The rise of globalisation has led to substantial increase in cross-border related party transactions (“RPTs”). For example, by moving a factory to a foreign country, businesses will be scrutinised by at least two tax jurisdictions on RPTs in purchases, sales, intangibles, financing, management fees, shared services etc. by tax offices in at least two jurisdictions. Businesses are expected to provide documentation to support the transfer pricing of each RPT. With the BEPS project, the amount of pressure on meeting the tax offices’ expectation on transfer pricing has increased to the highest.
The OECD, being the major driving force behind BEPS, have updated the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations in July 2017 (“TP Guidelines”), which is over 600 pages long, to help reduce possible differences between businesses and tax offices in determining the approach and factors to be considered on what should be the arm’s length price of RPTs.
This Article is based on the Hornbach case (C-382/16), ruled by the Court of Justice of European Union (“CJEU”) on 31 May 2018 to look at a relatively small, but common, RPT, discusses what issues businesses would face and the takeaways from the case that can help businesses strategize for future RPT of this kind.
The Hornbach Case
Hornbach-Baumarkt AG (“Hornbach”) is a public limited company established in Germany which operates do-it-yourself (DIY) and building materials shops in Europe. In 2003, Hornbach, through a German and a Dutch intermediate holding companies (“German Holdco” and “Dutch Holdco” respectively), held an indirect shareholding of 100% in two operating companies established in the Netherlands, Sub1 and Sub2 (collectively ‘the Subsidiaries”).
The Subsidiaries had negative equity capital and required, respectively, in order to continue their business operations and to finance the planned construction of a DIY store and garden centre, bank loans of EUR 10,057,000 as regards Sub1 and of EUR 14,800,000 as regards Sub2.
The financing bank had made the granting of the loans contingent on the provision of comfort letters containing a guarantee statement from Hornbach. In September 2002, Hornbach provided the comfort letters gratuitously. In the comfort letters, Hornbach undertook vis-à-vis the financing bank to refrain from divesting of or changing its shareholding in the Dutch Holdco and, in addition, undertook to ensure that the Dutch Holdco would likewise refrain from divesting of or changing its shareholding in the Subsidiaries without giving the bank written notice thereof at least three weeks prior to such divestment or change.
Furthermore, Hornbach irrevocably and unconditionally undertook to fund the Subsidiaries in such a way as to enable them to meet all of their liabilities. Accordingly, it had to make available those companies, as necessary, the requisite funds to enable them to settle any liabilities towards the funding bank.
The diagram below illustrates the case background.
Taking the view that unrelated third parties, under the same or similar circumstances, would agree on remuneration in exchange for granting the guarantees, the German Tax Office decided that, according to German tax laws, the income of Hornbach had to be increased by an amount corresponding to the presumed amount of the remuneration for the guarantees granted and accordingly amended the corporation tax and the basis of calculation for that company’s business tax for the year 2003. The Tax Office, therefore, corrected the amount of taxable income of Hornbach as a result of the guarantees granted to Sub1 and Sub2 by EUR 15,253 and EUR 22,447 respectively.
Hornbach objected to the assessment which was rejected by the German Tax Office. Hornbach brought an action against those decisions before the German Finance Court.
In the context of that action, Hornbach argued that the relevant German tax law leads to unequal treatment in cases involving domestic and foreign transactions since, in a case involving purely domestic transactions, no corrections of income would be made in order to reflect the presumed amount of the remuneration for guarantees granted to subsidiaries, which could be regarded as a restriction on freedom of establishment. In addition, the tax law does not contain any provision concerning the opportunity to present commercial justification in order to explain a non-arm’s-length transaction. In the present case, according to Hornbach, commercial reasons relate to supportive actions to replace the equity capital of the Subsidiaries explain why no remuneration was given for the comfort letters. The Tax Office contended that the taxpayer had the opportunity to present evidence of the reasonableness of the transaction carried out, and the concept of “commercial justification” within the meaning of the relevant tax laws must be interpreted in the light of the principle of free competition which, by its nature, rules out acceptance of economic reasons resulting from the position of the shareholder.
The German Finance Court was uncertain as to (1) whether the relevant German tax law was compatible with the freedom of establishment, and (2) whether commercial justification may be presented as evidence and, in particular, whether any commercial justification may include economic reasons resulting from the very existence of a relationship of interdependence between the parent company resident in the Member State concerned (Germany) and its subsidiaries which are resident in another Member State (the Netherlands).
Consequently, the Finance Court referred the questions to the CJEU for a preliminary ruling.
