Sunday, 14 July 2013

Benchmarking of corporate guarantees and/or performance guarantees

One of the readers of the blog asked to discuss an appropriate and practical methodology for benchmarking corporate and/or performance guarantees. Further the reader states:

"From the material I have been able to read till now, the interest saving approach discussed in the GE Canada judgment is one way to do it. Theoretically, the risk of loss approach also sounds plausible. However, I am not too convinced with the formula that ought to be used for computing the risk of loss for the guarantor. The formula broadly reads as follows:

    Return on capital at risk = Probability of default*Amount guaranteed*Guarantor's cost of capital."

The reader's concern is that "if the guarantor is a large multinational company, the cost of capital would be really high and availing of guarantee would not seem like a good option from the subsidiary's perspective, as it would just be better to borrow from the market."

Therefore the reader is concerned whether "the formula mentioned above would actually be useful for computing a guarantee fee in a real life benchmarking scenario."

Please note the above are the comments of a reader of the blog and are not mine, however, as the topic is very interesting I thought I share it here and get everyone's input.

In relation to the above I would like to note that a corporate guarantee and a performance guarantee are two very different guarantees and require a different approach.

From the GE Canada case it was held that a "yield approach" is the correct methodology to be applied for the specific facts and circumstances in the case (this was in relation to a corporate guarantee). The yield approach is meant to estimate the total potential interest rate savings achieved by the borrowing entity as a result of the explicit guarantee. The yield approach is applied in two steps - 1.) estimating the stand-alone credit rating and then notching that credit rating for the affect of the parent-subsidiary relationship and 2.) looking at the spread in corporate bond yields between the parents credit rating and the estimated credit rating of the subsidiary.

From a performance guarantee perspective there are different approaches which may have some estimations. I will do some more research before commenting on this in detail but I hope to get some more information from all of you out there in relation to the above.

Please continue sending your comments and concerns for any transfer pricing topics and hopefully we can have many more blog posts like this.

Tuesday, 25 June 2013

Arm's Length Standard

Deloitte has published its latest edition of the "Arm's Length Standard" with the following topics:
  • OECD Releases Draft Handbook on Transfer Pricing Risk Assessment
  • OECD’s Draft Handbook on Transfer Pricing Risk Assessment Examined from Canadian Perspective
  • Italy Releases Second Report on APA Program
  • Peru Issues Guidance on Transfer Pricing Documentation Requirements
  • Indonesia Issues New Regulation on Transfer Pricing Audits
For those of you who do not know what the "Arm's Length Standard" published by Deloitte is, find a little description from their website below:

"Arm's Length Standard
 is a bi-monthly transfer pricing newsletter designed to keep senior tax executives updated on transfer pricing developments around the world, featuring news and analyses from the transfer pricing professionals in Deloitte member firms."

The publication is a great way to stay up to date. Find the June/July 2013 edition here

If you have any comments, concerns or questions let's discuss them in the comment section below. Happy reading

Tuesday, 11 June 2013

Transfer Pricing Risk Assessment

As many of you know the OECD published its “Public Consultation: Draft Handbook on Transfer Pricing Risk Assessment” on 30 April 2013 (hereon referred to as "draft handbook"). The purpose of this handbook is to provide practical resources that can be used by tax administration seeking to develop/improve its risk assessment procedure, methods and practices. However, this will also be useful for taxpayers to ascertain what exactly tax administrations may look at to determine whether a taxpayer and his current/planned cross boarder related party transaction may be at risk for further investigation.   

The draft handbook is divided into the following six different sections which are discussed in more detail below:
  1. Introduction to transfer pricing risk assessment
  2. Questions to be answered in a transfer pricing risk assessment process
  3. Assessing when transfer pricing risk exists and when it does not
  4. Sources of information for conducting a transfer pricing risk assessment
  5. Risk assessment process – selecting cases for transfer pricing audit
  6. Building productive relations with taxpayers – the enhanced engagement approach

The following subsections are a summary of the sections within the draft handbook. Please note, in order to get a full understanding of the sections and problems discussed below, it is advisable to read the actual draft handbook.

