dusan thesis final to pdf1447350/... · 2020-06-25 · 'hsduwphqw ri /dz 6sulqj 7hup 0dvwhu...
Post on 09-Jul-2020
1 Views
Preview:
TRANSCRIPT
-
Department of Law Spring Term 2020 Master Programme in International Tax Law and EU Tax Law Master’s Thesis 15 ECTS
Transfer Pricing of Internal Banks In the Light of Fiat State aid Case and Transfer Pricing Guidelines on Financial Transactions
Author: Dusan Arsenovic Supervisor: Katia Cejie
-
1
Table of contents
Abbreviations ................................................................................................................ 2
1 Introduction................................................................................................................ 3
1.1 Issue .................................................................................................................... 3
1.2 Objective ............................................................................................................ 4
1.3 Delimitations ...................................................................................................... 4
1.4 Methodology and Materials................................................................................ 5
1.5 Outline ................................................................................................................ 8
2 FFT: Transfer pricing methodology and State aid ..................................................... 9
2.1 Background ........................................................................................................ 9
2.1.1 Transactions .............................................................................................. 10
2.1.2 Functions ................................................................................................... 10
2.1.3 Risks .......................................................................................................... 11
2.1.4 Assets ........................................................................................................ 12
2.1.5 Method ...................................................................................................... 12
2.2 EC Decision on State aid .................................................................................. 15
2.2.1 Introduction ............................................................................................... 15
2.2.2 Requisites for State aid ............................................................................. 15
2.2.3 TNMM vs CUP ......................................................................................... 17
2.2.4 The ‘correct’ application of TNMM ......................................................... 18
2.2.5 EC Conclusion .......................................................................................... 20
2.3 Recent development and criticism ................................................................... 20
2.3.1 Introduction ............................................................................................... 20
2.3.2 General Court Judgement.......................................................................... 21
2.3.3 TP Method Application Issues .................................................................. 24
3 Functional analysis for internal banks ..................................................................... 26
3.1 Introduction ...................................................................................................... 26
3.2 “Treasury functions” ........................................................................................ 27
3.3 Intra-group loans .............................................................................................. 28
3.3.1 Accurate delineation of a loan .................................................................. 28
3.3.2 Assumption and control of risks ............................................................... 32
4 Conclusion ............................................................................................................... 36
-
2
Abbreviations
APA Advanced Pricing Agreement
ALP Arm’s Length Principle
BEPS Base Erosion and Profit Shifting
CAPM Capital Asset Pricing Model
CUP Comparable Uncontrolled Price
ECJ Court of Justice of the European Union
EC European Commission
EU European Union
FF Fiat Finance S.p.A.
FFC Fiat Finance Canada Ltd.
FFNA Fiat Finance North America Inc.
FFT Fiat Finance and Trade Ltd.
OECD Organization for Economic Co-operation and
Development
TNMM Transactional Net Margin Method
TP Guidelines OECD Transfer Pricing Guidelines
TP Transfer Pricing
TFEU Treaty on the Functioning of the European Union
-
3
1 Introduction
1.1 Issue
Decision of the European Commission (EC) from 2016 and the judgment of the
General Court of the ECJ from 2019, which confirmed it in the Fiat
Luxembourg State aid case, has sparked controversy and academic interest by
its many far-reaching implications. Most writings dealing with this topic come
from the State aid perspective and bring into question the elements of the rulings
that are important for this legal field, for example, the determination of the
reference system for establishing whether an illegal advantage was granted. On
the other hand, commentators, which are more interested in the tax aspects of
Fiat, focus predominantly on the future of the advanced pricing agreements
(APAs) and whether EC is creating an EU arm’s length principle (ALP) that
infringes sovereignty of Member States.
In the extensive literature on Fiat and other recent EC State aid cases there seems
to be a gap in developing transfer pricing matters more deeply. Although all of
the previously mentioned legal points are very significant, the Fiat case in
business practice boils down to correctly determining prices and profit level of
an internal bank in line with the arm’s length principle. EC has dedicated most
of its decision to transfer pricing methodology, but research on whether it was
applied in the most suitable manner has been shadowed by the discussion on
whether Transfer pricing (TP) Guidelines can be applied at all.
Transfer pricing of internal banks has recently been given a new dimension. The
long-awaited clarifications on how to price financial transactions have been
published by the OECD on 11th of February 2020 as the Transfer Pricing
-
4
Guidelines on Financial Transactions, which will be added as Chapter X to the
2017 version of the Guidelines.1 This novelty awaits academic inquiry.
1.2 Objective
Considering that transfer pricing of internal banks is a highly relevant area of
interest for companies and tax advisors, the purpose of this thesis is providing
useful insight into how it should be conducted to comply with both Fiat case
and the latest edition of TP Guidelines. In this sense, the thesis is not about Fiat
per se but it will rather use the factual and legal circumstances of Fiat to analyze
how similar situations should be handled in the light of the Guidelines, with
regards to the existing doctrine of the EC and the General Court. To achieve this
aim, two main questions will be answered. The first is what can be learned from
the Fiat case for applying transfer pricing methods, which are at the heart of EC
and General Court’s rulings, to internal banks’ transactions in order to defend
them in the face of State aid scrutiny. The second will return with some guidance
on how to conduct a functional analysis with the emphasis on risk, which is
lacking in the aforementioned decisions, but is the central for reaching an arm’s
length outcome.
1.3 Delimitations
Although other State aid cases in which APAs were questioned are interesting
and connected with Fiat, they are only briefly touched upon when necessary for
the sake of argumentation. On the other hand, functional analysis conducted for
a transfer pricing issue of this complexity and in the light of the extended TP
Guidelines could easily go on for a hundred pages; therefore, it is reasonably
simplified by highlighting only the crucial points. Further demarcation of the
subject matter is clearly stated in the introductory paragraphs of relevant
1 https://www.oecd.org/tax/beps/oecd-releases-transfer-pricing-guidance-on-financial-transactions.htm
-
5
subsections. Finally, as was mentioned, since the existing literature has dealt
extensively with State aid implications and tax issues such as legality of an EU
ALP, this thesis will present and evaluate work in these areas in a summarized
way to provide a holistic grasp of the matter.
1.4 Methodology and Materials
The method used in this thesis is the legal dogmatic method. This traditional
method consists in applying legal reasoning within a specialist analysis carried
out in a specified area of law.2 The legal dogmatic perspective for this topic
therefore necessitates the interpretation and evaluation of what is given in the
Fiat rulings and TP Guidelines, without excessive digressions on policy aspects
and de lege ferenda.
The fundamental methodological issue of this thesis concerns the legal value of
the Transfer Pricing Guidelines. The matter of contention can be further broken
into three debatable points.
The OECD Transfer Pricing Guidelines are a non-binding instrument. This is
suggested not only by their self-identification as “guidelines”, but also in their
content.3 What is more, they are drafted in such a way that is not suitable for
compulsory application, since they do not provide solutions to TP issues, but
rather a working framework for their analysis.4 Therefore, from a theoretical
perspective, their legal status as soft law can be equated with the OECD Model
Commentary from which they originate as assistance in interpretation of the
arm’s length principle from OECD Model Tax Convention’s Article 9.
2 Jerzy Stelmach and Brożek Bartosz, Methods of Legal Reasoning, vol 78 (Springer 2006) 9. 3 Krzysztof Lasiński-Sulecki, 'OECD Guidelines: between Soft-Law and Hard-Law in Transfer Pricing Matters' (2014) 17/1 Comparative Law Review 68. 4 Jérôme Monsenego, Introduction to Transfer Pricing (Kluwer 2015) 33.
-
6
However, in spite of not being formally binding, TP Guidelines are widely used
by taxpayers, tax authorities and courts in practice.5 This has proven to be true
in the Fiat case as well, considering that the EC referred to the OECD TP
framework and the General Court affirmed this approach. The reasoning behind
the “hardening” of TP Guidelines’ soft law is best elucidated by the EC stating
that Guidelines are the result of expert discussions which develop techniques
aimed to address common challenges in international taxation. In this way, they
are currently the finest expression of international consensus on transfer
pricing.6 Although authority of OECD’s experts and their commonplace usage
establish the Guidelines as almost-binding internationally agreed principles, this
development is problematic for upholding the principle of legality in tax law.
