As part of its broader base erosion and profit shifting (BEPS) initiative, the OECD issued a non-consensus discussion draft in December 2014 on "Risk, Recharacterisation and Special Measures". That document delineated proposed changes to the OECD's transfer pricing guidelines that affect how tax authorities might evaluate risk allocation among members of multinational groups, along with instances when tax authorities could recharacterise a given transaction or set of transactions. Subsequent guidance from the OECD noted that "special measures" would not be required.
Significantly, the OECD leaves open the question whether the risk and recharacterisation discussion draft's precepts should apply to financial institutions, including commercial banks and other entities that deal in securities, loans, and commodities. For regulated financial services companies, cross-border risk management can constitute a significant component of their business. The role of capital, even if separated from functions, is important in these types of businesses, particularly in light of the introduction of the Bank for International Settlement's Basel III capital requirements. Basel capital requirements have been adopted in some form or fashion by most OECD members.
This analysis considers an important aspect of the risk and recharacterisation discussion draft – its views on the treatment of capital – and concludes that applying a key aspect of the thinking underlying the discussion draft to financial institutions would not be appropriate, given the role of capital in this sector. In particular, an objective of the discussion draft is "to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital". It is unclear how the OECD might apply this approach to the banking sector.
In broad terms, the risk and recharacterisation discussion draft proposes that returns associated with risk bearing should be allocated to entities that perform value-creating people functions, rather than to entities that merely provide capital. In a financial services context, this guidance could be interpreted to imply that if a derivatives trader in New York entered into a transaction and recorded (or booked) that transaction in the bank's London affiliate, the return associated with that transaction would be reattributed to the US entity, notwithstanding the fact that the UK affiliate would be required to hold regulatory capital, and the possibility that the UK affiliate might bear the economic losses from the trade. To the extent that the risk and recharacterisation discussion draft allows for a return to capital for the assumption of risk, the quantum of return may not be large, as noted in the discussion draft's section on inappropriate returns for providing capital:
"Transfer pricing rules, including the guidance in Part I of this discussion draft, focus on the functions actually performed in relation to those assets, including the management of risks, and may determine that little or no return is due to the capital-rich, asset-owning company, and in some circumstances may determine that the resulting intra-group transactions relating to that company's assets should not be recognised"
To the extent that an entity providing capital earns a return, the risk and recharacterisation discussion draft argues that it should receive only a "normal" return. This is perhaps best articulated at the end of the discussion draft, where the OECD states that "excess returns would need to be defined in accordance with design considerations but could target returns associated with intangibles and risk and equal all of the CFC's income, less an allowance for corporate equity, which may provide an exemption for normal returns on capital invested in real activities within a jurisdiction".
There is a broad body of academic literature that asserts that returns to equity capital are inherently volatile. Hence, when ascribing a fixed rate of return to risk-bearing functions, the very real possibility exists that the actual return to capital providers could deviate from a modeled, long-run return; this possibility increases as the risk of the underlying asset increases. Moreover, when contemplating the return to capital in a financial services business, it is important to note that regulators such as the Federal Reserve and its foreign counterparts view net income and retained earnings as a source of capital, and hence could be expected to have views about the legal entities to which net income is attributed and the extent to which such income is subject to tax (or double tax).
To illustrate the impact of ascribing a routine (fixed) return to capital and attributing residual returns to "people functions", we looked at publicly available data from Bloomberg and the Osiris database on the net income of approximately 20 large, regulated banks with significant multinational operations for the period from 2010 to 2014. While the primary regulator of these banks differs depending on the institution's parent country, all the banks in our set were subject to a regulatory regime based on the Basel Accords and had regulatory capital amounts that were supported by Tier 1 and Tier 2 capital.
It is a simplistic but useful shorthand to conceptualise Tier 1 capital as "equity-like" and Tier 2 capital as "debt-like". Applying this intuition, we looked at both book value estimates of the after-tax return on equity and market estimates (Bloomberg CAPM derived) of the after-tax return on equity. A 10% return on equity fell into both ranges, and hence appears to be a reasonable proxy for the average rate of return that one would expect regulatory capital to earn.
For approximately 70% of the banks in our sample of large, regulated banks with significant multinational operations, the routine return to Tier 1 capital was greater than or equal to the net income actually earned by the bank. For the other 30% of banks, the routine return to Tier 1 capital accounted for 80% of the bank's total net income, on average. Moreover, if one were to ascribe some return to the Tier 2 capital or to other routine functions, the amount of residual profit that could be attributed to value-creating people functions would be lower still.
