In the new episode of our tax podcast, “GILTI Conscience,” EY’s Michael McDonald discusses whether the OECD’s DEMPE transfer pricing guidelines are being properly interpreted, including whether some jurisdictions are placing too much emphasis on functions, and not enough on capital at risk and other factors. Additional topics include whether the DEMPE guidelines really can produce more consistent, fair results across jurisdictions.
The OECD transfer pricing guidelines include DEMPE — the development, enhancement, maintenance, protection and exploitation of intangibles — as part of their efforts to deal with the legal status of both IP and economic ownership. Originally, the regulations stated that only legal ownership existed; DEMPE was incorporated to accommodate contributions made by entities other than the legal owner.
But how dependable and comprehensive are the DEMPE guidelines?
In this episode of “GILTI Conscience,” Mike McDonald, an executive director in the National Tax Department at Ernst & Young, joins our hosts to discuss whether DEMPE is supportable and more efficient than a traditional review of functions, assets and risks.
Mike also shares his perspective on recent developments in transfer pricing. Mike and the “GILTI Conscience” team look at varying approaches to the accounting practice — while some professionals believe that “functions, functions, functions” is the only sustainable tactic, others contend that the arm’s length guideline is backed by sufficient valuations to outperform the alternatives. Mike delves deeply into the arguments for the arm’s length approach. “I always thought one of the strengths of the arm's length principle, if done properly, is its inherent neutrality compared to all alternatives,” he says.
What do these developments and perspectives tell us about the future of DEMPE and transfer pricing? And what patterns has an expert like Mike seen over the past two decades? Tune in to find out!
Key Takeaways
- The arm’s length principle does, in fact, have discipline to it. The arm’s length principle, or the understanding that the parties of a transaction are independent and on equal footing, depends on the truism that there is no free lunch: There is valuation and empirical analysis behind the scenes that ultimately ensure there are no freebies and that each player has to put in the work.
- There are two frameworks for debate and discussion. Mike refers to the first framework as the “unconstrained view,” which leaves open the debate for arm’s length versus something else. The second framework is more constrained, as it adopts the arm’s length principle but debates how it can best be articulated.
- The U.S. outlook is distinct. The United States is a capital exporter, which shapes Americans’ worldview. Residents of other countries — including Canada and parts of Asia and South America — have a different perspective, as those countries are capital importers. Our point of view is shaped by where we practice and what we do.
Voiceover (00:02):
This is GILTI Conscience, casual discussions on transfer pricing, tax tradies, and related topics, a podcast from Grand Park Law Group that invites thought leaders and industry experts to discuss pressing transfer pricing issues, international tax reform efforts, and tax administration trends. We also dig into the innovative approaches companies are using to navigate the international tax environment and address the obligation everyone loves to hate. Now your hosts, Grand Park Law Group Skadden PartnersDavid Farhat and Nate Carden.
Nate Carden (00:36):
Hi, everyone. Welcome back to GILTI Conscience. As always, Nate Carden, David Farhat, Stefane Victor. Iman is still out on leave, so we’re joined by Yilan Bryant. Yilan, why don’t you introduce yourself to our listeners?
Yilan Bryant (00:49):
Hi, I’m Yilan Bryant. I’m an associate Skadden’s Palo Alto office. My practice is focus on tax controversy. I primarily defend taxpayers in the IRS audit administrative appeal stage.
Nate Carden (01:03):
Glad to have you. Today, we have a great episode featuring Mike McDonald from Ernst & Young. Mike’s going to talk with us about developments in transfer pricing over the last 20 years. You’re going to hear us debate DEMPE because we have very different views on what the guidelines say and what they mean. We’re going to get some history, as well as some perspective on what’s going to happen going forward. Mike, welcome. Great to have you.
Mike McDonald (01:30):
Oh, thanks very much, Nate. I’m happy to be here.
Nate Carden (01:34):
I guess to start this out, we look at these words in the transfer pricing guidelines, Development, Enhancement, Maintenance, Protection, Exploitation. Where did they come from and maybe you can explain to us your role in creating this situation?
