The importance of substance in location for transfer pricing
TaxTalk - May 2024
Read time: 21 mins
When it comes to tax and business planning, multinationals should focus on economic substance and how it links to location.
When UK-based multinationals trade with an overseas affiliate, or foreign groups trade with a UK affiliate, economic substance matters. Under transfer pricing rules, an entity’s level of economic substance in the location is important. This will affect its entitlement to income and profits, or its claim to tax deductions and losses. This means transfer pricing can drive the profit and tax reporting outcomes of multinationals across entities in key operating markets.
The meaning of substance
Substance is a fundamental concept in international tax and appears in domestic tax law, tax treaties, tax authority guidance, and court rulings. Substance refers to, and requires, genuine economic activity in an entity’s location, which supports a claimed (or denied) tax position.
In-country substance may take a variety of forms and typically includes:
- key personnel with the relevant skills and experience to perform the entity’s business activities (such as directors responsible for corporate governance and strategy)
- Tangible and intangible assets (for example, an office or facility, registered or internally generated IP)
- Contractual relationships (such as supplier or customer contracts)
- Legal requirements (for example, a regulatory licence)
In a multinational group, substance directly affects an entity’s potential tax residence, permanent establishment, legal and regulatory compliance, as well transfer pricing positions. When we think about the relevant tax or other legal provision, the level of substance is determined by a critical evaluation of the entity’s business and commercial arrangements.
In the recent case of BlackRock HoldCo 5, LLC -v- HMRC [2024] EWCA Civ 330, UK tax deductions claimed for interest costs arising on loans as part of a business acquisition structure were disallowed under the unallowable purpose rule in section 441 of the Corporation Tax Act 2009. The Court of Appeal ruled that there was no reason to include a UK based entity with the relevant loans in the structure other than seeking to obtain a UK tax advantage. The taxpayer lost due to a lack of commercial function and substance.
Substance in transfer pricing
The legal framework alone (legal ownership of IP or contracts, etc.) does not determine profit attribution to entities in a multinational group. To comply with transfer pricing rules and the OECD arm’s length principle, multinationals must meet certain criteria. Provisions (whether in goods, services, IP, or financing) between related parties should be on terms and pricing which are consistent with open market conditions. This mitigates the risk of tax enquiries, adjustments, and penalties by tax authorities.
The location of substance is critically important to the application of the arm’s length principle:
- When reviewing related party transactions, a critical step is a functional analysis. It focuses on the ‘economically significant activities’. This means the functions performed, assets used, and risks assumed by an entity. The allocation of risks requires the entity to have ‘control of risk’ and the financial capacity to bear the risk. For example, senior management teams decide market strategy and budgets, new product development, sales channels, and customer pricing frameworks.
- In relation to intangibles, there should be a review of all the business activities which contribute towards the ‘development, enhancement, maintenance, protection and exploitation’ (or DEMPE) of IP. This could be, say, global marketing teams developing brand strategy and marketing collateral.
- When it comes to attributing profits to permanent establishments, OECD guidance emphasises the importance of ‘significant people functions’. This might include overseas sales personnel habitually exercising the authority to conclude the material terms and pricing of customer contracts.
- When operating in the financial sector, an analysis of ‘key entrepreneurial risk taking’ (or KERT) functions can drive the profit and loss outcomes between affiliated entities. An example would be offshore asset managers making key investment and retention of risk decisions which have profit and loss potential.
Generally, the more important the business activities an entity performs at arm’s length the greater its entitlement to income and profits (or risk of bearing losses). In other words, substance has a direct impact on the profit and tax outcomes of entities in a multinational group.
That’s why a substance analysis is essential to determine the allocation of income and profits (or losses) between affiliates in a multinational group. Profit attribution will be attached to where, and to the extent that, there is substance.
Business and tax structuring
Business and tax structuring are intricately linked to substance, given that multinationals often adopt centralised operating models. Hubs may be set up on a global, regional, business division, product category or functional basis. Key personnel may be housed in a hub location for strategic and operational efficiencies.
It’s also important to select location carefully when setting up a hub. Considerations include location-specific market attributes (such as access to skilled labour and proximity to customers), and tax attributes (including local tax rates and tax treaty networks). Multinationals should make sure that key personnel are working in the hub location; otherwise there may be unintended tax implications.
As businesses evolve, a mismatch may arise between income allocation and substance, where existing transfer pricing policies are no longer reflective of the business facts and circumstances. This can happen, for example, if there are developments in-country such as a new market strategy, creation of local intangibles, or hiring of new key personnel.
It’s wise to conduct a transfer pricing analysis, including a substance review, every year. This will ensure that intercompany pricing policies are reflective of the latest economic reality. Transfer pricing documentation should also be prepared to support compliance with the arm’s length principle.
Next steps
Multinationals should regularly assess transfer pricing policies. They should check that profit and tax outcomes align with substance, to mitigate the risk of misreporting and tax authority challenges.
For further guidance, please contact Farhan Azeem in the UK. He collaborates with local experts across PKF Global.