Written By: Morgan Jones – Corporate Finance
Transfer pricing is the result of the globalisation of our economies. On the one hand, big groups and banks are targeting all kinds of markets and countries; on the other, countries are competing to attract business with advantageous tax systems. “The phenomenon has intensified with the crisis. States preferred to keep businesses on their territory and increase taxation on household incomes and consumption,” explained John Christensen, director of the Tax Justice Network.
The OECD (Organisation for Economic Co-operation and Development) and the EU (European Union) have taken the problem head-on to modernize the rules of international taxation.
There are generally five accepted methods to determine the price of transactions and services between companies. They consist of three “traditional transaction” methods:
- the comparable uncontrolled-price method,
- the resale-price method, and
- the cost-plus method.
And two “transactional profit” methods:
- the transactional net-margin method, and
- the transactional profit-split method.
Both the OECD and the EU are constantly revising the rules to adapt them or to be more precise. The OECD established in 2015 a project to revise tax rules called Action Plan on Base Erosion and Profit Shifting (BEPS). But even for regulators, defining the conditions under which the method chosen is the most appropriate is a difficult task. Since 2015, Chapters 8-10 and 13, referring to transfer pricing, are constantly fed new reports and guidelines. Chapter 8-10 “Aligning transfer pricing outcomes with value creation” contain transfer-pricing guidance in relation to intangibles, including hard-to-value ones; to risks and capital; and to other high-risk transactions. Chapter 13 on “Transfer pricing documentation and country-by-country reporting” contains guidelines and documentation, including the template for country-by-country reporting, to enhance transparency while taking into consideration compliance costs
The landscape is changing every day in business. In the past, transfer pricing was based on material goods that were relatively simple to evaluate. Things have become more complicated with the internationalization of trade and the advent of digital technology.
Banks are moving to the centre of transfer-pricing topics.
Large banks are losing themselves, knowing that the OECD doctrine in this area takes up several hundred pages. And Chapter 13 of the BEPS now focuses on financial transactions, the core of banks’ activities. In the European Union, agreements between multinationals and EU member states have been more transparent since January 1, 2017. Since then, banks must transmit data on their customers to the tax authorities of the countries in which they operate. Subsequently, tax authorities must transfer this data automatically to foreign tax authorities.
Margrethe Vestager, a well-known member of the European Commission, has repeatedly led cases against the tax practices of big firms (such as Apple, Google, Gazprom, Amazon, McDonald’s, Volvo, Starbucks). Apple was fined a record €13 billion a few months ago as a result of tax arrangements with Ireland, although an appeal is pending.
The complexity and subjectivity of methods and documentation to justify calculations often leads to enormous transfer-pricing files and sometimes several years of trials between multinational groups and tax authorities. The final results of the trials are not always unfavourable to multinational groups. Just recently, the US Internal Revenue Service lost its case against Amazon and was rebuked by the tax court for “acting in an arbitrary, capricious, and unreasonable manner when it applied a discounted-cash-flow method to a cost-sharing arrangement that Amazon.com made with its Luxembourg subsidiary”. The case involved more than $234 million in assessed tax deficiencies for 2005 and 2006.
For banks, choosing and developing transfer-pricing methods can be a nightmare, as:
- all transactions are dematerialized, and determining their costs necessitates aggregating information-technology costs and splitting the costs for each type of transaction;
- the quotation of financial transactions on the market is changing every second; and determining a fair price for a counterpart in the group involves a mix of the market-price approach and the risk costs to apply to their own subsidiaries;
- banks are also responsible for providing the information of their clients to tax authorities.
Taking the simple example of the financial costs of deposits and loans, one can see how the topic is delicate when looking at the recent UK’s tax authority HMRC’s guidance related to cash pooling. This guideline in the International Manual finalised in February 2017 challenges whether a long-term or “structural” deposit is an arm’s-length arrangement. Long-term deposits should be clearly distinguished and could be qualified as long-term loans, meaning with higher rates.
In the UK, tax authorities will seek for financial transactions:
- details on the terms and commercial arrangements related to the deposits that impact the UK;
- the rates earned or paid and any changes during the year;
- transfer-pricing documentation specific to the cash-pool policy, including a functional analysis that incorporates the header company, even if it is not in the UK;
- the legal arrangements with the third-party bank; and
- economic support for the transfer pricing.
Banks will certainly be even more challenged by tax authorities in the future.