Financial services and transactions are a crucial part of the global economy. However, as financial institutions operate across multiple jurisdictions, there is a need to establish a clear framework for transfer pricing and taxation. In the US, the Internal Revenue Service (IRS) has proposed regulations that aim to provide guidance on the taxation of global trading of financial instruments.
The proposed regulations focus on the comparability analysis, arm’s length range, and transfer pricing methods, such as the comparable uncontrolled transaction (CUP), for global trading. They also provide guidance on determining income from global trading, the treatment of foreign currency transactions, and hedging transactions. The rules cover the maintenance of documentation on transactions covered by the regulations and allow the IRS to establish whether the taxpayer has dealt at arm’s length.
In addition to transfer pricing rules, the earnings stripping rules also apply to transactions with foreign related parties or debt guaranteed by a foreign related party. Under section 385, note issued by a US subsidiary to its foreign parent as a dividend or in a transaction that is economically similar to the payment of a dividend will be reclassified as equity if the debt does not finance new US investment. This is intended to reduce the incentive for corporate inversions because groups would no longer be able to load a US subsidiary with related-party debt to strip income out of the US through tax deductions while arranging for related interest income to be recognized in a low tax jurisdiction.
The Tax Cuts and Jobs Act introduced several amendments, including the disqualification of related party amounts paid or accrued under a hybrid transaction or paid by, or to, a hybrid entity. A disqualified related party amount is any interest or royalty paid or accrued to a related party if the amount is not included in the income of the related party under the tax law of the country where the related party is tax resident or subject to tax. The Act also amended section 163 (j) to limit the deductible interest for tax purposes to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA), which was increased to 50% for periods beginning in 2019 and 2020 under the CARES Act.
The final regulations issued on 14 September 2020 provide guidance on the calculation of the interest limitation, what constitutes interest for this purpose, the taxpayers and businesses subject to the limitation, and the application of the interest limitation to consolidated groups and other situations.
The global dealing regulations, which have not yet been finalized, set out detailed guidance in respect of the attribution of profits to a permanent establishment (PE) in a global dealing situation and these regulations will have an impact on transfer pricing for financial institutions. Global dealing operations are defined as the execution of customer transactions in a particular financial product or line of financial products in multiple jurisdictions.
The regulations set out functional analysis rules focusing on product R&D, marketing, pricing, brokering, and risk management. They cover other comparability factors, including the risk arising from the global dealing operations and the economic conditions, such as the similarity of geographic markets, relative size and sophistication of markets, volatility, availability of alternatives, and timing.
The three transactional transfer pricing methods specified in the global dealing regulations are the comparable uncontrolled financial transaction (CUFT) method, the gross margin method, and the gross markup method. The profit split (PS) method or residual profit split (RPS) method is also specified.
In conclusion, financial institutions must comply with transfer pricing rules and taxation regulations to operate effectively in a global marketplace. The proposed and final regulations provide guidance on transfer pricing and the limitations on the deduction of business interest expense, which are essential for multinational corporations to operate with certainty and comply with their tax obligations.