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Arm’s length principle encounters the big fluffy hairy finance animal


With the recently published discussion draft of the OECD on Financial Transactions of 3th July 2018 a new chapter is added to the question whether the at arm’s length principle (“ALP”) applied for transfer pricing purposes will be strong enough to tackle finance related topics regarding the challenges of BEPS.

Tax authorities can make adjustments based on the ALP “if conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises”.

Until recently the daily practice of tax authorities was far more focused on the ALP analysis of the operational results (Earnings Before Interest and Tax). For interest deduction purposes, tax authorities were more focused on local legislation, like thin capitalization rules and – to a certain extent – on the interest rate applied, which however often did not lead to a very sophisticated discussion.

This current guidance and the lack of consensus between OECD member states makes one thing clear: financial topics are no fortune cookies that can be cracked easily. Given the lack of consensus combined with the clear increase in attention by local tax authorities on financial intercompany relations, MNE’s should look into their governance and policies in this field.

Also, stakeholders like the OECD, EU, UN and individual countries are currently battling for the say in financial transfer pricing topics. However, as the BEPS project of the OECD is a clear starting point for this, there is a strong need for further guidance on finance topics. The question is whether the ALP applied by the OECD will be strong enough to provide sufficient guidance and will be able to avoid any double taxation and long-lasting MAPs.

The remarks made by some OECD member states – including the US – that these analyses and the deductibility of interest should be determined by local tax legislation shows that it will not be easy to come to an international consensus on finance related topics.

This paper intends to give an initial high-level comment on the above-mentioned OECD discussion draft on financial transactions. In follow-up blogs we will dig deeper into the finance topics addressed by this draft and share some of our practical experiences in this field. Obviously your comments, remarks or questions would be highly appreciated.

In the below, we will first give an overview of some of the actions taken by the OECD and the EU in this field.

ALP is climbing down the P&L towards the interest line

The actions of stakeholders have put more focus on the bottom line (Earnings Before Tax) and the actual contribution made to the treasuries of individual countries. Faire share argumentation has become more common and the various BEPS actions focus on taxation where the value is created.

Therefore, the ALP applied for transfer pricing purposes also seems to climb down the P&L, with more focus on the EBT. The finance as the big hairy animal.

In an overview this can be characterized as follows:


This focus on finance and tax requires more from an MNE’s governance and controls in respect of taxation. However, given the lack on guidance provided by the OECD in respect of finance this is difficult. Hence, careful management is required.

Instead of issuing a final report on financial transactions, the OECD released a discussion draft with a new time line. The aim is to reach final member state agreement around April next year.

The underlying question here is whether the ALP can provide adequate guidance on the characterization of a financial instrument as equity or debt.

It has to be acknowledged that a lot of effort and technical know-how has been put into the discussion draft on financial transactions of 3th July 2018. The draft gives for instance some guidance on the characterization of financial instrument (as debt or equity) and includes interesting remarks on the two-sided approach (borrower and lender), the capacity to take additional debt and the use of the overall group credit rating versus the individual rating of a group company.

The steps that are mentioned in this respect are the identification of financial relations and the economically relevant characteristics of actual financial transactions. Here the five factors of each transfer pricing analysis are mentioned: contractual terms, functional analysis, characteristics of financial products or services, the economic circumstances and the business strategies.

In the below, an overview of a possible step by step approach for his analysis is depicted.

As already mentioned this paper only intends to describe some of the finance topics included in the draft report on a high-level and will be followed by blogs which will dig deeper into the various topics addressed in this report.

Risk free rate of return for cash boxes

The draft report mentions a risk-free rate return as the possible at arm’s length remuneration for a cash box in situations in which 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. In this case the risk profile which is present in each finance arrangement, seems not to be considered at all. The question can therefore be asked whether the risks should only be aligned with the functionality of risk management, or whether the risk of the underlying investment should – to a certain extent – also be considered.

Treasury function

The main topics for a treasurer are ensuring that a company has sufficient liquidity and borrowing capacity, optimizing the use of the existing cash flow within the company and managing the company’s exchange rate risks, at the most optimal conditions possible in the market.
In intercompany finance relations the leverage (equity or loans), the interest rates, the cash pools arrangements and the exchange rate risks should be set at arm’s length conditions.

Group credit rating group versus individual company credit ratings

The discussion draft goes into the lender’s and borrower’s perspectives in determining the loan capacity, the use of credit ratings and the effect of being member of the group, including the effect of guarantees. Furthermore, the impact of an implicit guarantee in combination with the strategic importance of a group member is mentioned here.

In daily practice we encounter some MNE’s that limit the interest rate that is charged to group companies to the interest paid to third party banks, with often only a minor uplift to pay for the internal costs of the handling of the loans. On the other side of the medal, there are more and more MNE’s that rate each loan individually based on the credit rating of each individual group company (with some consideration for the implicit guarantee of being part of the group).