Secondly, even if the TP Guidelines are in general considered as internationally
agreed principles, there are significant differences between individual countries
on how they view their content, application and interpretation.7 Disparities are
present between OECD and non-OECD member countries, which is significant
in the EU context where not all EU members are at the same time a part of the
OECD, but also between OECD members as well. This results in a
heterogeneous interpretation on national levels. The EC tried to avoid this
perplexity by declaring that it applies the ALP inherent in EU State aid rule from
Article 107 TFEU, even if the principle is not incorporated in domestic law.8
The employment of OECD’s benchmark in this process was only “a tool”. In all
but name, TP Guidelines are used to respond to new EU State aid challenges,
but this legitimately raises sovereignty concerns among Member States.
5 ibid. 6 Commission Decision of 21 October 2015 on State aid SA.38375 (2014/C ex 2014/NN) which Luxembourg granted to Fiat, (C-2015) 7152 final (EC Decision) para 87. 7 Monsenego, Introduction to Transfer Pricing (n 4) 33-34. 8 EC decision para 228.
-
7
Finally, a key practical regard for TP Guidelines in this context is the dilemma
of static versus ambulatory application. Since OECD materials are often being
updated, there is an open discussion on which version of these materials should
be applied on situations taking place before their publishing date. For the OECD
Model Commentary, there is no consensus on this matter.9 The debate goes on
in a similar undecided fashion for the TP Guidelines, although there are some
suggestions on how to approach this question: whether the domestic law refers
to the OECD Guidelines (sometimes a specific version10) or not, whether they
are based on the same principles and whether the segment to be applied is a
clarification or a new concept.11 In contrast to the academic polemic, the
General Court has promulgated a clear restriction on retroactivity in State aid
investigations12, but since it did not explicitly express this view on TP
Guidelines, issues such as whether to apply “clarifications” are still relevant,
especially as the ECJ is the instance that will have the final word.
As for the materials used, the analysis in the thesis is mostly based on primary
sources such as the EC and General Court’s rulings and the TP Guidelines (2017
and 2020 editions). Here it is important to emphasize that the Fiat case is
analyzed only from the viewpoint of the TP Guidelines 2010 version, which was
applicable at the time when the APA was concluded, but the version from 2017
is referenced in the thesis. Since there were no significant differences in content
between the two versions for the segments that were used in the thesis, the latter
is put to work for practical reasons.
9 Katia Cejie, 'The Commentaries on the OECD Model as a Mechanism for Interpretation with Reference to the Swedish Perspective' (2017) 71/12 Bulletin for International Taxation 667. 10 For example: Australia, Austria, Ireland and the UK. OECD Transfer Pricing Country Profiles, http://www.oecd.org/tax/transfer-pricing/transfer-pricing-country-profiles.htm. (accessed 27.4.2020) 11 Johan Hagelin, 'Retroactive Application of the OECD Transfer Pricing Guidelines for Interpretation in Transfer Pricing Issues' (2018) 25/6 Intl. Transfer Pricing J. 406. 12 Judgment of the General Court in cases T-760/15 (Netherlands v. Commission) and T-636/16 (Starbucks v. Commission) ECLI:EU:T:2019:669 para 251.
-
8
Additionally, several articles and books are used to support the reasoning,
although there are still (at the time of writing) no relevant publications dealing
with the latest TP Guidelines on Financial Transactions. The most impactful
articles between equals were: 1) “The Recent Decisions of the European
Commission on Fiscal State aid: An Analysis from a Transfer Pricing
Perspective” by Miladinovic and Petruzzi, which pointed at the functional
analysis as a weak point in the EC’s decision, 2) “European Commission
Decision on Fiat: State aid Case Explained” by Rasch and Wroblewski, which
presented the essentials of the case with utmost clarity, and 3) Is Fiat’s Tank
Half-Full or Half Empty? The General Court’s Decision in Luxembourg v.
Commission (T-755/15)” by Lazarov and Buriak, the most transfer pricing
related and up-to-date article. All of the other publications, together with the
most relevant works which are not referenced directly in the text, but have
contributed to the comprehension of the topic and might be useful for the reader,
are listed in the Bibliography.
1.5 Outline
Apart from the introduction and the concluding section, the thesis is comprised
of two main chapters. This division is envisaged by the logic of the transfer
pricing process and its two steps: comparability analysis and application of the
selected method. In the paper, their order is reversed, with the aim of introducing
the Fiat case which deals mostly with methodological issues first. Chapter 2 on
Fiat is further developed into three segments: Background, introducing the
reader to the legal and factual situation of the case, followed by the analysis of
the transfer pricing aspects of the EC’s decision on State aid, and concluding
with the Recent development, represented in the General Court’s judgment, and
criticism in the form of a meta-analysis of the objections raised to both rulings,
primarily on methodological and TP issues. Chapter 3, preceding the
conclusion, provides a functional analysis based on Fiat’s circumstances,
-
9
relevant for internal banks, from the perspective of the newest TP Guidelines
on Financial Transactions from 2020. In focus are intra-group loans, as the
predominant transactions, and risk functions, the centerpiece of every
comparability analysis. The final segment integrates all of the conclusions from
the thesis into a (hopefully) useful piece of advice on how to set transfer prices
for internal banks in the EU.
2 FFT: Transfer pricing methodology and State aid
2.1 Background
Fiat Finance and Trade Ltd. (FFT) is a finance company registered in
Luxembourg. As suggested by its legal name, the company is a part of the Fiat
multinational corporate group active primarily in the automobile industry. Fiat
S.p.A, the Italian leader of the group, has full control over FFT by holding 40%
of its shares directly and 60% through yet another subsidiary Fiat Finance S.p.A.
(FF) incorporated in Italy. In its turn, FFT also has control over fully (100%)
owned companies Fiat Finance North America Inc. (FFNA) and Fiat Finance
Canada Ltd. (FFC).13
FFT is designated the role of an internal bank for the group entities located in
Europe, with the exception of Italy. It provides Fiat entities with treasury and
financial services, as well as cash pooling. FFT’s operations are run from the
head office in Luxembourg, as well as two branches – one based in the United
Kingdom and the other in Spain.14
In September 2012, FFT obtained an APA from the Luxembourg tax authorities
regulating its transfer pricing position for the following 5-year period. The APA
was essentially an endorsement of a transfer pricing report proposed by FFT’s
tax advisors on how to correctly allocate profits for its cross-border activity. The
13 EC Decision para 110. 14 ibid paras 34-39.
-
10
report was based on the application of Transfer Pricing Guidelines, which are
the most relevant, albeit not binding, tool in the area of transfer pricing. In line
with the Guidelines, the process of reaching an arm’s length outcome requires
first a comparability analysis of cross-border transactions, with an emphasis on
the functions, assets and risks, and followed by the application of the most
suitable transfer pricing method.
2.1.1 Transactions
Transactions relevant for the transfer pricing analysis, which FFT was a part of,
can be divided in two categories based on the status of the other party. In the
first category of (Intra-Sector) transactions, FFT was dealing with treasury
companies of the Fiat group, and in the second (Intra-Group) with entities other
than internal banks.
The main categories can further be broken down into transactions that constitute
them. For Intra-Sector, those transactions are intercompany loans from FFT to
FF, as well as loans from FFNA to FFT. Similarly, the Intra-Group category is
also mostly composed of loans which FFT grants the European Fiat companies,
but also deposits and other services closely related to financing which it supplies
them with. In addition, FFT is provided guarantees for its bonds and other
financial instruments (such as credit lines) by the group leader Fiat S.p.A.15
2.1.2 Functions
The functions FFT performs which were put forward by their tax advisors are:
1. Market funding and liquidity investments
FFT raises funds, mostly from the market and in a lesser extent from related
entities, to make them available for Fiat group members.
15 ibid para 40.
