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Transfer Pricing – How Tax Insurance has evolved to mitigate these risks

Transfer pricing (also known as “TP”) remains one of the most complex and contentious areas of tax and is a key factor for transactions between related parties. Specific Tax insurance can be an important tool to mitigate TP exposures and the insurance market has continued to evolve to cover such risks.

Transfer pricing involves setting prices for transactions between related entities within a multinational group. These transactions can range from the sale of goods and services to the intercompany loans amongst related parties.

TP regulations require that these transactions be conducted at arm’s length, mirroring the conditions that would apply between independent parties and are designed to prevent profit shifting and tax base erosion, ensuring that profits are taxed where economic activities and value creation occur.

Given its complexity, Transfer Pricing was always problematic for the Transactional Risk Insurance market, with it being a mandatory exclusion in Warranty & Indemnity (W&I) insurance policies, meaning that a separate Specific Tax insurance policy was the only feasible insurance solution if the M&A parties were concerned about an identified TP risk. Yet, the appetite from insurers to cover these risks was traditionally very limited.

Instead, TP risks associated with intercompany debt/shareholder loans, particularly interest rates, have been the primary focus of Tax insurance for TP and underwriters are now becoming generally comfortable insuring such risks.

However, the landscape is evolving, with underwriters increasingly covering a broader range of TP risks, including those not related to debt.

Traditional Focus of Tax Insurance: Debt-Related TP Risks

Historically, Tax insurance for TP risks has predominantly focused on intercompany debt arrangements. This includes ensuring that interest rates on loans between related entities fall within the arm’s length range identified through benchmarking studies.

Tax insurance protected the insured from a financial loss originating from the tax authorities challenging the interest rates applied and making adjustments that could result in additional taxes, penalties, and interest.

Usually, coverage is related to one particular intercompany loan agreement or a single transaction and not the general TP policies and documentation applicable to a group of companies.

Evolving Coverage: Non-Debt-Related TP Risks

Recently, the scope of Tax insurance has broadened to include TP risks beyond intercompany debt.

This expansion reflects the increasingly complex nature of global business operations and also the response from the Tax Insurance market to service these exposures. Underwriters have become more comfortable with insuring such risks, subject to the documentation available and robustness around the specific scenario.

Outside of the intercompany debt scenario, we have seen several recent examples of Tax insurance being used for TP risks. These include:

1. Intellectual Property (IP) Allocations: Insuring risks related to IP allocations and royalty payments between entities has become more prevalent. These transactions are complex and often subject to intense scrutiny, given the challenges in valuing IP and determining appropriate royalty rates.
2. Intercompany Services: Coverage now often includes TP risks associated with intercompany service payments. These services must be priced at arm’s length to avoid adjustments, making them a significant area of focus for tax authorities.
3. Tangible Goods Transactions: While traditionally less common, there has been a rise in insuring TP risks related to the pricing of tangible goods transactions. This shift is due to the increasing complexity of global supply chains and the need for meticulous documentation and compliance.

For both debt-related and non-debt-related risks, a robust TP benchmarking study is crucial. These studies provide the necessary evidence to support that the prices or interest rates applied are at arm’s length, which will provide the necessary information for underwriters to insure such risks.

Each risk is dependent on the specific facts and circumstances of a particular matter, and one factor that would make underwriters more confident to covering such risks is if prior periods have been audited without challenge.

Additionally, the insurability of TP risks heavily depends on the jurisdiction involved. Different countries have varying TP regulations and enforcement practices, influencing the risk assessment and the scope of coverage provided by underwriters.

Utilised effectively, Tax insurance can provide an effective safety net for companies, allowing them to manage the financial risks associated with TP disputes. It can be an essential tool for a group of entities facing complex and varied TP challenges, which could be involved in an M&A transaction scenario.

Conclusion: Where next for Tax Insurance and TP?

As global tax authorities intensify their scrutiny of TP practices, the importance of robust risk management strategies cannot be overstated and will only become more vital for businesses operating within this sector.

Tax insurance offers a pragmatic solution, now providing coverage for a wide range of TP risks and ensuring that companies are protected against the financial consequences of potential disputes. By using Tax insurance, companies can navigate the complex TP landscape with greater confidence and peace of mind, safeguarding their financial health and tax compliance standing.

While debt-related TP risks remain a significant focus when it comes to insuring TP risks, underwriters are increasingly offering coverage for non-debt-related risks, including IP allocations, intercompany services, and tangible goods transactions.

As underwriters continue to adapt to the changing TP environment and offer Tax insurance policies that address this landscape, our clients can expect more comprehensive and tailored insurance solutions to meet their diverse needs.