Asset-backed trading (ABT) has become prevalent in the energy and resources sector. The strategy triggers multiple transfer pricing (TP) and tax issues important to all taxpayers that are planning to implement, or already have set up, an ABT model.
What is asset-backed trading?
With an ABT model, an organisation owns assets related to the production, transportation and processing of a commodity, rather than just the commodity itself. This enables the organisation to maximise value by taking advantage of significant arbitrage benefits that would not be available otherwise.
For organisations that already owned assets, the move to this model unlocked additional value in absolute terms and helped reduce the impact of a downturn in commodity prices. A number of new asset traders have adopted a strategy of acquiring assets after experiencing lower profit levels on their trading transactions.
Trading for a specific commodity cargo would typically feature one or more of the following types of arbitrage.
A trader takes advantage of the difference between the spot price and the future price. For a market in which the future price is higher than the spot price (a contango market), this will involve the trader buying and storing the commodity, then selling it on the forward date (a cash and carry arbitrage). For a market in which the future price is discounted to the present (a backwardated market), the reverse would occur (a reverse cash and carry arbitrage).
This type of arbitrage arises from the existence of different prices in different geographic markets. For example, a trader buys heating oil in the northern hemisphere during summer when the price is low and sells it in the southern hemisphere, where it is winter and the prices are higher.
An ABT organisation can take advantage of price differentials for different qualities of a commodity (for example, heavy oil and light oil) by processing a commodity of a higher-priced grade or by adapting its refining/processing operations to utilise an input commodity of a lower-priced grade.
Organisations that own production assets may have an opportunity to adjust production schedules to lower production at times when the relevant commodity price is low and scale up production when there is a higher price.
Transfer pricing implications
To determine the TP implications, it is first necessary to delineate the controlled transactions and then consider whether those transactions should be recognised in line with the guidance in Chapter I of the OECD's TP guidelines for MNEs. The most appropriate pricing method is then selected and applied to support the arm's-length pricing in line with the guidance in Chapters II and III of the TP guidance.
Delineation of related-party transactions
The essence of the analysis is to identify the success factors for the particular sector that the trading activities relate to (paragraph 1.34), and then to identify what each group entity does, and hence what are the related-party transactions (paragraph 1.35). Such transactions for ABT activities could be the sale or purchase of goods, the provision of services, financing related to the trading activities, and potentially intangible payments, such as for the use of software.
Accurate delineation of the relevant related-party transactions involves consideration of the OECD's five comparability factors:
1) Contractual terms;
2) Functional analysis;
3) Characteristics of property or services;
4) Economic circumstances; and
5) Business strategy.
Although this article focuses primarily on the functional analysis, it is important to note that when there is any discrepancy between agreements and the actual conduct of the parties, it is the latter that takes precedence in the TP analysis. It is therefore essential that accurate written intercompany agreements be in place to secure proper tax treatment and to mitigate comprehensive discussions in tax audits.
In addition to understanding the overall functions performed by the entities within the ABT organisation, it is important to understand the functions and associated risks that apply to specific arbitrage opportunities to identify the relevant transactions. For time arbitrage trades that take advantage of contango markets, it is necessary to identify where the product will be stored until the future contract is settled, who owns the storage facility, and who retains legal title to the product.
In such a situation, the first issue is identifying whether there is a provision of services to the trading entity by another group entity. The second issue relates to permanent establishment (PE) implications. When the trading entity retains title to the product, and the product is stored in another country, this could create a PE for the trading entity in that country, with an ensuing attribution of profit to the PE. Whether a PE is created or not would depend on the specific fact pattern, the domestic tax law of the storage country for recognising a taxable presence, and whether the storage country has adopted the BEPS-updated version of Article 5 of the OECD's model tax convention in its income tax treaty with the trading country.
For geographic arbitrage trades, the central question is what entity has identified the arbitrage opportunity and initiates the trade (and hence assumes the risk).
For example, say an organisation has trading desks in separate legal entities in the UK and the US, and it determines that it would be profitable to sell a UK-sourced commodity in the US market. The question is whether the UK trading desk identified the opportunity and initiated the trade, and hence assumes the ensuing risks (with the US entity providing only support/logistics services for the trade), or whether it was identified by the US entity. It may be that both scenarios occur, in which case it would be necessary to distinguish between the two on an ongoing basis to determine the correct transaction types and pricing that apply to any given trade.
If a geographic arbitrage trade does not involve a group entity in the overseas country, then it would also have to be determined whether the trader's activities would give rise to a PE in that country.
For quality arbitrage trades, it is necessary to identify whether the arbitrage opportunity is identified by the trading entity as part of a wider optimisation role, or whether it is identified by the processing entity.
Similarly, for production arbitrages, it is important to determine whether the production part of the organisation has control over the timing and quantity of production above minimum limits, or whether the trading entity does.
The above discussion is based on the notion that the entity performing the risk-related functions would be characterised as assuming those risks. This would be the case only if the entity both exercises control over the risk and has the financial capacity to assume the risk. If not, then this would potentially create new delineated transactions related to the entity that has the control/financial capacity.
