Welcome to ‘5 minutes with…”

Welcome to ‘5 minutes with…”, a series of short discussions with leaders from KPMG member firms around the world on topics of interest to tax leaders. In this inaugural edition, we sat down with Theresa Kolish, Managing Director, Transfer Pricing Dispute Resolution Services, KPMG in the US, to discuss the key areas of consideration for tax leaders in financial services, specifically resulting from the learnings of a recent global soft drink company case.

Theresa, to kick things off, the results of a recent case involving a global soft drink company has been getting a lot of attention in the transfer pricing world.  Could you start off by telling us a bit about the case and why this case is important for tax leaders? 

To provide some background, a global soft drink company entered into a closing agreement with the IRS in 1996 that covered its transfer pricing methods from 1986 to 1995. The company continued to follow the terms of the agreement, however during the 2007-2009 audit cycle the transfer pricing method the company was using did not provide an arm’s length return. The tax court also looked at the consistency of the intercompany agreements with transfer pricing policies and whether they aligned with the economic substance of the transactions at issue. The company argued the agreement should continue but the tax court disagreed and affirmed that closing agreements are only good for the period expressly provided for in the closing agreement.

I think this case is important for tax leaders because the case sets precedent and affirms the notion that tax leaders have an obligation to ensure their transfer pricing methods align to an arm's length standard on an annual basis.

Why might a company rely on an expired agreement?

A company may rely on an expired agreement for a number of reasons – perhaps because there was a sense of comfort or security given the closing agreement had not been challenged over the course of five audit cycles, and perhaps the company felt nothing had changed. Nonetheless, I do think that companies have an obligation to ensure that their transfer pricing aligns with an arm's length standard on an annual basis. The court was clear that a closing agreement may only be relied on for the explicitly covered term.

Can you highlight some of the technical concerns that the court addressed and their relevance to financial services organizations?

The court looked at quite a few different issues in addition to looking at the expired closing agreements.

To start, the Tax Court spent a lot of time looking at the contracts between the parties involved in the case, with one relating to a licensing agreement between the company and its supply points. In this instance, the court had concerns that these agreements did not represent the methodology in the closing agreement. Moreover, the court was concerned that the agreements, with respect to the supply points, were inconsistent and incomplete. The court reiterated that the IRS can disregard terms of contracts that are inconsistent with the economic substance, but the drafter of the document lives by their pen. For financial services entities, this is great opportunity to do an intercompany contract health check. Are your contracts consistent? Do they reflect the realities of your transactions now? Do your contracts reflect the economic substance of your operations?

Economic ownership under IRC 482 and OECD was discussed during this case; can you tell us more about this and how economic ownership may impact financial services companies?

We hear a lot about development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE) through the OECD, but we don't necessarily have the term DEMPE in US regulations or codes. Under IRC 482, however, there is this notion of economic substance. The Tax Court was clear that the company did not carry its burden in proving that there was economic substance with respect to the supply points owning marketing intangibles. The court noted that “the party urging that expenditures generated intangible assets has the burden of showing how these assets came to exist,” and found that the company was unsuccessful in that endeavor.

The main takeaway here is that, when you have a contract in place, the contract is just one layer of analysis that the courts and tax authorities are going to look at. They will try to determine whether there is actually economic substance supporting those contractual terms on the ground, and if these tie into your company’s transfer pricing policies. These are really important issues for financial services companies, and every company needs to be mindful of making sure that this triangle of policy, written agreements and economic substance are supported by the economic activity actually happening. 

What parting advice do you have for tax leaders in the financial services space?

I think in the transfer pricing world, specifically within financial services, there is the excellent opportunity to do a health check on your organization.

When looking back at your company’s transfer pricing triangle – your policies, your written agreement, and your economic substance – are all points coming together correctly? If your contracts have not been updated to reflect your current transfer pricing policy or what was happening jurisdictionally within a particular entity, you have the opportunity to look at what you were doing to make sure that these points align. If you can identify a mismatch in your points, you have the opportunity to eliminate vulnerabilities, through something potentially simple, such as updating your contracts. We tend to get comfortable in what we're doing, and things just roll forward, which turned out to be an expensive endeavor for this company.

COVID-19 will empower tax authorities, with a decline in resources due to COVID-19 relief, governments will be looking to recapture funds and one way will be through transfer pricing audits, which generally can be fruitful. Certainly, taking steps now may protect your orchard.

By: Theresa Kolish, Managing Director, Transfer Pricing Dispute Resolution Services, KPMG in the US.