OECD Discussion Draft Released
Transfer pricing aspects of financial transactions
On 3 July 2018, the Organization for Economic Co-operation and Development (OECD) issued the much-awaited non-consensual public Discussion Draft on financial transactions (the Discussion Draft) as mandated under the 2015 report on Base Erosion and Profit Shifting (BEPS) Action Plan 8 - 10.
20 July 2018
The Discussion Draft is divided into four sections, with the first section dealing with guidance for determination of arm’s length conditions in accordance with Chapters I - III of the OECD Guidelines. More specifically, it deals with the accurate delineation of the actual transactions relating to the capital structure of an entity within the multinational group. Key features in this respect are the purpose of the arrangement and the conduct of the parties. The principles outlined in the Discussion Draft are broadly consistent with the 2018 Dutch Transfer Pricing Decree. The remaining sections of the Discussion Draft addresses specific issues relating to the transfer pricing of financial transactions such as Treasury functions (which includes intragroup loans, cash pooling and hedging), Financial guarantee arrangements and Captive insurance structures. These are discussed further below.
The OECD invites interested parties to submit comments by 7 September 2018.
1. Accurate delineation of transactions
The Discussion Draft serves as additional guidance on how taxpayers should assess intragroup financial arrangements for transfer pricing purposes. In section B of the Discussion Draft, the importance of identifying the actual commercial or financial relations between the parties is outlined, which ensures an accurate delineation of the transaction under review. Although the contractual terms of the transaction still serve as the starting point, in line with the OECD guidelines, the actual conduct of the parties prevail from any contractually agreed arrangements that they have entered.
The accurate delineation of the actual transaction should be based on a broad-based analysis of the relevant fact and circumstances following the framework as set out in Chapters I-III of the OECD guidelines. The analysis should consider factors affecting the performance of businesses in the industry sector that the multinational entity (MNE) operates. This is to identify industry specific financing structures, capital intensity and commercial needs for cash.
The industry practice should be considered in the context of the specific MNE and its group funding policy, to ensure that group funding practices and strategies are mirrored to group affiliates when assessing local funding requirements. As a general principle mentioned in the Discussion Draft the parties to the transaction should evaluate options realistically available to them, including an obligation for the lender to ensure the borrower is able to meet its obligations under the financial arrangement. The Discussion Draft further emphasis and provides high-level guidance on the five comparability factors in evaluating the commercial and financial relations and provides examples that are considered relevant.
The Discussion Draft also looks at circumstances where parties do not control the risk. In this case it is suggested that the owner of the financial asset is entitled to no more than a risk-free rate of return and any residual return should be allocated to the party actually undertaking these control functions. Further guidance is provided on the application of risk free rate in such circumstances. In situations involving funding of intangible property development or high-risk transactions where specific knowledge is required to manage the associated risks, the funding party may be entitled to a risk- adjusted return.
2. Treasury function
The Discussion Draft recognizes that the treasury operations within a multinational group is a complex activity and the structure is dependent on various factors including, but not limited to, group structure, business strategy, business cycle and industry sector.
The Discussion Draft outlines that the treasury function can operate under a spectrum of set-ups ranging from a decentralized structure with full autonomy to a centrally driven structure. In evaluating the treasury function, as with any other case, it is important to accurately delineate the actual transactions and to determine what function is being carried out and by whom.
For intragroup loan transactions, the perspective of the borrower and lender and the risks assumed by both parties must be taken into consideration in determining the economically relevant characteristics for pricing the transaction. From a lender’s perspective, the key factor to consider is the creditworthiness of the borrower. From a borrower’s perspective, the objective is to optimize the weighted average cost of capital and funding options realistically available. Other key factors to be considered in this regard are:
- Credit rating: It is recognized that various options are available in estimating the credit rating and due care should be taken in adopting the approach by weighing the quality of information available and the clarity in mechanism adopted under different approaches. Existence of other controlled transactions (e.g. intercompany sales of goods) may impact the financial metrics of the credit rating and could make the credit rating unreliable without appropriate adjustments. For start-up’s and other companies for which credit rating is hard to estimate, the Discussion Draft suggests that further due-diligence be made to estimate the credit worthiness of the borrower.
