New transfer pricing rules on financial transactions were released, on 11 February 2020, by the OECD (see bit.ly/3csIMpz). Traditionally, the OECD’s transfer pricing guidelines (TPG) have been consensus-based guidance. This has been a significant part of their strength, and many countries have incorporated the guidelines by reference in domestic law. The new guidance, though, shows more opportunity for divergent opinions and approaches, which may foreshadow more need for (bilateral or multilateral) dispute resolution.
Finalisation of financial transactions guidance
Two key issues held up the finalisation of the financial transactions guidance: MNE capital structure analysis; and MNE group credit rating.
MNE capital structure analysis
The first issue was whether tax authorities can challenge ‘the balance of debt and equity funding’ of an MNE group entity (meaning the capital structure) based on the arm’s length principle. This was addressed in the new OECD TPG:
‘This guidance is not intended to prevent countries from implementing approaches to address the balance of debt and equity funding of an entity and interest deductibility under domestic legislation, nor does it seek to mandate accurate delineation under Chapter 1 as the only approach for determining whether purported debt should be respected as debt.’ (OECD TPG (2020) chapter B.1 para 10.9)’
This text allows for divergence between countries, however, and the risk of double taxation in case of (transfer pricing) adjustments.
Countries can take different approaches to determine a maximum amount of debt that gives rise to deductible interest payments. A benefit of using the arm’s length principle is that its application is generally covered by the article on associated enterprises of treaties for the avoidance of double taxation. These treaties tend to provide for a mutual agreement process that can help resolve related disputes and double taxation. Domestic thin capitalisation rules, general anti-avoidance rules (GAARs) and special anti-avoidance rules (SAARs) do not have that benefit. However, allowing the arm’s length principle to recharacterise intercompany debt may, in some countries, be possible without explicit new legislation, leading to possible retroactive application and recharacterisation.
If countries can apply the arm’s length principle to recharacterise debt, intercompany debt could arguably be at risk of recharacterisation if:
Other characteristics (or a combination thereof) that can be considered are:
The next question is: how would the arm’s length principle determine the character of a loan? This could be by applying the process that third party lenders use to determine the maximum amount they would lend to the taxpayer, including consideration of:
It could also be determined by applying a ‘separate enterprise approach’ when postulating the borrowing capacity of MNE group affiliates, while:
MNE group credit rating
The second issue delaying publication of the new guidance was the proposal to use the MNE group credit rating for pricing intra-group loans. Consensus was found in stating that in those cases where the individual/stand-alone credit rating taking into account the effect of group membership is ‘not reliable’, the MNE group credit rating may be used to price intercompany loans. There is no definition of what constitutes an ‘unreliable’ outcome, so those countries that implement a group credit rating with a high reliability threshold can force taxpayers into using an MNE group credit rating when assessing intra-group loans (OECD TPG (2020) chapter C.1.1.4 paras 10.81–10.82).
The impact of accurate delineation
TPG chapter B explains the process of accurate delineation for financial transactions. We expect that the new guidance will have significant impact on the practice of pricing financial transactions as traditionally applied.
The OECD TPG provide that a comparability analysis is at the heart of the application of the arm’s length principle. This assumes that a comparison takes place between the conditions in a controlled transaction and the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances.
There are two aspects to this assumption. The first is the process of identification of commercial or financial relations between associated enterprises and the conditions and economically relevant circumstances attaching to those relations. The second is comparing the conditions and economically relevant circumstances of the controlled transaction with those of comparable transactions between independent enterprises. The new guidance emphasises the attention with which intra-group transactions ought to be delineated before they can be compared with third party transactions.
Traditionally, if an analysis would be requested to determine an arm’s length interest rate, in many ‘high level/plain vanilla’ cases (only) the following information would have been collected and reviewed:
With the availability of credit rating tools and databases, such information would have been considered more or less adequate for many taxpayers to determine a ‘third party’ interest rate. The new guidance on accurate delineation indicates that several additional aspects will need to be considered, with documentation to show that they were considered, at the time the loan was put in place.
The financial transaction must be accurately delineated based on an analysis of the contractual terms, functional analysis (including risks assumed and assets used), characteristics of financial instruments, economic circumstances and business strategies. Furthermore, it will need to be revisited during the term of the loan and be applied dynamically, just as unrelated parties would have done.
