Transfer Pricing Topics for High Tech Companies

TAX

Transfer Pricing Topics for High-Tech Companies

INFORMATION, COMMUNICATIONS & ENTERTAINMENT

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Table of Contents

Page

INTRODUCTION 4

I. THE CURRENT TRANSFER PRICING ENVIRONMENT 6

Considerations for Acquisitions 7

U.S. Regulatory Developments 10

U.S. Final Services Regulations and Cost Sharing Regulations 10

OECD’s New Guidelines 12

India and China Enforcement 14

Added Enforcement in Japan 16

II. RECENT TRENDS IN THE ECONOMIC ENVIRONMENT 18

Increased Tax Controversy 19

Economic Downturn and Uncertain Timing of Recovery 22

Recognition of Losses 23

Restructuring 24

III. RECENT TRENDS IN THE BUSINESS ENVIRONMENT 26

Conversion to Fabless Chip Companies 26

Software as a Service and Cloud Computing 27

Changes to Revenue Recognition 28

CONCLUSION 32


Since 2008, the world has experienced an unprecedented global economic shock that has presented challenges to nearly all aspects of business and corporate activity: broad business models, financial planning and analysis, customer and vendor relationships, government relationships, as well as intercompany activities. Many corporate decision makers have focused on revising their business models to fit the near-term business reality while seeking some ability to forecast in this uncertain environment. This reduced foresight has posed challenges, requiring these decision makers to potentially reconsider key relationships with suppliers, customers, the government, and other related parties.

As of summer 2010, there are strong signs that many emerging markets are recovering, and there are nascent signs that the global economy is beginning to stabilize. According to the World Bank, although global growth is expected to turn positive in 2010, the pace of the recovery will be slow and subject to uncertainty. The World Bank says global output contracted by 2.1 percent in 2009, but is forecast to register positive growth of 2.9 and 3.3 percent in 2010 and 2011, respectively. The main drag on global growth is coming from high-income countries, whose economies contracted by 3.3 percent in 2009 and are only expected to grow between 2.1 and 2.3 percent in 2010 and between 1.9 and 2.4 percent in 2011, due primarily to ongoing issues from the European debt crisis. Prospects for developing countries are for a relatively robust recovery in 2010, with growth of 5.7 to 6.2 percent continuing out to 2012.1

Should this growth spread to more established Organisation for Economic Co-operation and Development (OECD) economies,2 the general expectation is that initial public offering (IPO) and merger and acquisition (M&A) activity will rebound in the coming year. Preliminary data for the first quarter of 2010 show that the volume of announced technology M&A activity rose to its highest level since the breakout of the financial crisis, and deal activity could further increase as the economy improves.3 Accordingly, this white paper will adopt a positive outlook and address some considerations for high-tech businesses that are either contemplating or executing a business expansion, acquisition, or other combination in the face of new market realities and a changing regulatory environment.

This white paper considers three regulatory documents: OECD’s new Transfer Pricing Guidelines (OECD’s New Guidelines), the Final Services Regulations,4 and the Temporary Cost Sharing Regulations5 in the United States, as well as focused transfer pricing scrutiny globally, with particular attention to China and India.

While the general business outlook appears to be improving, the past two years have wreaked havoc for many high-tech companies. While corporate profitability may have been more challenging than ever before for this sector, many governments are even further in the red. Governments have been increasing federal spending to spur economic growth and provide increased social services, such as unemployment benefits. This spending has been accompanied by reduced tax receipts generating significant deficits. Not surprisingly, many governments are focused on increasing revenue from multinational companies by asserting any profits arising from the

Introduction

This white paper aims to provide commentary on several timely transfer pricing topics for high-tech companies, including:

• Thecurrenttransferpricing environment

• Recenttrendsintheeconomic environment

• Recenttrendsinthehigh-tech business environment.

1 THE WORLD BANK, GLOBAL ECONOMIC PROSPECTS SUMMER 2010: FISCAL HEADWINDS AND RECOVERY (June 9, 2010), http://www.worldbank.org/globaloutlook. 2 As of May 2010, OECD member countries are Australia, Austria, Belgium, Canada, Chile, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, and the United States. Countries invited to open discussions for membership are Estonia, Israel, Russia, and Slovenia. Finally, Brazil, China, India, Indonesia, and South Africa received enhanced engagement, which has the potential in the future to lead to membership. 3 Cyrus Sanati, Tech M&A Shows More Signs of Rebounding, N.Y. TIMES, Apr. 5, 2010, http://dealbook.nytimes.com. 4 On July 31, 2009, Treasury and the IRS filed with the Federal Register final regulations regarding the treatment of controlled service transactions under section 482 (T.D. 9456, 74 FED. REG. 38830 (Aug. 4, 2009) (hereinafter “Final Services Regulations”)). 5 On December 31, 2008, the U.S. Treasury Department and IRS released—in temporary and proposed form—regulations addressing a cost sharing arrangement (CSA) among controlled taxpayers. The new temporary regulations took effect upon publication in the Federal Register on January 5, 2009 (T.D. 9441, 74 FED. REG. 340 (Jan. 5, 2009) (hereinafter “Temporary Cost Sharing Regulations”)).4 Transfer Pricing Topics for High-Tech Companies


business are linked to their jurisdiction. As discussed in detail later in this document, tax audit controversy (specifically related to transfer pricing) was up sharply in 2009 and is expected to continue this trajectory in 2010 and beyond. Even if global markets improve and there is less tension on transfer pricing in 2010, the results from these challenging years will remain open for controversy for the next several years.

While a company’s financial statements and tax return generally focus on the year at hand, many transfer pricing methodologies incorporate multiple years of data in the analysis. Thus, for most companies, at least some transactions will include the results of these “bad” years that will impact the transfer pricing analysis and documentation for another three years. Importantly, tax authorities will have the opportunity to scrutinize any unusual results retrospectively for multiple tax years.

In this economic climate, KPMG firms are seeing the continuation of certain high-tech business trends such as increased separation of chip design and semiconductor manufacturing and increased offerings of software as a service and cloud computing, a style of computing where massively scalable and elastic IT-related capabilities are provided “as a service” using Internet technologies to multiple external customers.6 From an accounting perspective, new revenue recognition rules in the United States could lead to business changes with respect to contract terms and negotiations as well as incentives to sales teams. Each of these trends has implications on a company’s tax and transfer pricing policies.

This paper provides a perspective from KPMG on cross-border activities of high-tech companies in the current environment, and can serve as a catalyst for executive-level discussion and proactive management of transfer pricing impacts and opportunities.

The significance of transfer pricing in a global economy where multinational enterprises play a prominent role […] is especially relevant in the midst of the current economic challenges, when the location of profits and losses within a multinational group is very sensitive as it directly affects the group’s effective tax rate. Governments also are carefully monitoring the allocation of profits and losses to their jurisdictions, in a context where many of them are striving for a balance between business-friendly, pro-growth tax measures and measures to maintain the needed level of tax revenues to support public spending.Organisation for Economic Co-operation and Development’s Centre for Tax Policy and Administration6 Partha Iyengar, Gartner Symposium ITxpo, Application Development in the Cloud: Strategies and Tactics for a New Generation (Nov. 11, 2008).

Transfer Pricing Topics for High-Tech Companies 5


The current transfer pricing environment is one of intense scrutiny from nearly every jurisdiction with transfer pricing regulations. Macroeconomic forces have governments desperately seeking to stem budget deficits, and multinational corporations are seen as a key source of revenue. Many major jurisdictions, such as China, France, India, Ireland, Japan, the United Kingdom, and the United States, are reviewing their broader international tax policy and more rigorously enforcing existing regimes. Transfer pricing and an increased focus on interna-tional enforcement activity are garnering attention at the highest levels of the government.

Notably, China, France, and Ireland have recently introduced new transfer pricing regimes. China’s new Corporate Income Tax Law, effective from January 1, 2008, contains new transfer pricing regulations clarified in Guoshuifa [2009] No. 2.

FranceIn France, a new transfer pricing documentation requirement, codified as Article L13AA, was enacted into law in France on December 30, 2009, applying for all accounting periods beginning on or after January 1, 2010.

JapanIn Japan, an amended tax law and Cabinet Orders and Regulations (Ministry Ordinance) were promulgated on March 31, 2010, that include an amendment to Article 66-4(7), practically introducing documentation requirements.

IrelandOn February 4, 2010, the Irish Taxation Institute introduced a new transfer pricing regime through the 2010 Finance Bill. In particular, Part 35A of the Bill sets out transfer pricing rules that apply the arm’s-length principle to trading transactions between related parties. Transfer pricing will likely be a critical factor in this review of overall international tax policy.

IndiaIn India, the Finance Minister released a draft on the Direct Taxes Code (DTC) Bill and a Discussion Paper in August 2009. The DTC is currently in a draft stage and had been thrown open for public comments. The Finance Ministry is working on the comments received and proposes to table another draft soon. The DTC is proposed to be effective from April 1, 2011. When enacted, the DTC would replace

Transfer pricing and an increased focus on international enforcement activity are garnering attention at the highest levels of government.

I. The Current Transfer Pricing Environment

6 Transfer Pricing Topics for High-Tech Companies



the dated and existing Income-tax Act, 1961 (Income-tax Act) and the Wealth-tax Act, 1957 (Wealth-tax Act).7 Along with replacing the Income-tax Act, the DTC seeks to introduce several new transfer pricing provisions, including advance pricing agreements (APAs), anti-avoidance provisions, changes in conducting transfer pricing field audits, etc.

United KingdomThe U.K. tax authority (HM Revenue & Customs) on March 8, 2010, released updates to its thin capitalization guidance. In general, the new guidance indicates the increased scrutiny that the U.K. tax authorities will apply in addressing thin capital-ization situations and is part of a broader international tax reform effort.

United StatesPresident Obama proposed additional Internal Revenue Service (IRS) resources with respect to international enforcement. And in its recent Strategic Plan 2009–2013, the IRS highlighted the importance of hiring more examiners and providing those individuals with the sophisticated training and tools necessary for them to effectively do their job. On January 26, 2010, IRS Commissioner Doug Shulman addressed the New York State Bar Association and stressed the increase in transfer pricing-focused professionals at the IRS and the efforts to improve the transfer pricing auditing processes.8 As the IRS continues to coordinate enforcement efforts with the tax agencies of U.S. treaty partners, multinational taxpayers will need to be constantly aware of the activities of their affiliates throughout the world—and in particular, to be aware of any ongoing or impending transfer pricing examinations and potential issues. One area ripe for transfer pricing controversy is the treatment of acquisitions.

