FTSP Perspectives February 2008 - PwC · 2015-06-03 · insurance sector there is not the same level or intensity of post -risk assumption management of risk as there is in the banking

Financial Services
Tax and Transfer Pricing
Foreword

Dear Reader:

This year’s February issue of Harvard Business Review contains a thoughtprovoking article on leadership that might offer inspiration to tax legislatorsand authorities. A diagnostic template helps organizations to decide whichgoals are reasonable and where to focus performance-improvement efforts.The diagnosing tool is based on four principles. The most striking one says“simplicity gets results”.

Although it is designed to help company leaders taking the right decisions,this article may also have potential merit to public servant decision makers inthe field of taxation. The defence argument could be that the “race to thebottom” in terms of tax rates to attract investors necessitates a more agileresponse when it comes to deemed artificial tax base erosion through theviolation of the arm’s length standard when setting intra-group prices. Thekey question is presumably to figure out whether complexity in the policing istruly unavoidable?

This issue’s country focus on the Chinese developments might give a flavourof the challenges outstanding and in some sense of overkill even though noone will ever doubt that balancing government budgets is a fair aspiration.Jobst Wilmanns’ column talks about the dimensions of the in-house transferpricing paradigm in the FS industry in Europe.

PricewaterhouseCoopers' FSTPPerspectives is a bi-monthly publicationthat offers an insight into trends anddevelopments, tax authorities’approaches, and “hot” topic issues infinancial services transfer pricing.

Index

OECD: Interview with

Mary Bennett 3

Transfer Pricing Key Issues:

Reinsurance: a transfer pricing

‘hot topic’ 8

Trends & Developments

Germany: transfer pricing implications

of new German-US tax treaty 11

OECD Paper on Transactions Profit

Methods: Discussion Draft 12

India: Supreme Court reaffirms

position on taxability of BPO units 13

HMRC’s New Approach to Transfer

Pricing Work 14

Country Focus: China 15

Comment & Analysis

Jobst Wilmanns ‘From my

Perspective’ 19

Future Events 21

Recent FTSP Publications 22

FSTP PerspectivesA publication for financial services industrytax and transfer pricing professionals

February 2008

For more information related tothis publication, please contactany of the editorial team below:

Aamer [email protected]

Adam M. [email protected]

Irina [email protected]

Erin [email protected]

Tracy [email protected]

Business welcomes the fact that the initiatives taken by the OECD and the JointEU Transfer Pricing Forum are destined to step in the breach. The aim is tomitigate the risk that compliance efforts require a disproportionate cost totaxpayers taking into account the additional levies that can realistically becollected. The OECD’s ongoing initiatives such as on PermanentEstablishments, Business Restructurings and Dispute Resolution are just a fewin an array of others.

The risk of failure to “put things right” from the outset with potential devastatingconsequences is probably one of the main reasons why the finalization of theseprojects may be somewhat time-consuming. The interview with Ms MaryBennett, the OECD’s Head of Tax Treaties, Transfer Pricing and Financialtransactions will shed some light on the latest developments.

I grab the occasion to also underscore the efforts on improving the MutualAgreement Procedure under Article 25 of the OECD Model Treaty. The(protocol to the) US-Canada, US-Germany and the new US-Belgium Treatyshow that Binding Arbitration is included as an innovative technique to makethe procedure more effective. A plea for wider proliferation of such disputeresolution tool appears no more than logical even though we’re not yet homefree. Despite the valuable efforts of the Joint EU Transfer Pricing Forum tomake the Arbitration Convention actually work, some issues remain unsolved.Examples include so-called “triangular cases”. Within the EU this appears to bea matter that can be solved relatively easy, i.e. to see “which EU countryCompetent Authority steps in when”. Things might be getting more complexwhen non arm’s length price setting in a non-EU country, provokes taxadjustments in the hands of an EU taxpayer where recourse to a swiftremediation procedure seems less obvious at the current state of play.

Finally, in late February the Joint EU TP Forum embarked on its project around“centralised intra-group charges”. It will be interesting to see how the Forum willaddress ideas from Business to make life easier when it comes down to crossborder HQ charges and the countries’ reactions thereto. Topics such asshareholder expenses, allocation keys, mark-up determination and supportingdocumentation will probably all take the stage. At the end of the day, the maingoal is to reduce red tape for both taxpayers and tax authorities when dealingwith compliance in an area where probably limited or no premium profit is leftuntaxed on the table… Challenging times ahead!

I have the pleasure to present you a “FSTP Perspectives” that once againresults from the invaluable enthusiasm of our growing crowd of dedicated PwCexperts across the globe.

Best regards,

Isabel VerlindenPwC Eurofirms Transfer Pricing Leader

Financial Services Transfer Pricing Perspectives February 2008PricewaterhouseCoopers LLP 3

25 Questions for MaryBennett:

Richard Stuart Collier, PwC’sBanking & Capital Markets TaxLeader, met with Mary Bennetand asked her a few questions

regarding the current OECD initiatives andherself:

General

Richard Collier (RSC): Please give an overview of yourrole in the OECD:

Mary Bennett (MB): My role is as head of the division fortax treaties, transfer pricing and financial transactions.This is a very large area, although I am supported byJacques Sasseville in relation to tax treaties and CarolineSilberztein in relation to transfer pricing. In my role, Ireport to Jeffrey Owens, the Director of the Centre for TaxPolicy and Administration of the OECD.

RSC: Could you summarise the major issues on youragenda currently?

MB: It might be useful to summarise the work in progressin relation to the transfer pricing activities on the one handand the treaty activities on the other. The transfer pricingactivities relate to the ongoing project in relation to theattribution of profits to permanent establishments, which isnear to closing, but also includes the tax issues relating tobusiness re-structurings and work on the 1995 TransferPricing Guidelines. On the other hand, the treaty activitieswould include non discrimination, a special project oncollective investment vehicles, some work on disputeresolution and also some issues affecting cross-borderservices. In addition to all these issues, the OECD is alsointerested in looking at tax and growth; tax and theenvironment; and there is an ongoing project to achieve

OECD enlargement and enhanced engagement withnon-member countries.

Article 7

RSC: Picking up one of the first issues youreferred to, what is the current status of the Article7 project on the attribution of profits to PE's?

MB: This project has been running for approximately10 years. We now have a finalised text for Part I(General Considerations), Part II (Banking) and PartIII (Global Trading) although it is possible that theformat of these papers may change (but not thesubstantive content). Progress on Part IV (Insurance)is a little behind these other three parts. We arehoping to finalise Part IV shortly, following the publicconsultations at the end of last year. During 2008 weshould also see a new version of Article 7.

RSC: In relation to Part IV on insurance, certainbrief comments in the paper seem to suggest thatinternal reinsurance is not a KERT capable oflocating a risk in a different location. This is onthe basis of there not being sufficient activedecision making in the process. In the bankingreport, however, there is a significant amount offocus on the assumption and management of risk– but in the insurance report the discussion justseems to focus on the assumption of risk. Whythe difference?

MB: The comments in Part IV are simply aconsequence of the factual input which we receivefrom our delegates. What became clear is that in theinsurance sector there is not the same level orintensity of post-risk-assumption management of riskas there is in the banking sector and therefore thereport concludes that, as a factual matter, themanagement of risk is less likely to justify a finding ofan internal transfer of risk than in banking or globaltrading.

OECD: Interview with Mary Bennett


RSC: There does not always seem to be a completeconsistency amongst the tax authorities in relation totheir acceptance of and support for this project. Howdo you see this?

MB: I think the tax authorities do recognise the importanceof uniformity in approaching difficult tax issues and it willbe interesting to see how quickly the proposed newArticle 7, once agreed upon within the OECD, will bepicked up and incorporated into treaties. However, I doaccept that the current version of Article 7 will be a realityfor some time in the large number of existing treaties,although I expect tax authorities generally to shift overtime to using the new Article 7 in their new treaties. Ofcourse, the publication of new OECD Commentary for theexisting version of Article 7 is also intended to achievegreater consistency in the way countries apply theirexisting treaties.

RSC: Do you see the US tax authorities also beingentirely aligned with the OECD’s work on theattribution of profits to PE’s?

MB: I do think that the US tax authorities are taking a linewhich is entirely consistent with that of the OECD in thearea of how to attribute profits to permanentestablishments under Article 7. I think we will see morewhen the global trading regulations are released which Iunderstand is intended to be soon.

