The increasing scale of globalization means that international transfers of costs and profits form a much larger proportion of business turnover. And since the financial crisis, fiscal agencies have become more determined to extract the greatest benefit from transfer pricing arrangements: they are increasingly trying to maximize tax takes from every source and growing protectionism and competition between jurisdictions are leading to more intense scrutiny by individual tax authorities.
Financial services businesses are in a particularly sensitive position in this respect. Their ‘products’ and their ‘raw materials’ are both not tangible. They are especially mobile. Management and operations can be transferred around the globe. Asian financial services businesses have survived the crisis in reasonable shape and local economies are growing. It is not surprising that Asian tax authorities are pressing increasingly hard in the transfer pricing field.
Tax authorities are focusing much more attention on this area right across the region. The picture varies in detail from one jurisdiction to another. Trends in the region include:
Singapore: The authorities are much more active in transfer pricing recently; audits and examinations have increased, and a number of enquiries have been launched. Areas of focus have included head office cost allocations to bank branches as well as fee splits between offshore business centers and onshore booking centers in the wealth management businesses and other queries. Tax authorities do not seem to recognize or fully understand some of the key features of the financial services industry; however, they are learning quickly and it has been stated that the financial services sector will be a critical focus of examination by the Singapore tax authorities moving forward.
Hong Kong has seen increased transfer pricing activity in insurance and asset management companies, including private equity and alternative investment managers, and queries on reinsurance arrangements. For the asset managers, there is very close scrutiny on the offshore substance and numerous challenges on cost plus arrangements that require significant additional effort to defend and in some cases existing transfer pricing policies are being updated or freshly benchmarked in light of the recent challenges. Some insurance companies have been directly queried on reinsurance premiums. Those companies with well prepared, robust documentation and supporting economic analysis have been better placed to deal with tax office enquiries and arguably more effective in reaching audit settlements. Finally, financial regulators are also raising complex queries about remote bookings and the consequences of offshore/onshore profit splits. The direct financial regulatory implications for banking subsidiaries may revolve around regulatory capital and capital adequacy at the local level. However, the associated tax challenges are maintaining transfer-pricing policies that can work appropriately for tax but without adverse or unintended regulatory impact.
Japan is still very focused on banking; the authorities have been particularly reluctant to accept legitimate cases of risk transfers and there is a cost to maintain regulatory capital required to cover trading exposures which ought to be remunerated. Their approach tends to start from the assumption that when the traders are located in Japan then all trading profits or losses should be taxed in Japan; however, there are signs of a more realistic attitude developing with respect to the role of regulatory capital. This is a likely outcome of: increasing local bookings in Japan; more trading losses and a number of Japanese and foreign financial institutions are in Advance Pricing Arrangement (APA) discussions with the Japanese and foreign tax authorities which will hopefully allow for deeper reflection. While progress has been slow, the hope is that more clarity can be achieved soon.
Australia has an increasingly aggressive tax environment, with transfer pricing investigations focusing on loans, costs of funding, credit risk and guarantees. A number of banks have been subject to close scrutiny on their transfer pricing and this is expected to continue.
China also has an active policy of challenging transfer pricing arrangements, especially in relation to lending portfolios, the split of interest spread income, internal guarantees including cost allocations and intra-group service charges. The Chinese tax authorities have stated that in addition to banking, they will also focus more closely on asset managers/funds and securities businesses.
Multinational banks, asset managers and insurers active across the Asia Pacific region face particular challenges in demonstrating compliance and agreeing acceptable arrangements. Apart from the specific differences between individual countries, some – Australia and Japan for example – have a relatively more sophisticated approach, reflecting their longer experience in the area. Other countries can be a bit more unpredictable and inconsistent in their judgments, and are prone to change their position more frequently.
As a result, while the OECD Transfer Pricing Guidelines remain the most important basis for developing policy and demonstrating reasonableness, some jurisdictions only reflect them very partially in practice. Some of the more sophisticated transfer pricing practices, such as APAs and cost sharing arrangements are not universally accepted. Despite this, the number of APAs in the region continues to grow, with around 100 per year in Japan and 20-30 percent in Australia and Korea. Other countries such as China, Hong Kong and Thailand are introducing or improving APA programs.
The transfer pricing issues which tax authorities are focusing on are complicated by the fact that other regulators are concerned with similar issues of business configuration and structure. A number are looking particularly at offshoring of back office systems, IT etc., not from a cost and transfer pricing perspective, but from the point of view of ensuring adequate customer protection in the event of failure. The tension between tax and regulatory interests means that it can be difficult to develop a coherent picture free of contradiction. With a closer spotlight of financial regulators looking closely at transfer pricing, it is expected that financial institutions will be required to more robustly document their transfer pricing and in some cases, modifications to the policies may be inevitable.
Financial services companies already active in the region, or intending to expand in it, need to be prepared for increased scrutiny of their transfer pricing arrangements. There are twin strategies to adopt. The first is to recognize that while tax-efficient configuration of costs and revenues will always be sensible, excessively aggressive and extreme structures will increasingly be exposed and outlawed – often at significant financial and reputational cost. The second strategy is to review and update transfer pricing arrangements, ensure that they are defensible and document that defense. Many arrangements (for example in reinsurance) are difficult to verify. Companies need to prepare explanations and justifications in advance of enquiries being launched; take a step back, and consider how to justify costs transferred and fees charged. What is the underlying economic value? Are there industry benchmarks to support prices and charges? Are charges into and out of ‘tax havens’ involved and if so, how have the tax implications changed? These are often challenging and specialist tasks. In many cases, including asset management for example in demonstrating the value of offshore capital raising, and hence the proper return it should earn, the arguments can be both complex and subtle.
The situation is unlikely to get easier; tax authorities are likely to continue to challenge financial services companies over their transfer pricing policies. The increasingly stringent regulatory environment is a further complicating factor. At the margin, these trends are likely to dampen the spread of financial globalization and depress the volume of international cost transfers. At the same time, the increasing internationalization of both tax and regulatory activity is likely to lead – slowly – to a more harmonized approach. But banks, asset managers and insurers are going to face increasing constraints on their flexibility, in this respect as in others.
For further information, please contact: