Transfer Pricing in a Changing World
Given the significant and continued impact of the global economic crisis on financial markets, treasurers are considering more and more whether accepted industry practices that were prevalent before the crisis are still viable. Following behavioural shifts in the ‘real world’, it may also now be the time to consider the corresponding impact upon inter-company financing policies and practices.
Related party financial transactions are increasingly in the scope of tax office enquiries. These transactions are often governed by domestic transfer pricing rules and bilateral tax treaties, which many countries have concluded and which almost always include an article containing the ‘arm’s length’ principle in accordance with Article 9 of the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention, which reads:
“Where … conditions are made or imposed between [group companies] which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the [group companies], but, by reason of those conditions, have not so accrued, may be included in the profits of that [group company] and taxed accordingly.”
Simply put, this means that if a transaction between group companies is not at ‘arm’s length’, then a tax authority may disregard the transaction as structured by those companies, impose arm’s length conditions, and tax accordingly.
During the 1H08, global financial markets began to react to the collapse of the US sub-prime mortgage market. As such, mutual trust between banks was eroded and, despite interventions by several major central banks, interbank lending markets dried up and interbank interest rates increased significantly.
From the 2H08, central banks began to reduce reference rates to record lows and continued to inject cash into banking systems, while several governments intervened to support their local banks. This combination impacted ‘low risk’ interest rates. For example, the Euribor one-month rate tumbled from over 5% to approximately 1% in less than eight months.
The uncertainty surrounding the economic crisis and higher default risk has resulted in market participants becoming more risk-averse. These factors resulted in a significant increase in risk premiums that continued until 4Q08. At the same time, liquidity became very scarce. It is only since 2Q09 that significant reductions in risk premiums have been recorded.
Figure 2 illustrates the evolution of credit spreads on BBB credit rated quoted bonds between January 2007 and December 2009.
Despite efforts to instigate recovery and confidence, financial institutions still face more stringent capital requirements and an increase in default risk of their clients. Consequently, financial institutions remain cautious, with borrowers facing more rigorous screening processes and more stringent terms and conditions. Unique market conditions trigger different transfer pricing questions.
Tax authorities around the world are currently struggling with the question: ‘Should inter-company financing reflect funding conditions at a group level, or should the individual risk profile of the borrowing entity be considered?’
Even where tax authorities adopt an individual risk profile (‘separate entity’ or ‘standalone’) approach, there may be significant differences in the methodologies used. As the risk profile of an entity is of primary importance when establishing an arm’s length interest rate, these differences can have a material impact. The theoretical arguments in favour or against the various approaches should not be influenced by current conditions. However, given the increased risk premiums, the impact of discussions and adjustments in this area has become much more material.
The General Electric Tax Court Case (TCC) in Canada of 4 December 2009 contains an interesting debate on how to determine the credit risk profile of a subsidiary. This case relates to guarantee fees paid by a Canadian subsidiary in return for a formal guarantee granted by its AAA-rated US parent. The Canadian Tax Authorities (CTA) disallowed a deduction for the guarantee fee, arguing that the subsidiary benefitted from the group’s rating by virtue of affiliation (an ‘implicit guarantee’ or ‘passive association’) and that no benefit was actually received in return for the fee. The taxpayer asserted that the subsidiary’s rating should be assessed on a stand-alone basis and as such, affiliation should be disregarded. The taxpayer estimated the standalone rating of the subsidiary to be BB-/B+.
In its decision, the TCC disagreed with the CTA’s position, as the subsidiary had benefited from better financing conditions due to the explicit guarantee. As such, the guarantee fee was determined to be priced in accordance with the arm’s length principle. However, the TCC did recognise that, to a certain extent, the subsidiary would have benefited from ‘implicit support’ in the absence of a formal guarantee, resulting in an uplift of three notches on its standalone credit rating. Such implicit support is based on the theory that groups may be incentivised to support their subsidiaries due to various factors including, for example, reputational risk. Implicit group support is the result of what the OECD defines as ‘passive association’. The CTA filed an appeal against the TCC’s decision on 4 January 2010.