Considerations for AcquisitionsAs companies’ outlooks improve, many companies will seek growth through mergers or acquisitions. Accordingly, business combinations may be the fastest path to revenue and earnings growth in the near term. This integration of companies will be under increasingly intense scrutiny. Meanwhile, budgets for both internal and external resources to assess the impact of the transaction and make sound judgments related to the integration are likely more limited than ever before. While a great deal of focus is appropriately placed on the business impact of the transaction from a finance, accounting, operations, IT, or other perspective, there are also critical aspects of the deal, such as the business structure, that must be addressed for tax and, specifically, transfer pricing purposes.

IP and Transfer PricingTwo of the most important transfer pricing questions arising from a material merger or acquisition are: 1) What happens to the intangible property (IP); and 2) To what extent will the supply chains be integrated? With respect to the IP, it is important that IP ownership, both legal and beneficial, be clearly established during the due diligence process prior to the transaction. The next step is to determine what entity should ultimately own the IP post-closing. If the IP is not being moved and the supply chains are to remain separate, then the key items are establishing the support for the ownership post-closing and to provide evidence that the IP is intended to remain separate on a go-forward basis.

Transfer Pricing Checklist for Mergers and Acquisitions

The following checklist, while not exhaustive, may help to identify areas of transfer pricing exposure faced by high-tech companies involved in acquisitions.

• WhereistheIPoftheacquiringcompany located?

• WhereisIPofthetargetcompanylocated?

• Doestheacquiringcompanyorthe target have an international IP structure?

• Isthetarget’stransferpricingmethodology consistent with the acquirer’s? Should it be adapted to the acquirer’s?

• Willthetargetbeintegratedintothe acquiring company structure?

• Howwilltheintegrationaffectmovement of IP or manufacturing?

• Willtherebeanyplantclosingsorother cessation of operations?

• Wherewillrestructuringcostsbebooked?

• Canintercompanyandcustomercontracts be assigned?

• Willnewagreementsneedtobeput in place on an interim and final basis?

• IftherearechangestotheIPormanufacturing flows, what is the impact on invoicing?

• Doesthetargetcompanyhavetransfer pricing documentation?

• Dotheintercompanycontractsaccurately reflect the actual flows taking place?

• Willtheintegrationoftheacquired IP affect the status of any preexisting cost sharing arrangement under U.S. Temporary Cost Sharing Regulations?

7 KPMG LLP (United States) – TaxNewsFlash-Asia/Pacific 2009-50, India: Direct Tax Code 2009—Highlights (Aug. 14, 2009). 8 Doug Shulman, IRS Commissioner, Prepared Remarks to New York State Bar Association Taxation Section Annual Meeting in New York City (Jan. 26, 2010), www.irs.gov.



For many companies, the complexity of managing distributed IP ownership from a business and legal perspective outweighs the potential tax cost of consolidating the IP in a single jurisdiction, which is often the parent company’s high-tax jurisdiction. If the IP is moved, then the key questions are:

• Whoarepartiestothetransaction?

• WhatisthevalueoftheIPor,morespecifically,cantheIPbevalueddirectlyorinferred from the merger or acquisition price?

• Whatmodificationswillneedtobemadetotheexistingsupplychaintoembracethe new IP?

As part of the due diligence process, the existing legal and beneficial ownership of IP should be clearly established. The management of the combined entity will determine the buyer of IP. The jurisdictions in which the buyer and seller are located may impact the value of the transaction, namely because different taxing authorities hold differing views on the underlying asset. Some may view IP as a discrete transaction analogous to the IP value assigned to a specific asset, such as technology, in a purchase price allocation for financial statement purposes. While an increasing number of other tax authorities view an outbound transfer of IP as a transfer of a business, this view presumes a larger, even significantly larger, value for IP. Further, the view of the taxing authority regarding the nature of the transaction may be different for inbound versus outbound transactions. Specifically, taxing authorities may respect a narrower definition of IP, which suggests that they would respect a lower value for an inbound transaction than for an outbound transaction with similar facts.

If the consolidated IP will flow through the acquirer’s existing supply chain, existing intercompany agreements should be reviewed to ensure accuracy and inclusion of new IP. Further, a high-tech company must carefully consider whether the existing pricing policy makes sense for the new transactions. If the new policy is materially different than the acquired company’s existing policy, one should also consider whether there is any tax exposure arising from the conversion. For example, if the acquired company sold its goods through a commission agent/commissionaire network and the acquirer sells its goods through buy-sell distributors, then intercompany contracts, as well as activities undertaken and risks assumed, must be reviewed to ensure consistency with new pricing policy.

For companies without a cost sharing agreement (CSA), a significant merger or acquisition may provide an opportunity to consider the potential benefits, as well as the risks, of IP pooling arrangements such as a CSA, joint venture, or partnership.

For companies with an existing CSA or cost contribution arrangement, the IP may have to be added to the scope of the existing CSA or cost contribution arrangement (CCA). All of the valuation considerations noted above apply.

• Whoarepartiestothetransaction?ThisisparticularlyimportanttoestablishinaCSA context as it impacts the shares of expected benefits.

• WhatisthevalueoftheIP,ormorespecifically,cantheIPbevalueddirectlyorinferred from the merger or acquisition price?

• Whatmodificationswillneedtobemadetotheexistingsupplychaintoembracethe new IP?



Further, for cost sharing transactions involving a U.S. party, specific valuation methodologies are set forth in Treas. Reg. section 1.482-7T. There are a few specific new administration requirements in these regulations that pertain to the expansion of a CSA:

• Anupdateagreementmustbesignedanddatedwithin60daysofinclusionintheCSA (Treas. Reg. section 1.482-7T(k)(1)(iii)).

• Theannualstatementmustincludethisexpansion,whichisdueuponfilingofthenext return (Treas. Reg. section 1.482-7T(k)(3)(iii)(B)).

The new regulations seem particularly concerned about a “material change in scope” such that a material change in scope thrusts the entire CSA into the new regulations. However, what constitutes a material change in scope is not defined, and the regulations do not provide examples to clarify this point. Taxpayers may consider whether it is appropriate in the amendment to the agreement or other supporting working papers to assert whether individually or cumulatively this expansion constitutes a material change in scope. However, we recommend taxpayers consult their internal or external legal counsel prior to making these changes.

IP transfers are not the only outbound transfers attracting the attention of tax authorities. A wide range of business restructurings, including plant closings as well as other downsizings or functional realignments, are being evaluated. While these events may arise from strategic corporate decisions at any point in time, they are often considered during the integration of a merger or acquisition. Any restructuring activity in which the functions, risks, or profits of one legal entity are transferred to a related party in another jurisdiction warrants consideration of whether potential exit charges may be assessed by the local taxing authority. We are seeing taxing authorities assert that these restructurings are an outbound transfer of a business, much like the treatment of transfers of outbound IP. This point is addressed further in the discussion of the OECD’s New Guidelines.

One of the key takeaways is that one must ensure that the transfer pricing implications are factored into the business integration. Specifically,

The pre- and post- acquisition IP ownership must be clearly established.

If IP is migrated, care must be taken in its valuation.

If operations are migrated, care must be taken in evaluating potential exit charges.

Subsequent impacts to the supply chain must be reflected in intercompany pricing policy.

Any significant change in functions and responsibilities—including plant closings—are regarded as business restructurings under the OECD’s New Guidelines issued in July 2010.



U.S. Regulatory DevelopmentsFinal Services Regulations Most multinationals have some level of intercompany services. High-tech companies are, by their very nature, even more likely to have extensive cross-border service transactions as they are likely to have global operations and services embedded in the creation or delivery of their offerings. Recent trends, such as provision of software-as-a-service (also known as SaaS) and complex implementation and integration services offered alongside software or hardware offerings, are further increasing the complexity of intercompany service transactions. Accordingly, the distinction between IP transactions and services transactions is increasingly blurred.

On July 31, 2009, Treasury and the IRS filed Final Services Regulations with the Federal Register regarding the treatment of controlled service transactions under section 482.9 These regulations adopted, with a few minor clarifications, the temporary regulations that expired the same day.10 These Final Services Regulations cross-reference the IP regulations and explicitly state that the arm’s-length determination should be similar whether reviewed under Treas. Reg. section 1.482-9 or Treas. Reg. section 1.482-4.11

As high-tech companies migrate functionality to geographic clusters, two common issues arise. One is that there is tension in jurisdictions such as the United States and China, where there is an increasing number of service transactions and the respective transfer pricing rules are not entirely consistent. Further, business unit leaders often do not appreciate that centralization of certain services can have profound tax and transfer pricing implications.

Temporary Cost Sharing Regulations CSAs are pervasive for high-tech companies in the United States. Recent changes in these rules have broad implications for the full spectrum of high-tech companies from start-ups to established companies. On December 31, 2008, the U.S. Treasury Department and IRS released—in temporary form—cost sharing regulations addressing a CSA among controlled taxpayers. The new Temporary Cost Sharing Regulations took effect upon publication in the Federal Register on January 5, 2009. These regulations replaced the prior cost sharing regulations found in Treas. Reg. section 1.482-7, which were issued in 1995. The Temporary Cost Sharing Regulations generally follow proposed regulations issued in August 2005. In general, the Temporary Cost Sharing Regulations are more detailed than the 2005 proposed regulations, as key elements such as the investor model and the various methods (e.g., the income method and the residual profit split method) for determining the value of PCTs (platform contribution transactions or, formerly, buy-ins) continue as elements of the temporary regulations.

Generally, the Temporary Cost Sharing Regulations are viewed as less favorable to taxpayers than prior regulations such that, in most instances, CSAs created under the new rules may take longer to provide benefit, and that benefit may be diminished. For existing CSAs, the tension will lie in adherence to the new administrative rules and expansion in scope of the CSA, both from internal development and M&A activity.

9 The final regulations also modify the regulations under section 861 concerning stewardship expenses to be consistent with the changes made to the regulations under section 482. 10 Treas. Reg. § 1.482-9T (h)(3), 71 FED. REG. 44466 (Aug. 4, 2006). 11 Treas Reg. § 1.482-9T(m)(3).

As high-tech companies migrate functionality to geographic clusters, two common issues arise. One is that there is tension in jurisdictions such as the United States and China where there is an increasing number of service transactions and the respective transfer pricing rules are not entirely consistent. Further, business unit leaders often do not appreciate that centralization of certain services can have profound tax and transfer pricing implications.



