Transfer pricing update: report on a session at the 10th IBA London Finance and Capital Markets Virtual Tax Conference
Report on session at the 10th IBA London Finance and Capital Markets Virtual Tax Conference
24 February 2021
Guglielmo Maisto Maisto e Associati, Milan
James P Fuller Fenwick and West, Mountain View
Mark van Casteren Loyens & Loeff, Amsterdam
Sarah Bond Freshfields Bruckhaus Deringer, London
Guglielmo Maisto began the session by introducing the speakers. He indicated that, for this panel, two court decisions were selected for discussion: the US Tax Court (the Court) case decision in Coca-Cola, ruled on 18 November 2020, and the Impresa Pizzarotti decision by the Court of Justice of the European Union (CJEU) on 9 October 2020. The OECD Transfer Pricing Guidance on Financial Transactions would also be addressed, which was published in February 2020.
Maisto finished the introduction by mentioning that the Coca-Cola case received a lot of attention, not only in the US, but also globally. Then he gave the floor to James P Fuller.
Dealing with valuable intangibles (US Tax Court case decision in Coca-Cola, 18 November 2020)
Fuller indicated that Coca-Cola is an important court decision in the US, being the largest transfer pricing case in North American history. The adjustment for the three years in issue was about $10bn.
Fuller started by summarising the facts of the Coca-Cola decision. The US Coca-Cola parent company (USP) owned seven foreign manufacturing subsidiaries (one as a branch). The largest was in Ireland. They manufactured concentrate using USP’s intangibles. USP also owned over 60 foreign service subsidiaries that performed substantive marketing and other services in those locations. The tax years 2007–2009 were at issue. Fuller pointed out that the years involved were over a decade ago.
Bottlers, mostly unrelated to USP, purchased the concentrate from the manufacturing subsidiaries and bottled the concentrate. They then produced, marketed and sold the final product to unrelated customers. The taxpayer used the following transfer pricing methodology to remunerate the foreign manufacturing subsidiaries:
- The manufacturing subsidiaries were permitted to retain ten per cent profit of their gross sales, with the remaining profit split 50–50 with USP. This formula was derived from a closing-agreement settlement with the Internal Revenue Service (IRS) that covered the years 1987–1995. The closing agreement did not apply to subsequent years, except to protect USP from penalties if that methodology were used; and
- The foreign service subsidiaries were paid a cost–plus fee by USP. USP charged the foreign manufacturing subsidiaries their allocated shares of the foreign service company fees. Fuller indicated that this is actually an important factor that the Court probably did not fully address, although it did cover a major part. Furthermore, USP charged the foreign manufacturing subsidiaries with commissions (marked-up costs) plus allocated shares of the service companies’ third-party marketing expenses. These charges totalled approximately $3bn during the years in issue.
USP incurred marketing costs, as did the bottlers. These costs were split 50–50 between them.
The Court’s opinion
Fuller discussed the Court’s opinion, which stated that USP’s experts agreed that foreign manufacturing subsidiaries’ manufacturing function was a routine activity that could be benchmarked to the activities of contract manufacturers. Thus, those profits were not in issue.
He mentioned that this is an important point and should be compared with the Medtronic v Commissioner (8th Cir. 2018) decision, a case involving different products. The exact opposite result was reached on the facts of that case. Fuller emphasised that transfer pricing is factual. In the Medtronic case, the manufacturing did enhance the quality of the products and the manufacturing function had to be awarded commensurately with that contribution to the product. The products were different, being pacemakers and related products.
Fuller also noted that, while the Court said that USP’s experts agreed that the contract manufacturing comparable was relevant, the record is sealed. As a result, the parties’ briefs cannot be reviewed. Typically, you can review the parties’ briefs and see how the taxpayer made an argument in this regard.
The Court also stated that USP’s central submission in this case is that the foreign manufacturing subsidiaries owned immensely valuable off-book intangible assets that justified their extraordinarily high profits. The Court rejected this argument. The Court held that the foreign manufacturing subsidiaries did not own these valuable intangibles, and therefore were not entitled to a return on them. Thus, the Court concluded that the comparable profits method (CPM) was the best method and that the unrelated bottlers could serve as CPM comparables.
