On 3 July 2018, the Organisation for Economic Co-operation and Development (‘OECD’) released the first public discussion draft on the transfer pricing aspects of financial transactions (‘the Discussion Draft’).

What was in the Discussion Draft?

  • Clarification on the application of the principles covering the accurate delineation of financial transactions
  • Address specific issues related to the pricing of financial transactions such as treasury function, intra-group loans, credit ratings, cash pooling, hedging, guarantees, and captive insurance.

The Guidance

The OECD invited comments on the discussion draft from interested parties and based on the inputs received, on 11th February 2020, released the Transfer Pricing Guidance on Financial Transactions (‘Guidance’) aiming to achieve arm’s length price (‘ALP’) interpretation consistency.

This is significant as for the first time the OECD commentary provides guidance on the transfer pricing aspects of financial transactions, which aims to contribute to consistency in the application of transfer pricing and help reduce transfer pricing disputes and double taxation. The content of this Guidance will be included in the 2017 edition of OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD TPG’) as Chapter X.

Structure of the Guidance

The Guidance is divided into five main sections:

  1. Interaction with the guidance provided in section D.1 of Chapter I of the OECD TPG;
  2. Treasury function, including related transactions such as intra-group loans, cash pooling and hedging;
  3. Financial Guarantees;
  4. Captive insurance; and
  5. Risk-free and risk-adjusted rate of return

This article is designed to capture the references in the Guidance pertaining to the accurate delineation of financial transactions and intra-group loans.

1. Accurate delineation of financial transactions

The Guidance starts with laying out the principles that should be followed with respect to the accurate delineation of a financial transaction, by lending support to the notion that it is possible to determine an arm’s length capital structure. This inter-alia covers the following discussion:

1.1. Capital structure: Arm’s length rate vs arm’s length debt

The Guidance raises an important point of paying heed not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital.

Hence, not only is the arm’s length rate of interest a determining factor, but the arm’s length debt also deserved equal weightage.

In accordance with the guidelines established in Chapter I of the OECD TPG, the accurate delineation of the actual transaction should begin with a thorough identification of the economically relevant characteristics of the transaction – consisting of the commercial or financial relations between the parties and the conditions and economically relevant circumstances attaching to those relations, including an examination of the contractual terms of the transaction, the functions performed, assets used, and risks assumed, the characteristics of the financial instruments, the economic circumstances of the parties and of the market, and the business strategies pursued by the parties. The economically relevant characteristics of financial transactions have been discussed in detail in Section IV of this article.

It is acknowledged that countries may adopt approaches other than transfer pricing approaches, to address the capital structure and interest deductibility under domestic legislation.

As an active participant to the OECD/G20 BEPS project, India has endorsed Action 4 of the OECD’s BEPS Action Plan through Finance Act, 2017 and has implemented the legislative regulations concerning ‘limitation of interest deduction in certain cases to the extent of 30% of EBITDA’ in the Income Tax Law. The said regime has been introduced vide Section 94B in the Income Tax Act, 1961 (‘the Act’).

1.2. Contractual terms vs. actual conduct

Particular labels or descriptions assigned to financial transactions do not constrain the transfer pricing analysis. The actual conduct in a given case will outdo the documented terms, a classical case of ‘substance over form’.

The following economically relevant characteristics may be useful indicators:

  • the presence or absence of a fixed repayment date;
  • the obligation to pay interest;
  • the right to enforce payment of principal and interest;
  • the status of the funder in comparison to regular corporate creditors;
  • the existence of financial covenants and security;
  • the source of interest payments;
  • the ability of the recipient of the funds to obtain loans from unrelated lending institutions;
  • the extent to which the advance is used to acquire capital assets;
  • and the failure of the purported debtor to repay on the due date or to seek a postponement.

1.3. Options realistically available

The Guidance emphasises on the importance of assessing the options realistically available to the lender as well as the borrower when entering into financial transactions.

For instance, in the case of a lender, other investment opportunities may be contemplated, taking account of the specific business objectives of the lender.

From the borrower’s perspective, the options realistically available will include broader considerations than the entity’s ability to service its debt. In some instances, although an entity may have the capacity to borrow and service an additional amount of debt, it may choose not to do so to avoid placing negative pressure on its credit rating and increasing its cost of capital and jeopardising its access to capital markets and its market reputation.

Macroeconomic circumstances may lead to a possibility of the borrower or the lender to renegotiate the terms of the loan to benefit from better conditions, which will be guided by the options realistically available to both the borrower and the lender.