Introduction to transfer pricing risk assessment

The first section provides objectives and the rational of the draft handbook. Then it describes what a transfer pricing risk assessment is and how it progresses. This section also highlights some sensitive points such as “occasional losses are a genuine feature of business life and may not necessarily be the result of transfer pricing manipulation”.

All-in-all the first section provides a high-level overview as to how the OECD believes a transfer pricing risk assessment should be performed.     

Questions to be answered in a transfer pricing risk assessment process

This section deals with the fundamental transfer pricing risk assessment questions to be answered before an actual risk assessment is performed. The draft handbook states that before starting a transfer pricing risk assessment the following questions should be answered:
  • Are there material controlled transactions?
  • Is there an indication of transfer pricing risk – i.e. potential of shifting income and erode the local tax base – the types of payments that raise such issues could include:
    • Large royalty payments
    • Large rental payments
    • Large management fees
    • Large insurance payments
    • Financial derivative contracts
    • Large payments of deductible interest
  • Is the case worth an audit?
  • What specific issues need to be addressed during the audit?

Assessing when transfer pricing risk exists and when it does not

The first part of this section deals with the types of transactions in relation to transfer pricing risks and the second part deals with risk indicators. The whole section is the crux of the draft handbook.

The different types of transactions can be summarised as follows:
  • Risk arising from recurring transactions: For example, if a local taxpayer in one of the extraction industries sells all of its local country output to related parties, small pricing discrepancies in each individual sale can add up to large reductions in the local tax base. Accordingly, recurring related party transactions will be one key risk factor. Certain types of transactions (as listed above) may create more cause for caution than others.
  • Risk arising from large or complex one time transactions: A different type of transfer pricing risk can arise in connection with certain types of large and/or complex one time transactions such as business restructurings or transactions involving the creation/sale of intellectual property.
  • Risk arising from taxpayer behavior in governance, tax strategies or ability to deliver compliance: This risk factor stems from the taxpayer’s behavior rather than the nature of its transaction. I.e. is the taxpayer compliant?

In addition to the different types of transactions identified above a quantitative evaluation of the amount of potential tax at stake should form part of the risk assessment process. What is the point of performing a long lasting audit if the outcome may only provide a few bucks to the tax administrations?

The following is a summary of the risk indicators observed from related party transactions that may indicate higher transfer pricing risk, and therefore, in the opinion of the OECD support a decision to conduct a thorough audit:
  • Profitability/Financial results: The following points may indicate a higher transfer pricing risk in relation to profitability/financial results:
    • If the profitability/financial results of the company under review substantially differ to:
      • those of industry standards or potential comparable companies
      • its related party of the tested (i.e. same) transaction in the other tax jurisdiction
      • the whole of the group’s performance
    • If the company under review is a consistent loss maker, or if the company under review makes recurring low profits or low returns on investment.
    • If the profit trends of the company under review are contrary to market trends.
    • If from a group’s perspective of the company under review, a large portion of the overall income is allocated to a lower tax jurisdiction where few economic activities take place.
  • Transactions with related parties in low-tax jurisdictions: Even though there may be commercial reasons for trading with or in low-tax jurisdictions any sizeable transaction has a high potential for non-arm’s length pricing.
  • Intra-group service transactions: Intra-group service transactions may be one of the most frequently occurring transfer pricing issues. Depending on the nature of these service transactions and the charges made for them, the issues can have either large or limited significance.
  • Royalty, management fees, and insurance premium payments, particular to entities in low tax jurisdictions: These payments can be used to erode the local company’s tax base and as such these payments are always seen as more risky.
  • Marketing or procurement companies located outside countries where manufacturing takes place: There is a risk in these types of transactions in the sense that the taxpayer is strategically accumulating income in such marketing/procurement companies in excess of the income that can be justified by the economic activity in those companies.
  • Excessive debt and/or interest expense: Excessive debt can be used to erode the tax base, particularly when the interest is paid to related entities in low tax or conduit jurisdictions.
  • Transfer or use of IP to/for related parties: This is a topic on its own but in short when transferring an income-producing intangible, determining its arm’s length value is crucial. This process is very difficult and as such poses risks in relation to miss pricing of the IP.
  • Cost contribution arrangements: Similar to IP this is a difficult subject especially when creating unique or valuable IP. Cost contribution arrangements are seen as complex and as such pose a greater risk to tax administrations.
  • Business restructurings: This topic has been a hot topic around the world for quite some time. Transfer pricing issues arising with regard to business restructurings can be very complex and require a thorough transfer pricing audit.

