Department of Law
Spring Term 2020
Master Programme in International Tax Law and EU Tax Law
Master’s Thesis 15 ECTS
Transfer Pricing of Internal Banks
In the Light of Fiat State aid Case and Transfer Pricing Guidelines on
Financial Transactions
Author: Dusan Arsenovic
Supervisor: Katia Cejie
1
Table of contents
Abbreviations ... 2 1 Introduction... 3 1.1 Issue ... 3 1.2 Objective ... 4 1.3 Delimitations ... 41.4 Methodology and Materials... 5
1.5 Outline ... 8
2 FFT: Transfer pricing methodology and State aid ... 9
2.1 Background ... 9 2.1.1 Transactions ... 10 2.1.2 Functions ... 10 2.1.3 Risks ... 11 2.1.4 Assets ... 12 2.1.5 Method ... 12
2.2 EC Decision on State aid ... 15
2.2.1 Introduction ... 15
2.2.2 Requisites for State aid ... 15
2.2.3 TNMM vs CUP ... 17
2.2.4 The ‘correct’ application of TNMM ... 18
2.2.5 EC Conclusion ... 20
2.3 Recent development and criticism ... 20
2.3.1 Introduction ... 20
2.3.2 General Court Judgement... 21
2.3.3 TP Method Application Issues ... 24
3 Functional analysis for internal banks ... 26
3.1 Introduction ... 26
3.2 “Treasury functions” ... 27
3.3 Intra-group loans ... 28
3.3.1 Accurate delineation of a loan ... 28
3.3.2 Assumption and control of risks ... 32
2
Abbreviations
APA Advanced Pricing Agreement ALP Arm’s Length Principle
BEPS Base Erosion and Profit Shifting CAPM Capital Asset Pricing Model CUP Comparable Uncontrolled Price
ECJ Court of Justice of the European Union EC European Commission
EU European Union FF Fiat Finance S.p.A. FFC Fiat Finance Canada Ltd.
FFNA Fiat Finance North America Inc. FFT Fiat Finance and Trade Ltd.
OECD Organization for Economic Co-operation and Development
TNMM Transactional Net Margin Method TP Guidelines OECD Transfer Pricing Guidelines TP Transfer Pricing
3
1 Introduction
1.1 Issue
Decision of the European Commission (EC) from 2016 and the judgment of the General Court of the ECJ from 2019, which confirmed it in the Fiat Luxembourg State aid case, has sparked controversy and academic interest by its many far-reaching implications. Most writings dealing with this topic come from the State aid perspective and bring into question the elements of the rulings that are important for this legal field, for example, the determination of the reference system for establishing whether an illegal advantage was granted. On the other hand, commentators, which are more interested in the tax aspects of Fiat, focus predominantly on the future of the advanced pricing agreements (APAs) and whether EC is creating an EU arm’s length principle (ALP) that infringes sovereignty of Member States.
In the extensive literature on Fiat and other recent EC State aid cases there seems to be a gap in developing transfer pricing matters more deeply. Although all of the previously mentioned legal points are very significant, the Fiat case in business practice boils down to correctly determining prices and profit level of an internal bank in line with the arm’s length principle. EC has dedicated most of its decision to transfer pricing methodology, but research on whether it was applied in the most suitable manner has been shadowed by the discussion on whether Transfer pricing (TP) Guidelines can be applied at all.
Transfer pricing of internal banks has recently been given a new dimension. The long-awaited clarifications on how to price financial transactions have been published by the OECD on 11th of February 2020 as the Transfer Pricing
4 Guidelines on Financial Transactions, which will be added as Chapter X to the 2017 version of the Guidelines.1 This novelty awaits academic inquiry.
1.2 Objective
Considering that transfer pricing of internal banks is a highly relevant area of interest for companies and tax advisors, the purpose of this thesis is providing useful insight into how it should be conducted to comply with both Fiat case and the latest edition of TP Guidelines. In this sense, the thesis is not about Fiat per se but it will rather use the factual and legal circumstances of Fiat to analyze how similar situations should be handled in the light of the Guidelines, with regards to the existing doctrine of the EC and the General Court. To achieve this aim, two main questions will be answered. The first is what can be learned from the Fiat case for applying transfer pricing methods, which are at the heart of EC and General Court’s rulings, to internal banks’ transactions in order to defend them in the face of State aid scrutiny. The second will return with some guidance on how to conduct a functional analysis with the emphasis on risk, which is lacking in the aforementioned decisions, but is the central for reaching an arm’s length outcome.
1.3 Delimitations
Although other State aid cases in which APAs were questioned are interesting and connected with Fiat, they are only briefly touched upon when necessary for the sake of argumentation. On the other hand, functional analysis conducted for a transfer pricing issue of this complexity and in the light of the extended TP Guidelines could easily go on for a hundred pages; therefore, it is reasonably simplified by highlighting only the crucial points. Further demarcation of the subject matter is clearly stated in the introductory paragraphs of relevant
5 subsections. Finally, as was mentioned, since the existing literature has dealt extensively with State aid implications and tax issues such as legality of an EU ALP, this thesis will present and evaluate work in these areas in a summarized way to provide a holistic grasp of the matter.
1.4 Methodology and Materials
The method used in this thesis is the legal dogmatic method. This traditional method consists in applying legal reasoning within a specialist analysis carried out in a specified area of law.2 The legal dogmatic perspective for this topic
therefore necessitates the interpretation and evaluation of what is given in the Fiat rulings and TP Guidelines, without excessive digressions on policy aspects and de lege ferenda.
The fundamental methodological issue of this thesis concerns the legal value of the Transfer Pricing Guidelines. The matter of contention can be further broken into three debatable points.
The OECD Transfer Pricing Guidelines are a non-binding instrument. This is suggested not only by their self-identification as “guidelines”, but also in their content.3 What is more, they are drafted in such a way that is not suitable for
compulsory application, since they do not provide solutions to TP issues, but rather a working framework for their analysis.4 Therefore, from a theoretical
perspective, their legal status as soft law can be equated with the OECD Model Commentary from which they originate as assistance in interpretation of the arm’s length principle from OECD Model Tax Convention’s Article 9.
2 Jerzy Stelmach and Brożek Bartosz, Methods of Legal Reasoning, vol 78 (Springer 2006) 9.
3 Krzysztof Lasiński-Sulecki, 'OECD Guidelines: between Soft-Law and Hard-Law in Transfer Pricing
Matters' (2014) 17/1 Comparative Law Review 68.
