US Lawyers Urge Fresh Transfer Pricing Guidance

by Mike Godfrey, Tax-News.com, Washington

20 September 2012

Rudolph R. Ramelli, Chair of the Section of Taxation within the American Bar Association, has written a letter to Douglas Shulman, the Commissioner of the United States Internal Revenue Service (IRS), with comments and recommendations for guidance on the transfer pricing of related party guarantees.

In the Section’s comments, it is firstly noted that, in August 2006, the Treasury Department announced that it intended to issue transfer pricing guidance regarding financial guarantees along with other guidance concerning the treatment of global dealing operations.

More recently, the IRS has indicated that the government was studying two issues in particular concerning the transfer pricing treatment of related party financial guarantees: whether the issuance of a related party financial guarantee is a compensable transaction, and, if so, the method for determining its arm’s length price.

The Section said that it has prepared a report to offer some thoughts that may be of assistance in formulating IRS guidance that “should be as broad as possible”, and the report reaches the conclusion that IRS guidance “is sorely needed".

Many of the relevant issues have been on the table since the early 1980s, yet US taxpayers still have little stable authority concerning the proper transfer pricing treatment of guarantees and related credit enhancing instruments. Other jurisdictions have moved forward, with recent litigation in Canada and pronouncements from the Australian Tax Office.

“The forthcoming guidance should be framed broadly and should cover all financial and commercial credit enhancing instruments, not just instruments formally denominated ‘guarantees’", it adds. “The distinctions between financial and performance guarantees, and among guarantees and related instruments like ‘keep well agreements’, are often subtle and do not warrant differential treatment.”

The Section believes that credit enhancing instruments between related parties generally do give rise to compensable transactions, unless the transaction is structured as a present or future capital contribution. It actually recommends that compensability should be permitted in all situations “where one company transfers property or performs an activity that provides a direct and identifiable economic benefit to an affiliate”.

The benefit, it continues, “may take various forms, including reduced borrowing costs, the ability to bid on a contract, improved contract terms, improved access to funds or commercial opportunities, cost savings or efficiencies, or freedom from burdensome restrictive covenants”.

In addition, with regard to pricing methods for guarantees, it recommends that “market-based pricing should always be the starting point”. While numerous methods to a reliable arm’s length price have been suggested, including models using market evidence derived from credit default swaps, standby letters of credit, put options and insurance, the Section suggests the IRS should indicate its “openness to various pricing methods provided they have sound theoretical and evidentiary support under the circumstances”.

Finally, while the Section recognizes that there remain numerous complexities in pricing financial and performance guarantees, and similar credit or commercial enhancing instruments, it urges the government not to respond to these complexities by putting unreasonable burdens on taxpayers. "Taxpayers cannot be expected to engage a credit rating agency or the equivalent each time they need to price an instrument,” it said.

“Any forthcoming guidance should accordingly adopt a flexible approach that focuses on the reasonableness of the taxpayer’s pricing method and the evidentiary support for the transfer price,” it concludes. “To reduce disputes, safe harbour mechanisms should be made available.”

It is also emphasized that the Treasury should also work to develop common international principles for related party guarantees. The Section sees that, “at present, there are conflicting tax authority perspectives and it has not been unusual for US companies to be advised that if they charge a guarantee fee to a foreign affiliate, the foreign tax authority will deny a deduction for the payment. The US should lead the discussion in this area and work to forge consensus.”