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TransferPricingReport:NewsArchive
2015
LatestDevelopments
BNAInsights
Aligningsubstancewithvaluecreationandtheextenttowhichpeoplefunctionscanbeafactor
intheanalysishasbecomeheatedtopicsfordebateundertheOrganizationforEconomic
CooperationandDevelopment'splantocombatbaseerosion.Inthiscontext,theauthors
considerhowstructuressetupbyprivateequityfundshavecomeunderscrutinyfromtax
authorities.

TransferPricingforFunds:DealingwithPeopleFunctions'andChallengesfromTax
Authorities

BySteefHuibregtse,CarstenSchmid,MargievanderValkandAvishaSood,TPAGlobal
SteefHuibregtse,MargievanderValkandAvishaSoodarewithTPAGlobalinAmsterdam.CarstenSchmidiswith
thefirm'sofficeinStuttgart,Germany.
Taxauthoritieshavestartedtoquestionthevalidityofthetransferpricingsetupofprivateequityfundswherethe
managementandperformancetargetsaredrivenbylocalteams,whilefullmanagementfeeofrunningthe
portfolioandtheperformancefeewhenachievingthetargetreturnontheportfoliomightbelegallyattributable
totheleadlocationofthefund.AnexamplecanbefoundinLuxembourgwheremostandsometimesallofthe
workisperformedbyalocalteamforexample,intheU.K.,GermanyortheNetherlandsandbundledpeople
functionsareallocatedtotheleadlocation.
Taxauthoritiesareincreasinglychallengingthesestructures,withquestionnairesfromtaxauthoritiesinGermany
andtheU.K.representingthewritingonthewall.
Thisarticlesetsforththetypicalfundstructureinquestionanddescribesboththetypicalintercompanytransactions
involvedandthetransferpricingaspectsofthemanagementfee,allinthecontextoftheOrganizationforEconomic
CooperationandDevelopment'sActionPlanonBaseErosionandProfitShifting.
FundStructure
Thepicturebelowreflectsthestandardsituationofafundsetup.Inthisillustrationtheinvestmentfundislocated
inLuxembourg,investinginvariousequitysecurities(andtoalesserextentdebt)accordingtotheinvestment
strategiesasdevelopedbyandwiththeinvestors.Atypicalstructurecouldbeasfollows:
TheinvestorsinvestinthefundinLuxembourg(ontheinvestmentside)andthefundisresponsible
formanagingtheportfolioofinvestmentcontainedtherein.
ThereisafundmanagerinLuxembourgwhoisassistedbyconsultantsinNetherlands,Germanyand
theU.K.
Theseconsultantsprovideadvicetothefundmanagerthatisthebasisforinvestmentsmadeintheir
respectiveterritoriesorareasofexpertise.Theyarereimbursedonacostplusbasisfortheirservices.
Thefundmanagerreceivesamanagementfee(usuallybetween1percentand2percentofthecapital
invested)and,inadditiontothat,itreceivesaperformancefee(usually20percentoftheincreasein
thenetinvestmentvalue)basedontheoutcomesoftheinvestments.
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ApartofthisfeeistransferredtotheconsultantsintheNetherlands,GermanyandtheU.K.asan
advisoryfee,whichequalsremunerationonacostplusbasis.
Theconsultantsinthethosethreecountriesreceiveasmallamountrelativetothenatureofservices
theyperformed.Inthisscenario,theyprovidefulladvisoryservicesthatarethebasisformaking
investmentsbythefundand,therefore,reimbursingthemonacostplusbasiscouldleadtodisputes
withtaxauthorities.