RSC: I think it’s fair to say that the industry regardsthe consultative process that is being followed on thisproject as having led to some pretty mixed results. Doyou think the tax authorities really do listen to thevoice of industry, or do they just do what they want todo anyway?

MB: Generally, I think the tax authorities do want to listento Industry and that the consultative process can workquite well. Admittedly, there are varying practices amongstgovernments as to how they interact with taxpayers. Forexample, there is a great deal of interaction in the US andperhaps rather less so in some parts of Europe. For thisreason, therefore, some countries are probably lessfamiliar with the process of consultation and its potentialadvantages. At the OECD, however, we do spend a lot oftime on this area and the recent project on collectiveinvestment vehicles is a good example where consultationand cooperation between the tax authorities and theindustry is a pre-requisite for any progress to be made.That project is progressing well based on that cooperation.

RSC: What do you expect will be the likely take-up ofthe new Article 7 when it is released?

MB: As I mentioned, I do think the tax authorities are keento maintain a uniformity of approach to key internationaltax issues where this is possible and therefore I do expectto see a shift to the use of the new Article 7 once it isadopted by the OECD. There may be some exceptionsand of course the position may also be affected by non-

OECD countries who may not want to follow theOECD line when they negotiate bilateral tax treaties.

RSC: What do you think will be the timescalebefore we can see the use of the new Article 7 inall double tax treaties?

MB: This is clearly a long time – even assuminguniform acceptance of the policy of following the newArticle 7, it could take years or even decades forcountries to re-negotiate all their existing treaties toincorporate the new language, which is one of thereasons the OECD thought it was so important tohave as part of its implementation strategy thedevelopment of new Commentary for the existing textof Article 7 to clarify the extent to which the“authorised OECD approach” could be applied underexisting treaties. We are also interested in exploringmechanisms which might speed up the process ofre-negotiating treaties to reflect changes in the text ofthe Model itself, but as things stand we will have to beresigned to a gradual switchover.

Business Restructuring

RSC: In a relatively short time, the topic ofbusiness restructuring seems to have becomeone of the hottest issues in which the OECD isinvolved. How did the project come about?

MB: The work on business restructuring grew out ofthe recognition of the significant changes in the way inwhich business was being structured. These newdevelopments pose significant revenue challenges togovernments, but this is not just an anti-avoidanceissue for tax authorities. There has been a recognitionthat these developments raise issues that need to beclarified, for example in relation to the PermanentEstablishment threshold under Article 5 or how thearm’s length principle, as articulated in the OECD’sTransfer Pricing Guidelines, applies to the types oftransactions and structures one sees in typicalbusiness restructurings.

RSC: What are the key issues that the OECD isinvestigating in relation to business restructuringissues?

MB: A Joint Working Group involving delegates fromthe OECD’s Working Party No. 1 (responsible fortreaty issues) and Working Party No. 6 (responsiblefor transfer pricing issues) was set up and its area offocus has included issues such as: the recognition oftransactions; transfer pricing issues (such as whethercompensation is required upon the restructuring itself,or post restructuring for services rendered or propertyprovided); PE issues both in relation to whether or nota PE exists and also the quantum of profits that mightbe attributable to it. In the course of its preliminarywork in preparing a draft for public comment, the Joint


Working Group has obtained informal input from aBusiness Advisory Group formed for that purpose and hassolicited broader input through an invitation published onthe OECD website.

RSC: How do you see the future discussion of thistopic going?

MB: A draft is being prepared for public consultation, andwe expect to be able to issue this draft before the end of2008. This will probably focus mainly on transfer pricingissues relating to Article 9 but may also address someissues relating to attribution of profits to permanentestablishments (Article 7). Depending upon the outcomeof the public consultation, it may be that the TransferPricing Guidelines will need to be expanded to deal withthe issues arising from our consideration of the businessrestructuring issue.

Art 5

RSC: The permanent establishment threshold issues(under Article 5) have come up in the conversation atvarious points. Would you accept that the thresholdPE issues of Article 5 are currently under thespotlight?

MB: The relevance of those issues to the businessrestructuring developments and also the rejection of the"single taxpayer" approach in the documents on theattribution of profits to PEs project, have certainly helpedto focus attention in this area. Of course, the PE thresholdissues extend well beyond business restructuringsituations, and the OECD has recently decided to pursueits examination of these issues in the context of itsbroader programme of work in Working Party No. 1 ratherthan through the more narrowly focused Joint WorkingGroup on business restructurings.

RSC: The problem seemed quite acute given thatsome of the key concepts are not particularly clear.For example, the definition of "independent agent" inArticle 5 is fuzzy, to say the least.

MB: Some of these issues have begun to be discussedalready in the business restructuring project. As I’veindicated, we expect to do a thorough examination ofArticle 5 PE threshold issues in an upcoming project inWP1.

Services PE

RSC: On a matter related to PEs, could you explainwhat has been driving the discussions at the OECDon the services PE concept, particularly in light of thepublic discussion draft on the Tax Treaty Treatment ofServices released by the OECD in December 2006.

MB: The overall review of this area has been drivenby OECD members who believe that business hasevolved in significant ways in the service sector yet ina manner which is not fully accommodated by thefixed place of business PE test of Article 5(1). There isa view amongst some OECD members – although nota majority view – that these developments need to betaken account of in framing tax treaties.

The service PE provision is already in a number oftreaties, including those of some countries which donot prefer the lowered PE threshold represented bythe service PE concept – but this is simply a functionof the bilateral negotiation process which has led tothe treaty in question. The 2006 draft you referred toproposed to include in the OECD Commentary onArticle 5, as an alternative to the standard Modelprovision, an approach to drafting a service PEprovision for those countries which wanted to followthis view. Interestingly, a new Canada-US Treaty hasalready incorporated a similar services PE concept,reflecting that this is a matter that is of relevance andinterest to certain developed countries as well as todeveloping countries.

1995 Transfer Pricing Guidelines

RSC: You mentioned that other work was alsounderway on the 1995 Transfer Pricing Guidelines.Could you explain what areas you are looking at inparticular?

MB: There are two main areas we are looking. First,comparability issues and second profit basedmethodologies. In relation to comparability issues, ourintention is to collate experience after 12 years ofworking with the Guidelines as to what issues havearisen. We are aiming to look at the issues arising oncomparability and investigate what further guidancemay be given. For example, some countries tend toapproach the arm’s length standard on the basis of aprice comparison when setting a transfer price. Othercountries seem to be more results focused and askdid whatever arrangements were put in place andwhatever pricing was used lead to the right result. Weare also looking at questions about which data isappropriate to be used, when it was available, etc. Iwould expect that ultimately the work would lead to arevision of Chapter 1 of the guidelines.

RSC: And the work on profit based methods?

MB: With the passing of time, tax authorities aregenerally much more experienced with profit basedmethods and it is in practice more difficult to see thisas still being a “measure of last resort”. Rather, asreflected in the discussion draft on profit methods wepublished on 25th January, the right transfer pricing


method should be the most appropriate method in thecircumstances, not a consequence of applying slavishly arigid hierarchy of stipulated methodologies. We areseeking comments on the discussion draft on profit basedmethods and ultimately I am expecting this to lead to arevised Chapter 3 of the Transfer Pricing Guidelines.

RSC: Do you think we will see a shift to moreformulary apportionment given these developmentsand in the light of, for example, the project onAttribution of Profits to PEs?

MB: You will see from the discussion draft published on25th January that the OECD is not proposing anyfundamental change to the position reflected in the 1995Transfer Pricing Guidelines to the effect that globalformulary apportionment, notwithstanding the recognitionthat OECD-endorsed profit methods are no longer viewedas “exceptional” to the same extent they were in 1995.

Treaty Issues

RSC: Turning to a couple of treaty issues youmentioned, can you tell me what the current positionis on the project on non-discrimination, i.e. relating toArticle 24 of the Model Convention?

MB: This is certainly one of our more difficult projects butwe are approaching the work in two phases. First, wehave been working on collating experience on the existingarticle provisions and considering especially where wehave consensus on the interpretation of those provisionsand where this is lacking. The resulting discussion draft ofproposed amendments to the Commentary on existingArticle 24 which we published last May is now beingfinalized for inclusion in the 2008 update to the OECDModel Tax Convention. As a second phase, we are nowstarting to look more fundamentally at what the Model’sprovisions on non-discrimination should be from a policyperspective and, where changes are required, how thesemight be effected.

