7. Special Considerations for Specific Cases
7.5. Business Restructuring
7.5. Business Restructuring31
commercial reasons at the level of the Group does not mean that it is arm’s length from the perspectives of each of the restructured Group members.
Business Restructurings are typically accompanied by a reallocation of profit potential among the members of the MNE Group, either immediately after the restructuring or over a period of time. One major objective of this section is to discuss the extent to which such a reallocation of profit potential is consistent with the Arm’s Length Principle and more generally how the Arm’s Length Principle applies to Business Restructurings.
7.5.2. Arm’s Length compensation for the restructuring itself 7.5.2.1. Understanding Business Restructuring
The application of the Arm's Length Principle to a Business Restructuring must start, as for any Controlled Transaction, with the identification of:
• the commercial or financial relations between the Related Parties or Connected Persons involved in the Business Restructuring; and
• the conditions and economically relevant circumstances in relation to those relations.
Based on these, the Controlled Transactions comprising the Business Restructuring can be properly defined.
In addition, important aspects of identifying the commercial or financial relations relevant to determining the arm's length conditions of Business Restructuring need to be analysed:
1. determination of the Controlled Transactions comprising the Business Restructuring and the relevant functions, assets and risks before and after the restructuring;
2. business reasons for and the expected benefits to arise after the Business Restructuring, including the role of synergies; and
3. determination of the other options realistically available to the Related Parties or Connected Persons.
7.5.2.2. Accurate determination of transactions comprising the Business Restructuring
In order to determine whether, an arm’s length compensation would be payable upon a restructuring within an MNE Group, it is important to identify the Controlled Transactions occurring between the restructured entity and one or more other members of the Group.
The accurate characterisation of the Controlled Transactions comprising the Business Restructuring requires performing a Functional Analysis to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed before and after the restructuring by the parties involved. Accordingly, the analysis focuses on what the parties actually do and the capabilities, as well as the type and nature of assets used or contributed by the parties in pre-restructuring and post-restructuring scenarios.
7.5.2.3. The business reasons for and the expected benefits following the Business Restructuring
The pressure of competition in a globalised economy, savings from economies of scale, the need for specialisation and the need to increase efficiency and lower costs have all been described as important factors in driving Business Restructuring.
Where expected synergies are put forward by a Taxable Person as an important business reason for a restructuring, it is expected that the Taxable Person will document, at the time the restructuring is decided upon or implemented, what these synergies are, and the assumptions on which these synergies are based. This type of documentation is likely to be produced at the Group level in support of the decision- making process.
Care should be taken to ensure that the Related Parties or Connected Persons contributing to the synergistic benefit after the restructuring are appropriately remunerated.
7.5.2.4. Determination of the other options realistically available to the Related Parties or Connected Persons
In applying the Arm’s Length Principle, it is not sufficient that the Business Restructuring makes commercial sense for the Group in general. The arrangements must be at arm’s length at the level of each individual Taxable Person. In this respect the rights, assets and expected benefits from the arrangements (i.e. any consideration of the post-Business Restructuring arrangement and, if applicable, any payments made for the Business Restructuring itself) should be considered. Persons acting at arm’s length would generally only enter into a transaction if it does not make them worse off than their next best option. There are situations where the restructured parties would not have had a clear and more attractive option realistically available to them than to accept the conditions of the restructuring (for example, a contract termination with or without indemnification). Therefore, understanding the options realistically available to the Related Parties or Connected Persons is an important part of understanding the reason for the Business Restructuring from an arm’s length perspective.
7.5.2.5. Reallocation of profit potential
Business Restructurings have an impact on the profit potential of a Person. The “profit potential” means “expected future profits”, although in some cases it may encompass losses. The concept of “profit potential” is often used for valuation purposes, in determining the arm’s length compensation for a transfer of intangibles or of a going concern, or in determining the arm’s length indemnification for the termination or substantial renegotiation of existing arrangements.
In order to determine whether at arm’s length conditions the restructuring itself would give rise to a form of compensation, it is essential to understand the restructuring, including the changes that have taken place, how they have affected the Functional Analysis of the Related Parties or Connected Persons, what the business reasons for and the anticipated benefits from the restructuring were, and what options would have been realistically available to the Related Parties or Connected Persons.
A third party would not necessarily have the right to receive compensation when a change in its business arrangements results in a reduction of its profit potential or expected future profits. The Arm’s Length Principle does not require compensation for a mere decrease in the expectation of future profits.