As companies with cost sharing arrangements file their tax returns, attention should be paid to certain technical requirements in the new regulations. Specifically, the regulations require that each controlled participant attach a “CSA Statement” providing certain information regarding the arrangement and its participants.12 For taxpayers with an existing CSA, the first CSA Statement was due September 2, 2009.13 Subsequent statements are filed with the participant’s tax return (or Form 5471, etc., if the participant does not file a U.S. tax return).14 Generally, failure to comply with these requirements allows the IRS to deny the taxpayer relief under the transition rules of cost sharing regulations.15

The Temporary Cost Sharing Regulations also imposed other constraints on CSAs. One such limitation is the requirement that each participant have non-overlapping interests. These rights must be assigned by geographic exclusivity or adhere to the four-part non-overlapping interests rule.16 The IRS had originally proposed that participants must have exclusive geographic rights, but modified the regulations to be less restrictive non-overlapping interests. Nonetheless, this restriction on the assignment of rights can hamper common business practices such as selling global contracts to a customer’s headquarter entity.

Another new limitation is that intangibles acquired in a post-formation acquisition (PFA) that are expected to contribute to the intangible development activity must be promptly integrated into the CSA. This inclusion of IP generally constitutes a modification of the CSA. All modifications require contemporaneous written contractual agreements within 60 days of the first occurrence of any intangible development costs (IDCs).17 As a practical matter, executing such written agreements within 60 days is very challenging.

Whether or not a high-tech company has a CSA, the new cost sharing regulations change the landscape in which intangibles are valued in the United States. IP transactions are the lifeblood of high-tech companies. The regulations include new specified methods18 required to be considered by taxpayers for use in IP transactions, regardless of whether or not in connection with a CSA.19 These new specified methods include the acquisition price, market capitalization, and income methods. Each of these methods can result in valuations higher than those resulting from methods arising from the prior Treas. Reg. section 1.482-7 for cost sharing or the existing Treas. Reg. section 1.482-4 for transfers of IP as commonly applied by taxpayers. Further, the regulations explicitly state that valuations resulting from purchase price allocations performed for financial statement purposes are not necessarily adequate for valuing acquired intangibles, although it is acknowledged that such valuations may be an appropriate starting point.20 While these rules pertain specifically to cost sharing arrangements, they must be at least considered in all services and IP transactions through cross-references (coordination rules) in the transfer pricing regulations.

In addition to this new regulatory complexity in the United States, high-tech companies must consider the global regulatory environment. For instance, in the OECD there are several initiatives ongoing, which resulted in the OECD’s New Guidelines.

12 Treas. Reg. § 1.482-7T(k)(4). 13 Treas. Reg. § 1.482-7T(m)(2)(viii). 14 Treas. Reg. § 1.482-7T(k)(4)(iii). 15 Treas. Reg. § 1.482-7T(m)(1). 16 Treas. Reg. § 1.482-7T(b)(4)(iv). 17 Treas. Reg. § 1.482-7T(k)(1)(ii)(K)(iii). 18 Treas. Reg. § 1.482-7T(g)(1). 19 Treas. Reg. § 1.482-4T(g). 20 Treas. Reg. § 1.482-7T(g)(2)(vii).

Whether or not a high-tech company has a CSA, the new cost sharing regulations change the landscape in which intangibles are valued in the United States. IP transactions are the lifeblood of high-tech companies.



OECD’s New Guidelines On July 22, 2010, the OECD released a new edition of the Transfer Pricing Guidelines that 1) updated prior guidance in Chapters I–III, and 2) provided new guidance on the transfer pricing issues presented in the context of business restructuring. These new Guidelines represent the results of several years of intensive work on the part of the OECD exploring issues related to comparability, the use of transactional profits methods, and business restructuring.

Perhaps the most important outcome of this work is a strong reaffirmation that the pricing of transactions among associated enterprises should be based on the arm’s-length principle, i.e., that it should reflect the prices that would have been set had those transactions taken place among independent entities. Thus, the goal of the OECD Transfer Pricing Guidelines remains the same, even though the detailed guidance on how to reach this goal has been updated in several important respects. Another welcome development is that the new Guidelines reaffirm, as was the case in 1995, that tax authorities should respect the transaction actually undertaken by the taxpayer in all but extraordinary circumstances, which are defined as “rare” or “unusual.” Such exceptional cases are defined as situations in which 1) the substance of a transaction differs from its form or 2) the arrangements made in relation to the transaction, viewed in their totality, differ from those that would have been adopted by independent enterprises behaving in a commercially rational manner and the actual structure practically impedes the tax administration from determining an appropriate transfer price. The guidelines emphasize the importance of having a clear explanation of the structure of controlled transactions in terms of functions, assets, and risks, both before and after restructuring. Accordingly, written agreements with respect to intra-group transactions are recommended.

One key change in Chapters I–III is the replacement of the hierarchy of methods with a requirement to select the most appropriate method to the circumstances of the case. Under the prior 1995 guidelines, transactional profit methods, and in particular the transactional net margin method, were treated as “… methods of last resort” that should only be used if the three traditional transaction methods (comparable uncontrolled price method, resale price method, and cost plus method) could not be applied. The updated guidelines indicate that taxpayers and tax authorities should use the most appropriate method based on facts and circumstances, acknowledging that transactional profit methods may be more practical/reliable in many cases. This is, in effect, an acknowledgement of the changes in transfer pricing practice that have evolved since 1995.

There is also a substantially more detailed discussion of the application of transactional profit methods than was found in the 1995 Guidelines. For the most part, this additional discussion is welcome in that it acknowledges the range of issues that exists and generally provides a reasonable amount of flexibility to tax authorities and taxpayers in approaching such issues. In some cases, however, the level of detail is troubling in that it may lead to the adoption of prescriptive approaches by some tax authorities. For example, paragraphs 3.4 and 3.5 describe the steps in a “typical” comparability analysis that can be followed as a good practice. While there is nothing that is per se unreasonable with this list, equally reasonable alternative approaches may be possible, and make more sense, in many circumstances (as acknowledged at paragraph 3.4 itself).

The new guidelines also contain a much more robust discussion of risk than the 1995 guidelines. The guidelines make it clear that tax authorities should generally respect the contractual allocation of risk established by the multinational enterprise subject, however, to:

Perhaps the most important outcome of this work is a strong reaffirmation that the pricing of transactions among associated enterprises should be based on the arm’s-length principle, i.e., that it should reflect the prices that would have been set, had those transactions taken place among independent entities.



• Thepurportedcontractualallocationofriskbetweenassociatedenterprisesbeingconsistent with the economic substance of the transaction

• Theconductofthepartiesbeingconsistentwiththecontractualallocationofrisk

• Theallocationofriskinthecontrolledtransactionsbeingarm’slength.

Perhaps the most important of these factors is the need to demonstrate that the controlled transaction is arm’s length. In discussing this, the guidelines state that taxpayers can show that an agreement is arm’s length by either 1) showing that there are comparable third-party arrangements with a similar allocation of risk, or by 2) demonstrating that, while not seen in a third-party arrangement per se, the allocation of risk is, in fact, one that could be expected among independent parties. In showing the later, the guidelines stress the importance of control over risk and of the financial capacity to assume risk at the time of the risk allocation or transfer. In discussing control, the guidelines note that the risk-bearer would be expected to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider. This would require it to have people—employees or directors—who have the authority to, and effectively do, perform these control functions. The guidelines acknowledge that control does not require the day-to-day management of the risk, but state that in cases where the management of the risk is outsourced, the risk-bearer would generally be expected to make a number of relevant decisions to control its risk, including 1) taking responsibility for the decision to hire or terminate the entity that is managing risk on a daily basis on its behalf, 2) determining the type of work that is being done, 3) making key spending decisions, and 4) assessing the outcome of the work done. In discussing financial capacity to assume risk, the guidelines suggest that the risk bearer should generally have sufficient financial resources to assume the risk at the time of the contractual allocation or transfer of risk to it, but also note that the financial capacity to assume the risk is not necessarily the financial capacity to bear the full consequences of the risk materializing, as it can be the capacity for the risk-bearer to protect itself from the consequences of the risk materializing. Furthermore, a high level of capitalization by itself does not mean that the highly capitalized party carries risk.

The release of the new Chapter IX on business restructuring is also an important development. Business restructuring is defined very broadly to include:“… the cross-border redeployment by a multinational enterprise of functions, assets and/or risks.” In essence, a business restructuring can involve almost any substantive change in an intra-group business relationship: a change in the nature or scope of transactions between the associated entities involved, a shift in the allocation of risks among group entities, a change in responsibility for specific functions, or the termination of a commercial relationship between associated enterprises. To the extent that local documentation requirements extend to business restructuring, multinational enterprises may be expected to document a much broader range of changes in their business operations than has been expected in the past. In documenting these changes, it is important to consider:

• Theinitialstructure

• Thenewstructure

• Thetransfersofassetsand/orsubstantialchangesofcontractualrelationshipbetween associated enterprises

• Whatpayments—ifany—wouldbeexpectedatarm’slengthforthosetransfersorsubstantial contractual changes in order to go from one structure to the other.

In essence, a business restructuring can involve almost any substantive change in an intra-group business relationship: a change in the nature or scope of transactions between the associated entities involved, a shift in the allocation of risks among group entities, a change in responsibility for specific functions, the termination of a commercial relationship between associated enterprises.



Chapter IX states very clearly that the arm’s-length principle does not, and should not, apply differently in the case of post-restructuring transactions than in other transfer pricing contexts. Moreover, the guidelines state that under the arm’s-length principle there is not always a need for a payment because of a business restructuring or because of the termination of a business relationship. The guidelines take the position that payments are not needed for the mere transfer of profit potential, but note that they are required if compensations would be expected for comparable transactions among parties operating at arm’s-length.

Finally, the newly released guidelines emphasize the need to consider the alternatives that are “realistically available” to each of the controlled participants to the controlled transaction. This evaluation of realistic alternatives is intended to be somewhat pragmatic in nature—there is no need to explore all possible different options that could have been considered—but does allow taxpayers and tax authorities to consider alternative options that may be available to each participant to the controlled transaction. It is important to note that:

• Theexaminationofoptionsistwosided—theoptionsofboththecontrolledsellerand the controlled buyer may have to be taken into account.

• Theanalysishastobedonefromtheperspectiveofthecontrolledaffiliateasastand-alone entity rather than from the perspective of the corporate group.

While the new guidelines may not address all issues—for example, the discussion of losses does not seem to acknowledge that losses are a relatively common outcome of business investments, and that once incurred they may never be recovered—but, in general, the updated guidelines are an important step forward. But the key question, of course, is: How will the new guidelines be interpreted and applied by the local tax authorities?

Please visit the OECD Web site for more information on the OECD’s New Guidelines.

India and China EnforcementIndiaSince the beginning of the decade, there has been a rush to set up operations in India. A wealth of highly trained, multilingual professionals was available for significantly reduced wages when compared to more developed countries. In addition to favorable labor costs, India’s government officials incentives such as tax holidays to attract businesses to India. As late as the 1990s, few multinationals, including high-tech companies, had significant operations in India. Now, it is common for a high-tech multinational to have a presence in India.

