BEPS Actions 8-10: Discussion Draft on the Transfer Pricing of Financial Transactions
On 3 July 2018, the OECD released a Discussion Draft on the transfer pricing aspects of financial transactions. The Discussion Draft follows the work previously undertaken by the G20/OECD in relation to Actions 8-10 of the Base Erosion & Profit Shifting (BEPS) Action Plan on aligning transfer pricing outcomes with value creation. It contains draft additional guidance for future inclusion within the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘the OECD Guidelines’).
This Discussion Draft does not, at this stage, reflect a consensus position of the governments involved but is designed to provide substantive proposals for further review and comment.
The Discussion Draft sets out guidance for businesses and tax authorities on how to determine whether financial transactions between associated enterprises are consistent with the arm’s length principle of transfer pricing, and the documentation and evidence taxpayers are expected to hold in this regard. There is a lack of detailed specific guidance for financial transactions in the current version of the OECD Guidelines and international consensus on the application of the rules would be welcome. Specific issues including the role and remit of treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance are addressed. The draft guidance follows many long-standing practices of applying the OECD Guidelines to financial transactions, but it will nevertheless be helpful to have these approaches set out in detail and supported by examples. Given the delays in publishing this Discussion Draft, and the many key sections that remain subject to broad consultation questions, it is clear that differences in opinion currently exist between members of the BEPS Inclusive Framework. It will be important that a single international framework is established in order to minimise disputes and double taxation. Cash pooling arrangements have seen increased scrutiny from tax authorities in recent years and therefore the proposal for OECD guidance on this area is welcome. More detailed guidance on how to implement the approaches would be helpful, for example on practical approaches to measuring the overall benefit achieved from cash pooling arrangements. Explicit statements that the pricing of intra-group loans should take into account the perspectives of both borrowers and lenders are useful – in practice, more focus has often been placed on the circumstances of borrowers only. Other useful statements reinforcing existing practice include approaches to guarantee pricing, methodologies on performing benchmarking analyses, and the importance of documenting the features and attributes of transactions. The draft guidance discusses both the risk free and risk-adjusted rates of return, including various potential approaches that are aligned with established practice, and potential methodologies that may be appropriate. However, this is almost entirely posed as a question for consultation such that changes may be needed in future drafts to reach consensus agreement.
Delineation of financial transactions
The Discussion Draft includes guidance on the application of post-BEPS transfer pricing principles to financial transactions. This includes how to accurately delineate the capital structure (i.e. the mix and types of debt and equity) used to fund an entity within a multinational group. This accurate delineation is necessary before pricing a transaction to determine if adjustments are required, for tax purposes, to the legal form of the transaction.
As for other transactions, delineation of financial transactions should begin with the thorough identification of economically relevant characteristics. This should include: an examination of the contractual terms; a functional analysis identifying the functions performed, the assets used, and the risks assumed by the parties; the characteristics of the financial products and services; the wider economic circumstances of the parties and the market; and the business strategies of the parties and the wider group.
The Discussion Draft clarifies that the guidance does not prevent the implementation of other approaches to address capital structure and interest deductibility under countries’ domestic legislation.
Treasury functions, intra-group loans, cash pooling, and hedging
The Discussion Draft recognises that treasury functions differ from one multinational group to another, including in respect of the degree of centralisation, autonomy, and functionality of the treasury team. Differences also exist in groups’ strategies relating to corporate financial management, including how costs of capital are optimised, and investment returns are managed or maximised. Activities undertaken by the treasury function may, depending on facts and circumstances, be services that require remuneration from other group members.
The transfer pricing considerations for three particular treasury activities often performed within multinational groups are considered. Key issues include:
i) Determining an arm’s length rate of interest on intra-group loans through:
- Consideration of both the lender’s and borrower’s perspectives;
- Use of credit ratings to measure creditworthiness and identify potential comparables, including various methodologies for performing credit rating analyses and factors to be taken into account;
- The effects of group membership and any associated implicit support;
- Evaluation of covenants, loan fees and charges;
- Summary of the transfer pricing approaches to determine arm’s length rates, including comparable uncontrolled price (CUP), internal CUPs, and the cost of funds incurred by the lender in raising the funds to lend; and
- Reliance on written opinions from independent banks.
ii) Cash pooling enables a group to benefit from more efficient cash management by (notionally or physically) bringing together the balances on separate bank accounts. Considerations include:
- The appropriate basis upon which to reward the cash pool leader in various circumstances. Examples are provided where a cash pool leader (i) merely performs a co-ordination function and thus receives limited remuneration as a service provider; or (ii) performs additional functions, controls and bears the financial risks contractually allocated to it, and has the financial capacity to bear those risks, such that an enhanced reward may be appropriate.
