The OECD has released its long-awaited Transfer Pricing Guidance on Financial Transactions (hereafter ‘Final Paper’) on 11 February 2020. The guidance was published as a result of the public Discussion Draft on the Transfer Pricing Aspects of Financial Transactions (the Discussion Draft) originally released 3 July 2018 and part of the Base Erosion and Profit Shifting (BEPS) initiative, Actions 8-10. The Final Paper aims at providing guidance on specific transfer pricing issues of financial transactions on the following matters:
- The accurate delineation of financial transactions;
- Treasury functions including intra group loans and hedging;
- Cash pooling;
- Financial guarantees;
- Captive insurance; and
- Risk-free and risk-adjusted rates of return.
The guidance takes account of comments received in response to the Discussion Draft. This guidance is significant because it is the first time the Guidelines will be updated to include guidance on the transfer pricing aspects of financial transactions, which should contribute to consistency in the application of transfer pricing and help avoid transfer pricing disputes and double taxation. Given that the Final Paper has been approved by the Inclusive Framework of 137 member states, it also clarifies that the new guidance does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation. In particular, matters regarding debt versus equity funding, structures and interest deductibility may under domestic legislation divert from the OECD guidance. The ‘control over risk’ approach resonates through most, if not all, topics discussed. As financial transactions increasingly attract the attention of tax authorities in many jurisdictions, it is expected that this paper is likely to shape the environment of future bilateral and multilateral dispute resolutions. Therefore, it is necessary for MNE groups to assess their transfer pricing policies in light of this new guidance.
1.The accurate delineation of financial transactions
1.1.Debt versus equity determinations
Pursuant to section D.1. of the OECD Transfer Pricing Guidelines 2017 (the ‘Guidelines’) the guidance in the Final Paper includes an approach to determine if a purported loan should be
regarded as a loan through analysing the capital structure used to fund an entity, i.e. the mix and types of debt and equity, within a multinational enterprise (MNE) group.
the Final Paper starts by stating that it is possible to take into account the at arm’s length capital structure of the borrower, including specific terms and conditions applied, purpose of the loan, and ability to repay by the borrower. The Final Paper did change its wording to ‘capital structure’ from the ‘balance of debt and equity funding of an entity’, compared to the Discussion Draft, though that does not seem to have a material impact.
The Final Paper lists several useful indicators in accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances:
- The presence or absence of a fixed repayment date;
- The obligation to pay interest;
- The right to enforce payment of principal and interest;
- The status of the funder in comparison to regular corporate creditors;
- The existence of financial covenants and security;
- The source of interest payments;
- The ability of the recipient of the funds to obtain loans from unrelated lending institutions;
- The extent to which the advance is used to acquire capital assets; and
- The purported debtor’s failure to repay on the due date or to seek a postponement.
The Final Paper reflects an approach which acknowledges that domestically other approaches may apply in addressing the capital structure and interest deduction limitations. The new guidance is therefore not aimed at being the single approach for determining whether the purported loan is regarded correctly or should be recharacterized as equity for tax purposes.
1.2.The economically relevant characteristics of actual financial transactions
In accordance with the Guidelines, the Final Paper reaffirms the five well-known comparability factors (i.e. contractual terms, functional analysis, characteristics of financial transactions, economic circumstances and business strategies) and interlinks these with the context of financial transactions and how the financing policies of a group should be taken into account when delineating the financial intra-group transactions. Final Paper states that consideration of the conditions that independent parties would have agreed to in comparable circumstances is necessary and the options realistically available to each of the parties to the transaction.
The Final Paper acknowledges that the transfer pricing aspects of the treasury function within an MNE group, can have varying degrees of complexity and levels of centralization. This section provides an overview of the typical key functions performed by treasury in a group, arising from intra-group loans, cash pooling and hedging activities.
2.1.1.The lender’s and borrower’s perspectives
The Final Paper re-affirms the standing practice of the borrower’s ability to repay the debt as the most important variable in determining the interest rate. The OECD confirms when analysing the commercial and financial relations, the perspective of both the lender and the borrower should be considered. In particular, it is important to consider the risks that the funding arrangements carries for the party providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient. In particular, it is important to consider the risks providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient.
Compared to the Discussion Draft, the Final Paper provided more detail on the importance of analysing both qualitative as quantitative factors influencing a credit rating. Special considerations should be made for start-ups and groups that just have been through a merger, in assessing their creditworthiness.
With regards to the use of commercial financial tools or methodologies to approximate credit ratings, the OECD recognizes that these may be useful contributions to benchmark studies. Nevertheless, it should be considered that these tools are subject to the accuracy of the input parameters and that there is lack of clarity in the models and underlying algorithms.
