The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Jean-Benoit Voegele and Thibaut de Haller
Jean-Benoit Voegele, is a Transfer Pricing Manager at PwC Geneva, and Thibaut de Haller is a Director, Corporate Tax, at PwC based in Geneva and Philadelphia. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of PwC. The authors would like to thank Mrs. Monica Cohen-Dumani, Partner, International tax services, EMEA ITS leader and leader TLS Western Switzerland, PwC Geneva, and Mr. Salim Damji, Partner, Transfer Pricing and Value Chain Transformation, PwC Geneva, for their support and encouragement. The authors can be contacted at firstname.lastname@example.org and email@example.com
The OECD/G20 base erosion and profit shifting (BEPS) project examines the financing structures of multinational entities (MNEs) in the final reports on Actions 4 and 8-10.
The final report on Action 4 is titled “Limiting Base Erosion Involving Interest Deductions and Other Financial Payments,” and the final report on Actions 8 to 10 is titled “Aligning Transfer Pricing Outcomes with Value Creation.”
The final report on Actions 8-10 state that interest income should represent remuneration for risk taking:
“(…) a capital-rich member of the group provides funding but performs few activities. If this associated enterprise does not in fact control the financial risks (…) without any assessment of whether the party receiving the money is creditworthy, then it will not be allocated the profits associated with the financial risks and will be entitled to no more than a risk-free return, or less if, for example, the transaction is not commercially rational and therefore the guidance on non-recognition applies.”
This means that the OECD’s initiative against BEPS requires an entity to perform the risk assumption and risk management, in order to be entitled to the interest income. Whilst the proposed guidance is now more rigid it still must be adopted by countries into their domestic laws.
The final report on Actions 8-10 goes on to state:
“(…) Moreover, if this return qualifies as interest or an economically equivalent payment, then those already marginal profits will also be targeted by the interest deductibility rules of Action 4 (...)”
This means that OECD BEPS guidance also looks at the amount or percentage of interest deductibility for the entity being financed.
The BEPS recommendations have two consequences. Most important are the substance requirements for finance entities. If these are not fulfilled, there is a risk that:
In addition, the new OECD guidance limits the interest deductibility of the operating companies receiving loans from finance entities. This limitation of interest is determined by (1) the percentage amount of interest deduction (debt-equity) and by (2) the definition what kind of expense is part of the interest expenses (for example, hedges, guarantees, finance leases, etc.). The new guidance will affect the deductibility of interest expenses by the existing operating companies receiving financing from finance entities once the guidance is adopted into local law.
Both factors—risk taking by finance entities (Actions 8-10) as well as the interest deductibility by operating and holding companies (Action 4)—will have an impact on the set-up of the intercompany financing arrangements. Finance entities will have to prove that they employ specialists who conduct relevant economic activities—that is to what extent the risks can be managed by and allocated to the finance entity, so that it may earn the interest. The main challenge will be in risk control and risk assumption.
According to the final report on Action 4, an entity’s net interest deductions are directly linked to its level of economic activity, based on taxable earnings before deducting net interest expense, depreciation and amortization (EBITDA). This approach includes three parts: a group ratio rule; targeted rules to address specific risks; and a fixed ratio rule, which—in our view—can be considered as a backup rule.
The final report on Actions 8-10 deals with the remuneration of risk taking and with the allocation of income to the entity managing the risks. The return has to correspond to the level of risk taken and to the activity of the funding company.
The OECD identifies factors that indicate whether an entity may have sufficient substance:
“The term ‘risk management’ is used to refer to the function of assessing and responding to risk associated with commercial activity. Risk management comprises three elements:
“…taking on the upside and downside consequences of the risk with the result that the party assuming a risk will also bear the financial and other consequences if the risk materializes.” (Para. 1.63)
In order to attribute the risks to the finance entity, it is required that the entity:
(1) Can in fact exercise meaningful and specifically defined control over the risks being borne, and is capable to:
If the risk of a financial transaction is not attributable to the finance company, the risk will be allocated to the party that exercises risk control and has the capacity to assume the risk.
“Cash boxes” (capital-rich entities without any other relevant economic activities that just provide money when asked to do so), will not be allocated the profits associated with the financial risk. They will just be entitled to the risk-free rate of return.
