Introduction
On 11 February 2020, the OECD released transfer pricing guidance on financial transactions (the Guidance). This has been the first of its kind and will clarify the application of transfer pricing principles to financial transactions. The Guidance now forms Chapter X of the recently updated OECD Transfer Pricing Guidelines for Multinationals and Tax Administrations, January 2022.
The Guidance covers common financial transactions such as intragroup lending, cash pooling, hedging, guarantees and captive insurance as well as the issues related to the pricing of these transactions. Topical issues such as the application of implicit support in lending transactions, intragroup lenders that have limited or no substance, the terms and conditions of funding arrangements and how these compare against external funding and the appropriate remuneration due to cash pool leaders depending on their functionality are extensively addressed.
The following sets out the key highlights of the Guidance.
Accurate delineation of the transaction
Section B sets out the principles that govern the accurate delineation of a financial transactions. It outlines how the accurate delineation of transactions can be used as a framework for evaluating all the terms of the transaction, particularly whether intragroup funding should be treated as debt. The factors that should be taken into consideration include evaluating debt capacity of a borrower, purpose of the loan and ability of the borrower to repay the debt.
The concept of options realistically available is also discussed as part of the evaluation of the debt from the perspective of both the borrower and the lender. Guidance is also provided on how to treat lenders that have limited or no substance. It introduces the concept of risk free returns for lenders who lack the capability or do not perform the decision making functions and do not control the risk associated with investing in a financial asset.
Treasury functions
Treasury activities are discussed under Section C. While the guidance points out the importance of managing group finances, it distinguishes between a decentralised and a centralised treasury function in terms of the levels of relative autonomy the subsidiaries have with respect to financing and liquidity management decisions. Where treasury functions are a support service and not the core activities of the group, the guidance on intragroup services that is contained in Chapter VII of the OECD Guidelines may be more appropriate.
“The Transfer Pricing Guidelines continue to shape dialogue in respect to financial transactions, particularly when disputes with tax authorities arise.”
Intragroup loans
Several factors should be taken into account with respect to intragroup loans:
1. Two-sided approach - The perspective of both the lender and the borrower should be considered, particularly in terms of the commercial considerations of the transaction such as credit worthiness and credit risk.
2. Use of credit ratings - While estimated credit ratings are generally considered to be a helpful tool in assessing creditworthiness from a lender’s perspective, both quantitative and qualitative factors that influence a rating should be considered.
3. Effect of group membership - This is important in evaluating whether the terms and conditions of the intragroup debt are similar to the group’s external funding policies. Implicit group support is also a key consideration however, it depends on factors such as the importance of the subsidiaries relative to the group or parent company. Further, the usage of the group’s credit rating as a substitute for the rating of a subsidiary should only be done where the stand alone rating and implicit guarantee would not lead to a reliable outcome, the subsidiary benefits from a strong implicit group support, and the indicators of the subsidiary’s creditworthiness do not differ significantly from the group’s.
4. Covenants - Although typical for third party agreements, these are less likely to be included in intercompany agreements. However, it is important to determine if, in practice, such covenants would have existed between independent parties and whether that would impact pricing.
5. Pricing approaches - Different pricing approaches are considered and the abundance of potentially comparable market information makes it easier to apply the Comparable Uncontrolled Price (CUP) method. Specifically, Cost of funds can be a potential approach to loan pricing by reference to the cost of funding incurred by the lender cost of funding plus a profit margin. However, the options that are realistically available to the borrower must be considered when applying this approach for example the borrower’s ability to obtain funds under better terms. Instruments such as credit default swaps may be used to calculate risk premium although other factors other than default risk that could impact comparability ought to be considered such as the volatility of such instruments which may be reflected in the spreads. Where reliable comparable uncontrolled transactions cannot be identified, economic modelling tools may be used however as such models do not represent actual transactions, comparability adjustments would be required. Bank letters or opinions would not generally be regarded as providing evidence of arm’s length pricing given that they do not represent committed funds or executed transactions.