2. Economically relevant characteristics of financial transactions

Specific guidance in the context of financial transactions is provided for each of the economically relevant characteristics (comparability factors), i.e. contractual terms; functions performed, assets used, risks assumed; characteristics of financial products or services; economic circumstances of the parties and the markets; and the business strategies pursued by the parties.

2.1. Contractual arrangements

The Guidance stipulates that terms and conditions of written agreements should be considered in conjunction with other documents, the actual conduct of the parties, and economic principles that generally govern relationships between independent enterprises in comparable circumstances. As an illustration, in evaluating the pricing of an unsecured loan extended by a parent to its wholly-owned subsidiary, since the parent already has control and ownership of the subsidiary, the contractual granting of security is less relevant to its risk analysis as a lender; and it will be appropriate to consider whether those assets are available to act as collateral for the otherwise unsecured loan and the consequential impact upon the pricing of the loan.

2.2. Functional analysis

The Guidance provides an overview of the typical key functions performed by lenders and borrowers with respect to intra-group loans.

Lender Functions

  • Analysis and evaluation of the risks
  • Capability to commit capital of the business to the investment
  • Determining the terms
  • Organising and documenting
  • Ongoing monitoring and review

Borrower Functions

  • Ensuring the availability of funds to repay the principal and the interest on the loan in due time
  • Providing collateral
  • Monitoring and fulfilling any other obligation derived from the loan contract

2.3. Characteristics of financial instruments

The most important characteristics for transfer pricing purposes include, among others,

  • Amount of the loan
  • Maturity
  • Schedule of repayment
  • Nature or purpose of the loan
  • Level of seniority and subordination
  • Geographical location of the borrower
  • Currency
  • Collateral provided
  • Presence and quality of any guarantee
  • Interest rate, fixed or floating.

2.4. Economic circumstances

The most relevant economic circumstances for delineating financial transactions include macroeconomic trends such as:

  • Central bank lending rates or interbank reference rates
  • Financial market events (e.g., credit crisis)
  • Currency differences
  • Regulatory controls and restrictions.

As a practical illustration, insolvency law in the jurisdiction of the borrower may provide that liabilities towards associated enterprises are subordinated to liabilities towards unrelated parties.

2.5. Business strategies

Examples of relevant business strategies listed are:

  • Expansion (mergers or acquisitions) versus steady operations,
  • MNE group’s global financing policies
  • Pre-existing loans
  • Shareholder interests

3. Intra-group loans

The Guidance emphasises the importance of the two-sided perspective in considering the commercial and financial relations as well as in analysing the economically relevant characteristics of the financial transactions between the associated borrowers and lenders.

While acknowledging that there might be differences in the processes pertaining to the provision of loans between associated enterprises when compared to loans provided between independent enterprises, the Guidance recognises there are certain commercial considerations that are equally relevant for both intra-group and third-party loans, such as creditworthiness, credit risk and other economic circumstances.

3.1. The lender’s and borrower’s perspective

The Guidance emphasises the importance of the two-sided perspective in considering the commercial and financial relations as well as in analysing the economically relevant characteristics of the financial transactions between the associated borrowers and lenders.

The lender’s perspective in the decision of whether to make a loan, how much to lend, and on what terms, will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of the funds.

Borrowers seek to optimise their weighted average cost of capital, consider the potential impact of changes in economic conditions such as interest rates and exchange rates, as well as the risk of not being able to make timely payments of interest and principal on the loan if the borrower’s business encounters unexpected difficulties, and the risk of not being able to raise more capital, if necessary.

3.2. Credit Rating

The credit rating is an opinion about its general creditworthiness. Credit ratings can be determined for the overall creditworthiness of an MNE or MNE group or for a specific issuance of debt. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining what interest rate to charge.

3.2.1. Determination of credit rating

Where an MNE has a publicly available credit rating published by an independent credit rating agency, that rating may be informative for an arm’s length analysis of the MNE’s controlled financing transactions. However, where no such rating is available, recourse may be taken to publicly available tools to determine the credit rating. The Guidance recognises that the credit rating methodologies applied by independent rating agencies to determine official credit ratings are based on far more rigorous analysis, since they use both qualitative and quantitative factors, while credit rating methodologies used in commercial tools have a limitation of over-dependency on accuracy of the input parameters, tendency to prefer quantitative factors at the expense of the qualitative factors, and lack of clarity in the models used.

The Guidance emphasises the importance of adjustments within the credit rating process in cases where the reliability of the credit rating analysis might be jeopardised by the presence of related-party transactions which may not be priced at arm’s length.