6 However, in spite of not being formally binding, TP Guidelines are widely used by taxpayers, tax authorities and courts in practice.5 This has proven to be true
in the Fiat case as well, considering that the EC referred to the OECD TP framework and the General Court affirmed this approach. The reasoning behind the “hardening” of TP Guidelines’ soft law is best elucidated by the EC stating that Guidelines are the result of expert discussions which develop techniques aimed to address common challenges in international taxation. In this way, they are currently the finest expression of international consensus on transfer pricing.6 Although authority of OECD’s experts and their commonplace usage
establish the Guidelines as almost-binding internationally agreed principles, this development is problematic for upholding the principle of legality in tax law. Secondly, even if the TP Guidelines are in general considered as internationally agreed principles, there are significant differences between individual countries on how they view their content, application and interpretation.7 Disparities are
present between OECD and non-OECD member countries, which is significant in the EU context where not all EU members are at the same time a part of the OECD, but also between OECD members as well. This results in a heterogeneous interpretation on national levels. The EC tried to avoid this perplexity by declaring that it applies the ALP inherent in EU State aid rule from Article 107 TFEU, even if the principle is not incorporated in domestic law.8
The employment of OECD’s benchmark in this process was only “a tool”. In all but name, TP Guidelines are used to respond to new EU State aid challenges, but this legitimately raises sovereignty concerns among Member States.
5 ibid.
6 Commission Decision of 21 October 2015 on State aid SA.38375 (2014/C ex 2014/NN) which
Luxembourg granted to Fiat, (C-2015) 7152 final (EC Decision) para 87.
7 Monsenego, Introduction to Transfer Pricing (n 4) 33-34. 8 EC decision para 228.
7 Finally, a key practical regard for TP Guidelines in this context is the dilemma of static versus ambulatory application. Since OECD materials are often being updated, there is an open discussion on which version of these materials should be applied on situations taking place before their publishing date. For the OECD Model Commentary, there is no consensus on this matter.9 The debate goes on
in a similar undecided fashion for the TP Guidelines, although there are some suggestions on how to approach this question: whether the domestic law refers to the OECD Guidelines (sometimes a specific version10) or not, whether they
are based on the same principles and whether the segment to be applied is a clarification or a new concept.11 In contrast to the academic polemic, the
General Court has promulgated a clear restriction on retroactivity in State aid investigations12, but since it did not explicitly express this view on TP
Guidelines, issues such as whether to apply “clarifications” are still relevant, especially as the ECJ is the instance that will have the final word.
As for the materials used, the analysis in the thesis is mostly based on primary sources such as the EC and General Court’s rulings and the TP Guidelines (2017 and 2020 editions). Here it is important to emphasize that the Fiat case is analyzed only from the viewpoint of the TP Guidelines 2010 version, which was applicable at the time when the APA was concluded, but the version from 2017 is referenced in the thesis. Since there were no significant differences in content between the two versions for the segments that were used in the thesis, the latter is put to work for practical reasons.
9 Katia Cejie, 'The Commentaries on the OECD Model as a Mechanism for Interpretation with
Reference to the Swedish Perspective' (2017) 71/12 Bulletin for International Taxation 667.
10 For example: Australia, Austria, Ireland and the UK. OECD Transfer Pricing Country Profiles,
http://www.oecd.org/tax/transfer-pricing/transfer-pricing-country-profiles.htm. (accessed 27.4.2020)
11 Johan Hagelin, 'Retroactive Application of the OECD Transfer Pricing Guidelines for Interpretation
in Transfer Pricing Issues' (2018) 25/6 Intl. Transfer Pricing J. 406.
12 Judgment of the General Court in cases T-760/15 (Netherlands v. Commission) and T-636/16
8 Additionally, several articles and books are used to support the reasoning, although there are still (at the time of writing) no relevant publications dealing with the latest TP Guidelines on Financial Transactions. The most impactful articles between equals were: 1) “The Recent Decisions of the European Commission on Fiscal State aid: An Analysis from a Transfer Pricing Perspective” by Miladinovic and Petruzzi, which pointed at the functional analysis as a weak point in the EC’s decision, 2) “European Commission Decision on Fiat: State aid Case Explained” by Rasch and Wroblewski, which presented the essentials of the case with utmost clarity, and 3) Is Fiat’s Tank Half-Full or Half Empty? The General Court’s Decision in Luxembourg v. Commission (T-755/15)” by Lazarov and Buriak, the most transfer pricing related and up-to-date article. All of the other publications, together with the most relevant works which are not referenced directly in the text, but have contributed to the comprehension of the topic and might be useful for the reader, are listed in the Bibliography.
1.5 Outline
Apart from the introduction and the concluding section, the thesis is comprised of two main chapters. This division is envisaged by the logic of the transfer pricing process and its two steps: comparability analysis and application of the selected method. In the paper, their order is reversed, with the aim of introducing the Fiat case which deals mostly with methodological issues first. Chapter 2 on Fiat is further developed into three segments: Background, introducing the reader to the legal and factual situation of the case, followed by the analysis of the transfer pricing aspects of the EC’s decision on State aid, and concluding with the Recent development, represented in the General Court’s judgment, and criticism in the form of a meta-analysis of the objections raised to both rulings, primarily on methodological and TP issues. Chapter 3, preceding the conclusion, provides a functional analysis based on Fiat’s circumstances,
9 relevant for internal banks, from the perspective of the newest TP Guidelines on Financial Transactions from 2020. In focus are intra-group loans, as the predominant transactions, and risk functions, the centerpiece of every comparability analysis. The final segment integrates all of the conclusions from the thesis into a (hopefully) useful piece of advice on how to set transfer prices for internal banks in the EU.
2 FFT: Transfer pricing methodology and State aid
2.1 Background
Fiat Finance and Trade Ltd. (FFT) is a finance company registered in Luxembourg. As suggested by its legal name, the company is a part of the Fiat multinational corporate group active primarily in the automobile industry. Fiat S.p.A, the Italian leader of the group, has full control over FFT by holding 40% of its shares directly and 60% through yet another subsidiary Fiat Finance S.p.A. (FF) incorporated in Italy. In its turn, FFT also has control over fully (100%) owned companies Fiat Finance North America Inc. (FFNA) and Fiat Finance Canada Ltd. (FFC).13
FFT is designated the role of an internal bank for the group entities located in Europe, with the exception of Italy. It provides Fiat entities with treasury and financial services, as well as cash pooling. FFT’s operations are run from the head office in Luxembourg, as well as two branches – one based in the United Kingdom and the other in Spain.14
In September 2012, FFT obtained an APA from the Luxembourg tax authorities regulating its transfer pricing position for the following 5-year period. The APA was essentially an endorsement of a transfer pricing report proposed by FFT’s tax advisors on how to correctly allocate profits for its cross-border activity. The
13 EC Decision para 110. 14 ibid paras 34-39.
10 report was based on the application of Transfer Pricing Guidelines, which are the most relevant, albeit not binding, tool in the area of transfer pricing. In line with the Guidelines, the process of reaching an arm’s length outcome requires first a comparability analysis of cross-border transactions, with an emphasis on the functions, assets and risks, and followed by the application of the most suitable transfer pricing method.
