The Organization for Economic Co-operation and Development (OECD) on February 11, 2020 issued its final report on transfer pricing aspects of financial transactions, which will become Chapter X of the OECD Guidelines on Transfer Pricing Aspects for Multinational Enterprises. The report describes the transfer pricing aspects of financial transactions and provides examples to illustrate the principles behind such treatment. This article will analyze the key principles of certain types of transactions and treasury function which might be helpful to businesses in determining transfer pricing aspects of their financial transactions.
Determination of Whether a Purported Loan Should be Regarded as a Loan
There are possible instances in which the balance of debt/equity funding of a borrowing entity, part of an enterprise group, differs from that which would exist if it were an independent entity operating under the same or similar circumstances, i.e. the business may be thinly capitalized. This may affect the amount of interest payable by the borrowing entity and so may affect the profits accruing in a given jurisdiction. Commentary to Article 9 of the OECD Model Tax Convention notes at paragraph 3(b) that the Article is relevant “not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital.
The guidelines outline how “accurate delineation of transaction” can be used as a framework on whether and under what economically relevant conditions a related party funding transaction should be respected as debt, i.e. assessing the debt capacity of the borrower.
A business should accurately describe an actual transaction with a thorough identification of the economically relevant characteristics of the transaction—consisting of the commercial or financial relations between the parties and the conditions and economically relevant circumstances attaching to those relations. The elements considered include evaluating the debt capacity of the borrower, including specific terms and conditions applied, capacity to repay the debt, and the borrower’s ability to borrow from independent lenders (bank).
In common with the analysis of any other transaction between associated enterprises, in applying the arm’s-length principle to a financial transaction it is necessary to consider the conditions that independent parties would have agreed to in comparable circumstances. Specifically, with reference to analyzing the functions performed by the lending party, the OECD refers to the concept of “risk free rate of return” and where the accurate description of the transaction shows that funder lacks capability or does not perform the decision-making process function, to control the risk associated with investing in the financial assets, it will be entitled to no more than risk free rate of return as an appropriate measure of the profit it is entitled to retain.
Let us consider an example in which Company B, a member of a multinational enterprise (MNE) group, needs additional funding for its business activities. In this scenario, Company B receives an advance of funds from related Company C, which is denominated as a loan with a term of 10 years. It is clear from the financial projections of Company B that it would not be able to service a loan of such an amount. As such it can be concluded that an unrelated party, say a bank, would not be willing to provide such a loan to Company B due to its inability to repay the advance.
Accordingly, the accurate description of the amount of Company C’s loan to Company B for transfer pricing purposes would be a function of the maximum amount that an unrelated lender (bank) would have been willing to advance to Company B, and the maximum amount that an unrelated borrower in comparable circumstances would have been willing to borrow from Company C, including the possibilities of not lending or borrowing any amount. Consequently, the remainder of Company C’s advance to Company B would not be described as a loan for the purposes of determining the amount of interest which Company B would have paid at arm’s length and can be treated as an equity contribution or some other payment. This would also result in limitation on deduction of interest expense for Company B.
Intra-Group Loan
The OECD report suggests that the commercial and financial relations between the associated borrower and lender, and in an analysis of the economically relevant characteristics of the transaction, both the lender’s and borrower’s perspectives should be taken into consideration. An independent lender will carry out a thorough credit assessment of the potential borrower to enable the lender to identify and evaluate the risks involved and to consider methods of monitoring and managing these risks. That credit assessment will include understanding the business itself as well as the purpose of the loan, how it is to be structured and the source of its repayment which may include analysis of the borrower’s cash flow forecasts and the strength of the borrower’s balance sheet.
When a member of enterprise group is making a loan to another member of the group, it will not follow all of the same processes as an independent lender. The OECD report suggests, in considering whether the loan has been made on conditions which would have been made between independent enterprises, the same commercial considerations such as creditworthiness, credit risk and economic circumstances are relevant. The following factors should be taken into consideration by businesses with respect to the intra-group loan:
- Use of credit rating: the creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Multiple approaches are provided and estimated credit ratings generally are considered to be a helpful tool in assessing creditworthiness from the lender’s perspective. Businesses should apply quantitative and qualitative analyses of the individual characteristics applicable to it by using publicly available financial tools or independent credit rating agencies’ methodologies to seek to replicate the process used to determine the credit rating of the MNE group. For example, an enterprise receiving a loan from another associated enterprise can use Moody’s RiskCalc model which provides an estimation of a credit rating on the basis of a company’s key financial data (i.e. selected financial statement variables), geographical location and the type of industry in which a borrower operates, determining synthetic credit rating of the borrowing company.