2.1.3.Effect of group membership
The effect of group membership is relevant for analysing the conditions under which an MNE would have borrowed from an independent lender at arm’s length. The effect is relevant in two ways. In the first place, the external funding policies and practices of group management will assist in determining whether the form and terms and conditions of the debt are similar to those that the group entity would have entered into with an independent lender. Second, the group entity may receive support from the group to meet its financial obligations in the event of the borrower getting into financial difficulty.
The implicit support should be considered in the determination of the credit rating of the borrower. The level of implicit support depends on the relative status of an entity within the group, linkages between the entity and the group and the consequences for the group of non-support. Important entities within a group with strong linkages are more likely to receive support from the rest of the group. In cases where there is strong indication that no support would be provided by the group, the borrower’s credit rating may be more closely linked to the stand-alone credit rating of the entity.
2.2.Determining the arm’s length interest rate of intra-group loans
The following paragraphs present different approaches to pricing intra-group loans. As in any other transfer pricing situation, the selection of the most appropriate method should be consistent with the actual transaction as accurately delineated, in particular, through a functional analysis.
The Final Paper outlines the transfer pricing approaches to determine arm’s length rates, including:
- The comparable uncontrolled price (CUP) method;
- The cost of funds approach;
- Credit default swaps; and
- Economic modelling.
Due to the widespread availability of data and analysis of loan markets, the CUP method is typically easier to apply to financial transactions than other type of transactions. The Final Paper notes that in identifying suitable external comparables, taxpayers need not to be limited to loans. Depending on the facts and circumstances, realistic alternatives to intra-group loans could be, for instance, bond issuances, loans which are uncontrolled transactions, deposits, convertible debentures, commercial papers, etc. The search for comparable data is also not necessarily restricted to a stand-alone entities, provided that all other economically relevant conditions are sufficiently similar.
2.2.2.Cost of funds approach
In the absence of comparable uncontrolled transactions, the cost of funds approach could be used as an alternative to price intra-group loans in some circumstances. The cost of funds will reflect the borrowing costs incurred by the lender in raising the funds to lend, to which a profit margin is added.
2.2.3.Credit default swaps and bank opinions
A credit default swap is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. These financial instruments, as they are traded in the market, are accompanied with a high degree of volatility. Though the OECD recognizes that financial modelling tools may be useful where reliable comparable uncontrolled transactions cannot be identified, it notes that comparability adjustments are likely required. The Final Paper makes clear that external bank opinions to intra-group loans are informal letters and do not constitute an actual offer to lend and therefore cannot be considered comparable to actual transactions.
The Final Paper stipulates that the accurate delineation of the cash pooling transactions will depend on the particular facts and circumstances of each case. As cash pooling is not undertaken regularly, if at all, by independent enterprises, the application of transfer pricing principles requires careful consideration. Two broad pricing schemes are discussed: the remuneration for the cash pool leader and that of the cash pool members. The Final Paper discusses two approaches to allocating the benefits of cash pooling to the participating members: the facts and circumstances of the balances transferred and the wider context of the conditions of the pooling arrangement as a whole.
3.1.Rewarding the cash pool members
Key to determining the remuneration of the participating cash pool members is the debit and credit positions within the pool. The allocation of synergy benefits to the cash pool members will generally be done once the remuneration of the cash pool leader has been calculated. It is expected that all cash pool participants will be better off than in absence of the cash pool arrangement. Under prevailing facts and circumstances that could imply, for instance, that all cash pool participants would benefit from enhanced interest rates applicable to debit and credit position and access to liquidity.
3.2.Rewarding the cash pool leader
The appropriate remuneration of the cash pool leader depends heavily on the functional analysis. Where the cash pool leader performs merely a coordination or agency function, the reward should be in accordance with its routine function, unless proven otherwise. Activities other than coordination or agency functions should, in general, lead to a higher remuneration that is appropriate, which can include earning part or all of the spread between the borrowing and lending positions which it adopts. Consequently, taxpayers are called on to prepare comprehensive documentation of the pool structure as well as the returns to the cash pool leader and pool participants.
As part of the cash pooling arrangement, cross-guarantees and rights offset between participants in the cash pool may be required. This raises the question of whether guarantee fees should be payable. With other parties providing guarantees on the same loans, it may not be possible for the guarantor to evaluate its real risk in the event of a default. Thus, the practical result of the cross-guaranteeing arrangement is such that the formal guarantee may represent nothing more than an acknowledgement that it would be detrimental to the interests of the MNE group not to support the performance of the cash pool leader and so, by extension, the borrower. In such circumstances no guarantee fee would be due.
