21 April 2020 OECD's transfer-pricing guidance on financial transactions - considerations for US taxpayers A recent report from the Organisation for Economic Co-operation and Development (OECD) contains critical guidance for multinational enterprises (MNEs) and tax authorities on applying the arm's-length standard to controlled financial transactions. The guidance, which the OECD plans to include in the next publication of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG), is expected to enhance consistency and help reduce transfer-pricing disputes and double taxation, although it also raises many unanswered questions. This Tax Alert provides a brief overview and summarizes the most critical areas of the Report for US taxpayers and their relevance in the context of US transfer pricing issues. The OECD's final Transfer Pricing Guidelines on Financial Transactions (the Report) were released February 11 and make only modest changes to a discussion draft released by the OECD on July 3, 2018. The OECD plans to use the Report to form a new Chapter X of the OECD TPG, although it has not stated specifically how or when the Report will be integrated.1 The final Report addressed only a subset of public comments that followed OECD Working Party No. 6's request for input. Although it represents the first time that guidance on financial transactions is included in the OECD TPG and plays a critical role for multinational enterprise (MNE) groups and tax authorities in applying the arm's length standard to controlled financial transactions, it is important to note that Working Party No.6 is not the final arbiter on the correct application of the arm's length standard. It remains to be seen what guidance from the Report will be sustained in the context of tax audits and how it will interplay with domestic law in various jurisdictions. It also remains to be seen how this Report will affect the existing interpretation of US Treasury Regulations Section 1.385 or Section 1.482, although it does not directly change US domestic law. Any divergence between US domestic law and the Report may lead to increased controversy and may result in a greater need for competent authority proceedings where available. The Report covers the accurate delineation of financial transactions, in particular with respect to MNEs' capital structures. The Report also addresses specific issues related to the pricing of financial transactions such as credit ratings, interest rate benchmarking, treasury functions, cash pooling arrangements, hedging, guarantees, and captive insurance. It also provides guidance on the determination of risk-free rates of return and risk-adjusted rates of return where an associated enterprise is entitled to such return under the guidance in Chapter I and Chapter VI of the OECD TPG. Although the Report includes a small number of rebuttable presumptions, such as the default characterization of a cash pool leader as a routine service provider, in general it acknowledges that transfer pricing analysis is highly dependent on facts and circumstances that may vary significantly between taxpayers. The Report is not prescriptive but rather lists factors that taxpayers and tax authorities should take into consideration in reaching their conclusions. It makes two specific concessions in this area: first that the financial services industry is subject to regulatory constraints or industry standards that should be acknowledged when concluding the arm's length treatment, and second that thin capitalization analysis should defer to the domestic legislation of the borrower's jurisdiction, which may differ from or be simpler than an exhaustive economic analysis. The Report sets forth guidance on how to delineate a number of transaction considerations, including debt and equity. When addressing debt versus equity considerations, the Report acknowledges that other approaches may be considered to address the same issue under domestic legislation, and this guidance does not prevent countries from implementing such domestic laws (e.g., IRC Section 385 in the US). This also allows for the existence of simplified measures, such as statutory thin capitalization ratio tests. The Report discusses relevant factors that are useful to accurately delineate any advance of funds. Such factors include the presence or absence of a fixed repayment date, the obligation to pay interest and the right to enforce payment of principal and interest; the status of the lender compared 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. The Report acknowledges that MNE groups operating in different sectors may require, for example, different amounts and types of financing due to industry-specific facts and that regulated MNEs such as financial services entities are subject to industry-specific regulations (e.g., Basel requirements) and that such factors should be taken into consideration in the analysis to accurately delineate a financing transaction. While this guidance is broadly consistent with the requirements of IRC Section 385 and the case-law factors2 considered relevant in determining whether a financing transaction would be regarded as debt or equity, there is a significant point of departure. The Report discusses an example where a member of an MNE group receives related-party funding greater than what an unrelated lender would have been willing to lend (due to its inability to repay the advance) and proposes that the excess principal would not be delineated as a loan. This allows for bifurcating a putative debt instrument into debt and equity based on the capacity of any member of an MNE group to borrow. Although the Prop. Reg. Section 1.385-1(d) issued April 4, 2016, had a similar provision, the final and temporary related-party debt-equity regulations under IRC Section 385 released October 13, 2016, eliminated the bifurcation option. Under US domestic legislation, if a member of an MNE group receives funds exceeding its capacity to borrow, the entire advance will be treated as equity for US tax purposes. The Report provides detailed guidance on pricing intercompany loans. While the general outline of the methodology described by the Report is consistent with the equivalent guidance in US Treasury Regulation Section 1.482-2 and with standard transfer-pricing practice, the specifics of the guidance include significant new features. The Report indicates that the transfer-pricing analysis for intercompany loans should consist of each of the following:
