BEPS from a Private client perspective
Part I: Transfer Pricing
On 5 October 2015, the OECD released its final reports in connection with the Base Erosion and Profit Shifting (BEPS) Project.
Certain aspects of the BEPS project will impact Irish individuals and business owners, privately held Irish corporations, and global families and their private wealth structures, including the following:
1. Accessing treaty benefits (e.g. no CGT protection, preferential withholding tax rules)
2. Denial of interest deductions which will impact financial arrangements
3. Increased tax exposures
4. Additional reporting obligations/compliance burdens and costs
5. Increase of taxation audits and taxation under worldwide income systems
6. More effective cross-border dispute resolution through improvement of the mutual agreement procedure
In Part I of this three-part article on the impact of BEPS on private clients we consider the changes being proposed to the transfer pricing rules under the BEPS project.
The Irish transfer pricing rules were initially introduced in Ireland in 2010 and became effective for accounting periods commencing on or after 1 January 2011. There is an exemption from the formal transfer pricing regime for smaller companies that fall within the definition of a Small to Medium Enterprise, which is broadly defined as a company with a staff head count of fewer than 250 employees and either annual turnover of less than €50 million or a balance sheet total of less than €43 million (all calculated on a group-wide basis).
Ultimately, the BEPS Project seeks to align the taxation of profits with where real economic substance and people are located. It does so by aligning transfer pricing outcomes with value creation, and by providing documentation and transparency recommendations.
Rather than focusing on the detail included in the OECD recommendations pertaining to transfer pricing, for the remainder of this article we have taken certain private client relevant ‘live’ examples of common transactions where transfer pricing can be relevant and the related issues to be aware of.
Common cash extraction strategies – termination payments
A common cash extraction strategy adopted in an Irish context by certain key shareholders and directors is that relating to termination payments in order that a higher tax-free termination payment can be paid to directors and shareholders on retirement. Given that one of the mechanisms for calculating the tax-free amount that can be paid out is calculated as a function of the average remuneration over a three-year period prior to retirement, it is not unusual for the remuneration during those three years to be increased which has the effect of increasing the tax-free termination payment that can be paid. Transfer pricing does not prevent the use of this common cash-extraction strategy; however, there is a transfer pricing angle that needs to be considered in conjunction with this tax strategy.
The Irish transfer pricing rules apply to transactions between ‘associated persons’ and generally a controlling shareholder and the company that they control would be regarded as ‘associated persons’ for the purposes of the Irish transfer pricing legislation, such that certain transactions between the controlling shareholder in their capacity as director and the company that they control may be subject to the Irish transfer pricing rules. The transactions that are within the scope of these rules are transactions involving the supply and acquisition of goods, services, money or intangible assets where the acquirer or supplier carries on a trade for Irish corporation tax purposes. Therefore, the provision of executive services by a director to a company that they control would fall within the Irish transfer pricing regime.
For this typical cash extraction strategy to comply with the Irish transfer pricing regime, it would be important to be able to demonstrate that the payments made to the controlling director in the three years prior to retirement, and indeed the termination payment made on retirement, represent the amount that would have been paid between independent parties acting at arm’s length. If sufficient support is not available to support the payments made, the impact would be that a portion of the termination payment could be treated as a ‘distribution’ for Irish tax purposes, which would convert a portion of the termination payment from a tax-free receipt in the hands of the retiring controlling director to a fully taxable receipt subject to a maximum tax rate of 55 per cent.
Intellectual property planning
The Irish intellectual property (IP) regime is very competitive for Irish corporations, including indigenous Irish companies. Section 291A of the Taxes Consolidation Act, 1997 grants capital allowances for capital expenditure incurred on certain ‘specified intangible assets’, which are broadly defined. The effect of the relief is that a minimum effective tax rate on IP profits of zero per cent is achievable depending on the profitability of the IP asset in question.
The impact of the transfer pricing changes under the OECD BEPS Project on the above-mentioned capital allowances regime needs to be considered. The result of the revised transfer pricing guidelines relating to intangibles is that the role and profitability of the legal owner of the IP has been significantly devalued. The OECD has recommended that IP profits should be attributed between group members based on the location of the important functions relating to the IP; namely, the development, enhancement, maintenance, exploitation and protection of the IP asset in question. The OECD has also stated that the legal owner of the IP should only be allocated a risk-free/risk-adjusted financing return depending on whether that entity controls and has the financial capacity to assume the financing risk associated with the IP acquisition.
The impact on privately held Irish corporations is twofold. Firstly, where the important functions in relation to the IP are currently controlled outside of Ireland, the likelihood is that the IP-related returns will be attributed elsewhere with a potentially higher tax rate than currently is applicable in Ireland in relation to IP profits. Secondly, when considering the valuation of IP qualifying for allowances under section 291A, Irish tax law states that the amount or value of the IP acquired, and which underpins the quantum of expenditure incurred, must be calculated in accordance with the arm’s length principle. The valuation of the IP will be based on a function of the profitability of the IP asset in question, which in turn will be a function of the pricing structure related to the ongoing income stream to be derived from the asset. Arguably, the pricing structure would need to be based on the revised OECD guidelines once enacted into Irish law (expected in 2017), which would have the effect of significantly reducing the value attributed to the IP asset (looked at in isolation from the performance of the important functions relating to the IP) and, therefore, the quantum of capital allowances available in Ireland to shelter IP profits arising. In order to mitigate this risk area in an IP context, our recommendation to Irish privately held businesses currently considering an intra-group or third-party IP acquisition that might qualify for capital allowances under section 291A is to endeavour to complete the acquisition in 2016 in advance of the revised transfer pricing guidelines relating to intangibles being enacted into Irish law.
There are arguments that the OECD approach of attributing profits between the legal owner and the entities performing important functions relating to the IP does not reflect the true behaviour of independent parties acting at arm’s length; however, taking such a view is likely to attract tax authority scrutiny and the related costs that go with defending the position taken on audit.
In this first article of a three-part series, we have considered certain transfer pricing issues relevant to Irish individuals and privately held Irish corporations given the increased focus in the area of transfer pricing that is likely to emerge as a result of the OECD’s work on the BEPS Project.
Part II of the series of articles will focus on the impact on the proposed changes to the definition of permanent establishments to Irish individuals and privately held Irish corporations, with the final article dealing with all other relevant BEPS related issues for private clients.