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EUROPEAN AEROSPACE SYSTEMS plcAGN INTERNATIONAL – ITC Session – Case Study - Solution Guide

I. EUROPEAN AEROSPACE SYSTEMS CHINA LTD (EAS China)

Intangible property (know-how) transfer from EAS UK to EAS China

Summary

“EAS China gained expertise on how to manufacture the aircraft wings from 25 EAS UK personnel sent to China throughout 2006.”

EAS UK has transferred intangible property, ie, know-how and technology, to EAS China; therefore, EAS UK, through transfer pricing mechanisms, should receive arm’s-length remuneration for this transaction.

There are several possible approaches to address this intercompany transaction:

Option 1 – Contract Manufacturing EAS China could be characterised as a contract manufacturer and EAS UK could be characterised as an entrepreneur/principal. Under this scenario, EAS China would produce the aircraft wings on behalf of EAS UK and EAS UK would sell to third-party and related-party customers. EAS China would earn a routine return, eg, fully loaded cost plus mark-up, consistent with third-party manufacturing services providers. For EAS UK’ product sales to EAS China and EAS France, EAS China and EAS France would be characterised as resellers, and the transfer prices could be set so EAS China and EAS France would earn routine returns, eg, operating margins, consistent with third-party resellers. Given that EAS China is operating as a contract manufacturer on behalf of EAS UK, no royalty is due to EAS UK.

Option 2 EAS China could be characterised as a full-fledged licensed manufacturer and EAS UK could be characterised a licensor and distributor. Under this scenario, EAS China would pay EAS UK a royalty (as a percentage of net sales) on EAS China’s sales to third parties and related parties. For EAS China’s product sales to EAS UK and EAS France, EAS UK and EAS France would be characterised as resellers, and the transfer prices could be set so EAS UK and EAS France would earn routine returns, eg, operating margins, consistent with that of third-party resellers.

Option 3 Option 3, the more common approach, is a blend of options 1 and 2.

For products manufactured by EAS China and sold to EAS UK, EAS China could be characterised as a contract manufacturing services provider with EAS UK characterised as a principal. EAS China could earn a return, eg, fully loaded cost plus mark-up, consistent with a manufacturing services provider, and a royalty payment to EAS UK would not be required as contract manufacturers are often granted royalty-free license to produce goods on behalf of the principal.

For products manufactured by EAS China and sold to third-party customers in China or to EAS France, EAS China could be characterised as a full-fledged licensed manufacturer. EAS China could pay EAS UK a royalty, as a percentage of sales to third parties and to EAS France, to exploit transferred know-how. EAS France could be characterised as a reseller and could earn a routine return, eg, operating margin, consistent with third-party resellers. A derivative of option 3 may have EAS UK selling EAS China-manufactured aircraft wings to EAS France. In this case, with respect to EAS China-

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manufactured aircraft wings destined for resale by EAS France, EAS China would act as a contract manufacturer, EAS UK would act as a principal and EAS France would act as a reseller.

2. Functional Analysis Questions

How has EAS China compensated EAS UK in the past for the transferred know-how used by EAS China? Has a royalty or lump sum fee been paid? How were these amounts determined?

What do EAS UK and EAS China do to update and maintain the know-how for the aircraft wing models manufactured by EAS China?

If EAS UK is solely responsible for updating the above-mentioned know-how, it would be appropriate for EAS China to pay EAS UK a royalty.

If EAS China is solely responsible for updating the above-mentioned know-how, ownership of the know-how would migrate from EAS UK to EAS China over time. The royalty owed by EAS China to EAS UK would decay based on the useful life of the know-how and the magnitude of EAS China’s development activities.

3. Additional Considerations

Outbound royalty payments from China must be approved by a Chinese regulatory authority. A royalty agreement (and possibly a transfer pricing study) would need to be submitted to show support.

The outbound royalty may be subject to withholding and/or business taxes. There should be a review of local tax law and tax treaties.

