Background

In the context of international corporate taxation, countries determine their  method to tax on two factors: the residence of the taxpayer and the  source of the income to be taxed. The U.S. government taxes U.S.  corporations largely on a residence basis, meaning that the worldwide  income (both domestic and foreign) of corporations that are incorporated  (have residence) in the United States is taxed by the United States.  Alternatively, most other countries, including most OECD member  countries, use a largely source-based or territorial approach that exempts  certain foreign-earned income of their domestic corporations from  taxation. In this latter case, they assert jurisdiction to tax income that is  sourced within the taxing country and not the income earned abroad.  Regardless of the tax system, some counties—often called tax havens— assess little or no corporate income tax.
The U.S worldwide approach is sometimes called a hybrid system  because it has some features that resemble the territorial approach such  as deferring tax on some foreign income earned by foreign corporate  subsidiaries until that income is remitted or “repatriated” to the U.S.  parent company (often in the form of a dividend payment). Both the  worldwide and territorial systems provide incentives for corporations to  shift income to low tax jurisdictions: under the worldwide system, the  incentive is to take advantage of the deferral of taxation until income is  repatriated, while, under the territorial system, the incentive is to take  advantage of permanent exemption.
To avoid double taxation, countries, like the United States, that tax on a  worldwide basis provide a credit against domestic corporate tax liability  for foreign taxes paid. In addition, countries maintain tax treaties with  each other that cover a wide range of tax issues but have two primary  purposes: (1) avoiding double taxation—when two or more countries levy  taxes on the same income—and (2) enforcing the domestic tax laws of  treaty partners. Treaties can prevent double taxation, which can occur, for  example, when more than one country, under its domestic laws,  considers a taxpayer to be a resident. In these cases, double taxation is  often avoided through tax treaties that outline which country has  jurisdiction to tax under specific circumstances.
Large U.S. MNEs are often made up of groups of separate legal entities  that have complicated ownership relationships. A parent corporation may  directly own (either wholly or partially) multiple subsidiary corporations,  which in turn may own subsidiaries themselves. Large MNEs have an  incentive to shift profits among entities to reduce overall taxes by  exploiting differences in countries’ laws and regulations defining taxable  income, tax rates, and when tax is owed.
Transfer pricing is the area of international tax law that involves setting  prices for tax purposes for transferring property, both real and intangible,  between foreign related parties such as from a parent MNE to a  subsidiary. MNEs can use transfer pricing to artificially shift profits from  one jurisdiction to another to reduce taxation. When an MNE transfers a  product from one party, such as the parent corporation, to another, such  as a foreign subsidiary, it has to determine the price of that product— effectively “selling” products within the same MNE. To lower their taxes,  MNEs can shift profits by underpricing products or assets transferred from  an entity located in a high-tax jurisdiction to a related party located in a  lower-tax jurisdiction, thus increasing the profits reported by entities  located in low-tax countries.
The international standard for determining transfer prices is the “arm’s  length” principle. A transaction between related parties meets the arm’s  length standard if the results of the transaction are consistent with the  result that would have been realized if unaffiliated taxpayers executed a  comparable transaction under comparable circumstances. That is, the  transfer price should correspond to the price that unrelated parties would  agree upon in an open market. While there is no single approach to  determining a transfer price, in theory, the arm’s length principle provides  an objective measure of the value of goods by relying on market forces to  determine the price.
To illustrate, table 1 shows the example of a hypothetical chocolate  company we call “Chockolet” that sells the right to use its trademarked  name to its distributing subsidiary at an arm’s length price and at a price  below market value—that is, below the arm’s length price. As the table  shows, the MNE group is able to reduce its overall effective tax rate by  shifting profits (through the lower price) to the distributing subsidiary  located in a lower-tax jurisdiction.
In this example, the Chockolet parent corporation spends $100  developing its trademark, which is an intangible asset that allows  Chockolet to charge $160 for a license to distribute its product (a markup  of 60 percent over its development costs). This is the “arm’s length  price”—the price at which it would be willing to license the use of the  trademark to an unrelated distributing company. The Chockolet subsidiary  has distribution costs of $30 on which it earns a normal return of $1.5 (a  markup of 5 percent over its distribution costs). The sales price of the  product is $191.50, which covers (1) the costs of development and  distribution, (2) the 60 percent return on the trademark intangible asset  and (3) the 5 percent normal return on the distributer’s costs. In the arm’s  length pricing case in table 1, the Chockolet parent has a net profit of  $60—the revenues of $160 from charging the arm’s length license fee to  its subsidiary less its development cost of $100.The distributer has a net  profit of $1.50—the sales price of $191.50 less the license fee of $160  and its distribution cost of $30. Each corporation pays the local country  tax rate on its net profits which together add up a total tax liability for the  MNE group of $18.2 and an average tax rate of 29.6 percent. However,  because these corporations are related, there is an incentive to  underprice the license so that the Chockolet parent could shift profits to  its subsidiary located in the low-tax jurisdiction. As the underpricing  example in table 1 shows, by agreeing on a transfer price of $100 that is  equal to the cost of developing the trademark, the Chockolet parent  reports zero net profits, while the $60 profits accorded to the trademark  gets shifted to the related distributing subsidiary, which is located in the  lower tax jurisdiction. This underpricing of its trademark results in an  average tax rate of 15 percent for the MNE group.
To address this base erosion and profit shifting, OECD issued a plan in  October 2015 with 15 separate action items that would address different  areas of potential weakness in international tax enforcement. Countries  that adopted the BEPS plan agreed that they would implement four  minimum standards: 1) countering harmful tax practices (action 5), 2)  preventing treaty abuse (action 6), 3) increasing transfer pricing  documentation with CbC reporting (action 13), and 4) increasing dispute  resolution effectiveness (action 14). In addition to implementing country- by-country reporting, IRS is implementing procedures and practices to  meet the minimum standards of improving dispute resolution. IRS is also  implementing procedures for meeting the minimum standard of  exchanging rulings pursuant to preventing harmful tax practices.  According to Treasury, no additional steps need to be taken to meet the  other minimum standards. Other countries may require legislation to  implement the agreement.

