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European groups operating in the US: Managing transfer pricing risks

Introduction

The increasing number of cross-border transactions combined with the greater complexity of group structures can lead to ever-greater risk in tax planning and, in particular, in transfer pricing. European-based groups of companies doing business in the United States can face significant challenges partly because of the need to deal with two or more tax authorities whose perspective on particular transactions may be very different.

 

ImageScrutiny by tax authorities

Tax authorities are becoming more skilled in transfer pricing matters, and there is an increasing focus on intercompany transactions involving transfers of intangible assets and services. Transfer pricing documentation requirements are now very widespread, and markets and regulators are showing an increased interest in tax reporting. For example, in the United States, companies are generally required by FIN 48 to evaluate their uncertain tax positions. As a result, they may not be able to recognize all tax benefits. Another challenge that taxpayers are facing is the increased coordination between tax authority units that deal with different taxes, including indirect taxes (such as VAT). This leads to a greater possibility of joint audits.

Tax authorities in Europe closely scrutinize intercompany transactions involving moving of functions or assets between the group entities located in different jurisdictions. They may question the substance of these transactions and look closely at the value transferred to ensure that their fisc is protected.

Failure to plan properly for transfer pricing risks can result in significant tax exposure. Inability of companies to effectively deal with transfer pricing issues could damage their relations with the tax authorities, leading to increased scrutiny in later years and the need to devote more resources to defending their tax positions. The tax problems may lead to negative publicity with resulting damage to the company’s image and brand. Any increase in tax reserves may hit reported profits, resulting in a decrease in shareholder value and a negative public perception of the management.

Source of transfer pricing risks

Transfer pricing risks may result from different sources. For example, they could be caused by discrepancies in the way the business is organized and the way the business is described in the company’s transfer pricing documentation. For instance, due to a change in the company’s business model, a distributor entity became a limited risk distributor with the transfer pricing documentation still reflecting the prior arrangement. Particular care is also needed on issues related to the existence of permanent establishments, especially when dependent agents are involved. A lack of alignment between different business lines and legal entities within a group may lead to difficulties in both reporting and compiling transfer pricing documentation. One of the common mistakes some companies make is involving their tax departments, including transfer-pricing specialists, late in the game when a transaction has been already set up. The lack of coordination at the planning phase of a project can magnify transfer pricing risk exposure.

The changing business environment and the role of intangible assets, and services, may lead to disagreements with tax authorities over key business value drivers. Such disagreements could lead to disputes over determination of values attributable to jurisdictions where the intangible assets or service functions are located. The existence of valuable unique intangibles, for example, may greatly complicate searches for comparable and reliable market benchmarks leading to wide ranges of possible results.

Internal risk management

The tax department should be in a position to participate in discussions on any significant business changes from the start. Transfer pricing considerations should also be taken into account in decisions on changes in the group structure or the location of assets and functions. Decision makers in the company must be in a position to understand the potential tax risks, assess tax risk levels and the possible consequences. Above all, when transfer-pricing input has been given and the plans are carried out, they should be implemented, as agreed, to determine that the approach as implemented is reflected in the documentation.

A systematic analysis of transfer pricing risks should include the identification of areas of potential exposure, which typically involve complex or high value transactions. Other factors to be taken into account include the documentation requirements in each jurisdiction. Transfer pricing planning should also be coordinated with other areas, such as customs duties.

Once the risk exposure areas have been identified, a decision should be made on how to address these risks. The company could take either a defensive or a proactive approach or a combination of the two in addressing the identified risk exposures. In certain circumstances, the company may have a limited number of options, which should be carefully evaluated to foster a balanced and beneficial approach. A defensive approach could involve adequate documentation of internal decision-making, the preparation of transfer pricing studies and the development of supporting documentation, such as intercompany agreements, analysis of transfer pricing policy and the retention of important records. A proactive approach could be used in certain cases, for example, by notifying tax authorities of particularly complex transactions or structures, implementing a policy of periodic monitoring and necessary price adjustments, or entering into an advance pricing agreement (APA).

