Are banks charging for services actually rendered?

Summary: Regulatory restrictions on the most common of banking transactions — the cash attractions and depositing business — impacts transfer pricing methodologies applied by head bank offices and their branches.

Regulatory restrictions on banks and their impact on the branches

The global banking industry plunged into turmoil at the end of 2008 as a result of the events leading to the global financial crisis. Many central banks quickly took counter-measures to either add liquidity or guarantee bank debt, while financial supervisory authorities stepped up their regulatory activities by prohibiting banks from accepting more risk than their balance sheets could bear.

Because banks operate mainly through branches, and branches are treated as permanent establishments for tax purposes and taxed accordingly, it is inevitable that any regulatory restriction imposed on the head office will impact the business operations not only of the head office but also of its branches.

Modified branch services to head office require cost re‑evaluation

In the retail or consumer banking market, banks offer banking services to consumers through their branches. Employees of the branch who perform routine depositing services on behalf of the head office are generally compensated for the performance of these functions using the cost-plus method with an appropriate profit mark-up depending on the value of the function.

In this scenario, the financial supervisory authority of the head office has issued an immediate restriction prohibiting the acquisition of new business or additional deposits from existing customers due to solvency issues at the head office level. Likewise, the financial supervisory authorities of the countries in which the bank has branches follow suit and issue similar restrictions to prevent the branches from doing new business on behalf of the head office.

The impact of the regulatory restrictions is that the functions performed by these branches are reduced or made redundant, thereby resulting in idle capacity and an inefficient use of branch assets to the extent that these assets are not disposed of.

If certain functions are no longer performed as a result of the restrictions, then the branch cannot be seen to provide such services to its head office. The only services that the head office continues to receive are those with respect to existing banking business with existing customers that the branch still performs on behalf of its head office.

An unrelated party would not agree to pay for a service or benefit that it did not receive or bear the other party’s costs resulting from inefficiencies;¹ therefore, the costs associated with the services that are now prohibited should be removed from the cost base of the branch in determining the service charge to the head office.

Organization for Economic Co-op and Development transfer pricing guidelines

To harmonize the transfer pricing rules for head offices and branches with the rules for multinationals and subsidiaries, the Organization for Economic Co-op and Development (OECD) has developed the authorized OECD approach to attribute to the branch that portion of the entire enterprise’s profit that the branch has earned, in accordance with the arm’s-length principle. In this respect, business income and expenses are to be attributed to a branch to the extent they have been caused by the branch.

The OECD Guidelines prescribe that the remuneration for intra-group services (called “dealings” instead of “transactions”) can be determined by using the direct or indirect method.²

• The direct method is preferable if the costs are directly attributable to the provision of a specific service (dealing).
• An indirect method ought to be used if the direct method is not applicable or cannot be reliably applied to determine the cost incurred in rendering a specific service.

If the branch is not able to directly determine the cost associated with the cash-attraction services, it should apply an indirect method using a suitable allocation key. Such an allocation key could be any of the following:

• The ratio of time spent on cash attraction to the overall time spent for both cash-attraction and depositing services
• The ratio of headcount dedicated to cash attraction to the overall headcount for both cash-attraction and depositing services

Using this approach, the branch profit can be reduced to an arm’s-length level given the scope of activities after the regulatory restriction.

Is your local branch protected from head office liquidity issues?

There could be a risk that tax authorities in the branch country will argue that the regulatory restrictions and the resulting non-performance of cash-attraction services by the branch are due to the liquidity problems of the head office and, consequently, the branch should not be entitled to reduce its cost base.

In the context of local banking regulations, such an argument may prove to be invalid because the local regulator usually has the authority to restrict the local cash-attraction activity in view of the local situation, even if the regulatory authority of the country of residence of the head office refrains from imposing restrictions.

Evaluate what options will work for you before and after regulatory restriction

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¹ OECD Guidelines, Para. 2.45; OECD Report on the Attribution of Profits to Permanent Establishments, para. 3., Preface.
² See paras. 7.20 to 7.23 of the OECD Guidelines, 1995.