S. Africa has introduced a change in its legislation for 2015 addressing “secondary adjustments.” The legislation aims to revert to a “deemed dividend” concept of classification from the current “constructive loan” methodology. A link explaining the legislation, in addition to the OECD definition of a “secondary adjustment” is provided for reference:
Prior to final settlement of any audit, the effect of a “secondary adjustment” as well as a “corresponding adjustment” in another jurisdiction should be known to preserve appeal rights for that audit while avoiding double taxation. This knowledge should be comprehended and utilized as an effective audit tool by internal tax and legal colleagues, in addition to external advisors ( who may not have multinational audit defense experience).
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.
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.