Choice of a relevant method of allocation
The potential lack of tax neutrality concerning global trading activities stems from the difficulties usually encountered in financial matters as regards the allocation of a fair remuneration to each actor for the services rendered, the risks borne, the value added (this difficulty derives from the particularly intangible nature of the transactions being carried out).
Here again the diversity of the various potential approaches is pretty well illustrated in the comparison between Anglo-Saxon approaches on the one hand and French approach on the other hand.
a) The various approaches followed by countries
The structure and organisation of the group as well as the functions and financial risks (market and counterpart risk) between the different entities necessarily influence, from a tax point of view, the analysis that should be undertaken concerning the validity of the profit and remuneration allocation methods.
This can be explained by the fact that, in most of the countries involved, domestic tax laws as well as treaties provide that the transactions must be performed in accordance with the arm's length principle, i.e. under conditions prevailing on the market.
These so-called fully competitive conditions depend on the functions performed, the added value created, the risk assumed and the degree, autonomy and responsibility granted in the decision-making process which is inherent to any financial operation, at the headquarters' level as well as at the level of each entity involved in the global trading activities.
The complexity of the problem is reinforced by the characteristics of the internal laws relating to transfer prices.
For example, a remuneration method developed in accordance with fully competitive criteria could be contested by local tax authorities on the grounds that internal criteria used to set transfer prices would not have been respected.
b) The Anglo-Saxon approach
We should bear in mind the fundamental differences which exist between the US approach on the one hand and the European approach on the other hand (and to a smaller extent in Japan) as well as the very penalising consequences likely to emerge from the evolution of the American legislation concerning this matter.
Thus, the United States or the United-Kingdom seem to adopt or advocate a global method of profit allocation between the various entities or establishment of a single group: the overall profit due to transactions is allocated between the different entities or establishments in accordance with flat keys linked to various parameters, (number of operations, number of employees, ratios relating to traders remuneration, nature of the risk assumed, identification of the capital engaged...)
Obviously, because of this method, which is by nature difficult to objectives, the situation of the entities is quite difficult, in the event of US Internal Revenue Service investigations.
This explains the issue by the IRS of Advance Pricing Agreements to taxpayers who request it. These agreements aim at setting appropriate transfer prices as well as establishing a profit allocation method arising from global trading activities. For instance, it is well known that Barclays Bank and Sumitomo Bank obtained such agreements years ago (Tax Notes International, May 11, 1992, pp. 959 and 960; Tax Notes International, May 16,1992; Tax Notes International, May 23, 1994, nos. 1362 to 1364).
However, we understand that some companies feel reluctant to approach the IRS, to the extent that this process requires the unveiling of information (particularly concerning the world-wide structure of the group).
However the IRS has very recently revealed the logical line followed when negotiating and granting Advance Pricing Agreements as regards global trading, which should reassure the companies concerned. This is indeed the purpose of Notice 94-40 published April 25, 1994 whose main components are subject to the following developments.
The notice deals in particular with the following subjects:
- the concept of "Advance Pricing Agreement" (APA)
- the context in which the IRS has taken positions
- the specific procedure relating to global trading activities
- the criteria used to grant APA as regards global trading activities
- the practical implementation of the method chosen
- the eventual transposition of the present method to the future negotiations with residents or non-residents.
Concept of "Advanced Pricing Agreement"
First, it should be noted that in an Advance Pricing Agreement process, the Internal Revenue Service and the American taxpayer together choose a methodology which enables them to set transfer prices. Then this latter is applied to each allocation of revenues, costs, deductions or credits between (or within) two or more organisations, businesses, companies, enterprises held or controlled directly or indirectly by the same groups.
In financial matters, the Internal Revenue Service has already concluded APA's with several taxpayers operating on derivatives in accordance with an entirely centralised management system.
Accordingly, as mentioned in Notice 94-40, companies interested in APA's should have a fully centralised management system, at the risk management level as well as at the personnel management level. The transactions performed on all world-wide markets must be recorded on a global book. Every day, at the closure of the quotations, this book must be transferred from one establishment to another in accordance with the procedures and rules set by the headquarters.