	Transfer Pricing Guidelines

		Revised Transfer Pricing Guidelines May Reduce BEPS but Other Challenges Remain

OECD revised its guidance on how risk bearing should be accounted for  in transfer price contracts. Transfer price contracts can include  compensation for bearing the economic consequences of an uncertain  event should it occur, such as paying the cost of a product recall. OECD’s  revised guidance emphasizes that the transfer price should reflect actual  economic activities, such as who controls decisions related to risk and  who has the financial capacity to bear risk. Prior OECD guidelines  included risk analysis based on functions performed. However, OECD  was concerned that an emphasis on the terms of the contract for risk  allocation could allow for manipulation and continued base erosion and  profit shifting. This concern stems from the fact that a contract may  specify which of the related parties is responsible for assuming the risk of  a particular event occurring but the specified party may not correspond to  the party that is actually bearing the economic risk. Without examining the  functions of each party and the economic substance of the contract, risk  allocation could be used to shift profits between parties to reduce taxes  furthering base erosion.
To illustrate how the specifications of a transfer price contract can be  used to allow BEPS, consider the example of Chockolet the company  described earlier that licenses an intangible asset—the Chockolet  trademark—to its wholly-owned subsidiary. In this case, the contract  specifies that the parent corporation receives royalty payments and that  the subsidiary bears the risk (i.e., would bear the cost) of a product recall,  were one to occur. Under this contract, the royalty payment the subsidiary  pays to Chockolet would be less than it would be if the parent was  specified in the contract as bearing the risk. In other words, by agreeing  to bear the risk of a recall, the subsidiary can pay a lower royalty for the  license. However, if the parent is actually making major decisions that  mitigate recall risk, then it is apparent that the specifications of the  contract do not represent the economic reality. In such a case, although  the contract specified that the subsidiary assume risk, in reality the parent  corporation would bear the cost of managing recall risk. Contractually  assigning risk without economic substance is one way a parent could shift  profits to lower-tax jurisdictions: the parent receives less revenue in the  form of lower royalty payments and the subsidiary has lower costs due to  the smaller royalty payments. Therefore, risk can be used as part of a  contract for the transfer price of an intangible asset to shift profits from  one party in a high-tax jurisdiction to a related party in a lower-tax  jurisdiction, resulting is base erosion.
According to OECD and other subject matter specialists, the revised  guidelines are likely to be an improvement over prior guidelines in  reducing BEPS if it encourages MNEs and tax authorities to ensure that  transfer prices are set based on real economic activity. The guidelines  underscore the focus on supporting contractual agreements with  economic activity. In particular, the revised guidelines focus on the  ability of the parties to control risk by making decisions about risk taking  functions and on their financial capacity to bear risk. In the example  above, focusing on the actual functions of both parties would reveal that  the parent continued to manage recall risk, not the subsidiary as specified  by the contract. Exhibiting control and the financial capacity to absorb risk  would be stronger indicators of who bears the risk than the terms of the  contract alone. The scope for profit shifting is likely to be lower under an  enforcement regime that considers the true allocation of economic activity  rather than just the terms of contractual agreements. According to OECD,  the revisions are intended to address the concern that taxpayers have  sought to transfer risk, and the potential for profits associated with an  allocation of risk, through contractual allocation alone, without  accompanying economic substance. By increasing the emphasis on the  actual conduct of the parties, the revised guidance could increase the  ability of tax authorities and MNEs to better align the taxation of income  with the creation of value.
However, challenges remain for tax authorities and MNEs in applying the  arm’s length principle because the guidance does not account for all the  ways that entities can bear risk. For example, even if a parent  corporation’s transfer prices align with economic activity, it cannot fully  transfer risk to its subsidiary because any costs incurred by the subsidiary  will be reflected in a change in the market value of the parent corporation.  In general, related corporations do not have the same ability to transfer  risk as unrelated corporations. This is the case even when the ability to  control and the capacity to absorb risk has been isolated in one of the  related parties to the transaction. The parent that transfers an intangible  asset to its subsidiary has an equity interest in the subsidiary that ensures  that it will gain or lose from any future anticipated or unanticipated profits  and losses in a way that an unrelated corporation does not.
The Chockolet Company described above illustrates the limitations on the  ability of related parties to transfer risk. Chockolet’s subsidiary, acting as  its distributor in another country, is assigned all risk of product recall in  that country by contract. Following the new guidelines, the contract  stipulates that the subsidiary has the authority to manage any recalls and  the financial ability to absorb the cost of a recall should it occur. To  show that Chockolet’s limitations on its ability to shift risk to the  subsidiary, we examine below the consequences of a recall for the value  of the parent corporation Chockolet under the two possible financial  situations of its subsidiary.
The subsidiary has sufficient profits to absorb the cost. If the  recall occurs, Chockolet incurs the risk of a reduction or cessation of  the royalty payments and damage to the value of its brand. However,  because the subsidiary is owned by the parent MNE, Chockolet has  additional risks because, as a shareholder, its assets decline as the  subsidiary’s profits decline with the recall cost. Ultimately, the MNE as  a primary, if not sole, shareholder will bear a loss in profits.
The subsidiary does not have sufficient profits to absorb the  costs. In this case, the subsidiary would require equity from the  parent MNE or would have to borrow to pay for recall costs. If it  receives equity from the parent to pay for the recall, then the MNE is  directly affected with the loss in equity. If the subsidiary borrows from  an unrelated party then that debt affects the amount of leverage the  MNE group has and could restrict the ability of the parent to borrow  for its operations. Thus, the parent still bears costs and risks of a  recall that it does not bear when dealing with unrelated parties.
Unrelated corporations on the other hand, have greater ability to transfer  risk because the lack of an ownership relationship limits the potential  impact of a recall on the asset value of the corporation. If Chockolet  contracts with an independent distributer, it still incurs the risk of a  reduction or cessation of the royalty payments and damage to the value  of its brand. However, because the distributer is not owned by the parent  MNE, Chockolet does not have the additional risks as a shareholder  described above.
As this example shows, the use of arm’s length principle (ALP) becomes  problematic when allocating risk between related parties. As we noted  earlier, the arm’s length price is based on treating transactions between  related parties as if they were unrelated. According to OECD and  Treasury, the ALP allows risks to be assumed by one entity or another in  a related party transaction in the same way it can be assumed with  unrelated parties. One entity can be protected (or isolated) from the risk in  a contract that assigns risk bearing to the party that undertakes certain  functions. However, as we show in the example, the application of the  ALP is problematic in this situation because risk cannot be allocated  between parties by the very fact that they are related. In the case of recall  risk, the allocation of risk to a subsidiary based on functions of control and  capacity does not protect the MNE from exposure to the risk of loss in  asset value. Unrelated parties can isolate this risk while related parties  cannot and this difference in the ability to transfer risk makes the  application of the ALP more difficult.
The difference between the way risk is incurred by related and unrelated  parties is illustrated in figure 1. Chockolet, by being a shareholder of the  distributing subsidiary, is affected by the subsidiary’s loss in profits. In the  figure, both the parent and its subsidiary’s net assets decline by the recall  cost of $170 and the total value of the MNE shrinks from $600 to $430 (as  illustrated by the reduction in the relative size of the circles in the figure).  Therefore, the parent is affected, which would not be the case between  unrelated parties who do not own shares of each other’s assets. As the  figure illustrates, the value of Chockolet is $300 when it does not own the  distributor and this value is unaffected by the recall cost, while the value  of the unrelated distributor declines by the $170 recall cost.
OECD guidance may be less effective than it could be in reducing BEPS  because, without considering all the ways that entities can bear risk,  uncertainty about the correct transfer prices remains that could still allow  opportunities for profit shifting and, consequently, base erosion. For  related parties, the focus on functions related to risk may have little or no  relation to how much of the risk is actually borne by the parent company  and its subsidiary. Whatever the terms of a contract or however resources  are allocated between the related parties (as clarified by the revised  guidelines), the parent bears some or all of the costs of the event at risk,  in this case, a product recall.
Identifying who ultimately bears the burden of the risk is similar to  determining the incidence of a tax because both require consideration of  how market changes affect who bears the economic costs. With tax  incidence, the parties that pay the tax may not economically bear the cost  as when, for example, the payroll tax is collected and remitted by a  business to the tax authority, but the employees bear the burden of the  tax in the form of reduced wages. The tax incidence is determined by  market adjustments, in this case, a drop in wages. Similarly, risk  incidence is determined by market adjustments like the change in the  asset value of the MNE in the recall case. The potential market  adjustments that determine risk incidence depend on a number of factors  such as the type of transaction, the degree of the MNE’s integration of  corporate structure and function, and the MNEs market power in the  products it buys or sells. Aligning profits with risk requires determining the  economic incidence of the risk, which may not reflect either the explicit  terms of the contract or the explicit assignment of risk to particular  functions.
IRS considers risk as part of its overall economic analysis when  determining transfer prices during transfer pricing audits. According to  Treasury and IRS officials, the expanded guidance on risk allocations  under OECD guidelines is consistent with, but more detailed than, the  current U.S. transfer pricing regulations under section 482 of the Internal  Revenue Code. Under these regulations, the risk allocation between  related parties should be examined by reviewing the terms of contracts  between the parties and the economic substance of the transaction(s)  between them. The regulations provide guidance on interpreting the  terms of these intercompany contracts and on facts that are relevant to  determining the economic substance of the transaction under the ALP  method that treats related parties as unrelated. Treasury and IRS officials  stated that among the factors relevant to determining whether a purported  risk allocation has economic substance are (1) whether the pattern of the  taxpayer’s conduct over time is consistent with the risk allocation, (2)  whether the taxpayer has the financial capacity to assume the risk, and  (3) the extent to which the parties exercise managerial or operational  control over the business activities that directly influence the amount of  income or loss realized.
Treasury and IRS officials stated that risk allocations are critical to a  proper application of the arm’s length standard. The section 482  regulations require review of many aspects of intercompany transactions  when determining appropriate transfer pricing outcomes, notably the  functions performed, the assets employed, and the risks assumed by the  respective parties.
However, the problems of applying the ALP to risk and to certain other  aspects of the transaction complicate IRS’s task of adequately assessing  transfer prices. While the ALP is widely accepted for evaluating transfer  prices and applicable in many transactions, difficulties may arise in  certain situations, such as what to do about risk and how to allocate  profits among the entities in an integrated MNE. As OECD notes, the  separate entity approach may not always account for economies of scale  and interrelation of diverse activities created by integrated businesses.  According to OECD, there are no widely accepted criteria for allocating  the benefits of integration between associated entities. Our analysis  indicates that risk is another area where the application of the ALP may  be stressed because risk cannot be allocated between associated  entities.
These shortcomings of the ALP can have implications for economic  efficiency and for the equity of transfer pricing administration. For  example, if the issues concerning risk are not addressed, profit  allocations may not be equitable because profits could be unfairly  allocated to parties on the basis of risk bearing that do not actually bear  the burden of risk. As we have said in our prior reports, one criteria of a  good tax system is the equitable treatment of all taxpayers. In addition,  the revised guidance may be less likely to be effective in helping to  reduce BEPS because, without considering risk incidence, an uncertainty  about the correct transfer prices remains that could allow profit shifting.

