Over the past decade, many tax authorities have increased their scrutiny of cross-border related-party financial transactions, including intragroup loans, credit guarantees and financial derivatives. The base erosion and profit shifting (BEPS) initiative launched by the Organisation for Economic Cooperation and Development (OECD) has further advanced this focus, along with the resolve of many tax authorities to address instances of perceived taxpayer abuse of financial transactions. Financial institutions will likely be particularly affected by the OECD's latest efforts, in light of their intensive use of debt and derivative contracts. Nonfinancial corporate taxpayers, particularly those with significant amounts of intragroup debt or with internal risk transfer agreements, such as captive insurers, may also be significantly affected. In this article, we discuss the genesis of this issue, areas that have already attracted the interest of tax authorities, and potential methods of managing intragroup financial transactions amid the uncertainty introduced by conflicting tax authorities.
Why are certain financial transactions a source of tax controversy?
For years, some tax authorities appeared to avoid detailed scrutiny of financial transactions. Certain tax authorities lacked the expertise and the access to data sources to evaluate whether a loan or other financial agreements were priced on arm's-length terms. Tax authorities, at times, lacked interest in taking on cases when the parameters used to price the transaction appeared to be relatively subjective. At the same time, both tax authorities and taxpayers had little guidance and precedents available.
Over the past five years, however, tax authority audit activity of financial transactions has increased significantly. Several factors have driven this trend. In many jurisdictions, the value of intragroup financial transactions has increased considerably (some tax authorities, such as the Australian Taxation Office, attribute the increase to potential tax planning opportunities), thereby increasing the potential revenue benefit from focusing on this area from a tax administration perspective. At the same time, many taxpayers have failed to document the pricing of their intragroup financial transactions carefully. As a result, what was once one of the last areas a tax authority would challenge, has, in many jurisdictions, become one of the first to be reviewed.
Coincident with this increase in tax authority scrutiny of financial transactions, the ambiguity associated with the guidance on pricing intragroup financial transactions also has increased. A significant source of this ambiguity is the change in how some taxation authorities have been applying the arm's-length standard. The tax authorities of OECD member nations look to the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations for guidance on limiting the risk of double taxation that may arise from a disagreement between two countries' tax authorities as to the proper transfer price of a cross-border transaction. The guidelines, in turn, refer to the OECD's Model Tax Convention on Income and on Capital. Article 9 of the Model Tax Convention defines the arm's-length principle as follows:
[Where] conditions are made or imposed between the two 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.
A key source of ambiguity in the OECD's definition of the arm's-length standard is what constitutes an "independent" transaction. While most taxpayers have traditionally construed this to mean transactions between parties that are wholly independent, without the influence of related parties, some tax authorities have argued that a transaction between a subsidiary of a multinational and a third party (where the relationship between the subsidiary and its parent may influence how the third party evaluates the transaction) is also an independent transaction. They have made this argument despite OECD guidance in paragraph 1.6 of the OECD Transfer Pricing Guidelines that the arm's-length standard "follows the approach of treating the members of an MNE [multinational enterprise] group as operating as separate entities rather than inseparable parts of a single unified business" and ample precedent in the application of the arm's-length standard to non-financial transactions.
This subtle modification has had a significant impact on how some tax authorities have evaluated certain related-party financial transactions. A borrower's credit quality is generally a key determinant of the interest rate at which the borrower can obtain funds in the financial markets. Hence, it is also generally a key determinant of the rate on a related-party loan. Most taxpayers have interpreted the arm's-length standard as requiring taxpayers to hypothesise foreign subsidiaries of multinationals as being completely independent of their parent and subsequently estimating their credit quality on a stand-alone basis. Stated differently, "one of the underlying assumptions of the arm's length principle is that the more extensive the functions/assets/risks of one party to the transaction, the greater its expected remuneration will be and vice versa". OECD (2013), Addressing Base Erosion and Profit Shifting, OECD Publishing.
Under this alternative view of independence, it is necessary to consider the possibility that a subsidiary that faces a period of financial distress may be rescued by its parent, even without any legal obligation to do so. Furthermore, some tax authorities maintain that because this perceived credit enhancement arises solely from group membership, the interest rate at which a parent lends to a related-party subsidiary needs to be adjusted downward accordingly. In other words, a parent lender may need to adjust the rate at which it lends to an overseas subsidiary downwards in light of potential market perception that the parent itself will prevent the subsidiary from not performing on a loan from a third party. Such an adjustment would appear to undermine the perception of the subsidiary as "independent," in its ordinary definition. It is also not consistent with how both taxpayers and tax authorities have applied transfer pricing principles to nonfinancial transactions, where the impact of a parent on the risk of a subsidiary (or the influence that this parent-subsidiary relationship might have on the return the subsidiary is required to generate based on its own functions, assets, and risks) is generally explicitly disregarded.
