Updated operational guidelines drive a new focus on financial transaction transfer pricing (FTTP)

The updated guidelines align with the OECD guidance on FTTP and emphasize that where the contractual terms and conditions of intercompany financial transactions do not align with the facts, a tax examiner is able to adjust the terms, conditions, and pricing to reflect the reality of the transaction. The guidance provides examiners with a strong foundation from which to recharacterize and reprice transactions.

The pricing of intercompany financial transactions must be based explicitly on the creditworthiness of the intercompany borrower or the beneficiary of a guarantee; if this is enhanced due to the implicit support of the MNC group or parent company, this implicit support is an ancillary benefit for which no payment is due.

The transfer pricing methods for intercompany loans are focused on the Comparable Uncontrolled Price (CUP) method, and only give limited consideration to a method involving a cost of funds plus a mark-up. Loan pricing quotes from third parties do not provide proof of an intercompany loan price being consistent with the arm’s length principle.

For pricing intercompany guarantees, a case in the guidelines notes that the maximum guarantee charge may correspond to a price based on sharing the benefit of interest savings associated with the guarantee (the yield approach), and the minimum guaranteed fee may be based on the probability and the magnitude of the liability that would be transferred, and the cost of covering that liability (the expected loss approach).

Under the guidelines, cash pooling participants are assumed to be better off (with respect to interest rates, sources of funds, liquidity, exposure to banks, etc.) than those without cash pooling. If no benefit is received from cash pooling, other options may need to be considered, otherwise there is a risk that examiners may recharacterize the transaction or adjust the transfer pricing, or both.

Increased focus on FTTP in examinations: Going forward, examiners will apply the updated guidelines and request all relevant documentation. Taxpayers must expect increased scrutiny of FTTP decisions.

FTTP delineation may drive examiners’ adjustment arguments: There is an increased risk of recharacterization of intercompany financial transactions due to examiners’ potential lack of understanding of complex treasury arrangements, and third-party debt instruments and markets.

Potential disputes with respect to credit ratings: Some academic studies indicate Japanese rating agencies tend to rate entities higher than agencies outside Japan. Disputes may arise if Japanese agency ratings are used by tax examiners.

The focus on the CUP method may lead to lengthy pricing debates: The use of yield bond indices and cost of funds, as opposed to other sources of interest rate data, is likely to be an area of debate in tax examinations given their regular use in global FTTP policies and operations.

Potential challenges in rolling over of short-term loans or cash pooling balances: Short-term intercompany loans are normally rolled over, with the resulting risk of examiners applying long-term rather than short-term deposit or loan rates, and adjusting the interest income from the Japanese related party upwards, and this is expected to be seen as an easy and potentially sizable source of tax adjustments for examiners.