	The Revised Guidelines Effect on IRS Administrative Costs is Likely Small, But The Effect on Compliance Costs for U.S. MNEs is Uncertain

OECD revisions to the transfer pricing guidelines are currently being  implemented so no data are available to estimate prospective  administrative and compliance costs for IRS and U.S. MNEs. The change  in costs, including whether the revised guidelines result in decreased or  increased costs, depends on a number of factors—as explained below— that make even a qualitative estimate of the effect on cost difficult at this  time.
According to Treasury officials, the revised guidance would not have a  significant effect on U.S. tax administration because current U.S.  regulations already embody both the arm’s length standard and the role  of functions performed, assets employed, and risks assumed in  determining arm’s length prices between related entities. However, the  clarifications to the risk allocation guidance could increase the  administration costs for other countries to the extent those countries were  not already incorporating functional analysis in reviewing transfer pricing  cases.
The compliance costs of U.S. MNEs from the revised risk allocation  guidelines are also uncertain because they depend on what, if any, new  or additional actions are undertaken by MNEs to ensure compliance. For  companies that set transfer prices based, at least in part, on relative risk,  the costs can vary depending on whether the current specified risk  allocation aligns with parties’ capacity to assume and ability to control  risk. The costs can range from relatively small costs, if an MNE only  needs to make changes to existing contract language, or would be  significantly more costs if broader changes in corporate strategies are  necessary. According to subject matter specialists, relying on function  analysis as required by the clarified risk allocation guidance may induce  MNEs to rely even more on complex tax planning techniques to rearrange  what entities control which processes, increasing their costs.

		OECD Transfer Pricing Guidelines May Have a Small Effect on the U.S. Economy

According to subject matter specialists, because the revised guidelines  emphasize the importance of real business functions, such as  employment and investment, they may encourage MNEs to better align  their actual business activities with their reported profits. The net effect on  the U.S. economy depends on whether MNEs adjust actual activities to  support current profit allocations, move reported profits to where their  business activities are occurring, or choose to make no adjustment.  Furthermore, the effect also depends on whether these shifts happen  among foreign countries or between the United States and other  countries.
According to subject matter specialists, because the revised guidance  focuses on the location of decision making as support for allocating risk  and profits, MNEs may be encouraged to decentralize decision making  from the parent company to multiple jurisdictions to ensure that risk could  be attributed to low-tax countries. This could result in some U.S.  employees being relocated to tax-favored jurisdictions and reduced  demand for employment in the United States.
It is extremely difficult to predict how MNEs will respond. As subject  matter specialists have noted in the literature, the complexity of transfer  pricing administration and tax planning of those businesses makes it even  more challenging to predict how they will respond to numerous countries  changing guidelines in potentially different ways. However, given the  limited scope of the revised guidelines relative to the entire tax system, as  discussed below, it is unlikely that these changes would result in  significant changes in U.S. investment or employment.
We found no estimates of the effect of revisions to transfer pricing  guidance on investment, employment, or revenue. However, estimates  have been made of certain types of responses to other tax changes.  According to the studies we reviewed, these measures can help provide a  context for assessing the possible magnitude of any net change to the  U.S. economy. Though evidence on how corporations shift profits in  response to tax rates varies by study, the amount is generally low.  Studies suggest that a 1 percentage point reduction in a country’s tax rate  could lead to an increase in profits reported in that country by up to 5  percent, but the actual amount is likely to be much lower.
The responsiveness of businesses’ allocation of investment to changes in  tax rates is also likely to be low, according to the studies we reviewed.  One study found that a 1 percent reduction in a host country’s tax rates  leads to an increase of total foreign direct investment between 0.3  percent and 1.8 percent. Another study conducted a meta-analysis of  studies on foreign direct investment and found the median measure of  responsiveness to a percentage point reduction in the tax rate resulted in  an increased investment by 2.49 percent.
The profit and investment shifting responses discussed above are to a  major change in a tax system—its tax rate. While it is difficult to predict  how firms will respond to changes in tax administration, the  responsiveness to a change in one aspect of the enforcement of a tax  law—like a clarification of existing guidelines—could be much smaller and  possibly even zero. Additionally, based on our analysis of the economic  literature, the effect on labor is likely to be much smaller than the effect on  investment because labor is considered generally much less able to move  than investment, and thus would be even less likely to shift.
The effect on U.S. tax revenue is also unclear. According to subject  matter specialists, the revised guidelines increase the focus on functional  analysis, which could result in increases in taxes assessed by higher tax  countries like the United States, if more of the real business activities are  concentrated in those countries. However, these costs may be mitigated  to the extent that MNEs respond to OECD changes by re-locating  business activities to lower-tax countries to better align real business  activities with reported profit allocations. However, based on our review of  the international tax policy literature, there may still be an effect on U.S.  tax revenue even if MNEs make no significant adjustments to their  activities. Any increased foreign taxes that could result from an increased  focus on economic function and risk would reduce U.S. revenues in two  ways: (1) by increasing foreign tax credits when the income from that  country is repatriated, and (2) reducing U.S. shareholder’s capital gains  taxes due to reduced MNE profits.

	Transfer Pricing Documentation and Country-by-Country Reporting

		Country-by-Country Reporting Will Improve Transparency For Tax Authorities but May Have Unintended Consequences