In addition to considering whether the transaction is properly delineated as a loan or should be recharacterized as equity, the Report contemplates recharacterizing the terms and conditions of intercompany loans in a broad range of circumstances, including:
Loan recharacterization has the potential to be a significant source of controversy, because there are many ways in which a particular loan could have been structured, and it could be difficult to prove, after the fact, how unrelated parties would have decided to borrow or lend. Some jurisdictions, such as Australia and Switzerland, have a history of challenging the form of intra-group debt. The Report could lead more tax authorities to routinely challenge the terms and conditions of debt, as well as the arm's length nature of the interest rate. Another major point of departure from existing US domestic legislation is the Report's focus on functional analysis to evaluate the lender's ability to exercise control in investment decisions and financial capacity to assume risks associated with such transactions. The Report states that if a functional analysis finds that the lender (e.g., Company A) does not exercise control over the investment risk, and another company (e.g., the parent of the MNE group, Company P) is exercising control over those risks and has the capacity to bear such risks, then under Chapter I analysis, the parent will bear the financial consequences of such risks and Company A will be entitled to no more than a risk-free return. This approach may have far-reaching consequences, may affect many existing funding structures and could potentially lead to double taxation. Such reallocations of income pose a significant controversy risk, because it could be difficult to determine where any such financing income actually belongs. Further, tax authorities may be unwilling to "import" losses for a loan that was not legally issued by an affiliate in their jurisdiction. Companies would be wise to examine the terms and conditions of their intra-group debt and evaluate whether they are consistent with the group's third-party financing, with the needs of the borrower and with the actual behavior of the parties. Companies should also consider how to document and defend the character and form of their intra-group debt. Additionally, companies should assess whether any taxable income from financing activities resides in a jurisdiction without adequate people functions and consider how to remediate any situations that could result in a reallocation of profit. The Report discusses the circumstances in which intra-group debt might be deemed to be refinanced (i.e., cases where accurately delineating the transaction indicates that the parties, at arm's length, would have agreed to refinance). Intercompany loans commonly have a prepayment feature (also referred to as a call option) permitting the borrower to repay the debt early without any penalty. The Report indicates that in situations where the borrower of an intra-group loan has prepayable debt, and the market rate of interest has decreased, the company should evaluate whether at arm's length the borrower would elect to source new (cheaper) funds and exercise the prepayment option to repay the existing debt. This guidance is consistent with audit history in many countries, including the US. Companies should examine existing intra-group debt for prepayment options and should regularly evaluate whether those options should be exercised. Determining the borrower's credit rating has always been acknowledged as a key step in pricing an intercompany loan. The Report provides important new guidance in two areas: (i) assessing the impact of group membership on the credit rating of a subsidiary and (ii) the use of credit rating models. The 2017 OECD guidelines previously included the requirement to consider the impact of group membership on the credit rating of subsidiaries (also known as the "halo effect"). The Report provides more specific guidance on how to actually assess the impact of group membership. This guidance is largely consistent with the publicly available policies of major credit rating agencies for determining the credit ratings of subsidiaries. Many of these factors are subjective and hypothetical (e.g., how strong is the group's commitment to support the subsidiary in a potential future period of financial difficulty), which could be a source of controversy. The Report's guidance on credit rating models discusses the limitations of purely quantitative models (i.e., those that focus purely on financial data without considering qualitative factors). The Report is clear that simply providing the output of a "black-box" rating model is not adequate support. The Report also suggests validating/calibrating such models by testing whether they give results consistent with public credit ratings for the group parent and/or competitors similar to the tested borrower. Tax authorities in different jurisdictions may have varying preferences for more quantitative versus more qualitative credit rating models. Companies should evaluate their global policies for credit ratings of subsidiaries and seek to have a consistent, defensible position on how much credit support subsidiaries would receive from the group. Additionally, companies should evaluate how subsidiaries are rated and consider whether the overall results are reasonable and consistent with the relative importance of the subsidiaries and the credit ratings of the group. The guidance in the Report is generally consistent with existing US transfer pricing guidance, but the Report provides more detailed guidance on several aspects of interest-rate benchmarking. First, the Report makes clear that a bank quote (an opinion from a bank that it would lend to a subsidiary at a specified rate, but where no actual loan was made) has no evidentiary value as a comparable. This is consistent with audit experience in many countries, including the US, where the tax authorities routinely dismiss such quotes. Second, the