A financial services transfer pricing leader discusses some of the regulatory challenges that transfer pricing can trigger.
Effective practice of FSTP involves a keen appreciation of the interaction between three different sets of rules: transfer pricing rules; accounting rules and banking regulations. A financial services transfer pricing manager may be faced with the following:
(a) A transfer pricing doctrinal framework that has evolved for use in other industries;
(b) Whatever transfer pricing guidance that is available may not clearly distinguish between the services and the key product that your company is offering;
(c) A fluid business model with combinations of affiliates and FAR (functions performed, assets employed and risks assumed) varying by each product or even by each transaction;
(d) Overriding government regulation of every activity and aspect of your business; and
(e) A business that is seeking growth in the emerging non-OECD markets where the norms can be quite different from those commonly accepted in the West
The above represents the challenging world of cross-border FSTP. One important backdrop underlying the challenge in FSTP is dealing with the interactions between three different sets of rules set by three separate authorities to achieve three different aims.
The three rules
First, there are the transfer pricing rules designed to prevent evasion of taxes and reflect income as earned when transacting with related parties on an arm’s-length basis. These are set by the legislature, courts and tax authorities of each tax jurisdiction encapsulated in the respective tax codes, administrative guidance, rulings and case law.
Then, there are the accounting standards – International Financial Reporting Standards (IFRS), Generally Accepted Accounting Principles (GAAP) and their local variations - governing the preparation of financial or statutory books to provide a true and fair view of the business affairs of a company. These are set by international or national accounting bodies such as the International Accounting Standards Board and the Financial Accounting Standards Board.
Finally, there are the banking, securities and insurance regulations aimed at regulating risk taking by financial institutions and safeguarding the public in relation to the provision of financial services. These are set by the banking, securities and insurance regulators of each country.
Each of these rules is a complex area in its own right with specialist teams at every financial institution devoted to its technical interpretation and application. The problem facing the FSTP manager is that FSTP rules are much less established than the other two sets of rules. Yet, in practice, the latter often steer how FSTP can be implemented. FS regulations, in particular, control many aspects of FS activity and decide the acceptable methods to price financial service’s central product – risk.
Accounting rules may be more manageable as many transfer pricing practitioners have accounting backgrounds. Nevertheless, dealing with accounting rules is routine in transfer pricing implementation because accounting determine fundamental elements such as the nature of income and the timing of its recognition before transfer pricing adjustments in the financial books can be made. Accounting requirements, like periodic accruals, matching payables with receivables and reconciliation between different accounting books also shape how transfer pricing adjustments are affected through the finance infrastructure.
It may not have been as complicated if the three rules were aligned with each other but they are not, given their differing aims, nomenclature and institutional frameworks. The multi-jurisdictional nature of FS transactions where a single transaction can involve clients in one location, bankers in another, booking of asset in a third and distribution in multiple other locations means that the FSTP manager not only juggles between two or more tax authorities and transfer pricing rules, he has to reconcile the impact of his transfer pricing recommendations on multiple sets of non-transfer pricing rules governed by other authorities.
Banking regulations on transfer pricing
Of the three rules, FS regulations are easily the most pervasive, yet its impact on transfer pricing is perhaps the least understood by transfer pricing managers. Using banking to illustrate the importance of regulations, we start with the core purpose of banking; financial intermediation, which is the channeling of funds between capital surplus and capital deficit agents. Risk is central to such intermediation. Banking can be distilled into the pricing, assumption, packaging, monitoring and management of risk.
Applying the typical FAR functional analysis framework, banking functions would encompass activities such as marketing/origination, trading, structuring, risk management. Assets would consist of capital, financial assets (loans) and liabilities (deposits). Risks would comprise the major categories of credit, operational and market risks, along with less quantifiable notions of reputational, systemic and other risks.
Banking regulations impact all three FAR factors. A banking or securities license defines and controls the scope of permissible activities a bank can undertake. Some regulations target the individual bank employees and regulate the functions, particularly offshore activities that they can perform. Most countries’ prudential rules are guided by the Basel Committee on Banking Supervision accords (the Basel rules). These require banks to maintain minimum levels of capital against risks they assume and regulate their asset-liability profile. These prudential rules also define the acceptable approaches in calculating the various types of risks. The credit risk component can be calculated in three different ways: the standardised approach and the Foundation and Advanced internal ratings-based approaches (IRB) where banks are able to use their own models to determine their regulatory capital provisioning for credit risk.
