On 11 February 2020, the OECD released its first transfer pricing guidelines (“TP Guidance”) on financial transactions (OECD release) specifying how multinational companies should price intercompany financial transactions. Such guidelines constitute a follow up on the Base Erosion Profit Shifting (“BEPS”) Action 4 (‘Limiting base erosion involving interest deduction and other financial payments’) and Action 8-10 (‘Aligning transfer pricing outcomes with value creation’) having been published by the OECD in 2015 and which needed further guidance on transfer pricing aspects. The newly published guidelines shall significantly contribute to consistency in the interpretation of the arm’s length principle and help avoid transfer pricing disputes as well as issues of double taxation.
The report gives guidance on the application of the arm’s length principle to intercompany financial transactions (I) and the pricing of specific financial transactions (II), together with examples to illustrate the principles discussed in the report.
Application of the arm’s length principle to financial transactions
As one should first determine what should be treated as debt between related parties, the TP Guidance lists the following characteristics in order to identify debt instruments:
- The absence of a fixed repayment date;
- The obligation to pay interest;
- The right to enforce payment of principal and interest;
- Status of the funder in comparison to regular corporate creditors;
- Existence of financial covenants and security;
- Source of interest payments;
- Ability of the recipient of the funds to obtain loans from unrelated lending institutions;
- Extent to which the advance is used to acquire capital assets;
- Failure of purported debtor to repay on due date or to seek a postponement.
The TP Guidance further suggests that where it is clear according to good-faith financial projections of the creditor that a loan will not be repaid on time by the counterparty (being part of the same multinational enterprise (MNE) group), only the amount that an unrelated party would have been willing to advance would be classified as “loan” for the purpose of determining the amount of interest the counterparty would have paid at arm’s length. The remaining amount would be considered an advance of funds (i.e. equity).
In a second step, the commercial or financial relations between related parties should be assessed, so that the TP Guidance underlines the need to analyse the factors affecting the performance of businesses in the industry sector in which the MNE group operates. The analysis takes account of the fact that MNE groups operating in different industries may require different amounts and types of financing due to different capital intensity levels between sectors or may be affected in different ways by government regulations.
For transfer pricing purposes, the actual transaction needs to be identified by means of the economically relevant characteristics of the transactions, including:
- Contractual terms of the transaction (Evaluation of written agreements, actual conduct of parties, analysis of economic principles that usually govern relationships between independent parties in comparable circumstances);
- Functions performed, assets used and risks assumed (Where a group company other than the lender manages the risks of a loan and has the financial capacity to bear those risks, then the lender should only be credited with the risk-free return element of the interest income);
- Characteristics of the financial instrument (Amount, maturity, schedule of repayment, nature and purpose of the loan, level of seniority and subordination, geographical location of the borrower, currency, collateral, guarantee, fixed or floating interest);
- Economic circumstances of the parties and of the market (Currencies, geographic locations, local regulation, business sector, timing of the transactions);
- Business strategies pursued by the parties (Related parties should be allowed to enter into loans where the initial financial ratios would be poor if the borrower’s business plans and forecasts show that when it reaches its steady state, its ratios will be strong enough).
According to the TP Guidance, interest could be disallowed if the lender could have found a more profitable use for the funds, or if the borrower did not actually need all of the funds, or if borrowing so much would damage its credit rating, its market reputation and its access to the capital markets.
The pricing of intra-group loans
The report provides guidance on determining whether the rate of interest provided for in a loan agreement is at arm’s length. In order to avoid the granting of favourable interest rates on loans within MNE groups, the TP Guidance stresses that the lender and borrower of intra-group financing transactions need to apply the same evaluation process as independent parties. The lender must carry out a thorough credit assessment of the potential borrower in order to identify and evaluate the risks involved (e.g. identifying the business and purpose of the loan, source of repayment); they should consider methods of monitoring and managing the risks of the borrower failing to meet payment obligations. The borrower should seek to optimise his weighted average cost of capital and have the right funding available to meet both short-term and long-term objectives/needs. He must also analyse the risk of failing to meet timely repayment obligations (interest and principal).
