A TAX MANAGEMENT

TRANSFER
PRICING !
VOL. 19, NO. 3 REPORT JUNE 3, 2010

HIGHLIGHTS ALSO IN THE NEWS

Allow Rankings on UTP for Issues Beyond Transfer Pricing, Taxpayers Say AUSTRALIA: Australia issues draft
The Internal Revenue Service should consider applying a ranking approach guidance on how the nation’s
for reporting uncertain tax positions to issues beyond just transfer pricing and transfer pricing rules apply
valuation, several taxpayer groups say. But another group argued that even to business restructurings.
such rankings would require taxpayers to compute an amount similar to a Page 94; Text Page 114
maximum tax adjustment and that the IRS should instead spend more ‘‘qual-
ity time’’ on the transfer pricing information taxpayers already provide. INDIA: An appeals tribunal finds
Lead Report, Page 91; Text, Page 109 an identical transaction with
unrelated parties is insufficient
Brazil Has Yet to Allow Changes to Fixed Margins, Practitioners Say for a CUP without adjustments
The Brazilian Ministry of Finance has yet to issue a single ruling changing the for market conditions. Page 106
fixed profit margins that Brazilian importers and exporters must use to calcu-
late their related-party prices, two São Paulo practitioners say. . . . Meanwhile, JAPAN: Japan details plans to
practitioners suggest that legislative missteps concerning the new 35 percent reform the National Tax Admin-
unified margin create an opportunity for related-party importers to use the re- istration tribunal to ensure tax-
sale price minus profit transfer pricing method without deducting a gross mar- payers an impartial grievance
gin for 2009 and 2010. Page 100; Page 100 process. Page 98

Canada Challenges Landmark GE Capital Canada Credit Guarantee Ruling

The Canada Revenue Agency argues that the Tax Court of Canada erred in
law and fact and engaged in improper conduct in concluding that General SECTION INDEX
Electric Capital Canada Inc. was entitled to a deduction for guarantee fees
paid to its U.S. parent. Page 104; Text, Page 129 Lead Report ............................91
NYSBA Seeks Guidance on Using Transfer Pricing Methods for PEs Around the World .....................94
The New York State Bar Association Tax Section asks the IRS to develop guid- In the Courts .........................104
ance on whether transfer pricing methods can be used to attribute business Text .....................................109
profits to a permanent establishment under Organization for Economic Coop-
eration and Development guidelines. Page 96 In Practice ............................168
Analysis ................................170
P R A C T I T I O N E R A N A LY S I S Directory ...............................172

Mutual Agreement Procedures in Turkey

Metin Duran, formerly of KPMG and now with Mazars Denge in Istanbul, out- WEBINAR
lines the competent authority process in Turkey, explaining which taxpayers
are eligible and describing common issues as well as how the process inter- BNA June 9 will host a webinar
acts with litigation.In Practice, Page 168 with IRS Chief Counsel William
Wilkins, Disclosing Uncertain
Supporting Value with Transfer Pricing Data: Lessons from Customs Rulings Tax Positions: Q&A for Practical
Bill Methenitis of Ernst & Young LLP in Dallas and Karen King of the firm’s Implications on International Tax
office in New York examine three recent U.S. customs rulings that they assert Issues. To register, call 800-372-
provide a road map for successfully presenting transfer pricing data to satisfy 1033, opt. 6, or visit http://
U.S. customs requirements. Analysis, Page 170 www.bnatax.com/events.

Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN 1063-2069
90 (Vol. 19, No. 3)

In This Issue
TOPICAL SUMMARY
AUSTRALIA
ATO issues draft guidance on restructurings ............ 94
BRAZIL
Brazil to open special tax offices for large firms ...... 102
Congress approves decree setting thin cap rules ...... 101
Importers may use resale price, no margin in
2009-10 ......................................................... 100
Ministry of Finance has yet to allow changes to
fixed margins ................................................. 100
Brazil firms must now declare payments abroad...... 103
CANADA
CRA challenges GE Capital Canada ruling.............. 104
CHINA
Jiangsu tax authorities discuss deadlines................ 102
HONG KONG
Court disallows apportionment of contract
processing arrangement profit .......................... 106
INDIA
Employees sent to Indian firm did not create PE ..... 107
Comparison of identical product sales insufficient
for CUP, ITAT says ......................................... 106
ITALY
Italian decree allows taxpayers to avoid penalties ..... 97
JAPAN
Japan says IBM underreported $4 billion ................. 99
NTA announces details on tax tribunal reform.......... 98
Poll shows Japan, U.S. transfer pricing audit
activity ........................................................... 99
NETHERLANDS
Dutch complete 191 APAs in 2008......................... 103
OECD
Fifteen nations sign tax matters cooperation
agreement ....................................................... 94
NYSBA seeks guidance on methods for PE profit
attribution ....................................................... 96
New Art. 7 commentary refers to arbitration ............ 96
TURKEY
MAP in Turkey .................................................. 168
UNITED STATES
Supreme Court denies cert. in Textron case............ 108
Groups ask IRS to expand ranking approach............ 91
Supporting transaction value with transfer pricing
data: lessons from recent U.S. customs and
border protection rulings ................................. 170
TEXT
AUSTRALIA
ATO draft guidance on restructurings ................... 114
CANADA
CRA’s brief appealing GE capital Canada case ........ 129
OECD
OECD model tax treaty Article 7 update................. 148
UNITED STATES
Attorney’s comment on IRS schedule UTP ............. 109
TABLE OF CASES
Comr. of Inland Revenue v. C.G. Lighting Ltd. ......... 106
DDIT-IT vs. Tekmark Global Solutions LLC ............ 107
Her Majesty the Queen v. GE Capital Canada Inc. ... 104
Intervet India Pvt. Ltd. v. ACIT .............................. 106
RESOURCES
DIRECTORY
Government sources ........................................... 172
Private sector sources ......................................... 172

TAX MANAGEMENT
A TRANSFER PRICING REPORT
TAX MANAGEMENT INC., 1801 S BELL ST, ARLINGTON, VA 22202-4501 (703) 341-5913

Gregory C. McCaffery Darren McKewen

PRESIDENT GROUP PUBLISHER
Glenn B. Davis, Esq., EXECUTIVE EDITOR
Rita McWilliams, MANAGING EDITOR;
Molly Moses, Tamu N. Wright, Kevin A. Bell, STAFF WRITERS/EDITORS;
Rebecca Pearl McCracken, Alison Bennett, CONTRIBUTING EDITORS;
Nicholas Webb, TAX LAW EDITOR; Marji Cohen, Esq., DIRECTOR, INDEXING SERVICES;
Robert Creeden, Esq., INDEX EDITOR
Copyright Policy: Authorization to photocopy selected pages for internal or personal use is granted provided that appropriate fees are paid to Copyright Clear-
ance Center (978) 750-8400, http://www.copyright.com. For authorization of other uses, contact the TM Reprint Permission Coordinator at (703) 341-5884, or
send a written request via fax (703) 341-1624, or e-mail tm@bna.com. For more information, see http://www.bna.com/corp/copyright.
Tax Management Transfer Pricing Report (ISSN 1063-2069) is published bi-weekly by Tax Management Inc., 1801 S Bell St, Arlington, VA 22202-4501. Editorial
inquiries may be directed to the editors at (703) 341-5913. For customer service, call (800) 372-1033. Outside the U.S., call BNA International in London at
(+44) 171-559-4821.

6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069

Lead Report
Groups Ask IRS to Allow Ranking Approach
For Issues Beyond Transfer Pricing, Valuation
everal taxpayer groups said the Internal Revenue
S Service should consider applying a ranking ap-
proach for reporting uncertain tax positions to is-
sues beyond just transfer pricing and valuation, but a
transfer pricing group argued even ranking of those is-
sues requires creating new information, according to
comments on the IRS’s proposed disclosure schedule
submitted by June 1.
The American Bar Association Section of Taxation
May 28 wrote to applaud the ‘‘simplified approach’’ to
disclosing transfer pricing and valuation issues on
Schedule UTP, the IRS’s draft schedule for reporting
uncertain tax positions. For those issues, taxpayers
with $10 million or more in assets must rank them from
the largest potential adjustment to the smallest rather
than calculate a maximum amount (18 Transfer Pricing
Report 1213, 4/22/10).
Tax Executives Institute Inc., the law firm McDer-
mott, Will & Emery, and other groups urged the Service
to allow the same method for reporting other amounts.
However, Steven Hannes of McDermott, Will & Em-
ery in Washington, D.C., wrote separately from his firm
and asked the IRS to reconsider even the ranking ap-
proach for reporting uncertain transfer pricing posi-
tions. Writing on behalf of the Transfer Pricing Discus-
sion Group—a collection of companies from the auto-
motive, consumer goods, chemical, pharmaceutical,
and other industries—he noted that taxpayers still must
compute an amount similar to a maximum tax adjust-
ment to be able to rank their transfer pricing positions.
Saying taxpayers would have to create new information
to make this determination, Hannes recommended the
IRS spend more ‘‘quality time’’ on the transfer pricing
information taxpayers already provide.
The Transfer Pricing Discussion Group letter ap-
pears in the Text section of this issue.
Ranking Seen as Less Burdensome
Other groups, meanwhile, greatly favored the rank-
ing approach to the calculations required for other un-
certain tax positions and asked the IRS to broaden the
approach to areas. TEI, which recommended the IRS
substantially modify or eliminate the requirement to list
the maximum amount of potential liability for each un-
certain position, suggested ranking as a ‘‘less burden-
some means for measuring the significance of an is-
sue.’’ McDermott, Will & Emery, in a more general let-
ter addressing the disclosure schedule, also said a
ranking approach of some sort should be considered to
replace the maximum tax amount on the new schedule.
The Pennsylvania Institute of Certified Public Ac-
countants May 28 said that for positions not involving
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 91
valuation or transfer pricing, the IRS should consider
allowing taxpayers to list a range, such as:
s less than $500,000;
s between $500,000 and $999,999;
s $1 million to $10 million; and
s more than $10 million.
TEI Urges ‘Road Test’
TEI said it was concerned that the IRS had both un-
derestimated the burden to taxpayers of preparing the
disclosure schedule and overestimated the utility to the
agency of the information to be required. The group
further suggested the IRS ‘‘road test’’ the draft schedule
before mandating its widespread use.
An informal canvass of TEI members indicates that
the scope and amount of information to be required by
the draft schedule ‘‘are greater than most taxpayers
prepare and retain in their FIN 48 (or other accounting
standards) workpapers,’’ TEI said. Current accounting
standards contain no requirement to identify the maxi-
mum amount of potential tax liability, the group
pointed out. By including a maximum tax amount at-
tributable to a tax position, the IRS ‘‘may spawn differ-
ences of opinion between taxpayers and their financial
statement auditors as well as between taxpayers and
the IRS,’’ TEI said.
The group said the IRS’s expectations about the salu-
tary effect of the UTP schedule ‘‘may exceed what the
schedule actually generates or what the IRS can use ef-
fectively.’’ To help validate the IRS’s goals and allow
time to refine the form in response to feedback from
both taxpayers and IRS personnel, TEI recommended
asking taxpayers in the Compliance Assurance Process
to provide comments on the schedule. Those taxpayers
have entered into a memorandum of understanding
with the IRS that guarantees a significant amount of
transparency, the group noted.
TEI also said the IRS could approach Coordinated In-
dustry Case taxpayers—those whose gross receipts,
gross assets, and number of operating entities warrant
team examination procedures—and request their par-
ticipation in a pilot program regarding Schedule UTP.
Should the IRS decide to road test the schedule, TEI
said it would be pleased to assist the agency in identify-
ing potential participants in the pilot.
Concise Description Requirement
TEI agreed with the IRS’s stated objective of preserv-
ing its policy of restraint in seeking tax accrual work
papers. However, it argued that the requirement to pro-
vide a concise description of each uncertain tax posi-
tion, ‘‘including the ‘rationale for each position and a
BNA TAX 6-3-10
92 (Vol. 19, No. 3)
concise general statement of the reasons for determin-
ing that the position is an uncertain tax position,’ is any-
thing but restrained.’’
The schedule in its current form would require tax-
payers to disclose the pros and cons of each uncertain
position, TEI said. It contended that the schedule ‘‘will
plumb the taxpayer’s ‘mental impressions’ and ‘thought
processes’ nearly as intrusively as a requirement to dis-
close reserve amounts and risk assessments.’’
Thus, TEI recommended the IRS substantially
modify, if not abandon outright, the requirement that
taxpayers disclose the rationale for each position as
well as the reason the position is uncertain.
The ABA tax section agreed that taxpayers should
not have to disclose their rationale and give reasons for
a position’s uncertainty. ‘‘By requiring a taxpayer to
provide both the rationale for the taxpayer’s legal posi-
tion and the reasons that the taxpayer believes that the
tax position is uncertain, the Service is essentially ask-
ing the taxpayer for a glimpse into the substantive risk
assessment underlying the position—something the
Service has stated that it does not intend to do,’’ the
ABA tax section said.
Questions about the taxpayer’s legal position and its
rationale for the position ‘‘should be made in the con-
text of an examination as they are now,’’ the group
added, saying a taxpayer during examination is in a bet-
ter position to assess the risks associated with disclo-
sure and to either provide the requested information or
assert applicable privileges as appropriate.
Hannes said it was not clear what a taxpayer could
meaningfully say in response to the Service’s request
for a concise description of income tax exposures based
on its transfer pricing positions beyond what it already
has said in Forms 5471 and 5472 and in its Section
6662(e) documentation. He also asked the IRS to in-
clude, in the instructions to Schedule UTP, ‘‘examples
of satisfactory concise descriptions of uncertain trans-
fer pricing positions and any other transfer pricing dis-
closures that the Service would require.’’
Duplicative Requirements?
TEI asserted that the new schedule duplicates some
of the information on existing Schedule M-3, the form
on which taxpayers reconcile their financial statement
and U.S. taxable income. The requirements for Sched-
ule M-3, which expanded the scope and detail of the in-
formation required on the previous schedule, have con-
tinued to evolve as the IRS gains experience with the in-
formation, TEI said.
‘‘Although it has been more than five years since
Schedule M-3 was promulgated, it is unclear to what
extent the IRS is using the information in refining its
risk compliance metrics,’’ the group said. ‘‘Hence, the
question arises whether another, more robust disclo-
sure form—proposed Schedule UTP—is premature.’’
Hannes pointed out that the Schedule M already re-
quires a U.S. person to report 120 different categories
of intercompany transactions with foreign affiliates,
which allows field agents to focus their transfer pricing
audit initiatives based on the type and volume of inter-
company transactions reported.
Angel Lists
TEI also recommended creating angel lists to omit
unnecessary or avoid duplicative disclosures, noting
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
LEAD REPORT
that many FIN 48 reserves likely are attributable to five
categories of transactions:
s items reported on Forms 8275 (disclosure state-
ment), 8275-R (for disclosing positions that are contrary
to Treasury regulations), or 8886 (reportable transac-
tion disclosure statement);
s book-tax differences subject to disclosure and rec-
onciliation on Schedule M-3;
s international issues such as transfer pricing;
s issues considered of high interest to the IRS under
its tiered system for prioritizing audits; and
s significant corporate transactions, such as reorga-
nizations or liquidations, or accounting method
changes subject to specific and significant documenta-
tion and disclosure requirements.
Those transactions likely will continue to be exam-
ined regardless of whether an item or transaction is dis-
closed on the proposed schedule, TEI said.
Transfer Pricing Concerns
Hannes contended the IRS should not request trans-
fer pricing information on Schedule UTP, saying the
Service ‘‘already requires taxpayers to provide signifi-
cant information about the nature and materiality of
their transfer pricing both at the time of the filing of the
return and, later, at the beginning of an examination.’’
Thus, he said, the IRS already has enough information
to allow it to judge the materiality and to focus its re-
sources efficiently on the transfer pricing issues that
warrant attention. Hannes added that this ‘‘is particu-
larly true for large taxpayers that the Service audits
regularly.’’
The attorney also said that determining whether a
transfer pricing position should be ranked is difficult
because transfer pricing issues, unlike many others, are
not binary. Transfer pricing positions are inherently
factual, requiring the exercise of judgment and the use
of factors beyond pure legal analysis, Hannes said.
Thus, he said, when a U.S. taxpayer sells a widget to its
foreign affiliate, there might be a range of correct an-
swers under Section 482. Given that fact, it is difficult
to imagine that a typical transfer pricing position ever
will be disallowed in its entirety on audit, which is the
standard for reporting a maximum tax adjustment,
Hannes said.
Independent Auditor Relationship
The ABA tax section, meanwhile, expressed concern
about how the announcement might affect the relation-
ship between a taxpayer and its independent auditor.
Specifically, the group worried that the disclosure
schedule might:
s compromise the objectives of the auditing process
by making it less likely that taxpayers and their audi-
tors would reserve for potential tax liabilities;
s jeopardize the independence of auditors by re-
quiring them to assume a more significant role in tax
compliance in addition to their existing responsibilities
to the shareholders;
s increase the requirements imposed by auditors
concerned that the IRS might question a decision or im-
pose penalties on a client for underreporting an uncer-
tain tax position—a particular concern for issues that
do not lend themselves to a single answer, such as valu-
ation or transfer pricing; and
TMTR ISSN 1063-2069
LEAD REPORT
s require accounting firms to be arbiters of the re-
quirements for disclosure of uncertain tax positions,
which may result in inconsistent treatment of similarly
situated taxpayers when different accounting firms
have different views on the uncertainty of a given posi-
tion.
BY MOLLY MOSES
䡺 TEI’s comments on Schedule UTP are available
on its website, www.tei.org. Comments of the ABA
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 93
tax section are available at http://www.abanet.org/
tax.
IRS Chief Counsel William Wilkins will speak at a
BNA webinar June 9 on practical implications of
the disclosure proposal for international compa-
nies. To register, go to http://www.bnatax.com and
click on ‘‘Events & Training.’’
BNA TAX 6-3-10
94 (Vol. 19, No. 3)
Around the World
Australia
Australian Taxation Office Issues
Draft Guidance on Business Restructurings
he Australian Taxation Office issued draft guid-
T
ance June 2 on how Australia’s transfer pricing
rules apply to business restructurings as compa-
nies realign their functions, risks, and assets.
[Application of Transfer Pricing Provisions to Business Re-
structuring, Australian Taxation Office, Draft Taxation Rul-
ing 2010/D2, issued 6/2/10]
Draft Taxation Ruling 2010/D2 said if the pricing of
a business restructuring arrangement does not make
commercial sense, then the Commissioner would seek
to achieve an arm’s-length outcome by making a pric-
ing adjustment but would not deny recognition to the
restructuring.
This differs from the Organization for Economic Co-
operation and Development’s Sept. 19, 2008, discussion
draft, which in Note 4 would permit tax administration
to disregard business restructurings that are not ‘‘com-
mercially rational’’ (17 Transfer Pricing Report 399,
9/25/08).
Taxpayer delegates in June 2009 during a two-day
OECD consultation on the OECD draft criticized Note
4, and argued that the proposed test is entirely subjec-
tive, and would judge commercial rationality at the en-
tity, rather than group, level. At the time, an ATO offi-
cial said that Australia has dealt with many business re-
structuring cases and had yet to deny recognition to any
restructuring (18 Transfer Pricing Report 159, 6/25/09).
Draft Taxation Ruling 2010/D2 said the final ATO
guidance would follow the OECD guidance on business
restructuring when the OECD guidance is finalized ‘‘ex-
cept to the extent’’ that the OECD guidance conflicts
with the ATO’s guidance.
Draft Taxation Ruling 2010/D2 appears in the Text
section of this issue.
Commercial Sense. Draft Taxation Ruling 2010/D2
provided various scenarios of restructurings and how
the ATO would consider each. It also would require that
taxpayers identify comparables to establish an arm’s-
length consideration ‘‘for each of the dealings involved
in the business restructuring and for the dealings in
their entirety.’’
The draft ATO ruling said depending upon the extent
of the taxpayer’s comparables, the taxpayer may in-
stead obtain other available data to determine ‘‘whether
the pricing of the business restructuring makes com-
mercial sense for the parties, having regard to what is
in their best economic interests and the options realisti-
cally available to them at arm’s length.’’
The draft ruling said taxpayers would need to exam-
ine whether the contractual terms of the business re-
structuring ‘‘accord with the outcomes of the functional
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
analyses and determine the true nature, terms and ef-
fects of the business restructuring.’’
Taxpayers are to refer to any relevant contracts, the
draft said, including those entered into to implement
the business restructuring, and ‘‘those evidencing the
terms of the pre and post-restructuring arrangements
for the business activities affected by the restructur-
ing.’’
Three-Step Process. Draft Taxation Ruling 2010/D2
outlines a three-step analysis for taxpayers.
First, taxpayers are to analyze the terms and effects
of the business restructuring in their entirety and re-
view the functions, assets, and risks of the related par-
ties before and after the restructuring, taking into ac-
count the costs and benefits of the restructuring and the
documentation including related-party contracts.
Second, the draft said taxpayers are to select the
most appropriate transfer pricing methods, and in do-
ing so, are to evaluate:
s whether the restructuring makes commercial
sense;
s whether the related-parties parties acted in their
own best economic interests; and
s how the restructuring compares to the other op-
tions realistically available to the related-parties.
Under the third step, the taxpayer is to apply the
most appropriate method and determine an arm’s
length outcome.
1998 Ruling. Draft Taxation Ruling 2010/D2 said it is
adopting the process as a suggested basis for testing the
arm’s-length nature of business restructurings set out in
Chapter 5 of Taxation Ruling TR 98/11. The draft ruling
said taxpayers would not be required to engage in work
beyond that under TR 98/11 in documenting a reliable
arm’s-length outcome for a business restructuring.
Under TR 98/11, the functional and comparability
analyses needed in a particular case depends upon the
taxpayer’s facts and circumstances, including the com-
plexity of the dealings and arrangements, and the avail-
ability of reliable independent comparables data (14
Transfer Pricing Report S-31, 2/15/06).
BY KEVIN A. BELL
OECD
Fifteen Nations Sign OECD, Council of Europe
Agreement on Cooperation in Tax Matters
ARIS—Fifteen countries, including the United
P States, May 27 signed an update to a 1988 multi-
lateral pact on administrative cooperation in tax
matters that aims to provide a legal framework for
trans-border cooperation while respecting national sov-
ereignty and taxpayers’ rights. [Amended protocol to the
TMTR ISSN 1063-2069
AROUND THE WORLD
Convention on Mutual Administrative Assistance in Tax
Matters, signed May 27]
The updated protocol amended the Convention on
Mutual Administrative Assistance in Tax Matters,
which took effect in 1995, to include commitments to
new standards on transparency and exchange of infor-
mation to fight tax evasion, as requested by the Group-
of-20 countries at their 2009 London summit, according
to Jeffrey Owens, director of Organization for Eco-
nomic Cooperation and Development’s Center for Tax
Policy and Administration.
The updated convention provides for multilateral si-
multaneous tax examinations, service of documents,
and cross-border assistance in tax collection. It also
contains language assuring taxpayers that tax authori-
ties will consider ‘‘the necessity of protecting the confi-
dentiality of information, and taking account of interna-
tional instruments for the protection of privacy and
flows of personal data.⬙
Owens called the updated convention ‘‘a very power-
ful instrument, covering all forms of activity, including
transfer pricing audits, verification of whether a com-
pany is correctly dealing with its VAT obligations, a
whole range of issues.’’
As an example, Owens noted that transfer pricing
cases can involve as many as five or six countries. The
convention provides a legal framework in which like-
minded countries can agree to conduct a joint transfer
pricing audit.
‘‘It’s attractive from the perspective of governments
but also businesses, because it means less hassle and
greater consistency,’’ Owens said.
It also opened the accord to more jurisdictions, in-
cluding developing countries (18 Transfer Pricing Re-
port 1220, 4/8/10).
In a ceremony at the OECD’s Paris headquarters, the
update was signed by 11 countries already parties to the
convention—Denmark, Finland, Iceland, Italy, France,
the Netherlands, Norway, Sweden, Ukraine, the United
Kingdom, and the United States. South Korea, Mexico,
Portugal, and Slovenia also signed both the convention
and the amending protocol.
Government officials in December said tax informa-
tion exchange agreements are a priority and are ex-
pected to be helpful in transfer pricing and other inter-
national cases (18 Transfer Pricing Report 943, 1/14/10).
Aligning with International Standard. The update
aligned the convention with the international standard
on information exchange for tax purposes by allowing
exchange of bank information, as set out in article 26 of
the OECD Model Tax Convention, and it opened the
convention to non-OECD and non-CoE members.
The convention covers all taxes and all forms of as-
sistance, in the assessment of tax, in terms of providing
a framework within which there can be joint audits, si-
multaneous examinations, and assistance in collection,
if countries wish, Owens said.
The convention was founded by the OECD and the
Council of Europe, which now serve as its custodians.
More Countries. The original convention was open
only to OECD members and the 47 members of the
Council of Europe, which is based in Strasbourg,
France, and is independent from the European Union.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 95
The updated protocol stipulated that once ratified by
five countries, the convention will be open to countries
that are not OECD or CoE members. On request by the
G-20, the updated convention allows developing coun-
tries to join and benefit from today’s more transparent
tax-cooperation environment, he said.
Owens said he expected the amended convention to
eventually attract many more countries.
The ceremony was held on the first day of OECD’s
May 27-28 ministerial council, which gathers ministers
from OECD’s 31 member countries, which include the
world’s wealthiest economies and nine emerging
economies.
The annual ministerial council overlapped by one
day with this year’s May 26-27 OECD forum. Like the
forum, which is open to the public, the ministerial coun-
cil is considering ways for economies to recover from
the world’s worst economic crisis in half a century, with
a focus on green growth, trade, and job creation.
Before the signing ceremony at OECD’s Paris head-
quarters, Owens told BNA he expected the rest of the
organization’s 31 member countries to sign throughout
this year.
‘‘After that, we will focus on non-OECD countries. In
particular, the BRIC [Brazil, Russia, India and China]
countries have shown interest,’’ he said.
A New Climate. The OECD official said in April that
the original convention was in many ways ahead of its
time when drafted, and its value to tax administrations
has only recently been recognized.
‘‘The climate has changed very much since 1988.
There’s much less tolerance of offshore noncompliance
and greater awareness on the part of governments that
offshore noncompliance often involves multiple juris-
dictions. At last count something like 41 jurisdictions
were affected by the Liechtenstein affair,’’ he said.
‘‘To confront a multilateral problem, it’s helpful to
have a multilateral instrument,’’ Owens said.
He said the convention is intended to be complemen-
tary to bilateral conventions, including treaties, and tax
information exchange agreements, which have mainly
been signed by OECD countries and large non-OECD
countries like China, as well as offshore financial cen-
ters.
TIEAs provide for exchange of information only on
request. Article 26 also provides for spontaneous and
automatic exchange, when two countries agree. ‘‘What
the convention does is put that into a multilateral
framework,’’ said Owens.
He added, ‘‘The majority of OECD countries already
use automatic exchange of information . . . they see that
as complementary to on-request exchange.’’
BY RICK MITCHELL
䡺 The amended protocol to the Convention on Mu-
tual Administrative Assistance in Tax Matters is
available at http://www.oecd.org/dataoecd/48/11/
45037332.pdf. A news release on the convention is
available at http://www.oecd.org/document/61/
0,3343,en_2649_33767_45336893_1_1_1_1,00.html.
BNA TAX 6-3-10
96 (Vol. 19, No. 3)
OECD
Final Draft of 2010 OECD Model Refers
To Arbitration in New Article 7 Commentary
he final draft of the Organization for Economic Co-
T
operation and Development’s 2010 update to its
Model Tax Treaty, released May 21, slightly ex-
panded the Commentary to new Article 7—which will
apply the separate entity approach to calculating busi-
ness profits—to stress the role of arbitration.
The OECD Committee on Fiscal Affairs said it was
appropriate in the Commentary to new Article 7(3) to
emphasize ‘‘the critical role of arbitration in ensuring
that all issues that would otherwise prevent a mutual
agreement in cases not covered by paragraph 3 are re-
solved.’’
The additional draft Commentary language says the
arbitration provision, contained in paragraph 5 of Ar-
ticle 25, ‘‘will play a critical role in cases where the com-
petent authorities would otherwise be unable to agree
as it will ensure that the issues that prevent an agree-
ment are resolved through arbitration.’’
The final draft retains proposed paragraph 3 of Ar-
ticle 7, which provides a corresponding adjustment
mechanism similar to that of Article 9.
New Article 7(3). A revised discussion draft of new Ar-
ticle 7, released Nov. 24, replaced paragraph 3 of that
article as it stood in the organization’s July 2008 discus-
sion draft with a broader provision that provides a cor-
responding adjustment mechanism similar to that of Ar-
ticle 9 (18 Transfer Pricing Report 777, 12/3/09).
Business and industry groups in January said the
Nov. 24 draft, which would apply the separate-entity ap-
proach to calculating business profits, was an improve-
ment over the prior draft because it included the corre-
sponding adjustment mechanism (18 Transfer Pricing
Report 1060, 2/11/10).
Under the Nov. 24 draft of Article 7(3), if a contract-
ing state adjusts the profits attributable to a permanent
establishment, the other state should eliminate the
double taxation on the profits by making an appropri-
ate adjustment to the amount of the tax that it charged.
In determining the adjustment, the two competent au-
thorities are to consult with each other if necessary.
The draft Commentary to Article 7(3) said that in the
case of a dispute over the amount and character of the
appropriate adjustment, the mutual agreement proce-
dure provided for under Article 25 should be imple-
mented, as is the case with an adjustment under Article
9(2).
When a contracting state adjusts the profits attribut-
able to a PE without the other state granting a corre-
sponding adjustment, the draft said the taxpayer may
invoke the mutual agreement procedure of Article
25(1), and if necessary the arbitration provision of Ar-
ticle 25(5), ‘‘to require the competent authorities to
agree that either the initial adjustment by one State or
the failure by the other State to make a corresponding
adjustment is not in accordance with the provisions of
the Convention.’’
Final Approval. The OECD said May 21 that the final
draft of the 2010 update to the Model Tax Treaty is be-
ing released only for information purposes because
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
AROUND THE WORLD
drafts of the update previously were released for com-
ment.
In addition to the new Article 7, the update will in-
clude changes to taxation of collective investment ve-
hicles, state-owned entities, and telecommunication
transactions. The OECD said member countries’ reser-
vations and observations, and nonmembers’ positions,
‘‘will be added to the update in the next few weeks.’’
The 2010 update will be submitted to the Committee
on Fiscal Affairs for discussion and approval at its June
meeting and to the OECD Council in July, the OECD
said, with a revised version of the model likely being is-
sued in September.
Existing Article 7. New Article 7 and its Commentary
represents the second stage of implementing the final
report on attribution of profits to PEs.
The OECD in July 2008 approved the final report on
attribution of profits to PEs and a revised commentary
on existing Article 7 to reflect the group’s separate-
entity approach. The revised commentary imported the
separate-entity approach into the Model Tax Treaty to
the extent that it did not conflict with the existing Com-
mentary.
The OECD said May 21 that the revised commentary
on existing Article 7 will be relevant to the interpreta-
tion of tax treaties concluded before the OECD Council
approves the 2010 update.
BY KEVIN A. BELL
䡺 The final draft of the 2010 update to the OECD
Model Tax Treaty may be found at http://
www.oecd.org/dataoecd/19/44/45276697.pdf.
United States
NYSBA Seeks Guidance on Transfer
Pricing Methods for PE Profit Attribution
he New York State Bar Association Tax Section
T May 28 asked the Internal Revenue Service to de-
velop guidance on whether transfer pricing meth-
ods can be used to attribute business profits to a perma-
nent establishment under Organization for Economic
Cooperation and Development guidelines.
The letter, which also requested generic guidance on
a variety of other international tax issues, noted that the
guidance should be limited to issues that are deter-
mined under U.S. tax law. ‘‘Given the relatively limited
guidance today, we believe that further guidance,
whether in regulations or rulings, would be extremely
useful.’’
The tax section offered two suggestions on what it
would like to see from the IRS—guidance on treaty lan-
guage as well as on the attribution of profits under spe-
cific fact patterns.
The letter said it is seeking the guidance under re-
cent treaties that specifically refer to the use of the
OECD transfer pricing guidelines—such as those with
Belgium, Canada, Germany and Iceland—and under
older treaties that do not specifically refer to the OECD
transfer pricing guidelines. The letter also pointed to
new U.S. treaties, such as the recent protocol with
France, that similarly to not specifically refer to the
OECD guidelines.
TMTR ISSN 1063-2069
AROUND THE WORLD
The IRS’s rules for determining the income and ex-
pense of a U.S. trade or business are different than
those that would apply if there is a treaty and the treaty
was interpreted as treating the PE as a separate entity,
the tax section said.
When no treaty exists, the Internal Revenue Code’s
‘‘effectively connected’’ rules state that revenue and ex-
pense from inter-branch transactions generally would
not be recognized, the tax section said. Also, some
gross income items would be attributed to the U.S.
trade or business on an all-or-nothing basis, and there-
fore may far exceed what would be taxable under
arm’s-length principles, the tax section added.
In situations where a treaty is in place, either the old
or new formulations for attribution of business profits—
which attribute profits to a PE according to those that
would be made if it were a ‘‘distinct and separate enter-
prise’’ or profits derived from the ‘‘assets used, risks as-
sumed, and activities performed by’’ the PE—may imply
attribution of profits by the use of transfer pricing meth-
ods, the letter said.
The tax section also pointed out that the ‘‘effectively
connected’’ rules are sharply different from the func-
tional analysis required to determine the correct
amount of income under Section 482 and are influenced
by different tax policies.
Two Suggestions. The tax section first suggested that
it would be useful to have guidance on the interpreta-
tion of language in older treaties that do not incorporate
the explicit reference to the OECD transfer pricing
guidelines or to the ‘‘assets used, risks assumed, and ac-
tivities performed by’’ the PE. Because the ‘‘separate
and distinct enterprise’’ rule does not require a tax-
payer to wait on regulations, ‘‘the absence of a clear IRS
position as to what the rule means will likely influence
the outcome of any dispute in which taxpayers make
their own determination of what the rule means,’’ the
letter said.
The letter added that the OECD’s statement in a
technical explanation that the ‘‘attributable to’’ concept
of Article 7 is an alternative to the ‘‘effectively con-
nected’’ concept in Section 864(c) ‘‘is of no help at all.’’
The tax section added that although differences still ex-
ist, ‘‘the OECD transfer pricing guidelines are in most
respects similar to the Section 482 rules for arm’s-
length pricing and the trend is clearly towards conver-
gence.’’
The tax section also referred to ‘‘significant risk’’ to
the IRS and Treasury if the rules are not clarified and
pointed to two cases in which court interpretation of
profit attribution differed. In the first case, North West
Life Assurance Company of Canada, 107 T.C. 363
(1996), the court interpreted the older treaty language
as requiring that the attributable investment income of
a PE be determined by the specific facts of the PE, while
the court in National Westminster Bank plc v. United
States, 512 F.3d 1347 (2008), interpreted the older
treaty language as permitting transfer pricing methods
to determine the interest expense of a PE, the tax sec-
tion said.
In the NatWest case, the U.S. Court of Appeals for
the Federal Circuit upheld a lower court determination
that the bank was entitled to a $65.7 million refund with
interest for 1981-87 (16 Transfer Pricing Report 661,
1/17/08).
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 97
The tax section also suggested that the IRS provide
guidance on how the transfer pricing rules would apply
if allowed. For example, the section asked, can a tax-
payer use the appropriate method under Section 482
regulations to determine the net income attributable to
a U.S. PE in a case where the PE is making loans or en-
tering into derivatives rather than the all-or-nothing
rule in the effectively connected regulations?
BY TAMU N. WRIGHT
䡺 Text of the NYSBA tax section’s letter appears
at: http://www.nysba.org/. Click on the ‘‘sections/
committees,’’ ‘‘tax section,’’ ‘‘tax section reports,’’
and ‘‘tax section report and letter 1214.’’
Italy
Italian Decree Would Allow Taxpayers
To Avoid Penalties Through Documentation
draft law decree approved by the Italian govern-
A
ment May 25 would allow taxpayers to avoid ad-
ministrative penalties for transfer pricing adjust-
ments if they can document their transfer pricing poli-
cies in compliance with specific requirements, a
practitioner in Milan said.
Aldo Castoldi of Deloitte Touche Tohmatsu said the
requirements are not yet known, as the draft states that
they will be set forth in specific instructions to be pub-
lished 60 days from the final conversion of the draft de-
cree into law. Castoldi said the decree will become offi-
cial when it is published in the Official Gazette, which
is expected to happen within days.
If Parliament approves the decree within 60 days of
publication, it becomes law and is deemed to have been
in force from the date of publication, he added. Castoldi
also noted that the original provisions may be amended
on conversion into law.
The decree does not represent a requirement for con-
temporaneous documentation, as there seems to be no
formal connection between the preparation of docu-
mentation and submission of the tax return, he said. In
addition, Castoldi pointed out that no specific penalties
apply for failing to document transfer prices.
Documentation Recommended. Still, he said, the ad-
vantage to taxpayers of documenting their transactions
will be significant, as ordinary administrative penalties
of between 100 percent and 200 percent of the addi-
tional tax assessed normally would apply.
Moreover, a court in 2008 found that taxpayers must
follow documentation rules under Article 109 of the
Consolidated Income Tax Code, which governs the cal-
culation of taxes on intercompany service transactions
and requires proof of invoices and other accounting
documentation (17 Transfer Pricing Report 83, 6/5/08).
Effective Date. The new documentation provisions
would be effective from the fiscal year in which they are
introduced into law—presumably 2010 for calendar
year companies—and most likely for earlier fiscal years
within the statute of limitations if an audit of those
years has not commenced.
Castoldi said no details have yet been provided about
the content and type of documentation that will be re-
BNA TAX 6-3-10
98 (Vol. 19, No. 3)
quired and deemed to be sufficient to avoid administra-
tive penalties. However, he said, it is reasonable to as-
sume that the documentation requirements will refer to
those established in the Organization for Economic Co-
operation and Development transfer pricing guidelines.
BY MOLLY MOSES
Japan
NTA Announces Details on Reforming
Tax Tribunal, Grievance Review Structure
OKYO—Japan’s Ministry of Finance May 13 re-
T leased details of its plan to reform the National Tax
Administration’s tribunal and general administra-
tion structure to ensure the impartiality of the grievance
process through which taxpayers appeal tax assess-
ments, including allowing taxpayers to peruse docu-
ments filed with the tribunal. [Ministry of Finance Report
to the Subcommittee on Tax Payment Environments, dated
5/13/2010]
The MoF stated that the work by the NTA tribunal
should be objective and raised three points of discus-
sion in reforming the tribunal: increasing its efficiency,
increasing its objectivity, and considering its effect on
NTA’s tax enforcement and revision of its administra-
tive structure.
The 32-page document, submitted to the subcommit-
tee on tax payment environments, a commission report-
ing to the ministry, said reviews would:
s analyze the tribunal’s organizational and person-
nel administration policies;
s study the structure and implementation of the
present tax grievance filing policy; and
s require the tribunal to explain assessment deci-
sions in light of an overall review of the grievance sys-
tem.
The document was released as part of fiscal 2010 tax
reforms, adopted by the cabinet of Prime Minister
Yukio Hatoyama Dec. 22, which call for ensuring that
the tax appeals process is separated from the NTA’s
revenue interests.
The 2010 tax reform document declared that the
present NTA tribunal is insufficient for hearing tax-
payer grievances and complaints about NTA audits and
examinations, and that it was unacceptable that taxpay-
ers had been denied access to peruse or copy docu-
ments. It also noted as problematic that ‘‘many juries
[of the tribunal] that perform the most important work
in order for the tribunal to perform its duty are domi-
nated by former NTA employees’’ (18 Transfer Pricing
Report 956, 1/14/10).
The report covered a range of items including:
s the present taxpayer grievance filing structure;
s purpose of the objection, grievance filing policies;
s periods required for settlement;
s grievance filing, lawsuit-related costs, and the av-
erage processing period;
s the relationship between grievance filing and law
suits, and national tax collection;
s the perusal and copying of evidence and other
documents;
s the NTA tribunal organization;
s the reason for establishing the tribunal and the
abolition of the ‘‘NTA Consultation Group’’;
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
AROUND THE WORLD
s NTA tribunal juries qualifications;
s composition of NTA tribunal juries and appoint-
ment authorities;
s tribunal hearing processes to determination;
s conditions of tribunal jury public recruitments;
and
s tribunal jury salaries.
Grievance Filing Policies. Under tax laws, taxpayers
undergo a two-tiered approach to seek legal action for
NTA tax assessment revocation and remedy: first, filing
a grievance application, and then, if turned down, mov-
ing on to file an examination application. Examination
applications are taken up by the NTA tribunal. Courts
are the next step after the tribunal.
In 2008, NTA issued 234,760 tax assessments and
2,182 tax correction assessments, the latter of which
bear steeper penal taxes. The figures compared with
290,000 and 12,182 the previous year, according to the
report. A total of 1,134 grievances for remedy were sub-
mitted to local tax offices and other tax authorities,
down from 1,203 the previous year. The number of
cases brought to the NTA tribunal was 549, down from
559 the previous year. The number of cases brought to
court was 122, up from 117 the previous year.
Evidence Document Perusal, Copying. Under the
present administration grievance examination law and
the national tax enforcement law, taxpayers may ask
the NTA tribunal for permission to peruse documents
submitted by local tax offices and other tax authorities
that have issued assessments, while authorities that is-
sued assessments are denied access to documents sub-
mitted by the taxpayer.
Under the amendment of the administration griev-
ance examination law, the taxpayer will be allowed to
peruse documents collected by the NTA tribunal, a pro-
cess that currently can be denied, according to the re-
port.
In both cases, copying of documents is banned for
both the taxpayer and assessment-issuing authorities.
NTA Tribunal Personnel. The NTA tribunal has its main
office in Tokyo, 12 regional branches, and seven local
offices in major Japanese cities. As of 2008, it had 477
staff employees.
Of the 12 regional branch officers as of April 1, 2010,
the report said, only two had not been former NTA em-
ployees: one had been a public court judge and the
other a public prosecutor. Of the 153 NTA tribunal ju-
rors, only 15 had not been former NTA employees.
BY TOSHIO ARITAKE
䡺 The Ministry of Finance’s report to the subcom-
mittee on tax payment environments on NTA tribu-
nal reform is available in Japanese at: http://
www.cao.go.jp/zei-cho/senmon/pdf/
sennouzei8kai1.pdf.
TMTR ISSN 1063-2069
AROUND THE WORLD
Japan
Japan Says IBM Underreported
More Than $4 Billion in Income
OKYO—IBM Japan has received an income defi-
T ciency assessment of more than ¥400 billion ($4.4
billion)—a record for undeclared income—by al-
legedly exploiting a consolidated taxation method that
took effect in 2002.
An IBM Japan spokeswoman March 25 said the
group plans to appeal the case to the tax tribunal or
court.
The spokeswoman, Minako Ito, confirmed that IBM
Japan received the income underreporting deficiency
assessment from the Tokyo Regional Tax Bureau. She
declined to comment on other details, including the as-
sessment amount and the corporate tax and surcharges
the company needed to pay, as well as on details of the
tax return filings that resulted in the deficiency.
In a statement, the firm said IBM ‘‘has fully paid all
taxes required under Japanese law’’ and that ‘‘all IBM
transactions adhered to Japanese tax laws.’’ The state-
ment also noted plans for the appeal.
According to Japanese news reports, IBM Japan un-
derreported ¥400 billion or more, the largest unde-
clared income ever in Japan, and the TRTB is believed
to have issued a corporate income tax deficiency total-
ing about ¥30 billion ($333 million).
The IBM Japan group founded IBM AP Holdings in
2002, the year when Japan’s consolidated tax method
took effect, Ito said. The group embarked on a reorga-
nization in which IBM AP acquired all IBM Japan stock,
according to IBM Japan and news reports.
The group began tapping the tax consolidation
scheme around 2008, offsetting IBM AP’s debts with
IBM Japan’s profits. As a result, the transaction helped
reduce the group’s corporate taxes in the business year
ending in December 2008, the reports said.
The TRTB determined that IBM AP fell short of
meeting conditions for a permanent establishment to
quality for the consolidated tax program, which is
aimed at enhancing Japanese companies’ international
competitiveness.
IBM Japan’s website said the company, with paid-up
capital of ¥135.3 billion (US$1.4 billion), is owned 100
percent by IBM AP Holdings, and its sales in the latest
reporting year of 2009 was ¥1.13 trillion (US$12.6 bil-
lion).
IBM AP is registered in Hakozaki, Chuo-ku, Tokyo,
the same area where IBM Japan is located, Ito said.
Tax Result Called Unusual. A former senior National
Tax Administration official said IBM Japan group’s re-
organization was in part a response to the consolidated
tax method and that ‘‘in a sense, its tax return filing (the
offsetting transaction of the IMB AP debts with IBM Ja-
pan profits) was unusual.’’
While saying that the fate of court proceedings looks
fluid for the Japanese tax authorities, the official said
the Japanese tax authorities now have become ‘‘very
cautious’’ about issuing tax deficiency assessments in
response to a series of court rulings rejecting tax defi-
ciency assessments, such as those relating to stock op-
tions given to employees of foreign companies.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 99
Still, the official said that in the IBM Japan group
case, ‘‘the huge underreporting amount stands out as
an unusual number for anybody. How can a taxpayer’s
income change from the previous tax filing program to
the consolidated scheme? IBM has a lot of explaining to
do.’’
Possibility for Avoidance. Under the consolidated tax
method, a subsidiary’s loss or debts can be offset or net-
ted with the parent company’s profits or assets, or vice
versa. But there is the possibility of tax avoidance by a
corporate group—for example, acquiring shares of a
deficit-running company fully and netting that deficit
with the profit-making companies in the same group.
To discourage such transactions, the U.S. Internal
Revenue Service has the separate return limitation year
rule, which prohibits offsetting (or netting) group prof-
its and losses when a company was newly incorporated
in the group as a result of acquisition.
Japanese corporate tax codes have similar regula-
tions, requiring that losses of subsidiaries that join ac-
counting consolidation of a group be omitted and not
included in the consolidation, according to the former
NTA official.
In the IBM Japan group case, the official said IBM
AP, which is the parent and not a subsidiary, had come
to incur large losses as a result of stock transactions
with IBM Japan and possibly other parties. He specu-
lated that the IBM Japan group interpreted the Japa-
nese tax codes to apply to subsidiaries and not parent
companies and exploited that part of the tax codes,
which itself may be legitimate.
BY TOSHIO ARITAKE
Japan
Webcast Poll Illuminates Level of Japanese,
United States, Transfer Pricing Audit Activity
ight percent of companies polled during a May 12
E webcast said that either they, or their Japanese re-
lated party, is currently under transfer pricing au-
dit by both the Internal Revenue Service and the Japa-
nese tax authorities.
The poll was taken during a webcast by Deloitte en-
titled Transfer Pricing in Japan and the United States:
Gaining Firm Footing on Shifting Sands, which the firm
said had an audience of 875 companies.
Responding to the first poll question, 13 percent of
the companies said they are currently under transfer
pricing examination only in the United States, and 5
percent said that they are under exam only in Japan.
Seventy-five percent of companies said that they are
not currently under transfer pricing examination in ei-
ther jurisdiction.
Japanese Audits. The 875 companies also were asked
about their primary Japanese transfer pricing audit con-
cerns.
Forty percent of companies said services transac-
tions, including technical support, marketing support,
procurement services, and headquarters services, was
their primary audit concern.
BNA TAX 6-3-10
100 (Vol. 19, No. 3)
Thirty percent of companies said their primary audit
concern was tangible transactions, including compo-
nents, finished goods, equipment, and tooling.
Seventeen percent identified intangible property
transactions, including know-how, design, and trade
names, and 11 percent choose loan interest or guaran-
tee fees.
Documentation. Another poll question asked: Does
your company, or your company’s related U.S. entity,
prepare contemporaneous transfer pricing documenta-
tion in the United States?
Forty percent of the companies polled answered
‘‘Yes, every year.’’
Twenty percent of companies selected the answer
‘‘Yes, but not every year,’’ and another 20 percent an-
swered ‘‘We have a transfer pricing study, but are not
sure if it satisfies the contemporaneous documentation
requirement.’’
‘‘No, we have never prepared a contemporaneous
documentation in the United States’’ was the answer se-
lected by 25 percent of companies.
BY KEVIN BELL
Brazil
Brazilian Ministry of Finance Has Yet
To Allow Requests to Change Fixed Margins
he Brazilian Ministry of Finance has yet to issue a
T single ruling changing the fixed profit margins that
Brazilian importers and exporters must use to cal-
culate their related-party prices, two São Paulo practi-
tioners said May 17.
Gil Mendes of Ernst & Young Assessoria Empre-
sarial Ltda and Simone Musa of Baker & McKenzie said
that the Brazilian tax authorities, to date, have not ap-
proved any taxpayer requests to deviate from the statu-
tory margins under the resale price minus profit
method that require the deduction of a profit markup on
the resale of goods.
Mendes said only a handful of taxpayers have re-
quested a ruling seeking to change the fixed profit mar-
gins since Portaria 222/08 permitted such requests in
2008. Taxpayers may request a ruling from the ministry
to change the fixed profit margins when they can prove
through an economic study that a different transfer
pricing method is justified.
Normative Ruling 222, published in Brazil’s official
gazette Sept. 26, 2008, allows companies to demon-
strate that the fixed transfer pricing margins are incor-
rect by using examples of trading operations between
themselves and unrelated firms. If they do not have
such operations, they may present examples of trading
operations similar to theirs but between two other, un-
related firms (17 Transfer Pricing Report 480, 10/23/08).
The practitioners spoke on a transfer pricing panel at
a joint meeting of the U.S. and Brazil branches of the
International Fiscal Association in Miami.
Difficulties. Mendes explained that Portaria 222 is a
set of rules that tries to make it more flexible for tax-
payers to change the presumed profit margins of the
different transfer pricing methods in Brazil.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
AROUND THE WORLD
Although Portaria 222 is an advance over prior regu-
lations, Mendes said, many issues remain unanswered
and therefore many taxpayers are uncomfortable with
applying for a ruling to change their profit margins.
Musa said Portaria 222 allows the taxpayer go to the
tax authority and request a different margin through
documentation detailing the margins of comparable
companies, but many taxpayers are concerned about
disclosing information to the tax authorities and ‘‘open-
ing the doors to a possible audit.’’
Both Mendes and Musa encouraged taxpayers to
seek to negotiate profit margins with the tax authorities
by applying for a ruling in appropriate cases and said
Portaria 222 presents an opportunity for taxpayers and
the tax authorities to discuss transfer pricing issues.
Rigid Rules. Musa pointed out that Brazil does not
have advance pricing agreements and that taxpayers
and the tax authorities do not engage in discussions and
negotiations regarding disputed transfer pricing issues.
Mendes said Brazil’s transfer pricing rules are very
rigid, resulting in complaints from taxpayers that the
rules ‘‘always end up causing double taxation.’’
‘‘The government has realized that this has pushed
business away from Brazil,’’ Mendes said.
BY KEVIN A. BELL
Brazil
Brazilian Importers May Use Resale Price
Without Margin in 2009-10, Practitioner Says
Brazilian related-party importer may use the re-
A sale price minus profit transfer pricing method
without deducting a gross margin for its own dis-
tribution activities for financial years 2009 and 2010 be-
cause taxpayers have a strong argument that the earli-
est that the new unified margin of 35 percent would
come into force is Jan. 1, 2011, a São Paulo practitioner
said May 17.
Simone Musa of Baker & McKenzie said Brazilian
importers should not have to adjust the resale price be-
cause the Brazilian government made a legislative mis-
take in revoking the statutory gross margins of 20 per-
cent and 60 percent before Provisional Measure 478 es-
tablishes the new unified margin of 35 percent.
Musa said the result of the legislative snafu was a
two-year gap during which the resale price minus profit
method does not have a statutory margin.
Musa, Gil Mendes of Ernst & Young Assessoria Em-
presarial Ltda in São Paulo, and Luciana Galhardo of
Pinheiro Neto Advogados, also in São Paulo, said most
Brazilian importers use the resale price minus profit
method, which imposes fixed profit margins, because of
difficulties applying the comparable uncontrolled price
method and the production cost plus profits method.
The practitioners spoke on a transfer pricing panel at
a joint meeting of the U.S. and Brazil branches of the
International Fiscal Association in Miami.
Gross Margins. Musa explained that a Dec. 16, 2009,
measure—Provisional Measure 472—revoked the gross
margins under the statutory resale price minus profit
method, which had required a deduction of a 20 percent
profit markup on the resale of goods and deduction of a
TMTR ISSN 1063-2069
AROUND THE WORLD
60 percent markup on raw materials. Provisional Mea-
sure 472 was itself revoked days later through Provi-
sional Measure 476, which went into effect Dec. 24,
2009, she said.
Provisional Measure 478, enacted Dec. 29, 2009, uni-
fied the statutory gross margins of 20 percent and 60
percent, imposing a 35 percent margin on all imports
from a related party (18 Transfer Pricing Report 952,
1/14/10).
Brazilian Constitution. Under Article 62 of the Brazil-
ian constitution, when a provisional measure, enacted
by the executive body, creates or increases taxes, the
measure can come into force only in the year following
the year in which the provisional measure is converted
into law.
Musa said Provisional Measure 478 results in in-
creased taxation because it introduced the unified mar-
gin of 35 percent at a time when there were no statutory
gross margins given that the statutory margins of 20
and 60 percent were revoked by Provisional Measure
472.
Therefore, she said, taxpayers have a strong argu-
ment under the constitution that the earliest Provisional
Measure 478 could come into force is Jan. 1, 2011, as-
suming it is enacted in 2010, even though the measure
states it is effective Jan. 1, 2010.
Risk. Musa said for so-called pure distributors—
companies that do not manufacture in Brazil—
Provisional Measure 478 increases the tax burden from
20 percent to 35 percent, and for importers of raw ma-
terials it decreases the tax burden from 60 percent to 35
percent.
Although it is uncertain whether the effective date of
Provisional Measure 478 is Jan. 1, 2010, or Jan. 1, 2011,
Musa said importers of raw materials may decide to ap-
ply the 35 percent rate of Provisional Measure 478 in
2010 ‘‘rather than run the risk that a margin of 60
[percent] would be applied.’’
Musa said that if the Brazilian tax authorities were to
apply the 60 percent margin, the importer also would
face stiff transfer pricing penalties totalling 75 percent
of the tax deficiency.
Different Margins. Mendes said that under Provisional
Measure 478, the Brazilian Minister of Finance will be
able to establish different profit markups for different
industries.
Mendes said it is rumored that the government will
establish the profit margins by the end of the year.
Also under Provisional Measure 478, Mendes said,
once a transfer pricing audit is initiated, the taxpayer
cannot change its transfer pricing method.
CUP. Galhardo explained that a Brazilian importer
may choose one of three traditional methods to price its
intercompany transactions: the resale minus profit
method, the comparable uncontrolled price method,
and the cost plus markup method.
Mendes said another change under Provisional Mea-
sure 478 relates to the use of the CUP method, which in
Brazil is called the comparable independent price
method.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 101
Use of the CUP method by taxpayers may be re-
stricted to purchases by the same importer from unre-
lated parties, and to purchase and sale transactions car-
ried out between other unrelated parties, Mendes said.
He said that under the old rules, the taxpayer could
use internal comparables for the CUP method, but un-
der Provisional Measure 478, the taxpayer would ‘‘also
need external comparables, which would make it much
more difficult for taxpayers to prepare the transfer pric-
ing documentation for a CUP, because this information
is hard to get.’’
Galhardo said the CUP method is difficult to apply
because it deals with the concept of identical or similar
products, services, and intellectual property. Two prod-
ucts are similar under Brazilian transfer pricing law,
she said, when they have the same function, are inter-
changeable for the same intended purposes, and have
equivalent specifications.
However, Galhardo said the Brazilian tax authorities
‘‘often use a broad comparison’’ because they do not
take into account the origin, trademark, or quality of
the product.
Cost Plus. Galhardo said the production cost plus
profits method, the Brazilian equivalent of the cost plus
method, also is difficult to use because ‘‘foreign compa-
nies will hardly open the production costs to their Bra-
zilian controlled companies.’’
Under this method, a 20 percent profit margin is
computed on the production cost of the goods, services,
or intellectual property in the country of origin, in-
creased by the taxes and fees charged in that country.
Galhardo said the method is difficult to apply be-
cause of rigorous requirements related to documenting
the production costs.
BY KEVIN A. BELL
Brazil
Brazil’s Congress Approves Decree
Establishing Thin Capitalization Rules
IO DE JANEIRO—Brazil’s congress May 4 ap-
R proved the nation’s first legislation on thin capi-
talization rules. [Provisional Measure 472/2009,
5/4/10]
The decree attempts to limit the ability of companies
to transfer profits abroad to subsidiaries registered in
tax havens in cases where these remittances are listed
as interest payments on intercompany loans. These
payments can be deducted from a company’s income
tax payments but these deductions, when a tax haven is
involved, will be restricted to the payment of debts that
do not exceed 30 percent of a company’s net equity. For
remittances of interest payments to subsidiaries in non-
tax havens, the limit was set at twice a company’s net
equity.
The legislation raised many questions as to how the
new rules will operate in practice, according to tax at-
torneys. The rules will be applied for income tax pur-
poses starting in January 2011. Before then, attorneys
told BNA they expect tax officials to issue several clari-
fications to provide guidance.
In addition, the decree states that Brazilian compa-
nies claiming to have paid for services rendered by a
BNA TAX 6-3-10
102 (Vol. 19, No. 3)
firm located in a fiscal paradise will now have to present
evidence that the service provider actually exists and
the service was in fact rendered and payment received.
Another of the decree’s measures states that indi-
viduals claiming to be nonresidents of Brazil and resi-
dents of a tax haven country will have to present proof
of their residency claim.
Debt-to-Equity Ratio. The decree, introduced in De-
cember 2009, allows debt interest from related-party fi-
nancing to be deductible if the transactions meet two
conditions:
s the related party debt-to-equity ratio does not ex-
ceed 2:1 based on the proportion of related-party debt
to direct equity investment made by related parties; and
s the overall debt-to-equity ratio does not exceed 2:1
based on the proportion of total debt to total direct eq-
uity investment made by related parties.
For purposes of calculating total debt funding, every
form and term of financing shall be considered by the
Brazilian company, regardless of the registry of the
contract with the Brazilian Central Bank (18 Transfer
Pricing Report 952, 1/14/10).
BY ED TAYLOR
Brazil
Brazil to Open Specialized Tax Offices in Rio,
Sao Paulo, to Deal With Large Companies
IO DE JANEIRO—Brazil’s tax department has an-
R
nounced opening two offices to concentrate exclu-
sively on monitoring large company tax payments.
The first office are located in Rio de Janeiro and in
São Paulo, Brazil’s business capital. Otacilio Cartaxo,
head of Brazil’s federal tax authority, said 260 tax
agents will work out of the two offices and will monitor
the operations of 1,042 major companies that together
account for 37 percent of annual federal tax collections.
São Paulo and Rio are home to over half of the foreign
firms operating in Brazil.
Cartaxo said the tax department considers a com-
pany to be a major taxpayer when its annual revenues
are over $45 million and its payroll is at least $6 million.
He said 10,568 companies fit this profile and together
account for 76 percent of federal tax receipts. Sao Paulo
and Rio were chosen because they have Brazil’s largest
concentrations of these firms.
The opening of the two specialized offices is actually
an expansion of a recent department policy to concen-
trate on major taxpayers. In the last three years, tax
agents have been paying special attention to these
firms, but this is the first time that department units
have been set up to deal exclusively with large compa-
nies.
Rise in Tax Credit Claims by Large Companies. In 2009,
tax officials noticed a sharp increase in the tax credits
claimed by large companies. This was seen as a reac-
tion of these companies to falling sales caused by the
global financial crisis. But Cartaxo said tax agents have
found several cases where credits were claimed incor-
rectly.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
AROUND THE WORLD
‘‘It is common for large companies to use specialized
law firms to come up with tax planning operations to
avoid paying what they owe. With these new offices, we
hope to be more alert in our monitoring. If we can block
the irregularities more quickly, we will discourage this
conduct,’’ said Cartaxo.
He said the tax department assessed 55 large compa-
nies in São Paulo a total of $4.3 billion last year and that
with the new office he expects the numbers to increase.
In 2009, according to Cartaxo, 800 Sao Paulo firms
were collectively responsible for a $600 million decline
in federal tax collections. All of these firms are on the
list of companies that will be monitored by the new São
Paulo office, he said.
He added that if the new strategy proves successful
in São Paulo and Rio, more specialized offices will be
opened in other states.
BY ED TAYLOR
China
Jiangsu Tax Authorities Remind
Taxpayers of Documentation Deadlines
he Jiangsu tax authorities reminded several hun-
T dred taxpayers, who participated in a May 25 semi-
nar via video conference at locations throughout
the province, of the May 31 deadline for preparing con-
temporaneous transfer pricing documentation that
must be submitted to the tax authorities within 20 days
upon request.
The Jiangsu officials also reminded taxpayers that
loss-making single-function enterprises must submit
their transfer pricing documentation before June 20.
Regarding thin capitalization deadlines, the officials
said taxpayers whose debt-to-equity ratios exceed the
prescribed safe-harbor ratios must submit their docu-
mentation with their tax return, and that documenta-
tion for cost sharing arrangements must be submitted
by June 20.
Steven Tseng of KPMG in Shanghai said the tax au-
thorities discussed the level of detail required by Circu-
lar No. 2. Tseng reported that the officials directed tax-
payers to provide further information regarding the fac-
tors they considered in setting their related-party
prices, and that inconsistencies between the functional
and risk profile, or applications for high-technology sta-
tus, would lead to further questions from the tax au-
thorities.
Larger tax authorities, including Jiangsu, have taken
a targeted approach to collecting taxpayers’ transfer
pricing documentation and are focusing on large multi-
national companies with significant transactions (18
Transfer Pricing Report 1055, 2/11/10).
China’s State Administration of Taxation in January
2009 issued circular Guo Shui Fa [2009] No. 2 requiring
taxpayers to prepare contemporaneous documentation
when their annual related-party tangible property
transactions reach RMB 200 million (US$29 million),
with a threshold of RMB 40 million (US$6 million) for
intangible transactions (17 Transfer Pricing Report 671,
1/22/09).
Jiangsu is China’s third largest province by gross do-
mestic product and the fifth largest by population.
BY KEVIN A. BELL
TMTR ISSN 1063-2069
AROUND THE WORLD
Brazil
New Rule Requires Firms in Brazil to File
Tax Declaration on Remittances Abroad
IO DE JANEIRO—Brazil’s tax department May 18
R
released a directive requiring companies and indi-
viduals remitting more than $29,817 abroad in a
single year to file a tax declaration. [Instruction Norma-
tiva RFB No. 1.033, dated 5/14/2010]
At present, remittances are registered only with Bra-
zil’s central bank. Tax officials said the new measure
will help them crack down on tax evasion by comparing
a company’s actual profit remittances with profits de-
clared on its annual income tax declaration.
In addition to profits and dividends, the other remit-
tances that must be declared include funds for the pay-
ment of royalties, international freight charges, com-
missions paid by exporters, financial investments, rent-
als, and leasing operations.
BY ED TAYLOR
Netherlands
Dutch Complete 191 APAs in 2009;
Output Decreased by 7 Percent from 2008
he Netherlands’ Revenue Service completed 191
T advance pricing agreements during 2009, a 7 per-
cent decrease over the 206 agreements executed in
2008, according to statistics released by the Nether-
lands’ Revenue Service.
In addition, the statistics reveal a gradual decline in
APAs sought over the last three years, with taxpayers
requesting 323 APAs in 2007, 283 APAs in 2008, and
227 APAs in 2009. The chart below provides Dutch APA
and advance tax ruling statistics for 2006-09.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 103
Clive Jie-A-Joen of Baker & McKenzie in Amsterdam
attributed the decrease in both APA applications and
completed agreements to the economic downturn. The
number of APA requests received dropped 20 percent
between 2008 and 2009, he noted.
Although the Revenue Service does not disclose the
breakdown of executed APAs between unilateral and
multilateral agreements, most Dutch APAs are unilat-
eral (18 Transfer Pricing Report 603, 10/22/09).
Advance Pricing Agreements. The Revenue Service in
2009, in addition to granting 191 APA requests, denied
nine requests. Another 31 requests were either with-
drawn or not completed. The backlog of pending APAs
stood at 157 as of Dec. 31, 2009.
In 2008, the Revenue Service, in addition to granting
206 APA requests, denied 10 requests. Another 57 were
withdrawn or not completed. The backlog of pending
APA cases stood at 161 on Dec. 31, 2008.
Advance Tax Rulings. Hub Stolker of Baker & McKen-
zie in Amsterdam noted that applications for advance
tax rulings—which may address, among other issues,
whether a foreign taxpayer has a permanent establish-
ment in the Netherlands—declined 37 percent in 2009.
The Revenue Service granted 347 ATRs in 2009 and
denied 28 requests for ATRs, while 117 were withdrawn
or not completed. As of Dec. 31, 2009, the backlog of
pending ATR requests totaled 233. In 2008, the Revenue
Service granted 498 ATRs and denied 28 requests for
ATRs, with 150 requests withdrawn or not completed.
The backlog of pending ATR requests stood at 299 on
Dec. 31, 2008.
In 2009, the Revenue Service took an average of 53
days to process APA requests and 47 days to process
ATR requests, compared with an average of 50 days for
APAs and 40 days for ATR requests in 2008.
BY KEVIN A. BELL
BNA TAX 6-3-10
104 (Vol. 19, No. 3)
In the Courts
Canada
Tax Agency Challenges Landmark Ruling
On GE Capital Canada Credit Guarantee
TTAWA—Tax Court of Canada Justice Robert
O Hogan erred in law and fact and engaged in im-
proper conduct in concluding that General Elec-
tric Capital Canada Inc. was entitled to a C$136.4 mil-
lion ($128.2 million) deduction for a fee paid to its U.S.
parent for a guarantee that boosted its credit rating and
allowed it to raise necessary funds, the Canada Revenue
Agency said in its appeal of the Dec. 4, 2009, Tax Court
ruling. [Her Majesty the Queen v. General Electric Capital
Canada Inc., Federal Court of Appeal, No. A-1-10, Appel-
lant’s Memorandum of Fact and Law]
The CRA in its Memorandum of Fact and Law said
Hogan made numerous errors of law in undertaking the
necessary transfer pricing analysis—in identifying the
relevant transaction, in determining an unadjusted
arm’s-length price, in making adjustments to account
for differences between the actual transaction and an
arm’s-length transaction, and in conducting a ‘‘reason-
ableness’’ check.
The CRA’s memorandum submitted to the Federal
Court of Appeal, obtained May 21 by BNA, appears in
the Text section of this issue. Also see the text of the
Tax Court of Canada’s decision in the case.
Background. The Tax Court’s December 2009 ruling
upheld the tax agency’s ‘‘yield’’ approach to assessing
the value of the guarantee, but found that when applied
properly, the approach favored GE Capital Canada’s
position in the company’s challenge to the CRA reas-
sessment for 1996-2000 (18 Transfer Pricing Report
845, 12/17/09).
The interest rate differential between GE Capital
Canada’s potential borrowings with the BBB-/BB+
credit rating it had without the guarantee and its AAA
rating with the guarantee was approximately 183 basis
points, giving the 1 percent fee charged by its U.S. par-
ent for the guarantee a value at or below an arm’s-
length price for the transaction, the ruling said.
‘‘Without a guarantee, the appellant would have
been unable to procure standby letters of credit in an
amount sufficient to cover its commercial paper pro-
gram,’’ it said. ‘‘The appellant would have been unable,
in the absence of the guarantee, to execute its business
plan, as the Canadian commercial paper market was
geared to the highest investment-grade issuers.’’
The ruling rejected the CRA’s position that the guar-
antee by the U.S. parent was unnecessary because of
the implicit support that would be assumed by the par-
ent. ‘‘Implicit support is like a metaphorical ‘invincible
wallet’. It is something investors believe exists, and may
be available to provide financial support if the right cir-
cumstances are present, but few investors are foolish
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
enough to believe that it is equivalent to a guarantee,’’
the court said.
Irrelevant Hypothetical. The CRA said the Tax Court
judge misidentified the transaction at issue by introduc-
ing an irrelevant hypothetical fact and failed to give any
weight to economically relevant characteristics of the
transaction by preferring an expert’s report that failed
to properly consider those characteristics.
Further, the CRA said the judge failed to perform a
proper reasonableness check to validate the results of
his primary conclusion of value and misapplied what he
termed the ‘‘business judgment rule.’’
Despite the trial judge’s errors, the CRA said, the
record provides the evidence needed for the Court of
Appeal to make an appropriate finding on the pivotal is-
sue of the value of the explicit guarantee provided to
GE Capital Canada by its U.S. parent, allowing it to sub-
stitute its own decision for that of the trial judge and
conclude that the value of the explicit guarantee is nil.
‘‘If any doubt exists, there is sufficient and compel-
ling evidence before this court that [GE Capital Canada]
would be rated at least AA+, resulting in a reasonable
guarantee fee of no more than 0.15-0.24 percent,’’ it
said. ‘‘Alternatively, if this court concludes that the con-
duct of the trial judge so tainted the evidentiary record
as to make it impossible to reach a proper conclusion,
this court should remit the matter back to the Tax Court
of Canada for a new hearing before a new judge,’’ the
CRA said.
Appeal Highlights Errors in Law. In analyzing GE Capi-
tal Canada’s payment of a 1 percent fee to its U.S. par-
ent, General Capital Services Inc., in exchange for an
explicit guarantee used to boost its credit rating and fa-
cilitate borrowing, and subsequently assessing the
value of that guarantee to be at least 183 basis points,
Justice Hogan ignored a key element of the arm’s-
length principle by considering a hypothetical
possibility—the impact of removing the guarantee in
the absence of the fee, the government’s submission
said.
The arm’s-length principle requires a comparison of
the transaction at issue between related parties and the
same transaction between independent parties, but the
trial judge introduced withdrawal of the guarantee as a
relevant factor without any evidence, legal authority, or
expert opinion to suggest that it should be considered,
the CRA said.
Removal of the explicit guarantee should have
formed only part of the valuation exercise, not a fact of
the case, and the trial judge improperly rejected the tes-
timony of the CRA’s expert witnesses because they
failed to consider removal of the guarantee, it said. ‘‘As
a result, he reached a very different conclusion and im-
puted a larger value to the guarantee than if he had re-
stricted his analysis to the actual transaction between
the parties,’’ the government said.
TMTR ISSN 1063-2069
IN THE COURTS
Justice Hogan also relied on faulty analysis provided
by GE Capital Canada’s expert witnesses and therefore
failed to take into account all economically relevant fac-
tors in arriving at the value of the guarantee fee’s ben-
efit to GE Capital Canada and the arm’s-length price for
the explicit guarantee, it said. ‘‘He failed to address any
of these issues properly. Accordingly, no consideration
was given to economically relevant characteristics that
were identified by both parties as significant,’’ the gov-
ernment said.
The CRA’s Memorandum of Fact and Law criticized
Justice Hogan for failing to conduct a ‘‘sanity’’ or ‘‘rea-
sonableness’’ check of the transfer pricing analysis in
the case to confirm the validity and result of the primary
pricing method used. Although that check is not essen-
tial in determining the initial transfer price, it was an
important issue in the case at hand because of the lack
of comparable transactions, the memorandum said.
‘‘While acknowledging the need to find an alterna-
tive methodology to validate his primary conclusion as
to the value of the benefit, the trial judge failed to do so
with a reliable method. Not only was the single sanity
check he used in his analysis admittedly unreliable, but
he failed to explain his reasons for rejecting all the
other methods,’’ the CRA said. This is particularly trou-
bling because the evidence was that the value ultimately
chosen by the trial judge (1.83 percent) could amount to
over 60 percent of the respondent’s pre-tax/pre-
guarantee fee, a percentage for which comparables
were put forward, it said.
The government said Justice Hogan also misapplied
the ‘‘business judgment rule’’ by relying on the evi-
dence presented by Jeffrey Werner, a senior executive
with GE Capital Canada’s U.S. parent, as the arm’s-
length principle, at its core, requires the application of
objective evidence to support a transfer price. ‘‘Cana-
dian jurisprudence has recognized that the evidence of
a decision-maker like Werner, in a non-arm’s length
situation, must be scrutinized with great care and
treated with a degree of skepticism,’’ it said. ‘‘Transfer
pricing analysis requires that the decision in issue be
tested against objective evidence. To do otherwise and
rely on subjective business judgment of the decision
maker as objective eliminates the arm’s length stan-
dard.’’
Errors of Fact and Improper Conduct. The Memoran-
dum of Fact and Law alleged a number of errors of fact
by Justice Hogan that it argued significantly affected his
assessment of the ‘‘pivotal’’ fact in the case—what GE
Capital Canada’s credit rating would have been without
the explicit guarantee provided by its U.S. parent.
The conclusion that the rating would have been
BBB-/BB+ was based on erroneous findings, including
the rejection of evidence provided by the CRA’s expert
witnesses and reliance on the evidence presented by GE
Capital Canada’s witnesses, and the incorrect conclu-
sion that GE Capital Canada would have been unable to
obtain back up lines of credit without the explicit guar-
antee from its parent, the submission said.
‘‘The trial judge used improper and unjustifiable rea-
sons to discredit the conclusions of three of the [CRA’s]
witnesses. He then used inadmissible evidence to cor-
roborate [GE Capital Canada’s] principal witness, but
failed to address that witness’ factual errors and omis-
sions, and failed to reconcile his inconsistent testimony
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 105
with that of [GE Capital Canada’s] other witnesses,’’ it
said.
‘‘The trial judge added to these errors by linking an
erroneous conclusion on the availability of back-up
credit lines to the value of implicit support with the
need for explicit guarantees and misstated evidence
when it did not support his conclusions. These are all
palpable and overriding errors which led the trial judge
to place too much value on the explicit guarantees and
to undervalue [GE Capital Canada’s] credit rating with-
out them.’’
The submission criticized Justice Hogan for exces-
sively intervening in the trial by asking questions that
were allegedly improper, by introducing his own theo-
ries, by suggesting answers to witnesses, and by confus-
ing the witnesses and parties’ counsel as to who was
asking and answering questions.
‘‘The trial judge descended into the arena and took
on the role of counsel, resulting in a trial process that
was unfair. The trial judge also rendered Reasons for
Judgment which were inadequate as they fail to deal
with objections taken under reserve, introduced case
law which was not argued, and did not provide mean-
ingful analysis on pivotal issues,’’ the CRA said.
Justice Hogan particularly erred by introducing his
own theories on the effect of the removal of the guaran-
tee provided by GE Capital Canada’s U.S. parent, which
so preoccupied him that it became the basis for much of
his acceptance or rejection of witnesses and evidence,
the government said. That reliance came despite the
fact that neither party pleaded removal of the guaran-
tee as an economically relevant factor nor referred to it
in their opening arguments, but were directed by the
judge to address it in their closing arguments, the CRA
added.
The CRA argued that a trial judge’s interventions are
improper if they introduce new theories in the course of
trial. ‘‘Here, the trial judge diverted the trial away from
the issues the parties sought to present and toward
what he considered to be the central issue,’’ the CRA
said. ‘‘He prejudiced the parties by widening the scope
of admissible evidence without giving them the benefit
of procedural safeguards such as notice requirements
or knowing the case they must meet.’’
Finally, the CRA’s appeal said that the trial judge’s
interventions ‘‘were of a nature and extent that trans-
gressed permissible interventions and destroyed the im-
age of judicial impartiality. He usurped the function of
counsel. He took the trial away from the parties by in-
troducing his own theories, gathering his own evidence,
and making it difficult for counsel to know the case they
had to meet. The cumulative result of the errors was a
trial that was procedurally unfair, giving rise to a rea-
sonable apprehension of bias.’’
BY PETER MENYASZ
䡺 The ruling is available at http://decision.tcc-
cci.gc.ca/en/2009/2009tcc563/2009tcc563.html.
BNA TAX 6-3-10
106 (Vol. 19, No. 3)
Hong Kong
Hong Kong Court Disallows Apportionment
Of Contract Processing Arrangement Profit
ong Kong’s Court of First Instance determined
H May 3 that a taxpayer involved in a contract pro-
cessing arrangement with its wholly owned sub-
sidiary in mainland China cannot apportion its profit
between the two jurisdictions. [Comr. of Inland Revenue v.
C.G. Lighting Ltd., Hong Kong Court of First Instance, HCIA
8/2009, decision filed 5/3/10]
The court said the lack of a finding by the Board of
Review below, that the arrangement between C.G.
Lighting Ltd. and its subsidiary involved the sale of fin-
ished goods from China to Hong Kong, did not preclude
the taxing authority from denying apportionment to the
taxpayer and its subsidiary even though two recent
rulings—Comr. of Inland Revenue v. Datatronic Ltd.
and Ngai Lik Electronics Co. v. Comr. of Inland Rev.—
had permitted apportionment for similar offshore ar-
rangements between affiliates (18 Transfer Pricing Re-
port 395, 9/10/09; 18 Transfer Pricing Report 630,
10/22/09).
Processing Arrangement. In 1993, the taxpayer was in-
volved in a typical import processing arrangement in
which it sold raw materials to a third party in mainland
China that manufactured lighting fixtures and then sold
the fixtures back to the taxpayer. Under this arrange-
ment, its profits were taxed on a 50-50 basis by the IRD.
In 1994, the taxpayer formed a wholly owned subsidiary
in mainland China—CG Electrical (Shenzen) Ltd.—to
take over the manufacturing operation, switching to a
contract processing arrangement that was not endorsed
by mainland China’s revenue authority.
Under the new arrangement, the taxpayer provided
its Chinese subsidiary with raw materials, technical
know-how, management staff, production skills, com-
puter software, product designs, and skilled labor at no
cost. The paperwork involved in the arrangement in-
cluded documents detailing the sales of the finished
products from the subsidiary to the taxpayer.
The IRD assessed the full amount of the profit as tax-
able on the grounds that all of the profit from the ar-
rangement arose in Hong Kong. C.G. Lighting con-
tended that the IRD is required to consider its offshore
activities and operations and that it was instrumental in
the manufacturing process and the generation of profits
for the goods on the mainland. The taxpayer contended
that there were no sales of the finished products from
the subsidiary to C.G. Lighting because C.G. Lighting
created sales documents to get customs clearance in
bringing the goods from the mainland to Hong Kong.
Therefore, the taxpayer argued, part of its profits arose
in Hong Kong and the other part arose on the mainland.
The Board of Review found that because the taxpay-
er’s active involvement in the mainland production pro-
cess created some of the profit, then some of the profit
belongs offshore in spite of the fact that the activities
occurred under an import processing arrangement. The
board also determined that the characterization of the
operation was not important and that the taxpayer’s
profit-producing activities are to be separated from
those activities that are merely incidental to the cre-
ation of profit. The board allowed the taxpayer’s appor-
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
IN THE COURTS
tionment claim and sent the case back to the IRD to de-
termine the appropriate apportionment.
Court of First Instance. On the appeal to the Court of
First Instance, the taxing authority argued that the tax-
payer’s profit-making activities must be properly identi-
fied, and that antecedent or incidental activities are to
be eliminated. The taxing authority also contended that
the facts in this case are almost identical to those of the
taxpayer in Datatronic and that both the Datatronic and
Ngai Lik decisions are at odds with the board’s deci-
sion.
The court, in finding for the taxing authority, held
that the while the IRD determined that there was no
sale of the finished products by the subsidiary to the
taxpayer under the arrangement, the taxpayer’s cost of
acquiring the finished lighting products must still be
taken into account in arriving at the profits earned by
the taxpayer in the form of the sales to the taxpayer’s
customers. The court also determined that the board’s
finding that there was no contract of sale between the
taxpayer and the affiliate did not preclude a conclusion
that the subsidiary’s activities on the mainland could be
disregarded as incidental to the profit-making activities
in the case.
BY TAMU N. WRIGHT
䡺 Text of the decision can be found at http://
legalref.judiciary.gov.hk/lrs/common/ju/
judgment.jsp. Type ‘‘HCIA8/2009’’ into the search.
India
ITAT Says Mere Sale to Unrelated Party
Of Identical Product May Not Establish CUP
recent Mumbai International Tax Appellate Tribu-
A nal decision sided with an Indian member of the
Netherlands-based Akzo Nobel Group’s conten-
tion that the mere sale of an identical product to foreign
affiliates in Thailand and unrelated parties in Vietnam
is insufficient to use in applying the comparable uncon-
trolled price as the most appropriate method unless rea-
sonable adjustments for market and economic condi-
tions are made. [Intervet India Pvt. Ltd. v. ACIT, Mumbai
ITAT, ITA No. 2845/Mum/2006, decision filed 3/31/10]
In the March 31 decision, the tribunal remanded the
case to the Commissioner for Income Tax Appeals,
which had allowed Intervet India Private Ltd. to make
pricing adjustments to the transactions for volume,
credit risk, and credit periods that were higher than the
10 percent originally permitted by the transfer pricing
officer on audit, but lower than the 40 percent advo-
cated by the taxpayer.
Vispi T. Patel of Vispi T. Patel & Associates in Mum-
bai said that ‘‘the application of the CUP method for de-
termining the [arm’s-length price] hinges upon one of
its essential prerequisites that reasonably accurate ad-
justments are to be made to eliminate material factors
affecting price, cost, or the profit arising from such
transaction.’’
Pharmaceutical Products. The taxpayer, a subsidiary
of Intervet Holdings B.V. Netherlands, manufactured
and traded animal health and veterinary products, in-
cluding pharmaceutical products, feed additives, and
TMTR ISSN 1063-2069
IN THE COURTS
animal vaccines. Intervet India entered into transac-
tions involving importing and exporting raw materials
and finished goods, expense reimbursement, and inter-
nal audit services with foreign related parties.
The taxpayer used the transactional net margin
method (TNMM) as the most appropriate method to
benchmark the transactions. On audit, the TPO ob-
served that Intervet India had exported a total of five
products to both related and unrelated parties. For four
of the products, the prices charged to related and unre-
lated parties were similar. In the case of one product,
however, the price charged to the unrelated party was
US$3.66 per unit—$2.49 more per unit than the
US$1.17 charged to the affiliate.
The TPO asked Intervet India why the CUP method
should not be applied. Intervet India contended that if
CUP was applied, then adjustments are required for a
high volume of sales to the affiliate as compared with
the unrelated party, differences in the credit period,
credit risks, and adjustments for annual and future
business with the affiliate and related party. Therefore,
using the CUP method, Intervet India claimed a 40 per-
cent adjustment to the price.
The TPO concluded that Intervet’s adjustments in
light of voluminous sales to affiliates were too high and
determined that 10 percent was a more reasonable ad-
justment. The TPO also determined that a 12 percent
annual interest rate was reasonable, as compared with
the 18 percent sought by Intervet India. The TPO also
allowed a 5 percent credit risk adjustment.
However, the TPO rejected Intervet India’s claims on
an adjustment for annual and future business, saying it
was already covered within the volume adjustment.
Taking into account the adjustments for volume,
credit periods, and credit risk, the TPO found the trans-
actions were comparable on the grounds that:
s specific characteristics of the property transferred
in both cases were identical;
s functions performed, taking into account assets
employed and risks assumed by the respective parties
to the transactions, were the same except for the credit
risk;
s the delivery terms were the same in both cases;
s the payment terms differed, but the appropriate
adjustments were made; and
s the prevailing market conditions were similar be-
cause the affiliate was located in Thailand and the unre-
lated party was located in Vietnam, where incidences of
disease and retail drug prices are similar.
As a result, the TPO adjusted Intervet India’s export
prices to its affiliate upward by 2.7 million rupees
(US$57,735).
Commissioner of Income Tax (Appeals). On appeal, the
Commissioner of Income Tax (Appeals) partly allowed
Intervet’s appeal by permitting further adjustments to
the price for volume and the credit period.
Patel said Intervet India again appealed to the Mum-
bai ITAT on several grounds, saying all of the adjust-
ment factors were not taken into account in adopting
the CUP method and emphasizing the following differ-
ences in the Thailand and Vietnam markets:
s Thailand and Vietnam have completely different
market conditions, with Thailand dominated by the
poultry market and Vietnam dominated by the pork
market.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 107
s The Thailand market is larger than the Vietnam
market.
s Because of some defects, the vaccine was more
difficult to sell at a higher price in Thailand’s more de-
veloped, competitive market.
Patel pointed out that although the ITAT observed
CUP will form the basis of determining the arm’s-length
price for sales to an affiliate when an identical product
is sold to an unrelated party, one of the prerequisites is
that reasonably accurate adjustments be made to elimi-
nate material factors affecting price, cost, or the profit
arising from the transactions.
Patel said the ITAT determined that the TPO and
CIT(A) both ignored the disparate economic conditions
of Thailand and Vietnam, noting that mere geographic
proximity does not mean similar economic or market
conditions. Thus, the ITAT found adjustments for vol-
ume, credit period, and credit risk are not sufficient to
make the sale price to the affiliate in Thailand compa-
rable to the sale to an unrelated party in Vietnam and
remanded the case to the CIT(A).
BY TAMU N. WRIGHT
India
ITAT Says Employees Deputed to Indian Firm
Did Not Create Permanent Establishment
he Mumbai International Tax Appellate Tribunal
T
recently ruled that U.S.-based taxpayer Tekmark
Global Solutions LLC’s deputation of employees to
an unrelated party in India did not constitute a perma-
nent establishment under the U.S.-India tax treaty.
[DDIT-IT vs. Tekmark Global Solutions LLC, Mumbai ITAT, ITA
No 671/Mum/2007, decision filed 2/23/10]
The tribunal found that in that situation, no income
arose to Tekmark in the course of the deputation be-
cause the employees were under the control of Lucent
India, carried out the work as determined by Lucent In-
dia, and Tekmark was reimbursed by Lucent India for
the salary it paid to the deputed employees.
Pranay Bhatia of Economic Laws Practice in Mumbai
said the tribunal’s ruling placed principal emphasis on
the rule of ‘‘control and supervision’’ of the employees
deputed by the multinational corporation. If the multi-
national corporation does not exercise control or super-
vision over the activities of the deputed personnel, then
the personnel cannot be regarded as the employees of
the multinational corporation creating a service PE in
India, Bhatia said.
Deputation of Employees. U.S.-based Tekmark Global
Solutions LLC deputed personnel to Lucent Technolo-
gies Hindustan Private Ltd. in 2002-03 on a hire-out ba-
sis. The employees worked under the direction, super-
vision, and control of Lucent India. The taxpayer was
not held responsible for the work completed or any ac-
tions taken by the employees. However, the employees
remained on Tekmark’s payroll. Tekmark incurred
deputation costs, which it passed onto Lucent India.
The revenue authority determined that the income
directly accrued to Tekmark in India through its em-
ployees and hence 89.9 million rupees (US$1.9 million)
is taxable in India because Tekmark has a service PE
under the U.S.-India tax treaty. On Tekmark’s appeal to
BNA TAX 6-3-10
108 (Vol. 19, No. 3)
the Commissioner of Income Tax (Appeals), the CIT(A)
ruled that Tekmark did not have a PE in India and
therefore cannot be taxed.
The revenue authority appealed to the ITAT, con-
tending that the reimbursement for the deputation
should be characterized as business income and that
Tekmark has a PE under treaty Article 5.
Tekmark contended that it had no PE because it ren-
dered no services to Lucent India—it only deputed its
employees to the Indian firm at Lucent India’s request.
The firm also argued that because it followed the cash
system of accounting as allowed under Section 145 of
the Income Tax Act, it did not receive any payment for
the employees for 2002-03 and therefore has no taxable
income for that year. Tekmark also argued that even if
the income at issue is determined to be taxable in India,
it should be considered fees for technical services under
Section 9(1)(vii) of the Income Tax Act.
ITAT Ruling. The tribunal determined that the deputa-
tion cannot be considered technical services under the
treaty because Tekmark specifically offered the employ-
ees to work under the control and supervision of Lucent
India, and Tekmark was reimbursed for the salary paid
to the deputed employees.
The ITAT also found that the deputed employees are,
for all practical purposes, employees of Lucent India be-
cause Tekmark has no control over the activities or the
work to be performed by the deputed employees.
Therefore, the court determined, the employees cannot
be considered as constituting a PE of Tekmark.
The tribunal also noted that Tekmark received no
profit from deputing the employees, since they were
paid their normal salaries and the company was reim-
bursed only for those amounts.
BY TAMU N. WRIGHT
Attorney-Client Privilege
Denial of Certiorari in Textron Case Seen
Perpetuating Uncertainty Over Work Product
he U.S. Supreme Court announced May 24 that it
T will not review the ruling by the U.S. Court of Ap-
peals for the First Circuit against Textron Inc.,
leaving taxpayers to satisfy different standards in differ-
ent circuits over when tax accrual work papers are pro-
tected, according to practitioners. [Textron Inc. v. U.S.,
U.S., No. 09-750, cert. denied 5/24/10]
The high court’s rejection of the case lets stand the
First Circuit’s Aug. 13, 2009, ruling, which refused to
give work product protection to work papers the Inter-
nal Revenue Service sought in an administrative sum-
mons as part of an investigation into Textron’s alleged
use of an abusive tax shelter (18 Transfer Pricing Re-
port 394, 9/10/09).
In their briefs to the Supreme Court, Textron and the
government argued over whether the First Circuit’s de-
cision exacerbated the long-standing circuit split over
the scope of the work-product privilege. Textron con-
tended that there is a circuit conflict concerning the le-
gal standard for work-product protection. The govern-
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
IN THE COURTS
ment conceded there is a long-standing conflict over the
scope of the work-product privilege, but argued that the
Supreme Court need not review Textron because the
conflict does not extend to the types of documents at is-
sue in the case.
Tax Executives Institute Inc., which filed an amicus
brief in the Supreme Court case Jan. 26, argued three
different standards have been crafted and applied by
appeals courts on the question of whether documents
were prepared ‘‘in anticipation of litigation’’ and there-
fore are protected from disclosure. Eight circuits have
embraced a ‘‘because of’’ standard, protecting from dis-
closure documents prepared because of the prospect of
litigation. The U.S. Court of Appeals for the Fifth Cir-
cuit, meanwhile, employs a test that looks to whether
the ‘‘primary motivating purpose’’ for which the docu-
ment was prepared was to assist in litigation, and the
First Circuit ‘‘conjured up its own idiosyncratic stan-
dard that would permit the disclosure of documents ex-
cept where they were ‘prepared for use in possible liti-
gation,’ ’’ TEI said.
‘Muddled Area.’ Eli Dicker, chief tax counsel for TEI,
noted that his organization was one of 11 parties to file
an amicus brief in the Supreme Court case, reflecting ‘‘a
substantial body of taxpayers reaching out and asking
for clarity.’’ Now, he said, taxpayers ‘‘are left to con-
tinue to navigate a muddled area of the law.’’
Lawrence Hill of Dewey & LeBoeuf in New York,
while not necessarily agreeing that the diverging tests
for work product privilege constitute a split in the cir-
cuits, said the issue ‘‘is certainly a significant question
of federal law’’ and one the Supreme Court chose to
consider in U.S. v. Arthur Young & Co., 465 U.S. 805
(1984).
In that case, the court rejected a lower court’s find-
ing of accountant-client privilege and enforced IRS
third-party summonses for tax accrual work papers,
noting that the IRS recognized ‘‘the intrusiveness of de-
mands for the production of tax accrual workpapers.’’
Because of the Supreme Court’s refusal to consider
Textron, Hill said, ‘‘the issue of whether tax accrual
work papers are subject to discovery by the IRS re-
mains largely unsettled, as only the First and Fifth Cir-
cuits have weighed in on the issue.’’ Taxpayers, he said,
‘‘are left with differences in the Circuits as to what con-
stitutes materials prepared in ‘anticipation of litigation.’
Moreover, we are left with the peculiar ‘for use in litiga-
tion’ formulation that the First Circuit constructed, that
is clearly erroneous.’’
Alan Horowitz of Miller & Chevalier in Washington,
D.C., who served as counsel for Financial Executives In-
ternational on its amicus brief in support of Supreme
Court review, told BNA May 24 that it is fortunate that
other circuits have not adopted the First Circuit’s
‘‘novel’’ approach. He said Textron affects not only tax
accrual work papers, but other non-tax assessments
that are commonly made by business lawyers.
Dicker said TEI is ‘‘pretty disappointed that we’ll
have to wait for the next vehicle to come around so that
we can, hopefully, set the record straight and clarify
this area of the law.’’
BY J.P. FINET AND MOLLY MOSES
TMTR ISSN 1063-2069