-
11
2. Relations with financial (third-party) market actors
FFT provides information to support the group’s credit-worthiness.
3. Financial coordination and consultancy
FFT is responsible for examining financial needs and identifying the best
solutions for the group companies, as well as setting up financial contracts and
monitoring performance of their financial products.
4. Cash pooling
The cash flows, funding requirements and liquidity of the group is monitored
by FFT to optimize the management efficiency of the group's capital resources.
5. Provision of short and medium term loans
6. Coordination with other treasury companies.16
2.1.3 Risks
The main risks FFT is exposed to as outlined in the APA are:
1. Market risk
FFT bears the market risk ingrained in the interest rate and foreign exchange
rate movements. However, these risks are hedged by derivative financial
instruments (such as currency and interest rate swaps) in accordance with the
Fiat group risk management policies.
2. Credit and counterparty risk
The risk of default of the FFT’s external borrowers is (allegedly) mitigated by
dealing only with major financial institutions and diversified allocation of cash.
Without further justification, the report also states that group assets are not
16 ibid paras 42-49.
-
12
exposed to this risk, since the group has interest to financially support all
members so there would be no singular insolvency cases over time.
3. Operational risk
Financial operations are performed in line with Fiat S.p.A. guidelines and
procedures and are being constantly monitored and controlled to avoid
failures.17
2.1.4 Assets
FFT is in charge of managing significant financial assets. These assets relate to
intercompany loans, account receivables from group companies and, to a minor
degree, bank deposits. In its day-to-day operations, FFT uses IT systems.18
2.1.5 Method
As a result of the comparability analysis, the method that was chosen as the
most appropriate for determining an arm’s length outcome for FFT’s group
activity was the Transactional Net Margin Method (TNMM). TNMM is
designed to reach ALP through the examination of the net profit in relation to a
chosen base (costs, sales, assets) which a taxpayer realizes from controlled
transactions. This method is a one sided method and it is particularly appropriate
in relations where only one party makes unique and valuable contributions. In
that case, the tested party will be the party that does not make such a
contribution, the less complex one.19
Since FFT was considered less complex, not making a unique contribution or
owning intellectual property, it was selected as the tested party. In order to make
a comparison, external comparables where used. Internal comparables where
17 ibid para 50. 18 ibid para 51. 19 OECD (2017) Transfer Pricing Guidelines paras 2.64.-2.65.
-
13
not available due to the claim that FFT is the only entity providing financial
services of this kind to the Fiat group companies.20 The chosen net profit
indicator was the return on capital.
The outstanding remuneration for FFT was calculated through four steps:
1. Estimate of ‘capital at risk’
Taking as a starting point the fact that FFT functions as an internal bank for the
group, the minimal capital required to cover the risks to which it is exposed was
calculated by applying the Basel II framework. Basel II is an accord which
prescribes the adequate amount of capital for mitigation of financial and
operational risks in banks.21 Using this instrument by analogy, since it does not
apply to internal banks in practice, tax advisors calculated the hypothetical
regulatory capital for FFT to be 28.5 million euros.22
2. Identification of capital used to perform functions
In this step, from the total equity of FFT amounting to 287.5 million euros in
2011, two significant amounts where deducted to calculate equity used to
perform functions. The first deduction – 28.5 million – is the previously
calculated minimum equity at risk and the second – 165.2 million – is used to
offset participation interests in FFT’s branches FFNA and FFC. This leaves 93.7
million euros as the equity backing the functions performed.23
3. Estimate of expected remuneration by Capital Asset Pricing Model (CAPM)
20 EC Decision para 55. 21 Basel Committee on Banking Supervision, Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (2005), accessed 17 April 2020. 22 EC Decision paras 58-59. 23 ibid paras 60-61.
-
14
The remuneration for FFT’s hypothetical regulatory capital was estimated by a
return on equity investors would expect to receive (‘Expected Return Pre-Tax’).
This is commonly performed using the CAPM with the formula:
Expected Return Pre-Tax = (Risk-Free Rate + β × Equity Risk Premium)/(1-tax
rate)
The beta value in this formula represents the market risk that cannot be
diversified. This value was reached through a comparability study of 66 entities
that were selected by the tax advisors as independent companies active in the
financial sector comparable to FFT. The study resulted in an arm’s length range
of betas. In this range, the 25th percentile value was selected considering that
FFT bears low risk.24
Beside the minimum capital from step 1, the equity backing the functions
performed estimated in step 2 was also remunerated. For this purpose, market
interest rate for short-term deposits was applied.25
Finally, the equity FFT had in its branches FFNA and FFC was not remunerated
at all for purpose of taxation. The explanation why the largest portion of equity
was not remunerated was found in the fact that this equity is supposed to be
redeemed by dividends.26
4. Calculation of overall profitability left to FFT to remunerate risks born and
functions performed
Resulting from the conclusions of steps 1 to 3 the final remuneration is
calculated as a sum of a ‘risk remuneration’ calculated on the hypothetical
regulatory capital and a ‘functions remuneration’ on the capital used to perform
the functions. The estimated taxable base was 2.542 million and this is the
24 ibid paras 63-67. 25 ibid para 68. 26 ibid paras 69, 134.
-
15
amount which the Luxembourg tax authorities accepted through the APA and
on which corporate income tax in Luxembourg was charged.27
2.2 EC Decision on State aid
2.2.1 Introduction
The investigation and subsequent decision of EC in the Fiat case was a result of
two important factors. Firstly, the LuxLeaks scandal exposed Luxembourg for
issuing hundreds of questionable tax rulings in 2014, among others the APA for
FFT.28 Secondly, the Commission has been very active in the field of State aid
provided through fiscal measures in recent years and seems that this trend will
continue in the future. For this reason, multinational companies are advised to
preventively apply the guidance from the recent cases in order to mitigate
substantial reputational and financial blows. In that sense, the lesson that might
be learned from FFT is significant.
2.2.2 Requisites for State aid
The prohibition of incompatible State aid is found in Article 107(1) of the
TFEU. In accordance with the wording of this provision and settled case-law, a
measure of any kind, even fiscal, introduced by a Member State will constitute
State aid if it fulfills four requisites.29 The APA which Luxembourg provided
FFT with was tested on this basis:
1. An intervention of the State or through State resources
In the Fiat case, the EC found that there was both an intervention of
Luxembourg by accepting the transfer pricing analysis through the APA and
that it was (indirectly) financed by public resources. Since the Commission
27 ibid paras 70-72. 28 European Parliament resolution of 25 November 2015 on tax rulings and other measures similar in nature or effect (2015/2066 (INI)) A. 29 Richard Lyal, 'Transfer Pricing Rules and State Aid' (2015) 38 Fordham Int'l LJ 1028.
-
16
considered that the APA endorses artificial and complex methods to lower
FFT’s taxable profit, this lead to a reduction of state revenue.30
2. Liable to affect trade between Member States and
3. Distorts or threatens to distort competition in the single market
With regards to the fact that FFT is a part of a group which operates in most
Member States, EC plainly concluded that the aid Luxembourg provided could
interfere with intra-EU trade and strengthen the position of the group at the
expense of fair competition.31
4. Confers a selective advantage on an undertaking
The most querulous condition for existence of State aid, but also the most
significant for transfer pricing purposes, is whether the APA actually provides
FFT with an advantage and how this benefit is achieved. This requisite is tested
by investigating its three components:
1) Establishing the reference system
The general Luxembourg corporate income tax system was established as a
reference since it imposes tax on companies regardless of their affiliation to a
group, thus putting integrated and stand-alone entities in a comparable legal and
factual situation.32
2) Confirming that the measure deviates from the reference system
This is the central question of the EC decision in which TP matters are discussed
and it will be analyzed in the remaining section of this chapter.
30 EC Decision paras 187-188. 31 ibid paras 189-190. 32 ibid para 194.
-
17
3) If there is a deviation, checking whether it is consistent with the logic of the
system
The EC did not identify any justification for the preferential treatment FFT
received through the APA.33
2.2.3 TNMM vs CUP
In the process of testing whether the APA deviates from the Luxembourg
corporate income tax system, the EC focused primarily on the transfer pricing
method and how it was applied in the ruling. For the determination of whether
methodology of the APA was sound, TP Guidelines where used as a “tool”.
