Insurability of Transfer Pricing Risks

Tax authorities are increasingly focusing on cross-border transactions and there has been a steady rise in transfer pricing (TP) related tax audits in recent years. This development is likely to continue, as countries that are recovering from the negative economic impact of Covid-19 will focus on protecting the tax base to rebalance their economies. Historically, uncertainties in benchmarking methodologies, lack of comparable transactions in certain cases, and a somewhat subjective nature of arm’s length pricing determinations have deterred tax risk insurers from underwriting TP risks. Fortunately, this has changed over the last couple of years.

As more guidance in the shape of OECD guidelines and case law becomes available, and the overall familiarity with TP among companies and tax authorities alike is increasing, a growing number of insurers, often supported by TP specialists, are comfortable with insuring several types of TP risks. This development will, inter alia, provide the following benefits for taxpayers:

• Eliminating or limiting TP risks in the everyday business

• Avoidance of “deal-breakers” in a deal context

• No need for indemnities or funds in escrow to cover TP risks in a deal context

This bulletin outlines certain TP risks that can potentially be insured, the two main approaches for insuring such risks, and pricing and timing for obtaining a tax risk insurance.

Which TP risks are potentially insurable?

The development in insurers’ appetite over the last few years, as outlined above, have made many TP risks insurable and below you will find some examples of what can now be insured under the right circumstances:

• Interest rates applied to financing and loans

• Relocation of intellectual property (IP)

• Intra-group transactions related to goods and services   

Loans (in particular shareholder loans) have historically been the most common TP risk to insure, but nowadays also IP transfers and pricing of goods and services may be insured. This in turn is a development that is appreciated by our clients, given how common these transactions are and the amounts at stake. Hence, whether a company is transferring crude oil to a refinery in another country, selling refrigerators to a foreign subsidiary, or moving IP from one country to another, the TP risk(s) could potentially be insured.

Two ways to insure a TP risk

Two potential insurance approaches have been developed to deal with TP risks: the “bottom up” approach, and the “catastrophic risk” approach:

Bottom up Approach

Where a TP study has determined a certain transfer price (for example, 100), the insurer will take on the risk that a tax authority may adjust the transfer price higher or lower (for example, 105 or 95), resulting in an increased tax charge for the insured. Generally, the “bottom up” approach is more appropriate for relatively simple TP risks such as interest on shareholder loans. For more complex TP risks the “catastrophic risk” approach will often be more appropriate 

Catastrophic Risk Approach

In this case, the insurance will only respond when the adjustment of the transfer price exceeds a certain threshold. For example, if a market standard TP study has determined a transfer price of 100, with a variation between 85 and 115, then the insurer will only cover an adjustment outside of the set parameters – for example, over 115 or under 85.

TP Insurance solutions based on a “catastrophic risk” approach are typically cheaper, as the risk to the insurer is generally lower. Sometimes a combination of both the “bottom up”- and “catastrophic risk” approach may be appropriate. An example would be where insurance cover is provided on the basis of a price adjustment over 100 (“bottom up” approach) or below 85 (“catastrophic risk” approach).

Both approaches outlined above typically cover not only the underlying increased TP related tax liability, but also advance tax payments, interest, penalties, and defense costs.

Costs and timing?

The cost of TP insurance is typically between 2% and 8% of the insurance limit, which is slightly higher than most other tax risks, but pricing has gone down over the last couple of years making insurance a viable option to mitigate TP risks. Depending on the complexity of the matter, a policy can be incepted within two to four weeks and both historical and future TP risks can potentially be covered.

Concluding remarks

Whether you are in the process of divesting or acquiring a company, where a TP risk has been identified or you are about to price an intra-group transaction, we are here to help you manage the risk. Our team of tax-, corporate- and M&A lawyers have vast experience of insuring tax risks and we are well-positioned to assist you in the tax insurance placement.