Text
Transfer Pricing Discussion Group’s Comments on IRS Schedule UTP
[By Steven Hannes, McDermott, Will & Emery, 6/1/10]
Internal Revenue Service
CC:PA:LPD:PR (Announcement 2010-9)
Courier’s Desk
1111 Constitution Avenue, NW
Washington, DC 200
Re: Comments on Announcement 2010-9, Announcement
2010-30, Schedule UTP; Transfer Pricing
Dear Sir or Madam:
Introduction
On January 20, 2010, in Announcement 2010-9, the Ser-
vice stated that it is developing a schedule requiring busi-
ness taxpayers to report ‘‘uncertain tax positions’’ and
asked for interested taxpayers to submit comments on its
proposals. Announcement 2010-09 lists questions with re-
spect to which the IRS is particularly interested in com-
ments from taxpayers. On March 29, 2010, the Service
added questions for taxpayers and extended the comment
period by way of Announcement 2010-17. Next, the Service
published on April 19, 2010, in Announcement 2010-30, a
draft of the proposed schedule for reporting uncertain tax
positions (‘‘Schedule UTP’’) and a draft set of instructions
for the Schedule. The Service states that Schedule UTP
must be filed with returns for tax year 2010.
We are submitting this letter to discuss, on behalf of The
Transfer Pricing Discussion Group, the questions and is-
sues raised by the Service in Announcements 2010-9,
2010-19 and 2010-30 (collectively ‘‘the Announcements) as
they relate to uncertain tax positions taken under section
482 (‘‘transfer pricing’’) of the Internal Revenue Code of
1986, as amended (the ‘‘Code’’). The comments in this let-
ter are also relevant to uncertain tax positions taken under
other Code sections, such as section 367(d), that cross ref-
erence section 482 or use similar principles or rules.
The Group appreciates having the opportunity to present
its views on the Service’s proposals for reporting uncertain
tax positions. The Group’s suggestions and other com-
ments for transfer pricing are based on the collective expe-
rience and knowledge of its members. The Group’s mem-
bers are multinational corporations based in the United
States and in other countries. Participants in the Group un-
dertake a wide range of activities that are subject to the
rules of transfer pricing, including research and develop-
ment, licensing, manufacturing, distribution, marketing,
electronic commerce, and services. The industries repre-
sented in the Group include automotive, consumer nondu-
rable goods, chemicals, media, industrial equipment, news,
pharmaceuticals and technical information.
Among the Service’s proposals in the Announcements
that, in the view of the Group, would not apply well, or
would not work at all, in the context of transfer pricing po-
sitions are the following:
1. Ranking the taxpayer’s uncertain transfer pricing tax
positions based on either the amount recorded as a re-
serve for U.S. tax or the estimated adjustment to U.S.
tax that would result if the position taken in the tax re-
turn ‘‘is not sustained.’’ Although Announcement
2010-30 states that for transfer pricing the taxpayer is
not required to determine, or to disclose on Schedule
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 109
UTP, the otherwise applicable and problematic maxi-
mum tax adjustment (‘‘MTA’’), taxpayers may still
have to compute a similar and also problematic
amount for purposes of ranking uncertain pricing po-
sitions.
2. Providing a concise description of the transfer pricing
position ‘‘in sufficient detail so that the Service can de-
termine the nature of the issue.’’
The Service’s specific questions listed for taxpayers that
are among the most pertinent to transfer pricing are the
following:
s What alternative methods of disclosure of the amount
at issue would allow the Service to identify the relative
importance of uncertain tax positions.
s Whether the scope of Announcement 2010-9 should
be modified regarding the uncertain tax positions for
which information is required to be reported.
s Whether the list of information proposed to be in-
cluded should be modified, including whether certain
information should be requested in some circum-
stances during examinations rather than with the fil-
ing of the tax return.
This letter presents the comments of the Transfer Pricing
Discussion Group on the above matters as they relate to
transfer pricing. This letter does not address issues that
might arise under the Announcements for tax positions
generally for taxpayers; i.e., under Code sections other
than section 482 and related sections.1
The Group recognizes, however, that there are other ba-
sic problems with proposed Schedule UTP that are of
broad application, including the following:
s Schedule UTP would ask for information that is pro-
tected by the work product doctrine and other tax-
payer protections.
s Schedule UTP’s proposed approach may exceed the
Service’s current authority.
s In all events, Schedule UTP is contrary to the Service’s
announced policy of restraint in regard to requesting
tax accrual work papers and would otherwise conflict
with the sound administration of the tax laws.
The Group’s comments on Schedule UTP’s proposed
treatment of disclosures for transfer pricing should not be
interpreted to mean that the Group is not concerned with
such basic matters of general application. To the contrary,
in the Group’s view, if the Service is to proceed with any
measures requesting information about uncertain tax posi-
tions, then it should withdraw the currently proposed
Schedule UTP and determine if it can cure both the funda-
mental and general problems with Schedule UTP as well as
those that relate specifically to transfer pricing.
Among the Group’s specific suggestions for reporting
uncertain transfer pricing positions are the following.
1. A revised Schedule UTP should provide that a taxpay-
er’s reporting obligation is satisfied by responding to
the following questions:
1
Two separate letters sumitted by McDermott Will & Emery
comment on issues of general application under the Announce-
ments.
BNA TAX 6-3-10
110 (Vol. 19, No. 3)
(a) Has the taxpayer prepared documentation under
Code section 6662(e) for its transfer pricing on all
material transactions subject to section 482?
(b) Does the taxpayer’s tax return include Form 5471
or 5472, as the case may be?
(c) Is the taxpayer audited regularly on its transfer
pricing?
2. If there are other circumstances in which the Service
believes disclosure and/or ranking uncertain transfer
pricing positions is justified, then the Service should
provide clear guidance on the standards to be used.
For example, and as discussed below, the meaning of
the current reference to an uncertain transfer pricing
position that ‘‘is not sustained’’ is unclear.
3. Also, the Service should not require a taxpayer to cre-
ate new information, whether quantitative or other-
wise, for any such disclosure and/or ranking.
The consensus of the Group is that the Service could in-
crease its efficiency and effectiveness with respect to trans-
fer pricing examinations by:
1. spending more quality time on the information it al-
ready has concerning transfer pricing;
2. assuring during an audit that it receives any additional
factual information that it needs to analyze pricing;
3. improving the usefulness of information relevant to
Code section 6662(e) documentation; and
4. taking steps to assure that its Field examinations re-
sult in proposed adjustments that are more realistic
and supportable than has previously been the case.2
Taking these four steps will be far more effective than
creating additional requirements for tax return filings of in-
formation on uncertain transfer pricing positions.
Discussion
Background. In prepared remarks dated January 26,
2010, Commissioner Shulman introduced Announcement
2010-9. Among the stated reasons for requesting reporting
on uncertain tax positions were the following:
s The Service believes it would add efficiency to audits
if the Service had access to more complete informa-
tion earlier in the process regarding the nature and
materiality of a taxpayer’s uncertain tax positions.
The Service believes that the proposal will help
achieve the goals of cutting down the time it takes to
find issues and complete an audit.
s The Service is asking for a list of issues that the tax-
payer has already prepared for financial reporting
purposes. Taxpayers are already required to establish
tax reserves for uncertain tax positions in determining
their financial statement income. Thus, the taxpayer’s
work required to satisfy reporting for uncertain tax
positions has already been done. The Service is asking
only for more transparency.
s The ultimate goal of this reporting with respect to the
Service’s audit program is to bring taxpayers into
compliance and keep them there with strategies that
are less time and resource intensive than the Service’s
traditional audit process.
Requesting Transfer Pricing UTP Information is Unnec-
essary. In general, the Transfer Pricing Discussion Group
is of the view that the Service already requires taxpayers to
provide significant information about the nature and mate-
riality of their transfer pricing both at the time of the filing
of the return and, later, at the beginning of an examination.
Thus, the Service already has sufficient information allow-
ing it to judge materiality and to focus its resources effi-
ciently on those transfer pricing issues that warrant atten-
tion. This is particularly true for large taxpayers that the
Service audits regularly.
The Group notes that Announcement 2010-30 acknowl-
edges that proposed Schedule UTP may duplicate other re-
porting requirements in some circumstances. As is ex-
2
See the discussion beginning on page 16.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
plained further below, this appears to be true in the case of
transfer pricing. In fact, the appearance of transfer pricing
related questions on Schedule UTP and the responses tax-
payers provide to these questions could even reduce the ef-
ficiency of transfer pricing audits.
Taxpayers are also being asked to create new informa-
tion for Schedule UTP, such as the information needed to
rank their uncertain transfer pricing positions. For reasons
discussed below, this information is unlikely to increase
the efficiency of the Service in examining transfer pricing
items. Instead, the Group believes that there is a significant
chance that taxpayers’ responses to the UTP’s proposed
questions and request for a ranking will take time away
from the Service’s work in connection with the transfer
pricing information that taxpayers already provide to it.
Current Reporting Requirements on Transfer Pricing.
The Service already requires taxpayers to provide detailed
information on transfer pricing with the filing of the tax re-
turn. Form 5471, which applies to U.S. persons with re-
spect to certain foreign corporations, requires extensive re-
porting on transfer pricing matters. Schedule M of Form
5471 requires a U.S. person to report on 120 different cat-
egories of intercompany transactions with foreign affili-
ates. The form is designed to capture information on the
volume of intercompany transactions for all of the relevant
categories listed on the form.
It is widely understood by taxpayers that a principal pur-
pose for Form 5471 and Schedule M is to allow Field
agents to focus their transfer pricing audit initiatives based
on the type and volume of intercompany transactions tax-
payers report on Schedule M. In the case of foreign-owned
U.S. corporations and certain other foreign corporations,
the Service requires the filing of Form 5472. Part IV of
Form 5472 requires a reporting corporation to reveal the
quantum of intercompany transactions falling in 22 speci-
fied categories. Here again, it is widely understood that the
purpose of Part IV is to identify for Field agents intercom-
pany transactions for which transfer pricing is important.
Taxpayers also provide the Service with information an-
nually about their transfer pricing around the time they file
returns by way of annual reports required by advance pric-
ing agreements as well as by way of other disclosures with
the return such as that the taxpayer is using cost sharing.3
At the beginning of its audit of a corporate taxpayer, the
Service obtains additional information concerning transfer
pricing. A January 22, 2003 LMSB directive4 explains that
the Service will request written information from taxpay-
ers about their transfer pricing at the joint opening confer-
ence for each audit cycle. This request is for any transfer
pricing documentation that the taxpayer has prepared pur-
suant to Code section 6662(e). The directive even provides
the Field agents with the language to be used to request the
pricing documentation. The directive goes on to explain
that if a taxpayer has not prepared section 6662(e) docu-
mentation, than the Field is to issue a written information
document request ‘‘at the beginning of the audit’’ for rel-
evant information regarding the taxpayer’s transfer pricing
practices. The directive instructs the Field to refer the tax-
payer’s section 6662(e) documentation or other transfer
pricing information to an international examiner and/or
economist for risk assessment as soon as the taxpayer pro-
vides that information to the Service.
Other Service Techniques. The Service has also devel-
oped other means for making the Field efficient in its trans-
fer pricing examinations. For instance, in a March 21, 2008
memorandum for industry directors, the Service provides
guidance to the Field regarding specific transfer pricing is-
sues. In the case of the March 21, 2008 memorandum, the
focus is on providing ‘‘an appropriate level of examination
coverage’’ on cost sharing buy-ins. The Service has issued
3
Treas. Reg. § 1.482-7T(k)(4).
4
Last revised, March 1, 2006. See Internal Revenue Manual
(‘‘IRM’’) Exhibit 4.46.3-6—Transfer Pricing Compliance Processes.
TMTR ISSN 1063-2069
TEXT
other memoranda for the Field focusing them on other sec-
tion 482 issues and is likely to continue to do so.
For its part, the Internal Revenue Manual itself gives de-
tailed directions to the Field with respect to the conduct of
transfer pricing examinations. To start with, it lays out pre-
audit techniques, including a review of Forms 5471 and
5472.5 The IRM then goes on, over dozens of pages, to pro-
vide many other practical suggestions that should, if fol-
lowed, enable the Field to conduct efficient and productive
audits of transfer pricing.
In summary, the members of the Transfer Pricing Dis-
cussion Group believe that taxpayer responses on Forms
5471 and 5472 and the transfer pricing documentation de-
scribed in section 6662(e) already provide robust and ac-
cessible information regarding a taxpayer’s intercompany
transactions. It is the sense of the Group, moreover, that
with the guidance set forth in the 2003 LMSB Directive, the
IRM and other resources, the Field regularly utilizes this
taxpayer-provided information to conduct their transfer
pricing audits. While it must be acknowledged that evalu-
ating transfer pricing issues can be a time-consuming, fact-
intensive process that might be made more efficient, the
members of the Group doubt that the Service will achieve
any increased efficiency by requiring taxpayers to provide
it with information about their transfer pricing of the type
contemplated in the Announcements.
Unlike Most Uncertain Tax Positions, Transfer Pricing Is
Not ‘‘Binary’’. The Announcements are designed to apply
to uncertain tax positions under the Code broadly rather
than just to transfer pricing positions specifically. Let us as-
sume, for the sake of discussion, that reporting uncertain
tax positions and determining a maximum tax adjustment
or similar amount can be made to work satisfactorily if a
tax position is binary. That is, many tax positions are taken
under Code sections and regulations that involve inher-
ently legal questions for which an interpretation or answer
is either right or wrong (‘‘binary’’). In other words, in the
context of Code sections generally, the taxpayer may be
taking a legal position that in a court of law will either be
fully sustained or fully rejected.
In contrast, tax positions involving transfer pricing are
usually not solely issues of law, nor are they of a binary na-
ture. Tax positions involving transfer pricing are generally
inherently factual and require the exercise of judgment
and the use of factors beyond pure legal analysis including,
among others, financial, economic and industry expertise.
Thus, when a U.S. taxpayer sells a widget to its foreign af-
filiate there might be a range of correct answers under
Code section 482. For instance, the price for widgets may,
at arm’s length, range between $25 a unit and $30 a unit.
Alternatively, the selling corporation’s return on assets
might range, at arm’s length, from between 6 and 9 per-
cent, with a median of 7.5 percent, for its business of sell-
ing widgets to its foreign affiliate. Thus, it is difficult for the
Group to imagine the circumstances in which the typical
‘‘transfer pricing position’’ will ever, as a practical matter,
be ‘‘disallowed in its entirety on audit’’ (the maximum tax
adjustment standard), as might legal issues under other
Code sections, or will not be ‘‘sustained’’ (newly proposed
Schedule UTP standard) to some degree.
Using this example, and assuming a final judicial deter-
mination of an arm’s length range of between 8 and 10 per-
cent, was the taxpayer’s tax return ‘‘position’’ not ‘‘sus-
tained’’ because the taxpayer used 7.5 percent? The Group
would be interested in understanding what the Service be-
lieves the phrases uncertain tax ‘‘position’’ and ‘‘is not sus-
tained’’ mean in the context of transfer pricing. Does the
reference to ‘‘position’’ mean: (a) the taxpayer’s business
structure, contracts and other arrangements for setting
pricing on intra-group transactions (e.g., use of a low risk,
rather than entrepreneurial, distributor); (b) its choice of
comparables; (c) its selection of the transfer pricing
5 6
IRM 4.61.3.41.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 111
method; (d) its range of targeted financial results; or (e) the
single ultimate profit number (e.g., 7.5 percent) implicit in
the tax return? Even assuming that the Service intends the
term ‘‘position’’ to be interpreted very narrowly (i.e., the
7.5 percent), is the position ‘‘not sustained’’ to an extent, if
the arm’s length range of returns for the widget transac-
tions is ultimately determined (e.g., in court) to be 8 to 10
percent?
Triggering Reporting and Determining the Amount To
Be Reported for Transfer Pricing Under Schedule UTP. The
following paragraphs focus on two related topics under the
Announcements: (1) what triggers an obligation to report
an uncertain transfer pricing position; and (2) what the
taxpayer should report as the quantum of tax at stake for
an uncertain transfer pricing position. As to the first topic,
reporting is triggered under proposed Schedule UTP for an
uncertain transfer pricing position if, generally speaking:
1. The taxpayer has recorded a U.S. tax reserve for the
position; or
2. The taxpayer has not recorded a U.S. tax reserve that
otherwise would have been recorded for a position but
for the fact that:
(a) the probability of settlement is less than 50 percent
and the taxpayer expects to prevail in court; or
(b) the Service has a practice of not challenging the tax
position during an examination.
If transfer pricing reporting is triggered, then draft
Schedule UTP offers taxpayers a choice as to what they
should report relevant to the quantum of the tax exposure.
According to the instructions for Schedule UTP, the tax-
payer is instructed to rank its uncertain transfer pricing po-
sitions based on either:
1. the amount recorded as a reserve for U.S. federal in-
come tax; or
2. the estimated adjustment to U.S. federal income tax if
the tax position is not sustained.
According to the instructions for Schedule UTP, the
above two choices are in lieu of determining and reporting
the maximum tax adjustment as defined for Schedule UTP.
Also, the taxpayer need not report to the Service which of
the two ranking methods it chooses nor the reserve or ad-
justment amounts that support its rankings. In other
words, the quantum of exposure is indirectly addressed
through the rankings and the taxpayer need not disclose
any underlying amounts.
Schedule UTP Appropriately Rejects ‘‘MTA’’ for Pricing.
The approach reflected in Schedule UTP is intended to im-
prove upon the January 2010 general proposal of the Ser-
vice to determine and report the maximum tax adjustment
for transfer pricing and other matters. The MTA standard
in Announcement 2010-9, as it would have applied to trans-
fer pricing but for Announcement 2010-30 and Schedule
UTP, instructs the taxpayer not to take into account the
taxpayer’s ‘‘risk analysis regarding its likelihood of prevail-
ing on the merits.’’6 The MTA standard could mean that, in
determining the amount to be reported, the taxpayer
should use its evaluation of what the Field might propose
as an adjustment even though the taxpayer believes that at
Appeals the parties would agree to settle, based on their
understanding of the facts and law as well as the hazards
of litigation, for an amount substantially lower than what
the Field might propose or, alternatively, that the taxpayer
would prevail in court.
The Group supports the Service’s decision reflected in
Announcement 2010-30 and Schedule UTP not to ask tax-
payers to calculate maximum tax adjustment amounts to
determine the quantum of uncertain transfer pricing posi-
tions nor to report those amounts. The Service’s previously
proposed instructions to taxpayers not to account for pre-
vailing at Appeals or in court would have been trouble-
some. Among other things, this could have meant that the
calculated maximum adjustment would be based on prior
Announcement 2010-9, page 3.
BNA TAX 6-3-10
112 (Vol. 19, No. 3)
actual or predicted adjustments made by the Field. How-
ever, it is common that adjustments proposed by the Field
on transfer pricing are unrealistic (i.e., excessively large)
and, therefore, are not sustained.
IRS Appeals regularly rejects Field proposals on transfer
pricing. Public reports from the government on the subject
state that Appeals sustains only relatively small amounts,
as low as 17 percent and only as high as 34 percent, of the
Field’s proposed transfer pricing adjustments.7 For their
part, the courts have also regularly rejected the Service’s
proposed adjustments on transfer pricing, frequently in
their entirety8 and in other cases to a great extent.9
Given, in particular, that court cases rarely sustain the
Service’s proposed adjustments, the Group strongly en-
dorses the Service’s proposal in Schedule UTP that the tax-
payer not calculate or report the maximum tax adjustment
for uncertain transfer pricing positions. Proposed Schedule
UTP, in designing a special transfer pricing approach to
avoid the calculation or disclosure of maximum tax adjust-
ments, attempts to respond to the view of taxpayers that
Announcement 2010-9 is not suitable for reporting uncer-
tain transfer pricing positions.
Improving Schedule UTP’s Ranking Proposal. Unfortu-
nately, the specifics of the Service’s proposed accommoda-
tion do not go far enough to address the fundamental prob-
lems inherent in using Schedule UTP to report uncertain
transfer pricing positions. The proposed Schedule requests
rankings based on numbers that may not otherwise exist
and, if calculated for purposes of Schedule UTP, are fre-
quently not likely to be meaningful either to the taxpayer
or to the Service. In any case, in the experience of the
Group, taxpayers do not necessarily otherwise conduct
analyses or calculate numbers on the bases that Schedule
UTP proposes.
Announcement 2010-30 and the attached draft instruc-
tions for Schedule UTP explain that the taxpayer’s report-
ing obligation for uncertain transfer pricing positions is
satisfied by providing a ranking of any such tax positions
using one of two elective approaches. Whichever approach
7 no basis for recording a reserve. In these circumstances, on
For instance, the Service’s April 21, 1999, Report on the Ap-
plication and Administration of Section 482 states that the Field’s
sustension rates during 1994-1998, and for 1998, were only 27 per-
cent and 34 percent, respectively. A September 2003 report on Cur-
rent Trends in the Administrative and International Transfer Pric-
ing by the Internal Revenue Service (Reg. No.: 2003-30-174) pro-
vides additional sustension information. In fiscal year 2002,
Appeals tracked $899 million in recommended transfer pricing ad-
justments and determined that they had a sustension rate of only
17 percent; i.e., a rejection rate at Appeals of 83 percent. In a De-
cember 22, 2003 letter to Commissioner Everson, Senators Baucus
and Grassley asked the Service for additional information about
the Service’s sustension rates in section 482 cases during 1999-
2003. If it was provided, such information has not been made pub-
lic.
8
See, for example, Xilinx, in which the Ninth Circuit affirmed
the Tax Court and rejected entirely the Service’s proposal to re-
quire the taxpayer to take into account in cost sharing the cost of
stock-based compensation (06-74246, 06-74269, March 22, 2010,
aff’g 125 T.C. 37 (2009); Compaq Computer, in which the court re-
jected entirely the Service’s proposed adjustment to the prices of
components transferred between affiliates (T.C. Memo. 1999-220);
and Merck, in which the court rejected entirely proposed realloca-
tions of income for the benefits of being a member of a corporate
group (24 Cl. Ct. 73 1991)).
9
See, for example, Veritas, in which the court rejected entirely
the Service’s arguments for a $2.5 billion proposed adjustment that
the Service quickly reduced in court to $1.6 billion. Instead, the
court approved only relatively modest and focused changes to the
taxpayer’s approach that will likely generate only small amounts of
tax adjustments. (T.C ___ No. 14 (December 10, 2009)); and
Bausch & Lomb, in which the court rejected entirely the Service’s
attempt to recharacterize the taxpayer’s transactions as well as to
require a reallocation of income on sales of products, but allowed
some adjustment to the royalties charged (92 T.C. 525 (1989)), aff’d
933 F. 2d 1084 (2d Cir. 1991)).
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
the taxpayer chooses, it must use that approach consis-
tently for all uncertain transfer pricing positions.
Under the first proposed option, the taxpayer’s ranking
will be based on the amounts recorded as reserves for U.S.
federal income tax purposes for transfer pricing positions
taken in the tax return. Alternatively, the ranking will be
based on the ‘‘estimated adjustment’’ to U.S. federal in-
come tax that would result if the transfer pricing position
taken in the tax return ‘‘is not sustained.’’ The meaning of
the latter phrases is unclear for transfer pricing.
First of all, does the ‘‘estimated adjustment’’/’’is not sus-
tained’’ standard ask the taxpayer to prepare notional ad-
justment amounts that take into account or disregard what
it believes is likely to happen at Appeals or in court, or for
that matter even at the Field? Is this standard intended to
ignore the taxpayer’s belief that it will prevail in court, as
does the proposed recorded reserve alternative discussed
next? If so, then is the ‘‘estimated adjustment’’/’’is not sus-
tained’’ standard for transfer pricing really different from
the MTA standard that would apply to all Schedule UTP
items other than transfer pricing and valuations? If the Ser-
vice intends for there to be material differences between
the ‘‘estimated adjustment’’/’’is not sustained’’ and MTA
standards, then the Group recommends that the Service
explain the differences so that taxpayers can understand
and evaluate them.
If the ‘‘estimated adjustment’’/’’is not sustained’’ stan-
dard is even only similar in principle to the MTA standard,
then the new proposal may be just as seriously flawed as
its predecessor. See the discussion above of the difficulties
with the MTA standard. In brief, the proposed ‘‘estimated
adjustment’’/’’is not sustained’’ alternative does not clearly
resolve important problems inherent in the Service’s initial
proposal to ask taxpayers to determine and report their un-
certain transfer pricing positions using the MTA standard.
As to the proposed recorded reserve alternative, the
Group notes that reporting is triggered even if the taxpayer
expects to prevail in court and therefore does not have a
recorded reserve. In such a case, the taxpayer may believe
that it will prevail entirely or, if not, apparently there still is
what basis would the taxpayer determine an amount for
purposes of ranking this transfer pricing position on
Schedule UTP? For example, should the taxpayer assume
in estimating the quantum that Appeals will settle but will
not take into account hazards of litigation?
The Group observes that the recorded reserve alternative
may have been developed by the Service based on some in-
accurate assumptions. First of all, in the experience of both
the U.S.-based (outbound) and foreign based (inbound)
taxpayers in the Group, there may be surprisingly few cir-
cumstances in which there is an ‘‘amount recorded as a re-
serve for United States federal income tax’’ for a transfer
pricing position taken in the U.S. tax return. Financial au-
ditors have various positions with respect to reserves that
illustrate why such reserves may not exist. Set forth below
are three examples.
1. Some multinational groups calculate a reserve with re-
spect to a transfer pricing position involving an affili-
ate in a country that has a tax treaty with the United
States, after taking into account the amount of correla-
tive relief that is likely to be provided in that other
country and that will reduce the Group’s total tax li-
ability. In other words, the reserve may be based on
calculations made on a consolidated, net basis of the
two companies rather than just on the ‘‘United States
federal income tax for that tax position. . . ..’’
2. Other corporations prepare reserves by assigning ad-
justments to transfer pricing across a multi-affiliate
supply chain group in one ‘‘more likely than not’’ out-
come. If the recorded reserve alternative proposed for
Schedule UTP entails reporting a U.S.-only amount for
a position, then such a multinational would not have
an amount to report.
TMTR ISSN 1063-2069
TEXT
3. As another example, a taxpayer may record one re-
serve for all transfer pricing transactions of a particu-
lar type, such as for royalties paid or received on all
intercompany licenses between two affiliates. In such
a case there is no tax reserve recorded just for the U.S.
federal income tax. Also, the taxpayer’s actual reserve
amount is not for a license and associated royalty and
therefore presumably is not for a position as the Ser-
vice contemplates for Schedule UTP. On the other
hand, the taxpayer’s transfer pricing documentation is
done license-by-license. Thus, currently proposed
Schedule UTP asks for a U.S. tax reserve amount that
does not exist and the taxpayer’s recorded overall tax
reserve for reporting on licenses between the affiliates
is not helpful. Furthermore, the recorded reserve does
not match the taxpayer’s license-by-license documen-
tation under Code section 6662(e), which should be
helpful. In these circumstances, if the Service relies on
the taxpayer’s responses to request the relevant docu-
mentation, then it will receive the same set of docu-
mentation, studies or analyses that it gets today. How-
ever, both the taxpayer and the Service will expend
more time and effort than they do currently without
obtaining additional benefits.
It should be noted that taxpayers interested in avoiding
the complexity and work burden of determining and re-
porting on uncertain transfer pricing positions may find
the recorded reserve alternative attractive as it may require
disclosing and ranking only a few uncertain transfer pric-
ing positions for which there is a U.S. income tax reserve,
rather than a multi-jurisdiction, aggregated, or otherwise
netted income tax reserve.
Finally, and as illustrated above, financial auditors take
different approaches to determining transfer pricing re-
serves depending upon various factors relevant to the tax-
payer or the trade flow. Thus, there will not be consistent
reporting under the recorded reserve alternative even for
similarly situated taxpayers.
Concise Description of Tax Positions. Proposed Sched-
ule UTP asks the taxpayer to provide ‘‘a concise descrip-
tion of the tax positions, including information that reason-
ably can be expected to apprise the IRS of the identity of
the tax positions and the nature of the uncertainty. The de-
scription must include . . . the rationale for the position and
the reasons for determining the position uncertain. In most
cases, the description should not exceed a few sentences.’’
Given the nature of transfer pricing and of the Service’s
proposed requests, the Group questions whether taxpayer
responses can be helpful to the Service. As mentioned, the
uncertainty of transfer pricing issues is not usually due to
significant binary legal interpretations. Uncertainty in
transfer pricing typically arises in part because of the fac-
tual, subjective and judgmental elements involved and the
roles of disciplines other than law (such as finance and
economics) that have their own inherent uncertainties and
for which various positions may be correct. Thus, there is
rarely, if ever, only one correct price or analytical answer
to the transfer pricing of typical intercompany transac-
tions. Rather, it is common for there to be more than one
correct pricing analysis with a range of numerical answers.
Because of this, almost all transfer pricing positions might,
in a sense, be considered ‘‘uncertain.’’
In such circumstances, what can the taxpayer meaning-
fully say in response to the Service’s request for concise
descriptions proposed in Schedule UTP about its U.S. in-
come tax exposures on transfer pricing positions, beyond
what it has already said in Forms 5471 and 5472 and in its
Code section 6662(e) documentation? How is the taxpayer
to respond, in the case of transfer pricing, to Schedule
UTP’s request for ‘‘the rationale for the position and the
reasons for determining the position is uncertain’’ when
the issue is not a binary legal issue but rather one that in-
cludes consideration of financial, economic and industry
factors and requires judgment calls? Is it sufficient to state
that the ‘‘position’’ (to be clarified by the Service) ‘‘involves
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 113
financial, economic and industry inputs, and legal judg-
ment calls, that are inherent in arriving at a range of arm’s
length results under Code section 482’’? The Group recom-
mends that the Service include, in the instructions to
Schedule UTP, examples of satisfactory concise descrip-
tions of uncertain transfer pricing positions and any other
transfer pricing disclosures that the Service would require.
Will Schedule UTP Increase IRS Efficiency? Although
Announcement 2010-09 and the Commissioner’s accompa-
nying remarks state that the Service’s uncertain tax posi-
tion proposal would cut down on the time it takes the Ser-
vice to find issues and to complete an audit, this is not
likely the case with respect to transfer pricing positions. As
mentioned, transfer pricing issues are already identified
with the tax return through Forms 5471 and 5472, as well
as the information handed to the IRS in response to what
is typically international information document requests
(‘‘IDR’’) ‘‘number one’’. In this IDR the Service requests,
and the taxpayer then provides, the taxpayer’s transfer
pricing documentation or other transfer pricing informa-
tion. In this audit environment, how can the Service not ef-
ficiently find the transfer pricing issues of interest? Simi-
larly, and although the Commissioner claims that the pro-
posal will help the Service prioritize issues and taxpayers,
the fact is that in the audit of a typical multinational, the
Service quickly identifies transfer pricing issues and they
usually become the first topic in the examination.
Conclusion
The Group believes the Service would be well served to
take a different approach for transfer pricing in Schedule
UTP if the Service is able to address the more fundamental
problems of its general application mentioned in the intro-
duction of this letter. Instead of routinely requiring taxpay-
ers with uncertain transfer pricing positions to provide in-
formation on intercompany transactions that is either re-
dundant or new but of questionable utility, a revised
Schedule UTP should first excuse taxpayers that are au-
dited regularly from disclosing (again) uncertain transfer
pricing positions. The Service could also ask a taxpayer in
Schedule UTP if its tax return includes Form 5471 or 5472,
as the case may be, and if it has prepared documentation
under Code section 6662(e) for its transfer pricing on all of
its material intra-group transactions. If the answer is ‘‘no’’
then the Service has efficiently identified a taxpayer and
transactions for whom transfer pricing audit time and re-
sources may be beneficial. Also, as this suggested ap-
proach does not involve any ranking or determination of
tax adjustment amounts, it will be less confusing for the
Service as well as less burdensome on taxpayers than what
Schedule UTP currently proposes.
As already mentioned, the Service could increase its effi-
ciency and effectiveness with respect to transfer pricing ex-
aminations by:
1. spending more quality time on the information con-
cerning transfer pricing that it already has;
2. assuring during an audit that it receives any additional
factual information that it needs to analyze pricing;
3. improving the usefulness of information provided by
taxpayers for purposes of complying with Code sec-
tion 6662(e) documentation; and
4. taking steps to assure that its Field examinations re-
sult in proposed adjustments that are more realistic
and supportable than many times has been the case.
These proposed steps, which the Group can discuss fur-
ther with you, will be far more effective than creating addi-
tional requirements for tax return filings of information on
uncertain transfer pricing.
While Commissioner Schulman stated that the Service is
only asking for a list of issues that the taxpayer has already
prepared for financial reporting purposes, the Group hopes
that this letter explains clearly that the Service is request-
ing more than that from taxpayers, at least with regard to
transfer pricing. The Group respectfully suggests in that
regard that it is important for the Service to more specifi-
BNA TAX 6-3-10
114 (Vol. 19, No. 3)
cally address issues covered by the Paperwork Reduction
Act. The Service should further evaluate, and discuss with
taxpayers, the paperwork burdens its proposals would
place on taxpayers with respect to transfer pricing and
more generally, as well as how the proposals should be
changed to reduce these burdens.
Please contact the undersigned if you have any com-
ments or questions about the views of the Transfer Pricing
Application of Australian Transfer Pricing Provisions to Business Restructurings
[Draft Taxation Ruling 2010/D2 by Australian Taxation Office, Issued 6/2/10]
Income tax: application of the transfer pricing provisions
to business restructuring by multinational enterprises
This publication provides you with the following level of
protection:
This publication is a draft for public comment. It repre-
sents the Commissioner’s preliminary view about the way
in which a relevant taxation provision applies, or would ap-
ply to entities generally or to a class of entities in relation
to a particular scheme or a class of schemes.
You can rely on this publication (excluding appendixes)
to provide you with protection from interest and penalties
in the following way. If a statement turns out to be incor-
rect and you underpay your tax as a result, you will not
have to pay a penalty. Nor will you have to pay interest on
the underpayment provided you reasonably relied on the
publication in good faith. However, even if you don’t have
to pay a penalty or interest, you will have to pay the cor-
rect amount of tax provided the time limits under the law
allow it.
What this Ruling is about
1. This draft Ruling set outs the Commissioner’s views on
the application of Australia’s transfer pricing provisions in
Division 13 of Part III (Division 13) of the Income Tax As-
sessment Act 1936 (ITAA 1936)1 and the Associated Enter-
prises Article of Australia’s tax treaties (treaty Article 9) of
the International Agreements Act 1953 (Agreements Act)
to business restructuring arrangements.
2. For the purposes of this draft Ruling, ‘business re-
structuring’ refers to arrangements of multinational enter-
prises (MNEs) by which functions, assets and/or risks of a
business are transferred between jurisdictions.
3. This draft Ruling considers situations where such
transfers occur between MNE members to implement
changes in the MNE’s existing business arrangements or
operations. Common examples are product supply chain
restructurings involving conversion of a distributor into a
sales agency arrangement or of a manufacturer into a pro-
vider of manufacturing services. Business restructurings
also commonly involve the transfer of the ownership and
management of intangibles such as patents, trademarks
and brand names.
4. This draft Ruling does not address permanent estab-
lishment issues arising from business restructuring. The
Australian Taxation Office (ATO) has previously issued
guidance on the attribution of profit to a dependent agent
permanent establishment.2 This guidance is illustrated by
reference to examples of arrangements that are relevant to
business restructuring.
1
All subsequent legislative references in this draft Ruling are to
the ITAA 1936 unless indicated otherwise.
2 4
Attributing profits to a dependent agent permanent establish-
ment (September 2005) available on the ATO’s website www.ato-
.gov.au.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
Discussion Group concerning the Service’s proposals for
taxpayers to report uncertain transfer pricing positions.
Very truly yours,
/s/
Steven P. Hannes
5. This draft Ruling only addresses the application of the
transfer pricing provisions. It does not address the applica-
tion of other provisions in the Australian tax law that may
be relevant in the facts and circumstances of a particular
business restructuring arrangement. For instance, the capi-
tal gains tax provisions may be relevant where a taxpayer
disposes of an asset under a business restructuring ar-
rangement, or the Controlled Foreign Company (CFC) pro-
visions3 may be relevant in determining attributable in-
come of a taxpayer where a CFC is a party to a business re-
structuring.
6. In addition, this draft Ruling does not address the ap-
plication of the general anti-avoidance provisions.4
7. Where the Commissioner applies Division 13 to deter-
mine the arm’s length consideration, this deemed consid-
eration applies for all purposes of the Australian income
tax law in relation to the taxpayer.5 It is a matter for the
operative provisions of that law as to whether, and if so
how and when, the arm’s length consideration deemed un-
der Division 13 is brought into calculating a taxpayer’s tax-
able income. This draft Ruling does not address this mat-
ter. For instance, the deemed consideration may be rel-
evant to the amount assessable on the disposal of a capital
asset, the amount assessable or deductible in respect of the
disposal or acquisition of trading stock, or the amount as-
sessable on the termination of a contract.
Ruling
8. Division 13 permits adjustment where the consider-
ation for a supply or acquisition of property by a taxpayer
under an international agreement in respect of a business
restructuring is not an arm’s length amount. The arm’s
length consideration for a supply or acquisition of property
is that which might reasonably be expected under an
agreement between independent parties dealing at arm’s
length with each other in relation to the supply or acquisi-
tion.
9. Treaty Article 9 permits adjustment to a taxpayer’s
profits where the conditions of the taxpayer’s commercial
or financial relations with an associated enterprise in re-
spect of a business restructuring differ from those which
would be made between independent enterprises dealing
wholly independently with each other and this results in
profits not accruing to the taxpayer that would otherwise
have accrued.
10. Division 13 and treaty Article 9 are both based on the
arm’s length principle, so there should be no fundamental
inconsistency in the outcomes under the two sets of provi-
sions.6 Like Division 13, the practical application of treaty
Article 9 involves a comparison of the pricing of a transac-
tion or arrangement between associated enterprises in
implementing a business restructuring and the pricing of a
3
Part X.
Part IVA.
5
Refer to paragraphs 179 to 181 of Taxation Ruling TR 94/14.
6
Paragraph 186 of TR 94/14.
TMTR ISSN 1063-2069
TEXT
similar transaction or arrangement between independent
enterprises dealing at arm’s length in similar circum-
stances.7
11. Accordingly, the ATO approach is to adopt the same
process in applying Division 13 and treaty Article 9 to a
business restructuring.
12. Where a particular transaction is part of a broader
agreement in respect of a business restructuring, determin-
ing the arm’s length consideration for that transaction re-
quires that all of the circumstances relevant to the agree-
ment are taken into account in evaluating comparability
with the consideration that might reasonably be expected
under an agreement between independent parties dealing
at arm’s length.
13. Where possible and practicable, the arm’s length con-
sideration is determined by applying the most appropriate
arm’s length pricing method8 using available reliable data
relating to an agreement between independent parties
dealing at arm’s length for a comparable transaction in
comparable circumstances.
14. Where there are insufficient such reliable uncon-
trolled comparables data, the consideration that might rea-
sonably be expected under an agreement between inde-
pendent parties dealing at arm’s length in comparable cir-
cumstances can be determined by considering the
following indicia of arm’s length behaviour and outcomes
that might reasonably be expected to shape such an agree-
ment:
(a) an arm’s length outcome is one that makes business
sense in the circumstances of the particular tax-
payer;9
(b) an independent party dealing at arm’s length would
seek to protect its own economic interest;10
(c) an independent party dealing at arm’s length would
compare the options realistically available and seek
to maximise the overall value derived from its eco-
nomic resources;11
(d) one option might be not to enter into a transaction
because it does not make commercial sense for the
particular taxpayer.12
15. This enables a comparison, in the absence of suffi-
cient reliable uncontrolled comparables data, between the
consideration under the agreement in respect of a business
restructuring and the consideration that might reasonably
be expected under an agreement between independent
parties dealing at arm’s length. Based upon these indicia,
such consideration is predicated as that which makes com-
mercial sense for the parties, having regard to what is in
their best economic interests and the options realistically
available to them at arm’s length.
16. Where it is concluded from an examination of all rel-
evant matters that the consideration for a transaction un-
der the agreement in respect of a business restructuring is
comparable with that which might reasonably be expected
to be agreed between independent parties dealing at arm’s
length, then that consideration is regarded as satisfying the
arm’s length principle under the transfer pricing provi-
sions.
17. In most cases comparability with what might reason-
ably be expected to be agreed between independent parties
dealing at arm’s length should be achievable by adjusting
the consideration payable or receivable by the taxpayer
based upon the business restructuring arrangement as
agreed by the associated enterprises.
18. In the exceptional case where it is not possible or
practicable to achieve an arm’s length outcome in this way,
7
See paragraphs 2.4 and 2.5 of the OECD Guidelines.
8 13
Taxation Ruling TR 97/20 provides guidance on arm’s length
pricing methods.
9 15
Paragraphs 1.1 and 2.15 of TR 97/20.
10
Paragraphs 2.6 and 2.11 of TR 97/20.
11
Paragraph 2.4 of TR 97/20
12
Paragraph 2.17 of TR 97/20.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 115
the ATO considers that it may apply the transfer pricing
provisions to adjust the consideration receivable or pay-
able by the taxpayer by reference to an agreement that
might reasonably be expected between independent par-
ties dealing at arm’s length in comparable circumstances.
19. The following process provides a useful basis for set-
ting or reviewing transfer pricing for international dealings
between associated enterprises in respect of a business re-
structuring arrangement:
Step 1: Characterise the international dealings
between the associated enterprises in the context of
the taxpayer’s business13
s Identify the scope, type and value of the international
dealings with associated enterprises involved in the
business restructuring.
s Perform functional analyses of the pre and post-
restructuring business activities affected by the busi-
ness restructuring.
s Refer to any relevant contracts, including those en-
tered into to implement the business restructuring (for
example, contracts for the sale of property) and those
evidencing the terms of the pre and post-restructuring
arrangements for the business activities affected by
the restructuring.
s Examine whether the contractual terms accord with
the outcomes of the functional analyses and deter-
mine the true nature, terms and effects of the business
restructuring.
Step 2: Select the most appropriate transfer pricing
methodology or methodologies14
s Identify the available data that may establish an arm’s
length consideration for each of the dealings involved
in the business restructuring and for the dealings in
their entirety:
– obtain any available data as to arrangements be-
tween independent parties dealing at arm’s length in
comparable circumstances;15
– depending upon the extent of such comparables data,
obtain any other available data relevant to determin-
ing whether the pricing of the business restructuring
makes commercial sense for the parties, having re-
gard to what is in their best economic interests and
the options realistically available to them at arm’s
length.16
s Determine the most appropriate arm’s length pricing
methodology or methodologies based on the facts and
circumstances of the particular case.
Step 3: Apply the most appropriate method and
determine an arm’s length outcome17
s Determine the consideration that might reasonably be
expected under an agreement between independent
parties dealing at arm’s length in comparable circum-
stances.18
s Perform a comparability analysis using any available
data as to arrangements between independent parties
dealing at arm’s length in comparable circumstances.
s If this analysis is sufficiently reliable, use the out-
comes to apply the most appropriate arm’s length
pricing method(s) to determine the amount(s) of arm’s
length consideration receivable or payable by the tax-
payer in connection with the business restructuring.
s If not, then use the functional and comparability
analyses and any other relevant available data to ex-
amine whether the pricing of the business restructur-
Paragraphs 48 to 67 of this draft Ruling.
14
Paragraphs 68 to 106 of this draft Ruling.
Paragraphs 71 to 75 of this draft Ruling.
16
Paragraphs 76 to 106 of this draft Ruling.
17
Paragraphs 107 to 143 of this draft Ruling.
18
Paragraphs 110 to 134 of this draft Ruling.
BNA TAX 6-3-10
116 (Vol. 19, No. 3)
ing makes commercial sense for the parties, having re-
gard to what is in their best economic interests and the
options realistically available to them at arm’s length.
s If the pricing of the business restructuring arrange-
ment is considered to make commercial sense using
this analysis, then this determines the amounts of
arm’s length consideration receivable or payable by
the taxpayer under that arrangement.
s If the examination of these matters shows that the
pricing of the business restructuring arrangement
does not make commercial sense, then seek to achieve
an arm’s length outcome by a pricing adjustment by
reference to the arrangement as entered into by the
parties.
s If it is not possible or practicable to achieve an arm’s
length outcome in this way, then determine arm’s
length pricing using an arrangement that might rea-
sonably be expected to exist between independent
parties dealing at arm’s length in comparable circum-
stances.19
s If, for instance, the analysis in Step 3 leads the Com-
missioner to conclude that independent parties deal-
ing at arm’s length in comparable circumstances
would not be expected to have entered into the busi-
ness restructuring arrangement as actually agreed,
then the Commissioner may apply the transfer pricing
provisions to adjust the consideration receivable or
payable by the taxpayer by reference to the agreement
that might reasonably be expected between indepen-
dent parties dealing at arm’s length in comparable cir-
cumstances.
20. This process is an application of the 4-step process
for testing the arm’s length nature of international transfer
prices as set out in Chapter 5 of Taxation Ruling TR 98/
11.20 The guidance in this draft Ruling is intended as a sug-
gested basis for undertaking the process described in TR
98/11 in a business restructuring context. It is not intended
to require any work beyond that needed to adopt the pro-
cess in TR 98/11 in developing and documenting a reliable
arm’s length outcome for a dealing under a business re-
structuring arrangement. The processes set out in TR 98/11
and in this draft Ruling are neither mandatory nor pre-
scriptive and, importantly, need to be tailored to the facts
of the taxpayer’s case. As discussed in TR 98/11, the nature
and extent of the process and of the functional and compa-
rability analyses needed in a particular case will depend
upon the facts and circumstances, including the complex-
ity of the dealings and arrangements and the availability of
reliable independent comparables data.
21. The OECD is currently developing guidance on the
application to business restructuring of its Transfer Pricing
Guidelines for Multinational Enterprises and Tax Adminis-
trations (the OECD Guidelines). These guidelines are rel-
evant to treaty Article 9 of the OECD Model Tax Conven-
tion, and therefore to the Associated Enterprises Articles of
Australia’s tax treaties. The ATO has regard to the OECD
Guidelines in applying the arm’s length principle under
both Division 13 and treaty Article 9.21 The ATO will follow
the OECD guidance on business restructuring, once fi-
nalised and publicly released, except to the extent that it
conflicts with the final Ruling.
Date of effect
22. When the final Ruling is issued, it is proposed to ap-
ply both before and after its date of issue. However, the
Ruling will not apply to taxpayers to the extent that it con-
flicts with the terms of settlement of a dispute agreed to be-
19
Paragraphs 135 to 143 of this draft Ruling.
20
Step 4 of the process in TR 98/11, which involves ongoing re-
view and adjustment for material changes, is not addressed in this
draft Ruling given the one-off nature of dealings implementing a
business restructuring.
21
Paragraphs 7 and 1.13 of TR 97/20.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
fore the date of issue of the Ruling (see paragraphs 75 to
77 of Taxation Ruling TR 2006/10).
Commissioner of Taxation
2 June 2010
Appendix 1 – Case study
0 This Appendix is provided as information to help
you understand how the Commissioner’s preliminary
view has been reached. It does not form part of
the proposed binding public ruling.
23. The following case study illustrates the application of
the approach to business restructuring discussed in this
draft Ruling. The comments on the case study summarise
the indicative issues and questions that the scenario might
raise in addressing the application of the arm’s length prin-
ciple to the particular business restructuring arrange-
ment.22
Facts
24. SubCo is a taxpayer that operates a product manufac-
turing plant in Australia. SubCo has the following rights
and responsibilities under its existing business arrange-
ments:
(a) SubCo is responsible for arranging purchase of all
raw materials.
(b) SubCo has sole ownership interest and risk in all raw
materials, work-in-process and finished goods inven-
tories.
(c) SubCo owns or licenses all intangible property rights
(for example, patents, trademarks, etc.) in respect of
the products.
(d) SubCo controls what is produced, when, and in what
quantity.
(e) SubCo sells the products to associated distributors.
25. SubCo has a history of good profitability over its 20
years of operation; its profit levels have been relatively
stable over most of this period, although they have been
gradually declining over recent years.
26. The MNE of which SubCo is a member decides to re-
structure the group’s product manufacturing activity by
centralising its management and control in a regional
headquarters located outside Australia operated by an-
other group member (ForCo). The MNE asserts that its
commercial rationale for this decision is to achieve ex-
pected cost savings and efficiency gains for the group.
Arrangement
27. Implementing this decision involves the following:
(1) SubCo enters into a toll manufacturing agreement
with ForCo. This arrangement has the following fea-
tures:
s ForCo has sole ownership interest and risk in all
raw materials, work-in-process and finished goods
inventories;
s ForCo controls what is produced, when, and in what
quantity;
s ForCo has the right to dictate design specifications
for the product;
s ForCo has ultimate control over product quality;
and
s SubCo is paid a processing fee for its manufacturing
services. The fee is calculated on a ‘cost plus 10%’
basis. SubCo has no interest or risk in respect of the
profits or losses from sale of the products, and no
role in the sale of the products,
(2) SubCo transfers to ForCo all intangible property
rights (for example, patents, trademarks, etc.) that
22
The comments only address the application of Division 13
and treaty Article 9, and do not address any permanent establish-
ment issues or other tax issues that may arise from the facts as pre-
sented.
TMTR ISSN 1063-2069
TEXT
SubCo owns in respect of the products. All agree-
ments under which SubCo has rights as licensee in
respect of product intangibles are terminated as part
of an arrangement whereby ForCo will enter into
similar licensing agreements with the owners of these
intangibles. SubCo continues to use these rights on a
royalty-free basis as a toll manufacturer for ForCo;
(3) SubCo’s distribution agreements with associated en-
tities are terminated as part of an arrangement with
ForCo whereby it will enter into similar agreements
with these entities;
(4) SubCo agrees to transfer to ForCo a number of per-
sonnel with the skills and know-how needed to man-
age the particular product manufacturing activity.
Step 1: Characterise the international dealings
between the associated enterprises in the context of
the taxpayer’s business
28. The following types of questions are relevant:
s What are the true nature, terms and effect of the busi-
ness restructuring arrangement and SubCo’s interna-
tional dealings with associated enterprises (for ex-
ample, ForCo) under that arrangement?
s What are the business strategies behind the business
restructuring, including the expected benefits?
– For the MNE, what is the nature of the benefits and
what are they worth?
– How is the business restructuring arrangement, in its
agreed terms and form, needed to obtain these ex-
pected benefits?
– How do ForCo and SubCo contribute to producing
these benefits?
– What are the expected benefits for ForCo and
SubCo?
s Do the functional analyses of the business before and
after the business restructuring accord with the
changes and differences in the terms of the contrac-
tual arrangements?
– If so, then the contractual terms are used for pur-
poses of Step 2.
– If not, then the true nature, terms and effect of the
business restructuring must be determined from the
functional analyses and are used for purposes of Step
2.
29. Where the conduct of the parties does not reflect
their written agreements (for example, employees of
SubCo continue to manage production schedules, develop
quality and design specifications and manage the relation-
ships with the distribution entities in practice, rather than
under direction from ForCo), then the actual arrangement
between the parties must be determined. This then forms
the basis for Step 2.
Step 2: Select the most appropriate transfer pricing
methodology or methodologies23
30. The following question should be addressed:
s Are comparables data available evidencing similar
business restructuring arrangements entered into be-
tween independent parties dealing at arm’s length in
comparable circumstances?
31. Relevant data would include:
(i) similar uncontrolled arrangements involving busi-
ness restructuring by a manufacturer to a toll manu-
facturer;
(ii) similar uncontrolled transfers of patent and trade-
mark rights;
(iii) the terms governing termination of uncontrolled li-
censing and distribution agreements similar to the
pre-restructuring controlled agreements;
23
Note: the questions and comments in paragraphs 30 to 42 of
this draft Ruling are premised upon Step 1 establishing that the
contracts reflect the true nature, terms and effect of the business
restructuring.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 117
(iv) uncontrolled toll manufacturing arrangements simi-
lar to the post-restructuring controlled arrange-
ments.
32. Depending upon the extent of such comparables
data, any other available data should be obtained that are
relevant to determining whether the pricing of the business
restructuring makes commercial sense for SubCo and
ForCo, having regard to what is in their best economic in-
terests and the options realistically available to them at
arm’s length.
33. Using all of the above data, the most appropriate
arm’s length pricing methodology or methodologies based
upon the particular facts and circumstances should be de-
termined.
Step 3: Apply the most appropriate method and
determine an arm’s length outcome
34. The following question should be addressed:
s What consideration might be expected under an
agreement between independent parties dealing at
arm’s length in comparable circumstances?
For example:
– Is there a transfer of property from SubCo to ForCo?
If there is a transfer of property (for example, patent
and trademark intangibles), and if an independent
party might reasonably be expected to pay for it or to
obtain consideration for supplying it, then an arm’s
length consideration would be expected between
SubCo and ForCo.
– Is there a supply of a benefit from SubCo to ForCo?
– Did SubCo surrender its rights under its licensing
and/or distribution agreements or employment con-
tracts of its personnel for the benefit of ForCo?
As an independent party, would SubCo have realisti-
cally had the option of continuing those arrange-
ments?
If so, would this have been more beneficial to it than
termination of the arrangements given the terms of
the business restructuring?
– Is any such benefit something that ForCo as an inde-
pendent party would be expected to pay for and
SubCo as an independent party would be expected to
obtain consideration for supplying?
– Would ForCo as an independent party have other op-
tions realistically available to it that might obviate the
need to pay SubCo for any such benefit? (for ex-
ample, entry into similar licensing, distribution and
toll manufacturing arrangements without the need
for SubCo’s agreement, assistance or co-operation)
– Does SubCo expect to derive benefits from the busi-
ness restructuring that would explain why it would
make commercial sense for it to surrender its rights
under its existing arrangements without additional
consideration?
– If an identifiable benefit has been supplied by SubCo
to ForCo, and if an independent party might reason-
ably be expected to pay for it or to obtain consider-
ation for supplying it, then an arm’s length consider-
ation would be expected between SubCo and ForCo.
– Does SubCo have any right to compensation for ter-
mination of its existing arrangements?
– Did SubCo have its licensing and/or distribution
agreements terminated by the other parties to those
agreements, and if so would this give a right to com-
pensation as between independent parties?
– Is the consideration payable and receivable under the
post-restructuring (toll manufacturing) arrange-
ments arm’s length?
– Is cost plus 10% an arm’s length basis for remunerat-
ing the manufacturing activity performed by SubCo?
35. Comparability analyses should be performed using
any available data as to similar arrangements between in-
dependent parties dealing at arm’s length in comparable
circumstances.
BNA TAX 6-3-10
118 (Vol. 19, No. 3)
36. If these analyses are sufficiently reliable to determine
whether the pricing of the business restructuring accords
with what would be expected under an agreement between
independent parties dealing at arm’s length, then the out-
comes would be used to apply the most appropriate arm’s
length pricing method(s) to determine the amounts of
arm’s length consideration receivable or payable by SubCo
in connection with the business restructuring.
37. If the analyses are not sufficiently reliable in this re-
gard, then the following question is relevant:
s Does the pricing of the business restructuring make
commercial sense for SubCo and ForCo, having re-
gard to what is in their best economic interests and
given any other options realistically available to them
at arm’s length?
38. The functional and comparability analyses and all
other relevant available data would be used to determine
whether the pricing of the business restructuring is arm’s
length by addressing the following types of questions:
s What are the expected benefits of the business re-
structuring for SubCo and ForCo (see Step 1)?
s Would any options other than the business restructur-
ing be realistically available to ForCo and SubCo at
arm’s length?
– Given all of the legal, commercial, economic and fi-
nancial circumstances, would SubCo as an indepen-
dent party have any option realistically available to it
other than to enter into the business restructuring on
the agreed terms?
– For example:
s Would SubCo as an independent party legally
have any option to termination of its existing li-
censing and distribution arrangements?
s Are there commercial or economic imperatives for
SubCo to restructure?
s If SubCo as an independent party would have op-
tions other than the business restructuring realis-
tically available to it, how would the expected
benefits of those options compare to the expected
benefits of the restructuring?
s Would ForCo as an independent party have any
option realistically available to it other than to en-
ter into the business restructuring on the agreed
terms?
s Would ForCo have the option of entry into similar
licensing, distribution and toll manufacturing ar-
rangements without involving SubCo?
s If ForCo as an independent party would have
other options realistically available to it, how
would the expected benefits of those options com-
pare to its expected benefits from the business re-
structuring?
s Do the terms of the business restructuring make com-
mercial sense for ForCo and SubCo, given their rela-
tive bargaining positions at arm’s length?
s Does the risk-reward trade-off involved in entering
into the restructuring make commercial sense for
SubCo in the circumstances?
– What are the reasons for SubCo’s declining profit-
ability?
– What financial forecasts have been made for SubCo’s
existing business?
s Does the allocation of risk under the restructured ar-
rangements make commercial sense for ForCo and
SubCo?
– Is the allocation of risks consistent with decision-
making related to assuming and managing those
risks?
s Does ForCo have both the decision-making capa-
bility and financial capability to assume and man-
age the risks it is allocated?
s Does ForCo have the decision-making capability
to assume and manage the ownership risks of the
patent and trademark intangibles?
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
s Would an amount of consideration be expected to be
payable and receivable between independent parties
in comparable circumstances?
39. If the examination of these matters shows that the
pricing of the business restructuring makes commercial
sense for the parties, having regard to their economic cir-
cumstances and the options realistically available to them
at arm’s length, then this determines the amounts of arm’s
length consideration receivable or payable by SubCo under
that arrangement.
40. If the examination of these matters shows that the
pricing of the business restructuring arrangement does not
make commercial sense in this regard, then the Commis-
sioner would seek to achieve an arm’s length outcome by a
pricing adjustment (for example, by imputing a receipt of
consideration by SubCo or by adjusting any agreed amount
of consideration receivable or payable by SubCo) by refer-
ence to the arrangement as entered into by the parties.
41. If it is not possible or practicable to achieve an arm’s
length outcome in this way, then the Commissioner may
determine arm’s length pricing using an arrangement that
might reasonably be expected to exist between indepen-
dent parties dealing at arm’s length in comparable circum-
stances.
42. For instance, the analysis in Step 3 may lead the
Commissioner to conclude that independent parties deal-
ing at arm’s length in comparable circumstances would not
be expected to have entered into the business restructuring
arrangement as actually agreed. The Commissioner may
then apply the transfer pricing provisions to adjust the con-
sideration receivable or payable by SubCo by reference to
an agreement that might reasonably be expected between
independent parties dealing at arm’s length in comparable
circumstances.
Appendix 2 – Explanation
0 This Appendix is provided as information to help
you understand how the Commissioner’s preliminary
view has been reached. It does not form part of
the proposed binding public ruling.
43. This draft Ruling discusses the application of the
arm’s length principle under Australia’s transfer pricing
rules in a business restructuring context. The arm’s length
principle is the key concept that underpins both Division
13 and treaty Article 9.24 The operation of the arm’s length
principle in respect of Division 13 is addressed in several
ATO Rulings.25 The operation of the arm’s length principle
in respect of Article 9 of the OECD Model Tax Convention
is addressed in the OECD Guidelines. The International
Tax Agreements Act 1953 incorporates treaty Article 9 into
Australia’s tax laws. The ATO view is that treaty Article 9
authorises the making of transfer pricing adjustments in-
dependently of Division 13.26
44. The arm’s length principle requires that profits are al-
located between associated enterprises by reference to the
conditions that would have existed between independent
parties in comparable circumstances.27 It is inappropriate
to be prescriptive in discussing what these conditions
would be, particularly as this depends upon facts and cir-
cumstances and the availability of data on comparable un-
controlled transactions or arrangements.28 This draft Rul-
ing recognises that the application of the arm’s length prin-
24
Paragraphs 10, 164 and 184 of TR 94/14; paragraphs 1.5 and
1.6 of TR 97/20.
25
TR 94/14, TR 97/20 and TR 98/11 are considered of particular
relevance for purposes of this draft Ruling.
26
Paragraph 33 of Taxation Ruling TR 2001/13; paragraph 18 of
TR 94/14; paragraphs 25 to 27 of draft Taxation Ruling TR 2009/
D6.
27
Paragraph 1.6 of the OECD Guidelines; paragraph 10 of TR
94/14.
28
Paragraph 1.10 of the OECD Guidelines.
TMTR ISSN 1063-2069
TEXT
ciple requires judgement, particularly in the case of
business restructuring, where directly comparable uncon-
trolled transactions or arrangements may well be difficult
to identify.
45. A business restructuring gives rise to the need to de-
termine the amounts of arm’s length consideration payable
and receivable in connection with the restructuring itself
(that is, the transfers of functions, assets and risks accom-
panying changes in business arrangements or operations),
as well as in relation to the post-restructuring arrange-
ments. This draft Ruling provides guidance in dealing with
the first of these issues.
46. This draft Ruling does not address the issue of how
to determine an arm’s length outcome for associated enter-
prise dealings of a taxpayer entered into after it has partici-
pated in a business restructuring. In isolation, the same
principles and approach should be applied in selecting and
applying the most appropriate arm’s length pricing method
to those dealings as if they were not connected with a busi-
ness restructuring.29 Where the overall business restruc-
turing arrangements include agreement as to consideration
payable and receivable in respect of the post-restructuring
dealings, it is relevant to take account of that consider-
ation, and whether it is arm’s length, in determining
whether the consideration payable and receivable for the
business restructuring itself is arm’s length.
47. Paragraphs 48 to 143 of this draft Ruling explain in
more detail the process suggested at paragraph 19 of this
draft Ruling for applying the arm’s length principle under
the transfer pricing provisions to a business restructuring
arrangement.
Step 1: Characterise the international dealings between
the associated enterprises in the context of the taxpayer’s
business
48. For Division 13 purposes, this step is relevant to:
(a) determining whether a taxpayer has supplied or ac-
quired property under an international agreement
(paragraphs 136AD(1)(a), 136AD(2)(a) and
136AD(3)(a));
(b) determining whether parties to the international
agreement were dealing at arm’s length in respect of
a supply or acquisition of property (paragraphs
136AD(1)(b), 136AD(2)(b) and 136AD(3)(b));
(c) determining the arm’s length consideration for a sup-
ply or acquisition of property as defined in para-
graphs 136AA(3)(c) and 136AA(3)(d) by reference to
a comparable agreement between independent par-
ties dealing at arm’s length (paragraphs 136AD(1)(c),
136AD(2)(c) and 136AD(3)(c)).
49. For treaty Article 9 purposes, Step 1 is relevant to de-
termining comparability between the conditions of the tax-
payer’s commercial or financial relations with an associ-
ated enterprise in respect of the business restructuring ar-
rangement and the conditions which would be made
between independent enterprises.
50. A business restructuring may involve a series of inter-
related dealings. These may include transfers of functions,
assets and/or risks, transfers of property and/or benefits,
the termination of existing related party arrangements and
the entry into new arrangements. Where this is the case,
the proper application of the arm’s length principle re-
quires having regard to the arrangements in their entirety.
51. In applying Division 13 it is necessary to identify the
relevant international agreement or agreements. Division
13 is ‘agreement’ based and is not limited to considering
specific transactions.30 The term ‘agreement’ is broadly de-
fined in subsection 136AA(1) of Division 13. The term
‘agreement’ is broad enough to include situations where
parties other than those directly involved with the supply
or acquisition of property are somehow involved or can in-
29
See TR 97/20 for these principles.
30
Paragraphs 47, 264 and 265 of TR 94/14.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 119
fluence the outcome of the dealings between the parties di-
rectly involved.31 An arrangement (and therefore an
‘agreement’) would exist if the facts showed a course of
dealing between the parties, even though no formal agree-
ment had been entered into and no legally enforceable re-
lationship was intended.32
52. In appropriate cases an ‘agreement’ may comprise
more than one contract, transaction or arrangement which
together form a broader ‘agreement’.33 Where only a part
of the ‘agreement’ involves the supply or acquisition of
property, this part will not be viewed in isolation but in the
context of the broader arrangement, understanding or
scheme. It is only when all connected steps are viewed in
their proper context that the true nature, extent and effects
of an ‘agreement’ can be determined.34 The ATO does not
accept the view that in applying Division 13 regard can
only be had to a specific transaction when deciding
whether the parties were dealing at arm’s length in relation
to a supply or acquisition of property and whether the con-
sideration given was an arm’s length consideration.35
53. The ATO needs to examine whether all aspects of the
relevant agreement can be explained by reference to ordi-
nary commercial dealings and real bargaining.36
54. The most important aspects of Step 1 are:37
(a) identifying the scope, type and value of the interna-
tional dealings with associated enterprises involved
in the business restructuring; and
(b) preparing the preliminary functional analysis of the
business restructuring.
55. The functional analysis is needed to identify the eco-
nomically significant functions performed, assets used and
risks assumed in respect of the business affected by a busi-
ness restructuring, and to understand the relative eco-
nomic significance of the functions, assets and risks trans-
ferred in implementing the business restructuring. In ex-
amining a business restructuring, the ATO performs
functional analyses of both the pre-restructuring and post-
restructuring business circumstances and arrangements,
so as to understand and determine how the allocation of
functions, assets and risks has changed as a result of a
business restructuring. Performing these functional analy-
ses includes examining any relevant contracts, including
those entered into to implement the business restructuring
(for example, contracts for the sale of property) and those
evidencing the terms of the pre and post-restructuring ar-
rangements for the business activities affected by the busi-
ness restructuring.
56. The true nature, terms and effects of a business re-
structuring arrangement are determined by an examina-
tion of relevant formal contracts and what the functional
analyses show to be the actual functions performed, assets
used and risks assumed by the parties as evidenced by
their conduct.
57. The term ‘arm’s length consideration’ is defined in
subsection 136AA(3) of Division 13 as the consideration
that might reasonably be expected if the property had been
supplied or acquired under an agreement between inde-
pendent parties dealing at arm’s length with each other in
relation to the supply or acquisition.
58. This, therefore, requires an analysis of comparability
with an agreement between independent parties dealing at
arm’s length in similar circumstances. Step 1 of the process
is intended to determine the true nature, terms and effects
of the business restructuring arrangement for purposes of
performing this comparability analysis.
59. As stated at paragraph 5.20 of TR 98/11:
31
Paragraph 35 of TR 94/14.
32
Paragraph 37 of TR 94/14.
33
Paragraphs 42 and 257 of TR 94/14.
34
Paragraph 258 of TR 94/14.
35
Paragraph 264 & 265 of TR 94/14.
36
Paragraph 57 of TR 94/14.
37
Paragraph 5.18 of TR 98/11.
BNA TAX 6-3-10
120 (Vol. 19, No. 3)
The taxpayer needs to understand the nature and extent
of the dealings with associated enterprises in the context
of the Australian taxpayer’s business, the strategies
adopted by the MNE group, and the economic and mar-
ket circumstances in which the taxpayer is operating. In
determining whether the dealings are consistent with the
arm’s length principle it is important to understand:
(1) what the international dealings with associated enter-
prises are;
(2) which enterprises are party to what dealings;
(3) how and when the dealings were negotiated;
(4) the purpose or object of the dealings;
(5) the property or services involved;
(6) the contractual terms and timing of the dealings;
(7) what the taxpayer contributes and obtains from its
participation in them; and
(8) their significance to the taxpayer’s overall business
activities and those of the multinational group.
60. All of this information can be relevant to dealings en-
tered into to implement a business restructuring. This in-
cludes information on business strategies:
An evaluation of the strategies of the taxpayer and the
MNE group is also generally necessary and this should
be documented as part of the four steps. Information on
the business strategies can assist in establishing the se-
lection of methodologies and may be very important
when addressing questions associated with comparabil-
ity. In considering these issues, the underlying question
is whether an independent enterprise in the taxpayer’s
circumstances might have been expected to have initi-
ated or participated in these strategies or policies or ac-
cepted these objectives, and if so, what reward would
have been expected (see paragraphs 3.2 and 3.3 of TR 97/
20).38
61. The ATO therefore not only needs to understand the
benefits expected by an MNE from a business restructur-
ing, but in order to apply the arm’s length principle it needs
to understand the expected benefits from the business re-
structuring for the individual group members that are par-
ties to the arrangement.
62. The ATO’s examination of the benefits sought from a
business restructuring addresses the following aspects:
(a) the nature of the benefits;
(b) what the benefits are worth, in terms of additional
shareholder value or profit;
(c) why the business restructuring is needed in order to
derive these benefits;
(d) how the various elements or transactions within the
overall business restructuring arrangements help to
deliver these benefits;
(e) what the involvement of each of the parties contrib-
utes to producing these benefits; and
(f) how the parties share in these benefits.
63. The ATO analyses the value chain for the particular
business operations with a view to determining how it is
changed as a result of the business restructuring and what
the expected benefits of the changes are. Determining the
value added to the business from the expected benefits of
the business restructuring, the contributions of the parties
to adding that value by producing those benefits, and how
the parties share in those expected benefits are all factors
directly relevant to determining the amounts of arm’s
length consideration payable and receivable in connection
with the business restructuring.
64. Benefits expected from a business restructuring can
be any form of economic or commercial advantage that as-
sists an entity’s profitability or net worth by enhancing its
business circumstances. A business restructuring may be a
response to changes in business opportunities, competitive
pressures, market conditions, and changing operating and
regulatory environments. In light of such changes an entity
may restructure to protect its profit-making ability or fi-
38
Paragraph 5.30 of TR 98/11.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
nancial viability. It may seek to seize opportunities to im-
prove its revenue efficiency or cost efficiency. The alterna-
tives to restructuring may be operating less profitably, at a
loss, or going out of business.
65. For example, outsourcing is a common feature of
business restructurings. Outsourcing arrangements are in-
creasingly occurring between independent enterprises for
activities such as inventory management and logistics, IT
support, after-sales support, customer receivables manage-
ment, and R&D. The commercial explanation for this is
generally that there are expected to be net benefits to the
enterprise from contracting out compared to performing
the activity itself. These expected benefits essentially relate
to increased profits through having the activity performed
more effectively, efficiently and/or at less cost to the enter-
prise, or through opening up profit opportunities to the
business that would not be available within the constraints
of its own resources and in-house capabilities.
66. In making the decision to restructure, a MNE would
typically undertake a full cost benefit analysis. The ATO
will seek such documentation39 as well as other financial
and commercial data relevant to the matters at paragraph
62 of this draft Ruling. For a foreign owned MNE this docu-
mentation may have been prepared overseas for the MNE
group as a whole. The Commissioner will examine the rea-
sonableness and reliability of assumptions, data and fore-
casts used in the MNE’s analyses of the benefits sought
from the business restructuring.
67. In some cases the obtaining of tax benefits is a moti-
vation for entering into a business restructuring arrange-
ment.40 For instance, a business restructuring may involve
transferring functions, assets and/or risks to a tax advan-
taged location. This does not of itself warrant a conclusion
that it is a non-arm’s length arrangement if independent
parties dealing at arm’s length would be expected to have
entered into the business restructuring agreement and ac-
quired or supplied the property agreed to by the taxpayer.
Provided the pricing of the business restructuring itself and
of the post-restructuring arrangements accords with what
would be expected under an agreement between indepen-
dent parties dealing at arm’s length in comparable circum-
stances, then the arm’s length principle under the transfer
pricing provisions is satisfied.
Step 2: Select the most appropriate transfer pricing
methodology or methodologies
68. For Division 13 purposes, this step is relevant to de-
termining the arm’s length consideration for a supply or
acquisition of property as defined in paragraphs
136AA(3)(c) and 136AA(3)(d) by reference to a compa-
rable agreement between independent parties dealing at
arm’s length (paragraphs 136AD(1)(c), 136AD(2)(c) and
136AD(3)(c)).
69. For treaty Article 9 purposes, this step is relevant to
determining comparability between the conditions of the
taxpayer’s commercial or financial relations with an asso-
ciated enterprise in respect of the business restructuring
arrangement and those which would be made between in-
dependent enterprises.
70. The use of the concept of ‘arm’s-length consider-
ation’ in Division 13 is modelled on the arm’s length prin-
ciple. This principle is in turn modelled on notions of com-
parison and predication about what independent parties
dealing at arm’s length either did or might reasonably be
expected to have done in the taxpayer’s circumstances.41
71. In this step of the process, the Commissioner ascer-
tains whether any reliable uncontrolled comparables data
are available evidencing a similar transfer or reallocation
39
Paragraph 147 of this draft Ruling.
40
The general anti-avoidance provisions in Part IVA may apply
in these cases. The possible application of Part IVA is not ad-
dressed in this draft Ruling (see paragraph 6 of this draft Ruling).
41
Paragraph 54 of TR 94/14.
TMTR ISSN 1063-2069
TEXT
of functions, assets and/or risks on similar terms in similar
circumstances between independent parties dealing at
arm’s length. If so, then the uncontrolled comparables data
can be used to apply the most appropriate arm’s length
pricing method(s) to the taxpayer’s dealings under the
business restructuring arrangement.42
72. In some cases, an agreement in relation to a business
restructuring may consist of a single international dealing
between associated enterprises. For instance, the taxpayer
may simply transfer ownership of an intangible asset to a
foreign associate. In such a case, relevant uncontrolled
comparables data would evidence any similar intangible
transfers in similar circumstances between independent
parties dealing at arm’s length, and absent such data an in-
direct pricing method may be reliable.43
73. As previously discussed, a business restructuring is
commonly implemented through a series of inter-related
steps or transactions. For instance, the taxpayer may trans-
fer ownership of an intangible asset to a foreign associate
and also agree to a licence for the taxpayer’s future use of
the intangible. In seeking to apply an accepted arm’s
length pricing method to a dealing that is part of a broader
business restructuring arrangement, comparability needs
to be assessed by taking account of the dealing in the con-
text of the overall arrangement. The most reliable uncon-
trolled comparables data would evidence a similar overall
arrangement in similar circumstances between indepen-
dent parties dealing at arm’s length.
74. Absent such data, comparables data related to indi-
vidual dealings that are part of a broader arrangement
might have value in determining whether pricing under the
overall arrangement is arm’s length.
75. Depending upon the particular circumstances, rel-
evant uncontrolled comparables data might include that re-
lating to similar uncontrolled transfers of functions, assets
and/or risks, similar uncontrolled transfers of property
and/or benefits, the terms governing termination of uncon-
trolled arrangements similar to the pre-restructuring con-
trolled arrangements, and uncontrolled arrangements
similar to the post-restructuring controlled arrangements.
Importantly, the outcomes of the comparability analyses of
individual dealings that are inter-related parts of a broader
business restructuring arrangement must make commer-
cial sense when viewed in the context of the overall ar-
rangement in order for those outcomes together to be used
to reliably evidence that the pricing under that arrange-
ment is arm’s length.
76. The types of business restructuring arrangements
discussed in this draft Ruling tend to be unique to MNEs.
There are therefore ordinarily no available data as to un-
controlled arrangements that are comparable to the overall
business restructuring arrangement.
77. Simply because a related party arrangement is one
not seen between independent parties, this should not of it-
self justify a conclusion that the arrangement is non-arm’s
length.44 Conversely, it does not mean that the arm’s
length principle does not apply.45
78. Given that there is a need to find an answer in such
cases where there are insufficient data available as to com-
parable uncontrolled dealings, some reasonable basis has
to be used by the Commissioner to ensure that a suffi-
ciently reliable approximation of an arm’s length outcome
is produced.46 If necessary, subsection 136AD(4) of Divi-
sion 13 may be relied upon in these circumstances.47
42
See TR 97/20 for detailed guidance on the selection and ap-
plication of arm’s length pricing methods.
43
See paragraph 120 of this draft Ruling.
44
Paragraph 1.10 of the OECD Guidelines.
45
Paragraphs 84 and 341 of TR 94/14.
46
Paragraphs 3.88 and 3.89 of TR 97/20.
47
See paragraphs 138 and 139 of this draft Ruling and para-
graphs 1.15 to 1.24 of TR 97/20.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 121
79. Where the application of Division 13 is contemplated
in situations involving types of dealings between related
parties which may not occur between unrelated parties, the
role of the Division is to consider the underlying economic
and commercial reality of the situation.48
80. Implicit in the concept of the ‘arm’s length principle’
and of the expression ‘arm’s length consideration’ used in
Division 13 is the notion that independent parties when
evaluating the terms of a potential deal would compare the
deal to the other options realistically available to them and
would enter into the deal only if there was no alternative
clearly of greater commercial advantage to the individual
entity. It could therefore be said that independent parties
who were dealing at arm’s length would each seek to maxi-
mise the overall value of their respective entities from the
economic resources available to or obtainable by them.49
81. The appropriate arm’s length consideration should
reflect commercial and market realities, would have regard
to the nature of competition and the nature of business
(that is, what it means to compete and what it means to
carry on business) whereby it would generally be expected
that entities would seek to:
(a) maximise the consideration received in respect of the
supply of property;
(b) minimise the consideration to be given in respect of
the acquisition of property; and
(c) be adequately rewarded for the activities carried out
so as to be commercially viable.50
82. The determination of the arm’s length consideration
involves an element of judgment and is not a precise sci-
ence. Accordingly, taxpayers and ATO auditors need to ap-
proach cases with a degree of flexibility and commonsense,
having regard to business and market realities.51
83. Given the above, where there are insufficient reliable
uncontrolled comparables data to establish whether the
pricing of a business restructuring arrangement is arm’s
length, the Commissioner might need to evaluate compara-
bility with what might be expected under an arrangement
between independent parties dealing at arm’s length by
considering the following indicia of arm’s length behaviour
and outcomes that might be expected to shape such an
agreement:
(a) an arm’s length outcome is one that makes business
sense in the circumstances of the particular tax-
payer;52
(b) an independent party dealing at arm’s length would
seek to protect its own economic interest;53
(c) an independent party dealing at arm’s length would
compare the options realistically available and seek
to maximise the overall value derived from its eco-
nomic resources;54
(d) one option might be not to enter into a transaction
because it does not make commercial sense for the
particular taxpayer.55
84. Accordingly, in determining whether the pricing of a
business restructuring arrangement is arm’s length in the
absence of sufficient reliable uncontrolled comparables
data, the Commissioner may need to adopt an approach
that takes into account whether the pricing of the arrange-
ment makes commercial sense for each of the parties, hav-
ing regard to what is in their best economic interests and
the options realistically available to them at arm’s length.
85. This examination generally involves a consideration
of the following factors (bearing in mind the need for this
to be tailored to the particular circumstances):
48
Paragraphs 85 and 342 of TR 94/14.
49
Paragraphs 66 and 315 of TR 94/14.
50
Paragraph 68 of TR 94/14.
51
Paragraph 74 of TR 94/14.
52
Paragraphs 1.1 and 2.15 of TR 97/20.
53
Paragraphs 2.6 and 2.11 of TR 97/20.
54
Paragraph 2.4 of TR 97/20.
55
Paragraph 2.17 of TR 97/20.
BNA TAX 6-3-10
122 (Vol. 19, No. 3)
(a) the expected benefits of the business restructuring
for the parties (paragraphs 61 to 67 of this draft Rul-
ing);
(b) the other options realistically available to the parties
at arm’s length (paragraphs 86 to 100 of this draft
Ruling);
(c) the allocation of risk under the restructured arrange-
ments (paragraphs 101 to 106 of this draft Ruling);
(d) whether an amount of consideration might be ex-
pected under an agreement between independent
parties in comparable circumstances (paragraphs 110
to 134 of this draft Ruling).
The other options realistically available to the
parties at arm’s length
86. The OECD Guidelines state:56
Independent enterprises, when evaluating the terms of a
potential transaction, will compare the transaction to the
other options realistically available to them, and they will
enter into the transaction if they see no alternative that
is clearly more attractive.
87. Generally, independent parties would enter into a
transaction or arrangement only if they both expect to ob-
tain benefit by doing so, or at least if they do not expect to
be disadvantaged by doing so. Thus, the application of the
arm’s length principle to an arrangement between associ-
ated enterprises requires that neither enterprise as an inde-
pendent party would have a more beneficial option than
entering into the arrangement, or be worse off by doing so
compared to its other options. Real bargaining between in-
dependent parties may produce a range of outcomes in
agreeing the terms and conditions of the arrangement that
satisfy this requirement, depending upon the options real-
istically available to the parties and hence their relative
bargaining positions.
88. Whether an independent party has options realisti-
cally available other than to enter into a particular transac-
tion or arrangement directly affects its bargaining position
and hence the terms upon which it would be expected to
choose to enter into that transaction or arrangement. Ac-
cordingly, for the purpose of determining whether a busi-
ness restructuring arrangement accords with what inde-
pendent parties might be expected to agree, it is relevant
for the Commissioner to take account of whether the par-
ties, had they been independent, would have had options
realistically available to them other than to enter into the
business restructuring.
89. Where an entity as an independent party is found not
to have other options realistically available, it is in a rela-
tively weak bargaining position for negotiating the terms of
the business restructuring arrangement. For instance, it
might not as an independent party be expected to be able
to negotiate for receipt of consideration simply for agree-
ing to enter into the business restructuring, unlike an en-
tity with other options.
90. Where an entity as an independent party would have
had options realistically available other than the business
restructuring, then whether it would be expected to choose
the restructuring depends upon its expected benefits from
this, taking account of any consideration receivable and
payable in connection with the restructuring itself and the
post-restructuring activity, compared with its other avail-
able options. An independent entity would be expected to
choose the best available option. It would not be expected
to choose the business restructuring if it would be worse
off by doing so compared to its other options. An entity
with other options is in a stronger bargaining position than
one without options. Therefore, the independent entity
would be expected to use its bargaining position to either
refuse the business restructuring if it is not the best avail-
able option, or alternatively to negotiate terms for the busi-
ness restructuring that compensate it for forgoing the ben-
56
Paragraph 1.15.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
efits of another option. For instance, it might seek the pay-
ment of consideration for agreeing to enter into the
business restructuring.57 In this situation the consideration
received by the entity is itself an expected benefit from en-
try into the business restructuring and explains why as an
independent party it might choose to enter into the restruc-
turing compared to its other options.
91. The object of taking account of the options realisti-
cally available to the parties to a business restructuring is
only to test whether it is comparable with an agreement be-
tween independent parties dealing at arm’s length in com-
parable circumstances, for purposes of determining the
amounts of arm’s length consideration payable or receiv-
able by the taxpayer in connection with the restructuring.
This testing is performed by examining whether, consis-
tent with what would be expected of an agreement be-
tween independent parties, the pricing is such that both
parties expect to benefit, or at least not be disadvantaged,
by participating in the business restructuring compared to
their other realistically available options.
92. It is not the role of a tax administration to ‘second
guess’ the decision to restructure by using the existence of
other options as a ground of itself for disregarding the
business restructuring arrangement based upon a tax ad-
ministration’s views as to what may have been a better
available option for the taxpayer. Such an approach goes
beyond when it may be appropriate to use the arm’s length
principle to disregard the terms or form of the arrange-
ment actually entered into.58
93. In considering the options realistically available, all
of the legal, commercial, economic and financial circum-
stances affecting those options must be taken into account.
For instance, one option that an entity as an independent
party may realistically have in some cases is to refuse to
enter into a business restructuring and to continue operat-
ing its existing business. In considering whether an entity
as an independent party would have this option realisti-
cally available to it, all of the relevant circumstances
should be examined, including:
(a) Whether the contractual arrangements under which
the entity operates its business, give it the option to
legally resist termination of those arrangements; and
(b) Whether the commercial and economic conditions
(that is, market forces) affecting the entity’s pre-
existing business give it the realistic option of con-
tinuing to operate that business.
94. Thus, an entity may not legally have the option of
continuing to operate its existing business where its con-
tractual right to do so is legally terminated by the other
party. In any event, it may not have this as a realistic op-
tion given the commercial or economic circumstances af-
fecting the business. Even if a restructured entity has cho-
sen to retain its existing operations instead of restructur-
ing, it cannot necessarily be assumed that it would in
future have continued to earn a similar level of profit from
those operations to what it achieved pre-restructuring. This
is clearly so in circumstances where a business restructur-
ing is made in response to commercial or economic cir-
cumstances that mean the current operating structure can-
not profitably be maintained. In evaluating whether the op-
tion of continuing to operate the existing business was
realistically available, and for purposes of valuing this op-
tion and comparing it with the option of restructuring, it is
the forecast profitability of the business that is relevant.
95. The options realistically available at arm’s length
should be considered from the perspectives of all parties to
the business restructuring arrangement, not just the tax-
payer or the restructured entity. For instance, where a
business restructuring involves an entity becoming a ser-
57
See paragraphs 126 to 130 of this draft Ruling.
58
See paragraphs 140 to 143 of this draft Ruling regarding the
application of treaty Article 9 under paragraph 1.37 of the OECD
Guidelines.
TMTR ISSN 1063-2069
TEXT
vice provider to a principal (for example, a toll manufac-
turer or commissionaire), then subject to any legal, com-
mercial or other restrictions, the principal as an indepen-
dent party might realistically have the option of employing
other entities in the marketplace to perform such ser-
vices.59 As an independent party, the principal entity would
be expected to consider whether it could obtain the same
service at a lower price from another party.60
In identifying and evaluating the options realistically
available at arm’s length, the Commissioner takes account
of the circumstances existing and reasonably foreseeable,
and the information reasonably available, at the time the
business restructuring arrangement was proposed, negoti-
ated and entered into. This is the relevant time by refer-
ence to which the issue of whether the business restructur-
ing makes commercial sense for the parties is to be consid-
ered when applying the arm’s length principle. Hence, it
would be inappropriate for the Commissioner to use hind-
sight where it examines this issue at some time after the
business restructuring is implemented, for example in an
audit situation.
96. A factual circumstance potentially affecting the op-
tions realistically available to an associated enterprise is its
group membership. The options available to such an entity
may differ from, (for example, be more limited than), those
of a stand-alone entity. This raises a question as to whether
the arm’s length principle permits this circumstance to be
taken into account. A group member deals with the mar-
ketplace as a member of a group carrying on the business
of the group. Any effects of this on its business operations
and profits that are the result of independent commercial
and open-market forces are not attributable to non-arm’s
length conditions of its relationships with the group or its
other members.
97. The arm’s length principle therefore does not require
that an entity’s group membership be ignored as a factual
condition affecting its dealings with independent third par-
ties in the marketplace. The effects of such market forces
may be taken into account in considering the options real-
istically available to the entity at arm’s length. If, for in-
stance, a subsidiary is a manufacturer or distributor of the
MNE group’s products, and a third party (for example, a
competitor of the MNE) would not be expected in the par-
ticular circumstances to agree for the subsidiary to manu-
facture or distribute the third party’s products, then this is
a market condition limiting the options realistically avail-
able to the subsidiary at arm’s length if its right to manu-
facture or distribute the group’s products is terminated.
Relevance of the concept of ‘risk-reward trade-off’ to
the choice of options
98. A business restructuring typically involves the trans-
fer of functions, assets and risks from one group member
to another, so that the transferor’s opportunity to derive
profit and its risk of incurring loss from those functions, as-
sets and risks is transferred to the transferee. From the
transferor’s perspective, the commerciality of this might in
some cases be explained by the economic theory of the
‘risk-reward trade-off’; it is choosing to accept reduced
profit-making opportunity as a trade-off for reduced risk of
incurring loss.
99. Independent parties are known to agree to assume
limited risk for a more stable, albeit potentially lower, re-
turn compared to the option of higher risk with a more
volatile, albeit potentially higher return. Examples exist of
limited risk independent enterprises (for example, contract
manufacturers and R&D facilities). There is therefore noth-
ing inherently inconsistent with the arm’s length principle
for an enterprise to choose to be a low risk service pro-
vider. The arm’s length principle does not mandate that an
entity must always act to maximise its profit-making poten-
59
See also paragraph 131 of this draft Ruling.
60
Paragraphs 1.15 and 1.16 of the OECD Guidelines.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 123
tial (by maximising its risk of loss). A riskier option is not
an inherently better option; an entity is not necessarily
worse off by choosing a less risky option, given that this re-
duces both its potential profits and its potential losses.
100. However, where an existing arrangement is restruc-
tured, there is an issue as to whether the business restruc-
turing is arm’s length which is separate to the issue of
whether the new arrangement itself is arm’s length. Thus,
for instance, simply showing that independent parties op-
erate as limited risk contract manufacturers does not of it-
self demonstrate that the choice by a full risk manufacturer
to restructure into a limited risk contract manufacturer is
one that an independent party would be expected to make
based upon the concept of ‘risk-reward trade-off’. Whether
that concept provides a reasonable explanation of how a
business restructuring makes commercial sense for the re-
structured entity depends upon the particular circum-
stances and the answers to the following types of ques-
tions:
s What does the historical financial data for the busi-
ness show (for example, what is its history of profit-
ability, is profitability historically volatile or relatively
stable)?
s Recognising that in theory there is always a risk of
loss, what is the real risk of losses being incurred?
s Recognising that past performance is no guarantee of
future performance, what financial forecasts has the
entity made to inform its decision?
s Given the relevant historical and forecast data, would
an independent party acting in its own best economic
interests consider the trade-off of reduced potential
profit for reduced risk of loss to be a good deal for it?
The allocation of risk under the restructured
arrangements
101. In an economic sense, the types of business risk rel-
evant to business restructurings attach to either assets
(through ownership or use) or functions (through decision-
making). The most common of these risks are:
s operational risk;
s market risk;
s credit risk;
s inventory risk;
s foreign exchange risk; and
s risk related to ownership and management of intan-
gibles.
102. These types of risks should be viewed as incidental
to the performance of real value-adding functions in the
business and the use of any assets that may be relevant in
that process. Therefore, the shifting of such business risks
through a business restructuring should be treated as part
of examining whether the changed arrangements under
the business restructuring in the performance of the func-
tions and ownership or use of the assets to which those
risks relate reflect those that would exist under an agree-
ment between independent parties dealing at arm’s length
in comparable circumstances.
103. Whether the allocation of risk between related par-
ties is arm’s length is in the first instance to be determined
having regard to any available uncontrolled comparables
data. Even if this data shows a different allocation of risk
between independent parties, this of itself does not justify
a conclusion that the allocation of risk between the related
parties is non-arm’s length; that allocation is respected
(and the difference taken into account, if possible, through
a comparability adjustment), unless the risk allocation is
considered not to make commercial sense or to be incon-
sistent with the economic substance of the arrangement.61
104. Under an agreement between independent parties
dealing at arm’s length, the party to whom a risk is allo-
cated would generally be expected to be both:
(a) financially capable of assuming the risk of loss; and
61
See paragraphs 1.27 and 1.41 of the OECD Guidelines.
BNA TAX 6-3-10
124 (Vol. 19, No. 3)
(b) functionally capable of the decision-making needed
to assume and manage the risk.
105. As paragraph 1.27 of the OECD Guidelines states: In
arm’s length dealings it generally makes sense for parties
to be allocated a greater share of those risks over which
they have relatively more control.
106. Exercising control over a risk implies having a level
of decision-making capability relevant to that risk; risk
cannot generally be separated from decision-making asso-
ciated with taking on and managing that risk. Therefore,
independent parties would not be expected to allocate risk
to a party who lacks this decision-making capability. Nor
would they be expected to allocate risk to a party if it is the
decision-making of the other contracting party that deter-
mines the level of risk and the size and likelihood of poten-
tial loss.62 This would not make commercial sense for the
parties where one party is making such decisions in its own
best interests with no obligation or incentive to mitigate the
risk that is borne by the other party.
Step 3: Apply the most appropriate method and determine
an arm’s length outcome
107. Like Step 2, this step is relevant for Division 13 pur-
poses to determining the arm’s length consideration for a
supply or acquisition of property as defined in paragraphs
136AA(3)(c) and 136AA(3)(d) by reference to a compa-
rable agreement between independent parties dealing at
arm’s length (paragraphs 136AD(1)(c), 136AD(2)(c) and
136AD(3)(c)).
108. For treaty Article 9 purposes, as for Step 2, Step 3 is
relevant to determining comparability between the condi-
tions of the taxpayer’s commercial or financial relations
with an associated enterprise in respect of the business re-
structuring arrangement and those which would be made
between independent enterprises.
109. In Step 3, the data obtained in Steps 1 and 2 is used
to perform a comparability analysis to apply the methodol-
ogy selected in Step 2 to determine an arm’s length out-
come for the relevant dealing or dealings with associated
enterprises.
Determining the consideration that might reasonably
be expected under an agreement between
independent parties dealing at arm’s length in
comparable circumstances
110. Under the arm’s length principle, consideration
should be paid in connection with a business restructuring
arrangement between associated enterprises if the pay-
ment of consideration would be expected between inde-
pendent parties dealing at arm’s length in comparable cir-
cumstances.
111. In determining this, regard should be had to any
available, sufficiently reliable, uncontrolled comparables
data. Subject to this, in determining whether a payment of
consideration would be expected between independent
parties, all of the relevant facts and circumstances should
be analysed in addressing the following issues:
(a) whether there has been a transfer of property (para-
graphs 115 to 120 of this draft Ruling);
(b) whether there has been the supply of a benefit (para-
graphs 121 to 131 of this draft Ruling);
(c) whether the taxpayer as an independent party would
have a right to compensation for termination of its ex-
isting arrangements (paragraphs 132 to 134 of this
draft Ruling).
112. The relative bargaining positions of the parties to
the business restructuring arrangement, taking account of
the options realistically available to them at arm’s length,
is a relevant factor in determining whether a payment of
62
See example at paragraph 1.27 of the OECD Guidelines.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
consideration would be expected between independent
parties and the quantum of that consideration.63
113. In determining the amount of consideration payable
and receivable in connection with a business restructuring,
it is important to avoid double-counting. For instance,
profit potential may be factored into the value of an asset
transferred (for example, the market value of an intan-
gible), the amount of compensation due for termination of
an existing arrangement, or the value of a benefit supplied
by entry into the business restructuring. Independent par-
ties would not be expected to agree to compensate the
same loss of profit potential more than once.
114. The arm’s length principle does not always require
that an entity receive consideration or compensation where
its business activities or arrangements are restructured.
Even if the entity expects to suffer detriment or loss from
changes to its business, there are circumstances where this
would not give rise to a payment of compensation between
independent parties. The arm’s length principle does not
generally require a payment of consideration for the fol-
lowing per se, absent a transfer of property, supply of a
benefit or existence of a legal right to compensation:
(a) transfer of a function and/or a risk (paragraphs 124 to
125 of this draft Ruling);
(b) loss of potential profits or a ‘profit-making opportu-
nity’ (paragraphs 118 to 119 of this draft Ruling); and
(c) termination of contractual rights (paragraph 134 of
this draft Ruling).
Whether there has been a transfer of property
115. The arm’s length principle requires that the consid-
eration to be paid for a transfer of property between asso-
ciated enterprises accord with the consideration that would
be expected between independent parties dealing at arm’s
length in comparable circumstances. The term ‘property’
includes all forms of tangible and intangible property. For
Division 13 purposes, ‘property’ is defined in subsection
136AA(1) to include such things as a chose in action, an in-
terest, right or power in or over property, a right to receive
income, and services.
116. Relevant intangible property includes:
(1) legally protected intellectual property, for example
patents, copyrights, trademarks, brand names;
(2) legally enforceable rights, for example, contractual
rights.
117. Where a product manufacturer or a distributor/
marketer is restructured, its previous activities may have
created valuable intangibles that are transferred as part of
the business restructuring. For instance, where a
distributor/marketer’s distribution rights are terminated, it
may dispose of the customer list or customer base that it
has independently developed in using the rights. The trans-
fer of such an intangible asset to an associate that will in
future use this customer base in making sales would be ex-
pected to require the payment of consideration if the trans-
fer were between independent parties, to the extent that
any value could be attributed to that customer base. This is
so if there is a sale of the business as a going concern (in-
cluding its goodwill). However, in other cases there may be
no compensable transfer of such intangibles. For instance,
if the distributor has its agreement legally terminated by
the other party, it may simply lose its customers who are
free to be supplied by others. In this situation the distribu-
tor’s business simply ceases and it does not have any pro-
prietary right in those customers (that is, as an item of
goodwill, the customer list has no separate existence to the
business itself).
118. A ‘profit-making opportunity’, ‘business opportu-
nity’ or a ‘profit potential’ is not of itself a proprietary right
that is an intangible asset. Profit potential may be relevant
to valuing an asset, but is not of itself an asset. A restruc-
tured entity may be entitled to receive consideration for
63
See paragraph 88 of this draft Ruling.
TMTR ISSN 1063-2069
TEXT
loss of profit potential where this attaches to a valuable
presently existing asset, and is not a mere expectation of
future profit. This asset may be tangible property or it may
be an intangible such as intellectual property, a contractual
right or goodwill. The profit potential of such an intangible
asset is ordinarily factored into its market value, so that
disposal of the asset for that value effectively compensates
for loss of such profit.
119. A mere reduction in an entity’s expected or poten-
tial future profits or loss of a profit-making opportunity is
therefore not of itself a basis for a right to a payment of
consideration between independent parties. However, in
some cases an independent entity might agree to enter into
a business restructuring for the benefit of another entity if
compensated by reference to the loss of expected or poten-
tial profits from the best other option realistically available
to it at arm’s length.64
120. It is not within the scope of this draft Ruling to give
detailed guidance on how to determine an arm’s length
price or value for intangible property. General guidance on
this is to be found at paragraphs 6.13 to 6.35 of the OECD
Guidelines. In short, the most appropriate methodology to
be used will depend upon what data, if any, are available
as to comparable uncontrolled intangibles transfers. Sub-
ject to this, a comparable uncontrolled price (CUP) method
is preferred. Absent data enabling a direct benchmarking
of an arm’s length price, other indirect methods may be re-
liable depending upon the particular circumstances. These
include a profit split method and traditional valuation ap-
proaches such as an income approach based on the earn-
ings or cash flow generated by the intangible or a cost-
based approach using the costs incurred in developing the
intangible.
Whether there has been the supply of a benefit
121. If, as part of an arrangement between associated en-
terprises, one entity acts for the expected benefit of an-
other, then the arm’s length principle requires that the con-
sideration to be paid for this service accord with the con-
sideration that would be expected between independent
parties dealing at arm’s length in comparable circum-
stances.
122. The term ‘benefit’ may be defined as follows:
The word benefit contained in the definition of ‘services’
encompasses anything that would bestow an economic
or commercial advantage which an independent entity
might reasonably be expected to pay for, or to obtain
consideration for supplying. That is, something that
would assist a company’s profitability or net worth by en-
hancing, assisting or improving the company’s income
production, profit making, the quality of its products, or
which could result in a reduction of expenses or other-
wise facilitate the operations of the company.65
123. Thus, a valuable economic or commercial advantage
may be a benefit, the supply of which between associated
enterprises should be compensated if this would be ex-
pected between independent parties.66
124. The transfer of a business activity or operation ordi-
narily involves more than the mere transfer of functions
and risks, but also transfers or disposals of assets includ-
ing intangibles such as intellectual property and contrac-
tual rights. The shifting or transfer of functions and/or
risks, separate from any assets or property rights, is not of
itself the supply of a benefit for which independent parties
might be expected to agree the payment of consideration.
Unless a restructured entity has a valuable contractual
64
See paragraph 126 of this draft Ruling.
65
See paragraph 31 of TR 94/14. See also paragraph 18 of
Taxation Ruling TR 1999/1 and paragraph 7.6 of the OECD Guide-
lines.
66
For Division 13 purposes, subsection 136AA(1) defines ‘prop-
erty’ as including ‘services’, which is in turn defined to include
‘benefits’.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 125
right to perform a particular business activity (for example,
rights to distribute a product or manufacture it under li-
cence) or has created an identifiable intangible asset by
performing that activity, so that it is entitled to consider-
ation for disposal of that right or asset, disposal of the ac-
tivity itself (that is, by shifting the functions and risks)
would not be expected to give rise to a payment of consid-
eration between independent parties. The functions and
risks of themselves have no value or benefit that is trans-
ferred from one entity to another. The fact that an entity
presently performs a function or assumes a risk does not
of itself give a right to compensation for loss of any profits
from future performance of that function or assumption of
that risk by another entity.
125. Assumption of a risk does not guarantee the risk-
taker a profit; risk may be both the opportunity to make a
profit and to incur a loss. Therefore, where a business risk
is transferred as part of a business restructuring, the trans-
feror would not be expected to receive any consideration
merely for transfer of the risk (that is, for any loss of a
profit-making opportunity). As previously discussed, the
types of risk relevant to business restructuring attach to ei-
ther assets or functions. The mere transfer of a function
and its associated risk is not a compensable transfer of
property or supply of a benefit. The transfer of an asset is
ordinarily a compensable transfer of property, the arm’s
length value of which takes account of its associated risk.
An independent party transferring a business risk to an-
other party might expect to compensate the other party for
taking on the risk, particularly where the transferor ben-
efits from a reduction in risk of losses or improved cer-
tainty (for example, insurance, factoring, hedging, swaps).
126. An independent entity might agree to enter into a
business restructuring arrangement that is not otherwise to
its benefit compared to its other options, provided it is ad-
equately compensated. In this situation the entity’s entry
into the business restructuring arrangement is the supply
of a benefit to the other party. As an independent party the
entity would expect to receive consideration for supplying
this benefit. This is the case where, notwithstanding other
consideration receivable by the entity in connection with
the business restructuring, for example, for transfers of as-
sets or termination of existing arrangements, the entity is
regarded as acting to the benefit of the other party by en-
tering into the business restructuring given that this disad-
vantages the entity compared to its other options. A party
to a business restructuring might expect to derive benefit
from receipt of consideration for entering into the restruc-
turing, so that this together with any other expected ben-
efits explains why the restructuring makes commercial
sense for it in the particular circumstances.
127. Thus, for instance, where an entity agrees to termi-
nate a business activity or contractual arrangement to the
benefit of another entity, this may make commercial sense
for the first entity provided it is adequately compensated
for this supply of a benefit. For example, an MNE may de-
cide to restructure its product manufacturing and/or distri-
bution and marketing activity. Implementing this decision
might involve one group member shutting down its manu-
facturing and/or distribution and marketing operations as
part of an arrangement whereby another foreign group
member will take over those operations. This may also in-
volve the first entity surrendering valuable rights it has un-
der its existing arrangements (for example, under licens-
ing, distribution or supply agreements) as part of an ar-
rangement with the second entity enabling it to obtain
similar rights by entering into similar agreements. In these
situations, the Commissioner would examine all of the rel-
evant circumstances to determine whether the business re-
structuring involves the supply of property or a benefit by
one entity to the other for which independent parties would
be expected to agree the payment of consideration.
128. A business restructuring may involve the transfer of
personnel between the parties to the arrangement. For in-
stance, a business restructuring whereby responsibility for
BNA TAX 6-3-10
126 (Vol. 19, No. 3)
an activity is centralised in a regional headquarters may in-
volve transfer to the headquarters location of key decision-
makers or skilled employees from local entities that previ-
ously performed that activity. In this situation an issue may
arise as to whether, in agreeing to surrender its rights un-
der the employment contracts and shift valuable profit-
generating resources, the local entity is acting for the ben-
efit of the headquarters entity and independent parties
would be expected to agree the payment of consideration
for this.
129. It is not within the scope of this draft Ruling to give
detailed guidance on how to determine an arm’s length
price or value for any such benefit. The general guidance
on determining an arm’s length consideration for an intra-
group service applies.67 Whatever particular arm’s length
pricing method is used, it is important to bear in mind the
following:
In trying to determine the arm’s length price in relation
to intra-group services, the matter should be considered
both from the perspective of the service provider and
from the perspective of the recipient of the service. In
this respect, relevant considerations include the value of
the service to the recipient and how much a comparable
independent enterprise would be prepared to pay for that
service in comparable circumstances, as well as the costs
to the service provider.68
130. Therefore, the amount of any consideration that
might be expected between independent parties for the
supply of a benefit in these business restructuring situa-
tions would be influenced by considering the bargaining
positions of the parties and any other options realistically
available to each of them at arm’s length. From the per-
spective of the entity that is providing a benefit by entering
into the business restructuring, it might as an independent
party be expected to seek a consideration measured by ref-
erence to any net loss of profits or net loss of value it ex-
pects to suffer from the business restructuring compared to
its best other option (that is, its opportunity cost of enter-
ing into the restructuring). Depending upon the options re-
alistically available to the other party, it either may or may
not be expected to agree to pay such a consideration as a
cost of obtaining expected benefits from the business re-
structuring. Thus, the outcome of real bargaining as to the
level of compensation paid is likely to be determined by
reference to both the opportunity cost of the supplier of the
benefit and the value of that benefit to the recipient, as well
as other factors affecting their relative bargaining posi-
tions.
131. An independent party would not reasonably be ex-
pected to pay for a benefit where:
s it has not agreed for the benefit to be provided. Thus,
in a business restructuring context, the provider and
recipient of the benefit must both be parties to the ar-
rangement under which the provision of the benefit
occurs; or
s it could get the benefit without paying for it. This may
be the case, for instance, where it does not need the
other party’s agreement, assistance or co-operation in
order to obtain the benefit. The options realistically
available to the entity that is being asked to pay for the
benefit are relevant here. For example, as an indepen-
dent party it might not be expected to pay for the ben-
efit of an associate agreeing to restructure and be-
come a service provider to the entity (for example, a
toll manufacturer or commissionaire) if at arm’s
length it would realistically have the option of simply
contracting with another party to provide similar ser-
vices on terms that do not require any such payment.
On the other hand, it might be expected to pay if the
associate has a particular expertise or other business
67
Paragraphs 7.29 to 7.37 of the OECD Guidelines; paragraphs
54 to 74 of TR 1999/1.
68
Paragraph 7.29 of the OECD Guidelines.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
advantage that is not obtainable from another service
provider.
Whether the taxpayer as an independent party would
have a right to compensation for termination of its
existing arrangements
132. Where an entity’s existing arrangements are termi-
nated as part of a business restructuring, this may give rise
to a legally recognised right to compensation. This covers
any right that would be recognised between independent
parties, and thus includes contractual, statutory and equi-
table rights. For instance, a distribution or licensing agree-
ment may give a right to compensation upon early termi-
nation or there may be compensation available in the form
of damages if the agreement is terminated by breach. In
the absence of a formal agreement, the termination of an
arrangement evidenced by a course of conduct may give an
equitable right to compensation or an equitable interest in
property in respect of contributions made or value created
under that arrangement.
133. The arm’s length principle only requires compensa-
tion for termination of an arrangement if compensation
would be expected between independent parties dealing at
arm’s length in comparable circumstances. Thus, where an
entity’s existing arrangements are with a related party, it is
necessary to determine whether the terms of those ar-
rangements relevant to compensation for termination ac-
cord with what independent parties might be expected to
have agreed when negotiating and entering into those ar-
rangements. Where available, data as to the terms of com-
parable uncontrolled arrangements should be used in
evaluating this. Where no such data is available, it is nec-
essary to determine what terms would make commercial
sense having regard to all of the facts and circumstances of
the arrangements.
134. Not every termination of a legal or business ar-
rangement between independent parties gives a right to
compensation to a party that is disadvantaged or suffers
detriment or loss as a result. Even if an entity has a valu-
able contractual right that carries a profit-making opportu-
nity, a business restructuring that gives rise to a termina-
tion or surrendering of that right may not be grounds for
compensation under the arm’s length principle where that
right would not carry an entitlement to compensation in
such circumstances were the entity an independent party.
This might be the case, for instance, where an entity has
valuable distribution rights or a valuable trademark licence
and it suffers loss of this asset and its profit potential when
the agreement conferring those rights is terminated by the
licensor in accordance with (that is, without breaching) the
agreement.
Determining arm’s length pricing using an
arrangement that might reasonably be expected to
exist between independent parties dealing at arm’s
length in comparable circumstances
Division 13
135. In cases where no readily apparent comparable
arm’s length price can be ascertained because, for ex-
ample, the arrangements in question do not reflect com-
mercial and market realities and would not exist between
independent parties dealing at arm’s length, it is open to
the Commissioner, in determining the arm’s length consid-
eration, to have regard to available information as to the
pricing of an arrangement that would be expected to exist
between independent parties dealing at arm’s length in
comparable circumstances.
136. For instance, a taxpayer may have given consider-
ation for property acquired under a business restructuring
arrangement where, in all of the circumstances, it is con-
cluded that there is no expected benefit to the taxpayer
from acquiring the property and an independent party
would therefore not be expected to pay for it. If the acqui-
TMTR ISSN 1063-2069
TEXT
sition would not be expected to have occurred under any
agreement between independent parties dealing at arm’s
length in comparable circumstances, then the Commis-
sioner may conclude that the arm’s length consideration
for the property acquired is nil for purposes of subsection
136AD(3).
137. Another example is where a taxpayer has supplied
property as part of a business restructuring arrangement
under which the allocation of certain business risks is con-
sidered not to make commercial sense or lacks economic
substance. Assuming that the consideration that might rea-
sonably be expected if the business risks were allocated
under an agreement between independent parties dealing
at arm’s length in comparable circumstances is higher than
the consideration received by the taxpayer, the Commis-
sioner may treat the higher consideration as the arm’s
length consideration for the property supplied for purposes
of subsection 136AD(1).
138. This stance is supported by subsection 136AD(4).
Where for any reason (including an insufficiency of infor-
mation available to the Commissioner) it is not possible or
practicable to ascertain the arm’s length consideration for
a supply or acquisition of property under a business re-
structuring arrangement, subsection 136AD(4) of Division
13 allows the Commissioner to determine an amount which
is then deemed, for the purposes of section 136AD, to be
the arm’s length consideration.
139. The ATO’s views on the application of subsection
136AD(4) are set out at paragraphs 79 to 85 of Taxation
Ruling TR 94/14. Two important elements of those views
for present purposes are:
(a) determining the relevant amount under subsection
136AD(4) needs to be approached in a manner which,
in all the circumstances of the case, would lead to a
fair result that is as consistent as practicable with the
arm’s length principle as internationally accepted;69
and
(b) in situations involving dealings between associated
enterprises which may not occur between indepen-
dent parties, the role of Division 13 is to consider the
underlying economic and commercial reality of the
situation.70
Treaty Article 9
140. In applying treaty Article 9, paragraphs 1.36 to 1.41
of the OECD Guidelines recognise that there can be excep-
tional cases where the arm’s length principle cannot be sat-
isfied by determining arm’s length pricing for the associ-
ated enterprise dealings actually entered into by the tax-
payer. Under paragraph 1.37 of the OECD Guidelines, the
Commissioner may appropriately not recognise the parties’
characterisation or structuring of a transaction or arrange-
ment where, having regard to all of the facts and circum-
stances, it is concluded that either:
(a) the economic substance of the transaction or ar-
rangement differs from its form; or
(b) independent enterprises in comparable circum-
stances would not have characterised or structured
the transaction or arrangement as the associated en-
terprises have, and arm’s length pricing cannot reli-
ably be determined for that transaction or arrange-
ment.
141. For this purpose, the economic substance of a trans-
action or arrangement is determined by examining all of
the facts and circumstances, such as the economic and
commercial context of the transaction or arrangement, its
object and effects from a practical and business point of
view, and the conduct of the parties, including the func-
tions performed, assets used and risks assumed by them.
This examination is part of Step 1 of the process suggested
69
Paragraph 82 of TR 94/14.
70
Paragraph 85 of TR 94/14.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 127
in this draft Ruling, which is the same as for applying Divi-
sion 13.
142. Regarding whether comparable arrangements
would have been adopted by independent enterprises,
paragraph 1.37 of the OECD Guidelines refers to whether
the arrangements adopted by the associated enterprises
‘differ from those which would have been adopted by inde-
pendent enterprises behaving in a commercially rational
manner...’. In the absence of sufficient reliable data as to
comparable dealings between independent parties dealing
at arm’s length, the question of whether the associated en-
terprise arrangements accord with what would have been
adopted by independent enterprises behaving in a com-
mercially rational manner can be evaluated by considering
what makes commercial sense for the parties, having re-
gard to what is in their best economic interests and the op-
tions realistically available to them at arm’s length.
143. Where one of the circumstances in paragraph 1.37
applies to permit non-recognition of the parties’ characteri-
sation or structuring of the arrangement, Article 9 would
allow an adjustment of conditions to reflect those which
the parties would have attained had the transaction been
structured in accordance with the economic and commer-
cial reality of parties dealing at arm’s length.71 The Com-
missioner will apply treaty Article 9 in such a case to
achieve an outcome that is consistent with the outcome of
applying Division 13 in accordance with this draft Ruling.
Thus, treaty Article 9 will be applied to adjust the pricing
of a transaction between associated enterprises under a
business restructuring arrangement by reference to the
pricing that might reasonably be expected if the arrange-
ment were characterised or structured as under an agree-
ment between independent parties dealing at arm’s length
in comparable circumstances.
Documentation
144. In analysing a business restructuring, a tax adminis-
tration needs to examine the facts and circumstances of the
business restructuring so as to gain an understanding of
what has changed and the impact of those changes. In ap-
plying the arm’s length principle, it is relevant for a tax ad-
ministration to consider the underlying commercial and
strategic drivers for the business restructuring and the
business objectives being pursued. It should not be ex-
pected to simply accept a taxpayer’s assertions that the
business restructuring has a commercial and/or strategic
rationale.
145. The ATO recognises that within MNEs, commercial
strategy and objectives may be set at the global, regional or
product/functional group level. The local directors and
management are generally responsible for the implementa-
tion and/or execution of the overall strategy decisions
within their own areas of responsibility. In discharging
their duties to the local business or entity, the directors
should make a commercial assessment as to the terms and
conditions of the arrangements and ensure that these ac-
cord with the arm’s length principle for income tax pur-
poses, but this follows from, rather than drives the overall
strategic decision-making process.
146. In terms of documenting the decision-making pro-
cess, the practical result is that often, much of the docu-
mentation supporting the overall strategic decision-making
process will also be at the global, regional or product/
functional group level, not at the entity level. In order to
evidence that the terms of a business restructuring comply
with the arm’s length principle for income tax purposes,
detailed local documentation will also ordinarily need to be
prepared at the entity level, even if this is not required for
the decision-making process. The fact that this documenta-
tion is prepared outside the main decision-making process
relating to the business restructuring does not in itself in-
71
See paragraph 1.38 of the OECD Guidelines.
BNA TAX 6-3-10
128 (Vol. 19, No. 3) TEXT

