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1. Introduction
In mid-February of this year, the OECD released a 40 page paper describing global trading in financial instruments including derivatives and tentatively addressing the transfer pricing issues which it poses. The paper was designated as a "discussion draft" and circulated both to the tax authorities of the OECD member states and to the banking industry together with its advisors. The OECD's invitation to comment elicited responses in April of this year from KPMG, the British Bankers' Association, and the London Investment Banking Association, among others. Lengthy comments by the important American Bankers' Association (ABA) followed in mid-June. Most of the input for KPMG's comments came from its member companies in Japan, the United Kingdom, the United States, and Germany. The British Bankers' Association and the London Investment Banking Association, organisations which together represent over 300 banks and investment houses from more than 60 countries, submitted a single jointly authored response (referred to collectively as the British Bankers' Association and cited as "BBA" with paragraph number in the OECD draft). Comments submitted by the Banking Federation of the European Union broadly support those of the British Bankers' Association.
The OECD draft describes global trading as a factual matter, identifies the tax issues it poses, and discusses the various viewpoints on and possible solutions to these issues. Its authors state forthrightly that it "does not generally reach recommendations" and was not intended to do so (OECD Executive Summary, final paragraph).
The response to the OECD draft has been overwhelmingly positive. KPMG, the British Bankers' Association, the Banking Federation of the European Union, and the American Bankers' Association all commend the OECD for its initiative in this area and urge it to press forward with alacrity. It is hoped that at least a rough international consensus will emerge among OECD nations on the taxation of global trading so as to eliminate or at least reduce the potential for double taxation which currently exists.
2. Global trading and its tax problems in general
Global trading refers not to international transactions in goods and services in general, but rather to certain transactions of international financial institutions in financial instruments of all sorts. The two largest categories of such instruments are conventional debt and equity instruments (securities such as stock and public or private bond issues) on the one hand and derivatives on the other. Conventional instruments and derivatives may both be traded either on exchanges or "over the counter," that is to say, in a direct transaction between the financial institution and its client not involving any exchange. The OECD draft points out that many, if not most, of the enterprises engaging in global trading are banks as a strong capital base and credit rating are important prerequisites (OECD par. 28 - 31).
"Global trading" is a broad term popularly used to refer to the capacity of financial institutions "to execute customers' orders in financial products in markets around the world and/or around the clock" (OECD par. 9). To this end, financial institutions maintain complex organisations composed of branches and/or subsidiaries at various locations in tax jurisdictions around the world, all of which cooperate closely with one another. The essential tax problem posed by global trading is the correct determination of the profit or loss generated by each participant in "highly integrated" or "seamless" worldwide operations. If, as many believe, global trading is a proper case for application of the profit split method, then the overall profit to be split must be consistently determined by all the jurisdictions concerned and the correct share of such profit, including a "negative share" under certain circumstances, must be allocated to each and every location consistent with the arm's length standard. KPMG, the British Bankers' Association, the Banking Federation of the European Union, and the American Bankers' Association all caution, however, against a hasty and overly broad abandonment of transaction-based methods of determining profits.
3. Simplified example of global risk management
Risk is at the core of global trading. The British Bankers' Association states that the essential nature of global trading in financial instruments is "the assumption, creation, and management of risk positions"; global trading in its view means "global risk management" (BBA comment on par. 15).
The import of this statement is most easily grasped by means of a simplified example. The example chosen is built around a currency swap. Naturally, currency swaps are but one of a multitude of possible derivative financial instruments which can be used to limit risk. The example distorts reality by focusing on a single transaction. In practice, transactions are pooled for risk management purposes. It is therefore as a rule not possible to track transactions over their lifetime to determine how much profit each makes. In particular, it is generally not possible to determine whether, when, where or how a particular transaction is hedged (OECD par. 133 and BBA comment thereon).
