The market for tax insurance (TI) is currently undergoing vivid change as more and more insurers are interested in covering known tax risks and are in particular looking at transfer pricing risks (TP risks). Many insurers have insured TP risks in the past several years while others are now interested in exploring their business options with TP risks. This creates a beneficial market environment for companies to pass on their TP risks on to an insurer.
2. Background and recent development
Whereas Warranty and Indemnity insurance (W&I) is used to cover unknown tax risks in M&A transactions (i.e., the risks that have not been identified in the tax due diligence review), TI developed as a smart instrument to manage known tax risks. Historically, TI has been used to fill the gap between the coverage under a SPA and a W&I policy as TI explicitly covers known and disclosed tax risks (e.g. risks identified and disclosed in a tax due diligence report). This was, however, only the starting point for TI as it has developed into an all-round risk transfer platform for a broad range of uses. TI now covers various kinds of historical and future tax risks both in and out of the context of an M&A transaction. The increasing number of policies underwritten by insurers reflects a growing demand for the product in the market.
Despite the strong development of various TI products, TP risks remained uninsurable for many years. TP risks stood in uneasy waters: on the one hand, W&I insurance generally excludes TP from the policy; on the other hand, insurers offering TI reacted very cautiously as TP risks were outside of the insurer’s risk appetite due to their unpredictability. However, in recent months we have seen significant movement in the market. With relevant due diligence and solid documentation many TP risks have become insurable. This applies to simple TP risks such as arm’s length interest on an intercompany/shareholder loan, as well as more complicated TP risks.
3. Key parameter of a tax insurance
TI policies typically cover a tax liability including interest, penalties and defense costs for a period of up to 10 years. The policy is generally designed to cover tax interpretation risks rather than implementation or factual risks. It is therefore not the intention of the TI to insure structures that fail because the parties incorrectly implemented the steps necessary to achieve the desired treatment or because the underling fact pattern was incorrect.
4. What TP risks are insurable?
The key requirement for insurability of a TP risk are proper documentation and arm’s length analysis (e.g. a transfer pricing study). In general, TI can cover historic and future TP risks of any kind. In case of a higher uncertainty of the relevant risk, the insurer may ask for significant retention or reflect it in a higher premium.
5. Case studies for insurable TP risks
Based on our market experience, we have set out below the typical TP risks and the corresponding insurance solution offered in the European market:
5.1 Intercompany/shareholder loans
Intercompany or shareholder loans (SHL) are often used in addition to the third party financing for acquisition purposes or to finance daily business operations of the relevant group. Due to the different tax treatment of interest and dividends, SHLs can also be used to improve the group-wide tax position. The remuneration of the SHL loan must be at arm’s length keeping in mind that, as SHLs are often not secured and subordinated to third-party financing, they usually carry higher interest.
GER GmbH is a German manufacturer with a direct shareholder in Luxemburg (Lux Sarl.) and an ultimate shareholder in an offshore country (non-EU, no double taxation treaty). There are two shareholder loans in place: SHL1 by the ultimate shareholder to Lux Sarl and SHL2 by Lux Sarl. to GER GmbH, each amounting to EUR 100m and carrying interest of 6%. The third-party bank granted a bond for 3% interest. The TP study prepared for GER GmbH supports an interest rate corridor on SHL2 of 5% to 7%.
If the tax authorities successfully challenge the interest rate on SHL2 and reduces it from 6% to 5% or even to 3%, the interest payment amounting to 1% or 3% is requalified as constructive dividends not deductible for German tax purposes. In addition, non-refundable withholding tax on dividends may apply due to the German anti-treaty-shopping rules. Assuming that SHL2 had been four years in place before GER GmbH was audited, a reclassification leads to an additional tax payment of up to EUR 7m in a worst-case scenario (i.e., a downward adjustment of the interest to 3%. Including late payment interest, penalties and defense costs, the total worst-case cost may amount to c. EUR 10m.
- Insurance solution
The market has developed two possible approaches for such risks: “Full Coverage” and “Catastrophic Risk” approach. With the Full Coverage approach, the insurer would cover any adjustment of the interest below 6%. Clearly, this approach involves a higher risk for the insurer, which will be reflected in the higher price (rate on line of 5% to 7% of the policy limit).
In recent years, several Full Coverage policies on TP risks were offered in the market however, due to significant risks associated with TP insurance, this approach should only be possible in special circumstances.
The approach that is currently gaining more mainstream acceptance among insurers is the so-called Catastrophic Risk approach. In this case, the insurer would only cover the worst-case scenario, i.e. in our example, if the tax authorities successfully adjust the interest rate below 5% thereby leaving the corridor suggested by the TP study. Premium for this Catastrophic Risk approach will likely be around 3% to 5% of the policy limit.
5.2 Intercompany royalties
Intercompany royalties are the remuneration charged when intangible property is transferred or licensed between related company entities. Intangible assets are often pooled together in a single legal entity and licensed to related group entities. Such intangible assets include trademarks, trade names, software, technology and patents. Intercompany royalties must be agreed at arm’s length terms.
A French SA has developed a new patented technology which should be used for the production of goods in a GER AG. In the first step, French SA transferred the patent to the affiliated Irish Ltd. Then, the Irish Ltd concluded a license agreement with the GER AG. A TP study suggests that the purchase price for the license should be EUR 100m and the annual license fee should amount EUR 10m.
Both the transfer of the patented technology from the French SA to the Irish Ltd and the royalties paid by the GER AG must be at arm’s length. If, for example, the French tax authority successfully argues for an arm’s lengths purchase price equal to EUR 110m, the German tax authority concludes the arm’s length license fee of EUR 5m p.a. and the Irish tax authority otherwise agrees, the French and German tax base would respectively increase by EUR 10m and EUR 5m p.a.. Considering the corresponding decrease of the Irish tax base, there would be additional tax burden at the group level due to different tax rates in Germany, France and Ireland. In addition, the overpayments might be subject to withholding tax on constructive dividends. Assuming that a final determination of the arm’s length price is agreed five years after the transfer of the license to the Irish Ltd, a total amount at risk (including interest and penalties) could be up to EUR 20m.
- Insurance solution
As above both Full Coverage and Catastrophic Risk approach might be offered by insurance companies. Depending on the quality of the TP study, the insurer may ask for a significant retention covering the defense costs. The expected premium should be slightly higher than for the TP risks on intercompany loans (discussed above) due to a less reliable data basis of the respective TP studies.
5.3 Remuneration of routine entities
Some legal entities within an international group perform for other group entities routine activities, i.e. activities that do not carry major risks with only limited profit potential. Tax authorities often challenge the qualification of activities as routine or non-routine as well as the right choice of the applied TP methodology to determine the arm’s length price.
An international asset manager with its European hub in Ireland uses French and German permanent establishments (PE) of an Irish Ltd to market and distribute its products in France and Germany. The TP advisor of the US Corp considered the functions of the PE as routine and proposed to remunerate the PEs on a cost plus basis.
If the French or German tax authorities successfully consider the cost plus margin falling outside the arm’s length range or the services of the PEs being non-routine, the taxation basis in France or Germany respectively increases resulting in additional taxation. In such cases, the exact determination of the worst-case limit can be difficult and requires additional TP analysis.
- Insurance solution
The general approach for an insurance solution is similar to the examples discussed above. The rate on line for such risk can be expected to be around 3% to 5% of the insured limit.
With the emergence of the insurability of TP risks the insurance market is moving into the right direction in order to solve pressing issues of European companies. Insurers are expanding their expertise in the area of TP and are becoming more comfortable in underwriting such risks. This in turn opens up new methods for companies to manage TP risks more efficiently.