Readers would see that the CJEU was not asked to rule whether the commercial justification presented by Hornbach was sufficient in supporting the alleged “non-arm’s length” transaction. While CJEU ruled that the German tax law was compatible with the freedom of establishment, and in the case at stake, it is for the German Finance Court to determine whether Hornbach was in a position, without being subject to undue administrative constraints, to put forward elements attesting to a possible commercial justification for the transactions at issue in the main proceedings, without it being precluded that economic reasons resulting from its position as a shareholder of the non-resident company might be taken into account in that regard. In other words, the relationship between Hornbach and Subsidiaries shall be taken into account in assessing the commercial justification for the non-arm’s length transaction, which was what the German Tax Office refused to do. Therefore, whether Hornbach would eventually win the case is uncertain and it is worth keeping an eye on the development.
Food for Thoughts
This case has provided some food for thoughts as to whether a parent company should charge its subsidiary for support, such as the guarantee in this Hornbach case. Here are some of the key comments from CJEU:
- It is clear that Subsidiaries had negative equity capital and the financing bank made the granting of the loans required for the continuation and expansion of business operations contingent on the provision of comfort letters by Hornbach.
- In a situation where the expansion of the business operations of a subsidiary requires additional capital due to the fact that it lacks sufficient equity capital, there may be commercial reasons for a parent company to agree to provide capital on non-arm’s-length terms.
- Furthermore, it should be noted that, in the present case, no argument relating to the risk of tax avoidance has been advanced.
- Accordingly, there may be a commercial justification by virtue of the fact that Hornbach is a shareholder in Subsidiaries, which would justify the conclusion of the transaction at issue in the main proceedings under terms that deviated from arm’s-length terms. Since the continuation and expansion of the business operations of those foreign companies was contingent, due to a lack of sufficient equity capital, upon a provision of capital, the gratuitous granting of comfort letters containing a guarantee statement, even though companies independent from one another would have agreed on remuneration for such guarantees, could be explained by the economic interest of Hornbach itself in the financial success of Subsidiaries, in which it participates through the distribution of profits, as a shareholder, in the financing of those companies.
These comments would be quite helpful to companies in structuring their transfer pricing strategy and future defense.
It is common for the Ultimate Parent Entity (“UPE”) of a Multinational Enterprise (“MNE”) to provide guarantees to banks for funding to the MNE’s subsidiaries. Whether the UPE should charge for a guarantee fee or not is often an issue of debate. In the Hornbach case, the German Tax Office obviously considered that Hornbach should have charged a guarantee fee (in this case, the rate appears to be 0.15%p.a. on the loan amount) and therefore adjusted Hornbach’s taxable income upward. That brings up a few questions for MNEs facing similar situation: (1) when no third party would be in the position to provide the same guarantees, is this really an arm’s length price for the guarantee; (2) can the tax office make adjustment when there is no evidence of tax avoidance; and (3) would the tax office on one side (the Dutch tax office in this case) allow a corresponding deduction for deemed guarantee fee income imposed on the other side (Germany) and how to achieve that? These are very difficult questions that require tax and legal analysis of the tax laws and tax treaties of the jurisdictions involved at that point in time. MNEs are often less interested in what is the correct technical answers, but more interested in how to resolve the matter in the least expensive manner.
An arm’s length price is the consideration that unrelated parties would agree upon in the same or similar circumstances (and that is perhaps why the German Tax Office argued that the concept of “commercial justification” within the meaning of the relevant tax laws must be interpreted in the light of the principle of free competition which, by its nature, rules out acceptance of economic reasons resulting from the position of the shareholder). However, in the Hornbach case and often in real life situations involving parental guarantees, no third parties would be in the position to provide similar guarantees to funding bank because they would not be in the position to guarantee that they would “refrain from divesting of or changing its shareholding” in the Subsidiaries. If there can be no comparables, how does anyone derive an arm’s length price?
In Chapter 1: The Arm’s Length Principle of the TP Guidelines, Para 1.11. pointed out exactly the issue, “A practical difficulty in applying the arm’s length principle is that associated enterprises may engage in transactions that independent enterprises would not undertake. Such transactions may not necessarily be motivated by tax avoidance but may occur because in transacting business with each other, members of an MNE group face different commercial circumstances than would independent enterprises. Where independent enterprises seldom undertake transactions of the type entered into by associated enterprises, the arm’s length principle is difficult to apply because there is little or no direct evidence of what conditions would have been established by independent enterprises. The mere fact that a transaction may not be found between independent parties does not of itself mean that it is not arm’s length.”
Does the Para 1.11 help? Not much, because the guidelines is not saying that tax office have to accept whatever the price set by the taxpayers in this situation, even though no arm’s length comparable price can be found and “no adjustment” is probably the right answer. Therefore, disputes would still arise, as we see in the Hornbach case.
