Real Estate TP and IT

In October 2015 the OECD released new transfer pricing guidance under the BEPS project. The revised OECD guidance and the refocus of the functional analysis on e.g. decision making, control over risks and financial capacity to assume risks are important to the real estate industry. This sounds like another compliance burden but there are also good news. The new OECD guidance contains useful examples on the outsourcing of activities and risks by investors and statements that holding companies may not require much substance in order to exercise their main activity of holding and managing equity participations.

This post deals with some selected issues to be addressed in the real estate industry. One important issue is financing arrangements; another important issue is how to stay organised given the large number of entities that are normally involved in real estate investment structures.

Subordinated debt

The pricing of inter-company subordinated debt is probably the single most important transfer pricing issue in the real estate industry. Subordinated debt is the primary way for an investor to receive a direct return on an investment. At the same time it is the inter-company transaction type with the largest tax impact through the deduction for interest expense throughout the chain of entities between a real estate fund and the property company. The pricing of subordinated debt is not an easy exercise, though. The traditional information sources for third-party debt pricing do normally not provide sufficient details to price the additional credit risk associated with subordination and typically yield too low interest rates. Instead, it is critical to link the pricing of subordinated debt to the Loan-To-Value position of the subordinated debt. This will provide a more reliable quantification of the credit risk associated with subordination where the inter-company loan is the last liability to be settled before repayment of shareholder’s equity in the case of a default. Linking interest rates to the risks assumed through the Loan-To-Value position is a solid way to comply with OECD’s revised guidance on risks and risk allocation.

Investment Advisory Services

Larger real estate funds often establish investment advisory services teams who identify new investment opportunities for a real estate investment fund. With the renewed focus of the revised OECD guidance on transfer pricing on decision-making capability, some tax administrations are now trying to establish that the compensation for investment advisory services should include a portion of the return earned by the real estate fund. But the overall picture should not be overlooked. Investment in real estate requires capital, and the financial capacity to assume the related market risks is critical. Investment advisory companies will typically not have access to such funds. They also do not possess the full infrastructure to execute and manage real estate investments.

Holding & SPV Companies

Real estate investments often involve a number of holding, finance and SPV companies, and the question is how to determine arm’s length compensations for such entities. A few countries such as Luxembourg and The Netherlands have specific transfer pricing regimes for back-to-back finance companies but most countries have not provided any guidance. One therefore needs to seek the answer in general transfer pricing rules. Under the revised OECD guidance, an important criterion will be the assumption and exercise of control of credit risks in combination with the financial capacity to assume the risks. To avoid making this a too complex transfer pricing issue, a so-called Margin Table can be defined to provide practical guidance on how to determine the gross margin for holding, finance and SPV companies.

A Large Number of Entities

Investments in real estate normally require a large number of legal entities. It is common that each piece of real estate is owned by a separate property company and that a number of SPVs are used between the property company and the fund. Investing EUR 500 million across Europe might easily involve 50-100 legal entities. With an investment horizon of 7-10 years and the changes to transaction structures that might take place during the ownership period, managing transfer pricing issues and inter-company agreements for the investments quickly becomes complex. Staying organised will require tax technology.

Otico Software recently launched TP Controller, which is designed to save users significant time by streamlining the control and management of transfer pricing data and automating repetitive documentation tasks to produce content for documentation. TP Controller streamlines tasks such as structured filing of transfer pricing related documents, benchmarks management, risk management, and stakeholder reporting on compliance status and risk assessment. At the same time, TP Controller links relevant documents to support compliance and risk positions as well as allowing instant verification of the existence of such documents. This make the regular reporting to the board easy and the discussions with the external auditor shorter.

The software is part of a new generation of tax technology in the form of stand-alone applications with focus on user-friendly interfaces, significant time savings, limited implementation and low thresholds for stepping in and out. The technology is typically focused on automating processes where significant time and cost savings can be achieved.

Being in control of transfer pricing matters and the related documentation can be critical for real estate investors when the time for an exist comes. A buyer of a real estate investment and the related legal entities would like to have certainty that the past does not come with significant tax liabilities in the area of transfer pricing. Staying organised using tax technology that allows the investor to substantiate towards the buyer a low risk position facilitates the exit.