In today’s issue of Transfer Pricing Report, practitioners from Mayer Brown LLP make a case for seeking a financial services advance pricing agreement, pointing to increased uncertainty under Dodd-Frank and Basel III, more in-depth audits under the Internal Revenue Service's Transfer Pricing Practice, and improved efficiency in the IRS's Advance Pricing and Mutual Agreement Program. A separate story in today’s issue reports on a panel discussion from last month’s conference in Paris, also on the topic of financial transactions. In the story, a shortened version of which appears below, the panelists examine not only uncertainty in the financial area, but how the arm’s-length standard increasingly is being interpreted to consider the related-party relationship and the motives of the parties.
Challenges of Pricing Financial Transactions Include Overlapping Rules, Evolving Principles
Companies operating in the financialsector face increasing compliance burdens and uncertainty due to multiple overlapping rules and the growing interaction between arm's-length and anti-abuse approaches, practitioners said during a panel discussion at Bloomberg BNA and Baker & McKenzie's Paris transfer pricing conference in March.
The panelists, including an Italian tax official and an executive from Hewlett-Packard in the Netherlands, addressed the lack of international consensus about arm's-length and thin capitalization approaches, the use of motive-based rather than traditional arm's-length tests, and attempts by tax authorities to recharacterize transactions. They also noted that the arm's-length principle increasingly is being applied in a way that considers the influence of members of a related group.
The failure of countries to agree on an approach to loan pricing has led to “a plethora of rules,” said John Neighbour of KPMG in London. The United Kingdom has rules on arbitrage, unallowable purpose, debt cap, and now the general anti-avoidance rule expected to take effect in mid-2013.
“Those of you with long memories will remember that Chapter IX of OECD guidelines was not supposed to be about business restructuring, it was supposed to be about loan transactions,” he said. Although a report was issued on loan pricing, countries could not agree on how to apply the arm's-length principle to thin capitalization.
The Organization for Economic Cooperation and Development at least as far back as 2004—when Neighbour was head of its Tax Treaty, Transfer Pricing, and Financial Transactions Division—was considering whether and how the arm's-length principle applies to cross-border financial dealings and issues of thin capitalization.
Antonio Russo of Baker & McKenzie in Amsterdam noted that the Netherlands has “a complex series of limitations, and the interaction between different limitations is complex to manage.”
When a country has both the arm's-length principle and thin capitalization rules, Russo said, companies must test not only whether the interest rate is arm's-length, but whether the amount of debt is arm's-length.
“So you have determined the sustainable amount of debt that you can borrow at arm's length; you have determined based on that the interest rate that is arm's length—but you are not done because you have to test the same transaction under the thin capitalization rules,” he said. “Isn't this redundant? I have already answered the thin capitalization question by going through the analysis under the arm's-length principle.”
Neighbour said that in the United Kingdom, “what they want is a motive test. It's not enough to determine whether you could do this, it's ‘Why are you doing it? Are you doing it for tax avoidance?' ”
Moiz Shirazi, an economist with Baker & McKenzie in Chicago, said defending the purpose of a transaction “is not just a one-time exercise.” Using the example of an intercompany arrangement with a prepayment clause, he said the company at the beginning of the arrangement may have done “a great job of evaluating the loan and coming up with a rate, the terms, all those things.”
However, “let's say two months from now, interest rates drop and the company forgets to do anything about that, and the agreement goes on for years.” At that point, a question comes up about the business reasonableness of the arrangement.
“Wouldn't a third party facing such a declining rate have repaid this loan, or refinanced, or used some of its own cash to pay some of the loan?” Shirazi asked. “They would not have continued to pay the rate on this loan because the rate is so high.”
Arm's-Length or Anti-Abuse?
The interaction of transfer pricing and anti-avoidance or anti-abuse provisions is a gray area. Giammarco Cottani of the Italian Revenue Agency said that where countries do not have strong or specific anti-abuse rules in their domestic law, they “increasingly tend to resort to reference to the arm's-length principle.”
Others suggested the arm's-length principle is itself evolving to consider the motives of the parties. Russo said the current debate over how to apply the principle “is very much between an approach that sees entities as truly separate, following the principle literally, or an approach that takes into account the influence of the connection with other members of the group” and the fact that an entity, as part of a group, can affect pricing terms and conditions.
Shirazi agreed that “this is a very big area of debate,” pointing to General Electric Capital Canada Inc. v. The Queen, 2009 TCC 563 (2009), aff'd, 201 FCA 344 (2010). In the decision, affirmed by the Federal Court of Appeal, the Tax Court of Canada, while throwing out most of the Canada Revenue Agency's assessment, agreed with the CRA that the parent company's ability to exercise control over its subsidiary lessened the risk of the transaction at issue and supported a downward adjustment to the price.
In addition to considering the effect of the intercompany relationship on transactions, companies need to consider the impact of different types of intercompany transactions on each other, Shirazi said. “For example, if you have an entity that pays a royalty for trademarks and is also paying a guarantee fee to the parent, the question becomes, is some of the benefit from paying for that trademark carried over to the benefit from the guarantee?”
Joseph Andrus, head of the OECD's transfer pricing unit, has said the organization's Feb. 12 report on base erosion and profit shifting (BEPS) points to the need for better rules on intercompany financial transactions, among other things. The report details governments' growing concern that multinational companies are exploiting “gaps” in OECD transfer pricing rules and tax standards to shift profits away from jurisdictions where those profits were generated.
Cottani said that “when it comes to trying to funnel this debate into the BEPS project,” Italy in 2011 collected 1.5 billion euros ($2 billion) in tax by challenging aggressive taxpayer structures that were used by “most of the banking players.” Applying the arm's-length principle to intercompany finance arrangements, he said, “is going to be one of the key areas to be addressed in the BEPS project.”
Molly Moses, Managing Editor, Transfer Pricing Report
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