Did you also get forwarded the WhatsApp message with an explanation on the new verb “brexiting” (pronounced: /brekziting/)? It supposedly means as much as “telling everyone at the party that you are leaving but actually staying.” The example of verb-use provided in the same WhatsApp message is: “Theresa is at the party, brexiting near the fridge for over an hour now.” And indeed, earlier this calendar year, it appeared that Britain was scheduled to exit the European Union on March 29, 2019, but that deadline did not materialize. Next, Oct. 31, 2019, appeared to be the date, which now is less likely. Nevertheless, the cliffhanger story continues, and the next deadline appears to be anywhere between now and Jan. 31, 2020, the date of the latest extension granted by the EU, but may very well be extended again.
Whatever the actual departure date may be at this point, (leaked) Government documents reveal that shortage in products and border delays are expected, and that the cost of imported goods and services is likely to go up because of import duties and a negatively impacted domestic currency. A “no deal” Brexit is the worst-case scenario. That begs the question, for those companies who held off making (hard) Brexit plans, are there still—at this late time—steps that can be considered to protect against unfavorable tax consequences? To add insult to injury, the world economy is heading for a recession, if many of the economic forecasts are right. What will the impact be of this “perfect storm” for multinational enterprises? First, we advise companies and management to carefully consider and document the business rationale for any Brexit-related costs (to be) incurred. Similarly, if any of the U.K. company’s tax filings involve any EU-related filing systems (e.g., systems based on or required by EU laws), such systems ought to be used before the finally decided Brexit date or close of business of the finally agreed Brexit date, at the latest. Since as of that date, in case of a hard Brexit, those systems may no longer be operational for the U.K.
Transfer Pricing Considerations
Because of Brexit, many multinational enterprise (MNE) groups have already been (or are) evaluating their supply chain / value chain structures in Europe, and are considering transferring functions, risks, or assets from a U.K. group entity to an EU group entity. There is no perfect definition of what constitutes a business restructuring, but if and to the extent that there is a (cross-border) reorganization of the commercial or financial relations between associated enterprises, including termination or substantial reorganization of existing arrangements, that, for transfer pricing purposes will be considered a business restructuring. (Paragraph 9.1. 2017 OECD Transfer Pricing Guidelines.)
The OECD Transfer Pricing Guidelines acknowledge that business restructurings may be needed to preserve profitability or limit losses, e.g., in the event of an over-capacity situation or in a downturn economy. (Paragraph 9.4. 2017 OECD Transfer Pricing Guidelines.) As business restructurings are typically accompanied by a reallocation of profit potential among the members of the multinational enterprise group, the OECD Transfer Pricing Guidelines require consideration of whether such reallocations of profit potential are consistent with the arm’s-length principle.
Considering the following aspects related to business restructurings might be useful:
- Is there a transfer of profit potential between associated enterprises that will require a compensation payment to the restructured (U.K.) group entity for the transfer of functions, risks, or assets, if any, to another non-U.K. entity? If so, it needs to be determined what an arm’s-length compensation would be for the transferred functions, risks, or assets. The determination of whether there is a transfer of profit potential due to the business restructuring and whether that profit potential is priced at arm’s-length will hinge on whether “something of value” was transferred because of the business restructuring, and whether the termination or substantial renegotiation of existing arrangements would be compensated between independent enterprises in comparable circumstances. Transfer pricing rules require an analysis of the options realistically available to the respective parties, absent the restructuring. While Brexit may be a strong argument to maintain that historic profits may not be an accurate indicator of future profit potential, the arm’s-length nature of the transfer needs to be determined also considering the perspective of the transferee. This requirement of a two-sided analysis means that even if the transferor would have sound commercial reasons to restructure and transfer business abroad, the arm’s-length price for the transferred assets or business may be higher than if it were considered only on a one-sided (transferor) basis.
- If there is a transfer, the post business restructuring intra-group transactions between the U.K. entity and its non-U.K. associated enterprises must be conducted at arm’s-length. It is not at all unlikely that Her Majesty’s Revenue and Customs will closely audit the 2020 tax year, concerned about collecting U.K. tax revenue. To minimize audit exposure, multinational enterprises can benefit from a carefully designed, implemented, and documented transfer pricing policy. In this respect, it should be noted that post-Brexit tax disputes and resulting double taxation might no longer qualify for resolution under the multilateral European Arbitration Convention or the new European Arbitration Directive if the U.K. group entity no longer qualifies as a party to the multilateral European Arbitration Convention and no longer qualifies as a resident of an EU Member State.