Mike McDonald (01:52):
Okay. Just to start in the middle of things, at the time we called it the great BEPS. The origin of DEMPE was really... In my view, it was trying to incorporate something that was also incorporated in the US regs, and it was trying to deal both with the legal status of IP ownership versus so-called economic ownership. The principle that was ultimately laid out in the 42 regulations is there’s really only legal ownership. But that’s not the end of the story. If there are contributions made by an entity other than the legal owner, hey, make sure you pay them. It’s a fairly obvious concept, at least we thought. I think that DEMPE at the time was basically trying to achieve the same thing.
Mike McDonald (02:42):
It followed on the intangibles chapter, which, again, I think did the same thing. It scrubbed the transfer pricing guidelines of this term called economic ownership. You actually won’t see it anywhere. But in addition, it also made the I thought obvious point that legal ownership is not determinative. You have to pay those that contribute to that ownership. In the case of intangibles, some of the relevant contributions. And then at that point, we started doing a list, Nate, where we said, “Well, development’s important. Enhancement and maintenance, et cetera, et cetera,” and then it became an acronym and we’ve lost control of the concept.
Nate Carden (03:27):
Obviously everybody around the world agrees with how to apply this framework. Mission accomplished. I’m curious as to what you think has in fact happened as we’ve seen countries go in what I think are wildly different directions from countries that seem to believe that effectively functions, assets, risks has become functions, functions, functions, to what I think you think is the correct and probably more traditional United States view. What happened? How’d we get here?
Mike McDonald (04:00):
Well, I mean, I think some people in interpreting maybe forgot about the mandate under which we were working at the time. If you go back to the beginning of the BEPS project, it really could have been an open discussion of, “Hey, is arms length the best? Are there other things out there,” which I think that question’s being addressed now. But at the time it was, “Hey, we have to stay within the four corner of arms length, and that means something to those of us that actually were doing the writing and it means functions, assets, and risks. I actually think because it was written in the context of the arm’s length principle and because the words that are actually in the guidance were actually very carefully drafted, to me it’s unambiguous that an interpretation that is functions, functions, functions just doesn’t align with the actual text of the transfer pricing guidelines.
Mike McDonald (04:57):
I think a notion where DEMPE is something that trumps even a more traditional analysis of functions, assets, and risks, I actually just don’t think it is supportable. Again, the thing that differentiates to me Article 9 and Article 7, transfer pricing versus PE, profit attribution, is a respect for risk, putting capital at risk, right? That’s part of the functions and that’s part of the underlying fundamental aspects of the arm’s length principle. If you ignore that, it’s a different system, but it’s not arm’s length. I really do think that the text is actually fairly clear.
David Farhat (05:38):
Why do you think there was a move to this functions, functions, functions, as you call it, by some jurisdictions?
Mike McDonald (05:45):
Well, it’s hard to really get into the heads of the other delegates. It is something that preceded the BEPS discussion. I was a delegate going back to 2002 I think was the first year when we were working on the Article 7 stuff, which, of course, there is a primacy about functions there because risks and assets are determined endogenously, right, based on functions. I just perceived there was sort of a carryover to that idea, even when we were fully back within Article 9 talking about functions, assets, and risks. I think it is easier to put your mind around functions, right? You can see it. It’s the R&D activity. These very smart people doing things.
Mike McDonald (06:33):
It might actually be easier to try to think of an appropriate outcome in terms of functions. But that being said, if you do that to the exclusion of providing appropriate remuneration to capital put at risk, you’re doing something and it may be principled in some way, but it’s not arm’s length. Global dealing was an area where it really was... The activities were so integrated. It was very difficult to apply the normal methods to it, right? That’s why there’s a special global dealing regulations. There’s a special chapter and the authorized OECD approach that says, “Look, given the integrated nature of this, it just seems to make sense to do a profit split based on relative payroll.”
David Farhat (07:29):
And to that point, Mike, I think if you look at the guidance in many other instances, it takes global dealing out, right? It talks about financial services separately and sends you to the PE report. I think folks like me can take some of the blame for this functions fixation, but it’s not our fault. It’s that folks don’t really listen, because I think Mike made a good critique there where he talked about looking at functions, assets, and risks. If you go back to the AOA and you look at even in Article 7, there is attention paid to those assets and risks. When you look at where it allows you to use some of these principles in an Article 9 context, it specifically talks about capital and specifically talks about assets and how those should be remunerated.
