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Financial Services Tax News Private Equity - A transfer pricing evolution June 2012

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This newsletter summarises the survey work undertaken looking at transfer pricing issues being faced by private equity firms. ・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・

Introduction As private equity (PE) firms have become increasingly international in their outlook and operations, the correct application of transfer pricing legislation becomes a higher priority. The potential for incurring double taxation through adjustments and penalty payments, as well as the negative publicity linked to tax disputes and litigation, mean that ensuring that a robust transfer pricing policy is in place is becoming a key management focus. We work with a large number of PE firms to ensure that the transfer pricing arrangements that are implemented match the underlying value chain of the business and the commercial contribution of each of the global offices. This newsletter summarises our experience in 12 major jurisdictions1 covering the types of issues that have been considered by PE firms, whether as part of robustly documenting their arrangements or as a result of transfer pricing audits. The transfer pricing arrangements of PE firms are becoming more complex. The key value drivers of the business are increasingly shared between a number of jurisdictions, often on an integrated basis. This has contributed to a marked upturn in tax authority activity, with taxpayers experiencing detailed enquiries and ever growing compliance obligations.

1 Australia, China/Hong Kong, Germany, India, Italy, Japan, Poland, Singapore, Spain, Sweden, the UK, and the US.

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Transfer Pricing Analyses Activities reviewed The activities undertaken by PE firms outside their home territory are no longer limited to preliminary research and general marketing. Many groups now include deal sourcing and analysis, investment committee representation, deal execution (effectively referred to here as the “investment process”), investor relations, capital raising, fund administration and back office support services among the activities carried on overseas. Typically, these services are provided in an integrated manner from a number of locations, with the group’s intellectual property often being created on a joint basis. The table below shows the proportion of countries where the services listed above have been analysed as part of a cross-border transfer pricing review.

Intangible property

58%

Fund administration

42%

Support services

75%

Capital raising/marketing

33%

Investment process

75% 0%

20%

40%

60%

80%

Almost every territory has needed to price some element of the investment process, with most satellite offices set up initially to perform local research and deal sourcing. Cross-border capital raising and administration services are also present in the majority of territories. This means that typical transfer pricing analyses will need to cover the provision of a number of different services, often priced in the market on very different bases. Pricing methods Implementing a robust global transfer pricing methodology for a PE firm is challenging. This is due to factors such as the scarcity of data to benchmark the pricing of these services on an arm’s length basis, differing attitudes in tax authorities regarding what represents an acceptable pricing arrangement for a satellite office, and the varying importance of these services at different points in the fund investment cycle. Overseas operations are typically established with their income set on the basis of a recharge of the local costs, plus a mark up to provide a profit which is subject to tax in that territory. This pricing method is referred to as a Transactional Net Margin Method (“TNMM”) or Comparable Profits Method (“CPM”). (See following table.) This sort of cost mark up approach becomes more difficult to maintain as the office matures and both the scope of activities and level of influence that are provided from that location increase. This is often the result of highly skilled and experienced investment professionals being brought into the business; either as local hires or through the relocation of what is generally a highly mobile workforce. When an office becomes a significant contributor to the business, there is a need for more complex and innovative solutions to be developed. Typically this is based around actual data on third party arrangements or through determining an allocation of profits for each office in line with the arm’s length principle. The data used to support these approaches is often identified from the PE firm’s own activities, or generated through specific research with market participants. Capital raising, in particular, is an area where supporting data has been gathered and applied in support of activities undertaken internally by PE firms. The table below summarises the implementation of different transfer pricing methodologies2.

2 The methods listed here are those set out in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. No formal use of a transactional Cost Plus approach was identified that was differentiated from a TNMM so no separate category has been included here.

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While significant contributions to the investment process and capital raising activities are generally priced using third party data or a sharing of relevant profits, routine functions, such as support services and fund administration, are often still priced so the provider achieves a small guaranteed profit. The profit margin calculated is usually set by reference to the levels of profits achieved by independent entities providing similar services to the market.

TNMM / CPM

100%

Profit Split Method

80%

Comparable Uncontrolled Price Method ("CUP")

50%

Resale Price Method ("RPM")

20% 0%

20% 40% 60% 80% 100% 120%

Generally, in each jurisdiction surveyed, there is a strong preference from the tax authorities for the taxpayer to use local pricing data to support the transactions. The availability of benchmarking and comparative data varies amongst jurisdictions, for example:       

Australia: the requirement is for the most reliable available comparables data to be used. On this basis, in practice, local comparable data is preferred; however foreign comparables are accepted when reliable local comparables are not available if the data can be appropriately adjusted. Japan: local comparable data is available from a number of different sources. Foreign comparables are not generally accepted. Poland: foreign comparables are only accepted if the taxpayer can prove that local data is unavailable. Singapore: foreign comparables are acceptable if reasonably accurate adjustments can be made. Spain: there is a strong preference of local comparables to be used, although pan-European benchmarking may be acceptable. Italy: there’s a strong preference of local comparables to be used, although pan-European benchmarking may be acceptable. During an audit, the tax authority may reference its own, internally documented, local data as a benchmark (often referred to as secret comparables). The US: local comparable data is available from a number of different sources. Foreign comparables are not generally accepted.

