Transfer Pricing Adjustment

Additional Adjustments to Be Made in the Wake of a Transfer Pricing Adjustment

By Nicholas Webb, BNA Tax Management, for the Tax Management International Forum (2008)

In the fact pattern established for the discussion of the first topic, it was assumed that H was a business entity formed under the laws of Host Country and engaged in the assembly and sale of computers in Host Country. F, which was related to H, was a business entity formed under the laws of Foreign Country and engaged in the production of hard drives in Foreign Country. Both H and F were considered “corporations” for purposes of Host Country抯 income tax law and there was no income tax treaty between Host Country and Foreign Country.

H purchased computer components from various parties, including hard drives from F, and also periodically made loans to F. In 2003, H purchased hard drives from F for u$100 per carton (where u$ = units of Host Country currency). In 2006, the tax authorities of Host Country determined that the fair market value of the hard drives was actually u$80 per carton, and H agreed to that determination. In 2003, H also had a loan outstanding to F on which it accrued interest income of u$1000. In 2006, the tax authorities of Host Country determined that the arm抯 length interest on that loan was u$1300, and H agreed to that determination.

In relation to this fact pattern (and assuming that their own country was Home Country) the Forum members were invited to consider:

What additional adjustments would be made in the wake of the transfer pricing adjustment pertaining to the amount paid for the hard drives in 2003. In particular, how would the additional payment of u$20 per carton made by H to F be treated, assuming, in the alternative, that: (i) F wholly owned H; (ii) H wholly owned F; and (iii) a third corporation owned 95% of H and 100% of F (the remaining stock in H being held by an unrelated individual resident in Host Country). Did the tax authorities of Host Country (or H) have options as to how the additional payment of u$20 per carton would be treated?

How would the same questions be answered with respect to the transfer pricing adjustment pertaining to the interest income accrued by H in 2003. In particular, how would the difference between the amount actually accrued (u$1000) and the arm抯 length amount (u$1300) be treated? Could withholding tax be imposed under Host Country law on an amount deemed paid but not actually paid?

How would the answers to the questions set out above differ if there were a tax treaty between Host Country and Foreign Country and the competent authorities of the two countries agreed on the transfer pricing adjustments.
Herman Bouma of Buchanan Ingersoll & Rooney PC, Washington, D.C., opened the discussion of the first topic by observing that although in the United States there has been considerable focus on transfer pricing in the past 10 to 15 years, this focus has largely been directed at the question of how to establish an arm抯 length price. Less attention has been paid to the question of what additional adjustments might need to be made where an arm抯 length price has been established that differs from that applied by the parties to the transaction concerned. Bouma explained that, whileof the Internal Revenue Code, the basic transfer pricing section, is very simple and is silent on the issue of additional adjustments, the regulations under do offer some guidance on the adjustments that need to be made after a basic adjustment, referring to such adjustments collectively as “collateral adjustments.” Acknowledging that the use of terminology in this context is far from consistent and more than a little confusing, Bouma proposed using the following:

(i) Transfer pricing adjustment: to mean the adjustment made to the price of goods or services as a result of the application.
(ii) Income adjustment: to mean the adjustment made to the income (and, where a corporation is involved, to the earnings and profits (E&P)) of a U.S. taxpayer as a result of a transfer pricing adjustment.
(iii) Correlative adjustment: to mean the adjustment made to the tax position of another party to the transaction as a result of the transfer pricing adjustment, for example, where the Internal Revenue Service has adjusted downward the sale price of a product sold by a foreign person to a U.S. person, the resulting decreases to the foreign person抯 income and E&P.
(iv) Conforming adjustment: to mean an adjustment made to “make sense of” a transaction with respect to which it has been determined that either too much or too little has been paid for a good or service. Such an adjustment may take the form of a deemed dividend or a deemed contribution to capital, or, in certain circumstances, a deemed loan.
(v) Set-off: to refer to another transfer pricing adjustment that a U.S. taxpayer whose taxable income has been increased as a result of a basic transfer pricing adjustment may, in certain limited circumstances, be allowed to make to decrease its taxable income.

CORRELATIVE ADJUSTMENTS

Turning to the hypothetical situation before the meeting, Bouma explained that in the first scenario (i.e., where H pays F u$100 for a carton of computer hard drives, the arm抯 length price of which is established to be u$80) a correlative adjustment would be required that would decrease the income (and E&P) of F by u$20 per carton. If F was not subject to U.S. income tax, such a correlative adjustment would have no direct consequences for F, but the adjustment of E&P would be relevant for determining the extent to which a subsequent distribution made by F was a dividend.