4.1.Effect of group membership
In general, an explicit financial guarantee provides for the guarantor to meet specific financial obligations in the event of a failure to do so by the guaranteed party. There are various terms in use for different types of credit support from one member of an MNE group to another. Two types of economic benefits of financial guarantees are outlined: the enhancement of borrower’s conditions through, for example, a better credit rating and less needed collateral and the increase in borrowing capacity due to the improved credit rating. It is necessary to consider whether these two advantages should be accurately delineated and whether the guarantee fee paid with respect to this loan portion is at arm’s length. In other words, the delineation of the transaction may result it to be split into two parts: a loan from the lender to the borrower, based on the borrower’s capacity without the guarantee and a loan from the lender to the guarantor, followed by a capital contribution to the guarantee recipient.
4.2.Financial capacity of the guarantor
The examination of financial guarantees under accurate delineation needs also to consider the financial capacity of the guarantor to fulfil its obligations in case of default of the borrower. This requires an evaluation of the credit rating of the guarantor and the borrower, and of the business correlations between them, such as the extent to which an adverse market effects might affect both parties simultaneously.
4.3.Determining the arm’s length price of guarantees
The guidance describes five pricing approaches for circumstances in which a guarantee fee is found to be appropriate:
• The CUP method;
• The yield (differential) approach;
• The cost approach;
• The valuation of expected loss approach; and
• The capital support method.
The CUP method is considered the most reliable method though the availability of comparable data is still a challenge.
The yield approach quantifies the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates. The method calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The benefit of implicit support will be the difference between the borrowing terms attainable by the borrowing entity based on its credit rating as a member of the MNE group and those attainable on the basis of the stand-alone credit rating, if it were an entirely unaffiliated enterprise. In this approach the Final Paper considers the maximum fee for the guarantee, namely, the difference between the interest rate with the guarantee and the interest rate without the guarantee but with the benefit of implicit support to not necessarily reflect the outcome of a bargain made at arm’s length but represents the maximum that the borrower would be prepared to pay.
The cost approach aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee. The result of the cost approach represents the floor the guarantor would be willing to accept, which is also subject to bargaining between the borrower and the guarantor.
5.Captive insurance and reinsurance
There are many ways that MNE groups may manage risks within the group. For example, they may choose to set aside funds in reserves, pre-fund potential future losses, self-insure, acquire insurance from third parties or simply elect to retain the specific risk. In some other cases an MNE group may choose to consolidate certain risks through a so-called “captive” insurance.
Captive insurance refers to an insurance undertaking or entity substantially all whose insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs.
The Final Paper pays special consideration to the control functions that can be allocated to the captive insurance. Furthermore, the Paper elaborates on the importance of risk diversification within the insurance business and describes various ways in which diversification can be realized. For insurance business to thrive, there must be an assumption of risk as well as risk diversification. If a captive does not demonstrate risk diversification, the activities by the captive might not be considered as a genuine insurance business. If the captive is not found to have sufficient ‘control’ over the assumption of underwriting risk, the returns derived from the investment of insurance premiums would be allocated to those members of the MNE group that do exercise control over this risk.
6.Risk-free and risk-adjusted rates of return
Finally, the Final Paper provides guidance on how to determine a risk-free rate of return and a risk-adjusted rate of return in situations where, based on the accurate delineation, an associated enterprise is entitled to any of those returns.
If the accurate delineation of the actual transaction shows that a funder lacks the capability, or does not perform the decision-making functions, to control the risk associated with investing in a financial asset, the guidance states where an entity is only entitled to a risk-free rate of return, the funder’s cost of funding should be considered in determining such return.
An approach which is widely used in practice is to treat the interest rate on certain government issued securities as a reference rate for a risk-free return, as these securities are generally considered by market practitioners not to carry significant default risk. Alternatives may include interbank rates, interest rate swaps, or repurchase agreements of highly rated government-issued securities.
To eliminate currency risk, the reference security for determining the risk-free rate would need to be a security issued in the same currency as the investor's cash flows, i.e. the functional currency of the investor rather than its country of domicile. Another key consideration would be the maturity of the financial instrument. The duration of the reference security should match the duration of the investment since the duration of an investment will usually affect its price.
6.2.Risk-adjusted rate of return
The guidance states that in a situation in which a party exercises control over the associated financial risk, without controlling any other specific risk, it could generally only expect a risk-adjusted rate of return on its funding. In general, the expected risk-adjusted rate of return on a funding transaction can be considered to consist of two components: the risk-free rate and a premium reflecting the risks assumed by the funder.
The determination of the risk-adjusted rate of return can be based on the return of a realistic alternative investment which reflects the same risk. Another approach to determining the risk-adjusted rate of return would be to add a risk premium to the risk-free return, based on the information available in the market on financial instruments issued under similar conditions and circumstances. In determining the risk adjusted rate, it is important to differentiate between risks assumed by the funder in relation to its financing activity and the operational risks that the funded party may assume in connection to the use of the funds. Potential methods to determine the risk-adjusted rate of return include comparable uncontrolled transactions such as bond issuances or loans, adding a risk premium based on information available on comparable financial instruments, or the cost of funds approach.