Based on this guidance one could theoretically argue that the draft report of the OECD seems to give enough room for both positions as being compliant with the ALP. Arguments can be found in the existence of implicit guarantees, the strategic importance of an individual group company (as argumentation for the use of the groups credit rating) versus explicit guarantees

The draft report also discusses the pricing approaches to determine an arm’s length interest rate which is mainly based on CUPs to be found in data bases.

Next, the question arises how the guidance on the loan capacity can be combined with the two-sided perspective and with implicit guarantees, which can be challenging in practice. Issues that are relevant in that respect are e.g. how to deal at arm’s length with the loan capacity and the related leverage, what to do with changes in financial instruments and how to deal with fixed fee payments for credit facilities.

In our daily practice we are asked more and more for support in setting up transfer pricing policies, practical implementation and documentation. The questions to be answered therefore go beyond a benchmark for an interest rate and require a good knowledge of finance related topics, the at arm’s length principle and the local tax legislation of the countries involved.

Cash pool

Cash pools can be structured in many ways. The draft report mentions physical and notional arrangements and discusses the remuneration for the cash pool leader. One remark here is how to make a distinction between a cash pool position and an intercompany loan.
For instance, a cash pool participant that has a cash pool deficit regularly and for a long could be regarded as a borrower.

In the draft report the question is raised how to remunerate the cash pool leader and how to allocate the surplus generated by the cash pool. Should this only be allocated to cash pool participants that have surplus cash and how can it be ascertained that all participants are benefitting from the cash pool?
In this respect, the ALP struggles with the minimum required interest rates (borrowing rate versus surplus rate) also given the lack of comparables.

The examples in the draft report are obviously more simplified.

The draft report states that a cash pool leader will mostly perform no more than a co-ordination or agency function with the master account being a centralized point for a series of book entries to meet the pre-determined target balances for the pool members. Given this relatively low level of functionality, the cash pool leader’s remuneration as a service provider will therefore generally be limited.

The draft report contains two examples.

In the first example the functional analysis shows that the cash pool leader does not bear any risks, but merely performs a co-ordination function, i.e. the cash pool leader does not perform the functions nor assumes the risks of a bank. Therefore, the remuneration would not be equal to the remuneration a bank would expect, e.g. the interest spread between deposits and loans. Accordingly, the cash pool leader would earn a reward in line with with the service functions it provides to the pool.

The second example is a more interesting one. In the example the cash pool leader is the group treasury company that undertakes a range of different financial transactions both intra-group and externally and that provides treasury services to the group including strategy, management of group liquidity. Also, the cash pool leader is responsible for deciding how to invest surplus funds or fund any shortfall. In this case, the remuneration should therefore compensate the cash pool leader for the functions it performs and the risks it assumes. According to the draft report this may include (part of) the spread between the borrowing and lending positions which it adopts. However, it should also be borne in mind that the other group members which participate in the cash pool would still only do so if this leaves them no worse off than their next best option.

It is evident that the ALP has some problems with the comparability in cash pool arrangements, given the fact that the draft report includes three possible rewards schemes for cash pool members.

The above can be summarized as follows:


For tax payers, guarantees have always been a difficult area within the field of finance and certainly also for tax authorities. We experience that this area of finance is also a topic in which we are asked for support.

The draft report discusses this area and gives more guidance on explicit guarantees, implicit guarantees and cross-guarantees. In this respect, we refer to the overview in the below. In our follow up contribution, we will also go into the area of guarantees with more details on this guidance and our practical experiences.

Captive Insurance

The final chapter of the draft report is on Captive Insurance, which is a topic that was already more on the radar of tax authorities.

The report raises the question how to distinguish between real insurance activities and a more centralized administrative role and responsibilities.

The initial question is whether the transaction under consideration concerns an insurance risk distribution, with the pooling of a portfolio of risks by which the insurer reduces the impact of individual claims.

Large commercial insurers rely on having sufficiently large numbers of policies with similar probabilities of loss to allow statistical laws of averages to apply and to permit an accurate modelling of the likelihood of claims. The insurer also maintains a portfolio of risks for which it has a capital reserve based on regulatory needs and rating agency requirements. A captive insurer within an MNE may however lack the scale to achieve a significant risk diversification and may lack sufficient reserves to meet additional risks represented by the relatively less diversified portfolio of the MNE group. In that case, the accurate delineation of the actual transaction may indicate that the captive is operating a business other than an insurance activity.

Another interesting example deals with a company that sells goods with the possibility for buying an additional insurance policy. According to the draft report this could lead to insurance results that are too high for the captive insurance company.

Final comment

The draft report of the OECD on financial transactions again gives a clear signal that MNE’s have to be prepared and should invest in governance in the field of transfer pricing: i.e. in policies, sufficient resources, adequate substance and robust documentation.

If you have any questions or remarks, please feel free to give us a call or send an email.

Quantera Global Finance Team

Theo Elshof  LinkedIn      
Managing Director

Arnas Laurynas LinkedIn
Executive Director UK

Stefan Ubachs LinkedIn
Senior Manager

Adriaan van der Heijden LinkedIn
Junior Manager

Nard Donders LinkedIn