One factor contributing to base erosion and profit shifting has been a lack  of consistent information on MNEs’ business activities across tax  jurisdictions. According to OECD, the new transfer pricing documentation  addresses this deficiency and benefits tax authorities by providing  information on MNEs’ business activities that can be used to assess the  risk of profit shifting and improve the deployment of audit resources.  MNEs will be required to report transfer pricing policies under this  approach. OECD states that requiring MNE parent entities to submit a  single country-by-country (CbC) report to their tax jurisdictions, which, in  turn, will share the report through government exchanges, ensures  consistent documentation across countries at the same time limiting  compliance cost for MNEs.
While Treasury officials said their current documentation and reporting  requirements are sufficient for transfer pricing administration, they will be  implementing one tier of the transfer pricing documentation. OECD’s  transfer pricing documentation consists of a three-tiered approach: a CbC  report filed with the tax jurisdiction of the MNE’s parent entity covering  each jurisdiction in which the MNE operates, and a master file and local  file submitted, where required, by the MNE to the tax administration in  each jurisdiction in which it operates. On June 30, 2016, Treasury  issued final regulations for implementing CbC reporting as one of the  BEPS minimum standards. Treasury will not be requiring MNEs to  submit master and local files. While U.S. MNEs are not required to  prepare or file transfer pricing documentation, IRS officials stated that  most provide some documentation voluntarily to IRS that is typically more  detailed and informative than the information found in a CbC Report.  Additionally, they said that the information OECD recommends for  inclusion in the master or local file is generally available to IRS upon  request. Figure 2 illustrates the new transfer pricing documentation  mechanism.
The type of data CbC reporting provides—aggregated information for  each tax jurisdiction in which the MNE operates including revenues,  pretax profits (or losses), income taxes, capital, accumulated earnings,  number of employees, tangible assets, and business activities—will  improve transparency of MNEs’ activities for tax authorities to the extent  that such global information has not previously been reported. As we  reported in 2012, IRS does not have information on how much business a  non-U.S. MNE operating in the United States does in any particular  country, including the United States.
Master and local file documentation could potentially provide tax  authorities substantially more information on global operations. However,  tax jurisdictions are not bound to implement these reports. As outlined  by OECD, the master file would consist of a high-level overview of the  MNE’s global business, such as organizational structure, business  operations, intangibles, and financial and tax positions. The local file  would include more detailed information on the local entity and  intercompany transactions with entities in different tax jurisdictions,  including transfer pricing methods. Local tax jurisdictions would need to  implement these reporting requirements through local legislation and  administrative procedures presenting the jurisdiction the opportunity to  tailor the transfer pricing documentation for their own purposes.
Stakeholders we spoke with raised concerns about unintended  consequences. Stakeholders noted the possibility that tax authorities may  use the CbC reports in ways in which they were not intended. While  OECD explicitly states the CbC Reports should be used for high-level risk  assessment and not for assessing tax or as a substitute for a detailed  transfer pricing analysis, stakeholders worried that the reports could be  misused for these purposes. In particular, the format and data items of  the CbC Reports provide key business factors, such as revenues and  number of employees in each tax jurisdiction an MNE operates. The  availability of such data may facilitate the ability to implement formulary  apportionment, a factor-based tax system that would allocate an MNE’s  global profits based on the share of their business factors, which could  lead to double taxation. Varied stakeholders were concerned that, in  extreme cases, concurrent misuse by several countries could result in  assessments totaling more than 100 percent of MNE profits. Excessive  taxation would lead to audit disputes and potentially requiring resolution  among tax authorities which, in turn, result in additional cost for both the  MNEs and the competent authorities.
Another concern stakeholders we spoke with had is that countries may  not be implementing transfer pricing documentation consistently. OECD  officials stated OECD does not have any enforcement authority and will  rely on a review mechanism and “peer pressure” to foster compliance  with its recommendations. Nevertheless, countries generally implemented  CbC information requirements that are consistent with the BEPS’  minimum requirements, while diverging from the BEPS master and local  files recommendations. Countries varied on which entities are required to  report and the threshold for reporting. For example, Germany set its  threshold at €750 million for CbC reporting and €100 million for master file  reporting while Netherlands has thresholds of €750 million and €50 million  for CbC and master file respectively.

		Administrative and Compliance Costs of Country-by-Country Reporting Are Uncertain, but Could Be Mitigated.

IRS’s costs for implementing, exchanging, and analyzing CbC reporting  are uncertain, but it has taken steps to mitigate costs. IRS’s use of  existing data exchange systems should help to control the administrative  costs of implementing country-by-country reporting. Other administrative  costs related to CbC, such as form development and training, are similar  to other comparable tax regulation changes. The compliance costs of  firms are more uncertain and likely vary by size and type of firm. The  main cost to firms of CbC is likely to be developing systems to provide  consistent data to tax authorities.

			IRS Costs to Implement and Administer CbC Reporting Are Likely to Be Similar to Costs of Other Regulatory Changes of Comparable Scope and Complexity

Because IRS does not intend to require the master file or local file  reporting of the OECD approach, its cost of adopting BEPS transfer  pricing documentation is essentially the cost of adopting CbC reporting.  This cost is expected to include of costs of developing systems to collect,  store, and exchange CbC reports, and integrate CbC data with existing  IRS applications. IRS does not have estimates of these costs, but factors  that impact these costs can be identified.
IRS has issued final regulations for CbC reporting which requires U.S.  MNEs with consolidated annual revenue of at least $850 million to file  Form 8975 Country-by-Country Report electronically for the tax year  beginning on or after June 30, 2016. MNEs with fiscal years beginning on  January 1, 2016, or before the effective June 30, 2016 date may file  voluntarily enabling IRS to provide the CbC Report to other tax authorities  as appropriate. Form 8975 will be an attachment to the U.S. corporation  income tax return Form 1120 and subject to statutory confidentiality and  disclosure protections. IRS officials said they expect the form—currently  under review—that U.S. MNEs are to file in 2017 to be generally  consistent with the BEPS CbC template. IRS plans on issuing additional  guidance in early 2017 to outline the process for voluntary filing according  to officials.
To try to minimize implementation cost, IRS plans to use its existing  International Data Exchange Service (IDES) system with modifications to  support CbC. IRS developed IDES to facilitate the secure transmission  and exchange of Foreign Account Tax Compliance Act (FATCA) data.  Pursuant to the 2010 law, foreign financial institutions are to report to IRS  on accounts held by U.S. taxpayers. According to officials, IRS is  examining IDES to determine the extent to which it can be used to  exchange CbC Reports with other tax authorities. IRS officials stated that  treaty and tax information exchange agreement (TIEA) partners enrolled  to use IDES for FATCA reporting would be able to use IDES for CbC  exchanges. Currently, Treasury has signed 87 FATCA intergovernmental  agreements. According to IRS officials, the United States has treaties or  TIEAs with all but 6 of the 44 jurisdictions that have agreed to exchange  CbC Reports as of June 30, 2016. IRS officials said that the number of  CbC Reports does not drive the system cost but rather the number of  connections needed to exchange CbC Reports with other tax  jurisdictions. They believe that these are significantly less than those  required for FATCA.
IRS spent about $50 million for FATCA operations in fiscal year 2015 and  the first quarter of 2016. This cost excludes the development costs of  IDES. According to IRS officials, the costs for developing and  configuring IDES for FATCA were around $7 million annually in 2015 and  2016, and are expected to increase to about $9 million in 2017.
While IRS has a plan for how it will collect CbC data, a decision is  pending on whether to establish a new database to store CbC data or use  an existing FATCA platform. According to IRS officials, their strategy for  assessing transfer pricing risk is still evolving and will influence the  decision. IRS still needs to decide how to use CbC data in conjunction  with other international data. IRS officials said they expect the CbC costs  will be less than the cost of implementing FATCA because CbC  information is exchanged only between tax authorities, while FATCA  information is exchanged with individual banks as well as tax authorities.  In addition to developing systems to collect, store, and exchange CbC  Reports, implementation costs also include integrating CbC data with  existing IRS applications used in transfer pricing risk assessment,  developing Form 8975 and its instructions, online taxpayer assistance,  and staff training. IRS officials said they do not have an estimate for these  costs and will be in a better position to provide an estimate after the IRS  Information Technology Team develops its plan for filing and processing  the CbC form. According to these officials, these costs are routine for  implementing tax regulatory changes that involves a new IRS form, and  that the costs for CbC are not expected to be significantly different.
IRS will also incur some additional operational costs for annually  collecting, exchanging, and using CbC. These operational costs will be  affected by the number of CbC Reports IRS receives from U.S. and non- U.S. MNEs in addition to the number of CbC Reports from U.S. MNEs  that IRS will need to transmit to other tax authorities. IRS estimated about  2,200 U.S. MNEs would meet the $850 million threshold for filing CbC  Reports. IRS will need to transmit the CbC Reports of these U.S. MNEs  to the tax jurisdictions in which the respective MNEs have business  operations.
Based on BEPS CbC reporting requirements, IRS will receive CbC  Reports from non-U.S. MNEs with business operations in the United  States, although these CbC Reports will come from the respective tax  jurisdictions of the foreign parent entity. The European Commission  estimates around 5,000 non-U.S. MNEs meet the BEPS €750 million  threshold for CbC reporting. If all these large non-U.S. MNEs have  business operations in the United States, IRS could potentially be  receiving about 5,000 CbC Reports from other tax jurisdictions. However,  there is no reason to assume that all non-U.S. MNEs have operations in  the United States. Previously, our analysis of 2008 IRS data found that at  least 2,356 non-U.S. MNEs had business operations in the U.S. at that  time. IRS officials said they do not expect significant additional costs  associated with exchanging CbC Reports.
IRS is uncertain of whether it will need additional resources for CbC risk  assessments. IRS officials said that they are studying the most efficient  and effective means for using the CbC Reports and may be using the  reports in conjunction with other data sources IRS uses for risk  assessment, such as, for example, the data reported on Form 5471— Information Return of U.S. Persons with Respect to Certain Foreign  Corporations.
In addition to the initial startup and operating costs, adopting BEPS also  entails indirect costs affecting other areas of IRS. According to IRS  officials, due to budgetary constraints, CbC implementation may require  adjusting agency spending priorities and redirecting resources from other  IRS efforts. However, until IRS determines how it will use the CbC  Reports, it does not know whether it would need to divert resources for  CbC risk assessments.