This surge of multinational presence has focused considerable attention on India’s transfer pricing regime. India’s transfer pricing regulations were released in 2001, and shortly thereafter, i.e., in 2003, transfer pricing audits effectively began. The Central Board of Taxes in India introduced a specialized cell of trained officers that is responsible for all transfer pricing audits. Over the past years, there has been a significant increase in the number of transfer pricing audit officers (TPOs). “The TPOs in this short time have positioned India’s transfer pricing administration as an aggressive one.”21

21 Hardev Singh & Saurabh Dhanuka (KPMG in India), How to Survive a Transfer Pricing Audit In India, TP WEEK, May 22, 2008.

While the new guidelines may not address all issues—for example, the discussion of losses does not seem to acknowledge that losses are a relatively common outcome of business investments, and that once incurred they may never be recovered—but, in general, the updated guidelines are an important step forward.



Further, in the past couple of years, the TPOs have made significant transfer pricing adjustments to the income of several multinational enterprises’ operating captive centers in India, especially in the areas of technology and services. India’s revenue authorities have also made transfer pricing adjustments on account of royalty and management fee payouts by subsidiaries in India of high-tech companies headquartered in the United States and other parts of the world. The fact pattern of adjustments indicates that one in every four cases picked up for audit is adjusted. While transfer pricing adjustments are increasingly common, it is noteworthy that the U.S. and India competent authorities reached a negotiated settlement on a transfer pricing dispute in May 2010.

Other unique factors include currency controls, services payments, and expatriation of IP to tax havens. Currency controls, while modified recently,22 generally complicate extracting cash from operations in India for use in other activities. The liberalized currency controls now permit all payments for royalty, lump-sum fee for transfer of technology, and payments for use of trademark/brand name under the automatic route without any restrictions. However, it becomes equally important for a company to ensure that these liberalized payments adhere to the arm’s-length standard.

India’s authorities tend to scrutinize the inbound provision of services to companies in India that would result in an outbound payment further reducing mechanisms for extracting cash from Indian operations. India’s government, more specifically its transfer pricing authorities, asserts that companies in India should capture all of the location savings of outbound services generally through a markup that is considerably higher than those observed for similar transactions in other jurisdictions. Some of the other scenarios that would attract the attention of the TPOs for a transfer pricing audit would be:

• Consistentlossesofthetaxpayerattributabletointercompanytransactions

• Significantchangesintheprofitabilityofthetaxpayeranditsassociatedenterprises

• Unjustifiablylargepaymentofmanagementchargesnotpassingthe“benefittest”

• Lossesincurredbyroutinedistributors.

Further, India’s taxing authority has placed significant hurdles to extracting IP from India such that it is unclear whether any high-tech company has been successful in migrating material IP from India. These challenges are also being faced by several high-tech companies having their headquarters in India.

22 KPMG in India, Flash News (Dec. 18, 2009), read with Press Note No. 8 (Dec. 16, 2009).

In the past couple of years, the TPOs have made significant transfer pricing adjustments to the income of several multinational enterprises’ operating captive centers in India, especially in the areas of technology and services. India’s revenue authorities have also made transfer pricing adjustments on account of royalty and management fee payouts by subsidiaries in India of high-tech companies headquartered in the United States and other parts of the world.



ChinaChina’s GDP growth has been impressive, even in a challenging global economy, resulting in China’s supplanting of Japan as the world’s second largest economy in the second quarter of 2010.23 Not surprisingly, increasing numbers of high-tech companies have expanded into China. Meanwhile, China’s State Administration of Taxation (SAT) has invested considerable time and resources in designing its transfer pricing regime.

On January 8, 2009, China’s SAT formally issued new transfer pricing regulations. The new regulations significantly expanded upon the concepts of audit, advance pricing agreements, and annual filing requirements, as well as introducing contemporaneous documentation, thin capitalization requirements, and guidelines for controlled foreign corporations and CSAs.

There has been an increase in efforts by China’s tax authorities and a renewed focus on transfer pricing audits. During 2009, the SAT initiated 179 cases and concluded 167, leading to RMB 16.09 billion in income adjustments and RMB 2.09 billion in tax recovered. This represented a 68.5 percent increase in tax recovered over 2008. The largest supplementary payment was RMB 461 million, and there were 40 cases exceeding RMB 10 million (approximately USD 1.5 million), and four cases exceeding RMB 100 million (approximately USD 15 million).24

Not surprisingly, there are also some unique aspects to China’s transfer pricing regime. Like India, China has provided incentives to multinationals to attract inbound investment. Special tax regimes have been a cornerstone of the incentive program. It is important to note the specificity of any rulings applied for and received as part of this program, as such rulings may not cover the natural evolution of operations. For instance, a tax ruling for research and development activity will not cover back office services and may not even cover R&D employees providing consulting services. Further, the rulings are province-specific. Operations in separate locations within China generally require unique tax rulings and may have different incentives available to them. Similarly, operations in multiple locations within China are generally not eligible for a consolidated return as there are many local tax requirements.25

Other aspects of China’s transfer pricing regime include accelerated documentation deadlines, currency conversion complexity, and hurdles to IP migration. In China, transfer pricing documentation is due on May 31 of the subsequent year, which is earlier than deadlines in many other jurisdictions. This may force taxpayers to prepare documentation for the other parties to the transaction earlier to ensure consistency, which condenses an already compressed compliance calendar. With respect to currency conversion, as the Renminbi (RMB) is not freely floating, there are additional steps required to repatriate cash from China as well.26 Much like India, movement of IP out of China is expected to pose challenges to future business restructurings.

Added Enforcement in JapanJapan’s tax authority, the National Tax Agency (NTA), has been focusing on the changes in business environment and issues arising from the “hollowing out,” a Japanese term for the general shifting of manufacturing and other sectors to lower cost jurisdictions, which erodes the economic base in Japan. The Japanese transfer pricing rules dates back to 1986. Recently, however, transfer pricing rules and administrative guidelines have been the subject of yearly tax reform. “Hollowing

23 China Passes Japan As Second-Largest Economy, ASSOCIATED PRESS, Aug. 16, 2010. 24 Comments obtained from SAT officials during speeches delivered in Beijing on April 23, 2010, and in Shanghai on November 21, 2009; China Tax News (www.ctnews.com.cn) on April 12, 2010; Xinhua news; and Interviews with private sources. 25 See KPMG International, Asia Pacific Taxation, China, 2008/09 Edition, at 6 for more information. 26 See KPMG International, Asia Pacific Taxation, China, 2008/09 Edition, at 11 for more information.

In China, transfer pricing documentation is due on May 31 of the subsequent year, which is earlier than deadlines in many other jurisdictions. This may force taxpayers to prepare documentation for the other parties to the transaction earlier to ensure consistency, which condenses an already compressed compliance calendar.



out” brought about substantial reduction of tangible transactions as significant manufacturing activity is now performed in lower-cost markets such as China and Vietnam. Therefore, the recent focus of the tax authority has been on “service transactions,” which capture compensation for the headquarter function, and “intangible transactions,” which capture compensation for the development of an intangible. High-tech companies are active participants in this cost optimization trend as margins have been squeezed by increasing competition and the slow recovery from the economic downturn. Further, high-tech companies are seeing a shift to increasing services transactions as business models evolve such as the transition to software as a service.

In addition, the introduction of major changes in the corporate tax system, particularly the foreign dividend exclusion in 2009, brought an increased concern by the Japan’s tax authority that profits may be shifted from Japan to foreign subsidiaries.

As part of 2010 Tax Reform, Japan’s tax authority announced changes to their transfer pricing documentation requirements. These changes are effective from the fiscal year starting April 1, 2010.

Article 66-4(7) (now 66-4(6) under the amendment) of the measures known as “Special Provisions for Taxation on Transactions with Foreign Affiliated Persons” (the so-called “presumptive taxation” provision) vests the tax authorities with the authority to “presume” an arm’s-length price based on, for instance, information gathered through “secret” inquiries and inspections on the taxpayer’s peer companies and to reassess the taxpayer’s taxable income in the event the taxpayer fails to present or submit, without delay, certain information requested by the transfer pricing examiner during a transfer pricing audit. The information gathered through such means and used in calculating the “presumed” arm’s-length price is “secret,” because the tax authorities do not have to disclose this information. It is confidential under law.

The information required under the prior presumptive taxation provision was only for books and records (or copies of such) related to the intercompany transactions under audit. However, under the amended presumptive taxation provision, the type and coverage of documents and information required are clearly specified, and are expanded to include detailed information on intercompany transactions and the transfer pricing methodology adopted in determining the transfer price. These required documents include similar information required under the transfer pricing documentation rule in many OECD countries.

As part of 2010 Tax Reform, Japan’s tax authority announced changes to their transfer pricing documentation requirements. These changes are effective from the fiscal year starting April 1, 2010.




Many high-tech companies felt the brunt of the economic downturn in 2008, but the recovery began to take hold in 2009. Although the high-tech recovery appears to be continuing in 2010, the trajectory may vary widely among individual companies and regions.

This recession stands out from other recent downturns in terms of its severity, geographic breadth, and impact across all industries. The recession has led to persistently high unemployment and significantly lower tax revenue, both of which have strained government finances at a time when economists across the globe have been calling for government stimulus packages. As a result, many governments have identified multinational corporations as a potential source of additional tax revenue.

Many government pronouncements may manifest themselves through changes in tax law, more rigorous enforcement efforts, or most likely a combination of the two. A discussion of the myriad of possible and proposed tax law changes are beyond the scope of this paper. The ultimate impact is expected to be higher corporate tax payments, particularly for multinationals, in the near term through additional tax controversy and in the longer term by means of revised tax regimes.

How Some Governments Have Addressed Tax Revenue Shortfalls

Australia undertook a comprehensive review of its taxation system before the extent of the downturn was known. This review, Australia’s Future Tax System Review, also known as the AFTS Review or the Henry Review, published results in early 2010. The focus of this review is a comprehensive consideration of tax and transfer (welfare) systems and international corporate reform.

In the United States, the Obama Administration in early 2009 presented a plan to raise more than $200 billion in new taxes from multinational companies. According to The Wall Street Journal, Treasury Secretary Timothy Geithner and Lawrence Summers, the White House economic adviser, hosted a conference call on March 25, 2009, with top executives from several companies, including IBM, Citigroup Inc., GE, Google Inc. and Honeywell International Inc. to present the administration’s international tax reform proposal. In a May 2009 meeting with a Silicon Valley delegation, Mr. Summers acknowledged that the government was desperate for new sources of revenue.27 Essentially, the U.S. government has put large multinational CFOs on notice that the U.S. Treasury needs money and intends to seek tax revenue to fill the gap.