2.1.1 Transactions
Transactions relevant for the transfer pricing analysis, which FFT was a part of, can be divided in two categories based on the status of the other party. In the first category of (Intra-Sector) transactions, FFT was dealing with treasury companies of the Fiat group, and in the second (Intra-Group) with entities other than internal banks.
The main categories can further be broken down into transactions that constitute them. For Intra-Sector, those transactions are intercompany loans from FFT to FF, as well as loans from FFNA to FFT. Similarly, the Intra-Group category is also mostly composed of loans which FFT grants the European Fiat companies, but also deposits and other services closely related to financing which it supplies them with. In addition, FFT is provided guarantees for its bonds and other financial instruments (such as credit lines) by the group leader Fiat S.p.A.15
2.1.2 Functions
The functions FFT performs which were put forward by their tax advisors are: 1. Market funding and liquidity investments
FFT raises funds, mostly from the market and in a lesser extent from related entities, to make them available for Fiat group members.
11 2. Relations with financial (third-party) market actors
FFT provides information to support the group’s credit-worthiness. 3. Financial coordination and consultancy
FFT is responsible for examining financial needs and identifying the best solutions for the group companies, as well as setting up financial contracts and monitoring performance of their financial products.
4. Cash pooling
The cash flows, funding requirements and liquidity of the group is monitored by FFT to optimize the management efficiency of the group's capital resources. 5. Provision of short and medium term loans
6. Coordination with other treasury companies.16
2.1.3 Risks
The main risks FFT is exposed to as outlined in the APA are: 1. Market risk
FFT bears the market risk ingrained in the interest rate and foreign exchange rate movements. However, these risks are hedged by derivative financial instruments (such as currency and interest rate swaps) in accordance with the Fiat group risk management policies.
2. Credit and counterparty risk
The risk of default of the FFT’s external borrowers is (allegedly) mitigated by dealing only with major financial institutions and diversified allocation of cash. Without further justification, the report also states that group assets are not
12 exposed to this risk, since the group has interest to financially support all members so there would be no singular insolvency cases over time.
3. Operational risk
Financial operations are performed in line with Fiat S.p.A. guidelines and procedures and are being constantly monitored and controlled to avoid failures.17
2.1.4 Assets
FFT is in charge of managing significant financial assets. These assets relate to intercompany loans, account receivables from group companies and, to a minor degree, bank deposits. In its day-to-day operations, FFT uses IT systems.18
2.1.5 Method
As a result of the comparability analysis, the method that was chosen as the most appropriate for determining an arm’s length outcome for FFT’s group activity was the Transactional Net Margin Method (TNMM). TNMM is designed to reach ALP through the examination of the net profit in relation to a chosen base (costs, sales, assets) which a taxpayer realizes from controlled transactions. This method is a one sided method and it is particularly appropriate in relations where only one party makes unique and valuable contributions. In that case, the tested party will be the party that does not make such a contribution, the less complex one.19
Since FFT was considered less complex, not making a unique contribution or owning intellectual property, it was selected as the tested party. In order to make a comparison, external comparables where used. Internal comparables where
17 ibid para 50. 18 ibid para 51.
13 not available due to the claim that FFT is the only entity providing financial services of this kind to the Fiat group companies.20 The chosen net profit
indicator was the return on capital.
The outstanding remuneration for FFT was calculated through four steps: 1. Estimate of ‘capital at risk’
Taking as a starting point the fact that FFT functions as an internal bank for the group, the minimal capital required to cover the risks to which it is exposed was calculated by applying the Basel II framework. Basel II is an accord which prescribes the adequate amount of capital for mitigation of financial and operational risks in banks.21 Using this instrument by analogy, since it does not
apply to internal banks in practice, tax advisors calculated the hypothetical regulatory capital for FFT to be 28.5 million euros.22
2. Identification of capital used to perform functions
In this step, from the total equity of FFT amounting to 287.5 million euros in 2011, two significant amounts where deducted to calculate equity used to perform functions. The first deduction – 28.5 million – is the previously calculated minimum equity at risk and the second – 165.2 million – is used to offset participation interests in FFT’s branches FFNA and FFC. This leaves 93.7 million euros as the equity backing the functions performed.23
3. Estimate of expected remuneration by Capital Asset Pricing Model (CAPM)
20 EC Decision para 55.
21 Basel Committee on Banking Supervision, Basel II: International Convergence of Capital
Measurement and Capital Standards: a Revised Framework (2005), <https://www.bis.org/publ/bcbs118.htm> accessed 17 April 2020.
22 EC Decision paras 58-59. 23 ibid paras 60-61.
14 The remuneration for FFT’s hypothetical regulatory capital was estimated by a return on equity investors would expect to receive (‘Expected Return Pre-Tax’). This is commonly performed using the CAPM with the formula:
Expected Return Pre-Tax = (Risk-Free Rate + β × Equity Risk Premium)/(1-tax rate)
The beta value in this formula represents the market risk that cannot be diversified. This value was reached through a comparability study of 66 entities that were selected by the tax advisors as independent companies active in the financial sector comparable to FFT. The study resulted in an arm’s length range of betas. In this range, the 25th percentile value was selected considering that
FFT bears low risk.24
Beside the minimum capital from step 1, the equity backing the functions performed estimated in step 2 was also remunerated. For this purpose, market interest rate for short-term deposits was applied.25
Finally, the equity FFT had in its branches FFNA and FFC was not remunerated at all for purpose of taxation. The explanation why the largest portion of equity was not remunerated was found in the fact that this equity is supposed to be redeemed by dividends.26
4. Calculation of overall profitability left to FFT to remunerate risks born and functions performed
Resulting from the conclusions of steps 1 to 3 the final remuneration is calculated as a sum of a ‘risk remuneration’ calculated on the hypothetical regulatory capital and a ‘functions remuneration’ on the capital used to perform the functions. The estimated taxable base was 2.542 million and this is the
24 ibid paras 63-67. 25 ibid para 68. 26 ibid paras 69, 134.
15 amount which the Luxembourg tax authorities accepted through the APA and on which corporate income tax in Luxembourg was charged.27
2.2 EC Decision on State aid
2.2.1 Introduction
The investigation and subsequent decision of EC in the Fiat case was a result of two important factors. Firstly, the LuxLeaks scandal exposed Luxembourg for issuing hundreds of questionable tax rulings in 2014, among others the APA for FFT.28 Secondly, the Commission has been very active in the field of State aid
provided through fiscal measures in recent years and seems that this trend will continue in the future. For this reason, multinational companies are advised to preventively apply the guidance from the recent cases in order to mitigate substantial reputational and financial blows. In that sense, the lesson that might be learned from FFT is significant.