Intercompany agreements should be drafted to formalise intercompany arrangements. These may include a contract manufacturing services agreement, a development services agreement, a know-how licence agreement and supply/distribution agreements.

4. Transactions to be Imposed

The UK HMRC could impose a royalty to be paid by EAS China to EAS UK if EAS China is characterised as a full-fledged licensed manufacturer.

If EAS China is operating at a loss, the Chinese tax authority could impose a contract manufacturing arrangement where EAS China would earn a routine return, eg, cost plus a mark-up.

B. Production Equipment Transfer from EAS UK to EAS China

1. Summary“EAS UK also transferred to EAS China the production equipment previously used at its former manufacturing plant in Farnborough,England.”

Transfers of production equipment are typically charged out at cost or net book value. However, if the production equipment has been fully depreciated, the UK HMRC could challenge a transfer at net book value.

2. Functional Analysis Questions How were these transactions recorded? Does EAS UK still own the assets, or have they been transferred to the books of EAS China? What values were assigned to these transactions, and how were these values determined? Has EAS China made actual payments for the equipment?

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The UK HMRC could impose an incremental income adjustment to EAS UK to account for the transfer of equipment by EAS UK to EAS China.

C. Sale of Aircraft Wings from EAS China to EAS UK

1. Summary “EAS China sells the aircraft wings it manufactures to EAS UK …”

As discussed in Section I.A.1., there are several possible approaches to address this intercompany transaction:

Option 1 EAS China could be characterised as a contract manufacturer, and EAS UK could be characterised as an entrepreneur/principal. Under this scenario, EAS China would produce finished aircraft wings on behalf of EAS UK, and EAS UK would make sales to third-party and related-party customers. EAS China would earn a routine return, eg, fully loaded cost plus mark-up, consistent with that of third-party manufacturing services providers.

For EAS UK product sales to EAS China and EAS France, EAS China and EAS France would be characterised as resellers, and the transfer prices could be set so that EAS China and EAS France would earn routine returns, eg, operating margins, consistent with that of third-party resellers.

Option 2 EAS China could be characterised as a full-fledged licensed manufacturer, and EAS UK could be characterised a licensor and distributor. Under that scenario, EAS China would pay EAS UK a royalty, as a percentage of net sales, on EAS China’s sales to third parties and related parties. For EAS China’s product sales to EAS UK and EAS France, EAS UK and EAS France would be characterised as resellers, and the transfer prices could be set so that EAS UK and EAS France would earn routine returns, eg, operating margins, consistent with third-party resellers.

Option 3 Option 3, the more common approach, is a blend of Options 1 and 2.

For products manufactured by EAS China and sold to EAS UK, EAS China could be characterised as a contract manufacturing services provider, with EAS UK characterised as a principal. EAS China could earn a return, eg, cost plus mark-up, consistent with that of a manufacturing services provider, and a royalty payment to EAS UK would not be required.

For products manufactured by EAS China and sold to third-party customers in China or to EAS France, EAS China could be characterised as a full-fledged licensed manufacturer. EAS China could pay EAS UK a royalty, as a percentage of sales to third parties and to EAS France, to exploit the transferred know-how. EAS France could be characterised as a reseller and could earn a routine return, eg, operating margin, consistent with that of third-party resellers. A derivative of Option 3 may have EAS UK selling EAS China-manufactured wings to EAS France. If this is the case, then with respect to EAS China-manufactured aircraft wings destined for resale by EAS France, EAS China would act as a contract manufacturer, EAS UK would act as a principal and EAS France would act as a reseller.

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Intercompany agreements should be drafted to formalise the intercompany arrangements. These may include a contract manufacturing services agreement, a know-how licence agreement and supply/distribution agreements.

3. Transactions to be ImposedThe UK HMRC could impose a royalty to be paid by EAS China to EAS UK if EAS China is characterised as a full-fledged licensed manufacturer.

If EAS China is operating at a loss, the Chinese tax authority could impose a contract manufacturing arrangement where EAS China would earn cost plus a mark-up.

