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Transfer Pricing Non-matching tax adjustments

European Commission Code of Conduct While, at the time of writing, Ireland does not have comprehensive regulations or proposals for transfer pricing, the potential impact of such laws in other EU Member States is of interest. According to a Commission spokesperson at a meeting of FEE last September, a code of conduct proposed in April 2004 to deal with certain transfer pricing issues will probably be adopted in November 2005.

Back in October 2001, the Commission proposed a strategy for removing tax obstacles that inhibit full internal market benefits where companies do business across borders. A growing problem is the double taxation that can arise where an EU Member State increases the taxable profits of a company from its cross-border intra-group transactions but where there are no matching reductions of taxable profits in the Member State(s) of associated enterprise(s).

Tax administrations will frequently adjust intra-group transfer prices to bring them into line with those they consider as appropriate between unrelated enterprises. At the same time enterprises complain of the complexities and costs of compliance with OECD guidelines and the differing interpretation in EU Member States, as well as onerous transfer pricing documentation required by some tax administrations.

The Arbitration Convention and the mutual agreement procedures in Member States' double tax conventions are designed to resolve disputes where double taxation occurs but Member States differ in their practical application of these measures. Furthermore, the Convention has not been in force since 2000 because not all Member States have ratified a Protocol to prolong its application.

At present, therefore, companies must rely on the dispute settlement provisions in double taxation conventions that, unlike the Convention, do not impose a binding obligation to eliminate double taxation. There was therefore a perceived need to rectify the position.

Proposed code of conduct In April 2004, the European Commission presented a proposal for a Code of Conduct to eliminate double taxation arising from intra-group transactions. The proposal would apply in cases where an EU Member State's tax administration increased the taxable profits of a company from its cross-border intra-group transactions, for example by making a transfer pricing adjustment.

The draft Code of Conduct that the Commission is now proposing to the Council for adoption aims to establish common procedures concerning: 4 adoption of a starting point for a the three-year period where a company suffering double taxation as a result of a transfer pricing adjustment must present its case to a competent authority 4 the starting point of the two-year period during which Member States' tax administrations must attempt to reach mutual agreement on how to eliminate the double taxation that is the subject of the complaint 4 the arrangements to be followed during this mutual agreement procedure (the practical operation of the procedure, transparency and taxpayer participation) 4 the practical arrangements for the second phase of the arbitration procedure that must follow if there is no mutual agreement between the tax authorities within two years, and 4 the suspension of tax collection during cross-border dispute resolution procedures.

The Code would also recommend that Member States apply these rules to the dispute settlement provisions in their double taxation treaties with each other. It appears that the Arbitration Convention is not in force at present because not all Member States have ratified its extension yet. The draft Code of Conduct would be a political commitment and would not affect the Member States' rights and obligations or the respective spheres of competence of the Member States and the Community.

The Commission proposals were prompted by reports from the EU Joint Transfer Pricing Forum that the Commission established in July 2002 to consider these problems. The Forum consists of one tax expert from each Member State's tax administration and 10 high-level experts from the business community together with a Chairman. The Forum will present a further report on its work in early 2005.

Other applications of the Code The Commission has pointed out that the business representatives in the EU Joint Transfer Pricing Forum and the majority of representatives of Member States, as well as the Commission, have taken the view that the application of the Arbitration Convention and the proposed Code of Conduct should not be limited to transfer pricing cases.

The view is that it should also cover other cases of double taxation including, for example, problems arising from a Member State's application of its domestic thin capitalisation rules leading to the disallowance of interest deductions.

However, the Commission has noted that the question of whether these situations should also be covered within the Code is subject to discussion at the OECD in the context of the provisions on dispute settlement in double taxation treaties.

It is also worth noting that disallowing interest may have implications in the context of freedom of establishment and free movement of capital. Practitioners will be aware that certain interest paid by Irish companies within the EU but treated by default as distributions under Irish law may continue to be allowed, on election, as a trading expense in the case of IFSC and Shannon companies, banks and other trading companies

Transfer pricing documentation The Commission is also finalising a recommendation on EU documentation requirements which will be ready by the end of 2005. This Recommendation was discussed in September 2004 within the Transfer Pricing Forum. One of the key concepts of the document will be the master file on which some Member States have still to agree.

Given the eventual introduction of comprehensive regulation in Ireland, this recommendation will have relevance here also.

The Joint Transfer Pricing Price Forum will continue to work on related issues for at least another two years according to comments made by a Commission official at a meeting of FEE in December 2004.

TAKE OVER OF LOSSES Take over of losses is still on the agenda of the European Commission. Further developments of EC thinking is however likely to be delayed until the decision in the Marks & Spencer case is given.

There will be either a Proposal Directive or a Recommendation, not necessarily linked to the Common Consolidated Tax Base concept [see below].

The ECJ Maninen case provides some indications that the Marks & Spencer case may be decided against the UK. Readers will be aware of concerns in the UK business community that aspects of UK tax law are vulnerable to ECJ challenge and that this may prompt the UK government to adopt defensive tax measures including restricting possibly the ability of subsidiaries to surrender losses within a group.

The trouble is that many of the UK vulnerabilities are reflected also in Irish tax law so that we may have similar concerns.

Common Consolidated Tax Base However, as the Commission concluded already in 2001 and confirmed in 2003, in order to take full advantage of the Internal Market, companies need to have the possibility of using a common consolidated corporate tax base for their economic activities in the EU. Without such a tax base their rivals from the USA and also Japan will retain a distinct competitive advantage. The European business community is broadly supportive of this approach (seeing it as useful in dealing with take over of losses as well as transfer pricing) and its leaders are consistently calling on EU Finance Ministers to take action. Many Member States have initially been very cautious, if not hostile in some cases, a caution that may derive from concerns that this is part of a long term tax harmonisation strategy. That said, recently a number of Member States have expressed their strong support for the objective of a common corporate tax base.

MERGER DIRECTIVE There is a pending proposal for modification of the Merger Directive. It was a priority for the Dutch Presidency who planned to have it adopted by end of 2005. There are many sensitive issues but there is no single item which has been totally rejected by the Member States.

SAVINGS DIRECTIVE The Directive has been approved but there is still resistance from some new Member States.

OTHER ISSUES Following discussions with Member States, the European Commission will come up with a proposal on the Recast of the Capital Duty Directive. The Commission will be reviewing possible consequences to be drawn from the case of Lastérie du Saillant on exit taxation. Briefly, the decision suggests that such taxation may be in conflict with the principal of free movement of capital. It calls into question the validity of measure such as Ireland's Section 627 TCA 1997. The Interest and Royalties Directive seems to be on hold pending new amending proposals. In relation to the EU model tax treaty, the European Commission is finalising working documents for discussion with Member States. As it will need to take on board the current approaches of the ECJ, this is unlikely to be of immediate impact. Some decisions will possibly be taken in the first half of 2005.