Allocation Keys Where necessary to share the returns to a particular activity between a number of jurisdictions, one or more allocation keys need to be identified that will split the profit between the parties in proportion to the economic contribution provided by each party. The standard allocation keys are based on the number of personnel undertaking a particular activity or the level of compensation received. However, increasingly the contributions from each jurisdiction represent a complex combination of ongoing activities, decision making, risk assumption and the utilisation of intangible assets. This means that more innovative approaches need to be employed to establish an appropriate level of profits in each jurisdiction. Producing documentation that meets local requirements is therefore more challenging than has historically been the case.

Documentation Requirements The number of jurisdictions with specific transfer pricing documentation rules is increasing. Most jurisdictions require transfer pricing documentation to be provided either with the tax return, or within a very short period of time upon the initiation of a transfer pricing enquiry. The information generally required in a transfer pricing documentation set in any jurisdiction is wide ranging:

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     

details of the business, ownership and management structure of the group; full analysis of the associated enterprises, establishing the functions that it performs, risks it assumes, and assets it utilises; details of known comparable transactions between uncontrolled enterprises; the reasons for adopting the transfer pricing method used; a description of the business strategy and how this led to, or was judged compatible with, the chosen method of transfer pricing; and details of the general commercial and industry conditions relating to the product and the business at the time of setting the prices.

There are a number of further requirements based on local legislation:      

In terms of the language requirements of the local transfer pricing reports, globally many jurisdictions accept the documentation if presented in English (including Japan, India and Sweden). However, there are notable exceptions: China: documentation must be presented in Chinese. Germany: documentation must be presented in German. Upon application, German tax authorities may accept English documentation (or any other “living” language). However, tax authorities are not obliged to accept any language other than German. Italy: documentation must be presented in Italian. Poland: documentation must be presented in Polish. Spain: documentation in languages other than Spanish would be examined on a case-by-case basis, depending on the tax inspector’s preference. From a strategic perspective, it’s preferable to prepare documentation in Spanish. If needed as evidence (especially in Court) it should be translated into Spanish.

There are some specific points to be noted in relation to documentation requirements:        

Australia: disclosure relating to the intercompany transactions must be submitted with the tax return. China: key details to the related transactions such as names and locations of related parties, tax rate, and the methods used for transactions must be disclosed in forms that are submitted with the tax return. Germany: transaction-by-transaction detail may be required during an audit, as well as additional information such as intercompany agreements. Hong Kong: transactions with closely connected parties must be submitted with the tax return. Formal documentation is encouraged, however only required to be presented under audit. India: disclosure of service agreements and an independent accountant’s report in respect of all international transactions between associated enterprises is mandatory. Italy: tax return requires disclosure of direct or indirect control by non-resident entities and relationships with non-resident entities under common control. A box must be checked to communicate to the tax agency that “proper” documentation has been prepared to be considered for the penalty protection regime. Singapore: adequate documentation must be kept and submitted within a reasonable time frame upon request. UK: specific documentation is not required beyond basic accounting and tax records. However, upon enquiry, a taxpayer will need to be able to demonstrate that reasonable efforts were made to achieve arm’s length pricing, which typically means the production of documentation in line with the points set out above.

All jurisdictions indicate that penalties become due if documentation requirements cannot be met.

Increasing tax and transfer pricing audits Transfer pricing audits for PE firms have increased in significance and scope. In many jurisdictions such as Germany, India, and Japan, PE firms are subjected to regular tax audits and transfer pricing queries are beginning to feature regularly in these reviews. A number of specific enquiries relating to the transfer pricing arrangements of PE firms have been seen recently in countries including the UK, Germany, and Sweden. In Singapore the tax authorities have been specifically requesting submission of transfer pricing documents when examining the tax returns of PE firms. The level of future audits for PE transactions is expected to increase significantly. A number of challenges have already been made on the level of fees received by local operations for research and marketing operations. Discussions with tax authorities have shown that the presence of senior personnel, investment committee PwC

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representation, or where the office represents a material proportion of the overall group business, a simple mark up on costs based method of remuneration is likely to be strongly challenged. Specific areas of enquiry include:    

the global consistency of the transfer pricing arrangements in place; the duties and responsibilities of locally based personnel; details of all remuneration received by key employees, including carried interest; and the scrutiny provided to investment recommendations issued from the local territory, and the level of capital commitments raised by local marketing.