RSC: Do you also expect to see changes arising outthe collecting investment vehicles project?

MB: This project was sparked off by the increasingamount of cross-border investments held by mutual fundsand similar investment vehicles and by the perception thatthese intermediated investment structures gave rise to anumber of substantive and procedural difficulties in theapplication of tax treaties. The project is in fact a goodexample of the way industry and the OECD can worktogether on a matter driven by both the industry agendaand the tax authority agenda.

Enlargement of OECD and EnhancedEngagement

RSC: Turning to the project of enlargement andenhanced engagement, it is clear that this is animportant project right across the work of theOECD. What does it mean in the context of Tax?

MB: In the Tax sphere as in other areas, it is importantthat the OECD has an influence across the globe andthat this is not restricted to the traditionally developedcountries alone, particularly given the hugedevelopments in the economies of countries such asChina, India, etc. On a more tax specific basis, theprocess we are pursuing of enlargement andenhanced engagement should in time influencecurrently non-member countries to move closer topractices and standards which are consistent withexisting OECD members. This should be a positivedevelopment – for the operation of the tax systemitself and taxpayers also.

RSC: Could you explain what the process ofenlargement and enhanced engagement means inpractice?

MB: The process of enlargement refers to the fivecountries -- Chile, Estonia, Israel, Russia andSlovenia -- the OECD has invited to be candidates formembership in the Organisation. As part of theprocess of admitting these countries to membership,the OECD will be undertaking a review of their policiesand practices in tax and other areas to ensure thatthey are sufficiently consistent with the OECD’s coreprinciples and standards. For example, each of thesecountries will agree to be the subject of a “peerreview” by the OECD of their transfer pricing regimes.

A further number of five countries -- Brazil, China,India, Indonesia and South Africa -- have beenidentified as countries with which the OECD intends topursue “enhanced engagement” in order to strengthenour dialogue with them and perhaps ultimately to leadto their candidacy for membership. Practicalimplications include much more regular and extensivecontact between the OECD and those countries,including for example the participation of some ofthem as Observers in meetings of the OECD’sCommittee of Fiscal Affairs and its working parties, aswell as events such as the major OECD/IFA (India)conference held in Mumbai in late January.


Personal

RSC: Turning away from the technical issues, whatattracted you to come to the OECD in Paris from yourprevious private sector role?

MB: As a tax partner in a large law firm, I had beenadvising MNCs for a number of years and I wasincreasingly finding that issues on the OECD agenda wereof major importance to them. I think this reflects thesignificant growth and currency of the OECD’s workprogramme over the years. I also thought then – and stilldo now – that by virtue of its nature as a forum forachieving consensus among 30 member countries, theOECD works to effectuate change in a way and on a scalewhich is not available to any individual government. I hadworked in the US Treasury in the 1980s so had someexposure to international tax policy issues from thegovernment perspective. Therefore, when I was offeredthe chance to head up the division responsible for taxtreaty and transfer pricing issues, this sounded likesomething I would be very interested to do.

RSC: What have been the major challenges to theOECD in the time you have been here?

MB: The answer is undoubtedly, achieving consensusamongst participants. This has to be facilitated and built,not imposed – the OECD has an ability to influence butcertainly no power to direct sovereign governments.

RSC: Have you enjoyed your time at the OECD inParis so far?

MB: Yes, very much.

RSC: Thank you.

Mary Bennett will be one of the key note speakers duringthe 2008 FS TP Masters Series event in Amsterdam,where she will further discuss both the businessrestructuring and the PE profit allocation projects of theOECD. Invitations for the event will be sent out shortly.

For more information, please contact:

Richard Collier [email protected]

Aamer Rafiq [email protected]


The transfer pricing of intra group reinsurancehas become an increasingly high profile issueof late. This can be attributed to a number ofdevelopments

The insurance sector has seen significant recentconsolidation, resulting in post-integration restructuringwith a strong focus on capital structure and capitalmanagement. At the same time, analysts haveincreasingly started to focus on insurance groups’management of effective tax rate.

Historically, many tax authorities have put the transferpricing of reinsurance into the “too difficult” category,focusing on industry generic transactions such asmanagement services and brand royalties. However,recent work undertaken by the Organisation forEconomic Co-operation and Development (OECD) inrelation to the taxation of insurance branches has putthe tax spotlight on the insurance sector.

These developments have resulted in reinsurancetransactions, which are often the most material transferpricing transactions within insurance groups, comingunder increasing scrutiny.

Intra-group reinsurance arrangements

Within a group context, reinsurance may be purchased byeach insurer independently with external reinsurers or,more typically, a group’s reinsurance needs may becentralised within a group reinsurer (Group Re). Group Remay then choose to retrocede some or all of the riskbased on a consolidated risk assessment of thecombined/pooled reinsurance risks of the group.Utilisation of the Group Re structure typically offersdiversification and capital benefits as well as the ability tocommand more favourable pricing from externalreinsurers through a combination of bulk purchase and thecentralisation of reinsurance expertise within the group.

Commercial rationale

The commercial rationale for intra group reinsurancearrangements is critical for any transaction of thisnature. Generally, reinsurance is purchased for any ofthe following reasons:

To transfer insurance risk where risk of loss isabove an acceptable level;

Reduce volatility in annual results;

Help to increase premium writing capacity onexisting business;

Facilitate growth of an insurer’s new products or aidits entry in new business lines.

A strategic, risk based approach to reinsurancetransfer pricing

In order to ensure that a robust support of intra-groupreinsurance is in place, insurance groups areincreasingly taking a risk based approach tocategorising and supporting the arm’s length nature oftheir reinsurance transactions. This is even moreimportant where a group has several hundred intra-group reinsurance transactions, to ensure that time,effort and expense are spent where they are mostvaluable and that low risk contracts are supported anddocumented with minimum time and effort.

Transaction risk will be determined by the likelihoodand impact of potential adjustments, as shown in thediagram below.

Transfer Pricing Key Issues:Reinsurance: a transfer pricing ‘hot topic’


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A risk based approach to the assessment of the likelihoodand impact of a transfer pricing tax adjustment is essentialto identify high risk areas and to shape the extent oftransfer and pricing analysis and documentation. Anassessment of high risk will generally apply to transactionsin which:

Large portions of originated business are ceded torelated parties;

The ceded business is very profitable;

The nature of the risk ceded is complex and unique,with little likelihood of third party comparables beingavailable to support the arm's length nature of the price.

Reinsurance Transfer Pricing MethodsComparable Uncontrolled Prices

Using Comparable Uncontrolled Prices (CUPs) todemonstrate compliance with the "arm's length" standardis sometimes possible, when

a) the insurer has purchased the same reinsurancecoverage externally in the recent past or

b) a third-party reinsurer shares the same terms as thegroup reinsurer, as a co-reinsurer or retrocessionaire.

One should bear in mind, however, that the reinsurancemarket is highly cyclical, hence pricing, policy terms andconditions and returns can erode the comparability veryquickly. And in practice, there are many instances whereCUPs are either not available or applicable, and thepractitioner has to rely on alternative methods to assessdemonstrate compliance with the "arm's length" standard.

Broker Quotes

Reinsurance broker quotes are often put forward aspotential evidence to support the terms of internal quotashare reinsurance transactions. Broker quotes can oftenbe valuable sources of market data to the extent that thereis clearly some level of comfort in knowing that the cedingand profit commissions are broadly in line with what is

seen in the market. However, the economic result of areinsurance contract is so dependent on the specificterms and conditions of the contract; it is generally notpossible to rely exclusively on broker quotes whichrefer only to headline rates of commission. In addition,many revenue authorities are very reluctant to acceptquotes that are not associated with executedcontracts as primary evidence of arm's length pricing.

Pricing Methodology

A common statement made in support of the arm’slength nature of inter-company reinsurancetransactions is that “inter-company transactions arepriced on exactly the same basis as for externalreinsurance”. In principle, this is potentially goodsupport. Indeed, the IRS temporary servicesregulations (U.S. Treasury Regulations Section 1.482-9T(c) (5)) explicitly approves this approach (known asthe indirect evidence rule). However, this approachfrequently falls down at the first level of scrutinyunless there is a sufficient audit trail to support thatsuch a policy exists, that there are internal controls toensure the implementation of the policy, that the samepricing models and assumptions were applied andthat there is sufficient level of expertise at both endsof the transaction as well as evidence that genuinenegotiation has taken place.

