OECD’s Guidance on Financial Transactions – Light at the end of the tunnel!?

"Having published its long-awaited guidance on the transfer pricing of financial transactions, the OECD has completed one of the missing blocks of its BEPS puzzle!"

The OECD released its final Guidance with transfer pricing guidance on financial transactions (the Guidance) as follow up guidance in relation to Base Erosion and Profit Shifting (BEPS) Action 4 and Actions 8-10.

The guidance focuses on the accurate delineation of financial transactions, covers the transfer pricing of intra-group loans, cash-pooling, hedging and guarantees as well as captive insurance, and will be added as Chapter X to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPG).

While the guidance covers the above mentioned areas in detail, I’ve endeavored to capture some of the key elements requiring attention of MNEs in relation to their inter-company loans arrangements.

• Debt versus equity determinations:

The Guidance supplements the concept of the delineation of a transaction and depicts how that may relate to the capital structure (balance of debt and equity funding) of an entity within the multinational group.

Interestingly, the phrase ‘“accurately delineate” has been used 23 times over the 40 pages of the Guidance.

The Guidance indicates that an approach of accurate delineation, which may include a multi-factor analysis, can be used before pricing a loan to determine whether the purported loan is regarded correctly or should be re-characterized as equity for tax purposes. Effectively, the guidance suggests that it may be possible to first determine an ‘arm’s length capital structure’ before conducting any transfer pricing analysis for underlying interest payments.

Furthermore, the Guidance suggests that the re-characterization as equity of a purported loan is not limited to an all-or-nothing consideration; rather, the Guidance allows for a bifurcation of a purported loan between debt and equity as part of the accurate delineation analysis (example below).

Although the Guidance emphasizes that is not intended to prevent countries from implementing other approaches under domestic legislation, the Guidance is not prescriptive on how this should be approached.

Transfer pricing considerations for intra-group loans:

• Two-sided approach – A way to address lack of economic substance!  

The Guidance puts much more emphasis on a two-sided approach and the economic substance to a transaction. Historically, analysis have been largely driven by what the borrower could and would do (i.e. the need for finance and the ability to service it), however, now consideration also needs to be given to the lender.

The above entails a two-fold consideration (i) would the lender be willing to lend (are there more attractive investments available?); and (ii) is there sufficient economic substance in the lender (i.e. does it have the functions to control the risks associated with the loan as well as the funds to bear those risks?).

In cases where there are insufficient functions, the lender may only be entitled to a risk-free return on its capital (example below).

• Curious case of credit rating analysis:

The Guidance acknowledges that the credit worthiness of the borrower is one of the main factors considered by independent lenders. However, it also identifies that as a credit rating depends on a combination of quantitative and qualitative factors, there is still likely some variance in creditworthiness between borrowers with the same credit rating.

Moreover, the Guidance highlights that in performing a credit rating analysis, it is important to note that the financial metrics of the borrower may be influenced by other controlled transactions. In situations where a credit rating estimate for a particular entity using an established approach may result in an unreliable outcome (for example, due to the presence of controlled transactions), the Guidance suggests that it may be appropriate to rely upon the group credit rating for pricing of an intra-group loan. However, no specific guidance or examples are provided as to how these situations should be best addressed.

• Group membership – ‘Halo effect’:

The Guidance proposes a facts and circumstances-driven approach based on the entity’s relative importance to the group to determine the impact of implicit support. The Guidance suggests that in cases in which the borrower would be likely to receive support from other group members, the borrower’s credit rating is likely to be more closely linked to the group rating. In more limited circumstances, when a borrower is determined to be less likely to receive group support, the borrower’s credit rating may be more closely linked to the stand-alone credit rating of the entity.

• Pricing approaches:

The Guidance outlines the transfer pricing approaches to determine arm’s length rates, including the comparable uncontrolled price (CUP) method, a cost of funds approach, credit default swaps and economic modelling.

However, the Guidance indicates use of credit default swaps and economic modelling to price intra-group loans only in the absence of information on comparable uncontrolled transactions. Further, the Guidance denies the comparability of external bank opinions to intra-group loans as these informal letters do not constitute an actual offer to lend and therefore cannot be considered comparable to actual transactions.

Gazing at the future:

This is the first time that specific guidance on pricing intra-group financing transactions has been included and it represents a big step forward in preventing and resolving unilateral/ bilateral disputes in this area. The Guidance has been approved by the  members of the Inclusive Framework (137 countries) and therefore, its importance stretches beyond the OECD member countries.

It would be interesting to note the unilateral actions being taken by various countries in connection to ‘re-characterization of loans’ and consequent tax implication on the underlying interest payments.

Meanwhile, MNEs with intra-group financial transactions should assess whether their transfer pricing policies are aligned with the new guidance and ensure they have the supporting documentation in place to support these policies.