D. Sale of Aircraft Wings from EAS China to Third-Party Chinese Customers

1. Summary “EAS China sells the aircraft wings it manufactures to … EAS China’s own customers in China.”

In a similar way to the issues discussed in Section I.A.1., there are several possible approaches to address this intercompany transaction:

Option 1 EAS China could be characterised as a pure contract manufacturer, and EAS UK could be characterised as an entrepreneur/principal. In this scenario, EAS China would produce finished aircraft wings on behalf of EAS UK, and EAS UK would make sales to third-party Chinese customers. EAS China would earn a routine return, eg, cost plus mark-up, consistent with that of third-party manufacturing services providers.

Option 2 EAS China could be characterised as a full-fledged licensed manufacturer, and EAS UK could be characterised a licensor. Under that scenario, EAS China would pay EAS UK a royalty, as a percentage of net sales, on EAS China sales to third-party Chinese customers.


Since EAS China is selling to third parties under the EAS trademark/trade name, it may be appropriate to pay EAS UK a trademark royalty. This will depend on the perceived value of the existing marketing intangibles in EAS China’s region. To maintain ownership of future developed marketing intangibles, EAS UK could compensate EAS China for its marketing and advertising activities that contribute to marketing intangible value.

Intercompany agreements should be drafted to formalise the intercompany arrangements. These may include a contract manufacturing services agreement, a know-how license agreement, a trademark license agreement and a supply/distribution agreement.


The UK HMRC could impose a royalty for know-how and marketing intangibles to be paid by EAS China to EAS UK if EAS China is characterised as a full-fledged licensed manufacturer.

If EAS China is operating at a loss, the Chinese tax authority could impose a contract manufacturing arrangement where EAS China would earn cost plus a mark-up.

E. Sale of EAS China-Produced Aircraft Wings to EAS France

Refer to Section II.B. below

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F. Sale of Aircraft Wings from EAS UK to EAS China1. Summary

“Given China’s growing aerospace industry, EAS China also purchases other variations of aircraft wings from EAS UK’s Farnborough plant for resale to third-party aerospace companies in China.”

For this transaction, EAS China could be characterised as a distributor, with EAS UK characterised as a full-fledged manufacturer/entrepreneur.

As discussed in Section I.D.1, EAS China may need to compensate EAS UK for the use of marketing intangibles. Compensation for use of marketing intangibles may take the form of a royalty or a premium built into EAS UK’ sales price to EAS China.

2. Additional ConsiderationsAn intercompany distribution agreement and, potentially, a trademark license agreement should be drafted to formalise the intercompany arrangement.

3. Transactions to be ImposedBoth the UK HMRC and Chinese tax authority would likely expect that EAS China earns a routine return for its resale activity.

The UK HMRC could impose a royalty for marketing intangibles to be paid by EAS China to EAS UK if EAS China’s return appears excessive.

G. Management Services from EAS UK to EAS China

1. Summary It is not uncommon for subsidiaries to receive back-office and other management support from their parent company. If management activities performed by EAS UK to EAS China are beneficial, non duplicative and not stewardship related, it may be appropriate for EAS UK to charge EAS China a service fee.

If EAS China acts as a pure contract manufacturer, it could be acceptable to not include a management services charge from EAS UK, as the addition of these costs would create circularity in the cost plus mark-up transfer pricing mechanism, ie, double mark-up.


Has EAS UK charged EAS China for management services in the past? How have these charges been determined? What management functions does EAS UK perform that benefit EAS China? What management functions does EAS China perform for itself?


An intercompany management services agreement should be drafted to formalise the intercompany arrangement.

“Management” fees are not deductible for China income tax purposes, but “service charges” may be deductible. Although the services may be performed entirely outside of China, a 5 percent China business tax would apply. Please consult your Chinese tax advisor on this issue.

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If EAS China is characterised as a full-fledged licensed manufacturer, the UK HMRC may incrementally adjust EAS UK’ income to account for management services provided by EAS UK to EAS China.