3.2.2. Effect of group membership/ Implicit support

Based on the Guidance, implicit group support is a required step in the determination of the credit rating of the borrower. The Guidance mentions important factors to be considered when evaluating the level of implicit group support of the borrower, such as the relative importance of the entity to the group as a whole, linkages between the entity and the rest of the group, consequences of non-support of the entity. The specific criteria used to determine the status of the entity normally include legal obligations, strategic importance, operational integration and significance, shared name, potential reputation impacts, general statement of policy or intent and any history of support.

3.2.3. Issue rating vs Issuer rating vs Group rating

The credit rating of particular debt issuance (“issue rating”) is an opinion about the creditworthiness of the issuer with respect to a specific financial instrument.

The credit rating of an MNE or MNE group (usually referred to as the “issuer credit rating”) is an opinion about its general creditworthiness.

The Guidance states that when both an issuer and issue ratings are available, the issue rating of the particular debt issuance would be more appropriate to use to price the controlled financial transaction.

The Guidance also cautions that pricing approach based on the standalone entity credit ratings that are derived from publicly available financial tools, conducting an implicit support analysis, and the difficulties of accounting for controlled transactions reliably may pose challenges that, if not resolved, may result in outcomes that are not reliable. In such a case, the credit rating of the MNE group may also be used for the purpose of pricing the accurately delineated loan, particularly in situations where the MNE is strategically important to the group and where the MNE’s indicators of creditworthiness do not differ significantly from those of the group.

3.3. Pricing approaches to determining arm’s-length interest rates

3.3.1. Comparable Uncontrolled Price (CUP) method

The Guidance stipulates that due to the widespread availability of information and analysis of loan markets, it is typically easier to apply the CUP method to financial transactions than in the case of other types of transactions.

The information available often includes details on the characteristics of the loan and the credit rating of the borrower or the rating of the specific issuance.

  • Characteristics which usually increase the risk for the lender, such as long maturity dates, absence of security, subordination, or application of the loan to a risky project, will tend to increase the interest rate.
  • Characteristics which limit the lender’s risk, such as strong collateral, a high-quality guarantee, or restrictions on the future behaviour of the borrower, will tend to result in a lower interest rate.

Also, the Guidance states that depending on the facts and circumstances, realistic alternatives to intra-group loans could be bond issuances, deposits, convertible debentures, commercial papers, etc. The Guidance also emphasises that potential internal comparable uncontrolled prices should not be overlooked.

3.3.2. Other methods

The cost of funds approach could be used as an alternative to price intra-group loans in certain cases. The cost of funds will reflect the borrowing costs incurred by the lender in raising the funds to lend. To this would be added the expenses of arranging the loan and the relevant costs incurred in servicing the loan, a risk premium to reflect the various economic factors inherent in the proposed loan, plus a profit margin, which will include the lender’s incremental cost of the equity required to support the loan. In some intra-group transactions, the cost of funds approach may be used to price loans where capital is borrowed from an unrelated party which passes from the original borrower through one or more associated intermediary enterprises, as a series of loans, until it reaches the ultimate borrower.

Other alternatives which could be explored are credit default swaps and economic models, although both these are laced with inherent limitations. Credit default swaps are subject to a high degree of volatility, which in turn affect their reliability; and economic models’ outcomes do not represent actual transactions between independent parties and, therefore, comparability adjustments would be warranted.

3.3.3. Quotations

Finally, the Guidance denies the comparability of external bank opinions to the intra-group loans as these informal letters do not constitute an actual offer to lend and therefore cannot be considered comparable to actual transactions.

4. Analysis of the Guidance

The salient features of the Guidance have been discussed in sections III to V above. In this section, we propose to discuss our comments and expectations expressed by various stakeholders, which in some cases have been considered, but also leave room for interpretation and clarity.

4.1.  Capital structure

While it is agreed that it is appropriate to do a thorough function, asset and risk analysis for intercompany financing arrangements, accurately delineating the transaction in terms of guidance provided would lead to bringing in an approach in determining the capital structure of a business. The fundamental attributes of a capital structure takes into account various elements and no two businesses may consider a similar structure even when operating in a similar industry. The capital structure would be more a management’s decision based on varied factors such as risk appetite, long term strategic operation plans, growth of the business etc. and hence bringing in an ‘arm’s length’ concept thereby leading to a re-construction of the capital structure would lead to complexities. Also, the tax authorities may use it as a tool during tax audits, to further complicate the already complex litigation environment.

4.2. Options realistically available

In terms of the options realistically available, a prudent business is inherently going to make decisions based on the impact on the business, and choosing one option over the other may not necessarily be carved out to be non-arm’s length. One could document the commercial rationale for making a decision, however, the guidance should not open wide room for interpretation, thereby imposing a burden of documenting all the options realistically available. 

