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Recharacterising transactions – a global trend?
Based on the survey, re-characterisation seems indeed to be a challenge in many countries around the world, and the level of aggression of tax authorities has generally risen in the past few years. However, there are also countries in which re-characterisation is just starting to emerge, as well as countries in which the phenomenon is, in practice, non-existent. Taking into account the proposal to update the OECD Transfer Pricing Guidelines and the increasing cooperation among tax authorities, multinationals may expect the issue to become globally topical in such countries in the future.
The re-characterisation often involves unpleasant surprises and potentially lengthy litigation processes which involve more than one jurisdiction. In order to avoid re-characterisation, it is worth recognising the global trend and acquainting oneself with the state of play, at least in the countries of operation.
Taxand’s global tax disputes resolution team details the definition of re-characterisation globally and the prevalence of the issue in key jurisdictions.
Re-characterising usually means that a tax authority does not approve the legal/tax form utilised by the taxpayer. The tax authority will subsequently apply another legal/tax form within a certain transaction between related parties (or even the entire business model of the taxpayer), if it considers it more appropriate from a substance-over-form perspective.
A classic example would be to deny interest deductions to a loan, based on a claim that the instrument was actually an investment in equity. Such subsequent assessments may also result in hefty penalty payments. The legal basis and possibilities of re-characterisation vary between different countries, as do the consequences of re-characterisation. In transfer pricing matters, the taxpayer may have to deal with the tax authorities of several countries who do not always agree with each other’s views, which poses the threat of double taxation for the taxpayer.
The re-characterising of transactions is not a new phenomenon but the OECD Transfer Pricing Guidelines (2010), the proposals for updating the Guidelines, and the BEPS project have brought the issue into the limelight. As a general rule, the OECD Guidelines are based on the “as structured” principle and therefore prohibit the re-characterisation of transactions. However, where the economic substance of a transaction differs from its form, paragraph 1.65 of the Guidelines allows the tax authorities to consider re-characterisation of a transaction. Another situation where the Guidelines accept re-classification is when the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner. Re-classification can occur if the actual structure practically impedes the tax administration from determining an appropriate transfer price.
However, it is important to acknowledge that the OECD Guidelines are not equivalent to national legislation – the basis for re-characterisation must be found in national legislation.
For example, the Finnish tax laws include both general anti-avoidance rules (GAAR; especially the general substance-over-form provision) and a provision on making transfer pricing adjustments. The general anti-avoidance provision allows the tax authority to disregard the legal form used in a transaction (or the entire transaction, if it is clearly entered into for the purpose of avoiding taxes), and apply the form and related tax consequences to the real economic nature of the arrangement. In these cases the burden of proof is fairly high and lies primarily on the tax authority’s side. Potential double taxation may only be alleviated through mutual agreement procedures based on the applicable tax treaties. Despite a lengthy process, the tax authorities are not obliged to agree upon the interpretation of each case and relieve the double taxation.
The Finnish transfer pricing adjustment provision does not require any tax avoidance purpose, but allows for the correcting of the price in transactions and other conditions agreed between related parties. Between EU countries, potential double taxation resulting from the application of transfer pricing adjustments may be relieved through the EU Arbitration Convention, which forces the countries to find a common solution to each case.
In recent years, the Finnish tax authorities have increasingly tried to re-characterise transactions in their tax audits based on the transfer pricing adjustment provision, instead of the GAAR. Taxpayers have objected to this, as the threshold for applying transfer pricing adjustments seems to be lower than for the GAAR.
Based on the global survey conducted by Taxand Finland, it is evident that tax authorities in many other countries are using both GAAR and the transfer pricing rules in attempts to re-classify transactions. Our survey revealed that this is the case in Belgium, Italy (GAAR and abuse of law concept), Romania, Sweden and Turkey. Whereas only, or mostly, GAAR is used for reclassification purposes in:
- France (abuse of law concept)
- Greece (new GAAR just entered into force)
- India (although the formal GAAR has not yet entered into force there)
Mainly TP adjustments are utilised for example in the Netherlands and Poland. Countries in which re-classification does not yet seem to be such a problem currently include Cyprus, Denmark, Ireland, Japan, Malta and Thailand.
Quality tax advice, globally
In most of the Taxand countries surveyed the tax authorities have become increasingly aggressive in recent years. One feature of this is their more frequent attempts to re-characterise transactions, disregarding the form utilised by the taxpayer. The OECD Transfer Pricing Guidelines generally seem to support these attempts; however, the individual circumstances in the legislative environment of different countries vary, and the national authorities should respect the limits set in the legislation. In many cases, however, the position of the taxpayer is uncertain in that the taxpayer may have to undergo lengthy multi-country processes in order to eliminate double taxation. Multinationals should ensure that they are abreast of the current practices in countries where they have operations in order to assess their exposure to risk.