Implications for actions

On 11 February 2020, the OECD released its report, Transfer Pricing Guidance on Financial Transactions (the Guidance). The Guidance aims to clarify the application of the principles of the 2017 OECD Transfer Pricing Guidelines, in particular the accurate delineation analysis, to financial transactions. It covers not just loans and guarantees (which have attracted the majority of discussion in the past) but also includes cash pooling, risk-free and risk-adjusted rates of return, and captive insurances. The Report is a significant step by the OECD towards providing more comprehensive guidance on financial transactions, and makes it clear that the OECD expects to see significant progress by multinationals in updating their existing transfer pricing policies on financial transactions to comply with the Guidance.

The response of multinationals to the 2018 Draft Report was largely to express concern about several key aspects of it, but to adopt a "wait-and-see" strategy. Many commentators hoped that the OECD would retract some of the more problematic requirements. Now that the Guidance has been published, the multinational community is coming to grips with the fact that the OECD has retained the large majority of the contentious policies, which will therefore require a response.

Companies, especially those with significant treasury functions, cash pools and cross-border financial transactions, will - if they have not done so on the basis of the Draft - have to review their transfer pricing policy, consider whether any changes need to be made and in particular address the need for the accurate delineation of financial transactions to be properly documented.

Some of the most pressing issues that will require action include:

  • Loans that may be subject to re-characterization because the lender does not exercise sufficient control over the borrower's credit risks;

  • Interest rates that are not linked through analysis to the risks inherent in the loan;

  • Financial guarantees that are not accurately delineated, and which do not differentiate between the implicit support that associated enterprises receive as a result of their membership in a group and the additional benefit that results from the explicit contractual guarantee;

  • Guarantees that increase the borrowing capacity of a lender leading to the potential re-characterization of the portion of the loan that would not have been made without the guarantee.

  • Cash pool models in which the reward to the cash pool leader is inconsistent with its delineation and that do not consider whether there is a group synergy benefit that should be shared with the pool participants; and

  • Captive insurance arrangements for which there is little commercial rationale or where the captive lacks substance to control the risks and is therefore only providing a service rather than assuming the insurance risk.

The greatest challenge multinationals will face will be to devise a plan of action that addresses these points in a manageable way. The amount of analysis, policy change, implementation and documentation work that may be required could seem excessive, even if companies limit their focus to the arrangements with the greatest exposure. The key to success will be to take limited practical steps that efficiently address the most significant concerns. This Alert provides practical insights intended to help multinationals determine the best way forward.

Key points in the Guidance

The Guidance focuses on the concept of an arm's length capital structure. Reference in this respect is made to the Commentary to Article 9 of the OECD Model Tax Convention which states, in relation to domestic thin capitalisation rules, not only that the interest applied on a loan should be arm's length but also that the transaction as such, i.e., the loan, must stand the arm's length test.

The Guidance refers in this respect to the guidance in Section D.1 and Section D.2 of Chapter I of the Guidelines regarding the identification of the commercial and financial relations and the recognition of the accurately delineated transaction.

In the accurate delineation of advances of funds, the Guidance focuses on the characteristics of the transaction and related contractual documentation, such as the presence or absence of a fixed repayment date, the obligation to pay interest, the right to enforce payment of principal and interest, the existence of financial covenants and security. The analysis goes further, however, by also taking into account the broader commercial and financial context within which the advance of funds was made, such as the status of the funder, 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.

Example: Company B needs additional funding and receives an advance of funds from related Company C. The advance is denominated as a loan with a fixed term but all good-faith financial projections of Company B make it clear that the company will be unable to service the loan, i.e., to repay it within the fixed term. From that, it could be concluded that an unrelated party would not be willing to provide such a loan as a result of which the accurately delineated amount of the loan for transfer pricing purposes must be a function of the maximum amount that an unrelated lender would be willing to advance to Company B, and the maximum amount that an unrelated borrower would be willing to borrow. The remainder of the purported loan is consequently ignored for the purposes of determining the amount of interest which Company B would have paid at arm's length.