As for the selection of the method, TNMM was questioned in the Opening
Decision. EC has in several other cases expressed its preference for the use of
Comparable Uncontrolled Price (CUP) method as more direct and more reliable
for an approximation of a market-based outcome.34 The inclination towards
CUP instead of TNMM was presented especially in the light that this method is
recommended by the TP Guidelines as the most suitable for loans, which are
significantly represented among transactions performed by FFT. The
Commission even suggested a possible internal comparable embodied in
Chrysler, the US Company of the FIAT group.35
However, in the final decision, the EC changed its stance. TNMM was accepted
as an appropriate method for the situation at hand after arguments put forward
in the investigation procedure. The defendant’s claim was that all the loans and
bonds issued by FFT vary significantly in their qualities such as rates, form and
maturity. Consequently, the CUP method would require finding comparables
for each individual instrument. In this light, TNMM is more suitable for an
33 ibid para 338. 34 M. Rasch, P. Wroblewski, ʹEuropean Commission Decision on Fiat: State Aid Case Explainedʹ (2016) 23/6 Intl. Transfer Pricing J. 438. 35 EC Decision para 132.
-
18
estimation of an arm’s length remuneration for the functions performed and
risks born by FFT. Moreover, EC recognized the return on capital as an
acceptable performance indicator, since FFT is comparable to financial
institutions for which return of capital is regularly used in TP analysis.36
The acceptance of TNMM by the EC (and subsequently the General Court) is a
significant development in its doctrine on State aid and Transfer pricing.
Although TP Guidelines do not have a hierarchy between different methods for
applying ALP, the EC has consistently favored CUP in other State aid decisions.
Giving a green light on TNMM in FFT, the Commission has aligned itself
further with the Guidelines thus providing more certainty for companies which
are extensively using this method for their complex transactions. In addition,
for the transfer pricing of internal banks, the recognition of their position as
comparable to regulated financial institutions, indicates a route for conducting
the TP comparability analysis without triggering State aid repercussions.
2.2.4 The ‘correct’ application of TNMM
Despite the recognition of TNMM as an appropriate method for the TP analysis
of internal banks such as FFT, the actual application of the method was
scrutinized in great detail by the EC. The establishment of deviation from the
system was not based on the selection of the method, but rather on parameters,
adjustments and methodology that were used inconsistently and without
reasonable explanations.
1. Parameters: Amount of capital
Although FFT as an internal bank is in a comparable position to regulated
financial institutions, it is still not one of those entities to which the Basel II
framework applies. Therefore, the calculation of its hypothetical regulatory
capital by analogy is considered inconsistent with the chosen method.
36 ibid para 247.
-
19
Furthermore, even for regulated entities, the return on minimal regulatory
capital is not a common performance indicator. This translates into the lack of
market data for comparing such a parameter.
The EC concluded that the choice of applying TNMM by return on equity,
estimated through CAPM, necessitated the use of FFT’s accounting equity as
the profit indicator.37 This requirement has significant consequences
considering that FFT’s accounting equity (287.5 million) is ten times greater
than the hypothetical regulatory capital used in the APA (28.5 million).
2. Adjustments: FFNA and FFC
The remunerated capital base of FFT was reduced by a significant amount
(165.2 million) by excluding participation in equity in FFT’s branches FFNA
and FFC without an economically sound justification. Applying zero rate
remuneration to this capital is not envisaged by TP Guidelines nor by Basel II
framework and accounting rules. Since this equity is fully available to support
FFT’s solvency, it should be remunerated in full.38
3. Methodology: Comparables and median value
Finally, the estimated level of return on capital was found to be unreliable for
approximation of a market-based outcome. The methodology used in the APA
was strongly criticized for several reasons:39
- The list of 66 entities that were considered comparable by FFT’s tax advisors
encompassed two central banks, stock exchanges and other companies active in
very different business segment from FFT, thus making the comparison invalid;
37 ibid para 249. 38 ibid para 282. 39 ibid paras 292-295.
-
20
- The beta value (market risk that cannot be diversified) which was used was
significantly lower from the beta of comparable financial sector companies;
- Notwithstanding the previous objections, the beta calculation used the 25th
percentile and not the median value in the selected range. According to TP
Guidelines, the more complex the comparability, the more the central tendency
of the sample should be used to reach an arm’s length outcome.40
2.2.5 EC Conclusion
With regards to all the inconsistencies pointed out in the Decision, the EC
concluded that the correct estimate of FFT’s taxable base should be at least 10%
post-tax applied to the full amount of accounting equity. Such a return was
considered in line with the leverage corresponding to the average of the
industry, thus representing a market-based outcome.41 Since the method the
APA endorsed departed from the arm’s length principle, it was found to confer
a selective advantage resulting in illegal State aid. The practical consequence of
this breach of EU law was a claw back of deemed benefit with interest
amounting to 20 - 30 million euros.42
2.3 Recent development and criticism
2.3.1 Introduction
After the EC Decision was published, both Luxembourg and Fiat appealed
focusing primarily on selectivity requisite. The appeals led to the judgment of
the General Court in 2019, which confirmed the conclusions of the EC Decision
in full. However, the final resolution of this issue awaits, since Fiat has appealed
the judgment to the ECJ.43 Meanwhile, outside of the court, Fiat case has
sparked great academic interest which is mostly critical towards its reasoning.
40 TP Guidelines 2010 3.57. 41 EC Decision para 311. 42 https://ec.europa.eu/commission/presscorner/detail/en/IP_15_5880 accessed 18 April 2020. 43 https://www.reuters.com/article/us-eu-fiat-taxes/fiat-appeals-to-europes-top-court-against-33-million-eu-tax-order-idUSKBN1YB0G5 accessed 19 April 2020.
-
21
The disapproving argumentation is put forward from several angles, ranging
from sovereignty to transfer pricing. The following segment will evaluate only
those points that are in the scope of the thesis objective.
2.3.2 General Court Judgement
The leading criticism of the EC Decision derives from the principle of legal
certainty. By questioning APAs through the use of a benchmark that many are
calling “EU ALP”44 the EC is adding a new layer of complexity in an already
perplexing field of international transfer pricing.
As for APAs, the EC has publicly stated that they are not in themselves the
target of State aid investigation, but rather the selective advantage that might be
provided through them.45 The legality of rulings which do not confer such an
advantage is confirmed by the General Court.46 However, the possibility of
overruling by the EC undermines the aim of an APA which is foreseeability for
investors before the performance of costly transactions.47 The likely
consequence of this development is the reduction of requests for such rulings in
the EU Member States. To prevent the adverse reaction, the EC should engage
in APA review only in extreme cases where misuse is evident.48
An even greater cause for uncertainty is the “EU ALP”. General Court has
confirmed in its judgment that EC can rightfully asses the correct application of
ALP by Member States in their APAs. In the purpose of establishing whether
illegal State aid exists under Article 107(1) TFEU, the EC uses ALP as a
44 Stephen Daly, ʹThe Constitutional Implications of an EU Arm’s Length Principleʹ (2020) 60/2/3 Eur. Taxn. 70. 45 European Commission, ʹCommission Decides Selective Tax Advantages for Fiat in Luxembourg and Starbucks in the Netherlands Are Illegal under EU State aid Rulesʹ, accessed 21 April 2020. 46 Judgment of the General Court (General Court judgment) in T-755/15 (Luxembourg v. Commission) and T-759/15 (Fiat Chrysler Finance Europe v. Commission) ECLI:EU:T:2019:670 para 115. 47 Peter J. Wattel, ʹThe Cat and the Pigeons: Some General Comments on (TP) Tax Rulings and State aid After the Starbucks and Fiat Decisionsʹ in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 187. 48 Lyal (n 29) 1041-1042.