The major advantage of this approach is that, to theextent that it can be shown that the same pricingmodels and methodologies are applied for bothinternal and external reinsurance pricing, multipletransactions might be supported and documented onthis basis, particularly if carried forward with anongoing sample based review in the future.

Return on Allocated Capital

Reinsurance contracts can be highly complex. Somefeatures of inter-company reinsurance contractsheighten the risk for the group. For instance Nonstandard coverage and policy terms and conditionsmay appear relatively benign but can have asignificant impact on the overall transfer pricing.

For these transactions, a more actuarial approach isgenerally required to support the reinsurance pricing.In reinsurance pricing of specific contracts, there havegenerally been two possible approaches to take:

1. Using the cedant as the tested party; and

2. Using the reinsurer as the tested party.

On the face of it, using the cedant as the tested partyappears to offer certain attractions. By applying thetransactional net margin method (TNMM) the insurer

http://dict.leo.org/ende?lp=ende&p=eL4jU.&search=retrocessionaire


often seeks to demonstrate that the decision whether ornot to enter into the reinsurance transaction is, at the veryleast, economically neutral with regard to return on capital.In other words, the compensation which the insurerreceives in return for ceding the reinsurance is set at sucha level that the return on capital is at least the same afteras it was before the reinsurance. For proportionalreinsurance, the balancing figure is the cedingcommission. For an excess of loss contract or a lossportfolio transfer, the balancing figure is the premiumitself.

However, this approach has a number of potential pitfalls:

In the first instance, tax authorities are inherentlysceptical about using the onshore party as the testedparty, particularly where the line of business beingreinsured is expected to be particularly lucrative and/orwhere the reinsurer is showing a particularly high returnon capital.

Secondly, reinsurers are more typically price settersand insurers price takers, rather than vice versa, withsignificant potential volatility in the reinsurance marketbased on reinsurance capacity and the position in thereinsurance cycle.

Thirdly, this approach does not recognise any benefitsenjoyed by the reinsurer, such as a lower tax rate, lowercapital requirements, or diversification benefits frompooling reinsurance – effectively none of these benefitsare shared with the cedant under this approach.

Fourthly, many arm's length reinsurance transactionsresult in the cedant being worse off from an expectedprofit perspective as the ceded profits represent theprice to pay for off-loading some of their risks toreinsurers. Using the cedant's position to test the arm'slength nature of a reinsurance transaction can thereforelead to very uncertain conclusions.

Finally, and perhaps most basically, this approacheffectively allows all the profits on the ceded business toflow to the reinsurer.

The approach increasingly taken by insurers and taxauthorities is to benchmark the return to capital of thegroup reinsurer. In assessing an appropriate return on thereinsurer’s capital, it is essential to assess the extent towhich the capital supporting the business is genuine riskcapital as compared to excess capital, which is likely to beat a greatly reduced level of risk of loss. The benchmarkedreturn to capital will thus be determined by the type ofcapital and the associated benchmarked level of risk.

Regardless of the primary pricing method used, therevenue authorities will want comfort that the primary

insurer has retained sufficient profit on the cededpremiums.

Inevitably, the nature of transfer pricing disputesmeans that, for higher risk transactions, it will seldombe entirely comfortable to rely on a transfer pricingmethodology which benchmarks only one side of thetransaction, particularly where there is intellectualproperty or where the business line is particularlylucrative.

Regardless of the transfer pricing methodology usedto support the pricing of the transaction, there is anoverriding need to be able to be able to articulateclearly the commercial rationale behind entering intothe reinsurance contract in the first place. Thecommercial rationale question is increasingly the firstquestion asked by tax authorities, and must besatisfied as a matter of priority in any transfer pricingsupport/documentation.

Summary conclusions

A risk based approach to the assessment of thelikelihood and impact of a transfer pricing taxadjustment is essential to identify high risk areas andto shape the extent of transfer and pricing analysisand documentation.

CUPs are a good starting point, but the reinsurancemarket is highly cyclical, hence pricing, policy termsand conditions and returns can erode thecomparability very quickly.

The reinsurer is generally a ‘price-setter’ and thecedant is a ‘price-taker’, hence it is important todemonstrate that a reinsurer is expected to achieve areturn commensurate with the expected returns ofthird party reinsurers over the same period.


Lisa Casley [email protected]

Irina Diakonova [email protected]

Lucia Fedina [email protected]

Huw Jenkins [email protected]


Junko Yamato [email protected]


Germany: transfer pricing implicationsof new German-US tax treaty

On December 14, 2007 the US Senate finally approvedthe new protocol amending the 1989 US-German incometax treaty. The protocol to the new US-German tax treatywas signed by both countries on June 1, 2006 andentered into force on December 28, 2007 with theexchange of the instruments of ratification.

The most relevant changes from a transfer pricingperspective are:

Mandatory Arbitration Provision

The ratification of the new protocol - including themandatory arbitration provision - was a milestone in theUS treaty policy, since a mandatory arbitration provisionhad never been included in any US tax treaty while it hassince been included in treaties for Belgium and Canada.This incorporation into the tax treaty has in part beencaused by the recently increased international attention todispute resolution processes. Starting with the EUArbitration Convention within the European Union and theOECD member states agreeing in February 2007 tobroaden the Mutual Agreement Procedure ("MAP") andamending the OECD Model Tax Convention to ensure thatissues preventing the competent authorities from reachingan agreement on a MAP are to be resolved within twoyears (for more details see OECD report "Improving theResolution of Tax Treaty Disputes").

The scope of the arbitration provision is limited to casesdealing with the application of the treaty articles onresidence, permanent establishment, business profits,associated enterprises and royalties. Beside these casesthe provision allows the competent authorities to agree onthe application of the binding arbitration for other mattersas long as article 25 ("Mutual Agreement Procedure")applies to these cases as well.

Pursuant to the new provision cases including transferpricing cases which have not been solved by thecompetent authorities within two years will go toarbitration and the arbitration process is to becompleted within 6 months. Incorporated into the newprotocol is also the "last best offer" or so called"baseball" arbitration process, according to which bothcompetent authorities have to submit a proposedresolution, outlining the amounts of income,expenses, or taxation and their proposed positions.The board is then obliged to adopt one of the twoproposals.

Business Profits

The German transfer pricing rules traditionallyembraced transactional transfer pricing methodsrejecting profit-oriented methods or only allowing themas a method of last resort for validation purposes. Inthe new treaty Article 7 - Business Profits, providesthat any transfer pricing method described in theOECD Transfer Pricing Guidelines is accepted todetermine the profits attributable to a permanentestablishment. Hence, confirming Germany'sacceptance to apply profit oriented methods as a lastresort for cases where the transactional methodscannot be applied.

The new protocol to the German-US treaty treats apermanent establishment as if it were a separatedistinct enterprise for the purpose of determining theprofits attributable to the permanent establishment.This is in line with the OECD's functionally separateenterprise approach as outlined in the OECD "Reporton the attribution of profits to permanentestablishments" and can be seen as an initial steptowards an official acceptance of this approach inGermany. However, the German tax authorities havenot yet officially recognized their acceptance.

Trends & Developments:


Dividend withholding tax

The protocol imposes a new zero percent dividendwithholding tax rate for dividends paid by an enterprise toits parent company if the dividend receiving enterpriseowns directly at least 80% of the dividend payingenterprise's voting rights

(ii) for a 12 month period up to the date of the dividendresolution and

(iii) the conditions of the "Limitation of Benefits" clause aremet.

Alongside with the zero percent withholding tax rate thetax treaty provides for a 5% withholding tax rate for directinvestments of at least 10% of the dividend payingenterprise's voting rights or a 15% withholding tax rate forshareholdings of less than 10% respectively.

The protocol further contains specific provisions on thedividend withholding tax rates for RICs, REITs or GermanInvestmentaktiengesellschaften ("Investmentvermögen").

Entry into force of the new protocol

The protocol shall be effective as of January 1, 2008whilst the new provision regulating the reduction of thewithholding tax rates shall be effective as of the yearwhere the instruments of ratification have beenexchanged, i.e. are applicable to all payments made on orafter January 1, 2007.


Manuel Imhof manuel.imhof @de.pwc.com

Jobst Wilmanns [email protected]

OECD Paper on Transactional ProfitMethods: Discussion Draft

On 25 January 2008 OECD published a series of draftIssues Notes (www.oecd.org/dataoecd/18/48/39915180.pdf) for comment in relation to TransactionalProfit Methods (i.e., the transactional profit split andthe transactional net margin methods). Publiccomments are requested by April 30, 2008.

