The EU Joint Transfer Pricing Forum recently published a paper illustrating when to use the profit split method (PSM) and how to accomplish the split of profits per the OECD Guidelines. The report is linked as a reference.
The report is a complement to, and supports, the OECD Revised Guidelines on the application of the Transactional Profit Split Method issued in June 2018.
As this method is not simple, and is also a focus on transfer pricing issues in the US, this paper is valuable into the application and concepts of PSM.
The European Commission has formally established the EU Joint Transfer Pricing Forum expert group, based on the press release of 26/01/2015. The Forum will be composed of transfer pricing experts that will discuss TP problems, advise the Commission on TP issues and assist the Commission in finding practical solutions.
Members will consist of Member States’ tax administrations and 18 organisations, for which guidelines for application are also attached for reference. The names of the organizations will be published. Rules for observer status are also set forth. The Commission will publish all relevant documents such as agendas, minutes and participants’ submissions. The Decision is applicable until 31 March 2019.
The definition of organisations is stated as: “Companies, associations, NGO’s, trade unions, universities, research institutes, Union agencies, Union bodies and international organisations.” Application are to be submitted by 25 February 2015.
Further work on the work of the Forum may be accessed at:
The European Commission published a report 4 June 2014 on the work of the EU Joint Transfer Pricing Forum in the period July 2012 to January 2014. The report highlights the effect, including double taxation, of secondary and compensating adjustments, in addition to a flowchart for a recommended transfer pricing audit plan. The link to this report is included for reference, with key excerpts from the report:
The report presents the general aspects of secondary adjustments and gives recommendations on how to deal with possible double taxation in this context. Member States in which secondary adjustments are not compulsory are advised to refrain from making them in order to avoid double taxation. Member States in which secondary adjustments are compulsory are advised to provide ways and means to avoid double taxation.
Drawing on the EU Parent Subsidiary Directive (PSD) the report recommends characterising secondary adjustments within the EU as constructive dividends or constructive capital contributions. Accordingly, the PSD ensures that no withholding tax is imposed on the distribution from a subsidiary to its parent within the EU. For cases not covered by the PSD, the report describes and recommends the procedure of repatriation in the context of a Mutual Agreement Procedure (MAP) available under the respective applicable Double Taxation Agreement (DTA) or even at an earlier stage. Further it is recommended that Member States should refrain from imposing a penalty with respect to the secondary adjustment.
The report recommends that Member States should accept a compensating adjustment initiated by the taxpayer (upward as well as downward adjustment), if the taxpayer has fulfilled certain conditions: the profits of the concerned related enterprises are calculated symmetrically, i.e. enterprises participating in a transaction report the same price for the respective transaction in each of the Member States involved; the taxpayer has made reasonable efforts to achieve an arm’s length outcome; the approach applied by the taxpayer is consistent over time; the adjustment has been made before the tax return is filed; in case a taxpayer’s forecast differs from the result achieved, the taxpayer is able to explain why this occurred, should it be required by at least one of the Member States involved.
The application of secondary adjustments may lead to double taxation. Therefore, if secondary adjustments are not compulsory, it is recommended that MS refrain from making secondary adjustments when they lead to double taxation. Where secondary adjustments are compulsory under the legislation of a Member State, it is recommended that Member States provide for ways and means to avoid double taxation (e.g. by endeavouring to solve it through a MAP, or by allowing the repatriation of funds at an early stage, where possible). These recommendations assume that the taxpayer’s behavior does not suggest an intent to disguise a dividend for the purpose of avoiding withholding tax.
When repatriation is agreed in a MAP settlement, it is recommended that the MAP agreement states that no withholding tax will be applied by the Member State out of which the repatriation is made and no additional taxable burden will be imposed in the Member State to which the repatriation is made.
As taxpayers may not be aware of the fact that in certain situations a separate request needs to be made for avoiding double taxation resulting from secondary adjustments, Member States which do not consider that secondary adjustments can be treated under the AC are encouraged to highlight in their public guidance the fact that a separate request under Art 25 OECD MTC may be needed to remove double taxation. For reasons of efficiency, it is recommended that taxpayers submit both requests in the same letter.
TP Audit Work Plan
This TP audit work plan is an example of the various steps that are typically performed during a TP audit (not a comprehensive audit) on the side of the taxpayer and on the side of the tax administration, respectively. It should be understood as an informative guide rather than as prescriptive rules. It is recognised that the structure suggested may not fit into all MSs’ and taxpayers’ legal framework and administrative practice. An underlying assumption of the work plan is that properly prepared documentation – as requested by local tax authorities – is available and well-trained staff act on both sides.
Re: Best Practices, this is an excellent document to review. It explains secondary and corresponding adjustments, which are often areas overlooked in audits until the final assessment is issued and the audit has been settled in the primary jurisdiction. Additionally, the TP audit work plan is a valuable document to develop Best Practices with the tax authorities in planning an audit, developing mutual trust and cooperation. These principles should also be applied globally, not only within the EU.
