On the 11th of February 2020 the OECD released its new transfer pricing guidance on financial transactions which will be included in the OECD Transfer Pricing Guidelines. This guidance is a follow-up of the public discussion draft of July 3, 2018 and reflects a consensus position of the OECD members.
Briefly summarised, the report contains guidance on the following aspects:
- Accurate delineation of financial transactions
- Treasury functions within an MNE group
- Credit ratings and parental support
- Pricing of financial transactions
- Cash pools and rewarding the cash pool leader and participants
- Financial guarantees
- Captive insurance and reinsurance
- Risk-free and risk-adjusted rates of return
Overall, the report contains most of the elements which were also included in the discussion draft. Some interesting features which may have been overlooked in the past are, for example, the requirement of an elaborate analysis in order to actually qualify the transaction as a debt instrument, applying a two-sided approach, looking into other options realistically available and also analysing the capacity to bear additional debt. The five factors of each transfer pricing analysis are mentioned as well: contractual terms, functional analysis, characteristics of instruments, the economic circumstances and the business strategies.
However, on some aspects the new published guidance is more explicit and/or deviates from the discussion draft. The most important choices and changes made by the OECD are listed below.
Accurate delineation of financial transactions versus domestic law
The guidance includes useful indicators that may be used to qualify a financial transaction. Some examples are the presence or absence of a fixed repayment date, the obligation to pay interest, the ability of the recipient of the funds to obtain loans from unrelated lending institutions and the right to force payment of principal and interest.
However, it seems that the OECD countries could not reach full consensus on this topic as section 10.8 is included which explicitly acknowledges that “other approaches may be taken to address the issue of the balance of debt and equity funding of an entity under domestic legislation”.
Group credit rating
The creditworthiness of a borrower or specific debt issuance is one of the main factors that influences interest rates in the open market, which is now also explicitly acknowledged in the guidance (section 10.62). Rather familiar topics such as the group rating, stand-alone rating, the effect of explicit guarantees on the credit rating and the effect of group membership (implicit support) are described in detail.
New regarding the credit rating is the allowance to use the group credit rating for a particular group member or debt issuance. This is allowed under certain circumstances and can rather be seen as a last resort when other options did not result in a reliable outcome. We believe that the use of the group credit rating might be particularly relevant for investment and holding companies as they do not conduct “ordinary” operational activities.
Methods to determine the arm’s length interest rate of intra-group loan
Another important aspect of the new guidance is the inclusion of more methods to determine the arm’s length interest rate of intra-group loans. The guidance regarding the CUP method and the Cost of Funds approach remains similar, as well as Bank Opinions. For the latter, however, it is concluded that bank opinions do not produce an arm’s length outcome.
Added are the following methods, which are briefly discussed:
- Credit default swaps
Credit default swaps indicate the credit risk of a specific financial asset. As such, they can be used to determine the risk premium for intercompany loans if the CUP method cannot be used. Credit default swaps are however very volatile and may reflect the risk of non-related factors (e.g. liquidity of the swap or number of contracts negotiated). Therefore, using credit default swaps requires a thorough investigation of those credit default swaps.
- Economic modelling
For certain industries it is common to use economic models to determine an arm’s length interest rate. These economic models quite often calculate premiums connected to various aspects of loans in addition to the risk-free rate. Reliability of these models can vary, depending on the parameters used. Comparability adjustments are likely to be made.
In practice we believe that the CUP-method will still prevail, using external databases to look for comparable loan transactions. The approaches mentioned above seem to implicate an even more burdensome analysis, with a less reliable outcome.
In general, a cash pool arrangement should benefit both the cash pool leader and cash pool participants. The guidance on determining a remuneration for the cash pool leader remains broadly similar compared to the discussion draft (i.e. a spread remuneration for a more elaborate and riskier profile of the cash pool leader versus a routine remuneration for a standard cash pool leader with limited activities).
The challenging part is remunerating the cash pool participants. The three approaches mentioned in the discussion draft are not included in the final guidance and section 10.146 of the guidance also indicates that cash pool participants may benefit from the arrangement beyond enhanced interest rates (e.g. the availability of liquidity).
It is advised to have a well-thought policy in place which is also properly documented. In this policy, attention should be paid to the accurate delineation of the transaction, the terms and conditions of the cash pool and the involved functions, assets and risks, the effect of cross-guarantees within the cash pool and the remuneration of both the cash pool leader and the cash pool participants. Having a well-documented policy in place will avoid the reversal of burden of proof.
Guidance on the risk-free / risk-adjusted rate
Section F provides guidance on determination of the risk-free rate of return and the risk-adjusted rate of return. The risk-free rate needs to be determined for those entities that lack the capability to bear risks or do not perform the decision-making functions.
The risk-adjusted rate of return should be determined if an entity providing the funding exercises control over the financial risk related to the provision of funding but does not assume any control over any other risks. As such, the risk-adjusted rate of return consists of the risk-free rate as well as a risk premium for the risk borne. The risk-adjusted rate of return may be determined by using the CUP method, the cost of funds approach, or by taking into account alternative investments which entail the same risk. This could both be bond issuances or loan transactions.
The guidance on financial transactions again underlines the growing attention by tax authorities for this specific field of transfer pricing. It can be welcomed as it leads to some more clarifications on this issue. This new chapter to the OECD guidelines however leaves a lot of room for discussion and disputes.
A clear signal to analyse or set up your policy, look into adequate documentation and the actual pricing methods used.
In the above we obviously can only mention the key developments. For more information on the changes regarding financial transactions we invite you to join our QG Academy on financial transactions on February 19, 2020. Please subscribe here. Limited places available.
For the complete report “Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8-10”, by the OECD, please click here.
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