As part of its procedures for monitoring theimplementation of the 1995 Transfer PricingGuidelines, Working Party No. 6 of the OECDCommittee on Fiscal Affairs is examining theapplication of transactional profit methods. InFebruary 2006, the OECD released its first invitationto comment on issues in relation to profit methods andattracted many detailed responses from the public.

The current draft takes into account commentsreceived in 2006, builds further on experienceacquired by countries in applying transactional profitmethods since the adoption of the TP Guidelines in1995 and reviews the status of the profits methods asexceptions to the preference for traditional and CUPmethods. The potential change in the status of profitmethods would mean that they in practice will rankequal to CUPs and traditional transaction methods.OECD further provides additional draft guidance onhow profit methods are to be applied in practice.

The issues addressed in 2008 discussion draft arefollowing:

Status of transactional profit methods as last resortmethods

Use of more than one method (use of atransactional profit method in conjunction with atraditional transaction method, or sanity check)

Trends & Developments:

http://www.oecd.org/dataoecd/18/48/39915�180.pdf

http://www.oecd.org/dataoecd/18/48/39915�180.pdf


Access to the information needed to apply or review theapplication of a transactional profit method

Application of transactional profit methods and uniquecontributions

Application of the transactional net margin method:standard of comparability

Application of the transactional net margin method:selection and determination of the net profit marginindicator

Application of a transactional profit split method:determining the combined profit to be split

Transactional profit split method: reliability of a residualanalysis and a contribution analysis

Application of a transactional profit split method: how tosplit the combined profit

Other methods (use of internal pricing models, pricingmodels such as option pricing formula, use of adiscounted cash flow analysis, fair market valuationapproaches and other) and Global Formularyapportionment

Some Specific Comments regarding theDiscussion Paper

In supporting that change, the OECD has made severalimportant comments on a range of issues:

The application of a second method is valid as a sanitycheck to identify unusual outcomes or otherwise reviewthe use of a primary method and its applicationincluding comparability analysis in particular;

Access to information is critical for all transfer pricingmethods, which necessitates access to qualitativeinformation to be collected on the non-tested party(irrespective of whether the non-tested party is a foreignor domestic entity);

The lack of significant intangibles does not mean theTNMM is the only method to be used, since it ispossible that a party with unique contributions otherthan intangibles (e.g. unique functions, assets or risks)should be entitled to profits (and presumably losses)falling outside the typical ranges of a TNMM result;

The paper confirms the approach of excluding revenuesand costs not connected to the revenues and expensesof the comparable transactions, unless it is appropriateto aggregate transactions in accordance with theGuidelines.

In the calculation of a net profit margin, the Papersuggests exclusion of non-operating items, financialitems, and foreign exchange gains or losses wherethey are not related to the tested transactions.Other costs are treated on a case by case basisinclude depreciation and amortization, start-up andtermination costs

For financial activities however, the OECD notesthat where interest is trade interest – as well asother situations where the capital structure mayheavily influence prices, it will be generallyappropriate to consider the effect of interest whendetermining the net profit margin.

The application of different net margins (return onsales, assets, costs) is discussed in detailconcluding that the appropriate net profit marginshould be the one which is most relevant to thecircumstances of the case and where theavailability of information on uncontrolledtransactions enable a meaningful and reasonablyreliable comparison.



Annie Devoy [email protected]


Lucia Fedina [email protected]

Adam M Katz [email protected]

Geoffrey Morris [email protected]


Norbert Raschle [email protected]

Isabel Verlinden [email protected]


India: Supreme Court reaffirmspositionon taxability of BPO units

In a recent development, the Supreme Court in Indiarejected a review petition filed by the Revenueseeking to tax a portion of the global income of foreigncompanies, earned on account of their captive BPOunits in India.

Background

In July 2007, the Supreme (Apex) Court of India hadpronounced a landmark Ruling in the case of MorganStanley ('MS Co'), an investment bank incorporated inUSA. The Ruling dealt with whether Morgan Stanleyhad a Permanent Establishment (PE) in India as a

mailto:[email protected]




consequence of the back-office operations outsourced bythe US entity to its captive Business Process Outsourcing(BPO) unit in India ('MSAS'). The attendant question wasof profits attributable to such PE, on which, the SupremeCourt ruled that once Transfer Pricing to the Indian BPOunit adequately takes into account functions, assets andrisks of the PE, no further profits are attributable to the PE.

Specifically the Supreme Court held that MS Co. would nothave a Fixed place PE or Agency PE in India but wouldconstitute a Service PE since MS Co was responsible for thework of the employees deputed and the employees continueto be on the payroll of MS Co or they continue to have lien ontheir jobs with MS Co. It further held that Transactional NetMargin Method (‘TNMM’) was the appropriate method fordetermination of the arm's length price in respect of the backoffice support services provided by MSAS and ruled thatthough MSAS constituted a Service PE, it was remuneratedon an arm's length basis taking into account all risk takingfunctions of MSAS. Hence, nothing further would be left to beattributed to the PE.

Review Petition by the Indian Revenue

Subsequently, the Indian Revenue filed a review petitionwith the Supreme Court in October 2007, with a request toreconsider the above judgment. The outcome of such apetition was crucial as it would have a bearing on about110 captives operating in India that serve global parentcompanies. The Indian Revenue sought a revision on theruling as it felt that even an arm's length relationship(between MS Co and MSAS) cannot absolve a foreignentity from potential PE exposure. Further, this was basedon their view that such captives often function as costcentres and the only way to tax foreign entities would be aportion of their profits that could be traced to suchcaptives.

Typically once a review petition is moved, the Judgesreview the petition internally without a public hearing andnotices may be sent to initiate review process.

The Supreme Court finally dismissed such review petitionfiled by the Revenue. As a result, the earlier judgment ofthe Apex Court is final and the law on this issue is thussettled.


Dhaivat Anjaria [email protected] Kotwal [email protected]

HMRC’s New Approach to TransferPricing Work

Following a public consultation, in October 2007HMRC announced in the document "Making adifference: clarity and certainty" that it will implementthe introduction of a new approach to transfer pricingenquiries involving greater specialisation and teamwork, focus on issues of higher risk, action plans forenquiries, and active monitoring of progress.

The revenue authorities are launching a radically newtechnical specialism to support all of its units to deliverthe approach. HMRC's Transfer Pricing Specialistshave been appointed and additional training isprovided to enhance their specialist skills. HMRCplans for resolving transfer pricing enquiries within 18or 36 months, depending on the complexity, arelargely in place. From January 2008 a new internalgovernance process will address issues aroundconsistency of approach, allocation of resource to riskand wider departmental strategic objectives.



Annie Devoy [email protected]

David McDonald [email protected]

Andy Paton [email protected]


Mohamed Serokh [email protected]

Kevin Smith [email protected]




Introduction

Shyamala Vyravipillai is a manager inPwC's China/Hong Kong Transfer Pricingpractice, specialising in FinancialServices. The Chinese transfer pricingservices team is lead by Spencer Chong.It was voted "leading transfer pricing firm2006/07" by the International TaxReview. Our dedicated team isstrategically located in major cities across

China including Beijing, Tianjin, Shanghai, Guangzhou,Shenzhen, Dalian, Xian and the Hong Kong SAR andassists multinational businesses including financialservices firms with transfer pricing exposures andopportunities. Numerous multinational corporations arecurrently relying on us to guide them through thecomplexities of transfer pricing issues in China.

Country profile

Despite China's size, the abundance of its resources, andhaving about 20% of the world's population living within itsborders, for the last two centuries its role in the worldeconomy has been relatively small. However, China hasbeen the fastest growing nation for the past quarter of acentury with an average annual GDP growth rate above10%.

This drastic change in growth started approximately in1978 when the Chinese government reformed theeconomy from a centrally planned economy that waslargely closed to international trade, to a more marketoriented economy that has a rapidly growing private sectorand is a major player in the global economy. Thegovernment has allowed foreign investors to manufactureand sell a wide range of goods on the domestic market,eliminated time restrictions on the establishment of jointventures, allowed foreign partners to become chairs ofjoint venture boards, and authorised the establishment ofwholly foreign-owned enterprises. In addition preferentialtax treatment was granted to wholly foreign owned

enterprises and contractual ventures which invested inselected economic zones or in projects encouragedby the state, such as energy, communications andtransportation.

Many of the liberalisation policies have been part ofChina's accession to the World Trade Organisation("WTO"). China's effort to join the WTO began in 1986and was officially completed in November 2001. The15 years leading to WTO accession involvedremoving many barriers to trade such asimplementing a reformed foreign trade regime and areduction in tariffs. There were also many domesticreforms implemented to support trade, such asdevelopment of the legal system. China has viewedthe award of the 2008 Summer Olympics as anaffirmation of these economic reforms as well associal reforms made in the same period.

The removal of trade related investment measuresand hence the opening up of the China market hasled to foreign multinational nationals expanding theiroperations in China at an accelerating pace. Thistrend in liberalisation has prompted the Governmentto introduce new laws relating to tax, regulations, andadministrative measures in order to monitor andcontrol the foreign investment surge into China.

Introduction of new tax law

In order to entice foreign investment into China, thegovernment historically offered certain preferential taxtreatments for Foreign Investment Enterprises ("FIEs")and Foreign Enterprises (“FEs”). Despite thelegislated 33% corporate tax rate for FIEs in China,the government estimates that the average tax rate forFIEs and FEs was approximately 15% while forChinese Domestic Enterprises ("DEs") it was 25%.

On 16 March 2007 China's top legislature, theNational People's Congress (“NPC”), passed the longawaited China Corporate Income Tax Law (“CIT Law”)

Country focus: China

Shyamala Vyravipillai is a manager in PwC's China/Hong Kong Transfer Pricing practice, specialisingin Financial Services. The Chinese transfer pricing services team is lead by Spencer Chong. It wasvoted ‘leading transfer pricing firm 2006/07’ by the International Tax Review. Our dedicated team isstrategically located in major cities across China including Beijing, Tianjin, Shanghai, Guangzhou,Shenzhen, Dalian, Xian and the Hong Kong SAR and assists multinational businesses includingfinancial services firms with transfer pricing exposures and opportunities. Numerous multinationalcorporations are currently relying on us to guide them through the complexities of transfer pricingissues in China.


by dominant majority vote. This CIT reform is undoubtedlya significant milestone in China's tax history since theturnover tax reform in 1994.

This reform aims at establishing an income tax regime thatreflects a level playing field for DEs and FIEs. In addition,the Law provides for a fundamental change in China's taxincentive policy in shaping and directing the futuredevelopment of the country.

The biggest change under the new law involves therevision of the corporate income tax rate to 25%, althoughthere will be a 20% rate for small and thin profitcompanies and 15% for qualifying firms that are deemedto be developing high technology. The 25% rate will applyto DEs, FIEs and FEs.

Given the possible permutations of the tax benefits an FIEcould have enjoyed under the old tax regime, many FIEswill now face a higher tax burden. The Chinese authoritiesfelt that the 25% rate was still competitive for the region,and that interest in investing in China is robust enough notto suffer from the increase.

Like previous income tax laws, the CIT Law mainlyprovides a framework of general tax provisions. Importantdetails on the definition of numerous terms as well as theinterpretation and specific application of various provisionsare left to the Detailed Implementation Regulations (“DIR”)and supplementary tax circulars.

On 6 December 2007, the State Council approved the DIRto China's new CIT Law. The Ministry of Finance and theSAT prepared the final version of the DIR, which wasfinalised after rounds of consultations with localgovernments, central ministries, multinational companies,domestic groups, scholars and professional firms.

Specific transfer pricing implications

Legislation relevant to transfer pricing is mainly found inChapter 6 of the CIT Law titled 'Special Tax Adjustments'("Chapter 6"), which deals with tax avoidance and transferpricing issues. It contains enhanced legislation andregulations, including the introduction of new concepts tostrengthen tax avoidance and transfer pricingenforcement.

Below are the key concepts of Chapter 6 as they apply torelated party transactions:

Transfer pricing documentation

Special interest levy on tax adjustments

Anti-avoidance

Controlled foreign company ("CFC") rules

Thin capitalisation

Cost sharing arrangements

Advance pricing agreements

Transfer pricing documentation - tax filingrequirements

Chapter 6, the DIR and the set of administrativemeasures for transfer pricing documentation (to be

called “Documentation Requirements1”) provide the

legal framework for transfer pricing enforcement.Specifically, the transfer pricing regulations providethat with respect to transactions on and after 1January 2008, taxpayers must provide related partytransaction information to the tax authorities at thepoint of tax filing. In addition, taxpayers must submittransfer pricing documentation within 30 days uponrequest by the tax authorities when investigated.

It is important to note that the law is silent on thetransfer pricing documentation requirements fortransactions prior to 2008. However, given China’suncertain tax climate and increasing transfer pricingscrutiny, it is recommended that taxpayers should atthe very least have some form of adequate transferpricing documentation in place for related partytransactions prior to 2008.

Special interest levy on tax adjustments

One of the most significant practical impacts ofChapter 6 on transfer pricing is the imposition of aspecial interest levy on anti-avoidance taxadjustments made by the tax authorities. Before theCIT was introduced, there was no penalty for transferpricing adjustments made by the tax authorities,except for the tax on the adjustment itself. As such,there was limited incentive to comply until faced with atransfer pricing review or audit situation. Theimplementation of the special interest levy will nowsignificantly increase the financial cost associated withany anti-avoidance tax adjustments, including transferpricing tax adjustments.

The DIR clarifies that the interest levy shall comprisetwo parts:

(1) financing charge for the delayed tax payment; and

(2) an additional 5% penalty interest.

The interest levy is expected to act as a new deterrentto aggressive tax avoidance schemes.

1 Soon to be issued


It is also unknown at this time whether there may be someways to mitigate the penalty component of the specialinterest levy through 'good behaviour' on the part of thetaxpayer, for example, through the preparation ofappropriate contemporaneous transfer pricingdocumentation.

Anti-avoidance

The Legislation introduces a general anti-avoidance rulewhich formally authorises Chinese tax authorities to makean adjustment where the taxpayer enters into anarrangement 'without reasonable commercial purpose'.This is a strong signal of the tax authorities growingscrutiny on anti-avoidance schemes.

The key focus is on commercial reasonableness, whichcould be controversial. Since the onus of proof falls on thepart of taxpayers, it is imperative to justify any specialdeals with sound commercial grounds, and to compilesufficient documentation in case of enquiry and challengeby the tax authorities.

Controlled foreign company ("CFC") rules - aimedat DEs

Rules regarding CFCs were introduced to addresssituations where the profits of an enterprise that onecontrolled by a Chinese tax resident are not distributed ordistributed in a reduced amount without reasonablecommercial purposes. Chapter 6 empowers the taxauthority to deem such profits as the Chinese taxresident’s revenue and therefore subject to Chinesecorporate income tax.

Thin capitalisation

Chapter 6 contains a specific thin-capitalisation rule todisallow interest deductions on borrowings from relatedcompanies if the interest-bearing loans of the enterpriseexceed certain prescribed safe-harbour debt-equity ratios.The DIR provides definitions for debt and equity but theprescribed debt-equity ratio was intentionally left out to beaddressed by future circulars.

Cost sharing arrangements ("CSAs")

In the past, multinational companies were less willing toshare IP or services with Chinese subsidiaries for variousreasons – a key factor being that shared costs were non-deductible in the hands of the Chinese subsidiaries.Additionally, although there were a few reported casesand circulars providing the green light on CSAs, it seemedin practice that the acceptance of a CSA at the local taxbureau level was difficult. The new provision in Chapter 6formally introduces and provides the legal framework forCSAs, paving the way for China to attract more advanced

IP and sophisticated services from overseas whichshould benefit the whole country in long term.

Advance pricing agreements (“APAs”)

Finally, it should be noted that the Chinese taxauthorities have given enhanced legal status to APAswhich companies can potentially use to manageambiguity under the new tax regime. The first bilateralAPA between China and Korea was completed inNovember 2007, which was China’s third bilateralAPA after Japan and the United States. It is expectedthat APAs will grow in importance and be extended tomore complex transactions such as financingactivities.

The tax authority

The fiscal system in China is characterised by thesharing of tax revenues between the centralgovernment and local governments. The StateAdministration of Tax (“SAT”) is the highest taxauthority in China. The SAT is the ministry leveldepartment directly under the State Council, which isthe functional department in charge of the Staterevenue work. The SAT Headquarters exerts lineauthority over the SAT local offices at various levelsand together with local governments, guides the workof provincial, municipal and county tax bureaus (asshown below).