7.5.3. Other considerations
7.5.3.1. Indemnification of the restructured Person
Indemnification means any type of compensation that may be paid for detriments suffered by the restructured entity, whether in the form of an up-front payment, of a sharing in restructuring costs, of lower (or higher) purchase (or sale) prices in the context of the post-restructuring operations, or of any other form.
Terminations or renegotiations of arrangements generally involve changes in the risk and functional profiles of the relevant parties, with consequences for the allocation of profit potential between them. In addition, the termination or renegotiation of contractual relationships in the context of a Business Restructuring might cause the restructured entity to suffer determinants such as restructuring costs (for example, write-off of assets, termination of employment contracts), re-conversion costs (for example, in order to adapt its existing operation to other customer needs), and/or a loss of profit potential. In these situations, the question arises as to whether, at arm’s length, indemnification should be paid to the restructured entity, and if so, how much and calculated by what method.
As a starting point to determine whether indemnification for the termination or renegotiations of existing arrangements is appropriate, the legal arrangements need to be assessed (for example, are there termination clauses present / is there a
termination or notification period applicable). As a second step, it needs to be determined whether the legal arrangements include conditions that reflect arm’s length circumstances.
Once the restructuring arrangements have been accurately determined and the options realistically available to the Persons have been assessed, the following aspects should be considered:
• whether commercial law supports rights to indemnification for the restructured Person under the facts of the case;
• whether the existence or absence of an indemnification clause or similar provisions under the terms of the arrangement, is arm’s length; and
• the Person who should ultimately bear the costs related to the indemnification of the Person that suffers from the termination or renegotiation of the agreement.
To determine the indemnification upon a Business Restructuring the comparison of the pre-Business Restructuring and post-Business Restructuring functions performed, risks assumed, and assets used is essential to evaluate how the profit potential is impacted.
7.5.3.2. Valuations
In situations where reliable Comparable Uncontrolled Transactions for a transfer of one or more intangibles or in case of a Business Restructuring of a business (which could involve both tangible and Intangible assets) cannot be identified, it may be possible to use valuation techniques to estimate the arm’s length price for the determined Controlled Transaction. It is important to carefully consider the assumptions and other motivations that support particular applications of valuation techniques.
Business Restructurings sometimes involve the transfer of a going concern (i.e. a functioning, economically integrated business unit). The transfer of a going concern in this context means the transfer of assets, bundled with the ability to perform certain functions and assume certain risks.
The valuation of a transfer of a going concern should reflect all the valuable elements that would be remunerated between independent parties in comparable circumstances.
The application of income-based valuation techniques, especially valuation techniques premised on the calculation of the discounted value of projected future income streams or cash flows derived from the exploitation of the business, intangible, or going concern being valued, may be particularly useful when properly applied.
Where valuation techniques are utilised in a Transfer Pricing analysis involving the transfer of intangibles or rights in intangibles, it is necessary to apply such techniques in line with international valuation standards and in a manner that is consistent with the Arm’s Length Principle and the principles of this Guide.
Depending on the facts and circumstances of the individual case, there may be a situation where an agreeable range of values cannot be arrived at for the transfer of assets or going concerns, for example, because of differences in the buyer and seller’s positions. This may be an indication that a termination payment is required or the possibility that the transaction should be disregarded.
It is not the intention of this Guide to set out a comprehensive summary of the valuation techniques used by valuation professionals or to endorse or reject one or more sets of valuation standards applied by valuation or accounting professionals or to describe in detail or specifically endorse one or more specific valuation techniques or methods as being especially suitable for use in a Transfer Pricing analysis.
Nonetheless, it is important to recognise that the value estimates based on valuation techniques can be volatile and rely on various assumptions. Due to the importance of the underlying assumptions and valuation parameters, Taxable Persons using valuation techniques should be explicit in the valuation parameters and assumptions and should substantiate the valuation techniques (including the reasonableness of such assumptions) when creating the valuation model. These concerns, amongst others, are important in evaluating the reliability of the particular application of a valuation technique.
7.5.3.3. Remuneration of post-restructuring Controlled Transactions
The Arm’s Length Principle and this Guide do not apply differently to post-restructuring Controlled Transactions as opposed to transactions that were structured as such from the beginning. The Arm’s Length Principle must be applied not only to the post- restructuring Controlled Transactions, but also to additional Controlled Transactions that comprise the Business Restructuring.
7.6. Permanent Establishment