ImageManaging risk: Advance pricing agreements

There is increasing use of APAs as an effective tool in managing transfer pricing risks. The United States, for example, has one of the oldest and most experienced APA programs in the world. European countries are also adopting and expanding their APA programs. For example, Her Majesty’s Revenue and Customs (HMRC) in the United Kingdom recently introduced: “advance thin capitalisation agreements”, in addition to the regular APA program.

APAs can be valuable in cases where transfer pricing is difficult because of the lack of market benchmarks, where tax administrations can take potentially diverging views about intercompany arrangements, and where there is a high risk of audit. Apart from traditional and known benefits of APAs, companies can benefit from APAs in non-transfer pricing areas. For example, in certain cases, negotiating an APA with tax authorities may lead to a release of tax reserves. Stability of reporting and cash management are other potential key advantages.

Dispute resolution procedures

Where a dispute with the tax authorities arises, and there is a danger of double taxation, a mutual agreement procedure (MAP), if available under an applicable income tax treaty, can be used to help resolve the position. Under the MAP, the competent authorities of two countries are involved in the dispute attempt to resolve double taxation through a negotiation process. The MAP process can be lengthy and does not always result in a resolution. However, some treaties now contain a binding arbitration provision that is generally expected to accelerate and facilitate the resolution of the MAP cases.

Conclusion

European groups operating in the United States should be aware of transfer pricing risk factors and be prepared to take steps to manage such risks, either defensively and/or proactively.

About the authors: John Neighbour is a Global Transfer Pricing Services (GTPS) partner with the KPMG member firm in the UK and is based in London. Sean Foley is a GTPS principal with the KPMG member firm in the US and is based in Washington, DC.

The authors would like to thank Alexey Manasuev from the KPMG member firm in the US and Peter Hann from the KPMG member firm in the UK for their contributions to this article.
The views and opinions expressed herein are those of the authors and do not necessarily represent the views and opinions of KPMG’s network of firms.
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity.

Partner DLA Piper Milan

Attribution of Profit to the Italian Branch of a foreign EU Bank

Selected comments
By Phd Dr Maricla Pennesi, Tax Partner DLA Piper Milan

 

Recently, it has been noted that the Italian Tax Authorities have sought, with increasing frequency, to make assessments whereby interest charges are treated as non deductible costs.  This has been based on an uncritical and, at times, problematic application of the criteria resulting from the OECD’s observations  on the "attribution of profit to permanent establishments".  In particular, “regulatory” criteria are used for the purpose i.e. "thin capitalisation" in the country where the Branch of the foreign bank is located so as to quantify the amount of the “free” capital that has to be attributed to the Branch depending on the activities it undertakes and the risks it is exposed to.

For the Tax Authorities, the quantification of this “free” capital automatically leads to the partial or total non-deductibility of the interest charges incurred by the Branch which, in the absence of such capital, has had to take on debt to finance its activities and the related risks.

 

Image

The Tax Authorities’ position on the matter has been well known for some time now.  They have reiterated the concept of deemed free capital for tax purposes only  as from 30 March 2006 when with regard to Ministerial Resolution no 44/E on Thin Capitalization , they observed that it is, first of all, necessary to assess if and to what extent the resources that the parent company makes available, directly or indirectly, to its permanent establishment in the territory of another state can be considered as loans that generate interest deductible from the income of the said permanent establishment. This assessment, the Tax Authorities go on,  is required, especially, when the parent company allocates to the permanent establishment its own resources and/or part of loans arranged by it and on which it incurs interest charges but also where the loan agreement is entered into directly by the permanent establishment.