The following is an overview of aspects which, based on the new guidance, are likely to play a role in intra-group loans and intra-group financial guarantees.
Intra-group loans
For intra-group loans, taxpayers will need to substantiate that several considerations were made before determining the amount of the intra-group loan, the credit rating applied and the interest rate applied to the intra-group loan. This includes the decision-making process before putting in place an intra-group loan, which will likely be scrutinised for evidence of consideration of:
The choice for the type of loan (long-term, short-term, subordinated, mezzanine, revolving, etc.) to be put in place will most likely be compared to the following aspects:
As regards the actual contract underlying the funding instrument, it is expected that there is evidence that the following questions have been considered:
In addition, tax authorities are instructed to review whether the actual conduct of the borrower and creditor is consistent with the contractual terms underlying the loan.
The credit rating of the borrower used to price the loan is already a top audit topic. If anything, the reasons and selection of the credit rating used for a particular MNE when pricing intra-group loans must be documented appropriately to withstand scrutiny and be prepared for audits, including:
The tax authorities will review the interest rate applied and ask the following questions:
The new guidance reflects the issues covered in several court cases globally challenging such transactions. For example, the Chevron Australia Holdings case ([2017] FCAFC 62) concerns the pricing of an internal credit facility agreement amounting to the AUD equivalent of $2.5bn at AUD LIBOR plus 4.14% (about 9%) based on standalone credit rating of an Australian Chevron entity with no guarantee and covenant-lite was held to be not at arm’s length. The MNE group raised the funds made available to the Australian Chevron entity at rates of interest around 1.2% through an issuance of USD commercial paper with a credit guarantee provided by Chevron Corporation. This case shows the importance of analysing the arm’s length nature of the intra-group loan terms and conditions based on the external funding policies and practices of the MNE group.
Intra-group guarantees
For intra-group financial guarantees, taxpayers will need to substantiate that several considerations were made before putting in place a fee for the financial guarantee; and that there is a clear benefit.
This was litigated in GE Capital Canada [2010] FCA 344. In that case, Revenue Canada held that that the arm’s length fee to be paid by GECC for a financial guarantee from its parent company, GE Capital US, in connection with GECC’s borrowing in the capital market was zero. Revenue Canada argued that GECC’s credit rating was the same as that of GE Capital US due to implicit support resulting from GECC being part of the MNE group. Essentially, GECC could have borrowed the same amount of money at the same interest rate without an explicit guarantee. GECC argued that implicit support does not occur between independent enterprises and should therefore not be considered in determining the credit rating of GECC. The court was of the view that implicit support should be considered, but it disagreed with Revenue Canada on the extent of its impact. The court ruled that the 1% fee paid by GECC did not exceed an arm’s length amount. Whether the GE Capital US guarantee de facto provided GECC with economic benefit was the core of the dispute, and while GECC prevailed, the issue of implicit support and de facto benefit from financial guarantees have now been explicitly made part of the transfer pricing analysis.
A summary of the focus points is set out below.
The decision-making process
The decision-making process before putting in place an intra-group guarantee will be scrutinised for evidence of consideration of the following questions:
The financial guarantee
The form of the financial guarantee (explicit, implicit or as letter of comfort) is also considered to have relevance:
As regards the assertion that there is a guarantee in place, the following aspects will be scrutinised:
The price of the guarantee
The price of the guarantee fee is a hot audit topic. Audit questions to disallow a guarantee fee will particularly focus on the following issues:
The new transfer pricing guidance on financial transactions also covers treasury functions, hedging, cash pooling and captive insurance. Those have not been discussed in this article, but they require the same detail of information pursuant to the accurate delineation as intra-group loans and financial guarantees.
Final thoughts
What changed is that the accurate delineation process required for financial transactions has been clarified and is far more intricate and detailed than many taxpayers have considered so far. This may leave many taxpayers exposed in case of transfer pricing audits. To reduce exposure to transfer pricing adjustments, we recommend MNEs to conduct a review of their intra-group financial transaction portfolio and the application (and documentation) of the now explicit accurate delineation aspects.