Transfer pricing guidance regarding affiliation
Limited guidance exists from tax authorities regarding the need to account for affiliation when evaluating related-party financial transactions. Two countries that have led the push to require taxpayers to adjust for affiliation are Canada and Australia. In Canada's GE Capital Canada vs. the Queen (Can. Tax Ct., 2006-1385(IT)G, 12/4/09, followed by the appeal, The Queen v. General Electric Capital Canada Inc., 2010 FCA 344), the court ruled that it was appropriate to make adjustments for affiliation when evaluating the arm's-length nature of a credit guarantee provided to GE Capital Canada by its parent, GE Capital in the United States. However, in light of the facts in the case, the court concluded that the guarantee arrangement provided a benefit to the Canadian taxpayer and did not adjust the guarantee fees paid by GE Capital Canada.
The Australian Taxation Office has stated that it is necessary to account for the impact of affiliation when pricing related-party financial transactions, although it has provided this guidance in a nonbinding section of a taxation ruling, TR 2010/7, relegating its commentary to a brief footnote.
Attempting to adjust for the impact of affiliation
If one were to conclude that it is indeed appropriate to adjust for affiliation in a transfer pricing context, one would then be faced with the issue of how to make such an adjustment in a careful, replicable and consistent way that actually replicates market behaviour, and not merely one rating agency's broad guidance. Both Moody's Investors Service and Standard & Poor's have disseminated general guidance regarding how each firm broadly adjusts for the credit impact of group membership, but they have done so outside of a transfer pricing context. Several parties have attempted to develop a standardised approach to adjusting the credit quality of a subsidiary of a multinational for the potential impact of affiliation, but those attempts have generally tried to create structure around what is inherently a subjective and factually specific decision. Furthermore, even if a given credit ratings agency provides guidance regarding making adjustments for affiliation, it is still not clear whether and to what degree that guidance has actually been adopted by the financial markets, which provide the actual benchmark against which any potential adjustment should be applied. The pricing of debt can (and does) differ from what might be expected for transactions of a given credit rating.
It should also be noted that the impact of affiliation differs between financial and nonfinancial services firms. It also varies by country, by the respective credit quality of the parent and its subsidiary (or subsidiaries) and by prevailing credit market conditions. These variations make it nearly impossible to develop a reliable structured approach for adjusting for affiliation.
Managing the ambiguity of existing guidance on affiliation
While a taxpayer might justifiably express scepticism that it is appropriate to account for affiliation in light of the arm's-length principle and existing OECD transfer pricing guidance, it might nevertheless make sense from a tax risk management perspective to consider the views of the relevant tax authorities and proactively support the taxpayer's position. At the same time, these same tax authorities may be less concerned about extensions of credit that fail to account for affiliation. Transactions that are material and/or are priced based on the premise that the credit quality of the borrower or the guaranteed entity is significantly lower than that of the broader group likely merit further scrutiny. At the same time, some tax authorities have started to consider whether parent companies located in their jurisdictions are being appropriately compensated for the assumption of credit risk, such as that incurred in providing credit guarantees. Hence, it is critical to have an understanding of how different tax authorities might perceive a specific financial transaction, given their stated policies, audit history and financial interests, and to proactively prepare transfer pricing documentation that memorialises the taxpayer's position.
BEPS and capital structure
The OECD's BEPS initiative raises questions regarding interest deductions claimed by taxpayers in a given jurisdiction. This facet of the OECD's work could have a meaningful impact on both multinational financial institutions and nonfinancial corporate taxpayers, given the importance of debt financing. In 2013 alone, corporate issuers (including both financial and nonfinancial borrowers) raised US$3.2 trillion through the corporate debt markets, according to Standard & Poor's in its article "Credit Trends: More Than $3.2 Trillion in Global Corporate Bonds Came to Market In 2013," January 8 2014. In addition, banks extended US$4.2 trillion in syndicated loans globally to corporate borrowers, according to Thomson Reuters, Global Syndicated Loans Review for 2013.
Multinationals generally seek to allocate the cost of external debt financing among their branches and/or subsidiaries. However, if tax authorities in jurisdictions that receive allocations of externally raised debt seek to routinely characterise these allocations as attempts at harmful base erosion (whether through restrictive thin capitalisation limits, general anti-avoidance provisions, or other measures that may restrict otherwise arm's length interest deductions), the number of instances when members of a multinational group are not able to fully deduct a portion of their external debt expense in at least one jurisdiction may increase significantly.
While taxpayers with transactions covered by a tax treaty may have recourse to the mutual agreement procedure to resolve capital structure and other transfer pricing disputes, those procedures are typically long and generally require only that the taxation authorities discuss a given issue – not that they actually achieve resolution. Given the size of many multinationals' balance sheets, tensions may naturally arise between those countries that are home to a significant number of multinational headquarters (or their funding hubs) and those that tend to host their subsidiaries.