There was no discussion regarding whether the manufacturing subsidiaries might have been entitled to a return as a result of the $3bn in costs. After all, the costs incurred were marketing-related costs regarding their customers. If a manufacturer incurs marketing costs or funds them in relation to its customers, it should receive a return. The Court only considered the argument that the expenditure did not give rise to their manufacturing subsidiaries having valuable off-book intangible assets. Fuller mentioned again that the briefs in the case cannot be reviewed, and therefore it is not exactly clear how this was argued.
The Court said that since the USP had not established that the IRS’s adjustments were ‘arbitrary, capricious and unreasonable’, which is the taxpayers’ burden in transfer pricing cases in the US, the IRS’s adjustment was sustained. Fuller mentioned that this is very important from a litigation strategy standpoint. In section 482 cases, the taxpayers bear the burden of proof. The Court will not go further if the taxpayers do not satisfy the burden of proof. Hence, the IRS adjustment was sustained, without the Court going further.
However, USP argued successfully that $1.8bn of the increased royalty amounts should be treated as having been paid in the form of dividends from its subsidiaries, thus reducing the $10bn in transfer pricing adjustment by this amount.
Fuller explained that this is obviously a very costly loss for Coca-Cola. The company discussed this subject in its earnings report. Coca-Cola said that it would appeal the case. Coca-Cola has to deal with the years in issue, the ten to 11 years in between, and today. The ultimate tax burden will be a very large number. Thus, according to Fuller, an appeal can certainly be expected.
Maisto asked whether collection of tax in the US is suspended until there is a final judgment by the higher court, or whether it is preliminary collected.
Fuller answered that, when a company files a case in a US tax court, it does not have to pay the tax, which is very helpful. Once it loses in a tax court, however, it has to post a bond before it can appeal the case. Posting the bond can be very expensive. It must have a corporate security supporting the posted bond. What many taxpayers will therefore do is pay the tax. However, since it is such a huge amount in this situation, it may raise financing issues for Coca-Cola.
Sarah Bond had some observations on the lessons that perhaps others can learn from this case. One thing that really stood out was the importance of not assuming that the tax authorities will respect a previously reached agreement on the appropriate transfer pricing methodology. This can also be crucial for settlement agreements because, if an approach to continue an agreement after its term has ended leads to a challenge by a tax authority, it would obviously be useful for the taxpayer – and would have been useful for Coca-Cola in this case if they were able to point out something in the terms which supported its position. For example, a reference to the facts underpinning the methodology or that the agreement reflects arm’s-length pricing.
In addition, Bond mentioned that the agreement was a particular issue for Coca-Cola since the intercompany contract they had with the foreign manufacturers seemed to be slightly at odds with the arguments made in support of its profit allocation transfer pricing methodology. The Court was then left to look at what happened in practice, and all of the Court’s findings showed that the manufacturing subsidiaries were doing something that seemed to be focused on manufacturing rather than marketing activities. The lesson there, according to Bond, is that it is always going to be easier for a taxpayer to defend a transfer pricing methodology if it is supported by a contractual arrangement. However, what happens in practice is extremely important as well.
Mark van Casteren wondered if there could be any relief for Coca-Cola in this case by claiming corresponding adjustments, and what the US’s role would be in successfully claiming them.
Fuller answered that corresponding adjustments in a foreign country would probably have no bearing on the Court’s decision. The Court has the duty to focus on taxes in the US. Furthermore, the largest of these manufacturing subsidiaries was in Ireland, where a lower tax rate applies than in the US. So, if that argument was raised, Fuller did not believe it would help in court.
Fuller noted that Bond made some good comments about the contractual agreements. There are two different agreements. First, parties should ensure that their agreements encompass what they are doing and that they follow them. The second kind of agreement was the taxpayer’s agreement with the IRS. While the agreement with the IRS covered prior years, one can fairly say that Coca-Cola was somewhat blindsided by the IRS not following the agreement. It did provide that the IRS would not assert penalties if the taxpayer (Coca-Cola) followed the agreement. According to Fuller, this is a sticky point because the agreement did not literally apply and yet there was certainly an incentive for the taxpayer to continue to use that pricing method.
Maisto asked Fuller to elaborate on the mechanism that royalties should be treated like they have been paid in the form of dividends by overseas subsidiaries, which leads to a reduction.
