On 1 July 2022, the Dutch Ministry of Finance published a new transfer pricing decree replacing the prior version from 2018 but also retracting the prior guidance on the use of a spread for financial services companies, so called financial intermediaries (‘Dienstverleningslichamen’ or DVLs), in a questions and answers decree from 2014.
This new decree provides further guidance on the application of the arm's length principle and the Dutch Ministry of Finance’s view where the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD guidelines) leaves room for interpretation but also reflects a fundamental change to the way transfer pricing is dealt with for financial intermediaries.
Two decrees were recently published by the Dutch tax authorities related to transfer pricing and the attribution of profits to permanent establishments. In this podcast we are exploring what’s in the decrees, the potential impact for companies, and what actions taxpayers should take.
The prior transfer pricing decree was published in 2018 to reflect the outcomes of the OECD’s base erosion and profit shifting (BEPS) project. Since then, the OECD also published its transfer pricing guidance on financial transactions in 2020 and there has also been increasing pressure on shell companies and the use of related parties in low tax jurisdictions (e.g. ATAD III). These developments are reflected in the new transfer pricing decree, in addition to some changes in the wording on other parts of the decree that have been tweaked or streamlined. The most significant changes in comparison with the revoked decree include:
The biggest changes to the decree are reflected in the section on financial transactions and especially the inclusion of new guidance on the transfer pricing of financial intermediaries. The changes to the financial transactions section of the new decree are therefore discussed first, followed by the other important changes to the decree.
The biggest changes to the decree are included in the section on financial transactions, including the reflection of the OECD’s guidance on financial transactions in Chapter X of the OECD guidelines. Overall there is a significant emphasis on control over risks and having sufficient financial capacity, especially for financial intermediaries.
The decree now includes new guidance on implicit support, the methods for the determination of arm’s length interest (i.e., CUP, cost of funds and a mark-up on expenses are mentioned) and risk-adjusted / risk free rate.
The decree, similar to the previous decree, emphasizes that for loans to a non-investment grade rated borrower it must be substantiated that the loan was concluded under arm’s length conditions, predominantly when the intercompany lender lacks diversification. This requirement is not included in the OECD guidelines.
Furthermore, the decree explicitly states that a borrower is entitled to the deduction of an arm’s length interest rate, even if the lender is only entitled to a risk-free return if it lacks control over risks or financial capacity. The risk premium, in such cases, is allocable to the party that controls the risks. This statement should help in discussions on the deductibility of the interest when the lender lacks control over risks or financial capacity although discussions on where the interest income belongs would still be expected to be very complex.
The new decree includes very specific guidance on financial intermediaries, which had previously always been covered in a stand-alone decree (now revoked). This new guidance is a departure from the prior guidance and no longer states that comparable independent parties are remunerated based on the underlying transaction amounts, which was the basis for the typical ‘spread’ approach between the receivable and payable for financial intermediaries in the past. A distinction is now being made between three kinds of financial intermediaries based on their level of control over the underlying risks and their financial capacity to bear these risks (e.g., their level of equity): full control, no control and the financial intermediary shares control with the rest of the group. Each situation is dealt with differently:
It is worth noting that the revoked decree on financial intermediaries had provided details on the preferred way of pricing the underlying transactions, but this is much more limited in the new decree. The new decree lacks any specific guidance on factors to consider when pricing the transactions but is now also silent on possible ways that it can be determined that a financial intermediary has sufficient capital to have the financial capacity required for a transaction or what substance is required to be fully in control as a financial intermediary. Overall, the new guidance suggests a fundamental change without providing much clarity and without any clear guidance on the transition from past practices. For example, if the spread previously applied is no longer considered appropriate and is replaced by a lower remuneration based on a cost plus, then the taxable income of the financial intermediary would be subject to a downward adjustment, but this would still be taxed under new rules aimed to combat informal capital in case no corresponding upward adjustment is made there where control over risks is considered to be located. The decree also does not include any grandfathering provisions for existing financial intermediaries.
The new decree now includes some high level guidance on the transfer pricing related to cash pooling. This guidance is somewhat limited for such a complicated topic but is generally aligned with Chapter X of the OECD guidelines including confirmation that cross guarantees provided by cash pool participants is generally driven by shareholder motives and that this would not be expected to be reflected in the profits of the participants (i.e., no guarantee fee but also no costs related to any costs arising due to the guarantee - such as an default of another participants – would also not be deductible). Key points addressed are the possible recharacterization of cash pool balances from short term to long term but also the assertion that the functionality of a notional cash pool leader is more limited with less value creation by such a cash pool leader compared to that for zero balancing cash pool, which would be expected to also be reflected in the remuneration for this function.