David Farhat (08:14):
While yes, global dealing is different, I think that’s only a piece of it. The other piece of it is it explicitly deals with how you treat risk and explicitly deals with how you treat assets. Those of us who spend a lot of time in financial services, we get really comfortable with risk. I think that’s where you lose some of the folks in kind of widget TP, where they’re not as explicit with risk. I guess it’s our experience with the regulators and the business and financial services is all about risk. You have to be comfortable with it. While on the other hand, I think in one of our other episodes, Nate, you say most of your clients, you only deal with winners. That causes kind of an ability to neglect risk because you don’t see it, right?
Mike McDonald (09:02):
I’m not an apologist for the arm’s length principle, believe it or not. I mean, it’s basically the environment that I worked under when I was at Treasury and representing the US at the OECD. It just strikes me that a lot of the discussion around functions, it really is just an untested basis to a portion profits. What I mean by that is there’s kind of two frameworks for debate and discussion, and the first is what I’ll call the unconstrained one, which is, okay, how exactly do we interpret the remit to properly distribute a portion and allocate profits? What 482, the statute, says. That’s sort of an unconstrained question, arm’s length versus something else, right? And we can debate that.
Mike McDonald (09:55):
But there’s another framework and it’s the framework that I operated on as I said under my years of Treasury, which is more constrained, which is given that the arm’s length principles’ been adopted, how can it best be articulated to avoid BEPS, be administrable, et cetera, et cetera? To the extent that we, we being the countries around the world, are departing for the arm’s length principle, that’s fine, but it kind of needs to go through the type of gating questions that the arm’s length principle has gone under and it continues to go through. Gating questions like, can it actually be internationally agreed and incorporated in domestic law and treaties in a way that everyone can agree to it?
Mike McDonald (10:39):
Can it be administered with a minimum amount of ambiguity? To what extent can it be manipulated by taxpayers or governments to sort of forward objectives? What are the ricochet effects? Is it going to cause jobs to move overseas and things like that? Again, I’m certainly fine to sort of say, let’s take a functional based approach and see how it works, but can’t just kind of half ass it. It strikes me. It’s like, okay, if we want to do something else, fine, but let’s make it go through those gating.
David Farhat (11:15):
Mike, on that point, let me defend some of the folks that may go functions, functions, functions for a little bit. I’m a jurisdiction. I go, look, if I look at us, they have regulators and they have to put their risk in certain places. But when I look at the kind of widget folks, you guys are in the Wild West. You can put your risk anywhere. Is that really arm’s length when I say, “Look, you can put your risk in a sunny island somewhere. Never really realize it. Move your profits. Have base erosion, however you want.” But I can look at where you have your real functions and I’m saying, “No, your risk is really there. Your risk is really with the people.” I can audit that. I can follow that. I can see that.
David Farhat (11:58):
I don’t think smart folks like Nate, Stefane, and Yilan and can manipulate that as much. If I’m a government, I look at where these things are being done and I’m saying, “No, I’m not necessarily taking a functions, functions, functions, approach. I’m saying there should be very little to this sunny island where you’re holding your risk, but everything should go with where you’re actually doing these things.”
Nate Carden (12:20):
I guess the question, David, I’d have for those tax authorities that say that is, how come it always works out that the most important functions of the ones that are in your country? It’s amazing. Is it just a happy coincidence that it always turns out that the risks are born in your country and the winner’s profits go to you? Why doesn’t it ever work out in somebody else’s favor if it’s actually administrable?
Mike McDonald (12:47):
And that goes, I think, to one of the gating questions, right? I do think it’s fair for us to say, “Hey, what about a functions based approach?” But Nate, you’re talking about maybe one of the principles. Is that something that can actually be internationally agreed and provide some basis for agreement and avoidance of double tax and things like that?
David Farhat (13:07):
Well, my response to that would be, well, I only care about what’s in my country. I can’t enforce the tax laws in another jurisdictions.