4.3. Credit rating

With regard to credit rating (as mentioned in Section V, Point 2), the Guidance speaks about the use of issue rating, issuer rating and the MNE group rating. 

The guidance gives priority to the use of issue or issuer rating.  However, it mentions that the use of statistical tools to arrive at this rating, accounting for implicit support etc. would be led to challenges in ascertaining a reliable credit rating and hence, suggests the use of the MNE group credit rating in those cases.

Using group MNEs rating is not in line with the general practice/principle of transfer pricing which considers a separate entity approach.  Hence, in the first instance, due consideration should be given to using the entities standalone credit rating, if no credit rating has been assigned by any rating agency, use of publicly available tools such as Moody’s RiskCalc could be used to determine a credit rating based on quantitative and qualitative factors.  In case of absence of information to undertake a rating exercise for the MNE member, consideration could be given to using the MNE group credit rating after incorporating adjustments to notch the rating down appropriately based on various factors to determine strategic importance of the said company to the MNE group 

4.4. Realistic alternatives to intragroup loans

The Guidance has considered bonds, deposits, commercial paper and convertible debentures as alternatives to intragroup loans. 

While it is appreciated to consider alternatives with considerable adjustments where required, instead of convertible debentures, one would ideally consider non-convertible / redeemable debentures to be an alternative to loans rather than convertible debentures, which would have characteristics of equity, and hence, the interest rate would not be reflective of pure debt issuance.

4.5. Implicit support

The concept of implicit support is not a new concept and has been applied in landmark global cases in Canada (GE Canada)[1] and Australia (Chevron Australia)[2].  Generally, credit rating agencies such as Moody’s and S&P provide with models to assess implicit support.  However, in cases of multiple cross border debts involving multiple countries one would need to carefully look at domestic regulations in various countries, for e.g. UK legislation may not support the concept of implicit support, which then would create a difference in treatment between the OECD guidelines and local regulations.

4.6. Bank quotes

While the guidelines lean towards the acceptability of CUP as the method in determining the arm’s length price of inter-company financing transactions, it negates the use of bank quotes, not being based on actual transactions and hence, a deviation from the arm’s length approach.  However, in India, the regulations allow the use of a sixth method i.e. ‘Other Method’ which refers to a “price which has been charged or paid, or would have been charged or paid”, where guidance had been provided on the use of third-party quotations which could possibly provide some room for evaluating the use of bank quotes.

5. Takeaway Thoughts

The Guidance is largely in lines with the discussion draft issued in 2018. While it is appreciated that the Guidance brings in certain clarifications on the manner in which an arm’s length pricing of intragroup transactions could be looked at, there are certain key aspects that seem to be open to interpretation.

There has been wide representation from various stakeholders on the capital structure / accurate delineation of transactions, and its connotation which would lead to an open room for interpretation of intragroup financial transactions by the tax authorities, the guidance seems to have retained this principle, which could possibly lead to increased transfer pricing disputes, while this may directly contradict the purpose of this Guidance. Evaluation of options realistically available, if interpreted by the tax authorities in the stricter sense would require robust documentation to prove commercial business reasoning, which would add privation to corporates especially those with multiple intragroup transactions and multiple debt structures.

Further, while colossal representation has been made to keep MNEs operating in the financial services industries (banks, broker-dealers, and insurance companies) precluded from adopting these guidelines, being a highly regulated industry that has a different business model, there seems to be no specific exclusion granted in the Guidance. However, the Guidance does give indirect immunity by stating that “where the relevant MNEs are regulated, such as financial services entities subject to regulations consistent with recognised industry standards (e.g. Basel requirements), due regard should be given to the constraints those regulations impose upon them.”

Many countries across the globe place reliance on guidance issued by the OECD. While the guidance recognises that domestic legislations deal with certain aspects such as that of capital structure, interest limitation etc. there may be a need for countries implementing the guidance for intragroup transactions, to consider re-looking at their domestic legislation to counter any divergence that could lead to double taxation.

Also read: Will OECD’s “Unified Approach” change the way we think tax?


Reference

  1. Her Majesty the Queen v General Electric Capital Canada, Inc.[2010] Federal Court of Appeal 344
  2. Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation [2017] FCAFC 62

Jaiman Patel, Partner, International Tax Services, Ernst & Young LLP

Cheryl Jagtap, Manager, International Tax Services, Ernst & Young LLP

Husein Zaki, Manager, International Tax Services, Ernst & Young LLP

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