The OECD has released its final guidance on the transfer pricing of financial transactions. The report, ‘Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10’, is significant because it is the first time the OECD Transfer Pricing Guidelines include guidance on the transfer pricing aspects of financial transactions, which will contribute to consistency in the interpretation of the arm’s length principle and help avoid transfer pricing disputes and double taxation.
The guidance in this report describes the transfer pricing aspects of financial transactions. It also includes a number of examples to illustrate the principles discussed in the report. Section B provides guidance on the application of the principles contained in Section D.1 of Chapter I of the OECD Transfer Pricing Guidelines to financial transactions. In particular, Section B.1 of this report elaborates on how the accurate delineation analysis under Chapter I applies to the capital structure of a multinational enterprise (MNE) within an MNE group.
It also clarifies that the guidance included in that section does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation. Section B.2 outlines the economically relevant characteristics that inform the analysis of the terms and conditions of financial transactions. Sections C, D and E address specific issues related to the pricing of financial transactions (e.g. treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance). This analysis elaborates on both the accurate delineation and the pricing of the controlled financial transactions. Finally, Section F provides guidance on how to determine a risk-free rate of return and a risk-adjusted rate of return.
Addressing base erosion and profit shifting (BEPS) continues to be a key priority of governments around the globe. In 2013, OECD and G20 countries, working together on an equal footing, adopted a 15-point Action Plan to address BEPS. In 2015, the BEPS package of measures was endorsed by G20 Leaders and the OECD. In order to ensure the effective and consistent implementation of the BEPS measures, the Inclusive Framework on BEPS was established in 2016 and now has 137 members. It brings together all interested countries and jurisdictions on an equal footing at the OECD Committee on Fiscal Affairs.
A Global Tax Alert published by global consultancy EY has analysed a number of the implications for treasury from the transfer pricing guidance on financial transactions. Some of the key considerations from the EY Alert include:
The report describes the transfer pricing aspects of the treasury function within an MNE group and acknowledges that the management of group finances is an important and potentially complex activity. The organisation of the treasury function, including the level of centralisation, depends on the structure of the MNE group and the complexity of its operations. The report provides an overview of typical key functions performed by treasury.
According to the new guidance, usually the treasury function constitutes a support service to the main value-creating business operations. In other situations, the treasury function may be more complex and should be compensated accordingly. It is also recognised that the activities of the treasury are closely linked to and influenced by the vision, strategy, and policies established by group management. As such, the higher strategic decisions will usually be associated with policy setting at the group level, rather than driven by the treasury function itself.
The report states that the accurate delineation of cash pooling arrangements needs to take into account not only the facts and circumstances of the relevant balances, but also the context of the arrangements as a whole. One key consideration in the context of cash pools includes the allocation of synergy benefits. In this respect, the guidance stipulates that these benefits would generally be shared by the cash pool members, provided that an appropriate reward is allocated to the cash pool leader. Another key consideration is whether it is appropriate for the transaction to be treated as a short-term cash pool balance, or whether the facts and circumstances support an alternative view such as being a long-term deposit or term loan.
Rewarding the cash pool leader
The appropriate reward of the cash pool leader will depend on the facts and circumstances, the functions performed, the assets used, and the risks assumed in facilitating a cash pooling arrangement. Where a cash pool leader performs no more than a coordination or agency function to meet a pre-determined target balance, its remuneration as a service provider should be in accordance with these routine functions. The report states that in a notional pool setup many functions are primarily performed by the bank and little, if any, value is added by the cash pool leader. Activities other than coordination or agency functions may infer that a higher remuneration is appropriate, which can include earning part or all of the spread between the borrowing and lending positions which it adopts.
Rewarding the cash pool members
The remuneration of the cash pool members will be calculated through the determination of the arm’s-length interest rates applicable to the debit and credit positions within the pool. The allocation of synergy benefits to the cash pool members will generally be done once the remuneration of the cash pool leader has been calculated. All cash pool participants are expected to be better off than in the absence of the cash pool. Benefits for cash pool participants can take the form of enhanced interest rates to debit and credit positions, but also qualitative benefits such as access to a permanent source of financing, reduced exposure to banks, or access to liquidity that may not be available otherwise.
Cash pool arrangements may require cross-guarantees and rights of set-off between participants in the cash pool. Although the particular facts and circumstances of any situation should always be considered, the practical result of the cross-guarantees may factually represent nothing more than an acknowledgement that it would be detrimental to the interests of the group not to support the performance of the cash pool leader and so, by extension, the borrower. In such circumstances the benefits associated with the guarantee may not exceed the benefits related to the implicit support of the MNE group. If the prevailing facts and circumstances support such a conclusion, no guarantee fee would be due. On the other hand, the report concludes that any support, in the case of a default from another group member, should be regarded as a capital contribution.
The report acknowledges that hedges are frequently used in the ordinary course of business as a means of mitigating exposure to risks such as foreign exchange or commodity price movements. Whereas an independent entity may decide to accept or hedge such risks, within an MNE group these risks may be treated differently because of the group’s approach to risk management and hedging.
The guidance states that treasury functions relating to hedging will often be centralised to improve efficiency and effectiveness. This may result in the situation where risks are not hedged on an entity level but an MNE’s risk is hedged from a group perspective. The central arrangement of a hedging contract by treasury, that an operating entity enters into, can be seen as the provision of a service, for which treasury should get an arm’s-length compensation. More difficult transfer pricing issues may arise, however, if the contract instrument is entered into by the treasury company or another group company, with the result that the positions are not matched within the same company, although the group position is protected.
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