The guidance does not mandate the accurate delineation as the only approach to address the balance of debt and equity funding and the interest deductibility but also allows domestic interest deduction limitation and debt/equity requirements (e.g., the 30% EBITDA rule and thin capitalisation rules). If used in combination, these other rules should only be relevant for the interest still recognised under the arm's length principle but one could also advocate that specific rules based on an economic rationale rule out any further interest disallowance.

In the accurate delineation of a financial transaction, all factors affecting the performance of businesses in the relevant industry sector must be analysed. Groups that are operating in different sectors may require, for example, different amounts and types of financing or may require different levels of short-term cash balances. It is also important to consider how the particular group responds to the identified factors as a result of which the group policies may inform the accurate delineation of the specific transaction.

The Guidance refers to the concept of options realistically available as introduced by Chapter IX of the TP Guidelines on business restructurings. It is said that independent enterprises will consider all other options realistically available to them before entering into a financial transaction and will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity. The perspective of both parties to the transaction must be considered in this respect, i.e., a two-sided approach. A lender may for example contemplate other investment opportunities. With respect to the borrower, an example would be an assessment of the need for additional funds to meet operational requirements.

A useful statement (in our view, against a background of many discussions with different tax authorities) is that the Guidance clearly prefers that comparability adjustments are made to unrelated financial transactions according to quantitative factors based on good quality data, instead of comparing transactions with qualitative differences at the level of the borrowers.

Changes between the Guidance and the Draft

The changes are limited. Except for the emphasis on control over risks and its potential impact on the interest remuneration for the lender, and some further elaboration on the relevance of the group's strategies, the changes are mainly limited to small additions and clarifications.

An important caveat to the Guidance is, however, that it must be read together with the Commentary on Article 9 of the OECD Model Tax Convention as it will appear when the proposed changes agreed by Working Party No. 1 have been incorporated (and that the Commentary might be revised in the event that the proposals of Working Party No. 1 are materially changed). Working Party No. 1 is apparently increasingly focusing on the capital structure of a taxpayer in the context of double tax treaties.

The Guidance also makes clear that it applies to regulated entities as well, such as financial services entities, in respect of which due regard should, however, be had to the regulations imposed upon them (e.g., Basel requirements) and the consequential constraints.

Baker McKenzie insight

The reference in the Guidance to the broader commercial and financial context, e.g., the use of the funds advanced and the debtor's overall financial capacity, the need for an arm's length capital structure, the analysis of options realistically available when entering into a loan and the business strategies of the group to which the debtor belongs, require taxpayers to document appropriately the business rationale for entering into financial transactions and the decision to advance funds in the form of debt as opposed to equity.

Such documentation will need to focus on the circumstances and available options at the time the transaction is entered into using a two-sided approach with proper financial and economic analysis as tax authorities may try to enter into discussions on the appropriateness and rationality of certain business decisions. One question is whether such opportunistic assessments by tax administrations could conflict with domestic legislation in some cases when it comes to the consequent dis-allowance of business expenses.

It also remains to be seen whether tax authorities will systematically challenge more atypical, but not necessarily non arm's length, inter-company financial transactions. Certain specific loan features, such as subordination, bullet loans, long-term loans, etc. may according to some economic views, be appropriate while other, equally valuable, views may discourage them.

Finally, whether the use of risk-free returns can as such be arm's length is still open for discussion as well as how any remuneration for control exercised at a level than the lender's should be compensated.

Key points in the Guidance

The Guidance recognizes the rationale behind treasury centers within multinational groups and highlights that these can be structured in different ways from highly decentralized treasury structures to a centralized treasury having full control over the financial transactions of the group with the other group entities being responsible for operational but not for financial matters.

The treasury function is distinguished from corporate financial management and vision, strategy and policies as set out by group management.

As in the Draft, the OECD states in the Guidance that the treasury function is generally part of the process of making the financing of the commercial operations efficient and is therefore usually a support service to the main value-creating operations. The guidance on intra-group services in Chapter VII of the TP Guidelines may apply to such activities. The Guidance now also adds that a treasury center may act to centralize external group borrowing which it subsequently on-lends to the rest of the group and which requires an arm's length fee for the coordination activities.

More important, however, is that the Guidance explicitly states that the treasury center may be found to perform more complex functions for which it should be compensated accordingly.