Allocating the cost of liquidity premia
Allocating the cost of liquidity premia may raise similar issues to the allocation of external debt amounts. To reduce the possibility that a borrower cannot refinance its obligations as they become due (liquidity risk), both financial institutions and corporates generally raise funds with a variety of maturities, taking into account the maturity profile of forthcoming maturing debts and the firm's assets. In the wake of the financial crisis in 2008, the need for both financial and corporate borrowers to extend the maturity profile of their liabilities, and the cost of doing so, increased significantly. Borrowers with centralised funding models that raised funds on behalf of the broader group on a term basis, and on-lent those funds on a short-term basis incurred significant incremental costs in their funding centres. When the funding centres subsequently attempted to allocate those costs to the entities that arguably benefited from the presence of longer-term funding but paid only short-term rates (often through "liquidity fees"), some tax authorities balked at these incoming charges. To the extent that similar financial market conditions may reappear in the future, it may make sense to adjust the time to maturity on related-party loans (and their associated interest rates) to match the term structure of the borrower's local funding requirements.
The existing definition of the arm's-length standard refers to "arm's-length conditions" when pricing transactions between related parties. The OECD transfer pricing guidelines, in the context of intragroup funding, note that it may be necessary for a tax authority to recharacterise a loan transaction as equity if a subsidiary of a multinational is not adequately capitalised. Based on what the OECD has already announced about its BEPS initiative, OECD member tax authorities may seek to have expanded powers to recharacterise transactions they believe would not have occurred at arm's-length. Beyond potentially recharacterising a debt instrument as equity, tax authorities may question the validity of hedging agreements (for example, an interest rate swap or a cross-currency swap, which the OECD notes may provide a taxpayer with tax advantages by virtue of its domestic tax treatment).
Australia again appears to be at the forefront of increased powers of reconstruction. Its revised transfer pricing legislation, Subdivision 815-B, provides the Australian Commissioner of Taxation with the power to reconstruct cross-border related-party transactions, though supposedly only in extreme circumstances. Taxpayers may gain an understanding of what constitutes an "extreme" circumstance as such circumstances arise over time.
Although the OECD has indicated to taxpayers that it plans to implement measures designed to counteract perceived profit shifting through financial transactions, guidance has not yet been introduced. The absence of specific guidance, along with the disparate approaches tax authorities have taken to applying existing guidance to financial transactions, has consequently increased the tax risk faced by many multinational firms. If the OECD affirms that the arm's-length standard applies to financial transactions, it would be helpful to also clarify the definition of "independence" to enable taxpayers to price financial transactions on the same basis that they apply to other nonfinancial transactions. Regardless of how the OECD decides to proceed, it is unlikely that financial transactions will again become an area disregarded by taxation authorities; hence, taxpayers will need to structure and price intragroup transactions with care.
|Robert W. Plunkett Jr.|
2 Jericho Plz.
Robert Plunkett is the managing principal of Deloitte Tax LLP's Northeast Transfer Pricing Group. In addition, he leads the firm's Financial Services Transfer Pricing practice.
Robert has provided services to 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, Robert has worked on contemporaneous documentation, planning, audit defence and advance pricing agreements.
Some of the banking projects on which Robert has worked have involved income and expense allocation among branches for activities ranging from global trading to provision of ancillary and/or support services. His investment banking experience includes analysis of global trading of derivatives, merger and acquisition activity, loan syndication, and prime brokerage. In global trading transactions, Robert has helped to price the assumption of market risk, the assumption of credit risk, the performance of trading functions, and the provision of sales and/or marketing services. He has assisted insurance companies in pricing the transfer of risk among entities, and insurance brokerages in allocating income and expense from global placements. Robert has worked on a number of investment advisory projects, including the pricing of advisory functions, subadvisory functions, custody functions, and brokerage functions for both traditional and alternative investment managers.
Robert has also spent a considerable amount of time on the pricing of intercompany lending, the pricing of intercompany guarantees, and the pricing of various intangible assets and intangible asset transfers.
Robert has published numerous articles on transfer pricing and speaks frequently on transfer pricing issues.
Robert received his B.A. in economics from Harvard University and his Ph.D. in economics from the University of California, Los Angeles.
Bill Yohana is a director in Deloitte's Transfer Pricing practice in New York City. During the past 15 years, he has focused on financial transactions transfer pricing, 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 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 also 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.
Bill also advises clients in the financial services sector, as an adviser to commercial and investment banks, asset managers, finance companies, and insurers.
Before beginning work in transfer pricing, Bill worked for 10 years in the financial services sector, including roles in equity investment management and interest rate derivative structuring and marketing. He also worked at the Federal Reserve, where he held a payment system policy role.
Chartered Financial Analyst, CFA Institute