On February 11, 2020, the OECD published the “Transfer Pricing Guidance on Financial Transactions” (Guidance), which supplements the OECD Transfer Pricing Guidelines of July 2017. This new Guidance addresses the characterization of financial instruments, the pricing of financial transactions (such as treasury functions, intra-group loans, cash pooling, hedging, guarantees, captive insurance) and the determination of a risk-free or risk-adjusted rate of return related to the level of management and control exercised over financial risks.
In this Dentons Tax Alert we provide you with a bird’s eye view to put the Guidance into perspective by discussing: (i) the background, (ii) what’s new and (iii) key take aways.
One of the conclusions of the BEPS project in 2015 was that there was a lack of generally accepted guidance for the pricing of intra-group financial transactions. Therefore, the OECD’s Committee on Fiscal Affairs published draft guidelines for discussion purposes in 2018, with the aim to clarify the application of the OECD Transfer Pricing Guidelines to financial transactions. In particular, for an accurate delineation analysis and the specific issues relating to the pricing of loans, cash pooling, financial guarantees, and captive insurance.
With the publication of the Guidance, the OECD Transfer Pricing Guidelines are officially updated with the transfer pricing aspects of financial transactions in the form of the new Chapter X. Additionally, practical instructions to determine risk-free and risk-adjusted rates of return are added to Chapter I of the OECD Transfer Pricing Guidelines. The OECD envisages that the Guidance takes away the uncertainty around the transfer pricing treatment of financial transactions, contributes to the consistency in the application of transfer pricing and helps to avoid transfer pricing disputes and double taxation.
In this section we discuss what is formally new after the publication of the Guidance. Be aware of the fact that some of these ‘novelties’ were already common practice and that countries may have already developed a unilateral approach to the transfer pricing aspects of financial transactions which they will maintain.
1. Supplement to the comparability analysis - delineation of a financial transaction
To determine the arm’s length price for a controlled transaction, the conditions of a controlled transaction must be compared to the conditions of a comparable transaction under comparable circumstances between independent parties applicable to the controlled transaction. Therefore, the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances related to those relations must be identified in order to delineate (=define) the controlled transaction. The OECD Transfer Pricing Guidelines already contained provisions on the delineation of a transaction, but not specifically for financial transactions. The Guidance supplements the concept of the delineation of a transaction and depicts how that may relate to the capital structure (balance of debt and equity funding) of an entity within the multinational group. In that respect, reference is made to the Commentary on article 9 of the OECD Model Tax Convention, which states that it should not only be determined whether the interest rate provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital. The Guidance explicitly states that it does not prevent countries from implementing and/or applying unilateral approaches to address the balance of debt and equity funding of an entity and interest deductibility under domestic legislation, but it does provide some useful indicators (e.g. presence or absence of fixed repayment date, obligation to pay interest, concurrence of creditors, etc.). The approach is a case-by-case determination on a substance over form basis.
2. Treasury activities
The Guidance addresses specific challenges related to the management of the group finance or treasury function. Factors such as the complexity of the business, the business strategy, the industry, currencies of operations, etc. all affect the approach to treasury adopted by multinational groups. Therefore, there is not a uniform qualification for the treasury function and the Guidance prescribes determining exactly what functions an entity is carrying on rather than to rely to any extent upon a general description such as “treasury activities”. Treasury may for example only entail the support of the financing of a group entity or the centralized contact point for the external borrowing of the whole multinational group. Hence, it is crucial to determine what treasury means within the context of the group under examination. The Guidance also provides specific provisions for intra-group loans, cash pooling and hedging.
- Intra-group loans: the Guidance addresses both the lender’s and the borrower’s perspectives in the analysis of the commercial and financial relationships between these parties. Although in independent transactions both the lender and the borrower will go through certain processes to analyze the risks associated with the loan, the Guidance acknowledges that that process may be different and less thorough if it concerns group entities. Apart from the general assessments (economic circumstances, industry, pledge possibilities, specific business circumstances, etc.), the Guidance describes the credit rating as one of the main factors that independent investors take into account in determining an interest rate and that it is therefore a useful measure to identify potential comparables when determining an arm’s length interest. The Guidance underscores the possibility to use the internal comparable uncontrolled price (CUP) method, but also provides viable alternatives such as the costs of funds or economic modeling when the required data is available.
- Cash pooling: the Guidance also describes the main type of cash pool arrangements: (i) physical i.e. the actual transfer of funds and (ii) notional i.e. the bank settles the accounts without cash pool participants transferring funds. It is acknowledged that different business models may require different types of cash pool arrangements and that therefore variations may exist. The delineation of the cash pool transactions requires an analysis of the facts and circumstances at hand, but also of the wider context of the conditions of the pooling arrangement as a whole taking into account the broader group strategy. It may be that certain synergies and efficiencies (e.g. reduction of interest paid or increase of interest received) are achieved as a result of group synergies. According to the Guidance, it is in that case necessary to determine (i) the nature of the advantage or disadvantage, (ii) the amount of the benefit provided, and (iii) how that benefit should be divided among members of the group. Another key consideration is to make a clear distinction between short-term (cash pool) and long-term (not part of cash pool) funding arrangements. Another important factor in the analysis is the control and capacity related to the risks, such as the liquidity risk and credit risk. To determine the arm’s length remuneration, a distinction is made between the cash pool leader and the cash pool members. The remuneration for the cash pool leader’s activities depends on the type of cash pool arrangement and the level of activities it has to perform. The performance of a coordination or agency function will generally be rewarded with a limited remuneration. If additional activities are performed, the general rules in the OECD Transfer Pricing Guidelines apply. For the cash pool members, it seems that an external CUP (banking arrangement between the bank and the cash pool leader) taking into account the differences between the bank and the cash pool leader may result in a comparable interest rate.