IntercompanyTransactions
Typically,therewouldbeoneintercompanytransactionthatis,thepaymentofanadvisoryfee.Inthecurrent
exampleitcanrepresentedas:
paymentofanadvisoryfeebythefundinLuxembourgtotheconsultantsintheNetherlands,
GermanyandtheU.K.or
paymentofasubadvisoryfee(ifany)bythefundtotheconsultantsinthethreecountries.
However,insomecases,theinvestorsandthefundmayberelatedtoeachotherforexample,acompanymay
manageitsinvestmentsthroughaninternalfundsetup.Inthatcase,intercompanytransactionswillbe,inaddition
tothoselistedabove:
paymentofamanagementfeefromthefundassetsorrevenueand
paymentofaperformancefeefromthefundassetsorrevenue.
TransferPricingAspectsofFundManagement
TheOECDhasstressedgreatlytheconceptofriskcontrolandthecapacitytobearriskinitsreportonBEPSActions
8,9and10,whereinitstatesthatriskcontrolshouldbeunderstoodasthecapabilitytomakedecisionstotakeon
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theriskanddecisionsonwhetherandhowtomanagetherisk.Therefore,ifriskiscontractuallyallocatedtoa
relatedparty,itmustbesupportedbyevidencethattherelatedpartyhadthecapabilitytomakethedecisionto
undertakethisrisk.Furthermore,acompanymustdemonstratethattherelatedpartyalsohadthecapacityto
managetherisk,whichcapacityincludes:
thecapabilitytomakedecisionstotakeonordeclineariskbearingopportunity,togetherwiththe
actualperformanceofthatdecisionmakingfunction,
thecapabilitytomakedecisionsonwhetherandhowtorespondtotherisksassociatedwiththe
opportunity,togetherwiththeactualperformanceofthatdecisionmakingfunction,and
thecapabilitytomitigaterisk,thatisthecapabilitytotakemeasuresthataffectriskoutcomes,
togetherwiththeactualperformanceofsuchriskmitigation.
TheOECDstatesthatmerecontractualallocationofriskwillnotbeseenasarm'slengthwithoutevidenceofthe
abilitytocontrolthatrisk.
AsimilarintentionisalsoexpressedbytheOECDinsection9.25oftheOECDtransferpricingguidelines,whichgives
theexampleofaninvestorthathiresafundmanagertoinvestfundsonitsaccountandgivesthefundmanager
theauthoritytomakealltheinvestmentdecisionsonbehalfoftheinvestoronadaytodaybasis.Insuchacase,
theOECDconsiderstheriskofinvestmenttoremainwiththeinvestoritdoesnottransfertothefundmanager
merelybyhavingthemanagermakedaytodaydecisionsontheinvestment.Insuchanexample,theinvestoris
controllingitsrisksthroughthreerelevantdecisions:
tohire(orterminatethecontractwith)thatparticularfundmanager,
howmuchauthorityitgivestothefundmanagerandobjectivesitassignstothelatter,and
theamountoftheinvestmentthatitasksthisfundmanagertomanage.
Thefundmanagerismerelyprovidingaservicetotheinvestorandisresponsibleformanagingonlyhisown
businessrisk(forexample,protectinghiscredibility)ashedoesnothavecontrolovertheriskrelatedtothe
investment.
Thus,itisclearthattheOECDiskeenonaligningthecontractualallocationofriskstopartieswiththeactual
conductoftheparties,andthesamecanalsobeinterpretedtomeanthatthepeoplefunctionsshouldbealigned
withthecreationofvalue.
PeopleFunctions:Netherlands,Germany,U.K.
Underthistypeofstructure,thefullmanagementfeeofrunningtheportfolioandtheperformancefeewhen
achievingthetargetreturnontheportfoliowasusuallyattributedtotheleadlocationofthefund.Thispracticeis
beingquestionedinlightoftheBEPSproject.
Specifically,thediscussiondraftonlowvalueintercompanyservicesunderBEPSAction10reducesthescopefor
erosionofthetaxbasethroughexcessivemanagementfeesandheadofficeexpenses.1Thisisdonebyproposing
anapproachthatidentifiesawidecategoryofcommonintragroupservicescommandingaverylimitedprofitmarkup
oncosts,appliesaconsistentallocationkeyforallrecipientsandprovidesgreatertransparencythroughspecific
reportingrequirements.
1See23TransferPricingReport929,11/13/14.

Thereportaddressestwomainissues:whetherintragroupserviceshavebeenprovided,andwhetherthechargefor
thoseservicesmeetsthearm'slengthprinciple.Toachievethisobjective,thereportsetsforthnotonlyan
extensivedefinitionoflowvalueaddingservices,alongwithexamples,butalsovarioustestsforascertaining
whethertheservicesactuallyaddlowvalue.Secondly,thereportpresentsvariousdirectandindirectcharge
methodstoarriveatthecorrectarm'slengthrateforthoseservices.Thediscussiondraftintroducesasimplified
transferpricingmethodfordeterminingthearm'slengthpriceoflowvalueaddingintragroupserviceslike
managementfeesandheadofficeexpenses(whichmightraiseanumberoftechnicalandpracticalissueswhen
applied).TheoutcomeofthisBEPSitemwillinfluencewhichpartygetstheresidual.
Inthecurrentexample,itappearsthatthemanagementofdaytodayrisksrelatedtotheinvestmenthavebeen
allocatedtothefundmanagerbytheinvestorsthatis,throughacontractcoveringmanagementofthe
investmentbythefund.Thefundmanagerappearstobesubcontractingallofthekeypeoplefunctionsrelatedto
managingtheinvestment,suchasdevelopmentofasoftwareorplatformforrunningthedaytodaybusinessof
investing,totheconsultantsinoffshorelocations.Moreover,onlyonefulltimeemployeeispresentatthelead
locationofthefundinLuxemburg,while10FTEsarepresentineachoftheofficesintheNetherlands,Germany
andtheU.K.
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ChallengefromaBEPSPerspective
Inthepresentexample,baseduponthefactthatthemajorityoffunctionsarebeingperformedbyconsultantsin
theNetherlands,GermanyandtheU.K.,itcanbearguedthattheyareresponsibleformanagingthedaytoday
risksrelatedtotheinvestmentaswell.
However,theentiremanagementandperformancefeeispaidtothefundbytheinvestorsandonlyalimited
portionofthesameistransferredbythefundtothethreecountries.ThisappearstocontradicttheOECD'sprinciple
ofaligningpeoplefunctionswithvaluecreation.TheconsultantsintheNetherlands,GermanyandtheU.K.are
actuallyperformingmajorityofthepeoplefunctionsrelatingtoinvestmentsmadeintheirrespectivecountriesorin
areasoftheirrespectiveexpertise,whilethefundismerelymanagingthesesubcontractedfunctions.
Inlightofthefactthatthefunditselfdoesnotcarryoutthekeypeoplefunctionsofinvestmentandalsoinlightof
itsextensiveuseofsubcontractors,theOECD'sBEPSguidancewouldallowtaxauthoritiestochallengethekickback
portionofthemanagementfeeandtheperformancefeereceivedbythefundtothesubcontractors.
Conclusion
Toconclude,theexampleaboveillustratesthreemainpoints:
Designingaproperfundsetupwithsubcontractorsreceivinganarm'slengthcompensationmightin
thefutureinvolveapplyingaresidualprofitsplitonsomeofthemanagementandperformancefees.
Quiteafewofthefundstructuresarethinontransferpricingaudittrailsthatis,thereisno
alignmentbetweenlegalcontractsandconductofparties.
Peoplefunctionsdrivetaxationmorethanintercompanyagreements.

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