What is it all about?
More than 18 months after the publication of its non-consensus discussion draft on Financial Transactions (BEPS Actions 8 to 10), the OECD released its ‘final’ report on the transfer pricing of financial transactions on Tuesday 11 February 2020. The original draft left some 25 areas of disagreement, representing a non-consensus position of the OECD’s Committee on Fiscal Affairs. While those areas are largely resolved by the guidance, there remain some issues that have not been definitively addressed.
The guidance is significant because it is the first time the OECD Transfer Pricing Guidelines will be updated to cover the transfer pricing aspects of financial transactions. The guidance addresses specific issues on:
- How the ‘accurate delineation analysis’ of transactions advocated by the 2017 OECD Transfer Pricing Guidelines is to be applied to financial transactions (including to the capital structure of an MNE itself within an MNE group)
- The effect of group membership on debt capacity and loan pricing, such as the value (if any) of formal guarantees and implicit support
- Stand-alone credit ratings of individual subsidiaries of a multinational group (and their impact)
- How to determine risk-free and risk-adjusted rates of return
transfer pricing of:
- Treasury functions
- Intra-group loans (including the fact that implicit guarantees from a group can and should be taken into account when pricing loans)
- Cash pooling
- Captive insurance.
Good news, bad news
The OECD’s new guidance is designed to improve international consistency in the transfer pricing of financial transaction by promoting a set of common standards and to reduce the risk of double taxation. It should certainly reduce risk in many areas and is to be hugely welcomed.
There also remain, however, some contentious areas leaving scope for controversy between countries and leaving taxpayers with some difficult choices on their approach to pricing and structuring financing transactions. In addition, following the new guidance will require a higher level of documentation and analysis than some groups might historically have expected. We address some of these challenges below.
Capital structure – Whilst it acknowledges that the structure and interest rate of a prima facie loan in a related party situation should be subjected to the arm’s length standard, the guidance leaves it to the domestic legislation of countries to ‘address the balance of debt and equity funding of an entity and interest deductibility’. This allows individual jurisdictions to put aside an ‘accurate delineation analysis’ in favour of their own approach to determining the arm’s length mix of debt and equity – leaving the potential for significantly different approaches (and tax misalignment) between different jurisdictions.
Substance and allocation of risk – These are important in underpinning the proper delineation of transactions and transaction/entity characterisation. However, the guidance states that where a “lender is not exercising control over the risks associated to an advance of funds”, its return may still be (limited to) a risk-free return. This could lead to tax misalignment and challenging compliance issues.
Credit analysis of the borrower – The OECD guidance advocates the role of a credit analysis of the borrower in pricing intra-group loans, including the use of commercial hypothetical credit scoring tools and methodologies. It also emphasises the need to consider the ‘implicit support’ that an individual entity may derive from its membership of a multinational group. However, in some circumstances, the guidance anticipates the use of the credit rating of the MNE group as a whole by its constituent entities (an approach commonly taken by many countries) as opposed to separate entity credit ratings. This leaves a lot of room for arguments between tax authorities over the most appropriate approach to use.
Cash pooling – The guidance requires an ‘accurate delineation analysis’ for cash pooling. This will inevitably lead to particular challenges in proving the appropriate characterisation of debit and credit balances in the cash pool based on the length of time loans and deposits are left outstanding, the patterns of deposit and lending over time and the group’s overall funding policies, and in establishing the basis for allocating returns to the pool participants.
Financial guarantees – Implicit support should also be considered when pricing a financial guarantee but this is a difficult exercise and there is little direct guidance on how to measure it in the OECD material.
Interaction with other areas of tax?
In addition to transfer pricing, many jurisdictions now use prescriptive (and often mechanical) tax rules reflecting BEPS Action 4 eg Corporate Interest Restriction and anti-hybrid mismatch provisions. South Africa proposes to introduce a net interest expense limitation of 30% to EBITDA in line with BEPS Action 4 which Nigeria just implemented. These rules can potentially give rise to situations where a company in one country will be taxed on arm’s length interest income but the borrower in another country will not be able to deduct interest due to a mechanical interest limit. Therefore, a holistic approach to the analysis of the characterisation and pricing of financing transactions is critical to map the impact on group profitability.
Why look at this issue now?
Many will regard the level of analysis set out for financial transactions under this new guidance as highly demanding. The emphasis it places on risk management within a finance structure and its economic rationale could also cause some practical challenges with establishing and supporting appropriate pricing. However, the expectations outlined by the guidelines set a clear standard for taxpayers and, for the first time, provide tax authorities with reasonably clear guidance on how to scrutinise the transfer pricing of financial transactions. As a result, we expect tax authorities will increasingly challenge groups’ financial arrangements including South Africa.
Taxpayers should begin preparing for this increased scrutiny now to avoid the risk of tax adjustments and penalties, economic double taxation and accounting provisions for uncertain tax positions, not to mention the cost of deploying internal and external resource to handle associated tax enquiries. Failing to prepare will also expose the business to the reputational risks that can easily arise from major tax disputes and financial adjustments.