On 3 July 2018, the Organisation for Economic Co-operation and Development (OECD) published the much anticipated discussion draft on financial transactions (discussion draft) for public comment. Even though this discussion draft is a non-consensus document, it provides useful commentary and guidance on the application of arm's length principle to a broad range of intragroup transactions where international guidelines have been largely non-existent in the past.
The discussion draft also provides a peek into OECD's thinking on dealing with financing transactions and the direction that OECD countries might take in their domestic legislation. Multinationals seeking to structure financing transactions in the near future need to consider that a more holistic approach to financing transactions is now necessary to be consistent with the arm's length principle.
Key Features of the Discussion Draft
The discussion draft is divided into four sections:
- Accurate delineation of the financial transaction - this section describes how financial transactions need to be accurately delineated in accordance with the post BEPS 2017 OECD Transfer Pricing Guidelines;
- Treasury functions - this section describes the different levels of treasury activities within a multinational group, including guidance on dealing with intra-group loans and cash pools;
- Financial guarantees - this section defines the scope of chargeable guarantees and provides guidance on the application of arm's length principle to these guarantees; and
- Captive insurance - this section details the characteristics of captive insurance and arm's length pricing approaches which can be applied to such transactions.
To accurately delineate financial transactions, the discussion draft highlights the importance of conducting a debt capacity analysis of the borrower. This includes a review of the multinational group's financing policy, business strategies being pursued, and consideration of specific industry factors. Options realistically available to both parties (the borrower and the lender) should also be considered such that entering into a transaction should not result in either of the parties to the transaction being worse off.
On treasury functions the discussion draft generally recognises corporate treasury as a support service provider, with strategic decisions such as policy making being performed at the group level. For intra-group loans, the possibility of internal comparable transactions should be considered, but the discussion draft also indicates that the average interest rate paid on external debt is unlikely to be considered as an internal comparable including written opinions from banks.
One of the key factors in benchmarking intra-group loans is the credit rating of the borrower. In this context, the proposed guidance authorises the use of commercial credit rating tools to determine the credit rating of the borrower or the debt instrument, provided that it can be applied reliably. It is important to note that financial metrics used for the credit rating analysis might be influenced by controlled transactions.
More significantly, the draft guidance specifically requires implicit support or passive association with the group to be considered when determining the credit rating of the borrower. The level of implicit support is dependent on the relative importance of the borrower within the group. In case the standalone credit rating of the borrower is higher than the group credit rating, the discussion draft suggests to cap the borrower's credit rating to the group's credit rating.
The discussion draft outlines different types of cash pool structures and discusses how arm's length principles apply to such structures. In particular, the draft guidance suggests that:
- Arm's length remuneration of the cash pool leader should be determined based on a detailed functional analysis - activities such as co-ordination or agency type function would generally warrant a service based return, whereas higher risk activities would provide for a spread-based return
- It is important to recognise and quantify the cash pool benefit/advantage - the discussion draft provides a number of approaches to allocate this benefit amongst cash pool participants
- Cross guarantees and general set-offs are common features of the cash pool - such features do not provide any incremental credit enhancement and in that respect no guarantee fee is applicable
The discussion draft defines a guarantee as "a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation". In this respect, anything other than a legally binding commitment (eg letter of comfort) is not considered a guarantee. As with other financing transactions, any explicit guarantee arrangement needs to be considered from the perspective of the guarantor and the guaranteed entity, ensuring that none of the parties are worse off from entering into the arrangement.
Significantly, the draft guidance allows tax authorities to re-characterize an explicit guarantee in cases where the guarantee only increases the debt capacity of the borrower. In such cases, the guarantee may be re-characterised as a loan to the guarantor followed by an equity contribution by the guarantor to the guaranteed entity making guarantee fee non-applicable.
As with intra-group loans, the impact of implicit support or passive association has to be taken into account for the purposes of determining the benefit from an explicit guarantee. Only a benefit beyond the implicit support is attributable to the explicit guarantee and thus chargeable as a guarantee fee. In a similar vein, the discussion draft suggests that any benefit arising from cross guarantees is attributable to passive association and therefore no guarantee fee is applicable.
Due to the presence of certain covenants in banking agreements entered into by other members of the multinational group, it is possible that that even an explicit guarantee does not confer any benefit to the borrower. For instance, banking covenants may include the cancellation of the facility if any entity within the multinational defaults. This would suggest that the members of the multinational are financially interdependent and it would not be possible for the multinational to abandon the borrower in case of financial difficulties. In this respect, the benefit to the borrower is attributable to the implicit support and not the explicit guarantee and therefore no guarantee fee is applicable.
The draft guidance on captive insurance outlines two attributes that are necessary for an insurance business: i) assumption of risk by the insurer and ii) distribution of risk/pooling of a portfolio of risk. In the event that a captive insurer does not demonstrate the second attribute, it may not be characterized as carrying out an insurance business.
When applying the arm's length principle to determine the remuneration of captive insurers, the discussion draft advises to consider differences on account of capital adequacy between captive insurers and arm's length insurers. Furthermore, when highly profitable insurance contracts are sold by sales agents to customers, the ability to achieve a higher return is attributed to customer contacts at the point of sale. In this regard, the captive insurer should earn a benchmarked return based on returns of comparable insurers and the residual profit should be attributed to the sales agent for access to the customer at the point of sale.
Industry practices have evolved in the absence of formal OECD guidance on the application of arm's length principles to a wide range of intra-group financial transactions. While the guidance provided in the latest OECD discussion draft is broadly in line with current industry practice, there are some important principles that emerge out of the discussion draft which may have significant implications on the current set up of financing transactions within a multinational group.
One area of attention is the requirement in the draft guideline to delineate an intra-group financial transaction, taking into account options realistically available to both parties to the transaction. This requirement allows tax authorities to re-characterise financial transactions such as intra-group loans and guarantees as equity transactions between members of a multinational groups under certain circumstances.
The requirement to consider implicit support when applying arm's length principle to intra-group loans and guarantees has been specifically addressed in the latest guidelines. Although this requirement is arguably already reflected in international best practices currently, there are still many intra-group arrangements that multinational groups carry out which do not this take into account appropriately. It is time for such practices to be reviewed and rectified.