Lastly the second part of this section gives a brief description of non-tax factors that may distort pricing and the importance of contemporaneous transfer pricing documentation.

Sources of information for conducting a transfer pricing risk assessment

This section illustrates the information sources available to conduct a transfer pricing risk assessment. The following is a list of sources that may be available to different tax administrations:
  • Specific tax return disclosures – information returns
  • Contemporaneous transfer pricing documentation
  • Questionnaires issued to selected taxpayers
  • Taxpayer’s file and audit records of previous years
  • Publicly available information regarding the taxpayer (such as internet searches, commercial databases, press reports & trade magazines and security analysts’ reports
  • Site visits and meetings with company personnel
  • Customs data
  • Patent office
  • Exchange of information under tax treaties
  • Necessary legal provisions to facilitate access to information
  • Obtaining information relating to foreign associated enterprises
  • Obtaining information relating to domestic potentially comparable businesses

It is important to note that even though tax administrations may not use every available information source, none of the information sources available to the tax administration should contradict each other – be it through supplied information or publicly available information. For example taxpayers may provide tax authorities with low profit margins (or even losses) due to inefficiencies or a downturn in the economy, however, when looking at publicly available information, such as financial statements or websites, the information available may depict a different story as this information is mainly trying to please stakeholders (i.e. show a good investment).

It is important to note that tax administrations do not only look at tax returns.

Risk assessment process – selecting cases for transfer pricing audit

This section outlines the procedures and steps that a tax administration should follow to conduct a risk assessment. It is important to note that a risk assessment process should be consistent and regular and that all personnel involved must have a clear understanding of that process. Common steps in the risk assessment process may include the following:
  • Assembling quantitative data from tax returns, transfer pricing forms and contemporaneous documentation provided by the taxpayer
  • High level identification of possible transfer pricing risk by analysing processed quantitative data
  • High level quantification of potential risk
  • Reviewing qualitative information in contemporaneous information and gathering of additional intelligence from public sources
  • Tentative decision as to whether to proceed
  • More in depth risk review including analysis of functional and comparability descriptions in contemporaneous documentation
  • More detailed quantification of potential risk
  • Initial interactions with taxpayer personnel
  • Preparation of draft risk assessment report
  • Decision as to whether to proceed with an audit, including decisions regarding issues to target in the audit
  • Internal review and quality control processes, including central committee review if such a committee is used
  • Prepare final risk assessment report

Additional to the above process tax administrations use transfer pricing specialists or if needed industry specialists within their risk assessment process.

Building productive relationships with taxpayers – the enhanced engagement approach

The last section of the draft handbook mentions that several countries have adopted programmes intended to increase the amount of real time engagements with taxpayers on transfer pricing issues. The objective of such programmes is to increase communications between taxpayers and tax administrations to avoid long audits and save costs for both. Examples of some of the programmes are summarised within the draft handbook.

Closing remarks

The above is merely a summary of the draft handbook on transfer pricing risk assessment with a few examples. If you have any questions, concerns or recommendations please feel free to comment below. My personal view is that such a handbook is great for both tax administrations and taxpayers alike as it helps tax administrations to follow a simple process in their risk assessment and it provides full disclosure for taxpayers as to how a tax administration will assess risk.

Sunday, 5 May 2013

2nd Annual Africa Transfer Pricing Summit

As you may have noticed it has been a while since my last blog post. I hope you missed the updates/posts as much as I missed writing them. I also wanted to take this opportunity to thank the people who have sent comments in relation to the blog, your feedback is much appreciated. As previously mentioned I would like this blog to be as interactive as possible and as such would like you to send me queries or comments in relation to the blog or about anything transfer pricing related. If your question is rather complex, please feel free to send me a case study example to facilitate the discussion.

Before I write another technical blog post I wanted to highlight that the 2nd Annual Africa Transfer Pricing Summit is taking place on the 2nd - 5th September at the Hyatt Regency in Johannesburg, South Africa.