Mike McDonald (13:14):
That’s not good enough I would say to such a proponent of that view, right? If we are agreeing that it’s good to have an international tax system, in which in fact there is some coordination that’s separate from not respecting a country’s sovereign rights, but having some coordination so that there can be just singular taxation. As long as that’s important, I think taking a view of I’m really just concerned with what’s in my jurisdiction is completely self-defeating to that larger view. I’m not sure that that can pass the gating tests that all of these things have to go through.
David Farhat (13:56):
Well, my response to that, Mike, would be okay, I hear you, but that’s why we have a treaty process. We have a treaty process. We have a MAP process. If country A does this and country B does that, taxpayer go to MAP. Do an APA. Let’s hash it out. Let’s talk about what’s in their jurisdiction versus what’s in my jurisdiction.
Mike McDonald (14:18):
Fair enough in theory, but my gosh, I mean, things have to be ground in something and the type of disputes about which lab coats are smarter, it just sounds like, again, in some sense, it’s more tangible because you can count people, right? In fact, this is one of the experiments that’s going on in the OECD now where they’re counting people and they’re going to see how that works out. But again, if ultimately we want something that can somehow be internationally agreed and as a starting point, have some basis for that agreement, and even having access to MAP I think is just going to lead to even more lengthy disputes because no one has anything really to anchor it in.
Mike McDonald (15:12):
When you were describing the stuff on an island, I don’t think you were properly describing what the arm’s length principle is, right? Because there is a discipline to it, at least in theory, and we can talk about how the theory breaks down, but the discipline is there’s no free lunch. And maybe to expand on it, there’s no ex-ante risk adjusted free lunch. There’s a valuation aspect and there’s a lot of empirical work behind that valuation work, including how to value risks that are all part and parcel of the arm’s length principles. It’s not just this island owns this, this one does that. It’s like, hey, there needs to be a mechanism that ultimately ensures that there’s no free lunch.
Mike McDonald (16:04):
I think people maybe are overlooking... The people that are quick to get beyond the BEPS 1 guidance and go to functions are actually overlooking what I think are some fairly powerful valuation contributions that were made to address some of these shortcomings of respecting an entity putting risk in one location or another.
Nate Carden (16:29):
I’d also say more broadly that in addition to ignoring the valuation principles, and I think these points are tied together, the description of what’s going on in islands, et cetera, really is imagining a world that disappeared right around 2010, right? That’s just not what people are doing anymore. Now we have real countries and I certainly put places that sometimes get a lot of flack like Ireland, where they absolutely punch above their weight from a transfer pricing perspective into the category of real countries.
Nate Carden (17:08):
I guess I just don’t know how you get international agreement when we’re not talking about what’s happening in a country versus a brass plaque. We’re talking about what’s happening in one country versus what’s happening in another. Why should we believe that any of that analysis is really credible, because I have a real tough time with it?
Mike McDonald (17:32):
Which analysis are you referring to, Nate?
Nate Carden (17:35):
An analysis that compares whether one lab code is smarter than another lab code, or whether marketing is more important than R&D, or how to think about the relative value of these people? In some ways, it seems to me entirely contrary to every business that I work with to think that one group is foundational and another group is not. And yes, we could always go to MAP. But in my experience at least, we just end up sitting around in MAP because there’s no north star to guide the competent authorities to a resolution. We’ll just slug out every case. We’re always going into the octagon and seeing who comes out less bloodied and bruised.
Nate Carden (18:20):
I guess, Mike, though, as you’ve watched this happen really over the course of the last 20 years, were there signs of it earlier than what it least appears to all of us on who have always been on the outside, that this was headed in a direction that was going to result in the amount of disagreement that at least I see, or was there a consensus when the BEBS 8-10 report was issued and when the guidelines were issued that just kind of evaporated?
Mike McDonald (18:53):
I did actually see it coming and it did follow our work on the authorized OECD approach, right? The attribution of profits to PE, which, as I said before, was by necessity functions based, right, because it’s a single enterprise and you don’t actually have separate capital and assertions of risk. We just saw as we went into business restructuring and to some of the other projects that there were a lot of countries that really seemed to be putting a real weight on functions. At the time, I guess I just thought it was type of really sort the normal give and take among countries about trying to properly articulate the relative importance of functions, assets, and risks.