2.2.2 Requisites for State aid
The prohibition of incompatible State aid is found in Article 107(1) of the TFEU. In accordance with the wording of this provision and settled case-law, a measure of any kind, even fiscal, introduced by a Member State will constitute State aid if it fulfills four requisites.29 The APA which Luxembourg provided
FFT with was tested on this basis:
1. An intervention of the State or through State resources
In the Fiat case, the EC found that there was both an intervention of Luxembourg by accepting the transfer pricing analysis through the APA and that it was (indirectly) financed by public resources. Since the Commission
27 ibid paras 70-72.
28 European Parliament resolution of 25 November 2015 on tax rulings and other measures similar in
nature or effect (2015/2066 (INI)) A.
16 considered that the APA endorses artificial and complex methods to lower FFT’s taxable profit, this lead to a reduction of state revenue.30
2. Liable to affect trade between Member States and
3. Distorts or threatens to distort competition in the single market
With regards to the fact that FFT is a part of a group which operates in most Member States, EC plainly concluded that the aid Luxembourg provided could interfere with intra-EU trade and strengthen the position of the group at the expense of fair competition.31
4. Confers a selective advantage on an undertaking
The most querulous condition for existence of State aid, but also the most significant for transfer pricing purposes, is whether the APA actually provides FFT with an advantage and how this benefit is achieved. This requisite is tested by investigating its three components:
1) Establishing the reference system
The general Luxembourg corporate income tax system was established as a reference since it imposes tax on companies regardless of their affiliation to a group, thus putting integrated and stand-alone entities in a comparable legal and factual situation.32
2) Confirming that the measure deviates from the reference system
This is the central question of the EC decision in which TP matters are discussed and it will be analyzed in the remaining section of this chapter.
30 EC Decision paras 187-188. 31 ibid paras 189-190.
17 3) If there is a deviation, checking whether it is consistent with the logic of the system
The EC did not identify any justification for the preferential treatment FFT received through the APA.33
2.2.3 TNMM vs CUP
In the process of testing whether the APA deviates from the Luxembourg corporate income tax system, the EC focused primarily on the transfer pricing method and how it was applied in the ruling. For the determination of whether methodology of the APA was sound, TP Guidelines where used as a “tool”. As for the selection of the method, TNMM was questioned in the Opening Decision. EC has in several other cases expressed its preference for the use of Comparable Uncontrolled Price (CUP) method as more direct and more reliable for an approximation of a market-based outcome.34 The inclination towards
CUP instead of TNMM was presented especially in the light that this method is recommended by the TP Guidelines as the most suitable for loans, which are significantly represented among transactions performed by FFT. The Commission even suggested a possible internal comparable embodied in Chrysler, the US Company of the FIAT group.35
However, in the final decision, the EC changed its stance. TNMM was accepted as an appropriate method for the situation at hand after arguments put forward in the investigation procedure. The defendant’s claim was that all the loans and bonds issued by FFT vary significantly in their qualities such as rates, form and maturity. Consequently, the CUP method would require finding comparables for each individual instrument. In this light, TNMM is more suitable for an
33 ibid para 338.
34 M. Rasch, P. Wroblewski, ʹEuropean Commission Decision on Fiat: State Aid Case Explainedʹ
(2016) 23/6 Intl. Transfer Pricing J. 438.
18 estimation of an arm’s length remuneration for the functions performed and risks born by FFT. Moreover, EC recognized the return on capital as an acceptable performance indicator, since FFT is comparable to financial institutions for which return of capital is regularly used in TP analysis.36
The acceptance of TNMM by the EC (and subsequently the General Court) is a significant development in its doctrine on State aid and Transfer pricing. Although TP Guidelines do not have a hierarchy between different methods for applying ALP, the EC has consistently favored CUP in other State aid decisions. Giving a green light on TNMM in FFT, the Commission has aligned itself further with the Guidelines thus providing more certainty for companies which are extensively using this method for their complex transactions. In addition, for the transfer pricing of internal banks, the recognition of their position as comparable to regulated financial institutions, indicates a route for conducting the TP comparability analysis without triggering State aid repercussions. 2.2.4 The ‘correct’ application of TNMM
Despite the recognition of TNMM as an appropriate method for the TP analysis of internal banks such as FFT, the actual application of the method was scrutinized in great detail by the EC. The establishment of deviation from the system was not based on the selection of the method, but rather on parameters, adjustments and methodology that were used inconsistently and without reasonable explanations.
1. Parameters: Amount of capital
Although FFT as an internal bank is in a comparable position to regulated financial institutions, it is still not one of those entities to which the Basel II framework applies. Therefore, the calculation of its hypothetical regulatory capital by analogy is considered inconsistent with the chosen method.
19 Furthermore, even for regulated entities, the return on minimal regulatory capital is not a common performance indicator. This translates into the lack of market data for comparing such a parameter.
The EC concluded that the choice of applying TNMM by return on equity, estimated through CAPM, necessitated the use of FFT’s accounting equity as the profit indicator.37 This requirement has significant consequences
considering that FFT’s accounting equity (287.5 million) is ten times greater than the hypothetical regulatory capital used in the APA (28.5 million).
2. Adjustments: FFNA and FFC
The remunerated capital base of FFT was reduced by a significant amount (165.2 million) by excluding participation in equity in FFT’s branches FFNA and FFC without an economically sound justification. Applying zero rate remuneration to this capital is not envisaged by TP Guidelines nor by Basel II framework and accounting rules. Since this equity is fully available to support FFT’s solvency, it should be remunerated in full.38
3. Methodology: Comparables and median value
Finally, the estimated level of return on capital was found to be unreliable for approximation of a market-based outcome. The methodology used in the APA was strongly criticized for several reasons:39
- The list of 66 entities that were considered comparable by FFT’s tax advisors encompassed two central banks, stock exchanges and other companies active in very different business segment from FFT, thus making the comparison invalid;
37 ibid para 249. 38 ibid para 282. 39 ibid paras 292-295.
20 - The beta value (market risk that cannot be diversified) which was used was significantly lower from the beta of comparable financial sector companies; - Notwithstanding the previous objections, the beta calculation used the 25th
percentile and not the median value in the selected range. According to TP Guidelines, the more complex the comparability, the more the central tendency of the sample should be used to reach an arm’s length outcome.40
2.2.5 EC Conclusion
With regards to all the inconsistencies pointed out in the Decision, the EC concluded that the correct estimate of FFT’s taxable base should be at least 10% post-tax applied to the full amount of accounting equity. Such a return was considered in line with the leverage corresponding to the average of the industry, thus representing a market-based outcome.41 Since the method the
APA endorsed departed from the arm’s length principle, it was found to confer a selective advantage resulting in illegal State aid. The practical consequence of this breach of EU law was a claw back of deemed benefit with interest amounting to 20 - 30 million euros.42
2.3 Recent development and criticism
2.3.1 Introduction
After the EC Decision was published, both Luxembourg and Fiat appealed focusing primarily on selectivity requisite. The appeals led to the judgment of the General Court in 2019, which confirmed the conclusions of the EC Decision in full. However, the final resolution of this issue awaits, since Fiat has appealed the judgment to the ECJ.43 Meanwhile, outside of the court, Fiat case has
sparked great academic interest which is mostly critical towards its reasoning.
