CxC Reporting, Local File and Master File Documentation Practical Implications November 6, 2015

IRS Circular 230 Notice: To ensure compliance with the requirements imposed by the IRS, we inform you that any U.S. Federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Contents Introduction of CxC Reporting, Local File and Master File Documentation Case Study Example How it Affects You What Can You Do Benefits of a Proactive Approach

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Introduction • Master file – High-level global information regarding a multinational enterprise’s (“MNE’s”) global business operations and transfer pricing policies that would be available to all relevant country tax administrations

• Local file – More transactional transfer pricing documentation that identifies relevant related party transactions, the amounts involved in those transactions, and the company’s analysis of the transfer pricing determinations they have made with regard to those transactions

• Country-by-country reporting – Annual report annually showing for each tax jurisdiction in which the MNE does business: the amount of revenue, profit before income tax, income tax paid and accrued, total employment, capital, retained earnings, and tangible assets

– Also requires MNEs to identify each entity within the group doing business in a particular tax jurisdiction and to provide an indication of the business activities each entity engages in

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Introduction • Purpose – “Taken together, these three documents (country-by-country report, master file and local file) will require taxpayers to articulate consistent transfer pricing positions, will provide tax administrations with useful information to assess transfer pricing risks, make determinations about where audit resources can most effectively be deployed, and, in the event audits are called for, provide information to commence and target audit enquiries”

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Case Study Example – Background • Facts – Irish Principal Company • Serves as the key entrepreneurial risk-taking entity • Owns and is responsible for developing IP through a contract R&D arrangement with an affiliated company in the UK • Procures raw materials and owns work-in-process inventory during manufacturing • Sells finished goods to a related party distributor in Germany for resale to third parties

– UK Manufacturer • Serves as toll manufacturer for Irish principal • Drop ships finished goods to German distributor • Compensated by Irish principal for its own-incurred costs plus 10%

– UK Research Company • Conducts R&D on behalf of Irish principal • Compensated by Irish principal at cost plus 10%

– German Distributor • Purchases finished goods from Irish principal • Transfer price set to provide German distributor with a 5% operating margin

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Case Study Example – Background • Controlled transaction flows

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Case Study Example – Background • Financial results

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Case Study Example – Existing World • Transfer pricing documentation all prepared locally – Only one side of the transaction is disclosed and tested – UK prepares transfer pricing documentation • Tests the toll manufacturing arrangement with Irish principal using the TNMM and benchmarking the mark-up of 10% • Tests the contract R&D arrangement with the Irish principal using the TNMM and benchmarking the mark-up of 10%

– Germany prepares transfer pricing documentation • Tests the distribution arrangement with the Irish principal using the TNMM and benchmarking the operating margin of 5%

– The profitability of the Irish principal is never required to be disclosed

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Case Study Example – BEPS World • Table 1

Figures in Thousands of Euros (Other than Employees) Revenues Tax Jurisdiction Ireland United Kingdom Germany

Unrelated Party 1,000,000

Related Party 850,000 253,000 -

Profit Income Tax Income Tax (Loss) Paid Accrued Before (on cash Current Income Tax basis) Year Total 850,000 217,000 27,125 27,125 253,000 23,000 4,830 4,830 1,000,000 50,000 15,000 15,000

Tangible Accumulated Number of Assets Earnings Employees Other than Cash 10,000 1,000,000 50 5,000 20,000 50,000 500 500,000 10,000 100,000 200 10,000

Stated Capital

Germany

Principal Company Manufacturer Research Company Distributor

X X

X

Other

Dormant

Holding shares or other equity instruments

Insurance

Regulated Financial Services

Internal Group Finance

Provision of Services to unrelated parties

X

Administrative, Management or Support Services

X

Sales, Marketing or Distribution

X

Manufacturing or Production

Purchasing or Procurement

Ireland United Kingdom

Holding or Managing Intellectual Property

Tax Jurisdiction

Constituent Entities resident in the Tax Jurisdiction

Research and Development

• Table 2

X

X X

X 8

Case Study Example – BEPS World • CxC reporting highlights a potential issue with the transfer pricing – Irish principal earns roughly 75% of the “system” profit, with less than 1% of the total employees and less than 1% of the total tangible assets