In contrast to the United States, the United Kingdom has adopted a more business-friendly approach. In April 2008, the U.K. Chancellor of the Exchequer Alistair Darling launched a high-level forum for multinational senior executives. The thrust of this forum was to quiet executives’ fears that international tax reform in the United Kingdom would endanger their competitiveness.28 The United Kingdom aims to protect its tax base by ensuring its largest companies remain headquartered in the United Kingdom.

II. Recent Trends in the Economic Environment

27 Neil King Jr. & Elizabeth Williamson, Business Fends Off Tax Hit, WALL ST. J., Oct. 14, 2009. 28 Vanessa Houlder, Treasury Seeks to Reassure Multinationals, FINANCIAL TIMES, Feb. 21, 2010.




Increased Tax ControversyAs the number and scope of intercompany transactions continue to proliferate in the expanding global economy, the frequency of transfer pricing-related tax audits had been increasing, particularly in the high-tech sector, even before the economic downturn.

Penalties and assessments resulting from these audits can be significant. Against the backdrop of more vigilant taxing bodies around the world, businesses operating in the global high-tech industry are dealing with the transfer pricing implications growing out of ongoing mergers and acquisitions, joint ventures, strategic alliances, and corporate restructurings. In addition to these business combinations, the movement of IP and the inclusion of stock expense in intercompany services also bring complexity and scrutiny to high-tech companies. Conflicting positions and methodologies advocated by various taxing authorities may only serve to increase the amount of resources and the level of professional and technical judgment needed to determine both the tax position and the subsequent tax provision.

The main transfer pricing risks for high-tech companies revolve around IP and services. For example, IP development, use of cross-border consulting, centralized management services, and intercompany lending services are all intercompany transactions subject to scrutiny. Contributing to the increased importance of transfer pricing in the high-tech industry are a number of key elements:

• Newandexpandedtransferpricinglegislationinagrowingnumberofcountries

• Globalenforcementandademandformorethoroughdocumentationrelatingtotransfer pricing activities

• Increasingranksofgovernmentauditorswhoarewelltrainedinthetechnicalaspectsof transfer pricing

• Prevalenceofmergersandacquisitionsactivityandrelatedtransferpricingintegrationissues

• Importanceofstockoptiongrantsinemployeecompensationandtheirimpactonthecost base for services and the movement of IP

• Increasinglycommonpracticeofregionallyorgloballymanagedbusinessunits

• Complexissuesandtransactionsresultingfromthegrowingnumberofjurisdictionshousing tangible property such as plant and equipment, the location of service providers throughout the organization, and, most importantly, the location and ownership structure of intellectual property.

The transfer pricing compliance environment has evolved rapidly in a relatively short period of time. The list of nations that has imposed transfer pricing compliance requirements continues to grow, and with this phenomenon, there is a new and urgent focus on multinationals’ documentation of transfer pricing practices and policies. Hence, the need for globally consistent processes to create, share, and archive documentation has become critical.

Hiring Transfer Pricing Professionals

There was a time in the not-too-distant past when complex transfer pricing issues might have been too difficult for some nations’ taxing authorities to evaluate. Now, as a result of training and experience, complexity rarely dissuades taxing authorities from moving forward and challenging transfer pricing transactions, which can result in costly audits.

Helping to accelerate this long-term trend of increased transfer pricing scrutiny is the need for revenue by cash-strapped governments. To facilitate this additional enforcement and fulfill jobs programs, governments are hiring rapidly. In 2009, President Obama, as part of the recently announced international tax reform proposals, proposed to provide the IRS with 800 new staff members to increase international enforcement.29

In China, the SAT has been strengthening its anti-avoidance provisions and also its anti-avoidance teams. Companies under audit in China will face experienced auditors under pressure to produce tax revenue, with a growing array of regulatory options at their disposal. Transfer pricing adjustments to taxable income went from approximately 7 billion RMB in 2005 to more than 16 billion RMB in 2009.30

For additional insights on transfer pricing controversy, see KPMG International’s A Meeting of Minds—Resolving Transfer Pricing Controversies. To request a copy, e-mail us at [email protected].

29 Press Release, Office of the Press Secretary, The White House, Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives For Shifting Jobs Overseas (May 4, 2009), www.whitehouse.gov. 30 Comments obtained from SAT officials during speeches delivered in Beijing on April 23, 2010; China Tax News (www.ctnews.com.cn) on April 12, 2010; Xinhua news; and Interviews with private sources.



2008/2009ArgentinaArubaAustraliaAustriaBelgiumBrazil

2007 CanadaArgentina ChileAustralia China (People’s Republic of)

Austria ColombiaBelgium CroatiaBrazil Czech Republic

2006 Canada DenmarkArgentina Chile EcuadorAustralia China (People’s Republic of) EgyptAustria Colombia Estonia

2005 Belgium Czech Republic FinlandArgentina Brazil Denmark FranceAustralia Canada Ecuador Germany

2004 Austria Chile Egypt GreeceArgentina Belgium China (People’s Republic of) Estonia Hong KongAustralia Brazil Colombia Finland HungaryAustria Canada Czech Republic France IndiaBelgium Chile Denmark Germany Indonesia

2003 Brazil China (People’s Republic of) Ecuador Greece Ireland (Republic of)

Argentina Canada Colombia Egypt Hong Kong Israel2002 Australia Chile Czech Republic Estonia Hungary ItalyArgentina Austria China (People’s Republic of) Denmark France India JapanAustralia Brazil Colombia Ecuador Germany Indonesia KazakhstanAustria Canada Czech Republic Egypt Hungary Ireland (Republic of) KenyaBrazil Chile Denmark Estonia India Israel Korea (Republic of)

2001 Canada China (People’s Republic of) Estonia France Indonesia Italy LatviaArgentina Chile Czech Republic France Germany Israel Japan LithuaniaAustralia China (People’s Republic of) Denmark Germany Hungary Italy Korea (Republic of) Luxembourg

2000 Austria Czech Republic Estonia Hungary India Japan Latvia MalawiArgentina Brazil Denmark France India Indonesia Korea (Republic of) Lithuania Malaysia

1999 Australia Canada Estonia Germany Indonesia Italy Latvia Luxembourg MexicoArgentina Austria Chile France Hungary Italy Japan Lithuania Malaysia Montenegro

1998 Australia Brazil China (People’s Republic of) Germany India Japan Korea (Republic of) Luxembourg Mexico NetherlandsArgentina Austria Canada Czech Republic India Indonesia Korea (Republic of) Latvia Malaysia Montenegro New ZealandAustralia Brazil Chile Denmark Indonesia Italy Latvia Lithuania Mexico Netherlands NorwayAustria Canada China (People’s Republic of) Estonia Italy Japan Lithuania Luxembourg Montenegro New Zealand OECD

1997 Brazil Chile Czech Republic France Japan Korea (Republic of) Luxembourg Malaysia Netherlands OECD PeruAustralia Canada China (People’s Republic of) Denmark Germany Korea (Republic of) Latvia Malaysia Mexico New Zealand Peru PhilippinesAustria Chile Czech Republic Estonia India Latvia Luxembourg Mexico Montenegro OECD Philippines PolandBrazil China (People’s Republic of) Denmark France Indonesia Luxembourg Malaysia Montenegro Netherlands Peru Poland PortugalChile Czech Republic France Germany Italy Mexico Mexico Netherlands New Zealand Philippines Portugal Romania

1996 Czech Republic Denmark Germany Indonesia Japan Montenegro Montenegro New Zealand OECD Poland Romania RussiaAustralia France France Indonesia Italy Korea (Republic of) Netherlands Netherlands OECD Peru Portugal Russia Serbia

1995 Austria Germany Germany Italy Japan Latvia New Zealand New Zealand Peru Philippines Romania Serbia SingaporeAustralia Czech Republic Indonesia Indonesia Japan Korea (Republic of) Mexico OECD OECD Philippines Poland Russia Singapore Slovak RepublicCzech Republic France Italy Italy Korea (Republic of) Latvia New Zealand Peru Peru Poland Portugal Serbia Slovak Republic SloveniaFrance Germany Japan Japan Latvia Mexico OECD Philippines Philippines Portugal Romania Singapore Slovenia South Africa

<1994 Germany Indonesia Korea (Republic of) Korea (Republic of) Mexico New Zealand Peru Poland Poland Romania Russia Slovak Republic South Africa SpainAustralia Indonesia Italy Latvia Latvia New Zealand OECD Philippines Portugal Portugal Russia Serbia Slovenia Spain Sri LankaCzech Republic Italy Japan Mexico Mexico OECD Philippines Poland Russia Russia Serbia Singapore South Africa Sri Lanka SwedenFrance Japan Korea (Republic of) New Zealand New Zealand Philippines Poland Russia Serbia Serbia Singapore Slovak Republic Spain Sweden SwitzerlandGermany Latvia Latvia OECD OECD Poland Russia Serbia Singapore Singapore Slovak Republic Slovenia Sri Lanka Switzerland Taiwan (Republic of China)

Indonesia OECD OECD Philippines Philippines Russia Singapore Singapore Slovak Republic Slovak Republic South Africa South Africa Sweden Taiwan (Republic of China) ThailandItaly Philippines Philippines Poland Poland Singapore Slovak Republic Slovak Republic South Africa South Africa Sweden Sweden Taiwan (Republic of China) Thailand TurkeyJapan Poland Poland Singapore Singapore Slovak Republic South Africa South Africa Sweden Sweden Taiwan (Republic of China) Taiwan (Republic of China) Thailand Turkey UkrainePoland Singapore Singapore Slovak Republic Slovak Republic South Africa Sweden Sweden Thailand Thailand Thailand Thailand Ukraine Ukraine United KingdomSingapore Slovak Republic Slovak Republic South Africa South Africa Sweden Ukraine Ukraine Ukraine Ukraine Ukraine Ukraine United Kingdom United Kingdom United StatesSlovak Republic South Africa South Africa Sweden Sweden Ukraine United Kingdom United Kingdom United Kingdom United Kingdom United Kingdom United Kingdom United States United States VenezuelaSweden Sweden Sweden Ukraine Ukraine United Kingdom United States United States United States United States United States United States Venezuela Venezuela VietnamUnited States United States United States United States United States United States Venezuela Venezuela Venezuela Venezuela Venezuela Venezuela Vietnam Vietnam Zambia


Countries Imposing Transfer Pricing RulesThis chart reflects the stepped-up enforcement in the global transfer pricing arena. As many companies that have been subjected to tax audits can attest, countries no longer act in isolation when it comes to enforcement of transfer pricing tax matters. In fact, countries that adhere to OECD transfer pricing guidelines tend to monitor audits and sanctions imposed by other countries, particularly if those countries have active tax treaty networks.



