The arm's-length principles for pricing their intra-group debt are
complex in their application and are therefore difficult to comply with.
One significant source of uncertainty regarding these transactions
relates to the process for estimating the credit quality of a given
project or business in a certain country. Estimating the credit risk
associated with such transactions can be an involved exercise. A second
source of uncertainty for taxpayers, but particularly for those in the
energy sector, relates to how transfer pricing principles specifically
should be applied to the pricing of intra-group debt.
The need for multi-billion dollar investment and the resulting transfer pricing issues
The oil and gas (O&G) industry is paramount to the movement of
goods and capital, including human capital. The vast majority of
transportable goods and associated logistics infrastructure is moved
around and across economies and geographies primarily using the energy
generated from either oil or gas. Tax authorities from both developed
and emerging countries are trying to increase their knowledge and
understanding regarding this global movement of goods and the associated
profits.
Unlike many other industries, the O&G industry is a
capital-intensive sector with a need for significant funding.
Exploration and production (E&P) projects involve substantial
capital investments with long-term contracts and relatively uncertain
long-term returns. E&P companies engage in drilling and evaluation,
along with completion and production. These activities can have time
horizons from a few years up to a decade before a well may start to show
a return and up to quarter of a century or more for the overall
lifespan of some projects.
To receive the required financing, E&P companies may need to seek
significant funding from a variety of resources. Some funding is
extended through financial institutions that are sophisticated enough to
evaluate the project risk and have the capital to manage the risk.
E&P firms may also access the public bond market, the market for
privately-placed debt, as well as more narrow markets for project
finance. However, given the long time horizons for these projects, the
difficulty in predicting recoverable reserves, the challenge in
projecting revenues/profits, complexities/uncertainties of the analysis
and inexperience of financial institutions to properly evaluate the
risk, it is often the case that an E&P firm (or the E&P
subsidiary of a larger concern) may experience significant costs in
obtaining adequate project financing from third-party sources.
Therefore, the local E&P affiliate (or its ultimate parent) may
decide to secure a portion of its required financing from related
entities within its group, including the parent company. Such
transactions create potential transfer pricing considerations.
Determination of credit quality of the borrower
The credit quality of a borrower is a specific determinant of the
interest rate of a loan or the yield on a bond issued by an E&P
firm. However, credit analysts do not use uniform approaches to evaluate
the credit quality of a given borrower in the E&P sector. While
credit analysts might broadly rely on metrics relating to interest
coverage, leverage, the quality and amount of reserves and the like, the
emphasis placed by a credit analyst on each factor (and how each factor
maps to a given credit quality) can vary.
Furthermore, when creditors look to fund O&G projects, they need
to focus on the fact that these, especially those involving E&P, are
long-term projects that will span over a decade, rather than using a
typical one to two year financials projections, or extrapolating
historical data to reflect future performance. When assessing a
potential borrower's credit quality, such data is adjusted to create a
post-loan effect on the financials. However, for an E&P borrower, it
is necessary to have reliable projections of the financial profile of
the project over its lifetime.
Creditors typically adjust their interest rates to reflect the
inherent risk in lending O&G companies such funds, and with the
knowledge that, in certain instances, the borrower may not generate
substantial revenue until they begin production of oil and/or gas. Thus,
in determining credit ratings in the energy sector, some creditors
might also account for the credit quality of the borrower, as well as
any potential credit support that the legal borrower may receive from
its ultimate parent and that corporate parent's credit quality to
determine what credit risk rating to grant the subsidiary. The potential
for such adjustments raise various transfer pricing issues as to
whether creditors should account for the fact that an O&G subsidiary
is in fact part of a larger corporate group, which adds on to the
existing inherent inaccuracy in determining the stand-alone credit
quality of the borrower in this industry owing to the issue of
steady-state point of view alluded to before.