However, the Internal Revenue Service warns the reader that the above-mentioned instruction does not aim at setting general rules concerning the federal taxation of by-products.
In fact, Notice 94-40 only aims at describing a method and factors which must be considered in order to allocate the revenues stemming from the above-described transactions when these latter are executed both in the United States and in other countries and when these transactions are characterised by the transfer of a book including the positions of all the establishments of the company acting on those markets. However, the IRS does not prevent taxpayers whose activities are not centralised from trying to resort to the APA procedure.
The Internal Revenue Service points out that historically financial markets were bound to their national borders within which transactions were regularly carried out.
However, world-wide financial markets have become more and more integrated because of the technological developments, the financial innovations, and the progressive suppression of foreign exchange controls.
Consequently, numerous financial intermediaries henceforth act without interruption on the financial markets via world-wide traders : from which ensues the concept of "global trading".
Four general functions are common to global trading operations: trading, sale, management and technical assistance.
A trader conveys the prices, carries out the sale and purchase of instruments, and sets the method of covering or arbitrating the performed transactions.
A salesman advises the clients on the manner in which to manage the prices, the rate and exchange risks associated with its assets and liabilities, in order to sell them by-products.
A manager monitors the establishment level of risk and sets the limits which are not to be exceeded.
Finally, the assistance function which supports the three functions above, includes a wide range of activities : development of technologies and information systems, analysis of the counterpart risk, accounting and administrative assistance, etc.
Several international financial groups have integrated these functions for different business reasons.
Nevertheless, according to the Internal Revenue Service, we may distinguish two major kinds of operational structures: the organisations which are fully centralised and the ones which are not.
The global trading activities undertaken by fully integrated companies are characterised by the centralisation of the risk and personnel management.
In that case, the risks are globally managed.
Consequently, a global book is kept and sent every day at the closure of the quotations from one establishment to another.
A specialised department monitors the counterpart risk relating to the transactions performed by the traders in order to assist the risk evaluation and management.
Thanks to this information, the head office sets rules of conduct and determines customer credits which must be respected by all traders of the group.
Each book is concerned with a product or a group of products and is under the liability of a chief trader or a manager. The trader or the manager sets and enacts the rules which must be respected by each establishment.
This manager is liable for the economic performance of the book. In this respect, he supervises local traders to the extent that he is often near them.
In a fully integrated organisation, each establishment carries out the same functions with respect to the limits, procedures and rules of conduct sets by the head office.
For example, a seller may be located in one country, the purchaser may be located in another one. Furthermore this transaction can be covered by a third country. In such a case, each establishment contributes to the overall profitability of the world-wide activity.
According to notice 94-40, the APA procedure proved its efficiency in allocating the incomes issued from integrated global trading activities to the extent that the Internal Revenue Service has allowed this method of allocation among the different jurisdictions involved.
For each transaction, the taxpayer and the Internal Revenue Service have concluded an APA to allocate the revenues (in case of a treaty the US and foreign authorities conclude also an agreement).
According to the same notice, the IRS, the foreign partners and the taxpayers have considered that this method of allocation was suited to the integrated global trading activities, with respect to the volume and the nature of the transactions concerned by the APA process.
Indeed this method allows the taxpayers to correctly appreciate the contribution of each establishment to the overall profitability of the book.
When global trading activities are carried out by companies and subsidiaries located in different jurisdictions, the APA were concluded according to section 482 of the Internal Revenue Code and to the tax treaties concerned.
However for companies located in a given jurisdiction which act through branch offices located in the other jurisdictions involved, the APA were concluded according to the sole tax treaties between the United States and the countries where the taxpayer is located.
Generally speaking, those APA's which have been granted to taxpayers acting on financial markets in accordance with a globally integrated operating method, have covered transactions performed on financial term instruments as well as cover transactions tending to reduce the rate or the exchange risks.
Regarding global trading, the APA have been granted to American companies which performed their transactions through branch offices or subsidiaries located in the countries which have signed a non double taxation agreement.
At the same time, the Internal Service allowed foreign companies which partially undertake global trading activities through a branch office located in the United States to benefit from this procedure.