CORRESPONDING ADJUSTMENTS

While none of the other countries represented at the meeting appeared to provide for correlative adjustments in the U.S. sense (for example, E&P-type adjustments), Bouma remarks prompted a discussion of what, if any, adjustments might be made in the other countries represented at the meeting in response to the U.S. basic transfer pricing adjustment and consequent correlative adjustment to the E&P of the foreign party. These adjustments made by other countries may be referred to as “corresponding adjustments.” In particular, the discussion addressed the role that recourse to the Mutual Agreement Procedure (MAP) instituted by Article 25 of the OECD Model Convention would play in securing such adjustments. Walter Boss of Blum Attorneys at Law, Zurich, noted that if, in this situation, F were a Swiss resident company, then there could be no corresponding downward adjustment of Federal income for Swiss tax purposes if the relevant assessment had already become final, unless there was an applicable treaty between Switzerland and Home country of residence and such an adjustment was agreed to under the MAP. If the relevant assessment had not become final, a corresponding adjustment would be possible, subject to the agreement of the Swiss tax authorities. St. Gelin of CMS Bureau Francis Lefebvre, Paris, suggested that, where F was a French company, France would effectively ignore the U.S. treatment of the E&P of the French company, but would provide relief to deal with any double taxation arising as a result of the basic transfer pricing adjustment. Carola van den Bruinhorst of Loyens & Loeff N.V., Amsterdam, thought that where F was a Dutch company, typically a MAP would be initiated to secure a corresponding adjustment; normally, this would not be done on a unilateral basis.

Nicola Purcell of McDermott Will & Emery UK LLP, London, pointed out that within the European Union (EU), as an alternative to the MAP, recourse may be had to the procedures set out in the European Arbitration Convention, though she suggested that this was a road that historically had not been much travelled. This may, however, be changing according to Howard M. Liebman of Jones Day, Brussels, who cited a report recently published by the Transfer Pricing Working Group of the European Commission indicating that there are now more than 200 cases awaiting arbitration under this Convention. Gelin threw further light on the European arbitration procedure抯 somewhat fitful progress when he noted that a backlog of cases had built up in the five years during which the Convention was suspended, although he was aware of both French/German and French/Italian cases that had been settled using the procedure. Dr. Rosemarie Portner of PricewaterhouseCoopers, Dusseldorf, pointed out that while the 1989 U.S.-Germany treaty provides for a MAP, the relevant treaty article simply requires the competent authorities of the two countries to consult; it does not require them to come to an agreement. However, the recently signed Protocol to the treaty does provide for the possibility of binding arbitration where the competent authorities are not able to reach agreement. Picking up Portner point, Liebman explained that, in contrast to the MAP provided for in tax treaties, which is not binding (although some of the U.S. treaties do make separate provision for mandatory and binding arbitration), the EC Arbitration Convention is binding within the EU.

Bouma suggested that, in circumstances where there is no applicable tax treaty (as envisaged in the hypothetical situation set out above), the other party to the transaction that was subject to a transfer pricing adjustment could approach the tax authorities of its country of residence to attempt to obtain a corresponding adjustment for that country抯 tax purposes, although he did not seem to hold out much hope that such an approach would often succeed. Where there is an applicable treaty, double taxation can, of course, still arise where the MAP does not result in an agreement. In this context, Gelin was able to cite statistics issued by the French tax administration to the effect that 90-95% of French cases that go to competent authority do result in the avoidance of double taxation. Portner opined that most MAPs achieve a resolution, because the competent authorities have an interest in settling cases, although she alluded to cases taken by the German Competent Authority where no agreement could be reached, in particular cases involving Korea (ROK) and Brazil. Indeed, she suggested that the intractability of the differences between Germany and Brazil in this context had ultimately led to the termination of the Germany-Brazil treaty. Liebman ventured that there might be problems with the MAP in cases involving developing countries generally, giving India as an example. He also recalled seeing IRS statistics that indicated roughly 80% of U.S. MAP cases were resolved without double taxation, which still left a significant number of cases with unrelieved double taxation. Bouma remarked that there was a general feeling that the MAP has not always run smoothly in cases involving the competent authorities of the United States and Canada. However the two countries have entered into several specific agreements designed to facilitate the process, which according to Bouma “have been helpful.”