- Effect of group membership: The Discussion Draft outlines that group implicit support should be taken into consideration and should be based on strategic importance of the entity relative to the group. High-level guidance is provided on how to assess this.
- Covenants: It is stated that the covenants can be either incurrence or maintenance covenants. Incurrence covenants prohibit certain actions by the borrowers while maintenance covenants require the borrower to maintain certain minimum level of financial indicators. Due to less information asymmetry in the intragroup context, the related parties may generally choose not to have covenants.
- Guarantees: The Discussion Draft outlines that a guarantee provided should be taken into consideration and a lender relying on such guarantee would need to be reasonably satisfied that the guarantor would be able to meet the obligation in the event of default.
- Loan fees and charges: Generally this represents cost incurred in the process of raising capital and may not be incurred in the context of intragroup transactions.
- Pricing approaches: Given the frequency of transactions between independent parties and availability of such information, the Discussion Draft outlines that the CUP method may be easier to apply. In addition, the Discussion Draft also provides guidance on the application of cost of funds approach in pricing intragroup loan transactions. Finally, regarding the use of ‘Bank opinions’, the Discussion Draft established its position that such an approach would be a departure from the arm’s length approach as it is not based on an actual transaction.
This section of the Discussion Draft begins with outlining the different cash pool structures i.e. Physical pooling and Notional pooling. In this context, the cash pooling is defined as the pooling of cash balances for ‘short-term liquidity management’. The Discussion Draft recognizes that other variations of cash pooling arrangement could be put in place to meet the business needs.
The Discussion Draft lays emphasis on facts and circumstances including the overall purpose of the arrangement and the next best option available to the cash pool participants. In situations where the surplus or borrowing positions of cash pool participants become more long term, it would be appropriate to treat them as long-term deposits or term loans rather than cash pool balances. The Discussion Draft recommends that further thought be given by multinational groups in classification of short term and long-term balances.
Given the multi-jurisdictional nature of the participants, the Discussion Draft recommends that a detailed analysis of the cash pool positions along with associated workings be included in the transfer pricing documentation. Guidance provided regarding the pricing of cash pooling transactions are as follows:
- Generally, the role of the cash pool leader is limited to a co-ordination function and accordingly the remuneration should be limited to a routine services fee. In this circumstance, further reference is made to Chapter VII of the OECD Guidelines dealing with intragroup services. Where the functions carried out are more than mere coordination, then the remuneration should reflect the functions actually performed.
- For cash pool participants, the Discussion Draft focuses on the allocation of synergy benefits to cash pool participants which would be determined by considering the amount of interest the participant would have received or paid in the absence of the cash pooling arrangement. The Discussion Draft suggests three approaches as a mechanism for allocating synergy benefits:
- Enhancing interest rates for participants with significant balances (both debit or credit) which would accordingly increase the remuneration accordingly.
- Applying the same interest rate for all participants with the same credit profile.
- Allocating the benefit to depositors in situations where there is credit risk. This is based on the rationale that the depositors have their capital at risk across all borrowers.
Finally, the Discussion Draft also outlines that the cross-guarantee is a feature of an arrangement which would not occur between independent parties. Under cross-guaranteeing arrangements, the borrower may not benefit beyond the implicit support and given these circumstances, no remuneration would be due for such arrangements.
The Discussion Draft makes a short reference to hedging arrangements and how these may be treated by MNEs. Specific considerations are given to hedging arrangements in centralized treasury functions managing risk exposure (through external hedging or natural internal hedging), with the result of individual group affiliates not contractually entering into the hedging arrangement. Again, the options realistically available to the parties and determining the actual delineation of the transaction when pricing the hedging arrangements is considered key.
In the context of the Discussion Draft, guarantees are defined as a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation. Furthermore, the Discussion Draft also indicates that anything that does not constitute a legally binding commitment involves no explicit assumption of risk.
