On 3 July 2018, the OECD launched a consultation on the transfer pricing of financial transactions by publishing the first draft of a new chapter of the OECD Transfer Pricing Guidelines for Tax Administrations and Multinational Enterprises. Consultation comments were invited until the end of the consultation period on 7 September 2018. On 11 February 2020, the OECD published the final conclusions of its project in the form of a new chapter X of its Transfer Pricing Guidelines for Tax Administrations and Multinational Enterprises1 (except for certain text on the risk-free and risk-adjusted rate of return which will be added to Section D.1.2.1 in Chapter I, immediately following paragraph 1.106).
This new chapter can help to fill a large gap in the Transfer Pricing Guidelines, which has resulted in high profile disputes in this area having to be settled by courts around the world on the basis of expert evidence on how independent parties approach such transactions. The issues covered by the new chapter are especially relevant to Luxembourg, given its attractiveness to financial institutions and as a location for non-financial companies in which to place their group treasury centres.
The chapter recommends some controversial approaches and it is clear that all businesses with related party financial transactions will need to review how they price them, that the agreements are properly worded, that both parties are able to perform their roles in the transaction, that they actually do so in practice, and that the quantum of the transactions is not excessive.
The first part of the chapter provides guidance on the application of the arm’s length principle to financial transactions, while the remainder provides guidance on the pricing of financial transactions such as loans, cash pooling, hedging, financial guarantees and captive insurance.
The key elements of the new guidance may be summarised as follows.
1. Application of the arm’s length principle to financial transactions
1.1. Identifying what should be treated as debt for tax purposes
The new guidance states that one of its main purposes is to clarify the accurate delineation analysis under Chapter I of the Transfer Pricing Guidelines in the context of financial transactions. In this respect, it considers that the following economically relevant characteristics may be useful indicators depending on the facts and circumstances:
the presence or absence of a fixed repayment date;
the obligation to pay interest;
the right to enforce payment of principal and interest;
the status of the funder in comparison to regular corporate creditors;
the existence of financial covenants and security;
the source of interest payments;
the ability of the recipient of the funds to obtain loans from unrelated lending institutions;
the extent to which the advance is used to acquire capital assets; and
the failure of the purported debtor to repay on the due date or to seek a postponement.
As an example, it considers that part of a debt should be treated as equity (with no interest tax deduction) if in light of all good-faith financial projections at the time of granting, it is clear the borrower will not be able to service the full amount of the debt upon maturity.
1.2. Identifying the commercial or financial relations
The new guidelines reiterate the need to accurately delineate financial transactions by analysing the factors affecting the performance of the business in the relevant industry sector. The accurate delineation of a transaction should begin with the identification of the economically relevant characteristics of the transaction, i.e. the commercial and financial relations between the parties, and the conditions and economically relevant circumstances attaching to those relations, including:
an examination of the contractual terms of the transaction;
the functions performed, assets used and risks assumed;
the characteristics of the financial instruments;
the economic circumstances of the parties and of the market; and
the business strategies pursued by the parties.
Based on the above, the new guidelines consider that if, for example, a group as a whole has targeted a particular credit rating, then this could be a reason to deny an interest deduction for any part of a related party loan to a group member which would reduce its standalone rating below that level. Also, 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.
1.3. Economically relevant characteristics
According to the new guidelines, the following economically relevant characteristics should be considered to analyse the terms and conditions of the financial transaction or to price said transaction:
contractual terms: written agreements but also the actual conduct of the parties and the economic principles that generally govern relationships between independent parties in comparable circumstances have to be analysed;
functional analysis: the functions performed, the assets used and the risks assumed need to be identified. In this respect the guidelines remind that if 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 instruments: e.g. 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: e.g. currencies, geographic locations, local regulation, business sector, timing of the transaction; and
business strategies: e.g. 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.
2. Intra-group loans
2.1. Lender’s and borrower’s perspective
According to the new guidelines, both the lender’s and the borrower’s perspective need to be considered. Practical guidance as to the necessary analysis is provided, such as, on the lender’s side, the necessity to perform a credit assessment to identify and evaluate the risks, as well as methodologies to manage these risks. A very controversial suggestion is further made that shareholder loans could be priced as if they were secured, even if they are not secured according to the loan agreement, because “the parent already has control and ownership of the subsidiary”. Along the same lines, it states that borrowers would usually offer security over their assets in order to borrow more cheaply. On the borrower’s side, the realistically available alternatives need to be considered, keeping in mind that independent borrows would always seek the most cost effective solution.
2.2. Use of credit ratings
The new guidelines discuss the possible credit ratings, namely the rating of the issuer, the group or the issuance, as well as the use of publicly available credit ratings – which are considered informative – and publicly available financial tools to calculate credit ratings – which are not necessarily sufficiently reliable on a stand-alone basis.
2.3. Effect of group membership
Another controversial issue is further analysed, namely implicit group financial support for a borrower, where the guidelines indicate that such adjustments should be made to the standalone credit rating of the borrower when determining the interest rate. However, the guidelines warn against automatically assuming the same credit rating as the group because this should only be done where the borrower is important to the group and has similar financial ratios.