There are tax and non-tax reasons for MNEs to consider whether to charge a guarantee fee. In the Hornbach case, Subsidiaries needed funding, which could come from Hornbach in the form of capital or loan via the intermediate holding companies (from internal funds or external borrowing), or from bank borrowing directly by the Subsidiaries as in the present case. MNEs would need to review the cash flow, cost of capital and follow the internal policies in deciding the choice of funding, especially for larger amounts.
The reason for not charging a guarantee fee in the Hornbach case was not disclosed. It could be due to the reason that Subsidiaries may not be able to generate sufficient cash flow to pay the guarantee fee, which could create further funding issue for the group and may therefore incur additional interest expense.
In some situations, UPE may want to charge a guarantee fee. For example, the UPE holds a majority stake in the subsidiary and is providing the letter of comfort to the bank funding the subsidiary covering the full amount of the loan, while the minority shareholder (the “MI”) does not need to provide the proportionate guarantee. The MI would therefore be enjoying a free ride in terms of the subsidiary obtaining the bank loan, often at an interest rate lower than if it was borrowing on a standalone basis, and thus the MI would eventually receive a higher return on investment while the risk is borne by the UPE alone. In this situation, the UPE would often want to charge a guarantee fee to the subsidiary to eliminate this free ride.
The UPE may also charge a guarantee fee if overall tax savings of the group could be created, after taking into account the tax deduction benefit of the subsidiary, withholding tax that may be imposed, and the income tax that the UPE may be subject to after considering the tax credit available on the withholding tax paid. MNEs should fully recognise the BEPS risks for taking such approach.
In tax jurisdictions where there are statutory transfer pricing requirements (which will include Hong Kong soon), in deciding whether to charge a guarantee fee to the subsidiary when parent guarantee is provided, the thought process should cover the following:
- Consider from purely commercial perspective whether there is a preference for charging or not charging a guarantee fee. This preference is the best defense against tax avoidance accusation.
- Consider the tax implications of charging and not charging, including local practices, tax treaty applications, case law and compliance costs, and assess the risk of the two alternatives.
- Determine the approach based on commercial preference, costs, benefits and risks analysis.
- Prepare all necessary supporting documentations (e.g. board minutes, communication with external parties such as banks, loan agreements, guarantee fee agreement and transfer pricing reports) which must include the commercial rationale of the approach taken.
One of the significance of the Hornbach case is the CJEU comment that the parent-subsidiary relationship could justify terms that deviated from arm’s-length terms. Indeed, only the parent company would provide guarantees to banks for financing its subsidiaries, especially at the early development stage of the subsidiaries when banks refuse to lend without a parental guarantee. Such action should be regarded as an investment activity instead of a service. The parent, by providing the guarantee, can earn its return by sharing the future profits of the subsidiary, in just the same way as providing capital to fulfil the funding need. Unfortunately, many tax offices view guarantee as a service, however it arises. Therefore a risk assessment is needed on the attitude of the tax office involved when the UPE decides not to charge a guarantee fee.
Notwithstanding, the underlying nature of the guarantee could change to service when the subsidiary is capable of obtaining standalone financing (i.e. banks would be willing to lend to the subsidiary directly without parental guarantees), and the parental guarantee is provided for the purpose of reducing the financing costs of the subsidiary because banks would lend cheaper due to the lower risks. As the subsidiary would be truly benefiting from the guarantee, it may justify the charging of a guarantee fee from tax perspective.
Along the lines discussed above, MNEs may consider the following transfer pricing strategy on guarantee fees:
The above strategy would help MNEs make decision on whether to charge a guarantee fee. One should note that this may not necessarily be agreed by the tax office. If it is decided that a guarantee fee should be charged, finding the so-called arm’s length amount is another challenge, especially when no third party would enter into the same or similar transaction, as in the Hornbach case. For small amount of adjustments, the cost and administrative burden of searching the right amount is sometimes unproportionately high. If the method of how the German Tax Office derive the guarantee fee of 0.15%p.a. would be disclosed, it would be of good reference to many MNEs.
The problem with transfer pricing in practice is that there are many assumptions in the whole process, and the tax offices often do not understand the commercial rationale behind and they go after companies just because they smell revenue. After lodging objections which the tax offices have rejected, in practice companies would not go to the court in view of the cost and benefits, and may instead restructure the transactions to make the issue go away. It is not often that the taxpayer, like Hornbach in this case, would go to the court for the relatively small amount of tax involved, and those who seek fair treatment deserve much appreciation and applause from people who are concerned.
(This is an English translation of the Chinese article published in the Hong Kong Economic Journal Forum on 14 June 2018: https://manageyourtax.com/HKEJ Forum 12)
OECD TP Guidelines: