OECD Transfer Pricing Guidelines new Chapter X: Guidance on Financial Transactions

On February 11, 2020, the OECD has released its final report on the transfer pricing aspects of financial transactions (the “OECD FT Guidance” or the “Report”), which will be integrated in the OECD Transfer Pricing Guidelines (the “TP Guidelines”) as a new Chapter X. This represents the first time that the OECD will publish separate guidance on financial transactions in its TP Guidelines.

The main goal of the OECD FT Guidance is to provide consistent guidance in the interpretation of the arm’s length principle in regard to financial transactions between associated companies. In particular, intercompany financing via loans and cash pools, hedging, financial guarantees and captive insurances are in focus.

While the Report should lead to greater clarity and international consistency in the determination of transfer prices for intercompany financial transactions, it will most likely also increase the requirements for determining and documenting the arm's length nature of the transfer prices applied.

• Structure of the report »

  • Accurate delineation of the transaction »

  • Treasury Function »

  • Financial guarantees »

  • Risk-free and risk-adjusted rates of return »

• Takeaway »

Structure of the report

The OECD FT Guidance is divided into five main chapters:

1. Interaction with the guidance in Section D.1 of Chapter I of the OECD TP Guidelines (i.e., accurate delineation of the transaction), 
2. Treasury function (intercompany loans, cash pooling and hedging), 
3. Financial guarantees, 
4. Captive insurance and 
5. Risk-free and risk-adjusted rates of return.

The following chapters outline the key principles of the Report and highlight the main considerations and takeaways from a practical perspective.

Accurate delineation of the transaction

The Report’s first chapter stresses the importance of accurately delineating the transaction before determining how a financial transaction should be priced. Taxpayers should follow the guidance around the accurate delineation of a transaction as outlined in Chapter I of the TP Guidelines when analyzing a given intercompany financial transaction in order to address important questions such as whether and under what economically relevant conditions an intercompany financing transaction should be regarded as debt. Elements to consider in this regard include a thorough examination of the contractual terms and the overall profile of a given intercompany financial transaction both from a lenders and from a borrowers perspective. Taking important aspects into account such as whether there is a fixed repayment date or obligatory interest payment stipulated in the financing contract, or whether the borrower has the ability to service a debt facility – to name a few – is imperative to ensure the transaction is classified as debt and not as a contribution to the firm’s equity.

The OECD FT Guidance further points out the importance of the economic substance and the actual conduct of the parties to appropriately determine the arm’s length conditions of the financial transaction. To identify the underlying “commercial or financial relations” of a given financial transaction, in addition to the conditions stipulated in the contract, also other factors and parameters should be analyzed and assessed. These include market-relevant factors such as the sector and industry-specific financial and liquidity needs, the economic situation and strategic significance of an entity within its group, the group’s general business and funding strategies and alternatives to attract capital, as well as and most importantly a group-internal analysis of the functions performed, risks assumed and assets employed by the parties to the transaction.

 
This underlines the importance and need to perform a detailed and specific functional analysis for any given intercompany financial transaction, something which is currently often not yet included in transfer pricing policies and transfer pricing documentations of multinational companies.

Treasury Function

The OECD proceeds by giving a concrete description of the functions a treasury department within an multinational corporation should exercise and then proceeds to a detailed analysis and description of the various intercompany financial transactions, i.e. loans, cash pooling, hedging, financial guarantees and captive insurance. For each of the aforementioned transactions, the OECD FT Guidance provides valuable insights and practical considerations and approaches one should follow when analyzing the at arm’s length character of intercompany financial transactions.

With regard to intercompany loans, the Report analyses various factors that might influence the determination of the arm's length transfer price for the transaction. Specific focus is thereby placed on credit ratings and the effects of a group membership (i.e. implicit support) and how it impacts the arm’s length considerations of a given financial transaction. Depending on the extent of the group's support, any option, ranging from the so-called stand-alone rating (i.e. rating of the borrower as an independent company) to the group rating, may prove to be at arm's length.

Concerning the pricing approaches that may be used to determine the arm’s length transfer price for the transaction, the OECD FT Guidance provides the following guidance:

• Comparable uncontrolled price (CUP): the Report outlines the need to identify suitable external comparables and the likely requirement of comparability adjustments to ensure the highest possible comparability of the comparable transaction.
• Cost of funds: The Report states that in the absence of suitable external comparables, a potential approach may be to look at the lenders cost of funding plus a profit margin. The OECD FT Guidance, however, points out the need to analyze the transaction from the perspective of both parties and that a borrower would not enter into a transaction whose price is determined based on the cost of funds approach if he could obtain funding at more favorable conditions under an alternative transaction on the open market.
• Credit default swaps: the Report mentions credit default swaps and related instruments as potential comparable transactions to determine the risk premium of an intercompany loan.
• Economic modelling: Economic modelling may be used to determine the transfer price for an intercompany loan, especially in the absence of suitable external comparables. The Report points out that the reliability of the outcome of the economic modelling depends upon the parameters factored into the model and that the outcome does not represent an actual transaction and will therefore most likely require comparability adjustments.
• Bank opinions: Using bank letter or opinions as a proxy to determine the transfer prices for an intercompany loan is not considered an arm’s length approach as they do not consider an actual offer to lend.