For operational risk, there is the basic indicator approach, the standardised approach and the internal measurement approach. For market risk, the preferred approach is VaR (value at risk). In effect, these officially sanctioned ways to measure risks and required capital maintenance levels determine the price of risk. Some countries go beyond the Basel rules to set administrative guidance on lending and leverage, define interest rates and controlling capital flows into and out of the country.
In practice, these regulatory rules frequently take precedence over transfer pricing rules as the sanctions for violation (including loss or suspension of license) are severe and adjustments have to follow closely the contour of permissible functions set out under the regulatory rules.
Apart from defining the permissible functions, another pervasive impact of these regulations can be seen in the pricing of risk in an area known as funds transfer pricing (FTP). FTP, as distinguished from tax transfer pricing, is a method to measure how much each source of a bank’s funding is contributing to overall profitability. FTP is used by bank treasury and asset liability management desks, to compute the cost of funds and price internal funding across product lines and related entities. Each country’s regulatory capital requirements are costs that are factored into FTP pricing in the form of a statutory reserve spread. FTP pricing also incorporates the impact of regulations on FTP elements such as the fixed, tracker, base and managed rates used, the credit spread and the liquidity premium.
A further issue is that these regulations constantly evolve after each successive financial crisis. Basel (I), in 1988, focused on credit risk. Basel (II), in 2004, introduced more sophisticated approaches to quantifying risks and expanded to addressing operational and market risks. Basel (III) is an ongoing effort, since 2010, to introduce new regulatory requirements on bank liquidity and bank leverage. The table below further illustrates the potential impact of two recent regulatory developments using the FAR framework.
Impact of FS Regulations on FS Transfer Pricing
| *Functions |
*Assets/Capital |
Risks |
|
FS regulatory impact on TP |
License defines scope of permitted activities (entities & persons) |
Capital/liquidity buffer against loss |
How risk is managed, monitored/modeled & controlled |
Examples of Potential Impact of Recent Regulatory Developments |
|||
Volcker Rule |
Sell/close proprietary trading desks |
Fewer open trading positions means less market risk capital provision |
Risks split away and assumed by a separate entity |
Moving OTC derivatives to central counterparty clearing |
Execution/settlement on exchange |
Reduction in counterparty credit risk means less capital provision |
Risks centralised to a central counter party |
The Volcker rule prohibits purely proprietary trading activities for banks, with significant exceptions for facilitating client business. The second change mandates the shifting of certain over-the-counter (OTC) derivatives with financial counterparties to exchanges or central clearinghouses.
OECD transfer pricing guidelines fall short
In this respect, the OECD guidelines, with its roots in the manufacturing and pharmaceuticals, has long offered scant guidance specific to banking until the publication, in 2008, of the Report on the Attribution of Profits to Permanent Establishments. This report is a major advance in addressing the attribution of assets and risks to permanent establishments of banks engaged in making loans and global trading and in developing key concepts such as key entrepreneurial risk-taking or KERT functions. It is, however, limited in that it was never designed to be a comprehensive exposition of TP principles applicable to FS. It was meant to be an aid to the interpretation of Article 7 of the OECD model treaty. Even so, this limited effort created some doctrinal complications with the notion of free capital and confusion between the function of taking risk and the entity undertaking the risk, in the effort to attribute the reward for risk to the KERT function. In any case, by the time the report was finalised in 2010, the Basel (II) basis, upon which it had relied, was starting to be altered under Basel (III) and a host of other new regulatory initiatives such as the Dodd-Frank Act.
In short, FS regulation is a not frequently appreciated yet critical aspect of FSTP practice. This dynamic body of rules and FTP pricing practices resembles almost a parallel universe to tax TP in the way it impinges on almost every aspect of FSTP. And it is evolving much quicker than the OECD is able keep up with its revisions to the transfer pricing guidelines. Effective practice of FSTP means staying alert and developing a keen appreciation of how these FS regulation rules interact with transfer pricing and accounting rules.
The ongoing financial crisis in the West has compelled banks to expand into the emerging markets in search of growth. This trend can only increase the challenge of FS regulations in FSTP. These emerging markets often combine non-OECD TP practices with much more restrictive capital and financial markets policed with a range of administrative and rate setting or capital control measures that do not conform to the norms we are familiar with in the West. The FSTP manager has his work cut out for him.
By Sam Sim, head of wholesale banking transfer pricing for Standard Chartered. The views expressed herein are the author’s own. It does not represent in any way the view, position or facts of or related to Standard Chartered Bank or its affiliates.