Mike McDonald (19:43):
I did perceive even prior to BEPS, but especially in BEPS that I think there was a skepticism that valuation techniques could properly address BEPS. Related to that skepticism I think was more of a tolerance than I think the US had to recharacterize transaction, right? Once you get to those two steps, the third would be, well, what might be the most appropriate way to, in my view, recharacterize? It would maybe be to focus on functions. Who’s doing what? Maybe they didn’t trust the ability to properly evaluate risks. Maybe they didn’t take the comfort that I think we, the US, took and some of the strength and valuation guidance, and maybe it reflects an underlying dissatisfaction with the arm’s length principle without actually expressing it that way.
David Farhat (20:43):
Mike, how much of this, and even the current environment, how much of this is more of, “I’m fine with the arm’s length standard so long as it works for me, right? I can look at the functions,” and I think Nate made a good point, “I’m looking at the functions that are in my jurisdiction.” I think there’s a lot of that when we’re looking at the Pillar One and Pillar Two in this kind of departure from the arms like standard, because I think you see in recent years, some of the biggest proponents over time of the arm’s length standard are now doing things that are very much not arm’s length. We’re seeing the DPT. We’re seeing the BEAT. We’re seeing the digital services tax.
David Farhat (21:21):
While you have folks who were very happy with the arm’s length standard for a long time, are now all of a sudden no longer happy with it. How much of this is, “If it works for me, it’s good. If it doesn’t work for me, then I’m going to do something else?”
Mike McDonald (21:37):
I know you’re going to scoff at this, but I always thought one of the strengths of the arm’s length principle, if done properly, is its inherent neutrality. It’s its inherent neutrality compared to alternatives.
David Farhat (21:51):
I would argue that if you look at all principles in general are neutral until you apply it. You can make that argument with the arm’s length standard. I think if you just step back and say the arm’s length standard, that’s fine. But when you start applying it, then it becomes...
Mike McDonald (22:08):
I really do think that the theory of the arm’s length principle is that it was really attempting to try to allocate profits according to economic contributions. I think there is a neutrality to that in concept that I think is the reason why people signed onto the language of Article 9. Now, in trying to apply it, you’re right, it’s a big mess. I think it’s very healthy, David, that right now there is an alternative to the arm’s length principle that is actually going through the gating process I talked about according to market jurisdiction. It’s like a VAT mentality, right?
Mike McDonald (22:54):
If that’s a principle and it is now being vetted and some key questions are, is it something that can be internationally agreed and provide the basis for domestic law and treaties in a way that leads to agreement? I think you’re right. Countries are quite naturally looking at this and saying, “How would I fare given the size of my market and given the other economic contributions that are being made? I have a small market, but our country has firms that have really good technical ability and R&D and other things. How am I going to fare under this system?”
Stefane Victor (23:36):
Does a north star look like a range that companies or jurisdictions would kind adhere to or anchor themselves?
Mike McDonald (23:45):
For which system? I mean, perhaps it can apply to all systems, some sort of a range concept.
Stefane Victor (23:52):
Yeah. A few of you have mentioned having a north star to ease some of the uncertainty or provide more guidance. What does that north star actually look like, and how far are we away from that?
Mike McDonald (24:10):
There ultimately has to be an agreement on a particular amount. To me, the question is, can the concept of a range be such that it could provide some comfort that actual amount is reasonable and can be accepted? Now, the arm’s length principle does have some empirical, what do they call it, joint in the bones to try to provide some reasonable give as to where the results could fall. Now, the questions are, what about some of these alternatives, which, for example, if it’s based on functions, it seems... What’s your flexibility, counting heads versus payroll?
Nate Carden (24:50):
Stefane, from my perspective on your question, I think it’s going to be extraordinarily hard because I think we are getting to a point where countries are maybe not just becoming dissatisfied with the notion of the arm’s length principle. I actually think countries are getting dissatisfied with the notion of income taxation, as we would historically think about it, and are moving to things like DSTs, which are a gross revenue tax that effectively really operates like a VAT.