Changes between the Guidance and the Draft

An important change in the Guidance is the explicit nuance that a treasury center may be more than just a service provider which is entitled to a routine remuneration. While the Draft did not as such exclude such a view, it clearly tended towards a service-type remuneration for treasury centers, which was heavily criticized by business commentators.

Baker McKenzie insight

The more nuanced approach of the OECD as to the functional profile of a treasury center is very much welcome.

It will remain important to analyze the functional profile to determine and model an appropriate remuneration for the treasury activities but there should now be fewer impediments to being able to justify the profile of treasury centers whose activities exceed the provision of services and which act as "in-house" banks.

The Guidance also allows flexibility for more routine treasury activities not necessarily having to be remunerated by means of a service fee based on operational expenses, (which some local tax authorities seem to push for).

The question will be the position that tax authorities in jurisdictions with operational entities will take towards financial transactions entered into by those entities with a treasury center that may have taken overall financial responsibilities within the group, as a result of which little or no evaluations should be expected at the level of the operational entities with respect to the financial transactions they enter into.

Key points in the Guidance

The final section of the Guidance deals with the determination of a risk-free rate and risk-adjusted rates of return. It will be added to Chapter I of the TP Guidelines.

According to the Guidance, an entity that does not perform decision-making functions and controls the risks associated with the financial asset should be entitled to earn no more than a risk-free rate of return. The Guidance indicates that, subject to other factors, in this situation a borrower would still be entitled to deduct an arm's length interest rate. The difference between these amounts would subsequently be allocable to the party performing the relevant risk control functions.

With respect to determining a risk-free rate, the Guidance discusses the use of certain government-issued securities. In this respect, it is emphasized that certain characteristics should be aligned with the controlled transactions, including functional currency, temporal proximity and tenor of the reference security. Furthermore, the guidance describes the use of other options, such as inter-bank rates and interest rate swap rates.

The Guidance further elaborates on the applicability of a risk-adjusted rate of return where a party provides funding and exercises control over the financial risk with respect to the funding. It is important to differentiate, based on facts and circumstances, between the operational risk assumed by the funded party and the financial risk embedded in the provision of the funding.

A risk-adjusted rate of return generally consists of two elements, i.e., a risk-free rate and a risk premium to reflect to financial risks assumed by the lender. The Guidance also states that a risk-adjusted rate of return can be determined through different methods, including (i) the use of comparable uncontrolled transactions (e.g., bonds and loans) to calculate a risk premium and (ii) the costs of funds method by adding a profit margin to the costs incurred by the lender to raise the funds.

Changes between the Guidance and the Draft

The most notable change is the fact that the Guidance now contains guidance on risk-free rates and risk-adjusted rates of return in a separate section. Since the Guidance applies beyond plain-vanilla financing transactions (e.g., to funding of intellectual property) the Guidance will, as mentioned above, be included in Chapter I of the OECD Guidelines.

Baker McKenzie insights

The Guidance discusses the use of risk-free rates and risk-adjusted rates of return following the control of specific risks embedded in the relevant transaction. It is important to assess current financing structures involving loans and other forms of funding arrangements in order to review functions performed, specific risks assumed and the respective division of risks between the lender, borrower or other entities in multinational groups.

The Guidance leaves room for interpretation with respect to determining risk-free and risk-adjusted rates, as it mentions that not only highly-rated governments bonds should be considered risk-free in this respect.

A practical consideration relates to the applicability of risk-free rates that are currently trading with a negative yield in the market. In light of what the Guidance says with respect to the application of risk-free rates in situations where the lender does not control the relevant risks associated with investing in a financial asset, applying negative interest rates may lead to controversial outcomes.

Key points in the Guidance

The Guidance builds on the challenges to captive insurance arrangements in the Draft. In particular, the Guidance challenges the commercial rationale of captives and raises the bar on substance and the functions required to meet the "control over risks" standards set out in Chapter 1 of the TP Guidelines. The commercial rationale supporting a captive should include evidence on the value added by the arrangement, such as the ability to pool risks, achieve capital efficiency, and access reinsurance more efficiently. The Guidance points out that decisions are often made elsewhere (typically head office or group treasury) as to which risks are to be placed with the captive. The role of the captive is seen as managing the risk and perhaps placing all or part of the risk with re-insurers. It may also be the case that the risk management, reinsurance negotiation and pricing are performed by third parties or other related parties, leaving the captive with a limited role to play.