The OECD considers the “capability to make decisions” as:
“Decision-makers should possess competence and experience in the area of the particular risk for which the decision is being made and possess an understanding of the impact of their decision on the business. They should also have access to the relevant information, either by gathering this information themselves or by exercising authority to specify and obtain the relevant information to support the decision-making process.” (Final Report on Actions 8-10, para. 1.66)
“Neither a mere formalizing of the outcome of decision-making in the form of, for example, meetings organized for formal approval of decisions that were made in other locations, minutes of a board meeting and signing of the documents relating to the decision, nor the setting of the policy environment relevant for the risk (see paragraph 1.76), qualifies as the exercise of a decision-making function sufficient to demonstrate control over a risk.” (Para. 1.66)
This means that finance entities must have the capability to make decisions. Their decisions makers should possess competence and experience in the area of the particular risk being managed. They should have access to the relevant information (Para. 1.66). Significant people should be present in the entity. They should have an understanding of the impact of their decision. Setting policy is not a sufficient execution of a decision-making function. It is not sufficient to hold a board meeting in a location that just confirms decisions that have been made elsewhere.
A permanent presence of significant people is now necessary. The decisions should be documented in memos. The documentation should show why the loan was granted, what factors were considered, and how the loan fits into the overall portfolio of the finance company. A formalization of the general policy framework by the ultimate parent company does not contradict this, as long as the actual decisions are made at the financing entities in a non-trivial manner, that is on the basis of significant reasons.
The OECD considers the capability to mitigate risk as:
“Risk mitigation refers to measures taken that are expected to affect risk outcomes. Such measures may include measures that reduce the uncertainty or measures that reduce the consequences in the event that the downside impact of risk occurs. Control should not be interpreted as requiring risk mitigation measures to be adopted, since in assessing risks businesses may decide that the uncertainty associated with some risks, including risks that may be fundamental to their core business operations, after being evaluated, should be taken on and faced in order to create and maximize opportunities.” (Final report on Actions 8-10, para. 1.68).
For example, if finance entities order credit ratings and hedges from external providers, there need to be people in the entities that give the external providers precise instructions. The results need to be monitored in the finance entities. Under Actions 8-10, there need to be people present that can decide when to stop sourcing this information and gather it elsewhere. All these steps should be documented. Risk mitigation is not necessarily required. Finance entities might decide to take on risks, in order to create and maximize opportunities (Para. 1.68). Active decision making in the finance entities is needed.
In order to be able to decide whether and how to respond to risks, the OECD defines this capability as follows:
“References to control over risk should not necessarily be taken to mean that the risk itself can be influenced or that the uncertainty can be nullified. Some risks cannot be influenced, and are a general condition of commercial activity affecting all businesses undertaking that activity. For example, risks associated with general economic conditions or commodity price cycles are typically beyond the scope of an MNE group to influence. Instead control over risk should be understood as the capability and authority to decide to take on the risk, and to decide whether and how to respond to the risk, ...” (Actions 8-10, para. 1.67).
Some risks associated with general economic conditions or commodity price cycles can typically not be influenced (Actions 8-10, para. 1.67). The finance entity should therefore have the authority and capacity to decide on whether and how to respond to risks (Final Report on Actions 8-10, para. 1.67). Under Actions 8-10 finance entities need to be in the position to decide to grant a loan or refuse a loan and to change the timing of the loans. There need to be people present in the finance entity with the capability and experience to take on these decisions and to monitor their mandates (debtors). The finance entities should have the capability to match the maturities, currencies etc., in order to deal with the risks. They can deliberately build a heterogeneous portfolio and match the risk in that portfolio. This allows them to increase profitability by not insuring all risks, but by matching different classes of risks (for example nuclear, water, and solar for energy groups). The finance entities can bear these risks if they have a sufficient capital buffer.
All of the above needs to be delineated (Final report on Actions 8-10, para.1.78 and 1.120).
In order to define the financial capacity to assume risk, the OECD states:
“Financial capacity to assume risk can be defined as access to funding to take on the risk or to lay off the risk, to pay for the risk mitigation functions and to bear the consequences of the risk if the risk materializes” (Final Report on Actions 8-10, para. 1.64)
The finance entity has to take the upside and downside consequences of the risk. The party assuming the risks will therefore bear the financial and other consequences (Para. 1.63). In order to bear the financial consequences of the risks, all entities assuming the risk will need to be equipped with sufficient equity, for example, in order to be able to absorb a default if the financing entity does not have sufficient cash. The party further needs to have access to a short-term credit line, for cases where it needs liquidity. Therefore, having access to the funding means:
It should be checked whether the party assuming the risks operating as an unrelated party would under these circumstances pay for the risk mitigation functions and bear the consequences of the risk if the risk materializes (Para. 1.63).
