USA Law and Practice Contributed by: Devon M Bodoh, Joseph M. Pari and Blake D. Bitter, Weil, Gotshal & Manges LLP
• the “special tax regime” concept, which denies treaty benefits for items of income subject to a preferential tax regime; and • a limitation that denies treaty benefits for certain payments made by expatriated entities. The most significant, effective income tax treaty that does not include either a “limitation on benefits” arti - cle or a triangular branch provision is the treaty with Poland. However, a new treaty that includes both such provisions is currently awaiting US Senate approval to replace this treaty. In addition to the “limitation on benefits” provisions, certain US income tax treaties also contain “anti- hybrid” provisions (such as in the “residency” article) that address a taxpayer’s entitlement to treaty benefits for amounts derived through or paid by a hybrid entity – that is, an entity characterised as fiscally transpar - ent in one jurisdiction and fiscally opaque in another. For example, an item of income may not be treated as “derived by” a treaty resident if it is derived by the resident through an entity that is not resident in the same country as its owner(s) (the entity could be resi - dent either in the source country or in a third country) and that is not treated as fiscally transparent in the owner’s country of residence. 4.4 Transfer Pricing Issues for Inbound Investors Specifically, the Code authorises the IRS to adjust items of income, deductions, credits or allowances of commonly controlled taxpayers to prevent tax evasion. The applicable standard in examining inter - company transactions is that of a “taxpayer dealing at arm’s length with an uncontrolled taxpayer” (ie, the arm’s length standard), which generally is met if the results of the transaction are consistent with the results that would have been realised if uncontrolled taxpayers had engaged in a comparable transaction under comparable circumstances. The US tax regula - tions include detailed rules regarding how such stand - ards may be met. If the IRS exercises its adjustment authority, the tax - payer bears the burden of proof to show that the arm’s length standard was met; and, depending on the circumstances, taxpayers may be subjected to
adverse penalties for non-compliance. Consequently, it is recommended that taxpayers routinely maintain robust, contemporaneous documentation to support their transfer pricing practices given that valuation misstatement penalties and reporting penalties may apply. The USA’s aggressive transfer pricing regime has caused controversy with some of its trading partners, not all of whom have agreed with the USA’s interpreta - tion of this arm’s length standard. The tax regulations, together with a greater level of enforcement activity, have resulted in an increasing number of transfer pric - ing issues being considered through the competent authority process under the mutual agreement article of tax treaties concluded between the USA and most of its major trading partners. 4.5 Challenges to Related-Party Limited Risk Distribution Arrangements A typical limited risk distributor (LRD) agreement may provide for the LRD to earn a predictable, fixed margin and for all residual profit or loss to inure to the prin - cipal. While the LRD agreement may provide for the principal to bear most of the LRD’s costs and risks in the ordinary course of business, tax authorities might challenge whether the agreement should be respect - ed based on such agreement’s compliance with the transfer pricing rules and regulations, especially in circumstances (eg, the impacts of COVID-19) where significant deviations from the arm’s length standard arise (see 4.4 Transfer Pricing Issues for Inbound Investors ). 4.6 Local Transfer Pricing Rules and OECD Standards Local transfer pricing rules and/or enforcement are generally consistent with OECD standards. That said, the OECD standards are generally less restrictive concerning market penetration strategies than the US regulations, which require a very extensive fac - tual showing and documentation. Additionally, unlike the more restrictive US rules, OECD standards gener - ally do not include specific rules for establishing (or benchmarking) an appropriate arm’s length range. Moreover, the primary focus of the US regulations is on whether a taxpayer has reflected arm’s length results
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