Although the Internal Revenue Service has not yet entered into such a negotiation, a foreign company acting in the United States through a subsidiary could a priori benefit from this procedure. It would be no procedural obstacle.
Thanks to its flexible nature, the APA's process is not necessarily applied to all global trading book. Therefore, the taxpayer can choose those activities to which the process will be applied. It is understood that each APA is specifically adapted to the particular situation of the taxpayer.
Criteria used in an APA's process specific to global trading activities
Regarding global trading activities, notice 94-40 includes a general description of APA's delivered by the Internal Revenue Service to taxpayers who operate in accordance with an integrated operating system.
In each of these APA, the Internal Revenue Service, the taxpayer and the tax authority of the country concerned have agreed that the world-wide profit issued from each book covered by the procedure would be allocated among the various locations where the global trading activity is undertaken, in accordance with a profit split method.
Indeed, this method aims at measuring the economic activity of each establishment and its contribution to the profit of the group, calculated on a world-wide basis.
From this perspective, three factors have been identified. They are :
- the relative value of the establishment (the "value" factor);
- the risk relating to a specific establishment (the "risk" factor);
- the volume of the activity of each establishment (the "activity" factor).
These factors are weighted to reflect the contribution of each establishment to the group's overall profitability.
In addition, the APA's process evaluates these factors in different manners: indeed, the procedure is adjusted to the circumstances by choosing criteria which reflect as much as possible the taxpayer situation.
For each factor, some parameters are taken into consideration such as the taxpayer's management structure, its information system, the functions fulfilled, the risks assumed and the capital invested by each establishment.
The "value" factor enables the measurement the contribution of each establishment to the group's world-wide profit. It is understood that the by-product "trading" generates significant profits and losses for the establishment.
As regards taxpayers concerned by the APA's process, it has been noticed that their resources came essentially from the traders to the extent these latter have a client list and know the market very well.
Indeed, the traders are responsible for negotiating the prices, performing the transactions and setting the coverage strategies to be applied. In return, they receive a compensation which is usually made up of a fixed salary and a bonus depending on the contribution of each establishment to the world-wide profit.
The amount of these compensations is therefore a good indicator of the contribution of each establishment to the world-wide profit and is considered by the US authorities as well as by the foreign authorities as the best instrument to measure this contribution.
The "risk" factor measures the potential risk to which the company's capital is exposed as a result of the activity of each of its establishments.
This factor provides an interesting indication of each establishment's contribution to the world-wide gross profit. Since this factor is based on the proper characteristics of each taxpayer, it can be evaluated in different ways: weighed maturity of the volume of swaps transactions (calculated by multiplying the notional amount of each rate exchange contract or foreign currency exchange contract by its maturity) or amount of the opened positions at the end of the establishment's fiscal year.
Sometimes, the weight of this factor is less important than the other factors (especially the "activity" factor).
The "activity" factor also enables the measurement of the contribution of each establishment to the world-wide company gross profits. This factor is measured in reference to the remuneration of the personnel required for support functions (for example personnel responsible for the back office). It can also be measured in reference to the present net value of the transactions undertaken by the establishment (this value corresponds to the sum of the present value of the future cash flow).
Implementation of the allocation method
According to notice 94-40, the first step is to assess the amount of the profits and the losses, to which the method is therefore applied.
Traditionally, this amount (world-wide profit or loss) includes world-wide profits and losses resulting from the trading transactions performed on the domestic and foreign by-products markets and from the attached cover transactions, to the extent the taxpayer and the tax authority have decided to include them in the APA.
The expenses directly related to the market transactions must be deducted from this amount (for example, the expenses involved by the computer system, the payment due to a specific personnel, the commissions and fees paid to the brokers).
Other expenses such as rent, office supplies and telecommunications are inherent in the functioning of each establishment , and are therefore allocated to them, subject to the application of specific US tax rules.
The second step consists of calculating the ratio resulting from each factor.
For example, in order to calculate the ratio relating to the "value" factor, the amount of remuneration paid to US traders is divided by the total of remuneration paid to all traders (US and non US combined).
This percentage can bear, if necessary, a weighted coefficient.
Once the three ratios are calculated, the percentage of revenues or losses attributable to the US is calculated by dividing the sum of the three factors by the weighted sum of each factor.