All finance entities need to be equipped with an equity level high enough to be able to absorb credit defaults and sufficient liquidity to deal with short-run income fluctuations.
Example Risk Allocation:
In order for a financing structure to be sustainable, the finance entity has to have the capability to make decisions. Does it have the competence to make decisions and are there enough significant people in the entity? Does it actually make the ultimate decisions to grant or refuse a loan? Does it have the necessary organization to create value—has a professional loan reviewing process been implemented?
The OECD considers that it is not sufficient to hold board meetings to confirm decisions of ultimate shareholders or to exercise formal decision making by the finance Entity. However, it does not contradict the decision making process if the shareholder sets the general policy framework, for example, the maximum loan capacity per entity.
The finance entity must have the capacity to mitigate risks. Such risk mitigation can be assumed if the finance entity structures the terms of the loans, pays for and determines the objectives and terms of the hedges and swaps, and is conducting the due diligence, credit ratings, or buying them at arm’s-length.
For a sustainable finance structure, the finance entity must have the capacity to respond to risks.
The entity has the capacity to manage the risk, if the managers decide which loans to grant and if they decide the timing of loans. This concrete decision-making, matching maturities and currencies, have to be documented in memos. In general, a “market standard” loan reviewing and granting procedure needs to be implemented.
The finance entity has the financial capacity to assume risks if the entity has sufficient equity to bear the consequences. Therefore the balance sheet needs to be able to absorb default risks that materialize and the entity must have access to short term liquidity if needed, for example via a cash pool. The entity should also be in the position to buy hedges and currency swaps. Therefore, a procedure to determine and justify capital needs has to be established.
EU state aid rules are based on the fact that a company receiving support from a government has an advantage over competitors and that this should be prevented unless justified by economic development reasons. The European Commission has therefore been charged to ensure that EU countries comply with state aid rules. Article 107 of the Treaty of the Functioning of the European Union (TFEU) therefore provides for a general prohibition against state aid.
State aid will be recognized when:
When dealing with tax measures, including transfer pricing, and multinational companies, the focus will be on item 2 and 4—whether a company is being granted a selective advantage.
An “advantage” will generally involve a decrease in a company’s tax burden (for example via special deductions, reduction of tax amount due or even a delay in the payment of a tax amount due) through arrangements, measures, rulings, and out-of-court settlements.
“Selectivity” is generally assessed, for an individual undertaking or a number of undertakings, through a derogation, with no justification, to a “reference framework”.
“As a rule, fiscal measures of a general nature that apply to all undertakings without distinction fall within the remit of the Member States’ fiscal autonomy and cannot constitute State aid, since they do not selectively advantage certain undertakings over others. By contrast, fiscal measures that discriminate between taxpayers in a similar factual and legal situation constitute, in principle, State aid”(EU Commission’s “Working Paper on State aid and tax rulings,” para.2, “EC Working Paper,” http://ec.europa.eu/competition/state_aid/legislation/working_paper_tax_rulings.pdf).
A state may grant a taxpayer a selective advantage by allowing it to report less profit than would otherwise apply – for example because a tax inspector has the latitude to agree transfer prices that are not arm’s-length—and one of the Commission’s focus is on “cases where there is a manifest breach of the arm’s length principle” (EC Working Paper, para. 23).
In this respect, the Commission considers that the OECD transfer pricing guidelines “provide useful guidance […] on how to ensure that a transfer pricing methodology produces an outcome in line with market conditions. Consequently, if a transfer pricing arrangement complies with the guidance provided by the OCED Transfer Pricing Guidelines, including the guidance on the choice of the most appropriate method and leading to a reliable approximation of a market based outcome, a tax ruling endorsing that arrangement is unlikely to give rise to State aid.” (EC Working Paper, para. 18).
It is also important to note that the “arm’s length principle […] necessarily forms part of the Commission’s assessment […] of tax measures granted to group companies, independently of whether a Member State has incorporated this principle in its national legal system” (See Commission decision dated Oct. 21, 2015 on FIAT case, SA.38375 (2014/C), para. 228.)