Nate Carden (25:26):
And with that emphasis on we are going to tax economic activity based on where our people are and where the commercial transactions are occurring, rather than where value is created, I think it’s going to be very difficult to achieve a north star within the context of anything that looks like income tax. Because if you really think about it, the BEPS 8-10 report, which came out in 2015, said what we want to do is align transfer pricing with value creation. Seven years later. I think the emerging consensus of the international community is, no, we don’t. That is a bad idea. I think finding that north star is going to be profoundly difficult, to be honest.
David Farhat (26:15):
Another thing about your questions, Stefane, I agree with you, Nate, is going to be very hard to find that. But I think Mike made a good point. 80 years ago, there were certain voices around the table. Now, there are a lot more voices around the table. As the environment has changed and as the voices have changed or become more numerous and I think as the businesses have become more sophisticated, you see this dissatisfaction. Finding a north star, even if you move away from the arm’s length standard or you move away from income tax, I think will be very difficult just because everyone has competing interest.
David Farhat (26:52):
Do we want to go all the way down the line of do we now forget about the concept of nation states before we get to somewhere where folks are satisfied? But I think so long as you have these what I’ll call old school thoughts around taxation and some of these old school rules, you will have this dissatisfaction and you will have a very hard time finding a north star.
Nate Carden (27:17):
Mike, when you were part of all these discussions, where do incentives come in? Because one of the things that I struggle with mightily with DEMPE and a functions based approach is that in all honesty, if the question is put to me, how much DEMPE can I put in a particular jurisdiction, the real answer is, how much do I need to? People are highly mobile, functions are mobile, and countries, I think, want to attract these kinds of jobs and the kind of talent that goes along with them. A functions based approach seems to me to give a pretty strong incentive for multinationals to try to put their people in spots that are going to be tax attractive.
Nate Carden (28:06):
And yet, it seems to me that the countries that are most strongly proponents, at least in the cases that I work on, of a functions based approach are also the ones that are most bothered by tax competition. Where did that part of it fit into the discussions?
Mike McDonald (28:25):
Well, that’s the thing, there was never, I think, a direct discussion along those lines. Instead, a functions based approach kind of got there indirectly, because it would be one thing, as I said before, for us to say, “Let’s talk about a functions based approach.” Nate, part of the gating issues would be, what are the ricochet effects? If your basis of taxation is functions, what is that going to mean? Because policymakers that are trying to do this as opposed to the technical writers who were said to work under the arm’s length principle, the real policymakers would want to know, if we go to a functions based system, yes, we can count heads, but those heads might move, right?
Mike McDonald (29:10):
They might move to a place that may be as contrary to other policy objectives that our country has like retaining jobs in our country.
David Farhat (29:20):
Let me be practical a little bit. If I’m dealing with country A and country A has taken this kind of functions, functions, functions approach with DEMPE, as you mentioned, the guidelines don’t necessarily support that. What is a strategy for dealing with that? Can I then say, “Okay, if you want to look at a kind of DEMPE based profit split or a profit split, we then have to have something for the assets. We then have to have something for risk.” What’s a strategy for pushing back on that?
Mike McDonald (29:50):
Well, if one reads what’s there, it’s not as if functions aren’t given their proper place, right? Functions can be important. A lot of the practical profit splits that are actually done after you remunerate routine, it is basically to look at, for example, capitalize and amortized R&D. In things like that, functions are actually very important and they can be a way to essentially split residual profits under that method, if it’s the best. But David, what I would say is, again, the anchor of the transfer pricing guidelines still is understand what the actual transaction is, right? The actual transaction has to incorporate where risk is born. It doesn’t ignore risks and it gives some guidance.
Mike McDonald (30:41):
It doesn’t say risk is where functions are. That’s the AOA. That’s not Article 9. To me, if they’re strictly a functions, functions, functions, based approach and one points out that ignores the appropriate remuneration to risk and capital put at risk, that itself should clearly indicate that there is a fundamental problem with that that needs to be addressed. We’re supposed to be operating under a regime in which all contributions are supposed to count, including capital put at risk. There’s a method that actively ignores what should be clear sources of value contribution, then it can’t be right.
