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The COVID-19 Downturn and Limited-Risk Structures: A Spanish View

Posted on May 4, 2020

Josep Serrano is an international tax and transfer pricing partner and Bernardo Misle is the transfer pricing controversy manager with Deloitte Spain in Barcelona.

In this article, the authors discuss how limited-risk structures widely used by multinational groups for transfer pricing purposes can be affected by the COVID-19 crisis, focusing on potential Spanish tax administration reactions based on different precedents.

It is necessary to consider the potential tax consequences of the health, economic, and social crisis we are now going through. Among them is the challenge to multinational groups splitting pandemic-generated losses (with the exception of businesses less — or even positively — affected by the crisis, such as digital or pharmaceutical companies) among member entities. Considering the magnitude of the crisis and the enormous potential losses, decisions may have enduring effects on the assignment of tax attributes in jurisdictions in which the group has a presence.

The OECD base erosion and profit-shifting project actions 8-10’s modifications to Chapter I of the OECD transfer pricing guidelines have consolidated a new paradigm. The performance of key risk-assuming functions within the group now takes precedence over financial and legal aspects. It is based on “control over risks” and “financial capacity to bear risks” concepts, in which the actual transactional delineation within a multinational group, and the corresponding functional characterization (from a transactional point of view) of its members, relies on determining which entity or entities bear the relevant risks affecting the group’s business performance.

Those entities within the group that employ key decision-making personnel and hold assets, like intangible assets, that expose them to the most risk, and therefore place them in the best position to differentiate the group’s performance from that of its competitors, can expect to earn a major portion of the group’s profits or losses. On the other hand, those entities with lower risk exposure can only expect limited profitability, and are thus characterized as limited-risk entities.1

For groups with strongly integrated value chains, potential COVID-19 pandemic consequences (of which we are only seeing the initial effects) and the allocation of losses among their entities may be controversial. On the one hand, attribution could follow the same standard principal versus limited-risk scenario in which residual results (in this case losses) flow to the principal entity, leaving the limited-risk entities mostly unscathed.

On the other hand, in these extraordinary circumstances, entities characterized as limited-risk should also share the burden by taking on some of the pandemic-generated losses. The extraordinary risks are similar to what took place a century ago during the Spanish flu pandemic and are beyond the control of any group member. Perhaps they should therefore be dealt with from a different perspective.

The basis for selecting between these alternatives may not be easily reconciled, and controversy may arise between tax authorities and taxpayers. Also, within the group, delineation itself may be complex. In the crisis environment, multinational groups may balk at paying taxes in jurisdictions in which low-function entities are resident by guaranteeing them a limited profitability.

The impact on financial results may therefore be aggravated by a company’s fixed-cost leverage. For example, the effect of the crisis on a company with a more flexible cost structure (and hence a lower portion of fixed costs) will be less than for those with a more limited capacity to adapt their costs to revenue reductions brought about by the pandemic.

The following is a non-exhaustive list of general considerations from recent Spanish tax administration (STA) resolutions and court rulings. While reference to OECD directives is embedded in the preface to the Corporate Income Tax Act (Law 27/2014 of Nov. 27, 2014), the act’s transfer pricing provisions follow OECD guidance, and the STA and courts widely refer to OECD directives to support resolutions, there are inevitably details in their interpretations and potential controversies worth analyzing.

Contractual Terms

Transactions between related parties should not be determined solely by intercompany agreement terms, but also by the parties’ conduct. Nevertheless, the intercompany agreement terms represent the starting point for describing the transaction. Their identification and analysis are essential in determining the intended distribution of responsibilities, risks, and anticipated outcomes at the time of entering into the contract. The feasibility of sharing pandemic-induced losses between a limited-risk entity and its counterpart may depend on their original contractual terms.

For instance, in the ACER case (Appeal No. 125/2017 (Mar. 29, 2019)), the National High Court (Audiencia Nacional) took into account intercompany distribution agreement clauses and found that financial expenses accrued in factoring transactions because of a collection period extension, or the cancellation of orders, were not deductible for a limited-risk distributor subsidiary. The court agreed with the STA in focusing on the terms of the intragroup agreement evaluating the deductibility of expenses at the Spanish subsidiary level.

Therefore, the success of any measure designed to apportion pandemic effects (for example, by including in the cost base on which the limited-risk entity may be remunerated any nonrecurring or extraordinary costs) will depend to a great extent on the related parties’ intragroup agreement.

Ideally, an intercompany agreement’s contractual terms will provide clear evidence of a commitment to assume risk before the materialization of that risk. However, given the origin and depth of the pandemic crisis, intercompany agreements may not have foreseen the counterparties’ economic consequences. Furthermore, the introduction of force majeure clauses may not be common in an intragroup scenario. This only underlines the importance of adequate and careful preparation of intragroup contracts.

While the terms of the intercompany contract should be the starting point of the analysis, that should not preclude interpreting them in line with a third-party situation. In this scenario, alternatives available to both parties should be considered. Therefore, an entity should not be expected to continue to guarantee a steady remuneration if it can find a more advantageous option in a comparable arm’s-length relationship.

