by Julian Feiner, Dentons
One of the OECD’s more difficult tasks in the BEPS Action Plan is to attain consensus for updated transfer pricing guidance on the application of the arm’s length principle to financial transactions.
After a long period of deliberation, considering many different views, the OECD on July 3 released a discussion draft to identify the relevant issues and set out its proposals.
The draft focuses on the application of general principles in chapter I of the OECD transfer pricing guidelines to financial transactions and addresses specific issues such as treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance.
Unfortunately, the draft falls short because it omits discussion of key issues, especially the treatment of over-capitalised lowly taxed group companies and the method of disregarding a transaction. Moreover, the draft’s discussion of group synergy adjustments seems to endorse a more stringent approach than that in the final BEPS report.
Scope of the discussion
The treatment of capital under transfer pricing principles is a difficult and controversial area and the exclusion of detailed guidance in this area is a major limitation of the paper.
Some countries believe it is possible for the transfer pricing rules to police the transfer of capital to low-tax jurisdictions, while others consider it a matter for domestic anti-avoidance rules.
As set out in the original BEPS Action Plan in 2013, at pages 19-20, it was a key objective of the plan to find a solution to this issue:
“[M]ultinationals have been able to use and/or misapply [transfer pricing] rules to separate income from the economic activities that produce that income and to shift it into low-tax environments. This most often results from…over-capitalisation of lowly taxed group companies and from contractual allocations of risk to low-tax environments in transactions that would be unlikely to occur between unrelated parties. […] [T]he best course is to directly address the flaws in the current system, in particular…risk and over-capitalisation. Nevertheless, special measures, either within or beyond the arm’s length principle, may be required with respect to…risk and over-capitalisation to address these flaws.”
The reality now, five years later, is that the BEPS project is addressing the contractual allocation of risk but not also the over-capitalisation of lowly taxed group companies.
The discussion draft suggests that capital structuring may be addressed instead by domestic rules. Presumably, this is due to strongly held divergent views on the appropriate solution. It is a concern that on this fundamental issue we may end up with inconsistent domestic rules, instead of broad multilateral consensus.
One potential approach that could be considered is to have “thick capitalisation” rules, which treat the excess amount of capital in low-tax jurisdictions as debt, resulting in deemed income received by the capital provider.
Another approach might be to adapt the OECD’s treatment of capital for attribution to permanent establishments. In that context, capital is attributed to the deemed separate entity in an amount that is commensurate with its functions, assets and risks.
There are several other possibilities and this is an issue that will continue to attract attention in the future.
Delineation and disregard of transactions
The discussion draft includes an analysis of the economically relevant characteristics of financial transactions for the purpose of delineating the actual transaction. This is a tailored version of the general guidance in the OECD transfer pricing Guidelines, but specifically for financial transactions.
Naturally the first characteristic is the “contractual terms” of the transaction. In this section, it is noted briefly that contractual terms “may be inconsistent with the actual conduct of the parties or other facts and circumstances”, and “it is therefore necessary to look to other documents, the actual conduct of the parties – notwithstanding that such consideration may ultimately result in the conclusion that the contractual form and actual conduct are in alignment – … in order to accurately delineate the transaction”. This generally accords with the OECD’s existing transfer pricing guidance.
However, the discussion paper does not go on to provide detailed guidance on the more difficult and important issue of how a delineated financial transaction might be disregarded for transfer pricing purposes.
The paper merely mentions the existing general principle that a transaction may be disregarded if it lacks the commercial rationality of arrangements between unrelated parties under comparable economic circumstances (OECD transfer pricing guidelines at 1.122).
The only examples of commercially irrational transactions in those OECD guidelines refer to a manufacturing business and a developer of intangibles. The discussion draft on financial transactions would present an opportunity to analyse how it should apply to financial transactions, but this has not been taken.
More guidance is needed on this point in relation to financial transactions, as the current level of uncertainty about disregarding transactions continues to result in complex and prolonged disputes.
Group synergy adjustments
One notable issue that is addressed directly is the synergistic benefit of MNE groups. Previously in the final BEPS report on actions 8-10, the OECD stated that in some circumstances, synergistic benefits of group membership may arise because of “deliberate concerted group actions” which provide “a material, clearly identifiable structural advantage or disadvantage in the marketplace”. The examples provided included a centralised purchasing function in a single group company to take advantage of volume discounts. In such cases, the benefit would be spread among group companies.
The discussion draft applies this approach liberally in the context of financial transactions. In particular, it includes the example of a captive insurer, who can access the re-insurance market to divest itself of risk through insuring risk outside a group, whilst making cost savings over using a third-party intermediary, by pooling risks within the MNE group.
The guidance concludes that “these benefits arise as a result of the concerted actions of the MNE policyholders and the captive”, though “the synergy benefit arises from the collective purchasing arrangement, not from value added by the captive”, and so the “group synergy benefit should be allocated among the insured participants by means of discounted premiums”.
A similar approach is proposed in respect of cash pool leaders in an MNE group who achieve more effective liquidity management and an enhanced return.
This appears to endorse a more stringent approach than the final BEPS report, which cautioned that the benefit must not be incidental but arise because of “deliberate concerted” action that provides a “material, clearly identifiable structural advantage”.
There is no analysis in the discussion draft of those suggested conditions and I would expect further deliberation on these points in the future.
Comments on the discussion draft are invited by 7 September 2018.
In my view, there will be a lot more work to do to obtain consensus on the OECD’s proposals, and further work must be done to provide meaningful guidance on over-capitalisation and the disregard of financial transactions.
—Julian Feiner is a senior associate in the tax practice at Dentons in London. He advises on a broad range of UK and international tax issues, with a focus on international structuring, M&A, financing anddisputes.
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