Simplified example:
Bank A headquartered in London maintains offices around the world. The personnel in its office in Tokyo are approached on Day 1 by a large Japanese firm with which they have had prior dealings. The Japanese client wishes to know the terms offered by Bank A for a currency swap of the sum of US-$ 100 million for Japanese yen payable in 90 days. The background of the inquiry is that the Japanese firm has made a sale to a U.S. firm at a price in dollars, payable in 90 days. The Japanese firm does not wish to accept the risk of depreciation of the dollar against the yen over this period. Instead, it wishes to acquire the right to exchange the dollars it will receive for yen at a fixed exchange rate. The Tokyo office of Bank A has guidelines for currency swaps between relatively stable currencies such as the dollar and the yen. These guidelines have been set by the Bank's London headquarters and are updated every ten minutes on the screens of the Tokyo branch via data link to London. Within certain limits, the updates are automatically calculated by a computer program. Again, it is the London headquarters which has developed the computer program and set the limits. If the markets behave in such a way as to exceed the set limits, automatic updating is suspended and different guidelines apply. These essentially require human decisions on a case-to-case basis. The Tokyo office has no authority to make such decisions. Instead, authority is vested in the currently operative currency trading desk of Bank A. This trading desk, depending on the time of day, is located in Hong Kong, New York, or London (change of location every 8 hours).
The currency markets are stable on Day 1. Normally, the Tokyo Office could offer terms to the client based on the information on its computer screens. However, the sum of US-$ 100 million exceeds the limit for transactions without specific authority. Tokyo therefore refers the matter to the Hong Kong trading desk, which is the currently operative one. The client has not requested a reply until Day 2. Hong Kong therefore refers the matter to London, provides London however with its recommendations for the terms of the transaction. These take account of a wide variety of considerations, including the assumption that Bank A is bidding against other banks for the contract and the strong desire of Bank A to further cement its business relations with the Japanese client in question.
London approves the transaction on Day 2 on the terms suggested by Hong Kong. The Tokyo branch enters into a contract with the client the same day. Because of the desire to acquire the client, and because of Hong Kong's analysis that the dollar will remain stable against the yen over the 90 day period in question and perhaps even rise somewhat, the exchange rate offered to the client is identical to the current dollar-yen exchange rate.
Other traders also anticipate a rising dollar-yen relationship over the coming 90 days. Bank A could therefore, if it wished, on Day 2, immediately after signing the contract with its client, enter into a reverse swap with another financial institution under which it would exchange the sum of US-$ 100 million in 90 days for more yen than it has contracted to pay to its client. The terms of the swap between Bank A and its client thus, from the perspective of the bank, have a certain profit built into them. Let us say that this initial built-in profit or bid/offer spread, expressed in dollars, amounts to US-$ 10,000 or 0.01 % of the amount of the swap.
The decision whether to enter into a reverse swap is reserved to the operative currency trading desk and is not made in Tokyo. A reverse swap is not entered into until Day 15, when the New York trading desk decided that, in view of the unexpected steady decline of the dollar against the yen, the position should be closed. To secure on Day 90 the sum in yen which the bank must pay to its Japanese client, the bank was obliged to swap the sum of US-$ 101 million.
On Day 90, settlement is made on both swaps by the London headquarters of Bank A. It therefore transfers US-$ 101 million to its reverse swap partner and receives from this partner the sum in yen which it must pay to its Japanese client. Because the dollar has gained steadily against the yen in the period from Day 15 to Day 90, the sum in yen received by the Japanese firm is worth only US-$ 95 million at the rate prevailing on Day 90. However, its swap has prevented it from benefiting from this dollar appreciation. Bank A would have made a profit of US-$ 5 million on the deal, but it also swapped away its risk (and its opportunity) on Day 15. Consequently, it instead lost US-$ 1 million on the overall transaction.
How should this loss be allocated for tax purposes? Should it fall on the Tokyo branch of Bank A for having originated the transaction? Should it be allocated to the London headquarters as the party ultimately responsible for planning worldwide activities? Or should it belong to New York as the trading desk which closed the position at a loss? What if exchange rates had gone the other way and the bank had entered into a reverse swap on Day 15 at a profit of US-$ 1 million?
In their comments on the OECD paper, the British Bankers' Association insists on the distinction between the selling activity (performed by the Tokyo office in the above example) and the risk management activity (performed by the three trading desks in rotation). Furthermore, the British Bankers' Association calls attention to the difference between the bid/offer spread when a product is sold (in the above example, US-$ 10,000 or 0.01 % of the amount of the swap) and the final profit or loss which results from the decision to keep a risk open or to close it (BBA comment on par. 49 and 146). In the above example, the bank kept the risk of adverse exchange rate fluctuation open from Day 2 to Day 15. During this period, the risk was "proprietary" to the Bank. Had it chosen to close this risk immediately, it would have made a modest gross profit on the transaction, before deduction of allocable costs. The British Bankers' Association perceptively notes that "the crucial decisions are the opening of a long or short position and the keeping open" of that position (BBA comment on par. 49). From Day 2 to Day 15, any of the three trading desks could have closed the position several times without loss or at a loss less than the one actually realised.
