Brand location and transfer pricing issues for hotel groups
Definition
Transfer pricing is a term used to describe all aspects of inter-company pricing arrangements between related business entities, and commonly applies to intercompany transfers of tangible and intangible property.
Overview
Transfer pricing is an area that presents both exposure and opportunity to modern multinational corporations such as hotel groups. Exposure - because inappropriate transfer prices can result in economic double taxation. Opportunity - because proactive use of transfer pricing can be a very powerful tool for tax reduction.
In this context, transfer pricing refers to the prices charged for transactions between members of an international group of companies. These transactions are typically eliminated in an accounting sense because the related companies most commonly file consolidated financial statements. However, these transactions are not eliminated for tax purposes - and the prices charged may have a crucial effect on tax obligations of the group of companies.
One of the most important elements of transfer pricing is pricing for the use of intangible assets and for services.
The most significant intangible assets for the hotel industry are the unique brand names associated with the hotels. A hotel group's competitive advantage will be linked to its brand name. This association creates both tax exposures and opportunities for the group.
As already mentioned, the primary exposure is the risk of economic double taxation. This could occur, for example, if the tax authorities of the country of ownership of the brand name were to require royalty income at a greater rate than might be allowed as a tax deduction in the country of use. Proper documentation and, in some cases, valuation studies, can minimize or eliminate this tax risk. Other exposures include CFC risks, transfer and indirect taxes, the impact of double tax treaties and residence issues as well as the cost of dealing with or defending audits by tax authorities.
Opportunities include, for example, the possibility of permanent tax reduction by legitimately establishing (or moving) the ownership of brand names in suitable low tax jurisdictions. Other opportunities might include planning of royalty flows to defer their payments until start up operations become profitable.
Transfer pricing rules
Most tax jurisdictions of the world have adopted transfer pricing rules. Satisfying the tax authorities in all countries involved is a difficult but not impossible task. In recent years many countries have begun to require specific disclosures in tax returns regarding the transfer pricing methodology used. This increases the visibility of transfer pricing with tax authorities.
The heart of the proactive use of transfer pricing lies in legitimate movement of profits to tax favourable jurisdictions. Obviously, tax authorities in developed high-tax-rate countries will take a significant interest in planning of this sort. However, legitimate planning techniques exist to allow such transfers within the tax rules of most jurisdictions.
For most countries, the standard for determining an acceptable transfer price is the "arm's length principle" recommended by the Organisation for Economic Co-operation and Development ("OECD"). The OECD developed Transfer Pricing Guidelines for International Enterprises and Tax Administrations (the "OECD Guidelines"). These establish price methodology based on the terms and conditions that independent parties would have used in a similar transaction.
The OECD rules are very influential, although not controlling over local practice. Even in countries that are not members of the OECD, there has been a general tendency towards the arm's length standard as articulated by the OECD. However there remains variance in practice, including most notably the USA, with its own concepts of what constitutes an arm's length price. These differences can usually be accommodated without major tax exposures, but care must be taken to do so.
At an international level, transfer pricing disputes are regulated through a variety of treaty provisions, most notably the "mutual assistance procedures" to allow different tax authorities to deal with differences in transfer pricing approaches for specific taxpayers.
Brand name - pricing strategies
To avoid exposures from transfer pricing, the group company which owns the brand name (the "Brand Owner") must charge its associated entity royalties for the use of the name on an arm's length basis. In establishing appropriate royalty levels, the primary test is the amount of royalties an independent party within the hotel industry would be prepared to pay for the right to use the name in the comparable transaction. Where good comparables are not available, other methods are required to be used.
Regardless of the method chosen, it is advisable for hotel groups to have a developed transfer pricing policy in place, applied as consistently as possible, with appropriate legal documentation and justified by business and economic data. This practice will provide benefits by saving money on subsequent audits or enquiries.
There is a potential for profit maximization for the group by moving the brand name to an affiliate in the "right" location. The OECD Guidelines identify two ways of making intangibles available to affiliates: by means of licensing arrangements or by the use of cost contribution (or cost sharing) arrangements. It is important to ensure that there is an appropriate contribution from affiliates for the use of the brand name. On the other hand, royalty payments (or, indeed, other payments, like management fees) that do not appear to make commercial sense will create transfer pricing risks.
The best tax position may be achieved if the payment is also paid without withholding tax while the affiliate bearing the relevant costs obtains a tax deduction.
Below are some specific strategies which should be considered.
Licensing brand name and other services
One example of a tax planning technique to exploit the brand name efficiently is the formation of a company in a low tax jurisdiction. Such company could develop the group brand name, own it and receive royalty payments from the affiliate hotel companies for its use. If the brand is already established, a strategy could be developed to transfer the brand to such low-tax company in a tax-efficient manner.
