On Tuesday, November 26, 2013, the Deputy Minister of Finance released a new decree on transfer pricing. The Deputy Minister’s decree dated November 14, 2013 takes account of recent developments in transfer pricing and cancels the earlier decrees of March 30, 2001, and August 21, 2004. The new decree combines these earlier decrees as well as introducing some new matters or matters that were previously only partially dealt with. The starting point remains the arm’s length principle as codified in the Corporate Income Tax Act 1969. The new decree entered into force on November 27, 2013.
The Deputy Minister has used the new decree to clarify the policy on transfer pricing. While he has succeeded on a number of issues, we would argue that the position taken in a number of cases is open to interpretation. Taxpayers should, nevertheless, anticipate the introduction of this policy. In particular, it is important to ensure there is transfer pricing documentation that explains the commercial rationale behind existing and proposed structures and group transactions and which substantiates functionality. This also applies to financial transactions for which a ‘simple’ benchmark is no longer appropriate. In this respect, the decree is in line with international developments.
The following issues from the new decree are discussed below:
- intra-group services;
- financing transactions including non-business motivated loans;
- combating non-business motivated profit shifting (in particular as it concerns intangible fixed assets, central purchasing within the group and internal insurance/reinsurance activities);
As was the case with the old decree of August 21, 2004, the new decree contains a list of activities that are regarded as being performed in a shareholder capacity. Therefore, the taxpayer should not charge the other group companies for that particular part of the activities. The new decree clarifies this list. It also explains that costs for corporate governance can be regarded as costs relating to mixed activities (group services and shareholder activities).
Intangible fixed assets
The new decree contains a separate section on tangible and intangible fixed assets. This section deals with the situation where an intangible fixed asset is transferred to a group company that does not have the required functionality to manage the risks associated with the intangible fixed asset. Under the new decree, the transfer of assets to an acquiring group company that has no added value is regarded as not being at arm’s length. Because the joint profit will not increase, the price offered by a potential purchaser will be less than the asking price of the potential vendor. According to the new decree, such a transfer would therefore not take place between third parties. With this measure, the Deputy Minister appears to be combating situations where such assets are only contractually relocated to low tax jurisdictions, while the purchaser lacks the required functionality. However, it is also clear that a relocation of the intangible fixed asset within the group must also be substantiated in order to explain the logic behind the transaction from a financial and commercial perspective.
Central purchasing within the group
According to the Deputy Minister, it is generally accepted that the activities performed by local unassociated purchasing agents mostly consist of support activities. Their remuneration is generally based on the cost of the purchases. The Deputy Minister argues that, in practice, it appears difficult to find reliable comparables for a purchasing office, which can be used to carry out a comparison based on a percentage of the cost of purchases. In such situations, the Dutch Tax and Customs Administration will therefore generally apply a cost plus method as test to assess the arm’s length nature of the remuneration. According to the Deputy Minister, this will, in principle, limit the cost base to the purchasing office’s own operating costs, given the routine tasks performed by it, but will exclude the cost price of the purchases. This argument by the Deputy Minister is not new and is based on a judgment rendered by the Supreme Court on April 23, 2004. As this concerned a very specific case, the judgment cannot simply be applied to every situation. It is therefore very important that the substantiation of the payment for purchasing activities is based on a functional analysis and an analysis of the group’s commercial position.
Internal insurance/reinsurance activities
It is standard practice within a group to have group companies that formally act as the group’s internal insurer/reinsurer (also referred to as ‘captives’). According to the Deputy Minister, in some cases these companies lack the activities that are characteristic of a professional insurer/reinsurer, such as product development, marketing and sales, screening of potential policyholders, asset/liability management and developing an independent reinsurance policy. Nor do these companies ‘actively’ diversify (i.e. outside the group) the risks run by the reinsurer in respect of the internal insurance/reinsurance activities; any diversification that takes place is ‘passive’, i.e. within the group. Two types of insurance/reinsurance activities are explained in more detail, i.e. the passive pooler and insurance as by-product. The Deputy Minister is of the opinion that these cases solely involve an administrative function that justifies no more than a limited payment. This argument appears to lump all internal reinsurers together. However, in practice, many internal insurers/reinsurers are set up with a functionality that justifies a much higher payment than, for example, cost plus. Given the policy described in the new decree, it is very important to substantiate and document the commercial reasons for setting up an internal insurer/reinsurer, as well as its functionality.
There are various reasons for providing guarantees to group companies for loans granted in associated relationships. If the group company is not able to independently − without a guarantee from associated companies − raise a loan on the capital market, the guarantee will be provided in a shareholder capacity. According to the Deputy Minister, this does not involve a chargeable group service. Even if the group company is able to independently raise a loan, the extent to which it can negotiate conditions that are more favorable than they would be with an explicit guarantee from an associated company, must be assessed. The underlying reason for this is that the group company has a higher credit rating by virtue of its inclusion in the group and therefore can borrow under more favorable conditions. The new decree refers to this as an implicit guarantee, but this also does not involve a chargeable group service. According to the Deputy Minister, a fee for an explicit guarantee can only be charged if the guarantee exceeds the value of the implicit guarantee.
The amount of an explicit guarantee fee is partly dependent on the credit rating of the relevant group company and the group as a whole. The rates given in the example used in the decree are as follows:
- interest on the basis of the standalone rating (i.e. of the company excluding the group): 6%;
- interest on the basis of the derived rating (taking into account the fact that the company is part of a group): between 4-6 %;
- interest on the basis of the group rating: 4%.
The Deputy Minister is of the opinion that the guarantee fee cannot, in principle, be higher than the difference between the interest rate based on the derived rating and the interest rate based on the group rating. In the above example, the guarantee fee should therefore lie between 0-2%.
Determining and documenting the guarantee fees and interest payments will therefore increase the administrative burden for the taxpayer. It is not possible to unequivocally establish what influence the group will have on the credit rating of the party receiving the loan and to whom the guarantee applies. It is therefore important to carefully substantiate and document the choices that were made in determining the credit rating.
With regard to financing transactions, the new decree states that the conditions (including the price) under which the transaction was entered into must be evaluated to see whether they are the same as the conditions that third parties would have agreed for a comparable transaction entered into under comparable circumstances. The credit rating must also be taken into account in this arm’s length evaluation. The credit ratings AAA through BBB- reflect excellent to adequate creditworthiness (the borrower is also referred to as ‘investment grade’). The Deputy Minister’s position is that only in special circumstances will unassociated borrowers and lenders enter into a loan transaction with a borrower with a credit rating under investment grade/BBB-. Whether this position reflects the reality of the financial markets is debatable. Moreover, the Deputy Minister’s position will further increase the burden of proof resting on the borrower and lender in a financing transaction between associated parties to demonstrate that the loan is at arm’s length. Not being able to meet this burden of proof can result in all or part of the interest or all or part of the write-down on a bad debt being non-deductible.
In its judgment of November 25, 2011 the Supreme Court concluded that if the interest on a loan between associated parties is not determined in accordance with the arm’s length principle, the calculation of the profit for tax purposes must nevertheless be based on interest that is at arm’s length. The interest rate on a non-business motivated loan must − as a rule of thumb − be corrected so that it is line with the interest rate that the borrowing group company would have paid had it borrowed from a third party under the same conditions and in the same circumstances with the lending company acting as guarantor. The Supreme Court did not address the situation where the credit rating of the lender is lower than that of the borrower. In that case, the deemed guarantee would make no difference. The Deputy Minister is of the opinion that in such cases only the risk-free interest on the loan should be taken into account.