- It should be noted that the transfer pricing documentation rules that apply under the OECD’s Transfer Pricing Masterfile format (already) require that taxpayers describe any important business restructuring transactions occurring during the year. Similarly, in the Local Documentation file, taxpayers are asked to indicate whether the legal entity has been involved in or affected by business restructurings occurring during the year or immediately past year and to explain the aspects of such transactions affecting the local entity. This information will be material in assessing whether the business restructuring will be considered as conducted at arm’s-length, as will be including text on (expected) Brexit consequences in transfer pricing documentation relating to 2019. If during later tax audits, the transfer pricing documentation presents a rosy business picture, but the reality is (very) different, that may raise unnecessary questions or at least affect the credibility of your transfer pricing documentation.
- At arm’s-length, it is important to check the termination clause of current agreements, to see what the term for termination is.
- It will be relevant to check the change of circumstances clause that allows for a renegotiation of terms. It cannot be automatically assumed that costs resulting from Brexit can be shared with or passed on to associated enterprises.
- Intercompany agreements are likely to need revision going forward, due to revised functions and responsibilities post-Brexit for associated enterprises.
- Unexpected costs may hide in intercompany agreements, including the currency in which transactions are priced. Not only are costs of transactions with EU mainland countries likely to go up, but that effect may be augmented if the pound falls against the euro. Inventory valuation will be affected, and the impact thereof needs to be carefully considered if the U.K. operations are conducted through a permanent establishment. This might impact the amount for which avoidance of double taxation can be claimed, and whether any currency losses can be claimed at parent level as well.
- If the U.K. entity has contractual responsibilities versus customers/clients that it cannot fulfill because of shortages or increased costs to import products, in issue is what resulting liabilities can be for the U.K.-based entity and to what extent these liabilities can be managed and minimized (and by whom). Unexpected warehousing costs, cost of delays, and produce losses will need to be allocated to an entity within the group, and the question will be who gets allocated those costs and losses at arm’s-length. The decision-making process for Brexit actions and costs within the MNE group to which the company belongs are relevant in this respect as well. Considering this up front and documenting this will help set guidelines for handling and allocating those costs.
- Undoubtedly, planning for Brexit will include services from outside advisors and due diligence efforts. Allocation of these costs may present its own set of challenges. Material in this respect is generally for whose benefit the consulting costs are incurred.
- If Brexit costs are financed by a group company, even if just for an interim period to relieve cash flow pressures, the arm’s-length remuneration for such financing facility will need to be considered.
- If U.K. companies consider that they will restructure and transfer functions, assets, and risks to a newly incorporated entities on the EU mainland, it must be considered that costs generally cannot be allocated to non-existent entities. Therefore, it will be material to identify the new legal entity and clearly consider what costs are to be allocated to that entity and make sure steps are taken to incorporate that entity so that it can be identified, and costs can properly be allocated for tax and accounting purposes. In this respect, making sure that invoices are addressed to the proper legal entity is also highly recommended.
In preparation for a Brexit, it is recommended that a list be prepared of what assets, functions, and risks will be transferred between the associated enterprises (also explicitly considering intangibles) and the decision process followed within the company and group will be considered. This may help support that the business restructuring takes place at arm’s-length. In our experience, tax authorities are not only keen to determine if an arm’s-length transfer price is applied to a business restructuring between associated enterprises, but also whether the intercompany transactions post the restructuring are conducted at arm’s-length and whether the transferor is reporting an arm’s-length margin with respect to its (remaining) post restructuring activities. We have seen (and assisted with) several lengthy audits where post restructuring facts were closely reviewed and compared with those before the restructuring to assess the arm’s-length nature of either of those transactions prior to or post restructuring. We recommend reducing this exposure by considering the above aspects up front. Unless your company is just brexiting, of course.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Clive Jie-A-Joen and Monique van Herksen work in the Financial Markets practice group of Simmons & Simmons LLP and focus their practice on transfer pricing. Any errors or admissions are those of the authors, and this article is written in their personal capacity. They can be reached at email@example.com, Clive.Jie-A-Joen@simmons-simmons.com