Factoring arrangements has been saved
What to consider from a Transfer Pricing perspective?
Factoring schemes have become increasingly popular as a cash management and working capital optimization mechanism. This popularity has also translated to related-party transactions. Over the past few years, we have witnessed an increased focus of tax authorities on intercompany factoring schemes.
Factoring schemes have become increasingly popular as a cash management and working capital optimization mechanism. This popularity has also translated to related-party transactions, where multinational groups are also implementing intercompany factoring schemes in an effort to:
- Facilitate working capital financing of group affiliates;
- Optimize the collection of receivables; and
- If applicable, centralize liquidity, credit and FX risks in selected group companies (i.e. group Factors) with the ability to control and absorb such risks.
Over the past few years, we have witnessed an increased focus of tax authorities on intercompany factoring schemes. In Belgium, for instance, such schemes have been specifically targeted in audit waves since 2017, but have received similar attention and scrutiny across Europe in recent years.
Factoring is gaining in popularity recentlty as an intercompany financial transaction in which a company sells its trade receivables to another (related) party, called a Factor, at a discount, in exchange for immediate cash. The Factor subsequently takes care of payment collection from the debtor.
Two main types of factoring schemes are commonly observed:
- Recourse factoring schemes where the risk of non-payment of the invoice (i.e. credit risk) is not assumed by the Factor but remains with the selling entity. The selling entity must therefore buy back any unpaid receivable from the Factor that it is not able to collect.
- Non-Recourse factoring schemes where the receivables are definitively transferred to the Factor. The latter will therefore assume the credit risk related thereto.
What are the main learnings from the current environment ?
In February 2020, the OECD finally published its first formal guidance on the transfer pricing aspects of financial transactions with the release of Chapter X of the OECD TP Guidelines.
Unfortunately, despite the upward trend observed in the emergence of intercompany factoring schemes, this type of intragroup financial transaction is not directly addressed in Chapter X of the OECD TP Guidelines.
The lack of clear and specific guidance is not ideal at a time where tax authorities are increasingly scrutinizing intercompany factoring schemes, so one has to resort to the general guidance prevailing in the OECD TP Guidelines and interpret such in the context of a factoring arrangement, particularly the guidance in Chapter I (arm’s length principle), Chapter VII (Services) and Chapter X (financial transactions).
Just like with any other intercompany transaction it would be prudent to first accurately delineate the overall factoring scheme:
- The contractual arrangements of the factoring arrangement and particularly the risk allocation therein;
- The benefits effectively derived by the participants to the factoring scheme;
- Historic data on receivables, payment terms and bad debt and
- The Factor’s ability to control, absorb and effectively manage the risks assumed.
The absence of specific guidance also gives rise to difficulties, or subjectivity, when it comes to correctly implementing and maintaining such intercompany financial transactions. Frequently observed concerns revolve around:
- The tolerance for such transaction in various countries;
- The substance needed at the level of the Factor;
- Lack of comparable transactions / benchmarks;
- Factoring of intercompany receivables and impact of synergies and/or implicit support;
- The appropriate transfer pricing policy to remunerate the Factor, particularly for non-recourse factoring schemes where the Factor absorbs the credit risk related to the receivables transferred by group affiliates.
On that last point, the key concerns are in accurately assessing the credit risk embedded in the receivables factored, and dealing with negative interest rates in certain markets (time value of money).
It can be expected that intercompany financial transactions, such as factoring, will increasingly become the subject of intense scrutiny by tax authorities. Transfer pricing documentation will be the first line of defense in case of a tax audit. While Chapter X of the OECD Guidelines does not provide direct or specific recommendations on intercompany factoring arrangements, general guidance provided on other types of intragroup (financial) transactions can, to a large extent, be leveraged (including substance requirements and credit risk analysis).
It is recommended to establish a holistic and thorough transfer pricing policy or intragroup factoring arrangements, ensuring that the substance, risk management, contractual arrangements, benefits realized and pricing applied are coherent and all at arm’s length. The actual pricing applied pursuant such policy should aim to accurately remunerate the different components of the contributions made the Factor, including, for example:
- Pre-financing of the receivables;
- Any FX risk or credit risk absorbed by the Factor;
- The equity buffer (financial capacity) that needs to be maintained by the Factor;
- Any other services rendered by the Factor (e.g. collection).
A transfer pricing policy report is commonly prepared in order to document the factoring arrangement and support the arm’s length nature thereof. Such policy report can subsequently be leveraged for transfer pricing documentation compliance purposes, e.g. the multinational group’s master and local files.