Due to the current crisis, real-life examples now exist where groups have intervened to avoid the bankruptcy of a subsidiary and, in other cases, where subsidiaries have been allowed to fail.
The arm’s length principle is anchored in Article 9 OECD Model Tax Convention and stipulates that associated companies should deal with each other as if they were acting with third parties. Traditionally, a transfer pricing analysis of an inter-company loan was typically limited to an analysis of the applicable interest rate (i.e. on the price of the transaction as it was structured by the taxpayer). However, tax authorities are increasingly questioning whether the other terms and conditions of an inter-company loan, which in fact are also subject to the arm’s length principle, also reflect arm’s length behaviour. This may especially be the case where tax authorities adhere to a ‘substance-over-form’ approach . Recent examples of such questions relate to where entities have financed long-term needs via short-term facilities and where no securities have been requested by the lender in a high-risk transaction. As a high-level test to understand whether a transaction may reflect arm’s length dealings, it may be worth asking whether the transaction makes sense for all parties involved from an economic perspective and also, would unrelated parties enter into this transaction on comparable terms and conditions?
When testing the arm’s-length nature of specific terms and conditions, risk allocation (between the lender, borrower and any other relevant parties) is an important factor to consider. Guidance in this respect can be gained from the OECD’s draft ‘Report on the Transfer Pricing Aspects of Business Restructurings’. According to this document, the allocation of risks as reflected in an inter-company agreement should be the starting point of a transfer pricing analysis or discussion with the tax authority. However, in some cases, the OECD allows for the reallocation of risks if the contractual allocation would not have been agreed by independent parties. In order to assess the latter, control of the risk is an important factor. The OECD starts from the standpoint that an independent party would only be willing to accept a risk if it has a certain level of control over it.
Various angles should be covered when testing the party controlling the risk, i.e. which employees or directors have the authority to take the relevant decisions, do those employees or directors have the required expertise, who takes the decisions in practice and does the entity have the financial capacity to bear the risk, etc.
Recently, there has been extensive press coverage with respect to banks imposing more stringent and comprehensive covenants for new funding. Moreover, where in the past banks rarely enforced covenants, nowadays, more and more banks are withdrawing or renegotiating existing credit facilities where covenants are not met. One might argue that, for inter-company funding, such covenants are less important, as one could reasonably assume that a group would protect the financial health and interests of its subsidiaries. Consequently, such covenants would have a rather theoretical impact. However, this may actually be considered a ‘shareholder argument’ which cannot be used in a transfer pricing context. At the same time, as covenants are widely applied in third-party funding, tax authorities could argue that, since comparable terms and conditions should be reflected within inter-company loan agreements, covenants should also be included within inter-company loan agreements.
Local thin capitalisation rules have historically been based on simple financial tests such as debt to equity ratios. However, recently, some countries, including Germany and Italy, have revised their thin capitalisation rules and have introduced limits specifically addressing the level of inter-company interest that can be deducted.
In addition to questioning interest rates and the terms and conditions of inter-company transactions, some tax authorities are also increasingly interested in the volume of debt and whether the decision to grant or accept an inter-company loan with a certain volume is an arm’s length decision. If not, the loan may, from a tax perspective, be re-qualified, for example, as non-interest bearing equity.
Existing loans that were concluded prior to the financial crisis should reflect the market conditions – and reasonably available information – at the time the transaction was established. Changing market conditions do not therefore automatically affect existing loans. Nevertheless, for these transactions, it should be considered whether any of the parties are (legally) entitled to renegotiate existing loans and, if so, whether either party would have an interest in doing so. Particular attention should be paid to the economics of each transaction to assess whether the parties have behaved and continue to behave in an arm’s length manner. Potential areas for consideration include: call and prepayment options, automatic renewal clauses and penalty clauses where the cost of the penalty does not outweigh the advantage of early termination. In other words, transfer pricing is not only relevant at the moment of origination of a financial transaction but also throughout the full term of the transaction.
