Department of Law Spring Term 2020 Master Programme in International Tax Law and EU Tax Law Master’s Thesis 15 ECTS

Transfer Pricing of Internal Banks In the Light of Fiat State aid Case and Transfer Pricing Guidelines on Financial Transactions

Author: Dusan Arsenovic Supervisor: Katia Cejie

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Table of contents

Abbreviations ................................................................................................................ 2

1 Introduction................................................................................................................ 3

1.1 Issue .................................................................................................................... 3

1.2 Objective ............................................................................................................ 4

1.3 Delimitations ...................................................................................................... 4

1.4 Methodology and Materials................................................................................ 5

1.5 Outline ................................................................................................................ 8

2 FFT: Transfer pricing methodology and State aid ..................................................... 9

2.1 Background ........................................................................................................ 9

2.1.1 Transactions .............................................................................................. 10

2.1.2 Functions ................................................................................................... 10

2.1.3 Risks .......................................................................................................... 11

2.1.4 Assets ........................................................................................................ 12

2.1.5 Method ...................................................................................................... 12

2.2 EC Decision on State aid .................................................................................. 15

2.2.1 Introduction ............................................................................................... 15

2.2.2 Requisites for State aid ............................................................................. 15

2.2.3 TNMM vs CUP ......................................................................................... 17

2.2.4 The ‘correct’ application of TNMM ......................................................... 18

2.2.5 EC Conclusion .......................................................................................... 20

2.3 Recent development and criticism ................................................................... 20

2.3.1 Introduction ............................................................................................... 20

2.3.2 General Court Judgement.......................................................................... 21

2.3.3 TP Method Application Issues .................................................................. 24

3 Functional analysis for internal banks ..................................................................... 26

3.1 Introduction ...................................................................................................... 26

3.2 “Treasury functions” ........................................................................................ 27

3.3 Intra-group loans .............................................................................................. 28

3.3.1 Accurate delineation of a loan .................................................................. 28

3.3.2 Assumption and control of risks ............................................................... 32

4 Conclusion ............................................................................................................... 36

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Abbreviations

APA Advanced Pricing Agreement

ALP Arm’s Length Principle

BEPS Base Erosion and Profit Shifting

CAPM Capital Asset Pricing Model

CUP Comparable Uncontrolled Price

ECJ Court of Justice of the European Union

EC European Commission

EU European Union

FF Fiat Finance S.p.A.

FFC Fiat Finance Canada Ltd.

FFNA Fiat Finance North America Inc.

FFT Fiat Finance and Trade Ltd.

OECD Organization for Economic Co-operation and

Development

TNMM Transactional Net Margin Method

TP Guidelines OECD Transfer Pricing Guidelines

TP Transfer Pricing

TFEU Treaty on the Functioning of the European Union

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1 Introduction

1.1 Issue

Decision of the European Commission (EC) from 2016 and the judgment of the

General Court of the ECJ from 2019, which confirmed it in the Fiat

Luxembourg State aid case, has sparked controversy and academic interest by

its many far-reaching implications. Most writings dealing with this topic come

from the State aid perspective and bring into question the elements of the rulings

that are important for this legal field, for example, the determination of the

reference system for establishing whether an illegal advantage was granted. On

the other hand, commentators, which are more interested in the tax aspects of

Fiat, focus predominantly on the future of the advanced pricing agreements

(APAs) and whether EC is creating an EU arm’s length principle (ALP) that

infringes sovereignty of Member States.

In the extensive literature on Fiat and other recent EC State aid cases there seems

to be a gap in developing transfer pricing matters more deeply. Although all of

the previously mentioned legal points are very significant, the Fiat case in

business practice boils down to correctly determining prices and profit level of

an internal bank in line with the arm’s length principle. EC has dedicated most

of its decision to transfer pricing methodology, but research on whether it was

applied in the most suitable manner has been shadowed by the discussion on

whether Transfer pricing (TP) Guidelines can be applied at all.

Transfer pricing of internal banks has recently been given a new dimension. The

long-awaited clarifications on how to price financial transactions have been

published by the OECD on 11th of February 2020 as the Transfer Pricing

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Guidelines on Financial Transactions, which will be added as Chapter X to the

2017 version of the Guidelines.1 This novelty awaits academic inquiry.

1.2 Objective

Considering that transfer pricing of internal banks is a highly relevant area of

interest for companies and tax advisors, the purpose of this thesis is providing

useful insight into how it should be conducted to comply with both Fiat case

and the latest edition of TP Guidelines. In this sense, the thesis is not about Fiat

per se but it will rather use the factual and legal circumstances of Fiat to analyze

how similar situations should be handled in the light of the Guidelines, with

regards to the existing doctrine of the EC and the General Court. To achieve this

aim, two main questions will be answered. The first is what can be learned from

the Fiat case for applying transfer pricing methods, which are at the heart of EC

and General Court’s rulings, to internal banks’ transactions in order to defend

them in the face of State aid scrutiny. The second will return with some guidance

on how to conduct a functional analysis with the emphasis on risk, which is

lacking in the aforementioned decisions, but is the central for reaching an arm’s

length outcome.

1.3 Delimitations

Although other State aid cases in which APAs were questioned are interesting

and connected with Fiat, they are only briefly touched upon when necessary for

the sake of argumentation. On the other hand, functional analysis conducted for

a transfer pricing issue of this complexity and in the light of the extended TP

Guidelines could easily go on for a hundred pages; therefore, it is reasonably

simplified by highlighting only the crucial points. Further demarcation of the

subject matter is clearly stated in the introductory paragraphs of relevant

1 https://www.oecd.org/tax/beps/oecd-releases-transfer-pricing-guidance-on-financial-transactions.htm

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subsections. Finally, as was mentioned, since the existing literature has dealt

extensively with State aid implications and tax issues such as legality of an EU

ALP, this thesis will present and evaluate work in these areas in a summarized

way to provide a holistic grasp of the matter.

1.4 Methodology and Materials

The method used in this thesis is the legal dogmatic method. This traditional

method consists in applying legal reasoning within a specialist analysis carried

out in a specified area of law.2 The legal dogmatic perspective for this topic

therefore necessitates the interpretation and evaluation of what is given in the

Fiat rulings and TP Guidelines, without excessive digressions on policy aspects

and de lege ferenda.

The fundamental methodological issue of this thesis concerns the legal value of

the Transfer Pricing Guidelines. The matter of contention can be further broken

into three debatable points.

The OECD Transfer Pricing Guidelines are a non-binding instrument. This is

suggested not only by their self-identification as “guidelines”, but also in their

content.3 What is more, they are drafted in such a way that is not suitable for

compulsory application, since they do not provide solutions to TP issues, but

rather a working framework for their analysis.4 Therefore, from a theoretical

perspective, their legal status as soft law can be equated with the OECD Model

Commentary from which they originate as assistance in interpretation of the

arm’s length principle from OECD Model Tax Convention’s Article 9.

2 Jerzy Stelmach and Brożek Bartosz, Methods of Legal Reasoning, vol 78 (Springer 2006) 9. 3 Krzysztof Lasiński-Sulecki, 'OECD Guidelines: between Soft-Law and Hard-Law in Transfer Pricing Matters' (2014) 17/1 Comparative Law Review 68. 4 Jérôme Monsenego, Introduction to Transfer Pricing (Kluwer 2015) 33.

