Transfer pricing - Treasury issues 2010

The results of tax surveys of tax and finance directors consistently show that transfer pricing is the tax risk of greatest concern for multi-national enterprises. The central principle of transfer pricing is that companies within the same group are legally required to ensure that any transfer of services, goods, intangibles or finance between them is carried out on the same terms as would be agreed as between independent parties dealing at arm’s length; this is known as the "arm's length principle". This article aims to highlight the key transfer pricing rules that treasury departments of multinational companies need to bear in mind.

Thin Capitalisation

A group enterprise can adopt one of two methods for managing treasury functions. One method is for each company in the group to manage its own financial needs; the other method is for the group to have a central treasury function, usually but not always at head office, that manages the financial needs of other companies in the group. Most group enterprises, particularly the larger ones, have centralised group services over the last decade.

As a general rule, if the group enterprise adopts a centralised treasury function, to comply with the arm's length principle it must treat each group company’s finances on a stand alone basis. This means that all financial transactions between companies in the group, including any intra group lending, must be based on those companies' assets, liabilities and income; it is not to be based on the whole group’s balance sheet and income statement.

If, for example the whole group's capitalisation ratio is more favourable than that of one of the group companies, using the whole group's balance sheet as the financial basis for the terms of any of that company's transactions could well trigger an investigation by the relevant tax authority for breach of the transfer pricing rules.

If a group entity is thinly capitalised, that entity will not obtain a tax deduction on the amount it has been lent in excess of what it would have been lent by an independent third party. Tax authorities can also make adjustments if the terms of the agreement or the rate of interest are not comparable to those that would have been agreed by independent companies. Therefore it is necessary that the group's tax or treasury department maintains contemporaneous records that demonstrate their intra group arrangements comply with the arm’s length principle.

FX risk

Foreign exchange risk can be a significant exposure for multinational enterprises. Indeed, many larger groups try to hedge their risk by buying forward contracts amongst other financial derivatives. More complex treasury departments undertake currency speculation activities. Transfer pricing rules require that the group enterprise holds a document that explains which entity’s capital is being used to bear these risks. The capital utilised by the relevant entity and the risk and reward it has assumed need to correspond with each other.  The same issues apply to capital invested and resulting income.

Intra group guarantees

The rate at which an entity may borrow may be materially different based upon its credit rating. However, if the entity has a guarantee from a related entity which has a better credit rating than itself then it may be able to borrow at a better rate of interest. Certain tax authorities insist that group entity providing the guarantee must charge an arm’s length fee for this. There is no consistent application of rules in relation to this area by tax authorities therefore it may be advisable to obtain local advice. However, to have a consistent group policy is best approach.

Stewardship function

Functions of the group's treasury department that benefit headquarters but do not benefit other group companies are not tax deductable. The cost of such functions must be drawn out from the services fee charged to group companies.

The key action point for treasury departments therefore is to liaise with their tax functions to ensure they have suitable procedures and contemporaneous documentation in place.