The role of the OECD guidelines
Another specific source of uncertainty for E&P firms relates to
available transfer pricing guidance – in other words, how a taxpayer or a
taxation authority should attempt to evaluate a given transaction,
particularly given that a credit analyst may account for the fact that a
subsidiary is part of a larger group (even though it appears counter to
arm's-length principles to do so for transfer pricing purposes).
To better streamline transfer pricing regulations, the OECD has
issued guidelines that are recommendations providing principles and
standards for responsible business conduct for multinational
corporations. Tax authorities throughout the world follow these
guidelines and apply their principles to their own legislation (though
how they do so may differ by country). In particular, the OECD
guidelines are based upon an arm's-length principle when dealing with
intra-group transactions. The arm's-length principle is designed to
prevent income shifting between different taxing jurisdictions. The OECD
guidelines, under article 9, paragraph 1, allow tax authorities to
reserve the right to make the appropriate adjustments to the profits
between two related enterprises to more accurately reflect a transaction
that would have occurred between two unrelated parties. In particular,
the OECD guidelines note:
[Where] conditions are made or imposed between the two [associated]
enterprises in their commercial or financial relations, 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 enterprises, but, by reason of those conditions, have not so
accrued, may be included in the profits of that enterprise and taxed
accordingly.
This is especially important when considering how to evaluate credit
risk in the context of multinational groups in the O&G industry.
Financial transactions in the O&G industry, including intra-group
loans and credit guarantee arrangements, allow O&G parent companies
to finance their global businesses. However, the OECD has provided
little specific guidance regarding how arm's-length principles should be
applied to intra-group financial transactions. This lack of concrete
guidance has made it difficult for taxpayers to determine that they are
appropriately applying the arm's-length standard to their intra-group
financial transactions and thereby managing their transfer pricing
compliance and potential exposures. Taxation authorities have been
adopting views inconsistent with one another regarding how intra-group
financial transactions should be transfer priced by taxpayers. To make
matters worse, individual authorities have not necessarily adopted
consistent positions between their own taxpayer cases.
Separate entity versus group affiliation precept
Based upon the guidance in the OECD guidelines, taxation authorities,
taxpayers, and tax advisers have broadly adopted two separate (and
generally incompatible) approaches towards evaluating intra-group
financial transactions. We describe these two approaches below.
Separate entity precept
Under the separate entity precept, for transfer pricing purposes,
creditors analyse the credit risk profile for the loan solely based on
the subsidiary's risk profile, and do not take into consideration the
parent company's credit ratings or any contingent credit support that a
member of a multinational group might provide to a related party. This
approach might be argued with reference to how credit analysts might
evaluate the credit quality of a borrower, how the OECD guidelines apply
to a given financial transaction, or both. Some argue that, unlike the
contingent credit support precept, a subsidiary should be viewed as a
separate entity from the corporation, and it is not appropriate to
assign any credit enhancement to a subsidiary of a multinational, absent
formal and legally binding credit support from the subsidiary's parent.
The creditor, when lending to the subsidiary as a separate entity, is
taking on more of an inherent risk when the corporate parent is not
involved in the transaction. Thus, the subsidiary should be charged a
higher interest rate to compensate the lender for this inherent risk.
The tax authorities that have adopted the separate entity precept
rely heavily on paragraph 1.3 of the OECD guidelines which indicates:
By seeking to adjust the profits by reference to the conditions which
would have obtained between independent enterprises in comparable
circumstances (i.e., in 'comparable uncontrolled transactions'), the
arm's-length principle follows the approach of treating the members of a
multinational enterprise ("MNE") group as operating as separate
entities rather than as inseparable parts of a single unified business.
Based upon this language, it would appear as though the OECD would
prefer the separate entity precept; however, this language is found in
the first paragraph of article 9 of the OECD Model Tax Convention, which
defines transfer pricing concepts, in general. It does not specifically
address the type of precept to apply when dealing with intra-group
credit risk evaluations.
Group affiliation precept
Legally, a subsidiary is a separate legal entity from its parent.