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However, in spite of not being formally binding, TP Guidelines are widely used

by taxpayers, tax authorities and courts in practice.5 This has proven to be true

in the Fiat case as well, considering that the EC referred to the OECD TP

framework and the General Court affirmed this approach. The reasoning behind

the “hardening” of TP Guidelines’ soft law is best elucidated by the EC stating

that Guidelines are the result of expert discussions which develop techniques

aimed to address common challenges in international taxation. In this way, they

are currently the finest expression of international consensus on transfer

pricing.6 Although authority of OECD’s experts and their commonplace usage

establish the Guidelines as almost-binding internationally agreed principles, this

development is problematic for upholding the principle of legality in tax law.

Secondly, even if the TP Guidelines are in general considered as internationally

agreed principles, there are significant differences between individual countries

on how they view their content, application and interpretation.7 Disparities are

present between OECD and non-OECD member countries, which is significant

in the EU context where not all EU members are at the same time a part of the

OECD, but also between OECD members as well. This results in a

heterogeneous interpretation on national levels. The EC tried to avoid this

perplexity by declaring that it applies the ALP inherent in EU State aid rule from

Article 107 TFEU, even if the principle is not incorporated in domestic law.8

The employment of OECD’s benchmark in this process was only “a tool”. In all

but name, TP Guidelines are used to respond to new EU State aid challenges,

but this legitimately raises sovereignty concerns among Member States.

5 ibid. 6 Commission Decision of 21 October 2015 on State aid SA.38375 (2014/C ex 2014/NN) which Luxembourg granted to Fiat, (C-2015) 7152 final (EC Decision) para 87. 7 Monsenego, Introduction to Transfer Pricing (n 4) 33-34. 8 EC decision para 228.

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Finally, a key practical regard for TP Guidelines in this context is the dilemma

of static versus ambulatory application. Since OECD materials are often being

updated, there is an open discussion on which version of these materials should

be applied on situations taking place before their publishing date. For the OECD

Model Commentary, there is no consensus on this matter.9 The debate goes on

in a similar undecided fashion for the TP Guidelines, although there are some

suggestions on how to approach this question: whether the domestic law refers

to the OECD Guidelines (sometimes a specific version10) or not, whether they

are based on the same principles and whether the segment to be applied is a

clarification or a new concept.11 In contrast to the academic polemic, the

General Court has promulgated a clear restriction on retroactivity in State aid

investigations12, but since it did not explicitly express this view on TP

Guidelines, issues such as whether to apply “clarifications” are still relevant,

especially as the ECJ is the instance that will have the final word.

As for the materials used, the analysis in the thesis is mostly based on primary

sources such as the EC and General Court’s rulings and the TP Guidelines (2017

and 2020 editions). Here it is important to emphasize that the Fiat case is

analyzed only from the viewpoint of the TP Guidelines 2010 version, which was

applicable at the time when the APA was concluded, but the version from 2017

is referenced in the thesis. Since there were no significant differences in content

between the two versions for the segments that were used in the thesis, the latter

is put to work for practical reasons.

9 Katia Cejie, 'The Commentaries on the OECD Model as a Mechanism for Interpretation with Reference to the Swedish Perspective' (2017) 71/12 Bulletin for International Taxation 667. 10 For example: Australia, Austria, Ireland and the UK. OECD Transfer Pricing Country Profiles, http://www.oecd.org/tax/transfer-pricing/transfer-pricing-country-profiles.htm. (accessed 27.4.2020) 11 Johan Hagelin, 'Retroactive Application of the OECD Transfer Pricing Guidelines for Interpretation in Transfer Pricing Issues' (2018) 25/6 Intl. Transfer Pricing J. 406. 12 Judgment of the General Court in cases T-760/15 (Netherlands v. Commission) and T-636/16 (Starbucks v. Commission) ECLI:EU:T:2019:669 para 251.

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Additionally, several articles and books are used to support the reasoning,

although there are still (at the time of writing) no relevant publications dealing

with the latest TP Guidelines on Financial Transactions. The most impactful

articles between equals were: 1) “The Recent Decisions of the European

Commission on Fiscal State aid: An Analysis from a Transfer Pricing

Perspective” by Miladinovic and Petruzzi, which pointed at the functional

analysis as a weak point in the EC’s decision, 2) “European Commission

Decision on Fiat: State aid Case Explained” by Rasch and Wroblewski, which

presented the essentials of the case with utmost clarity, and 3) Is Fiat’s Tank

Half-Full or Half Empty? The General Court’s Decision in Luxembourg v.

Commission (T-755/15)” by Lazarov and Buriak, the most transfer pricing

related and up-to-date article. All of the other publications, together with the

most relevant works which are not referenced directly in the text, but have

contributed to the comprehension of the topic and might be useful for the reader,

are listed in the Bibliography.

1.5 Outline

Apart from the introduction and the concluding section, the thesis is comprised

of two main chapters. This division is envisaged by the logic of the transfer

pricing process and its two steps: comparability analysis and application of the

selected method. In the paper, their order is reversed, with the aim of introducing

the Fiat case which deals mostly with methodological issues first. Chapter 2 on

Fiat is further developed into three segments: Background, introducing the

reader to the legal and factual situation of the case, followed by the analysis of

the transfer pricing aspects of the EC’s decision on State aid, and concluding

with the Recent development, represented in the General Court’s judgment, and

criticism in the form of a meta-analysis of the objections raised to both rulings,

primarily on methodological and TP issues. Chapter 3, preceding the

conclusion, provides a functional analysis based on Fiat’s circumstances,

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relevant for internal banks, from the perspective of the newest TP Guidelines

on Financial Transactions from 2020. In focus are intra-group loans, as the

predominant transactions, and risk functions, the centerpiece of every

comparability analysis. The final segment integrates all of the conclusions from

the thesis into a (hopefully) useful piece of advice on how to set transfer prices

for internal banks in the EU.

2 FFT: Transfer pricing methodology and State aid

2.1 Background

Fiat Finance and Trade Ltd. (FFT) is a finance company registered in

Luxembourg. As suggested by its legal name, the company is a part of the Fiat

multinational corporate group active primarily in the automobile industry. Fiat

S.p.A, the Italian leader of the group, has full control over FFT by holding 40%

of its shares directly and 60% through yet another subsidiary Fiat Finance S.p.A.

(FF) incorporated in Italy. In its turn, FFT also has control over fully (100%)

owned companies Fiat Finance North America Inc. (FFNA) and Fiat Finance

Canada Ltd. (FFC).13

FFT is designated the role of an internal bank for the group entities located in

Europe, with the exception of Italy. It provides Fiat entities with treasury and

financial services, as well as cash pooling. FFT’s operations are run from the

head office in Luxembourg, as well as two branches – one based in the United

Kingdom and the other in Spain.14

In September 2012, FFT obtained an APA from the Luxembourg tax authorities

regulating its transfer pricing position for the following 5-year period. The APA

was essentially an endorsement of a transfer pricing report proposed by FFT’s

tax advisors on how to correctly allocate profits for its cross-border activity. The

13 EC Decision para 110. 14 ibid paras 34-39.

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report was based on the application of Transfer Pricing Guidelines, which are

the most relevant, albeit not binding, tool in the area of transfer pricing. In line

with the Guidelines, the process of reaching an arm’s length outcome requires

first a comparability analysis of cross-border transactions, with an emphasis on

the functions, assets and risks, and followed by the application of the most

suitable transfer pricing method.

2.1.1 Transactions

Transactions relevant for the transfer pricing analysis, which FFT was a part of,

can be divided in two categories based on the status of the other party. In the

first category of (Intra-Sector) transactions, FFT was dealing with treasury

companies of the Fiat group, and in the second (Intra-Group) with entities other

than internal banks.