Elements of what is now reflected for guarantees in Chapter X of the OECD guidelines were already included in the revoked decree. Nonetheless, the new decree has been substantially revised with the biggest changes being the statement that implicit support should be reflected in any guarantee fee analysis but also the possibility for the Dutch tax authorities to delineate a part (or whole) of a third-party loan with a corporate guarantee as a loan to the guarantor followed by a capital contribution in the borrower, when the guarantee allows for increased borrowing capacity. The new decree recognizes that such a (partial) recharacterization is not fully aligned with Dutch jurisprudence and as such creates uncertainty for taxpayers in the Netherlands and emphasizes the importance of a debt capacity analysis when external borrowings are covered by a corporate guarantee. Furthermore, when it is appropriate that an intercompany guarantee fee is charged but no specific guarantee fee can be determined, the Dutch tax authorities find it acceptable that a guarantee fee is equal to half of the benefit that the guarantee provides the borrower.
More details are now also included on captive insurance companies in the new decree although the Dutch tax authorities remain skeptical of the value that a captive adds within a multinational enterprise. The changes are mainly an increased focus on the commercial rationale for the use of a captive and emphasizing the importance of the control over risks, e.g., is there a risk mitigation and underwriting function within the captive entity, and the financial capacity in view of the level of diversification of the insured risks. In addition to passive pooling and insurance as a by-product, the decree now also includes details on insurance fronting with the assertion that any high profits due to the time and place of the sale would not be attributable to the captive.
The structure on the application of the arm’s length principle remains the same with some additions such as the requirement to attribute an entity’s overall profit to the counterparties when a transfer pricing method is used that aggregates transactions to ensure avoidance of double (non-) taxation. This is needed for recent Dutch legislation introduced to prevent mismatches when applying the arm’s length principle. There is also some further clarification when statistical methods can be appropriate to improve the reliability of the full range of observation when comparability differences cannot be qualified and / or quantified.
The impact of subsidies, tax incentives and non-deductible costs on transfer pricing was covered as a separate section in the revoked decree but is now included within the section on government policies as part of the application of the arm’s length principle. This section has therefore been expanded and now also includes guidance on the impact of support measures, such as COVID, but unfortunately, the decree is not very conclusive on the impact as it refers to the way third parties deal with such subsidies should be considered.
The changes to the section on intra-group services are more subtle. The potentially most impactful change is that a benchmark is now also required for transactions of taxpayers that do not fall under the Master / Local File requirements, whereas the revoked decree indicated that the lack of a benchmark for so-called 8b documentation would not result in the reversal of the burden of proof. Another important change is that the new decree asserts that the Dutch tax authorities have discretionary authority when services can be charged without a mark-up (based on OECD guidelines’ par. 7.37 and that charging costs without a mark-up would also require that all financing costs are also charged out). A more positive move, in line with general business developments, is that costs related to reporting on ESG policies are not necessarily considered to be shareholder activities anymore.
The section of services in the new decree now adds contract manufacturing to the part on contract research, emphasizing the importance that the beneficiary of the services has control over the underlying risks but also has the financial capacity to bear these risks.
As indicated, the new decree does not provide for any grandfathering of past practices such as those for financial intermediaries. This is a concern because of the changes already mentioned but also because the decree no longer includes any guidance on the interaction between the OECD guidelines and Dutch tax law, whereas the prior version stated that the OECD guidelines had a direct application in Dutch tax law. Certain explicit statements have also been removed which may also create uncertainty:
In contrast to the omissions above, the decree now also includes a summary of the documentation requirements in the Netherlands. These require certain larger taxpayers to prepare Master / Local File documentation for cross-border transactions and include a more open norm for other domestic and cross-border intercompany transactions. The decree now offers the ability for taxpayers to obtain certainty from the tax inspector whether the documentation requirement according to the open norm is met but also indicates that Master / Local File documentation is sufficient to meet the open norm for domestic and cross-border transactions.
The new decree is a narrower interpretation of the arm’s length principle and emphasizes the importance of both control over risks and the financial capacity to bear such risks. This is expected to create more discussions between the Dutch tax authorities and taxpayers in practice, especially for intercompany financial transactions, and could possibly lead to double taxation that would need to be resolved.
It is therefore critical that companies revisit their policies for financial transactions in general and more specifically the transfer pricing of financial intermediaries and any guarantees provided for third party debt across the group. We are more than happy to assist in performing these analyses with our proprietary Economically Significant Function (ESF) and Financial Transaction Transfer Pricing (FTTP) analyzers, respectively.