Dutch Tax Authority Wins Challenge of British American Tobacco's Intercompany Financing

British American Tobacco (BAT) announced the following on page 211 of its 2018 Annual Report:

The Dutch tax authority has issued a number of assessments on various issues across the years 2003-2016 in relation to various intra-group transactions. The assessments amount to an aggregate net liability across these periods of £902 million covering tax, interest and penalties. The Group has appealed against the assessments in full.

Press reports claimed that the Dutch tax authority (Belastingdienst) accused BAT reduced the profits of its Dutch affiliate by €4 billion over the 2003 to 2016. Part of this claim involved intercompany guarantee fees and intercompany factoring. An October 17, 2022 decision addressed these two issues for the years from 2008 to 2010 where the Dutch affiliate had declared taxable income near €157 million per year, which was raised to €199 million per year. In other words, the transfer pricing adjustments represented approximately €42 million per year. The largest transfer pricing adjustment was the disallowance of intercompany guarantee fees exceeding €35 million per year.  Another transfer pricing adjustment was a reduction in the intercompany factoring fees that was almost €4 million per year.

Intercompany Guarantee Fees 

The UK parent guaranteed certain loans taken by the Dutch affiliate. These loans totaled just over €3 billion and the guarantee ranged from as low as 0.8% to as high as 1.85%. The intercompany guarantee fee was eventually set at 1.18%, which would put the intercompany guarantee fees at just over €35 million per year. At the time of the intercompany transaction, interest rates on long-term German government bonds were 4.25%. Table 1 assumes Euro denominated long-term corporate debt for borrowers with various credit ratings.

Table 1: Market Interest Rates Under Alternative Credit Ratings

The court record noted that BAT’s group rating was BBB+ through 2011 and improved to A- in subsequent years. The representatives of the taxpayer provided a standalone credit rating for the Dutch affiliate at BB+, which improved to BBB- after 2010. In other words, the standalone credit rating was 3 notches below the group rating. If the credit spread for the group credit rating was near 1.25% the market interest rate would have been 5.5%. The credit spread for the standalone credit rating was near 2.45%, which would imply that the Dutch affiliate would have paid an interest rate = 6.7% without a guarantee. As such the borrowing affiliate would have paid at most a 1.2% guarantee fee.

Table 1 considers two alternative credit ratings. Had the appropriate credit rating been BB, then the market interest rate absent a guarantee fee would have been 7.35% implying a credit spread = 1.85%. While the court record noted that the taxpayer at once had considered a guarantee fee = 1.85%, such a high intercompany fee would have been inconsistent with even the standalone credit rating.

Under the implicit support doctrine, the appropriate credit standing for the Dutch affiliate should be higher than the standalone credit rating. How much the credit rating should be notched up depends on whether implicit support was seen as weak implicit support versus strong implicit support. Our table notes that if the appropriate credit rating had been BBB-/BB+, then the market interest rate in the absence of a guarantee would have been 6.3%, which is consistent with a credit spread = 2.05%. Under these assumptions, the guarantee should have been only 0.8%. The Dutch tax authority successfully argued in this case that the Dutch affiliate was a core affiliate, which convinced the court to disallow the guarantee fees in their entirety.

Intercompany Factoring Fees

The court decision described the intercompany factoring arrangement as:

The provision of services by [company 4] to [company 5] in the present years took place on the basis of an agreement signed on 23 June 1999, 'Receivables Purchase Agreement' (hereinafter: RPA agreement). In brief, this agreement provided that [company 5] transferred its receivables from customers to [company 4] when they arose, after which it took care of collection and administration on behalf of these receivables. [company 4] provided its factoring services to [company 6] under the same conditions under an agreement concluded as of 1 October 2007. The factoring by [company 4] to [company 5] and [company 6] took place without pre-financing. One of the group companies provided factoring services to the claimant. The factoring fee of €2,500,000 charged annually for this purpose includes a risk fee to cover the debtor risk - excluding a bad debtor - and an annual fee of €1,200,000 for other services. Noting that the debtor risk - including the bad debtor - can be insured on the market for €438,000, the court inferred that an independent third party would not be willing to pay the risk fee. Given the large share of the risk fee, the court qualifies the entire factoring fee as non-business.