For those of you who have not heard of the Annual Africa Transfer Pricing Summit, it is a transfer pricing event which takes place over 4 days, with 2 multi-speaker conference days and 2 workshop days featuring 5 practical and technical workshops. Organised by the Institute for International Research ("IIR"), in partnership with the South African Institute of Tax Practitioners, the event is a great transfer pricing knowledge sharing platform. I have not heard of a similar transfer pricing event like this that is hosted in South Africa (or Africa) and I do believe it is a great event to partake in. 

The main drawing point to this event is the speakers and there are many brilliant speakers at this event. The speakers at the event include but are not limited to the following: 
  • Joseph Andrus, Head of Transfer Pricing Unit, Centre for Tax Policy and Administration, OECD
  • Nishana Gosai, Manager: Transfer Pricing, SARS
  • Logan Wort, Executive Secretary, ATAF
  • Mark Badenhorst, Director  & National Leader: Transfer Pricing, PwC
  • Karl Muller, Tax Director, Unilever
  • Natasha Vaidanis, Director, International Tax, KPMG
  • Cobus Viljoen, Tax Manager, Investec Bank
  • Richard Stern, Global program manager: Business Taxation, World Bank Group
  • Karen Miller, Director: International Tax: Transfer Pricing, Ernst & Young
  • Emil Brincker, Director, National Practice Head Tax, DLA Cliffe Dekker Hofmeyr
  • Billy Joubert, Head: Transfer Pricing, Deloitte & Touche
  • Jens Brodenbeck, Tax Executive, ENS
  • Mark Robson, GM: Finance, Toyota
I had the privilege to work or interact with some of the presenters listed above and I must say the wealth of knowledge that these individuals have is fascinating. It does not matter whether you have been doing transfer pricing for your whole life or just a short term, you will definitely learn something new at this event.

For further information on the 2nd Annual Africa Transfer Pricing Summit visit the IIR website.

Thursday, 11 April 2013

Thin Capitalisation and secondary adjustments

Thin Capitalisation in relation to transfer pricing (“thin cap”) has been a hot topic for quite some time. A company is said to be thinly capitalised when its capital structure has an excessive high ratio of debt to equity. What this excessive high ratio is deemed to be varies from tax jurisdiction to tax jurisdiction.

Some tax jurisdictions may provide a fix debt to equity ratio such as a 3:1 (3 times debt to 1 times equity) and anything over that is deemed to be excessive whereas other tax jurisdictions state that the company must behave at arm’s length including its capital structuring. The latter raises many concerns as to how a company would determine whether it is at arm’s length in relation to its capital structure or not. In theory an arm’s length thin cap analysis seems easy, one must analyse what a company could borrow and how much it would borrow taking into account its capital structure, the purpose for the loan and other relevant factors (i.e. other alternatives etc.). In practice, however, this is much more difficult. Probably the biggest issue is to find relevant and reliable data on which a company can base its conclusion that the amount it has borrowed is at arm’s length (i.e. it could borrow and would borrow the amount). This post is not trying to discuss the different ways of determining an arm’s length loan arrangement and/or an arm’s length interest charge, however, should you want to discuss this please let me know and I am happy to write something about that too.

If you are not too familiar with thin cap from a transfer pricing perspective you may ask yourself why does it matter if a company is thinly capitalised or not. The problem is that if a company is thinly capitalised the excess portion of the debt that the company pays interest on is usually disallowed as a tax deduction. Further, some tax authorities may implement a secondary adjustment. The purpose of a secondary adjustment is to tax the allocated profits from the primary transaction according to its form. In other words, a secondary adjustment is taxing the transferred profits from the primary transaction either as a dividend, equity contribution or loan. This may result in additional tax such as withholding taxes. For example, where a company is deemed to be paying excess interest on a loan the excess amount may be deemed to be a dividend which means the excess portion is not allowable as an interest deduction and secondly the excess amount will attract dividend withholding taxes. Some tax jurisdictions may deem the excessive portion paid as a loan provided to that other company, this in turn will attract interest payable on the outstanding deemed loan. Without going into too much detail, the issue with secondary adjustments is that they may result in double taxation as the other tax jurisdiction may not provide for a credit, further, some countries reject secondary adjustments all together due to practical difficulties they present.

