On 11 February 2020, the OECD published the new Transfer Pricing Guidelines on Financial Transactions. This publication represents a substantial advance on the initiatives carried out in 2015, following the publication of the Reports on Actions 4 and 8-10 of the BEPS project, as well as the draft for public discussion launched on 3 July 2018. The content of this new report has been incorporated into the wording of the 2017 OECD Transfer Pricing Guidelines as a new Chapter X, exclusively dedicated to financial transactions.
These new guidelines represent the first consensus document to clarify financial transactions between related companies, and they may help to fill a large gap in the OECD Transfer Pricing Guidelines, which has resulted in multiple disputes in this area.
Accurate delineation of the financial transaction
The first section emphasizes the importance of correctly delineating a financial transaction between related entities in order to be able to subsequently determine a remuneration that complies with the arm’s length principle. Analysing the factors affecting the sector in which the multinational group (MNE) operates, and the “economically relevant characteristics” (comparability factors) of the financial transaction will be necessary, in first place, to determine whether what the parties call a loan is indeed a loan from a tax point of view.
Therefore, if it were concluded that the capital and debt structure of the borrowing entity of the group is different from that which an independent company would have adopted in comparable circumstances, then the excess of debt may be reclassified for tax purposes as a contribution to equity capital.
The next section describes the main aspects of the treasury function within an MNE group. In particular, the OECD provides guidance on (i) intra-group loans, (ii) cash pooling and (iii) hedging.
With regard to intra-group loans, the report refers to a number of factors that should be considered in the determination of arm’s length interest rates, including the following:
- Two-sided perspective.- Intra-group loans must be evaluated from the perspective of both the lender and the borrower, assessing the risks borne, the contractual terms and the compensation policy;
- Credit rating.- It indicates the creditworthiness of the borrower. A number of qualitative and quantitative factors may influence a company’s credit rating;
- Implicit support.- The OECD report emphasizes the importance of the implicit support of the group, even if no contractual guarantee is given. Thus, entities that have a strong position and are strategically important within the group could benefit from the group’s credit rating.
- Covenants.- The OECD indicates that covenants are not usually included in intra-group loans, and therefore the existence of implicit covenants and their consequent impact on the terms of the loan should be assessed.
- Determining the arm’s length interest rate of intragroup loans.- The OECD report outlines different approaches to determine arm’s length interest rates on intra-group loans.
The following methodologies are analysed:
- Comparable Uncontrolled Price (CUP) method.- The search of comparable transactions should take into account the credit rating of the borrower and the terms of the loan, making any comparability adjustments when necessary.
- Cost of funds.- In the case of not finding comparable transactions, the lender’s cost-of-funds approach could be adopted, with the addition of a risk premium in case of default and a profit mark-up.
- Credit default swaps (CDS).- The CDS reflects the credit risk of an asset.
- Economic modelling.- This approach is based on the design of a financial model based on the risk-free interest rate by adding certain variables such as default risk, liquidity risk or expected inflation.
- External bank opinions.- These informal letters cannot be considered as comparable as they do not constitute an actual loan offer.
Regarding centralized cash management systems or cash poolings, the new guidelines begin by analyzing the possible structures, which may be physical or notional, and highlight the importance of both the functional profile of the cash pool leader and the entities participating in the transaction, as well as correctly locating the significant economic risks in order to establish an appropriate remuneration policy.
An important consideration consists of analysing whether, in the cash pooling debit or credit positions that are extended over time, the correct delineation of the related-party transaction may imply that these positions should be treated for tax purposes as generating long-term remuneration and, therefore, susceptible to generate a different interest rate.
The OECD report mentions that in financial transactions between related entities it is common practice to use instruments aimed to transfer risk between the different entities, either explicitly or implicitly. The situation is different when dealing with independent entities, which cannot benefit from belonging to a group. In relation to this issue, it is essential to identify whether these functions are being performed centrally by a group entity and, if so, to establish an arm’s length remuneration for the company assuming this role.
Section D of the report describes financial guarantees as legally binding commitments where the guarantor must assume the obligations undertaken by the guaranteed in case of default. In particular, the OCDE provides guidance on the qualification of a guarantee and approaches to pricing.
Two types of guarantees should be distinguished in this regard, firstly, the implicit guarantees, which result from implicit support due to the effect of group membership, and on the other hand, the explicit guarantees, in which a legal commitment is undertaken that leads to the explicit assumption of risks in the transaction and which must therefore be compensated.
As well as intra-group loans, the OECD report lists several approaches for establishing the guarantees’ compensation, such as (i) Comparable Uncontrolled Price (CUP) method, (ii) the yield approach, (iii) the cost approach, (iv) the valuation of expected loss approach, and (v) the capital support approach.
Section four of the new OECD guidelines on captive insurance within multinational groups emphasizes the need to ensure that companies engaged in these activities have the capacity to demonstrate their financial strength to bear the risks insured, as well as their capability to meet any claims that may arise.
In order to establish remuneration that complies with the arm’s length principle, different approaches are proposed, analyzing their strengths and weaknesses, to reach a methodology with two phases of analysis that takes into account both (i) the profitability of claims and premiums, and (ii) a return on capital.
Risk-free and risk-adjusted rates of return
In the last section (which is incorporated into Chapter I of the OECD Transfer Pricing Guidelines), the report on financial transactions analyses risk-free and risk-adjusted interest rates and their transfer pricing implications. In this regard, for the purpose of setting risk-free interest rates, the OECD provides that comparisons could be made with sovereign bonds, issued in the same currency and with a similar maturity, as well as with interbank interest rates, or interest rate swaps. For the determination of risk-adjusted interest rates, reference is made to each of the two elements to be included: (i) the risk-free interest rate, and (ii) a risk premium reflecting the risks assumed.
The publication of this new report is an opportunity for business groups to analyse if the transfer pricing policies they are currently applying in their related-party financial transactions are indeed in line with the OECD guidelines and recommendations and, if not, to propose the appropriate modifications or adjustments, supporting them with consistent transfer pricing documentation that takes into account these new recommendations.