The main categories can further be broken down into transactions that constitute

them. For Intra-Sector, those transactions are intercompany loans from FFT to

FF, as well as loans from FFNA to FFT. Similarly, the Intra-Group category is

also mostly composed of loans which FFT grants the European Fiat companies,

but also deposits and other services closely related to financing which it supplies

them with. In addition, FFT is provided guarantees for its bonds and other

financial instruments (such as credit lines) by the group leader Fiat S.p.A.15

2.1.2 Functions

The functions FFT performs which were put forward by their tax advisors are:

1. Market funding and liquidity investments

FFT raises funds, mostly from the market and in a lesser extent from related

entities, to make them available for Fiat group members.

15 ibid para 40.

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2. Relations with financial (third-party) market actors

FFT provides information to support the group’s credit-worthiness.

3. Financial coordination and consultancy

FFT is responsible for examining financial needs and identifying the best

solutions for the group companies, as well as setting up financial contracts and

monitoring performance of their financial products.

4. Cash pooling

The cash flows, funding requirements and liquidity of the group is monitored

by FFT to optimize the management efficiency of the group's capital resources.

5. Provision of short and medium term loans

6. Coordination with other treasury companies.16

2.1.3 Risks

The main risks FFT is exposed to as outlined in the APA are:

1. Market risk

FFT bears the market risk ingrained in the interest rate and foreign exchange

rate movements. However, these risks are hedged by derivative financial

instruments (such as currency and interest rate swaps) in accordance with the

Fiat group risk management policies.

2. Credit and counterparty risk

The risk of default of the FFT’s external borrowers is (allegedly) mitigated by

dealing only with major financial institutions and diversified allocation of cash.

Without further justification, the report also states that group assets are not

16 ibid paras 42-49.

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exposed to this risk, since the group has interest to financially support all

members so there would be no singular insolvency cases over time.

3. Operational risk

Financial operations are performed in line with Fiat S.p.A. guidelines and

procedures and are being constantly monitored and controlled to avoid

failures.17

2.1.4 Assets

FFT is in charge of managing significant financial assets. These assets relate to

intercompany loans, account receivables from group companies and, to a minor

degree, bank deposits. In its day-to-day operations, FFT uses IT systems.18

2.1.5 Method

As a result of the comparability analysis, the method that was chosen as the

most appropriate for determining an arm’s length outcome for FFT’s group

activity was the Transactional Net Margin Method (TNMM). TNMM is

designed to reach ALP through the examination of the net profit in relation to a

chosen base (costs, sales, assets) which a taxpayer realizes from controlled

transactions. This method is a one sided method and it is particularly appropriate

in relations where only one party makes unique and valuable contributions. In

that case, the tested party will be the party that does not make such a

contribution, the less complex one.19

Since FFT was considered less complex, not making a unique contribution or

owning intellectual property, it was selected as the tested party. In order to make

a comparison, external comparables where used. Internal comparables where

17 ibid para 50. 18 ibid para 51. 19 OECD (2017) Transfer Pricing Guidelines paras 2.64.-2.65.

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not available due to the claim that FFT is the only entity providing financial

services of this kind to the Fiat group companies.20 The chosen net profit

indicator was the return on capital.

The outstanding remuneration for FFT was calculated through four steps:

1. Estimate of ‘capital at risk’

Taking as a starting point the fact that FFT functions as an internal bank for the

group, the minimal capital required to cover the risks to which it is exposed was

calculated by applying the Basel II framework. Basel II is an accord which

prescribes the adequate amount of capital for mitigation of financial and

operational risks in banks.21 Using this instrument by analogy, since it does not

apply to internal banks in practice, tax advisors calculated the hypothetical

regulatory capital for FFT to be 28.5 million euros.22

2. Identification of capital used to perform functions

In this step, from the total equity of FFT amounting to 287.5 million euros in

2011, two significant amounts where deducted to calculate equity used to

perform functions. The first deduction – 28.5 million – is the previously

calculated minimum equity at risk and the second – 165.2 million – is used to

offset participation interests in FFT’s branches FFNA and FFC. This leaves 93.7

million euros as the equity backing the functions performed.23

3. Estimate of expected remuneration by Capital Asset Pricing Model (CAPM)

20 EC Decision para 55. 21 Basel Committee on Banking Supervision, Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (2005), accessed 17 April 2020. 22 EC Decision paras 58-59. 23 ibid paras 60-61.

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The remuneration for FFT’s hypothetical regulatory capital was estimated by a

return on equity investors would expect to receive (‘Expected Return Pre-Tax’).

This is commonly performed using the CAPM with the formula:

Expected Return Pre-Tax = (Risk-Free Rate + β × Equity Risk Premium)/(1-tax

rate)

The beta value in this formula represents the market risk that cannot be

diversified. This value was reached through a comparability study of 66 entities

that were selected by the tax advisors as independent companies active in the

financial sector comparable to FFT. The study resulted in an arm’s length range

of betas. In this range, the 25th percentile value was selected considering that

FFT bears low risk.24

Beside the minimum capital from step 1, the equity backing the functions

performed estimated in step 2 was also remunerated. For this purpose, market

interest rate for short-term deposits was applied.25

Finally, the equity FFT had in its branches FFNA and FFC was not remunerated

at all for purpose of taxation. The explanation why the largest portion of equity

was not remunerated was found in the fact that this equity is supposed to be

redeemed by dividends.26

4. Calculation of overall profitability left to FFT to remunerate risks born and

functions performed

Resulting from the conclusions of steps 1 to 3 the final remuneration is

calculated as a sum of a ‘risk remuneration’ calculated on the hypothetical

regulatory capital and a ‘functions remuneration’ on the capital used to perform

the functions. The estimated taxable base was 2.542 million and this is the

24 ibid paras 63-67. 25 ibid para 68. 26 ibid paras 69, 134.

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amount which the Luxembourg tax authorities accepted through the APA and

on which corporate income tax in Luxembourg was charged.27

2.2 EC Decision on State aid

2.2.1 Introduction

The investigation and subsequent decision of EC in the Fiat case was a result of

two important factors. Firstly, the LuxLeaks scandal exposed Luxembourg for

issuing hundreds of questionable tax rulings in 2014, among others the APA for

FFT.28 Secondly, the Commission has been very active in the field of State aid

provided through fiscal measures in recent years and seems that this trend will

continue in the future. For this reason, multinational companies are advised to

preventively apply the guidance from the recent cases in order to mitigate

substantial reputational and financial blows. In that sense, the lesson that might

be learned from FFT is significant.

2.2.2 Requisites for State aid

The prohibition of incompatible State aid is found in Article 107(1) of the

TFEU. In accordance with the wording of this provision and settled case-law, a

measure of any kind, even fiscal, introduced by a Member State will constitute

State aid if it fulfills four requisites.29 The APA which Luxembourg provided

FFT with was tested on this basis:

1. An intervention of the State or through State resources

In the Fiat case, the EC found that there was both an intervention of

Luxembourg by accepting the transfer pricing analysis through the APA and

that it was (indirectly) financed by public resources. Since the Commission

27 ibid paras 70-72. 28 European Parliament resolution of 25 November 2015 on tax rulings and other measures similar in nature or effect (2015/2066 (INI)) A. 29 Richard Lyal, 'Transfer Pricing Rules and State Aid' (2015) 38 Fordham Int'l LJ 1028.