Cash pooling

In the context of cash pooling, the Report points out that a cash pool in principle should be considered a short-term liquidity arrangement and therefore a detailed analysis of the transaction is necessary to accurately delineate the transaction and assess whether it is of short-term or long-term nature.

Furthermore, the Report explains that the remuneration of the cash pool leader and cash pool members will depend on the functions actually performed, risks assumed and assets employed. It points out that in general, a cash pool leader does perform no more than a coordination function for which it should be remunerated as a routine service provider. If the functional analysis does, however determine that the cash pool leader carries on valuable activities other than the coordination function, it will have to be compensated accordingly for these additional activities. This may include earning part or all of the spread between the borrowing and lending positions it adopts.

Lastly the Report points out that synergy benefits achieved through the cash pool are the result of a deliberate concerted action of all cash pool members and would therefore generally be shared among the members.

Financial guarantees

With regard to financial guarantees, the Report stresses that only explicit and thus legally binding guarantees should be taken into account and remunerated separately. The Report then points out different drivers that could be impacted by a financial guarantee and how these should be viewed from an arm’s length perspective. Where a guarantee results in an enhancement of the borrowing terms (e.g. more favorable interest rates) an arm’s length fee would generally be expected to be paid to the guarantor. Where the guarantee affects the amount of borrowing (i.e., access to a larger amount of borrowing) the OECD FT Guidance suggests a recharacterization of the incremental portion hypothesizing a loan from the lender to the guarantor followed by an equity contribution from the guarantor to the borrower.

Various applicable methods are listed as potentially suitable to determine arm’s length transfer prices for explicit guarantees that provide a value to the recipient of the guarantee, including the CUP method, the yield, cost and valuation of expected loss approach and the capital support method.

Risk-free and risk-adjusted rates of return

A welcomed update to the guidance is the section covering the Risk-free and risk-adjusted rates of return. It outlines principles very similar to the one already implied in the previous chapters and publications, namely determining the degree of risk a given entity assumes, when providing financing to an affiliated company. Quintessentially, if the funding party is not in a decision-making position, “to control the risk associated with investing in a financial asset” it should not be entitled to a remuneration that exceeds the applicable risk free rate. When determining the risk free interest rate at arm’s length key specifics such as e.g. currency and maturity equivalence should be factored in. Respectively, only lenders that assume unanticipated profits should be entitled to a risk adjusted return.

Takeaway

The OECD FT Guidance contains a number of detailed analysis approaches and practical considerations regarding the determination of arm's length transfer prices for intercompany financial transactions. Hopefully, in the near future, this will lead to greater clarity and international consistency in the testing of the arm’s length character of the prices applied to these transactions. In a further stage, this should lead to greater legal certainty for the taxpayer.

However, the statements and considerations in the Report are also likely to lead to more stringent requirements concerning the determination and documentation of the transfer prices, especially with regard to the analysis of the actual circumstances and economic substance of the parties to the transactions as well as the risk assumption.

Thus, taxpayers are well-advised to start analyzing and, if necessary, adjust the transfer prices of their intercompany financial transactions in order to ensure that they are in line with the principles and requirements outlined in the OECD FT Guidance. Some questions that should be answered in this regard are:

General

• Does the group have an intercompany financing policy that lays out the methodologies to determine and set transfer prices for intercompany financial transactions?
• Are the methodologies aligned with the principles outlined in the OECD FT Guidance?
• Is there a transfer pricing documentation in place that documents the transfer prices applied for the intercompany financial transactions?
• Does the documentation contain all the important aspects and considerations outlined in the Report, such as for instance a detailed analysis of the functions performed, risks assumed and assets employed by the parties to the financial transaction?

Intercompany loans

• Is there a proper process in place to analyze and assess the economic circumstances as well as the realistically available options for both the lender and the borrower prior to entering into an intercompany loan?
• Does the lender have the necessary resources and capacity to bear the risks arising from the granting of the loan and does he actually control those risks?
• How are the interest rates for the intercompany loans determined? Does the process correspond to one of the methodologies outlined in the OECD FT Guidance?
• Does the process of determining the interest rates involve the use of credit ratings? If so, is the implicit support by being a group member being considered?

Cash Pooling

• Is the transfer pricing mechanism within the cash pool aligned with the actual conduct and economic substance of the parties involved?
• How is the cash pool leader being compensated? If he earns more than a routine return, is this aligned with its functions performed, risks assumed and assets employed?
• Do all cash pool members gain an advantage from accessing the cash pool?
• Are synergy benefits arising from the cash pool membership accurately shared among the cash pool members?
• Does the cash pool have a short term character or is there a risk that some positions could be recharacterized into long term loan arrangements?

Financial guarantees

• Are legally binding financial guarantees that provide a value to the recipient being charged?
• How are the prices for these guarantees determined? Does the process correspond to one of the methodologies outlined in the Report?

On the basis of the above questions, taxpayers should be able to assess whether their current set-up is aligned with the new requirements or if adjustments are required.