All material subject to strictly enforced copyright laws. © 2022 ITR is part of the Euromoney Institutional Investor PLC group.

Transfer pricing issues on intra-group financing: The non-recognition mechanism

Spain big

According to the OECD Transfer Pricing Guidelines, recharacterisation of an intra-group transaction is a residual mechanism available to tax authorities to be used in exceptional circumstances to identify the economic reality behind a contrived transaction since the reconstruction of legitimate business transactions would be a totally arbitrary exercise. Ramón López de Haro and Antonio Baena of Deloitte take a closer look.

There has been a recent increase in the use of recharacterisation by tax authorities to analyse and verify that the agreed consideration in an intra-group transaction reflects the arm's-length principle.

The Chevron Case from October 2015 set a significant precedent in this area. In this case, the Australian courts questioned the commercial rationality of a credit facility between the Australian subsidiary of the Chevron Group and its US subsidiary, claiming that the terms and conditions would not have been agreed upon between independent parties (particularly, without providing security or imposing covenants or restrictions on the use of the financing). As a result, the Australian Taxation Office significantly reduced the amount of the finance costs deducted by Chevron Australia, on the basis of scenarios that disregarded key aspects of the related-party transaction performed. The adjustment was based mainly on the premise that, under similar conditions, an independent entity would have been required to provide appropriate security to obtain such a level of financing and would have been subject to certain financial or operational covenants, therefore paying interest at a lower rate.

In line with this precedent, the objective of this article is to analyse the position of the Spanish tax authorities and courts with regard to the use of the recharacterisation mechanism in recent decisions. We will also explore the possible effects of a potential increase in the use of this mechanism by the tax authorities.

In any event, in our view, the fact that related parties do not structure their transactions in a particular way may be grounds for close examination of the economic logic behind such transactions, but should not be sufficient cause, per se, for recharacterising them and not recognising their tax effects.

The Chevron case

In the Chevron case, the Australian courts based the non-deductibility of a portion of the interest paid by Chevron Australia to its US subsidiary on the following arguments:

  • The interest rate applied to the intra-group financial transaction was high because the debt granted was not secured or subject to any financial or operational covenants;

  • Under similar conditions, an independent entity would have been required to provide appropriate security to obtain such a level of financing and would have been subject to certain financial or operational covenants, therefore paying interest at a lower rate; and accordingly,

  • If the intra-group transaction had been performed at arm's length (i.e. if the borrower had provided guarantees of payment and accepted financial or operational covenants), a hypothetical scenario, the applicable market interest rate would have been lower.

The Australian courts therefore upheld the stance taken by the Australian tax authorities, which recharacterised (informally) the intra-group transactions to reflect in their consideration the arm's-length conditions that should have been applied if the transactions had been arranged between independent entities.

This decision shows a broad view of the term "consideration" for the analysed intra-group transaction which goes beyond the agreed price (the interest rate) and allows the tax authorities to make adjustments to other factors (security and financial or operational covenants) that could have an impact on the price.

OECD’s approach to the non-recognition mechanism

The OECD Guidelines establish certain safeguards with respect to the use of this mechanism as a method for comparing the conditions effectively agreed upon between related parties with those that would be expected to have been applied between independent entities.

In effect, the latest version of the OECD Guidelines, following the amendments introduced in light of the BEPS project, only establishes one situation in which it would be appropriate to use recharacterisation.

In particular, the new paragraph 1.123 establishes that the key question in the analysis is whether the transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties. However, it should be noted that the OECD Guidelines do not examine the concept of commercial rationality for these purposes.

Spanish regulations amended to align them with BEPS outcome

In Spain, following the amendments to the Corporate Income Tax Law in 2015, the tax authorities' powers to analyse related-party transactions were extended.

Specifically, the tax authorities' powers have developed from being able to verify that related-party transactions were priced at their normal market value and make the applicable valuation adjustments (former Article 16.2), to being able, in general, to review related-party transactions and make any adjustments that may be applicable under the terms that would have been agreed between independent parties on an arm's-length basis (Art. 18.10 of the Spanish Corporate Income Tax Law).

Therefore, based on these different nuances in wording, a review by the tax authorities may go beyond verifying the consideration agreed upon in related-party transactions, and any adjustments made will not be limited to evaluating them on the basis of how they were structured but on the terms that would have been agreed between independent parties.

Use of the non-recognition mechanism by the Spanish tax authorities

In Spain, there are precedents of adjustments of related-party transactions based on the recharacterisation mechanism, although it appears that the courts have not yet adopted a definite position in this respect.

On the one hand, among the rulings in favour of a relatively general use of the recharacterisation mechanism, the Supreme Court judgment of July 18 2012 (Appeal No. 3779/2009) upheld an adjustment by the tax authorities based on the non-recognition of the tax effects of a series of related-party transactions performed as part of a leverage share purchase between companies in the same group.

According to the tax authorities, ”the analysis of the transaction performed by the claimant shows that it accepted that it be carried out under conditions that would not have been accepted by independent companies, thereby displaying (…) a genuine lack of free will on the part of the claimant who did not follow the law of supply and demand and, accordingly, the transaction in question was not performed in accordance with the arm's-length principle”.

