1. Introduction

Tax risk insurance is a tool that transfers tax-related risks from the taxpayer to a third party. It is designed to provide protection to (multinational) taxpayers against adverse financial implications resulting from tax-related risks in the event a tax position fails to achieve its intended outcome.

With tax risk insurance coverage, the financial risk transfers to a third party (i.e., an insurance company) for a premium, and protects the insured if the tax authorities successfully challenge a tax position before the court. The risks covered by such insurance typically include challenges or disputes with tax authorities, unexpected tax liabilities, audits, or changes in tax laws that may adversely affect the company’s financial situation.

Tax risk insurance policies typically also cover the costs associated with defending against tax audits or challenges, as well as any fines, penalties, or additional taxes that may be imposed as a result of these audits or disputes.

In the ensuing paragraphs, we will discuss, among other things:

• The growing trend among multinationals to obtain insurance coverage to mitigate and manage their transfer pricing risks when faced with the traditional approaches of negotiating with local tax authorities and obtaining binding rulings.
• The types of transfer pricing risks that can potentially be insured.
• What insurance providers look for when assessing to insure such risks.
• Why getting expert advice along the way is essential.

2. Transfer pricing risk management

Transfer pricing has been a key focus area for tax authorities around the world, and it has seen its fair share of controversies over the last decade. Given the complexity and subjectivity involved in determining appropriate transfer prices, there is often a risk that tax authorities may challenge the transfer prices set by the company. Such challenges can lead to disputes, audits, potential adjustments to taxable income, double taxation and potentially significant financial liabilities in the form of additional taxes, penalties and interest. In the post-BEPS environment and considering the wide range of transfer pricing issues globally, there is a need for identifying and developing strategies that can help multinationals in mitigating and managing their transfer pricing risks. One such strategy that is gaining popularity among multinational taxpayers nowadays—and that we have been assisting our clients with—is to secure insurance coverage to mitigate their potential tax and transfer pricing–related risks.

Traditionally, taxpayers have been managing their transfer pricing risks by establishing transfer pricing policies and by maintaining appropriate transfer pricing documentation. In some cases, they apply for Advance Pricing Agreements (APA), attempt to settle the dispute through negotiations or arbitration, or agree on a Mutual Agreement Procedure (MAP) with local tax authorities. While APA and MAP procedures have provided some certainty to the taxpayers, these processes are typically long-drawn and resource-consuming and the outcome is often based on specific facts and circumstances leaving taxpayers with little to zero flexibility.

An alternative approach to these traditional procedures involves using tax insurance to shield taxpayers from transfer pricing risks. In the past, tax liability insurance was mainly used during mergers and acquisitions (M&As). For instance, when a known tax issue was found during due diligence or when the deal was structured for specific tax treatment, or to reduce risks linked to general tax planning. However, recent developments indicate that tax insurance is becoming increasingly more important in handling transfer pricing risks as well. If an insurer deems the taxpayer’s position reasonable and defensible, in the event of a challenge from tax authorities it may step in and compensate the taxpayer for any losses incurred, including assessed taxes and defense expenses. By strategically employing tax insurance, multinationals can effectively manage their potential transfer pricing tax exposures, whether it be an M&A scenario or any other similar situation.

Also, as the traditional approaches (i.e., APA/ MAP) are based on a fixed set of facts and circumstances and applicable for a fixed period for one or more controlled transactions, they may not be valid if the taxpayer’s business model changes during the term in which the approach is in force. Thus, it may not be an efficient solution: such approaches sometimes fail to provide flexibility to the taxpayer and can take years to negotiate. Moreover, with increased transparency rules, tax authorities are less inclined to provide certainty in advance, which makes the outcome of such procedures less predictable. As a result, more and more taxpayers are preferring to obtain insurance coverage for their transfer pricing risks instead of an APA or MAP.

3. Insurable transfer pricing risks

In our experience assisting clients in assessing and managing their transfer pricing–related risks, we have come across the following types of transfer pricing risks which can be managed through insurance coverage:

• Remuneration of various intercompany transactions including:
  • Interest on intercompany financing
  • Royalties paid for use and exploitation of intellectual property (IP), including trademark, tradename, know-how, patent, customer list, etc.
  • Profit splits for joint ownership or contributions to unique and valuable activities
  • Remuneration to companies performing routine activities such as contract manufacturers, limited-risk distributors, service companies.
• Transfer of functions and assets, including (hard-to-value) intangible assets, as a result of business reorganizations, and corresponding exit tax/remuneration.
• Deductibility of amortization expenses resulting from IP ownership (when there is a dispute regarding the functional profile of the entity including IP related DEMPE functions (i.e., development, enhancement, maintenance, protection and exploitation).
• Other transfer pricing exposures related to (equity/asset) valuations, application of tax treaties, debt-versus-equity treatment (incl. debt-capacity/gearing) and permanent establishments.
• Compliance with transfer pricing policies within the arms-length principle.
• Tax risks associated with the activities of investment funds in foreign jurisdictions/cross-border transactions, profit repatriation at the time of winding of fund, exit tax, etc.