However, this does not deter some creditors from adjusting their credit
evaluations of O&G subsidiaries based on the credit rating of their
parent corporations. Creditors perform these adjustments to account for
the fact that a parent corporation may provide credit support (as in, an
implicit guarantee) to one of its subsidiaries even if they had no
legal or explicit obligation to do so. Thus, this credit adjustment may
reflect a situation in which a creditor analyzes the risk of the loan
based on the subsidiaries' corporate group affiliation.
Certain tax authorities argue that, because the market takes into
account the credit quality of a broader multinational when considering
the credit quality of a subsidiary, it is appropriate to do so within a
transfer pricing context. For example, if the market lowers the
subsidiary's credit risk rating based on the assumption that the parent
company will guarantee the debt, then it is reasonable for the parent
corporation to also lower the credit risk, and thus the interest rate,
when establishing an intra-group loan to its subsidiary.
In support of the group affiliation precept, many tax authorities
consider the fact that the global reputation of the parent corporation
can affect the subsidiary reputation in other foreign jurisdictions.
Likewise, one subsidiary can affect the global credit rating of the
entire group. For example, if a subsidiary in one jurisdiction defaults
and the parent company fails to "bail" them out, since there is no
contractual obligation to do so, this default can affect the perceived
credit quality of other entities within the group. Similarly, if a
subsidiary in a jurisdiction is responsible for environmental damages,
it can reduce the entire group rating. Since no subsidiary is totally
independent from its own group, some tax authorities deem it reasonable
to adjust credit risk ratings of the group as a whole.
Incidental benefits and passive association
The transfer pricing of intra-group funding and the pricing of credit
risk ratings represent differing points of view among tax authorities.
Unfortunately, the OECD has provided very little guidance regarding how
the arm's-length principles should be applied to intra-group loans.
Since the OECD has not offered any concrete guidance cross-border
financial transactions have become a key risk area for major O&G
companies.
What makes these issues even more prominent is the fact that the OECD
has previously attempted to develop guidance specifically addressing
intra-group loan financing issues, but it has failed to reach the
consensus necessary to publish any relevant recommendations. During
these negotiations, the OECD addressed benefits that naturally derive
from being a member of a group:
… an associated enterprise should not be considered to receive an
intra-group service when it obtains incidental benefits attributable
solely to its being part of a larger concern, and not to any specific
activity being performed. For example, no service would be received
where an associated enterprise by reason of its affiliation alone has a
credit-rating higher than it would if it were unaffiliated, but an
intra-group service would usually exist where the higher credit rating
were due to a guarantee by another group member, or where the enterprise
benefitted from the group's reputation deriving from global marketing
and public relations campaigns. In this respect, passive association
should be distinguished from active promotion of the MNE group's
attributes that positively enhances the profitmaking potential of
particular members of the group. Each case must be determined according
to its own facts and circumstances.
Since a contingent credit support is not attributed to any activity
of the parent, it is not a service warranting compensation. Accordingly,
the benefit derived from contingent credit support is to be subtracted
from the transfer pricing of a loan. The US Treasury Regulations Section
1.482-9 stipulates that:
A controlled taxpayer generally will not be considered to obtain a
benefit where that benefit results from the controlled taxpayer's status
as a member of a controlled group. A controlled taxpayer's status as a
member of a controlled group may, however, be taken into account for
purposes of evaluating comparability between controlled and uncontrolled
transactions.
This language indicates that the US will readjust credit risk
valuations as though the subsidiary was not to receive contingent credit
support from its parent company.
In addition, different tax authorities have been adopting views
inconsistent from one another regarding how intra-group financial
transaction should be transfer priced by taxpayers. O&G companies
are also involved in O&G exploration activities in unsophisticated
tax regimes, which have also not come to a conclusion on these issues;
thus, making implementation that much harder. These inconsistent views
among tax authorities have just led to further confusion among O&G
companies as to what guidance to follow, and potentially have increased
their transfer pricing exposure.
