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OECD releases Discussion Draft on Transfer Pricing of Financial Transactions

In July 2018, the OECD released a non-consensus discussion draft on the transfer pricing aspects of financial transactions. Its aim was to clarify the application of the OECD transfer pricing guidelines (TPG) concerning financial transactions.

The discussion draft addresses debt-versus-equity determinations as well as specific issues related to financial transactions such as rates of return, intragroup loans, cash pooling, hedging, guarantees, and captive insurance companies. These are discussed in more detail below.

Debt versus equity determinations

The discussion draft provides guidance with regard to the accurate delineation of the actual transaction to determine the capital structure (the mix and types of debt and equity) used to fund an entity within a multinational enterprise (MNE) group.

The accurate delineation of the transaction should begin by identifying the economically relevant characteristics of the transaction, consistent with the application to other transactions. Various examples are provided in the guidance, such as the examination of contractual terms, the functions performed, assets used and risks assumed, economic circumstances of the parties and the market and more.

The discussion draft lists a number of factors that can be used to distinguish intercompany debt from other forms of funding such as equity, to accurately delineate the transaction. The figure below provides some of these examples:

Figure 1 : Factors that can be used to distinguish intercompany debt from other forms of funding

In applying the arm's length principle to a financial transaction, the guidance advocates for consideration of the conditions that independent parties would have agreed to in comparable circumstances and to consider the options realistically available to each of the parties to the transaction.

Risk- free and risk adjusted rates of return

An interesting point considered by the discussion draft is that when a funder lacks the capability, or does not perform the decision-making functions, to control the risk associated with investing in a financial asset, it will be entitled to no more than a risk-free return as an appropriate measure of the profits it is entitled to retain.

To determine the risk-free return, the guidance refers to the use of interest rates on certain government-issued securities as reference, as well as any other realistic alternatives.

Where a related party provides funding control over the financial risk associated with the provision of funding, without the assumption of or control over any other specific risk, it could generally expect only a risk-adjusted rate of return on its funding. The risk-adjusted rate of return can be determined under different approaches, for example: comparable uncontrolled transactions, the addition of a risk premium to the risk-free return, or a cost of funds approach.

Treasury functions: Intragroup loans, cash pooling and hedging

The organization of the treasury function will depend on the structure of the MNE group and the complexity of its operations. Differences in the treasury function may flow from variations in the function’s degree of autonomy and the range of activities it performs.

Intragroup loans

In determining the arm’s length interest rate on intragroup loans, a number of factors should be considered, including:

Figure 2 : Factors that can be used to evaluate the arm’s length nature of intragroup loans

The issue of implicit support and performing a credit rating analysis is discussed throughout the report. The discussion draft suggests that rather than adopting a single top-down or bottom-up approach for implicit support consideration, a facts and circumstances-driven approach is proposed based on the entity’s relative importance to the group.

The discussion draft suggests that in cases in which the borrower would be more likely to receive support from other group members than a less integral member, the borrower’s credit rating is likely to be more closely linked to the group rating. Conversely, when a borrower is determined to be less likely to receive group support in more limited circumstances, it may be appropriate to first consider a stand-alone credit rating of the entity and then modify the rating upward to account for implicit support.

The guidance emphasizes the importance of both quantitative and qualitative factors in determining arm’s length pricing. Qualitative factors include both the effects of group membership, as discussed above, and qualitative aspects of the borrower’s business.

The discussion draft outlines the transfer pricing approaches to determine arm’s length rates, including the comparable uncontrolled price (CUP) method, a cost of funds approach, and reliance on bank opinions.

According to the discussion draft, bank opinions are not regarded as providing evidence of arm’s length terms and conditions, as it’s not based on actual transactions and that it do not constitute an actual offer to lend.

Cash pooling

Cash pooling enables a group to benefit from more efficient cash management by (notionally or physically) bringing together the balances on separate bank accounts. The main points as set out by draft guidance is discussed below:

Accurate delineation

• Physical vs. Notional cash pooling;

• Cash pooling arrangement must provide a clear benefit to participants; and

• Facts and circumstances will dictate appropriate remuneration to leader and participants.

Pricing:

• Rewarding cash pool leader for functions performed, assets employed and risks assumed; and

• Rewarding cash pool members for functions performed, assets employed and risks assumed.

Guarantees

The discussion draft provides guidance on how to accurately delineate and price financial guarantees. The guidance also refers to if the effect of a guarantee is to permit a borrower to borrow a greater amount of debt than it could in the absence of the guarantee, it is necessary to consider whether a portion of the loan from the lender should be more accurately delineated as a loan from the lender to the guarantor and whether the guarantee fee paid with respect to the loan portion is arm’s length.

The draft guidance also discusses explicit and implicit guarantees. In general, the benefit of any such implicit support would arise from passive association and for an explicit guarantee, a borrower generally would not be prepared to pay for a guarantee if it did not expect to obtain an appropriate benefit in return.

The draft guidance describes five pricing approaches for circumstances in which a guarantee fee may be appropriate:

Figure 3 : Pricing principles for guarantees

Captive insurance companies

A captive insurance company is used to manage risks within a MNE group. The discussion draft provides guidance on applying the arm’s length principle to these transactions. A frequent concern when considering the transfer pricing of captive insurance transactions is whether the transaction is accurately delineated. The draft guidance provides indicators, all or substantially all of which would typically be expected in an independent insurer:

Figure 4 : Circumstances that would typically be expected to apply to an independent insurer

For more information in relation to the revised discussion draft, please refer to our Deloitte Global Transfer Pricing Alert.

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