2008/2009ArgentinaArubaAustraliaAustriaBelgiumBrazil

2007 CanadaArgentina ChileAustralia China (People’s Republic of)

Austria ColombiaBelgium CroatiaBrazil Czech Republic

2006 Canada DenmarkArgentina Chile EcuadorAustralia China (People’s Republic of) EgyptAustria Colombia Estonia

2005 Belgium Czech Republic FinlandArgentina Brazil Denmark FranceAustralia Canada Ecuador Germany

2004 Austria Chile Egypt GreeceArgentina Belgium China (People’s Republic of) Estonia Hong KongAustralia Brazil Colombia Finland HungaryAustria Canada Czech Republic France IndiaBelgium Chile Denmark Germany Indonesia

2003 Brazil China (People’s Republic of) Ecuador Greece Ireland (Republic of)

Argentina Canada Colombia Egypt Hong Kong Israel2002 Australia Chile Czech Republic Estonia Hungary ItalyArgentina Austria China (People’s Republic of) Denmark France India JapanAustralia Brazil Colombia Ecuador Germany Indonesia KazakhstanAustria Canada Czech Republic Egypt Hungary Ireland (Republic of) KenyaBrazil Chile Denmark Estonia India Israel Korea (Republic of)

2001 Canada China (People’s Republic of) Estonia France Indonesia Italy LatviaArgentina Chile Czech Republic France Germany Israel Japan LithuaniaAustralia China (People’s Republic of) Denmark Germany Hungary Italy Korea (Republic of) Luxembourg

2000 Austria Czech Republic Estonia Hungary India Japan Latvia MalawiArgentina Brazil Denmark France India Indonesia Korea (Republic of) Lithuania Malaysia

1999 Australia Canada Estonia Germany Indonesia Italy Latvia Luxembourg MexicoArgentina Austria Chile France Hungary Italy Japan Lithuania Malaysia Montenegro

1998 Australia Brazil China (People’s Republic of) Germany India Japan Korea (Republic of) Luxembourg Mexico NetherlandsArgentina Austria Canada Czech Republic India Indonesia Korea (Republic of) Latvia Malaysia Montenegro New ZealandAustralia Brazil Chile Denmark Indonesia Italy Latvia Lithuania Mexico Netherlands NorwayAustria Canada China (People’s Republic of) Estonia Italy Japan Lithuania Luxembourg Montenegro New Zealand OECD

1997 Brazil Chile Czech Republic France Japan Korea (Republic of) Luxembourg Malaysia Netherlands OECD PeruAustralia Canada China (People’s Republic of) Denmark Germany Korea (Republic of) Latvia Malaysia Mexico New Zealand Peru PhilippinesAustria Chile Czech Republic Estonia India Latvia Luxembourg Mexico Montenegro OECD Philippines PolandBrazil China (People’s Republic of) Denmark France Indonesia Luxembourg Malaysia Montenegro Netherlands Peru Poland PortugalChile Czech Republic France Germany Italy Mexico Mexico Netherlands New Zealand Philippines Portugal Romania

1996 Czech Republic Denmark Germany Indonesia Japan Montenegro Montenegro New Zealand OECD Poland Romania RussiaAustralia France France Indonesia Italy Korea (Republic of) Netherlands Netherlands OECD Peru Portugal Russia Serbia

1995 Austria Germany Germany Italy Japan Latvia New Zealand New Zealand Peru Philippines Romania Serbia SingaporeAustralia Czech Republic Indonesia Indonesia Japan Korea (Republic of) Mexico OECD OECD Philippines Poland Russia Singapore Slovak RepublicCzech Republic France Italy Italy Korea (Republic of) Latvia New Zealand Peru Peru Poland Portugal Serbia Slovak Republic SloveniaFrance Germany Japan Japan Latvia Mexico OECD Philippines Philippines Portugal Romania Singapore Slovenia South Africa

<1994 Germany Indonesia Korea (Republic of) Korea (Republic of) Mexico New Zealand Peru Poland Poland Romania Russia Slovak Republic South Africa SpainAustralia Indonesia Italy Latvia Latvia New Zealand OECD Philippines Portugal Portugal Russia Serbia Slovenia Spain Sri LankaCzech Republic Italy Japan Mexico Mexico OECD Philippines Poland Russia Russia Serbia Singapore South Africa Sri Lanka SwedenFrance Japan Korea (Republic of) New Zealand New Zealand Philippines Poland Russia Serbia Serbia Singapore Slovak Republic Spain Sweden SwitzerlandGermany Latvia Latvia OECD OECD Poland Russia Serbia Singapore Singapore Slovak Republic Slovenia Sri Lanka Switzerland Taiwan (Republic of China)

Indonesia OECD OECD Philippines Philippines Russia Singapore Singapore Slovak Republic Slovak Republic South Africa South Africa Sweden Taiwan (Republic of China) ThailandItaly Philippines Philippines Poland Poland Singapore Slovak Republic Slovak Republic South Africa South Africa Sweden Sweden Taiwan (Republic of China) Thailand TurkeyJapan Poland Poland Singapore Singapore Slovak Republic South Africa South Africa Sweden Sweden Taiwan (Republic of China) Taiwan (Republic of China) Thailand Turkey UkrainePoland Singapore Singapore Slovak Republic Slovak Republic South Africa Sweden Sweden Thailand Thailand Thailand Thailand Ukraine Ukraine United KingdomSingapore Slovak Republic Slovak Republic South Africa South Africa Sweden Ukraine Ukraine Ukraine Ukraine Ukraine Ukraine United Kingdom United Kingdom United StatesSlovak Republic South Africa South Africa Sweden Sweden Ukraine United Kingdom United Kingdom United Kingdom United Kingdom United Kingdom United Kingdom United States United States VenezuelaSweden Sweden Sweden Ukraine Ukraine United Kingdom United States United States United States United States United States United States Venezuela Venezuela VietnamUnited States United States United States United States United States United States Venezuela Venezuela Venezuela Venezuela Venezuela Venezuela Vietnam Vietnam Zambia




Economic Downturn and Uncertain Timing of RecoveryBy now, many high-tech companies believe they have seen the worst of the downturn and are either anticipating or beginning to return to profitability.31 Given the impetus of the downturn, a global financial crisis, and its severity, the recovery is expected to be less robust than recoveries from the tech bubbles of the 1990s. Historically, recessions associated with financial crises have been deeper, longer lasting, and followed by slower recoveries.32

In April 2010, the International Monetary Fund (IMF) projected that global economic activity contracted by 0.6 percent in 2009 and would grow by 4.2 percent in 2010. The IMF projections are significantly weaker for the advanced economies (including the United States, the United Kingdom, the Euro area, Canada, and Japan): a 3.2 percent decline in 2009 and 2.3 percent growth in 2010. IMF projections for developing Asia are relatively better, calling for 6.6 percent growth in 2009 and 8.7 percent growth in 2010. After growing at 2.8 percent in 2008, and declining at 10.7 percent in 2009, world trade volume is expected to grow at 7 percent in 2010.33 More recent economic indicators have been mixed, with some economists predicting a double-dip recession in major markets.34

The global economic recession has led to lower profits and/or losses for a number of high-tech companies. Some companies may not have anticipated the lower profits and/or losses when their transfer pricing policies were established. Further, many high-tech companies have undertaken significant cost-reducing and other restructurings, whose treatment for transfer pricing purposes must be carefully considered. Tax authorities in jurisdictions where losses are recorded may challenge the substance behind the assumption of risk leading to the losses. Clearly written intercompany agreements can be very helpful in this regard; other factors typically considered by the tax authority include whether the entity had decision-making authority matching the risks assumed and the financial capacity to bear the resulting outcomes.35

Documenting and sustaining transfer pricing in this economic environment can create many difficult issues for tax departments. While the problems may be particularly acute for a high-tech company facing system losses that must be recognized somewhere, volatility and uncertainty of profits and prices can affect transfer pricing even at profitable companies. For example, the documentation required in one jurisdiction of a transaction affected by the global downturn may be very different from that needed to substantiate the transaction in another. Analyses prepared in these circumstances will require careful consideration of attribution of risk, adjustments to comparable results, and consideration of “loss splits.”

As companies file their tax returns and prepare transfer documentation for 2009, high-tech companies are paying particular attention to the treatment of items related to the recession, such as the recognition of losses and restructuring charges.

The documentation required in one jurisdiction of a transaction affected by the global downturn may be very different from that needed to substantiate the transaction in another. Analyses prepared in these circumstances will require careful consideration of attribution of risk, adjustments to comparable results, and consideration of “loss splits.”

31 KPMG LLP United States, TECHNOLOGY INDUSTRY EXECUTIVE SURVEY (July 2010). 32 INTERNATIONAL MONETARY FUND (IMF), WORLD ECONOMIC OUTLOOK: CRISIS AND RECOVERY 98 (Apr. 2009). 33 All projections cited are from IMF World Economic Outlook, supra note 32, table 1.1. 34 Stiglitz Says European Economy at Risk of Double-Dip Recession, BLOOMBERG NEWS, Aug. 24, 2010; Simon Constable, Economist Shiller Sees Potential for ‘Double Dip’ Recession, WALL ST. J., Aug. 28, 2010. 35 Treas. Reg. § 1.482-1(d)(3)(iii)(B).



Recognition of LossesWhen a high-tech company as a whole, or a line of business within the broader group, experiences losses, transfer pricing policies help determine how those losses are recognized among the various legal entities. Many tax authorities, themselves under pressure to maintain tax revenue collections, are likely to assert that the burden of losses should fall outside their own jurisdictions.

More specifically, transfer pricing policies help determine how business risks are shared within the group. As a simple example, suppose the group manufactures products in one country and sells to controlled distributors abroad. As a result of the recession, the end user price may have fallen sharply. If the transfer pricing policy is based on a fixed price paid to the manufacturer, then the distributor is bearing the entire burden associated with the price reductions. If, alternatively, the transfer pricing policy sets the unit price so the distributor earns an arm’s-length profit, then much of the burden of the price reduction is passed back to the manufacturer.

Many high-tech companies have implemented transfer pricing policies that treat most of their subsidiaries (not just distributors) as “limited risk” entities with targeted operating margins. In such cases, nearly the entire burden of declines in both price and unit volume may fall on a single central entrepreneur. The consolidated group may pay taxes in many jurisdictions despite system losses; the resulting tax inefficiency will be particularly large if the central entrepreneur is located in a low-tax jurisdiction or faces other restrictions on future tax benefits associated with these losses.

High-tech companies in this position may consider changes to these structures. However, changes to the allocation of risk must be done before the fact. Tax authorities may consider attempts to allocate risks ex post to be inconsistent with the arm’s-length principle. Such ex post allocations of risk will likely receive increased scrutiny from tax authorities.

