IFM40670 - Other tax issues: transfer pricing: pricing

Pricing of the transaction

Rewarding functions

Where the QAHC is performing ancillary support services or activities, consideration should be given to whether the activities meet the conditions for applying the low value adding services (LVAS) guidance within the transfer pricing guidelines (see INTM440071 for further details).

As noted in paragraph 7.43 of the Transfer Pricing Guidelines, the low value-adding intra-group services guidance provides for a simplified approach to determining the arm’s length reward for such functions. It recognises the arm’s length reward for providing such services is closely related to costs, thereby proposing a markup of 5 percent. This approach is not mandatory; MNE groups may decide that another method is more appropriate provided it can be supported by evidence. If similar services are supplied in comparable circumstances to both associated enterprises and to independent third parties such that there is a readily available comparable uncontrolled transaction, the simplified approach would be unnecessary (as there would be no substantial allocation of resources required) and should not be applied.

In order to apply the LVAS guidance, the functions performed by the QAHC must:

• Be of a supportive nature
• Not be part of the core business of any MNE group
• Not require the use of unique and valuable intangibles nor lead to the creation of unique and valuable intangibles
• Not involve the assumption or control of substantial or significant risk by the QAHC nor give rise to the creation of significant risk by the QAHC

Whether the functions of the QAHC meet these conditions will depend on the specific facts and circumstances of the arrangement. However, where the functions of the QAHC are limited to administrative activities it is likely that they will meet the LVAS pre-requisites.

Where the LVAS guidance is applied, or any other mark up on costs, consideration should be given to the cost base that markup is being applied to and whether it is representative of costs incurred by third parties in similar circumstances or if adjustments are necessary.

Where the functions of the QAHC exceed what could be covered by the LVAS guidance, but are less than that which would result in the QAHC being considered to control substantial or significant risks, a suitable reward should be identified for those functions in line with the transfer pricing guidelines. This would require a comparability analysis to be conducted to determine what independent service providers of those functions would be compensated.

When implementing a reward calculated by reference to a markup on costs, the mechanism in which the QAHC is rewarded may still be through retaining a margin between the interest income received by the QAHC and interest paid to its interest holders provided it is equivalent to the return calculated by reference to a markup on costs.

Rewarding the assumption of risk

The reward for assumption of risk by a QAHC will depend on the specific facts of the case and the accurate delineation of the transaction. Where a QAHC acts as an intermediary between the investors and the investments but is not assuming the economically significant risk and is merely performing a coordination function, it would not be expected to earn a risk-based reward, such as an interest spread, but should still be rewarded for the services it provides. Where, however, it is performing functions and assuming risks that go beyond a coordination role, it should be remunerated accordingly. In such a scenario, a risk-based reward may be appropriate.

Example 1

A QAHC has entered into a profit participating loan with its interest holders. Under the profit participating loan, the QAHC is only required to pay the interest holders the net income it receives from the investments it makes.

A functional analysis identified that the functions performed by the QAHC are limited to the processing of receivables, coordinating the flow of funds, and preparation of financial statements to meet reporting obligations of the QAHC.

The functional analysis also identified that the currency risk, credit risk, interest rate risk, default risk and liquidity risks associated with the QAHC’s investments are contractually born by the interest holders and not the QAHC under the profit participating loan. This contractual allocation of risk is consistent with the conduct of the parties, for example when an investment of the QAHC defaults, the amounts due under the profit participating loan are also written off. This contractual allocation of risk is also consistent with the fact that the functions of the QAHC do not indicate the QAHC exercises control over the economically significant risks. Although the directors of the QAHC approve the decision to make an investment, this decision making is based on specific recommendations provided and therefore may not necessarily be considered to be controlling risks. Further guidance on risk allocation can be found at INTM485023.

Based on the functional analysis performed, the QAHC assumes none of the economically significant risks in relation to the investments it makes. A functional analysis shows that the QAHC’s functions are supportive in nature, do not relate to identification of investment opportunities, subsequent due diligence, negotiation of contracts, managing investments, or otherwise making substantive decisions around the investments.

The reward to the QAHC for its functions has been determined under the low value-adding intra-group services guidance to be 5 percent of the relevant costs incurred by the QAHC. This is commensurate with the service it provides in that role.

Considerations over the quantum of financing

Where a QAHC is funded through an instrument which links the return to the investors directly to the return received by the QAHC, with no recourse to pursue the QAHC in respect of defaults, the question of whether the quantum of the loan is sustainable is determined by reference to whether the underlying investment by the QAHC can support the level of funding. The guidance at INTM413000 should be applied in such scenarios.

Careful consideration will need to be given to situations where the terms of the instrument are not completely aligned with the relevant financial assets held by the QAHC. In these cases, the QAHC may be assuming economically significant risks in relation to the financial assets it holds. For example, consideration should be given to the QAHC’s obligations if the underlying investment has defaulted, or where the investment and instrument are in different currencies . In such situations, the QAHC is likely to be assuming some level of risk and consideration would need to be given to whether it can support the risk associated with that level of funding and if so, how its return should be priced.