Source of tax risk
Many tax authorities have recently been focused on the credit risk
ratings of intra-group loan financing transactions, both in the O&G
and other industries. The pricing of a loan impacts both the borrowing
jurisdiction (in terms of the deductions that it can claim) and the
lending jurisdiction (by virtue of the income that it receives.) Absent
global consensus on this issue, combined with additional guidance that
can be applied to financial transactions, we can expect this area within
transfer pricing to remain a specific source of tax risk for
multinationals and tax controversy.
Footnotes
- OECD Guidelines, Art. 9, ¶ 1.6
- OECD Guidelines, Art. 9, ¶ 7.9.
| Randy Price
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Deloitte
1111 Bagby Street, Suite 4500
Houston, TX 77002
US
Tel: +1 713 982 4893
Email: raprice@deloitte.com
Randy Price is the leader of Deloitte Tax's transfer pricing practice
for the Houston office. His transfer pricing practice involves client
projects spanning the entire energy value chain. Randy's primary area of
focus is helping energy related clients address global transfer pricing
planning, documentation, and tax controversy matters. In addition to
his core energy related experience, he has significant experience with
transfer pricing issues involving the cost sharing of intangibles and
related buy-in payments for technology focused industries.
Before joining Deloitte, Randy spent more than 10 years as an
international tax/transfer pricing executive for a Fortune 500
multinational company where he developed, implemented, and ultimately
defended multiple transfer pricing transactions from the Internal
Revenue Service exam phase through appeals. In addition, he has
experience with transfer pricing planning and controversy matters in
multiple jurisdictions outside of the US. Given Randy's experiences both
within industry and Deloitte Tax, he provides the key practical and
technical transfer pricing skills sets that clients' appreciate in
today's complex transfer pricing environment.
|
| Nadim Rahman
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|
Deloitte
1111 Bagby Street, Suite 4500
Houston, TX 77002
US
Tel: +1 713 982 3963
Email: nrahman@deloitte.com
Nadim is a senior manager and an economist in Deloitte Tax's US
transfer pricing practice and has seven years of transfer pricing
experience working in both the Dallas and Houston markets. During his
tenure with Deloitte Tax, he has managed various projects for large
Fortune 500 clients, overseeing work related to global documentation,
cost sharing, intangible valuation, headquarter cost allocation,
intercompany financing, planning studies, competent authority
assistance, and audit defence. He has developed relationships with
clients in the US, Europe, Asia, and Latin America. Nadim works on a
variety of diverse industries and has a focus on energy and oilfield
services industries.
Nadim has an MSc degree in economics from Texas A&M University,
was a Visiting Student in the MBA programme at the Indian Institute of
Management, Ahmedabad and has a bachelors of technology degree in
mechanical engineering from the Indian Institute of Technology in
Mumbai.
Nadim is a member of the American Society of Mechanical Engineers and the American Bar Association.
|
| Bill Yohana |
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|
Deloitte
2 World Financial Center
New York, NY 10281
US
Tel: +1 212 436 5578
Email: byohana@deloitte.com
Bill is a director in Deloitte's transfer pricing practice in New
York. Bill has been providing clients with transfer pricing advice for
the past 14 years, with a focus on addressing financial transactions
transfer pricing issues across industries, including the pricing of
related-party loans, credit guarantees, the development of global loan,
and guarantee pricing policies and the evaluation of thin capitalisation
issues. He also has experience in financial services transfer pricing,
as an adviser to commercial and investment banks, asset managers,
finance companies, and insurers.
Bill has an MBA from Johnson School of Management, Cornell
University; a BA in economics from the University of Chicago and was a
visiting student in philosophy and economics at Jesus College, Oxford.
He is a chartered financial analyst from the CFA Institute.
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The authors would like to thank Lani Payne, a consultant with
Deloitte's global transfer pricing services, for her significant
contributions in assisting with the research and drafting of this
article.