- Effect of group membership: the effect of group membership is relevant for informing the conditions under which an MNE would have borrowed from an independent lender at arm’s length in two ways: firstly, on the form and the terms and conditions under which the business would have borrowed. Secondly, the enterprise may receive support from the group to meet its financial obligations in the event of the borrower getting into financial difficulty, i.e., implicit guarantee. Implicit support from the group may affect the credit rating of the borrower or the rating of any debt which it issues. The relative status of the businesses within the group will help to determine what impact that potential group support has on credit rating of a debt issuer.
- Covenants: the purpose of covenants in a loan agreement is generally to provide a degree of protection to the lender and so limit its risk. That protection may be in the form of incurrence covenants or maintenance covenants which are absent in an inter-company loan agreement. This might be warranted because related parties do not suffer from information asymmetry. Businesses should make an accurate description of the transaction to determine the equivalent of such covenants that would have existed in the unrelated parties and if that would impact pricing of the loan.
- Guarantees: most of the time, lenders will have recourse to a parent entity to recover the debt, if the associated enterprise is unable to service the loan. Such type of corporate guarantee can also influence the pricing of a loan. Businesses should factor a guarantee into the analysis if the lender would need to be satisfied that the guarantor would be able to meet any potential shortfall in the event of any default by the borrower.
Determining Arm’s-Length Interest Rate of intra-Group Loan
The following pricing approach suggested by the OECD can be used by businesses:
- Comparable uncontrolled price method (CUP method): business can use comparable market information available for a loan to determine the pricing of the interest rate. The arm’s-length interest rate for a tested loan can be benchmarked against publicly available data for other borrowers with the same credit rating for loans with sufficiently similar terms and conditions and other comparability factors. This method can be extended to other relevant transactions like bonds, deposits, convertible debentures and commercial papers. Businesses need to make potential comparability adjustments to eliminate the material effects of differences between the controlled intra-group loan and the selected alternative in terms of liquidity, maturity, existence of collateral or currency, etc.
- Loan fee and charges: independent commercial lenders will sometimes charge fees as part of the terms and conditions of the loan, for example arrangement fees or commitment fees in relation to an undrawn facility. If such charges are seen in a loan between associated enterprises, they should be evaluated in the same way as any other intra-group transaction. Businesses should consider suitable comparability adjustment towards the cost incurred in raising funds by independent lenders.
- Cost of funds: if CUP is not available, then cost of funds approach (internal weighted average cost of capital) could be used as an alternative to price intra-group loans in some circumstances. The cost of funds will reflect the borrowing costs incurred by the lender in raising the funds to lend, with suitable adjustment for the expenses incurred in arranging the loan and the costs incurred in servicing the loan, a risk premium to reflect the various economic factors inherent in the proposed loan, plus a profit margin, which will generally include the lender’s incremental cost of the equity required to support the loan.
- Credit default swaps: credit default swaps reflect the credit risk linked to an underlying financial asset. Businesses may use the spreads of credit default swaps to calculate the risk premium associated to intra-group loans. Credit default swaps may be subject to a high degree of volatility. The OECD warns that the use of credit default swaps to approximate the risk premium associated to intra-group loans will require careful consideration to arrive at an arm’s-length interest rate.
- Economic modeling: under this approach, an interest rate is calculated through a combination of a risk-free interest rate and a number of premiums associated with different aspects of the loan—for example, default risk, liquidity risk, expected inflation or maturity are added to it. The OECD report acknowledges that such models may be representative tools to determine an arm’s-length interest rate in cases wherein CUP is not available and businesses can use these models to benchmark interest cost.
- Bank opinion: taxpayers may seek to obtain written opinions from independent banks to evidence the arm’s-length rate of interest on an intra-group loan. The OECD report makes it clear that, in general, these would not be regarded as providing evidence of arms’-length pricing and the terms and conditions, given that they do not represent committed funds or executed transaction.
Treasury Function
The OECD report initially draws the distinction between centralized and decentralized treasury functions. Decentralized treasury structures may be present in business groups with multiple operating divisions that operate in discrete industries or with regional hub structures, or in business groups required to comply with specific local regulations. On the other side, a centralized treasury has full control over the financial transactions of the group, with entities within the group responsible for operational but not financial matters. The OECD Financial transaction report emphasized that when evaluating the transfer pricing issues related to treasury activities, it is important to accurately describe the actual transactions and determine exactly what functions an entity is carrying on rather than to rely to any extent upon a general description such as “treasury activities.” The report suggests that treasury function is usually a support function to the main value creation of the group and therefore intra-group services in Chapter VII of the Transfer Pricing Guidelines in certain instances may be applicable.