It seems logical to attribute the loss resulting from the decision to keep the forward exchange position open for 14 days to the three trading desks (in three different jurisdictions). The British Bankers' Association suggests remunerating the selling activity with a commission based on bid/offer spread, noting that "there seems to be no reason why the salesman should be regarded as playing any part in creating trading profits and losses arising from position taking" (BBA comment on par. 146).
Indeed, the British Bankers' Association would exclude all activities except risk management ("trading activities") from an apportioned share of profit or loss on the risk proprietary to a financial institution. Non-trading activities including selling and support functions (e.g. settlement, accounting, monitoring of transactions, legal and documentation services) should instead receive "justifiable service and commission payments" (BBA comment on par. 151/153). "There is no case for attributing trading profit or loss to a territory where the activity performed is unrelated to management of trading risk" (BBA comment on par. 130).
In the view of the British Bankers' Association, the term "global trading" should only be used to refer to discretionary risk management conducted from locations in more than one tax jurisdiction. In its view, functions preparatory or ancillary to the actual trading activity pose no tax issues which cannot be resolved under the existing framework (BBA comment on par. 10/11 and 125/127).
The OECD paper does not entirely share this opinion. The OECD paper in its present form sees risk management as but one of several functions of global trading, albeit a very important one (OECD par. 185).
4. Selected tax issues on global trading
4.1 Lack of guidance for taxpayers
The OECD paper notes that institutions engaged in global trading have in many cases had to structure their operations with "little specific guidance as to what tax administrations find acceptable" (OECD par. 95). This statement evokes the strong support of KPMG in their written comments (p. 2).
4.2 Structure of global trading
The structure of global trading varies considerably from institution to institution. The OECD paper identifies three basic models, but emphasises that they are seldom encountered in pure form and that the industry is constantly evolving (OECD par. 46 - 63). The three operating models, which may use branches or subsidiaries or both, are as follows:
Integrated Trading (responsibility for a portfolio of risk positions, called a "trading book," rotates in the course of a day between several trading locations, each of which is a branch of the same legal entity; this model was adopted for the example in sec. 3 above).
Centralised Product Management (trading responsibility for certain products is centralised in one trading location, responsibility for other designated products in another, and so forth; when a transaction in a product managed from Location A is originated by Location B, the risk is moved to Location A by an inter-branch or inter-company transaction).
Separate Enterprise Trading (each trading location, whether a subsidiary or a branch, has independent general trading authority within certain guidelines established by the group headquarters).
It should be noted that the a group may have many more locations than it has trading locations under each of the above models. For instance, in the example under sec. 3 above, Bank A had an office in Tokyo, but its only Far East trading location was in Hong Kong.
The British Bankers' Association notes with respect to integrated trading that the authority of the operative trading desk may not be absolute. With respect to certain transactions, it may have to contact a head of trading at another location irrespective of the time of day where this person is located (BBA comment on par. 47/51).
Under part I.B of its comments, the American Bankers' Association further analyses the three basic models. It notes that, for reasons of cost efficiency, "the centralised product management model is the industry norm". Under this model, authority for each product is centralised in its primary market centre or "natural home" (ABA part I.B sec. 1 par. 2). Foreign exchange transactions, however, generally follow the separate trading model for spot and short term forward transactions (characterised by high volume and thin bid/offer spreads) and the integrated model for currency option transactions (characterised by relatively high bid/offer spreads). Furthermore, the ABA observes that the three models relate solely to the trading function (risk management function) and have nothing to do with the other economic functions, such as marketing, support, settlement, or risk-bearing. Particularly with regard to risk-bearing (which refers to the economic ability to absorb the risks, i.e. the potential liability from global trading transactions, as opposed to risk management, which involves the trading function only), the American Bankers' Association emphasises that the capital needed in this connection is generally concentrated in a single entity (ABA part I.B sec. 2).