Particular care should be taken when making amendments to existing transactions, especially at a time when tax authorities are becoming increasing sophisticated in their approach to the transfer pricing of financial transactions. It is strongly recommended always to review (and document) the economic rationale of such amendments from both the borrower’s and lender’s perspective.
Several countries have adopted domestic safe-harbour rules that identify interest rate thresholds that are deemed to be at arm’s length. However, most of these safe harbour regimes allow for the application of higher interest rates if the taxpayer can demonstrate that a higher rate satisfies the arm’s length principle.
Most of these safe harbour rules are based on local reference rates that are updated from time to time. However, these reference rates are often low-risk rates, resulting in relatively low safe harbours. At the same time, credit margins are at relatively high levels, resulting in an increasing number of cases where conflict arises between safe harbour rules and arm’s length interest rates.
As a result of the financial and economic crisis, companies are increasingly relying on their internal cash pools for liquidity management. Taxpayers should address certain specific transfer pricing issues in this respect such as how arm’s length debit and credit interest rates are set, how underlying cross-guarantee structures are priced and how cash pool leaders are remunerated.
Scrutiny from tax authorities has also increased significantly in this area, which has led to questions primarily relating to the long-term nature of cash pool positions (to which short-term interest rates are applied). Furthermore, tax authorities are increasingly questioning the allocation of the cash pool benefit (which should reflect the assumption of risk of the parties involved and the functions performed).
Third-party financial institutions are increasingly requiring additional collateral in the form of parental guarantees when granting debt finance to subsidiaries. This raises the question if and to what extent guarantee fees should be charged by those parent companies.
Charging guarantee fees can be contentious in some countries, but are a requirement in others. Where a benefit is conferred, the taxpayer should consider charging for this benefit. However, care should be taken when establishing whether a guarantee fee is due. For instance, the provision of certain guarantees could be considered a ‘shareholder’ service, for which no fee should be paid. This may be the case where a subsidiary could not have secured funding of any kind without a parental guarantee. On the other hand, if a subsidiary could have secured funding, but a better rate or better conditions were achieved by virtue of a parental guarantee, a fee may be due.
The different approaches taken by various tax authorities (and the impact of the GE TCC case) should be considered when establishing whether a guarantee fee is due, and the arm’s length guarantee fee.
It may appear that the transfer pricing requirements to substantiate and document every inter-company financial transaction can be burdensome and inflexible. However, this does not necessarily need to be the case in practice. The starting point to address transfer pricing requirements may be to develop a loan pricing policy, which sets out the various types of inter-company financial transactions that take place within the group and the processes and tools used to substantiate and price those transactions. In developing such a policy, theoretical requirements versus practical needs can be balanced in a way which best suits the needs and the transfer pricing risk profile of the company.
Policies can be tailored towards the information systems used within an organisation and as such, can accommodate the day-to-day operations. At the same time it should, as much as possible, address the transfer pricing requirements to provide robust documentation and a stronger line of defence.
The role of group treasury departments can vary significantly. However, one primary function is to secure the financial position of the group as a whole. Conflict often arises between what makes the most commercial sense for the group and what makes sense from a transfer pricing/separate entity standpoint for the individual group entities.
As the cost of adjustments and associated penalties can be material, compliance with respect to transfer pricing is increasingly important. It is therefore critical that treasurers are fully aware of transfer-pricing requirements so that the objectives of the group can be satisfied, while being compliant at an entity level.
The unpredictable nature of financial markets presents many challenges for most treasurers. The transfer pricing of inter-company financial transactions may be one of those challenges, with policies having to be fine-tuned and long-established inter-company practices having to be changed or updated. However, current market conditions may also create opportunities that can be realised with the right planning, implementation and monitoring processes.
Once financial markets stabilise, governments may reduce or withdraw their market intervention and stimulus packages. Such future changes are likely to change the dynamics of open market pricing drastically. As transfer pricing should continuously mirror the market and transactions between third parties, group treasurers should remain vigilant and avoid rigid rules when updating their inter-company financing policies.
This is particularly true because the increased attention tax authorities are giving inter-company financial transactions is something that is unlikely to change.