-
22
“tool”.49 Nevertheless, the framework for this benchmark and its material
content are left vague by the Court.50
The dominant perspective in academic writings on the reference system for
applying ALP is best expressed by Schon: “to protect the Member States’
prerogative in tax matters, the decisive benchmark for fiscal state aid can only
be the tax legislation of the relevant country itself”.51 Contrary to this, the EC
viewed ALP as integral element of Article 107(1) TFEU, establishing the right
to apply the principle even when it is not explicitly incorporated in the domestic
legal system of the particular Member State.52 In the Fiat case, the basis for
application would not make a difference, since Luxembourg law contains
ALP.53 Conversely, the ambiguity in this respect which was maintained by the
General Court might be important for future cases, such as Apple where Ireland
is claiming the absence of ALP in its national tax law. Some commentators
believe this was the intention of the Court in the purpose of preparing a
precedent for the judgment in Apple.54
An indication that the General Court is leaning towards the EC’s push for an
autonomous ALP that is grounded in Article 107(1) TFEU is the acceptance,
without much motivation, of what this principle is as a “tool”. The ALP in itself
has no material content.55 It was developed by the OECD and for the purpose
49 General Court judgment para 151. 50 Jérôme Monsenego, ʹSome observations on Starbucks, Fiat, and their potential impact on future amendments to the arm’s length principleʹ, (2019) Kluwer International Tax Blog, http://kluwertaxblog.com/2019/09/28/some-observations-on-starbucks-fiat-and-their-potential-impact-on-future-amendments-to-the-arms-length-principle/?doing_wp_cron=1588158936.9704051017761230468750 accessed 23 April 2020. 51 Wolfgang Schön, ʹTax Legislation and the Notion of Fiscal aid: A Review of 5 Years of European Jurisprudenceʹ, in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 9. 52 EC decision para 228. 53 Daly (n 44) 75. 54 Ruth Mason, ʹImplications for Apple in the Lower Court Rulings in Starbucks and Fiatʹ (2019) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3459466 accessed 25 April 2020. 55 Monsenego ʹSome observations on Starbucks and Fiatʹ (n 50).
-
23
of double (non-)taxation and profit shifting, which cannot so easily be
transposed for EU State aid need for reaching a market-based outcome. As much
as EC claims that they are not applying the OECD ALP, for which they would
have no basis since it is found in soft law instruments of OECD Model Tax
Convention and TP Guidelines, they are using these very documents to give
content to their “autonomous” and “universal” principle of equal taxation.
The use of OECD materials, albeit necessary in the lack of other means, is
problematic not only for legality reasons discussed in the Methodology section
in the Introduction to this paper (section 1.4 above). Additional issue is the fact
that EC is not bound by TP Guidelines when conducting its investigation in
State aid, since it is not applying them directly. This theoretically translates into
the possibility of preparing TP documentation fully in line with the Guidelines,
but still being persecuted for illegal State aid because of different interpretation
by the EC. However, the EC has maintained that “if a transfer pricing
arrangement complies with the guidance provided by the OECD TP Guidelines
… a tax ruling endorsing that arrangement is unlikely to give rise to State aid”.56
General Court has also affirmed this line of reasoning.57 The pertinent question
of which version of TP Guidelines will be used in the investigation seems to be
answered in Starbucks case – only information existing in the time of
concluding the APA will be taken into account.58
General Court’s judgment on Starbucks, published on the same day as the FFT,
is important for understanding its “twin”. Although the Court accepted the use
of ALP on the same grounds as in Fiat, the EC decision in Starbucks was
annulled since the Commission was unable to successfully demonstrate the
56 Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union, (2016) OJ C 262 para. 173. 57 General Court judgment para 147. 58 Starbucks judgment (n 12) para 251.
-
24
existence of an advantage.59 There are substantial differences between these two
cases and the formulation of the EC decisions in each, yet this serves to prove
that the Court does not necessarily endorse EC’s handling of TP issues in fiscal
State aid investigations in all aspects. In Fiat ongoing procedure, lack of
convincingly demonstrated advantage is a possible course which ECJ can take
to overrule the lower court by its own reasoning. In any respect, ECJ’s judgment
will hopefully resolve the previously discussed issues and provide more
certainty for both taxpayers and Member States.
2.3.3 TP Method Application Issues
Both the EC and the General Court have rightfully reaffirmed that transfer
pricing is not an exact science, the idea that is the leitmotif of TP Guidelines. It
is thus disputable how the EC, with the unreserved support of the General Court,
reaches its definitive conclusions on the “correct” application of TNMM in FFT.
Starting from the range of arm’s length outcomes, the EC has decided in FFT
that the central tendency i.e. the median value is the one that should be used for
approximating a market-based outcome. Although the median is indeed
frequently preferred in transfer pricing practice, the OECD views any point in
the range as meeting the ALP.60 A logical result of the inaccuracy “inherent in
the application of a method designed to obtain a reliable approximation of a
market-based outcome” would be the recognition of an acceptable range of
values for State aid purposes and not just one point in the range such as the
median.61 Nevertheless, the General Court has not expressed a clear view on
this matter.
Secondly, the use of return on equity as a parameter calculated on the full
amount of accounting equity of an internal bank creates a loophole for tax
59 ibid para 561. 60 Rasch, Wroblewski (n 34) 441. 61 Monsenego ʹSome observations on Starbucks and Fiatʹ (n 50).
-
25
planning. Namely, since internal banks are not required to maintain a certain
higher level of capital under the Basel II (now the Basel III) accord as regulated
entities, they could reduce their level of equity down to the minimal capital
requirement in domestic corporate law.62 What is more, the TP Guidelines do
not suggest the use of the return on equity precisely because of this arbitrage
opportunity. The application of parameters such as return on assets and return
on capital employed is advisable as a more reliable benchmark.63
Although internal banks are comparable to regulated entities in the first step of
the TP analysis, the same analogy in the method application comes with
admonitions. The fact is that the EC and the General Court did not explicitly
condemn the use of Basel II for the calculation of hypothetical regulatory
capital, which some authors even advocate as the most appropriate in
combination with the return on equity.64 Moreover, the EC inspected whether
Basel II was applied correctly in FFT, but this did not legitimize its use. For this
reason, reliance on non-transfer pricing instruments such as Basel II in reaching
the ALP should be carried out with care, extensively justified and documented.65
One additional twister related to TP methods was created by the General Court
when deciding on “neutralization”. This is the possible lack of an advantage on
the group level where a lower tax burden in one country, such as Luxembourg,
is neutralized by the higher tax burden in another, e.g. Italy. The General Court
concluded that “the tax situation of another undertaking of the same group in
another Member State has no bearing on the existence of the advantage”.66 By
62 To ilustrate this, the minimum capital requirement in Luxembourg for a public limited company (SA) is just 31 000 euros, according to: https://guichet.public.lu/en/entreprises/creation-developpement/forme-juridique/societe-capitaux/societe-anonyme.html Applying the EC’s 10% post-tax rate to calculate the tax base we arrive at (sic!) 3100 euros. 63 Ivan Lazarov and Svitlana Buriak, ʹIs Fiat’s Tank Half-Full or Half Empty? The General Court’s Decision in Luxembourg v. Commission (T-755/15)ʹ (2020) 27/1 Intl. Transfer Pricing J. 74. 64 ibid 75. 65 Rasch, Wroblevski (n 34) 441. 66 General Court judgment para 318.