4. The tax risk insurance process

Typically, the process for obtaining a tax risk insurance policy would include following steps:

1. Assessment and identification of risk: The insurance provider starts off by assessing the company’s tax positions, compliance history, and potential exposures to tax risks, usually with the help of a broker, to determine whether such risks are appropriate for the tax liability insurance market.
2. Policy design: Based on the assessment, the insurance company designs a policy tailored to the company’s specific needs, covering potential tax liabilities, penalties, interest and legal expenses associated with tax disputes. The insurer may exclude certain types of risks from coverage, such as intentional tax evasion or fraud.
3. Premium and underwriting: The premium for tax risk insurance is determined based on factors such as the level of risk exposure, the company’s financials, compliance track record, industry sector and the coverage limits requested. In case of transfer pricing risk insurance, the insurer also takes into consideration other aspects, such as adequacy of available data/ comparables, business purpose, quantum of potential adjustment/potential settlement, high risk areas like intercompany debt with non-market interest, minimal documentation, valuation of intangibles, ownership of IP in relation to DEMPE functions, entities with significant income and minimal headcount, etc. In addition to a premium, the insurers’ price may also include a monitoring fee.
4. Coverage limits: Once the policy is in place, it typically covers the costs associated with defending against tax audits, disputes and litigation, as well as any resulting tax assessments, penalties, interest payments and legal fees.
5. Claims process: If the company faces a tax audit or dispute, it notifies the insurance provider and submits a claim. The insurance company then evaluates the claim and, if approved, provides financial support to cover eligible expenses as per the policy terms and conditions.

In addition to the typical process involved in obtaining insurance coverage, the insurance market also considers following two potential insurance approaches when it comes to transfer pricing risks:

• The “bottom up” approach
• The “catastrophic risk” approach

“Bottom up” approach: In this approach, the insurer takes on a limited risk against the risk of adjustment from the tax authorities, which would result in a higher tax charge for the insured.

For instance, if the transfer pricing study determined a certain transfer price for the controlled transaction (for example, €100), the insurer would take on the risk that the tax authority may adjust the transfer price higher or lower to a limited extent (for example, €105 or €95). This approach is appropriate for relatively low risk transfer pricing adjustments, such as the transfer price for routine support activities.

“Catastrophic risk” approach: Under this approach, the insurance will only respond when the adjustment of the transfer price exceeds a certain threshold. For example, if a transfer pricing study determined a transfer price of €100, with a variation between €85 and €115, then the insurer will only cover an adjustment outside of the set parameters—say, over €115, or under €85. Insurance based on a “catastrophic risk” approach is typically cheaper, as the risk to the insurer is typically lower.

Moreover, to be eligible for insurance coverage, the taxpayer will usually need to meet the following criteria:

• The transfer pricing liability risk to be insured should ideally relate to a single issue, i.e., the insurance coverage will relate to a specific area of transfer pricing or the successful outcome of a single claim/ litigation.
• The insurance request should be supported by a strong legal opinion, which must generally be that a tax liability risk “should not arise” or “will not arise.” The weakest level of opinion is one that states that the tax risk is “more than likely not to arise.” In our practical experience and also as an industry practice, tax insurance is placed where a “should level” legal opinion is available.
• The subject of the insurance must not be fully determined, i.e., insurers are unlikely to cover known breaches or non-compliance with applicable legislation.

5. Benefits of insuring for a transfer pricing risk

Some of the key benefits of obtaining an insurance coverage for transfer pricing–associated risks are:

• Certainty: Transfers an uncertain liability (i.e., possible tax payable as the result of a future transfer pricing adjustment) from the insured to the insurer, helping the insured manage costs related to the risk.
• Risk management: Allows taxpayers to transfer some of their tax-related risks to an insurance provider, enabling better risk management and strategic planning.
• Financial protection: Helps mitigate the financial impact of unexpected tax liabilities, penalties, and legal expenses, thereby safeguarding the company’s profit margins and cash flow.
• Efficient remedy: Provides a streamlined underwriting and policy placement process that can be completed on commercial timelines (compared to an APA process that can take a year or more).
• Eliminating double taxation: Covers potential tax authority challenges from multiple jurisdictions and pays out in multiple currencies.
• Financial reporting: Once insured, companies may—depending on the local rules— eliminate uncertain liabilities (e.g., UTPs) or claims/liabilities from their balance sheets, which can yield additional commercial benefits. Such benefit could also be valuable in potential disputes, as it would no longer be apparent to authorities.
• Audit protection: In some cases, positions that are already under audit or review by the tax authorities may still be insurable.

6. Key features of tax risk insurance

• The insurance forms a legally binding transfer of the tax risk from insured to insurer.
• Coverage extends to tax risks that arise in countries with stable legal systems throughout the world.
• Covers additional taxes, interest, penalties, contest/ defense costs and gross-up.
• Premiums are typically in the range of 2 percent to 8 percent of the potential exposure; however, we have also been involved in cases with significantly higher (e.g., more than 20 percent) in relation to specific transfer pricing risks, such as disputes over IP-related deductions and returns.
• Quantification of (potential) risks allows for negotiating better terms for the insurance coverage. For instance, in complex cases such as IP valuation, we have performed extensive financial modellings and scenario-analyses in order to quantify the identified risk exposure. Given the complexity and subjectivity involved in valuation (such as that in case of IP valuation), quantitative valuation analysis by an expert provides strong support for the actual coverage. Quantification analysis may include numerous scenarios including the well-educated relevant probabilities resulting in combined risk quantification.

7. Conclusion

Transfer pricing risk insurance can provide peace of mind for multinational corporations facing the complexities and uncertainties of transfer pricing regulations. It allows companies to transfer some of the financial risks associated with (potential) transfer pricing audits and disputes to an insurance company, helping to mitigate and manage their overall tax risk profile. Additionally, it offers a simplified underwriting and policy placement procedure that aligns with commercial timelines, in contrast to the lengthy APA process, which can extend over years, thereby leading to a shift in demand from traditional approaches to obtaining insurance coverage.

Companies interested in transfer pricing risk insurance should carefully review policy terms, coverage limits, exclusions and premiums to ensure that the insurance meets their specific needs and risk tolerance. Additionally, they should consider working with insurance brokers, valuation experts or advisors with the relevant expertise in transfer pricing, valuation and international tax to identify appropriate coverage strategies and negotiate the best possible terms.