New transfer pricing rules on financial transactions were released, on 11 February 2020, by the OECD (see bit.ly/3csIMpz). Traditionally, the OECD’s transfer pricing guidelines (TPG) have been consensus-based guidance. This has been a significant part of their strength, and many countries have incorporated the guidelines by reference in domestic law. The new guidance, though, shows more opportunity for divergent opinions and approaches, which may foreshadow more need for (bilateral or multilateral) dispute resolution.
Finalisation of financial transactions guidance
Two key issues held up the finalisation of the financial transactions guidance: MNE capital structure analysis; and MNE group credit rating.
MNE capital structure analysis
The first issue was whether tax authorities can challenge ‘the balance of debt and equity funding’ of an MNE group entity (meaning the capital structure) based on the arm’s length principle. This was addressed in the new OECD TPG:
‘This guidance is not intended to prevent countries from implementing approaches to address the balance of debt and equity funding of an entity and interest deductibility under domestic legislation, nor does it seek to mandate accurate delineation under Chapter 1 as the only approach for determining whether purported debt should be respected as debt.’ (OECD TPG (2020) chapter B.1 para 10.9)’
This text allows for divergence between countries, however, and the risk of double taxation in case of (transfer pricing) adjustments.
Countries can take different approaches to determine a maximum amount of debt that gives rise to deductible interest payments. A benefit of using the arm’s length principle is that its application is generally covered by the article on associated enterprises of treaties for the avoidance of double taxation. These treaties tend to provide for a mutual agreement process that can help resolve related disputes and double taxation. Domestic thin capitalisation rules, general anti-avoidance rules (GAARs) and special anti-avoidance rules (SAARs) do not have that benefit. However, allowing the arm’s length principle to recharacterise intercompany debt may, in some countries, be possible without explicit new legislation, leading to possible retroactive application and recharacterisation.
If countries can apply the arm’s length principle to recharacterise debt, intercompany debt could arguably be at risk of recharacterisation if:
Other characteristics (or a combination thereof) that can be considered are:
The next question is: how would the arm’s length principle determine the character of a loan? This could be by applying the process that third party lenders use to determine the maximum amount they would lend to the taxpayer, including consideration of:
It could also be determined by applying a ‘separate enterprise approach’ when postulating the borrowing capacity of MNE group affiliates, while:
MNE group credit rating
The second issue delaying publication of the new guidance was the proposal to use the MNE group credit rating for pricing intra-group loans. Consensus was found in stating that in those cases where the individual/stand-alone credit rating taking into account the effect of group membership is ‘not reliable’, the MNE group credit rating may be used to price intercompany loans. There is no definition of what constitutes an ‘unreliable’ outcome, so those countries that implement a group credit rating with a high reliability threshold can force taxpayers into using an MNE group credit rating when assessing intra-group loans (OECD TPG (2020) chapter C.1.1.4 paras 10.81–10.82).
The impact of accurate delineation
TPG chapter B explains the process of accurate delineation for financial transactions. We expect that the new guidance will have significant impact on the practice of pricing financial transactions as traditionally applied.
The OECD TPG provide that a comparability analysis is at the heart of the application of the arm’s length principle. This assumes that a comparison takes place between the conditions in a controlled transaction and the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances.
There are two aspects to this assumption. The first is the process of identification of commercial or financial relations between associated enterprises and the conditions and economically relevant circumstances attaching to those relations. The second is comparing the conditions and economically relevant circumstances of the controlled transaction with those of comparable transactions between independent enterprises. The new guidance emphasises the attention with which intra-group transactions ought to be delineated before they can be compared with third party transactions.
Traditionally, if an analysis would be requested to determine an arm’s length interest rate, in many ‘high level/plain vanilla’ cases (only) the following information would have been collected and reviewed:
With the availability of credit rating tools and databases, such information would have been considered more or less adequate for many taxpayers to determine a ‘third party’ interest rate. The new guidance on accurate delineation indicates that several additional aspects will need to be considered, with documentation to show that they were considered, at the time the loan was put in place.
The financial transaction must be accurately delineated based on an analysis of the contractual terms, functional analysis (including risks assumed and assets used), characteristics of financial instruments, economic circumstances and business strategies. Furthermore, it will need to be revisited during the term of the loan and be applied dynamically, just as unrelated parties would have done.