Both in the “Starbucks case” and the “FIAT case,” the European Commission has challenged rulings on transfer pricing whereby the Commission has considered that the transfer pricing arrangements set up did not reflect market conditions.
More specifically in the financing area, in the FIAT case, the Commissions had reviewed a ruling relating to a finance company, Fiat Finance and Trade (FFT), based in Luxembourg, which provided various financial services, such as intra-group loans, to other group companies in Europe. Its conclusion was that FFT’s taxable profits should be determined in a similar way to a bank, as a calculation of return on capital employed. Even though the Commission accepted that the transfer pricing method applied could in fact be appropriate, the overall result was adjusted through assumptions and downwards adjustments on the capital base as well as remuneration rates inconsistent with market rates.
When considering the setup of a financing structure, it is therefore critical to ascertain that any transfer pricing arrangement is in line with the OECD guidelines and its amendments under BEPS. Otherwise, a company established in the EU may face the risk of being considered as benefiting from state aid and seeing the member state forced to recover taxes “unduly” saved by a taxpayer.
The OECD’s BEPS project aims to restrict groups from placing higher levels of intercompany debt in high tax countries, using intragroup loans to generate interest deductions in excess of the group’s actual interest expense on third party liabilities, and using third party or intragroup financing to fund the generation of tax-exempt income.
The OECD imposes rules to limit the interest deductibility similar to the “Zinsschranke” in Germany, limiting interest expenses by certain ratios, for example in relation to EBITDA.
The OECD suggests two rules that countries may implement:
“On balance and taking into account the above factors, it appears that for a fixed ratio rule earnings is the most appropriate measure of economic activity, for groups operating in the majority of sectors and in different countries. In applying a group ratio rule, the differences between an earnings-based and an assets-based approach are less significant.” (Final Report on Action 4, para. 81)
The Best Practices Approach (Para. 22) recommended in Action 4 includes the fixed ratio rule, the group ratio rule, the “de minimis threshold” to exclude small entities (optional), targeted rules (for example the holistic approach to avoid circumvention), a carry forward for disallowed interest (optional), and specific rules for banks.
The fixed ratio rule limits the entity’s net deduction of interest and payments, economically equivalent to 10-30 percent of EBITDA. The countries decide the ratio.
It does not restrict the group’s ability to raise third-party debt centrally in a country, where it is most efficient for non-tax reasons, such as credit rating, currency or access to capital markets. These funds can then be on lent within the group according to economic activity. The final report on Action 4, para. 85 states that “Interest paid to third parties (…) is deductible up to this fixed ratio, but any interest (…) above this benchmark is disallowed.”
Some groups are highly leveraged with third party debt, for non-tax reasons. In these cases, the group ratio rule might be applied alongside the fixed ratio rule. The group ratio rule allows an entity to deduct net interest expenses exceeding the respective country’s fixed ratio rule level, up to the interest of the EBITDA level of the entire group. Countries may use different group ratio rules. Alternative approaches are possible, for example, net interest to assets.
The rules apply to interest on all forms of debt (from related or third parties) and to expenses incurred in connection with the raising of finance as well as to payments economically equivalent to interest, such as payments under PPLs (profit participating loans), bonds (also convertible and zero bonds), finance lease payments, amortization of capitalized interest, derivatives or hedging for the entity’s borrowings, foreign exchange (FX) gains or losses connected to raising of finance as well as to guarantee fees with regard to financing arrangements.
The rules do not apply to such FX gains or losses, which are not connected to the raising of finance. They are also not applicable to derivatives and hedging instruments not related to borrowings (commodity derivatives, such as gas and oil) and not to operating lease payments. They are also not used for royalties and accrued interest for pension plans.
The rules for the maximum amount of interest deduction will primarily apply to the interest deductibility of operating companies, and not only when interest is paid to finance entities. Countries may introduce targeted rules including thin capitalization rules.
Such targeted rules have been applied by Sweden in the past (10 percent rule and 25 percent rule).
Authorities may also introduce stricter group rule ratios, for example:
The rule to be applied is at the discretion of the respective countries.