For example, if the UK entity in the geographic arbitrage example above did not have the financial capacity to assume a loss that could arise on the trade, then it would be necessary to identify which group entity would finance such a loss, and characterise the relevant intercompany transaction in respect of this.
Asset-backed trading creates value through the effective utilisation of the infrastructure associated with the production, transport and processing of the relevant commodity, combined with knowledge of the markets for that commodity. To conduct a functional analysis, the first step is to identify which group entities and third parties own or lease the relevant tangible assets within the commodity value chain. It is also necessary to identify funding sources, especially when a trading entity does not have the financial capacity to absorb the risks it is assuming. Then, the intangible assets that enable the optimisation of the tangible assets must be identified. Paragraph 6.6 of the OECD guidelines states that an intangible is:
"something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances."
Under Chapter VI of the OECD guidelines, it is first necessary to identify the intangible assets that are relevant to an ABT business, which would typically include the know-how of the traders and production and processing asset owners, IT systems (including access to trading platforms and developed algorithms), processes, and data.
The next step is to identify which entities perform the activities related to the development, enhancement, maintenance, protection and exploitation (DEMPE) of those intangibles. It is then possible to determine whether an intangible asset gives rise to a transaction in its own right (such as the licensing of trading algorithms developed by one group entity), or whether it is only a comparability factor in another transaction (for example, employee know-how).
The increased computerisation of trading and optimisation necessary for ABT, plus ongoing developments (e.g. blockchain, trading algorithms, use of data from assets, and artificial intelligence), mean that careful consideration must be given to identifying all economically relevant intangible assets.
Recognition of delineated transactions
Paragraph 1.122 states that an accurately delineated transaction may be disregarded or potentially replaced by an alternative:
"Where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances…taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction."
Many ABT models are based on regional or global trading books, rather than legal entities. It is therefore possible to arrange trades that make a profit on a total book basis, but could give rise to a non-arm's-length result for one or more of the legal entities involved. It is a practical challenge for those organisations to have systems in place to ensure that the legal entity TP requirements are met for trades, without negatively affecting the traders' ability to conclude deals on a timely basis.
Pricing of transactions
The question of which pricing methods should be used to test the delineated transactions will depend on what the specific transaction types are and their fact patterns. For example, the comparable uncontrolled price (CUP) method may be appropriate for many commodity transactions (see paragraph 2.18).
Special care is needed for a transaction where an entity provides trading services to another entity, either directly or indirectly, as a deduction part of a netback pricing calculation for the sale of products. An important question is whether a one-sided method (such as the transactional net margin method, or TNMM) can be used defensibly, or whether it is necessary to use a profit split method (PSM). The latter is potentially relevant to ABT models (see paragraph 2.115), either because they are potentially highly integrated value chains and/or both parties may be providing unique and valuable contributions, such as trading algorithms by the trader and data from another legal entity.
If a PSM is appropriate, it is necessary to determine what profit there is to be split and the methodology for doing so, and there may be associated legal issues to consider in some countries, such as the possibility of a deemed partnership.
The determination of which method is most appropriate for trading services will be fact-dependent for particular organisations. The potential tax risk can be significant, especially when the provision of trading services is to an entity that is taxed under a high tax rate commodity regime. This emphasises the need for the accurate identification of intangibles and delineation of transactions to provide a defendable TP position for the pricing methods applied.
Overall, ABT models require careful analysis of the facts to ensure that TP policies are developed for the relevant transactions, combined with systematic implementation of those policies.
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Nick Pearson-Woodd is a director with Deloitte Norway based in Oslo. Nick is a UK chartered tax advisor with almost 20 years of experience working in direct tax. For the past nine years he has been based in Norway with Deloitte's transfer pricing team.
Nick has served clients across all industry sectors, and notably in the oil and gas sector. He is responsible for Deloitte Norway's documentation and operational TP services, and has led numerous TP, advisory, documentation, operational TP and controversy projects for outbound and inbound multinational groups.
Nick focuses on providing technically robust BEPS-compliant solutions that are both aligned to a group's value chain and strategic drivers and that are practical to implement.
Tel: +47 980 15 500
Marius Basteviken is a partner with the Deloitte Norway transfer pricing practice. He is an experienced international tax and TP advisor for several multinational enterprises and has more than 12 years of experience providing assistance on a wide range of TP issues. This includes consultancy, implementation, compliance and dispute resolution services. Marius has experience in a wide range of industries.
Marius has been the advisor and project leader in several major tax audit processes in Norway. These audits have dealt with issues such as pricing mechanisms for tangible goods transactions, tax deductibility for centralised services, validity of financial analyses, interest deductions, and pricing of guarantee provisions.
Marius joined Deloitte Norway as a partner in September 2017. Before joining Deloitte, he was the head of TP at another Big Four accounting firm in Norway. Marius' educational background includes law and business degrees. He is an experienced lecturer and the author of several articles in domestic and international publications.