4.3 Split hedges
Global trading involves transactional pairs. An initial transaction with a client opens a risk position for the global trading institution and a subsequent offsetting transaction "hedges," that is, closes or limits that risk. In between, the risk is proprietary to the institution. There need be no connection between the location where a transaction originates and the location where the respective open position is closed. Indeed, it may not even be possible to match the various open risk positions with the originating transactions since open risk positions are pooled and analysed in their entirety, not in isolation. However, viewed in isolation the two halves of a transactional pair can have very different results.
In the example under sec. 3 above, Bank A lost US-$ 1 million when one considers both halves of the transaction (assuming this were possible). However, if one looks only at the initial swap arranged through the Tokyo office, a gain of US-$ 5 million appears to be the result. In a worst case tax scenario, Japan would tax the Tokyo branch of Bank A on a gain of US-$ 5 million while all of the other jurisdictions involved would refuse to recognise the loss of US-$ 1 million, since in their view it is attributable to Japan as the originator of the transaction. The two halves of the transactional pair have been split apart, with unfortunate tax results for Bank A. The avoidance of split hedges is obviously a necessary feature of a rational tax system for global trading (cf. OECD par. 99 - 102).
4.4 Recognition of inter-branch and intra-group transactions (internal payments)
Financial institutions may do business in branch or subsidiary form in other jurisdictions. In some jurisdictions, an institution may have both branches and subsidiaries. In others, it may maintain a representative office which does not constitute a branch under the OECD model tax treaty. Whatever the formal status of a location, the degree of cooperation among them is high. As the OECD paper notes, this swift and complex global interaction makes it difficult for tax authorities "to satisfy themselves that they are taxing an appropriate portion of global trading profits" (OECD par. 98).
Jurisdictions may refuse to recognise inter-branch transactions on the grounds that a legal entity cannot contract with itself or because of difficulty in verifying that the transactions are at arm's length. The latter problem also arises as to transactions between group subsidiaries. Failure to recognise such transactions poses the danger of split hedges discussed above. It also leads to an inappropriate allocation of expense, particularly in the case of internal interest payments.
Charges (interest payments) for capital used by a trading location to fund its activities are a particularly important type of global trading expense. Typically, groups and institutions engaged in global trading fund their trading locations internally. The British Bankers' Association makes an important distinction between capital "borrowed" internally to pay for purchased securities or margin thereon on the one hand and borrowing to pay for deemed distribution of profits calculated on a mark-to-market basis on the other. It is absolutely crucial that at least the former type of interest be recognised unconditionally. In hedging certain transactions, it may be advantageous to purchase e.g. fixed interest securities instead of entering into a derivatives contract. While conclusion of a derivatives contract involves no immediate cash outlay, purchases of securities require capital and lead to interest expense. If this expense is not recognised or not properly allocated for tax purposes because it is inter-branch expense, the purchase of a derivatives contract will have an advantage for tax reasons, even though, viewed economically, it may be the less desirable hedging choice. See BBA comments on par. 82/87 and 140 - 143.
Both KPMG and the British Bankers' Association criticise the interest expense rules as applied to internal payments in the United States and Japan. KPMG refers to the internal payments issue as one which "confounds the international treatment of permanent establishments" and urges recognition of all internal transactions provided at arm's length (KPMG pp. 4, 5).
4.5 Separate enterprise principle for determination of profits of permanent establishments
The American Bankers' Association takes a position similar to that of KPMG and the British Bankers' Association on the issue of recognition of internal payments. As a general matter, the American Bankers' Association strongly supports the view that "operations which are economically identical should produce similar tax results, whether conducted in branch or subsidiary form" (ABA part IV.A par. 1 and OECD par. 122). This conclusion is derived from the "separate enterprise principle" of determining the profits of a permanent establishment under Article 7 of the OECD model tax treaty. The recognition of internal payments when the payments are at arm's length (ABA part IV.E par. 4) may be seen as a logical consequence of this principle.
4.6 Agency-based permanent establishments
Financial institutions engaged in global trading sometimes designate a single entity, perhaps a special-purpose subsidiary, as a "booking vehicle" to become the legal party to all global trading transactions vis-a-vis the client. This may be done to pool capital in the booking entity in order to secure a strong credit rating for the booking entity, which is something clients naturally insist on. Actual risk responsibility may be located elsewhere in the group, e.g. by virtue of intra-group transactions by which another group entity assumes the risk positions in question.