- Three approaches for allocating benefits of cash pooling to the participating members (which are not necessarily mutually exclusive):
- enhancing the interest rate for all participants (depositors and borrowers);
- applying the same interest rates for all participants (in situations where all members have the same or similar credit profile) regardless of whether they are depositors or borrowers; and
- allocating cash pooling benefits to depositors, and not borrowers, within the group (in situations where there is genuine credit risk to the depositors).
- Cross-guarantees and rights of set off may be required between participants in the cash pool. To the extent that this represents nothing more than credit enhancement attributable to the implicit support of other group members, no guarantee fee would be due. Any support, in case of a default from another group member, should be regarded as a capital contribution.
iii) Where a centralised treasury function arranges a hedging contract that an operating company enters into – where the treasury function has provided a service to the operating company and should be rewarded accordingly. More complex situations include where the contract instrument and the risks hedged arise in different entities within the group.
Draft guidance is given on how to accurately delineate and price financial guarantees on intra-group guarantee transactions, most typically where a guarantor provides a guarantee on a loan taken out by a fellow group member from an unrelated lender.
The draft guidance distinguishes between explicit guarantees (where the guarantor is legally committed to pay if the borrower defaults) and implicit guarantees (more passive support, not backed up by a legally binding commitment, derived from the borrower’s status as a member of a group). In general, the benefit of any such implicit support would arise from passive association and not from the provision of a service for which a fee would be payable. Even in respect of an explicit guarantee, a borrower would not generally be prepared to pay for a guarantee if it did not expect to obtain an appropriate benefit beyond the implicit support of other group members.
Where the effect of a guarantee is to permit a borrower to borrow a greater amount of debt, it is necessary to consider: i) whether a portion of the loan from the lender is accurately delineated as a loan from the lender to the guarantor (followed by an equity contribution from the guarantor to the borrower); and ii) whether the guarantee fee paid with respect to the remaining portion of the loan is arm’s length.
Five different approaches to pricing guarantee fees are described: comparable uncontrolled price (although it is difficult to find sufficiently similar guarantees between unrelated parties.); Yield approach; Cost approach; Valuation of expected loss approach; and Capital support method.
The Discussion Draft includes guidance on the application of the arm’s length principle to captive insurance arrangements. A group may choose to pool certain risks through a group member, the ‘captive’ insurance company, for a number of commercial reasons e.g. diversification of risk or volatility reduction on inherent material risks. The group member then provides insurance services exclusively or mainly to other members of the group. For regulatory reasons, risks are typically ceded by the operating company through a fronting company (usually an insurance broker or agent) which in turn reinsures the risk to the group captive. The Discussion Draft discusses the complexity of pricing the premium paid to the group captive given the participation of third parties that are indifferent to the levels of the price for insurance and reinsurance transactions.
A frequent concern is whether the transaction is genuinely one of insurance (ie a transfer of insurance risk) and draft guidance on how to determine this through accurate delineation is provided. Further comments are provided on: the pricing of premiums, including arriving at a comparable uncontrolled price through considering the combined ratio of the classes of business insured - which can be difficult to benchmark given lack of publicly available data and return on capital; group synergies; and the effect of agency sales.
Consultation questions highlight the need for significant further work
Included throughout the Discussion Draft are a number of questions on which responses are specifically sought. Issues highlighted for discussion include:
- Proposed guidance on approximating risk free and risk-adjusted rates of return. The practical implementation of guidance in situations where funders lack the capability to control the risk associated with investing in a financial asset such that the excess over a risk free return is allocable to another party exercising control over the risk.
- Whether as a simplification there should be a rebuttable presumption that the group credit rating should be used as a proxy for individual group members’ credit ratings (or alternatively as a starting point from which adjustments are made).
- Views on the roles of credit default swaps and economic models on the pricing of intra-group loans.
- The accurate delineation of hedging arrangements within multinational groups where exposures to risk and off-setting positions are booked in separate entities.
The OECD have invited interested parties to make comments on the above by 7 September 2018. The working party intends to prepare a further discussion draft after considering input received. With increased scrutiny by tax authorities on financing transactions, taxpayers need to be diligent in reviewing their financing arrangements from an Irish transfer pricing perspective. With the review of Ireland’s tax regime nearing its conclusion, which may result in material changes to certain parts of Ireland’s domestic transfer pricing law such as non-trading transactions / interest-free loan arrangements, the potential impact of OECD and domestic law changes needs to be assessed as a priority.