dicate that the terms of the restructuring are not arm’s Paragraph
length.
Ruling 8
147. The ATO’s expectations as to the documentation
that a taxpayer should have to evidence compliance with Date of effect 22
the arm’s length principle are stated in general terms in TR Appendix 1 – Case study 23
98/11. These expectations apply to business restructuring Facts 24
arrangements. Chapter 5 of TR 98/11 discusses in detail the
nature and extent of the documentation relevant to the Arrangement 27
4-Step process suggested in that Ruling. TR 98/11 indicates Step 1: Characterise the international dealings
why it is in a taxpayer’s interests to have contemporaneous between the associated enterprises in the con-
documentation, relevant to managing its risk of transfer text of the taxpayer’s business 28
pricing audit, adjustments and penalties. It also indicates Step 2: Select the most appropriate transfer pric-
that a taxpayer should apply a ‘reasonable business per- ing methodology or methodologies 30
son’ approach to determining the amount of documenta- Step 3: Apply the most appropriate method and
tion it should have, taking account of the significance and determine an arm’s length outcome 34
complexity of the issues involved.
148. Consistent with TR 98/11, in examining the applica- Appendix 2 - Explanation 43
tion of the arm’s length principle to a business restructur- Step 1: Characterise the international dealings
ing, the Commissioner will ordinarily seek at a minimum between the associated enterprises in the con-
the following types of documentation: text of the taxpayer’s business 48
(a) the MNE’s internal analyses, reports, submissions Step 2: Select the most appropriate transfer
and calculations relevant to the decision to restruc- pricing methodology or methodologies 68
ture and to shift particular functions, assets and risks; The other options realistically available to the
(b) documentation articulating the business context for parties at arm’s length 86
the business restructuring and the benefits and effi-
ciencies that are expected from it, both from the per- Relevance of the concept of ‘risk-reward trade-
spectives of the MNE group and the individual group off’ to the choice of options 98
members involved; The allocation of risk under the restructured ar-
(c) any relevant contracts, including those entered into to rangements 101
implement the business restructuring (for example, Step 3: Apply the most appropriate method and
contracts for the sale of property) and those evidenc- determine an arm’s length outcome 107
ing the terms of the pre and post-restructuring ar- Determining the consideration that might reason-
rangements for the business activities affected by the ably be expected under an agreement between
restructuring; independent parties dealing at arm’s length in
(d) documentation of functional analyses of the func- comparable circumstances 110
tions performed, assets used and risks assumed un-
der both the pre and post-restructuring arrangements Whether there has been a transfer of property 115
for the business activities affected by the restructur- Whether there has been the supply of a benefit 121
ing; and Whether the taxpayer as an independent party
(e) documentation of comparability analyses using avail- would have a right to compensation for termi-
able uncontrolled comparables data to determine nation of its existing arrangements 132
arm’s length pricing for the business restructuring. Determining arm’s length pricing using an ar-
rangement that might reasonably be expected to
Appendix 3 – Your comments exist between independent parties dealing at
149. You are invited to comment on this draft Ruling. arm’s length in comparable circumstances 135
Please forward your comments to the contact officer by the
due date. Division 13 135
150. A compendium of comments is also prepared for the Treaty Article 9 140
consideration of the relevant Rulings Panel or relevant tax Documentation 144
officers. An edited version (names and identifying informa- Appendix 3 – Your comments 149
tion removed) of the compendium of comments will also be
prepared to: Appendix 4 – Detailed contents list 151
s provide responses to persons providing comments;
and References
s publish on the ATO website at www.ato.gov.au.
Please advise if you do not want your comments included Previous draft:
in the edited version of the compendium. Not previously issued as a draft