– Taxes paid in Ireland are roughly 58% of total taxes paid

• Transfer pricing documentation prepared centrally or locally – Master file requires the disclosure of all group transfer pricing policies – UK local file documentation • Tests the toll manufacturing arrangement with Irish principal using the TNMM and benchmarking the mark-up of 10% • Tests the contract R&D arrangement with the Irish principal using the TNMM and benchmarking the mark-up of 10%

– Germany local file documentation • Tests the distribution arrangement with the Irish principal using the TNMM and benchmarking the operating margin of 5%

– Although it may not be specifically tested, all documentation will need to address the appropriateness of the transfer pricing policies as a whole, as well as the profitability of all parties within the supply chain

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How It Affects You • Increased transparency – Now have to assume that tax authorities on all sides of your intercompany transactions will have full access to all material relevant information

– Although still able to test one-side of the transaction, will have to demonstrate that overall transfer pricing is appropriate, and not just “arm’s length” within the selected transfer pricing method

– The functions performed, assets owned, and risks borne by all parties to the intercompany transactions will need to be evaluated and explained

• Need for consistency – Companies will have to be consistent in the treatment of transactions in documentation for each jurisdiction

– Consistency between the economic substance and legal form of the functions, assets, and risks will be paramount

• Decreased reliance on CPM/TNMM

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How It Affects You • Decreased reliance on CPM/TNMM – CPM/TNMM are “one-sided” transfer pricing methods that do not tell the whole story of an intercompany transaction • A distributor that earns a 3% operating margin in a system with a total operating margin of 15% is much different than a distributor earning a 3% operating margin in a 6% operating margin system

– While a CPM/TNMM may still be the best or most appropriate method, taxpayers will need to justify results within the context of the entire supply chain

– Profit splits as a means for evaluating the arm’s length nature of transactions will likely become more prevalent

– More emphasis on commercial transactions, e.g. CUPs and CUTs, will assist in demonstrating that transfer pricing is appropriate

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What Can You Do • Align allocation of functions, assets, and risks with profits – Particularly in supply chains with principal companies, taxpayers must show that profit is aligned with the value created by each of the entities

– Given the nature of the CxC reporting template, allocations of functions (at least as measured by employees) and assets will be the easiest for the tax authorities to identify

– Justifying, and quantifying, profits associated with risks will be the biggest challenge for taxpayers

• Ensure legal agreements match economic substance • Leverage technology to improve data gathering/retention – CxC reporting is a data gathering challenge, so develop templates/models/processes to assist in collecting and organizing relevant information

– Full participation from the business is key

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What Can You Do • Proactively manage transfer pricing – Taxpayers may want to consider changing pricing in advance so that profits and functions, assets, and risks are more aligned

– Making transfer pricing adjustments once or twice a year may be a red-flag to authorities that the actual pricing is not in line with the commercial realities of the business

– Utilize technology to manage the day-to-day pricing to avoid large periodic adjustments (e.g. operational transfer pricing)

• Centralize documentation process – Given the need for consistency, and transparency, in all aspects of documentation, it may be a best practice to centralize the preparation of the master file and local file documentation

– Taxpayers need to ensure a consistent message across all jurisdictions – Although some countries may have certain local documentation requirements, it is a myth that local file documentation needs to be prepared by a local advisor in order to be accepted by the tax authority or to survive an audit

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Benefits of a Proactive Approach • Reduce transfer pricing risk – The introduction of BEPS has greatly increased the level of transfer pricing risk across all jurisdictions

– Preparing thorough, consistent master file and local file documentation will help to identify areas of transfer pricing risk and provide a means for addressing or supporting these areas of risk

– Proactively managing intercompany pricing will also help to avoid risk by changing pricing in advance, rather than after-the-fact

• Effectively respond to inquiries from tax authorities • Having an organized approach to pricing/data gathering/documentation may help to identify potential areas of improvement to transfer pricing policies that could improve tax efficiency

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