Understanding the problem
Globalisation and digitisation has created powerful multinationals who structure their transactions in a way to minimise their tax incidence. For instance, they may create contractual rights and obligations between associated-enterprises which clearly lack the financial ability or decision-making control to fulfil their commitments. They may transfer intellectual property and other mobile assets to shell companies in low-tax jurisdictions, while masquerading it as a real economic transaction on paper. Reliance on such contracts is difficult because they are confidential, not public, and can be altered later.
Initially, in 1979, OECD tackled this issue by advising tax authorities to examine the economic substance of a transaction rather than its form. This approach was further refined by focussing on the conduct of the parties instead of mere contractual terms.[1] Subsequent guidelines allowed the tax authorities to disregard a transaction, if it significantly deviated in substance or couldn’t have occurred between independent entities.[2] The tax authorities started looking for real economic activity and whether there was ‘value-creation’ in line with G-20/OECD-BEPS-Action Plan 8-10.[3]
Presently, the modified 2017 guidelines emphasise on accurately delineating the actual transaction and looking at whether an independent enterprise behaving in a commercially-rational manner in a comparable circumstance would have undertaken the transaction. A ‘commercially rational transaction’ is entered into after proper cost-benefit analysis of realistically available options.[4] If a transaction fails these tests, it may be recharacterized but in rare cases,[5] such transactions may be recharacterized and replaced with alternative transaction. Any such alternative transactions that are substituted for transfer pricing purposes should correspond as closely as possible to the actual facts.[6]
Case for Re-characterisation
If used sparingly and with careful thought, recharacterization of transactions may ensure tax system fairness, while countering loophole exploitation and aggressive tax planning. Developing countries, reliant on corporate tax revenues for public services and infrastructure, may benefit from recharacterization of transactions in cases of substantial revenue losses due to multinational tax evasion/avoidance.
Simultaneously, taxpayers may be dissuaded from engaging in expansive tax evading structures out of the fear of recharacterization of their transactions. This would lead to greater inter-taxpayer equity and transaction neutrality. It shall also rebuild public perception and trust in the tax system.
Moreover, Article 9 of the OECD Model tax convention allows tax authorities to rewrite accounts and make quantitative adjustments. In such cases, qualitative changes should also be allowed to be made to the transactions when on accurately delineating a transaction they are found to be different from what would be undertaken by arm’s length parties.
Circumstances where justified
Recharacterisation has been a useful tool in the hands of the tax authorities and is justified in certain cases. In, Chevron-Australia-Holdings-Pty-Ltd-v-Commissioner-of Taxation-[2017]-FCAFC-62,the court was able to alter the form of the transaction by analysing it in a real world business context of what independent parties in such circumstances would do. It held that in the real world, the taxpayer could not have borrowed this sort of money on an unsecured basis without covenants. The most commercially rational option could have been the taxpayer borrowing with a guarantee from the parent company as this would drive down the interest cost and be consistent with group practice.[7]
The ratio in this case was reiterated in Commissioner-of-Taxation-v-Glencore-Investment-Pty Ltd, where the courts held that the price at which copper concentrate was sold would never have been agreed to by independent parties.
Similarly, in Switzerland-v.-R&D-Pharma (2C_11/2018) emphasised substance over form while concluding that the royalty paid to a shell company with no financial capacity and no employees cannot be a commercially justified expense.
Case against recharacterisation
In a globalised economy, tax systems strive for international consistency and harmonisation. Introducing subjective criteria and hindsight analysis for recharacterisation of transactions could lead to inconsistencies and conflicts between different jurisdictions, making it more challenging to enforce tax laws globally. It will lead to inequity if tax authorities of one state has recharacterisation laws and disregards the transaction but the other state does not have such a law or otherwise refuses to make the secondary adjustment, leading to double taxation.[8]
Furthermore, it would lead to increased disputes[9] between the taxpayers and the tax authorities. It may lead to arbitrary results including misuse in the hands of tax authorities. For instance in General-Electric-Capital-Canada-Inc-v.-Queen(2009), the tax authorities had classified the guarantee fees as dividends, leading to prolonged litigation. Such decisions are bad for business and investor confidence.
Moreover, if not applied properly, recharacterisation of transactions can undermine comparability analysis and disregard the purpose of transfer pricing rules. In Cameco-Corporation-v-The-Queen-[2018]-TCC-195, the court noted that sometimes there may be a different commercial reason for the transaction, which may not be apparent immediately. Thus, it is not right to disregard all the transactions because unrelated parties would not have entered into the transaction.
Furthermore, McKesson-Canada-Corporation-v-The Queen,-2013-TCC -04, puts certain limits to recharacterisation of transactions, which need to be adhered to. It firstly states that Canadian domestic law does not permit a recharacterisation or substitution of transactions. Then states that only in tax-abuse cases, where transactions only purpose is tax benefit or where independent parties would never have entered into such transaction, even with different terms, can there be a case for recharacterisation.
The courts have specifically refused any recharacterisation of debt as equity by the tax authorities[10].For instance, in Perot Systems-TSI(India)-Ltd-v.-DCIT-(2010-TIOL-51-ITAT-DEL), the court did not allow such a recharacterisation. Similarly, in CJ-Wildbird-Foods-Limited-v-HMRC-[2018]UKFTT341, the argument of HMRC that the transaction didn’t have the characteristics of a traditional loan because they were not immediately repayable and didn’t carry interest, failed. The court instead ruled in favor of CJ Wildbird Foods, stating that the clear terms of the loan agreement and evidence of the company’s commercial intentions showed that it was indeed a proper loan, even if repayment was contingent and no interest was charged. The court refused to apply the recharacterisation used in Smart v Lincolnshire Sugar Ltd.
Forward
The recharacterization of a transaction has to be read in line with ‘accurate delineation of transaction’, which means seeing a transaction in its real economic context. Its aim is to promote legitimate economic activities, while deterring multinationals from engaging in artificial transactions with no commercial rationality. Achieving this balance will contribute to a more stable and equitable international tax landscape.
[1]OECD-Transfer-Pricing-Guidelines,1995-quoted-in-Raffaele-Petruzzi-and-Myzithra-Argyro,Substance-in-TP-in-a-Post-BEPS-World-and-Beyond,International-Transfer-Pricing-Journal-November/December,2020,430
[2] OECD-Transfer-Pricing-Guidelines-2010(Para 1.36-1.38)
[3] In fact, Action 10, BEPS specifically mentions adopting rules to clarify recharacterisation of high risk transactions.
[4]OECD-Transfer-Pricing-Guidelines-paragraph-1.144
[5] OECD-Transfer-Pricing-Guidelines-paragraph-1.143
[6] UN-Manual-Para-3.3.2.5
[7] Also found useful in Abbey-National-Treasury-Services-PLC-v-HMRC-[2015]-UKFTT-341(TC)
[8] OECD-Guidelines-paragraph-1.143
[9] UN-Manual-Para-3.3.2.6 warns that recharacterisation creates tax uncertainty and disputes
[10]2010-OECD-Guidelines treated thin capitalisation as a circumstance where a transaction need not be recognised as undertaken, however no such specific reference has been made in 2017 guidelines.
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