Many high-tech companies have implemented transfer pricing policies that treat most of their subsidiaries (not just distributors) as “limited risk” entities with targeted operating margins. In such cases, nearly the entire burden of declines in both price and unit volume may fall on a single central entrepreneur.



RestructuringIn response to the economic downturn, many high-tech companies took preemptive action to control costs and cash at the outset of the recession. These actions may have included significant reductions in force, facility closings or consolidations, and even exiting certain markets. These restructurings frequently included reorganization of responsibilities and decision-making authority within the company.

The arm’s-length principle generally requires that attribution of risk be aligned with the capacity to bear and manage that risk. Restructurings in which the key decision-making authority is removed from—or moved into—legal entities should be reflected in revised transfer pricing policies.

Business restructurings often result in nonrecurring charges, such as severance costs and/or impairment charges, being recorded on financial statements. The treatment of such charges for transfer pricing purposes is often not obvious. In some cases, restructuring charges and/or other cost variances can interact with a company’s transfer pricing policy in ways that make little sense. Should severance charges associated with a significant reduction in force be included in the cost base for cost plus entities? The inclusion of restructuring charges in the cost base may result in increases in profits and taxes even when economic conditions suggest that profits should fall.

If the restructuring has a material impact on the current period’s profitability or future potential for earnings, the high-tech company must also consider whether an exit charge is appropriate or would be deemed appropriate by the local taxing authority. In evaluating the treatment of these charges, the key factors are to determine what entity benefits from the restructuring, what the intercompany agreement says, and whether the resulting financial outcomes make sense. Such issues are likely to be viewed differently by the tax authorities on the charging and receiving ends of the transaction, and careful thought and documentation of the facts and circumstances supporting the treatment chosen is highly recommended.

“Cash is king” became a popular phrase during the course of the economic downturn. Managing the cash in a high-tech multinational became more challenging as there was generally less cash available. For many high-tech companies, this cash constraint was a new challenge after many years of significant cash build-up from successful IPOs, other offerings, and growing profitability.

The arm’s-length principle generally requires that attribution of risk be aligned with the capacity to bear and manage that risk. Restructurings in which the key decision-making authority is removed from—or moved into—legal entities should be reflected in revised transfer pricing policies.



One mechanism for managing cash is related-party loans. Related-party debt warrants review during any economic shock. Of particular concern is whether the one party fails to follow the stated terms of a loan agreement. For example, the lender may waive loan covenants or permit the borrower to skip a payment during a cash crunch. Such lapses may result in a tax authority asserting that the debt is not bona fide indebtedness, attempting to recharacterize it as equity.36 Alternatively, the lender and borrower may significantly modify the terms of a loan and fail to realize that they have created a new debt instrument.37 In this case, the old transfer pricing documentation would no longer apply, and the arm’s-length nature of the new loan would have to be documented using contemporaneous transactions.38 Given the volatility in the credit markets, previous rates and terms may be difficult to defend and should be carefully examined.

Major economic and regulatory developments in 2009 that may have created a variety of transfer pricing issues for high-tech companies have increased the importance of ongoing examination of unusual profit results and restructuring items. While many high-tech companies are on the road to recovery and some are experiencing record revenues and profits, it may be appropriate to invest the time and resources to document the basis for these restructuring items. It will be critical for transfer pricing documentation to clearly articulate the business factors behind the financial results as well as demonstrate how the treatment of unusual items is consistent with transfer pricing policies and agreements.39

36 Laidlaw Transp., Inc., v. Commissioner, T.C. Memo. 1998-232, 75 T.C.M. (CCH) 2598 (1998). 37 See Treas. Reg. § 1.1001-3. 38 Treas. Reg. § 1.482-2(a). 39 See additional insights on transfer pricing in the current economic environment, in KPMG International’s Planning for the Recovery – Examining Transfer Pricing in the Current Environment and Beyond, 2009. To request a copy, e-mail us at [email protected].

Major economic and regulatory developments in 2009 that may have created a variety of transfer pricing issues for high-tech companies have increased the importance of ongoing examination of unusual profit results and restructuring items.




Conversion to Fabless Chip Companies The current prevailing mode for chip design companies is to be fabless. For those with fabs, several have expanded their third-party fab production. Notably, Advanced Micro Devices (AMD) sold its semiconductor fabrication facilities (fabs) into a joint venture with Advanced Technology Investment Company, a sovereign wealth fund wholly owned by the Emirate of Abu Dhabi in 2009. The joint venture, GLOBALFOUNDRIES, assumed ownership of all AMD’s fabs, in an effort to increase profits by lowering the cost model.40 AMD‘s chief competitor, Intel, is so far bucking this trend and keeping production in-house. In 2009, Intel decided to invest US$7 billion in refurbishing its semiconductor fabrication plants in the United States.41 Intel believes that keeping production in-house provides a comparative advantage, because the company has direct control over processes, quality control, product cost, volume, timing of production, and other factors.42 Other major chip makers with primarily outsourced production include , Altera, Atheros, LSI Logic, NVidia, and Xilinx, among others.

While decisions about whether to manufacture in-house or through third parties are driven by business considerations—i.e., cost, capacity, turnaround time, investment, protection of manufacturing IP, etc.—the tax and transfer pricing impact of such changes must be evaluated as part of the overall cost benefit analysis. The selection of a new manufacturer can cause changes in the entire supply chain. The functions and risks of all parties to the intercompany transactions as well as the character of the income arising from the transactions will need to be reviewed and, perhaps, reconsidered. For business models where a related-party manufacturer was the entrepreneur, significant support for the remaining activities in that jurisdiction will be required.

For chip companies, investment in fabs is generally the single largest tangible investment. A new fab can cost up to US$7 billion. In 2005, a new fab in the United States cost US$3 billion to build.43 In 2008, a new fab in Japan was expected to exceed JPY 700B (US$6.6 billion at the time of announcement).44 The cost of the fab varies based on wafer size (i.e.,, a 300mm fab) and the process dimension (i.e., a 43 nm process) as well as the location of the facility. In shifting to a fabless company, the balance sheet will be materially different. Additional consideration as to relevant business metrics and profit level indicators (PLIs) will be necessary to appropriately evaluate and test transactions.

III. Recent Trends in the Business Environment

The functions and risks of all parties to the intercompany transactions as well as the character of the income arising from the transactions will need to be reviewed and perhaps, reconsidered.

40 Ed Sperling, Why AMD’s Arab Joint Venture Matters, FORBES, Mar. 9, 2009. 41 Id. 42 Intel Corp., Annual Report (Form 10-K) (fiscal year ending Dec. 27, 2008), at 11. 43 Mark LaPedus, Intel to Build New 300-mm Fab in Arizona, EE TIMES, July 25, 2005 44 Press Release, David Lammers, Semiconductor Int’l, Toshiba Plans Two Memory Fabs (Feb. 19, 2008); Press Release, David Lammers, Semiconductor Int’l, SanDisk, Toshiba Announce Flexible MOU (Feb. 19, 2008).




One defining characteristic of the high-tech industry is that nothing is static. As significantly as the hardware business model has changed in recent years, the software model has evolved in kind.

Software as a Service and Cloud Computing Software was originally resident on mainframe computers. In the 1980s, with the birth of client servers and desktop computers, software existed on the server as well as desktops and was portable on discs and other media. With increasingly mobile workforces, software needs to be accessed from a bevy of new devices such as laptops, netbooks, and smartphones. Installing and maintaining software on each device is a resource-intensive process. Accordingly, software is increasingly being offered as a service, meaning that it is hosted by another party, often the software provider, and accessed by various customer devices. Cloud computing is an extension of this trend in which software applications are accessed via the Internet in a manner that is generally dynamically scalable, and the responsibility for maintenance and support is abstracted from the user.

This evolution of the software industry has unique implications for tax and transfer pricing. Instead of “to be or not to be,” the eternal question is: What is it? In other words, is it tangible property, IP, or a service? Or is it all of the above? This characterization dilemma has been present since the emergence of the software industry. However, recent trends in customer delivery and use have added new complexity and variability. Notably, software is increasingly distributed electronically either for download or online use. The fact that the delivery of the software has been decoupled from the physical media moves it one step away from a tangible property transaction and that much closer to IP, or a service. Software made available to customers from cloud computing is one level more abstract from the original physical media. Still, the characterization determination is highly fact-specific and similar transactions may, in fact, have different characters.

In this potential bundle of IP and services, one must clearly establish the nature of the transaction for a host of tax reasons. In the United States, one must also determine what transfer pricing methods apply, i.e., Treas. Reg. section 1.482-4 or Treas. Reg. section 1.482-9.45 Under the OECD guidelines, only one set of methods applies regardless of character of income. Nonetheless other tax issues may be triggered, e.g., VAT, withholding, and customs. Further, this determination of license versus service may impact revenue recognition. While the accounting treatment is not controlling for the tax treatment or vice versa, it is important for both the tax and accounting teams to understand each others’ factual basis for their determination.

Depending on the specific contract, the same software may be a sale/license of property in one instance and a service in another. This poses challenges from a transfer pricing perspective. Factual development is necessary to assess whether the functions and risks are sufficiently different to warrant separate pricing mechanisms or different profit outcomes.

This trend to electronic transmission of software also generates nexus issues. Specifically, which jurisdiction has the right to tax the transaction? Is it the country where the server is located or the country where the customer uses the software? Again, specific factual development is necessary to make this determination. From a transfer pricing perspective, the key is to determine which entities are party to the transaction. Regardless, cloud computing makes this determination even more complex.

Cloud computing is an extension of this trend in that software applications are accessed via the Internet in a manner that is generally dynamically scalable, and the responsibility for maintenance and support is abstracted from the user.

45 Treas. Reg. § 1.6662-6(d)(3).



If software is stored and retrieved from the cloud, which jurisdiction governs? There is considerable lack of clarity in existing regulations and guidance, so intercompany agreements should be very clear as to where the software and related IP is owned and the specific nature of distribution rights. This specificity could also drive clarity in customer agreements as well.

In addition to jurisdiction issues, companies should also consider timing issues. Are intercompany payments triggered by the contribution of software to the cloud or delivery/access from the cloud? Again, it may be important to confer with the accounting team on the facts pertinent to revenue recognition and customer payment in determining the timing of intercompany payments.

In general, an APA may make sense in situations where there is little regulatory guidance and room for interpretation of value. However, the very multilateral nature of cloud computing and the presence of low tax jurisdictions in the cloud may complicate the effectiveness of the APA process.

Changes to Revenue Recognition Any material change in accounting policy has the potential to impact transfer pricing. Revenue recognition is one area of evolving accounting policy. One of several key differences between U.S. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) relates to the recognition of revenue.