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considered that the APA endorses artificial and complex methods to lower

FFT’s taxable profit, this lead to a reduction of state revenue.30

2. Liable to affect trade between Member States and

3. Distorts or threatens to distort competition in the single market

With regards to the fact that FFT is a part of a group which operates in most

Member States, EC plainly concluded that the aid Luxembourg provided could

interfere with intra-EU trade and strengthen the position of the group at the

expense of fair competition.31

4. Confers a selective advantage on an undertaking

The most querulous condition for existence of State aid, but also the most

significant for transfer pricing purposes, is whether the APA actually provides

FFT with an advantage and how this benefit is achieved. This requisite is tested

by investigating its three components:

1) Establishing the reference system

The general Luxembourg corporate income tax system was established as a

reference since it imposes tax on companies regardless of their affiliation to a

group, thus putting integrated and stand-alone entities in a comparable legal and

factual situation.32

2) Confirming that the measure deviates from the reference system

This is the central question of the EC decision in which TP matters are discussed

and it will be analyzed in the remaining section of this chapter.

30 EC Decision paras 187-188. 31 ibid paras 189-190. 32 ibid para 194.

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3) If there is a deviation, checking whether it is consistent with the logic of the

system

The EC did not identify any justification for the preferential treatment FFT

received through the APA.33

2.2.3 TNMM vs CUP

In the process of testing whether the APA deviates from the Luxembourg

corporate income tax system, the EC focused primarily on the transfer pricing

method and how it was applied in the ruling. For the determination of whether

methodology of the APA was sound, TP Guidelines where used as a “tool”.

As for the selection of the method, TNMM was questioned in the Opening

Decision. EC has in several other cases expressed its preference for the use of

Comparable Uncontrolled Price (CUP) method as more direct and more reliable

for an approximation of a market-based outcome.34 The inclination towards

CUP instead of TNMM was presented especially in the light that this method is

recommended by the TP Guidelines as the most suitable for loans, which are

significantly represented among transactions performed by FFT. The

Commission even suggested a possible internal comparable embodied in

Chrysler, the US Company of the FIAT group.35

However, in the final decision, the EC changed its stance. TNMM was accepted

as an appropriate method for the situation at hand after arguments put forward

in the investigation procedure. The defendant’s claim was that all the loans and

bonds issued by FFT vary significantly in their qualities such as rates, form and

maturity. Consequently, the CUP method would require finding comparables

for each individual instrument. In this light, TNMM is more suitable for an

33 ibid para 338. 34 M. Rasch, P. Wroblewski, ʹEuropean Commission Decision on Fiat: State Aid Case Explainedʹ (2016) 23/6 Intl. Transfer Pricing J. 438. 35 EC Decision para 132.

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estimation of an arm’s length remuneration for the functions performed and

risks born by FFT. Moreover, EC recognized the return on capital as an

acceptable performance indicator, since FFT is comparable to financial

institutions for which return of capital is regularly used in TP analysis.36

The acceptance of TNMM by the EC (and subsequently the General Court) is a

significant development in its doctrine on State aid and Transfer pricing.

Although TP Guidelines do not have a hierarchy between different methods for

applying ALP, the EC has consistently favored CUP in other State aid decisions.

Giving a green light on TNMM in FFT, the Commission has aligned itself

further with the Guidelines thus providing more certainty for companies which

are extensively using this method for their complex transactions. In addition,

for the transfer pricing of internal banks, the recognition of their position as

comparable to regulated financial institutions, indicates a route for conducting

the TP comparability analysis without triggering State aid repercussions.

2.2.4 The ‘correct’ application of TNMM

Despite the recognition of TNMM as an appropriate method for the TP analysis

of internal banks such as FFT, the actual application of the method was

scrutinized in great detail by the EC. The establishment of deviation from the

system was not based on the selection of the method, but rather on parameters,

adjustments and methodology that were used inconsistently and without

reasonable explanations.

1. Parameters: Amount of capital

Although FFT as an internal bank is in a comparable position to regulated

financial institutions, it is still not one of those entities to which the Basel II

framework applies. Therefore, the calculation of its hypothetical regulatory

capital by analogy is considered inconsistent with the chosen method.

36 ibid para 247.

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Furthermore, even for regulated entities, the return on minimal regulatory

capital is not a common performance indicator. This translates into the lack of

market data for comparing such a parameter.

The EC concluded that the choice of applying TNMM by return on equity,

estimated through CAPM, necessitated the use of FFT’s accounting equity as

the profit indicator.37 This requirement has significant consequences

considering that FFT’s accounting equity (287.5 million) is ten times greater

than the hypothetical regulatory capital used in the APA (28.5 million).

2. Adjustments: FFNA and FFC

The remunerated capital base of FFT was reduced by a significant amount

(165.2 million) by excluding participation in equity in FFT’s branches FFNA

and FFC without an economically sound justification. Applying zero rate

remuneration to this capital is not envisaged by TP Guidelines nor by Basel II

framework and accounting rules. Since this equity is fully available to support

FFT’s solvency, it should be remunerated in full.38

3. Methodology: Comparables and median value

Finally, the estimated level of return on capital was found to be unreliable for

approximation of a market-based outcome. The methodology used in the APA

was strongly criticized for several reasons:39

- The list of 66 entities that were considered comparable by FFT’s tax advisors

encompassed two central banks, stock exchanges and other companies active in

very different business segment from FFT, thus making the comparison invalid;

37 ibid para 249. 38 ibid para 282. 39 ibid paras 292-295.

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- The beta value (market risk that cannot be diversified) which was used was

significantly lower from the beta of comparable financial sector companies;

- Notwithstanding the previous objections, the beta calculation used the 25th

percentile and not the median value in the selected range. According to TP

Guidelines, the more complex the comparability, the more the central tendency

of the sample should be used to reach an arm’s length outcome.40

2.2.5 EC Conclusion

With regards to all the inconsistencies pointed out in the Decision, the EC

concluded that the correct estimate of FFT’s taxable base should be at least 10%

post-tax applied to the full amount of accounting equity. Such a return was

considered in line with the leverage corresponding to the average of the

industry, thus representing a market-based outcome.41 Since the method the

APA endorsed departed from the arm’s length principle, it was found to confer

a selective advantage resulting in illegal State aid. The practical consequence of

this breach of EU law was a claw back of deemed benefit with interest

amounting to 20 - 30 million euros.42

2.3 Recent development and criticism

2.3.1 Introduction

After the EC Decision was published, both Luxembourg and Fiat appealed

focusing primarily on selectivity requisite. The appeals led to the judgment of

the General Court in 2019, which confirmed the conclusions of the EC Decision

in full. However, the final resolution of this issue awaits, since Fiat has appealed

the judgment to the ECJ.43 Meanwhile, outside of the court, Fiat case has

sparked great academic interest which is mostly critical towards its reasoning.

40 TP Guidelines 2010 3.57. 41 EC Decision para 311. 42 https://ec.europa.eu/commission/presscorner/detail/en/IP_15_5880 accessed 18 April 2020. 43 https://www.reuters.com/article/us-eu-fiat-taxes/fiat-appeals-to-europes-top-court-against-33-million-eu-tax-order-idUSKBN1YB0G5 accessed 19 April 2020.

21

The disapproving argumentation is put forward from several angles, ranging

from sovereignty to transfer pricing. The following segment will evaluate only

those points that are in the scope of the thesis objective.

2.3.2 General Court Judgement

The leading criticism of the EC Decision derives from the principle of legal

certainty. By questioning APAs through the use of a benchmark that many are

calling “EU ALP”44 the EC is adding a new layer of complexity in an already

perplexing field of international transfer pricing.