			Country-by-Country Reporting May Entail Additional Compliance Costs for U.S. MNEs That Would Vary by Size and Complexity of the MNE

According to OECD, CbC reporting could reduce compliance costs by  standardizing documentation across tax jurisdictions and limit the need  for multiple filings. However, stakeholders we interviewed said that the  reporting requirement will increase compliance costs because CbC  information is not information U.S. MNEs routinely collect or report, and  thus will require new data systems and processes. Moreover,  stakeholders we spoke with believe that the new transfer pricing reporting  requirements will increase audit activities and disputes, and potentially  increase competitive and reputational risks.
Stakeholders we spoke with were concerned that the new transfer pricing  documentation requirements would increase compliance burden. While  stakeholders we interviewed have generally commended Treasury  officials for successfully reducing potential compliance burden by  decreasing the amount of CbC information to be reported, they do not  expect the additional reporting requirements to reduce compliance burden  because of streamlined or consolidated reporting, as OECD has  suggested. Rather, they said that the reporting requirements will add to  and in some cases duplicate current reporting requirements. For  example, certain items, such as revenues, number of employees, pretax  profits or loss, and income tax, are reported in both the European Union’s  (EU) CbC reporting requirements for banks and investment firms as well  as the BEPS CbC Report.
According to stakeholders interviewed, most transfer pricing  documentation implementation cost for MNEs comes from developing the  necessary information technology system and processes for CbC  reporting even though U.S. MNEs will also have to submit local and  master files to local tax authorities where the U.S. MNE has operations.  These stakeholders noted that the initial cost for implementing CbC  reporting varies widely depending on the size and complexity of the MNE  and particularly on its ability to extract CbC information from existing data  systems. For example, stakeholders explained, MNEs may need to  extract CbC information from hundreds or thousands entities which use  incompatible data systems with different accounting methods, in different  languages. This may be the case if a U.S. MNE expanded through  mergers and acquisitions without centralizing its financial systems.  Accordingly, the relative burden of CbC reporting for MNEs will vary.
More transparent data on MNE’s could help tax authorities better identify  potential profit shifting and focus limited enforcement resources.  However, increased audit activity would increase cost to MNEs. OECD  specifies that MNEs do not need to reconcile the information reported in  their CbC Reports with similar information reported for other purposes.  However, stakeholders we spoke with pointed out that if global CbC  information is not reconciled with master and local file information, tax  authorities might misinterpret the information or request additional  information for clarification.
One stakeholder pointed out that the compliance cost for a local audit  often entails contracting for local tax professionals to manage the audit  including site visits and interviews, which may be in different languages,  because MNEs generally do not have local tax personnel. For example,  one large MNE with operations in about 120 countries has tax personnel  in only a fourth of those countries.
Stakeholders we spoke with also expect audit disputes to increase where  local tax authorities may misinterpret or use global CbC information in  ways inconsistent with OECD’s recommendations. Of particular concern  is the use of CbC Reports for formulary allocation or tax assessment.  Formula apportionment is a factor-based tax system that would allocate  an MNE’s global profits based on the share of its business factors, such  as sales, employment, or physical capital, located in a given country. The  data included in CbC Reports are the type of factors that have been  proposed for use under formulary tax systems. MNEs would incur  additional costs to resolve disputes with the local tax authority and may  require resolution among authorities of different tax jurisdictions.  According to OECD, disputes under mutual agreement procedures (MAP)  were taking on average 2 years to resolve. Furthermore, OECD  reported that at the end of 2014—the most recent data available—there  were 5,423 unresolved MAP disputes among OECD members, more than  double the number of cases for 2006. Recognizing the need to improve  the effectiveness and efficiency of the dispute resolutions, tax jurisdictions  adopting BEPS minimum standards agreed to change their mutual  agreement approach to dispute resolution. Whether the changes will  actually result in greater efficiency remains to be seen.
MNEs could also incur costs through the inadvertent or deliberate  disclosing of transfer pricing information, resulting in competitive or  reputational risks. According to stakeholders, CbC information could  potentially reveal where an MNE is expanding or contracting especially if  the MNE has a single product in a particular country or is just entering a  market. Such marketing information could be valuable to a competitor.  Stakeholders also expressed concern about the exposure of confidential  information in master files. For example, transfer pricing policies and cost  contribution arrangements are considered confidential and not publicly  available. While MNEs need to prepare master files with accurate  information, a balance must be struck so that information reported would  not be harmful if publicly disclosed.
Although CbC reporting is protected from disclosure by law, MNEs could  also incur costs if disclosure occurs and ultimately damages the MNE’s  reputation. Stakeholders said differences in the way items are reported on  the CbC Report and tax returns—such as profits and taxable income,  which includes allowable deductions and credits—could lead to  reputational risk. One such risk is public perception that the MNE is not  paying its fair share of taxes to the local jurisdiction.
IRS safeguards CbC information through treaty and TIEA provisions  governing tax information exchanges, but dissemination of CbC Reports  to the many local tax authorities where U.S. MNEs operate increases the  risk of disclosure. IRS officials maintain that their ability to pause  exchanges if foreign tax jurisdictions fail to meet the confidentiality  requirements and data safeguards creates an incentive for foreign tax  jurisdictions to safeguard CbC information. Stakeholders we spoke with  expressed concern about how effective this strategy would be in deterring  disclosure.

		Increased Transparency of MNEs’ Global Activities Could Lead to a Reallocation of Real Economic Activity For Tax Purposes but the Net Effect is Uncertain

The CbC Report includes information on where an MNE’s income, capital,  and employment are located. Stakeholders pointed out that in cases  where there is an apparent disparity between the location of profits and  the location of employment and investment, MNEs may have an incentive  to realign their profits with their real business activities. As we noted  earlier, MNEs could respond by: (1) relocating profits to align with current  location of real activity or (2) adjusting the location of their business  activities, such as employment and physical capital, to better support the  current location of reported profits.
Based on international tax policy literature, the implications for U.S.  revenue depend on how and whose profits are relocated. To illustrate, if  U.S. MNEs relocate profits out of low-tax jurisdictions into non-U.S.  higher-tax jurisdictions, that would result in higher foreign tax credits and  lower corporate profits, which, in turn, would reduce U.S. corporate tax  revenues. However, if U.S. MNEs relocate profits from low-tax foreign  countries into the United States, then that would result in increased U.S.  corporate tax revenues. Additionally, if foreign MNEs relocate profits from  low-tax jurisdictions into the United States, U.S. corporate tax revenues  would also increase.
Alternatively, MNEs may relocate employment and investment to support  the distribution of profits across jurisdictions. If U.S. MNEs relocate real  business activities among foreign countries, there would be likely no  effect on U.S. employment and investment. However, if MNEs relocate  U.S. operations abroad to support reported profits, then that would lower  U.S. investment, particularly to the extent that most BEPS by U.S. MNEs  is done to avoid U.S. taxes.
While some business groups suggested that MNEs would be more likely  to move employment and investment to align their real activity with their  reported profits, others thought that both reactions were likely. They also  noted that some MNEs rely on differences in the taxation of entities  across jurisdictions, such as the use of debt, to support their profit  allocations. Such MNEs may be less affected by transfer pricing revisions  than MNEs that rely on uncertainty in transfer pricing outcomes. MNEs  that rely on the differences in taxation would be less likely to relocate their  employment and investment.
As we noted earlier, it is extremely difficult to predict how individual MNEs  will react to the increased scrutiny, or if that scrutiny is even sufficient to  change their behavior. Each MNE would make decisions weighing the  relative costs of moving business functions against the tax savings. Thus,  the net effect is unknown.