This structure can achieve a reduction in the effective tax rate for the group as a whole by accumulating profits in a low tax jurisdiction - apart from other potential tax benefits, as many countries give a privileged fiscal status to companies which hold intangibles.
A related issue is that of withholding taxes imposed on royalties. Typically the payer of the royalties is required to withhold. To minimise such withholding, the Brand Owner would grant an international licence of the brand name to another group company (the "Intermediary") in a jurisdiction with access to a wide double tax treaty network (for example, the Netherlands). The Intermediary would then exploit the brand and receive royalties - free of or subject to minimal withholding - and similarly pay royalties to the Brand Owner free of or subject to minimal withholding. The Intermediary would earn a small taxable margin, but the bulk of the royalty income would be received by the Brand Owner and would be subject to a low level of direct taxes. Some countries - in particular, the USA - do however attack these so-called conduit structures.
There are other helpful techniques. For example, the Brand Owner may sell the brand name to an affiliate which is eligible to obtain tax allowances on the purchase price. Those allowances are offset against the royalty income earned by the affiliate from the exploitation of the brand name. Or, for example, the royalty income flow can be re-classified (for withholding tax purposes) as services, by mixing technical services rendered with the licensed use of the intangible in such a way that it becomes difficult to segregate one from the other where it is necessary to achieve a more advantageous tax position.
Building on the "right location" strategies, some groups may also find it beneficial to create common service centres in countries which have a special status for headquarters or other such facilities; or use a captive company for re-insurance operations in a location which grants such companies fiscal advantages; or set up a finance subsidiary, again carefully located, in charge of all banking and financial services within the groups…the list is not exhaustive.
None of these structures are without their difficulties. For example, many double tax treaties contain articles designed to prevent "treaty shopping" (the treaty between the Netherlands and the USA is a clear example). The effect of these is to withdraw the withholding tax reduction/elimination benefit otherwise available under the treaty.
Further, the domestic tax laws of some jurisdictions may attribute income earned by "controlled subsidiaries" in low tax jurisdictions back to the controlling company - under the so-called controlled foreign company ("CFC") rules. It is, however, surprising how many developed countries have not yet implemented such legislation. Arguably, this gives multinational hotel companies with established headquarters in these jurisdictions something of a competitive advantage in terms of the higher available post tax profit. The UK, Germany, France, Canada, the USA, Denmark and Finland all have the CFC rules; the rules have been recently introduced in Austria and Italy; however, Luxembourg and the Netherlands do not have them. CFC risks may be reduced by, for example, giving sufficient substance and activity to the structure - broadly, ensuring that most of the profits on the exploitation of the brand name are earned by the Brand Owner.
Last, but not least, there are the transfer pricing rules themselves. However, they can work in favour of the hotel group in this instance where charging a healthy royalty to the local operator in the higher tax jurisdiction is clearly justified, provided it is not excessive.
Although the principle of brand location appears in itself to be relatively simple, the practical achievement is not as easy. Certainly, for a real life multinational hotel group, the exit costs of moving the developed brand to a low tax jurisdiction (e.g. capital gains or corporate income tax) are potentially huge and careful tax planning such as establishing or manipulating the availability of losses and other reliefs will be necessary.
Cost contribution arrangements
Under a cost contribution arrangement, two or more associated parties agree to fund the development of a brand from which each will benefit. Thus, the brand name will be owned by a single entity - for example, a parent company, but the benefits will actually be available to all the contributing members of the group.
One advantage in relation to such arrangements is that the payments under them may be made in lieu of a dividend and can, in certain circumstances, be tax deductible as well as permitting the avoidance of withholding tax implications. However, local rules on deductibility of expenses caused by such arrangements should be carefully considered: different accounting and tax treatment, and different restrictions prevailing in different jurisdictions can hinder an overall efficacy of such a scheme.
Pricing Strategies
Service and management contracts, centralised booking and other systems
A common issue in this area is the identification of services performed by the home office for foreign related enterprises. There are often services such as computer support, management assistance, personnel advice and the like, as well as transfers of knowledge regarding the business. It is important to identify these services and to develop appropriate mechanisms to allow for payment.
Within the context of international hotel industry, services between related hotel and service companies are subject to transfer pricing rules, and payments under these contracts are assessable on arm's length basis. The contracts between the provider and recipients of the services should set out clearly the services which are to be provided (and, in some cases, evidence that services were actually provided) and how any fees are to be calculated. All the arrangements should be appropriately reflected in contracts, as otherwise tax authorities may not allow tax deductions.