An Illustration
Let’s discuss the provision by way of an illustration. Company A, parent of a group, has centralized treasury function in its corporate office which strategises all treasury-related activities like syndicating borrowings from the bank, raising funds, hedging transactions, cash pooling, etc and provides support to all group enterprises. Other members of the group only perform day-to-day routine treasury functions. In such a situation, the corporate office can charge a service fee, as any other unrelated service provider would charge for such services, to other group members and such service fee should satisfy the arm’s-length principle. If an enterprise is following a decentralized treasury function, then each member of the group will have its own treasury team which will drive its strategies even though the local treasury team reports into treasury function in the parent entity. In these situations, there will not be any intra-group service charge from the parent entity to other group members.
Cash Pooling
Cash pooling is the pooling of cash balances as part of a short-term liquidity management arrangement. For example, one common structure is that the participating members of the MNE group conclude a contract with an unrelated bank that renders cash pooling services, and each participating member opens a bank account with that bank.
There are two types of cash pooling arrangements—physical pooling and notional pooling. In a physical pooling arrangement, the bank account balances of all the pool members are transferred daily to a single central bank account owned by the cash pool leader. Any account in deficit is brought to a target balance (usually zero) by a transfer from the master account to the relevant sub-account. In notional pooling, combining of all credit and debit balances of several accounts is achieved without any physical transfer of balances between the participating members’ accounts.
The remuneration for the cash pool leader needs to be ascertained first before determining the debit and the credit interest. The remuneration can be worked out by using either service-based return or spread-based return with detailed description of the role of cash pool leader. No compensation can be charged for cross guarantees as such arrangement will not exist between independent parties and no incremental credit enhancements of the participants. Businesses which are participants in a cash pool within an MNE generally do not charge an annual fee or interest on borrowings and do not receive interest on deposits. A third-party bank would typically charge the cash pool participants an annual fee and interest on borrowings; however, the cash pool participants would typically receive interest on deposits or pay interest on a deficit. As such business should evaluate whether there is possibility to charge fees and interest on deposits and determine whether these charges are at an arm’s-length price.
Financial Guarantees
Financial guarantees are a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor were to default on its obligation. Where a financial guarantee results in more favorable interest conditions on debt funding, an arm’s-length guarantee fee would be payable. The more favorable may be the result of the stronger credit rating of the guarantor or the guarantor’s asset pool. However, if the guarantee results in increased debt capacity, the OECD report suggests re-characterization of the incremental debt capacity by hypothesizing a loan to the guarantor followed by equity contribution to the guarantee recipient. Where there is an explicit guarantee, businesses should evaluate the benefits conferred by that guarantee by comparing third-party banking agreements for covenants that may reduce or offset the value of the guarantee. The OECD provides the following pricing approaches:
- CUP method;
- yield approach—interest saving from the guarantee, focused on the benefit provided to the guaranteed party;
- cost approach—based on the cost suffered by the guarantor;
- valuation of expected loss approach—a business could consider the expected default rate and the expected recovery rate in the event of default, available in the market. The guarantee could be priced based on expected return on this amount of capital based on an available commercial pricing model like the capital asset pricing method (CAPM);
- capital support method—a business can evaluate the guarantee based on capital enhancement or substitution it provides.
Planning Points
The OECD guidance on financial transactions implies that greater focus should be placed on the design of intra-group financing policies, in particular terms and conditions applied with reference to the wider financing behavior of the group and treasury function.
Businesses should consider the arm’s-length conditions of financial transactions, including the performance of the business in the industry sector (for example, where MNE entities are regulated, like financial services companies are subject to regulations consistent with recognized industry standards, i.e. Basel norms, due regard should be given to those regulations imposed on them).
The OECD report provides more guidance on estimating credit ratings of intra-group loans and emphasizes the importance of documenting the rejections and selections of credit rating used in arm’s-length pricing. Businesses should document these financial transactions in the transfer pricing documentation to comply with the transfer pricing requirements. Businesses should also check if there are any transfer pricing adjustments that arise due to execution of different types of financial transactions.
This column does not necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Rajeev Agarwal is Head of global tax with Qatar Navigation QPSC.
The author may be contacted at: [email protected]
Disclaimer: The content of this article is intended for general information purposes. You should always seek professional advice before acting. No responsibility is taken for any loss because of any action taken or refrained from in consequence of its contents.