The Financial Accounting Standards Board’s (FASB’s) Emerging Issues Task Force (EITF) recently reached two Consensuses affecting revenue recognition. The first Consensus (EITF 08-01)46 requires a vendor to allocate revenue to each unit of accounting in many arrangements involving multiple deliverables based on the relative selling price of each deliverable. It also changes the level of evidence of stand-alone selling price required to separate deliverables by allowing a vendor to make its best estimate of the stand-alone selling price of deliverables when more objective evidence of the selling price is not available. The second Consensus (EITF 09-03)47 excludes sales of tangible products that contain “essential” software elements from the scope of revenue recognition requirements for software arrangements. Due to these changes, revenue will be recognized earlier for many revenue transactions involving multiple deliverables and for sales of software-enabled devices.

The FASB ratified these Consensuses on September 23, 2009. Accounting Standards Updates (ASUs) 2009-1348 and 2009-1449 amend FASB Accounting Standards Codification™ (ASC) for EITF 08-01 and EITF 09-03. The ASC is now the exclusive authoritative reference for non-governmental U.S. GAAP for use in financial statements for interim and annual periods ending after September 15, 2009.

EITF 08-01 can be applied on a prospective basis or in certain circumstances on a retrospective basis. If prospective adoption is elected, it is to be applied to arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010. Earlier adoption is permitted. If an entity elects early adoption on a prospective basis and the period of adoption is not the beginning of the reporting entity’s fiscal year, the requirements are applied retrospectively to the beginning of the fiscal year. Entities that early adopt at an interim period with retrospective application to the beginning of the year would be required to disclose, at a minimum, the changes

In addition to jurisdiction issues, companies should also consider timing issues. Are intercompany payments triggered by the contribution of software to the cloud or delivery/access from the cloud?

46 EITF Issue No. 08-1, Revenue Arrangements with Multiple Deliverables, available at www.fasb.org. 47 EITF Issue No. 09-3, Certain Revenue Arrangements That Include Software Elements, available at www.fasb.org. 48 FASB Accounting Standards Update No. 2009-13, Revenue Recognition (Topic 605)-Multiple-Deliverable Revenue Arrangements, available at www.fasb.org. 49 FASB Accounting Standards Update No. 2009-14, Software (Topic 985)-Certain Revenue Arrangements That Include Software Elements, available at www.fasb.org.



For many high-tech companies, changing to the new U.S. GAAP standards or IFRS is appealing as companies have greater discretion in how they recognize revenue, which may often lead, at least in the near term, to more comparable financial statements.

from the retrospective application on revenue, income before taxes, net income, earnings per share, and the effects of the change for the appropriate captions presented in those previously reported interim periods.

As companies adopt either the new U.S. GAAP standard or convert to IFRS from their local country GAAP, the impact of the change in revenue recognition on intercompany payments should be thoughtfully considered.

For many high-tech companies, changing to the new U.S. GAAP standards or IFRS is appealing as companies have greater discretion in how they recognize revenue, which may often lead, at least in the near term, to more comparable financial statements. When significant differences in accounting policy are present, one must consider the impact on comparability. As the adoption of these new revenue recognition standards unfolds, it may, in the short term, impact the comparability of financial statements among companies in the same market. As will be demonstrated below, the profit outcomes may become widely variable at the outset of adoption. High-tech companies may need to carefully review the adoption status of potentially comparable companies when using a profit-based transfer pricing methodology such as the comparable profits method (CPM).

Such changes may impact more than the testing of transfer pricing policy; they may also impact the execution of transfer pricing policies. In general, if the existing deferred revenue rolls off naturally, i.e., is recognized over time as originally intended from an accounting standpoint, then the transition issues, from a transfer pricing perspective, are generally forward-looking. The calculation or timing of subsequent intercompany payment may need to be modified to be consistent with third-party pricing or profitability results.

If the existing deferred revenue is accelerated or never recognized because the revenue recognition treatment is retroactively applied, then the impact on intercompany payments should be considered. For example, an electronics device company under its old revenue recognition policy recognized US$300 in revenue ratably over three years because of an ongoing three-year post-delivery customer support obligation for which objective and reliable evidence of fair market value did not exist.



Original Revenue Recognition for Year 1 Contract

Revenue Recognition under New Policy for Year 2 Contract

Period Year 1 Year 2 Year 3

Revenue 100 100 100

Costs 90 90 90

Profit 10 10 10

Taxes at 30 percent 3 3 3

If the intercompany agreement determines payments based on the accounting treatment, then payment for this sale in year 1 is drawn out evenly over three years (see chart). Now suppose that in year 2, the accounting standards change such that a greater portion of the revenue from a new agreement would be recognized in the first year of the agreement, as shown in the following table.

Period Year 1 Year 2 Year 3 Year 4

Revenue 250 25 25

Costs 230 20 20

Profit 20 5 5

Taxes at 30 percent 6 1.5 1.5




Revenue Recognition of Year 1 and Year 2 Contract with Retrospective Adoption

Taxing authorities will likely resist a change in year 2 that results in an additional US$150 of revenue in year 1 without a corresponding increase in taxable revenue. If this additional US$150 revenue were to be picked up in year 2 for tax purposes, then the erratic profit result widens further.

Then one must consider what happens to the deferred revenue related to the arrangements accounted for under the old guidance. If the new guidance is adopted retrospectively, then the financial statements for prior periods are restated to reflect the new policy for all periods presented. However, there may not be a trigger in the intercompany agreement to recomputed intercompany balances subsequent to restatements. In this instance, the related party would recognize additional revenues of US$150 in year 1 in the restated financial statements that may not trigger an intercompany payment. This result makes little sense. If the intercompany agreement provides no guidance, the parties to the transaction must agree to a reasonable solution.

High-tech companies would be advised to consider the tax and transfer pricing impact of retrospective application of changes in accounting policy to manage these types of nonsensical and highly variable profit outcomes.

For more information that analyzes the new standards and addresses many other implementation issues that a high-tech firm may encounter, please see KPMG LLP’s publication Issues In-Depth, “Implementing the New EITF Consensuses on Multiple Element Revenue Arrangements,” October 2009, No. 0-03.50


Revenue 250 275 50 25

Costs 230 250 40 20

Profit 20 25 10 5

Taxes at 30 percent 6 7.5 3 1.5


Revenue 100 425 50 25

Costs 90 390 40 20

Profit 10 35 10 5

Taxes at 30 percent 3 10.5 3 1.5

50 http://us.kpmg.com/microsite/attachments/us_accounting_bulletin_2009/issues-in-depth-09-3--implementing-the-New-EITF-consensuses-revenue.pdf.



ConclusionAs the business outlook for the high-tech sector has improved significantly, the outlook for tax and transfer pricing controversy remains challenging. Governments are likely to place increased emphasis on fiscal responsibility and bringing budgets into balance as any recovery takes hold. While stimulus money will diminish, increased tax receipts will be a necessary lever in this balancing act. It is anticipated that both corporate tax reform and more rigorous global tax enforcement will contribute to government revenue.

With tax scrutiny at potentially an all-time high, high-tech companies should seek to address a range of issues for which reasonable minds could determine different outcomes, such as treatment of losses, renegotiation of internal and external agreements, attribution of profit, and restructuring charges. In this period of change, high-tech companies are expected to be particularly turbulent since their industry is among the most rapidly evolving. Particular care should be taken to establish the business factors leading to any unusual outcome and reconcile treatment to existing intercompany arrangements. Given the multiyear nature of many transfer pricing methodologies and of tax audits, issues arising from this economic shock will remain relevant for the foreseeable future.

KPMG: Experienced TeamsKPMG’s Information, Communications & Entertainment (ICE) professionals offer skills, insights, and experience culled from our firms’ experiences of working with technology companies to deliver the services you need to help you succeed wherever you compete in the world. We offer audit, tax, and advisory services that focus on addressing your most pressing business requirements. KPMG’s network of highly qualified professionals in member firms in the Americas, Europe, the Middle East, Africa, and Asia Pacific can help you reduce costs, mitigate risk, improve controls over a complex value chain, protect intellectual property, and meet the myriad challenges of the digital economy.

AuthorsThis paper was written by Global Transfer Pricing professionals Tamara Gracon and David Houston, with insights from Yoko Hatta, Cheng Chi, and Rohan Phatarphekar.

ContributorsIn addition, we would like to thank the following people who contributed to the production of this white paper: David Crosswy, Danny Dentone, Kevin Davidson, Bruce Hager, Federica Marchesi, Sheafali Patel, Maryia Poli, Matt Powers, Patricia Rios, and Anne Welsh (KPMG in the U.S.).




Contact UsFor more information about this publication, or about KPMG’s Information, Communications & Entertainment practice and high-tech industry capabilities, please contact the following practice leaders:

GlobalRusty Thomas Partner KPMG in the U.S. Silicon Valley, California +1 650 404 5008 [email protected]

Anne Welsh Principal KPMG in the U.S. Seattle, Washington +1 206 913 4132 [email protected]

US/North AmericaTamara Gracon Managing Director KPMG in the U.S. Silicon Valley, California +1 650 404 4705 [email protected]

Margaret Critzer Principal KPMG in the U.S. Silicon Valley, California +1 650 404 4932 [email protected]

Steve Felgran Principal KPMG in the U.S. New York, NY +1 212 872 6799 [email protected]

Mary Furlin Partner KPMG in Canada Ontario, Canada +1 416 228 7202 [email protected]

EuropeDavid Houston Director KPMG in Ireland Dublin, Ireland +35 317 004233 [email protected]

Matthias Kaut Partner KPMG in Germany +49 211 475 7390 [email protected]

Jan Martens Partner Fidal* La Defense, France +33 (1) 5568 1618 [email protected]

Eduard Sporken Director KPMG in The Netherlands Amstelveen, Netherlands +31 (0) 20 656 16 18 [email protected]

Markus Wyss Partner KPMG in Switzerland Zurich, Switzerland +41 44 249 24 72 [email protected]

Asia PacificYoko Hatta Partner KPMG in Japan Tokyo, Japan +81 (3) 6229 8350 [email protected]

Rohan Phatarphekar Executive Director KPMG in India Mumbai, India +91 (22) 30902000 [email protected]

Cheng Chi Partner KPMG in China Shanghai, China +86 (21) 2212 3433 [email protected]

Tony Gorgas Partner KPMG in Australia Sydney, Australia +61 (2) 9335 8851 [email protected]

* FIDAL is an independent legal entity that is separate from KPMG International and its member firms.

As e-mail addresses and phone numbers change frequently, please e-mail us at [email protected] if you are unable to contact an individual via the information noted above.


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