The challenges noted above lead the OECD to suggest that in many cases the captive insurance undertaking will be a service provider rather than a true risk-bearing entity under transfer pricing principles. The OECD goes further and proposes that even if the captive has the substance and commercial rationale necessary to support its characterization as a fully-fledged insurer, then the group synergy argument is likely to apply and the captive would be expected to share its profits with the group companies that insure their risks with the captive.

Changes between the Guidance and the Draft

The section on captives has been substantially rewritten, placing greater emphasis on the commercial rationale and substance requirements needed to support the delineation of a captive arrangement as true insurance. Considerations with enhanced focus include whether there is in fact an insurance transaction that would occur at arm's length, or whether the role of the captive is merely that of a provider of risk mitigation services, whether actually provided by the captive or outsourced to third parties or a related company. It is clear from the changes to the language in this section that the OECD has rejected the large majority of comments made in response to the Draft and hardened its position.

Baker McKenzie Insights

The OECD has been clear about its views on captives since the launch of the BEPS program. The Guidance provides tax authorities with many ways to challenge a captive insurance arrangement. Faced with these risks, many multinationals will need to review their captive arrangements. Companies that find that their arrangements meet the challenges imposed by the Guidance will find it beneficial to document the facts revealed during the review in anticipation of challenges by tax authorities. Those that do not meet the requirements should consider how to re-characterize and reprice their policies to meet the standards imposed by the Guidance. We expect that this will be an area that receives considerable focus from tax authorities and should therefore be a priority issue.

Key points in the Guidance

The Guidance retains a number of points that caused concern to commentators in 2018, and will therefore continue to cause concern. The key areas of focus regarding the impact of guarantees on loans are (1) when the guarantee leads to the lender providing more favorable terms on a loan that it would have been willing to make without the guarantee, and (2) whether the guarantee leads the lender to offer a larger loan than it would have otherwise been willing to extend. The Guidance also offers a slightly more detailed discussion of the pricing of guarantees, including consideration of the implicit support resulting from being a member of a group.

The Guidance on (1) follows previous guidance but takes the issue of the benefit of implicit support further. The TP Guidelines (2017 edition) established that the pricing of a formal guarantee should only address the incremental benefit over the implicit support resulting from passive association with the group. While the Guidance provides a helpful analysis of the pricing of a formal guarantee, it fails to elaborate on the pricing of the implicit support, leaving this open to interpretation by multinationals. The new guidance does however discuss situations in which the price of a formal guarantee may be zero, such as when loan covenants to a parent require it to support all group companies in the event of a potential default. Situations like this will need to be considered actively by companies with guarantees in place. The Guidance also includes an updated discussion of cross-guarantees which is somewhat inconclusive.

While the discussion of the topic is reduced from the Draft, the Guidance retains the position that when the effect of a guarantee is to increase the borrowing capacity of the recipient, then the portion of the loan that would not have been made without the guarantee is re-characterized as a loan to the guarantor, which is then contributed as equity to the borrower. Commentators on the Draft discussed a range of practical concerns raised by this position, but the Guidance is silent on these.

What the Guidance says on the pricing of guarantees is helpful but incomplete. It is largely dismissive of the CUP approach, and suggests that the pricing should be a negotiated result falling in the range between the pricing determined by the yield and cost approaches. Its position on implementing the yield approach includes a consideration of implicit support. What it says on the cost approach, however, is less precise and suggests various models that might be used but is silent on the extent to which costs should be absorbed by the guarantor to represent the implicit support portion of the guarantee. (To illustrate, if the yield approach indicates that 40% of the spread is attributable to implicit support, would it follow that 40% of the cost approach result should also be attributed to implicit support?)

Changes between the Guidance and the Draft

Some of the key changes are noted above. Most notable are areas where guidance that appeared in the Draft has been reduced, such as on cases in which a guarantee increases borrowing capacity, leading to a re-characterization. The additional guidance on the pricing of guarantees is helpful but, as noted, there is further work to be done on this issue.