Along the same lines, the Spanish Central Economic-Administrative Tribunal (TEAC) in a decision dated November 5 2015 (05110/2012/00), upheld the position taken by the tax authorities who rejected the deductibility of interest paid by a foreign-securities holding company to its immediate parent, a Netherlands entity, both belonging to a multinational group with a Brazilian parent. The financing granted by the Netherlands company was for the purchase of investments in two Argentinean entities by the Spanish company from a third party outside the group.

The tax authorities took the view that the Spanish company would not have obtained a similar volume of financing from an independent entity, and not under the conditions that it did (e.g. automatic renewal of the repayment term) and, therefore, the transaction was not performed at arm's length and the resulting financial cost was not deductible.

On the other hand, more recently, the Spanish Supreme Court, in a judgment of May 31 2016 (Appeal no. 58/2015), appeared to place a limit on the use of recharacterisation by partially upholding the taxpayer's claims in its appeal of the National Appellate Court judgment of December 11 2014 (Appeal No. 317/2011) – Peugeot case.

In this judgment, the National Appellate Court upheld the non-deductibility of the impairment losses recognised on its investment in an Argentinean company (recently acquired from a related entity) arising from the conversion into capital of loans granted to the entity by other group companies, loans which had been acquired by the Spanish taxpayer. The adjustment was based on the fact that the acquisition of such loans would not have taken place between independent parties due to the economic situation in Argentina at that time.

However, the Supreme Court considered this conclusion to be wrong for two reasons:

  • From a technical point of view, it was unacceptable to consider that the loans had no market value, since economic reality shows that even in situations of apparent insolvency there is an active market to purchase loans that are apparently uncollectible. If the loans acquired could have a market value, it was not possible to deny that they had such value without proving it; and

  • From a legal point of view, it was not possible to disregard transactions actually carried out between related parties which could be attributed a market value by simply referring to the direct application of Article 9 of the International Convention on the avoidance of double taxation between Spain and France or between Spain and Argentina. It would have been necessary in this case to apply a general internal anti-abuse clause to carry out this reclassification.

Potential effect of an increasing use of the non-recognition mechanism when assessing intra-group transactions

Despite the fact that recharacterisation is supposed to be used on an exceptional basis, under the new approach to the analysis of related-party transactions that transpires from the stance taken by the Australian courts in the Chevron case, and from the decisions in the economic-administrative jurisdiction and the Spanish courts mentioned above, it is an informal recharacterisation of transactions that would not be restricted by the criteria stipulated in that respect.

Likewise, although recharacterisation should be applied in exceptional circumstances (as reiterated in the amendments to the OECD Guidelines in the context of the BEPS project), there is a risk that, in practice, it could become a mechanism that the tax authorities use frequently to adjust the tax effects of related-party transactions and, for the time being, there has been no clear definition of the main limitation on its use (i.e. the concept of commercial rationality).

In this regard, a potential increase in the use of recharacterisation in audits of related-party transactions could lead to a substantial increase in international double taxation which would mean an increase in costs for taxpayers and tax authorities alike.

  • For taxpayers, the double taxation resulting from the recharacterisation of a related-party transaction would occur immediately, as it is unlikely that the various tax authorities would share the same opinion as to whether it was warranted or appropriate and, also, there is no common frame of reference (notwithstanding the possibility of commencing a mutual agreement procedure); and

  • For tax authorities, the increase in adjustments based on the recharacterisation of related-party transactions will result in an increase in internal appeals and mutual agreement procedures instigated by taxpayers in order to eliminate double taxation, and more resources will need to be dedicated to processing these procedures.

In any event, the recharacterisation of cross-border related-party transactions in accordance with the arm's-length principle - instead of in accordance with anti-abuse regulations that clearly define cases of tax avoidance - without a doubt results in greater legal uncertainty, notwithstanding the penalty regime applicable to the latter compared to transfer pricing-based adjustments.

Written by Ramón López de Haro and Antonio Baena of Deloitte

ramon lopez de haro

Ramón López de Haro



antonio baena

Antonio Baena

more across site & bottom lb ros

More from across our site

Corporations risk creating administrative obstacles if the pillar two rule is implemented too soon, sources say.
Important dates for the Women in Business Law Awards 2023
The Italian government published plans to levy capital gains tax on cryptocurrency transactions, while Brazil and the UK signed a new tax treaty.
Multinational companies fear the scrutiny of aggressive tax audits may be overstepping the mark on transfer pricing methodology.
Standardisation and outsourcing are two possible solutions amid increasing regulations and scrutiny on transfer pricing, say sources.
Inaugural awards announces winners
The UN’s decision to seek a leadership role in global tax policy could be a crucial turning point but won’t be the end of the OECD, say tax experts.
The UN may be set to assume a global role in tax policy that would rival the OECD, while automakers lobby the US to change its tax rules on Chinese materials.
Companies including Valentino and EveryMatrix say the early adoption of EU public CbCR rules could boost transparency of local and foreign MNEs, despite the short notice.
ITR invites tax firms, in-house teams, and tax professionals to make submissions for the 2023 ITR Tax Awards in Asia-Pacific, Europe Middle East & Africa, and the Americas.