Tax & Accounting Blog

The UK Bareboat Charter Measure and the Arm’s Length Standard

Blog, Global Tax Compliance, ONESOURCE, ONESOURCE Transfer Pricing, Transfer Pricing June 26, 2014

Drilling rig multinationals often place ownership of their key assets – drilling rigs – in tax haven affiliates, which often lease this property to operating affiliates at lease rate around 14 percent of the value of the rigs.  The UK government argues that these intercompany lease rates are generous and result in over 80 percent of profits being sourced with the tax haven.  Its Bareboat Charter Measure took effect on April 1, 2014 and would limit the intercompany lease payment to 7.5 percent of rig value.

Industry groups such as the International Association of Drilling Contractors expressed disappointment in what they see as a limitation of this intercompany deduction.  Intercompany leasing deductions have certainly generated considerable controversy as to what represents arm’s length pricing.  Financial economists would evaluate the appropriate lease to value ratio as the sum of the expected rate of depreciation of the leased asset and what would represent a reasonable return for the owner of the rig.  While the economic useful life of any rig is generally hard to estimate, a 4 percent rate of depreciation is a reasonable assumption.  Maintaining this assumption, the UK Bareboat Charter Measure translates into only a 3.5 percent return whereas the typical transfer pricing policy translates into a 10 percent return.  Is either extreme consistent with the arm’s length standard or is a middle ground position more reasonable?

The drilling rig sector faces significant systematic risk with most estimates of its cost of capital being 10 percent, which can be seen as a 4 percent risk-free return plus a 6 percent premium for bearing risks.  The Bareboat Charter Measure would leave the rig owner with something near a risk-free return as if it bore no risks.  This view is consistent with financial economics only if intercompany leases are financial leases.  While some intercompany leases may be long-term, none are for the economic useful life of the rig.  As such, the rig owner would deserve a premium over the risk-free rate as it bears the risk of obsolescence.

The traditional accounting firm defense of lease rates equal to 14 percent of the value of the rig relies on an evaluation of the profits of the operating affiliate.  These approaches assert that the operating affiliate formally own few assets and take very little risk.  The proponents of the Bareboat Charter Measure appear to be challenging the assumption that the owner is the only risk taker with their view going to the other extreme by assuming that the owner takes no risk.  Given the fact that intercompany arrangements are typically operating leases and not financial leases, the concern that this limitation is set at only 7.5 percent of lease value is inconsistent with arm’s length pricing is reasonable.

A middle ground view is likely supported by financial economics, which would asset that both the operating affiliate and the formal owner of the rig bear a portion of overall systematic risk.  Under this view, the appropriate lease to value ratio would likely be greater than the 7.5 percent proposed in this legislation but less than the 14 percent observed in many intercompany contracts.

Our understanding is that the IRS is determining how best to benchmark the appropriate intercompany lease rate.  An evaluation of the profits of the rig owner – as suggested by section 1.482-2(c) of the U.S. regulations – would also likely indicate this middle ground view.  The IRS approach, however, seems to be evaluations of the profits of the operating affiliate but in ways that not only differ from what the accounting firms put forth but also leads to results even more extreme that what is being proposed by this UK Bareboat Charter Measure.  We believe, however, that a more careful analysis based on the profits of the operating affiliate could lead to results consistent with the results from financial economics.

Learn more about how ONESOURCE Transfer Pricing Services can assist with transfer pricing analyses here.