H. Opportunities

The company could use a Hong Kong holding company (HK Holdco) to take advantage of Hong Kong’s lower corporate tax rates. HK Holdco would act as the regional entrepreneur, with EAS China acting as a contract manufacturing services provider. HK Holdco would take title to the goods produced by EAS China and resell to third parties and related parties. Apportionment issues may be triggered which requires consulting by tax advisors knowledgeable in this area. Transfer of intangible property to HK Holdco would need to be addressed.

II. EUROPEAN AEROSPACE FRANCE SARL (EAS France)

A. Transfer of Client Relationship from EAS UK to EAS France

1. Summary

“… EAS UK’ sales personnel won a large contract with Airbus (EADS) in 2007 …”

Because EAS UK won the contract with EADS, there has been a transfer of marketing intangibles, ie, customer relationship, from EAS UK to EAS France for which EAS UK should receive compensation. Compensation may be in the form of a royalty, as a percentage of net sales, or a premium on the price of goods sold by EAS UK to EAS France.


What do EAS UK and EAS France do to maintain and sustain the relationship with Airbus? Was there any sort of compensation by EAS France to EAS UK for the customer contract?

B. Sale of EAS UK and EAS China-Produced Aircraft Wings to EAS France

1. Summary “EAS France purchases aircraft wings from EAS UK’ Farnborough plant and from EAS China’s Suzhou plant and resells them to Airbus for use in production of its commercial airplanes.”

For EAS UK-produced aircraft wings, EAS France could be characterised as a reseller/distributor, and EAS UK could be characterised as a full-fledged manufacturer/entrepreneur.

For EAS China-produced aircraft wings resold by EAS France, there are two possible approaches. In each approach, EAS France would be characterised as a reseller/distributor. If EAS China sells wings directly to EAS France, EAS China could be characterised as a full-fledged licensed manufacturer, and EAS China would need to compensate EAS UK with a royalty to exploit the wing know-how. If EAS UK invoices EAS Franced for EAS China-produced wings, EAS China could be characterised as a contract manufacturing services transaction provider with EAS UK acting as a principal.

EAS could also consider alternative scenarios. EAS France could also be characterised as a commission agent or a customer support services provider. As a commission agent, EAS France would earn a commission as percentage of net sales. As a customer support services provider, also known as pre- and post-sales support services provider, EAS France would earn cost plus a mark-up.

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2. Functional Analysis Questions What functions does EAS France really perform? How many people does it employ? Does EAS France have a warehouse or take on significant inventory levels/risks? What is the title flow for wings produced by EAS China?

3. Additional ConsiderationsIntercompany agreements should be drafted to formalise the intercompany arrangements, eg, sales/distribution agreements, license agreement and contract manufacturing agreement.

4. Threats/Challenges“For the financial year ended December 31, 2012, EAS France earned a pre-tax operating margin of 25.4 percent on its purchase and resale of aircraft wings purchased from EAS UK and EAS China.”

If EAS France is a distributor, commission agent or customer support services provider, the 25.4 percent operating margin is likely to be considered unacceptably high by the UK and/or Chinese tax authorities, especially given the functions performed and risks assumed by EAS France. EAS France does not appear to have developed the customer relationship and does not appear to add much intangible property (IP) or value-add. EAS France’s profitability for earlier years, eg, 2007 and 2009, should be reviewed for additional exposure.

There are also possible French customs issues. Earning excessive profits could mean EAS France paid a lower than arm’s-length value for the imported aircraft wings. As such, EAS France could have underpaid import duties. If customs officials and income tax officials communicate openly, inappropriate transfer pricing could result in customs exposures.

III PACIFIC AIR SERVICES COMPANY

A. Transfer of Intangible Property

1. Summary

Pacific US created and maintained a services database benefitting Pacific affiliates. This IP has allowed Pacific foreign affiliates to earn significant margins for provision of aircraft wing maintenance services. For past years, Pacific US should have received compensation for providing this IP to the foreign affiliates. The IRS could impose a royalty to determine additional US tax.

Now that the foreign affiliates are contributing to the service database, Pacific US could take two approaches. Under a licensing arrangement, Pacific US could pay the foreign affiliates a contract research and development (R&D) fee, keeping worldwide IP ownership with Pacific US. The foreign affiliates would then pay Pacific US a royalty for use of the IP. Alternatively, Pacific US could use a cost-sharing arrangement (CSA), which would allow the Pacific affiliates to have exclusive, non overlapping IP rights in their respective territories. The Pacific affiliates would pay a portion of the total intangible development cost (IDC) based on each entity’s reasonably anticipated benefits (RAB). A cost-sharing arrangement would require a PCT (Platform Contribution Transaction), also known as a buy-in payment, from the foreign affiliates for existing IP owned by Pacific US.


Has Pacific US been compensated in the past for its provision of IP to the foreign affiliates?

Do the Pacific foreign affiliates actively sell the services or are their customers referred to them by EAS entities?

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Who enters into service contracts with the third-party customers? Is it the local service affiliate or the principal, e.g., Pacific US or EAS UK? Should the local service affiliates be treated as subcontractors?

How profitable are the foreign affiliates?

Do the Pacific affiliates receive any management support from Pacific US? If so, which entity performs the services?

Does EAS UK provide any management support to Pacific US?

Are Pacific US employees shared among the different Pacific affiliates?


Intercompany agreements, eg, license, cost-sharing, and contract R&D services, should be drafted to formalise the intercompany arrangements. The cost-sharing agreement is a specified documentation requirement for US tax purposes.

Pacific US must disclose the cost-sharing arrangement to the IRS annually. Cost-sharing statements providing certain details must be included in Pacific US tax returns. All parties to the cost-sharing arrangement require US tax EIN and a Form 5471. There is detailed guidance on the IRS website on CSAs http://www.irs.gov/Businesses/Checklist-for-Cost-Sharing-Arrangements.

Are there any ways to consolidate multiple entities in the same country to simplify the organisational chart? Are many of these entities dormant?

If Pacific US employees are shared among the different Pacific affiliates, are there permanent establishment issues to be considered for longer projects?


The IRS could impose a royalty to be paid by the Pacific affiliates to Pacific US.

IV SPECTRUM AEROSYSTEMS CORPORATION

A. Cost Contribution Arrangement between EAS UK and EAS Cayman

1. SummaryUnder a cost contribution arrangement (CCA), two or more entities would jointly develop IP, ie, software, and each would maintain exclusive, non overlapping rights to exploit those intangibles in their respective territories. Ongoing IDCs would be shared by participating entities in proportion to RABs to be obtained from exploiting the IP. If intangibles exist prior to entering the cost contribution arrangement, the new owners will be required to make a PCT, or buy-in, to purchase rights to the existing IP.

2. Functional Analysis Questions What function/substance does EAS Cayman have with respect to this cost contribution

arrangement? What charges have occurred to date with respect to the cost contribution arrangement? Was the acquisition structured as an asset or stock purchase? How are IDCs allocated between EAS UK and EAS Cayman? Is it reasonable that the third-party valuation firm’s valuation report did not assign any value

to the pre-existing IP?

B. Additional Considerations

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Intercompany agreements (cost-sharing and contract R&D services) should be drafted to formalise the intercompany arrangement. The cost contribution agreement is a specified documentation requirement for UK tax purposes and will require specific considerations to meet the strict documentation requirements for cost contribution arrangements.

EAS UK must disclose the cost contribution arrangement to HMRC on an annual basis. Cost contribution statements providing certain details must be included in EAS UK tax returns.

C. Threats/ChallengesThe UK tax authority would be most likely to argue there was value related to the existing IP. The third-party valuation firm likely did not address the IP value specifically and probably accounted for the IP value in goodwill. Another possibility is the valuation firm used alternative valuation rules, such as book valuation, which could assign very little value to IP. It is very unlikely the third-party valuation firm addressed the IP value separately and concluded that no value should be attributed to the IP. The UK. transfer pricing rules have very specific methodologies for valuing IP. HMRC would argue EAS UK is entitled to a PCT from EAS Cayman. EAS UK likely has created some IP value in the past year for which it should be compensated.

