Using Tax Insurance Strategically Allays Transfer Pricing Risks

Using tax insurance to mitigate transfer pricing risk offers a strategic way to manage potential financial risks that can arise from transfer pricing audits and disputes. Companies considering this option should review policy terms, coverage limits, exclusions, and premiums carefully.

Tax insurance, which initially became popular for representations and warranties made in mergers and acquisitions, is increasingly being used to manage transfer pricing risks. Tax risk insurance shifts tax-related risks from the taxpayer to a third-party insurer.

Businesses traditionally have managed their transfer pricing risks by setting up transfer pricing policies and maintaining proper documentation. Some have opted for advance pricing agreements, negotiation, arbitration, or the mutual agreement procedure to resolve disputes.

While APAs and MAPs offer some certainty, they have limited flexibility as they are typically prolonged, resource-intensive, and highly specific.

Tax risk insurance typically covers disputes with tax authorities, unexpected tax liabilities, or changes in tax laws that may adversely affect the company’s financial situation. If an insurer finds a taxpayer’s position is reasonable, it may agree to cover losses, including assessed taxes and defense costs, in the event of a challenge.

Insurers may require the insured to produce a tax opinion or transfer pricing documentation related to the underlying issue to verify that the position taken by the insured is in fact reasonable. This provides additional protection to the insurer that what they are insuring is unlikely to result in significant financial losses for them.

By strategically employing tax insurance, multinationals can effectively manage their potential transfer pricing tax exposures. There are several types of transfer pricing risks that can be effectively managed through insurance coverage.

Intercompany transaction remuneration: Interest on intercompany financing, royalties or purchase price for intellectual property, and profit splits for joint ownership or contributions to valuable activities.

It also includes payments to companies performing routine functions, such as research and development services, contract manufacturing, and distribution, plus valuation of entities that need to be transferred between group members.

Transfer of functions and assets: Exit taxes related to business reorganizations and intangible asset transfers.

Amortization expense deductibility: Resolving disputes over the functional profile of entities holding intellectual property.

Other transfer pricing exposures: Issues related to equity/asset valuations, tax treaty applications, debt versus equity treatment, and permanent establishments.

Tax risks for investment funds: Concerns related to cross-border transactions, profit repatriation, and exit taxes.

There are also several important benefits of transfer pricing risk insurance.

Certainty: Shifts potential future tax liabilities from the insured to the insurer, aiding in effective cost management.

Risk: Allows companies to transfer some tax-related risks to insurers, enabling better strategic planning.

Financial protection: Mitigates the financial impact of unexpected tax liabilities, penalties, and legal costs.

Efficient resolution: Offers a quicker underwriting and policy placement process compared to lengthy APA procedures.

Eliminating double taxation: Covers potential tax authority challenges from multiple jurisdictions.

Financial reporting: May allow companies to remove uncertain liabilities from their financial statements, depending on local rules.

Audit protection: In some cases, positions already under tax audit may still be insurable.

In the insurance industry, insurers often assess and manage risks by setting various thresholds and limits. There are two main insurance approaches for transfer pricing risks.

In the bottom-up approach, the insurer covers limited risk against potential tax authority adjustments. In the catastrophic risk approach, insurance responds only when transfer price adjustments exceed a certain threshold.

In some other variations, an insurer may only be willing to insure a risk if it exceeds a specified threshold, a practice known as excess of loss insurance. In this arrangement, the insurer provides coverage only for losses that surpass a certain amount, while the insured retains responsibility for losses below this threshold.

Coverage is typically limited below a catastrophic risk threshold, beyond which the insurer won’t cover losses. By implementing these thresholds, insurers can better control and reduce the likelihood of significant risks materializing, thereby managing their exposure to potentially catastrophic events.

To qualify for insurance coverage, the taxpayer typically needs to satisfy a few criteria.

Single issue focus: The transfer pricing liability risk to be insured should ideally pertain to a single issue. This means the insurance coverage will address a specific area of transfer pricing or the successful resolution of a single claim or litigation.

Strong legal opinion: The insurance request must be supported by a robust legal opinion. Generally, this opinion should assert that a tax liability risk shouldn’t or won’t arise.

The weakest acceptable opinion is that the tax risk is “more than likely not to arise.” In both practical experience and industry practice, tax insurance is usually obtained with a “should level” legal opinion.

Undefined insurance subject: The subject of the insurance must not be fully determined. Insurers are unlikely to cover known breaches or instances of non-compliance with applicable legislation.

Working with experienced insurance brokers, valuation experts, and tax advisers can help secure appropriate coverage and favorable terms.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Linda Pfatteicher is partner in Dentons’ venture technology group focused on international corporate tax and operational structuring,

Rezan Ökten is partner and head of transfer pricing at Dentons’ Amsterdam office.

Davy Schoorl is an associate at Dentons’ transfer pricing practice in Amsterdam.

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