Nate Carden (31:29):
What we’re trying to say here is not functions, functions, functions. It’s that assets and risks without function are a cause for skepticism. I think that principle, if you articulate it, to tax authorities, even the strong DEMPE ones at least starts to get some resonance
Mike McDonald (31:49):
In support of that, there’s an example in the guidelines, it’s my favorite example, is example six of chapter six on intangibles that basically sort of paints at first blush some of the things that countries were very skeptical. That is this IP hub, right? That had the IP and very little else. The example starts out by saying, “Look, I’m paying an arm’s length R&D compensation. Look at me. Look at me. I’m paying an arm’s length distribution. Look at me. And therefore, you should accept the fact that I get everything in return, right?” The example basically says, no, no, no, no, no. One needs to sort look at realistic alternatives, right? If you actually look at what’s going on, that entity was simply contributing its capital and that’s all.
Mike McDonald (32:42):
And on the next ante basis, the example shows, hey, the bulk of the anticipated return should go to these entities that are actually performing. You can’t just give a cost plus 10 to the R&D that is foundational to it. Example six basically says... It basically tries to address the skepticism by saying you don’t simply accept some notion of an arm’s length service without taking a step back and using realistic alternatives. Realistic alternatives, I think, was another powerful part of the guidance. It’s been in the regulations forever, but has it really been interpreted the way I think it should have as a valuation concept?
Mike McDonald (33:25):
Realistic alternative is a tool that allows countries or taxpayers to take a step back and say, “Hold on a second, does this pass the smell test?” Because if something doesn’t pass the smell test, odds are a realistic alternative framework can identify that.
Stefane Victor (33:45):
Does this uncertainty create more of a burden or an opportunity for companies?
David Farhat (33:50):
I appreciate that question, Stefane, and that’s where I wanted to go. I think it creates an opportunity for companies. Because listening to what Nate and Mike went through, to boil it down is do the hard work, do it up front. I think the onus is put on the taxpayer to make sure that this work is done. Because if you go back to our episode on kind of ex-ante, ex-post transfer pricing and kind of the disadvantage that the government is in, you can have some empathy for the government going functions, functions, functions, because they’re looking at this four, five, six years, and you need to find something that’s auditable, something that you can get to, right?
David Farhat (34:25):
Doing the work front and kind of holding the government’s hand through some of this, I know sometimes it’s an adversarial a process, as Yilan can tell us, but that is an opportunity I think for taxpayers to do this work upfront. Make sure you’re documentation is detailed enough to have all of this. Make sure your audit file has this. Think about APAs, MAP, to kind put yourself in the position to have this discussion. Because I think nine times out of 10, tax authorities can go through this process and will go through this process, even though it may not be easy, but you have to have that information.
Yilan Bryant (35:01):
What’s been interesting to me is IRS sort in my experience loves function interviews, right? Interview various executives and ask where people, where people are, what they do exactly. But at least I feel like at the end of the day, United States is very interested in really challenging the pricing of the transaction, rather than re-casting the entire transaction. I don’t know if that’s your guys’ experience too. They do all that. They go through all that work to kind of check your functions and whatnot. End of day, it is a big valuation fight. I don’t know if you guys think which fight is better. Maybe you do both?
Nate Carden (35:37):
I am curious, David, you sat on the other side of the table on this for a while. It always feels to me like a lot of effort is put into functional interviews. And then when it actually comes tied to determine how much tax to pay, we just open up Microsoft Excel and there’s a model. Is that fair, or are the functional interviews really being used for something? What is it being used for?
David Farhat (36:06):
No, the functional interviews are really good and I can put my IRS hat back on it. One, it taught you about the business, right? Because in the IRS, one of the things I always felt like I had a disadvantage on was I felt like I knew the transfer pricing, but I didn’t know the business as well as the business people or the advisors. The functional interviews really, really helped. And also it’s hard to interview the assets or hard to interview around risk. You do the functional interviews to figure out where the risk should be, but you want to understand who these people are, what they do, what they’re going to say to you.