Fuller said that this was a very unusual issue. A procedure requires that there is an agreement with the IRS at that time. And therefore, if the dividends were paid by, for example, an Italian subsidiary, those dividends would not bring with them a foreign tax credit. This instead would be treated as payment of the royalties. Here, the Court addressed whether there actually was this kind of agreement with the IRS that the taxpayer could rely on. The Court found that on the usual facts involved in the Coca-Cola case and the prior audit that there was sufficient acknowledgement of such an agreement. However, Fuller emphasised that this is not the norm in the US.
Transfer pricing and EU law (Impresa Pizzarotti, CJEU (C-558/19), 8 October 2020)
Van Casteren pointed out the Impresa Pizzarotti case was an CJEU decision taken in October 2020.
Facts and legal background
Van Casteren addressed the facts of the case, which was about a dispute between an Italian company and the Romanian tax authorities. There was an Italian company (Pizzarotti Italia) that had a Romanian permanent establishment (PE, Impresa Pizzarotti). The Romanian permanent establishment provided, as a lender, two interest-free loans to Pizzarotti Italia back in 2012. The loan agreements had a one-year term, which could be extended, and the two loans totalled €13.7m.
The Romanian tax authorities argued that because these loans did not carry any interest, the interest was not at arm’s length. They corrected the Romanian PE’s profits with an imputed interest income of €525,000. Van Casteren noted that it cannot be deduced from the decision as to which interest rate was used instead and how it was determined. Therefore, the risk profile the Romanian tax authorities gave to the loan is unknown.
The Romanian PE argued that the Romanian national legislation that tax authorities relied on infringed Articles 49 and 63 Treaty on the Functioning of the European Union (TFEU). The Regional Court of Romania requested that the CJEU deliver a preliminary ruling regarding the national legislation’s impact on the tax treatment of a money transfer between a branch established in Romania and its parent company established in another EU Member State.
The question at stake is really whether the imputation of interest income by Romania is in violation of the freedom of establishment (Article 49, TFEU). This question came up because a PE is considered a related person in Romanian law, and therefore its head office’s transactions must be priced in accordance with the arm’s-length principle – but only if the head office is in a foreign country and is not a Romanian company. The CJEU considered this was a different treatment. Namely, it was a less beneficial treatment purely based on the seat of the head office company if it was not located in Romania. Therefore, the CJEU considered the imputation of interest to be a violation of the freedom of establishment.
Van Casteren stressed that a second question was still to be answered: namely, whether there was a justification for the discrimination. This could be justified by the difference in tax treatment which concerns situations that are not objectively comparable or by overriding reasons in the public interest. The CJEU decided that the Romanian legislation appropriately preserved the allocation of the power to tax between EU Member States, which constitutes an overriding reason in the public interest.
He also mentioned that the most interesting part is the last part of the CJEU's analysis, where the CJEU assessed whether the Romanian tax authorities’ measures go beyond what is necessary to attain the legitimate objective underlying that legislation. The CJEU stated that these measures do not go beyond because, firstly, the possibility would always be open to the taxpayer to demonstrate there were objective reasons for concluding a price not reflecting the market price. Secondly, the Romanian tax authorities imposed an income adjustment that concerns only the difference between the market price of the transaction and the price applied by the parties.
Van Casteren explained that, if Pizzarotti Italia was a Dutch company, the internal loan would not be taken into account from a Dutch tax perspective. As a result, the loan between the Dutch head office and the PE would not be considered in determining the taxable profits of the Dutch company.
He also mentioned that, in the Netherlands, prices can typically be adjusted upwards and downwards based on the arm’s-length principle in transactions between related parties. However, a new Dutch bill is expected to be proposed which will disallow a downward pricing adjustment in the Netherlands if there is no corresponding pickup of the downward adjustment in the other country.
Maisto said that the CJEU decision is unusual, considering that the CJEU said that there is always the possibility for the taxpayer to demonstrate that there were objective reasons for concluding a price which is not at arm’s length. Although the CJEU confirms prior case law, the CJEU basically says that there is a justification for the application of transfer pricing rules solely to cross-border transactions in order to protect the public interest. However, if there is a justification – which is a group justification – then the tax authorities will be prevented from making the adjustment. This is odd because, in transfer pricing matters, group justification is not considered. Group justification is, by itself, the application of the transfer pricing rules.