-
26
a priori and in general rejecting to take into account the cross-border situation
of the group as a whole, General Court has ruled contrary to the nature of
transfer pricing which is designed with the idea of zero-sum game between two
countries in mind. It is however true that in Fiat case no such effect was proven,
so that for the case at hand the Court has decided correctly.67 On the other hand,
the EC justly acknowledged the prospect of neutralization in cases where the
transaction-by-transaction methods (such as CUP) are used, contrary to TNMM
where the estimated taxable profit of one group member does not directly
influence the profit of others.68
Finally, beside these objections that might be raised on how the EC and General
Court examined the TP method used in FFT, an even more important
shortcoming lies in what they (mostly) did not examine – the functional
analysis. If the assessment of the accurate delineation and recognition of the
actual transaction would have pointed to FFT as the entity ultimately carrying
all of the risks related to analyzed transactions in the Fiat group, EC’s further
methodological conclusions would be more or less correct. Otherwise, if the
risks proved to be borne by another entity of the group, such as the Fiat parent
company, this should be reflected in FFT’s remuneration.69
3 Functional analysis for internal banks
3.1 Introduction
Without pretension of challenging the conclusions in the ruling on FFT, I will
use the information provided in the case as a basis for conducting a simplified
functional analysis of an internal bank in the following chapter. The analysis
will be performed in line with the TP Guidelines 2017 version and the latest
67 Lazarov, Buriak (n 63) 76-77. 68 EC Decision para 92. 69 Alexandra Miladinovic and Raffaele Petruzzi, ʹThe Recent Decisions of the EC on Fiscal State Aid: An Analysis from a Transfer Pricing Perspectiveʹ (2019) 26/4 Intl. Transfer Pricing J. 251.
-
27
addition to the existing rules in the form of TP Guidelines on Financial
Transactions from 2020. It is important to note, once again, that this analysis is
not applicable to the actual Fiat case, since FFT falls in the scope of the previous
(2010) version of the Guidelines, but is of significance for future similar cases.
3.2 “Treasury functions”
In FFT the tax advisors decided to package all the transactions that the internal
bank provides and receives into a single “treasury function”. This choice was
not challenged by the EC nor the General Court and the focus of the dispute
turned to the transfer pricing method. However, if this step of the comparability
analysis was brought into question, that might have changed the course of the
subsequent reasoning completely.
The new TP Guidelines on Financial Transactions are clear in this regard stating
that “it is important to accurately delineate the actual transactions and determine
exactly what functions an entity is carrying on rather than to rely to any extent
upon a general description such as treasury activities”.70 In the facts of the EC
decision, the treasury function was disassembled into transactions that
constituted it for comprehending the general perspective of FFT’s business.71
For transfer pricing purposes, roughly three types of functions can be deduced
based on FFT’s activities:
1) Intra-Group Loans
2) Cash pooling
3) Hedging
These activities are also recognized by the new TP Guidelines as the most
relevant treasury activities that are performed by internal banks in a
70 OECD (2020) Transfer Pricing Guidelines on Financial Transactions para 10.44 71 See section Transaction 2.1.1.
-
28
multinational group.72 Each of them entails specific considerations for the
delineation of actual transaction and subsequently differing recommendations
on the choice and application of the appropriate TP method.
Considering that intra-group loans are arguably the first in significance when it
comes to the internal banks’ business model, the functional analysis in this paper
will only focus on those transactions. This is particularly necessary because the
Fiat case publically provides more detail for the crediting activity only and thus
this data can be used as an example to be tested against the new TP Guidelines.
3.3 Intra-group loans
3.3.1 Accurate delineation of a loan
As highlighted in a special caveat, the new TP Guidelines allow for their
application to loans only if they are respected as loans pursuant to the accurate
delineation in line with Chapter I of the existing TP Guidelines (2017 version)
and domestic legislation.73 The importance of this precondition is underlined in
the OECD Model Commentary itself on Article 9 as applicable “not only in
determining whether the rate of interest provided for in a loan contract is an
arm’s length rate, but also whether a prima facie loan can be regarded as a loan
or should be regarded as some other kind of payment, in particular a contribution
to equity capital”.74
OECD emphasizes the determination of whether a loan itself is commercially
rational because of the inherent bias that exists in favor of debt financing
compared to equity. This consideration stretches further from TP to other
international taxation matters, such as the fact that dividends, resulting from
equity, are usually subject to economic double taxation – first on the corporate
level and second on the shareholder level. In contrast, interest is subject to only
72 TP Guidelines on Financial Transactions para 10.50. 73 TP Guidelines on Financial Transactions 14. 74 OECD Model Commentary (2017) Article 9 para 3(b).
-
29
one level of tax and it is deductible as a cost for one of the parties.75 Therefore,
integrated companies have an incentive to take on more debt than stand-alone
entities would, in order to achieve these tax benefits. Although the BEPS project
has been tackling this issue by limiting the amount of interest that can be
deducted76 and the expansions of domestic thin capitalization rules, interest rate
higher than the market are still a common form of aggressive tax planning.
In order to accurately delineate the actual transaction new TP Guidelines are
following in the footsteps of the existing guidance in Chapter I of the TP
Guidelines 2017. The process should begin with a thorough identification of
economically relevant characteristics of the transaction, which are commercial
and financial relations between the parties and the conditions and circumstances
attached to those relations.77 These characteristics can be grouped as follows:
1) Contractual terms of the transaction
Loan contracts are by a general rule written contracts and as such should be the
starting point for delineating a transaction. However, in line with the TP
Guidelines 2017 the actual conduct of the parties must also be taken into
consideration. If from the other economically relevant characteristics flows that
the actual conduct is inconsistent with the contract, the actual transaction should
be delineated for the purpose of the transfer pricing analysis.78
2) Functional analysis
The functions performed, assets used and risk assumed will be discussed in
more detail in the following sections of this paper aiming at reaching the ALP.
However, it is important to understand that in this phase of accurately
75 Brian J. Arnold, International Tax Primer, 3rd edition (Kluwer 2016) 115. 76 OECD, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 (OECD 2016). 77 TP Guidelines on Financial Transactions para 10.17. 78 OECD (2017) TP Guidelines paras 1.42-1.45.
-
30
delineating the transaction, the same factors are analyzed in order to define how
much of the loan should be recognized as a loan for transfer pricing purposes.
Only after the loan is respected as such and not treated as, for example, equity,
the functional analysis is taken under advisement again, but this time with the
purpose of reaching an ALP interest for that accurately delineated and
recognized loan.
3) Characteristics of the financial instruments
The features of a loan might influence its pricing. The new TP Guidelines list
several examples of transaction attributes that were certainly relevant in the Fiat
case, but were not analyzed, such as79:
- Maturity of the loan: A nominal distinction was made between short-term and
medium-term loans of FFT, but they were priced together;
- Amount, nature and purpose of a loan;
- Geographical location of the borrower and currency: Fiat group members are
present in several jurisdictions, and many of those such as the UK, Switzerland,
Denmark and others have different currencies from the euro zone;
- Collateral or guarantees provided etc.
FFT has submitted an objection accepted by the EC stating that the applicable
rates, form and maturity of the loans provided by FFT greatly vary. Since this
variety would require finding comparables for each individual transaction, it
was concluded that the CUP method is not applicable and these attributes where
essentially overlooked.80 On the contrary, in line with the clarification of the
new TP Guidelines, variations in financial instruments’ features must be taken
into consideration already in the comparability analysis.
79 TP Guidelines on Financial Transactions para 10.29. 80 EC Decision para 246.
-
31
4) Economic circumstances of the parties and the market
Local differences such as regulations and economic factors (inflation, growth
and exchange rates) must be taken into account, as well as macroeconomic
trends. In the current climate, the defining trend might be the record low central
bank lending rates, which affects the prices and willingness to borrow or lend
in the private sector. As for FFT, a significant component of the calculation is
the fact that all loans are provided to the automobile industry, which makes them
particularly sensitive to changes in this volatile sector.
5) Business strategies
Differences in strategies pursued by multinationals can have a profound effect
on the terms and conditions which would be agreed by independent enterprises.
This analysis also must include consideration for the group’s global financing
policy and the identification of preexisting relationships between the members
such as shareholder interests.81
After the actual transaction is delineated with the help of the listed factors, it is
compared to similar arrangements which are or would have been adopted by
independent entities behaving in a commercially rational manner in comparable
circumstances.82 The crucial concept, as set by Section D.2 of Chapter I of the
TP Guidelines 2017, is the commercial rationality of the examined transaction
in order for it to be recognized as it is structured. If either the internal bank, such
as FFT, or the group entities to which it advanced funds, had options of
concluding a similar contract with a third party that were realistically available
at the time and that would make them or the group better off, this indicates
behavior contrary to a rational market actor. In such context, the existing
transaction might be disregarded in whole or in part and replaced by an
81 TP Guidelines on Financial Transactions paras 10.34-10.36. 82 ibid para 10.7.
-
32
alternative.83 For an internal bank, this translates into a loan not being delineated
as such for the purpose of determining the amount of arm’s length interest.84
The part of the loan or even the whole amount will then require an entirely
different comparability analysis from the one performed for FFT and analyzed
in the remainder of this paper.