As for APAs, the EC has publicly stated that they are not in themselves the

target of State aid investigation, but rather the selective advantage that might be

provided through them.45 The legality of rulings which do not confer such an

advantage is confirmed by the General Court.46 However, the possibility of

overruling by the EC undermines the aim of an APA which is foreseeability for

investors before the performance of costly transactions.47 The likely

consequence of this development is the reduction of requests for such rulings in

the EU Member States. To prevent the adverse reaction, the EC should engage

in APA review only in extreme cases where misuse is evident.48

An even greater cause for uncertainty is the “EU ALP”. General Court has

confirmed in its judgment that EC can rightfully asses the correct application of

ALP by Member States in their APAs. In the purpose of establishing whether

illegal State aid exists under Article 107(1) TFEU, the EC uses ALP as a

44 Stephen Daly, ʹThe Constitutional Implications of an EU Arm’s Length Principleʹ (2020) 60/2/3 Eur. Taxn. 70. 45 European Commission, ʹCommission Decides Selective Tax Advantages for Fiat in Luxembourg and Starbucks in the Netherlands Are Illegal under EU State aid Rulesʹ, accessed 21 April 2020. 46 Judgment of the General Court (General Court judgment) in T-755/15 (Luxembourg v. Commission) and T-759/15 (Fiat Chrysler Finance Europe v. Commission) ECLI:EU:T:2019:670 para 115. 47 Peter J. Wattel, ʹThe Cat and the Pigeons: Some General Comments on (TP) Tax Rulings and State aid After the Starbucks and Fiat Decisionsʹ in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 187. 48 Lyal (n 29) 1041-1042.

22

“tool”.49 Nevertheless, the framework for this benchmark and its material

content are left vague by the Court.50

The dominant perspective in academic writings on the reference system for

applying ALP is best expressed by Schon: “to protect the Member States’

prerogative in tax matters, the decisive benchmark for fiscal state aid can only

be the tax legislation of the relevant country itself”.51 Contrary to this, the EC

viewed ALP as integral element of Article 107(1) TFEU, establishing the right

to apply the principle even when it is not explicitly incorporated in the domestic

legal system of the particular Member State.52 In the Fiat case, the basis for

application would not make a difference, since Luxembourg law contains

ALP.53 Conversely, the ambiguity in this respect which was maintained by the

General Court might be important for future cases, such as Apple where Ireland

is claiming the absence of ALP in its national tax law. Some commentators

believe this was the intention of the Court in the purpose of preparing a

precedent for the judgment in Apple.54

An indication that the General Court is leaning towards the EC’s push for an

autonomous ALP that is grounded in Article 107(1) TFEU is the acceptance,

without much motivation, of what this principle is as a “tool”. The ALP in itself

has no material content.55 It was developed by the OECD and for the purpose

49 General Court judgment para 151. 50 Jérôme Monsenego, ʹSome observations on Starbucks, Fiat, and their potential impact on future amendments to the arm’s length principleʹ, (2019) Kluwer International Tax Blog, http://kluwertaxblog.com/2019/09/28/some-observations-on-starbucks-fiat-and-their-potential-impact-on-future-amendments-to-the-arms-length-principle/?doing_wp_cron=1588158936.9704051017761230468750 accessed 23 April 2020. 51 Wolfgang Schön, ʹTax Legislation and the Notion of Fiscal aid: A Review of 5 Years of European Jurisprudenceʹ, in R. Isabelle, W. Schön and E. Traversa (eds), State aid Law and Business Taxation (Springer Berlin 2016) 9. 52 EC decision para 228. 53 Daly (n 44) 75. 54 Ruth Mason, ʹImplications for Apple in the Lower Court Rulings in Starbucks and Fiatʹ (2019) https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3459466 accessed 25 April 2020. 55 Monsenego ʹSome observations on Starbucks and Fiatʹ (n 50).

23

of double (non-)taxation and profit shifting, which cannot so easily be

transposed for EU State aid need for reaching a market-based outcome. As much

as EC claims that they are not applying the OECD ALP, for which they would

have no basis since it is found in soft law instruments of OECD Model Tax

Convention and TP Guidelines, they are using these very documents to give

content to their “autonomous” and “universal” principle of equal taxation.

The use of OECD materials, albeit necessary in the lack of other means, is

problematic not only for legality reasons discussed in the Methodology section

in the Introduction to this paper (section 1.4 above). Additional issue is the fact

that EC is not bound by TP Guidelines when conducting its investigation in

State aid, since it is not applying them directly. This theoretically translates into

the possibility of preparing TP documentation fully in line with the Guidelines,

but still being persecuted for illegal State aid because of different interpretation

by the EC. However, the EC has maintained that “if a transfer pricing

arrangement complies with the guidance provided by the OECD TP Guidelines

… a tax ruling endorsing that arrangement is unlikely to give rise to State aid”.56

General Court has also affirmed this line of reasoning.57 The pertinent question

of which version of TP Guidelines will be used in the investigation seems to be

answered in Starbucks case – only information existing in the time of

concluding the APA will be taken into account.58

General Court’s judgment on Starbucks, published on the same day as the FFT,

is important for understanding its “twin”. Although the Court accepted the use

of ALP on the same grounds as in Fiat, the EC decision in Starbucks was

annulled since the Commission was unable to successfully demonstrate the

56 Commission Notice on the notion of State aid as referred to in Article 107(1) of the Treaty on the Functioning of the European Union, (2016) OJ C 262 para. 173. 57 General Court judgment para 147. 58 Starbucks judgment (n 12) para 251.

24

existence of an advantage.59 There are substantial differences between these two

cases and the formulation of the EC decisions in each, yet this serves to prove

that the Court does not necessarily endorse EC’s handling of TP issues in fiscal

State aid investigations in all aspects. In Fiat ongoing procedure, lack of

convincingly demonstrated advantage is a possible course which ECJ can take

to overrule the lower court by its own reasoning. In any respect, ECJ’s judgment

will hopefully resolve the previously discussed issues and provide more

certainty for both taxpayers and Member States.

2.3.3 TP Method Application Issues

Both the EC and the General Court have rightfully reaffirmed that transfer

pricing is not an exact science, the idea that is the leitmotif of TP Guidelines. It

is thus disputable how the EC, with the unreserved support of the General Court,

reaches its definitive conclusions on the “correct” application of TNMM in FFT.

Starting from the range of arm’s length outcomes, the EC has decided in FFT

that the central tendency i.e. the median value is the one that should be used for

approximating a market-based outcome. Although the median is indeed

frequently preferred in transfer pricing practice, the OECD views any point in

the range as meeting the ALP.60 A logical result of the inaccuracy “inherent in

the application of a method designed to obtain a reliable approximation of a

market-based outcome” would be the recognition of an acceptable range of

values for State aid purposes and not just one point in the range such as the

median.61 Nevertheless, the General Court has not expressed a clear view on

this matter.

Secondly, the use of return on equity as a parameter calculated on the full

amount of accounting equity of an internal bank creates a loophole for tax

59 ibid para 561. 60 Rasch, Wroblewski (n 34) 441. 61 Monsenego ʹSome observations on Starbucks and Fiatʹ (n 50).

