The Organization for Economic Co-operation and Development (OECD) issued guidance
on transfer pricing for financial transactions on Feb. 11, 2020, marking the first time such guidance was included in the OECD Transfer Pricing Guidelines.
The accurate delineation of transactions receives significant attention in the guidance. In particular, it provides that the analysis of intercompany transactions should focus not merely on determining whether the interest rate for a loan is arm’s length but also whether a loan should be considered as such or regarded as some of other kind of payment, such as contribution to equity capital. In order to make an assessment, tax authorities may examine the economically relevant characteristics of transactions such as presence or absence of fixed repayment date, obligation to pay interest, right to enforce payment of principal and interest, existence of covenants, etc. A review of contractual terms, functional analysis, characteristics of the financial instruments, economic circumstances, and business strategies should all be considered in making an accurate delineation of the transaction.
The guidance also discusses the accurate delineation of transactions involving a corporate treasury and suggests better definition of functions and risk undertaken by that treasury. A general description of an organization’s treasury functions will likely be deemed insufficient as a key concern of the guidance is the identification and allocation of economically significant risks.
The guidance focuses a great deal on the consideration of both the lender’s and the borrower’s perspective in conducting a proper analysis of loan transactions. It emphasizes the role of credit assessments along with an analysis of the purpose of the loan, structure of the transaction and source of repayment. It discusses credit ratings and use of publicly available financial tools or methodologies to approximate credit ratings and suggests considering the impact of “implicit support” by the parent company on a subsidiary’s credit rating. Regarding methods for determining the arm’s-length interest rate for intra-group loans, the comparable uncontrolled price (CUP) method and the cost of funds approach are most prominent. Credit default swaps and economic modelling are discussed but deemed more difficult and less reliable to apply, while bank opinions should generally not be regarded as evidence of arm’s-length terms and conditions.
As with other financial transactions covered in the guidance, an accurate delineation of cash-pooling transactions is important in order to avoid re-characterizations of debit and credit balances in the cash pool into long-term loans or deposits. The guidance recognizes the practical difficulties in determining how long a balance should be treated as part of the cash pool before it could be treated as something else, such as a term loan. The guidance suggests an allocation of the benefits from the pool to the participants, although the data and analysis required for such allocations may be challenging. Particular attention should be given to the remuneration for the cash pool leader. As such, a careful evaluation of its functions and risks should be undertaken.
Often multinationals centralize hedging activities at the entity that conducts central treasury functions. The guidance discusses the distinction between transactions where the centralized treasury function arranges a hedging contract that an operating entity enters into, in which case the activity can be viewed as service, versus other situations in which the treasury entity enters into a hedging contract with the result that the positions are not matched within the same entity even though the group position might be protected.
The guidance recognizes financial guarantees as compensable so long as they provided a measurable benefit, such as reductions in the borrower’s interest rate. To the extent that a guarantee results not only in a more favorable interest rate but also increased borrowing capacity, an accurate delineation analysis should be performed to determine whether the increased borrowing capacity should be considered a loan from the lender to the guarantor followed by a capital contribution to the borrower. A number of methods are enumerated as potentially applicable in the analysis of the guarantee fees including the CUP method, yield approach and cost approach. With respect to the yield approach, which is probably the most commonly applied on guarantee transactions, implicit support should be considered in measuring the benefit to the borrower.
Captive insurances may be subject to regulation in the same way as other insurance and reinsurance companies under the guidance. As with other transactions, an accurate delineation of these transactions is important. Questions regarding sufficient diversification of pooling of risk, improvement in the capital position of entities, whether the risk would be insurable outside the group, and what entity exercises control of risk are among those that should be addressed for a proper assessment. If the captive company is accurately characterized as an insurance company, the guidance suggests establishing an arm’s-length price as the sum of a benchmarked return over claims and expenses plus and arm’s-length investment return. Similar to cash pooling, any synergies created by a captive program may need to be shared among the participants.
Finally, the guidance provides how to determine the risk-free rate of return and a risk-adjusted rate of return when an associated enterprise is entitled to those returns. While recognizing that there is no investment with zero risk, the guidance points to the use of certain government issued securities as a reference rate for a risk-free return. To eliminate currency risk, the security should be in the same currency as the investor’s cash flows, and the reference security should be issued at the time of the controlled transaction to achieve temporal proximity. In addition to government securities, interbank rates, interest rate swap rates, or repurchase agreements may be alternatives. In determining a risk-adjusted rate, it is important to address the financial risk assumed by the funder in its financing activity. The risk-adjusted rate of return can be based upon the return of a realistically available alternative investment with the same risk profile. Another approach would be to add a risk premium to the risk-free return.
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