Remuneration of fund managers Fees subject to transfer pricing If contributions to the services provided by the PE firm include inputs from various locations, the fees received from the fund will have to be shared between offices in an appropriate arm’s length manner. There are a number of income streams that a PE firm may receive for providing its services to investors. As well as management fees, typically calculated as a percentage of committed capital or investment value, there may also be a combination of transaction/structuring fees, monitoring fees, debt placement fees, and other miscellaneous items which add to the overall group revenues. These fees may be calculated on a range of different methods, making calculation of the total fees received against a common base more difficult. While these fees are characterised as being provided for distinguishable services, they are often considered fungible when establishing the arrangements with investors. There will typically be an offset for a proportion of transaction fees, for example, against the management fee received by the PE firm. It is therefore necessary to understand both the contribution of each office to the generation of each income stream and also how different fee flows were negotiated within the overall remuneration structure. Typical analyses in a number of projects lead from a number of other territories have started from a position of aggregation of the various income streams, with individual categories then considered to see whether they in fact represent a purely local activity where the remuneration should be retained by a particular office (e.g., debt placement). Carried interest remains a separate topic. As most jurisdictions still consider it to be an investment return, it’s typically outside any transfer pricing analysis. However, tax audits in a number of locations, including India, Poland and Spain, have resulted in carried interest returns being included within the transfer pricing calculations. The analysis therefore does need to be carefully considered on a country by country basis. As the taxation of carried interest remains a topic of debate in many countries the analysis also needs to be kept up to date with any changes in this area.

Conclusion PE firms face an evolving landscape, with increasingly global business models and more sophisticated tax authority audits making simple, centralised, transfer pricing arrangements more difficult to sustain. A clearly documented analysis of the PE firm’s value chain, and the contribution of each office, has become critical. Finding a methodology which recognises high value inputs from a number of locations, while challenging, is now necessary to meet the growing requirements in the territories where PE firms typically base their operations. Further, making sure that the methodology is able to keep pace with the changing scope of activities in each location, as well as the ever increasing disclosure requirements, means that transfer pricing will need to be a continuing agenda item.

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For more detailed information, please do not hesitate to contact your financial tax services representative or any of the following members: Zeirishi-Hojin PricewaterhouseCoopers Kasumigaseki Bldg. 15F, 2-5, Kasumigaseki 3-chome, Chiyoda-ku, Tokyo 100-6015 Telephone: 81-3-5251-2400, http://www.pwc.com/jp/tax Financial Services Partner

Senior Manager

Manager

Sachihiko Fujimoto

81-3-5251-2423

[email protected]

Katsuyo Oishi

81-3-5251-2565

[email protected]

Yuka Matsuda

81-3-5251-2556

[email protected]

Tetsuo Iimura

81-3-5251-2834

[email protected]

Akemi Kito

81-3-5251-2461

[email protected]

Hiroshi Takagi

81-3-5251-2788

[email protected]

Raymond Kahn

81-3-5251-2909

[email protected]

Stuart Porter

81-3-5251-2944

[email protected]

Kenji Nakamura

81-3-5251-2589

[email protected]

Nobuyuki Saiki

81-3-5251-2570

[email protected]

Akiko Hakoda

81-3-5251-2486

[email protected]

Kyoko Imamura

81-3-5251-2855

[email protected]

Takashi Nonaka

81-80-3592-6104

[email protected]

Hiroko Suzuki

81-80-3592-6100

[email protected]

Nobuyoshi Hiruma

81-80-3592-6099

[email protected]

Naoko Makihira

81-80-3592-6016

[email protected]

Seigo Sugiyama

81-80-3592-6017

[email protected]

Kohei Kobayashi

81-80-4104-5446

[email protected]

Teruyuki Takahashi

81-3-5251-2873

[email protected]

Ryann Thomas

81-3-5251-2356

[email protected]

Naoki Hayakawa

81-3-5251-6714

[email protected]

Transfer Pricing Consulting Group Partner Senior Manager

PwC Japan Tax (Zeirishi-Hojin PricewaterhouseCoopers), a PwC member firm, is one of the largest professional tax corporations in Japan with about 480 people. Within this practice, our Financial Services Tax Group is comprised of approximately 70 professionals, dedicated specifically to advising the financial services industry. In addition to tax compliance services our tax professionals are experienced in providing tax consulting advice in all aspects of domestic/international taxation including financial and real estate, transfer pricing, M&A, group reorganization, global tax planning, and the consolidated tax system to clients in various industries. PwC firms help organisations and individuals create the value they’re looking for. We’re a network of firms in 158 countries with close to 169,000 people who are committed to delivering quality in assurance, tax and advisory services. Tell us what matters to you and find out more by visiting us at www.pwc.com This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. © 2012 Zeirishi-Hojin PricewaterhouseCoopers. All rights reserved. PwC refers to Zeirishi-Hojin PricewaterhouseCoopers, a member firm in Japan, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.

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