In addition, EAS Cayman is located in a tax haven and arguably has minimal economic substance. HMRC could, if there is little or no substance, collapse the structure, attributing all IP rights to EAS UK.

D. Opportunities

Given the level of scrutiny related to cost-sharing structures and the HMRC’s increased focus on the level of economic substance for all participants, EAS UK should consider alternative affiliates in establishing a cost contribution arrangement. For example, EAS has recently created EAS Zurich and EAS Singapore, which have more economic substance than EAS Cayman. EAS could establish a cost-sharing arrangement to establish these three regional IP owners:

EAS US: North America (a new entity) EAS Zurich: EMEA region (covering EU and other European countries) EAS Singapore: Asia

E. Transactions to be Imposed

The UK HMRC could collapse the structure and impose a royalty to be paid by the foreign affiliates to EAS UK.

V EUROPEAN AEROSPACE SYSTEMS DO BRAZIL LIMITADA (EAS BRAZIL)

A. Provision of Pre- or Post-Sales Support by EAS Brazil to EAS UK

“EAS UK sells the aircraft wings directly to Aerotec Bravo, while EAS Brazil provides customer services to Aerotec Bravo..”

EAS Brazil provides pre- and post-sales support to EAS UK with respect to Brazilian customer Aerotec Bravo. EAS UK sells directly to Aerotec Bravo, and EAS Brazil does not take title to any inventory. EAS Brazil should earn a services fee, eg, fully loaded costs plus a mark-up, from EAS UK for its activity.

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An intercompany services agreement should be drafted to formalise the terms of the intercompany relationship.

The Brazilian regulations do not adhere to the arm’s-length standard, which is the foundation of the OECD Transfer Pricing Guidelines.

It needs to be verified that a cost plus mark-up arrangement is permitted under Brazilian transfer pricing rules.

Are there customs or withholding tax issues?

C. Threats/Challenges

EAS Brazil began operations in 2008; however, it hasn’t recorded any profits to date. As a service provider, EAS Brazil should earn a return on its costs or a commission that enables it to earn a profit, so its taxable income is likely understated from a Brazilian tax perspective.

This arrangement may create a permanent establishment for EAS UK. There should be a review of local tax law and treaties to assess this exposure.

D. Transactions to be Imposed

The Brazil tax authority could recharacterise EAS Brazil as a commission agent or reseller.

VI EAS ZURICH AND EAS SINGAPORE

A. Opportunities

As regional headquarters, EAS Zurich and EAS Singapore will likely provide regional management services to EAS France and EAS China, respectively. It would be appropriate for EAS Zurich and EAS Singapore to receive service fees for their back-office activities performed on behalf of EAS France and EAS China, if applicable.

EAS Zurich and EAS Singapore could act as regional IP owners as part of a geography-oriented principal structure. They could be know-how IP owners as participants in the cost contribution arrangement with EAS UK. They could also be owners of foreign customer contracts and record all third-party revenue outside the UK. The remaining entities would be considered service providers earning a return on operating costs. EAS Zurich and EAS Singapore would be good candidates for this structure since they have substance by employing key decision makers for their respective regions.

A cost contribution arrangement would require PCTs by EAS Zurich and EAS Singapore to EAS UK.

There would be a transfer of customer relationships, and perhaps brand IP, to the foreign principals that would need to be addressed.


Intercompany agreements should be drafted to formalise the intercompany arrangements.

C. Transactions to be Imposed The Swiss and Singaporean tax authorities could impose a management fee for services provided by EAS Zurich and EAS Singapore to EAS France and EAS China, respectively.

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VII IMPORTANCE OF TRANSFER PRICING

A. Tax Purposes1. Transfer Pricing ComplianceThe United Kingdom and many developed nations (including those in which company subsidiaries operate) have transfer pricing rules and accuracy-related penalties for multinational corporations engaging in cross-border transactions.