In general, the taxpayer must deal with a number ofquasi independent tax authorities, depending on thelocation of the taxpayer. These local authorities reportto the SAT, but in practice have much latitude in howthey carry on their enforcement activities.Furthermore, their levels of expertise and theirinterpretations of relevant fiscal law can vary whichpresents a challenging environment for tax planningfor multinationals.

Implication for the financial services industry

The business of foreign financial servicesorganisations in China is booming as the Chinesemiddle-class takes root, foreign investment in theindustry soars and China’s regulatory environment


governing the sector continues to open up under WTOrules.

According to a recent survey conducted byPricewaterhouseCoopers (May 2007), the majority of thebanks surveyed predict annual revenue growth rates of atleast 20% per annum for 2007. The optimism of theforeign banks going forward was very evident with 100%of the respondents predicting that in the next three years,their profits will be greater than at present, up from 85% in2005. Assets are expected to double by 2010 to overUS$100 billion.

In March 2007 the most important change taking place inthe financial services market in China, was the movetowards local incorporation of foreign banks. The impact ofthis move to incorporation is expected to have far-reaching implications for foreign banks, particularly in theareas of increased capital requirements, widersupervision, greater transparency and new productopportunities. The PricewaterhouseCoopers survey statesthat appropriately 20 to 30 banks will incorporate locally by2010. This enables banks to offer new retail products e.g.credit cards, investment products, mortgages and newwholesale products such as Renminbi denominatedinterest rate and currency swaps, structured products anddebt capital markets into the China market.

Given China’s accession to the World Trade Organisation,the trend of growth predicted for the financial servicesindustry in China and the fact that China’s tax authoritieshave been increasing their transfer pricing enforcement,we expect the Chinese tax authorities will graduallyexpand their transfer pricing enforcement into the financialservices sector as they learn from their overseascounterparts and become more sophisticated.

Although there have been no transfer pricing audits in thefinancial services sector to date, it is evident that theChina tax authorities have been adopting an increasinglyaggressive stance in protecting their tax base in face ofChina’s burgeoning foreign investment. This is evident inthe significant increase in the number of transfer pricingaudits and associated transfer pricing adjustments, whichprovide a clear indication of the China tax authority’sattitude towards transfer pricing enforcement.

Considering China’s dynamic liberalisation of itsbanking and financial services sector, and thetremendous growth opportunities now available,multinational companies may rank transfer pricing at alow priority. However with heavier transfer pricingpenalties such as the interest levy, impact of whichcould be substantial given China’s 10-year statute oflimitations, companies must now carefully assess theirtransfer pricing risks and ensure compliance to thenew transfer pricing requirements.


Spencer Chong [email protected]

Julian Hine [email protected]

Elis Tan [email protected]

Joseph Vu [email protected]

Shyamala Vyravipillai [email protected]


Jobst Wilmanns: ‘From my Perspective’

The FS industry is confronted with anincreasing requirement for thedetermination, organisation anddocumentation of transfer pricing. Thecrucial question internal transfer pricingspecialists are facing these days iswhether the definition and subsequentdefence of a uniform transfer pricingsystem is sustainable within theincreasingly dynamic market

developments. Bilateral coordinated transfer pricingsystems to ensure worldwide enforceability could be analternative but increase the risk to create internalcomparables.

The interpretation of articles 7 and 9 of the OECD ModelTax Treaty, both through the OECD itself andincorporation of these principles into the local legislations,has caused a complexity in determining a unique transferpricing approach. One example is that the OECDestablished the functionally separate enterprise approachwhich provides a framework for dealing with permanentestablishments. The implementation of the authorizedOECD approach on the attribution of profits to permanentestablishments requires the FS industry to focus on theidentification and application of the Key EntrepreneurialRisk-Taking (KERT) functions. From an industryperspective, it is difficult to clearly identify which part of theentity performs the KERT functions.

A second example is that each jurisdiction imposesspecific local regulations, divergence in theimplementation of profit oriented approaches, while theassociated documentation requirements increase thecomplexity of applying internationally consistentstandards. The application of these standards andprinciples requires comprehensive knowledge of thematter including in-depth knowledge of the value chainand the associated implications in order to define the

"Best Practices". To make this work, in-house taxdepartments need to posses necessary expertise andability to gather the relevant information real-time.

In addition to OECD, other factors driving the FSIndustry include the capital markets pressure which inturn requires an optimization of the transfer pricingsystems and cash-flow positions, the developments inother industries, the desire to streamline operationalprocesses and the outsourcing of complianceactivities, including for example aggregation oftransactions for documentation purposes, to achievecost-savings. As result, sometimes the economicrational for global restructurings may becomeoverruled by financial objectives (like minimization oftax burden or elevated cash-flow position), which maylead to significant tax risks if no sufficient attention isgiven to documentation and compliance with localregulatory requirements. Tax departments alonewould not be able to manage these factorsindependently; thereby, involvement and coordinationof multiple departments in different jurisdictions isnecessary. In practice, for example, "Task Forces" areformed to control and ensure that in each jurisdictiononly relevant information is provided during a taxaudit.

In response to these changes and developments,many countries are now considering how toimplement the authorized OECD approach to theattribution of profits to permanent establishments aswell as other international initiatives into locallegislation. Local governments and tax authoritieshave demonstrated their continuous focus on transferpricing through ongoing tax audits, creation ofdedicated resources and training of transfer pricingspecialists. In Germany, tax authorities hire more andmore economists, in contrast to the traditionalpreferences for lawyers, and assign them intospecialized industry clusters.

Comment & Analysis:


Moreover, there have been on-going issuances of newtransfer pricing rules, administrative principles and specificcourt rulings in various jurisdictions which increase the riskof double taxation. At the beginning of this year forinstance, Germany included specific rules on businessrestructurings into its legislation, whilst the OECD is onlyplanning to publish its own paper illustrating its position onthis topic by the end of 2008. As for the US, theimplementation of the recently introduced Service and FIN48 Regulations has led to a new transfer pricing trend. Inaddition, countries like China and India have made aninternationally coordinated transfer pricing system morecomplicate by applying non-OECD compliant definitions ofpermanent establishments (e.g. Services PEs) or therequirement of governmental contract approval. Giventhese differences in local interpretation and application, anincreasing acceptance of international binding arbitrationprocesses such as mandatory arbitration clauses, e.g. thenew protocols to the US-Germany or US-Belgium taxtreaties, or Advance Pricing Agreements (APAs), enablesthe companies to achieve a certain level of comfort withregards to the acceptance of their transfer pricingsystems.

In conclusion one can constitute that the ongoingdevelopment of international standards and initiativesrequires FS companies to carefully assess thefeasibility of a global transfer pricing system and uponits implementation constantly monitor its compliancewith new standards. This becomes even moreimportant with the tax authorities tending to assumethe existence of a permanent establishment in case ofinsufficiently planned and documented transfer pricingsystems. It is therefore, in the interest of everyindustry player to ensure that they posses thenecessary expertise to cope with this challenge andutilize the possibility of achieving a higher comfortlevel by using APAs or mutual agreement proceduresmore often.

For more information please contact:



Our 2008 global Masters Series for Financial Services Industry

Professionals will be held in:

April 2, 2008, Singapore;

May 15, 2008, New York, USA;

May 21, 2008, Amsterdam, Netherlands

Financial services transfer pricing specialists, togetherwith guest speakers, will guide the discussion around thecomplex and unique environment issues including adiscussion on the OECD final papers and ramifications ofthe November 2007 US Treasury Department Report toCongress around earnings stripping, transfer price and USincome tax treaties.

The focus will also lay on global experiences related toFIN 48, as well as inter-company lending, guarantees andthin cap and many other hot topics.


April 2, 2008, Singapore:

Paul Lau [email protected]

Shyamala Vyravipillai [email protected]

May 15, 2008, New York:

Adam Katz [email protected]

May 21, 2008, Amsterdam:

Michel van der Breggen [email protected]

Hugo Vollebregt [email protected]

Hungary & Switzerland

2nd Treasury Breakfast, Zurich, Switzerland

April 2, 2008: Topic: Managing FX Risk -Policies, Tax, Transfer Pricing



FSTP Breakfast Briefing Meeting, Zurich,Switzerland

May 29, 2008: Topic: US Transfer PricingUpdate



Transfer Pricing Financial Services for NonFinancial Institutions, Budapest, Hungary29 February, 2008

Topic: Key practical issues with regards todocumenting related party debt from a HungarianTransfer Pricing perspective as well as using TransferPricing techniques for planning future related partytransactions.