40 TP Guidelines 2010 3.57. 41 EC Decision para 311.
42https://ec.europa.eu/commission/presscorner/detail/en/IP_15_5880 accessed 18 April 2020. 43
21 The disapproving argumentation is put forward from several angles, ranging from sovereignty to transfer pricing. The following segment will evaluate only those points that are in the scope of the thesis objective.
2.3.2 General Court Judgement
The leading criticism of the EC Decision derives from the principle of legal certainty. By questioning APAs through the use of a benchmark that many are calling “EU ALP”44 the EC is adding a new layer of complexity in an already
perplexing field of international transfer pricing.
As for APAs, the EC has publicly stated that they are not in themselves the target of State aid investigation, but rather the selective advantage that might be provided through them.45 The legality of rulings which do not confer such an
advantage is confirmed by the General Court.46 However, the possibility of
overruling by the EC undermines the aim of an APA which is foreseeability for investors before the performance of costly transactions.47 The likely
consequence of this development is the reduction of requests for such rulings in the EU Member States. To prevent the adverse reaction, the EC should engage in APA review only in extreme cases where misuse is evident.48
An even greater cause for uncertainty is the “EU ALP”. General Court has confirmed in its judgment that EC can rightfully asses the correct application of ALP by Member States in their APAs. In the purpose of establishing whether illegal State aid exists under Article 107(1) TFEU, the EC uses ALP as a
44 Stephen Daly, ʹThe Constitutional Implications of an EU Arm’s Length Principleʹ (2020) 60/2/3 Eur.
Taxn. 70.
45 European Commission, ʹCommission Decides Selective Tax Advantages for Fiat in Luxembourg and
Starbucks in the Netherlands Are Illegal under EU State aid Rulesʹ, <https://ec.europa.eu/commission/presscorner/detail/en/IP_15_5880> accessed 21 April 2020.
46 Judgment of the General Court (General Court judgment) in T-755/15 (Luxembourg v. Commission)
and T-759/15 (Fiat Chrysler Finance Europe v. Commission) ECLI:EU:T:2019:670 para 115.
47 Peter J. Wattel, ʹThe Cat and the Pigeons: Some General Comments on (TP) Tax Rulings and State
aid After the Starbucks and Fiat Decisionsʹ in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 187.
22 “tool”.49 Nevertheless, the framework for this benchmark and its material
content are left vague by the Court.50
The dominant perspective in academic writings on the reference system for applying ALP is best expressed by Schon: “to protect the Member States’ prerogative in tax matters, the decisive benchmark for fiscal state aid can only be the tax legislation of the relevant country itself”.51 Contrary to this, the EC
viewed ALP as integral element of Article 107(1) TFEU, establishing the right to apply the principle even when it is not explicitly incorporated in the domestic legal system of the particular Member State.52 In the Fiat case, the basis for
application would not make a difference, since Luxembourg law contains ALP.53 Conversely, the ambiguity in this respect which was maintained by the
General Court might be important for future cases, such as Apple where Ireland is claiming the absence of ALP in its national tax law. Some commentators believe this was the intention of the Court in the purpose of preparing a precedent for the judgment in Apple.54
An indication that the General Court is leaning towards the EC’s push for an autonomous ALP that is grounded in Article 107(1) TFEU is the acceptance, without much motivation, of what this principle is as a “tool”. The ALP in itself has no material content.55 It was developed by the OECD and for the purpose
49 General Court judgment para 151.
50 Jérôme Monsenego, ʹSome observations on Starbucks, Fiat, and their potential impact on future
amendments to the arm’s length principleʹ, (2019) Kluwer International Tax Blog,
http://kluwertaxblog.com/2019/09/28/some-observations-on-starbucks-fiat-and-their-potential-impact-
on-future-amendments-to-the-arms-length-principle/?doing_wp_cron=1588158936.9704051017761230468750 accessed 23 April 2020.
51Wolfgang Schön, ʹTax Legislation and the Notion of Fiscal aid: A Review of 5 Years of European
Jurisprudenceʹ, in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 9.
52 EC decision para 228. 53 Daly (n 44) 75.
54 Ruth Mason, ʹImplications for Apple in the Lower Court Rulings in Starbucks and Fiatʹ (2019)
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3459466 accessed 25 April 2020.
23 of double (non-)taxation and profit shifting, which cannot so easily be transposed for EU State aid need for reaching a market-based outcome. As much as EC claims that they are not applying the OECD ALP, for which they would have no basis since it is found in soft law instruments of OECD Model Tax Convention and TP Guidelines, they are using these very documents to give content to their “autonomous” and “universal” principle of equal taxation. The use of OECD materials, albeit necessary in the lack of other means, is problematic not only for legality reasons discussed in the Methodology section in the Introduction to this paper (section 1.4 above). Additional issue is the fact that EC is not bound by TP Guidelines when conducting its investigation in State aid, since it is not applying them directly. This theoretically translates into the possibility of preparing TP documentation fully in line with the Guidelines, but still being persecuted for illegal State aid because of different interpretation by the EC. However, the EC has maintained that “if a transfer pricing arrangement complies with the guidance provided by the OECD TP Guidelines … a tax ruling endorsing that arrangement is unlikely to give rise to State aid”.56
General Court has also affirmed this line of reasoning.57 The pertinent question
of which version of TP Guidelines will be used in the investigation seems to be answered in Starbucks case – only information existing in the time of concluding the APA will be taken into account.58
General Court’s judgment on Starbucks, published on the same day as the FFT, is important for understanding its “twin”. Although the Court accepted the use of ALP on the same grounds as in Fiat, the EC decision in Starbucks was annulled since the Commission was unable to successfully demonstrate the
56 Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the
Functioning of the European Union, (2016) OJ C 262 para. 173.
57 General Court judgment para 147. 58 Starbucks judgment (n 12) para 251.
24 existence of an advantage.59 There are substantial differences between these two
cases and the formulation of the EC decisions in each, yet this serves to prove that the Court does not necessarily endorse EC’s handling of TP issues in fiscal State aid investigations in all aspects. In Fiat ongoing procedure, lack of convincingly demonstrated advantage is a possible course which ECJ can take to overrule the lower court by its own reasoning. In any respect, ECJ’s judgment will hopefully resolve the previously discussed issues and provide more certainty for both taxpayers and Member States.