South Africa just released its Draft Interpretation Note on thin cap (available on the SARS website). As some may be aware the new transfer pricing legislation in South Africa is primarily based on that in the UK. The same is true for the thin cap provision which is now part of the normal transfer pricing provisions. Ernst & Young summarised the Draft Interpretation Note here. The Draft Interpretation Note is open for public comment and I was hoping to get some comments from you, if there are enough I am happy to combine them and send them to the South African Revenue Service ("SARS").

My first comment which I would like some clarity on in relation to the SARS’ Draft Interpretation Note on thin cap is on the proposed secondary adjustments. This comment may be applicable in other tax jurisdictions that have a similar approach.

Section 6.2 of SARS' Draft Interpretation Note states:
“This means that in addition to the primary adjustment, the amount of the disallowed deduction is deemed to be a loan by the taxpayer that constitutes an affected transaction. As a result the taxpayer will have to calculate and account for interest income at an arm’s length rate on the deemed loan. The accrued interest on the deemed loan will be capitalised annually for the purpose of calculating the deemed loan outstanding.”

My issue with the secondary adjustment is that it states that a taxpayer will have to calculate and account for interest income at an arm’s length rate on the deemed loan. My question is - how can you calculate an arm’s length interest rate on a loan which was deemed to be a loan because of a primary adjustment to a loan which was excessive (i.e. deemed to be not at arm’s length)? In other words, the Draft Interpretation Note wants the taxpayer to calculate an arm’s length interest rate on a loan that is not arm’s length. Surely this is not possible? As discussed secondary adjustments are usually done to account for other taxes that would have been due and payable if the taxpayer had structured its tax affairs in a compliant manner. A possible solution to this conundrum could be to implement a fixed and fair interest rate rather than an arm’s length interest rate.

There are other issues from a South African perspective in relation to the secondary adjustment, such as Exchange Control approvals for payments of the deemed loan. The question here is what happens to a taxpayer’s taxable position if the Exchange Control does not allow the money to leave the country? As the accrued interest is capitalised annually and there is no way of repaying the debt, the interest expense will increase every year which at some stage may render a company bankrupt! 

Let me know what you think about the Draft Interpretation Note and if you have any comments.

Saturday, 23 March 2013

The interrelation of transfer pricing and customs

I came across an interesting topic the other day and thought I would write my next blog post on it. This topic has been a discussion point between many authoritative bodies, professional service firms and tax jurisdictions. I thought I would try and shed some light on the topic. As you are well aware there is more to a cross border transaction than just transfer pricing. Especially when structuring certain transactions, there are many different aspects that should be taken into account. One of the factors that must be taken into account when looking at cross border transactions (be it related or independent) is customs.

Customs are the duties levied by a government on imported goods which are payable by the importer of a product. Should the imported product be in relation to a cross border related party transaction, both customs and transfer pricing are applicable. Important to note here is that customs only looks at goods and not at services. Further, customs duties are usually a big part of the total cost in selling a product to a foreign market and as such it is important to comply with the different customs regulation to ensure certainty for total taxes payable on the transaction.

Both disciplines try to create an arms length price/transaction. Therefore the topic that is often discussed in relation to both disciplines is whether both can be complied with by deriving the one from the other. For example, would a MNE be able to determine its customs duties from a detail transfer pricing analysis?

In order to analyse the topic it may be beneficial to look at the similarities and differences of both disciplines first.

What transfer pricing is and how it is dealt with has been discussed previously, but for this blog post it is important to understand that in practice, from a transfer pricing perspective an arms length price is rarely determined for an individual product or service between related parties but it is rather determined on an overall return such as an operating margin. On the other hand, customs is concerned with the valuation of each individual product that is imported (sometimes exported).