The group locations in jurisdictions around the world may arguably constitute agency based permanent establishments of this booking vehicle under Article 5 (5) of the OECD Model Treaty because these locations regularly negotiate contracts with clients into which the booking vehicle then enters. The OECD paper, KPMG, the British Bankers' Association, and the American Bankers' Association all consider that great potential for "conflicting claims to the book profits among the tax authorities and hence of double taxation" (OECD par. 130) is created by treating the booking vehicle as having permanent establishments everywhere a group location assists it in entering into a global trading transaction (OECD par. 128 - 130, BBA comment on par. 128 - 130, KPMG p. 3 ff., ABA part IV.C).
It is noted that the group location may be an agent of an independent status within the meaning of Article 5 (6) of the OECD Model Treaty and hence not create a permanent establishment. The apprehension exists, however, that it will not be possible to use this argument successfully in all cases.
It is accordingly furthermore argued that the permanent establishment issue should, in KPMG's words, "not be pressed" when the domestic location (potential permanent establishment), in light of its specific functions, has received arm's length remuneration for its economic contribution. The underlying premise is that the profits attributable to a permanent establishment would be equal to adequate third party compensation in any event, hence that tax authorities should not be concerned whether they are taxing a branch profit or fees paid to a domestic entity as long as the amount in question is the correct one. The American Bankers' Association echoes the KPMG position when it states that "as long as the marketer has received an arm's length payment, there should be no additional taxation by the permanent establishment's state" (ABA part IV C).
The British Bankers' Association goes somewhat further and advocates "limited changes in the agency rules" for permanent establishments "to cover the specific situation of global trading" (BBA comment on par. 128, last paragraph).
KPMG reports on a recent U.S. case posing these issues in which an offshore company was taxed on profits found to be attributable to its domestic agent-based permanent establishment. The offshore company had regarded its U.S. subsidiary as an independent agent and paid it fees for its services, which the agent had declared and paid taxes on in the U.S. These fees were, however, not allowed as expenses for the deemed agent-based permanent establishment because the offshore company had filed no U.S. tax return, resulting in double taxation in the amount of the fees. KPMG urges the OECD to encourage its members not to impose penalties on formal grounds (here, denial of a deduction for failure to file) when the taxpayer has made a good faith effort to comply with the law.
4.7 Profit determination
Comparing the OECD draft with the comments submitted by KPMG, the British Bankers' Association, and the American Bankers' Association, one cannot help but conclude that profit determination is an area in which all concerned are still far from a consensus. Agreement exists only as to the confusion, uncertainty, and multiplicity of views relating to this issue.
At the heart of the controversy is the extent to which the traditional transactional methods are inadequate to the reality of global trading. The OECD paper devotes considerable space to a discussion of how a profit split methodology might be applied to global trading (OECD par. 149 - 195). KPMG and the British Bankers' Association both caution against an overly hasty abandonment of the traditional methods. The American Bankers' Association likewise maintains that transactional methods are adequate to most aspects of global trading, including the problem of determining the income allocable to a branch (ABA part IV.D). Particularly the British Bankers' Association contends that the profit attributable to all functions except the global risk management function can be arrived at using the traditional transactional methods (BBA comment on par. 10/11 and 125/127; see also above sec. 3, last three paragraphs). By applying traditional methods to the greatest extent possible, the need to resort to a profit split based on formulary profit apportionment should be kept to a minimum (BBA comment on par. 133, 167).
Be this as it may, both KPMG and the British Bankers' Association believe that it will be necessary to fall back on a profit split methodology in certain cases. The American Bankers' Association appears to favour the profit split method primarily "when the parties have themselves agreed to divide a portion of the combined profits" (ABA part III.A par. 1 and 2; cf. also part II.B par. 1). This follows from "the respect [to be] accorded to the actual transactions undertaken by the taxpayer and the manner of doing business in fact chosen" by him (ABA part II.A par. 2), which is a major theme of the ABA paper (cf. e.g. also ABA part II.B sec. 5 par. 2).
Aside from the issue of when to use a profit split method, the four institutions and the OECD are also still groping towards agreement on the details of the method to be used.