2.3.3 TP Method Application Issues
Both the EC and the General Court have rightfully reaffirmed that transfer pricing is not an exact science, the idea that is the leitmotif of TP Guidelines. It is thus disputable how the EC, with the unreserved support of the General Court, reaches its definitive conclusions on the “correct” application of TNMM in FFT. Starting from the range of arm’s length outcomes, the EC has decided in FFT that the central tendency i.e. the median value is the one that should be used for approximating a market-based outcome. Although the median is indeed frequently preferred in transfer pricing practice, the OECD views any point in the range as meeting the ALP.60 A logical result of the inaccuracy “inherent in
the application of a method designed to obtain a reliable approximation of a market-based outcome” would be the recognition of an acceptable range of values for State aid purposes and not just one point in the range such as the median.61 Nevertheless, the General Court has not expressed a clear view on
this matter.
Secondly, the use of return on equity as a parameter calculated on the full amount of accounting equity of an internal bank creates a loophole for tax
59 ibid para 561.
60 Rasch, Wroblewski (n 34) 441.
25 planning. Namely, since internal banks are not required to maintain a certain higher level of capital under the Basel II (now the Basel III) accord as regulated entities, they could reduce their level of equity down to the minimal capital requirement in domestic corporate law.62 What is more, the TP Guidelines do
not suggest the use of the return on equity precisely because of this arbitrage opportunity. The application of parameters such as return on assets and return on capital employed is advisable as a more reliable benchmark.63
Although internal banks are comparable to regulated entities in the first step of the TP analysis, the same analogy in the method application comes with admonitions. The fact is that the EC and the General Court did not explicitly condemn the use of Basel II for the calculation of hypothetical regulatory capital, which some authors even advocate as the most appropriate in combination with the return on equity.64 Moreover, the EC inspected whether
Basel II was applied correctly in FFT, but this did not legitimize its use. For this reason, reliance on non-transfer pricing instruments such as Basel II in reaching the ALP should be carried out with care, extensively justified and documented.65
One additional twister related to TP methods was created by the General Court when deciding on “neutralization”. This is the possible lack of an advantage on the group level where a lower tax burden in one country, such as Luxembourg, is neutralized by the higher tax burden in another, e.g. Italy. The General Court concluded that “the tax situation of another undertaking of the same group in another Member State has no bearing on the existence of the advantage”.66 By
62 To ilustrate this, the minimum capital requirement in Luxembourg for a public limited company (SA)
is just 31 000 euros, according to: https://guichet.public.lu/en/entreprises/creation-developpement/forme-juridique/societe-capitaux/societe-anonyme.html Applying the EC’s 10% post-tax rate to calculate the post-tax base we arrive at (sic!) 3100 euros.
63 Ivan Lazarov and Svitlana Buriak, ʹIs Fiat’s Tank Half-Full or Half Empty? The General Court’s
Decision in Luxembourg v. Commission (T-755/15)ʹ (2020) 27/1 Intl. Transfer Pricing J. 74.
64 ibid 75.
65 Rasch, Wroblevski (n 34) 441. 66 General Court judgment para 318.
26 a priori and in general rejecting to take into account the cross-border situation of the group as a whole, General Court has ruled contrary to the nature of transfer pricing which is designed with the idea of zero-sum game between two countries in mind. It is however true that in Fiat case no such effect was proven, so that for the case at hand the Court has decided correctly.67 On the other hand,
the EC justly acknowledged the prospect of neutralization in cases where the transaction-by-transaction methods (such as CUP) are used, contrary to TNMM where the estimated taxable profit of one group member does not directly influence the profit of others.68
Finally, beside these objections that might be raised on how the EC and General Court examined the TP method used in FFT, an even more important shortcoming lies in what they (mostly) did not examine – the functional analysis. If the assessment of the accurate delineation and recognition of the actual transaction would have pointed to FFT as the entity ultimately carrying all of the risks related to analyzed transactions in the Fiat group, EC’s further methodological conclusions would be more or less correct. Otherwise, if the risks proved to be borne by another entity of the group, such as the Fiat parent company, this should be reflected in FFT’s remuneration.69
3 Functional analysis for internal banks
3.1 Introduction
Without pretension of challenging the conclusions in the ruling on FFT, I will use the information provided in the case as a basis for conducting a simplified functional analysis of an internal bank in the following chapter. The analysis will be performed in line with the TP Guidelines 2017 version and the latest
67 Lazarov, Buriak (n 63) 76-77. 68 EC Decision para 92.
69 Alexandra Miladinovic and Raffaele Petruzzi, ʹThe Recent Decisions of the EC on Fiscal State Aid:
27 addition to the existing rules in the form of TP Guidelines on Financial Transactions from 2020. It is important to note, once again, that this analysis is not applicable to the actual Fiat case, since FFT falls in the scope of the previous (2010) version of the Guidelines, but is of significance for future similar cases.
3.2 “Treasury functions”
In FFT the tax advisors decided to package all the transactions that the internal bank provides and receives into a single “treasury function”. This choice was not challenged by the EC nor the General Court and the focus of the dispute turned to the transfer pricing method. However, if this step of the comparability analysis was brought into question, that might have changed the course of the subsequent reasoning completely.
The new TP Guidelines on Financial Transactions are clear in this regard stating that “it is important to accurately delineate the actual transactions and determine exactly what functions an entity is carrying on rather than to rely to any extent upon a general description such as treasury activities”.70 In the facts of the EC
decision, the treasury function was disassembled into transactions that constituted it for comprehending the general perspective of FFT’s business.71
For transfer pricing purposes, roughly three types of functions can be deduced based on FFT’s activities:
1) Intra-Group Loans 2) Cash pooling 3) Hedging
These activities are also recognized by the new TP Guidelines as the most relevant treasury activities that are performed by internal banks in a
70 OECD (2020) Transfer Pricing Guidelines on Financial Transactions para 10.44 71 See section Transaction 2.1.1.
28 multinational group.72 Each of them entails specific considerations for the
delineation of actual transaction and subsequently differing recommendations on the choice and application of the appropriate TP method.
Considering that intra-group loans are arguably the first in significance when it comes to the internal banks’ business model, the functional analysis in this paper will only focus on those transactions. This is particularly necessary because the Fiat case publically provides more detail for the crediting activity only and thus this data can be used as an example to be tested against the new TP Guidelines.
3.3 Intra-group loans
3.3.1 Accurate delineation of a loan
As highlighted in a special caveat, the new TP Guidelines allow for their application to loans only if they are respected as loans pursuant to the accurate delineation in line with Chapter I of the existing TP Guidelines (2017 version) and domestic legislation.73 The importance of this precondition is underlined in
the OECD Model Commentary itself on Article 9 as applicable “not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital”.74
OECD emphasizes the determination of whether a loan itself is commercially rational because of the inherent bias that exists in favor of debt financing compared to equity. This consideration stretches further from TP to other international taxation matters, such as the fact that dividends, resulting from equity, are usually subject to economic double taxation – first on the corporate level and second on the shareholder level. In contrast, interest is subject to only
72 TP Guidelines on Financial Transactions para 10.50. 73 TP Guidelines on Financial Transactions 14.
29 one level of tax and it is deductible as a cost for one of the parties.75 Therefore,
integrated companies have an incentive to take on more debt than stand-alone entities would, in order to achieve these tax benefits. Although the BEPS project has been tackling this issue by limiting the amount of interest that can be deducted76 and the expansions of domestic thin capitalization rules, interest rate
higher than the market are still a common form of aggressive tax planning. In order to accurately delineate the actual transaction new TP Guidelines are following in the footsteps of the existing guidance in Chapter I of the TP Guidelines 2017. The process should begin with a thorough identification of economically relevant characteristics of the transaction, which are commercial and financial relations between the parties and the conditions and circumstances attached to those relations.77 These characteristics can be grouped as follows:
1) Contractual terms of the transaction
Loan contracts are by a general rule written contracts and as such should be the starting point for delineating a transaction. However, in line with the TP Guidelines 2017 the actual conduct of the parties must also be taken into consideration. If from the other economically relevant characteristics flows that the actual conduct is inconsistent with the contract, the actual transaction should be delineated for the purpose of the transfer pricing analysis.78
2) Functional analysis
The functions performed, assets used and risk assumed will be discussed in more detail in the following sections of this paper aiming at reaching the ALP. However, it is important to understand that in this phase of accurately
75 Brian J. Arnold, International Tax Primer, 3rd edition (Kluwer 2016) 115.
76 OECD, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action
4 (OECD 2016).
77 TP Guidelines on Financial Transactions para 10.17. 78 OECD (2017) TP Guidelines paras 1.42-1.45.
30 delineating the transaction, the same factors are analyzed in order to define how much of the loan should be recognized as a loan for transfer pricing purposes. Only after the loan is respected as such and not treated as, for example, equity, the functional analysis is taken under advisement again, but this time with the purpose of reaching an ALP interest for that accurately delineated and recognized loan.
3) Characteristics of the financial instruments
The features of a loan might influence its pricing. The new TP Guidelines list several examples of transaction attributes that were certainly relevant in the Fiat case, but were not analyzed, such as79:
- Maturity of the loan: A nominal distinction was made between short-term and medium-term loans of FFT, but they were priced together;
- Amount, nature and purpose of a loan;
- Geographical location of the borrower and currency: Fiat group members are present in several jurisdictions, and many of those such as the UK, Switzerland, Denmark and others have different currencies from the euro zone;
- Collateral or guarantees provided etc.
FFT has submitted an objection accepted by the EC stating that the applicable rates, form and maturity of the loans provided by FFT greatly vary. Since this variety would require finding comparables for each individual transaction, it was concluded that the CUP method is not applicable and these attributes where essentially overlooked.80 On the contrary, in line with the clarification of the
new TP Guidelines, variations in financial instruments’ features must be taken into consideration already in the comparability analysis.
79 TP Guidelines on Financial Transactions para 10.29. 80 EC Decision para 246.
31 4) Economic circumstances of the parties and the market
Local differences such as regulations and economic factors (inflation, growth and exchange rates) must be taken into account, as well as macroeconomic trends. In the current climate, the defining trend might be the record low central bank lending rates, which affects the prices and willingness to borrow or lend in the private sector. As for FFT, a significant component of the calculation is the fact that all loans are provided to the automobile industry, which makes them particularly sensitive to changes in this volatile sector.
5) Business strategies
Differences in strategies pursued by multinationals can have a profound effect on the terms and conditions which would be agreed by independent enterprises. This analysis also must include consideration for the group’s global financing policy and the identification of preexisting relationships between the members such as shareholder interests.81
After the actual transaction is delineated with the help of the listed factors, it is compared to similar arrangements which are or would have been adopted by independent entities behaving in a commercially rational manner in comparable circumstances.82 The crucial concept, as set by Section D.2 of Chapter I of the
TP Guidelines 2017, is the commercial rationality of the examined transaction in order for it to be recognized as it is structured. If either the internal bank, such as FFT, or the group entities to which it advanced funds, had options of concluding a similar contract with a third party that were realistically available at the time and that would make them or the group better off, this indicates behavior contrary to a rational market actor. In such context, the existing transaction might be disregarded in whole or in part and replaced by an
81 TP Guidelines on Financial Transactions paras 10.34-10.36. 82 ibid para 10.7.
32 alternative.83 For an internal bank, this translates into a loan not being delineated
as such for the purpose of determining the amount of arm’s length interest.84
The part of the loan or even the whole amount will then require an entirely different comparability analysis from the one performed for FFT and analyzed in the remainder of this paper.
3.3.2 Assumption and control of risks
The examinations of functions performed, risks assumed and assets used are inseparable parts of the functionality analysis.85 However, while it is not
possible to isolate any of them without detriment to a comprehensive understanding of the tested entity’s situation, the fact remains that risks are the most complex in the sense that they are not so conspicuous.86 This is particularly
true in the recently developed framework discerning between control and assumption of risk. For this reason, it might be beneficial to investigate the situation of an internal bank such as FFT from the perspective of risk, while providing functions and assets with their rightful place in the analysis when needed. For the sake of simplicity, only loans provided by FFT to related entities are subject to inspection.
The accurate delineation of the actual transaction in respect of risks is envisaged as a 6 step process87:
1) Identification of economically significant risks
For an internal bank, risks that were identified for FFT would most likely be relevant: Market, Credit, Counterparty, and Operational risk.
2) Determination of how risks are contractually assumed
83 OECD (2017) TP Guidelines para 1.122.
84 TP Guidelines on Financial Transactions para 10.13.
85 Michael Lang et al. Fundamentals of Transfer Pricing: A Practical Guide (Kluwer 2019) 59. 86 OECD (2017) TP Guidelines para 1.59.
33 The identified risks are contractually assumed by FFT as the lender. However, FFT has claimed non-exposure to some of these such as Credit and Counterparty risk since the Group has interest to financially help its members and over time, there would be no insolvency cases.88 For the claim of complete non-exposure
to these significant contingencies there is no basis in the TP Guidelines, both the 2017 and 2020 edition. Therefore, internal banks should abstain from a priori excluding risks that are typical for the provision of loans and rather try to show how they might be mitigated in the functional analysis.