Bond found it quite hard to see how the two rules interact and how the CJEU decision affects transfer pricing rules generally.
Bond also made an observation from the UK perspective. She believed that – although the taxpayer would have the opportunity to make comments during an audit or challenge of a particular transaction, or defend the reasons why a particular transaction might be at arm’s length – there is no real possibility for the taxpayer to defend its position, as opposed to the tax authority’s position. Therefore, it is quite hard to see in what context this decision could apply. This EU-only decision would no longer be relevant for the UK going forward.
Maisto finally mentioned that it would be interesting to see the reactions of domestic courts on the CJEU’s decision.
Peter Flipsen from the audience raised a question about how this case relates to the OECD principles of allocation of income to permanent establishments. Van Casteren answered that, in his view, no interest on internal loans (between head office and branch) should be taken into account and this aligns with the Organisation for Economic Co-operation and Development (OECD) approach. This also aligns with the Dutch tax authorities’ view. Flipsen agreed and asked whether this aspect played a role in the matter between Italy and Romania. Van Casteren answered that as far as he was aware, this was not addressed.
OECD Transfer Pricing Guidance on Financial Transactions
Chapter X of the OECD Transfer Pricing Guidelines
Bond started by mentioning that the OECD Transfer Pricing Guidance on Financial Transactions were published in March 2020, following a consultation and a draft paper. The topics covered are characterisation of debts as a loan and various treasury functions, including:
- integrated loans;
- cash pooling;
- guarantees; and
- captive insurance arrangements.
She mainly focused on the changes in the discussion draft because there was substantial engagement with more than 75 responses to the revised draft. However, the key point was that not much had changed. While there was contentious debate over the discussion draft, much of the original guidance had been retained.
Bond mentioned one particular change in relation to guarantees in situations where the effective guarantee would increase the borrowing capacity. The effect of a guarantee currently in place is that the borrower is able to borrow more. The draft guidance and the final guidance suggest that an accurate delineation of that transaction might require that the additional amount that the borrower is able to borrow is re-characterised as a loan to the guarantor, and then equity to the borrower, which is quite extraordinary despite responses from the public suggesting otherwise.
According to Bond, there are a few key changes. Firstly, there is more focus on the use of credit ratings in pricing intra-group loans. More detailed guidance provides information on how to perform a credit rating analysis. There is also more guidance on approaches to analysing interest rates aside from using a comparable uncontrolled price method and also benchmarking – such as looking at funds and economic modelling.
Second, on cash pooling, it further explains delineating transactions and also on allocating synergy benefits among cash pool members resulting from enhanced interest rates. Third, the section on captive insurance in particular has changed quite significantly. In order for a captive insurance company to be viewed as providing real insurance, it needs to assume actual risks. Most of the comments made on that section in the draft paper have been rejected.
Bond also mentioned that the guidance had stated to be consistent with the commentary on Article 9 of the OECD Model Treaty. The proposed changes which were agreed by the OECD Working Party No. 1 have been incorporated in that commentary, and it also notes that the guidance might be revised if those proposals are not materially changed. Those changes to the commentary to Article 9 have not yet been published so, according to Bond, that is still something that remains to be seen.
Bond discussed some of the guidance’s general themes on how to transfer price in financial transactions. This essentially involves applying existing transfer pricing tools from the 2017 OECD Guidelines in the financial transactions concept, with the key concept being accurate delineation of the transaction. Bond believes that the OECD is testing the limits with what that concept can do. It is effectively being used in some cases as a form of economic re-characterisation, for example, as if they were equity. Therefore, it uses the concept to get a complete picture of what the relevant transaction or arrangement is by reference to the contracts and what happens in practice, but also to assess whether those transactions would have taken place at all at an arm’s-length basis. Thus, a sort of ‘could’ versus ‘would’ question: Could the company have borrowed on those terms as compared to what it would have done?
Bond then mentioned the particular considerations that feed into an accurate delineation of the transaction, such as commercial and financial relations, and the economically relevant characteristics. In the ‘loan’ context, that might include:
- examination of the contract;
- functional analysis;
- what characteristics the financial instruments may have;
- the parties’ economic circumstances and business strategies; and
- the market of the relevant industry sector.