Finance lease payments will be under interest expense. The rules are also applied to FX gains/losses, for example short in euros, long in foreign currency. Also certain derivatives and hedges may be part of interest, including gas, oil, or commodities. Hedges for business reasons, and royalties or operating leases might be included in the non-interest income of finance entities.
The limitation might be applied to intermediate finance entities. Some intermediates might have 100 percent interest income, or they may be beyond interest limitation rules. Companies can deduct their interest expense up to 10 percent to 30 percent of EBITDA due to a fixed ratio. The group ratio rule might allow for a higher ratio up to group level to third parties.
Independently from or in conjunction with the BEPS guidance, some countries, including Germany, have already issued rules relating to interest limitation.
However, the BEPS guidance clearly sets the trend that countries will follow--to a greater or lesser extent--when implementing their own interest limitation rules. They are also flexible enough to afford little or no adjustment to pre-existing domestic rules.
Amongst all existing local proposals to implement interest limitation rules, one that will have a major impact on the international tax landscape is the EU anti-tax avoidance directive (ATAD).
The ATAD is part of the Anti-Tax Avoidance Package (ATAP) presented by the EU Commission in January 2016. Amongst other measures targeting tax avoidance, such as hybrid instruments and entities, controlled foreign companies (CFCs) or exit taxation, the ATAD also includes interest limitation rules largely inspired from the OECD work. It also includes a general anti-abuse rule (GAAR) to fight avoidance schemes not covered by specific anti-avoidance measures.
The ATAD will apply to all taxpayers (including permanent establishments) subject to corporate tax in the EU. Member states will generally be required to adopt these measures in their domestic law by December 31, 2018 such that they generally may apply as of January 1, 2019. There is an exception for exit taxation and hybrid mismatches rules which will apply as of January 1, 2020, and there are specific additional hybrid mismatches rules (reverse hybrid entities) that will apply as of January 1, 2022.
More specifically, the ATAD foresees that interest limitation rules are necessary to discourage excessive interest payment practices and therefore seeks to create minimum standards for member states to apply, implying also that member states could apply stricter rules (See ATAD recitals (6).)
The rules set forth in Article 4 provide: the interest limitation rules apply to “exceeding borrowing costs”. “Borrowing costs” are defined as “interest expenses on all forms of debt, other costs economically equivalent to interest and expenses incurred in connection with the raising of finance as defined in national law” (article 2 (1)). “Exceeding” borrowing costs mean amounts in excess of taxable interest and equivalent revenues (art 2 (2)).
This definition which has a very broad scope and may include:
• payments under profit participating loans;
• imputed interest on convertible bonds or zero coupon bonds;
• finance cost element of lease payments;
• capitalized interest;
• notional interest under derivatives or hedging instruments; and
• certain foreign exchange gains and losses, guarantee fees, arrangements fees and similar costs on financing arrangements.
Exceeding borrowing costs will be allowed provided they do not exceed 30 percent of the taxpayer’s EBITDA (excluding tax adjustments and tax-exempt income). There is an option given by the ATAD to carry forward without time limitation any exceeding borrowing costs that cannot be deducted (with or without the option for a carryback for a maximum of 3 years or a carry forward for 5 years of unused “interest capacity”).
Similarly to the BEPS proposal, an option for a group carve-out rule exists for consolidated entities under IFRS or local GAAP. A group ratio results from comparing the group’s external exceeding borrowing costs over the group’s EBITDA.
An alternative is to allow full expensing of exceeding borrowing costs provided the taxpayer can demonstrate that it has a higher or equivalent equity ratio than the group. The equity ratio is computed as the ratio of equity over total assets. It will be deemed equivalent to the group as long as the equity ratio of the taxpayer is not lower than 2 percent compared to the group ratio.
These rules will not apply where the taxpayer is a stand-alone entity (not part of a consolidated group) or does not deduct exceeding borrowing costs for more than 3 million euros. Another exclusion applies to long-term public infrastructure projects.
The ATAD also provides for a grandfathering clause whereby it will not apply to loans concluded before June 17, 2016, unless they are subsequently modified.
The OECD have further defined what is required for a financing structure, in particular the following points are important:
The deductibility of interest (Action 4) will depend on future local rules, which may be applicable in some countries as of 2017, and in other countries since 2016. In any case, these rules will be largely applicable in the Europe through the Anti-Tax Avoidance Directive and are due to mostly come into force on January 1, 2019.
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