Due date: 30 July 2010 Related Rulings/Determinations:

TR 94/14; TR 97/20; TR 98/11;
Contact officer: Marc Simpson
TR 1999/1; TR 2001/13;
Email address: marc.simpson@ato.gov.au TR 2006/10; TR 2009/D6
Telephone: (03) 9275 2577
Facsimile: (03) 9275 2606 Subject references:
Address: Australian Taxation Office - arm’s length consideration
- arm’s length principle
PO Box 9977 - associated enterprises
Box Hill VIC 3128 - business restructuring
- commercial sense
Appendix 4 – Detailed contents list - commercially rational
151. The following is a detailed contents list for this Rul- - commissionaire arrangement
ing: - comparability
- comparability analysis
Paragraph
- dealing at arm’s length
What this Ruling is about 1 - documentation

6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069
TEXT (Vol. 19, No. 3) 129

- double tax agreements - ITAA 1936 136AD(1)(b)

- economic substance - ITAA 1936 136AD(1)(c)
- functional analysis - ITAA 1936 136AD(1)(d)
- intangible property - ITAA 1936 136AD(2)
- international agreement - ITAA 1936 136AD(2)(c)
- multinational enterprise - ITAA 1936 136AD(3)
- options realistically available - ITAA 1936 136AD(3)(c)
- organisation for economic co-operation & development - ITAA 1936 136AD(4)
- product supply chain - ITAA 1936 Pt IVA
- risk allocation - ITAA 1936 Pt X
- risk transfer - International Tax Agreements Act 1953
- toll manufacturing
- transfer of assets Other references:
- transfer of functions - Attributing profits to a dependent agent permanent es-
- transfer pricing tablishment
September 2005, available on the ATO’s website ww-
Legislative references: w.ato.gov.au
- ITAA 1936 - Transfer Pricing Guidelines for Multinational Enter-
- ITAA 1936 Pt III Div 13 prises and Tax Administrations,
- ITAA 1936 136AA(1) Organisation for Economic Co-operation & Develop-
- ITAA 1936 136AA(3) ment 2009
- ITAA 1936 136AA(3)(c) ATO references
- ITAA 1936 136AA(3)(d) NO: 1-1W3DXPC
- ITAA 1936 136AD ISSN: 1039-0731
- ITAA 1936 136AD(1) ATOlaw topic: Income Tax ~~ Entity specific matters
- ITAA 1936 136AD(1)(a) ~~ transfer pricing

Canada Revenue Agency’s Brief in Queen v. GE Capital Canada

[Canada’s Federal Court of Appeal, No. A-1-10]

APPELLANT’S MEMORANDUM OF FACT AND LAW B. ERRORS OF LAW

i) The trial judge failed to identify the relevant transac-
Ontario Regional Office tion by introducing a non-existent fact or hypothetical
The Exchange Tower fact into the analysis
130 King St. West ii) The trial judge failed to consider all economically
Suite 3400, Box 36 relevant characteristics that might impact on pricing
Toronto, Ontario iii) The trial judge failed to do a ‘‘reasonableness’’
M5X 1K6 check
Naomi Goldstein iv) The trial judge misapplied the ‘‘business judgment
Myra J. Yuzak rule’’
Justine Malone C. PALPABLE AND OVERRIDING ERRORS OF FACT
William Softley i) The trial judge erred in rejecting the evidence of Em-
mer and the corroborating evidence of Saunders and
Tel: (416) 973-2334 Meyerman for inappropriate reasons
Fax: (416) 973-0810 ii) The trial judge erred in concluding that the evidence
of Chambers was preferable
Counsel for the appellant
iii) The trial judge erred in concluding that the respon-
dent could not get back-up credit facilities
Osler, Hoskin & Harcourt LLP iv) Other errors in comprehending the evidence
Barristers and Solicitors D. THE TRIAL JUDGE’S CONDUCT AMOUNTED TO A FAILURE
1 First Canadian Place, Box 50 TO OBSERVE THE PRINCIPLES OF NATURAL JUSTICE AND
Toronto, Ontario PROCEDURAL FAIRNESS
M5X 1B8 i) Unfairness During the Trial Process
AL Meghji ii) Reasons for Judgment are Inadequate
Joseph M. Steiner PART IV—ORDER SOUGHT
Martha MacDonald PART V—LIST OF AUTHORITIES
Neil Paris APPENDICES
A. Examples of Inconsistencies in Testimony of Werner
Tel: (416) 862-5677 B. Errors and Omissions in Chambers’ Report and Testi-
Fax: (4t6) 862-6666 mony
Counsel for the respondent C. Questions asked by Counsel and Trial Judge
D. History of Issue re: the Impact of the Removal of the
TABLE OF CONTENTS Explicit Guarantee
E. Nova Scotia Unlimited Liability Corporation
PART I—STATEMENT OF FACTS F. Cases and Authorities Considered by Trial Judge that
PART II—POINTS IN ISSUE were not addressed by the Parties
PART III—SUBMISSIONS G. Evidentiary Rulings Taken Under Advisement by Trial
A. STANDARD OF REVIEW Judge, but not addressed in Reasons

TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 6-3-10
130 (Vol. 19, No. 3)
H. Significant Evidence Put to the Witnesses not ad-
dressed in the Reasons
APPELLANTS MEMORANDUM OF FACT AND LAW
1. Between 1996 and 2000, General Electric Capital Cor-
poration was General Electric Company’s principal financ-
ing subsidiary, responsible for raising in excess of $50 bil-
lion every week in the commercial paper market and bil-
lions more in the longer term bond market. Both the
commercial paper and bond markets rely on banks, traders
or specialized agents to buy or identify buyers for the prod-
ucts.
2. Reputation is extremely important in this unregulated
market and General Electric Company and General Elec-
tric Capital Corporation work hard to maintain their out-
standing reputations. Their commitment to upholding the
highest standards of integrity and character was well
known in the industry. Maintaining the highest possible
credit rating of AAA, a rating above those of the Canadian
banks, was essential to their business model. No financing
subsidiary bearing the General Electric name has ever de-
faulted on any of its debt.
3. The treasury department of General Electric Capital
Corporation, in Stamford, Connecticut, was responsible for
managing all of the debt issuances of its financing subsid-
iaries, including those issued in the name of the respon-
dent, General Electric Capital Canada Inc. The treasury de-
partment determined how much debt would issue in the re-
spondent’s name, its terms, the type of debt, to whom it
would offer the debt issuances and whether it would repay
the debts. In 1995, the treasury department decided that it
should, for the first time, charge a 1% fee for the explicit
guarantees which had appeared on the respondent’s debts
since 1967. The respondent had no say in any of this; in-
deed it had no treasury people in Canada.
4. The respondent sought to deduct guarantee fees paid
to its parent totalling approximately $135 million in the
1996 to 2000 taxation years. The Canada Revenue Agency
disallowed the deductions on the basis that the explicit
guarantees were superfluous and of no value since credit
rating agencies would recognize that General Electric
Capital Corporation would have economic incentives to im-
plicitly support the respondent and it would not permit it
to default on the debt issuances issued in its name.
PART I—STATEMENT OF FACTS
Background
5. The respondent was a financial services company dur-
ing the years under appeal and an indirect wholly-owned
subsidiary of General Electric Company (‘‘GE’’) and its
subsidiary General Electric Capital Corporation (‘‘GE-
CUS’’), both United States companies.
6. Both GECUS and the respondent borrowed funds from
the capital markets by issuing commercial paper and unse-
cured debentures (bonds) at a low cost. The funds bor-
rowed by GECUS were lent to the operating branches
within the GE group of companies and the funds raised
through the debt issued in the respondent’s name were
mostly used by the operating branches in Canada.
7. In the years under appeal (1996-2000), commercial pa-
per and bonds issued in the respondent’s name were ex-
plicitly guaranteed by GECUS. The respondent paid GE-
CUS a guarantee fee of 1% (100 basis points) of the face
amount of these debt issuances.
8. The debt offerings issued in the respondent’s name
had, between 1967 and 1988, been explicitly guaranteed by
its Canadian parent company. The reason for this was to
enable the respondent’s debt issuances to meet the defini-
tion of a ‘‘Legal for Life’’ investment in acts like the
Canada Pension Plan or the Trust Company Act or for in-
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
surance companies.2 While the definitions were removed
in 1991, the explicit guarantees continued.3
9. The debt issuances made in the respondent’s name
had been explicitly guaranteed by GECUS since 1988, but
no guarantee fees were charged by GECUS to the respon-
dent for the explicit guarantees until 1996, the first taxation
year under appeal. The payment of the fee was introduced
on the advice of tax counsel for GECUS. The amount of the
fee paid by the respondent to GECUS was determined by
Jeff Werner of the GECUS treasury department and Jim
Parke of GECUS, on behalf of both GECUS and the re-
spondent.
10. While no documentation was retained by GECUS re-
lating to how the amount of the 1% fee was determined,4
Werner testified that it was based on the difference in in-
terest rates (yield spread) between the credit rating the re-
spondent received with the explicit guarantees in place
(AAA) and the credit ratings Werner believed the respon-
dent would achieve without the explicit guarantees, that is
credit ratings for commercial paper were probably not in-
vestment grade (i.e., below BBB), and for bonds, were on
the edge of investment grade (i.e. BBB+).5
11. The Canada Revenue Agency disallowed the deduc-
tion of the guarantee fees because the explicit guarantees
were superfluous. Under Standard & Poor’s (‘‘S&P’’) crite-
ria for parent/subsidiary rating links, the respondent would
be considered a core subsidiary: a subsidiary whose parent
would support it under any foreseeable circumstance6 and
the respondent’s credit rating would have been the same as
that of its parent without the explicit guarantees.
Interaction between GECUS debt issuances and those of
the respondent
12. The business model of GECUS provided for the fund-
ing of the operating branches through debt issuances by
GECUS.7 The respondent was one of only two GE financial
companies (the other being GE Capital Australia) that were
permitted to have commercial paper and bonds issued in
their own names.8 These two exceptions were put in place
to avoid the payment of withholding tax that would have
been payable if GECUS had borrowed the funds directly
and loaned them to Canada or Australia)9
13. GECUS was the largest corporate issuer of bonds in
the world’s capital markets. The main underwriters and
syndicate members with respect to the bonds issued in the
2
If there was a guarantee, the respondent did not have to meet
specified financial ratios. Testimony of Booth, p. 827, ll. 08-25; p.
828, l. 01 to p. 829, l. 10; Testimony of Werner, p. 468, l. 01 to p.
470; l. 06.
3
Testimony of Booth, p. 827, l. 08 to p. 829, l. 10.
4
Reasons for Judgment (‘‘Reasons’’), para [13].
5
Testimony of Werner, p. 211, l. 20 to p. 212, l. 02; p. 214, ll.
10-16; p. 225, ll. 04-13; p. 238, ll. 16-25. Although different credit
rating agencies use different rating systems (see Exhibit A-80, Re-
port of Booth, p. 12 and Tabs 2, 3, and 4, Appeal Book, Vol. 12, Tab
96 at pp. 3201 and 3220-3222), S&P would consider BBB+ to be in-
vestment grade and DBRS would consider R-1 low to be invest-
ment grade. R-2 corresponds to BBB+ (Testimony of Booth, p. 535,
l. 23 to p. 536, l. 04; p. 570, ll. 16-21).
6
See e.g. Exhibit R-12, Parent/Subsidiary Rating Links, Tab 3,
Appeal Book, Vol. 17, Tab 129, pp. 5059-5065. A ‘‘strategically im-
portant’’ subsidiary is one where there is some doubt concerning
unequivocal eligibility for core group status. Non-strategic (or in-
dependent) is regarded as akin to passive investments of the group
(Exhibit R-12, Criteria/Financial Institutions/General: Revised Fi-
nancial Services Group Methodology Addresses Increased Willing-
ness to Sell Underperforming Subsidiaries, Tab 6, Appeal Book,
Vol. 17, Tab 129, p. 5090 and p. 5092).
7
Testimony of Werner, p. 144, ll. 03-14.
8
Testimony of Werner, p. 113, ll. 18-23; p. 157, l. 16 to p. 158, l.
13.
9
Reasons, para. [87]; Testimony of Werner, p.158, l. 25 to p.
159, l. 19; p. 311, ll. 20-25.
TMTR ISSN 1063-2069
TEXT
respondent’s name were the same as those for GECUS’s is-
suances in the mid-term note Euro bond program.10
Commercial Paper Program
14. Commercial paper is generally issued for 30 days
only. The commercial paper market attracts sophisticated
investors looking for a place to ‘‘park’’ funds for a short pe-
riod. GECUS was the largest commercial paper issuer in
the US, Canada and the world. GECUS issued a total of
$1.3 trillion (USD) of commercial paper debt in the first six
months of 1999.11
15. As a result of previous credit crises, commercial pa-
per issuers had12 to have bank credit back-up facilities
equal to 50% of the outstanding debt in case of liquidity
problems. GECUS had such facilities which were available
to support all of the commercial paper issued in the name
of the respondent. In addition, substantially all of GE’s
credit lines (approximately $4.2 billion) were available to
GECUS and its affiliates, including the respondent.13 The
fees paid by GE and GECUS for these credit lines, 5 to 6
basis points, were described as ‘‘immaterial’’ by GE.14
16. Any whiff of default in the commercial paper market
would cause ‘‘a flight to quality’’; that is, investors would
move their money from the commercial paper market to
Treasury Bills.15 The back-up lines of credit might provide
GECUS with a week’s worth of funds if the commercial pa-
per market switched to Treasury Bills.16
17. In 1995, GECUS enquired of the Royal Bank of
Canada and the Bank of Nova Scotia as to the respondent’s
ability to obtain unguaranteed credit facilities of up to $2
billion.17 These banks responded in 1995 with pricing op-
tions for credit facilities in the respondent’s name. At trial,
the two bankers who had responded to GECUS confirmed
that a syndication of banks might have been put together
to procure the respondent with lines of credit of $2 billion
without an explicit guarantee by GECUS.
GECUS’s Credit Rating
18. GECUS had a AAA issuer rating from the premier
rating company, S&P, for 1996 to 2000 and was one of the
very few companies in the world whose debt issuances had
been assigned ratings of AAA, R-1 (high) and A-1 (high). It
was the only full service US financial institution with an
AAA rating.
19. GECUS, as an unregulated financial services com-
pany, greatly valued its reputation and the AAA rating,
which allowed it to have access to low-cost debt issuances.
The credit rating of GECUS was one of its most valuable
resources.18 A default of the debt issued in the respon-
dent’s name would have jeopardized the AAA rating of GE-
CUS, costing it hundreds of millions of dollars per annum
in interest in the event of even a one notch downgrade19
10
Testimony of Werner, p. 378, ll. 02-08.
11
Testimony of Werner, p. 387, l. 15 to p. 388, l. 21.
12
Although not a legal requirement, the credit rating agencies
would not issue a credit rating unless the issuer or its guarantor
had back-up lines of credit (Testimony of Booth, p. 553, ll. 06-18).
13
Testimony of Werner, p. 367, l. 10 to p. 368, l. 06.
14
Testimony of Werner, p. 369, ll. 10-25.
15
Testimony of Booth, p. 603, l. 19 to p. 604, l. 16.
16
GECUS turned over $50 billion per week in commercial pa-
per and if GECUS allowed the respondent to default, there would
result a massive shock to the commercial paper market. GECUS
would have great difficulties raising $50 billion in a week (Testi-
mony of Booth, p. 867, l. 01 to p. 871, l. 09; Testimony of Emmer,
p. 2930, l. 04 to p. 2931, l. 13).
17
The highest year end outstanding commercial paper issued in
the respondent’s name was $2,331,903,096 in 1996, so $2 billion
would suffice to cover 50% of the outstanding commercial paper.
Notice of Appeal, 2006(1385)(IT)G, Exhibit A, Appeal Book, Vol. 1,
Tab 3, p. 113.
18
Testimony of Werner, p. 327, ll. 15-24 and Exhibit R-3, In-
struction Manual, Appeal Book, Vol. 17, Tab 119, pp. 4816-4824.
19
Testimony of Booth, p. 823, l. 13 to p. 824, l. 07.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 131
and compromised GECUS’s ability to roll over its commer-
cial paper.20
20. GECUS had never allowed any of its financial subsid-
iaries to default on their debt.21 A wholly owned subsidiary
with the GE name had never been allowed to fail.22 Werner
testified that the significance of having the AAA rating
meant ‘‘. . .that customers always knew we were going to
be there to honour our commitments. . .’’23
Treasury Functions
21. GECUS controlled all treasury functions relating to
the debt issuances in the respondent’s name. The respon-
dent had no treasury department of its own.24 The deci-
sions in respect of the amount of debt to be issued in the
respondent’s name were made daily by GECUS. GECUS
had complete control over the capital market borrowings
of the respondent and centralized policies had been put in
place to ensure prior approval by GECUS for all borrow-
ings by its subsidiaries:
The purpose of this instruction and this letter
[Exhibit R-3] that went out was to control all bor-
rowings at the Stanford [sic] corporate level. Sub-
sidiaries could not enter the market. They couldn’t
dictate terms. They couldn’t write covenants. Any-
thing that a subsidiary did in the market, or any-
body did in the market, affected all of our out-
standing debt. I couldn’t have people going out
running around saying they were GE Capital, and
issuing bonds and borrowing money and selling
commercial paper on terms that were not favour-
able to us.25
22. Werner was the treasurer of both GECUS and the re-
spondent. GECUS had management control over the re-
spondent.26 Werner could not recall the respondent ever
having a board meeting.27 He testified that the respondent
should be viewed as an extension of the U.S. operations of
GECUS.28 Further, as a wholly owned subsidiary, the re-
spondent’s debt to equity ratio was also determined by GE-
CUS.29
23. GECUS charged the respondent a 1% guarantee fee
totalling approximately $135 million for 1996 to 2000, de-
spite GECUS’s complete control over its debt issuances.
Evidence presented before the Tax Court
24. There were 17 days of testimony at trial, during
which 20 witnesses testified.
25. The appellant called 5 experts:
s Prof. Anthony Saunders, an expert economist, spe-
cializing in credit risk measurement, analysis and
valuations relating to debt guarantees based on
creditworthiness;
20
Testimony of Booth, p. 863, l. 19 to p. 864, l. 13; Testimony of
Emmer, p. 2930, l. 06 to p. 2931, l. 13.
21
Testimony of Emmer, p. 2925, ll. 07-23; Testimony of
Daubaras, p. 2223, l. 21 to p. 2225, l. 18: that the respondent could
locate only 3 instances where a GE company ‘‘went under.’’ None
were financial subsidiaries; Testimony of Chambers, p. 1739, ll. 08-
17: who could not recall a GE-named subsidiary that defaulted, ex-
cept ‘‘. . . vague memories of a Venezuelan sub that was allowed to
default, but that probably involved sovereign risk elements. . .’’
22
Testimony of Werner, p. 421, ll. 08-12.
23
Testimony of Werner, p. 185, l. 16 to p. 186, l. 13.
24
Reasons, para. [11]; Testimony of Werner, p. 332, ll. 14-24.
25
Testimony of Werner, p. 326, ll. 01-24; p. 329, l. 23 to p. 330,
l. 10; p. 355, l. 17 to p. 356, l. 21; Exhibit R-3, Instruction Manual,
Appeal Book, Vol. 17, Tab 119, p. 4816.
26
Testimony of Werner, p. 318, l. 18 to p. 321, l. 17.
27
Testimony of Werner, p. 320, ll. 13-24.
28
Testimony of Werner, p. 134, l. 19 to p. 135, l. 10.
29
Testimony of Werner, p. 410, ll. 17-22.
BNA TAX 6-3-10
132 (Vol. 19, No. 3)
s Harold Meyerman, a banking expert and former
Head of Financial Institutions Group at Chase Man-
hattan, GECUS’s top tier bank (in rebuttal); s Ed-
ward Emmer, an expert in credit risk analysis and a
former S&P employee;
s Dr. Brian Becker, a transfer pricing expert; and
s Dr. Deloris Wright, a transfer pricing expert (in re-
buttal).
26. The respondent called 7 experts:
s Prof. Lawrence Booth, an expert in the capital mar-
kets, who also attempted to value an arm’s length
guarantee fee by analogy to Banker’s Acceptance
rates;
s John Hull, an expert in credit derivatives and risk
management who attempted to determine the value
of the explicit guarantee by analogy to credit default
swaps;
s John Coombs, an expert in banking and credit mat-
ters;
s Stephen Cole, a valuator;
s Anthony Scilipoti, a chartered accountant and ana-
lyst of financial data of companies;
s Dr. William Chambers, a former S&P employee,
qualified as an expert in the credit rating industry
and credit rating procedures within the credit rating
agencies; and
s Mark Fidelman, a transfer pricing economist and in-
surance pricing industry specialist, who presented
an insurance model analogy as a means of valuing
the explicit guarantee.
Valuation of the guarantee—credit rating differential
27. In order to determine whether the respondent en-
joyed any benefit as a result of the explicit guarantees from
GECUS, and, if it did, its value, both parties presented ex-
pert evidence on the credit rating that S&P would have as-
signed to the respondent’s debt issuances without explicit
guarantees.
28. For the appellant, Emmer and Saunders opined that
S&P would assign AAA to the respondent in the absence of
explicit guarantees. Meyerman assumed that if Chase
Manhattan had done an internal review on the issue, it, too,
would have arrived at an AAA rating.30 Saunders also con-
sidered the possibility that the respondent might only be
Considered a strategically important subsidiary31 and
rated AA+, with the result that the guarantee fee would av-
erage between. 15% and .24% per annum.32
29. For the respondent, Coombs testified that he would
not be surprised if the credit rating agencies gave the re-
spondent a rating of AAA in the absence of an explicit
guarantee,33 while Chambers concluded that the best rat-
ing it could expect to receive without an explicit guarantee
would be BB/BB+.34
Judgment of the Tax Court of Canada
30. The trial judge made the following findings:
(a) the explicit guarantees of the respondent’s debt
were necessary for the respondent’s credit rating to
be equalized with that of its parent;35
30
Testimony of Meyerman, p. 2718, l. 13 to p. 2720, l. 06.
31
Exhibit R-24, Report of Saunders, pp. 12 and 15, Appeal
Book, Vol. 18, Tab 141, pp. 5208 and 5211.
32
Testimony of Saunders, p. 2403, l. 08 to p. 2404, l. 24; Exhibit
R-24, Report of Saunders, Tabs 8 and 13, Appeal Book, Vol. 18, Tab
141, pp. 5254 and 5259.
33
Testimony of Coombs, p. 1210, l. 12 to p. 1211, l. 09.
34
Exhibit A-85, Report of Chambers at pp. 28-30, Appeal Book,
Vol. 13, Tab 101, pp. 3726 to 3728.
35
Reasons, paras. [290] and [291].
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
(b) the respondent’s credit rating in the absence of
the explicit support would have been no higher than
BBB-/BB+;36 and
(c) no large banking syndicate could have been put
together to support the respondent’s commercial pa-
per program.37
31. The trial judge concluded that the interest rate differ-
ential between a BBB-/BB+ and an AAA rating was at least
183 basis points and, therefore, the benefit which the re-
spondent received was 183 basis points, higher than the 1%
guarantee fee being charged. The appeal was allowed and
the reassessments vacated.
PART II—POINTS IN ISSUE
32. The issues in this appeal are whether:
(a) the trial judge erred in law in his application of
transfer pricing principles and methodology and in
his understanding of the .use he could make of evi-
dence of business judgment;
(b) the trial judge made palpable and overriding er-
rors of fact; and
(c) the trial judge’s conduct amounted to a failure to
observe the principles of natural justice and proce-
dural fairness during the trial process.
PART III—SUBMISSIONS
A. STANDARD OF REVIEW
33. The general standard of appellate review is correct-
ness for pure questions of law and palpable and overriding
error for conclusions of fact or mixed fact and law.38 A
question of mixed fact and law can amount to a pure error
of law subject to the correctness standard, such as the mis-
application of a legal standard to the facts, a mischaracter-
ization of the legal consequences that result from the facts
or a question of precedential significance.39
34. On questions of fact, a trial judge’s finding should not
be interfered with unless it is established that the trial
judge made a ‘‘palpable and overriding error.’’40 The
‘‘functional equivalents’’ of palpable and overriding error
include: ‘‘clearly wrong’’, ‘‘unreasonable’’ and ‘‘not reason-
ably supported by the evidence.’’41
35. However, the traditional deferential standard of re-
view for factual conclusions of trial judges ‘‘assumes a de-
cision which is the product of a fair and impartial pro-
cess.’’42 An appeal court should show less deference to
findings and conclusions of fact,43 including decisions as to
36
Reasons, para. [301].
37
Reasons, para. [296].
38
Housen v. Nikolaisen, [2002] 2 S.C.R. 235 (‘‘Housen’’) at paras.
8, 26-28, and 36.
39
See generally Housen, supra paras. 27, 31, 33, and 35; St.-
Jean v. Mercier, [2002] 1 S.C.R. 491 at paras. 48-49; ABB Inc. v.
Domtar Inc., [2007] 3 S.C.R. 461 at paras. 36-37; Gallop v. Mulatz,
2008 SKCA 29 at para. 34; Murphy v. S.G.I., 2008 SKCA 57 at para.
4; Canada (Director of Investigation and Research) v. Southam
Inc., [1997] 1 S.C.R. 748 at paras. 32-39, para. 35 cited with ap-
proval in Singleton v Canada, [1999] 4 F.C. 484 per Rothstein at
para. 42 (affirmed by the SCC at [2001] 2 S.C.R. 1046), para. 39
cited with approval in Housen at para. 27.
40
Housen, supra at paras. 5-6; H.L. v. Canada (Attorney Gen-
eral), [2005] 1 S.C.R. 401 (‘‘H.L.’’) at paras. 53-54; Geffen v. Good-
man Estate, [1991] 2 S.C.R. 353 at paras. 66-68.
41
H.L., Ibid. at paras. 55-56 and 71-75. See also R. v. W., [1992]
2 S.C.R. 122 at pp. 131-132; Waxman v. Waxman, [2004] O.J. No.
1765 (Ont. C.A.) at paras. 305-306; Rich v. Canada, [2003] 3 F.C.
493 (FCA) per Evans J.A. at para. 38.
42
Sloboda v. Sloboda, 2007 SKCA 15 (‘‘Sloboda’’) at para 13.
43
Nunn v. Canada, [2006] F.C.J. No. 1852 at para. 23; C.U.P.E.
v. Ontario (Minister of Labour), [2003] 1 S.C.R. 539; Ellis-Don Ltd.
TMTR ISSN 1063-2069
TEXT
credibility, which are tainted by breaches of due process.
Questions of procedural fairness and natural justice are
questions of law and are to be reviewed against the stan-
dard of correctness.
B. ERRORS OF LAW
36. Both former subsection 69(2), applicable to the 1996
and 1997 taxation years, and subsection 247(2) of the In-
come Tax Act (the ‘‘Act’’), applicable to the 1998 and sub-
sequent taxation years, incorporate the arm’s length stan-
dard to determine whether the terms and conditions of a
transaction between related parties, in this case the price
paid by the respondent to GECUS for the guarantee fees,
are the same as they would have been had the transactions
taken place between unrelated parties. In Canada, the de-
termination of whether a transfer price is in line with an
arm’s length price is informed by the OECD Guidelines
and reiterated in the Canada-U.S. Tax Treaty.44
37. Generally, in analyzing a transfer pricing issue, the
following steps are undertaken:45
(a) identify the relevant transaction, the facts and the
parties to the transaction;
(b) identify all important characteristics of the trans-
action that may impact on pricing between unrelated
parties, including functions performed and risks in-
curred (‘‘the economically relevant characteristics’’);
(c) identify comparables and/or other pricing meth-
odologies to arrive at an unadjusted arm’s length
price;
(d) make adjustments, if any, to the Comparable
price to take into account the economically relevant
differences between the comparable and the relevant
transaction; and
(e) in some instances, do a ‘‘reasonableness’’ or
‘‘sanity’’ check.
38. In the present case, the trial judge made numerous
errors in applying the foregoing steps. He misidentified the
transaction in issue by introducing an irrelevant hypotheti-
cal fact and he failed to give any weight to economically
relevant characteristics of the transaction by preferring an
expert’s report which failed to properly consider those
characteristics. He did not do a proper reasonableness
check to validate the results of his primary conclusion of
value. In addition, he misapplied what he termed the ‘‘busi-
ness judgment role’’ while acknowledging that its applica-
tion in the context of section 247 and transfer pricing is
problematic.
i) The trial judge failed to identify the relevant transaction
by introducing a non-existent fact or hypothetical fact
into the analysis
39. A transfer pricing analysis begins by identifying the
transaction in issue. It is the transaction between the par-
ties that must be valued. In the present case, the trial judge
identified and took into account a fact which did not exist,
namely the removal of the explicit guarantee. As a result,
he analyzed and valued a transaction different from the
one that took place between the parties.
v. Ontario (Labour Relations Board), [2001] 1 S.C.R. 221 at para
65.
44
SmithKline Beecham Animal Health Inc. v. Canada, 2002
FCA 229 at para. 8; GlaxoSmithKline v. The Queen, 2008 TCC 324 at
para. [59]; Transfer Pricing Guidelines for Multinational Enter-
prises and Tax Administration (Paris: OECD Publishing, 1995), as
supplemented through 2001 (‘‘OECD Guidelines (1995)’’);
Canada-US Income Tax Convention (1980), Article IX, Section 1.
45
Testimony of Wright, p. 3240, l.05 to p. 3242, l. 08; Reasons,
paras. [231] to [305]; OECD Guidelines (1995), Chapters I, II and
III.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 133
40. The arm’s length principle requires a comparison of
the transaction at issue between related parties and the
same transaction between independent parties.46 Only a
single fact is changed, namely, that the transaction is as-
sumed to occur between arm’s length parties.47
41. In the present case, the transaction at issue was the
imposition of the guarantee fee by GECUS in 1996 and
subsequent years for the explicit guarantees of the debt is-
suances in the respondent’s name.48
42. The trial judge introduced the withdrawal of the
guarantee49 as a relevant factor, without any evidence, le-
gal authority50 or expert opinion51 suggesting that the po-
tential removal of the guarantee was a condition that
should be considered. The withdrawal of the guarantee
was a factor which the witnesses had discussed only hypo-
thetically,52 if at all, and it was Undisputed that the explicit
guarantee in place was likely to continue indefinitely.53
Moreover, both Werner54 and Chambers,55 testifying for
the respondent, identified that there was a distinction be-
tween a situation where there had never been an explicit
guarantee and one where there would be an unexplained
withdrawal of ‘an explicit guarantee.
43. The trial judge wrongly justified his introduction of
the impact of the removal of the explicit guarantee by rely-
ing on the fact that both parties approached the starting
point of the valuation exercise (steps (b) and (c) in. para.
37 above) by asking ‘‘what would be the respondent’s
credit rating without an explicit guarantee?’’56 This valua-
tion approach is correct since the structure adopted by the
respondent and GECUS (the existence of the explicit guar-
46
OECD Guidelines (1995), para 1.15; Exhibit R-31, Report of
Beeker, paras. [2] and [4], Appeal Book, Vol. 19, Tab 148, p. 5470.
47
Testimony of Wright, p. 3240, ll. 19-24 ‘‘. . .unrelated, but oth-
erwise unchanged, is the language we tend to use. . .’’ and p. 3248,
l. 14 to p. 3249, l. 03 ‘‘. . .basically, you are trying to price the trans-
action, as it occurred, with the facts that existed in the intercom-
pany transaction just ignoring ownership.’’; See also Markham,
Michelle, The Transfer Pricing of Intangibles, 2005 Kluwer Law In-
ternational, The Hague, at p. 29 which states ‘‘Another criticism of
the arm’s length principle is that it depends on treating associated
or related enterprises as if they were unrelated, but, at the same
time, all other aspects of .the relationship were to remain un-
changed. . .’’; DSG Retail Limited et al v The Commissioners for
Her Majesty’s Revenue and Customs, [2009] UKFTT 31 (TC) (31
March 2009) at para. 78.
48
Testimony of Wright, p. 3240, ll. 09-18; p. 3247, ll. 20-22: She
acknowledged that Cole had also correctly identified the transac-
tion to be examined. See also Appellant’s [Respondent’s] Response
to the Respondent’s [Appellant’s] Supplementary Submissions,
para. 27, Appeal Book, Vol. 43, Tab 178, p. 10180.
49
Reasons, paras. [247], [279], [280], [298] and Appendix D
50
In non-transfer pricing valuation cases, the need to value
only the transaction in issue, as opposed to introducing hypotheti-
cal facts, is well recognized. See: e.g. Sun Life Assurance Co. of
Canada v Montreal, (City), [1950] S.C.R. 220 per Rinfret C.J. at pp.
223-225 and Great Western and Metropolitian Railway Companies v. Kensing-
ton Assessment Committee, [1916] 1 A.C. 23 (H.L.); Municipality Prop-
erty Assessment Corporation v. BCE Place Limited, (2010), 98 O.R.
(3d) p. 581 Superior Court of Justice.
51
The expert qualified by the respondent, Fidelman, was not
asked the question. Wright testified that if such a situation had in
fact happened, it would be a factor (Testimony of Wright, p. 3253,
ll. 17-22), as did both Chambers and Emmer. Exhibit A-88, Report
of Cole, pp. 36-41; Appeal Book, Vol. 13, Tab 104, pp. 3828-3833.
See Appendix D
52
Testimony of Werner, p. 216, ll. 14-21; Testimony of Cham-
bers, p. 1471, l. 19 to p. 1474, l. 23.
53
Testimony of Booth, p. 668, ll. 07-09; Testimony of Hull, p.
1888, l. 02 to p. 1889, l. 01; Exhibit A-87, Report of Hull, p. 3, para.
9 and footnote 2 thereto; Appeal Book, Vol. 13, Tab 103, p. 3763.
54
Testimony of Werner, at p. 504, ll. 06-12.
55
Testimony of Chambers at p. 1471, l. 19 top. 1473, l. 12.
56
Exhibit R-28, Report of Emmer, pp. 7 and 41, Appeal Book,
Vol. 18, Tab 145, pp. 5333 and 5366; Exhibit A-85, Report of Cham-
bers, p. 1, Appeal Book, Vol. 13, Tab 101, p. 3699.
BNA TAX 6-3-10
134 (Vol. 19, No. 3)
antee) impedes the valuation of the benefit of the implicit
support. However, the trial judge failed to appreciate that
the hypothesis of the lack of an explicit guarantee was a)
not a fact of the transaction and b) should only be consid-
ered for the purpose of the valuation exercise, a separate
undertaking required subsequent to the identification of
the relevant facts of the transaction.57
44. The trial judge improperly also rejected the testimony
of the appellant’s experts on the basis that they had failed
to consider the removal of the guarantee.58 As a result, he
reached a very different conclusion and imputed a larger
value to the guarantee than if he had restricted his analysis
to the actual transaction between the parties.
ii) The trial judge failed to consider all economically
relevant characteristics that might impact on pricing
45. There were no comparable transactions from which
the value of a reasonable guarantee fee could be inferred59
The trial judge identified that the initial determination of
the value of the benefit of the explicit guarantees rested on
the assessment of the respondent’s credit rating, absent an
explicit guarantee. Each party called evidence as to the
likely credit rating of the respondent, absent an explicit
guarantee, using S&P and other criteria.
46. The trial judge preferred the analysis of the respon-
dent’s expert Chambers in determining the respondent’s
credit rating without an explicit guarantee. However,
Chambers’ report was deficient insofar as it failed to ad-
dress four significant characteristics which the trial judge
recognized were relevant in assessing the value of the ex-
plicit guarantees, namely:
a) the lack of risk to the respondent because of GE-
CUS’s total control over the default risk;
b) the economic incentive to GECUS in avoiding a
default;
c) the interrelationship of customers and sources of
capital of both GECUS and the respondent and the
reputational value of maintaining good relationships
with common investors; and
d) GE’s and GECUS’s public posture and prior track
record.
In relying on Chambers’ faulty analysis, the trial judge
failed to take into account relevant factors in arriving at the
value of the benefit to the respondent and an arm’s length
price for the explicit guarantees.
47. The functions and risks that may impact on a trans-
fer price are often referred to as ‘‘economically relevant
characteristics’’ and a proper identification of the functions
and risks of each related party to the transaction lies at the
heart of determining an appropriate transfer price.60
Where no price is directly comparable (i.e. no comparable
uncontrolled prices), transfer pricing methods attempt to
determine an arm’s length compensation based on the
57
Testimony of Wright, p. 3251, ll. 02-18.
58
Reasons, para. [279].
59
Reasons, para. [252].
60
Testimony of Fidelman, p. 972, ll. 06-23; Exhibit R-31, Report
of Becker, p. 13, Appeal Book, Vol. 19, Tab 148, p. 5482; Exhibit
R-33, Report of Wright, (status uncertain), p. 2, Appeal Book, Vol.
19, Tab 150 p. 5523; GlaxoSmithKline, supra paras. [79] and [129];
OECD Guidelines (1995); Eden, Lorraine, Taxing Multinationals:
Transfer Pricing and Corporate Income in Taxation in North
America, University of Toronto press, Toronto, 19.98 at p. 235
‘‘. . . .The auditor must identify the principal functions performed
by each party, their economic significance, any employed assets,
and any material risks assumed by the parties, [footnote omitted]
and attempt to value these functions’’; Feinschreiber, Transfer
Pricing Handbook, Volume 1, John Wiley & Sons, Inc. New York,
Chapter Six, General Principles and Guidelines, at pp. 6-7; Rea-
sons, para [232].
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
functions performed, taking into account the assets used
and the risks assumed by each party to the transaction.61
48. These ‘‘economically relevant characteristics’’ are
also important factors to consider in arriving at a conclu-
sion as to the extent of implicit support, which S&P crite-
ria for determining parent/subsidiary rating links also seek
to determine. To a large degree, the two overlap regarding
the identification of tractions and risks. S&P criteria gener-
ally identify 13 factors which go toward establishing the
extent of parental implicit support and a subsidiary’s credit
rating.62 All experts, including bankers, capital market ex-
perts, and academics,63 shared the view that the question
at the root of this analysis is: does the parent have the eco-
nomic incentive to rescue the subsidiary? In analyzing this
question; the S&P criteria consider:
(a) the control or management assumed by both the
parent and subsidiary;
(b) the impact of a default by the respondent on the
parent’s business;
(c) the common customers and common sources of
capital and reputational value of maintaining a good
relationship with common investors; and
(d) the parent’s public position and prior track
record.64
49. Regarding the control or management of the debts is-
sued in the respondent’s name, Chambers was not aware
that the respondent had no treasury department,65 leading
him to conclude that the respondent would be viewed as an
‘‘independent subsidiary’’, one which ‘‘functioned in a
largely independent manner during the period of 1995 to
1999. . .’’66 This assumption underlies his entire report.
However, all decisions about debt issuances in the respon-
dent’s name were made in Stamford by GECUS. The appel-
lant’s experts and the respondent’s lay witnesses con-
firmed that control and the corresponding ability to man-
age the default risk was an economically relevant
characteristic in determining whether the explicit guaran-
tees had any value. The trial judge, by relying on Cham-
bers’ report, did not address this erroneous assumption
and thus failed to give any consideration to one of the most
important economically relevant characteristics.
50. Default risk by the respondent was an economically
relevant characteristic.67 S&P perception of the likelihood
of a default by the respondent depended upon a number of
factors, including:
(a) the impact a default by the respondent would
have on GECUS’s debt and GECUS’s ability to Con-
tinue with its commercial paper program;68
61
OECD Guidelines (1995), para. 1.20.
62
Exhibit R-12, S&P Credit Rating throughout the Years, i.e.
Tab 1 at pp. 91-93, Appeal Book, Vol. 17, Tab 129(1), pp. 5029-
5031.
63
Exhibit A-80, Report of Booth, p. 20, Appeal Book, Vol. 12,
Tab 96, p. 3209; Testimony of Saunders, p. 2384, l. 13 to p. 2385, l.
11; Testimony of Emmer, p. 3050, l. 10 to p. 3052, l. 22; Testimony
of Chambers, p. 1626, ll. 01-04.
64
Exhibit R-12, S&P Credit Rating throughout the Years, i.e.
Tab 1 at p. 93, Appeal Book, Vol. 17, Tab 129(1), pp. 5031 and 5035.
65
Testimony of Chambers, p. 1557, ll. 09-23.
66
Exhibit A-85, Report of Chambers, p. 29, Appeal Book, Vol.
13, Tab 101, p. 3727.
67
Reasons, para. [235]: ‘‘. . .the price for the guarantee would
vary with the degree of default risk assumed by the guarantor. . . .’’
68
Testimony of Booth, p. 868, l. 01 to p. 871, l. 09; p. 874, ll. 07-
24; Testimony of Emmer, p. 2930, l. 06 to p. 2931, l. 13.
TMTR ISSN 1063-2069
TEXT
(b) the effect a default by the respondent would have
on the global market it shared with GECUS;69
(c) the effect it might have on GECUS’s AAA rat-
ing;70
(d) the consequences of GECUS being downgraded
just a single notch;71
(e) the shock such a default would have on the finan-
cial community;72
(f) the consensus of the experts that GECUS would
take steps to prevent such a situation from ever aris-
ing;73 and
(g) the fact that none of the experts could imagine a
scenario where GECUS would allow the respondent
to default, except perhaps the unrealistic (in this
situation) episodic shock74 or the decline of the
whole of GE.75
The evidence was considerable and nearly unanimous
about the extent of the default risk and its impact on GE-
CUS. The sole exception was Chambers, who, while admit-
ting that it was a factor S&P guidelines did consider,76 neu-
tralized its impact by improperly focusing on the respon-
dent’s small size. He then compounded the error by
equating the effect of a default by the respondent with the
possibility that the respondent could be sold.77
51. GECUS and the respondent had common sources of
capital and customers. The overwhelming and unanimous
evidence was that the capital markets into which GECUS
issued debt, both on its own behalf and in the respondent’s
name, were composed of 40-50 institutions which were in-
tegrated and mostly common.78 Chambers dismisses this
fact as insignificant to his analysis.79 He concentrated in-
69
Testimony of Booth, p. 859, l. 17 to p. 860, l. 02; p. 860, ll. 08-
23; Testimony of Emmer, p. 2916, ll. 12-16; p. 2916, l. 22 to p. 2917,
l. 07.
70
Testimony of Booth, p. 824, l. 01 to p. 825, l. 06; p. 864 ll. 03-
13; Testimony of Saunders, p. 2401, l. 02 to p. 2403, l. 07; Testi-
mony of Emmer, p. 2921, ll. 09-22; Exhibit R-1, Annual Reports,
1996, (status uncertain), Tab 1 at p. 2 of Annual Report, Appeal
Book, Vol. 16, Tab 117, p. 4445; Exhibit R-3, Instruction Manual;
Appeal Book, Vol. 17, Tab 119, p. 4816; Exhibit R-34, Respondent’s
[Appellant’s] Read-ins, Tabs 47 and 60, Appeal Book, Vol. 19, Tab
151, pp. 5641 and 5671.
71
Testimony of Booth, p. 823, l. 13 to p. 824, l. 07; Testimony of
Saunders, p. 2384, l. 24 to p. 2385, l. 11; Exhibit R-28, Report of
Emmer, p. 15, Appeal Book, Vol. 18, Tab 145, p. 5341; Testimony
of Werner, p. 383, ll. 06-14.
72
Testimony of Booth, p. 590; p. 864,. l. 19 to p. 865, l. 02; Tes-
timony of Emmer, p. 2876, l. 22 to p. 2877, l. 14; p. 2916, l. 22 to p.
2917, l. 07; p. 2930, l. 06 to p. 2931, l. 13; Testimony of Chambers,
p. 1466, l. 17 to p. 1467, l. 12.
73
Testimony of Booth, p. 866; l. 02 to p. 867, l. 08; p. 875, l. 08
to p. 876, l.07; p. 878, ll. 22-25; Testimony of Meyerman, p. 2753, ll.
10-22; Testimony of Emmer, p. 2842, l. 19 to p. 2843, l.04; p. 2843,
ll. 05-20.
74
In order for there to be an episodic shock within the respon-
dent, one would have to assume the existence of a treasury depart-
ment within the respondent, which did not exist. On this issue,
Booth testified ‘‘as long as Stanford [sic] controls all of the money,
it is highly unlikely that would happen’’ (Testimony of Booth, p.
880, ll. 17-19).
75
Testimony of Booth, p. 914, ll. 16-22; Testimony of Meyer-
man, p. 2709, l. 04 to p. 2710, l. 20; Testimony of Saunders, p. 2387,
l. 08 to p. 2388, l. 07; Testimony of Emmer, p. 2928, l. 24 to p. 2929,
l. 16; p. 2968, l. 24 to p. 2969, l. 08.
76
Testimony of Chambers, p. 1466, l. 17 to p. 1467, l. 12.
77
Exhibit A-85, Report of Chambers, pp. 1 and 28, Appeal
Book, Vol. 13, Tab 101, pp. 3699 and 3726.
78
Testimony of Booth, p. 858, l. 05 to p. 859, l. 24.
79
Exhibit A-85, Report of Chambers, pp. 25-26, Appeal Book,
Vol. 13, Tab 101, pp. 3723-3724.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 135
stead on whether the businesses (i.e. the operating groups
which borrowed funds. raised by GECUS and the respon-
dent) were integrated, an irrelevant exercise.80
52. The public position and prior track record of the par-
ent, GE, was impeccable. The evidence was that GE had
made numerous statements as to the importance of integ-
rity and maintaining its AAA rating and S&P had published
statements as to GECUS’s strong credit culture and com-
mitment to credit quality.81 Chambers inexplicably as-
cribed no value to this factor.82 Similarly, instead of noting
that no financing subsidiary with GE in its name had ever
defaulted on its debt,83 he relied on the very different ex-
ample of Montgomery Ward as an indication of GE’s prior
track record.84
53. The trial judge attempted to rely on Chambers’ analy-
sis and then adjust for differences between the existing
transaction, specifically complete control by the parent
over the respondent’s debt issuances and the impact of a
default on the parent, and that involving a third party guar-
antor who would not have that same default risk.85 How-
ever, the fact of lack of control makes comparisons to third
parties improper.86
54. The trial judge accepted that the four relevant eco-
nomic characteristics set out in paragraph 37 were signifi-
cant in identifying the functions and risks and that they
would lead, ultimately, to the correct transfer price. How-
ever, by relying on Chambers’ incomplete and faulty analy-
sis, he failed to address any of these issues properly. Ac-
cordingly, no consideration was given to economically rel-
evant characteristics that were identified by both parties as
significant.
iii) The trial judge failed to do a ‘‘reasonableness’’ check
55. A ‘‘sanity’’ or ‘‘reasonableness’’ check may be part of
undertaking a transfer pricing analysis to confirm the va-
lidity and result of the primary pricing methodology
used.87 Although not essential in determining the initial
transfer price,88 it was important in the present case be-
cause of the lack of comparable transactions. The trial
judge recognized the need to conduct this step, but then
proceeded to dismiss or ignore all methods offered by the
parties save for one which he had already concluded was
unreliable.
80
Exhibit A-85, Report of Chambers, p. 24, Appeal Book, Vol.
13, Tab 101 at p. 3722.
81
See Exhibit R-1, Annual Reports: 1996, Tab 1 at p. 46, 1997,
Tab 2, at p. 46, 1998, Tab 3, at p. 32, 1999, Tab 4, at p. 40, 2000,
Tab 5 at p. 40; Appeal Book, Vol. 16, Tab 117 at pp. 4489, 4559,
4615, 4695 and 4775; Exhibit R-11, S&P publication: Heller’s Fi-
nancial Ratings Revised, Appeal Book, Vol. 17, Tab 128, p. 4942;
Testimony of Meyerman, p. 2661, l. 07 to p. 2662, l. 25; p. 2703, l.
08 to p. 2705, l. 01; p. 2728, l. 15 to p. 2732, l. 16; p. 2735, l. 09 to p.
2736, l. 17; Testimony of Werner, p. 252, l.20 to p. 253, l. 15; Testi-
mony of Chambers, pp. 1549-1550, p. 1615 to p. 1617, l. 20; Testi-
mony of Emmer, p. 2841 to p. 2843.
82
Exhibit A-85, Report of Chambers, p. 27, Appeal Book, Vol.
13, Tab 101, p 3725.
83
As noted by a number of witnesses, see supra, para. 20 and
footnotes thereto.
84
Exhibit A-85, Report of Chambers, p. 27, Appeal Book, Vol.
13, Tab 101, p. 3725. Montgomery Ward was a retailer, not a fi-
nancing company and hence, not in the capital markets. GE had
acquired it in a bankruptcy situation and had taken active steps to
advise potential creditors that it was not guaranteeing its debt. Tes-
timony of Werner, p. 234, ll. 19-22; p. 431, l. 24 to p. 432, l. 22; Tes-
timony of Chambers, p. 1655, l. 05 to p. 1657, l. 06.
85
Reasons, para. [304].
86
Testimony of Wright, p. 3242, ll. 19-25; p. 3248, ll. 14-25; p.
3258, ll. 16-22.
87
GlaxoSmithKline v. The Queen, supra at paras. 144 and 152.
88
Information Circular 87-R2, International Transfer Pricing,
September 27, 1999, at paras. 61 and 62; OECD Guidelines (1995),
para. 1.69.
BNA TAX 6-3-10
136 (Vol. 19, No. 3)
56. Both Cole89 and Scilipoti90, for the respondent, of-
fered secondary methods91 as reasonableness checks, us-
ing various financial ratios, while Fidelman, also for the re-
spondent, said he could not locate any reliable transac-
tional or net margin (i.e. financial ratios) information.92
57. Cole justified the guarantee fee on the basis that a.
1% guarantee fee amounted to ‘‘only’’ 33-40% of the pre-
tax and pre-guarantee fee profits of the respondent. No evi-
dence or third party comparables were offered by Cole93 to
support his assertion that guarantee fees equal to 33-40%
of the pre-tax/pre-guarantee fee profits would be paid in an
arm’s length transaction, except a passing reference to
high risk non-financial institutions such as sub-prime lend-
ers or mortgage funds.94 Similarly, while both Cole and the
trial judge understood that if a 2% guarantee fee were ap-
propriate, over 60% of the respondent’s pre-tax/pre-
guarantee profits would go to paying the guarantee fee,95
but there was no evidence to support Cole’s inference that
an arm’s length party would give up approximately 60% of
its profits to pay a guarantee fee.
58. In his Reasons, the trial judge made no mention of
the respondent’s expert, Scilipoti, or his evidence. He did
identify that Cole attempted to do a reasonableness check,
but reached no conclusion as to its application in the Rea-
sons. He misapprehended and disagreed with Saunders’
approach96 and failed to mention Wright’s testimony97 on
this point. The only ‘‘sanity check’’ he relied upon was the
insurance model proposed by Fidelman, despite conclud-
ing it was unreliable.98
59. While acknowledging the need to find an alternative
methodology to validate his primary conclusion as to the
value of the benefit, the trial judge failed to do so with a re-
liable method. Not only was the single sanity check he used
in his analysis admittedly unreliable, but he failed to ex-
plain his reasons for rejecting all the other methods. This
is particularly troubling because the evidence was that the
value ultimately chosen by the trial judge (1.83%) could
amount to over 60% of the respondent’s pre-tax/pre-
guarantee fee, a percentage for, which no comparables
were put forward.
89
Testimony of Cole, p. 2000, l. 24 to p. 2001, l. 16. He added
also that if GECUS injected capital sufficient to give the respondent
an 8:1 equity ratio, this would allow GECUS to earn about 18% af-
ter tax return on investment (Testimony of Cole, p, 2001, l. 16 to p.
2002, l. 14).
90
Transcript from Oral Hearing before Justice Hogan dated
April 30, 2009, p. 48, l. 24 to p. 49, l. 17, Appeal Book, Volume 1,
Tab 11, pp. 282-283. Scilipoti was tendered to demonstrate that the
profits of the respondent were similar to those of other ‘‘similar’’
corporations.
91
The primary methods offered by most of the respondent’s ex-
perts were offered as ‘‘analogies’’ from which the trial judge might
choose whichever he thought appropriate. Transcript from Oral
Hearing before Justice Hogan dated April 30, 2009, p.4, ll.04-19,
Ibid.
92
Testimony of Fidelman, p. 971, l. 04 to p. 974, l. 22.
93
Testimony of Cole, p. 2039, l. 18 to p. 2043, l. 16.
94
Testimony of Cole, p. 2041, l. 23 to p. 2043, l. 16.
95
Testimony of Cole, p. 2000, l. 24 to p. 2001, l. 16; p. 2037, l. 13
to p. 2039, l. 16.
96
Saunders testified that if one hypothesized the amount of an
expected loss reserve, the amount earned by GECUS far exceeded
a usual rate of return; Reasons, paras. [299] and [300].
97
Wright testified that the guarantee was a transaction within
which GECUS makes all of the decisions, manages and controls all
the risk including whether or not the respondent defaults on its
debt. In this context, she concluded that the respondent would not
accept to pay any fee in respect of what is essentially the risk of
GECUS; Testimony of Wright, p. 3255, l. 05 to p. 3256, l. 03.
98
Reasons, para. [257]. Once a judge has determined, that evi-
dence is unreliable, it ceases to be a factor. Kovalik Estate v
Griffen, [2002] M.J. No. 261 (C.A.) at para. 38.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
iv) The trial judge misapplied the ‘‘business judgment
rule’’
60. The trial judge gave great evidentiary weight to the
‘‘business judgment’’ of Werner. In so doing, he miscon-
strued the purpose behind the transfer pricing provisions
in the Act and the OECD Guidelines. Transfer pricing rules
are premised on the reality that multi-national enterprises
have the ability to manipulate prices among related parties
to achieve global tax savings. Because the usual safety net
of arm’s length bargaining does not exist between related
parties,99 the Act and the OECD Guidelines have adopted
the arm’s length principle. At its core, the principle re-
quires objective evidence to support the transfer price. In
relying on Werner’s ‘‘business judgment’’, the subjective
evidence of the very person whose decision was being chal-
lenged became determinative.
61. Transfer pricing analysis does not prefer subjective
evidence over the objective evidence of disinterested ex-
perts. Canadian jurisprudence has recognized that the evi-
dence of a decision-maker like Werner, in a non-arm’s
length situation, must be scrutinized with great care and
treated with a degree of scepticism.100
62. It was Werner who concluded in 1988, on behalf of
both the respondent and its parent company, that the re-
spondent should continue to have explicit guarantees on its
debt issuances and that no fee should initially be attached
to them. It was Werner who decided in 1995, after direction
from GECUS tax counsel, that a fee equal to 1% should be
charged on all debt issuances for the tax years in question.
This decision was made while he was under the influence
and authority of GECUS in a tax-driven, non-arm’s length
context. Presumably the purpose of the valuation was to
maximize the tax benefit while maintaining an arguable
position if challenged.
63. The trial judge did not treat Werner’s testimony with
the scepticism necessary in a non-arm’s length, non-
bargaining situation driven by tax motives. He also failed
to recognize that it was Werner’s decision that was under
review when assessing Werner’s credibility and objectiv-
ity.101 For example, where Werner’s testimony differed
from that of other witnesses or was not credible, it was
simply ignored.102
64. Moreover, the trial judge’s use of ‘‘business judg-
ment’’ to evaluate credibility103 is novel. No cases could be
located which have applied the business judgment of one
witness to test the credibility of other witnesses. Its appli-
cation has been limited to situations establishing if a debt
is bad or not,104 in earlier cases where the reasonable ex-
pectation of profit test was applied105 and in some cases in-
volving section 67 of the Act.106
65. Transfer pricing analysis requires that the decision in
issue be tested against objective evidence. To do otherwise
and rely on subjective business judgment of the decision
99
OECD Guidelines (1995), paras. 1.2 and 1.3; Canada v
McLarty, [2008] 2 S.C.R. 79 per Rothstein, J. at para. 43.
100
Flexi-Coil Ltd. v R, 1996 CarswellNat 1459 (F.C.A.) at para.
8; Indalex Ltd. v. Canada [1987] F.C.J. No. 1150 (C.A.) (‘‘Indalex’’) at
pp. 5 and 8.
101
Faryna v. Chorny, [1951] B.C.J. No. 152 (C.A.) at para. 11;
Indalex, supra note 149.
102
See Appendix A.
103
At Reasons, para. [298]; the trial judge rejects the expert tes-
timony of Saunders and cites as one of the reasons for rejecting his
expert opinion ‘‘His conclusion is at odds with the business judg-
ment of Mr. Werner.’’
104
For example, see Heron Bay Investments Ltd. v. The Queen,
2009 TCC 337; Beaudry v. Canada, [1998] T.C.J. No. 353 (T.C.C.)
at para. 43.
105
For example, see Nichol v Canada, [1993] T.C.J. No. 541
(T.C.C.) at para. 17; Tonn v. Canada, [1995] F.C.J. No 1635 (C.A.)
at para. 39.
106
Ankrah v Canada., [2003] T.C.J. No. 422 (T.C.C.) at paras.
33-34.
TMTR ISSN 1063-2069
TEXT
maker as objective107 effectively eliminates the arm’s
length standard embedded in the Act.
C. PALPABLE AND OVERRIDING ERRORS OF FACT
66. The trial judge made significant errors of fact which
impacted on his assessment of the pivotal fact in this case,
namely what would be the credit rating of the respondent
without the explicit guarantee by GECUS. The trial judge’s
conclusion that the credit rating would be BBB-/BB+108
was based on three erroneous findings:
(a) that the evidence of Emmer should be rejected, as
should the corroborating evidence of Saunders and
Meyerman;
(b) that the evidence of Chambers was preferable;
and
(c) that the respondent would be unable to obtain
back-up lines of credit in the absence of an explicit
parental guarantee.
67. While it is not disputed that the trial judge is entitled
to prefer the evidence of one witness over another, when
the reasons for so doing are unreasonable, improper or not
based on the evidence,109 the cumulative effect of such
preference may lead to palpable and overriding errors, as
it did in this instance.
i) The trial judge erred in rejecting the evidence of Emmer
and the corroborating evidence of Saunders and
Meyerman for inappropriate reasons
68. The trial judge’s justifications for dismissing the con-
clusions of the appellant’s experts Emmer, Saunders and
Meyerman were clearly wrong. In particular, he dismissed
Emmer’s conclusions because:
(a) the trial judge attributed the demand for the GE/
GECUS keep-well agreement110 to S&P, where Em-
mer worked;
(b) Emmer did not determine a stand-alone rating;
(c) the trial judge determined that Emmer failed to
adequately explain why S&P had rated GE Financial
Corp. A+;
(d) Emmer made a computational error;
(e) Emmer failed to address in his written report the
impact of the removal of the guarantee; and
(f) Emmer’s objective evidence did not accord with
Werner’s subjective business judgment; therefore,
this fact and his demeanour made him a non-credible
witness.
69. The trial judge wrongly concluded that ‘‘. . .[t]he evi-
dence shows that S&P, the rating agency where Emmer
spent his career, demanded that GE execute a keep-well
107
See Reasons, para. [292]: The only basis upon which the
trial judge attributed objectivity to Werner was the fact that he
‘‘. . .has been retired from GE and GECUS for a number of years.
The passage of time has freed him from the influence of his former
employer and undoubtedly contributed to his objectivity on the
subject of the guarantee.’’ There was no evidence of whether he re-
tained any ties with GE.
108
Reasons para. [301].
109
Schreiber Brothers Ltd. v Currie Products Ltd. et al., [1980]
2 S.C.R. 78, per Laskin, J. at p. 84; Toneguzzo-Norvell (Guardian ad litem
of) v. Burnaby Hospital, [1994] 1 S.C.R. 114 (‘‘Toneguzzo-Norvell’’),
per McLachlin, J at paras. 13, 15 and 16. See also supra note 75 and
accompanying text.
110
The keep-well was an agreement between GE and GECUS
that GE would ensure that GECUS’s debt-to-equity ratio remained
at 8:1. It was requested by Moody’s, in order for it to continue rat-
ing GECUS AAA (Testimony of Werner, p. 240, ll. 16-25).
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 137
agreement under which it committed to maintaining GE-
CUS’s debt-to-equity ratio to 8 to 1’’.111 In fact, it was not
S&P which sought out the keep-well, but another rating
agency, Moody’s,112 which has different methodologies.
Emmer had never worked there. While Emmer was aware
of the keep-well agreement, the inferences that the trial
judge drew from this incorrect fact were very damaging.
70. For example, the trial judge concludes that: ‘‘I imag-
ine that, if GECUS’s debt-to-equity ratio was unimportant,
S&P would not have seen the need to demand the execu-
tion of the keep-well agreement.’’ This inference is unsup-
portable in light of the correct fact; namely that it was not
S&P that requested the keep-well agreement. The opposite
inference could have been drawn from the correct fact, as
Emmer and the Crown postulated, that S&P was not as
concerned about the debt-to-equity ratio when rating
wholly-owned financing subsidiaries113 and that, in such
instances, S&P placed much stronger reliance on the quali-
tative factors114 in assessing the extent of implicit support
that could be expected.115
71. The trial judge finds that Emmer failed to follow S&P
methodology by ‘‘. . . skipping over an essential first step
imposed by the rating methodology criteria used for rating
subsidiaries of a public corporation. . .’’;116 namely, com-
pleting a stand-alone rating of the respondent. The trial
judge relies on Chambers’ testimony for the proposition
that a stand-alone rating is a necessary first step, but none
of the S&P published criteria specified that.117 Moreover,
Emmer did review the financial information to determine
the respondent’s stand-atone profile,118 but testified that
further reliance on the financial statements in this situation
was not justified.119 Neysmith, testifying as a material wit-
ness for the respondent, emphasized that CBRS, which was
subsequently bought by S&P, did not conduct a stand-
alone rating in the context of establishing the respondent’s
credit rating, but simply did, as Emmer did, a Stand-alone
profile.120
72. The trial judge notes that ‘‘[o]n cross-examination,
Mr. Emmer was confronted with the S&P rating report is-
sued in 1999 for the GE group. GE Financial Corp., an in-
direct insurance subsidiary of two AAA-rated parents, GE-
CUS and GE, was rated A+, that is four notches below the
AAA rating of its parent corporation’’ and infers from this
that ‘‘[i]f reputation alone is a strong factor for ratings
equalization, surely GE Financial Corp. would have been a
better candidate for the ratings uplift. . .’’121 Not only was
there no direct evidence for the inferences drawn by the
trial judge from this document, but there was evidence to
the contrary. Emmer explained that GE Financial Assur-
111
Reasons, paras. [266] and [277].
112
Testimony of Werner, p. 240, Respondent’s [Appellant’s]
Read-ins, Exhibit R-34, at Tab 104, Appeal Book, Vol. 20 at p. 5765.
113
Testimony of Emmer, p. 2882, l. 06 to p. 2886, l. 04.
114
Qualitative factors are non-financial factors such as: owner-
ship and corporate structure, long-term corporate strategies, and
management style and reputation (see S&P criteria generally, su-
pra).
115
Testimony of Emmer, p. 2827, l. 22 to p. 2828, l. 13.
116
Reasons, para. [274]
117
Exhibit R-12, S&P Credit Rating throughout the Years, Tabs
1-3, Appeal Book, Vol. 17, Tab 129(1)(2) and (3). Such methodol-
ogy may have been undertaken in subsequent years (S&P Credit
Rating throughout the Years, Exhibit R-12, Tab 6, General: Revised
Financial Services Group Methodology addresses Increased Will-
ingness to sell Underperforming Subsidiaries, dated 2002, Appeal
Book, Vol. 17, Tab 129 (6) p. 5088), but even then there was doubt
as to whether that applied only to insurance companies (Testimony
of Emmer, p. 3043, l. 23 to p. 3046, l. 07).
118
Testimony of Emmer, p. 2871, l. 09 to p. 2872, l. 06.
119
Testimony of Emmer, p. 2872, ll. 14-17; p. 2873, l. 15 to p.
2875, l. 16.
120
Testimony of Neysmith, p. 745, l. 20 top. 746, l. 10; p. 750, ll.
04-18.
121
Reasons, para. [277].
BNA TAX 6-3-10
138 (Vol. 19, No. 3)
ance Holdings Inc. (its proper name) appeared to be an in-
surance company, as well as a holding company, both fac-
tors which would cause S&P to give it a lower rating.122 As
an insurance company, it was not issuing debt in the same
marketplaces as GECUS and the respondent123 and, there-
fore, had a completely different ‘‘default risk’’ profile.
73. The trial judge notes that ‘‘Mr. Emmer made a com-
putational error in his application of a quantitative fact.’’124
This error was readily admitted and had no impact on Em-
mer’s opinion relating to the extent of implicit support in
this case.125
74. The trial judge criticizes Emmer for ‘‘failing to ad-
equately consider the impact of the removal of GECUS’s
guarantee.’’126 For the reasons stated earlier, the removal
of the guarantee was not a relevant inquiry and this criti-
cism was unwarranted.
75. He notes the ‘‘demeanour’’ of the witness and con-
cludes that Emmer was ‘‘very uncomfortable’’ about an-
swering questions posed by him relating to the removal of
the guarantee.127 In such a context, the trial judge’s com-
ment about the ‘‘demeanour’’ of a witness, if meant to re-
flect negatively on credibility, was improperly done.128 Em-
mer himself told the trial judge that this line of enquiry on
the removal of the guarantee was problematic to him as it
was an unrealistic and hypothetical scenario.129
76. The trial judge rejects the testimony of Emmer relat-
ing to the necessity of the guarantee in the context of main-
taining the respondent’s AAA rating,130 yet uses his testi-
mony to corroborate the business judgment of Werner.131
In doing so, he misapprehends and misapplies the testi-
mony of Emmet132 and, for the reasons stated above, im-
properly used Werner’s subjective business judgment to
discredit Emmer’s objective evidence.
77. In addition, the trial judge rejects the evidence of
Saunders for the same, equally improper, reasons.133 He
also rejects the evidence of Saunders on the basis that he
was not an expert in applying credit rating methodology af-
ter he had allowed Saunders to testify as ‘‘. . .an expert
economist, specializing in credit risk measurement, analy-
sis and valuations relating to debt guarantees.’’134
78. The trial judge rejects the corroborating evidence of
Meyerman for equally unsupportable reasons. Meyerman
testified that the banks, GECUS and the credit rating agen-
cies would work together to ensure that debt issued in the
respondent’s name without explicit guarantees would be
rated AAA.135 He was not challenged on these issues dur-
122
Testimony of Emmer, p. 3111, l. 02 to p. 3112, l. 02; p. 3118,
l. 24 to p. 3.119, l. 07. See also Testimony of Chambers, p. 1483, l.
22 to p. 1497, l. 13; Testimony of Werner, p. 177, l. 20 to p. 185, l.
19.
123
In this context Werner testified that only the respondent,
GECUS and GE Capital Australia would enter the capital markets
(Testimony of Werner, p. 315, ll. 02-12).
124
Reasons, para. [278].
125
Testimony of Emmer, p. 2813, l. 14 to 2815, l. 19.
126
Reasons, paras. [279] and [283].
127
See also Reasons, para. [139].
128
Weeks v. Weeks, [1955] B.C.J. No. 111 (C.A.) per O’Halloran
J.A. at para. 25; Toneguzzo-Norvell, supra note 159 at paras. 13,
15-16; Corsault v. Canada (M.N.R.), 2005 TCC 112 at para, 15;
I.F.K. v. College of Physicians and Surgeons of British Columbia,
[1998] B.C.J. No. 577 (C.A.) at paras. 38-39.
129
Testimony of Ernmer, p. 3099, l. 11 to p. 3100, l. 13.
130
Reasons, paras. [291] and [292].
131
Reasons, para. [149].
132
F.H. v. McDougall, 2007 BCCA 212 per Rowles J.A. at para.
71, rever’d on other grounds by 2008 SCC 53.
133
Reasons, para. [301].
134
Reasons, para. [298]; Testimony of Saunders, p. 2330, l. 13
to p. 2331, l. 08; p. 2338, ll. 14-23. Saunders had written a book
about how credit rating agencies work and had provided seminars
to credit rating agency employees.
135
Reasons, para. [126].
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
ing cross-examination.136 The trial judge rejects Meyer-
man’s conclusions on the basis that he was not ‘‘. . .an ex-
pert in credit rating agency methodologies’’,137 but failed
to appreciate that he was not presented as such. He testi-
fied only as to how a bank would react to the respondent’s
debt issuances without an explicit guarantee.138
ii) The trial judge erred in concluding that the evidence of
Chambers was preferable
79. If the trial judge had based his decision on admissible
evidence, the only conclusion he could have reached was
that Chambers’ report was uncorroborated and contra-
dicted by the respondent’s other witnesses. Instead, to rely
on Chambers’ opinion that the respondent would not re-
ceive an AAA rating without an explicit guarantee, the trial
judge purported to rely on statements by other experts to
this effect. However, the experts who gave such opinions
were not qualified to do so and referring to their testimony
in that regard was inappropriate.139 Further, on this point,
the trial judge permitted inadmissible evidence from non-
experts and failed to address the completely contradictory
evidence of one of the respondent’s experts.
80. Both respondent’s experts Booth and Cole admitted
they were not experts in applying credit rating agency
methodologies. Furthermore, both had knowledge of
Chambers’ conclusion prior to testifying and relied on it.140
For example, the testimony of Booth recited in Reasons,
para. [23] appears confirmatory, but the footnoted refer-
ence does not support the trial judge’s assertion.141 Booth
was not qualified to give that expert opinion.142 Neither
was Cole,143 rebut the trial judge referred to a gratuitous
and evasive comment to that effect.144
81. The trial judge states in his reasons that Neysmith
testified that ‘‘CBRS would have rated the appellant
[respondent] lower than A+ or A-1 high’’,145 but not only
had the trial judge ruled that Neysmith’s evidence was in-
admissible on that point as he had not been qualified as an
expert, he also misapprehended Neysmith’s evidence.146
82. The trial judge also neglected to mention in his analy-
sis that one of the respondent’s own experts, Coombs, con-
tradicted Chamber’s conclusion.147 As well, the Reasons
are silent on the evidence that other fact witnesses had pre-
viously come to conclusions that differed from Chambers
both on the stand-alone rating and the extent of implicit
support.148
83. Chambers’ opinions were also erroneous because his
limited assignment impaired his ability to infer informa-
136
Unchallenged testimony cannot be disregarded, see Man-
drake Management Consultants Ltd. v. Toronto Transit Commission (1993),
102 D.L.R. (4th) 12 (Ont. C.A.) at p. 39, 40 and 42.
137
Reasons, para. [290].
138
Testimony of Meyerman, p. 2650, l. 17 to p. 2651, l. 17.
139
R v Marquard, [1993] 4 S.C.R. 223, per McLachlin at paras.
[30] to [39].
140
Exhibit A-88, Report of Cole, p. 2, Appeal Book, Vol. 13, Tab
104, p. 3794; Testimony of Booth, p. 780, ll. 07-20.
141
Testimony of Booth, p. 554, ll. 03-12.
142
Testimony of Booth, p. 533, l. 05 to p. 535, l. 14; p. 539, ll.
01-11. As Booth admitted he had not spent much time analyzing
the respondent’s credit rating, the trial judge indicated he would
take that into account in assigning his testimony probative value.
143
Testimony of Cole, p. 1918, l. 20 to p. 1919, l. 02 where he
stated ‘‘I am absolutely not an expert in that narrow field.’’
144
Reasons, para. [80]; Testimony of Cole, p. 2014, l. 06 to p.
2015, l. 18.
145
Reasons, para. [28].
146
His testimony was ‘‘[w]ithout the guarantee we would not
have given it the Triple A rating, or A plus plus nor the A-1 high
rating.’’ In doing so he was indicating only that the rating would be
lower than the highest rating available for issuers and their issu-
ances, but not by how much (Testimony of Neysmith, p. 727, ll. 18-
21).
147
Testimony of Coombs, p. 1210, ll. 12-23.
148
See Appendix B.
TMTR ISSN 1063-2069
TEXT
tion, he was not provided with crucial pieces of information
and he arrived at an unsupported conclusion not even ac-
cepted by the Court, that the respondent should be consid-
ered an ‘‘independent subsidiary.’’149 All of these deficien-
cies were ignored by the trial judge.
84. If the trial judge had properly analyzed Chambers’ re-
port and testimony, the fact that it was uncorroborated and
it contained numerous omissions and errors, he would
have concluded that it was inherently unreliable.
iii) The trial judge erred in concluding that the respondent
could not get back-up credit facilities
85. The trial judge’s conclusion that the respondent
could not get back-up credit facilities was .contradicted by
all the evidence, coloured by a mistake in quantifying the
amount of unguaranteed loans of the respondent, based
upon the evidence of a single expert who had not explored
the possibility that a syndicate of banks could be put to-
gether to provide the back-up facilities and seemed to be
based largely on the trial judge’s own beliefs.150 Not only
is the finding unreasonable, but it caused the trial judge to
attribute more value to the explicit guarantee.
86. Apart from his own belief, the trial judge’s conclusion
may have been based on the opinion of one expert,
Coombs, whom the respondent called for the purpose of
establishing that it could not have obtained the back-up
credit facilities it would have needed to issue commercial
paper without the GECUS explicit guarantee.151 However,
Coombs only stated that the TD Bank would not extend
more than $100 million to the respondent and admitted he
had not inquired as to the possibility of putting together a
syndication of banks to increase that amount.152
87. The trial judge did not reconcile his conclusion with
that of:
(a) Booth, who testified that the respondent could
have obtained, through a syndication of banks, a
100% credit facility back-up for its commercial paper
and that the price of these lines would have been be-
tween 5 and 6 basis points;153
(b) Meyerman, who testified that in the years under
appeal, the reputation of the GE group of companies
was second to none154 and, as such, if GECUS had
requested that a syndication of banks be set up to
provide the respondent back-up lines of credit of up
to $3.5 billion for the issuance of unguaranteed com-
mercial paper in the respondent’s name, this could
have been arranged for 5-6 basis points (un-
drawn);155
(c) two fact witnesses, both bankers who testified
that, when actually asked by GECUS in 1995, their
banks would have considered extending a $2 billion
credit facility to the respondent without an explicit
guarantee and confirmed it in writing at that time;156
149
See Appendix B.
150
Reasons, para. [296].
151
Testimony of Coombs, p. 1159, ll. 07-18.
152
Testimony of Coombs, p. 1223, ll. 07-18.
153
Testimony of Booth, p. 617, ll. 04-09; p. 618, l. 01 to p. 619, l.
12.
154
Testimony of Meyerman, p. 2661, l. 07 to p. 2662, l. 25.
155
Testimony of Meyerman, p. 2677, l. 14 to p. 2678, l. 02.
156
Testimony of Mitchell, p. 2262, ll. 17-22; p. 2267, ll. 13-15;
Testimony of Clark, p. 2289, 11.02-14; Exhibits R-9A and R-9B, Let-
ters between bankers and GECUS in 1995, Appeal Book, Vol 17,
Tabs 125 and 126, pp. 4917-4923.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 139
(d) the fact that the respondent had been able to se-
cure unguaranteed bank loans totaling approxi-
mately $700 million in 1998;157
(e) the evidence before him that GE had back-up fa-
cilities available for all affiliates;158 and
(f) GECUS might have provided the respondent with
the liquidity support it needed (i.e. the back-up lines
of credit) even without a parental guarantee.159
88. The trial judge’s belief and conclusion that the re-
spondent could not have obtained back-up credit facilities
to support debt issued in the commercial paper market in
its name is contradicted by the evidence adduced at trial
and is palpably wrong.
iv) Other errors in comprehending the evidence
89. There are instances where the evidence is improperly
stated in the Reasons, such as:
(a) ‘‘Mr. Coombs dismissed the implicit guarantee
argument. . .’’160 but Coombs said ‘‘I expected that
the parent company, or would expect the parent
company to supply support, even if it is not guaran-
teeing it.’’161
(b) ‘‘Given a choice between an unguaranteed debt
issuance of the Appellant and a debt issuance of GE-
CUS or GE, Texaco would buy the latter. . . ..’’162 but
Lewis did not say this and, if he had, it would have
been inadmissible as being hypothetical. Rather, he
testified that Texaco had never bought GECUS’s
commercial paper;163
(c) The Reasons refer to the amount of unguaranteed
debt of the respondent as $75 million.164 It was
closer to $700 million, comprised of 8 unguaranteed
term loans;165
(d) The Reasons state: ‘‘. . . it appears implausible
that the Appellant [respondent] could have raised
the same large sums of money at the low interest
rates that it benefited from even if its debt had been
rated AAA. E. Emmer confirmed this fact during his
cross-examination.’’166 However, Footnote 264, cited
in support, does not reference the testimony of Em-
mer and this ‘‘implausible’’ scenario was confirmed
as plausible by the respondent’s own experts, Booth
and Cole.167
90. In the present case, the trial judge used improper and
unjustifiable reasons to discredit the conclusions of three
of the appellant’s witnesses. He then used inadmissible evi-
dence to corroborate the respondent’s principal witness,
but failed to address that witness’ factual errors and omis-
sions and failed to reconcile his inconsistent testimony
157
Exhibit R-10, Term Loan Agreements dated December 29,
1998, Appeal Book, Vol. 17, Tab 127, pp. 4924-4941.
158
Exhibit R-1, Annual Reports, (status uncertain), 1996 Tab 2
at p. 57, Appeal Book, Vol. 16, Tab 117, p. 4570; Testimony of
Werner, p. 367, l. 03 to p. 368, l. 08.
159
Testimony of Werner, p. 502, l. 22 to p. 503, l. 01.
160
Reasons, para. [42].
161
Testimony of Coombs, p. 1212, ll. 13-15.
162
Reasons, para. [82].
163
Testimony of R. Lewis, p. 2106, ll. 18-23.
164
Reasons, footnote 262 to para. [281].
165
Exhibit R-10, Term Loan Agreements dated December 29,
1998, Appeal Book, Vol. 17, Tab 127, pp. 4924-4941; Testimony of
Werner, p. 477, l. 18 to p. 478, l. 13.
166
Reasons, para. [288].
167
Testimony of Booth, p. 796, ll. 02-10; Testimony of Cole, p.
2015, ll. 09-18.
BNA TAX 6-3-10
140 (Vol. 19, No. 3)
with that of the respondent’s other witnesses. The trial
judge added to these errors by linking an erroneous con-
clusion on the availability of back-up credit lines to the
value of implicit support with the need for explicit guaran-
tees and misstated evidence when it did not support his
conclusions. These are all palpable and overriding errors
which led the trial judge to place too much value on the ex-
plicit guarantees and to undervalue the respondent’s credit
rating without them.
D. THE TRIAL JUDGE’S CONDUCT AMOUNTED TO A
FAILURE TO OBSERVE THE PRINCIPLES OF NATURAL
JUSTICE AND PROCEDURAL FAIRNESS
91. During the trial, the trial judge intervened excessively
by asking questions which were often improper, by intro-
ducing his own theories, by suggesting answers to wit-
nesses and by confusing the witnesses and counsel as to
who was asking and answering questions. The trial judge
descended into the arena and took on the role of counsel,
resulting in a trial process that was unfair. The trial judge
also rendered Reasons for Judgment which were inad-
equate as they fail to deal with objections taken under re-
serve, introduced case law which was not argued and did
not provide meaningful analysis on pivotal issues.
i) Unfairness During the Trial Process
92. The trial process was unfair because the trial judge
(a) introduced his own-theories, taking the issues beyond
the pleadings; (b) elicited improper evidence from the wit-
nesses, taking their testimony outside the scope of admis-
sibility; and (c) intervened excessively during witness ex-
aminations, taking the case out of the hands of counsel.
a) The trial judge introduced issues not raised by the
parties
93. The trial judge introduced his own theories of the
case by his questioning on the effect of the removal of the
guarantee168 and the difference in effect between the re-
spondent and its sister company, a Nova Scotia unlimited
liability company.169
94. The issue of the removal of the guarantee so pre-
occupied the trial judge that it became the basis for much
of his acceptance or rejection of witnesses and evidence.170
Neither party pleaded that the removal of the guarantee
was an economically relevant characteristic,171 nor re-
ferred to it in their opening arguments, but were specifi-
cally directed to address it by the trial judge in closing ar-
gument.172
95. A trial judge’s interventions are improper if they in-
troduce new theories in the course of trial.173 Here, the
trial judge diverted the trial away from the issues the par-
ties sought to present and toward what he considered to be
the central issue.174 He prejudiced the parties by widening
the scope of admissible evidence without giving them the
benefit of procedural safeguards such as notice require-
ments or knowing the case they must meet.175
96. The trial judge’s introduction of the effect of the re-
moval of the guarantee and the effect of the respondent’s
168
See Appendix D.
169
See Appendix E.
170
For example, see Reasons, paras. [66], [247-249], [279],
[280], [283],[298].
171
To the contrary, the respondent’s position was that the only
issue was ‘‘the guarantee that was given, not the guarantee that
they might have given or that they thought they might give.’’ Re-
spondent’s [appellant’s] Read-ins, Exhibit R-34, Tab 24. Appeal
Book, Vol. 19, p. 5586.
172
Transcript, p. 3422, ll. 08-11.
173
Phillips et al v. Ford Motor Co. of Canada Ltd. et al., [1971] O.J. No.
1564 (C.A.) (‘‘Phillips’’) per Evans J.A. at paras. 64-66.
174
Lennox v. Arbor Memorial Services Inc., [2001] O.J. No.
4725 (C.A.) at para. 16.
175
Farrar v Farrar, [2003] O.J. No. 181 (C.A.) at para. 25.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
sister company being a Nova Scotia unlimited liability
company took the issues beyond the pleadings. These theo-
ries were integral to the trial judge’s decision and were
used to undermine the appellant’s witnesses and the appel-
lant’s theory of the case.176
b) The trial judge elicited improper evidence from
witnesses
97. The trial judge overstepped his role by directing im-
proper questions to the witnesses. He asked questions to
experts which were outside their areas of expertise or the
scope of their reports and asked lay witnesses to give opin-
ion evidence. The parties were prejudiced since they were
denied the usual notice requirements, the ability to call evi-
dence to counter the improperly elicited evidence and did
not know the case they had to meet.
98. Reliance on expert testimony which the experts are
not qualified to give is inappropriate.177 For example, he
asked Wright, a transfer pricing expert with no legal train-
ing, to interpret the earning stripping roles concerning
related-party debt in the U.S. Internal Revenue Code.178 He
also elicited opinion evidence from lay witnesses Neysmith
and Werner.179
99. In one instance, the trial judge justified the appropri-
ateness of such questions on the basis of his prior interven-
tion.180
100. The trial judge also asked questions that were im-
proper and inadmissible, such as asking Werner for the
reasons why the respondent borrowed funds locally rather
than being lent them by GECUS, which respondent’s coun-
sel objected to on the basis that a prior order of the Tax
Court prevented such line of inquiry.181 When the same
question had been asked by appellant’s counsel, the trial
judge had ruled it improper.182
101. The trial judge often introduced his perceptions of
how the market might react in the form of questions to ei-
ther lay or expert witnesses,183 all of which should have
been the subject of notice. The improperly elicited evi-
dence became part of the record.
c) The trial judge took the case out of the hands of
counsel
102. The trial judge’s excessive interventions184 during
witness examinations had the effect of the trial judge tak-
ing the case into his own hands and out of the hands of
counsel.185 The interventions hampered counsel in the pre-
176
See paras. 44-49, 92-93 and 96 above and Appendix D.
177
R v Marquard, [1993] 4 S.C.R. 223; per McLachlin, J. at
paras. 30-39; Marchand (Litigation guardian of) v. Public General Hospital So-
ciety of Chatham, [2000] O.J. No. 4428 (C.A.) at paras. 30-40.
178
Testimony of Wright, p. 3299, l. 09 to p. 3300, l. 09. See also,
e.g., Testimony of Booth, p. 562, ll. 22-23 and Reasons, paras.
[282], [287] and [288].
179
See, e.g. Testimony of Werner, p. 153, l. 12 to p. 154, l. 08p.
203, l. 04 to p. 207, l. 17; p. 241, l. 11 to p. 244, l. 14; p. 246, l. 23 to
p. 248, l. 05; p. 408, l. 05 to p. 410, l. 10p. 503, ll. 11-25; p. 504, l. 14
to p. 507, l. 07; Testimony of Neysmith, p. 727, l. 22 to p. 728, l. 23.
180
Testimony of Fidelman, p. 3408, l. 12 to p. 3409, l. 04; See
also, e.g. Testimony of Booth, p. 580, ll. 13-25.
181
Testimony of Werner, p. 158, l. 25 to p. 159, l. 19.
182
Testimony of Werner, p. 315, l. 24 to p. 316, l. 17.
183
See e.g. Testimony of Cole, p. 2041, ll. 07-21; Testimony of
Werner, p, 153, l. 12 to p. 154, l. 21; p. 503, l. 11 to p. 504, l. 10;
Testimony of Hull, p. 1871, l. 14 to p. 1872, l. 15; Testimony of
Booth p. 866, l.02 to p. 867, l. 08.
184
See Appendix C, which contains a list of witnesses and the
approximate total number of questions asked in direct by the court
and counsel and the total number of questions asked during cross-
examination by the Court and counsel. The list is subjective and at-
tempts were made to eliminate obvious clarification questions and
the like.
185
Johnston v. Simmons, [1981] B.C.J. No. 1424 (C.A.) at paras. 16-
17; James v. Canada (Minister of National Revenue), [2000] F.C.J.
No. 2135 (F.C.A.) (‘‘James’’) at para. 52.
TMTR ISSN 1063-2069
TEXT
sentation of the evidence, destroyed the effectiveness of
the evidence and diverted counsel from their task of or-
derly examination, all of which is contrary to the limits es-
tablished in the jurisprudence.186
103. The trial judge appreciated that his questions were
disruptive when it was suggested to him by counsel.187 He
seemed to understand that his interventions were im-
proper. He apologized for it on numerous occasions.188
Some witnesses politely asked him to refrain from asking
his questions at a particular point in time.189 The trial
judge even attempted to justify his interventions in his Rea-
sons even though the point was not raised in argument by
either party.190
104. The trial judge intervened on matters not yet
touched on in direct-examination.191 During the direct-
examination of Wright, the appellant’s counsel asked ap-
proximately 60 questions and the trial judge asked 77.192
The direct examination of Wright was interrupted by the
trial judge on many occasions and the witness asked coun-
sel to redirect her to where she had left off her testimony
before the interruption.193 To the extent that intervention
by the trial judge was necessary for clarification, such in-
tervention should have taken place at a point during the
evidence where counsel has completed a particular area of
questioning or at the end of the witness’ evidence.194
105. Some of the trial judge’s interventions had the effect
of preventing cross-examination. For example, during the
cross-examination of Wright, he interrupted respondent’s
cross-examination by indicating that he and Wright had al-
ready come to a conclusion on the issue during ‘‘our sepa-
rate conversations’’.195
186
Phillips, supra at para. 65; and see Majcenic v. Natale,
[1968] 1 O.R. 189-205 (C.A.); Sloboda, supra at para. 46; NCJ Edu-
cational Services v. Canada, 2009 FCA 131 at para. 39; McFarlane
v. Safadi, [2004] O.J. No. 1763 (C.A.) at para. 30; and Metis Child
Family and Community Services v. A.J.M, 2008 MBCA 30 (‘‘Me-
tis’’) at para. 50; James, supra; Brouillard v. R., [1985] 1 S.C.R. 39;
Morley v. The Queen, 2006 FCA 171.
187
Testimony of Saunders, p. 2385, l. 12 to p. 2386, l. 20; see
also Testimony of Booth, p. 550, ll. 02-16.
188
See e.g. Testimony of Chambers, p. 1446, ll. 15-22; Testi-
mony of Saunders, p. 2404, l. 25 to p. 2405, l. 05; Testimony of
Coombs, p. 1159, l. 25 to p. 1160, l. 16; Testimony of Fidelman p.
1030, ll. 18-23.
189
See e.g. Testimony of Cole, p. 1940, ll. 15-16; Testimony of
Booth, p. 545, l. 12 to p. 546, l. 04; Testimony of Saunders, p. 2404,
l. 25 to p. 2405, l. 05; p. 2407, ll. 18-21.
190
Reasons, paras. [214] to [230].
191
See, e.g, Testimony of Werner, p. 135, ll. 11-20; p, 137, l. 06
to p. 138, l. 09; p. 189, l. 18, to p. 191, l. 16; p. 218, ll.01-18; Testi-
mony of Booth, p. 545, l. 02 to p. 550, l. 20; Testimony of Hull, p.
1821, l. 14 to p. 1823, l. 19; Testimony of Neysmith, p. 728, ll. 04-
23; Testimony of Fidelman, p. 980, l. 23 to p. 981, l. 02; p. 996, l. 05
to p. 1000, l. 19; Testimony of Chambers, p. 1351, l. 23 to p. 1353,
l. 08; p. 1362, l. 18 to p. 1363, l. 02; p. 1367, ll. 18-22; p. 1405, l. 25
to p. 1406, l. 14; p. 1417, l. 22 to p. 1418, l. 04; Testimony of Cole,
p. 1941, l. 07 to p. 1945, l. 05; p. 1973, l. 14 to p. 1974, l. 15; Testi-
mony of Saunders, p. 2379, ll. 19-24; p. 2383, ll. 02-04; p. 2399, ll.
20-23; Testimony of Meyerman, p. 2674, l. 16 to p. 2675, l. 08; p.
2689, l. 17 to p. 2691, l. 09; Testimony of Emmer, p. 2937, l. 02 to
p. 2939, l. 12; Testimony of Becket, p. 3187, l. 17 to p. 3191, l. 11.
p. 3195, l. 18 to p. 3201, l. 10; Testimony of Wright, p: 3259, ll. 05-
12; p. 3264, ll. 01-07; p. 3266, l. 08 to p. 3267, l. 07; p. 3299, ll. 09-
25.
192
Appendix C.
193
Testimony of Wright, p. 3288, l. 07 to p. 3294, l. 11 and see:
Shoppers Mortgage & Loan Corp. v. Health First Wellington
Square Ltd., [1995] O.J. No. 1268 (C.A.) at para. 26.
194
Chippewas of Mnjikaning First Nation v. Chiefs of Ontario,
2010 ONCA 47 (‘‘Chippewas’’) at para. 239; Metis, supra at para.
74; J. O. Wilson, A Book for Judges (Ottawa: Minister of Supply
and Services Canada, 1980) at pp. 45-48.
195
Testimony of Wright, p. 3324, l. 18 to p. 3325, l. 23; see also
e.g.: Testimony of Chambers, p. 1743, l. 01 to p. 1744, l. 16; Testi-
mony of Cole; p. 2036, ll. 11 to p. 2039, l. 16.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 141
106. The trial judge intervened and suggested answers to
the questions which the witness then adopted. For ex-
ample, when Werner indicated three times in cross-
examination that he did not know if GECUS would ensure
that the respondent would not default on its $700 million
in unguaranteed loans, the trial judge ‘‘reminded’’ him that
the loans were to GECUS and, therefore, there was a
matching of liabilities and a source of repayment.196
107. In still other instances, the trial judge’s questions so
confused the witness that counsel had to clarify the an-
swer:
08 MR. JUSTICE HOGAN: You are saying
09 that the parent would not have had an economic
10 incentive to not continue the program?
11 THE WITNESS: [Cole] That is correct.
12 MR. STEINER: No, no, no, no.197
108. The trial judge also directed questions of fact to
counsel when the witness could not answer and no evi-
dence of that fact had been tendered.198
109. The failure of counsel to strenuously object to ex-
cessive interventions is not fatal to a successful appeal on
the basis of undue interference and unfairness.199 As
noted, the trial judge was alert to the issue, but did not re-
sist intervening. Moreover, some of the prejudice caused
by the excessive interventions, especially on the issue of
the removal of the guarantee, was not apparent until the
Reasons were issued.
110. The appearance of judicial impartiality is compro-
mised when the trial judge assumes the role of counsel.
Since the parties were represented by experienced coun-
sel, there was no reason for the trial judge to descend into
the arena to test the objectivity, independence or neutrality
of lay or expert witnesses.200 If there was a concern about
the impartiality of witnesses, it was counsel’s role to bring
forth such evidence.
d) the unfairness of the trial process led to a
reasonable apprehension of bias
111. In the context of the proceedings as a whole, the
trial process was unfair. The test that must be applied is
whether the particular conduct gives rise to a reasonable
apprehension of bias.201 A determination of whether a trial
judge’s interventions give rise to a reasonable apprehen-
sion of bias is a fact-specific inquiry and must be assessed
in relation to the facts and circumstances of a particular
trial. The test is an objective one, with the trial record be-
ing assessed in its totality and the interventions com-
plained of evaluated cumulatively.202
112. The trial judge’s interventions in this case were of a
nature and extent that transgressed permissible interven-
tions and destroyed the image of judicial impartiality. He
usurped the function of counsel. He took the trial away
from the parties by introducing his own theories, gathering
his own evidence and making it difficult for counsel to
196
Testimony of Werner, p. 480, l. 23 to p. 482, l. 05; see also
e.g. Testimony of Cole, p. 2029, l. 18 to p. 2033, l. 20 to p, 2039, l.
16.
197
Testimony of Cole, p. 1969, ll. 08-12.
198
Testimony of Fidelman, p. 3382, l. 15 to p. 3383, l. 17; p.
3384, ll. 03-11; and p. 3390, l. 04 to p. 3390, l. 25.
199
Chippewas, supra at paras. 254; R. v. J.F.A. (Ont. C.A.),
[1993] O.J. No. 1494 at para. 26; Sawbridge Band v. Canada,
[1997] 3 F.C. 580 (F.C.A.) at para. 13; Sloboda, supra at para. 58.
200
See Reasons, paras. [214] to [230], particularly [227].
201
R. v. S. (R.D.), [1997] 3 S.C.R. 484 per Cory J. at para. 109.
Committee for Justice and Liberty v. National Energy Board,
[1978] 1 S.C.R. 369 per Grandpre J. in dissent at pp. 394-395 and
R. v. S. (R.D.), supra per L’Heureux-Dubé and McLachlin JJ. at
para. 31 and per Cory J. at para. 111.
202
Chippewas, supra, at para. 230.
BNA TAX 6-3-10
142 (Vol. 19, No. 3)
know the case they had to meet. The cumulative result of
the errors was a trial that was procedurally unfair,203 giv-
ing rise to a reasonable apprehension of bias.
ii) Reasons for Judgment are Inadequate
113. The trial judge’s Reasons do not address outstand-
ing evidentiary objections, rely on cases not raised at the
hearing, treat evidence inconsistently, ignore significant
evidence of many witnesses and fail to provide adequate
analysis on pivotal issues, preventing meaningful appellate
review.204
114. The Reasons are silent with respect to:
(a) many of the evidentiary objections taken under
reserve;205
(b) why no adverse inferences were drawn from the
respondent’s failure to call witnesses on significant
factual points at issue despite being asked to draw
such inferences;206
(c) why the trial judge commented, advised or ruled
one way during the trial but treated the evidence an-
other way in the Reasons;207
(d) significant evidence that was put to many wit-
nesses.208 For example, the appellant relied heavily
on the situation of Heller Financial Inc.209 as an in-
stance where S&P had equalized the ratings of a
newly acquired subsidiary on the basis of implicit
support by its new parent, GECUS. Despite this evi-
dence confirming the appellant’s theory of the case,
the trial judge did not mention it;
(e) how the potential removal of the explicit guaran-
tee was a relevant factor, how he used this factor in
his analysis or how much the removal would affect
value, despite evidence that the impact could be mi-
nor210 or huge.211 As a factor used to make credibil-
ity findings, it was erroneous and poorly ex-
plained;212
203
Stevens v. Plachta, [2006] B.C.J. No. 2809 (C.A.) at para. 24 and
James, supra at paras. 52-53.
204
Hill v. Hamilton-Wentworth Regional Police Services Board, [2007] 3
S.C.R. 129 at para. 100; see also R. v. Sheppard, [2002] 1 S.C.R.
869.
205
Appendix G contains evidentiary objections taken under re-
serve, but were not specifically addressed during the trial or in the
Reasons. This is an unsatisfactory procedure, see: Landeta v
Toronto Area Transit Authority, [2003] O.J. No. 2260 (Ont. C.A.) at
para. 3.
206
Respondent’s [Appellant’s] Written Submissions at paras.
140-147, Appeal Book, Vol. 42, Tab 176 at pp. 9953-9956.
207
e.g. The trial judge ordered that if expert evidence was du-
plicative, counsel could object (Order dated May 7, 2009, para.
[15], Appeal Book, Vol. 1, Tab 12, p. 302) but disregarded such ob-
jections when made (Testimony of Cole, p. 1925, ll. 13-18; p. 1928,
ll. 06-15). The trial judge ruled that Neysmith could not provide
opinions, then (incorrectly) reiterated Mr. Neysmith’s opinion (see
para 100 above). Testimony of Neysmith, p. 727, ll. 18-21 and p.
736, l. 12 to p. 738, l. 18 and Reasons, para. [28]).
208
Appendix H contains significant evidence put to various wit-
nesses and not mentioned in the Reasons.
209
Exhibit R-11, S&P Publication Heller Financial Inc. Ratings
Raised and Removed from CreditWatch, Appeal Book, Vol. 17, Tab
128, p. 4942.
210
Testimony of Wright, p. 3269, ll. 16-23; Testimony of Cham-
bers, p. 1749, l. 13 to p. 1759, l. 02; Testimony of Meyerman, p.
2685, l. 20 to p. 2689, l. 16.
211
Exhibit A-85, Report of Chambers, pp. 25-26, para. 7, Appeal
Book, Vol. 13, Tab 101, pp. 3723-3724.
212
Francis v. Canada (‘‘Francis’’), [2007] T.CJ. No. 204, per
Bowman C.J.T.C at paras. 5-16.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
(f) why the trial judge assessed the respondents
credit rating based on a lack of explicit support
rather than the lack of explicit guarantees;213 and
(g) the fact that the determination of the respon-
dent’s credit rating was only the first step in the
analysis, not the only step and that a similar analysis
in the context of evaluating the value of the guaran-
tee to the guarantor was also essential to arrive at an
arm’s length price.
116. The trial judge considered numerous cases not
brought to his attention by either party. The purpose for
the citation or the proposition the trial judge extracted
from these cases is not always clear.214 As a matter of fair-
ness, parties should be given an opportunity to Comment
on cases that the trial judge considers when they raise a
new point or modify a point or conclusion.215 In addition, it
appears that on at least one occasion, he researched factual
matters, referring to Warren Buffett.216 A judge should
never conduct an ex parte factual inquiry.217
117. The Reasons make it difficult to determine how the
trial judge arrived at decisions on key issues. Most signifi-
cantly, the trial judge appeared to reject Chambers’ conclu-
sion and arrived at his own conclusion as to what would be
the respondent’s credit rating without any analysis or ex-
planation.
118. Chambers’ conclusion was that the respondent
should be viewed as an independent subsidiary and only be
given a minimal uplift of one or two notches from its stand-
alone rating, to a maximum of BB/BB+.218 Although not
mentioned in the Reasons, Chambers’ report had also ob-
served that some analysts might conclude that the respon-
dent would be considered ‘‘strategically important’’ and
that, within that range, its credit rating could be anything
from a 3 notch uplift (to BBB-/BB+) based on the informa-
tion he had before him to bordering on core219 or, as ad-
mitted in cross-examination, to AAA based on implicit sup-
port and the nature of undertakings.220 Without explana-
tion, the trial judge increased the respondent’s stand-alone
credit rating proposed by Chambers by three notches to
bring it to BBB-/BB+ to take into account implicit support.
119. The overwhelming evidence was that GECUS had
compelling economic incentives to support the respondent,
presumably leading to the conclusion that an S&P analyst,
having all the information Chambers lacked, would notch
the respondent much more than the three notches that
Chambers suggested.
120. The trial judge did not explain why he rejected
Chambers’ conclusion that the respondent’s highest credit
rating without the explicit guarantees would be BB/BB+.
He did acknowledge that implicit support existed, and, by
notching up to BBB-/BB+, appeared to assume that the re-
spondent would be considered a strategically important
subsidiary, but failed to specify that. Nor did he explain
why the respondent would be a strategically important sub-
213
Reasons, para. [301].
214
See Appendix F for the list of cases and authorities consid-
ered by the trial judge which were not referenced by either party.
215
Re Lawrence’s Will Trusts, [1972] Ch. 418 at p. 437.
216
See Reasons, para. [200]. The trial judge apparently under-
took internet research at footnote 225.
217
Gernhart v. Canada, [2000] 2 F.C. 292 (C.A.); see also:
679619 v. Windsor, 2007 ONCA 7 per Gillese J.A. at para 51; Cronk
v. Canadian General Insurance Co. (1995), 25 O.R. (3d) 505 (C.A.).
218
The trial judge accepts a 3 notch uplift and concludes that
the Appellant’s final credit rating would be in the range of BBB-/
BB+, the equivalent of a strategically important subsidiary. See
Reasons at paras [65] and [301]; Exhibit A-85, Report of Chambers
at pp. 28-29, Appeal Book, Vol. 13, Tab 101, pp. 3699 and 3726-
3727; Testimony of Chambers, p. 1334, l. 05 to 1335, l. 06.
219
Exhibit A-85, Report of Chambers, pp. 28-29; Appeal Book,
Vol. 13, Tab 101, pp. 3726-3727.
220
Testimony of Chambers, p. 1665, ll. 01-16.
TMTR ISSN 1063-2069
TEXT
sidiary entitled only to a three notch upgrade as opposed
to a strategically important subsidiary that bordered on
core, resulting in an upgrade to AA+ or equalized at AAA.
E. CONCLUSION
121.The evidence necessary for this Court to make the
appropriate ruling on the pivotal issue of the value of the
explicit guarantee is contained in the appellate record. To
the extent that the trial judge reached his conclusion based
on errors of law and/or errors in conclusions of fact which
are palpable and overriding,221 this Court may, therefore,
allow the present appeal, substitute its own decision for
that of the trial judge and conclude that the evidence of
Emmet, Saunders, Meyerman and Coombs on the AAA rat-
ing of the respondent should be accepted and therefore,
the value of the explicit guarantees is nil.
122. If any doubt exists, there is sufficient and compel-
ling evidence before this court that the respondent would
be rated at least AA+, resulting in a reasonable guarantee
fee of no more than 0.15% to 0.24% for the years 1996 to
2000.222
123. Alternatively, if this Court concludes that the con-
duct of the trial judge so tainted the evidentiary record as
to make it impossible to reach a proper conclusion, this
Court should remit the matter back to the Tax Court of
Canada, for a new hearing before a new judge.
PART IV—ORDER SOUGHT
124. The appellant, therefore, requests that this appeal
be allowed with costs to the appellant in this Court and the
Court below, and that the Part I reassessments be restored.
Alternatively, the appellant requests that this Court direct
a new trial be held before a different trial judge.
ALL OF WHICH IS RESPECTFULLY SUBMITTED
Dated at Toronto this 14th day of April, 2010.
/s/
Naomi Goldstein
Counsel for the appellant
TO: The Administrator
Federal Court of Canada
180 Queen Street West Suite 200
Toronto, Ontario
M5V 3L6
AND TO: Al Meghji
Osler, Hoskin & Harcourt LLP
Barristers and Solicitors
1 First Canadian Place, Box 50
Toronto, Ontario
M5X 1B8
Counsel for the respondent
PART V—LIST OF AUTHORITIES
Statutes
1. .Federal Court Act, R.S.C. 1985, c. F-7, s. 52(c)
2. Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.), as
amended, s. 69 and s. 247
3. Canada-US Income Tax Convention (1980)
Cases
4. ABB Inc. v. Domtar Inc., [2007]3. S.C.R. 461
5. Ankrah v Canada, 2003 TCC 413, [2003] T.C.J. No 422
(T.C.C.)
6. Beaudry v. Canada, [1998] T.C.J. No. 353 (T.C.C.)
221
Federal Courts Act, R.S.C. 1985, c. F-7, s. 52(c)(i); Boars Es-
tate v. Toronto General Hospital, [1997] O.J. No. 3727 (C.A.); Scott v.
Canada, [2008] F.C.J. No. 1356 (C.A.).
222
Exhibit R-24, Report of Saunders, Tabs 8 and 13, Appeal
Book, Vol. 18, Tab 141, pp. 5254 and 5259. These numbers are also
more conservative than those of the respondent’s expert, Hull. See
Exhibit A-87, Report of Hull, p. 12, Appeal Book, Vol. 131 Tab 103,
p. 3772.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 143
7. Broulliard v. R., [1985] 1 S.C.R. 39, [1985] S.C.J. No.3
8. Bryars Estate v. Toronto General Hospital, 152 D.L.R.
(4th) 243, [1997] O.J. No. 3727 (C.A.)
9. C.U.P.E. v. Ontario (Minister of Labour), [2003] 1
S.C.R. 539, 2003 SCC 29
10. Canada v. McLarty, [2008] 2 S.C.R. 79, 2008 SCC 26
11. Canada (Director of Investigation and Research) v.
Southam Inc., [1997] 1 S.C.R. 748
12. Chippewas of Mnjikaning First Nation v. Chiefs of
Ontario, 2010 ONCA 47
13. Cronk v. Canadian General Insurance Co., (1995), 25
O.R. (3d) 505, [1995] O.J. No. 2751 (C.A.)
14. Committee for Justice and Liberty v. National Energy
Board, [1978] 1 S.C.R. 369
15. Corsault v. Canada (M.N.R.), 2005 TCC 112, [2005]
T.C.J. No. 148 (T.C.C.)
16. DSG Retail Limited et al. v. The Commissioners for
Her Majesty’s Revenue and Customs, [2009] UKFTT 31
(TC)
17. Ellis-Don Ltd. v. Ontario (Labour Relations Board),
[2001] 1 S.C.R. 221, 2001 SCC 4
18. Farrar v Farrar, [2003] O.J. No. 181. (C.A.)
19. Faryna v. Chorny, [1952] 2 D.L.R. 354, [1951] B.C.J.
No. 152 (C.A.)
20. Flex-Coil Ltd. v R., 1996 CarswellNat 1459 (F.C.A.)
21. Francis v Canada, [2007] T.C.J. No. 204 (T.C.C.)
22. Gallop v. Mulatz, 2008 SKCA 29
23. Gernhart v. Canada [2000] 2 F.C. 2929 (C.A.)
24. GlaxoSmithKline v The Queen, 2008 TCC 324
25. Geffen v. Goodman Estate, [1991] 2 S.C.R. 353
26. Great Western and Metropolitan Railway Companies
v. Kensington Assessment Committee, [1916] 1 A.C. 23
(H.L.)
27. H.L v. Canada (Attorney General), [2005] 1 S.C.R.
401, 2005 SCC 25
28. Heron Bay Investments Ltd. v. The Queen, 2009 TCC
337
29. Hill v. Hamilton-Wentworth Regional Police Services
Board, [2007] 3 S.C.R. 129, 2007 SCC 41
30. Housen v. Nikolaisen, [2002] 2 S.C.R. 235, 2002 SCC
33
31. I.F.K. v. College of Physicians and Surgeons of Brit-
ish Columbia, [1998] B.C.J. No.577 (BCCA)
32. Indalex Ltd. v. Canada (F.C.A.), [1987] F.C.J. No.
1150
33. James v. Canada (Minister of National Revenue),
[2000] F.C.J. No. 2135 (C.A.)
34. Johnston v. Simmons, [1981] B.C.J. No. 1424 (C.A.)
35. Kovalik Estate v Griffen, [2002] M.J. No. 261 (C.A.)
36. Landeta v Toronto Area Transit Authority, [2003]
O.J. No. 2260 (C.A.)
37. Re: Lawrence’s Will Trusts, [1972] Ch. 418
38. Lennox v. Arbor Memorial Services Inc., [2001] O.J.
No. 4725 (C.A.)
39. Majcenic v. Natale, [1968] 1 O.R. 189-205 (C.A)
40. Mandrake Management Consultants Ltd. v. Toronto
Transit Commission, 102 D.L.R. (4th) 12 (Ont. C.A.)
41. Marchand (Litigation guardian of) v. Public General
Hospital Society of Chatham, [2000] O.J. No. 4428 (C.A.)
42. McFarlane v. Safadi, [2004] O.J. No. 1763 (C.A.)
43. Metis Child, Family and Community Services v.
A.J.M., 2008 MBCA 30
44. Morley v. The Queen, 2006 FCA 171
45. Municipal Property Assessment Corporation v. BCE
Place Limited, (2010) 98 O.R. (3d) (SCJ)
46. Murphy v. S.G.I., 2008 SKCA 57
47. NCJ Educational Services v. Canada, 2009 FCA 131
48. Nichol v Canada [1993] T.C.J. No 541 (T.C.C.)
49. Nunn v. Canada [2006] F.C.J. No. 1852 (C.A.)
50. Phillips et al v. Ford Motor Co. of Canada Ltd. et al.,
[1971] O.J. No. 1564 (C.A.)
51. R. v. J.F.A., (Ont. C.A.), [1993] O.J. No. 1494 (C.A.)
52. R v. Marquard, [1993] 4 S.C.R. 223
53. R. v. Sheppard, [2002] 1 S.C.R. 869, 2002 SCC 26
54. R. v. W., [1992] 2 S.C.R. 122
BNA TAX 6-3-10
144 (Vol. 19, No. 3)
55. R. v. S. (R.D.) [1997] 3 S.C.R. 484
56. R. v. McDougall, 2007 BCCA 212
57. Rich v. Canada, [2003] 3 F.C. 493 (FCA)
58. Ross v. New Brunswick Teachers’ Assn. (2001), 2001
NBCA 62
59. St-Jean v. Mercier, [2002] 1 S.C.R. 491
60. Sawbridge Band v. Canada, [1997] 3 F.C. 580
(F.C.A.)
61. Scott v. Canada, [2008] F.C.J. No. 1356 (F.C.A.)
62. Schreiber Brothers Ltd. v Currie Products Ltd. et al.,
[1980] 2 S.C.R. 78
63. Shopper’s Mortgage & Loan Corp. v. Health First
Wellington Square Ltd. [1995] O.J. No 1268 (C.A.)
64. Singleton v Canada, [2001] 2 S.C.R. 1046 affirming
Singleton v Canada, [1999] 4 F.C. 484
65. Sloboda v. Sloboda, 2007 SKCA 15
66. SmithKline Beecham Animal Health Inc. v Canada,
2002 FCA 229
67. Stevens v. Plachta, [2006] B.C.J. No. 2809 (C.A.)
68. Sun Life Assurance Co. of Canada v Montreal (City),
[1950] S.C.R. 220
69. Toneguzzo-Norvell (Guardian ad litem of) v.
Burnaby Hospital, [1994] 1 S.C.R. 114
70. Tonn v Canada [1995] F.C.J. NO 1635 (C.A.)
71. Waxman v. Waxman, [2004] O.J. No. 1765 (Ont.
C.A.)
72. Weeks v. Weeks, [1955] B.C.J. No. 111 (C.A.)
73. 679619 v. Windsor, 2007 ONCA 7
Textbook Sources
74. Eden, Lorraine, Taxing Multinationals: Transfer Pric-
ing and Corporate Income in Taxation in North America,
(Toronto: University of Toronto press, 1998)
75. Feinschreiber, Transfer Pricing Handbook, vol. 1, 3rd
ed. (New York: John Wiley & Sons, Inc., 2001)
76. Markham, Michelle, The Transfer Pricing of Intan-
gibles, (The Hague: Kluwer Law International, 2005)
77. J.O, Wilson, A Book for Judges, (Ottawa: Minister of
Supply and Services Canada, 1980)
Other Publications
78. Organisation for Economic Co-operation and Devel-
opment, Transfer Pricing Guidelines for Multinational En-
terprises and Tax Administrations (Paris: OECD, 1995)
79. Information Circular 87-2R, International Transfer
Pricing, September 27, 1999
APPENDICES
A. Examples of Inconsistencies in the Evidence of Werner
B. Errors and Omissions in Chambers’ Report and Testimony
C. Questions Asked by Counsel and Trial Judge
D. History of Issue re: the Impact of the Removal of the Ex-
plicit Guarantee E. Nova Scotia Unlimited Liability Corporation
F. Cases and Authorities Considered by Trial Judge That Were
Not Addressed by the Parties
G. Evidentiary Rulings Taken Under Advisement by Trial
Judge, But Not Addressed in Reasons
H. Significant Evidence Put to the Witnesses Which is Not
Addressed in the Reasons
A. EXAMPLES OF INCONSISTENCIES IN TESTIMONY OF
WERNER
1. Werner testified that GE Capital did not use any bank
debt in any developed country except for back-up lines of
credit223 but later admitted he was aware that GECUS had
directed the respondent to enter into 8 unguaranteed term
loans with banks totalling $700 million.224
2. His understanding of the phrase ‘‘implicit support’’ in
the credit rating context was ‘‘size matters’’,225 but he used
223
Testimony of Werner, p.156, ll. 14-20 and p. 157, ll. 09-20.
224
Testimony of Werner, p. 477, l. 02 to p. 479, l. 24 and Exhibit
R-10, Loan Agreement, Appeal Book, Vol. 17, Tab 127, p. 4924.
225
Testimony of Werner, p. 188, l. 15 to p. 189, l. 17.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
the same term much differently in A-53, Presentation to
CBRS, p. 64.226 It was used differently by S&P in its Finan-
cial Analysis of GECUS227 where it noted ‘‘a significant
factor in the company’s strength derived from its owner-
ship by GE and the continued implicit and explicit support
it provides to GECUS.’’.
3. He testified that he did not know and never knew if the
loans from GECUS to its European subsidiaries were at
cost or cost plus.228 In cross-examination, he admitted GE-
CUS charged interest on its loans to its European subsid-
iaries.229
4. He originally testified that the respondent did not have
a strong record in the [capital markets], but, in cross-
examination, admitted he had no actual knowledge prior to
1988 and relied solely on the financial statements.230
5. Werner testified that he believed that the bankers at
the Royal Bank of Canada and the Bank of Nova Scotia
knew or would have assumed that GECUS was not making
real inquiries in the 1995 letters between GECUS and Bank
of Nova Scotia/Royal Bank.231 Both bankers testified that
they believed the inquiries were genuine.232
B. ERRORS AND OMISSIONS IN CHAMBERS’ REPORT AND
TESTIMONY
1. Chambers admitted he was given a limited assignment
insofar as he was precluded from drawing inferences ex-
cept where there were explicit statements about, or evi-
dence of, explicit support by GECUS to the respondent.233
2. He also failed to draw any inferences about the exist-
ence of implicit support, even though such implicit support
was assumed to exist by CBRS234 and the expert bank-
ers.235
3. Chambers was not given access to crucial pieces of
factual evidence, including:
s an example of a S&P equalization to GECUS’s AAA
credit rating of a newly acquired subsidiary and
comments by Werner and other credit rating agen-
cies or analysts of the substantial support the re-
spondent could expect to receive from GECUS;236
s Appellant’s [Respondent’s] Notice to Admit;237
s The $700 unguaranteed term loan agreements made
to the respondent by various banks in 1998;238
s The rating assessment and commentary prepared
by the actual S& P analyst most familiar with GE-
CUS, Richard Schmidt, in 1995;239
226
Exhibit A-53, Presentation to CBRS, p. 64, Appeal Book, Vol.
3, Tab 69, p. 756; Testimony of Werner p. 193, l. 02 to p. 195, l. 15;
p. 493, ll. 03-17; p. 495, l. 10 to p. 496, l. 16.
227
Exhibit A-58, S&P’s Financial Analysis of GECUS, Appeal
Book, Vol. 3, Tab 74, p. 862.
228
Testimony of Werner, p. 181, ll. 12-25.
229
Testimony of Werner, p. 500, l. 22 to p. 501, l. 08.
230
Testimony of Werner p. 278, l. 06 to p. 280, l. 15; p. 281, ll.
01-18; and p. 290, ll. 01-13.
231
Exhibits R-9A and R-B; Letters between GECUS and Bank of
Nova Scotia/Royal Bank, Appeal Book, Vol. 17, Tabs 125 and 126,
p. 449, l. 10 to p. 450, l. 15.
232
Testimony of Mitchell, p. 2258, ll. 04-22; Testimony of Clark,
p. 2284, ll. 09-17.
233
Transcript of Chambers, p. 1510, l. 05 to p. 1511, l. 25; p.
1631, l. 05 to p. 1636, l. 11; p. 1737, l. 19 to p. 1738, l. 15.
234
Testimony of Neysmith, p. 730, l. 21 to p. 732, l. 09.
235
Testimony of Coombs, p. 1212, ll. 13-15; Testimony of Mey-
erman, p. 2666, ll. 02-16 and p. 2669, l. 20 to p. 2670, l. 23.
236
S&P Credit Week Article, Appeal Book, Vol. 18, Tab 132, p.
5134; Testimony of Chambers, p. 1704, ll. 12-18.
237
Appellant’s [Respondent’s] Notice to Admit, Appeal Book,
Vol. 1, Tab 13; Testimony of Chambers, p. 1557, l. 05 to p. 1558, l.
01.
238
Exhibit R-10, Term Loan Agreements, Appeal Book, Vol. 17,
Tab 127 at p. 4924; p. 1569, l. 09 to p. 1570, l. 17.
239
Exhibit R-7, Letter from Werner to R. Schrnidt (S&P) and
Exhibit R-8, Letter from Werner to Schmidt, Appeal Book, Vol. 17,
TMTR ISSN 1063-2069
TEXT (Vol. 19, No. 3) 145

