IFM40660 - Other tax issues: transfer pricing: accurate delineation

Transfer Pricing considerations in analysing QAHCs

HMRC operates both an advanced pricing agreement (APA) programme and advanced thin capitalisation agreement (ATCA) programme. These programmes lend themselves to QAHC arrangements which contain complex functionality or nuanced issues, for example, where the QAHC undertakes significant additional activities or exercises a considerable amount of due diligence and control over the investments. Consideration should also be given to the activities condition in these situations.

Accurate delineation of the transaction

As part of the accurate delineation of the transaction, an analysis is required of the functions performed, assets held, and risks assumed by each party to the transaction. Where the QAHC performs relatively simple functions of a supportive nature and assumes little to no risk, the transfer pricing analysis is expected to be straightforward. As the functions performed and risks assumed increase, the complexity of the transfer pricing analysis will increase commensurately.

Risks being assumed by the QAHC

The QAHC regime provides for a number of benefits. Most relevant to the transfer pricing analysis are the changes to distributions rules outlined in IFM40720, permitting deductions for the use of instruments which link the payment due by the QAHC to its interest holders with the payment received by the QAHC from its investments. Using this type of instrument allows the QAHC to transfer the risks related to the income from the investments it owns to its own interest holders, absolving the QAHC of many of the risks it would otherwise have assumed from the investment transaction. This permits deductions for certain interest payments, such as those related to profit participating loans (PPLs), that would usually be denied. Through the use of such instruments, the risks associated with the making of investments that would normally be assumed by an AHC are now contractually assumed by the holder of the PPL thereby reducing the risk profile of the QAHC and its corresponding return.

As part of the functional analysis, it will be necessary to identify whether the contractual agreements entered into between the QAHC and interest holders, and the economic assumption of risk where that differs from contractual form, cause the interest holders to assume risks in relation to the investment made by the QAHC that would otherwise have been assumed by the QAHC. Consideration should be given to which party assumes the following risks (this should not be taken as an exhaustive list):

  • The potential risks associated with the late payment, uncertainty of payment, or non-payment in relation to the investment made by the QAHC
  • The potential risks associated with defaults in relation to the investment made by the QAHC
  • The potential risks associated with foreign exchange currency movements in relation to the investment made by the QAHC
  • The potential risks associated with movements in interest rates in relation to the investment made by the QAHC.
Interaction of risk assumption and functions

In accordance with the six-step process as part of the OECD’s transfer pricing guidelines’ risk analysis framework, consideration would need to be given to whether the party contractually assuming the risks, exercises control over that risk and has the financial capacity to control that risk. Where that is not the case and the other party does exercise control over that risk and has the financial capacity to control the risk, the assumption of risk should be reassigned to that other party. Where another party controls the risk but may not assume the risk, that party should be appropriately compensated for its control functions in relation to the risk which will usually be derived from the upside benefits and downside costs arising as a consequence of the risk.

Where the activities of the QAHC are relatively simple because the economically significant risks are not contractually assumed by the QAHC and the functions of the QAHC do not extend to controlling the economically significant risks, the determination of the functions being performed and the risks being assumed by the QAHC is relatively straightforward. This allows for a clear identification of an appropriate reward for the QAHC in relation to these aspects. In such cases, the QAHC will be expected to retain no more than a marginal return reflecting its limited functionality and no risk adjusted return would be expected.

Where the activities of the QAHC are relatively simple but the QAHC does assume some of the economically significant risks because not all of them are transferred to its own interest holders under the PPL, the QAHC will be expected to retain a risk adjusted return based on the risks the QAHC assumes. For example, where back-to-back loans are used instead of a PPL and the QAHC assumes credit risk in relation to the underlying investment.

Where the QAHC is employing investment professionals conducting substantial activities such as due diligence, negotiating the terms of investments, and negotiating the quantum of the investments on behalf of the QAHC, more detailed consideration would need to be given to whether the QAHC is in fact exercising control over the economically significant risks associated with making the investments.

The potential consequences of performing these more complex functions requires a commensurately more complex analysis to be undertaken. In situations where the QAHC is controlling most or all the risks associated with the underlying investment, a QAHC may wish to consider applying for certainty on their pricing under the ATCA programme or APA programme.