In 2020, the OECD published a new revised document, “Transfer Pricing Guidance on Financial Transactions”, which aims to further define financial transactions in terms of pricing of related party transactions, i.e., transfer pricing. The discussion draft of the 2020 guidance was published in 2018 and has since drawn suggestions and comments from member states. This article provides an overview of the main topics in the latest version.
Overview of the delineation of financial transactions
Transfer prices must correspond to arm’s length principle and determining the correct arm’s length price range requires the details of the transaction to be taken into consideration – i.e., delineated. The delineation of financial transactions must take into account the business cycle, local regulations and the specifics of the sector, as the structure of companies' short-term cash flows in each sector depends on these parameters. When executing financial transactions, related parties must evaluate the transaction in a neutral manner and consider all options from the perspective of both the financing source and the beneficiary, including alternative sources of financing outside the group. When pricing a specific transaction, an analysis of functions must be performed, which must be based on the assets involved in the transaction, risk management and the functions performed.
Treasury functions include managing the corporate group's funds and liquidity, the company's financial management, management of equity and loan capital, and communication with credit institutions. In a multinational company, the aforementioned functions may be centralised according to the structure of the company and the complexity of the functions. The updated version of the OECD guidance notes that the role of treasury functions often supports the core activity. The treasury strategy is developed at the group level and therefore the risks also take shape based on the strategy, not just from the functions. If a treasury unit has additional functions and risks due to the specifics of the sector (for example, in the banking sector, the treasury has a larger number of duties), this should be explained in the transfer pricing documentation. The documentation must substantiate how the additional tasks and risks relate to the principal business activities and how they affect the remuneration paid for treasury to a company with a treasury function.
In the case of intra-group loans, attention is paid to three aspects: assessing the credit rating of the group companies, taking into account the effect of being a part of the group and determining arm’s length interest rates. A group-wide credit rating can be a useful starting point, and there are situations where the group's rating is considered suitable for the companies in the group to set arm’s length interest rates. On the other hand, if the credit risk for a particular company is not the same as that of the group or the parent company, a new rating analysis must be performed using the ordinary quantitative and qualitative approach to credit ratings.
Credit ratings should be set taking into account the appropriate guarantees that the borrower is expected to obtain as a result of being a member of the group, especially if that member is considered important for the entirety of the business activity. The guidance calls for a more detailed assessment of whether the effect of indirect support can range from the equivalent of a full guarantee from the parent company to little or no support in cases where the parent company refuses to support a non-profitable affiliated company.
The third main focus of intra-group loans is the establishment of interest rates on loans to related parties. The updated guidance emphasises comparability – in other words, the currency, term, credit risk rating, collateral and other factors that may apply to a particular loan must be taken into account when setting interest rates. The credit analysis also includes consideration of the potential impact of indirect support of group membership, as discussed above.
The use of cash pools is popular among multinational companies, enabling better cash flow management and savings on expenses on interest and service fees. According to the guidance, the remuneration of a member or group company in such a cash pool system should be linked to liquidity and credit risk, as a participant in a cash pool may not have merely a financial edge. In the case of cash pools, it is necessary to analyse whether it is fair to recognise a transaction as a short-term deposit to the account or whether it is a long-term deposit or a long-term loan.
The remuneration of the members of the cash pool is calculated through the market interest rate applied to the account. In addition, it is emphasised that the cash pool agreement should benefit all members, taking into account the realistically available alternatives (e.g., other sources of funding). Potential benefits that cash pool members receive include better interest rates, constant access to liquidity and less risk exposure with a foreign bank.
Hedging is often used to counterbalance fluctuations in international exchange rates or asset values. While an individual company has full control of whether to take a risk or engage in hedging, the approach taken by companies in a group is different. In a group of companies, hedging is often centralised to increase the effectiveness of intra-group exploitation of funds. With such a structure, hedging may not be structured from the perspective of the companies, but at the group level. If hedging contracts are centralised, this function can be considered the provision of a service for which the service provider must receive an arm’s length fee.
The updated guidance devotes additional attention to legally binding financial guarantees. Before concluding a guarantee agreement, the borrower must neutrally analyse the economic benefits arising from the financial guarantee agreement. Here, two beneficial aspects should be distinguished from a transfer pricing perspective. The first benefit is an improvement in the situation of the borrower, which allows it to obtain a loan on better terms. The second benefit is that the financial guarantee increases the borrowing capacity. The guidance states that if the borrower's borrowing capacity increases as a result of the guarantee, the part of the loan that would not have been granted in the absence of the guarantee is characterised as a loan granted to the guarantor. In other words, it must be assessed whether the borrower is in a better position if it pays both interest and a guarantee fee (the borrower pays a fee to the group member for the granting of the guarantee) than if it were simply to pay interest without the guarantee. Therefore, the guarantee fee is only relevant if it improves the borrower's financial situation.
A captive insurer is a group company whose purpose is to provide insurance to other companies in the same group if the insurance providers on the market do not provide an appropriate insurance. Today, captive insurers are often set up in a tax haven; the parent company pays an insurance premium to that insurer and can deduct insurance costs from its profits. The new comments released by the OECD focus on whether the captive insurer is really able to manage the risks assumed should they materialise. In other words, similarly to other fields of transfer pricing, the guidance draws attention to whether the captive insurer has been created for a so-called fictitious purpose in order to reduce tax liability, or whether the insurer was essentially founded to hedge the company's risk. Transfer pricing documentation should fully reflect the expression of the captive insurer's ability to manage risks and thereby enable the group to be more capital efficient.
Risk-free and risk-adjusted rate of return
According to the guidance, an entity that does not perform functions related to financial asset management and does not control the risks involved should be entitled to earn only a risk-free return on its lending activity. In addition, unless altered by other factors, the borrower would be entitled to deduct the market-value interest rate in such a situation. The difference between these amounts is subsequently allocated to the counterparty performing the relevant risk control functions.
The guidelines recommend relying on government-issued securities to determining the risk-free rate. In this context, it is emphasised that certain characteristics should be aligned with the controlled transactions, including currency differences and the temporal proximity of the financial instruments (e.g. remaining maturity). In addition, the guidance describes the use of other reference sources, such as interbank interest rates and interest rate swaps.
The revised OECD Guidance is a step towards international tax clarity. Although the guidance does not cover all cases, it provides a wealth of practical advice on fair pricing of intra-group financial transactions. The amendments to the guidance are also likely to lead to stricter requirements for documenting transfer pricing, especially as regards the analysis of the actual circumstances and economic substance of the counterparties and the assumption of risks.
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