CONFORMING ADJUSTMENTS

Bouma explained that the regulations specify that a conforming adjustment in the wake of a basic transfer pricing adjustment may take the form of a deemed dividend or capital contribution, or, provided both parties to the transaction concerned are corporations and subject to certain conditions, an election may be made to treat the additional amount as a loan, which would have to bear interest at an arm抯 length rate. In some cases, apparently, the IRS has applied deemed loan treatment, even where the taxpayer made no election to that effect. Van den Bruinhorst characterized The Netherlands approach to conforming adjustments as essentially the same as that of the United States. The Netherlands shares with the United States the concept of a deemed dividend, and applies deemed dividend treatment even if the other party to the transaction is not the parent of the party whose transaction is subject to the basic transfer pricing adjustment, but both parties share a common parent.

Recharacterization as a deemed dividend is based on old Dutch case law that dates to before the introduction of the transfer pricing rules. The Netherlands may also adopt a deemed loan approach where there is no “shareholder抯 motive” to justify treating an additional amount as a deemed dividend. For example, in the first situation envisaged in the scenario set out above (and where F wholly owned H), there would be a deemed loan from H to F, unless the Dutch authorities were able to establish that both H and F were aware of the benefit provided to F by the overpayment of u$20 per carton, in which case there would be a deemed dividend from H to F.

Germany approach to conforming adjustments was characterized by Portner as “very formal and strict.” The requirement to make conforming adjustments is derived from the application of Germany抯 general tax rules, and a conforming adjustment will take the form of either a deemed capital contribution or a constructive dividend (with attendant withholding tax implications) even where the shareholding of the deemed dividend recipient in the deemed payer of the dividend is only 1%. Neither deemed capital contribution nor constructive dividend treatment can be reversed if it is later decided to make an actual repayment of the additional amount concerned. Instead there would be a deemed capital contribution to reflect the amount so returned.

France in a sense goes even further by treating every non-justified payment out of France to a third party as a deemed dividend for French tax purposes, even if the payment is made by a parent to a subsidiary. In principle, tax will have to be withheld on the deemed dividend. However, Gelin explained that, if there is an applicable tax treaty between France and the country of residence of the recipient of the deemed dividend and the definition of “dividend” in the treaty concerned does not cover such a deemed dividend, then it will be regarded as other income for treaty purposes and no withholding tax will apply.

Peter Parmentier of Jones Day, Brussels, contrasted the position in Belgium where no conforming adjustments are made following a basic transfer pricing adjustment, by recharacterizing the additional payment concerned either as a deemed distribution or as a capital contribution. The amount will simply be considered a nondeductible expense and that will be the end of the story. In theory, it would be open to the Belgian authorities to argue that an excess payment was a constructive dividend, but so far they have never done so. The Belgian position prompted Bouma to wonder whether Belgian taxpayers were inclined to use transfer pricing to avoid the withholding tax that would apply to dividend payments to foreign related parties. Parmentier replied that Belgian taxpayers tend not to resort to such a strategy because, since the introduction of more formal arm抯 length rules in 2004, it is not possible, where a transfer pricing adjustment is made under those more formal rules, to lessen the tax impact of increased income by offsetting the additional income with current or prior tax losses. In any case, as Parmentier pointed out, where the other party to the transaction was a parent company resident in another EU Member State, no withholding tax could generally be imposed because of the EC Parent朣ubsidiary Tax Directive. (The EC Parent-Subsidiary Tax Directive, broadly speaking, provides for a zero rate of withholding tax on dividends paid by a subsidiary resident in one EU Member State to its parent resident in another EU Member State.) Recently, there has also been a proposal to exempt dividends from withholding tax where the dividends are paid to a shareholder resident in any country that is a treaty partner of Belgium, provided there is at least a 15% shareholding relationship between the parties concerned.

Javier Mart韓 of Ernst & Young, Madrid, indicated that there is no express provision in current Spanish law requiring a conforming adjustment to be made in the wake of a basic transfer pricing adjustment, but generally, as a matter of practice, such an adjustment will lead to the taxpayer concerned being treated as having paid a deemed dividend or made a deemed capital contribution. However, a draft law, which awaits the approval of Congress, specifically envisages constructive dividend/capital contribution treatment in these circumstances. The draft law, which, if passed, will go into effect at the beginning of 2007, introduces a broad overhaul of Spain抯 transfer pricing rules to bring them into line with those of other EU Member States. Using the term, “secondary adjustment” rather than “conforming adjustment,” Christian Emmeluth, who practices in Copenhagen, explained that in Denmark such an adjustment may take the form of a constructive loan, a hidden profit distribution or a taxable contribution. Secondary adjustments may, however, be avoided in certain circumstances where an undertaking is made to make actual payments to adjust the cash position of related parties to that which it would have been had the transaction concerned taken place at arm抯 length.