Transfer pricing rules allow relevant tax authorities to make income allocations between or among the members of a controlled group if a controlled taxpayer has not reported an appropriate taxable income. In determining the level of appropriate taxable income, the tax authorities will typically apply the arm’s length standard, which is the outcome that would have been realized if uncontrolled taxpayers had engaged in the same transactions under the same circumstances.

Taxpayers found to be negligent or requiring adjustments above certain thresholds will be subject to non deductible pricing accuracy-related penalties. For example, in the US, penalties may be from 20 percent to 40 percent of additional taxes payable that result from a transfer pricing “misstatement.” As an additional example, the United Kingdom’s tax authority may levy maximum penalties equivalent to 100 percent of underpaid taxes, and interest also may be applied to the unpaid taxes. A more dire consequence of a transfer pricing adjustment will be double taxation, as the company paid tax for the same income in the corresponding jurisdiction. The ability to gain relief from double taxation may not exist or relief may not be granted. Mutual agreement procedures also are time consuming and expensive.

To comply with transfer pricing regulations and avoid penalties related to transfer pricing valuation misstatements, a taxpayer must make reasonable efforts to establish the arm's length nature for its inter-company pricing policies. This requires both the creation and maintenance of contemporaneous transfer pricing documentation on an annual basis and the proper implementation of transfer pricing policies. The documentation must exist before filing income tax returns so as to attest the accuracy of the return.

2. US Tax Rules - Schedule UTP

In 2010, the IRS released final instructions for Schedule UTP, which requires US taxpayers to report uncertain US tax positions on their federal tax returns. Taxpayers will be required to rank these uncertain tax positions (UTP) issues based on the US federal income tax reserve recorded for the position taken in the return, including interest and penalties. Taxpayers also must designate those tax positions for which reserve exceeds 10 percent of the aggregate amount of the reserves for all uncertain tax positions reported.

The UTP filing requirement will be phased in over five years. Corporations with total assets equal to or exceeding $100 million, $50 million and $10 million must file Schedule UTP beginning in the tax years 2010, 2012, 2014, respectively. Only corporations that recorded a reserve with respect to a tax position in audited financial statements or did not record a reserve because the corporation expects to litigate the position must report such positions. For UTPs related to transfer pricing, the taxpayer must write “T” followed by a number to indicate a ranking of that position among all other uncertain tax positions.

B. Conclusion

Intercompany transactions should be analysed and documented to mitigate risks of income adjustments by tax authorities that could result in additional tax, penalties and interest.

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COST SHARING ARRANGEMENTS IN USA - SUMMARY

Cost sharing arrangements (CSAs) in the USA permit all foreign profits derived from exploiting developed intellectual property (IP) to be earned by foreign subsidiaries. Such arrangements can provide significant cost savings because foreign tax rates often are materially lower than the U.S. general tax rate of 40%.

What is a CSA?

US Treasury regulations explicitly provide for cost sharing arrangements. A CSA consists of an agreement between participants - generally a US member of a multinational group and one or more foreign subsidiaries. The participants divide the world into regions, eg, the United States and the rest of the world (ROW). The US company bears the R&D costs for the US market and the foreign affiliate bears the R&D costs for the ROW market. For example, if the reasonably anticipated benefits from exploiting the developed IP is 60% in the US and 40% in the ROW, the annual R&D costs are funded by the participants according to the same percentages.

What are the benefits of a CSA?

The principal benefit of a CSA is that the foreign affiliate is entitled to all of the profits associated with the ROW IP that is developed under the arrangement because it funds the development costs and bears the associated risks. Also, importantly, the IRS cannot argue that the transfer pricing rules entitle the US parent to a portion of the ROW IP profits. This is the result even if all of the R&D activities are performed in the US by employees of the US parent.