For risk management activity only, the British Bankers' Association seems to favour, or be resigned to, "formulary profit apportionment" along the lines of the OECD draft. The factors discussed in the OECD draft are the compensation of traders and marketers, risk, and the compensation of key support staff (back office). These factors mirror those outlined in IRS Notice-94-40 (cf. OECD par. 171 - 173 and 174 ff.). Measurement of the risk inherent in a portfolio is a very complicated matter which the OECD draft anticipates to be beyond the means of most countries. It is suggested that such countries could adopt methods devised by financial institutions to the same ends (OECD par. 184). After arriving at a formula, the OECD paper states that the weighting of its components should be adjusted according to the particulars of each situation, but concedes that there is no consensus as to how this might be done (OECD par. 195, 196).
The British Bankers' Association is critical of compensation as an allocation factor, but willing to accept it to a limited extent (comment on par. 174/175). It strongly advocates making risk the central allocation factor in any apportionment formula (comment on par. 185) and emphasises the need to distinguish the degree of risk responsibility allocated to a particular location (comment on par. 189/187). While analysis of the degree of risk in a portfolio may be a complex task, the British Bankers' Association points out that the level of discretionary authority vested in a particular location can be identified on the basis of the institution's internal guidelines and its reports to regulatory authorities. Many locations may have only circumscribed authority (akin to that of Tokyo in the example in sec. 3 above). Finally, the British Bankers' Association criticises the failure to consider transactional volume and bid/offer spread as allocation factors (BBA comment on par. 194).
KPMG, on the other hand, is critical of what it fears to be an "overly formulaic" approach, pointing out that while "a profit split method based on subjectively selected allocation factors and weights" may be cost effective, "it does not guarantee an arm's length result." KPMG instead advocates an objective selection of allocation factors based on a large-scale analysis of global trading operations. KPMG also suggests exploring whether the transactional net margin method might not be superior to a profit split based on fairly subjective, that is to say, arbitrary criteria (KPMG pp. 6, 7).
The American Bankers' Association shares KPMG's acute concern for respecting the arm's length principle, stating that certain passages in the OECD paper (particularly OECD par. 170) sound "ominously like a justification for unitary profit splits" (ABA part III.C par. 4). The ABA's lengthy comments comparing transactional and profit-based methods (part. II.B) and on the profit split method in particular (part III) are intended to help ensure that the profit split method yields an arm's length result, not just one which is administratively convenient and "manipulation-proof".
If a profit split method is used, it is of course necessary to have agreement on the profit to be split. The British Bankers' Association supports the suggestion that the total profits from a trading book be calculated with respect to the accounting standards in force where the book is kept, i.e. where legal ownership of its positions is held. However, both KPMG and the American Bankers' Association oppose this approach, on which the OECD paper itself is non-committal (see OECD par. 164 and comments of BBA and KPMG thereon; ABA part III, last par.). However, OECD, the British Bankers' Association, and KPMG agree that a mark-to-market approach is probably the best for global profit determination, although KPMG cautions that implementation of such an approach should be by degrees (BBA comment on par. 97, 164; KPMG p. 5). The British Bankers' Association suggests in particular that the accounts produced by financial institutions for bank regulatory purposes be made the basis for profit determination and that the tax authorities abstain from prescribing separate profit determination rules for tax purposes (BBA comment on par. 97, 164). The American Bankers' Association does, however, consider the books of the enterprise and the tools developed by management to reward economic functions to be an appropriate starting point for tax analysis (ABA part II.B sec. 2 par. 3).
Lastly, a profit split method also presupposes a consensus on expense allocation. While there is agreement on the idea of distinguishing between "local costs" and "global costs," with the former being attributed to particular locations and the latter being apportioned, there is uncertainty as to which costs belong in which category, not to mention the correct method for apportioning global costs. See OECD par. 159, 160.
4.8 Documentation and Advance Pricing Arrangements (APAs)
KPMG urges the OECD to work towards a consensus on the documentation requirements associated with transfer pricing for global trading. It also suggests that the OECD consider proposals for streamlining the existing APA procedures to reduce the time and cost they involve.
5. Conclusion
As the reader will doubtless have long since guessed, the conclusion to this article is that, while a valuable start has been made in the difficult area of transfer pricing for global trading, a lot of work still remains to be done.
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