	Conclusions

OECD’s revised guidance expands prior guidance on transfer pricing to  try to better ensure that profits are aligned with economic activities. The  revisions address the concern that taxpayers have sought to transfer risk,  and the compensation for bearing the risk, through contractual  arrangements alone without accompanying economic substance. The  guidelines are intended to emphasize that the ability to control risk and  the financial capacity to absorb risk are key functions for supporting the  contractual arrangements. By increasing the emphasis on the actual  conduct of the parties, the revised guidance could increase the ability of  tax authorities and MNEs to better align the taxation of income with the  economic activity that creates that income. IRS considers risk as part of  its overall economic analysis when determining transfer prices during  exams, and views the OECD revised guidance as consistent with but  more detailed than its own regulations.
The arm’s length principle (ALP) is widely accepted for evaluating transfer  prices and is applicable in many transactions. In particular, OECD  guidance on risk allocation is based on the ALP. However, this principle  has limitations that make its application to risk allocation problematic.  Because of these limitations, uncertainty about the correct transfer prices  could allow for profit shifting.

	Agency Comments

We provided a draft of this report to the Commissioner of Internal  Revenue and the Secretary of the Treasury for comment. In its written  comments, reproduced in appendix III, IRS agreed with the importance of  addressing risk allocation between related parties. IRS and Treasury also  provided technical comments, which we incorporated where appropriate.  Subsequently, we met with Treasury and IRS officials to discuss these  technical comments and based on new information they provided we  removed a recommendation that we had included in the draft. We had  recommended that IRS clarify its guidance on risk allocation between  related parties. We determined that the challenges of risk allocation are  inherent in the arm’s length principle that is the international standard for  determining transfer pricing and that clarifying IRS guidance would not  necessarily address this issue.
We are sending copies of this report to appropriate congressional  committees, the Department of the Treasury, and other interested parties.  In addition, the report will be available at no charge on the GAO website  at http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-9110 or by email at mctiguej@gao.gov. Contact  points for our Offices of Congressional Relations and Public Affairs may  be found on the last page of this report. Key contributors to this report are  listed in appendix IV.

Appendix I: Organization for Economic Co- operation and Development Action Items

Action 1 – Addressing the Tax Challenges of the Digital Economy  The Organisation for Economic Co-operation and Development (OECD)  proposes rules and implementation mechanisms for cross-border  business-to-consumer transactions in the digital economy to facilitate the  efficient collection of value-added tax. The digital economy’s features and  business models such as e-commerce, online advertising, and online  payment, exacerbate profiting shifting risk. OECD rules and mechanisms,  based on the country where the consumer is located, are also intended to  level the playing field between domestic and foreign suppliers. As the  digital economy continues to develop, work on this issue will also  continue and developments monitored. OCED expects a report on these  efforts to be produced by 2020.
Action 2 – Neutralizing the Effects of Hybrid Mismatch  Arrangements  OECD provides recommendations for designing domestic rules and treaty  provisions to address hybrid mismatch arrangements—arrangements  which exploit differences in tax treatment of entities or instruments  between two or more tax jurisdictions to achieve little or no taxation. The  rules and provisions are intended to increase the coherence of global  corporate income taxation. For example, mismatches have resulted in  multiple deductions for a single expense, deductions without  corresponding taxation, and the generation of multiple foreign tax credits  for a single amount of foreign tax paid. OECD also provides guidance on  asset transfer transactions (such as stock-lending and repo transactions),  imported hybrid mismatches, and the treatment of payment that is  included as income under a controlled foreign company tax system.
Action 3 – Designing Effective Controlled Foreign Company Rules  OECD provides recommendations for controlled foreign company (CFC)  rules, or rules that apply to foreign companies that are controlled by  shareholders in a parent jurisdiction. The CFC rules are to prevent the  shifting of profits from the parent entity into foreign companies, in  particular shifting mobile income such as those from intellectual property  (such as copyrights and patents), services, and digital transactions.  Existing CFC rules have design features which do not effectively prevent  base erosion and profit shifting (BEPS) and need to be revised to address  changes in the international business environment.
Action 4 – Limiting Base Erosion Involving Interest Deductions and  Other Financial Payments  OECD developed best practices for designing rules to prevent the use of  interest deductions to shift profits. Since money is mobile and fungible,  favorable tax outcomes can be achieved by adjusting the amount of debt  among entities of the multinational enterprise MNE. Moreover debt at the  MNE’s individual entity level can be multiplied through intra-group  financing. Additionally, financial instruments, which are economically  equivalent to interest but have different legal forms, can be used to avoid  restrictions on the deductibility of interest. OECD analyzed several best  practices and recommends an approach to address these risks. Technical  work continues on specific areas of the recommended approach and is  expected to be complete in 2016. Additional work on the transfer pricing  aspect of financial transactions also continues during 2016 and 2017.
Action 5 – Countering Harmful Tax Practices More Effectively,  Taking into Account Transparency and Substance  OECD developed a methodology for assessing preferential regimes that  provides preferential tax treatment to determine their risk for profit shifting  and a framework for mandatory spontaneous exchange of information on  rulings that could give rise to such concerns. Such rulings include those  for preferential regimes, cross border unilateral advance pricing  arrangements, and permanent establishments. Concern over harmful tax  practices currently relates primarily to the risk of using preferential  regimes to artificially shift profits and the lack of transparency on rulings.  The information exchange commences from April 1, 2016 for future  rulings. Exchanges for certain past rulings need to be completed by  December 31, 2016. Both agreement with the methodology for assessing  preferential regimes and the framework for compulsory spontaneous  exchange of ruling is one of the four BEPS minimum standards.
Action 6 – Preventing the Granting of Treaty Benefits in  Inappropriate Circumstances  OECD provides new treaty anti-abuse provisions with safeguards to  prevent treaty abuse, including treaty shopping strategies through which a  taxpayer who is not a resident of a particular tax jurisdiction attempts to  obtain benefits of a tax treaty concluded by that tax jurisdiction. However,  the adoption of treaty anti-abuse provisions is not sufficient to address tax  avoidance strategies that circumvent domestic tax law, and such abuse  must be addressed through domestic anti-abuse rules. Accordingly  OECD also provides recommendations for designing domestic rules to  prevent granting of treaty benefits inappropriately. Inclusion of anti-abuse  provisions in tax treaties including a minimum standard to counter treaty  shopping as well as flexibility for implementation is one of the four BEPS  minimum standards agreed upon by countries adopting BEPS.
Action 7 – Preventing the Artificial Avoidance of Permanent  Establishment Status  OECD provides recommendations for changes to the definition of  permanent establishment in its Model Tax Convention—widely used as  the basis for negotiating tax treaties—to address some commonly used  tax avoidance strategies. As generally specified in tax treaties, a foreign  enterprise’s business profits are taxable in a jurisdiction only to the extent  that the foreign enterprise has a permanent establishment in that  jurisdiction to which the profits are attributable. For example, one strategy  used to avoid taxes replaces subsidiaries that traditionally acted as  distributors with commissionaire arrangements where the entity would  begin selling products in its own name (on behalf of the foreign  enterprise). This arrangement would technically eliminate the foreign  enterprise’s permanent establishment status without any substantive  change to the functions the former subsidiary performed. Profits could,  then, be shifted out of the jurisdiction where sales occurred.
Action 8-10 – Aligning Transfer Pricing Outcomes with Value  Creation  OECD revised the existing transfer pricing rules used for tax purposes to  determine the conditions, including price, for transactions between related  entities within an MNE which result in the allocation of profits among the  MNE entities in different countries. The misapplication of the transfer  pricing rules can lead to profit allocations that are not aligned with where  the economic activity that produced the profits occurred. OECD focuses  on:  transfer pricing issues relate to intangibles which are inherently mobile  and hard-to-value;  contractual allocation of risk and the resulting allocation of profits  based on those risks; other high-risk areas such as transactions that are not commercially  rational, profit diversion from the most economically important  activities for the MNE and the use of certain payments, like  management fees, among related entities to erode the tax base.
Further work on the transfer pricing guidance will be undertaken related to  profit splits and financial transactions. Additionally the guidance will be  supplemented following OECD’s work on the impact of BEPS on  developing countries.
Action 11 – Measuring and Monitoring BEPS  OECD recommends improving access to and enhancing the analysis of  existing data to measure and monitor BEPS, as well as evaluate the  impact of actions taken to address BEPS. OECD points out that some  useful information already collected by tax administrations is not analyzed  or made available for analysis. Although currently available data across  jurisdictions and MNEs are limited, the country-by-country information  (required under action item 13) has the potential for significantly  enhancing economic analysis of BEPS.
Action 12 – Mandatory Disclosure Rules  OECD provides a framework for designing mandatory disclosure rules to  obtain early information on potentially aggressive or abuse transactions,  arrangements, or structures and their users. With timely, comprehensive,  and relevant information, tax authorities have the opportunity to respond  quickly to tax risks through informed risk assessments, audits, or changes  to legislation or regulations. For countries that already have mandatory  disclosure rules, the framework can also be used to enhance the  effectiveness of those rules.
Action 13 – Transfer Pricing Documentation and Country-by-Country  Reporting  Taking into consideration the compliance cost for business, OECD  developed a three-tiered standardized approach to its revised transfer  pricing documentation to enhance transparency for tax administration.  The country-by-country (CbC) report provides aggregated information  such as the MNE’s global allocation of income, taxes paid, and number of  employees by each tax jurisdiction in which the MNE operates. A high- level overview of the MNE’s global business operations and transfer  pricing policies is reported in the master file. The local file provides  detailed transactional transfer pricing documentation specific to the tax  jurisdiction. Tax authorities can use information from these three  documents to assess transfer pricing risks, determine most effective  deployment of audit resources, as well as determine whether to initiate an  audit. CbC reporting is one of the four BEPS minimum standards.
Action 14 – Making Dispute Resolution Mechanisms More Effective  OECD developed measures to strengthen the effectiveness and  efficiency of the mutual agreement procedure (MAP)—a mechanism  independent of the ordinary legal remedies available under domestic law,  through which the competent authorities of the tax jurisdictions may  resolve differences regarding the interpretation or application of the  OECD Model Tax Convention on a mutually-agreed basis. Improving the  dispute resolution mechanism should reduce uncertainty for MNEs as  well as unintended double taxation. Commitment to the effective and  timely resolution of disputes through MAP including the establishment of  an effective monitoring mechanism to ensure its effective implementation  is one of the four BEPS minimum standards.
Action 15 – Developing a Multilateral Instrument to Modify Bilateral  Tax Treaties  Based on its analysis of tax and public international law, OECD concludes  that a multilateral instrument on tax treaty measures for BEPS is  desirable and feasible. Given the number of bilateral treaties, conforming  to BEPS changes by updating the current tax treaty network would be  highly burdensome especially considering the substantial amount of time  and resources required for most bilateral tax treaties. OECD began  developing a multilateral instrument to streamline the implementation of  the tax treaty-related BEPS measures in May 2015, and plans to open the  instrument for signature by December 31, 2016. Participation in the  development of the multilateral instrument is voluntary and open to all  interested countries on an equal footing. Moreover participation does not  entail a commitment to sign the resulting instrument.