The court discussion suggested that the amount of receivables factored may have been only €660 million, but this figure is inconsistent with the discussion of intercompany fees charged for the various factor services. Table 2 provides an illustration that assumes that the accounts receivables were €1 billion and that the intercompany factoring provided the three basic functions of a factoring affiliate.

Factoring entities may provide various functions: provide cash in lieu of accounts receivable to the company, collect the client's accounts receivable from customers and provide related bookkeeping and reporting services, and assume the credit risk of customers in nonrecourse factoring situations. Many intercompany financing arrangements have the factoring entity effectively extend a short-term loan to its affiliate and absorb some of the credit risk. In a November 2008 discussion of factoring in the Journal of International Taxation, I offered a model for the factoring rate that ignored the cost of collection focusing on two other elements.

Discount rates on nonrecourse factoring arrangements depend on two key factors:

• Expected loss from defaults by customers.
• Expected return to the holder of the accounts receivable.

For recourse loans, the expected loss from defaults is zero, so the discount rate captures the expected return. If annualized expected return is R, and the term of the factor is such that there could be n terms per year, the discount (D) for a factor with recourse is represented by equation (1):

(1) d = (1 +R)( 1/n ) - 1

This formula can be extended to nonrecourse factors to include the expected loss from defaults as a percentage of the amounts factored (L), which is shown in equation (2):

(2) d = L + (1 +R)( 1/n ) - 1

At the time of the October 1, 2007 agreement, interest rates on short-term government bond denominated in Euros were approximately 4%. If the term of the receivables were 30 days such than n = 12, then the appropriate discount for the time value of money (TVM) would be equation (1), which represents a 0.33% discount even in the absence of default risk or collection.

Table 2: An Illustration of an Intercompany Factoring Fee

It is interesting that the intercompany policy set a 0.33% discount to cover collection costs and expected defaults as it appears that the factoring company but was not rewarded the time value of money from holding the factored receivables. Interest rates on short-term government bond denominated in Euros were near zero from 2013 to 2021 so this financing aspect would have been less important for this later period than the issues of the cost of collection or the expected cost of default.

The taxpayer’s claim that the cost of collection was only 0.1% may be seen as conservative. The cost of collection under this assumption would be €1 million per year. The taxpayer also assumed that the expected cost of default was only 0.23%, which would imply an additional fee = €2.3 million per year. While this assumption might be seen as conservative, the Dutch tax authority challenged it arguing that the expected costs were mere 0.045%. If a factoring fee of only 0.045% is applied to €1 billion in receivables, the factoring fee would be less than €0.45 million per year.

The representatives of the taxpayer asserted the reasonableness of the 0.23% estimate for the expected cost of default using an analysis that relied upon estimates of the credit rating for the main customers of the Dutch affiliate and their implied credit rating. This calculation was presented as the weighted average portfolio spread. The Dutch tax authority supported its lower estimate for the expected cost of default using the cost of a credit insurance policy that the Dutch affiliate took out on October 7, 2007. The court decision accepted the Dutch tax authority’s approach, reducing the intercompany factoring fee.

Concluding Remarks

The intercompany guarantee fees and factoring discounts charged to the Dutch affiliate of BAT may seem conservative in light of intercompany fees for other multinationals. The representatives of the taxpayer also provided reports defending these intercompany charges. The Dutch tax authority prevailed in its challenge of the intercompany guarantee fee by appealing to a strong version of implicit support, whereas the taxpayer relied upon the standalone principle. The Dutch tax authority was also able to challenge even a modest intercompany factoring fee by providing an interesting approach that relied on the cost of insuring against credit risk.

References

Netherlands vs “Tobacco B.V.”, October 2022, Rechtbank Noord-Holland, Case No ECLI:NL:RBNHO:2022:8936.