3) Functional analysis in relation to risk
A lender such as FFT needs to decide whether to make a loan, in what amount and on what terms. If the decision was made by an independent lender, this would require a thorough evaluation of the borrower’s situation, wider economic factors, and other options realistically available.89 An internal bank
possibly does not need to invest as much effort in research as a stand-alone entity, since it may already have the necessary data about its group members readily available. However, in order for a loan to be commercially rational, even for intra-group loans, factors such as creditworthiness must be evaluated.90
The pivotal importance of credit rating was already recognized in literature, since it directly influences the level of the risk taken by the creditor.91 This is
the main factor that independent investors take into account when determining what interest rate to charge. The new TP Guidelines also propagate its usefulness for identifying potential comparables in the context of related party transactions.92
88 EC Decision para 50.
89 TP Guidelines on Financial Transactions paras 10.53-10.54. 90 ibid 10.55.
91 Monsenego, Introduction to Transfer Pricing (n 4) 88-89. 92 TP Guidelines on Financial Transactions para 10.62.
34 In FFT, it seems that this criterion was not used at all. This is apparent from the fact that FFT excluded its intra-group loans from its assets when calculating its hypothetical regulatory capital. The only reason to exclude these loans would be if their risk weight was 0 per cent, i.e. - no risk, which is awarded to items such as cash.93 Since none of the Fiat group members had the credit rating AAA,
which is equal to no risk94, this brings into question how did FFT decide on
whether to provide related entities with loans and at what price.
An important consideration in accurately delineating a transaction is the wider analysis of the group and how it creates value. The functions and assets of an internal bank may be different from an independent bank since it might be limited in its options for funding and lending because of its designated role in the group’s value creation.95 The effect of belonging to a group can also
influence the delineation by, for example, using the credit rating of the group when deciding on risk for a specific loan to be granted to a member.96 However,
the credit rating of the Fiat group was certainly not risk free, but rather significantly lower97, which further points to the lack of consideration for
creditworthiness by FFT when advancing funds to related entities. 4) Actual conduct
The functional contribution of FFT is certainly providing the financing for the loan that makes it the party assuming the financial risks in the loan contract. FFT also mitigates some of these risks, such as the currency exchange risk by hedging.
93 Lazarov, Buriak (n 63) 74.
94 Even in Fiat's own Transfer Pricing Policy document was FFT's credit and counterparty risk towards
the group classified as ‘limited’, not non-existent. See EC Decision para 269.
95 OECD (2017) TP Guidelines paras 1.51-1.52.
96 TP Guidelines on Financial Transactions paras 10.81-10.82.
97 Ba3, which carries 100% risk weight, according to Rating Action: Moody’s downgrades Fiat to Ba3;
negative outlook https://www.moodys.com/research/Moodys-downgrades-Fiat-to-Ba3- negative-outlook--PR_257083 (accessed 24 April 2020), as found in Lazarov and Buriak (n 63) 75.
35 The main issue when analyzing the actual conduct of FFT is whether it exercises control over the risks and has the financial capacity to assume it.98 The disregard
for the credit rating of the borrower when advancing funds might indicate that in actuality FFT does not fully autonomously decide on whether it is commercially rational to provide a loan to a related entity. This would consequently entail limited control over the risks such as the Credit and Counterparty risk.
It is also uncertain in what degree does FFT bear the potential downside consequences of risk outcomes. From the facts of the case, the parent company Fiat S.p.A. provides guarantees on instruments such as bond and credits through which FFT collects its funds. If, as a result of its related borrowers’ default, FFT was not able to finance its own obligations, the financial capacity for assuming this Counterparty risk might prove to be, at least in part, on the Italian parent. 5) Allocation of risk
If it is identified that control over the risk and the financial capacity for assuming it are in the actual transaction shared or fully in the hands of another group member, such as the parent, the risk must be reallocated to follow the actual transaction.99
6) Pricing
The parties performing control activities should be remunerated appropriately according to their importance. The assumption of risk should be compensated with an appropriate anticipated return, while risk mitigation should be accordingly remunerated.100 If FFT would be classified as an entity that lacks
the capability to control the risk, it might be entitled to a risk-free return only.
98 OECD (2017) TP Guidelines para 1.86. 99 ibid para 1.98.
36 In an opposite scenario, an internal bank both assuming and controlling its financial risks would have the right to an arm’s length interest rate comparable to stand-alone entities established by the CUP method, as suggested in the new TP Guidelines.101 This serves to demonstrate how divergent consequences can
be if the accurate delineation of the actual transaction results in allocating the risks of intra-group loans to parties other than the internal bank lender and consequently why this process is vital to every transfer pricing analysis.
4 Conclusion
The aim of this paper has been providing insight into the latest development in transfer pricing of internal banks, primarily for those entities based in the EU. In order to achieve its purpose of establishing guidance on the safest road to compliance, the analysis was twofold, looking both at the past and the future, to ascertain what is to be done in the present.
The first finding is related to how the EC scrutinized transactions of internal banks in the previously existing legal circumstances. It is important to keep in mind that all of the conclusions which were made in the Fiat case were based on the Transfer Pricing Guidelines of 2010, a version published before the BEPS project has even been initiated. Additionally, the APAs concluded in Luxembourg where laid out in such a way to accommodate the requirements of the particular national tax authority. It is likely that none of Fiat’s tax advisors took into consideration the idea that their report might be questioned by any other authority, such as the EC, which, in the light of the notion that “transfer pricing is not exact science”, has certainly influenced their argumentation and conclusions.
37 However, now that the policing of transfer pricing possibilities for illegal State Aid has become a frequent activity of the EC, with the right to do so guaranteed by the General Court, it is a good precaution measure for internal banks in the EU to try to reach the standard set in the Fiat rulings. On the other hand, all the benchmarks set up to this point might be rendered null if the ECJ decides so. In that sense, none of the findings on how to apply the transfer pricing method presented in the first part of the paper are to be taken as conclusive.
Even if the reasoning of the EC is ultimately rejected, it is still useful as an authoritative view on the transfer pricing methodology for internal banks. The most significant takeaways can be summarized as follows:
- Internal banks are comparable to regulated entities, which facilitates the search for comparables in the TP analysis;
- Although CUP is the preferred method, other methods, such as TNMM are equally appropriate, if impelled by the facts of the case;
- Use of uncommon instruments, such as the Basel II, and unconventional parameters and adjustments which are not envisaged by the TP Guidelines should be reassessed and thoroughly justified;
- Central tendency (median) of the sample of comparable values is preferred in situations that are not clear-cut.
Although all of these points where heavily criticized in academic circles, as was presented in the paper, they are still highly relevant in practice since the General Court’s confirmation has provided them with even more authority in both Fiat and Starbucks case. That being said, the impact of these verdicts might be severely limited for future cases for which the latest editions of the TP Guidelines apply.