25

planning. Namely, since internal banks are not required to maintain a certain

higher level of capital under the Basel II (now the Basel III) accord as regulated

entities, they could reduce their level of equity down to the minimal capital

requirement in domestic corporate law.62 What is more, the TP Guidelines do

not suggest the use of the return on equity precisely because of this arbitrage

opportunity. The application of parameters such as return on assets and return

on capital employed is advisable as a more reliable benchmark.63

Although internal banks are comparable to regulated entities in the first step of

the TP analysis, the same analogy in the method application comes with

admonitions. The fact is that the EC and the General Court did not explicitly

condemn the use of Basel II for the calculation of hypothetical regulatory

capital, which some authors even advocate as the most appropriate in

combination with the return on equity.64 Moreover, the EC inspected whether

Basel II was applied correctly in FFT, but this did not legitimize its use. For this

reason, reliance on non-transfer pricing instruments such as Basel II in reaching

the ALP should be carried out with care, extensively justified and documented.65

One additional twister related to TP methods was created by the General Court

when deciding on “neutralization”. This is the possible lack of an advantage on

the group level where a lower tax burden in one country, such as Luxembourg,

is neutralized by the higher tax burden in another, e.g. Italy. The General Court

concluded that “the tax situation of another undertaking of the same group in

another Member State has no bearing on the existence of the advantage”.66 By

62 To ilustrate this, the minimum capital requirement in Luxembourg for a public limited company (SA) is just 31 000 euros, according to: https://guichet.public.lu/en/entreprises/creation-developpement/forme-juridique/societe-capitaux/societe-anonyme.html Applying the EC’s 10% post-tax rate to calculate the tax base we arrive at (sic!) 3100 euros. 63 Ivan Lazarov and Svitlana Buriak, ʹIs Fiat’s Tank Half-Full or Half Empty? The General Court’s Decision in Luxembourg v. Commission (T-755/15)ʹ (2020) 27/1 Intl. Transfer Pricing J. 74. 64 ibid 75. 65 Rasch, Wroblevski (n 34) 441. 66 General Court judgment para 318.

26

a priori and in general rejecting to take into account the cross-border situation

of the group as a whole, General Court has ruled contrary to the nature of

transfer pricing which is designed with the idea of zero-sum game between two

countries in mind. It is however true that in Fiat case no such effect was proven,

so that for the case at hand the Court has decided correctly.67 On the other hand,

the EC justly acknowledged the prospect of neutralization in cases where the

transaction-by-transaction methods (such as CUP) are used, contrary to TNMM

where the estimated taxable profit of one group member does not directly

influence the profit of others.68

Finally, beside these objections that might be raised on how the EC and General

Court examined the TP method used in FFT, an even more important

shortcoming lies in what they (mostly) did not examine – the functional

analysis. If the assessment of the accurate delineation and recognition of the

actual transaction would have pointed to FFT as the entity ultimately carrying

all of the risks related to analyzed transactions in the Fiat group, EC’s further

methodological conclusions would be more or less correct. Otherwise, if the

risks proved to be borne by another entity of the group, such as the Fiat parent

company, this should be reflected in FFT’s remuneration.69

3 Functional analysis for internal banks

3.1 Introduction

Without pretension of challenging the conclusions in the ruling on FFT, I will

use the information provided in the case as a basis for conducting a simplified

functional analysis of an internal bank in the following chapter. The analysis

will be performed in line with the TP Guidelines 2017 version and the latest

67 Lazarov, Buriak (n 63) 76-77. 68 EC Decision para 92. 69 Alexandra Miladinovic and Raffaele Petruzzi, ʹThe Recent Decisions of the EC on Fiscal State Aid: An Analysis from a Transfer Pricing Perspectiveʹ (2019) 26/4 Intl. Transfer Pricing J. 251.

27

addition to the existing rules in the form of TP Guidelines on Financial

Transactions from 2020. It is important to note, once again, that this analysis is

not applicable to the actual Fiat case, since FFT falls in the scope of the previous

(2010) version of the Guidelines, but is of significance for future similar cases.

3.2 “Treasury functions”

In FFT the tax advisors decided to package all the transactions that the internal

bank provides and receives into a single “treasury function”. This choice was

not challenged by the EC nor the General Court and the focus of the dispute

turned to the transfer pricing method. However, if this step of the comparability

analysis was brought into question, that might have changed the course of the

subsequent reasoning completely.

The new TP Guidelines on Financial Transactions are clear in this regard stating

that “it is important to accurately delineate the actual transactions and determine

exactly what functions an entity is carrying on rather than to rely to any extent

upon a general description such as treasury activities”.70 In the facts of the EC

decision, the treasury function was disassembled into transactions that

constituted it for comprehending the general perspective of FFT’s business.71

For transfer pricing purposes, roughly three types of functions can be deduced

based on FFT’s activities:

1) Intra-Group Loans

2) Cash pooling

3) Hedging

These activities are also recognized by the new TP Guidelines as the most

relevant treasury activities that are performed by internal banks in a

70 OECD (2020) Transfer Pricing Guidelines on Financial Transactions para 10.44 71 See section Transaction 2.1.1.

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multinational group.72 Each of them entails specific considerations for the

delineation of actual transaction and subsequently differing recommendations

on the choice and application of the appropriate TP method.

Considering that intra-group loans are arguably the first in significance when it

comes to the internal banks’ business model, the functional analysis in this paper

will only focus on those transactions. This is particularly necessary because the

Fiat case publically provides more detail for the crediting activity only and thus

this data can be used as an example to be tested against the new TP Guidelines.

3.3 Intra-group loans

3.3.1 Accurate delineation of a loan

As highlighted in a special caveat, the new TP Guidelines allow for their

application to loans only if they are respected as loans pursuant to the accurate

delineation in line with Chapter I of the existing TP Guidelines (2017 version)

and domestic legislation.73 The importance of this precondition is underlined in

the OECD Model Commentary itself on Article 9 as applicable “not only in

determining whether the rate of interest provided for in a loan contract is an

arm’s length rate, but also whether a prima facie loan can be regarded as a loan

or should be regarded as some other kind of payment, in particular a contribution

to equity capital”.74

OECD emphasizes the determination of whether a loan itself is commercially

rational because of the inherent bias that exists in favor of debt financing

compared to equity. This consideration stretches further from TP to other

international taxation matters, such as the fact that dividends, resulting from

equity, are usually subject to economic double taxation – first on the corporate

level and second on the shareholder level. In contrast, interest is subject to only

72 TP Guidelines on Financial Transactions para 10.50. 73 TP Guidelines on Financial Transactions 14. 74 OECD Model Commentary (2017) Article 9 para 3(b).

29

one level of tax and it is deductible as a cost for one of the parties.75 Therefore,

integrated companies have an incentive to take on more debt than stand-alone

entities would, in order to achieve these tax benefits. Although the BEPS project

has been tackling this issue by limiting the amount of interest that can be

deducted76 and the expansions of domestic thin capitalization rules, interest rate

higher than the market are still a common form of aggressive tax planning.

In order to accurately delineate the actual transaction new TP Guidelines are

following in the footsteps of the existing guidance in Chapter I of the TP

Guidelines 2017. The process should begin with a thorough identification of

economically relevant characteristics of the transaction, which are commercial

and financial relations between the parties and the conditions and circumstances

attached to those relations.77 These characteristics can be grouped as follows:

1) Contractual terms of the transaction

Loan contracts are by a general rule written contracts and as such should be the

starting point for delineating a transaction. However, in line with the TP

Guidelines 2017 the actual conduct of the parties must also be taken into

consideration. If from the other economically relevant characteristics flows that

the actual conduct is inconsistent with the contract, the actual transaction should

be delineated for the purpose of the transfer pricing analysis.78

2) Functional analysis

The functions performed, assets used and risk assumed will be discussed in

more detail in the following sections of this paper aiming at reaching the ALP.