The following is an overview of aspects which, based on the new guidance, are likely to play a role in intra-group loans and intra-group financial guarantees.
Intra-group loans
For intra-group loans, taxpayers will need to substantiate that several considerations were made before determining the amount of the intra-group loan, the credit rating applied and the interest rate applied to the intra-group loan. This includes the decision-making process before putting in place an intra-group loan, which will likely be scrutinised for evidence of consideration of:
The choice for the type of loan (long-term, short-term, subordinated, mezzanine, revolving, etc.) to be put in place will most likely be compared to the following aspects:
As regards the actual contract underlying the funding instrument, it is expected that there is evidence that the following questions have been considered:
In addition, tax authorities are instructed to review whether the actual conduct of the borrower and creditor is consistent with the contractual terms underlying the loan.
The credit rating of the borrower used to price the loan is already a top audit topic. If anything, the reasons and selection of the credit rating used for a particular MNE when pricing intra-group loans must be documented appropriately to withstand scrutiny and be prepared for audits, including:
The tax authorities will review the interest rate applied and ask the following questions:
The new guidance reflects the issues covered in several court cases globally challenging such transactions. For example, the Chevron Australia Holdings case ([2017] FCAFC 62) concerns the pricing of an internal credit facility agreement amounting to the AUD equivalent of $2.5bn at AUD LIBOR plus 4.14% (about 9%) based on standalone credit rating of an Australian Chevron entity with no guarantee and covenant-lite was held to be not at arm’s length. The MNE group raised the funds made available to the Australian Chevron entity at rates of interest around 1.2% through an issuance of USD commercial paper with a credit guarantee provided by Chevron Corporation. This case shows the importance of analysing the arm’s length nature of the intra-group loan terms and conditions based on the external funding policies and practices of the MNE group.
Intra-group guarantees
For intra-group financial guarantees, taxpayers will need to substantiate that several considerations were made before putting in place a fee for the financial guarantee; and that there is a clear benefit.
This was litigated in GE Capital Canada [2010] FCA 344. In that case, Revenue Canada held that that the arm’s length fee to be paid by GECC for a financial guarantee from its parent company, GE Capital US, in connection with GECC’s borrowing in the capital market was zero. Revenue Canada argued that GECC’s credit rating was the same as that of GE Capital US due to implicit support resulting from GECC being part of the MNE group. Essentially, GECC could have borrowed the same amount of money at the same interest rate without an explicit guarantee. GECC argued that implicit support does not occur between independent enterprises and should therefore not be considered in determining the credit rating of GECC. The court was of the view that implicit support should be considered, but it disagreed with Revenue Canada on the extent of its impact. The court ruled that the 1% fee paid by GECC did not exceed an arm’s length amount. Whether the GE Capital US guarantee de facto provided GECC with economic benefit was the core of the dispute, and while GECC prevailed, the issue of implicit support and de facto benefit from financial guarantees have now been explicitly made part of the transfer pricing analysis.
A summary of the focus points is set out below.
The decision-making process
The decision-making process before putting in place an intra-group guarantee will be scrutinised for evidence of consideration of the following questions:
The financial guarantee
The form of the financial guarantee (explicit, implicit or as letter of comfort) is also considered to have relevance:
As regards the assertion that there is a guarantee in place, the following aspects will be scrutinised:
The price of the guarantee
The price of the guarantee fee is a hot audit topic. Audit questions to disallow a guarantee fee will particularly focus on the following issues:
The new transfer pricing guidance on financial transactions also covers treasury functions, hedging, cash pooling and captive insurance. Those have not been discussed in this article, but they require the same detail of information pursuant to the accurate delineation as intra-group loans and financial guarantees.
Final thoughts
What changed is that the accurate delineation process required for financial transactions has been clarified and is far more intricate and detailed than many taxpayers have considered so far. This may leave many taxpayers exposed in case of transfer pricing audits. To reduce exposure to transfer pricing adjustments, we recommend MNEs to conduct a review of their intra-group financial transaction portfolio and the application (and documentation) of the now explicit accurate delineation aspects.