In the table below are other important similarities and differences in relation to transfer pricing and customs:

Transfer Pricing
Arms length
Both disciplines try to ascertain an arm’s length price/remuneration for the transaction under review (arm’s length connotes fair value or market value)
The transaction value method from a customs perspective is similar to the comparable uncontrolled price method from a transfer pricing perspective
Type of Discipline
Indirect Tax
Direct Tax
Limited window of opportunity (usually at the moment of invoice or sale)
Usually audited after the tax return is filed
When applicable
Customs duties are applicable at the moment of importation
Forms part of corporate tax which is applied based on taxable income reported for the year

From the above it seems that transfer pricing and customs are indeed very different but do have a similar goal of trying to ascertain a market value/arms length return for the transaction under review. The big difference between transfer pricing and customs lies in how an arms length price/remuneration (or market value of a unit) is determined. Except for the comparable uncontrolled price ("CUP") method, transfer pricing methods use a margin to ensure a cross border related party transaction is at arms length (i.e. the party receives a fair remuneration for functions performed, assets used and risks assumed) whereas customs is only looking at a unit price. Even though many courts are arguing in favour of using a CUP method when performing a transfer pricing study, in practice the CUP method is rarely used.

The problem that a taxpayer may face within a normal tax jurisdiction is that both disciplines try to pull the cost per unit in different directions. In other words, a low cost price of an imported good will result in low customs duty but a low cost price will inversely increase the taxpayers profitability resulting in a higher corporate tax payable and vice versa. In practice the customs department of a tax authority will try to increase the price per unit, whereas, the transfer pricing department of the same tax authority will try to decrease overall cost by decreasing the cost per unit. Both departments try to achieve the highest return for the fiscus possible by increasing or decreasing the same cost price respectively. 

Depending on how a tax jurisdiction determines an arms length price/remuneration for both disciplines, there may be some room for tax planning due to the different rates applicable. I.e. if customs duties are higher than corporate taxes a taxpayer may be able to lower its cost price through certain structuring exercises as long as he is still within an arms length price/remuneration for both disciplines. On the other hand, because both disciplines do not necessarily use similar methods to determine an arms length price/remuneration it may happen that for each discipline the arms length price/remuneration is different. This may result in double tax for a taxpayer (or if lucky - savings) and therefore it is important to compare the outcome of both disciplines.
Even though transfer pricing and customs can rarely leverage an arms length price from each other it is still important to analyse both disciplines when looking at cross border related party transactions. Tax authorities should (and do) use information collected from customs for transfer pricing audits and vice versa to ensure compliance with both disciplines.

Lastly, from the above one can see that a joint process for the two disciplines could benefit both tax authorities and taxpayers through simplification and cost/time savings. 

Tuesday, 5 March 2013

Attribution of profits - notional transactions

The OECD has provided a new business profits article in its 2010 Model Tax Convention ("MTC") and discusses the concept of notional transactions within the Commentary to the MTC. A notional transaction in short can be defined as "An estimate of a real transaction, not based on direct measurement". In other words, for transfer pricing purposes a notional transaction is the hypothetical creation of a transaction between a head office and its permanent establishment ("PE") to simulate a transaction that would generally exist between third parties.

The new "functionally separate entity" approach implemented by the OECD changed the previous business profit article as follows:

  • It requires a much further/deeper separation of the PE from its head office; and
  • The PE can now claim certain expenditure relating to notional interest, notional royalties/licences and mark ups on notional management fees, which it previously couldn't.  

So how come the new "functionally separate entity" approach is not followed by all OECD member countries or UN countries? I am not certain as to why some countries have elected to not follow the new approach but the following is a plausible answer.

When creating/simulating a notional transaction in order to attribute profits to a PE this will create more expenditures than previously available. The creation of extra expenditure will result in less taxes payable by that PE within its tax jurisdiction. This in itself means that the countries who 'house' the PEs will be worse off than previously. Now one might argue - but what if I create a subsidiary, then all the expenses would also be deductible. That is correct, but with real transactions other taxes are applicable. For example a 'real' transaction involving interest payments usually triggers withholding taxes, a notional transaction will not trigger such a tax.

From the above it seems that tax jurisdictions which generally have more PEs, such as the UN countries would be worse off implementing the new "functionally separate entity" approach.

What are your thoughts on the above? Have you got another plausible answer?


This weblog does not represent the thoughts, intentions, plans or strategies of my employer. It is solely my opinion.

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