Zaid Sethi [email protected]

Future Events:

Global Transfer PricingMasters Series for FinancialServices Professionals*

*connectedthinking






As part of a dedicated series written by PwC financialservices tax and transfer pricing practitioners for theTransfer Pricing Report the following articles have beenpublished recently:

The Agency PE Conundrum

Authors: Richard Collier, Sanjay Tolia and PrashantBohra

Publication: Tax Management Transfer Pricing Report,Date of Publication: October 18, 2007

This article discusses the key issues of the Agency Ethreshold as well as the recent OECD developments n thesubject of profit attribution to PEs and how they apply toAgency PEs.

Financial Services Transfer Pricing, Specialcompilation for 61st congress of IFS in Kyoto

Publication: BNA Tax Management Transfer PricingReport, Special Report, Date of Publication: September25, 2007

Hedge Funds - Fringe No More. The Tax ManCometh...

Authors: Aamer Rafiq, David McDonald, Lirize Loots,Mimi Wang, Adam M. Katz, Frank Douglass, Mac Calva,Irina Diakonova, Ryann Thomas, Florence Yip, MarianaEast and Paul Lau

Publication: Tax Management Transfer Pricing Report,Date of Publication: September, 2007

Does Debt Matter? The Transfer PricingPerspective

Authors: Michel van der Breggen, Barry Dennis, IrinaDiakonova, Aamer Rafiq, Jeff Rogers, Mohamed Serokhand Bill Yohana

Publication: Tax Management Transfer PricingReport, Date of Publication: July 11, 2007

Recent litigation on guarantee fees between Canadaand two financial institutions—General Electric andHSBC—and a recent case on interest rates inSweden highlight that nations are becoming moreinterested in assessing whether intercompanyfinancial transactions are at arm’s-length prices.Practitioners from PricewatershouseCoopers’ officesin Amsterdam, Calgary, London, Melbourne, NewYork, and Zurich provide an overview of the issuesarising as companies and governments estimate thepricing of these transactions, with a focus onintercompany debt.

BPO units in India: Recent Supreme CourtRuling in the Case of Morgan Stanley on PEand Profit Attribution

Authors: Rahul Krishna Mitra and Sanjay Tolia

Publication: BNA’s Tax Planning InternationalReview, Date of Publication: July, 2007

Rahul Krishna Mitra and Sanjay Tolia, PwC India,analysed the Supreme Court of India’s ruling in thecase of creation of PE and allocation of income of thebusiness process outsourcing (“BPO”) of a globalbank. As India is an established outsourcing hub forinformation technology, research & developmentsservices and back-office functions in the financialservices industry, these recent developments help toclarify the grounds and implications for PE and profitattribution issues.

Recent FSTP Publications


Financial Services and Transfer Pricing in Italy:

Authors: Fabrizio Acerbis, Alessandro Caridi

Publication: Tax Management Transfer Pricing Report,Date of Publication: May 16, 2007

Fabrizio Acerbis and Alessandro Caridi ofPricewaterhouseCoopers in Milan review the recentincrease in Italian transfer pricing audit activities in thefinancial services industry—a trend they say is likely tocontinue as use of derivatives, complex financialtransactions, and the lack of transparency compel furthermonitoring of the capital market and the financial sector.

Financial Institutions - Profit Split's New Frontier

Authors: Lucia Fedina, Adam Katz and Stan Hales

Publication: Tax Management Transfer Pricing Report,Date of Publication: May 2, 2007

Lucia Fedina and Adam Katz of PricewaterhouseCoopersLLP in New York and Stan Hales of the firm’s SanFrancisco office examine tax authorities’ increasing use ofthe profit split method for financial institutions.

Financial Services Transfer Pricing Trends andDevelopments

Authors: Aamer Rafiq, Annie Devoy, Adam M. Katz, IrinaDiakonova, Ryann Thomas and Ana Carolina Albero

Publication: Tax Management Transfer Pricing Report,Date of Publication: April 18, 2007

Practitioners from PricewaterhouseCoopers’ offices inNew York, London, Zurich, and Tokyo examine draftreports released in December by the Organization forEconomic Cooperation and Development on theattribution of profits to permanent establishments, whichthey say highlight the unique nature of the transfer pricingissues faced by financial services organizations.

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Europe FSTP Country Leaders Email Phone numberAustria Herbert Greinecker [email protected] +43 1 50 188 3300

Belgium Patrick Boone [email protected] +32 2 710 4366

Denmark Jorgen Andersen [email protected] +45 3 945 9434

Finland Jukka Karjalainen [email protected] +358 9 2280 1792

France Marie-Laure Hublot [email protected] +33 1 5657 4351

Germany Jobst Wilmanns [email protected] +49 69 9585 5835

Hungary Zaid Sethi [email protected] +36 1 461 9289

Iceland Elin Arnadottir [email protected] +354 (0) 550 5322

Ireland Gavan Ryle [email protected] +353 1 704 8704

Italy Fabrizio Acerbis [email protected] +3902 91605 001

Luxembourg David Roach [email protected] +352 49 4848 3057

Netherlands Michel van der Breggen [email protected] +31 20 568 6160

Hugo Vollebregt [email protected] +31 20 568 66 32

Norway Morten Beck [email protected] +47 9 526 0650

Poland Piotr Wiewiorka [email protected] +48 2 2523 4645

Portugal Carlos Bernarde [email protected] +351 2 1791 4202

Russia Christian Ziegler [email protected] +7 49 5232 5461

Spain Javier Gonzalez Carcedo [email protected] +34 91 568 4542

Sweden Pär Magnus Wiséen [email protected] +46 8 5553 3295

Switzerland Irina Diakonova [email protected] +41 58 792 4210

South Africa Jacques van Rhyn [email protected] +27 11 797 5340

Aamer Rafiq [email protected] +44 20 7212 8830

Annie Devoy [email protected] +44 20 7212 5572

United Kingdom

Lisa Casley [email protected] +44 20 7213 8333

Asia Pacific FSTP Country Leaders Email Phone numberAustralia Nick Houseman [email protected] +61 2 8266 4647

China Cassie Wong [email protected] +86 10 6561 2233, ext. 7823

Hong Kong Florence Yip [email protected] +85 22 289 1833

India Dhaivat Anjaria [email protected] +91 22 6669 1471

Japan Teruyuki Takahashi [email protected] +81 3 5251 2873

Korea Shin-Jong Kang [email protected] +82 2 709 0578

Malaysia ThanneermalaiSomasundaram

[email protected] +60 3 2693 1077, ext. 1852

New Zealand Michael J Bignell [email protected] +64 9 355 8051

Singapore Paul Lau [email protected] +65 6236 3733

Taiwan Richard Watanabe [email protected] +88 62 2729 6666, ext. 6704

Americas FSTP Country Leaders Email Phone numberArgentina Juan Carlos Ferreiro [email protected] +54 11 4850 6712

Brazil Marcos Almeida [email protected] +55 11 3674 3350

Canada Brenda Humphreys [email protected] +1 416 814 5765

Chile Roberto Carlos Rivas [email protected] +56 2 940 0151

Colombia Carlos Mario Lafaurie Escorce [email protected] +57 1 634 0492

Mexico Jaime Heredia [email protected] +52 55 5263 5721

Peru Rudolf Röder [email protected] +51 1 211 6500, ext. 1906

Adam Katz [email protected] +1 646 471 3215

Barry Dennis [email protected] +1 646 471 3390

Joseph Andrus [email protected] +1 617 530 5455

Stan Hales [email protected] +1 415 498 6086

United States

Junko Yamato [email protected] +1 646 471 1432

Venezuela Fernando Miranda [email protected] +58 212 700 6123

Financial Services Transfer Pricing Perspectives December 2007 — JanuarPricewaterhouseCoopers LLP

MC-NY-08-0575A © 2008 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP (a Delawarelimited liability partnership) or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is aseparate and independent legal entity.

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FTSP Perspectives February 2008 - PwC · 2015-06-03 · insurance sector there is not the same level or intensity of post -risk assumption management of risk as there is in the banking