It could therefore be argued that the party initially characterized as a limited-risk entity should not have to bear all the costs and losses registered by the other party if an entity in a comparable third-party arm’s-length relationship would not. Providing examples of comparable third-party cases in which the parties did not follow the terms of the intragroup contract would be important to justifying departure from those terms.

The STA and Spanish courts have advocated for a substance-over-form view in various rulings. They have disregarded the effects of some transactions on the basis of article 9 of the tax treaties and the arm’s-length principle, for example, the landmark Supreme Court (Tribunal Supremo) decision in the BICC case (Appeal No. 3779/2009 (Sept. 18, 2012)). In this case, the Court confirmed an assessment in which capital losses and financial expenses connected to a Spanish company’s investment in a U.S. subsidiary were disregarded under the assumption that the investment had been imposed by the U.K. parent, and no third party would have accepted the transaction. This decision could be invoked to support a less formalistic interpretation of an intragroup contract regulating a Spanish subsidiary’s risk characterization within a multinational group.

Limited-Risk Structures

While it is difficult to find a general pattern in the STA and Spanish courts’ interpretation of limited-risk structures, it is interesting to note that they have on occasion been skeptical of them. Case in point are two relatively recent court resolutions.

In Microsoft (Appeal No. 337/2014 (Feb. 26, 2018)), the National High Court reviewed the STA adjustment made to the commission received by the local subsidiary under a marketing assistance agreement for the distribution of products in the Spanish market. While not challenging the allocation of the residual profit to the principal counterparty, the STA and the court challenged the arm’s-length range of the Spanish subsidiary’s level of profitability within the intercompany agreement. Specifically, the STA and the court found that the profitability level should align with the Spanish subsidiary’s functional profile that went beyond that of a limited-risk distributor. The range therefore should have been in line with the upper quartile of the arm’s-length range.

In the Colgate-Palmolive decision (Appeal No. 568/2014 (Feb. 22, 2018)), the National High Courtreviewed the adequacy of the transfer pricing policy implemented after a business restructuring that led to a shift in characterization of a Spanish subsidiary from entrepreneur to limited-risk entity. The court concluded that the subsidiary continued to have the same function as it had before the restructuring and should therefore earn the same residual profit from the parent.

This decision echoes similar judgments involving a restructuring or recharacterization of a Spanish subsidiary toward limited risk. Other examples include Roche (Appeal No. 1626/2008 (Jan. 12, 2012)) and Dell (Appeal No. 2555/2015 (June 20, 2016)), which have been rejected on similar grounds (lack of significant change in the function of the Spanish entity) and assessed through other mechanisms — that is, not through the questioning of transfer pricing policies, but rather permanent establishment claims by the foreign principal entity in Spain.

The extensive PE concept use by the STA and courts is undoubtedly a salient feature of these assessments. It could be deemed a creative and innovative interpretation by the STA and courts based on BEPS action 7, via the antifragmentation rule. In the STA and courts’ view, a restructuring using a variety of intragroup agreements (toll manufacturing, commissionnaire, and so forth), that limits the risk of the group’s Spanish entity or entities gave the foreign principal a fixed place of business.

On the other hand, in our experience, the STA has been a forceful defender of the limited-risk character of foreign groups’ Spanish subsidiaries facing losses over an extended period of time.

Conclusion

In the challenging times ahead, transfer pricing practitioners and taxpayers face a two-pronged structure:

  • On the one hand, the new control-over-risk paradigm could be used to determine the parties’ true transaction. The contractual terms of the agreements (as a starting point for delineating the intercompany transaction) will be a critical aspect for these purposes because they are highly valued by the STA and Spanish courts for comparability analysis. However, the third-party alternatives available to the parties could dictate a different outcome from sticking exclusively to the agreement’s terms, or could provide a wider interpretive view.

  • On the other hand, taking into consideration the magnitude and lack of foreseeability of the pandemic crisis, one could also argue that arm’s-length parties would have not required a price adjustment mechanism to accommodate such an unforeseen event or, in other words, would create a change in value so fundamental that it would have led to a renegotiation of the transaction.

Depending on the inbound/outbound nature of the case, the STA may be inclined to apply a different approach to judge the effect of the pandemic crisis on the group’s transfer pricing policies.

Taxpayers seeking to avoid the harsh context of an audit should negotiate an advance pricing agreement with the STA. This is a field in which the STA has been very active in recent years and provides a significantly more flexible approach than a tax audit.

FOOTNOTES

1 This article does not deal with the potential impact of the OECD initiative’s pillar 1 in relation to transfer pricing policies affecting consumer industry and highly digitalized businesses that could be deemed to run counter to the concept of limited-risk structures (see OECD, “Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising From the Digitalisation of the Economy” (Jan. 2020)). The evolution of the initiative in the context of the pandemic crisis and the fulfillment of its scheduled completion remains to be seen.

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