Baker McKenzie Insights

The pricing of guarantees has always been contentious and difficult. Many people may consider that the Guidance has failed to address a number of these challenges. Accordingly, multinationals must now consider the facts and circumstances of their business and plot a course that reduces their risk as much as possible, given the incomplete and in some cases complicated guidance outlined above. Interpretation of the Guidance by tax authorities will evolve over time, so it will be important to monitor changes in domestic legislation and guidance and potentially to engage in consultation with tax authorities, possibly with a goal of achieving formal agreements.

Key points in the Guidance

The Guidance covers three main issues: assessing credit rating, considering the impact of group membership, and determining arm's length interest rates. The focus on credit ratings has increased from the Draft, and more detailed guidance is provided. There is an expanded discussion of credit ratings and guidance on how a credit rating analysis should be performed. The group rating may be a useful starting point and, indeed, there are circumstances when the group rating is considered to be a valid proxy for companies in the group. On the other hand, where the credit risk of a particular company is clearly not the same as the group or the parent, then a rating analysis may be required following quantitative and qualitative approaches typically used in the credit rating industry.

Credit ratings should of course consider any explicit guarantees that may be relevant, and also any implicit support that the borrower is expected to receive as a result of being a member of a group, particularly if the member is considered to be important to the overall business of the group. The Guidance calls for a more detailed assessment of this issue as the impact of implicit support may range from the equivalent of a full parental guarantee (except that no payment is required for implicit support) to little or no support at all in cases where the parent might reasonably decline to support a failing related company.

The third main topic is setting interest rates on loans to associated enterprises. The guidance retains much of the original discussion of the use of the CUP method which is based on interest rates observed in the market. The focus is on comparability, considering currency, term, credit risk rating, collateral, and other factors that may be unique to a particular loan. The credit analysis will include a consideration of the possible impact of implicit support as discussed above. The Guidance has added significant discussions of other approaches to analysing interest rates, including considering loan fees and charges, a method based on adjusting the group's cost of funds, credit default swaps, and economic modelling. In summary, the method guidance now offers a range of methods that can be considered which gives multinationals greater flexibility in how they approach the issue.

Changes between the Guidance and the Draft

There is a general increase in the focus on credit ratings, and there is new guidance requiring a more robust approach to analysing ratings. The Draft contained efforts by the OECD to offer a simplification of the ratings analysis by offering safe harbours, based on the group rating, as a rebuttable presumption. Based on comments received, the OECD has removed the simplified approaches and merely noted that there may be situations in which the group rating may be appropriate as an indicator, possibly with adjustments, of the credit rating of a related enterprise. There is also additional detail in the section on setting interest rates, as outlined above.

Baker McKenzie Insight

While the Draft offered ways to simplify the analysis of inter-company loans, the Guidance has changed course, rejected the efforts to simplify the issue, and instead proposed a more rigorous approach to the benchmarking of interest rates. While some multinationals may welcome the fact that the Guidance gives them the scope to analyse the issue in detail and support a true arm's length result, others will be frustrated by the fact that the Guidance raises the bar on the required analysis and the level of analysis that tax authorities may require. In response, multinationals should consider whether it makes sense to design and implement a practical, manageable approach that can deliver the required analysis and support without requiring an excessive amount of work and resources.

Key points in the Guidance

The Guidance describes the following key concepts:

  • The use of cash pools by multinational enterprises and the benefits of cash management structures. Key benefits include reduced financing costs and more efficient liquidity management in multinational groups. The main types of cash pools described in the Guidance are:
    • Physical pooling: which applies to a cash pool from which (automatic) physical cash transfers are made on a daily basis between local accounts of subs and the master account managed by the cash pool leader.
    • Notional pooling: a cash pool structure in which there are no physical cash transfers. In this model the individual positions are effectively (notionally) aggregated with interest paid or charged according to their respective net balance through an arrangement with a third-party bank.

    The Guidance further acknowledges that various forms of cash pools are operated by multinational groups which combine features of physical and notional cash pools.