2.4. Use of group credit rating
Although separate entity credit rating seems to be favoured, the new guidelines accept the use of the group rating if the separate entity credit rating is not reliable.
The guidelines analyse the purpose of the contractual covenants between unrelated parties and suggest that where loan agreements between affiliates do not include the usual financial covenants, the tax administration may be justified in imputing them and assuming a lower interest rate accordingly.
2.6. Arm’s length interest rate
Different approaches regarding the pricing of intra-group loans are presented:
CUP (comparable uncontrolled price) method: this method is favoured, including the use of internal CUPs;
loan fees and charges: these should also need to be justified in the same way as any other intra-group transaction;
cost of funds: the guidelines warn against using the lender’s cost of funds as a basis for setting the interest rate as the borrower may have been able to borrow from a party with a lower cost of funds. There is however an exception to this rule, namely where capital is borrowed from an unrelated party and then passes from the original borrower through one or more associated intermediary enterprises, as a series of loans, until it reaches the ultimate borrower. In such cases, where only agency or intermediary functions are being performed, it may not be appropriate to determine the arm’s length pricing as a mark-up on the costs of the services but rather on the costs of the agency function itself;
credit default swaps: the guidelines caution against basing interest rates on credit default swaps as credit default spreads are volatile and move in response to other factors such as the liquidity of the credit default swap market;
economic modelling: although the reliability of economic models is questioned and their use subject to comparability adjustments, they seem to be acceptable in situations where no reliable comparable uncontrolled transactions can be identified; and
bank opinions: bank opinions are not based on a comparison of actual transactions and hence not according to the arm’s length principle. Hence, they are not accepted as evidencing arm’s length terms and conditions.
3. Cash pooling
The new guidelines state that a cash pool header carries out minimal functions in a notional (as opposed to physical) cash pooling arrangement and therefore it should not receive its remuneration through an adjustment to the interest rates. It also suggests that longer term balances in cash pools could be recharacterised as involving terms with a different interest rate.
The guidelines further describe how the reward for the cash pool header should be determined by its control over, and ability to bear the costs of, liquidity risk and credit risk, e.g. a header of a physical cash pool which does not have these risk functions is not credited with any of the interest spread, whereas where the cash pool header borrows externally, sets the intra-group interest rates and is at risk for any differences between the rates it sets with other group members and the rates at which it transacts with the independent lenders, and it bears credit risk, liquidity risk and currency risk for intra-group finance, and then it should be rewarded through the interest spread.
Rather surprisingly, the guidance passes over the key question of how the “synergy” benefits of cash pooling should be allocated between the participants, except to state that it will depend on their functions, risks and assets.
4. Financial guarantees
The new guidelines state that the benefit of a financial guarantee to a borrower is that which is net of the impact of any implicit group support. The price which a borrower would pay for a guarantee is determined by the interest rate saving resulting from the guarantee. However, this is a maximum, relative to which there would be a bargain. Where a guarantee also increases the amount that can be borrowed, this additional borrowing should be recharacterised as equity and the guarantee fee should only be paid as a percentage of the remaining debt.
The guidance is refined by noting that a guarantee from a party with a similar credit rating can still provide a benefit by allowing the lender to access wider recourse, but only to the extent that the guarantor and borrower’s risks of default are not strongly correlated.
The guarantor’s expected cost sets a floor to the guarantee fee. This could be its loss given default multiplied by the probability of default, and the cost of setting aside the capital at risk.
5. Captive insurance
Substantial reference is made in this part of the chapter to Part IV of the OECD’s Report on the Attribution of Profits to Permanent Establishments.
A checklist is provided of features of a captive insurance arrangement which could indicate whether it should not in fact be respected as a shifting of risks for which a fee should be paid. Possible methods are discussed for pricing related party insurance premiums, including third party premiums (adjusted for the absence of distribution and sales costs), an “actuarial” build-up of the administrative costs and expected losses plus a return on the capital required to cover the expected losses, achieving the arm’s length profitability for the activity (while noting that this return should only be against that part of the captive’s capital that is needed to cover its risks), or an administrative coordination fee which leaves the synergy benefits of accessing the external insurance through one company to be shared between the insured companies.
6. Implications for taxpayers
Although the new rules provided by the OECD are strictly speaking guidance as opposed to binding law, it is most likely that the tax administrations of OECD member countries that have enshrined the arm’s length principle in their domestic TP legislation (such as Luxembourg) will follow them when assessing financial transactions between related parties.
The application of the new guidance may allow tax administrations to reclassify intra-group loans into equity contributions for transfer pricing purposes, thus denying interest deductions and applying potential dividend withholding taxes, in cases where the taxpayer is not able to produce a comprehensive and complete transfer pricing documentation. The scope of transfer pricing documentation now seems to be significantly widened and must include new justifications regarding, for example, the debt classification, the capacity of the borrower to obtain third party financing, to maintain a better credit rating, etc. A notable theme of the new guidance is the permission for tax administrations to impute lower interest rates on loans than that actually agreed between the parties on the basis of certain economic assumptions.
Based on the above, we strongly recommend to taxpayers engaged in intra-group financial transactions to double check compliance with the new guidance of their transactions and related transfer pricing documents in order to avoid reclassification issues or interest adjustments.