 

It is interesting to note that the references to the “reasonableness” of the profit made by a permanent establishment – as determined considering the profits and costs that would have been made and incurred in the case of a distinct and separate entity conducting similar or identical business in similar circumstances and fully independent from the entity of which it is a permanent establishment   – and, in particular, to the matter regarding the correct debt to equity ratio – where it is clear that the calculation of interest charges has a direct impact on taxable income in the host country of the permanent establishment – are used for functional motives  in a ministerial response on the application of the thin cap method to permanent establishments under Art 98 of the TUIR (Corporate Income Taxes Act). While it is also debatable – for the reasons stated in the note – for permanent establishments in general, the ministerial resolution and the criteria laid down in it becomes wholly questionable with regard to the application of the thin cap method to the branch of a foreign bank to which the thin cap method was not applicable– under Article 98 (5) of the TUIR) – in relation to loans made as part of its banking activities.

 

We have argued that there can be no all encompassing reference to the thin cap rules for branches of foreign banks in relation to the non deductibility of interest charges for tax purposes, given the lack of specific rules on the matter.  Therefore, it must be understood, based on the guidelines issued by the OECD – in its aforementioned report on the allocation of profits to permanent establishments – that the reasonableness of the interest charges incurred by the branch has tot be analysed together with the amount of the free capital for tax purposes and the use of the method required for regulatory purposes for purposes other than the basic ones. As stated in part II (D) of the aforementioned report "Applying the authorised OECD approach to banks operating through a PE" paragraph no 52 , the factual analysis performed so as to allocate the free capital primarily requires a detailed assessment of the risks associated with the activities of the branch.  This is because the free capital must be attributed on an arm’s length basis to ensure the right level of taxable profit for the permanent establishment. So, the OECD lays down a fundamental concept i.e. any reference to capital and its attribution, based on whatever method, must be performed on an arm’s length basis considering the activities undertaken by the permanent establishment and the associated risks.

 

1 Now contained in a specific report dated 17 July 2008

2 With regard to banks and financial institutions, it must be recalled that the free capital for branches – also for regulatory purpose – can no longer be requested in terms of  

   the EU Directives adopted in 1989 Directive 89/646/EEC of the Council of Ministers of 15 December 1989)

3 Under Art 98 TUIR (Consolidated Income Taxes Act)
4 Principle established by all Double Taxation Agreements entered into by Italy under Art 7, paragraph 2.
5 For functional motives because although the regulations subjectively bring branches under the thin cap rules, the method of application of these rules did not precisely identify with the characteristics of permanent establishments lacking in capital and approved financial statements from which to obtain the net equity for use in calculating the debt equity ratio.

 

This process cannot be performed automatically merely by referring to principles that act as guidelines  but do not constitute hard and fast rules.  Paragraph 90 provides further guidance stating that, irrespective of the methods used in various countries (regulatory or thin capitalization rules) to determine the correct capitalisation of a branch for tax purposes, reference cannot be made to the book value of the assets or to the information provided by a mere accounting overview.  Instead, the method used to attribute the free capital must be assessed in relation to the risks of the business of the branch that this capital has to cover.  Economic criteria must be borne in mind and paragraph 90 goes on to state that any method based solely on accounting evidence cannot be considered acceptable to the OECD for the purposes set out above. The approach cannot be standardised at the expense of the economic reasonableness of the operating margins of the business represented by the branch on Italian territory.

 

In conclusion, any analysis performed and findings made with regard to the non deductibility of interest charges cannot be based merely on partial assessments or on accounting records when they also regard regulatory issues.  This is unless the economic unreasonableness of the financial structure i.e. capital and interest bearing debt is first proven and its impact on the reasonableness of the profits considered.

 

Any attempt by the Tax Authorities to apply the guidelines of international bodies like the OECD to tax matters, solely in order to increase taxable income by disallowing the deduction of interest charges, without performing an economic analysis of the reasonableness of the profits and the cost structure  including financial circumstances – as required by the aforementioned standards – must be rejected as absolutely unfounded and wholly illegitimate.

 

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