Appendix II: The Organisation for Economic Co-operation and Development’s (OECD) Proposed Revisions on Profit Splits Focus on Risk Which Present Difficulties

The practical challenges with using arm’s length principle (ALP) have led  to employing other methods to value the sale of goods and services  within a multinational enterprise (MNE). ALP is difficult to use as a  method for valuing market power, synergies, and other firm related  benefits unique to related party transactions within an MNE. These  challenges drive the demand for continued refinements to transfer pricing  guidelines that rely on the ALP and for alternative methods when the ALP  proves difficult.
As we have reported in the past, the arm’s length principle works well to  the extent that a market exists for the sale of the good in question or for a  good that is comparable. As products become increasingly differentiated,  finding a comparable product being sold in the market place becomes  increasingly difficult. The difficulty of finding comparables becomes even  greater in the case of unique intangible assets, such as goodwill,  trademarks, and production techniques. The relationship between  unrelated parties is fundamentally different than that between related  parties. For example, intangible assets that are licensed to independent  parties are more at risk to lose value than if they are licensed to affiliates.  Additionally, MNE’s greater size and centralized control can result in  greater efficiencies and thus greater cost savings than if the companies  were separate. Thus, transfer prices in such cases will not be the same  as the arm’s length price used by independent companies. For these  reasons, tax authorities and MNEs have difficulty applying the arm’s  length principle for these assets and MNEs.
One method used as an alternative to the arm’s length approach is the  profit split method. The profit split method can be used in the absence of  comparable arm’s length prices to allocate profits for certain transactions  between two related parties by reference to the relative value of each  party’s contribution to the combined profit of the parties. The profit split  method allows for greater flexibility by taking into account specific,  possibly unique, facts and circumstances of the related parties that are  not present with unrelated parties. However, the profit split method also  can be used to allocate profits to lower tax jurisdictions. A division of  profits based on easily measureable factors like the share of expenditures  may not, in every case, reflect where value is created. Profit splits that are  more complex and reflect a variety of contributing functions, such as  research and development (R&D), advertising, use of another intangible  assets, and formulas may better measure the actual contribution to value  of the different parties.
To illustrate how the profit split method can be used to shift profits from  high tax to low tax jurisdictions, we return of the example of the  Chockolet. As before, Chockolet has developed an intangible asset in  terms of its trademarked brand “Chockolet” that allows the company to  sell its product at a higher price than a generic. In this case, Chockolet  does not have a comparable arm’s length price for the trademark license  that can be used to allocate profits. In the absence of such a price,  Chockolet adopts the profit split method to allocate profits between the  parent company and its distributing subsidiary. Under this method, the  profits in excess of the normal mark-up (what a generic would get), which  are the profits that reflect the value of the trademark, are split according  to the relative contribution of the two parties.) In this simple example  shown in table 2, relative contributions are measured as their share of  total expenditures.
As table 2 illustrates, Chockolet’s product receives a 60 percent (or $160)  mark-up—higher than what a generic would earn. Its subsidiary earns a 5  percent mark-up of $32 on its expenditures, which are routine in nature.  In this case, the total profit in excess of the generic return is $55 ($192 -  $137) and is split by multiplying it by each party’s share of expenditures  giving Chockolet $47 (its 77 percent share) and the subsidiary $14 (its 23  percent share). As tables 1 and 2 show, the profit split method results in a  lower overall effective tax rate for the MNE group than the effective tax  rate of 29.6 percent, which would be achieved by using a price based on  the arm’s length principle, were it available. This profit split method, which  is based on relative expenditures by the two related parties, assigns too  much profit to the distributing subsidiary. Because the subsidiary  performs routine distribution functions that did not contribute to creating  the intangible asset, the contributions of the distributing subsidiary should  only earn a normal return. But, under this method, the subsidiary is  allocated some of the profits that reflect the value of the intangible. More  complex profit split methods could alleviate this misallocation, but would  reduce the simplicity that is often a key attraction of profit split methods.  For example, an adjustment to the expenditure method shown in table 2  that distinguished between the type of expenditures and whether those  expenditures earn a normal return, or contribute to the value of the  intangible asset may result in an arms’ length pricing outcome, but would  require being able to determine the types of expenditures that contribute  to the value of the intangible.
OECD’s final report issued in October 2015 did not provide guidance on  the profit split method but instead provided a plan for future guidance.  This plan raised concerns about whether the future revisions will ensure  that the application of this method is not subjective or arbitrary. In July  2016, OECD issued a discussion draft for public comment to clarify and  strengthen its guidance on the profit split method. The additional  guidance includes, for example, the recognition that profit split methods  may enable tax authorities and MNEs to better align creation of value with  profits than relying on the ALP in situations where related parties both  contribute intangible assets. Additionally, the draft provides guidance on  potential limitations in the use of some common profit splitting factors. For  example, cost-based profit splitting factors should be used when there is  a strong correlation between expenses incurred and relative value  contributed. The discussion draft also cautions that cost-based profit  splitting factors can be sensitive to country variations such as price levels  or wages, which could distort the relative contribution and final profit  allocation.
In addition to providing more guidance for applying profit splits, the OECD  final report and discussion draft introduced a new distinction between the  types of profits to which a profit split method would apply. That new  distinction is based on risk by recognizing two different types of profits  that could be split—actual or anticipated profits. In a profit split of actual  profits, the profits of the parties to the transaction are combined and the  actual profits are split based on the relative contributions of each party.  While the basis (i.e., formula or share) of the split of combined profits is  established before profits are realized, the split is applied to actual,  combined profits resulting from the transaction. Alternatively, the  combined profits may be split based on the anticipated profits according  to the contributions of each party. In the latter case, one party to the  transaction receives a fixed payment for tax purposes based on its share  of anticipated profits regardless of what actual profits are, while the other  party receives whatever actual profit remains after the payment is made.  The actual profit split method results in a greater sharing of the uncertain  profit allocations than under a profit split of anticipated profits  To illustrate how these methods could be applied, we consider again the  example of the Chockolet where, in this case, the expected mark-up over  costs for Chockolet is 60 percent. Under a profit split based on anticipated  profits, the expected Chockolet profits of $55 ($192-$137) would be split  according to the relative shares of expenditures, resulting in a fixed  payment of $44 (and a net profit of $14) to the distributing subsidiary. The  Chockolet parent would be assigned the residual Chockolet profits from  actual final sales of $117 ($162-$44) resulting in a net profit of $17. In this  type of profit split, the distributing subsidiary is assigned a guaranteed  payment while the transfer pricing outcome for Chockolet depends on  actual outcomes of the business activities and risks. However, under a  profit split based on actual profits in this example, the actual total profits  from the producer and the subsidiary are combined and split according to  the relevant share of expenditures between them. In this case, the  transfer pricing outcome for the distributing subsidiary would also depend  on factors influencing the final realized profits and could be assigned less  profit, as in the case below where profits were less than expected.
The choice of splitting actual or anticipated profits could be manipulated  to shift profits to lower-tax jurisdictions. For example, if the Chockolet  parent in table 3 suspected that profits might end up lower than the  anticipated profits specified in a contract, a profit split based on  anticipated profits would be preferable as a way to shift profits to its  lower-taxed distributing subsidiary. This information asymmetry could  happen when the parent corporation knows more about the likely profit  outcomes than tax authorities. For example, the expected profits could be  the result of a high probability of slightly lower profits combined with a low  probability of very high profit. If the parent knows about the likely  outcomes, while tax authorities only know the expected profit, the parent  corporation would have an incentive to pursue the anticipated profit split  as the appropriate method for allocating profits so that it will have a higher  chance of shifting profits to a low-tax subsidiary.
The OECD discussion draft recommends that a profit split based on  actual profits (one that “shares risk”) require a higher level of integration  of activities. OECD asserts that MNEs that are highly integrated share  risk, and therefore a profit split method that facilitates the ability to  allocate (or share) risk across parties is the more appropriate method.  However, as discussed previously, related parties cannot be treated the  same as unrelated parties. The more closely related the parties are, such  as a parent and its wholly owned subsidiary, the less likely the parent is  able to export or share risk. Thus, care should be taken in using risk as  an implicit factor for splitting profits.
The United States does not differentiate between actual or anticipated  profits as the OECD discussion draft has put forth. According to  Department of Treasury regulations, profits splits must be based on two  methods — (1) the comparable profit split or (2) the residual profit split.  The comparable profit splits allocates profits based on the division of  profits of unrelated parties whose transactions and activities are similar to  those of the related parties in question. The residual profit split allocates  profit or loss from the relevant business activity following a two-step  process. The first step allocates operating income to each party to  provide a market return for its routine contributions. In the second step,  any residual profit associated with intangible assets is divided among the  parties based on the relative value of their contributions of intangible  property that were not accounted for as a routine contribution. The value  of these contributions may be determined by factors such as market  benchmarks, capitalized values of R&D, or other expenditures.
Specialists have also expressed concerns that OECD’s discussion draft  may signal an additional reliance on profit split methods. They are  concerned that if the guidance is not explicit on when a profit split method  is appropriate, what factors should be used to allocate the profit, and how  it can be applied, countries may increasingly rely on profit split methods  as a way of moving away from arm’s length pricing and toward adopting  formula apportionment. Formula apportionment is a factor based tax  system that would allocate an MNE’s global profits based on the share of  their business factors, such as sales, employment, or physical capital,  located in a given country. Profit split methods can have features of  formulary apportionment. The concern is that, to the extent that a country  relies on profit split methods over arm’s length pricing, the allocation of  profits based on some kind of functional analysis becomes more routine,  making the adoption of a tax system that effectively taxed MNE’s profits  based on formulary apportionment more likely. While it is uncertain  whether an increased use of profit split methods would lead to the  adoption of a formulary apportionment tax system, adopting formulary  apportionment in an uncoordinated fashion, as we have reported in the  past, would increase the probability of double taxation.