If the IP used outside the US had been partially developed by the US participant prior to entering the CSA, the foreign affiliate will be required to pay for its utilisation of the platform technology. The payment generally is in the form of a declining royalty taking into account the depreciating value of IP developed pre-CSA as new IP is developed. The royalty must be for an arm’s length amount. Nevertheless, the foreign profits attributable to IP developed under the CSA remain with the foreign affiliate.

IRS CHECKLIST ON CSA - http://www.irs.gov/Businesses/Checklist-for-Cost-Sharing-Arrangements.

COST CONTRIBUTION ARRANGEMENTS IN THE UK - SUMMARY FROM HMRC

Nearly all transfer pricing cases will involve one of the five methodologies but occasionally associated enterprises enter into arrangements to share costs and they involve a different means of ensuring consistency with the arm’s length principle.

The OECD refers to these as ‘cost contribution arrangements’ (“CCAs”) and there is extensive discussion of them in Chapter VIII of the OECD Transfer Pricing Guidelines. They may sometimes be referred to loosely as ‘cost sharing arrangements’ but the principles in Chapter VIII will still apply to them.

The OECD Guidelines (Chapter VIII) can be found at this link:

http://www.keepeek.com/Digital-Asset-Management/oecd/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2010/cost-contribution-arrangements_tpg-2010-11-en#page1

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As noted in Paragraph 8.3 of the Guidelines, a CCA is a framework for enterprises ‘to share the costs and risks of developing, producing or obtaining assets, services or rights and to determine the nature and extent of the interests of each participant in those assets, services or rights.’

The two fundamental principles on which the CCA concept is founded are that:

its participants have the expectation of mutual benefit from the activity and agree to share the contributions to that activity in proportion to the benefits each expects to obtain; and

each participant has an ownership interest in the property acquired or the intangibles resulting from the activity which it can exploit separately in its own interests without payment of further consideration to anyone.

The second of these two principles may not apply in some cases, eg where the arrangement is to share the cost and risks of service provision which does not result in an exploitable asset. However, such arrangements may nevertheless constitute a CCA.

CCAs between unrelated enterprises are not common in most sectors of industry perhaps because independents tend to favour other structures for sharing costs or pooling resources. That is no reason to question the bona fides of a CCA between associated enterprises as there are often good commercial reasons for them to seek to share costs including

spreading the risk and thus reducing the potential for large losses from an activity, e.g. on long-term, capital intensive R&D projects with a high chance of failure;

utilising the different skills and resources of separate entities within an MNE to make possible a venture that might otherwise be beyond any single one of them;

achieving savings through economies of scale and removing duplication, e.g. by obtaining services in common;

avoiding a complicated web of intra-group agreements charging royalties or service fees.

Accordingly, CCAs can be viewed as an alternative mechanism for establishing the sort of collaborative arrangements for the sharing of costs and pooling resources that are commonly seen, though perhaps in different form, between third parties.

It is nevertheless important, if the level of tax risk warrants it and subject to the transfer pricing governance to consider a CCA carefully to ensure that the methods employed to share contributions amongst its participants do not differ from those that would have been agreed between independents in similar circumstances.

Paragraph 8.7 of the Guidelines mentions that CCAs can exist for obtaining intra-group services. A CCA may be distinguished from the latter through the concept of mutual benefit and the sharing of contributions to that activity in proportion to the benefits each participant expects to obtain.

It can be difficult to identify the existence of a CCA from accounts and tax computations although changes in the entries could indicate a newly introduced CCA and so may be worth following up. A good knowledge of the business and the structure of a group will help to gauge the potential for cost sharing but the best way to identify a CCA is to ask the group itself in risk assessment discussions whether it has any cost sharing arrangements in place in which UK entities participate.

If contributions are not in line with those that independents would have agreed in similar circumstances, they should be adjusted in line with paragraph 8.27 of the Guidelines. That paragraph cautions against making minor or marginal adjustments and, generally, adjustments based on

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evidence from a single year should be avoided. That is because CCAs are often long-term projects where costs and benefits may need to be measured over a period of years.

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