The relocation of central management and, in particular, computerised functions such as booking and ordering should be considered. Ireland, Switzerland, possibly Cyprus and other low tax jurisdictions with a treaty network, a developed infrastructure and educated workforce should be considered for such functions as a means of reducing taxable income in the high tax operating jurisdictions. Any exit costs on relocation (including capital gains tax on deemed goodwill disposals) should be factored into the analysis.
Intra-group funding
Intra-group finance, which is an important aspect of managing hotel business, may also receive particular attention from tax authorities. In this context, the key issues are:
- whether the transfer pricing rules apply to a particular transaction;
- whether a company is thinly capitalised; setting arm's length interest rates, guarantee fees, etc;
- avoiding withholding tax.
The transfer pricing issue may arise where no interest is charged on outstanding balances, as this would not be normal in an arm's length situation. The tax authorities may challenge not only the price of the loan (i.e. interest charged) between related parties, but also other aspects of the arrangement, such as whether the loan would have been made if the parties have been acting at arms' length, and other terms of the loan besides the rate of interest.
Where liquidity is provided to an affiliated company by a loan, the resulting interest expense would normally be deductible against taxable income. However, in many countries (the UK, for example), if a company is thinly capitalised, the tax authorities would contend that no independent third party, dealing at arm's length, would have provided a loan on those terms (if at all). The excess amount of interest paid is then recharacterised as a distribution, and no tax deduction is available in respect of it. In other countries, such as the USA and Germany, there are also specific statutory or regulatory limits to deduction based on the relationship of debt to equity or other measures.
There may be a domestic requirement to withhold income tax on interest payments, but this is may be overridden by a treaty if the recipient is in a qualified treaty country.
Despite all the difficulties, group financing remains a popular method of reducing the group tax bill overall. Related options include the use of offshore or onshore finance companies in or through the Netherlands, Luxembourg, or Ireland, or double dip structures.
The recent ECJ decision in Lankhorst-Hohorst GmbH v Finanzamt Steinfurt regarding thin capitalisation rules within EU groups indicates that excess debt structures as a means of extracting profit may enjoy a renaissance for hotel groups wherever headquartered - although the EU states affected (such as the UK) may simply respond by insisting that both foreign and domestic finances should be on arm's length terms!
Avoiding double taxation
As large part of the business of multi-national hotel groups is centred in developed countries with correspondingly high tax rates, any transfer pricing adjustment by one tax authority could well lead to effective double taxation. Say, the Brand Owner in the USA receives royalties from the affiliate hotel company in Germany for the use of the brand name. The German tax authorities may contend the royalties are too high whilst the IRS may argue that it is too low. In order to reduce such possibilities, many double taxation treaties contain a "mutual agreement procedure" clause. Such provisions enable a taxpayer resident in one country to present a case to the competent authority in his country if he considers that the actions of the tax authorities in either country could result in effective double taxation.
If double taxation has not been eliminated by agreement between the competent authorities, there could be a further remedy for intra-EU transactions provided by the EC Arbitration Convention. The Convention (which applies to EU member states and deals with transfer pricing only) introduces an arbitration procedure and establishes the deadlines and time limits for completion of each step.
Another method to manage transfer pricing risk is the advance pricing agreement (APA). This is an advance agreement between a taxpayer and a tax authority (or, in the case of a bilateral or multilateral APA, an agreement between the taxpayer and several different tax authorities) regarding transfer pricing methodology. APAs allow companies to diminish the risks from possible transfer pricing audits, especially if they are bilateral or multilateral. They give taxpayers the benefit of determining the transfer pricing rules in advance and are limited to a set number of years, usually around four or five. As long as all the facts were disclosed at the time of reaching agreement, there is no risk of audit or adjustment. While APAs are very common in the USA, very few have been put in place in Europe and some jurisdictions do not allow them.
Compliance
Generally speaking, there will be no adjustment if a company can demonstrate the appropriateness of the transaction, the real benefits resulting from it and the validity of the operation from a non-tax aspect. There are severe penalties in some jurisdictions for failure to document transfer pricing in the event of an adjustment, most notably in the USA.
Consequently, every multinational group should ensure its transfer pricing policies are solidly established, recorded and are subject to regular review. All major pricing decisions relating to intra-group business should be fully documented and such documentation should be preserved. This would help to avoid unpleasant surprises such as penalties and significant costs of defence against an audit.
Conclusion
Clearly, transfer pricing and associated issues pose considerable challenges but also opportunities for multinationals. Hotel groups should consider substantive, economically driven risk management strategies and use these to balance two important and not necessary competing goals: complying with local transfer pricing requirements while using transfer pricing proactively to achieve their own business objectives.
For further information please contact Mark Nichols (UK Head of Tax) at mark.nichols@cms-cmck.com or on +44 (0)20 7367 2051.