In the risk and recharacterisation discussion draft, the OECD asks whether this guidance should apply to financial services firms:
"Is the discussion of risk of a general nature such that the concepts apply to financial services activities notwithstanding the fact that for financial services activities risk is stock in trade and risk transfer is a core component of its business? If not, what distinctions should be made in the proposed guidance?"
The analysis above also suggests that the risk and recharacterisation guidance may be difficult to apply in the financial services industry – or at least that portion of the industry involving the use of significant amounts of regulatory capital – because the attribution of routine returns to regulatory capital may not leave sufficient levels of residual profit to attribute value to any function other than the provision of capital and the assumption of risk.
Robert W. Plunkett Jr.
New York, NY
Robert Plunkett is the managing principal of Deloitte Tax's transfer pricing group in the East region. In addition, he leads the firm's financial services transfer pricing practice.
Rob has served a wide array of the firm's clients including those involved in banking, investment banking, asset management, insurance, insurance brokerage, private equity and hedge fund management. In serving these and other clients, Rob has worked on contemporaneous documentation, planning, audit defence and APAs.
Some of the banking projects on which Rob has worked have involved income and expense allocation among branches for activities ranging from global trading to provision of ancillary/support services. His investment banking experience includes analysis of global trading of derivatives, merger & acquisition activity, loan syndication, and prime brokerage. In global trading transactions, Rob has helped to price the assumption of market risk, the assumption of credit risk, the performance of trading functions, and the provision of sales/marketing services.
He has assisted insurance companies in pricing the transfer of risk among entities, and in allocating income and expense from global placements. He has worked on risk transfers involving both facultative and treaty contracts. He has also worked on developing arm's-length ranges for ceding commissions.
Rob has assisted with the transfer pricing of investment advisory functions for registered investment companies, for alternative investment advisers and captive investment managers working with insurance companies. Transactions covered include the pricing of advisory functions, sub-advisory functions, custody functions, and brokerage functions.
Rob has also spent a considerable amount of time to price intercompany lending, intercompany guarantees, and the pricing of various intangible assets and intangible asset transfers.
Rob has published numerous articles on transfer pricing and speaks frequently on transfer pricing issues. He has also been identified – over a period of years – as one of the world's leading transfer pricing advisers in Euromoney's Guide to the "World's Leading Transfer Pricing Advisers".
Brian Green is a consultant in Deloitte Tax's global transfer pricing service line based in New York. Brian started in the New York office in June 2013 as an intern before joining the firm full-time in June 2014. Since joining with Deloitte, Brian has served a broad range of clients, preparing planning and documentation studies to help taxpayers determine appropriate prices for intercompany transfers of tangible goods, intellectual property, and services. He has served multiple Fortune 500 companies across a variety of industries, including telecommunications, media, energy, and finance.
As a consultant, Brian prepares deliverables and manages internal deadlines. With his experience in multijurisdictional engagements, Brian regularly works with transfer pricing advisors across multiple jurisdictions and experts across different tax functions to help clients achieve their global tax objectives.
Education and publications
Brian has contributed to articles including the "Technology, Media, and Telecoms Guide" for International Tax Review, No. 82, September 10, 2013 and "Media & Entertainment: The price of content" for International Tax Review, No. 93, September 23, 2014. Brian graduated from the University of Chicago with a Bachelors of Arts in Economics, as well as in Statistics.
Bill is a director in Deloitte's transfer pricing practice in New York City. Bill has been providing clients with transfer pricing advice for the past 17 years, with a focus on addressing financial services transfer pricing issues as an adviser to commercial and investment banks, asset managers, finance companies and insurers. He also has extensive experience in 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 capital structure and thin capitalisation issues.
Bill also has considerable experience in tax controversy matters arising from financial transactions, including responding to taxation authority position papers and creating strategies in taxation authority audits. Bill has worked with clients in the energy sector, particularly in relation to the funding of their businesses, the establishment of commercially realistic capital structures and developing models for cross-border energy trading.
Before beginning work in transfer pricing, Bill worked for four years in US and international equity investment management and for four years in interest rate derivative structuring. He also worked at the Federal Reserve, where he held a payment system policy role.