However, it is important to understand that in this phase of accurately

75 Brian J. Arnold, International Tax Primer, 3rd edition (Kluwer 2016) 115. 76 OECD, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 (OECD 2016). 77 TP Guidelines on Financial Transactions para 10.17. 78 OECD (2017) TP Guidelines paras 1.42-1.45.

30

delineating the transaction, the same factors are analyzed in order to define how

much of the loan should be recognized as a loan for transfer pricing purposes.

Only after the loan is respected as such and not treated as, for example, equity,

the functional analysis is taken under advisement again, but this time with the

purpose of reaching an ALP interest for that accurately delineated and

recognized loan.

3) Characteristics of the financial instruments

The features of a loan might influence its pricing. The new TP Guidelines list

several examples of transaction attributes that were certainly relevant in the Fiat

case, but were not analyzed, such as79:

- Maturity of the loan: A nominal distinction was made between short-term and

medium-term loans of FFT, but they were priced together;

- Amount, nature and purpose of a loan;

- Geographical location of the borrower and currency: Fiat group members are

present in several jurisdictions, and many of those such as the UK, Switzerland,

Denmark and others have different currencies from the euro zone;

- Collateral or guarantees provided etc.

FFT has submitted an objection accepted by the EC stating that the applicable

rates, form and maturity of the loans provided by FFT greatly vary. Since this

variety would require finding comparables for each individual transaction, it

was concluded that the CUP method is not applicable and these attributes where

essentially overlooked.80 On the contrary, in line with the clarification of the

new TP Guidelines, variations in financial instruments’ features must be taken

into consideration already in the comparability analysis.

79 TP Guidelines on Financial Transactions para 10.29. 80 EC Decision para 246.

31

4) Economic circumstances of the parties and the market

Local differences such as regulations and economic factors (inflation, growth

and exchange rates) must be taken into account, as well as macroeconomic

trends. In the current climate, the defining trend might be the record low central

bank lending rates, which affects the prices and willingness to borrow or lend

in the private sector. As for FFT, a significant component of the calculation is

the fact that all loans are provided to the automobile industry, which makes them

particularly sensitive to changes in this volatile sector.

5) Business strategies

Differences in strategies pursued by multinationals can have a profound effect

on the terms and conditions which would be agreed by independent enterprises.

This analysis also must include consideration for the group’s global financing

policy and the identification of preexisting relationships between the members

such as shareholder interests.81

After the actual transaction is delineated with the help of the listed factors, it is

compared to similar arrangements which are or would have been adopted by

independent entities behaving in a commercially rational manner in comparable

circumstances.82 The crucial concept, as set by Section D.2 of Chapter I of the

TP Guidelines 2017, is the commercial rationality of the examined transaction

in order for it to be recognized as it is structured. If either the internal bank, such

as FFT, or the group entities to which it advanced funds, had options of

concluding a similar contract with a third party that were realistically available

at the time and that would make them or the group better off, this indicates

behavior contrary to a rational market actor. In such context, the existing

transaction might be disregarded in whole or in part and replaced by an

81 TP Guidelines on Financial Transactions paras 10.34-10.36. 82 ibid para 10.7.

32

alternative.83 For an internal bank, this translates into a loan not being delineated

as such for the purpose of determining the amount of arm’s length interest.84

The part of the loan or even the whole amount will then require an entirely

different comparability analysis from the one performed for FFT and analyzed

in the remainder of this paper.

3.3.2 Assumption and control of risks

The examinations of functions performed, risks assumed and assets used are

inseparable parts of the functionality analysis.85 However, while it is not

possible to isolate any of them without detriment to a comprehensive

understanding of the tested entity’s situation, the fact remains that risks are the

most complex in the sense that they are not so conspicuous.86 This is particularly

true in the recently developed framework discerning between control and

assumption of risk. For this reason, it might be beneficial to investigate the

situation of an internal bank such as FFT from the perspective of risk, while

providing functions and assets with their rightful place in the analysis when

needed. For the sake of simplicity, only loans provided by FFT to related entities

are subject to inspection.

The accurate delineation of the actual transaction in respect of risks is envisaged

as a 6 step process87:

1) Identification of economically significant risks

For an internal bank, risks that were identified for FFT would most likely be

relevant: Market, Credit, Counterparty, and Operational risk.

2) Determination of how risks are contractually assumed

83 OECD (2017) TP Guidelines para 1.122. 84 TP Guidelines on Financial Transactions para 10.13. 85 Michael Lang et al. Fundamentals of Transfer Pricing: A Practical Guide (Kluwer 2019) 59. 86 OECD (2017) TP Guidelines para 1.59. 87 ibid para 1.60.

33

The identified risks are contractually assumed by FFT as the lender. However,

FFT has claimed non-exposure to some of these such as Credit and Counterparty

risk since the Group has interest to financially help its members and over time,

there would be no insolvency cases.88 For the claim of complete non-exposure

to these significant contingencies there is no basis in the TP Guidelines, both

the 2017 and 2020 edition. Therefore, internal banks should abstain from a

priori excluding risks that are typical for the provision of loans and rather try to

show how they might be mitigated in the functional analysis.

3) Functional analysis in relation to risk

A lender such as FFT needs to decide whether to make a loan, in what amount

and on what terms. If the decision was made by an independent lender, this

would require a thorough evaluation of the borrower’s situation, wider

economic factors, and other options realistically available.89 An internal bank

possibly does not need to invest as much effort in research as a stand-alone

entity, since it may already have the necessary data about its group members

readily available. However, in order for a loan to be commercially rational, even

for intra-group loans, factors such as creditworthiness must be evaluated.90

The pivotal importance of credit rating was already recognized in literature,

since it directly influences the level of the risk taken by the creditor.91 This is

the main factor that independent investors take into account when determining

what interest rate to charge. The new TP Guidelines also propagate its

usefulness for identifying potential comparables in the context of related party

transactions.92

88 EC Decision para 50. 89 TP Guidelines on Financial Transactions paras 10.53-10.54. 90 ibid 10.55. 91 Monsenego, Introduction to Transfer Pricing (n 4) 88-89. 92 TP Guidelines on Financial Transactions para 10.62.

34

In FFT, it seems that this criterion was not used at all. This is apparent from the

fact that FFT excluded its intra-group loans from its assets when calculating its

hypothetical regulatory capital. The only reason to exclude these loans would

be if their risk weight was 0 per cent, i.e. - no risk, which is awarded to items

such as cash.93 Since none of the Fiat group members had the credit rating AAA,

which is equal to no risk94, this brings into question how did FFT decide on

whether to provide related entities with loans and at what price.

An important consideration in accurately delineating a transaction is the wider

analysis of the group and how it creates value. The functions and assets of an

internal bank may be different from an independent bank since it might be

limited in its options for funding and lending because of its designated role in

the group’s value creation.95 The effect of belonging to a group can also

influence the delineation by, for example, using the credit rating of the group

when deciding on risk for a specific loan to be granted to a member.96 However,

the credit rating of the Fiat group was certainly not risk free, but rather

significantly lower97, which further points to the lack of consideration for

creditworthiness by FFT when advancing funds to related entities.

4) Actual conduct

The functional contribution of FFT is certainly providing the financing for the

loan that makes it the party assuming the financial risks in the loan contract.