3.3.2 Assumption and control of risks
The examinations of functions performed, risks assumed and assets used are
inseparable parts of the functionality analysis.85 However, while it is not
possible to isolate any of them without detriment to a comprehensive
understanding of the tested entity’s situation, the fact remains that risks are the
most complex in the sense that they are not so conspicuous.86 This is particularly
true in the recently developed framework discerning between control and
assumption of risk. For this reason, it might be beneficial to investigate the
situation of an internal bank such as FFT from the perspective of risk, while
providing functions and assets with their rightful place in the analysis when
needed. For the sake of simplicity, only loans provided by FFT to related entities
are subject to inspection.
The accurate delineation of the actual transaction in respect of risks is envisaged
as a 6 step process87:
1) Identification of economically significant risks
For an internal bank, risks that were identified for FFT would most likely be
relevant: Market, Credit, Counterparty, and Operational risk.
2) Determination of how risks are contractually assumed
83 OECD (2017) TP Guidelines para 1.122. 84 TP Guidelines on Financial Transactions para 10.13. 85 Michael Lang et al. Fundamentals of Transfer Pricing: A Practical Guide (Kluwer 2019) 59. 86 OECD (2017) TP Guidelines para 1.59. 87 ibid para 1.60.
-
33
The identified risks are contractually assumed by FFT as the lender. However,
FFT has claimed non-exposure to some of these such as Credit and Counterparty
risk since the Group has interest to financially help its members and over time,
there would be no insolvency cases.88 For the claim of complete non-exposure
to these significant contingencies there is no basis in the TP Guidelines, both
the 2017 and 2020 edition. Therefore, internal banks should abstain from a
priori excluding risks that are typical for the provision of loans and rather try to
show how they might be mitigated in the functional analysis.
3) Functional analysis in relation to risk
A lender such as FFT needs to decide whether to make a loan, in what amount
and on what terms. If the decision was made by an independent lender, this
would require a thorough evaluation of the borrower’s situation, wider
economic factors, and other options realistically available.89 An internal bank
possibly does not need to invest as much effort in research as a stand-alone
entity, since it may already have the necessary data about its group members
readily available. However, in order for a loan to be commercially rational, even
for intra-group loans, factors such as creditworthiness must be evaluated.90
The pivotal importance of credit rating was already recognized in literature,
since it directly influences the level of the risk taken by the creditor.91 This is
the main factor that independent investors take into account when determining
what interest rate to charge. The new TP Guidelines also propagate its
usefulness for identifying potential comparables in the context of related party
transactions.92
88 EC Decision para 50. 89 TP Guidelines on Financial Transactions paras 10.53-10.54. 90 ibid 10.55. 91 Monsenego, Introduction to Transfer Pricing (n 4) 88-89. 92 TP Guidelines on Financial Transactions para 10.62.
-
34
In FFT, it seems that this criterion was not used at all. This is apparent from the
fact that FFT excluded its intra-group loans from its assets when calculating its
hypothetical regulatory capital. The only reason to exclude these loans would
be if their risk weight was 0 per cent, i.e. - no risk, which is awarded to items
such as cash.93 Since none of the Fiat group members had the credit rating AAA,
which is equal to no risk94, this brings into question how did FFT decide on
whether to provide related entities with loans and at what price.
An important consideration in accurately delineating a transaction is the wider
analysis of the group and how it creates value. The functions and assets of an
internal bank may be different from an independent bank since it might be
limited in its options for funding and lending because of its designated role in
the group’s value creation.95 The effect of belonging to a group can also
influence the delineation by, for example, using the credit rating of the group
when deciding on risk for a specific loan to be granted to a member.96 However,
the credit rating of the Fiat group was certainly not risk free, but rather
significantly lower97, which further points to the lack of consideration for
creditworthiness by FFT when advancing funds to related entities.
4) Actual conduct
The functional contribution of FFT is certainly providing the financing for the
loan that makes it the party assuming the financial risks in the loan contract.
FFT also mitigates some of these risks, such as the currency exchange risk by
hedging.
93 Lazarov, Buriak (n 63) 74. 94 Even in Fiat's own Transfer Pricing Policy document was FFT's credit and counterparty risk towards the group classified as ‘limited’, not non-existent. See EC Decision para 269. 95 OECD (2017) TP Guidelines paras 1.51-1.52. 96 TP Guidelines on Financial Transactions paras 10.81-10.82. 97 Ba3, which carries 100% risk weight, according to Rating Action: Moody’s downgrades Fiat to Ba3; negative outlook https://www.moodys.com/research/Moodys-downgrades-Fiat-to-Ba3- negative-outlook--PR_257083 (accessed 24 April 2020), as found in Lazarov and Buriak (n 63) 75.
-
35
The main issue when analyzing the actual conduct of FFT is whether it exercises
control over the risks and has the financial capacity to assume it.98 The disregard
for the credit rating of the borrower when advancing funds might indicate that
in actuality FFT does not fully autonomously decide on whether it is
commercially rational to provide a loan to a related entity. This would
consequently entail limited control over the risks such as the Credit and
Counterparty risk.
It is also uncertain in what degree does FFT bear the potential downside
consequences of risk outcomes. From the facts of the case, the parent company
Fiat S.p.A. provides guarantees on instruments such as bond and credits through
which FFT collects its funds. If, as a result of its related borrowers’ default, FFT
was not able to finance its own obligations, the financial capacity for assuming
this Counterparty risk might prove to be, at least in part, on the Italian parent.
5) Allocation of risk
If it is identified that control over the risk and the financial capacity for assuming
it are in the actual transaction shared or fully in the hands of another group
member, such as the parent, the risk must be reallocated to follow the actual
transaction.99
6) Pricing
The parties performing control activities should be remunerated appropriately
according to their importance. The assumption of risk should be compensated
with an appropriate anticipated return, while risk mitigation should be
accordingly remunerated.100 If FFT would be classified as an entity that lacks
the capability to control the risk, it might be entitled to a risk-free return only.
98 OECD (2017) TP Guidelines para 1.86. 99 ibid para 1.98. 100 ibid para 1.100.
-
36
In an opposite scenario, an internal bank both assuming and controlling its
financial risks would have the right to an arm’s length interest rate comparable
to stand-alone entities established by the CUP method, as suggested in the new
TP Guidelines.101 This serves to demonstrate how divergent consequences can
be if the accurate delineation of the actual transaction results in allocating the
risks of intra-group loans to parties other than the internal bank lender and
consequently why this process is vital to every transfer pricing analysis.
4 Conclusion
The aim of this paper has been providing insight into the latest development in
transfer pricing of internal banks, primarily for those entities based in the EU.
In order to achieve its purpose of establishing guidance on the safest road to
compliance, the analysis was twofold, looking both at the past and the future, to
ascertain what is to be done in the present.
The first finding is related to how the EC scrutinized transactions of internal
banks in the previously existing legal circumstances. It is important to keep in
mind that all of the conclusions which were made in the Fiat case were based
on the Transfer Pricing Guidelines of 2010, a version published before the BEPS
project has even been initiated. Additionally, the APAs concluded in
Luxembourg where laid out in such a way to accommodate the requirements of
the particular national tax authority. It is likely that none of Fiat’s tax advisors
took into consideration the idea that their report might be questioned by any
other authority, such as the EC, which, in the light of the notion that “transfer
pricing is not exact science”, has certainly influenced their argumentation and
conclusions.