s The CBRS credit rating for the respondent;240 C. QUESTIONS ASKED BY COUNSEL AND TRIAL JUDGE
s The presentations prepared for the Canadian Credit
Rating Agencies, CBRS and DBRS, by Werner;241 Approximate Number Approximate Number
s The GECUS Instruction Manual;242 and of Questions Asked of Questions Asked
Respondent’s During Direct During Cross-
s The draft DBRS credit rating prepared in 2001.243
Witnesses Examination Examination
4. Chambers made substantial errors including identify-
ing a trust as a subsidiary244 and incorrectly suggesting Counsel Trial Judge Counsel Trial Judge
that the reason Heller Financial Inc.’s credit rating was R. Oryschuk 82 7 29 0
raised to AAA upon being acquired by GECUS was be- J. Werner 390 57 957 93
cause its debt was to be subsequently guaranteed by its L. Booth 112 53 290 47
new parent.245
J. Hull 53 10 110 18
5. Chambers omitted relevant but unsupportive informa-
tion from the rating literature in his written report to the J. Coombs 161 19 189 15
effect that Moody’s stated: ‘‘. . . when rating financial insti- B. Neysmith 108 36 50 6
tutions, certain additional factors may also be consid- M. Fidelman 207 116 66 24
ered. . . .’’246
A. Scilipoti 83 5 43 1
6. Chambers concluded that the respondent would be
ranked as an ‘‘independent subsidiary’’ of its parent,247 a W. Chambers 344 77 805 65
conclusion that was neither corroborated by Werner nor R. Lewis 47 0 7 0
any other witness248 nor accepted by the Court.249 To the S. Cole 73 56 130 52
contrary, Werner saw it as more than a mere investment, D. Daubaras 119 3 217 7
recognized that it had similar clients and lines of business
and confirmed that it was part of GE’s global strategic B. Bennett 69 4 2 0
plan.250
Approximate Number Approximate Number
7. Chambers opined that the implicit support the respon- of Questions Asked of Questions Asked
dent received Was ‘‘minimal’’, but he agreed on cross- Appellant’s During Direct During Cross-
examination that others, including the actual rating analyst Witnesses Examination Examination
at S&P who had prepared a rating assessment for the re-
spondent, had concluded that the implicit support would Counsel Trial Judge Counsel Trial Judge
be ‘‘significant.’’251 S. Mitchell 54 4 40 0
8. Chambers conceded that the respondent’s credit rat- K. Clark 73 7 4 0
ing could be equalized to that of GECUS, that is, AAA, if he A. Saunders 85 25 409 18
had located tangible evidence of implicit support, but his
H. Meyerman 115 17 147 15
assignment prevented him from inferring that.252
E. Emmer 436 11 361 24
B. Becker 49 10 33 2
Tabs 123 and 124, pp. 4897 to 4916; Testimony of Chambers, p. D. Wright 60 77 80 20
1554, ll. 13-24 and p. 1581, l. 01 to p. 1582.
240
Exhibit A-54, CBRS Credit Analysis, Appeal Book, Vol. 3, D. HISTORY OF ISSUE RE: THE IMPACT OF THE REMOVAL
Tab 70, pp. 777-780; Testimony of Chambers, p. p. 1578, l. 24 to p. OF THE EXPLICIT GUARANTEE
1579, l. 03.
241
Exhibits A-48, A-49 and A-53: Presentations prepared for
credit agencies, Appeal Book, Vol. 3, Tabs 64, 65, 69; Testimony of
Pleadings
Chambers, p. 1551, l. 24 to p. 1552, l. 14. Not raised by either party.
242
Exhibit R-3, Instruction Manual, Appeal Book, Vol. 17, Tab
119; Testimony of Chambers, p. 1567, l. 14 to p. 1568, l. 25.
243
Exhibit R-23, Draft DBRS Credit Rating (Status Uncertain),
Discovery
Appeal Book, Vol. 18, Tab 140, pp. 5191 to 5195 and Testimony of [The issue is] ‘‘. . .the guarantee that was given, not the
Chambers, p. 1579, l. 08 to p. 1584, l. 06; p. 1792, l. 01 to p. 1795, l. guarantee that they might have given or that they thought
06; they might give.’’ Respondent’s [appellant’s] Read-ins, Ex-
244
Testimony of Chambers, p. 1764, l. 08 to p. 1765, l. 01. hibit R-34, Tab 24. Appeal Book, Vol. 19, p. 5586.
245
Testimony of Chambers, pp. 1665-1669 and pp. 1711-1714;
Exhibit R-11, S&P Publication dated 26-Oct.-2001, Exhibit R-11,
Heller Financial Inc. Ratings Raised and Removed from Credit Expert Report of Chambers dated April 15, 2009 at p. 27
Watch, Appeal Book, Vol. 17, Tab 128, p. 4942. & 33
246
Testimony of Chambers, p. 1690, l. 07 to p. 1692, l. 04; p. Chambers states that in ‘‘assessing the impact and neces-
1679, l. 05 to p. 1684, l. 09; Exhibit R-13, Moody’s Rating Method- sity for the parental guarantee, one could ask what would
ology, Rating Non-Guaranteed Subsidiaries: Credit Considerations have been the effect if, in 1996, GECUS had announced
in assigning Subsidiary Ratings in the Absence of Legally Binding that it would no longer provide a guarantee to new debt is-
Support, Appeal Book, Vol. 18, Tab 130 pp. 5106-5117. sues of GECCI [the respondent] rather than provide an on-
247
Testimony of Chambers, p. 1592, ll. 03-19; p. 1640, ll. 08-12; going guarantee without receiving a guarantee fee?’’ He
p. 1692, l. 24 to p. 1693, 1.08; Exhibit R-12, S&P Credit rating postulates that such an event would result in an immediate
Throughout the Years, Tab 7, Criteria/Financial Institutions/ review by the rating agencies and would have likely re-
General Group Methodology for Financial Services Companies, sulted in a substantial downgrade of the AAA rating on
Appeal Book, Vol. 17, Tab 129, p. 5097.
248 GECCI’s long term debt issuances.
Testimony of Neysmith, p. 761, ll. 06-25; Exhibit A-54, CBRS
Report, Appeal Book, Vol. 3, Tab 70, p. 777; Exhibit R-23, Draft
DBRS Credit Rating (Status Uncertain), Appeal Book, Vol. 18, Tab
140, p. 5191.
Expert Report (Rebuttal) of Meyerman dated May 10,
249
Reasons, para. [301]. 2009 at p, 16
250
Testimony of Werner, p. 333, ll. 08-16; p. 347, ll. 07-19. Responding to Chambers, Meyerman states that if, in
251
Testimony of Chambers, p. 1582, l. 25 to p. 1584, l. 06; Ex- 1996, GECUS had announced that it would no longer pro-
hibit R-8, Rating Assessment by Richard Schmidt of S&P, Appeal vide a guarantee for new debt issues, the impact might
Book, Vol. 17, Tab 124, pp. 4913-4916. have been quite manageable if GECUS had explained its
252
Testimony of Chambers, p. 1574, l. 11 to p. 1577, l. 02; p. reasons for doing so as GE and GECUS had great leverage
1665, ll. 01-16; p. 1635, l. 20 to p. 1636, l. 11. with its banks.

TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069 BNA TAX 6-3-10
146 (Vol. 19, No. 3)
Opening Submissions
Not raised by either party
Werner
Cross-examination:
Trial judge asks the witness a hypothetical question; pre-
suming GECCI could go into the market on its own and get
an investment grade rating, would he still go out and get
third party credit default insurance or a guarantee. The
witness responds that if GECCI had been rated AAA, he
would be reluctant to remove the guarantee as the inves-
tors would be intelligent enough to-see through it. The trial
judge stated that the removal of the guarantee would send
a bad message to the market (p. 503, 1. 11 to 504, 1. 12).
J. Coombs
Direct:
Respondent’s counsel asks what the market reaction
would be if GECUS and GECCI announced that new debt
issuances were not going to be guaranteed by GECUS (p.
1174, l. 20 to p. 1176, l. 04).
Chamber
Direct:
Respondent’s counsel asks questions relating to how
S&P would view a default on the unguaranteed debt of the
respondent (p.1468, l. 01 to 1469, l. 03). The trial judge in-
tervenes and suggests the reaction would depend upon
how the company had postured previously, which he notes
‘‘we will never know, because we are after the fact’’ (p.
1469, l. 04 to p. 1471, l.03). The trial judge asks further in
this context how S&P would view a decision by GECUS to
remove the guarantee in 1995/1996 and the witness re-
sponds it would have raised a lot of questions and been a
shock ‘‘not just to the to the rating agencies, but to the gen-
eral capital markets, as well. . .’’ (p. 1471, l. 19 to p. 1473, l.
12).
Cross:
Appellant’s counsel asks how the rating agencies would
view the withdrawal of the guarantee from new debt issu-
ances and what explanations could be provided that would
satisfy the rating agencies. The witness states that the
agencies would ask for a very clear articulation of exactly
what level of support there was to be by GECUS (p. 1522,
l. 24 to p. 1526, l. 21).
Redirect:
Respondent’s counsel asks what effect a withdrawal of
the guarantee would have on the rating of the commercial
paper. Chambers states that, absent some other form of
support such as a keepwell agreement or cross-default cov-
enants, the rating agencies would downgrade the entity.
Counsel also asks how an explanation would be received
by the rating agencies that the guarantee was not neces-
sary any longer due to changes to legal-for-life rules. The
witness explains that the agencies would need to be satis-
fied that there was a compelling reason for withdrawing
the guarantee (p. 1804, l. 10 to p. 1807, l. 08).
Cole
Direct:
In the context of disagreeing with the witness that the
terms of the guarantee would be long term and be in exist-
ence for as long as the business was functioning (p. 1966,
ll.06-18), the trial judge intervenes and has an exchange
with counsel and the witness suggesting the guarantee
could be removed tomorrow and the subsidiary forced to
issue high-yield unsecured notes (p. 1967, l. 10 to p. 1971,
l. 02).
Saunders
Direct
The trial judge intervenes to ask how the hypothetical re-
moval of the guarantee would impact on the judgment of
the credit rating agencies. Respondent’s counsel objects
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
and the trial judge withdraws the question (p. 2385, l. 12 to
p. 2386, l. 21).
Appellant’s counsel asks what impact removal would
have on credit rating agencies and investors (p. 2439, l. 16
to p. 2440, l.05) and mid-question the trial judge intervenes
to question as to the impact of the removal of the guaran-
tee (p. 2440, l. 06 to p.2442, l. 12)
Cross-examination:
Respondent’s counsel asks whether the withdrawal of
the guarantee would provoke a discussion with the rating
agencies and GECUS. (p. 2455, ll. 01-09) The trial judge in-
tervenes to take over cross-examination to ask how an in-
vestor would react to the removal of the guarantee (p.
2456, l. 03 to p. 2457, l. 13).
Meyerman
Direct:
Appellant’s counsel raises the issue (p. 2685, l. 20 to p.
2686, l. 25) and the trial judge intervenes to take over ques-
tioning on the point of how the bank would view the re-
moval of the guarantee (p. 2686, l. 26 to 2689, l. 16) and
then moves into an exchange with the witness on the price
differential between two AAA rated issuances, one guaran-
teed and one unguaranteed (p. 2689, l. 17 to p. 2693, l. 11);
Emmer:
Direct:
Appellant’s counsel refers Emmer to p. 27 of Chambers
report and asks him to consider the rating agencies’ reac-
tion to a decision by GECUS not to guarantee new debt is-
suances by GECCI (p. 2961, l. 22 to p. 2963, l. 09).
The trial judge intervenes and asks whether GECUS
would take such a risk and whether it could have provided
a reasonable explanation for this decision (p. 2963, l. 10 to
p. 2966, l. 20).
Cross-examination:
Respondent’s counsel asks Emmer to agree that if, in
1996, GECUS decided to stop guaranteeing the debt of
GECCI a sophisticated investor would want to know the
reason why and an inference could be drawn that GECUS
wanted to keep its options open (p. 3094, l. 07 to p. 3096, l.
16).
The trial judge intervenes to ask what reason S&P would
accept for removal of the guarantee and questions witness
at length on the issue noting fact pattern before the Court
is not that the guarantee was never there from the begin-
ning but rather was in place for many years then removed
(p. 3096, l. 02 to p.3102, l. 15).
D. Wright:
Direct:
Trial judge intervenes to ask whether removal of the
guarantee is something experts should have considered in
valuing implicit support (p. 3249, l. 19 to 3253, l. 11)
Appellant’s counsel asks one follow-up question related
to where removal of the guarantee fits into the analysis (p.
3253, ll. 12-16). The trial judge intervenes and continues
with line of questioning extensively (p. 3253., l. 23 to p.
3258, l. 22). The trial judge comes back to the question (p.
3265, ll. 18-20) and states, ‘‘I am not sure we agreed yet on
the analytical framework for this question’’ (p. 3267, l. 08
to p. 3269, l. 20)
Submissions by Counsel
The trial judge invites submissions as to whether the ‘‘re-
moval of the guarantee’’ fits within the ‘‘transaction box’’
(p. 3422, ll. 07-17). Both parties deliver submissions on the
relevance and effect of the hypothetical removal of the
guarantee.
E. NOVA SCOTIA UNLIMITED LIABILITY CORPORATION
The trial judge introduced his own theory into the case
when he examined the difference between the respondent
and its sister company, a Nova Scotia unlimited liability
company.
TMTR ISSN 1063-2069
TEXT
The Pleadings:
The issue of the Nova Scotia unlimited liability company
was never raised in the pleadings.
Opening Statements:
Neither party referred to it during their opening state-
ments.
Oral Evidence:
The role of the respondent’s sister company, GE Capital
Canada Funding Company, was first mentioned during the
cross-examination of the appellant’s expert, Saunders.
Through leading questions, the respondent’s counsel sug-
gested to Saunders that this company acted as a financial
intermediary; it borrowed funds in the public markets and
then on-lent the funds to the respondent and its subsidiar-
ies (p. 2607, l. 21 to p. 2609, l. 16). Saunders testified he
had limited information about this company (p. 2611, ll. 13-
15). The trial judge, by the suggestion of respondent’s
counsel, concluded that both the respondent’s and the sis-
ter company’s financials should be viewed on a consoli-
dated basis (p. 2613, l. 14 to p. 2615, l. 07).
At no time during trial was there any evidence as to the
details of the lending relationship between the respondent
and its sister company, nor was there any evidence as to
the legal characteristics of the sister company (p. 3133, ll.
01-08 [Emmer] and p, 3378, ll. 18-25 [Fidelman]).
The proposition that the sister company was a Nova Sco-
tia unlimited liability company was first introduced by the
trial judge during the recall examination of Fidelman (p.
3379, l. 14 to p. 3380, l. 13). Fidelman was the final witness
to testify at the hearing. During the course of his testimony,
the trial judge, on his own accord, examined the effect of
the sister company being a Nova Scotia unlimited liability
company without the requisite evidence (p. 3382, l. 15 to p.
3383, l. 17; p. 3384, ll.03-11; and p. 3390, l. 04 to p. 3390, l.
25). The trial judge further inquired into the possibility of
tendering the sister company’s financials, but the appellant
objected to this proposition as its case was already closed
(p. 3385, ll. 05-11).
Written Arguments:
In closing arguments, neither party was specifically di-
rected to address the difference between the respondent
and its sister company, a Nova Scotia unlimited liability
company by the trial judge and neither did.
F.CASES AND AUTHORITIES CONSIDERED BY TRIAL JUDGE
THAT WERE NOT ADDRESSED BY THE PARTIES
1. Boucher v. Doiron, [2000] N.B.J. No. 382 (QL) (N.C.C.A.)
2. Covert v. Nova Scotia (Minister of Finance), [1980] 2
S.C.R. 774
3. Gestion Ivan Drouin Inc. v. The Queen, 2001 DTC 72
(TCC)
4. Giang v. Clayton, 2003 BCSC 1236, [2003] B.C.J. No.
1874
5. Gosselin v. The Queen, [1997] 2 C.T.C. 2830 (TCC)
6. Heron Bay Investments Ltd. v. The Queen, 2009 TCC
337
7. H.T. Hoy Holdings Limited v. The Queen; [1997] 2
C.T.C. 2874 (TCC)
8. Jolly Farmer Products Inc. v. The Queen, 2008 TCC
409
9. Lennox v. Arbor Memorial Services Inc., [2001] O.J.
No. 4725 (QL), 56 O.R. (3d) 795 (Ont. C.A.)
10. Metis Child, Family and Community Services v.
A.J.M., [2008] M.J. No. 76 (QL) (Man. C.A.)
11. Millward v. The Queen, 86 DTC 6538 (FCTD)
12. M.N.R. v. Merritt Estate, 69 DTC 5159 (Ex. Ct)
13. M.N.R. v. Pillsbury Holdings Ltd., 64 DTC 5184 (Ex.
Ct.)
14. National Justice Compania Naviera S.A. v. Pruden-
tial Assurance Co., Ltd. (‘‘Ikarian Reefer’’), [1993] 2
Lloyd’s Rep. 68 (Q.B., Com. Ct.)
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 147
15.Nichol v. The Queen, [1993] 2 C.T.C. 2906, 93 DTC
1216 (TCC)
16. Peoples Department Stores Inc. v. Wise, 2004 SCC 68
17. Peter Cundill & Associates Ltd. v. The Queen, 91 DTC
5085 (TCC)
18. Placer Dome Canada Limited v. Minister of Finance
(Ontario), 2006 DTC 6532 (SCC)
19. R. v. Sussex Justices; ex parte McCarthy, [1924] 1
K.B. 256
20. Robson Leather Co. Ltd. v. M.N.R., 74 DTC 6666
(FCTD)
21. Swiss Bank Corporation v. M.N.R., [1971] C.T.C. 427
(Ex. Ct.)
22. Teichgraber v. Gallant, 2003 ABQB 58
23. Tonn v. The Queen, [1996] 1 C.T.C. 205, 96 DTC 6001
(FCA)
24. W.D. Latimer Co. v. Dijon Investments Ltd., [1992]
O.J. No. 2909 (QL) (Ont. C.J.)
25. Windsor Plastic Products Ltd. v. The Queen, 86 DTC
6171 (FCTD)
26. Salomon v. A. Salomon and Co., [1897] A.C. 22 (H.L.)
27. Smith v. Van Gorkom, (Del. 1985) 488 A.2d 858
G.EVIDENTIARY RULINGS TAKEN UNDER ADVISEMENT BY
TRIAL JUDGE, BUT NOT ADDRESSED IN REASONS
Werner:
Whether the lay witness could testify as to the meaning
of ‘‘core subsidiary’’; p. 203, l. 23 to p. 205.l. 14;
Whether the GE Annual Reports are admissible; p. 260, l.
21 to p. 269, l. 16;
Whether evidence of meetings held between witness and
others in 1988 was admissible given respondent’s answers
at Discovery that there were no documents/meetings/
recollections, etc. deferred until discovery nominee,
Dabaraus testifies; p. 474, l. 04 to p. 476, l. 06.
Booth:
Objection to re-examination questions that did not refer
to matters brought out on cross-examination; p. 945, ll. 10-
23.
Chambers:
Chambers’ report deals with irrelevant document not in
evidence; The trial judge advised he ‘‘understood’’ the ba-
sis of the objection; p. 1331, ll.20-21.
Cole:
Issue of potential benefits to GECUS not mentioned in
Coles’ report; Allows question and says he will deal with it
in judgment; p. 1996, l. 05 to p. 1997, l. 17.
Daubaras:
Exhibit R-19 contains hearsay, pp. 2159-2163 and p.
2173;
Whether Exhibit 21 can be admitted for the truth of con-
tents and related subissues, beginning at p. 2155 to p. 2176,
l. 17);
Objection to using discovery evidence to impeach cred-
ibility of witness; p. 2182, ll. 01-05 and p. 2193, ll. 17-22 and
p. 2182;
Objection re: using discovery evidence to exclude Mr.
Werner’s testimony, p. 2186 to p. 2187, l. 18;
Objection regarding admissibility of evidence of reason
for putting guarantee fee in place; pp. 2198-p. 2203;
Objection re: admissibility of the DBRS report (Exhibit
R-23), p. 2207.
Bennett:
Objection to question being put to witness where re-
sponse differed from respondent’s answers at discovery; p.
2986, l. 01 to p. 2992, l. 18.
BNA TAX 6-3-10
148 (Vol. 19, No. 3)
Meyerman:
Objection regarding whether Meyerman would be al-
lowed to give a banker’s perspective on facts that are also
relevant to rating agencies; p. 2651 and Reasons [127].
Emmer:
Objection to allowing Exhibit A-58 to be put to the wit-
ness to speculate as to the reasons why some of the com-
panies were rated the why they were; p. 2956, l. 22 to p.
2957, l. 23.
Becker:
Objection as to whether his report and testimony are ad-
missible since they go to the ultimate issue; p. 3171, l. 06 to
p. 3177, l. 11.
Wright:
Objection as to whether her report and testimony are ad-
missible since they go to the ultimate issue; p. 3226, l. 08 to
p. 3239, l. 02.
H. SIGNIFICANT EVIDENCE PUT TO THE WITNESSES NOT
ADDRESSED IN THE REASONS
Heller Financial Inc.’s debt and credit rating upgraded
and equalized as a result of its acquisition by GECUS. Ex-
hibit R-11, S&P Publication dated 26-Oct.-2001, Heller Fi-
nancial Inc. Ratings Raised and Removed from Credit
Watch (Appeal Book, Vol. 17, Tab 128, p. 4942).
Testimony of Chambers, p. 1518, l. 10 to p. 1521, l. 15; p.
1665, l. 21 to p. 1668, l. 22; p. 1709, l. 3 to p. 1714, l. 21;
and p. 1784, l. 19 to p. 1791, l. 07.
Testimony of Werner, p. 497, l. 18 to p. 499, l. 15; and p.
501, l. 20 to p. 502, l. 15.
Testimony of Emmer, p. 2841, l. 05 to p. 2842, l. 08; and
p. 2868, l. 14 to p. 2869, l. 04.
Exhibit R-23, Draft DBRS credit rating (status uncertain)
(Appeal Book, Vol. 18, Tab 140, p. 5191).
Testimony of Chambers, p. 1579, ll. 04-07.
Testimony of Daubaras, p. 2206, l. 08 to p. 2217, l. 11.
Exhibit R-3, Memo dated May 31, 1996 to GECUS Tax
Council with attached GE Capital Instruction Number 49.0
(Appeal Book, Vol. 17, Tab 119, p. 4816).
Testimony of Werner, p. 326, l. 02 to p. 328, l. 22; p. 476,
l. 17 to p. 477, l. 01; and p. 479, ll.03-08.
Testimony of Emmer, p. 2877, l. 20 to p. 2879, l. 05.
Testimony of Chambers, p. 1567, l. 14 to p, 1572, l. 03;
and p. 1652, l. 20 to p. 1653, l. 25.
Exhibit R-7—Letter dated June 7, 2000 from Jeffrey
Werner to Richard Schmidt requesting S&P private rating
for GE Capital Canada and GE Capital Canada Funding
Company (Appeal Book, Vol. 17, Tab 123, p. 4897).
Excerpts on Article 7 from 2010 Update of OECD Model Tax Convention
[Final Draft Issued by OECD 5/21/2010]
21 May 2010
DRAFT 2010 UPDATE TO THE OECD MODEL TAX
CONVENTION
Introduction
This note includes the draft contents of the next update
to the OECD Model Tax Convention (the 2010 update) pre-
pared by Working Party 1 of the OECD Committee on Fis-
cal Affairs. It has not yet been approved by the CFA or the
OECD Council. It will be submitted for approval of the CFA
in June and the Council in July. It therefore does not nec-
essarily reflect the final views of the OECD and its member
countries.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
Testimony of Werner, p. 438, l. 24 to p. 440, l. 19; and p
442, l. 15 to p. 447, l. 25.
Testimony of Emmer, p. 2894, l. 19 to p. 2896, l. 12; p.
2935, l. 01 to p. 2939, l. 23; p. 2950, l. 04 to p. 2952 l. 23;
and p. 3121, l. 08 to p. 3129, l. 08.
Testimony of Chambers, p. 1537, l. 10 to p. 1588; l. 13; p.
1791, ll. 8-4; p, 1386, l. 06 top. 1396, l. 15; p. 1480, l. 18 p.
1481, l. 11; p. 1950, ll. 01-16; and p. 1324, l. 17 to p. 1325,
l. 12.
Exhibit R-8—Letter dated June 27, 2000 from Jeffrey
Werner to Richard Schmidt requesting S&P rating for GE
Capital Australia & New Zealand (Appeal Book, Vol. 17,
Tab 124, p. 4913).
Testimony of Werner, p. 442, l. 15 to p. 447, l. 25:
Testimony of Emmer, p. 2935, l. 01 to p. 2939, l. 23; p.
3121, l. 08 to p. 3129, l. 08; and p. 3140, l. 05 top. 3143, l.
05.
Testimony of Chambers, p. 1791, l. 08 p. 1796, l. 21; p.
1537, 1, 10 to p. 1588, l. 13; and p. 1386, l. 06 to p. 1396,
l. 15.
Exhibit R-9A—Letter dated November 7, 1995 from
Steve Mitchell to James Tremente; and Letter dated Octo-
ber 10, 1995 from James Tremente to Peter Steffen (Appeal
Book, Vol. 17, Tab 125, p. 4917).
Testimony of Werner, p. 450, l. 19 to p. 460, l. 22.
Testimony of Daubaras, p. 2219, l. 01 to p. 2215, l. 05.
Testimony of Mitchell, p. 2252, l. 25 to p. 2277, l. 08.
Testimony of Clark, p. 2299, l. 04 to p. 2302, l. 08.
Exhibit R-9B—Letter dated July 24, 1995 from James
Tremente to Kevin Clark; and Letter dated August 2, 1995
from Kevin Clark to James Tremente (Appeal Book, Vol.
17, Tab 126, p. 4922).
Testimony of Werner, p. 450, l. 19 to p. 460, l. 22.
Testimony of Clark, p. 2280, l. 05 to p. 2307, l. 19.
Exhibit R-11—S&P Publication ‘‘Heller Financial Inc.
Ratings Raised and Removed from Credit Watch; GE Capi-
tal Ratings Affirmed’’ dated October 26, 2001 (Appeal
Book, Vol. 17, Tab 128, p. 4942).
Testimony of Werner, p. 497, l. 18 to p. 499, l. 15; and p.
501, l. 20 to p. 502, l. 15.
Testimony of Emmer, p. 2841, l. 5 to p. 2842, l. 18; and p.
2868, l. 14 to p. 2869, l. 04.
Testimony of Coombs, p. 1206, l. 19 to p. 1211, l. 09.
Testimony of Chambers, p. 1518, l. 10 to p. 1521, l. 15; p.
1665, l. 01 to p. 1668, l. 22; p. 1709, l. 03 to 1714, l. 21;
and p.1784, l. 19 to p. 1791, l. 07.
Exhibit R-15—Standard & Poor’s CreditWeek Article
‘‘Analyzing Joint Ventures/Projects’’ dated May 20, 1996
(Appeal Book, Vol. 18, Tab 132, p. 5134).
Testimony of Emmer, p. 2863, l. 15 to p. 2866, l. 04.
Testimony of Chambers, p. 1660, l. 10 to p. 1661, l. 24;
and p. 1667, ll.02-25.
As explained more fully below, comments are not re-
quested at this time as all the contents of the 2010 update
have previously been released for comments.
The 2010 update will include the changes that were pre-
viously released for comments in the following discussion
drafts:
***
– Revised discussion draft of a new Article 7 of the OECD
Model Tax Convention, released on 24 November 2009
(see
http://www.oecd.org/dataoecd/30/52/44104593.pdf).
That revised draft reflected a number of changes made
to the first version of the new Article released on 7 July
2008 (see
TMTR ISSN 1063-2069
TEXT
http://www.oecd.org/dataoecd/37/8/40974117.pdf). A Conversely, whilst one commentator who supported
few additional changes were made, based on the com-
ments received on the revised draft, at the February
2010 meeting of WP1.
***
2. Revised discussion draft of a new Article 7 of the
OECD Model Tax Convention
Each of the comments that were received on that discus-
sion draft (see http://www.oecd.org/document/6/
0,3343,en_2649_33747_44461574_1_1_1_1,00.html) was ex-
amined by WP1 at its February 2010 meeting. As the Work-
ing Party was dealing with the incorporation in Article 7 of
the conclusions of the Report on Attribution of Profits to
Permanent Establishments (the ‘‘Report’’), which was ap-
proved by the OECD in 2008, it could not accept the sug-
gestions included in the few comments that were related to
the Transfer Pricing Guidelines or that challenged the con-
clusions of the Report. The following briefly address some
of the main points raised in other comments and explain
the few changes that WP1 made to the Commentary on Ar-
ticle 7.
– References to the Report on Attribution of Profits to
Permanent Establishments. Some commentators sug-
gested that the Commentary should include express
cross-references to, or specific paragraphs of, the Re-
port (e.g. as regards the guidance on when it is appro-
priate to recognise a dealing). The Commentary, how-
ever, already includes a general cross-reference to that
Report, stating expressly (in paragraph 9) that the new
Article ‘‘reflects the approach developed in the Report
and must be interpreted in light of the guidance con-
tained in it’’. Given the length of the Report, the inclu-
sion in the Commentary of all, or of a substantial part,
of the guidance included therein would not be practical
and would be contrary to the way in which the guid-
ance found in the Transfer Pricing Guidelines is re-
ferred to in the Commentary on Article 9. Based on a
suggestion by one commentator, however, the Commit-
tee made a few changes, reflected in paragraphs 5 to 9,
clarifying dates and references to the Report.
– Corresponding adjustment mechanism in paragraph 3
of Article 7. Whilst commentators generally welcomed
the new version of paragraph 3 of Article 7, which deals
with corresponding adjustments, some suggested that
the alternative provision included in paragraph 68 of
the Commentary might be preferable as it imposes an
obligation on the Contracting States to solve all cases
of disagreement related to a corresponding adjustment.
WP1 noted, however, that paragraph 3 of Article 7 only
deals with cases where the initial adjustment is in con-
formity with paragraph 2 because that paragraph is
part of the Model Tax Convention, which includes an
arbitration provision that guarantees the MAP resolu-
tion of cases of double taxation arising from adjust-
ments that are not in accordance with the principles of
paragraph 2. The alternative in paragraph 68 does not
go further: it also guarantees that all cases of double
taxation will be resolved through the MAP. The situa-
tion could, however, be different if two States did not
agree to include paragraph 5 of Article 25 (the arbitra-
tion provision) when adding the new Article 7 to a bi-
lateral convention. In that case, however, the Working
Party concluded that it was unlikely that these States
would adopt the alternative provision in paragraph 68
as this would impose on them a more stringent obliga-
tion than the one imposed under paragraph 2 of Article
9 in a case where the initial adjustment to the profits of
an associated enterprise is considered not to be in ac-
cordance with the arm’s length principle. Whilst the
Committee therefore decided to keep paragraph 3 as
drafted, it decided that paragraph 64 should be slighted
expanded to stress the critical role of arbitration in en-
suring that all issues that would otherwise prevent a
mutual agreement in cases not covered by paragraph 3
are resolved.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 149
the new paragraph 3 asked that the alternative provi-
sion in paragraph 68 be deleted, the Committee con-
cluded that this should not be done as the alternative
reflected the fact that some countries were only willing
to guarantee relief from double taxation in Article 7
cases through the mechanism of that alternative provi-
sion.
One commentator raised the issue of corresponding ad-
justments under existing treaties, noting that the cur-
rent version of Article 7 does not offer the same protec-
tion as new paragraph 3. Whilst it was considered that
the interpretation of treaties based on the existing
wording of the Model should not be dealt with in the
Commentary on the new Article, OECD member coun-
tries feel a high level of commitment to avoiding double
taxation in Article 7 cases and will seek, where neces-
sary, to achieve that objective through robust use of the
mutual agreement procedure under treaties that do not
include the provisions of the new Article.
– Documentation requirements. A number of comments
dealt with paragraph 26, which refers to documenta-
tion requirements and the extent to which documenta-
tion prepared by taxpayers would be followed by tax
administrations. It was concluded that since the para-
graph merely reflects the conclusions of the Report, no
further changes should be made with respect to that is-
sue given that the drafting of the new Article 7 is a pro-
cess for implementing the conclusions of that Report
and should not lead to revisiting these conclusions. It
was noted that the Commentary included language
drawn from the Report itself, which stressed the inten-
tion generally to avoid imposing more burdensome
documentation requirements than apply in the Article
9 context or that impose costs and burdens dispropor-
tionate to the circumstances. The concerns expressed
in the comments were noted, however, by Working
Party No. 6, and that Working Party indicated its will-
ingness to consider monitoring the issue if future expe-
rience under the AOA reveals serious problems with
documentation policies.
– Allocation of assets and risks to a permanent establish-
ment. One commentator proposed an alternative draft-
ing of changes proposed to the Commentary on Ar-
ticles 11, 12, 13, 21 and 22 based on the stated view that
‘‘the only way to definitely declare an allocation of
assets/risks to a PE is to show it in the books/accounts
of the PE’’. The Committee could not accept this pro-
posal, which assumed a greater role for accounting
records than that recognized in the Report.
– Source taxation of notional payments. Whilst some
commentators suggested that paragraph 29, which re-
fers to the policy views of some States concerning
source taxation of notional payments recognised for
the purposes of Article 7, should not be included, the
Committee considered that the paragraph, which re-
flects a compromise, should remain in the Commen-
tary. Given the Committee’s conclusion that notional
charges equivalent to interest that are recognized for
the purpose of Article 7 would not constitute interest
payments taxable under Article 11, the Committee also
decided, however, not to follow the suggestions to refer
to that conclusion in the Commentary on Article 11 and
to address possible corresponding adjustment issues
that would arise under treaties that would provide for a
different result.
The Committee did agree, however, with the sugges-
tion of a commentator who asked that the paragraph
maintain the exception already included in the Com-
mentary in respect of internal interest charges within a
bank. It was therefore decided to expand the paragraph
and recognise the special considerations applicable to
internal interest charges between different parts of a fi-
nancial enterprise (e.g. a bank), which have long been
recognised in the Commentary.
BNA TAX 6-3-10
150 (Vol. 19, No. 3)
– Deletion of paragraph 5 of existing Article 7. As re-
gards the deletion of paragraph 5 of the existing Article
7 dealing with profits from mere purchasing activities,
one commentator requested confirmation that there
was no current plan to modify paragraph 4 of Article 5
to remove the permanent establishment exception ap-
plicable to the maintenance of a fixed place of business
solely for the purpose of purchasing goods or merchan-
dise. As previously indicated by the OECD Secretariat,
the mandate of the new Working Group on the Defini-
tion of Permanent Establishment rules out making rec-
ommendations for changes to Article 5.
– Paragraph 7.2 of the Commentary on Article 15: Whilst
two commentators proposed to clarify the circum-
stances when a notional charge for services will consti-
tute remuneration borne by a permanent establishment
for the purposes of Article 15, the Committee consid-
ered that this was a peripheral issue on which agree-
ment would be difficult to reach.
– Other drafting changes resulting from comments.
Whilst the comments included a number of suggestions
for minor drafting changes, the Committee generally
refrained from making such changes unless there was
an obvious mistake or risk that the Commentary be
misinterpreted. Nevertheless, as a result of comments
received, drafting changes were made to paragraph 9
(replacing the phrase ‘‘sets up a permanent establish-
ment’’ by ‘‘has a permanent establishment’’), para-
graph 28 (clarifying the relationship between Articles 7
and 13), paragraph 31 (correcting the reference to ex-
penses incurred for the purposes of a permanent estab-
lishment and of an enterprise), paragraph 48 (clarify-
ing that the paragraph deals with a set of circum-
stances completely different from those of paragraph
47) and paragraphs 47 and 68 (removing references to
the concept of ‘‘most appropriate’’ arm’s length condi-
tions, price or method found in these paragraphs)
– Paragraphs 74-75 of the Commentary on Article 7. Fi-
nally, two additional changes unrelated to the com-
ments received were made to the Commentary on Ar-
ticle 7. First, a sentence was added to paragraph 74 of
the Commentary to repeat the conclusion, already ex-
pressed in paragraph 4 of the Commentary on Article
21 and paragraphs 9 and 10 of the Commentary on Ar-
ticles 23 A and 23 B, that where an enterprise of a Con-
tracting State derives income from immovable property
through a permanent establishment situated in the
other State, that other State may not tax that income if
it is derived from immovable property situated in the
first-mentioned State or in a third State. Second, the
last two sentences of paragraph 75 have been deleted
as these sentences, which had remained unchanged
since the 1963 Draft Convention, were rendered obso-
lete by the exclusion, in 1992, of the leasing of equip-
ment from the scope of Article 12 (see paragraph 9 of
the Commentary on Article 12) and by the fact that
countries have generally not included in their treaties
additional rules for the allocation of what these sen-
tences referred to as ‘‘special profits’’.
***
Next steps
As the changes to the OECD Model Tax Convention in-
cluded in this note have all previously been released for
comments (twice, in the case of the new Article 7 and its
Commentary, the changes to the Commentary on para-
graph 2 of Article 15 and the changes resulting from the re-
port on CIVs), this note is released for information only
and not for additional comments.
The Committee on Fiscal Affairs has been asked to dis-
cuss and approve the proposed changes included in this
note at its June meeting. The revised version of the Model
is expected to be released in September following approval
by the OECD Council.
***
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
CHANGES TO BE INCLUDED IN THE 2010 UPDATE TO THE
MODEL TAX CONVENTION
[The changes to the existing text of the Model Tax Con-
vention appear in strikethrough for deletions and bold italics
for additions; the modifications made to the version of
these changes that appeared in previous discussion drafts
are underlined]
***
B. ARTICLES
Article 7
2. Replace the existing Article 7 by the following new Ar-
ticle:
Article 7
BUSINESS PROFITS
1. Profits of an enterprise of a Contracting State shall be taxable
only in that State unless the enterprise carries on business in the
other Contracting State through a permanent establishment situated
therein. If the enterprise carries on business as aforesaid, the profits
that are attributable to the permanent establishment in accordance
with the provisions of paragraph 2 may be taxed in that other State.
2. For the purposes of this Article and Article [23 A] [23B], the
profits that are attributable in each Contracting State to the perma-
nent establishment referred to in paragraph 1 are the profits it might
be expected to make, in particular in its dealings with other parts of
the enterprise, if it were a separate and independent enterprise en-
gaged in the same or similar activities under the same or similar con-
ditions, taking into account the functions performed, assets used and
risks assumed by the enterprise through the permanent establishment
and through the other parts of the enterprise.
3. Where, in accordance with paragraph 2, a Contracting State ad-
justs the profits that are attributable to a permanent establishment of
an enterprise of one of the Contracting States and taxes accordingly
profits of the enterprise that have been charged to tax in the other
State, the other State shall, to the extent necessary to eliminate
double taxation on these profits, make an appropriate adjustment to
the amount of the tax charged on those profits. In determining such
adjustment, the competent authorities of the Contracting States shall
if necessary consult each other.
4. Where profits include items of income which are dealt with sepa-
rately in other Articles of this Convention, then the provisions of those
Articles shall not be aected by the provisions of this Article.
C. COMMENTARY
****************************************
Article 7
11. Replace the existing Commentary on Article 7, to-
gether with the sections on Reservations and Observations,
by the following new Commentary, including the new sec-
tions on Reservations and Observations and the Annex:
I. Preliminary remarks
1. This Article allocates taxing rights with respect to the business
profits of an enterprise of a Contracting State to the extent that these
profits are not subject to dierent rules under other Articles of the
Convention. It incorporates the basic principle that unless an enter-
prise of a Contracting State has a permanent establishment situated
in the other State, the business profits of that enterprise may not be
taxed by that other State unless these profits fall into special catego-
ries of income for which other Articles of the Convention give taxing
rights to that other State.
2. Article 5, which includes the definition of the concept of perma-
nent establishment, is therefore relevant to the determination of
whether the business profits of an enterprise of a Contracting State
may be taxed in the other State. That Article, however, does not itself
allocate taxing rights: when an enterprise of a Contracting State car-
ries on business in the other Contracting State through a permanent
establishment situated therein, it is necessary to determine what, if
any, are the profits that the other State may tax. Article 7 provides
the answer to that question by determining that the other State may
tax the profits that are attributable to the permanent establishment.
TMTR ISSN 1063-2069
TEXT
3. The principles underlying Article 7, and in particular paragraph
2 of the Article, have a long history. When the OECD first examined
what criteria should be used in attributing profits to a permanent es-
tablishment, this question had previously been addressed in a large
number of tax conventions and in various models developed by the
League of Nations. The separate entity and arm’s length principles, on
which paragraph 2 is based, had already been incorporated in these
conventions and models and the OECD considered that it was su-
cient to restate these principles with some slight amendments and
modifications for the main purpose of clarification.
4. Practical experience has shown, however, that there was consid-
erable variation in the interpretation of these general principles and
of other provisions of earlier versions of Article 7. This lack of a com-
mon interpretation created problems of double taxation and non-
taxation. Over the years, the Committee on Fiscal Aairs spent con-
siderable time and eort trying to ensure a more consistent interpre-
tation and application of the rules of the Article. Minor changes to the
wording of the Article and a number of changes to the Commentary
were made when the 1977 Model Tax Convention was adopted. A re-
port that addressed that question in the specific case of banks was
published in 1984.1 In 1987, noting that the determination of profits
attributable to a permanent establishment could give rise to some un-
certainty, the Committee undertook a review of the question which led
to the adoption, in 1993, of the report entitled Attribution of Income
to Permanent Establishments2 and to subsequent changes to the
Commentary.
5. Despite that work, the practices of OECD and non-OECD coun-
tries regarding the attribution of profits to permanent establishments
and these countries’ interpretation of Article 7 continued to vary con-
siderably. The Committee acknowledged the need to provide more cer-
tainty to taxpayers: in its report ‘‘Transfer Pricing Guidelines for Mul-
tinational Enterprises and Tax Administrations’’, adopted in 1995, it
indicated that further work would address the application of the arm’s
length principle to permanent establishments. That work resulted, in
2008, in a report entitled Attribution of Profits to Permanent Estab-
lishments3 (hereinafter referred to as ‘‘the Report’’) (the ‘‘2008 Re-
port’’).
6. The approach developed in the 2008 Report was not constrained
by either the original intent or by the historical practice and interpre-
tation of Article 7. Instead, the focus was on formulating the most
preferable approach to attributing profits to a permanent establish-
ment under Article 7 given modern-day multinational operations and
trade. [FROM OLD PARAGRAPH 5] When it approved the 2008
Report, the Committee considered that the guidance included therein
represented a better approach to attributing profits to permanent es-
tablishments than had previously been available. It also recognised,
however, that there were dierences between some of the conclusions
of the 2008 Report and the interpretation of Article 7 previously given
in this Commentary. [FIRST TWO SENTENCES OF OLD
PARAGRAPH 7]
7. For that reason, the Committee decided that a new version of Ar-
ticle 7 should be included in the Model Tax Convention to allow the
full incorporation of these principles. In order to provide maximum
certainty on how profits should be attributed to permanent establish-
ments, the Committee therefore decided that the 2008 Report’s full
conclusions should be reflected in a new version of Article 7, together
with accompanying Commentary, to be used in the negotiation of fu-
ture treaties and the amendment of existing treaties.[BASED ON
PARAGRAPH 9 OF THE PRELIMINARY REMARKS TO
THE DECEMBER 2006 RELEASE OF PART I-III] In addition,
in order to provide improved certainty for the interpretation of trea-
ties that had already been concluded on the basis of the previous
wording of Article 7, the Committee decided that a revised Commen-
tary for that previous version of the Article should also be prepared,
1
‘‘The Taxation of Multinational Banking Enterprises’’, in
Transfer Pricing and Multinational Enterprises - Three Taxation
Issues, OECD, Paris, 1984.
2 interest and royalties arising from sources in their territory was fully
Attribution of Income to Permanent Establishments, Issues in
International Taxation No. 5, OECD, Paris, 1994; reproduced in
Volume II of the loose-leaf version of the OECD Model Tax Con-
vention at page R(13)-1.
3
Available at
http://www.oecd.org/dataoecd/20/36/41031455.pdf.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 151
to take into account those aspects of the report that did not conflict
with the Commentary as it read before the adoption of the 2008 Re-
port. [BASED ON PARAGRAPH 10 OF THE PRELIMINARY
REMARKS TO THE DECEMBER 2006 RELEASE OF PART
I-III]
8. The new version of the Article, which now appears in the Model
Tax Convention, was adopted in 2010. At the same time, the Commit-
tee adopted a revised version of the 2008 Report in order to ensure
that the conclusions of that report could be read harmoniously with
the new wording and modified numbering of this new version of the
Article. Whilst the conclusions and interpretations included in the re-
vised report that was thus adopted in 20101 (hereinafter referred to
as ‘‘the Report’’) are identical to those of the 2008 Report, that re-
vised version takes account of the drafting of the Article as it now
reads (the Annex to this Commentary includes, for historical refer-
ence, the text of the previous wording of Article 7 and that revised
Commentary, as they read before the adoption of the current version
of the Article). [NEW]
9. The new Article, which was adopted in [2010], current version of
the Article therefore reflects the approach developed in the Report
and must be interpreted in light of the guidance contained in it.
[LAST SENTENCE OF OLD PARAGRAPH 7] The Report
deals with the attribution of profits both to permanent establishments
in general (Part I of the Report) and, in particular, to permanent es-
tablishments of businesses operating in the financial sector, where
trading through a permanent establishment is widespread (Part II of
the Report, which deals with permanent establishments of banks, Part
III, which deals with permanent establishments of enterprises carrying
on global trading and Part IV, which deals with permanent establish-
ments of enterprises carrying on insurance activities). [OLD PARA-
GRAPH 6]
II. Commentary on the provisions of the Article
Paragraph 1
810. Paragraph 1 incorporates the rules for the allocation of taxing
rights on the business profits of enterprises of each Contracting State.
First, it states that unless an enterprise of a Contracting State has a
permanent establishment situated in the other State, the business
profits of that enterprise may not be taxed by that other State. Sec-
ond, it provides that if such an enterprise carries on business in the
other State through a permanent establishment situated therein, the
profits that are attributable to the permanent establishment, as deter-
mined in accordance with paragraph 2, may be taxed by that other
State. As explained below, however, paragraph 4 restricts the applica-
tion of these rules by providing that Article 7 does not aect the ap-
plication of other Articles of the Convention that provide special rules
for certain categories of profits (e.g. those derived from the operation
of ships and aircraft in international trac) or for certain categories
of income that may also constitute business profits (e.g. income de-
rived by an enterprise in respect of personal activities of an enter-
tainer or sportsman).
911. The first principle underlying paragraph 1, i.e. that the profits
of an enterprise of one Contracting State shall not be taxed in the
other State unless the enterprise carries on business in that other
State through a permanent establishment situated therein, has a long
history and reflects the international consensus that, as a general
rule, until an enterprise of one State has sets up a permanent estab-
lishment in another State, it should not properly be regarded as par-
ticipating in the economic life of that other State to such an extent
that the other State should have taxing rights on its profits.
1012. The second principle, which is reflected in the second sen-
tence of the paragraph, is that the right to tax of the State where the
permanent establishment is situated does not extend to profits that
the enterprise may derive from that State but that are not attributable
to the permanent establishment. This is a question on which there
have historically been dierences of view, a few countries having
some time ago pursued a principle of general ‘‘force of attraction’’
according to which income such as other business profits, dividends,
taxable by them if the beneficiary had a permanent establishment
therein even though such income was clearly not attributable to that
1
Attribution of Profits to Permanent Establishments, OECD, Paris, 2010.
BNA TAX 6-3-10
152 (Vol. 19, No. 3)
permanent establishment. Whilst some bilateral tax conventions in-
clude a limited anti-avoidance rule based on a restricted force of at-
traction approach that only applies to business profits derived from
activities similar to those carried on by a permanent establishment,
the general force of attraction approach described above has now
been rejected in international tax treaty practice. The principle that is
now generally accepted in double taxation conventions is based on the
view that in taxing the profits that a foreign enterprise derives from a
particular country, the tax authorities of that country should look at
the separate sources of profit that the enterprise derives from their
country and should apply to each the permanent establishment test,
subject to the possible application of other Articles of the Convention.
This solution allows simpler and more ecient tax administration and
compliance, and is more closely adapted to the way in which business
is commonly carried on. The organisation of modern business is highly
complex. There are a considerable number of companies each of
which is engaged in a wide diversity of activities and is carrying on
business extensively in many countries. A company may set up a per-
manent establishment in another country through which it carries on
manufacturing activities whilst a dierent part of the same company
sells dierent goods in that other country through independent
agents. That company may have perfectly valid commercial reasons
for doing so: these may be based, for example, on the historical pat-
tern of its business or on commercial convenience. If the country in
which the permanent establishment is situated wished to go so far as
to try to determine, and tax, the profit element of each of the trans-
actions carried on through independent agents, with a view to aggre-
gating that profit with the profits of the permanent establishment, that
approach would interfere seriously with ordinary commercial activities
and would be contrary to the aims of the Convention.
1113. As indicated in the second sentence of paragraph 1, the prof-
its that are attributable to the permanent establishment are deter-
mined in accordance with the provisions of paragraph 2, which pro-
vides the meaning of the phrase ‘‘profits that are attributable to the
permanent establishment’’ found in paragraph 1. Since paragraph 1
grants taxing rights to the State in which the permanent establish-
ment is situated only with respect to the profits that are attributable
to that permanent establishment, the paragraph therefore prevents
that State, subject to the application of other Articles of the Conven-
tion, from taxing the enterprise of the other Contracting State on prof-
its that are not attributable to the permanent establishment.
1314. The purpose of paragraph 1 is to limit the right of one Con-
tracting State to tax the business profits of enterprises of the other
Contracting State. The paragraph does not limit the right of a Con-
tracting State to tax its own residents under controlled foreign com-
panies provisions found in its domestic law even though such tax im-
posed on these residents may be computed by reference to the part of
the profits of an enterprise that is resident of the other Contracting
State that is attributable to these residents’ participation in that en-
terprise. Tax so levied by a State on its own residents does not reduce
the profits of the enterprise of the other State and may not, therefore,
be said to have been levied on such profits (see also paragraph 23 of
the Commentary on Article 1 and paragraphs 37 to 39 of the Com-
mentary on Article 10).
Paragraph 2
1315. Paragraph 2 provides the basic rule for the determination of
the profits that are attributable to a permanent establishment. Ac-
cording to the paragraph, these profits are the profits that the perma-
nent establishment might be expected to make if it were a separate
and independent enterprise engaged in the same or similar activities
under the same or similar conditions, taking into account the func-
tions performed, assets used and risks assumed through the perma-
nent establishment and through other parts of the enterprise. In addi-
tion, the paragraph clarifies that this rule applies with respect to the
dealings between the permanent establishment and the other parts of
the enterprise.
1416. The basic approach incorporated in the paragraph for the
purposes of determining what are the profits that are attributable to
the permanent establishment is therefore to require the determination
of the profits under the fiction that the permanent establishment is a
separate enterprise and that such an enterprise is independent from
the rest of the enterprise of which it is a part as well as from any other
person. The second part of that fiction corresponds to the arm’s
length principle which is also applicable, under the provisions of Ar-
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
ticle 9, for the purpose of adjusting the profits of associated enter-
prises (see paragraph 1 of the Commentary on Article 9).
1517. Paragraph 2 does not seek to allocate the overall profits of
the whole enterprise to the permanent establishment and its other
parts but, instead, requires that the profits attributable to a perma-
nent establishment be determined as if it were a separate enterprise.
Profits may therefore be attributed to a permanent establishment even
though the enterprise as a whole has never made profits. Conversely,
paragraph 2 may result in no profits being attributed to a permanent
establishment even though the enterprise as a whole has made prof-
its.
1618. Clearly, however, where an enterprise of a Contracting State
has a permanent establishment in the other Contracting State, the
first State has an interest in the directive of paragraph 2 being cor-
rectly applied by the State where the permanent establishment is lo-
cated. Since that directive applies to both Contracting States, the
State of the enterprise must, in accordance with either Article 23 A or
23 B, eliminate double taxation on the profits properly attributable to
the permanent establishment (see paragraph 2527 below). In other
words, if the State where the permanent establishment is located at-
tempts to tax profits that are not attributable to the permanent estab-
lishment under Article 7, this may result in double taxation of profits
that should properly be taxed only in the State of the enterprise.
1719. As indicated in paragraphs 78 and 9 above, Article 7, as cur-
rently worded, reflects the approach developed in the Report adopted
by the Committee on Fiscal Aairs in 20082010. Theat Report dealt
primarily with the application of the separate and independent enter-
prise fiction that underlies paragraph 2 and the main purpose of the
changes made to that paragraph following the adoption of the Report
was to ensure that the determination of the profits attributable to a
permanent establishment followed the approach put forward in that
Report. The Report therefore provides a detailed guide as to how the
profits attributable to a permanent establishment should be deter-
mined under the provisions of paragraph 2.
1820. As explained in the Report, the attribution of profits to a per-
manent establishment under paragraph 2 will follow from the calcula-
tion of the profits (or losses) from all its activities, including transac-
tions with independent enterprises, transactions with associated en-
terprises (with direct application of the 1995 Transfer Pricing
Guidelines) and dealings with other parts of the enterprise. This analy-
sis involves two steps which are described below. The order of the list-
ing of items within each of these two steps is not meant to be pre-
scriptive, as the various items may be interrelated (e.g. risk is initially
attributed to a permanent establishment as it performs the significant
people functions relevant to the assumption of that risk but the rec-
ognition and characterisation of a subsequent dealing between the
permanent establishment and another part of the enterprise that man-
ages the risk may lead to a transfer of the risk and supporting capital
to the other part of the enterprise).
1921. Under the first step, a functional and factual analysis is un-
dertaken which will lead to:
– the attribution to the permanent establishment, as appropriate, of
the rights and obligations arising out of transactions between the
enterprise of which the permanent establishment is a part and
separate enterprises;
– the identification of significant people functions relevant to the
attribution of economic ownership of assets, and the attribution
of economic ownership of assets to the permanent establishment;
– the identification of significant people functions relevant to the
assumption of risks, and the attribution of risks to the permanent
establishment;
– the identification of other functions of the permanent establish-
ment;
– the recognition and determination of the nature of those dealings
between the permanent establishment and other parts of the
same enterprise that can appropriately be recognised, having
passed the threshold test referred to in paragraph 2426; and
– the attribution of capital based on the assets and risks attributed
to the permanent establishment.
2022. Under the second step, any transactions with associated en-
terprises attributed to the permanent establishment are priced in ac-
cordance with the guidance of the 1995 Transfer Pricing Guidelines
and these Guidelines are applied by analogy to dealings between the
permanent establishment and the other parts of the enterprise of
TMTR ISSN 1063-2069
TEXT
which it is a part. The process involves the pricing on an arm’s length
basis of these recognised dealings through:
– the determination of comparability between the dealings and un-
controlled transactions, established by applying the Guidelines’
comparability factors directly (characteristics of property or ser-
vices, economic circumstances and business strategies) or by
analogy (functional analysis, contractual terms) in light of the
particular factual circumstances of the permanent establishment;
and
– the application by analogy of one of the Guidelines’ methods to
arrive at an arm’s length compensation for the dealings between
the permanent establishment and the other parts of the enter-
prise, taking into account the functions performed by and the as-
sets and risks attributed to the permanent establishment and the
other parts of the enterprise.
2123. Each of these operations is discussed in greater detail in the
Report, in particular as regards the attribution of profits to permanent
establishments of businesses operating in the financial sector, where
trading through a permanent establishment is widespread (see Part II
of the Report, which deals with permanent establishments of banks;
Part III, which deals with permanent establishments of enterprises
carrying on global trading, and Part IV, which deals with permanent
establishments of enterprises carrying on insurance activities).
2224. Paragraph 2 refers specifically to the dealings between the
permanent establishment and other parts of the enterprise of which
the permanent establishment is a part in order to emphasise that the
separate and independent enterprise fiction of the paragraph requires
that these dealings be treated the same way as similar transactions
taking place between independent enterprises. That specific reference
to dealings between the permanent establishment and other parts of
the enterprise does not, however, restrict the scope of the paragraph.
Where a transaction that takes place between the enterprise and an
associated enterprise aects directly the determination of the profits
attributable to the permanent establishment (e.g. the acquisition by
the permanent establishment from an associated enterprise of goods
that will be sold through the permanent establishment), paragraph 2
also requires that, for the purpose of computing the profits attribut-
able to the permanent establishment, the conditions of the transac-
tion be adjusted, if necessary, to reflect the conditions of a similar
transaction between independent enterprises. Assume, for instance,
that the permanent establishment situated in State S of an enterprise
of State R acquires property from an associated enterprise of State T.
If the price provided for in the contract between the two associated
enterprises exceeds what would have been agreed to between inde-
pendent enterprises, paragraph 2 of Article 7 of the treaty between
State R and State S will authorise State S to adjust the profits attrib-
utable to the permanent establishment to reflect what a separate and
independent enterprise would have paid for that property. In such a
case, State R will also be able to adjust the profits of the enterprise
of State R under paragraph 1 of Article 9 of the treaty between State
R and State T, which will trigger the application of the corresponding
adjustment mechanism of paragraph 2 of Article 9 of that treaty.
2325. Dealings between the permanent establishment and other
parts of the enterprise of which it is a part have no legal conse-
quences for the enterprise as a whole. This implies a need for greater
scrutiny of these dealings than of transactions between two associ-
ated enterprises. This also implies a greater scrutiny of documenta-
tion (in the inevitable absence, for example, of legally binding con-
tracts) that might otherwise exist.
2426. It is generally not intended that more burdensome documen-
tation requirements be imposed in connection with such dealings than
apply to transactions between associated enterprises. Moreover, as in
the case of transfer pricing documentation referred to in the Report
‘‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Ad-
ministrations’’, the requirements should not be applied in such a way
as to impose on taxpayers costs and burdens disproportionate to the
circumstances. Nevertheless, considering the uniqueness of the na-
ture of a dealing, countries would wish to require taxpayers to dem-
onstrate clearly that it would be appropriate to recognise the dealing.
Thus, for example, an accounting record and contemporaneous docu-
mentation showing a dealing that transfers economically significant
risks, responsibilities and benefits would be a useful starting point for
the purposes of attributing profits. Taxpayers are encouraged to pre-
pare such documentation, as it may reduce substantially the potential
for controversies regarding application of the approach. Tax adminis-
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 153
trations would give eect to such documentation, notwithstanding its
lack of legal eect, to the extent that:
– the documentation is consistent with the economic substance of
the activities taking place within the enterprise as revealed by the
functional and factual analysis;
– the arrangements documented in relation to the dealing, viewed
in their entirety, do not dier from those which would have been
adopted by comparable independent enterprises behaving in a
commercially rational manner, or if they do, the structure as pre-
sented in the taxpayer’s documentation does not practically im-
pede the tax administration from determining an appropriate
transfer price; and
– the dealing presented in the taxpayer’s documentation does not
violate the principles of the approach put forward in the Report
by, for example, purporting to transfer risks in a way that segre-
gates them from functions.
2527. The opening words of paragraph 2 and the phrase ‘‘in each
Contracting State’’ indicate that paragraph 2 applies not only for the
purposes of determining the profits that the Contracting State in
which the permanent establishment is situated may tax in accordance
with the last sentence of paragraph 1 but also for the application of
Articles 23 A and 23 B by the other Contracting State. Where an en-
terprise of one State carries on business through a permanent estab-
lishment situated in the other State, the first-mentioned State must
either exempt the profits that are attributable to the permanent es-
tablishment (Article 23 A) or give a credit for the tax levied by the
other State on these profits (Article 23 B). Under both these Articles,
that State must therefore determine the profits attributable to the per-
manent establishment in order to provide relief from double taxation
and is required to follow the provisions of paragraph 2 for that pur-
pose.
2628. The separate and independent enterprise fiction that is man-
dated by paragraph 2 is restricted to the determination of the profits
that are attributable to a permanent establishment. It does not extend
to create notional income for the enterprise which a Contracting State
could tax as such under its domestic law by arguing that such income
is covered by another Article of the Convention which, in accordance
with paragraph 4 of Article 7, allows taxation of that income notwith-
standing paragraph 1 of Article 7. Assume, for example, that the cir-
cumstances of a particular case justify considering that the economic
ownership of a building used by the permanent establishment should
be attributed to the head oce (see paragraph 75104 of Part I of the
Report). In such a case, paragraph 2 could require the deduction of a
notional rent in determining the profits of the permanent establish-
ment. That fiction, however, could not be interpreted as creating in-
come from immovable property for the purposes of Article 6. Indeed,
the fiction mandated by paragraph 2 does not change the nature of
the income derived by the enterprise; it merely applies to determine
the profits attributable to the permanent establishment for the pur-
poses of Articles 7, 23 A and 23 B. Similarly, the fact that, under
paragraph 2, a notional interest charge could be deducted in deter-
mining the profits attributable to a permanent establishment does not
mean that any interest has been paid to the enterprise of which the
permanent establishment is a part for the purposes of paragraphs 1
and 2 of Article 11. The separate and independent enterprise fiction
does not extend to Article 11 and, for the purposes of that Article, one
part of an enterprise cannot be considered to have made an interest
payment to another part of the same enterprise. Clearly, however, if
interest paid by an enterprise to a dierent person is paid on indebt-
edness incurred in connection with a permanent establishment of the
enterprise and is borne by that permanent establishment, this real in-
terest payment may, under paragraph 2 of Article 11, be taxed by the
State in which the permanent establishment is located. Where, how-
ever,Also, where a transfer of assets between a permanent establish-
ment and the rest of the enterprise is treated as a dealing for the pur-
poses of paragraph 2 of Article 7, Article 13 does not prevent States
from treating any gain from such a transfer as a capital gain to which
the rules of that Article will applytaxing profits or gains from such a
dealing as long as such taxation is in accordance with Article 7 (see
paragraphs 4, 8 and 10 of the Commentary on Article 13).
2729. Some States consider that, as a matter of policy, the sepa-
rate and independent enterprise fiction that is mandated by paragraph
2 should not be restricted to the application of Articles 7, 23 A and
23 B but should also extend to the interpretation and application of
other Articles of the Convention, so as to ensure that permanent es-
BNA TAX 6-3-10
154 (Vol. 19, No. 3)
tablishments are, as far as possible, treated in the same way as sub-
sidiaries. These States may therefore consider that notional charges
for dealings which, pursuant to paragraph 2, are deducted in comput-
ing the profits of a permanent establishment should be treated, for the
purposes of other Articles of the Convention, in the same way as pay-
ments that would be made by a subsidiary to its parent company.
These States may therefore wish to include in their tax treaties provi-
sions according to which charges for internal dealings should be
recognised for the purposes of Articles 6 and 11 (it should be noted,
however, that tax will be levied in accordance with such provisions
only to the extent provided for under domestic law). Alternatively,
these States may wish to provide that no internal dealings will be
recognised in circumstances where an equivalent transaction between
two separate enterprises would give rise to income covered by Article
6 or 11 (in that case, however, it will be important to ensure that an
appropriate share of the expenses related to what would otherwise
have been recognised as a dealing be attributed to the relevant part
of the enterprise). States considering these alternatives should, how-
ever, take account of the fact that, due to special considerations ap-
plicable to internal interest charges between dierent parts of a fi-
nancial enterprise (e.g. a bank), dealings resulting in such charges
have long been recognised, even before the adoption of the present
version of the Article.
2830. Paragraph 2 determines the profits that are attributable to a
permanent establishment for the purposes of the rule in paragraph 1
that allocates taxing rights on these profits. Once the profits that are
attributable to a permanent establishment have been determined in
accordance with paragraph 2 of Article 7, it is for the domestic law of
each Contracting State to determine whether and how such profits
should be taxed as long as there is conformity with the requirements
of paragraph 2 and the other provisions of the Convention. Paragraph
2 does not deal with the issue of whether expenses are deductible
when computing the taxable income of the enterprise in either Con-
tracting State. The conditions for the deductibility of expenses are a
matter to be determined by domestic law, subject to the provisions of
the Convention and, in particular, paragraph 3 of Article 24 (see para-
graphs 31 and 32 33 and 34 below).
2931. Thus, for example, whilst domestic law rules that would ig-
nore the recognition of dealings that should be recognised for the pur-
poses of determining the profits attributable to a permanent establish-
ment under paragraph 2 or that would deny the deduction of expenses
not incurred exclusively for the benefit of the permanent establish-
ment would clearly be in violation of paragraph 2, rules that prevent
the deduction of certain categories of expenses (e.g. entertainment
expenses) or that provide when a particular expense should be de-
ducted are not aected by paragraph 2. In making that distinction,
however, some dicult questions may arise as in the case of domes-
tic law restrictions based on when an expense or element of income
is actually paid. Since, for instance, an internal dealing will not involve
an actual transfer or payment between two dierent persons, the ap-
plication of such domestic law restrictions should generally take into
account the nature of the dealing and, therefore, treat the relevant
transfer or payment as if it had been made between two dierent per-
sons.
3032. Variations between the domestic laws of the two States con-
cerning matters such as depreciation rates, the timing of the recogni-
tion of income and restrictions on the deductibility of certain expenses
will normally result in a dierent amount of taxable income in each
State even though, for the purposes of the Convention, the amount of
profits attributable to the permanent establishment will have been
computed on the basis of paragraph 2 in both States (see also para-
graphs 39-43 of the Commentary on Articles 23 A and 23 B). Thus,
even though paragraph 2 applies equally to the Contracting State in
which the permanent establishment is situated (for the purposes of
paragraph 1) and to the other Contracting State (for the purposes of
Articles 23 A or 23 B), it is likely that the amount of taxable income
on which an enterprise of a Contracting State will be taxed in the State
where the enterprise has a permanent establishment will, for a given
taxable period, be dierent from the amount of taxable income with
respect to which the first State will have to provide relief pursuant to
Articles 23 A or 23 B. Also, to the extent that the dierence results
from domestic law variations concerning the types of expenses that
are deductible, as opposed to timing dierences in the recognition of
these expenses, the dierence will be permanent.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
3133. In taxing the profits attributable to a permanent establish-
ment situated on its territory, a Contracting State will, however, have
to take account of the provisions of paragraph 3 of Article 24. That
paragraph requires, among other things, that expenses be deductible
under the same conditions whether theyse are incurred for the pur-
poses of the taxation of the profits of a permanent establishment situ-
ated in a Contracting State or for the purposes of the taxation of the
profits of an enterprise of that State. As stated in paragraph 40 of the
Commentary on Article 24:
Permanent establishments must be accorded the same right as
resident enterprises to deduct the trading expenses that are, in
general, authorised by the taxation law to be deducted from taxable
profits. Such deductions should be allowed without any restrictions
other than those also imposed on resident enterprises.
3234. The requirement imposed by paragraph 3 of Article 24 is the
same regardless of how expenses incurred by an enterprise for the
benefit of a permanent establishment are taken into account for the
purposes of paragraph 2 of Article 7. In some cases, it will not be ap-
propriate to consider that a dealing has taken place between dierent
parts of the enterprise. In such cases, expenses incurred by an enter-
prise for the purposes of the activities performed by the permanent
establishment will be directly deducted in determining the profits of
the permanent establishment (e.g. the salary of a local construction
worker hired and paid locally to work exclusively on a construction
site that constitutes a permanent establishment of a foreign enter-
prise). In other cases, expenses incurred by the enterprise will be at-
tributed to functions performed by other parts of the enterprise wholly
or partly for the benefit of the permanent establishment and an ap-
propriate charge will be deducted in determining the profits attribut-
able to the permanent establishment (e.g. overhead expenses related
to administrative functions performed by the head oce for the ben-
efit of the permanent establishment). In both cases, paragraph 3 of
Article 24 will require that, as regards the permanent establishment,
the expenses be deductible under the same conditions as those appli-
cable to an enterprise of that State. Thus, any expense incurred by the
enterprise directly or indirectly for the benefit of the permanent es-
tablishment must not, for tax purposes, be treated less favourably
than a similar expense incurred by an enterprise of that State. That
rule will apply regardless of whether or not, for the purposes of para-
graph 2 of this Article 7, the expense is directly attributed to the per-
manent establishment (first example) or is attributed to another part
of the enterprise but reflected in a notional charge to the permanent
establishment (second example).
3335. Paragraph 3 of Article 5 sets forth a special rule for a fixed
place of business that is a building site or a construction or installa-
tion project. Such a fixed place of business is a permanent establish-
ment only if it lasts more than twelve months. Experience has shown
that these types of permanent establishments can give rise to special
problems in attributing income to them under Article 7.
3436. These problems arise chiefly where goods are provided, or
services performed, by the other parts of the enterprise or a related
party in connection with the building site or construction or installa-
tion project. Whilst these problems can arise with any permanent es-
tablishment, they are particularly acute for building sites and con-
struction or installation projects. In these circumstances, it is neces-
sary to pay close attention to the general principle that income is
attributable to a permanent establishment only when it results from
activities carried on by the enterprise through that permanent estab-
lishment.
3537. For example, where such goods are supplied by the other
parts of the enterprise, the profits arising from that supply do not re-
sult from the activities carried on through the permanent establish-
ment and are not attributable to it. Similarly, profits resulting from the
provision of services (such as planning, designing, drawing blueprints,
or rendering technical advice) by the parts of the enterprise operating
outside the State where the permanent establishment is located do
not result from the activities carried on through the permanent estab-
lishment and are not attributable to it.
3638. Article 7, as it read before [2010], included the following
paragraph 3:
In determining the profits of a permanent establishment, there shall
be allowed as deductions expenses which are incurred for the pur-
poses of the permanent establishment, including executive and gen-
eral administrative expenses so incurred, whether in the State in
which the permanent establishment is situated or elsewhere.
TMTR ISSN 1063-2069
TEXT
Whilst that paragraph was originally intended to clarify that para-
graph 2 required expenses incurred directly or indirectly for the ben-
efit of a permanent establishment to be taken into account in deter-
mining the profits of the permanent establishment even if these ex-
penses had been incurred outside the State in which the permanent
establishment was located, it had sometimes been read as limiting the
deduction of expenses that indirectly benefited the permanent estab-
lishment to the actual amount of the expenses.
3739. This was especially the case of general and administrative
expenses, which were expressly mentioned in that paragraph. Under
the previous version of paragraph 2, as interpreted in the Commen-
tary, this was generally not a problem since a share of the general and
administrative expenses of the enterprise could usually only be allo-
cated to a permanent establishment on a cost-basis.
3840. As now worded, however, paragraph 2 requires the recogni-
tion and arm’s length pricing of the dealings through which one part
of the enterprise performs functions for the benefit of the permanent
establishment (e.g. through the provision of assistance in day-to-day
management). The deduction of an arm’s length charge for these deal-
ings, as opposed to a deduction limited to the amount of the ex-
penses, is required by paragraph 2. The previous paragraph 3 has
therefore been deleted to prevent it from being misconstrued as lim-
iting the deduction to the amount of the expenses themselves. That
deletion does not aect the requirement, under paragraph 2, that in
determining the profits attributable to a permanent establishment, all
relevant expenses of the enterprise, wherever incurred, be taken into
account. Depending on the circumstances, this will be done through
the deduction of all or part of the expenses or through the deduction
of an arm’s length charge in the case of a dealing between the perma-
nent establishment and another part of the enterprise.
3941. Article 7, as it read before 2010, also included a provision
that allowed the attribution of profits to a permanent establishment to
be done on the basis of an apportionment of the total profits of the
enterprise to its various parts. That method, however, was only to be
applied to the extent that its application had been customary in a Con-
tracting State and that the result was in accordance with the prin-
ciples of Article 7. For the Committee, methods other than an appor-
tionment of total profits of an enterprise can be applied even in the
most dicult cases. The Committee therefore decided to delete that
provision because its application had become very exceptional and be-
cause of concerns that it was extremely dicult to ensure that the re-
sult of its application would be in accordance with the arm’s length
principle.
4042. At the same time, the Committee also decided to eliminate
another provision that was found in the previous version of the Article
and according to which the profits to be attributed to the permanent
establishment were to be ‘‘determined by the same method year by
year unless there is good and sucient reason to the contrary.’’ That
provision, which was intended to ensure continuous and consistent
treatment, was appropriate as long as it was accepted that the prof-
its attributable to a permanent establishment could be determined
through direct or indirect methods or even on the basis of an appor-
tionment of the total profits of the enterprise to its various parts. The
new approach developed by the Committee, however, does not allow
for the application of such fundamentally dierent methods and
therefore avoids the need for such a provision.
4143. A final provision that was deleted from the Article at the
same time provided that ‘‘[n]o profits shall be attributed to a perma-
nent establishment by reason of the mere purchase by that permanent
establishment of goods or merchandise for the enterprise.’’ Subpara-
graph 4 d) of Article 5 recognises that where an enterprise of a Con-
tracting State maintains in the other State a fixed place of business
exclusively for the purpose of purchasing goods for itself, its activity
at that location should not be considered to have reached a level that
justifies taxation in that other State. Where, however, subparagraph 4
d) is not applicable because other activities are carried on by the en-
terprise through that place of business, which therefore constitutes a
permanent establishment, it is appropriate to attribute profits to all
the functions performed at that location. Indeed, if the purchasing ac-
tivities were performed by an independent enterprise, the purchaser
would be remunerated on an arm’s length basis for its services. Also,
since a tax exemption restricted to purchasing activities undertaken
for the enterprise would require that expenses incurred for the pur-
poses of performing these activities be excluded in determining the
profits of the permanent establishment, such an exemption would
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 155
raise administrative problems. The Committee therefore considered
that a provision according to which no profits should be attributed to
a permanent establishment by reason of the mere purchase of goods
or merchandise for the enterprise was not consistent with the arm’s
length principle and should not be included in the Article.
Paragraph 3
4244. The combination of Articles 7 (which restricts the taxing
rights of the State in which the permanent establishment is situated)
and 23 A and 23 B (which oblige the other State to provide relief from
double taxation) ensures that there is no unrelieved double taxation
of the profits that are properly attributable to the permanent estab-
lishment. This result may require that the two States resolve dier-
ences based on dierent interpretations of paragraph 2 and it is im-
portant that mechanisms be available to resolve all such dierences
to the extent necessary to eliminate double taxation.
4345. As already indicated, the need for the two Contracting States
to reach a common understanding as regards the application of para-
graph 2 in order to eliminate risks of double taxation has led the Com-
mittee to develop detailed guidance on the interpretation of that para-
graph. This guidance is reflected in the Report, which draws on the
principles of the Committee’s 1995 report ‘‘Transfer Pricing Guide-
lines for Multinational Enterprises and Tax Administrations’’.
4446. Risks of double taxation will usually be avoided because the
taxpayer will determine the profits attributable to the permanent es-
tablishment in the same manner in each Contracting State and in ac-
cordance with paragraph 2 as interpreted by the Report, which will
ensure the same result for the purposes of Articles 7 and 23 A or 23
B (see, however, paragraph 6466). Insofar as each State agrees that
the taxpayer has done so, it should refrain from adjusting the profits
in order to reach a dierent result under paragraph 2. This is illus-
trated in the following example.
4547. Example. A manufacturing plant located in State R of an en-
terprise of State R has transferred goods for sale to a permanent es-
tablishment of the enterprise situated in State S. For the purpose of
determining the profits attributable to the permanent establishment
under paragraph 2, the Report provides that a dealing must be recog-
nised and a notional arm’s length price must be determined for that
dealing. The enterprise’s documentation, which is consistent with the
functional and factual analysis and which has been used by the tax-
payer as the basis for the computation of its taxable income in each
State, shows that a dealing in the nature of a sale of the goods by the
plant in State R to the permanent establishment in State S has oc-
curred and that a notional arm’s length price of 100 has been used to
determine the profits attributable to the permanent establishment.
Both States agree that the recognition of the dealing and the price
used by the taxpayer are in conformity with the principles of the Re-
port and of the Transfer Pricing Guidelines. In this case, both States
should refrain from adjusting the profits on the basis that a dierent
arm’s length price should have been used; as long as there is agree-
ment that the taxpayer has conformed with paragraph 2, the tax ad-
ministrations of both States cannot substitute their judgment for that
of the taxpayer as to what are the most appropriate arm’s length con-
ditions. In this example, the fact that the same arm’s length price has
been used in both States and that both States will recognise that price
for the purposes of the application of the Convention will ensure that
any double taxation related to that dealing will be eliminated under
Article 23 A or 23 B.
4648. In the previous example, both States agreed that the recog-
nition of the dealing and the price used by the taxpayer were in con-
formity with the principles of the Report and of the Transfer Pricing
Guidelines. The Contracting States, however, may not always reach
such an agreement. In some cases, however, the Report and the
Transfer Pricing Guidelines may allow dierent interpretations of
paragraph 2 and, to the extent that double taxation would otherwise
result from these dierent interpretations, it is essential to ensure
that such double taxation is relieved. Paragraph 3 provides the
mechanism that guarantees that outcome.
4749. For example, as explained in paragraphs 105-171136-206 of
Part I of the Report, paragraph 2 permits dierent approaches for de-
termining, on the basis of the attribution of ‘‘free’’ capital to a perma-
nent establishment, the interest expense attributable to that perma-
nent establishment. The Committee recognised that this could create
problems, in particular for financial institutions. It concluded that in
this and other cases where the two Contracting States have inter-
BNA TAX 6-3-10
156 (Vol. 19, No. 3)
preted paragraph 2 dierently and it is not possible to conclude that
either interpretation is not in accordance with paragraph 2, it is im-
portant to ensure that any double taxation that would otherwise result
from that dierence will be eliminated.
4850. Paragraph 3 will ensure that this result is achieved. It is im-
portant to note, however, that the cases where it will be necessary to
have recourse to that paragraph are fairly limited.
4951. First, as explained in paragraph 4446 above, where the tax-
payer has determined the profits attributable to the permanent estab-
lishment in the same manner in each Contracting State and both
States agree that the taxpayer has done so in accordance with para-
graph 2 as interpreted by the Report, no adjustments should be made
to the profits in order to reach a dierent result under paragraph 2.
5052. Second, paragraph 3 is not intended to limit in any way the
remedies already available to ensure that each Contracting State con-
forms with its obligations under Articles 7 and 23 A or 23 B. For ex-
ample, if the determination, by a Contracting State, of the profits at-
tributable to a permanent establishment situated in that State is not
in conformity with paragraph 2, the taxpayer will be able to use the
available domestic legal remedies and the mutual agreement proce-
dure provided for by Article 25 to address the fact that the taxpayer
has not been taxed by that State in accordance with the Convention.
Similarly, these remedies will also be available if the other State does
not, for the purposes of Article 23 A or 23 B, determine the profits
attributable to the permanent establishment in conformity with para-
graph 2 and therefore does not comply with the provisions of this Ar-
ticle.
5153. Where, however, the taxpayer has not determined the profits
attributable to the permanent establishment in conformity with para-
graph 2, each State is entitled to make an adjustment in order to en-
sure conformity with that paragraph. Where one State makes an ad-
justment in conformity with paragraph 2, that paragraph certainly per-
mits the other State to make a reciprocal adjustment so as to avoid
any double taxation through the combined application of paragraph 2
and of Article 23 A or 23 B (see paragraph 6365 below). It may be,
however, that the domestic law of that other State (e.g. the State
where the permanent establishment is located) may not allow it to
make such a change or that State may have no incentive to do it on
its own if the eect is to reduce the amount of profits that was previ-
ously taxable in that State. It may also be that, as indicated above,
the two Contracting States will adopt dierent interpretations of para-
graph 2 and it is not possible to conclude that either interpretation is
not in accordance with paragraph 2.
5254. Such concerns are addressed by paragraph 3. The following
example illustrates the application of that paragraph.
5355. Example. A manufacturing plant located in State R of an en-
terprise of State R has transferred goods for sale to a permanent es-
tablishment of the enterprise situated in State S. For the purpose of
determining the profits attributable to the permanent establishment
under paragraph 2, a dealing must be recognised and a notional arm’s
length price must be determined for that dealing. The enterprise’s
documentation, which is consistent with the functional and factual
analysis and which has been used by the taxpayer as the basis for the
computation of its taxable income in each State, shows that a dealing
in the nature of a sale of the goods by the plant in State R to the per-
manent establishment in State S has occurred and that a notional
price of 90 has been used to determine the profits attributable to the
permanent establishment. State S accepts the amount used by the
taxpayer but State R considers that the amount is below what is re-
quired by its domestic law and the arm’s length principle of paragraph
2. It considers that the appropriate arm’s length price that should
have been used is 110 and adjusts the amount of tax payable in State
R accordingly after reducing the amount of the exemption (Article 23
A) or the credit (Article 23 B) claimed by the taxpayer with respect to
the profits attributable to the permanent establishment. In that situa-
tion, since the price of the same dealing will have been determined as
90 in State S and 110 in State R, profits of 20 may be subject to
double taxation. Paragraph 3 will address that situation by requiring
State S, to the extent that there is indeed double taxation and that
the adjustment made by State R is in conformity with paragraph 2, to
provide a corresponding adjustment to the tax payable in State S on
the profits that are taxed in both States.
5456. If State S, however, does not agree that the adjustment by
State R was warranted by paragraph 2, it will not consider that it has
to make the adjustment. In such a case, the issue of whether State S
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
should make the adjustment under paragraph 3 (if the adjustment by
State R is justified under paragraph 2) or whether State R should re-
frain from making the initial adjustment (if it is not justified under
paragraph 2) will be solved under a mutual agreement procedure pur-
suant to paragraph 1 of Article 25 using, if necessary, the arbitration
provision of paragraph 5 of Article 25 (since it involves the question
of whether the actions of one or both of the Contracting States have
resulted or will result for the taxpayer in taxation not in accordance
with the Convention). Through that procedure, the two States will be
able to agree on the same arm’s length price, which may be one of
the prices put forward by the taxpayer and the two States or a dier-
ent one.
5557. As shown by the example in paragraph 5355, paragraph 3
addresses the concern that the Convention might not provide ad-
equate protection against double taxation in some situations where
the two Contracting States adopt dierent interpretations of para-
graph 2 of Article 7 and each State could be considered to be taxing
‘‘in accordance with’’ the Convention. Paragraph 3 ensures that relief
of double taxation will be provided in such a case, which is consistent
with the overall objectives of the Convention.
5658. Paragraph 3 shares the main features of paragraph 2 of Ar-
ticle 9. First, it applies to each State with respect to an adjustment
made by the other State. It therefore applies reciprocally whether the
initial adjustment has been made by the State where the permanent
establishment is situated or by the other State. Also, it does not apply
unless there is an adjustment by one of the States.
5759. As is the case for paragraph 2 of Article 9, a corresponding
adjustment is not automatically to be made under paragraph 3 simply
because the profits attributed to the permanent establishment have
been adjusted by one of the Contracting States. The corresponding ad-
justment is required only if the other State considers that the adjusted
profits conform with paragraph 2. In other words, paragraph 3 may
not be invoked and should not be applied where the profits attribut-
able to the permanent establishment are adjusted to a level that is
dierent from what they would have been if they had been correctly
computed in accordance with the principles of paragraph 2. Regard-
less of which State makes the initial adjustment, the other State is
obliged to make an appropriate corresponding adjustment only if it
considers that the adjusted profits correctly reflect what the profits
would have been if the permanent establishment’s dealings had been
transactions at arm’s length. The other State is therefore committed
to make such a corresponding adjustment only if it considers that the
initial adjustment is justified both in principle and as regards the
amount.
5860. Paragraph 3 does not specify the method by which a corre-
sponding adjustment is to be made. Where the initial adjustment is
made by the State in which the permanent establishment is situated,
the adjustment provided for by paragraph 3 could be granted in the
other State through the adjustment of the amount of income that must
be exempted under Article 23 A or of the credit that must be granted
under Article 23 B. Where the initial adjustment is made by that other
State, the adjustment provided for by paragraph 3 could be made by
the State in which the permanent establishment is situated by re-
opening the assessment of the enterprise of the other State in order
to reduce the taxable income by an appropriate amount.
5961. The issue of so-called ‘‘secondary adjustments’’, which is
discussed in paragraph 8 of the Commentary on Article 9, does not
arise in the case of an adjustment under paragraph 3. As indicated in
paragraph 2628 above, the determination of the profits attributable
to a permanent establishment is only relevant for the purposes of Ar-
ticles 7 and 23 A and 23 B and does not aect the application of
other Articles of the Convention.
6062. Like paragraph 2 of Article 9, paragraph 3 leaves open the
question whether there should be a period of time after the expiration
of which a State would not be obliged to make an appropriate adjust-
ment to the profits attributable to a permanent establishment follow-
ing an upward revision of these profits in the other State. Some States
consider that the commitment should be open-ended — in other
words, that however many years the State making the initial adjust-
ment has gone back, the enterprise should in equity be assured of an
appropriate adjustment in the other State. Other States consider that
an open-ended commitment of this sort is unreasonable as a matter
of practical administration. This problem has not been dealt with in
the text of either paragraph 2 of Article 9 or paragraph 3 but Con-
tracting States are left free in bilateral conventions to include, if they
TMTR ISSN 1063-2069
TEXT
wish, provisions dealing with the length of time during which a State
should be obliged to make an appropriate adjustment (see on this
point paragraphs 39, 40 and 41 of the Commentary on Article 25).
6163. There may be cases where the initial adjustment made by one
State will not immediately require a corresponding adjustment to the
amount of tax charged on profits in the other State (e.g., where the
initial adjustment by one State of the profits attributable to the per-
manent establishment will aect the determination of the amount of
a loss attributable to the rest of the enterprise in the other State). The
competent authorities may, in accordance with the second sentence
of paragraph 3, determine the future impact that the initial adjust-
ment will have on the tax that will be payable in the other State be-
fore that tax is actually levied; in fact, in order to avoid the problem
described in the preceding paragraph, competent authorities may wish
to use the mutual agreement procedure at the earliest opportunity in
order to determine to what extent a corresponding adjustment may be
required in the other State at a later stage.
6264. If there is a dispute between the parties concerned over the
amount and character of the appropriate adjustment, the mutual
agreement procedure provided for under Article 25 should be imple-
mented, as is the case for an adjustment under paragraph 2 of Article
9. Indeed, as shown in the example in paragraph 5355 above, if one
of the two Contracting States adjusts the profits attributable to a per-
manent establishment without the other State granting a correspond-
ing adjustment to the extent needed to avoid double taxation, the tax-
payer will be able to use the mutual agreement procedure of para-
graph 1 of Article 25, and if necessary the arbitration provision of
paragraph 5 of Article 25, to require the competent authorities to
agree that either the initial adjustment by one State or the failure by
the other State to make a corresponding adjustment is not in accor-
dance with the provisions of the Convention (the arbitration provision
of paragraph 5 of Article 25 will play a critical role in cases where the
competent authorities would otherwise be unable to agree as it will
ensure that the issues that prevent an agreement are resolved through
arbitration).
6365. Paragraph 3 only applies to the extent necessary to eliminate
the double taxation of profits that result from the adjustment. As-
sume, for instance, that the State where the permanent establishment
is situated adjusts the profits that the taxpayer attributed to the per-
manent establishment to reflect the fact that the price of a dealing
between the permanent establishment and the rest of the enterprise
did not conform with the arm’s length principle. Assume that the other
State also agrees that the price used by the taxpayer was not at arm’s
length. In that case, the combined application of paragraph 2 and of
Article 23 A or 23 B will require that other State to attribute to the
permanent establishment, for the purposes of providing relief of
double taxation, adjusted profits that would reflect an arm’s length
price. In such a case, paragraph 3 will only be relevant to the extent
that States adopt dierent interpretations of what the correct arm’s
length price should be.
6466. Paragraph 3 only applies with respect to dierences in the
determination of the profits attributed to a permanent establishment
that result in the same part of the profits being attributed to dierent
parts of the enterprise in conformity with the Article. As already ex-
plained (see paragraphs 28 and 2930 and 31 above), Article 7 does
not deal with the computation of taxable income but, instead, with the
attribution of profits for the purpose of the allocation of taxing rights
between the two Contracting States. The Article therefore only serves
to allocate revenues and expenses for the purposes of allocating tax-
ing rights and does not prejudge the issue of which revenues are tax-
able and which expenses are deductible, which is a matter of domes-
tic law as long as there is conformity with paragraph 2. Where the
profits attributed to the permanent establishment are the same in
each State, the amount that will be included in the taxable income on
which tax will be levied in each State for a given taxable period may
be dierent given dierences in domestic law rules, e.g. for the rec-
ognition of income and the deduction of expenses. Since these dier-
ent domestic law rules only apply to the profits attributed to each
State, they do not, by themselves, result in double taxation for the pur-
poses of paragraph 3.
6567. Also, paragraph 3 does not apply to aect the computation
of the exemption or credit under Article 23 A or 23 B except for the
purposes of providing what would otherwise be unavailable double
taxation relief for the tax paid to the Contracting State in which the
permanent establishment is situated on the profits that have been at-
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 157
tributed to the permanent establishment in that State. This paragraph
will therefore not apply where these profits have been fully exempted
by the other State or where the tax paid in the first-mentioned State
has been fully credited against the other State’s tax under the domes-
tic law of that other State and in accordance with Article 23 A or 23
B.
6668. Some States may prefer that the cases covered by paragraph
3 be resolved through the mutual agreement procedure (a failure to
do so triggering the application of the arbitration provision of para-
graph 5 of Article 25) if a State does not unilaterally agree to make a
corresponding adjustment, without any deference being given to the
adjusting State’s preferred position as to the appropriate arm’s length
price or method. These States would therefore prefer a provision that
would always give the possibility for a State to negotiate with the ad-
justing State over what is the most appropriate arm’s length price or
method to be applied. States that share that view may prefer to use
the following alternative version of paragraph 3:
Where, in accordance with paragraph 2, a Contracting State adjusts
the profits that are attributable to a permanent establishment of an
enterprise of one of the Contracting States and taxes accordingly
profits of the enterprise that have been charged to tax in the other
State, the other Contracting State shall, to the extent necessary to
eliminate double taxation, make an appropriate adjustment if it
agrees with the adjustment made by the first-mentioned State; if
the other Contracting State does not so agree, the Contracting
States shall eliminate any double taxation resulting therefrom by
mutual agreement.
6769. This alternative version is intended to ensure that the State
being asked to give a corresponding adjustment would always be able
to require that to be done through the mutual agreement procedure.
This version diers significantly from paragraph 3 in that it does not
create a legal obligation on that State to agree to give a correspond-
ing adjustment, even where it considers the adjustment made by the
other State to have been made in accordance with paragraph 2. The
provision would always give the possibility for a State to negotiate with
the other State over what is the most appropriate arm’s length price
or method. Where the State in question does not unilaterally agree to
make the corresponding adjustment, this version of paragraph 3
would ensure that the taxpayer has the right to access the mutual
agreement procedure to have the case resolved. Moreover, where the
mutual agreement procedure is triggered in such a case, the provision
imposes a reciprocal legal obligation on the Contracting States to
eliminate the double taxation by mutual agreement even though it
does not provide a substantive standard to govern which State has the
obligation to compromise its position to achieve that mutual agree-
ment. If the two Contracting States do not reach an agreement to
eliminate the double taxation, they will both be in violation of their
treaty obligation. The obligation to eliminate such cases of double
taxation by mutual agreement is therefore stronger than the standard
of paragraph 2 of Article 25, which merely requires the competent au-
thorities to ‘‘endeavour’’ to resolve a case by mutual agreement.
6870. If Contracting States agree bilaterally to replace paragraph 3
by the alternative above, the comments made in paragraphs 64 and
6566 and 67 as regards paragraph 3 will also apply with respect to
that provision.
Paragraph 4
6971. Although it has not been found necessary in the Convention
to define the term ‘‘profits’’, it should nevertheless be understood that
the term when used in this Article and elsewhere in the Convention
has a broad meaning including all income derived in carrying on an
enterprise. Such a broad meaning corresponds to the use of the term
made in the tax laws of most OECD Member countries.
7072. Absent paragraph 4, this interpretation of the term ‘‘profits’’
could have given rise to some uncertainty as to the application of the
Convention. If the profits of an enterprise include categories of income
which are dealt with separately in other Articles of the Convention,
e.g. dividends, the question would have arisen as to which Article
should apply to these categories of income, e.g. in the case of divi-
dends, this Article or Article 10.
7173. To the extent that the application of this Article and of the
relevant other Article would result in the same tax treatment, there is
little practical significance to this question. Also, other Articles of the
Convention deal specifically with this question with respect to some
types of income (e.g. paragraph 4 of Article 6, paragraph 4 of Articles
BNA TAX 6-3-10
158 (Vol. 19, No. 3)
10 and 11, paragraph 3 of Article 12, paragraphs 1 and 2 of Article
17 and paragraph 2 of Article 21).
7274. The question, however, could arise with respect to other
types of income and it has therefore been decided to include a rule of
interpretation that ensures that Articles applicable to specific catego-
ries of income will have priority over Article 7. It follows from this rule
that Article 7 will be applicable to business profits which do not be-
long to categories of income covered by these other Articles, and, in
addition, to income which under paragraph 4 of Articles 10 and 11,
paragraph 3 of Article 12 and paragraph 2 of Article 21, fall within
Article 7. This rule does not, however, govern the manner in which the
income will be classified for the purposes of domestic law; thus, if a
Contracting State may tax an item of income pursuant to other Ar-
ticles of this Convention, that State may, for its own domestic tax pur-
poses, characterise such income as it wishes (i.e. as business profits
or as a specific category of income) provided that the tax treatment
of that item of income is in accordance with the provisions of the Con-
vention. It should also be noted that where an enterprise of a Con-
tracting State derives income from immovable property through a per-
manent establishment situated in the other State, that other State
may not tax that income if it is derived from immovable property situ-
ated in the first-mentioned State or in a third State (see paragraph 4
of the Commentary on Article 21 and paragraphs 9 and 10 of the
Commentary on Articles 23 A and 23 B).
7375. It is open to Contracting States to agree bilaterally upon spe-
cial explanations or definitions concerning the term ‘‘profits’’ with a
view to clarifying the distinction between this term and e.g. the con-
cept of dividends. It may in particular be found appropriate to do so
where in a convention under negotiation a deviation has been made
from the definitions in the special Articles on dividends, interest and
royalties. It may also be deemed desirable if the Contracting States
wish to place on notice, that, in agreement with the domestic tax laws
of one or both of the States, the term ‘‘profits’’ includes special
classes of receipts. such as income from the alienation or the letting
of a business or of movable property used in a business. In this con-
nection it may have to be considered whether it would be useful to in-
clude also additional rules for the allocation of such special profits.
7476. Finally, it should be noted that two categories of profits that
were previously covered by other Articles of the Convention are now
covered by Article 7. First, whilst the definition of ‘‘royalties’’ in para-
graph 2 of Article 12 of the 1963 Draft Convention and 1977 Model
Convention included payments ‘‘for the use of, or the right to use, in-
dustrial, commercial, or scientific equipment’’, the reference to these
payments was subsequently deleted from that definition in order to en-
sure that income from the leasing of industrial, commercial or scien-
tific equipment, including the income from the leasing of containers,
falls under the provisions of Article 7 or Article 8 (see paragraph 9 of
the Commentary on that Article), as the case may be, rather than un-
der those of Article 12, a result that the Committee on Fiscal Aairs
considers appropriate given the nature of such income.
7577. Second, before 2000, income from professional services and
other activities of an independent character was dealt with under a
separate Article, i.e. Article 14. The provisions of that Article were
similar to those applicable to business profits but Article 14 used the
concept of fixed base rather than that of permanent establishment
since it had originally been thought that the latter concept should be
reserved to commercial and industrial activities. However, it was not
always clear which activities fell within Article 14 as opposed to Ar-
ticle 7. The elimination of Article 14 in 2000 reflected the fact that
there were no intended dierences between the concepts of perma-
nent establishment, as used in Article 7, and fixed base, as used in
Article 14, or between how profits were computed and tax was calcu-
lated according to which of Article 7 or 14 applied. The eect of the
deletion of Article 14 is that income derived from professional services
or other activities of an independent character is now dealt with un-
der Article 7 as business profits. This was confirmed by the addition,
in Article 3, of a definition of the term ‘‘business’’ which expressly
provides that this term includes professional services or other activi-
ties of an independent character.
Observations
[to be added]
Reservations
[to be added]
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
ANNEX
[The following is the text of Article 7 and its Commentary as
they read before (date of approval of the 2010 update by the OECD
Council) 2010. That previous version of the Article and Com-
mentary is provided below for historical reference as it will con-
tinue to be relevant for the application and interpretation of bi-
lateral tax conventions concluded before that date.]
Article 7
BUSINESS PROFITS
1. The profits of an enterprise of a Contracting State shall
be taxable only in that State unless the enterprise carries
on business in the other Contracting State through a per-
manent establishment situated therein. If the enterprise
carries on business as aforesaid, the profits of the enter-
prise may be taxed in the other State but only so much of
them as is attributable to that permanent establishment.
2. Subject to the provisions of paragraph 3, where an en-
terprise of a Contracting State carries on business in the
other Contracting State through a permanent establish-
ment situated therein, there shall in each Contracting State
be attributed to that permanent establishment the profits
which it might be expected to make if it were a distinct and
separate enterprise engaged in the same or similar activi-
ties under the same or similar conditions and dealing
wholly independently with the enterprise of which it is a
permanent establishment.
3. In determining the profits of a permanent establish-
ment, there shall be allowed as deductions expenses which
are incurred for the purposes of the permanent establish-
ment, including executive and general administrative ex-
penses so incurred, whether in the State in which the per-
manent establishment is situated or elsewhere.
4. Insofar as it has been customary in a Contracting State
to determine the profits to be attributed to a permanent es-
tablishment on the basis of an apportionment of the total
profits of the enterprise to its various parts, nothing in
paragraph 2 shall preclude that Contracting State from de-
termining the profits to be taxed by such an apportionment
as may be customary; the method of apportionment
adopted shall, however, be such that the result shall be in
accordance with the principles contained in this Article.
5. No profits shall be attributed to a permanent establish-
ment by reason of the mere purchase by that permanent
establishment of goods or merchandise for the enterprise.
6. For the purposes of the preceding paragraphs, the
profits to be attributed to the permanent establishment
shall be determined by the same method year by year un-
less there is good and sufficient reason to the contrary.
7. Where profits include items of income which are dealt
with separately in other Articles of this Convention, then
the provisions of those Articles shall not be affected by the
provisions of this Article.
COMMENTARY ON ARTICLE 7
CONCERNING THE TAXATION OF BUSINESS PROFITS
I. Preliminary remarks
1. This Article is in many respects a continuation of, and
a corollary to, Article 5 on the definition of the concept of
permanent establishment. The permanent establishment
criterion is commonly used in international double taxa-
tion conventions to determine whether a particular kind of
income shall or shall not be taxed in the country from
which it originates but the criterion does not of itself pro-
vide a complete solution to the problem of the double taxa-
tion of business profits; in order to prevent such double
taxation it is necessary to supplement the definition of per-
manent establishment by adding to it an agreed set of rules
by reference to which the profits attributable to the perma-
nent establishment are to be calculated. To put the matter
in a slightly different way, when an enterprise of a Con-
tracting State carries on business in the other Contracting
State the authorities of that second State have to ask them-
TMTR ISSN 1063-2069
TEXT
selves two questions before they levy tax on the profits of
the enterprise: the first question is whether the enterprise
has a permanent establishment in their country; if the an-
swer is in the affirmative the second question is what, if
any, are the profits on which that permanent establishment
should pay tax. It is with the rules to be used in determin-
ing the answer to this second question that Article 7 is con-
cerned. Rules for ascertaining the profits of an enterprise
of a Contracting State which is trading with an enterprise
of the other Contracting State when both enterprises are
associated are dealt with in Article 9.
2. Articles 7 and 9 are not particularly detailed and were
not strikingly novel when they were adopted by the OECD.
The question of what criteria should be used in attributing
profits to a permanent establishment, and of how to allo-
cate profits from transactions between associated enter-
prises, has had to be dealt with in a large number of double
taxation conventions and in various models developed by
the League of Nations before the OECD first dealt with it
and the solutions adopted have generally conformed to a
standard pattern.
3. It is generally recognised that the essential principles
on which this standard pattern is based are well founded,
and, when the OECD first examined that question, it was
thought sufficient to restate them with some slight amend-
ments and modifications primarily aimed at producing
greater clarity. The two Articles incorporate a number of
directives. They do not, nor in the nature of things could
they be expected to, lay down a series of precise rules for
dealing with every kind of problem that may arise when an
enterprise of one State makes profits in another. Modern
commerce organises itself in an infinite variety of ways,
and it would be quite impossible within the fairly narrow
limits of an Article in a double taxation convention to
specify an exhaustive set of rules for dealing with every
kind of problem that may arise.
4. It must be acknowledged, however, that there has
been considerable variation in the interpretation of the
general directives of Article 7 and of the provisions of ear-
lier conventions and models on which the wording of the
Article is based. This lack of a common interpretation of
Article 7 can lead to problems of double taxation and non-
taxation. For that reason, it is important for tax authorities
to agree on mutually consistent methods of dealing with
these problems, using, where appropriate, the mutual
agreement procedure provided for in Article 25.
5. Over the years, the Committee on Fiscal Affairs has
therefore spent considerable time and effort trying to en-
sure a more consistent interpretation and application of the
rules of the Article. Minor changes to the wording of the
Article and a number of changes to the Commentary were
made when the 1977 Model Tax Convention was adopted.
A report that addressed that question in the specific case of
banks was published in 1984.1 In 1987, noting that the de-
termination of profits attributable to a permanent estab-
lishment could give rise to some uncertainty, the Commit-
tee undertook a review of the question which led to the
adoption, in 1993, of the report entitled ‘‘Attribution of In-
come to Permanent Establishments’’2 and to subsequent
changes to the Commentary.
6. Despite that work, the practices of OECD and non-
OECD countries regarding the attribution of profits to per-
manent establishments and these countries’ interpretation
of Article 7 continued to vary considerably. The Committee
acknowledged the need to provide more certainty to tax-
payers: in its report Transfer Pricing Guidelines for Multi-
national Enterprises and Tax Administrations, adopted in
1995, it indicated that further work would address the ap-
1
‘‘The Taxation of Multinational Banking Enterprises’’, in
Transfer Pricing and Multinational Enterprises - Three Taxation
Issues, OECD, Paris, 1984.
2
Reproduced in Volume II of the loose-leaf version of the
OECD Model Tax Convention at page R(13)-1.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 159
plication of the arm’s length principle to permanent estab-
lishments. That work resulted, in 2008, in a report entitled
Attribution of Profits to Permanent Establishments. The
approach developed in that report was not constrained by
either the original intent or by the historical practice and
interpretation of Article 7. Instead, the focus has been on
formulating the most preferable approach to attributing
profits to a permanent establishment under Article 7 given
modern-day multinational operations and trade.
7. The approach put forward in that Report deals with
the attribution of profits both to permanent establishments
in general (Part I of the Report) and, in particular, to per-
manent establishments of businesses operating in the fi-
nancial sector, where trading through a permanent estab-
lishment is widespread (Part II of the Report, which deals
with permanent establishments of banks, Part III, which
deals with permanent establishments of enterprises carry-
ing on global trading and Part IV, which deals with perma-
nent establishments of enterprises carrying on insurance
activities). The Committee considers that the guidance in-
cluded in the Report represents a better approach to attrib-
uting profits to permanent establishments than has previ-
ously been available. It does recognise, however, that there
are differences between some of the conclusions of the Re-
port and the interpretation of the Article previously given
in this Commentary. For that reason, this Commentary has
been amended to incorporate a number of conclusions of
the Report that did not conflict with the previous version of
this Commentary, which prescribed specific approaches in
some areas and left considerable leeway in others. The Re-
port therefore represents internationally agreed principles
and, to the extent that it does not conflict with this Com-
mentary, provides guidelines for the application of the
arm’s length principle incorporated in the Article.
8. Before 2000, income from professional services and
other activities of an independent character was dealt with
under a separate Article, i.e. Article 14. The provisions of
that Article were similar to those applicable to business
profits but it used the concept of fixed base rather than that
of permanent establishment since it had originally been
thought that the latter concept should be reserved to com-
mercial and industrial activities. However, it was not al-
ways clear which activities fell within Article 14 as opposed
to Article 7. The elimination of Article 14 in 2000 reflected
the fact that there were no intended differences between
the concepts of permanent establishment, as used in Ar-
ticle 7, and fixed base, as used in Article 14, or between
how profits were computed and tax was calculated accord-
ing to which of Article 7 or 14 applied. The effect of the de-
letion of Article 14 is that income derived from professional
services or other activities of an independent character is
now dealt with under Article 7 as business profits. This was
confirmed by the addition of a definition of the term ‘‘busi-
ness’’ which expressly provides that this term includes pro-
fessional services or other activities of an independent
character.
II. Commentary on the provisions of the Article
Paragraph 1
9. This paragraph is concerned with two questions. First,
it restates the generally accepted principle of double taxa-
tion conventions that an enterprise of one State shall not
be taxed in the other State unless it carries on business in
that other State through a permanent establishment situ-
ated therein. It is hardly necessary to argue here the mer-
its of this principle. It is perhaps sufficient to say that it has
come to be accepted in international fiscal matters that un-
til an enterprise of one State sets up a permanent establish-
ment in another State it should not properly be regarded as
participating in the economic life of that other State to such
an extent that it comes within the jurisdiction of that other
State’s taxing rights.
10. The second principle, which is reflected in the second
sentence of the paragraph, is that the right to tax of the
BNA TAX 6-3-10
160 (Vol. 19, No. 3)
State where the permanent establishment is situated does
not extend to profits that the enterprise may derive from
that State but that are not attributable to the permanent es-
tablishment. This is a question on which there have histori-
cally been differences of view, a few countries having some
time ago pursued a principle of general ‘‘force of attrac-
tion’’ according to which income such as other business
profits, dividends, interest and royalties arising from
sources in their territory was fully taxable by them if the
beneficiary had a permanent establishment therein even
though such income was clearly not attributable to that
permanent establishment. Whilst some bilateral tax con-
ventions include a limited anti-avoidance rule based on a
restricted force of attraction approach that only applies to
business profits derived from activities similar to those car-
ried on by a permanent establishment, the general force of
attraction approach described above has now been rejected
in international tax treaty practice. The principle that is
now generally accepted in double taxation conventions is
based on the view that in taxing the profits that a foreign
enterprise derives from a particular country, the tax au-
thorities of that country should look at the separate sources
of profit that the enterprise derives from their country and
should apply to each the permanent establishment test,
subject to the possible application of other Articles of the
Convention. This solution allows simpler and more effi-
cient tax administration and compliance, and is more
closely adapted to the way in which business is commonly
carried on. The organisation of modern business is highly
complex. There are a considerable number of companies
each of which is engaged in a wide diversity of activities
and is carrying on business extensively in many countries.
A company may set up a permanent establishment in an-
other country through which it carries on manufacturing
activities whilst a different part of the same company sells
different goods or manufactures in that other country
through independent agents. That company may have per-
fectly valid commercial reasons for doing so: these may be
based, for example, on the historical pattern of its business
or on commercial convenience. If the country in which the
permanent establishment is situated wished to go so far as
to try to determine, and tax, the profit element of each of
the transactions carried on through independent agents,
with a view to aggregating that profit with the profits of the
permanent establishment, that approach would interfere
seriously with ordinary commercial activities and would be
contrary to the aims of the Convention.
11. When referring to the part of the profits of an enter-
prise that is attributable to a permanent establishment, the
second sentence of paragraph 1 refers directly to para-
graph 2, which provides the directive for determining what
profits should be attributed to a permanent establishment.
As paragraph 2 is part of the context in which the sentence
must be read, that sentence should not be interpreted in a
way that could contradict paragraph 2, e.g. by interpreting
it as restricting the amount of profits that can be attributed
to a permanent establishment to the amount of profits of
the enterprise as a whole. Thus, whilst paragraph 1 pro-
vides that a Contracting State may only tax the profits of
an enterprise of the other Contracting to the extent that
they are attributable to a permanent establishment situated
in the first State, it is paragraph 2 that determines the
meaning of the phrase ‘‘profits attributable to a permanent
establishment’’. In other words, the directive of paragraph
2 may result in profits being attributed to a permanent es-
tablishment even though the enterprise as a whole has
never made profits; conversely, that directive may result in
no profits being attributed to a permanent establishment
even though the enterprise as a whole has made profits.
12. Clearly, however, the Contracting State of the enter-
prise has an interest in the directive of paragraph 2 being
correctly applied by the State where the permanent estab-
lishment is located. Since that directive applies to both
Contracting States, the State of the enterprise must, in ac-
cordance with Article 23, eliminate double taxation on the
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
profits properly attributable to the permanent establish-
ment. In other words, if the State where the permanent es-
tablishment is located attempts to tax profits that are not
attributable to the permanent establishment under Article
7, this may result in double taxation of profits that should
properly be taxed only in the State of the enterprise.
13. The purpose of paragraph 1 is to provide limits to the
right of one Contracting State to tax the business profits of
enterprises of the other Contracting State. The paragraph
does not limit the right of a Contracting State to tax its own
residents under controlled foreign companies provisions
found in its domestic law even though such tax imposed on
these residents may be computed by reference to the part
of the profits of an enterprise that is resident of the other
Contracting State that is attributable to these residents’
participation in that enterprise. Tax so levied by a State on
its own residents does not reduce the profits of the enter-
prise of the other State and may not, therefore, be said to
have been levied on such profits (see also paragraph 23 of
the Commentary on Article 1 and paragraphs 37 to 39 of
the Commentary on Article 10).
Paragraph 2
14. This paragraph contains the central directive on
which the attribution of profits to a permanent establish-
ment is intended to be based. The paragraph incorporates
the view that the profits to be attributed to a permanent es-
tablishment are those which that permanent establishment
would have made if, instead of dealing with the rest of the
enterprise, it had been dealing with an entirely separate
enterprise under conditions and at prices prevailing in the
ordinary market. This corresponds to the ‘‘arm’s length
principle’’ discussed in the Commentary on Article 9. Nor-
mally, the profits so determined would be the same profits
that one would expect to be determined by the ordinary
processes of good business accountancy.
15. The paragraph requires that this principle be applied
in each Contracting State. Clearly, this does not mean that
the amount on which the enterprise will be taxed in the
source State will, for a given period of time, be exactly the
same as the amount of income with respect to which the
other State will have to provide relief pursuant to Articles
23 A or 23 B. Variations between the domestic laws of the
two States concerning matters such as depreciation rates,
the timing of the recognition of income and restrictions on
the deductibility of certain expenses that are in accordance
with paragraph 3 of this Article will normally result in a dif-
ferent amount of taxable income in each State.
16. In the great majority of cases, trading accounts of the
permanent establishment — which are commonly available
if only because a well-run business organisation is nor-
mally concerned to know what is the profitability of its
various branches — will be used to ascertain the profit
properly attributable to that establishment. Exceptionally
there may be no separate accounts (cf. paragraphs 51 to 55
below). But where there are such accounts they will natu-
rally form the starting point for any processes of adjust-
ment in case adjustment is required to produce the amount
of profits that are properly attributable to the permanent
establishment under the directive contained in paragraph
2. It should perhaps be emphasized that this directive is no
justification to construct hypothetical profit figures in
vacuo; it is always necessary to start with the real facts of
the situation as they appear from the business records of
the permanent establishment and to adjust as may be
shown to be necessary the profit figures which those facts
produce. As noted in paragraph 19 below and as explained
in paragraph 39 of Part I of the Report Attribution of Prof-
its to Permanent Establishments, however, records and
documentation must satisfy certain requirements in order
to be considered to reflect the real facts of the situation.
17. In order to determine whether such an adjustment is
required by paragraph 2, it will be necessary to determine
the profits that would have been realized if the permanent
establishment had been a separate and distinct enterprise
TMTR ISSN 1063-2069
TEXT
engaged in the same or similar activities under the same or
similar conditions and dealing wholly independently with
the rest of the enterprise. Sections D-2 and D-3 of Part I of
the Report Attribution of Profits to Permanent Establish-
ments describe the two-step approach through which this
should be done. This approach will allow the calculation of
the profits attributable to all the activities carried on
through the permanent establishment, including transac-
tions with other independent enterprises, transactions with
associated enterprises and dealings (e.g. the internal trans-
fer of capital or property or the internal provision of ser-
vices – see for instance paragraphs 31 and 32) with other
parts of the enterprise (under the second step referred to
above), in accordance with the directive of paragraph 2.
18. The first step of that approach requires the identifica-
tion of the activities carried on through the permanent es-
tablishment. This should be done through a functional and
factual analysis (the guidance found in the Transfer Pric-
ing Guidelines for Multinational Enterprises and Tax Ad-
ministrations1 will be relevant for that purpose). Under
that first step, the economically significant activities and
responsibilities undertaken through the permanent estab-
lishment will be identified. This analysis should, to the ex-
tent relevant, consider the activities and responsibilities
undertaken through the permanent establishment in the
context of the activities and responsibilities undertaken by
the enterprise as a whole, particularly those parts of the en-
terprise that engage in dealings with the permanent estab-
lishment. Under the second step of that approach, the re-
muneration of any such dealings will be determined by ap-
plying by analogy the principles developed for the
application of the arm’s length principle between associ-
ated enterprises (these principles are articulated in the
Transfer Pricing Guidelines for Multinational Enterprises
and Tax Administrations) by reference to the functions
performed, assets used and risk assumed by the enterprise
through the permanent establishment and through the rest
of the enterprise.
19. A question that may arise is to what extent account-
ing records should be relied upon when they are based on
agreements between the head office and its permanent es-
tablishments (or between the permanent establishments
themselves). Clearly, such internal agreements cannot
qualify as legally binding contracts. However, to the extent
that the trading accounts of the head office and the perma-
nent establishments are both prepared symmetrically on
the basis of such agreements and that those agreements re-
flect the functions performed by the different parts of the
enterprise, these trading accounts could be accepted by tax
authorities. Accounts should not be regarded as prepared
symmetrically, however, unless the values of transactions
or the methods of attributing profits or expenses in the
books of the permanent establishment corresponded ex-
actly to the values or methods of attribution in the books of
the head office in terms of the national currency or func-
tional currency in which the enterprise recorded its trans-
actions. Also, as explained in paragraph 16, records and
documentation must satisfy certain requirements in order
to be considered to reflect the real facts of the situation.
For example, where trading accounts are based on internal
agreements that reflect purely artificial arrangements in-
stead of the real economic functions of the different parts
of the enterprise, these agreements should simply be ig-
nored and the accounts corrected accordingly. One such
case would be where a permanent establishment involved
in sales were, under such an internal agreement, given the
role of principal (accepting all the risks and entitled to all
the profits from the sales) when in fact the permanent es-
tablishment concerned was nothing more than an interme-
1
The original version of that report was approved by the Coun-
cil of the OECD on 27 June 1995. Published in a loose-leaf format
as Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations, OECD, Paris, 1995.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 161
diary or agent (incurring limited risks and entitled to re-
ceive only a limited share of the resulting income) or, con-
versely, were given the role of intermediary or agent when
in reality it was a principal.
20. It may therefore be concluded that accounting
records and contemporaneous documentation that meet
the above-mentioned requirements constitute a useful
starting point for the purposes of attributing profits to a
permanent establishment. Taxpayers are encouraged to
prepare such documentation, as it may reduce substan-
tially the potential for controversies. Section D-2 (vi) b) of
Part I of the Report Attribution of Profits to Permanent Es-
tablishments discusses the conditions under which tax ad-
ministrations would give effect to such documentation.
21. There may be a realisation of a taxable profit when
an asset, whether or not trading stock, forming part of the
business property of a permanent establishment situated
within a State’s territory is transferred to a permanent es-
tablishment or the head office of the same enterprise situ-
ated in another State. Article 7 allows the former State to
tax profits deemed to arise in connection with such a trans-
fer. Such profits may be determined as indicated below. In
cases where such transfer takes place, whether or not it is
a permanent one, the question arises as to when taxable
profits are realised. In practice, where such property has a
substantial market value and is likely to appear on the bal-
ance sheet of the importing permanent establishment or
other part of the enterprise after the taxation year during
that in which the transfer occurred, the realisation of the
taxable profits will not, so far as the enterprise as a whole
is concerned, necessarily take place in the taxation year of
the transfer under consideration. However, the mere fact
that the property leaves the purview of a tax jurisdiction
may trigger the taxation of the accrued gains attributable
to that property as the concept of realisation depends on
each country’s domestic law.
22. Where the countries in which the permanent estab-
lishments operate levy tax on the profits accruing from an
internal transfer as soon as it is made, even when these
profits are not actually realised until a subsequent com-
mercial year, there will be inevitably a time lag between the
moment when tax is paid abroad and the moment it can be
taken into account in the country where the enterprise’s
head office is located. A serious problem is inherent in the
time lag, especially when a permanent establishment trans-
fers fixed assets or — in the event that it is wound up — its
entire operating equipment stock, to some other part of the
enterprise of which it forms part. In such cases, it is up to
the head office country to seek, on a case by case basis, a
bilateral solution with the outward country where there is
serious risk of overtaxation.
23. Paragraph 3 of Article 5 sets forth a special rule for a
fixed place of business that is a building site or a construc-
tion or installation project. Such a fixed place of business
is a permanent establishment only if it lasts more than
twelve months. Experience has shown that these types of
permanent establishments can give rise to special prob-
lems in attributing income to them under Article 7.
24. These problems arise chiefly where goods are pro-
vided, or services performed, by the other parts of the en-
terprise or a related party in connection with the building
site or construction or installation project. Whilst these
problems can arise with any permanent establishment,
they are particularly acute for building sites and construc-
tion or installation projects. In these circumstances, it is
necessary to pay close attention to the general principle
that income is attributable to a permanent establishment
only when it results from activities carried on by the enter-
prise through that permanent establishment.
25. For example, where such goods are supplied by the
other parts of the enterprise, the profits arising from that
supply do not result from the activities carried on through
the permanent establishment and are not attributable to it.
Similarly, profits resulting from the provision of services
(such as planning, designing, drawing blueprints, or ren-
BNA TAX 6-3-10
162 (Vol. 19, No. 3)
dering technical advice) by the parts of the enterprise op-
erating outside the State where the permanent establish-
ment is located do not result from the activities carried on
through the permanent establishment and are not attribut-
able to it.
26. Where, under paragraph 5 of Article 5, a permanent
establishment of an enterprise of a Contracting State is
deemed to exist in the other Contracting State by reason of
the activities of a so-called dependent agent (see paragraph
32 of the Commentary on Article 5), the same principles
used to attribute profits to other types of permanent estab-
lishment will apply to attribute profits to that deemed per-
manent establishment. As a first step, the activities that the
dependent agent undertakes for the enterprise will be iden-
tified through a functional and factual analysis that will de-
termine the functions undertaken by the dependent agent
both on its own account and on behalf of the enterprise.
The dependent agent and the enterprise on behalf of which
it is acting constitute two separate potential taxpayers. On
the one hand, the dependent agent will derive its own in-
come or profits from the activities that it performs on its
own account for the enterprise; if the agent is itself a resi-
dent of either Contracting State, the provisions of the Con-
vention (including Article 9 if that agent is an enterprise as-
sociated to the enterprise on behalf of which it is acting)
will be relevant to the taxation of such income or profits.
On the other hand, the deemed permanent establishment
of the enterprise will be attributed the assets and risks of
the enterprise relating to the functions performed by the
dependent agent on behalf of that enterprise (i.e. the activi-
ties that the dependent agent undertakes for that enter-
prise), together with sufficient capital to support those as-
sets and risks. Profits will then be attributed to the deemed
permanent establishment on the basis of those assets, risks
and capital; these profits will be separate from, and will not
include, the income or profits that are properly attributable
to the dependent agent itself (see section D-5 of Part I of
the Report Attribution of Profits to Permanent Establish-
ments).
Paragraph 3
27. This paragraph clarifies, in relation to the expenses
of a permanent establishment, the general directive laid
down in paragraph 2. The paragraph specifically recog-
nises that in calculating the profits of a permanent estab-
lishment allowance is to be made for expenses, wherever
incurred, that were incurred for the purposes of the perma-
nent establishment. Clearly in some cases it will be neces-
sary to estimate or to calculate by conventional means the
amount of expenses to be taken into account. In the case,
for example, of general administrative expenses incurred
at the head office of the enterprise, it may be appropriate
to take into account a proportionate part based on the ra-
tio that the permanent establishment’s turnover (or per-
haps gross profits) bears to that of the enterprise as a
whole. Subject to this, it is considered that the amount of
expenses to be taken into account as incurred for the pur-
poses of the permanent establishment should be the actual
amount so incurred. The deduction allowable to the perma-
nent establishment for any of the expenses of the enter-
prise attributed to it does not depend upon the actual reim-
bursement of such expenses by the permanent establish-
ment.
28. It has sometimes been suggested that the need to rec-
oncile paragraphs 2 and 3 created practical difficulties as
paragraph 2 required that prices between the permanent
establishment and the head office be normally charged on
an arm’s length basis, giving to the transferring entity the
type of profit which it might have been expected to make
were it dealing with an independent enterprise, whilst the
wording of paragraph 3 suggested that the deduction for
expenses incurred for the purposes of permanent estab-
lishments should be the actual cost of those expenses, nor-
mally without adding any profit element.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
29. In fact, whilst the application of paragraph 3 may
raise some practical difficulties, especially in relation to the
separate enterprise and arm’s length principles underlying
paragraph 2, there is no difference of principle between the
two paragraphs. Paragraph 3 indicates that in determining
the profits of a permanent establishment, certain expenses
must be allowed as deductions whilst paragraph 2 provides
that the profits determined in accordance with the rule
contained in paragraph 3 relating to the deduction of ex-
penses must be those that a separate and distinct enter-
prise engaged in the same or similar activities under the
same or similar conditions would have made. Thus, whilst
paragraph 3 provides a rule applicable for the determina-
tion of the profits of the permanent establishment, para-
graph 2 requires that the profits so determined correspond
to the profits that a separate and independent enterprise
would have made.
30. Also, paragraph 3 only determines which expenses
should be attributed to the permanent establishment for
purposes of determining the profits attributable to that per-
manent establishment. It does not deal with the issue of
whether those expenses, once attributed, are deductible
when computing the taxable income of the permanent es-
tablishment since the conditions for the deductibility of ex-
penses are a matter to be determined by domestic law, sub-
ject to the rules of Article 24 on Non-discrimination (in par-
ticular, paragraphs 3 and 4 of that Article).
31. In applying these principles to the practical determi-
nation of the profits of a permanent establishment, the
question may arise as to whether a particular cost incurred
by an enterprise can truly be considered as an expense in-
curred for the purposes of the permanent establishment,
keeping in mind the separate and independent enterprise
principles of paragraph 2. Whilst in general independent
enterprises in their dealings with each other will seek to re-
alise a profit and, when transferring property or providing
services to each other, will charge such prices as the open
market would bear, nevertheless, there are also circum-
stances where it cannot be considered that a particular
property or service would have been obtainable from an in-
dependent enterprise or when independent enterprises
may agree to share between them the costs of some activ-
ity which is pursued in common for their mutual benefit. In
these particular circumstances, it may be appropriate to
treat any relevant costs incurred by the enterprise as an ex-
pense incurred for the permanent establishment. The diffi-
culty arises in making a distinction between these circum-
stances and the cases where a cost incurred by an enter-
prise should not be considered as an expense of the
permanent establishment and the relevant property or ser-
vice should be considered, on the basis of the separate and
independent enterprises principle, to have been trans-
ferred between the head office and the permanent estab-
lishment at a price including an element of profit. The
question must be whether the internal transfer of property
and services, be it temporary or final, is of the same kind
as those which the enterprise, in the normal course of its
business, would have charged to a third party at an arm’s
length price, i.e. by normally including in the sale price an
appropriate profit.
32. On the one hand, the answer to that question will be
in the affirmative if the expense is initially incurred in per-
forming a function the direct purpose of which is to make
sales of a specific good or service and to realise a profit
through a permanent establishment. On the other hand,
the answer will be in the negative if, on the basis of the
facts and circumstances of the specific case, it appears that
the expense is initially incurred in performing a function
the essential purpose of which is to rationalise the overall
costs of the enterprise or to increase in a general way its
sales.1
1
Internal transfers of financial assets, which are primarily rel-
evant for banks and other financial institutions, raise specific is-
TMTR ISSN 1063-2069
TEXT
33. Where goods are supplied for resale whether in a fin-
ished state or as raw materials or semi-finished goods, it
will normally be appropriate for the provisions of para-
graph 2 to apply and for the supplying part of the enter-
prise to be allocated a profit, measured by reference to
arm’s length principles. But there may be exceptions even
here. One example might be where goods are not supplied
for resale but for temporary use in the trade so that it may
be appropriate for the parts of the enterprise which share
the use of the material to bear only their share of the cost
of such material e.g. in the case of machinery, the depre-
ciation costs that relate to its use by each of these parts. It
should of course be remembered that the mere purchase of
goods does not constitute a permanent establishment (sub-
paragraph 4 d) of Article 5) so that no question of attribu-
tion of profit arises in such circumstances.
34. In the case of intangible rights, the rules concerning
the relations between enterprises of the same group (e.g.
payment of royalties or cost sharing arrangements) cannot
be applied in respect of the relations between parts of the
same enterprise. Indeed, it may be extremely difficult to al-
locate ‘‘ownership’’ of the intangible right solely to one
part of the enterprise and to argue that this part of the en-
terprise should receive royalties from the other parts as if
it were an independent enterprise. Since there is only one
legal entity it is not possible to allocate legal ownership to
any particular part of the enterprise and in practical terms
it will often be difficult to allocate the costs of creation ex-
clusively to one part of the enterprise. It may therefore be
preferable for the costs of creation of intangible rights to
be regarded as attributable to all parts of the enterprise
which will make use of them and as incurred on behalf of
the various parts of the enterprise to which they are rel-
evant accordingly. In such circumstances it would be ap-
propriate to allocate between the various parts of the enter-
prise the actual costs of the creation or acquisition of such
intangible rights, as well as the costs subsequently in-
curred with respect to these intangible rights, without any
mark-up for profit or royalty. In so doing, tax authorities
must be aware of the fact that the possible adverse conse-
quences deriving from any research and development ac-
tivity (e.g. the responsibility related to the products and
damages to the environment) shall also be allocated to the
various parts of the enterprise, therefore giving rise, where
appropriate, to a compensatory charge.
35. The area of services is the one in which difficulties
may arise in determining whether in a particular case a
service should be charged between the various parts of a
single enterprise at its actual cost or at that cost plus a
mark-up to represent a profit to the part of the enterprise
providing the service. The trade of the enterprise, or part
of it, may consist of the provision of such services and
there may be a standard charge for their provision. In such
a case it will usually be appropriate to charge a service at
the same rate as is charged to the outside customer.
36. Where the main activity of a permanent establish-
ment is to provide specific services to the enterprise to
which it belongs and where these services provide a real
advantage to the enterprise and their costs represent a sig-
nificant part of the expenses of the enterprise, the host
country may require that a profit margin be included in the
amount of the costs. As far as possible, the host country
should then try to avoid schematic solutions and rely on
the value of these services in the given circumstances of
each case.
37. However, more commonly the provision of services is
merely part of the general management activity of the com-
pany taken as a whole as where, for example, the enter-
prise conducts a common system of training and employ-
ees of each part of the enterprise benefit from it. In such a
case it would usually be appropriate to treat the cost of pro-
sues which have been dealt with in Parts II and III of the Report
Attribution of Profits to Permanent Establishments.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 163
viding the service as being part of the general administra-
tive expenses of the enterprise as a whole which should be
allocated on an actual cost basis to the various parts of the
enterprise to the extent that the costs are incurred for the
purposes of that part of the enterprise, without any
mark-up to represent profit to another part of the enter-
prise.
38. The treatment of services performed in the course of
the general management of an enterprise raises the ques-
tion whether any part of the total profits of an enterprise
should be deemed to arise from the exercise of good man-
agement. Consider the case of a company that has its head
office in one country but carries on all its business through
a permanent establishment situated in another country. In
the extreme case it might well be that only the directors’
meetings were held at the head office and that all other ac-
tivities of the company apart from purely formal legal ac-
tivities, were carried on in the permanent establishment. In
such a case there is something to be said for the view that
at least part of the profits of the whole enterprise arose
from the skilful management and business acumen of the
directors and that part of the profits of the enterprise
ought, therefore, to be attributed to the country in which
the head office was situated. If the company had been man-
aged by a managing agency, then that agency would doubt-
less have charged a fee for its services and the fee might
well have been a simple percentage participation in the
profits of the enterprise. But whatever the theoretical mer-
its of such a course, practical considerations weigh heavily
against it. In the kind of case quoted the expenses of man-
agement would, of course, be set against the profits of the
permanent establishment in accordance with the provi-
sions of paragraph 3, but when the matter is looked at as a
whole, it is thought that it would not be right to go further
by deducting and taking into account some notional figure
for ‘‘profits of management’’. In cases identical to the ex-
treme case mentioned above, no account should therefore
be taken in determining taxable profits of the permanent
establishment of any notional figure such as profits of man-
agement.
39. It may be, of course, that countries where it has been
customary to allocate some proportion of the total profits
of an enterprise to the head office of the enterprise to rep-
resent the profits of good management will wish to con-
tinue to make such an allocation. Nothing in the Article is
designed to prevent this. Nevertheless it follows from what
is said in paragraph 38 above that a country in which a per-
manent establishment is situated is in no way required to
deduct when calculating the profits attributable to that per-
manent establishment an amount intended to represent a
proportionate part of the profits of management attribut-
able to the head office.
40. It might well be that if the country in which the head
office of an enterprise is situated allocates to the head of-
fice some percentage of the profits of the enterprise only in
respect of good management, whilst the country in which
the permanent establishment is situated does not, the re-
sulting total of the amounts charged to tax in the two coun-
tries would be greater than it should be. In any such case
the country in which the head office of the enterprise is
situated should take the initiative in arranging for such ad-
justments to be made in computing the taxation liability in
that country as may be necessary to ensure that any double
taxation is eliminated.
41. The treatment of interest charges raises particular is-
sues. First, there might be amounts which, under the name
of interest, are charged by a head office to its permanent
establishment with respect to internal ‘‘loans’’ by the
former to the latter. Except for financial enterprises such
as banks, it is generally agreed that such internal ‘‘inter-
est’’ need not be recognised. This is because:
— From the legal standpoint, the transfer of capital
against payment of interest and an undertaking to re-
pay in full at the due date is really a formal act incom-
BNA TAX 6-3-10
164 (Vol. 19, No. 3)
patible with the true legal nature of a permanent es-
tablishment.
— From the economic standpoint, internal debts and re-
ceivables may prove to be non-existent, since if an en-
terprise is solely or predominantly equity-funded it
ought not to be allowed to deduct interest charges that
it has manifestly not had to pay. Whilst, admittedly,
symmetrical charges and returns will not distort the
enterprise’s overall profits, partial results may well be
arbitrarily changed.
42. For these reasons, the ban on deductions for internal
debts and receivables should continue to apply generally,
subject to the special situation of banks, as mentioned be-
low.
43. A different issue, however, is that of the deduction of
interest on debts actually incurred by the enterprise. Such
debts may relate in whole or in part to the activities of the
permanent establishment; indeed, loans contracted by an
enterprise will serve either the head office, the permanent
establishment or both. The question that arises in relation
to these debts is how to determine the part of the interest
that should be deducted in computing the profits attribut-
able to the permanent establishment.
44. The approach suggested in this Commentary before
1994, namely the direct and indirect apportionment of ac-
tual debt charges, did not prove to be a practical solution,
notably since it was unlikely to be applied in a uniform
manner. Also, it is well known that the indirect apportion-
ment of total interest payment charges, or of the part of in-
terest that remains after certain direct allocations, comes
up against practical difficulties. It is also well known that
direct apportionment of total interest expense may not ac-
curately reflect the cost of financing the permanent estab-
lishment because the taxpayer may be able to control
where loans are booked and adjustments may need to be
made to reflect economic reality, in particular the fact that
an independent enterprise would normally be expected to
have a certain level of ‘‘free’’ capital.
45. Consequently, the majority of Member countries con-
sider that it would be preferable to look for a practicable
solution that would take into account a capital structure
appropriate to both the organization and the functions per-
formed. This appropriate capital structure will take ac-
count of the fact that in order to carry out its activities, the
permanent establishment requires a certain amount of
funding made up of ‘‘free’’ capital and interest-bearing
debt. The objective is therefore to attribute an arm’s length
amount of interest to the permanent establishment after at-
tributing an appropriate amount of ‘‘free’’ capital in order
to support the functions, assets and risks of the permanent
establishment. Under the arm’s length principle a perma-
nent establishment should have sufficient capital to sup-
port the functions it undertakes, the assets it economically
owns and the risks it assumes. In the financial sector regu-
lations stipulate minimum levels of regulatory capital to
provide a cushion in the event that some of the risks inher-
ent in the business crystallise into financial loss. Capital
provides a similar cushion against crystallisation of risk in
non-financial sectors.
46. As explained in section D-2 (v) b) of Part I of the Re-
port Attribution of Profits to Permanent Establishments,
there are different acceptable approaches for attributing
‘‘free’’ capital that are capable of giving an arm’s length re-
sult. Each approach has its own strengths and weaknesses,
which become more or less material depending on the facts
and circumstances of particular cases. Different methods
adopt different starting points for determining the amount
of ‘‘free’’ capital attributable to a permanent establishment,
which either put more emphasis on the actual structure of
the enterprise of which the permanent establishment is a
part or alternatively, on the capital structures of compa-
rable independent enterprises. The key to attributing
‘‘free’’ capital is to recognise:
— the existence of strengths and weaknesses in any ap-
proach and when these are likely to be present;
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
— that there is no single arm’s length amount of ‘‘free’’
capital, but a range of potential capital attributions
within which it is possible to find an amount of ‘‘free’’
capital that can meet the basic principle set out above.
47. It is recognised, however, that the existence of differ-
ent acceptable approaches for attributing ‘‘free’’ capital to
a permanent establishment which are capable of giving an
arm’s length result can give rise to problems of double
taxation. The main concern, which is especially acute for
financial institutions, is that if the domestic law rules of the
State where the permanent establishment is located and of
the State of the enterprise require different acceptable ap-
proaches for attributing an arm’s length amount of free
capital to the permanent establishment, the amount of
profits calculated by the State of the permanent establish-
ment may be higher than the amount of profits calculated
by the State of the enterprise for purposes of relief of
double taxation.
48. Given the importance of that issue, the Committee
has looked for a practical solution. OECD member coun-
tries have therefore agreed to accept, for the purposes of
determining the amount of interest deduction that will be
used in computing double taxation relief, the attribution of
capital derived from the application of the approach used
by the State in which the permanent establishment is lo-
cated if the following two conditions are met: first, if the
difference in capital attribution between that State and the
State of the enterprise results from conflicting domestic
law choices of capital attribution methods, and second, if
there is agreement that the State in which the permanent
establishment is located has used an authorised approach
to the attribution of capital and there is also agreement that
that approach produces a result consistent with the arm’s
length principle in the particular case. OECD member
countries consider that they are able to achieve that result
either under their domestic law, through the interpretation
of Articles 7 and 23 or under the mutual agreement proce-
dure of Article 25 and, in particular, the possibility offered
by that Article to resolve any issues concerning the appli-
cation or interpretation of their tax treaties.
49. As already mentioned, special considerations apply
to internal interest charges on advances between different
parts of a financial enterprise (e.g. a bank), in view of the
fact that making and receiving advances is closely related
to the ordinary business of such enterprises. This problem,
as well as other problems relating to the application of Ar-
ticle 7 to the permanent establishments of banks and enter-
prises carrying on global trading, is discussed in Parts II
and III of the Report Attribution of Profits to Permanent Es-
tablishments.
50. The determination of the investment assets attribut-
able to a permanent establishment through which insur-
ance activities are carried on also raises particular issues,
which are discussed in Part IV of the Report.
51. It is usually found that there are, or there can be con-
structed, adequate accounts for each part or section of an
enterprise so that profits and expenses, adjusted as may be
necessary, can be allocated to a particular part of the en-
terprise with a considerable degree of precision. This
method of allocation is, it is thought, to be preferred in gen-
eral wherever it is reasonably practicable to adopt it. There
are, however, circumstances in which this may not be the
case and paragraphs 2 and 3 are in no way intended to im-
ply that other methods cannot properly be adopted where
appropriate in order to arrive at the profits of a permanent
establishment on a ‘‘separate enterprise’’ footing. It may
well be, for example, that profits of insurance enterprises
can most conveniently be ascertained by special methods
of computation, e.g. by applying appropriate co-efficients
to gross premiums received from policy holders in the
country concerned. Again, in the case of a relatively small
enterprise operating on both sides of the border between
two countries, there may be no proper accounts for the per-
manent establishment nor means of constructing them.
There may, too, be other cases where the affairs of the per-
TMTR ISSN 1063-2069
TEXT
manent establishment are so closely bound up with those
of the head office that it would be impossible to disentangle
them on any strict basis of branch accounts. Where it has
been customary in such cases to estimate the arm’s length
profit of a permanent establishment by reference to suit-
able criteria, it may well be reasonable that that method
should continue to be followed, notwithstanding that the
estimate thus made may not achieve as high a degree of ac-
curate measurement of the profit as adequate accounts.
Even where such a course has not been customary, it may,
exceptionally, be necessary for practical reasons to esti-
mate the arm’s length profits based on other methods.
Paragraph 4
52. It has in some cases been the practice to determine
the profits to be attributed to a permanent establishment
not on the basis of separate accounts or by making an esti-
mate of arm’s length profit, but simply by apportioning the
total profits of the enterprise by reference to various for-
mulae. Such a method differs from those envisaged in
paragraph 2, since it contemplates not an attribution of
profits on a separate enterprise footing, but an apportion-
ment of total profits; and indeed it might produce a result
in figures which would differ from that which would be ar-
rived at by a computation based on separate accounts.
Paragraph 4 makes it clear that such a method may con-
tinue to be employed by a Contracting State if it has been
customary in that State to adopt it, even though the figure
arrived at may at times differ to some extent from that
which would be obtained from separate accounts, provided
that the result can fairly be said to be in accordance with
the principles contained in the Article. It is emphasized,
however, that in general the profits to be attributed to a
permanent establishment should be determined by refer-
ence to the establishment’s accounts if these reflect the real
facts. It is considered that a method of allocation which is
based on apportioning total profits is generally not as ap-
propriate as a method which has regard only to the activi-
ties of the permanent establishment and should be used
only where, exceptionally, it has as a matter of history been
customary in the past and is accepted in the country con-
cerned both by the taxation authorities and taxpayers gen-
erally there as being satisfactory. It is understood that
paragraph 4 may be deleted where neither State uses such
a method. Where, however, Contracting States wish to be
able to use a method which has not been customary in the
past the paragraph should be amended during the bilateral
negotiations to make this clear.
53. It would not, it is thought, be appropriate within the
framework of this Commentary to attempt to discuss at
length the many various methods involving apportionment
of total profits that have been adopted in particular fields
for allocating profits. These methods have been well docu-
mented in treatises on international taxation. It may, how-
ever, not be out of place to summarise briefly some of the
main types and to lay down some very general directives
for their use.
54. The essential character of a method involving appor-
tionment of total profits is that a proportionate part of the
profits of the whole enterprise is allocated to a part thereof,
all parts of the enterprise being assumed to have contrib-
uted on the basis of the criterion or criteria adopted to the
profitability of the whole. The difference between one such
method and another arises for the most part from the vary-
ing criteria used to determine what is the correct propor-
tion of the total profits. It is fair to say that the criteria com-
monly used can be grouped into three main categories,
namely those which are based on the receipts of the enter-
prise, its expenses or its capital structure. The first cat-
egory covers allocation methods based on turnover or on
commission, the second on wages and the third on the pro-
portion of the total working capital of the enterprise allo-
cated to each branch or part. It is not, of course, possible to
say in vacuo that any of these methods is intrinsically more
accurate than the others; the appropriateness of any par-
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 165
ticular method will depend on the circumstances to which
it is applied. In some enterprises, such as those providing
services or producing proprietary articles with a high profit
margin, net profits will depend very much on turnover. For
insurance enterprises it may be appropriate to make an ap-
portionment of total profits by reference to premiums re-
ceived from policy holders in each of the countries con-
cerned. In the case of an enterprise manufacturing goods
with a high cost raw material or labour content, profits may
be found to be related more closely to expenses. In the case
of banking and financial concerns the proportion of total
working capital may be the most relevant criterion. It is
considered that the general aim of any method involving
apportionment of total profits ought to be to produce fig-
ures of taxable profit that approximate as closely as pos-
sible to the figures that would have been produced on a
separate accounts basis, and that it would not be desirable
to attempt in this connection to lay down any specific direc-
tive other than that it should be the responsibility of the
taxation authority, in consultation with the authorities of
other countries concerned, to use the method which in the
light of all the known facts seems most likely to produce
that result.
55. The use of any method which allocates to a part of an
enterprise a proportion of the total profits of the whole
does, of course, raise the question of the method to be used
in computing the total profits of the enterprise. This may
well be a matter which will be treated differently under the
laws of different countries. This is not a problem which it
would seem practicable to attempt to resolve by laying
down any rigid rule. It is scarcely to be expected that it
would be accepted that the profits to be apportioned should
be the profits as they are computed under the laws of one
particular country; each country concerned would have to
be given the right to compute the profits according to the
provisions of its own laws.
Paragraph 5
56. In paragraph 4 of Article 5 there are listed a number
of examples of activities which, even though carried on at
a fixed place of business, are deemed not to be included in
the term ‘‘permanent establishment’’. In considering rules
for the allocation of profits to a permanent establishment
the most important of these examples is the activity men-
tioned in paragraph 5 of this Article, i.e. the purchasing of-
fice.
57. Paragraph 5 is not, of course, concerned with the or-
ganisation established solely for purchasing; such an or-
ganisation is not a permanent establishment and the prof-
its allocation provisions of this Article would not therefore
come into play. The paragraph is concerned with a perma-
nent establishment which, although carrying on other busi-
ness, also carries on purchasing for its head office. In such
a case the paragraph provides that the profits of the perma-
nent establishment shall not be increased by adding to
them a notional figure for profits from purchasing. It fol-
lows, of course, that any expenses that arise from the pur-
chasing activities will also be excluded in calculating the
taxable profits of the permanent establishment.
Paragraph 6
58. This paragraph is intended to lay down clearly that a
method of allocation once used should not be changed
merely because in a particular year some other method
produces more favourable results. One of the purposes of a
double taxation convention is to give an enterprise of a
Contracting State some degree of certainty about the tax
treatment that will be accorded to its permanent establish-
ment in the other Contracting State as well as to the part of
it in its home State which is dealing with the permanent es-
tablishment; for this reason, paragraph 6 gives an assur-
ance of continuous and consistent tax treatment.
BNA TAX 6-3-10
166 (Vol. 19, No. 3)
Paragraph 7
59. Although it has not been found necessary in the Con-
vention to define the term ‘‘profits’’, it should nevertheless
be understood that the term when used in this Article and
elsewhere in the Convention has a broad meaning includ-
ing all income derived in carrying on an enterprise. Such a
broad meaning corresponds to the use of the term made in
the tax laws of most OECD member countries.
60. This interpretation of the term ‘‘profits’’, however,
may give rise to some uncertainty as to the application of
the Convention. If the profits of an enterprise include cat-
egories of income which are treated separately in other Ar-
ticles of the Convention, e.g. dividends, it may be asked
whether the taxation of those profits is governed by the
special Article on dividends, etc., or by the provisions of
this Article.
61. To the extent that an application of this Article and
the special Article concerned would result in the same tax
treatment, there is little practical significance to this ques-
tion. Further, it should be noted that some of the special
Articles contain specific provisions giving priority to a spe-
cific Article (cf. paragraph 4 of Article 6, paragraph 4 of Ar-
ticles 10 and 11, paragraph 3 of Article 12, and paragraph
2 of Article 21).
62. It has seemed desirable, however, to lay down a rule
of interpretation in order to clarify the field of application
of this Article in relation to the other Articles dealing with
a specific category of income. In conformity with the prac-
tice generally adhered to in existing bilateral conventions,
paragraph 7 gives first preference to the special Articles on
dividends, interest, etc. It follows from the rule that this Ar-
ticle will be applicable to business profits which do not be-
long to categories of income covered by the special Ar-
ticles, and, in addition, to dividends, interest, etc. which un-
der paragraph 4 of Articles 10 and 11, paragraph 3 of
Article 12 and paragraph 2 of Article 21, fall within this Ar-
ticle (cf. paragraphs 12 to 18 of the Commentary on Article
12 which discuss the principles governing whether, in the
particular case of computer software, payments should be
classified as business profits within Article 7 or as a capital
gain within Article 13 on the one hand or as royalties
within Article 12 on the other). It is understood that the
items of income covered by the special Articles may, sub-
ject to the provisions of the Convention, be taxed either
separately, or as business profits, in conformity with the
tax laws of the Contracting States.
63. It is open to Contracting States to agree bilaterally
upon special explanations or definitions concerning the
term ‘‘profits’’ with a view to clarifying the distinction be-
tween this term and e.g. the concept of dividends. It may in
particular be found appropriate to do so where in a conven-
tion under negotiation a deviation has been made from the
definitions in the special Articles on dividends, interest and
royalties. It may also be deemed desirable if the Contract-
ing States wish to place on notice, that, in agreement with
the domestic tax laws of one or both of the States, the term
‘‘profits’’ includes special classes of receipts such as in-
come from the alienation or the letting of a business or of
movable property used in a business. In this connection it
may have to be considered whether it would be useful to
include also additional rules for the allocation of such spe-
cial profits.
64. It should also be noted that, whilst the definition of
‘‘royalties’’ in paragraph 2 of Article 12 of the 1963 Draft
Convention and 1977 Model Convention included pay-
ments ‘‘for the use of, or the right to use, industrial, com-
mercial, or scientific equipment’’, the reference to these
payments was subsequently deleted from that definition in
order to ensure that income from the leasing of industrial,
commercial or scientific equipment, including the income
from the leasing of containers, falls under the provisions of
Article 7 rather than those of Article 12, a result that the
Committee on Fiscal Affairs considers to be appropriate
given the nature of such income.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
TEXT
Observations on the Commentary
65. Italy and Portugal deem as essential to take into con-
sideration that — irrespective of the meaning given to the
fourth sentence of paragraph 8 — as far as the method for
computing taxes is concerned, national systems are not af-
fected by the new wording of the model, i.e. by the elimi-
nation of Article 14.
66. Belgium cannot share the views expressed in para-
graph 13 of the Commentary. Belgium considers that the
application of controlled foreign companies legislation is
contrary to the provisions of paragraph 1 of Article 7. This
is especially the case where a contracting State taxes one
of its residents on income derived by a foreign entity by us-
ing a fiction attributing to that resident, in proportion to his
participation in the capital of the foreign entity, the income
derived by that entity. By doing so, that State increases the
tax base of its resident by including in it income which has
not been derived by that resident but by a foreign entity
which is not taxable in that State in accordance with para-
graph 1 of Article 7. That Contracting State thus disregards
the legal personality of the foreign entity and acts contrary
to paragraph 1 of Article 7.
67. Luxembourg does not share the interpretation in
paragraph 13 which provides that paragraph 1 of Article 7
does not restrict a Contracting State’s right to tax its own
residents under controlled foreign companies provisions
found in its domestic law as this interpretation challenges
the fundamental principle contained in paragraph 1 of Ar-
ticle 7.
68. With reference to paragraph 13, Ireland notes its gen-
eral observation in paragraph 27.5 of the Commentary on
Article 1.
69. With regard to paragraph 45, Greece notes that the
Greek internal law does not foresee any rules or methods
for attributing ‘‘free’’ capital to permanent establishments.
Concerning loans contracted by an enterprise that relate in
whole or in part to the activities of the permanent estab-
lishment, Greece allows as deduction the part of the inter-
est which corresponds to the amount of a loan contracted
by the head office and actually remitted to the permanent
establishment.
70. Portugal wishes to reserve its right not to follow the
position expressed in paragraph 45 of the Commentary on
Article 7 except whenever there are specific domestic pro-
visions foreseeing certain levels of ‘‘free’’ capital for per-
manent establishments.
71. With regard to paragraph 46, Sweden wishes to
clarify that it does not consider that the different ap-
proaches for attributing ‘‘free’’ capital that the paragraph
refers to as being ‘‘acceptable’’ will necessarily lead to a re-
sult in accordance with the arm’s length principle. Conse-
quently, when looking at the facts and circumstances of
each case in order to determine whether the amount of in-
terest deduction resulting from the application of these ap-
proaches conforms to the arm’s length principle, Sweden
in many cases would not consider that the other States’ ap-
proach conforms to the arm’s length principle. Sweden is
of the opinion that double taxation will therefore often oc-
cur, requiring the use of the mutual agreement procedure.
72. Portugal wishes to reserve its right not to follow the
‘‘symmetry’’ approach described in paragraph 48 of the
Commentary on Article 7, insofar as the Portuguese inter-
nal law does not foresee any rules or methods for attribut-
ing ‘‘free’’ capital to permanent establishments. In elimi-
nating double taxation according to Article 23, Portugal, as
the home country, determines the amount of profits attrib-
utable to a permanent establishment according to the do-
mestic law.
73. Germany, Japan and the United States, whilst agree-
ing to the practical solution described in paragraph 48,
wish to clarify how this agreement will be implemented.
Neither Germany, nor Japan, nor the United States can au-
tomatically accept for all purposes all calculations by the
State in which the permanent establishment is located. In
cases involving Germany or Japan, the second condition
TMTR ISSN 1063-2069
TEXT
described in paragraph 48 has to be satisfied through a mu-
tual agreement procedure under Article 25. In the case of
Japan and the United States, a taxpayer who seeks to ob-
tain additional foreign tax credit limitation must do so
through a mutual agreement procedure in which the tax-
payer would have to prove to the Japanese or the United
States competent authority, as the case may be, that double
taxation of the permanent establishment profits which re-
sulted from the conflicting domestic law choices of capital
attribution methods has been left unrelieved after applying
mechanisms under their respective domestic tax law such
as utilisation of foreign tax credit limitation created by
other transactions.
74. With reference to paragraphs 6 and 7, New Zealand
notes that it does not agree with the approach put forward
on the attribution of profits to permanent establishments in
general, as reflected in Part I of the Report Attribution of
Profits to Permanent Establishments.
Reservations on the Article
75. Australia and New Zealand reserve the right to in-
clude a provision that will permit their domestic law to ap-
ply in relation to the taxation of profits from any form of
insurance.
76. Australia and New Zealand reserve the right to in-
clude a provision clarifying their right to tax a share of
business profits to which a resident of the other Contract-
ing State is beneficially entitled where those profits are de-
rived by a trustee of a trust estate (other than certain unit
trusts that are treated as companies for Australian and
New Zealand tax purposes) from the carrying on of a busi-
ness in Australia or New Zealand, as the case may be,
through a permanent establishment.
77. Korea and Portugal reserve the right to tax persons
performing professional services or other activities of an
independent character if they are present on their territory
for a period or periods exceeding in the aggregate 183 days
in any twelve month period, even if they do not have a per-
manent establishment (or a fixed base) available to them
for the purpose of performing such services or activities.
78. Italy and Portugal reserve the right to tax persons
performing independent personal services under a sepa-
rate article which corresponds to Article 14 as it stood be-
fore its elimination in 2000.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 167
79. The United States reserves the right to amend Article
7 to provide that, in applying paragraphs 1 and 2 of the Ar-
ticle, any income or gain attributable to a permanent estab-
lishment during its existence may be taxable by the Con-
tracting State in which the permanent establishment exists
even if the payments are deferred until after the permanent
establishment has ceased to exist. The United States also
wishes to note that it reserves the right to apply such a rule,
as well, under Articles 11, 12, 13 and 21.
80. Turkey reserves the right to subject income from the
leasing of containers to a withholding tax at source in all
cases. In case of the application of Articles 5 and 7 to such
income, Turkey would like to apply the permanent estab-
lishment rule to the simple depot, depot-agency and opera-
tional branches cases.
81. Norway and the United States reserve the right to
treat income from the use, maintenance or rental of con-
tainers used in international traffic under Article 8 in the
same manner as income from shipping and air transport.
82. Australia and Portugal reserve the right to propose in
bilateral negotiations a provision to the effect that, if the in-
formation available to the competent authority of a Con-
tracting State is inadequate to determine the profits to be
attributed to the permanent establishment of an enterprise,
the competent authority may apply to that enterprise for
that purpose the provisions of the taxation law of that
State, subject to the qualification that such law will be ap-
plied, so far as the information available to the competent
authority permits, in accordance with the principles of this
Article.
83. Mexico reserves the right to tax in the State where
the permanent establishment is situated business profits
derived from the sale of goods or merchandise carried out
directly by its home office situated in the other Contracting
State, provided that those goods and merchandise are of
the same or similar kind as the ones sold through that per-
manent establishment. The Government of Mexico will ap-
ply this rule only as a safeguard against abuse and not as a
general ‘‘force of attraction’’ principle; thus, the rule will
not apply when the enterprise proves that the sales have
been carried out for reasons other than obtaining a benefit
under the Convention.
***
BNA TAX 6-3-10
168 (Vol. 19, No. 3)
In Practice
Mutual Agreement Procedures in Turkey
The author outlines the competent authority process in Turkey, explaining which taxpay-
ers are eligible and describing common issues as well as how the process interacts with liti-
gation.
BY METIN DURAN, MAZARS DENGE
urkish transfer pricing regulations effective in
T 20071 are expected to increase audits and, as a re-
sult, the number of applications for mutual agree-
ment procedure cases. Until recently, application proce-
dures were not clearly stated by the Turkish Revenue
Administration (TRA). MAP guidelines published by the
TRA’s European Union and Foreign Relations Division
(Avrupa Birligi ve Dis Iliskiler Daire Baskanligi) July
31, 2009, however, should give taxpayers a better un-
derstanding of the requirements for obtaining a MAP,
the types of issues appropriate for the procedure, and
what remedies a taxpayer may seek in court without
forfeiting its right to the competent authority process.2
Turkey to date has signed 71 income tax treaties.
The MAP guidelines aim to explain the procedures in
Turkey that apply to the MAP articles contained in Tur-
key’s treaty network. Although the treaties have de-
tailed and well-prepared provisions, double tax cases
may arise from differing approaches by the tax authori-
ties.
Article 25
Article 25 of Organization for Economic Cooperation
and Development Model Tax Convention and the
double tax treaties signed by Turkey explain the proce-
dures in the case of a disagreement about the imple-
mentation or the execution of tax laws:
Where a person considers that the actions of one or
both of the Contracting States result or will result for
him in taxation not in accordance with the provisions
of this Convention, he may, irrespective of the rem-
edies provided by the domestic law of those States,
present his case to the competent authority of the
1
See 16 Transfer Pricing Report 760, 2/14/08.
2
For prior coverage of the MAP guidelines, see 18 Transfer
Pricing Report 653, 11/5/09.
Metin Duran was KPMG’s global transfer
pricing services partner in Turkey before join-
ing Mazars Denge in April. He is based in
Istanbul.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
Contracting State of which he is a resident or, if his
case comes under paragraph 1 of Article 24, to that
of the Contracting State of which he is a national.
The case must be presented within three years from
the first notification of the action resulting in taxa-
tion not in accordance with the provisions of the
Convention.
As noted above, the OECD Model Tax Convention in-
dicates a three-year period for application, but this
clause can vary depending on the contracting states
with which Turkey has treaties.
Article 25 further states:
The competent authorities of the Contracting States
shall endeavor to resolve by mutual agreement any
difficulties or doubts arising as to the interpretation
or application of the Convention. They may also con-
sult together for the elimination of double taxation in
cases not provided for in the Convention. The com-
petent authorities of the Contracting States may
communicate with each other directly, including
through a joint commission consisting of themselves
or their representatives, for the purpose of reaching
an agreement in the sense of the preceding para-
graphs.
Eligibility for MAP, Application
In Turkey, the competent authority is the European
and International Relations Department of the TRA.
Under the new MAP guidelines, to apply for competent
authority assistance, the taxpayer must be a resident of
one of the contracting states. However, a taxpayer also
may apply to the country in which it is a citizen if ap-
plying for MAP under Article 24, titled ‘‘Non-
Discrimination.’’
If a taxpayer changes its residency from one con-
tracting state to another contracting state, it should ap-
ply to the one in which it resided when the conflict oc-
curred.
The MAP guidelines provide some examples of top-
ics that are appropriate for a competent authority case,
but they stress that cases are not limited to these topics.
According to the guidelines, MAP applications fall
into three categories. First, residents of one contracting
state believe that tax treatment by one or both of the
contracting states is not in line with one or more articles
of the relevant treaty. In other cases, double taxation
problems arise that are not covered by the treaties. Fi-
TMTR ISSN 1063-2069
IN PRACTICE
nally, problems may arise from the implementation or
observations of the treaties by the contracting states.
Beyond misinterpretation and misapplications of tax
treaties, there may be other instances in which issues
under current tax treaties are still awaiting resolution.
Frequently encountered cases include those involving:
s those related to Article 7 (business profits) of the
OECD Model Tax Convention;
s transfer pricing adjustments from differing treaty
interpretations;
s disguised profits via transfer pricing;
s arm’s-length pricing of related-party transactions
under Article 9;
s permanent establishment;
s residency in the contracting states;
s royalty, interest, and dividend taxation; and
s problems due to the characteristics of provided
services.
Resident taxpayers of either contracting states that
are subject to unfair taxation, as well as the contracting
states’ competent authorities, are allowed to apply for
MAP. Citizens regardless of their residency are also
welcome to apply under the nondiscrimination prin-
ciple within the tax treaties.
Timing, Interaction with Courts
A MAP application timetable for each contracting
state is contained in Attachment 1 to the guidelines.
Time limitations generally should be considered ac-
cording to the local legislation, unless otherwise stated
in the tax treaties.
According to the guidelines, taxpayers cannot apply
for MAP if they choose to take a case to the court. If a
taxpayer already has submitted its case to the court, it
must withdraw that submission before applying for
MAP.
The MAP guideline states that if taxpayers are not
satisfied with the TRA treatment of their case, they may
go to court, invoke other domestic complaints proce-
dures, or apply for a MAP. However, if a taxpayer goes
to court and the court reaches a verdict, neither the tax-
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 169
payer nor the tax administration can appeal to any au-
thority, including the Competent Authority, about the
verdict.
According to the Turkish Administrative Procedure
Act, taxpayers can apply to the tax court within 30 days
and to the State Council (Supreme Court) within 60
days. The general statute of limitation in Turkish tax
laws is five years. After five years, tax authorities can-
not claim tax for a particular taxable transaction from
the taxpayer. However, certain things can eliminate this
five-year period—for instance, an application to the tax
office for valuation.
In the case of a rejected application, the Competent
Authority will give a reason for the rejection. Although
there are exceptions, cases generally are concluded
within two years of the initial application. Therefore, a
period of limitation has been made a priority in the
MAP guidelines and included in the guidelines as At-
tachment 2.
Taxpayers that are not satisfied with the result of a
competent authority proceeding can apply to the courts
as well regarding allegations of unfair tax treatment
within the period of limitation under local legislation.
However, as stated previously, the time limitation for
applying to tax court is 30 days, and to the State Coun-
cil is 60 days. Therefore, by the time the competent au-
thority declares its decision, it is almost certain that the
time frame for applying to court will be over.
To achieve solid results and accelerate the MAP, a
third attachment to the guidelines—Information
Form—should be attached to the application letter. Fur-
ther documentation also may be required.
Conclusion
As noted earlier, the transfer pricing regulations ef-
fective beginning in 2007 are expected to increase of
transfer pricing audits and, as a result, MAP applica-
tions. The July 2009 guidelines should give taxpayers a
better understanding of the eligibility requirements for
obtaining a MAP as well as whether and how to seek re-
dress in court at the same time.
BNA TAX 6-3-10
170 (Vol. 19, No. 3)
Analysis
Supporting Transaction Value with Transfer Pricing Data:
Lessons from Recent U.S. Customs and Border Protection Rulings
The authors examine three recent customs rulings that they assert provide a road map
for successfully presenting transfer pricing data to satisfy U.S. customs requirements.
BY BILL METHENITIS & KAREN KING
ERNST & YOUNG LLP
he single biggest challenge for companies in sup-
T porting customs valuation for related-party sales is
demonstrating that the sales price was unaffected
by the relationship, thus allowing the importer to use
the transaction value method of appraisement. The cus-
toms rules and guidance in this area generally have
been elusive, leaving business without a practical road
map to guide them through this challenge.
Recent rulings from the U.S. Customs and Border
Protection (CBP) Office of Regulations and Rulings pro-
vide welcome new direction in this area. The rulings
give significant attention to data found in transfer pric-
ing studies and indicate how to successfully present
such data to satisfy the customs requirements, thus pro-
viding a better road map for business in managing this
complex issue.
Transfer Pricing, Customs Rules
While the objective of both income tax transfer pric-
ing rules and customs related-party valuation rules is
the same—arriving at arm’s-length prices—the rules are
different. As a result, documentation prepared to sup-
port income tax transfer pricing purposes is not gener-
ally, in and of itself, sufficient to support the customs
analysis.
The vast majority of importers declare import values
based on the transaction value method—the price paid
or payable for merchandise. Ease of documentation and
recordkeeping often are primary reasons that a busi-
ness prefers using transaction value.
However, when importers purchase from related
parties, special rules apply in order to use transaction
Bill Methenitis, william.methenitis@ey.com, is
Americas director, customs and international
trade, with Ernst & Young LLP in Dallas.
Karen King, karen.king@ey.com, is a senior
consultant with E&Y’s customs and inter-
national trade practice in New York. The
views expressed herein are those of the
authors and do not necessarily reflect the
views of Ernst & Young LLP.
6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc.
value. Transaction value is an acceptable appraisement
method between related parties if:
s an examination of the circumstances of the sale
indicates that the relationship between the parties did
not influence the price actually paid or payable; or
s the transaction value of the imported merchandise
approximates certain test values.
Test values are not commonly used, and importers usu-
ally attempt to demonstrate the acceptability of transac-
tion value under the ‘‘circumstances of sale’’ test.
Circumstances of Sale
The circumstances of sale test examines the relevant
aspects of a transaction to determine that the relation-
ship between the buyer and seller did not influence the
price. The U.S. Customs regulations give three ex-
amples of how companies can demonstrate that the re-
lationship did not influence the price. Under the first, a
company shows that the price was settled in a manner
consistent with the normal pricing practices of the in-
dustry in question. Under the second example, it shows
that the price was settled in a manner consistent with
the way the seller settles prices for sales to unrelated
buyers, and under the third, the price is shown to be ad-
equate to ensure recovery of all costs plus a profit that
is equivalent to the firm’s overall profit realized over a
representative period of time in sales of merchandise of
the same class or kind.
These examples are non-exclusive. However, be-
cause they are the only examples provided in the U.S.
regulations and the only examples discussed in CBP’s
April 2007 Informed Compliance Publication, Deter-
mining the Acceptability of Transaction Value for Re-
lated Party Transactions, they have tended to be the
frame of reference.1
Unfortunately, none of these examples align directly
with transfer pricing concepts, and importers have had
limited success in their attempts to use transfer pricing
data to support one of these examples. Moreover, CBP
made clear in the 2007 Informed Compliance Publica-
tion that ‘‘an importer that relies solely on an APA or
transfer pricing study to conclude that transaction value
1
Customs in the April 2007 guidance said an advance pric-
ing agreement or a transfer pricing study by itself is not
enough to support use of the transaction value method. See 16
Transfer Pricing Report 40, 5/16/07.
TMTR ISSN 1063-2069
ANALYSIS
is acceptable would not be exercising reasonable care.’’
CBP went on to say that some aspects of a transfer pric-
ing study may contain underlying facts relevant to a cir-
cumstances of sale analysis, but offered no guidance in
how to analyze that data.
Recent Rulings
CBP recently issued three rulings in response to In-
ternal Advice Requests (HQ W563467, HQ H029658,
and HQ H037375) that address the support required to
satisfy the circumstances of sale test. In the first ruling,
the importer fails to provide sufficient support, but the
second two importers meet the test.
Auto Sales: Transaction Value Not Allowed
The first ruling, HQ W563467, dated June 22, 2009,
involves sales of automobiles from a foreign manufac-
turing subsidiary of a U.S. auto company to a U.S. im-
porting distributing company. The U.S. importer re-
quested refunds through the U.S. reconciliation pro-
gram related to post-entry transfer pricing adjustments.
CBP port officials objected to the importer’s use of
transaction value, and CBP headquarters determined
the importer failed to demonstrate that it met the cir-
cumstances of sale test.
While CBP acknowledged that the primary activity
was in accord with the importer’s transfer pricing
policy, CBP criticized the importer for not developing
and submitting appropriate supporting documentation,
stating that ‘‘if the importer believes that information in
the transfer pricing study and/or in some other support-
ing documentation is relevant to the application of the
[circumstances of sale] test, the importer should iden-
tify that information, explain why it is relevant, and
submit the relevant documentation to CBP.’’
Auto Sales: Transaction Value Allowed
HQ HO29658, issued Dec. 8, 2009, stands in sharp
contrast. The ruling approves the use of transaction
value on the importation of foreign automobiles and
parts into the United States by a U.S. distributor of the
foreign automaker.2 As would be expected, much of the
discussion of the foreign automaker’s approach to pric-
ing sounds similar to the approach discussed by the
U.S. automaker in HQ W563467. In this case, however,
the importer provided CBP with a significant amount of
information explaining the circumstances of sale from
a variety of perspectives. CBP did not find any factor de-
terminative, but noted these factors as material to its
conclusion:
s The importer provided a third-party report on
pricing practices of the automotive industry, as well as
descriptive evidence of its process for setting prices
consistent with those described in the report.
2
See 18 Transfer Pricing Report 946, 1/14/10; 18 Transfer
Pricing Report 1041, 1/28/10.
TAX MANAGEMENT TRANSFER PRICING REPORT ISSN 1063-2069
(Vol. 19, No. 3) 171
s The importer provided a transfer pricing compa-
rables study, with an explanation of how the accumu-
lated data supported its position.
s The importer provided information on historic
consistency of its profits as the purchaser and reseller
of imported products.
s The importer had entered into a bilateral advance
pricing agreement and provided CBP with access to all
documentation provided to the IRS.
Health Care Products Ruling
Three days later, on Dec. 11, 2009, CBP issued per-
haps its most useful guidance in the form of HQ
HO37375. This ruling involved a variety of imported
health care products entered under transaction value,
and like those of the first ruling, the transactions were
flagged for reconciliation. A transfer pricing study had
been conducted using the resale price method, compar-
ing the profits of the importer to other similarly situated
companies. No APA was in place.
CBP concluded that the importer’s explanation of
why its transfer pricing study should be viewed as meet-
ing the circumstances of sale test was correct. Factors
important to CBP’s determination included:
s The transfer pricing study, which analyzed com-
panies that were in the same industry as the importer,
including some competitors. The consistent gross mar-
gins on resale of imported products among these com-
panies allowed CBP to conclude that the importer’s
pricing was consistent with the market as a whole and
in accordance with normal industry practice.
s Internal comparables provided by the importer in
the form of gross margins earned on products manufac-
tured by unrelated parties. Although the margins were
not consistent, the importer was able to provide an ex-
planation of the extra marketing and distribution costs
undertaken with regard to products produced by re-
lated parties, allowing CBP to reach the conclusion that
the margins as adjusted were comparable.
Conclusion
It is notable that in the latter two rulings CBP found
different types of circumstances material to its conclu-
sion. This is an encouraging sign for importers, who
have often felt a lack of guidance limits their ap-
proaches to establishing transaction value. It is also
clear that CBP expects both an explanation of the sig-
nificance of particular circumstances of sale the im-
porter believes relevant, and objective documentation
supporting the explanation. With a supported explana-
tion, two importers received a positive ruling; without it
the importer failed to meet its burden of proof.
Bridging the gap between transfer pricing and cus-
toms valuation remains one of the most complex areas
of customs law. While these rulings do not provide a de-
finitive link, they do provide clear guidance on paths
that may be effective.
BNA TAX 6-3-10
172 (Vol. 19, No. 3)