- Hedging: the Guidance states that where the centralized treasury function arranges a hedging contract that the operating entity enters into, that centralized function can be seen as providing a service to the operating entity, for which it should receive compensation on arm’s length conditions.
3. Financial guarantees
The Guidance addresses specific challenges related to the financial guarantees on certain intra-group transactions. Financial guarantees from other group members or just being part of a group can result in economic benefits arising to the borrower. To determine the transfer pricing consequences of a financial guarantee, the nature and extent of the obligations guaranteed and the consequences for all parties must be determined in order to delineate a transaction. More concrete: does the borrower derive any benefits from the guarantee? If not, an unrelated party would not pay a fee for such guarantee. Also, the issues were raised for the situation that a borrower has multiple benefits from the guarantee: (i) the borrowing capacity may increase and (ii) the interest rates on existing borrowings may be reduced. The pricing of these benefits follows the general rules in the OECD Transfer Pricing Guidelines.
Another item to take into account is the form in which the guarantee is provided. The Guidelines state that, although it is a case-by-case review, the guarantor should provide an explicit guarantee to assume the additional financial risks associated with that guarantee (a legally binding commitment). However, the substance over form approach applies as for example a formal guarantee provided that was already in place due to the effect of group membership, should generally not be remunerated.
An arm’s length remuneration can be determined with different methods, although the CUP method will likely be impossible to apply because of the lack of information on comparable transactions. Independent parties providing guaranties will likely always increase the guarantee fee with for example costs for meeting regulatory requirements and for the raising of capital. These costs will not occur between related parties. An alternative is the yield approach. This approach quantifies the interest rate spread between the interest charged to the borrower with and without the guarantee. The determined spread is the maximum fee the borrower would pay the guarantor. The Guidance also describes the cost approach. This approach quantifies the expected cost the guarantor will make in case of default by the borrower. The value of the expected loss determines the costs. Another alternative focuses on the capital requirements the borrower would have to meet to carry the risks assumed by the guarantor on its own. Both the yield and the cost approach result in the maximum fee the borrower would be willing to pay to the guarantor. The fee may be lower in practice.
4. Captive insurance
To manage certain risks, multinational groups can consolidate such risks through captive insurance. For example by appointing one of the group entities as the captive insurer, providing insurance policies to related entities. The Guidance refers to the general provisions in the OECD Transfer Pricing Guidelines dealing with the analysis of the applicable risks and control over these risks. In case of captive insurance, it should be determined whether the insurer actually bears the risks and is also capable of bearing these risks and controlling them. For example, can the insurer suffer a loss and would the risk be insurable by a third party in case there is no captive insurer? The Guidance provides a list of these indicators to determine whether there can actually be a captive insurance transaction.
To determine the remuneration for the captive insurance, the CUP method is appropriate but can in practice likely not be applied due to a number of differences between the controlled and the uncontrolled transaction. An option proposed in the Guidance is to price the premiums with actuarial analyses, taking into account that comparability adjustments would likely be required. Additional benefits derived from group synergies and agency sales (for example lower rates on the reinsurance market with third parties) should generally be allocated to the policy holders.
5. Risk-free and risk-adjusted rates of return
The Guidance offers practical instructions as to determine risk-free and risk-adjusted rates of return. A risk-free rate (sometimes referred to as a handling fee) is determined if the funder cannot or does not bear the financial risks related to for example the provision of a loan, but that another party bears and controls those risks that will then be remunerated with the difference of the overall remuneration and the risk-free rate. An adjustment can be made if for example the funder does assume a specific anticipated risk related to the funding of a specific investment. In that respect a risk premium may apply which results in the risk-adjusted rate.
It is acknowledged in the Guidelines that the starting point to determine the risk-free rate would be to identify a security (for example a government bond in the same currency) at the time the funding was provided and that – if multiple securities can be selected – the lowest rate of return available at that time may be selected. In that respect, factors as credit ratings and the maturity of the instruments impact such analysis. Other references to calculate the risk-free rates are explicitly not excluded. The Guidance states that the CUP method may be used to determine the risk premium to be added to the risk-free return or alternatively for example the cost of funds approach.
Key take aways
- Since all multinational companies cope with treasury activities (intra-group loans / cash pooling / hedging etc.) and items as guarantees and insurance provided within the group are quite common, but often not properly documented and priced, these guidelines provide a perfect occasion to create a new transfer pricing policy or, where necessary, amend existing policies.
- This new ‘default’ approach on various financial transactions can be a viable alternative for unilateral rules currently in place and may therefore result in amendments of these unilateral rules in various countries. Moreover, it provides tax authorities with a new toolset to challenge positions taken in the past if not in line with the Guidance.
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