Purcell reported that, like Belgium, the United Kingdom has no rules providing for conforming adjustments in a cross-border context. A consultation document prepared in 1997, in advance of the U.K.抯 1998 overhaul of its transfer pricing regime, directly addressed the issue of secondary adjustments, but did not propose any specific provisions to impose such adjustments, preferring instead simply to express the Government抯 wish to encourage the voluntary repatriation of funds to restore the arm抯 length cash position (which remains a tax-neutral event). Interestingly, the 2004 changes, which essentially brought the U.K.抯 thin capitalization measures within the transfer pricing regime, introduced a provision for a compensating adjustment designed to relieve payments of excessive interest from the double taxation that would otherwise arise as a result of the excess not being recharacterized under U.K. rules. Under the old thin capitalization rules, payments of excess interest to a group member abroad were generally recharacterized as dividends, which treatment did not give rise to double taxation because the United Kingdom does not impose withholding tax on dividends. Under the new rules, excessive interest is not recharacterized but remains interest; this creates potential double taxation, both nondeducibility for U.K. tax purposes and the imposition of U.K. withholding tax because there is no treaty withholding tax relief for excessive interest. The United Kingdom has, therefore, provided for a compensating adjustment that allows such excessive interest to be paid to a foreign lender without deduction of tax. Purcell cautioned, however, that there is no equivalent compensating adjustment for payments of excess royalties, which therefore remain subject to potential double taxation.

GRANT OF A LOAN AT A REDUCED INTEREST RATE

Bouma then turned to the second scenario envisaged in the fact pattern set out above, where H accrues interest income of u$1,000 on a loan to F, and it is determined by the Host Country tax authorities that the arm抯 length interest on the loan is u$1,300. In these circumstances, F is deemed to have paid the additional interest to H, and H is then deemed to have paid the amount of the additional interest back to F (the difference between this scenario and the first being, therefore, that in this scenario there are two deemed payments, instead of one actual payment consisting of two parts, one of which is a deemed dividend, deemed capital contribution, or deemed loan). Bouma explained that the United States could treat the deemed payment back to F either as a deemed dividend (i.e., where H is a subsidiary of F) or as a deemed capital contribution (i.e., where F is a subsidiary of H). As in the first situation, subject to certain requirements H would also be able to make an election to have the deemed payment to F treated as a loan.

The discussion that followed Bouma抯 explanation of the U.S. rules made it clear that the other countries represented at the meeting would take essentially the same approaches to the deemed payment back to F (after the deemed interest payment to H) as they would take to the excess payment made by H for the hard drives, as discussed above. Thus, for example, Germany and Switzerland would treat the deemed payment as either a constructive dividend or a capital contribution, depending on the shareholder relationship between H and F; France would treat it as a deemed dividend, irrespective of the shareholder relationship; and Belgium and the United Kingdom would simply add the deemed interest payment back to the taxable income of H, and not worry about a deemed payment back to F.

EFFECT OF A TRANSFER PRICING ADJUSTMENT ON OTHER TAXES

Gelin raised the interesting question of what impact, if any, transfer pricing adjustments of the kinds envisaged might have on other taxes and levies, in particular value added tax (VAT) and customs duties. Mart韓 noted that under the EC Sixth Directive, the taxable base for VAT purposes is the actual consideration (i.e., the invoiced amount). Thus, in principle, a transfer pricing adjustment for income tax purposes should have no consequences for the charging of VAT within the EU. However, Mart韓 also explained that the EU Member States may apply for an exception to the general rule, which allows them to insist on VAT being charged on the arm抯 length value of the goods or services concerned, where these are supplied between related parties. The United Kingdom has been granted such an exception. Spain has applied, but has not yet had its application accepted. Spain would, however, adjust its customs duties to reflect the arm抯 length value of goods established by an income tax transfer pricing adjustment. Bouma and Gelin were of the opinion that neither the United States nor France, respectively, would be likely to make an adjustment for customs duty purposes. Liebman also thought it unlikely that Belgium would make such an adjustment, if only because of Belgium抯 very formalistic approach to customs duties generally. Van den Bruinhorst said that, theoretically, because the basis for customs duty in The Netherlands is the arm抯 length price, an adjustment could be made for customs duty purposes in response to a transfer pricing adjustment that established an arm抯 length price for goods that differed from the price actually charged. She thought, however, that such an adjustment would be very difficult to achieve in practice. Portner confirmed that the position in Germany was the same as that in The Netherlands, i.e., obtaining an adjustment for customs duty purposes is a theoretical possibility that is unlikely to be achieved in practice.