Report clarifies that "realistic alternative" transactions may be considered as comparables, as long as material differences are accounted for with adjustments. For example, to benchmark an intercompany loan, various forms of debt such as bonds or commercial paper may be used as comparables (potentially with adjustments). This is generally consistent with standard transfer-pricing practice. Third, the Report provides specific guidance for on-lending — in which a group member borrows funds externally and then passes those funds to a related party. The Report indicates that where the on-lender is acting merely as an agent for the ultimate borrower, the lender simply earns a markup on its direct costs. However, where the on-lender has the functional substance and equity to actually borrow the funds and then extend loans to group members (e.g., an in-house bank), the on-lender earns a return on its costs and risks including the opportunity cost of equity. The Report separately addresses transfer pricing for cash pools. It differentiates between physical cash pools and notional cash pools for which transactional costs are typically lower and the cash pool leader bears substantially less risk. The Report dedicates a subsection to the accurate delineation of transactions specifically for cash pools and the need to evaluate such arrangements in their entirety. The Report repeatedly refers to the concept of options realistically available and the need to ensure that parties to a cash pool are no worse off than they would be if they refused to participate. This has particular application in negative interest rate environments, where net depositors might require a zero percent floor in order to participate in a cash pool. The Report notes that as part of accurate delineation of a cash pooling transactions, the cash pool should not necessarily be disaggregated into separate components. For example, net depositors in a physical cash pool may enter into the arrangement expecting a share in any synergistic benefits arising from the cash pool, in addition to a deposit rate of return. The Report does acknowledge however that net borrowers from a cash pool may benefit sufficiently from access to a permanent source of financing and reduced exposure to external banks, which could preclude the need for enhanced interest rates. Another facet of accurate delineation is the correct use of cash pools as short-term arrangements. The Report advises that balances which become long-term may be recharacterized as longer-term loans and deposits. This is consistent with the historical positions taken by many tax authorities. The Report makes a rebuttable presumption that cash pool leaders perform coordination or agency functions that should be characterized as routine services and compensated accordingly. Nevertheless, the Report acknowledges that cash pool leaders can perform additional functions or manage additional risks, which if clearly delineated would result in additional arm's-length compensation. This is an important concession because cash-pool leaders often perform functions relating to liquidity planning or foreign exchange risk management. A detailed functional analysis is now an essential component of any transfer-pricing study of a cash pooling arrangement. Banks generally require cross-guarantees between cash-pool participants to establish notional cash pools. The Report acknowledges that the existence of a cross-guarantee does not necessarily imply that one subset of participants has extended its creditworthiness to another, and that such arrangements may be pro forma and non-compensable. The Report advocates a facts-and-circumstances approach while conceding that cross-guarantees do not per se exist under arm's length conditions and may therefore be difficult to reliably price. The Report provides guidance on explicit, legally binding financial guarantees. According to the Report, the accurate delineation of financial guarantees requires initial consideration of the economic benefit to the borrower beyond the benefit derived from passive association. The economic benefits from the guarantee could include an enhancement in the borrowing terms through a more favorable interest rate or access to a larger amount of borrowing. If the guarantee results in enhanced borrowing terms, the guarantee fee should be calculated based on the difference between the cost of borrowing with and without the guarantee, taking into account any implicit support. If the guarantee enables the borrower to increase its borrowing capacity, two additional issues arise as follows:
A similar issue may arise with cross-guarantees. An analysis of the facts may lead to the conclusion that the cross-guarantee does not enhance the credit standing of the borrower beyond the level of passive association. In this case, no compensation may be required, and the support provided in the case of default from the guarantor may be regarded as a capital contribution. In terms of pricing methods, the application of the comparable uncontrolled price (CUP) method through uncontrolled guarantees is viewed as the most reliable method, but it is not commonly available. In the absence of reliable CUPs, the yield approach, the cost approach, or other methods may be applied. The yield approach quantifies the benefit based on the spread between the cost of borrowing with and without the guarantee (considering the impact of any implicit group support), and the OECD suggests that this should be considered the maximum guarantee fee a borrower would be willing to pay. The cost approach quantifies the cost expected by the guarantor if the borrower defaults, and the OECD suggests that this represents the minimum fee the guarantor would be willing to accept. The arm's-length amount should be derived from a consideration of the borrower's and guarantor's perspectives. The Report covers captive insurance and provides considerations in relation to reinsurance captives. Although the focus is on captive insurance, intra-group reinsurance within an MNE group is also discussed and is distinguished from captive insurance within the OECD TPG. While the Report does not "carve out" reinsurance within an MNE insurance enterprise, it does treat such reinsurance as