The OECD published the highly anticipated final Transfer Pricing Guidance on Financial Transactions on February 11, 2020. The paper does indeed give improved guidance on pricing; however, further discussions in tax audits on the topic seem to be quite likely.
Loans, credits and guarantees
The guidance now also deals with the classification of financial transactions as debt or equity instrument, which is of significant importance for the general acceptance of the deductibility of interest from a tax point of view. Similar to the case law of the Austrian Higher Administrative Court regarding hidden equity, the guidance gives some useful indicators for the delineation of funds, such as e.g. explicit agreements regarding repayment, the obligation to pay interest, the right to enforce payment, the existence of securities as well as the ability of the recipient of the funds to alternatively obtain loans from unrelated lending institutions and therefore being able to repay on the due date. However, by solely listing some indicators, the classification as debt capital still remains a matter of uncertainty. Still, at least a certain international political acceptance of actual practice, that results from case law of Austrian courts can now be seen.
With regard to the arm’s length nature of interest rates of a loan, influencing factors are identified in a rather broad manner, which together with alternative options have to be appropriately documented. When using a comparability analysis, apart from the credit contract conditions, especially the particularities of the respective industry, such as different capital intensities or different needs for short-term financing, are of relevance. Given that a (lending) parent entity already has control and ownership to the subsidiary, for appropriate pricing it has to be taken into account whether the shares owned could already classify as security for the financing.
The discussion of TP methods for addressing the arm’s length compensation of debt financing brings an overview of state-of-the-art methodologies. It is emphasized that the “one and only” correct transfer price does not exist. Instead, there will always be a range of applicable rates. The paper mentions the comparable uncontrolled price method is mainly used with external comparables, where loans and bonds between third parties are taken as proxies. The issuance of a comparable financial instrument is to be close to the issuance of the tested transaction.When assessing the creditworthiness, it particularly has to be noted that rating agencies also consider qualitative aspects (such as strategic importance and operational integration in the group or history of financial support in the past) as well as historic and forecast entity performance. Therefore, those aspects also have to be considered in case of controlled transactions. Other factors to be recognized include the industry, since for companies within higher-risk industries better results should be expected than for low-risk industry companies, in order to achieve an identical credit rating. Consequently, if a credit rating for a separate entity is not reliably determinable, the use of the parent entity’s official credit rating may also be appropriate. If a company’s rating improves due to its mere affiliation to the group, this improvement in interest conditions has to be taken into account without the subsidiary having to compensate the parent entity (so-called implicit support). Moreover, the issuance of an explicit guarantee through a related company may not imply an improvement of the creditworthiness if financial support can already be assumed due to the strategic importance of the subsidiary. In such a case, the subsidiary will not be willing to pay for the issuance of the guarantee.
Furthermore, the paper – for the first time - explicitly endorses the view that bank opinions cannot be regarded as evidence for arm’s length terms and conditions (which was already widely accepted in Austria). In fact, a bank opinion does not constitute an actual offer to lend, but usually is issued before any due diligence and approval processes are carried out. As possible alternatives to the CUP method, the cost of funds approach as well as the economic modelling are set forth. It is worth noting that the use of credit default swaps to calculate the risk premium associated to intra-group loans, however, is critically viewed. Indeed, the OECD points out the high volatility credit default swaps may be subject to, which in turn may affect the reliability of credit default swaps as proxies.
Whenever a funder does not perform the decision-making functions to control the risk associated with investing in a financial asset, the funder is only entitled to a risk-free return according to the point of view set out in the guidance. The OECD mentions interest rates on government issued securities, interbank rates and interest rate swaps as possible reference rates for determining the risk-free interest rate.
For determining the arm’s length price of guarantees, the guidance sets forth the so-called yield approach as well as other appropriate methods such as e.g. the cost approach or the valuation of expected loss approach.
With regard to cash pooling the OECD highlights that cash pooling is not commonly used amongst independent enterprises and therefore the application of transfer pricing principles has to be considered carefully. In addition, long-term constant balances in cash pools are addressed in the guidance. As experience from Austrian tax audits and legal proceedings shows, such constant surpluses within cash pools could - from an economic point of view – be classified as long-term loan agreements and therefore require a compensation according to loan standards. The remuneration of the cash pool leader shall depend on whether the pool leader operates as mere service provider or whether he also takes the material decisions associated with the respective risks (such as how to invest surplus funds of the cash pool or whether foreign currency risks are to be hedged) and also has the financial capacity to bear those risks. The latter one has a right to earn part of the spread. Regarding the group members, it is stated that usually all cash pool members should be able to achieve improved interest conditions. Synergies arising from the cash pool (e.g. related to the possibility of netting positive and negative balances) should be allocated between the group members. Unfortunately, the guidance lacks explicit hints on how to allocate the synergy benefits amongst the pool members. Further, also advantages other than beneficial interest rates may arise out of the participation in a cash pool, e.g. such as access to a permanent source of liquidity and reduced exposure to external banks.
A captive insurance is an insurance undertaking or entity within the group who provides insurance policies for risks of entities of its group. Some of those group entities are located in tax havens and generate substantial profit. Such entities are carrying out a so-called risk mitigation function but are not actually assuming that risk. The comparability of the entity with an (independent) insurance company depends on whether there also is a real possibility of suffering losses and a diversification of risks and whether the underwriting functions are actually exercised by the company. The application of the comparable uncontrolled price method may require difficult adjustment calculations. Alternatively, an actuarial analysis or the determination of comparable “combined ratios” (ratio of costs of claims, administrative expenses and conclusion of insurance contracts to premiums receivable) could be applied. Synergies have to be passed on to the group entities.
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Tax & Transfer Pricing Specialist
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