  • The accurate delineation of cash pooling transactions and the interaction with Chapter I of the TP Guidelines. Main considerations include the characterization of cash pool transactions (short-term vs. long-term, type of transaction, benefits created through the cash pool structure and their allocation). Furthermore, it is emphasized that - in line with the guidance in Chapter I - the economically significant risks should be identified when determining the arm's length remuneration to be earned by the cash pool leader. Relevant risks include credit risk and liquidity risk inherent to the cash pooling structure.
  • OECD Guidance

  • The role of a cash pool leader, which should be determined on a case-by-case basis taking into account the functions performed and risks assumed. Two specific examples are provided in the Guidance which describe scenarios where (i) the cash pool leader performs a mere coordination function, assuming limited risks and (ii) the cash pool leader is a risk-bearing central financing entity controlling significant risks with respect to the cash pooling arrangement. The Guidance stipulates that the remuneration for a cash pool leader should be determined based on the facts and circumstances, limited remuneration should be appropriate for mere coordination activities but- in the second scenario (Example II), earning (part of) the interest spread might be warranted.
  • OECD Guidance

  • Remuneration for cash pool members, which will effectively be calculated through the arm's length interest rate applicable in the cash pool structure. Specific facts and circumstances of the cash pool structure determine the arm's length rates, although the Guidance does not intend to prescribe an approach to allocating cash pooling benefits. It is further emphasized that the cash pooling arrangement should provide for a benefit to all cash pool members, taking into account the options realistically available (e.g., other sources of financing). Potential benefits obtained by cash pool members include enhanced interest rates, access to liquidity on a permanent basis and reduced exposure to external banks.

  • The existence and arm's length treatment of cross guarantees in cash pool structures. The Guidance emphasizes that, depending on the facts and circumstances of the case, cross-guarantees may effectively be put in place from a group perspective in order to support the performance of the cash pool leader. In this case the benefits associated with the guarantee may not exceed the benefits related to the implicit support of the multinational group and hence no guarantee fee should be charged. In this situation, the Guidance stipulates that any support given, in the case of a default by another group member, should be regarded as a capital contribution.
  • OECD Guidance

Changes between the Guidance and the Draft

The Guidance elaborates in more detail than the Draft on the delineation of cash pool transactions and the potential consequences (e.g., short-term vs. long-term transactions) with respect to re-characterization. Furthermore, specific sections on allocating cash pool benefits to cash pool members have been removed. While the Draft outlined several potential options for allocating benefits among cash pool members, the Guidance limits itself to enhanced interest rates from which all cash pool participants could benefit (taking into account options realistically available).

Baker McKenzie insights

  • Cash Pooling remains a hot topic with detailed coverage in the Guidance.

  • Emphasis should be placed on delineation of cash pool transactions and the functionality of the cash pool leader when pricing transactions. Cash pool financing policies should allow for re-characterizing cash pool transactions that are effectively long-term in nature.

  • The arm's length remuneration for a cash pool leader function should be determined on a case-by-case basis. Following the Guidance, remunerating a cash pool leader based on the full interest spread requires significant functionality and management / control of relevant risks.

  • Cash pool benefits may be allocated to cash pool members by providing benefits through access to the cash pool structure, e.g., in terms of pricing arrangements. Analysis should be performed with respect to the options realistically available to cash pool members.

The Guidance

The Guidance describes the hedging activities typically undertaken by multinational groups to mitigate exposure to risks such as foreign exchange or commodity price movements. An independent entity may decide to assume such risks or hedge against them according to its own policies. However, in an MNE group, such risks might be treated differently depending on the approach to risk management and hedging. Hedging activities may be centralized from an efficiency and effectiveness perspective, in which case, FX risks are typically hedged from a group perspective rather than on an entity level.

If hedging contracts are centrally arranged, this function can be seen as providing a service to the operating entity for which it should receive an arm's length remuneration. On the other hand, if hedging contracts are entered into from a group perspective or in the absence of contractual instruments (e.g., natural hedging), a different conclusion may be warranted. The Guidance refers to Chapter I of the TP Guidelines with respect to a comprehensive analysis and accurate delineation of potential transactions in such cases.

Changes between the Guidance and the Draft

No significant changes.

Baker McKenzie insights

  • Hedging transactions should be reviewed from both a local entity and central group perspective. Where appropriate, there should be arm's length remuneration for centralized arrangements of hedging contracts.
  • Management of (centralized) hedging transactions should be incorporated within the general approach to risk management in the group financing policy.
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