Putting this in practical terms, this requires looking at things like whether there is an obligation to pay interest, existence of financial covenants and any fixed repayment date. There is also a need to examine the broader context, such as the ability of the borrower to obtain funds from unrelated lenders and its ability to repay the loan. The guidance also considers the two-sided approach from the lender and borrower perspectives, including options realistically available to both. For example, for the lender:
- considering business objectives;
- context of the transactions; and
- other investment opportunities.
For the borrower:
- what funds are actually required;
- whether it would rather choose not to borrow if that might adversely affected its credit rating; and
- any increase on its cost of existing capital.
The last consideration that Bond mentioned is the implicit support. By this, she meant the incidental benefit assumed to be received solely by virtue of a group affiliation, which goes to the potential credit rating of the borrower or of the issued debt.
Bond mentioned that, after the transaction is accurately delineated, the most appropriate transfer pricing method should be consistent with that transaction. The preference would be the comparable uncontrolled price (CUP) method, noting the availability of the public data for benchmarking purposes. The alternatives might be looking at the cost of the lender’s funds, building a risk premium and profit margin, or a risk-free or risk-adjusted return depending on the transaction. For example, the leader of a national cash pool might be expected to receive a risk-free return.
Bond concluded by giving several comments from a UK perspective. In the UK, compliance with the OECD Transfer Pricing Guidelines is enshrined in UK law. However, UK law is not yet updated to refer to the latest version of the OECD Transfer Pricing Guidelines, including the 2020 updated Guidance on Financial Transactions. Strictly speaking, compliance is not required until that has happened. In practice, the tax authorities’ approach is to access the historic position by referring to the most recent guidance if it clarifies the previous position.
Bond further noted that the updated guidance is fundamentally aligned with the UK tax authorities’ perspective on financial transactions. Finally, she mentioned that the updated guidance does not prevent other tools from being used to adjust the tax treatment of financial transactions or interaction with other rules for restricting interest deductions (eg, loans). The UK might use other tools for that such as its general corporate interest restriction which can limit the deductible interest expense on a group basis. Another tool is often the ‘unallowable purpose’, which often is used alongside transfer pricing as an alternative way of disallowing deductions of interest. If a company’s main purpose is securing a UK tax advantage by being a party to a loan, deductions denied for interest that is adjusted on a reasonable basis are attributable to that bad tax purpose. However, if the unallowable purpose conditions are not satisfied, transfer pricing provides an alternative way to disallow that deduction.
Maisto added that, in some countries, it is very controversial if the transaction can be re-characterised through a transfer pricing rule, compared to anti-abuse rules. In these cases, arbitration of mutual agreement procedures (MAP) could prevent this.
Fuller commented from a US perspective on loan bifurcation. If there is a country where a loan can be part equity and part loan, that could raise huge concerns between countries trying to negotiate resolution of that issue. He mentioned the creditworthiness of the borrower. According to Fuller, the US approached it in the past as a sort of debt capacity analysis. By this, he meant that if you are making a large loan, you should have experts make an economic or financial assessment on the debt capacity analysis. However, there may be other issues here beyond credit worthiness. For example, there is US case law concerning related parties being a manufacturer and a supplier. In this case, the supplier made some low-interest loans to the manufacturer, and the Court found that this was motivated by business reasons and they were dealing at arm’s length.
Finally, to conclude this panel discussion, Fuller noted that the second big issue is the interest-free rate versus the risk-adjusted rate, and how that will be applied in practice. For example, if the treasury function with a treasury lender function is hedging or carrying out other similar transactions, does that have to be actually in the lending subsidiary’s head office or can it be in the parent company’s head office?
According to Fuller, if the treasury function is not in the lender’s office, then you cannot count on treasury functions for interest rate purposes to be performed elsewhere. He also believed that guarantee fees will be another issue. The US had this issue in the past few decades. Fuller referred to a Canadian tax court case involving General Electric, which dealt with how to take the interest rate spread approach to a guarantee fee.
Lastly, Fuller mentioned cash pools. He believes that tax authorities globally do not always understand what a cash pool is. In fact, there are different kind of cash pools and they are very common. Fuller hopes that these new rules do not interfere with the appropriate use of cash pools, which essentially do not have anything to do with taxes but rather with funding an international business.