BUSINESS RESTRUCTURINGS REMAIN A HOT TAX ENQUIRY ISSUE
Since the publication of the updated OECD Guidelines on 22 July 2010, many companies have faced tax enquiry challenges for business restructurings they had made for sound business reasons. Many have asked themselves whether tax authorities were stepping in their shoes and judging with hindsight the decisions they made in the past. How come?
The OECD has definitely lifted the bar for proving the arm’s length nature of a business restructuring. The concept was also defined in a broad way so that many more cases are captured nowadays.
According to the OECD a business restructuring is defined as the cross-border redeployment by a multinational enterprise of functions, assets and/or risks. A business restructuring may involve cross-border transfers of valuable intangibles, although this is not always the case. It may also involve the termination or substantial renegotiation of existing arrangements (e.g. the conversion from a full risk distributor to a limited risk distributor).
A lot of attention was paid to business restructurings by the OECD and many tax authorities around the globe, as they were seen as a way to lower the tax burden in high tax countries and optimise the effective tax rate by shifting profits to low tax jurisdictions such as Switzerland or Ireland.
In order to demonstrate that a business restructuring is at arm’s length, a company should not only support the arm’s length nature of the transfer pricing arrangements before and after the restructuring; it should also support the arm’s length nature of the restructuring itself. In order to do so, it can review the restructuring transactions and the functions, assets and risks before and after the restructuring, the business reasons for and the expected benefits from the restructuring, including the role of synergies, and finally the options realistically available to the parties involved in the restructurings. We provide below some real life examples of tax enquiries we have recently experienced.
A company decided to merge the back office of a sales organisation active in Belgium and the Netherlands to streamline its operations. Some people were relocated; others were laid off as they did not agree to move to the new central location in the Netherlands. As the company felt responsible for the laid off people, a generous leave package was paid. In its enquiries a number of years later, the Belgian tax authority questioned whether any compensation was due to the Belgian entity, as it considered that the Dutch entity benefited more from the restructuring than its Belgian counterpart. In particular it felt that the layoff costs, including the generous package, were too high compared to the overall benefit for the entity. The Belgian tax authorities also referred to the comments provided in the Guidelines on outsourcing arrangements. They seem to illustrate that in some outsourcing arrangements a compensation is paid between parties. This example demonstrates that a sound business restructuring, especially from a group perspective, could still be challenged. We had to demonstrate that in the long term the benefits would outweigh the costs, even on a Belgian level. To do so, we used documentation that was created at the time of the transaction, which was not specifically drawn up for tax purposes (e.g. presentations to the management team and personnel).
Another example is that of a Canadian group selling branded fast moving consumer goods that grew significantly across Europe through a combination of organic growth and some acquisitions. In particular, it acquired production plants in various countries. At one point in time, the group was faced with a structural capacity issue in the market. It reviewed its footprint and decided to close one plant in the Netherlands. Production was shifted subsequently to another plant in the Netherlands and one in France. In this case, the Dutch tax authorities challenged the transfer pricing arrangements before the restructuring (a cost-plus approach was applied for the tolling activities of the plant) and the deductibility of the restructuring costs. We demonstrated with a CUP analysis, making reference to tolling activities performed for third parties as private label supplier, that the cost-plus was both in terms of method and in terms of mark-up acceptable. Further, we demonstrated that along the group’s history each and every location had to bear its own restructuring cost. In addition, most of the production was shifted to another Dutch plant. Finally, one could question what the most realistic option was for the plant on a standalone basis. Most likely, it did not make any business sense to invest heavily in the plant to improve its productivity, knowing that already a structural capacity issue existed in the market.
Finally, we touch upon the change in transfer pricing method that was agreed between a French distributor and its related company in the Netherlands. In the past, products were sold from the Netherlands to France on a cost-plus basis. Significant losses were incurred in France over a long period of time (more than ten years). The new system would provide the distributor with a guaranteed net margin that would be slightly increased or decreased, taking into account the performance of the French entity. In their enquiries, the French tax authorities made their own benchmarking analysis to test the arm’s length nature of the transfer pricing arrangements and challenged the recurring loss position. They did not in particular question the change in transfer pricing policy as such; also the question whether something of value was transferred upon conversion was not put forward. Nevertheless some adjustment had to be accepted, even when it was demonstrated that a large portion of the losses had to be attributed to an expensive flagship store in downtown Paris.
The above are just a few examples that could be challenged by the tax authorities upon restructuring of a group’s value chain. Even though tax aspects are not driving the decision to restructure, a company should be prepared to deal with a challenge a few years later. Contemporaneous documentation that is created for non-tax purposes will play a crucial role. However, a prudent business manager would also document the analysis from a transfer pricing perspective.
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