The Discussion Draft explicitly outlines considerations as to the benefits that the guarantee may provide, especially if this not only provides a reduction of cost of funding, but also permits the borrower a greater amount of funding. In this case it is indicated that it may be appropriate to recharacterize the transaction into a loan from the lender to the guarantor with a subsequent capital contribution to the borrower.
A key point in the Discussion Draft is the ability to demonstrate a clear and measurable benefit provided by the guarantor which is more than an implicit guarantee that can be derived from the group affiliation. Moreover, in assessing the impact of the implicit guarantee, other legal obligations that the group may have should be considered. If it is determined that an explicit guarantee delivers value to the recipient, the Discussion Draft provides examples of approaches which may be used to determine the arm's length price:
- CUP method – The difficulties in applying the CUP method reliably is recognized, however, if sufficiently comparable guarantees can be identified the CUP method is considered the most reliable method.
- Yield approach – This approach quantifies the benefit that the guaranteed party receives by determining the interest savings for the borrower.
- Cost approach – This approach quantifies the cost for the guarantor in providing the guarantee, by quantifying the loss given default, cost of capital (by quantifying capital requirements) or by treating the guarantee as a put option and using option pricing models.
- Valuation of expected loss approach – This method estimates the fee by calculating the probability of default and adjust for the expected recovery rate. The return on the capital could then be priced relying in commercial pricing models such as the Capital Asset Pricing Model.
- Capital support method – This method determines the additional capital that the borrower would require in order to achieve the same credit rating as the guarantor. The guarantee could then be priced by estimating the return required on this additional capital amount.
5. Captive insurance
The Discussion Draft recognizes that MNEs may choose to consolidate certain risks in a captive insurance company and defines insurance by referencing Part IV of the 2010 report on Attribution of Profits to Permanent Establishments. The Discussion Draft outlines a list of key features of an insurer, including diversification and pooling of risks, reference to external insurance arrangements covering similar risks, and the availability of requisite skills (including underwriting skills) at the insurer. Furthermore, it must be demonstrated that the insurance provides a real economic benefit to the group and that the insurer has a real possibility of suffering a loss.
If the above criteria are not sufficiently met the Discussion Draft suggests that the captive is operating a business other than an insurance business. The Discussion Draft outlines potential pricing methods that can be used to determine the insurance premium:
- CUP method - The difficulties in applying the CUP method reliably is recognized, however, if sufficiently comparable arrangements can be identified the CUP method is considered to most reliable method.
- Actuarial approaches – Uses the expected losses on claims and other costs to determine the premiums by estimating an appropriate return on capital. This is described as combined ratio and return approach, whereby the remuneration for the insurer is based on premium income minus losses and claims, adding an investment return on its capital.
Certain group synergies may be achieved through reduced insurance costs, such benefits should be allocated amongst the insured participants through a discount on the premium.
Lastly there is an example of agency sales, whereby there is a direct link between a product sale and insurance (e.g. specific product insurance). In these situations, if the profit for the insurer exceeds an arm's length return, this excess should be allocated to the selling party, based on the assumption that they would be able to negotiate higher agency fees in the market.
6. Our remarks
The Discussion Draft raises several questions for which interested parties can submit their comments. It provides a helpful outline of some of the key issues and challenges faced by taxpayers in assessing the arm's length nature of financial arrangements. Broadly, the principles outlined in the Discussion Draft is consistent with the 2018 Dutch Transfer Pricing Decree. The key focus, as outlined in these documents, can be summarized as follows:
- Applying a two-sided approach in assessing and pricing financial arrangements;
- Considering the actual conduct of the parties than contractual arrangements;
- Understanding the commercial rationale for entering into the arrangement; and
- Factoring into analysis the group policies and external characteristics affecting certain financial disposition.
The Discussion Draft highlights the direction and the increased scrutiny that taxpayers can expect around the broader facts and circumstances relevant for pricing intragroup financial transactions from a transfer pricing perspective.