101 TP Guidelines on Financial Transactions para 10.89.
-
37
However, now that the policing of transfer pricing possibilities for illegal State
Aid has become a frequent activity of the EC, with the right to do so guaranteed
by the General Court, it is a good precaution measure for internal banks in the
EU to try to reach the standard set in the Fiat rulings. On the other hand, all the
benchmarks set up to this point might be rendered null if the ECJ decides so. In
that sense, none of the findings on how to apply the transfer pricing method
presented in the first part of the paper are to be taken as conclusive.
Even if the reasoning of the EC is ultimately rejected, it is still useful as an
authoritative view on the transfer pricing methodology for internal banks. The
most significant takeaways can be summarized as follows:
- Internal banks are comparable to regulated entities, which facilitates the search
for comparables in the TP analysis;
- Although CUP is the preferred method, other methods, such as TNMM are
equally appropriate, if impelled by the facts of the case;
- Use of uncommon instruments, such as the Basel II, and unconventional
parameters and adjustments which are not envisaged by the TP Guidelines
should be reassessed and thoroughly justified;
- Central tendency (median) of the sample of comparable values is preferred in
situations that are not clear-cut.
Although all of these points where heavily criticized in academic circles, as was
presented in the paper, they are still highly relevant in practice since the General
Court’s confirmation has provided them with even more authority in both Fiat
and Starbucks case. That being said, the impact of these verdicts might be
severely limited for future cases for which the latest editions of the TP
Guidelines apply.
-
38
The second main finding of this paper was thus concerned with the TP disputes
that are yet to arise. After the results of the BEPS project were incorporated in
the Guidelines in 2017, the emphasis on taxation in line with value creation of
group as a whole has led to increase in importance for the accurate delineation
of the actual transaction. There are authors who deem that this progress towards
authentic delineation and assumption of risk has decreased the likelihood of
performing an analysis in line with the Guidelines and constituting State aid.102
This optimism might turn out to be just wishful thinking in the years to come.
This thesis has allowed for only a glimpse on how the functional analysis for
intra-group loans can be performed, but even this limited demonstration can
serve as proof on how ambiguous and uncertain such a process can be in the
complex structures of internal bank’s group.
The new TP Guidelines on Financial Transactions are a welcomed step for
facilitating the analysis of internal banks’ transactions, but when it comes to the
actual load of work that is required, compared to previous times, it will almost
certainly bring about a substantial increase. Instead of a bundle named “treasury
functions”, all the transactions of an internal bank need to be analyzed
separately, which includes an individual comparability analysis and possibly
different methods for intra-group loans, cash pooling, hedging and guarantees.
This will require substantial time and resources, but may be worth it if the result
attained is both aligned with BEPS and taxpayer’s need for certainty and
foreseeability in taxation.
The key indicator in the functional analysis is still the risk assumed, in
combination with functions performed and assets used. On this issue, the new
Guidelines primarily refer for support to the existing section D of the 2017
version. A decisive point on which the latest edition of the Guidelines insists is
102 Ruth Bonnici, ʹThe EC’s Arm’s Length Standard: Relationship and Compatibility with the Arm’s Length Principle under Transfer Pricingʹ (2019) 26/1 Intl. Transfer Pricing J. 62.
-
39
the accurate delineation and recognition of a loan as a loan for transfer pricing
purposes, before the process of establishing the ALP interest. As another result
of BEPS, only after the whole amount of the loan is recognized, based on the
functional analysis, as not being equity in disguise, can the further “usual” TP
considerations take place.
As a final comment, the field of transfer pricing of internal banks is just starting
to develop and it will be interesting to see how the theoretical conclusions hold
up in practice, particularly after the ECJ’s judgments and the implementation of
BEPS 2.0.
-
40
Bibliography
Official documents:
Basel Committee on Banking Supervision, Basel II: International Convergence
of Capital Measurement and Capital Standards: a Revised Framework (2005),
accessed 2 November 2019.
Cases T-755/15 (Luxembourg v. Commission) and T-759/15 (Fiat Chrysler
Finance Europe v. Commission) [2019] ECLI:EU:T:2019:670.
Cases T-760/15 (Netherlands v. Commission) and T-636/16 (Starbucks v.
Commission) ECLI:EU:T:2019:669.
Commission Decision on State Aid SA.38375 (2014/C ex 2014/NN) which
Luxembourg granted to Fiat, C(2015) 7152 final [2015] 32016D2326.
Commission Notice on the notion of State aid as referred to in Article 107(1) of
the Treaty on the Functioning of the European Union, (2016) OJ C 262.
OECD materials:
OECD, Limiting Base Erosion Involving Interest Deductions and Other
Financial Payments - Action 4, 2016, OECD Publishing, Paris.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations 2010, OECD Publishing, Paris.
OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and
Tax Administrations 2017, OECD Publishing, Paris.
OECD, OECD Transfer Pricing Guidelines on Financial Transactions 2020,
OECD Publishing, Paris.
-
41
Bibliography:
Arnborg Suzanne, 'The Fiat Case – unlawful State aid?', 2016, Master thesis,
Uppsala University.
Arnold B.J, International Tax Primer, 3rd edition (Kluwer 2016).
Bonnici R, 'The EC’s Arm’s Length Standard: Relationship and Compatibility
with the Arm’s Length Principle under Transfer Pricing' (2019) 26/1 Intl.
Transfer Pricing J.
Cejie K, 'The Commentaries on the OECD Model as a Mechanism for
Interpretation with Reference to the Swedish Perspective' (2017) 71/12 Bulletin
for International Taxation.
Daly S, ʹThe Constitutional Implications of an EU Arm’s Length Principleʹ
(2020) 60/2/3 Eur. Taxn.
Hagelin J, 'Retroactive Application of the OECD TP Guidelines for
Interpretation in Transfer Pricing Issues' (2018) 25/6 Intl. Transfer Pricing J.
Lang M. et al. Fundamentals of Transfer Pricing: A Practical Guide (Kluwer
2019).
Lasiński-Sulecki K, 'OECD Guidelines: between Soft-Law and Hard-Law in
Transfer Pricing Matters' (2014) 17/1 Comparative Law Review.
Lazarov I, Buriak S, ʹIs Fiat’s Tank Half-Full or Half Empty? The General
Court’s Decision in Luxembourg v. Commission (T-755/15)ʹ (2020) 27/1 Intl.
Transfer Pricing J.
Lyal R, 'Transfer Pricing Rules and State Aid' (2015) 38 Fordham Int'l LJ.
-
42
Mason R, ʹImplications for Apple in the Lower Court Rulings in Starbucks and
Fiatʹ (2019) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3459466
accessed 25 April 2020.
Miladinovic A, and Petruzzi R, ʹThe Recent Decisions of the European
Commission on Fiscal State Aid: An Analysis from a Transfer Pricing
Perspectiveʹ (2019) 26/4 Intl. Transfer Pricing J.
Monsenego J, Introduction to Transfer Pricing (Kluwer 2015).
Monsenego J, ʹ Some observations on Starbucks, Fiat, and their potential impact
on future amendments to the arm’s length principleʹ, (2019) Kluwer
International Tax Blog, http://kluwertaxblog.com/2019/09/28/some-
observations-on-starbucks-fiat-and-their-potential-impact-on-future-
amendments-to-the-arms-length-
principle/?doing_wp_cron=1588158936.9704051017761230468750 accessed
23 April 2020.
Rasch M, Wroblewski P, ʹEuropean Commission Decision on Fiat: State Aid
Case Explainedʹ (2016) 23/6 Intl. Transfer Pricing J.
Schön W, ʹTax Legislation and the Notion of Fiscal aid: A Review of 5 Years
of European Jurisprudenceʹ, in R. Isabelle, W. Schön and E. Traversa (eds),
State aid Law and Business Taxation (Springer Berlin 2016).
Stelmach J, Bartosz B, Methods of Legal Reasoning, vol 78 (Springer 2006).
Wattel P.J, ʹThe Cat and the Pigeons: Some General Comments on (TP) Tax
Rulings and State Aid After the Starbucks and Fiat Decisionsʹ in R. Isabelle, W.
Schön and E. Traversa (eds), State Aid Law and Business Taxation (Springer
Berlin 2016).
top related