Finally, in order to calculate the share of the world-wide profit attributable to the US, the world-wide profit or loss is multiplied by the percentage described above.
Transposition to future APA
In sum, we should keep in mind that notice 94-40 is not intended to give a standard method or standard factors.
Other methods can be used to the extent that they enable a better measurement of the contribution of each establishment to the overall profit.
For some fully integrated companies, the method and factors described in Notice 94-40 do not permit precise measurements of the contribution of each trading location to the overall profits of the global trading activities.
In addition, with respect to the management or information system specificities, other methods or factors could be applied.
In these two cases, the IRS admits the implementation of other methods or factors to the extent that they permit a more precise measurement.
Furthermore, various methodologies may be suited to non fully integrated global trading activities which are not characterised by the transfer of the global trading book positions in accordance with the closure of the market.
c) French approach
Other countries, such as France, seem to adopt another approach which generally consists of identifying each function of the financial market activity at an international level, or in the global trading process and proposing an appropriate compensation of these methods.
From this perspective, in order to set an appropriate method of compensation, the world-wide financial market or global trading must be analysed in detail, in France as well as in each location involved, in accordance with predetermined criteria.
Three standard schemes are usually distinguished : global book (as described in Notice 94-40 by the IRS), centralised organisation per product, decentralised independent system.
The implicit and explicit criteria include in the various internal laws concerning the transfer prices must then be identified.
Finally, with respect to compensation, certain choices must be made such as:
- choice between an overall remuneration for each location, considering its contribution to the overall activity (same approach as the Anglo-Saxon approach)
- and an individual remuneration of each function, based on an operational approach (conception, management, trading, economic function, counterpart risk, capital cost, logistical and computer support).
And, in an operational approach, the choice must be made between a profit allocation and the payment of commission or cost plus.
In this respect, an entity whose responsibility in the profit-making process is prevalent would rather receive a profits or losses allocation, for example global trading activities or management of position.
On the other hand, a secondary activity in the profits or losses process should be compensated by means of commission or cost-plus.
Finally, in case in which the assuming of the counterpart risk would be disconnected from the management, a specific compensation could be considered.
In conclusion, there is a serious risk that the tax authorities will contest the compensation modes chosen. If this risk can not be entirely suppressed, it can nevertheless be substantially reduced thanks a suitable analysis of the operating modes of the activity performed. In this manner, the compensation modes chosen should be appropriate and accepted by the various tax authorities concerned.
Because of these uncertainties, an analytic and specific method must be applied taking into account all the establishment departments involved.
The understanding of the flows, the identification of the risks and the consideration of the processes and objectives could be useful in drafting a kind of white paper which afterwards enables a suitable analysis of the tax situation.
Thanks to this first approach, it is then possible to determine the more appropriate allocation of the income and expenses among the various entities involved.
Of course, handling the problem solely from the tax perspective is illusory; operational aspects also deserve specific attention.
Various connection rules
The sole allocation method does not permit the attaining of complete tax neutrality.
In this respect, a harmonization of the rules relating to the calculation and connection of the profits among the various countries is necessary.
Indeed, the fourth obstacle to tax neutrality could stem from the lack of harmonization between the various internal laws relating to the use of financial instruments : either taking into or not account the deferred losses and/or gains, the evaluation methods of these deferred gains or losses, the specific rules concerning coverage transactions or symmetrical positions, the diversity of regulations according to the kind of product under consideration.
Therefore, even if the first technical difficulties are resolved - for the record, on one hand, consideration from a tax perspective of the internal flows, and on the other hand, implementation of an appropriate allocation method - a solution should be found concerning the formation of the allocated revenues as well as the connection rules of the planned commissions.
If the methods of result assessment are different among the various countries or if the connection rules relating to the planned commissions or incurred costs become divergent afterwards, the risk that the tax neutrality can only be reached at the conclusion of the activities performed must be seriously considered.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. For additional information contact Claire Acard on 33/(1)/55 61 10 10. The members of Archibald Andersen Association d'Avocats (S.G. Archibald and Arthur Andersen International) are registered with the Hauts-de-Seine Bar and the Lyon Bar.