Directory
Private Sector Sources dhill@dl.com Ernst & Young LLP
2100 Ross Ave., Suite 1500
Aldo Castoldi Alan Horowitz
Dallas, Texas 75201
Deloitte Touche Tohmatsu Miller & Chevalier
(214) 969-8585
Via Tortona, 25 655 15th Street N.W., Suite 900
william.methenitis@ey.com
20144 Milan, Italy Washington, D.C. 20005-5701
(202) 626-5839 Simone Musa
39 02 8332 4036
ahorowitz@milchev.com Baker & McKenzie
acastoldi@deloitte.it
Av. Dr. Chucri Zaidan No., 920, 13
Eli Dicker Clive Jie-A-Joen andar
Chief Tax Counsel Baker & McKenzie São Paulo, 04583-904
Tax Executives Institute Inc. Claude Debussylaan 54 Brazil
1200 G St. N.W., Suite 300 P.O. Box 2720 55 11 3048 6814
Washington, D.C. 20005 1000 CS Amsterdam simone.musa@bakermckenzie.com
(202) 638-5601 The Netherlands
Vispi T. Patel
edicker@tei.org 31 20 551 7555
Vispi T. Patel & Associates
Clive.Jie-A-Joen@bakernet.com
#10, 3rd Floor Dwarka Ashish
Metin Duran Karen King Apartment
Mazars Denge YMM AS Ernst & Young LLP Jambul Wadi, Opp. Edward Cinema
Hürriyet Mah. 5 Times Square Kalbadevi Road, Marine Lines
Dr. Cemil Beng Cad. New York, N.Y. 10036 Mumbai, India 400 002
Hak Is Merkezi No: 2 K.1-2 (212) 773-8582 91 22 22 08 4605
34403 Çaglayan / Istanbul karen.king@ey.com vispitpatel@vispitpatel.com
Turkey
(90 212) 296 51 00 Ext. 113 Al Meghji Steven Tseng
mduran@mazarsdenge.com.tr Joseph M. Steiner KPMG Advisory (China) Limited
Martha MacDonald 50th Floor, Plaza 66
Luciana Galhardo Neil Paris 1266 Nanjing West Road
Pinheiro Neto Advogados Osler, Hoskin& Harcourt LLP Shanghai 200040
Rua Hungria No. 1.100, 3 andar Barristers and Solicitors China
São Paulo, 01455-000 1 First Canadian Place, Box 50 86 21 2212 2888 ext. 3408
Brazil Toronto, Ontario steven.tseng@kpmg.com.cn
55 11 3247 8617 M5X 1B8 Canada
lrgalhardo@pn.com.br
Government Sources
(416) 862-5677
Naomi Goldstein
Steven Hannes Gil Mendes Myra J. Yuzak
McDermott, Will & Emery Ernst & Young Assessoria Justine Malone
1850 K St. N.W. Empresarial Ltda William Softley
Washington, D.C. 20006 Av. Presidente Juscelino Kubitschek, Department of Justice
(202) 756-8218 1830 Ontario Regional Office
shannes@mwe.com Torre II 7 andar The Exchange Tower
São Paulo, 04345-900 130 King St. West
Lawrence Hill
Brazil Suite 3400, Box 36
Dewey & LeBoeuf
55 11 2573-3466 Toronto, Ontario
1301 Avenue of the Americas
gil.f.mendes@br.ey.com M5X 1K6 Canada
New York, N.Y. 10019-6092
(212) 259-8330 William Methenitis (416) 973-2334

6-3-10 Copyright 姝 2010 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TMTR ISSN 1063-2069