By Stefan Ubachs – Senior Manager Quantera Global
Given the fungible nature of money, the use of intercompany debt has always been one of the easiest ways to achieve base erosion and profit shifting. In its BEPS project, the OECD has addressed these risks in various BEPS reports published in 2015 and 2016. BEPS Action 9 is one of the three BEPS Actions that deal with the alignment of transfer pricing outcomes with value creation. Where BEPS Action 8 focuses on intangibles and value creation, BEPS Action 9 specifically deals with risks and capital.
In 2018, we can expect further guidance on the arm’s length level of return in respect of financial transactions. Important aspects in respect of financial transactions are e.g. financial capacity, the use of cash boxes, intragroup guarantees and cash pool arrangements.
In the 2015 Final Reports on Actions 8 – 10, the OECD referred to the concept of “financial capacity” as a key element to determine an arm’s length remuneration for a group entity involved in intercompany financing.
Financial capacity to assume risk means that a company has access to funds to take on a risk or to lay off a risk and to bear the consequences of the risk if the risk materializes.
Next to financial capacity, control over risk is an important factor. Control over risk involves the following elements:
- The capability to take decisions related to the provision of funding;
- The capability to make decisions on whether and how to respond to risks associated to the funding;
- The capability to take decisions to mitigate these risks.
Obviously, the question rises how a taxpayer in practice has to deal with financial capacity. When does the taxpayer have sufficient financial capacity to assume risks and if not, what should be done to increase it?
In the 2015 Final Reports, the OECD also announced that it would issue guidance in respect of so-called “cash boxes”. A cash box can be defined as a capital-rich entity without any other relevant economic activities, which is therefore unable to exercise control over investments and other risks.
In order to align the remuneration for transfer pricing purposes with value creation, the OECD mentioned that a cash box entity should not be entitled to any premium returns. Therefore, the profits that the cash box is entitled to retain would be equivalent to no more than a risk-free financial return.
We can therefore expect that capital-rich entities without any relevant economic activities or material substance will be under scrutiny and may not be entitled to excess profits.
Obviously, it would be helpful for taxpayers to get guidance on what is considered as “relevant economic activity” in respect of financing companies. In any case it is clear that material and relevant substance remains a key focus for entities that perform financing activities within a group.
Another important element in respect of intercompany financial transactions are guarantees. Guarantees provided by other group companies can be explicit or implicit. Furthermore, guarantees can be downstream (provided by the parent company to the subsidiary), upstream (in which the subsidiary guarantees its parent’s debt), or cross guarantees (group companies reciprocally guarantee each other’s debts).
It would also be helpful to get additional guidance on how to deal with other credit enhancing arrangements, such as keepwell agreements or comfort letters.
For the group companies involved, the question is what the nature of the guarantee (or other credit enhancing arrangement) is and how it should be valued. For the guaranteed entity, it is relevant whether there is a benefit from the guarantee (e.g. a decrease in interest rate or an increase in its borrowing capacity) and how the guarantee / arrangement should be priced.
Cash pool arrangements
Another important financial transaction for multinational groups is a cash pool arrangement. In order to optimize the allocation of cash within the group, many groups have set up a cash pool arrangement in which group companies participate. Group companies that avail of excess cash deposit funds to the account of the cash pool, whereas group companies that require additional cash can draw from the cash pool account.
In order to meet the requirements of the arm’s length principle, participating in the cash pool should be beneficial for its participants. In addition, the cash pool leader should receive an arm’s length remuneration for its handling activities. A question that also rises, is how the risks of the cash pool should be allocated.
A key feature of a cash pool is the synergy benefit it generates for its participants. In a stand-alone situation, each group company would have to enter an own arrangement with its bank. As a result of the cash pool, excess cash of group companies can be provided to companies that have a cash deficit. First, the cash pool leader will have to be remunerated for its handling services. The question is how the remaining synergy benefit has to be divided amongst the cash pool participants. Are all cash pool participants (net contributors and borrowers) entitled to a part of the synergy benefit and which allocation key should be used?
Another relevant aspect is the delineation between a negative cash pool position and a loan. If a cash pool participant has a long-term cash pool deficit, can this still be considered as a cash pool position, or is it in fact a loan? If so, when did the conversion take place and what are the transfer pricing consequences?
Additional guidance in respect of cash pools would therefore be welcome.
Most multinational groups will have intercompany financial transactions within their group. As money is fungible, the use of intercompany debt has always been an easy way to achieve base erosion and profit shifting. Hence, the OECD has addressed intercompany financing in its BEPS Action Plan. It is expected that the OECD will release additional guidance on intercompany financial transactions.
Given the relevance of intercompany financial transactions for most multinational groups and the increased scrutiny by local tax authorities, it is important that taxpayers check their transfer pricing policy in respect of financial transactions.
The transfer pricing experts of Quantera Global are of course pleased to assist you if you require assistance.