Cash pooling
The Guidance highlights the importance of the allocation of synergies that arise from the deliberate and concerted action of all members. The benefits should be shared among the pool members subject to the determination of the appropriate level of reward for the cash pool leader. However, the reward for the cash pool leader should depend on the accurate delineation of the leader’s functions, assets and risks assumed in relation to the cash pooling arrangement.
The remuneration could either be a service based return or a spread-based return for lower and higher risk activities. With regard to rewarding cash pool members, the general rule is that the members should be better off than if the cash pool did not exist. Members of a cash pool should ideally benefit from improved interest rates as well as other benefits such as reduced exposure to banks.
Hedging
The Guidance acknowledges the use of hedging as a risk management tool especially against forex or commodity price volatility. However, it is important to ensure that parties to the external hedge and the underlying transaction match to avoid situations where only the group position is protected. Ultimately, the options realistically available to both the borrower and lender should be considered as well as the group’s treasury policy.
Financial guarantees
Financial guarantees are covered by Section D of the Guidance. Specifically, guarantees should be legally binding on the part of the guarantor to assume a specified obligation of the debtor if they were to default on the debt obligation. Non-binding commitments such as letters of comfort involve no explicit assumption of risks and should be treated as arising from passive association and not from the provision of a service for which a fee would be payable. However, where a guarantee results in more favourable interest conditions, an arm’s length guarantee fee would be payable. Where the guarantee increases the borrower’s capacity to borrow, the Guidance suggests treated the additional capacity as a loan to the guarantor followed by an equity contribution by the guarantor to the borrower. The financial capacity of the borrower to fulfil its obligations should also be considered as part of the delineation of financial guarantees. Factors that should be considered in assessing the capacity include the credit rating of the guarantor and the borrower as well as the business correlation between them when adverse market affects both parties simultaneously.
Pricing of guarantees
While several approaches are discussed, the CUP method is the most reliable approach to determining arm’s length guarantee fees provided that sufficiently comparable transactions exist. Other approaches included the yield approach which quantifies the benefit to the borrower by determining the spread between the interest cost to the borrower without the guarantee and the interest cost with the guarantee. The cost approach on the other hand focuses on the risks borne by the guarantor in terms of the costs that the guarantor will incur in the event of default by the borrower.
Captive Insurance
Captive Insurance, through which groups may choose to consolidate certain risk is addressed under Section E of the Guidance. It defines captive insurance as an insurance undertaking or entity substantially all of whose insurance business is to provide insurance policies for risks of entities of the group to which it belongs. A concern that commonly arises with captive insurers is whether the transaction concerned is genuinely covered under the insurance and particularly whether the risk exists. The Guidance discusses a number of indicators, all or substantially all of which would be found if captive insurance was found to undertake a genuine insurance business. These include:
- there is diversification and pooling of risk in the captive insurance;
- the economic capital position of the entities within the MNE group has improved as a result of diversification and there is therefore a real
- both the captive insurance and any reinsurer are regulated entities with broadly similar regulatory regimes and regulators that require evidence of risk assumption and appropriate capital levels;
- the insured risk would otherwise be insurable outside the MNE group;
- the captive insurance has the requisite skills, including investment skills, and experience at its disposal;
- the captive insurance has a real possibility of suffering losses.
The Guidance notes that if the delineation of actual transactions involving captive insurers requires identifying whether the captive is exercising control on the assumption of underwriting risk, to determine whether the risk and associated return should be allocated to the captive or to the members of the group exercising such control.
Implications of the Guidance
As economies open up and business activity rebounds following two years of sustained disruption caused by the COVID-19 global pandemic, no doubt that tax authorities will be looking for gaps in transfer pricing arrangements involving financial arrangements. Without a doubt, the Guidance will shape transfer pricing dialogue in respect to financial transactions, particularly when disputes with tax authorities arise. Therefore, it is important for companies to revisit the guidance and assess the robustness of their existing group intercompany financing policies.
