TP specialists sometimes focus exclusively on economic analysis and the arm's-length result. There are many complexities that arise within banking and other industries that will often mean the 'best method' for TP purposes is completely impractical. There is very rarely a single correct answer in TP. In selecting the most appropriate method many factors need to be weighed up. The OECD guidelines recognise that TP should not be unduly onerous. The robust and appropriate TP method may be the simplest one.
Any TP specialist worth their salt can arrive at an appropriate TP answer. A functional analysis is conducted and a TP method is concluded upon. The following documentation should then be put in place
Any TP specialist worth their salt can arrive at an appropriate TP answer. A functional analysis is conducted and a TP method is concluded upon. The following documentation should then be put in place:
- TP report including supporting benchmarking and comparables (part of the master and local file documentation);
- Service level agreement / intra-group contract; and
- Invoice / settlement instructions.
The real challenge is implementing this policy, executing the supporting documentation, ensuring proper administration, consistency with tax and regulatory laws and it gels with the changing tax landscape.
How a TP policy will operate needs to be assessed before its conception and implementation. There is no point in devising a perfect TP solution if it will give rise to huge operational risk or cost.
I would break down ongoing operational risks and costs into three principal areas of consideration:
- Taxation: what is the ongoing indirect and direct tax treatment of TP payments?
- Regulatory and compliance: are there any banking regulation considerations?
- Process: how will the TP policy be implemented and administered?
The in-house tax function needs to understand the full impact of any TP method. Their interest is not limited to whether the method achieves an arm's-length result; the TP method, form of payment and documentation can influence the indirect and direct tax treatment. Taxpayers are wise to implement a checklist of measures to consider in this regard:
- Is the payment a service fee and subject to VAT or GST? If the payment is a fee for service, indirect tax may be applicable. Should the TP be VAT/GST inclusive or exclusive? The invoice, contract description and TP report contents could all influence the treatment.
- A single payment or multiple payments for different services? Thought needs to be given as to how a payment is invoiced. For instance IT charges invoiced as part of head office costs may not be tax deductible. Several jurisdictions – for example, India and South Korea – incorporate a cap on the deduction taken for head office expenses. If separately invoiced and documented as services being rendered for the direct benefit of the recipient a deduction may be available.
- Consider withholding tax treatment. Is the payment being made for exploitation of intellectual property? China's State Administration of Taxation (SAT) is challenging IT intra-group recharges. Significant portions of charges are being characterised as royalty, giving rise to withholding tax. Terms of a related party loan could result in recharacterisation from debt to equity. For instance terms allowing a roll up or non-payment of interest. How a payment is documented could influence the tax treatment. If loan interest is treated as equity, no deduction is likely to be received and withholding tax treatment could be different.
- Does the method result in additional risk and risk-weighted assets (RWAs) in the UK? Is there an additional bank levy cost?
- Assess profit and loss (P&L) impact and potential tax claims. For example many banks claim double tax relief on withholding on traded equities. A TP method involving the equities trading business could impact the level of the double tax relief claim.
Checking the tax treatment of payments and receipts of the related parties involved in the transaction is crucial. It could influence how you formulate your TP policy. Assessment of the tax treatment needs to be made based on the facts documented in the TP functional analysis, service level agreement and contents of the invoice. Remember this will be the documentation that the tax authority will use to make its assessment of the treatment.
Regulatory capital and compliance
Regulators have shown an increasing interest in related party transactions and the potential impact on the financial stability of the entity(s) trading in their jurisdiction. There is increasing overlap between banking regulation and TP requirements. Often the two can conflict. It is very important for any banking TP specialist to have a general awareness of the regulatory regimes which govern the bank's business. Failure to adhere to banking regulation could result in the revocation of a licence to do business in a jurisdiction. This would make TP somewhat academic.
- TP documentation should be consistent with regulated activities. If the bank is not licensed to perform an activity in a jurisdiction, documentation should not be created to suggest this activity is being performed. For example a bank may not be licensed to conduct direct selling in a jurisdiction. A restricted referral activity could be incorrectly drafted by external advisers as a full blown sales function for TP purposes.
- A profit split method could result in the sharing of losses. There may be regulatory restrictions on the booking of losses in a jurisdiction. Some banking regulators insist on certain levels of profitability or prohibit sharing of losses if their jurisdiction does not directly control the underlying asset to which the loss belongs. Regulation could compel that credit and market risk resides in the booking location.
- Does your TP impact whether a transaction achieves a hurdle rate return to capital? If your TP method shares profit from a client transaction, should the initial decision to do the transaction incorporate the different tax liabilities arising after application of TP? For instance, the corporate tax rate difference between the UK and an India branch could be more than 20%. When factoring additional tax cost into the assessment of a client transaction, the return achieved may not meet the bank's hurdle rate return.
- If looking at a branch of a bank trading in another jurisdiction you should consider the regulatory capital requirements of the head office jurisdiction versus the branch jurisdiction. Capital requirements could be very different. This could impact TP in the branch applying return on equity (ROE) or other return on capital calculations. The ROE could be much higher or lower than domestic banks in the branch jurisdiction which could lead to TP challenges where methods incorporate a return to capital.
- Are underlying transactions to which TP is being applied subject to regulatory reporting?
Great care needs to be exercised that any TP documentation reflects the factual reality from a regulatory perspective. Compliance teams should be involved in the review of documentation to ensure that TP does not infringe any regulatory requirements.
When developing and implementing any TP policy, consideration of process is key to successful risk management. The parties to the transaction should be asked to annually reconfirm underlying facts on which the TP is based.
The company's finance function needs to play an active role in the administration of TP, identification of TP risk and take responsibility for the operational process. Failure to get your operational process right could give rise to greater TP risk than having no policy at all. Once you have a documented policy it is straightforward for tax authorities, regulators and external auditors to identify and check whether you are applying your TP correctly.
- In developing your TP policy, consult the finance function on the accounting system capabilities. Does the TP policy require data which will be manually retrieved by the finance department? Or is a system change required? What is the expense and lead time for making such a change? Consider revising your TP policy if operational risk or cost of system change is too great.
- Finance should provide advice on correct accounting bookings. The related party transactions need to be readily identifiable so that the group finance team can eliminate these in the consolidated accounts. Clear account booking advice needs to be provided to all related parties to ensure consistency. For instance, how should any mark-up on costs be booked?
- At the outset, clear roles and responsibilities for administration and review of the TP policy should be agreed with the finance function. Best practice would be to agree an operating manual which covers the administration of the TP policy.
- Service level agreements or intra-group contracts covering the related party transactions need to be executed. It is important that an agreement follows the format of a similar third party arrangement. The agreement is often one of the first items the tax authority or regulator will request. In some jurisdictions payment cannot be made without such an agreement in place.
- Training should be given to the business and finance staff on the TP method. Not only do staff need to understand the mechanics of the method, staff need to understand the risk they are managing in order to identify any ongoing issues or changes which could impact the appropriateness of the TP method. Training should be given annually on TP methods in place.
Overlaying all these considerations is the current tax environment in light of the BEPS action plan. TP needs to align with value creation. This is somewhat confusing as surely robust TP should already address this? In reality this will likely mean it will be much harder to transfer risk around the group without demonstrably showing that informed decision-making and active risk management is taking place in the risk location. The evidence to support this will be determined by the underlying facts but it is important to remember that the medium through which this will be communicated to the tax authority or banking regulator will likely be your TP documentation.
One thing is for sure, the more broadly you think about the risks associated with your TP policy the more chance it has of standing the tests of time and external scrutiny from both tax authorities and banking regulators.