discount the testedparty’s routine returns, thereby acknowledging the is-sue of the lower risk in the tested party’s revenue orcost base to which the benchmarked profit margin isapplied.

ConclusionThis paper demonstrated why it is not appropriate to

discount routine returns using the market yield or mar-ket interest rate on corporate bonds, and why doing sois inconsistent with finance theory and principles. Spe-cifically, it demonstrated why the discount rate appliedto routine returns should be higher than the corporatebond interest rate. Using a corporate bond interest ratefor routine returns will result in a value for the routinefunctions that is higher than the arm’s-length result.

This will consequently result in a value for the intan-gible property under review that is lower than thearm’s-length result (note that the intangible propertyvalue is equal to the value of the overall business cashflows minus the present value of the routine returns),thereby opening up the taxpayer for challenge from taxauthorities.

In valuing intangible property to be transferred inter-company, the practitioner must not only consider trans-fer pricing regulations and methods, but also applythem in a manner that is consistent with finance theoryand principles. This article proposes that the discountrate for routine returns should be calculated by refer-ence to the discount rates for the selected routine com-parables themselves—an approach that is consistentwith finance theory and principles as well as the tempo-rary cost sharing regulations in that the resultant rou-tine return discount rate takes into account the correla-tion between the routine return cash flows and a diver-sified market portfolio.

PERSPECTIVE (Vol. 20, No. 7) 313


JournalCONFERENCES, HEARINGS, AND MEETINGS

Aug. 29-31 Transfer Pricing Aspects of BusinessRestructurings

Beijing IBFD; see http://www.ibfd.org/portal/Product_course_AP11TPBR1.html or call (31) (20)554-0160.

Sept. 20-21 11th Annual Global Transfer Pricing Forum London International Tax Review; visit http://www.internationaltaxreview.com/TPforum2011 ore-mail [email protected].

Oct. 20-22 2011 Joint Fall CLE Meeting Denver American Bar Association Section of Taxation; visithttp://www.americanbar.org/groups/taxation.html.

Dec. 12-13 U.S. International Tax Reporting &Compliance

New York BNA Tax & Accounting Council for International TaxEducation (CITE); see http://www.citeusa.org or call(914) 328-5656.

Dec. 15-16 24th Annual Institute on Current Issues inInternational Taxation

Washington,D.C.

George Washington University Law School andInternal Revenue Service; see http://docs.law.gwu.edu/ciit/.

Jan. 19-20,2012

Pacific Rim Tax Institute Palo Alto, Calif. Pacific Rim Tax Institute; visit http://www.pacificrimtaxinstitute.com or [email protected].

314 (Vol. 20, No. 7)


http://www.ibfd.org/portal/Product_course_AP11TPBR1.html

http://www.ibfd.org/portal/Product_course_AP11TPBR1.html

http://www.internationaltaxreview.com/TPforum2011

http://www.internationaltaxreview.com/TPforum2011

http://www.americanbar.org/groups/taxation.html

http://www.citeusa.org

http://docs.law.gwu.edu/ciit/

http://docs.law.gwu.edu/ciit/

http://www.pacificrimtaxinstitute.com

http://www.pacificrimtaxinstitute.com

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(Vol. 20, No. 7) 315


DirectoryPrivate Sector Sources

Matthew FrankSenior Tax Counsel, Transfer PricingGeneral Electric Co.120 Long Ridge RoadStamford, Conn. 06927(203) [email protected]

Vinay KapoorDuff & Phelps LLC55 East 52nd Street, 31st FloorNew York, N.Y. 10055(212) [email protected]

Milind KothariMZS & Associates1116, Raheja ChambersNariman Point, Mumbai 400 021,Maharashtra, India+91 22 [email protected]

Paul McNabPricewaterhouseCoopersDarling Park Tower 2201 Sussex St.Sydney 2000Australia61 (2) [email protected]

Craig SharonBingham McCutchen LLP2020 K Street N.W.

Washington, D.C. 20006-1806(202) [email protected]

Hardev SinghKPMG11-12/1Inner Ring RoadKoramangala, Bangalore 560071Karnataka, India.+91 80 39806727

Vladimir StarkovNERA Economic Consulting875 North Michigan Ave., Suite 3650Chicago, Ill. 60611(312) [email protected]

Government SourcesRakesh BhaskarDirector of Income Tax (International

Taxation)4th Floor, A Block, IT TowersA.C. Guards, Masab TankHyderabad 500004, Andhra PradeshIndia+91 40 23425466

Michael DanilackDeputy Commissioner (International)Internal Revenue ServiceLarge Business and International

DivisionMint Annex BuildingLM:IN Room MA3-332

1111 Constitution Ave. N.W.Washington, D.C. 20224(202) 435-5000

R.N. DashDirector General of Income TaxInternational Taxation, 407Drum Shape Building, I.P. EstateNew Delhi 110001India91 11 2337 [email protected]

Diego Jose Gonzalez-Bendiksen DeZaldıvarSubdirectorSubdireccion de Gestion de

Fiscalizacion InternacionalDireccion de Impuestos y Aduanas

NacionalesCra. 7 No. 6-54, Piso 7, BogotaColombia57 1 607 9800, ext. [email protected]

Samuel MarucaDirector, Transfer Pricing OperationsLarge Business & International

DivisionInternal Revenue Service1111 Constitution Ave. N.W.Room MA3-322DWashington, D.C. 20224(202) [email protected]

316 (Vol. 20, No. 7)


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