FFT also mitigates some of these risks, such as the currency exchange risk by

hedging.

93 Lazarov, Buriak (n 63) 74. 94 Even in Fiat's own Transfer Pricing Policy document was FFT's credit and counterparty risk towards the group classified as ‘limited’, not non-existent. See EC Decision para 269. 95 OECD (2017) TP Guidelines paras 1.51-1.52. 96 TP Guidelines on Financial Transactions paras 10.81-10.82. 97 Ba3, which carries 100% risk weight, according to Rating Action: Moody’s downgrades Fiat to Ba3; negative outlook https://www.moodys.com/research/Moodys-downgrades-Fiat-to-Ba3- negative-outlook--PR_257083 (accessed 24 April 2020), as found in Lazarov and Buriak (n 63) 75.

35

The main issue when analyzing the actual conduct of FFT is whether it exercises

control over the risks and has the financial capacity to assume it.98 The disregard

for the credit rating of the borrower when advancing funds might indicate that

in actuality FFT does not fully autonomously decide on whether it is

commercially rational to provide a loan to a related entity. This would

consequently entail limited control over the risks such as the Credit and

Counterparty risk.

It is also uncertain in what degree does FFT bear the potential downside

consequences of risk outcomes. From the facts of the case, the parent company

Fiat S.p.A. provides guarantees on instruments such as bond and credits through

which FFT collects its funds. If, as a result of its related borrowers’ default, FFT

was not able to finance its own obligations, the financial capacity for assuming

this Counterparty risk might prove to be, at least in part, on the Italian parent.

5) Allocation of risk

If it is identified that control over the risk and the financial capacity for assuming

it are in the actual transaction shared or fully in the hands of another group

member, such as the parent, the risk must be reallocated to follow the actual

transaction.99

6) Pricing

The parties performing control activities should be remunerated appropriately

according to their importance. The assumption of risk should be compensated

with an appropriate anticipated return, while risk mitigation should be

accordingly remunerated.100 If FFT would be classified as an entity that lacks

the capability to control the risk, it might be entitled to a risk-free return only.

98 OECD (2017) TP Guidelines para 1.86. 99 ibid para 1.98. 100 ibid para 1.100.

36

In an opposite scenario, an internal bank both assuming and controlling its

financial risks would have the right to an arm’s length interest rate comparable

to stand-alone entities established by the CUP method, as suggested in the new

TP Guidelines.101 This serves to demonstrate how divergent consequences can

be if the accurate delineation of the actual transaction results in allocating the

risks of intra-group loans to parties other than the internal bank lender and

consequently why this process is vital to every transfer pricing analysis.

4 Conclusion

The aim of this paper has been providing insight into the latest development in

transfer pricing of internal banks, primarily for those entities based in the EU.

In order to achieve its purpose of establishing guidance on the safest road to

compliance, the analysis was twofold, looking both at the past and the future, to

ascertain what is to be done in the present.

The first finding is related to how the EC scrutinized transactions of internal

banks in the previously existing legal circumstances. It is important to keep in

mind that all of the conclusions which were made in the Fiat case were based

on the Transfer Pricing Guidelines of 2010, a version published before the BEPS

project has even been initiated. Additionally, the APAs concluded in

Luxembourg where laid out in such a way to accommodate the requirements of

the particular national tax authority. It is likely that none of Fiat’s tax advisors

took into consideration the idea that their report might be questioned by any

other authority, such as the EC, which, in the light of the notion that “transfer

pricing is not exact science”, has certainly influenced their argumentation and

conclusions.

101 TP Guidelines on Financial Transactions para 10.89.

37

However, now that the policing of transfer pricing possibilities for illegal State

Aid has become a frequent activity of the EC, with the right to do so guaranteed

by the General Court, it is a good precaution measure for internal banks in the

EU to try to reach the standard set in the Fiat rulings. On the other hand, all the

benchmarks set up to this point might be rendered null if the ECJ decides so. In

that sense, none of the findings on how to apply the transfer pricing method

presented in the first part of the paper are to be taken as conclusive.

Even if the reasoning of the EC is ultimately rejected, it is still useful as an

authoritative view on the transfer pricing methodology for internal banks. The

most significant takeaways can be summarized as follows:

- Internal banks are comparable to regulated entities, which facilitates the search

for comparables in the TP analysis;

- Although CUP is the preferred method, other methods, such as TNMM are

equally appropriate, if impelled by the facts of the case;

- Use of uncommon instruments, such as the Basel II, and unconventional

parameters and adjustments which are not envisaged by the TP Guidelines

should be reassessed and thoroughly justified;

- Central tendency (median) of the sample of comparable values is preferred in

situations that are not clear-cut.

Although all of these points where heavily criticized in academic circles, as was

presented in the paper, they are still highly relevant in practice since the General

Court’s confirmation has provided them with even more authority in both Fiat

and Starbucks case. That being said, the impact of these verdicts might be

severely limited for future cases for which the latest editions of the TP

Guidelines apply.

38

The second main finding of this paper was thus concerned with the TP disputes

that are yet to arise. After the results of the BEPS project were incorporated in

the Guidelines in 2017, the emphasis on taxation in line with value creation of

group as a whole has led to increase in importance for the accurate delineation

of the actual transaction. There are authors who deem that this progress towards

authentic delineation and assumption of risk has decreased the likelihood of

performing an analysis in line with the Guidelines and constituting State aid.102

This optimism might turn out to be just wishful thinking in the years to come.

This thesis has allowed for only a glimpse on how the functional analysis for

intra-group loans can be performed, but even this limited demonstration can

serve as proof on how ambiguous and uncertain such a process can be in the

complex structures of internal bank’s group.

The new TP Guidelines on Financial Transactions are a welcomed step for

facilitating the analysis of internal banks’ transactions, but when it comes to the

actual load of work that is required, compared to previous times, it will almost

certainly bring about a substantial increase. Instead of a bundle named “treasury

functions”, all the transactions of an internal bank need to be analyzed

separately, which includes an individual comparability analysis and possibly

different methods for intra-group loans, cash pooling, hedging and guarantees.

This will require substantial time and resources, but may be worth it if the result

attained is both aligned with BEPS and taxpayer’s need for certainty and

foreseeability in taxation.

The key indicator in the functional analysis is still the risk assumed, in

combination with functions performed and assets used. On this issue, the new

Guidelines primarily refer for support to the existing section D of the 2017

version. A decisive point on which the latest edition of the Guidelines insists is

102 Ruth Bonnici, ʹThe EC’s Arm’s Length Standard: Relationship and Compatibility with the Arm’s Length Principle under Transfer Pricingʹ (2019) 26/1 Intl. Transfer Pricing J. 62.

39

the accurate delineation and recognition of a loan as a loan for transfer pricing

purposes, before the process of establishing the ALP interest. As another result

of BEPS, only after the whole amount of the loan is recognized, based on the

functional analysis, as not being equity in disguise, can the further “usual” TP

considerations take place.

As a final comment, the field of transfer pricing of internal banks is just starting

to develop and it will be interesting to see how the theoretical conclusions hold

up in practice, particularly after the ECJ’s judgments and the implementation of

BEPS 2.0.

40

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Basel Committee on Banking Supervision, Basel II: International Convergence

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Cases T-755/15 (Luxembourg v. Commission) and T-759/15 (Fiat Chrysler

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OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and

Tax Administrations 2017, OECD Publishing, Paris.

OECD, OECD Transfer Pricing Guidelines on Financial Transactions 2020,

OECD Publishing, Paris.

41

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