A Report on Compensating Adjustments, issued by the EU Joint Transfer Pricing Forum in January 2014, provides a practical solution to address different approaches by EU Member States. The Glossary of the OECD Transfer Pricing Guidelines defines a “compensating adjustment” as “an adjustment in which the taxpayer reports a transfer price for tax purposes that is, in the taxpayer’s opinion, an arm’s length price for a controlled transaction, even though this price differs from the amount actually charged between the associated enterprises. This adjustment would be made before the tax return is filed.” In general, an adjustment is made at a later time to the transfer prices set at the time of a transaction.
A link to this report, and an excellent article by CGMA, are provided for reference:
Compensating adjustments are enacted using one of two approaches, an ex-ante (arm’s length price setting approach), or ex-post (arm’s length outcome testing approach). The ex-post approach generally involves testing, and possible adjustment, of transfer prices at year-end, prior to closing the books or filing the tax return.
When both Member States apply an ex-post approach and require compensating adjustments, a risk of double taxation, or double non-taxation, may arise.
An ex-post approach by one Member State, with an ex-ante approach by a separate Member State, presents conflicts on making such adjustments.
Guidance by the OECD is limited, with reference to the Mutual Agreement Procedure (MAP) to resolve disputes. Member States use their discretion re: application of compensating adjustments.
A practical solution is described for transactions in which (i) profits are calculated symmetrically, and (ii) a compensating adjustment initiated by the taxpayer should be accepted if various conditions are met. However, if the Member States have less prescriptive rules for such adjustments, those rules are to apply.
Upward as well as downward adjustments should be accepted.
The practical solution provided should not limit a tax administration’s ability to make a subsequent adjustment and has no bearing in a MAP procedure.
The adjustment should be made to the most appropriate point in an arm’s length range, with reference to OECD guidance.
The subject of compensating adjustments is an important topic in addressing potential double taxation, or double non-taxation. The Report is timely, offering practical guidance for Member States to achieve consistency, although only within the EU.
It will be interesting to follow this topic, and future guidance, by the OECD, as well as commentaries from EU Member States, UN, and other interested parties. The practical solution will be most effective if adopted in principle, or in legislation, by the EU Member States, with other countries referring to such guidance to resolve challenging transfer pricing issues fairly and effectively.
The EU Joint Transfer Pricing Forum (JTPF) report on secondary adjustments was agreed in October 2012. With the OECD Base Erosion and Profit Shifting (BEPS) Action Plan currently under discussion, it is worthy to review the process of secondary adjustments and their various implications and complexities. The report discusses the adjustments under the EU Parent Subsidiary Directive, EU Arbitration Convention, and Mutual Agreement Procedure (MAP). For non-EU countries, it is imperative to review consequences of a secondary adjustment due to additional costs, complication and double taxation risks.
It is possible that a transfer pricing adjustment is accompanied by a so-called “secondary adjustment”.
Transfer pricing legislation in some States allows or requires “secondary transactions” in order to make the actual allocation of profits consistent with the primary adjustment. Double taxation may arise due to the fact that the secondary transaction itself may have tax consequences and results in an adjustment.
The OECD MTC does not prevent secondary adjustments from being made where they are permitted under domestic law.
Secondary adjustments may in some Member States be subject to specific penalties or result in penalties under the general penalty regime.
Procedure for removing double taxation: In their responses to the questionnaire on secondary adjustments most Member States which apply secondary adjustments stated that they do not consider double taxation issues resulting from secondary adjustments as being covered by the Arbitration Convention (AC), only a few consider them covered by the AC Convention, and some other MS indicated that the applicability of the AC to secondary adjustments remains an open question for them. However, most Member States applying secondary adjustments would be willing to address them in the course of a MAP. Therefore, in cases where it is not possible to avoid double taxation at the outset, e.g. by way of applying the Parent Subsidiary Directive (PSD), a taxpayer would – in a case of (potential) double taxation resulting from a secondary adjustment – have to file two requests, i.e. a request under the Arbitration Convention and a request for a MAP. The latter would require in each case a treaty being concluded between Member States that includes a MAP provision comparable to Article 25 of the OECD MTC (preferably including an arbitration clause as per Article 25 (5) OECD MTC).
A review of secondary adjustments, and their application for transfer pricing adjustments, should be reviewed in advance of final audit settlements to ensure additional complexities do not arise.
The EU Joint Transfer Pricing Forum has released statistics for pending Mutual Agreement Procedures (MAPs) and APAs under the Arbitration Convention.
The MAP comparables provide interesting observations for countries in which there is no activity in contrast to active case developments in France, Germany, and the UK. The average cycle time noted in several countries ranges from 9 to 47 months, which presents additional challenges in timely case resolution. Reasons provided for cycle time variations included 24% being waived for the time limit with taxpayer’s agreement, 16% pending before court and 15% settled in principle, waiting exchange of closing letters for MAP.
The APA statistics reflect 222 EU and 168 Non-EU APAs in force at the end of 2012, 561 EU and 119 Non-EU APA requests in 2012, while 353 EU and 85 Non-EU APAs were granted in 2012.
The statistics for seeking resolution via the EU Arbitration Convention provide additional insight for evaluation of issues that are not being settled effectively at the local country level.