fundamentally different and less likely to be without substance. One of the key items covered is the accurate delineation of captive insurance and reinsurance. The guidance discusses indicators needing to be satisfied in order to be considered a genuine insurance transaction, including the existence of risk, diversification of risk, or the insurability of the risk outside the MNE group. These factors are consistent with the US Tax Court's definition of insurance, so that a captive that is appropriately treated as insurance for US tax purposes is likely to meet these criteria. In a stark contrast with US domestic law, the Report highlights the importance of the captive insurance entity's assumption and management of economically significant risks. This would require a determination of whether the captive assumes and controls the insurance risk contractually transferred to the captive insurance entity. The Report argues that when management of these risks is outside the captive insurance entity, the value generated by the risk diversification should accrue to the entity managing that risk rather than to the captive insurer itself. However, many US-based MNEs elect to tax their captive insurance companies as domestic companies under IRC Section 953(d). Having the risk management functions located in the US may therefore help support the argument that the captive, as part of the US tax group, has the appropriate level of control and substance and should be entitled to an appropriate level of compensation. US MNEs with global captive programs would do well to incorporate their captives in their TP documentation to emphasize the management of the captive by the US taxpayer. The guidance acknowledges that practical difficulties may arise in the application of the CUP method to determine an appropriate price for captive insurance and reinsurance. While the Report is silent on the use of quotes in the captive insurance context, prior comments about the unreliability of quotes to price intercompany debt are reasonably assumed to apply to captive insurance. It should be noted that many MNEs use broker quotes to price captive insurance premiums, which would suggest that a secondary analysis supporting the pricing is prudent. One suggested alternative to the CUP method is the actuarial analysis. From a US perspective, this is a common method applied to price captive insurance and reinsurance transactions. Depending on the specific lines insured, the actuarial method could be considered an appropriate unspecified method if the right assumptions and tested-party data are used. For profitability-based methods, the guidance suggests performing a two-staged approach, taking into account both the profitability of claims and return on capital for the captive. The guidance recognizes the importance of capital adequacy requirements, noting that the requirements for captives are likely to be significantly lower than for an insurer writing policies for unrelated parties. This may require the performance of appropriate adjustments to account for differing capital adequacy requirements, which is consistent with the US transfer-pricing rules and our experience with these transactions. Finally, the Report also addresses group synergies. The captive insurance entity should receive an appropriate reward for the basic services provided, and the remaining group synergy benefit should be allocated among the insured participants through discounted premiums. This is inconsistent with how captive insurers allocate the benefits, as the benefits are typically split between the captive insurer, the entity managing the risks and the insured participants. Finally, many US MNE groups include the captives under their US tax return through an IRC Section 953(d) election. Therefore, US MNE groups may argue that the captive, as part of the US tax group, has the appropriate level of control and substance and should be entitled to an appropriate level of compensation consistent with IRC Section 482 and the OECD Guidelines. The Report provides guidance on (a) determining the risk-free rate and (b) determining a risk-adjusted rate when an entity providing funding does assume risks. The guidance on determining risk-free rates is consistent with the standard definition of a risk-free rate used in economics and is generally straightforward, especially for major currencies. The guidance on determining a risk-adjusted rate indicates the risk-adjusted rate is determined by adding a risk premium to the risk-free return; however, few details or specifics are provided. Determination of risk-adjusted rates of return for financing remain important due to the guidance on rewarding funding risk versus DEMPE (Develop, Enhance, Maintain, Protect and Exploit) functions in the 2017 OECD Guidelines, but it remains to be seen how companies and tax authorities will actually determine such rates. The Report represents a significant step in the development of the OECD TPG, as it is the first time that guidance on such transactions will be included. The 137 members of the OECD's Inclusive Framework have approved the Report, and therefore its importance stretches beyond the OECD member countries. The Report's perspectives and proposed transfer-pricing approaches are broadly consistent with many current best practices that had developed organically among transfer pricing practitioners. However, as noted in this Tax Alert, there are some discrepancies and novelties, and the preferences of some continental European tax authorities are clearly exhibited. Despite extensive public commentary on the July 2018 discussion draft, OECD Working Party No. 6 did not make significant changes in concluding the final version of the Report. The Report extensively lists factors that could affect the appropriate transfer-pricing analysis but is not able to present a consensus view in every case as to how taxpayers should prioritize these factors or quantitatively address them. Because it raises more questions than answers, the Report increases the risk of tax authority scrutiny.
1 The guidance on the determination of risk-free and risk-adjusted rates of return will be included in Chapter I of the OECD TPG rather than Chapter X. Document ID: 2020-1059 | |||||||||||||||||||