a) Determination of credit rating
With regards to the determination of credit rating, the TP Guidance reiterates that the credit rating of an MNE or MNE group is an opinion about its general creditworthiness, which is determined based on the MNE’s capacity and willingness to meet its financial obligations in accordance with the terms of those obligations, in comparison to other borrowers. The credit rating can be used for identifying potential comparables when determining an arm’s length interest. As such, a lower credit rating will indicate a higher risk of default and be expected to result in a higher rate of return for lenders. The guidance draws attention to the fact that credit rating methods used in publicly available financial tools may differ significantly from those applied by independent rating agencies to determine official credit ratings. Publicly available tools normally use only a limited amount of quantitative data to determine a credit rating and are not as rigorous as independent rating agencies and may lack clarity in the rating processes. Finally, the TP report underlines that MNEs must properly document the reasoning and selection of the credit rating used for a particular MNE when pricing intra-group loans and other controlled financial transactions.
The guidance also acknowledges that the relative status of an entity within the group and any potential group support could have an impact on the entity’s credit rating of a debt issuer as group entities are more likely to receive an incidental benefit arising solely by virtue of group affiliation. Where there is evidence of no support by the MNE group, it is possible to assess the entity on the basis of its own stand-alone credit rating only. Generally, the stand-alone entity credit rating is given preference. The report clarifies that an MNE’s group rating should only be used when an MNE entity is important to the group and its indicators of creditworthiness do not differ significantly from those of the MNE group. Overall, the group credit rating would only be appropriate, if it is determined to be the most reliable indicator of the MNE credit rating in light of all the facts and circumstances.
b) Determining the arm’s length interest rate of intra-group loans
The report considers the CUP method to be the most suitable method to use for intra-group loans especially due to the large amount of public data available and the frequency of such transactions between independent borrowers and lenders. Furthermore, a comparable does not necessarily need to be a stand-alone entity but could also be a member of an MNE group which has borrowed from an independent lender or a member of a different MNE group, provided all economically relevant conditions are sufficiently similar. Yet, even in the presence of an external comparable with similar features, it always needs to be checked first whether an internal comparable is available. As an alternative to the CUP method, the report suggests to use in the absence of comparable uncontrolled transactions the so-called ‘cost of funds’ method. The method compares the borrowing costs incurred by the lender in raising the funds to lend as well as other costs related to arranging and servicing the loan. Economic modelling should be used only where no reliable comparable can be identified by using another method. Credit default swaps are not recommended as they are subject to high volatility that may affect their reliability. Lastly, the TP guidance rejects bank opinions as a means of providing evidence of arm’s length terms and conditions as they are not based on comparison of actual transactions, but merely a written opinion of an independent bank.
Additionally, the TP Guidance provides further input on other intra-group financial transactions, such as cash pooling, hedging, financial guarantees and captive insurances and suggests specific indicators to be used in order to ease the transfer pricing analysis.
Final comments regarding the remuneration of parties unable to control the risk of transactions
A risk-free rate of return is the hypothetical return expected on investment with no risk of loss (i.e. government-issued securities). In the absence of the funder having any capability or decision-making functions to control the risk associated with investing in a financial asset, he will only be entitled to a risk-free return as an appropriate measure of the profits he is entitled to retain. According to the TP guidance, the security would need to be issued in the same currency as the investor’s cash flows; both the security and the controlled transaction should preferably be issued at the same time and have the same maturity. Where the funder exercises control over the associated financial risk, without controlling any other risk, it would generally expect only a risk-adjusted rate of return on its funding. The risk-adjusted rate of return should include two components; (i) the risk-free rate and (ii) a premium reflecting the risks assumed by the funder. The determination of the risk-adjusted rate of return can be based on different approaches, such as the return of a realistic alternative investment reflecting the same risk, the cost of funds or by adding a risk premium to the risk-free return based on the information available in the market.
The OECD’s TP Guidance increases the compliance burden of MNEs and widens their documentation obligations. Even though the TP Guidance is not legally binding as such, it is likely that the tax administration will invoke it as a source of interpretation for transfer pricing purposes. In doing so, the tax administration could, for instance, requalify an intra-group loan into an equity contribution and hence deny interest deductions and impose withholding tax on dividends, provided no appropriate and precise documentation is produced by the MNE. Careful review of intra-group financial transactions as well as their proper documentation should thus be at the top of taxpayers’ agenda.