Appendix III: Comments from the Commissioner of Internal Revenue

Appendix IV: GAO Contact and Staff Acknowledgments

	GAO Contact

James R. McTigue, Jr. (202) 512-9110 or mctiguej@gao.gov.

	Staff Acknowledgments

In addition to the above named contact, Kevin Daly (Assistant Director),  Ann Czapiewski, Bertha Dong, Edward Nannenhorn, Cynthia Saunders,  Andrew J. Stephens, and Jennifer G. Stratton made key contributions to  this report.

Summary:
Why GAO Did This Study

Globalization has increased incentives for multinational corporations to shift profits from country to country to use differences in the countries' corporate tax systems to reduce taxes. This profit shifting can lead to the erosion of U.S. and other countries' corporate tax bases, reducing tax revenues. OECD did a comprehensive analysis of corporate base erosion and profit shifting and, in the fall of 2015, issued 15 action plans to address the problem. GAO was asked to analyze the effects on the U.S. economy of adopting OECD actions.
GAO analyzed the potential effects of the two actions furthest along in implementation: revised transfer pricing guidelines and new transfer pricing documentation, including country-by-country reporting. For these actions, GAO examined (1) how likely it is that the action would reduce BEPS, (2) what is known about the potential administrative and compliance costs of the action, and (3) what is known about the potential effects the actions could have on the U.S. economy. GAO reviewed documents, conducted a literature review, and interviewed officials from IRS, the U.S. Department of the Treasury, OECD, and trade groups of industries likely to be affected by the actions.

What GAO Found

In 2015, the Organization for Economic Co-Operation and Development (OECD) issued revised guidelines, including 15 actions to help reduce base erosion and profit shifting (BEPS) of multinational enterprises (MNEs). One action focuses on transfer pricing guidance with the intent of aligning MNE profits with the location of economic activity, and preventing corporations from shifting and assigning profits to lower-taxed related corporations by artificially setting below-market transfer prices of property and services. Another action makes MNE activities more transparent, through documentation and reporting shared among countries.
Transfer Pricing Guidance : OECD's guidance emphasizes that transfer price analysis should reflect actual economic activities, such as who controls decisions related to risk and who has the financial capacity to bear the risk. This clarifies prior guidelines, which also included risk analysis based on functions, but that now focus on the parties' ability to control and finance risk. GAO found that
OECD's revised guidance may reduce BEPS if it encourages MNEs and tax authorities to ensure that transfer prices are based on real economic activity. U.S. regulations consider risk as part of the analysis of transfer prices. The arm's length principle, which treats transactions between related parties as if they were unrelated, is widely accepted for evaluating transfer prices. However, its application to risk is problematic because related parties cannot transfer risk the way unrelated parties can. Without addressing the application of the arm's length principle under these situations, uncertainty about the correct transfer prices may allow for continued BEPS.
Administration costs of implementing the guidelines will be minor according to Internal Revenue Service (IRS) officials because IRS's transfer price reviews are consistent with the revised guidance. However, taxpayer compliance costs are uncertain because they will depend on how MNEs respond to the revisions.
According to stakeholders and industry literature, U.S. employment and investment are unlikely to be significantly affected because the transfer pricing guidance affects a relatively narrow area of the tax code.
Transfer Pricing Documentation and Reporting : OECD's guidance includes new country-by-country (CbC) documentation and reporting actions where information on MNEs activities in different countries will be shared among the countries' tax authorities. GAO found that
CbC reporting may decrease BEPS because more consistent information will be available to tax authorities on the worldwide activities of MNEs.
According to IRS officials, CbC implementation costs are uncertain at this time, but can be mitigated by using existing systems and processes. However, MNE compliance costs would likely increase due to new data system needs, according to stakeholders.
The economic effect of CbC reporting is uncertain because it depends on the extent to which MNEs move business functions to low-tax countries in response to the potential increased scrutiny of BEPS.

What GAO Recommends

GAO does not make recommendations in this report. GAO provided a draft of this report to IRS and Treasury for review and comment. IRS provided technical comments, which were incorporated, as appropriate.