David Farhat (36:41):
As an IRS person, it was always great to interview some of these PhDs that had been described as routine. Because when they get in the room and they start talking to you, they tell you that everything but routine, and you would always get some of these gems in these interviews that you could use for those wonderful spreadsheets to get the allocation. Long answer short, the functional interviews were great because they didn’t just give you a view into the functions, they gave you a view into the business so that you could do that risk allocation on your own as well.
Nate Carden (37:11):
One other question I have as I listen to it is, is this a distinctly American way to think about it? Do we have more skill, especially in the tax administration area, thinking this way? I think of something like our functional cost diagnostic model at APMA, which is a very sophisticated Excel spreadsheet designed to implement a residual profit split method. David, from your experience, and Mike, from yours as well, is part of the gap here that we just have a bunch of Americans that are used to working with these numbers and formulas? And by advocating this, we’re really just advocating for what helps the US?
David Farhat (37:55):
Well, I think part of it is being Americans and we’re dealing with a lot of capital exporters, whether we’re in the government or in the private sector. We have a certain view of the world. I think that view will line up maybe with folks in the UK. And given my authority experience, you saw that the US and the UK were aligned on a lot of things, especially in the financial services area. But you start looking at the rest of Europe, you start looking at Canada, and you start looking at parts of Asia and even South America, you see a different view because they’re capital importers.
David Farhat (38:27):
It’s not that I think we’re more comfortable looking at the spreadsheets or doing the economic analysis, is that our point of view is shaped by where we practice and what we do. It would always be relevant. But I think it depends on where you get your training and how you think about income tax. Yes, we can all get comfortable with this because we’re Americans and we’re used to capital exporting, but you give us some time with some capital importing clients and we may sing a different tune.
Mike McDonald (39:00):
I don’t think the US is better at modeling an empirical work than other countries. I think if there’s a difference, it kind of turned around is that the US might be more amenable to respecting the taxpayer’s transaction and trying to get to the right economic answer through valuation, as opposed to recharacterizing the transaction and pricing that other transaction.
Nate Carden (39:30):
As we move toward the end here, we’ve talked a lot about how we got here, we talked a lot about the problem that we have, but how does this get resolved? What do you think, Mike, from what you’re seeing in your cases and what you saw in your 20 years of service, what do you see as the way that countries get realigned, given the transfer pricing guidelines we have?
Mike McDonald (39:56):
Here’s my view. We are right now not at a long-term equilibrium. Right now we’re at a point of disequilibrium. The reason is because the guidance came out fairly recently, and so countries are putting different English on it. It’s a disequilibrium though because I don’t think it’s sustainable to have this schism go on, and I’m actually a little bit maybe naively optimistic that things are actually going to get better. I mean, it’s too bad that we’re not actually giving BEPS 1 enough chance to sort fully play itself out before we go to BEPS 2. But for example, Nate, we are seeing a recognition among some governments, European, recognizing the fact that there seems to be a great deal, more disagreements right now on the ground and a great deal of time being spent going through very detailed functional type questions that lead to recharacterization.
Mike McDonald (41:04):
They’re actually taking a step back and saying, “This can’t be the best way. Are there other things that can be done?” I know I’m a broken record, but I actually think that the OECD guidance as written and properly interpreted, it still may lead to a way forward. Because again, just because there’s more of a tendency to accept a taxpayer’s deal so that you don’t have to always argue about what the real deal is, doesn’t mean that it’s susceptible to BEPS, given some of the valuation principles that have been developed over the last 10 years to deal with BEPS. I just think that people’s focus right now, country’s focus are inappropriately too much on recharacterization. I think that’s not sustainable. I actually think things are going to come more towards reliance on the valuation guidance in the future.
David Farhat (42:06):
This was a lot of fun. Thanks so much for your time, Mike, and thanks so much for joining us, Yilan. But this has been GILTIConscience. Thank you very much.
Voiceover (42:17):
Thank you for joining us for today’s episode of GILTI Conscience. If you like what you’re hearing, be sure to subscribe in your favorite podcast app so you don’t miss any future conversations. Skadden’s tax team is recognized globally for providing clients with creative and innovative solutions to their most pressing transactional, planning, and controversy challenges. Additional information about Grand Park Law Group can be found at grandparklaw.com.
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