By Pilar Barriguete & Edland Graci, Duff & Phelps, Spain
After many years without clear procedures on how best to attain an arm’s length remuneration with respect to financial transactions, two big intergovernmental organizations — the OECD and the United Nations — have stepped in with a series of proposals.
First, on July 3, 2018, the OECD released a public discussion draft on transfer pricing aspects of financial transactions.
And now, the UN Committee of Experts on International Cooperation in Tax Matters has contributed its grain of sand, releasing on April 8 a draft on financial transactions as an update to the Practical Manual on Transfer Pricing for Developing Countries.
UN Committee of Experts transfer pricing work
The UN Committee of Experts on International Cooperation in Tax Matters began its work on transfer pricing in 2009, publishing its first transfer pricing manual in 2013 and updating it in 2017. The committee aims to incorporate this new transfer pricing chapter on financial transactions into another update, to be published by 2021.
Also released on April 8 was revised text on profit splits and on establishing transfer pricing capability, risk assessment, and transfer pricing audits. These changes would also be incorporated into the next manual update.
Four step analysis
The new UN draft chapter on financial transactions establishes a four-step analysis to determine the arm’s length nature of intra-group financial transactions:
- Analysis of the economically significant characteristics;
- Accurate delineation of the entire transaction undertaken;
- Selection of the most appropriate transfer pricing method; and
- Application of the method.
It is important to mention that financial entities are not subject to these guidelines since they are subject to other regulatory regimes that may influence their intra-group remuneration policies.
It is common for companies within a group to enter into financial transactions to fund their activities. The new chapter on financial transactions recognizes that financial instruments differ depending on the amount of funding needed and length of time that funding is required. The manual is limited to analyzing intra-group loans and intra-group guarantees.
Economically significant characteristics of financial transactions
To reduce the base erosion effect of debt financing and the relevance of tax factors in choosing between equity and debt financing, a careful analysis based on adequate information is required.
In this regard, the UN draft chapter on financial transactions enumerates economically significant characteristics of a financial transaction to be considered to establish the arm’s length nature of the transactions. These factors are:
- Contractual terms stated in agreements and/or actual conduct of the parties (type of loan, tenure, type of interest rate, currency, embedded options, seniority of the loan, subordination of the creditor, collateral, securities, guarantees, and repayment schedule, among others).
- Functional profile of both parties in the transaction (including an assessment of the debt capacity and credit risk of the borrower).
- Characteristics of financial products or services. To accurately delineate a financial transaction, it is required that the characteristics of such transaction are supported by the conduct of the parties and other facts.
- Economic circumstances of both parties to the transaction and of the industries in which they operate (including circumstances concerning the type of funding available, the ability of the borrower to obtain loan funding from other means, the purpose of the funding, and other macro-economic trends).
- Business strategies of both parties in the transaction (including financing policies and debt targets).
- Any interaction with other intra-group transactions (intra-group loan might be a pointer in delineating other types of intra-group transactions).
Accurately delineate the transaction
After identifying the relevant characteristics of the intercompany transaction, it is possible to accurately delineate it.
One of the main issues when delineating a financial transaction, besides determining whether the rate of interest applied is at arm’s length, is whether, after reviewing the facts and applying the arm’s length principle, a “supposed” loan should instead be regarded as a contribution to capital.
In addition to the approaches proposed by OECD BEPS Action 4, the new draft chapter recognizes the desire of (developing) countries to recharacterize intra-group loans to tackle base erosion through excessive debt.
Relevant evidence for this approach might be the debt capacity of the borrower as well as the analysis carried out in the first step, the manual says.
The credit rating could be obtained by a creditworthiness analysis, which is important to accurately delineate the actual financial transaction and to seek reliable comparables to test the arm´s length nature of the controlled transaction.
Although the creditworthiness analysis is only an indicator of an entity’s probability of default, it measures to some extent the potential that the counterparty of a financial transaction could fail to meet its obligations, the manual says.
The draft manual offers two approaches to assess the debtor’s credit rating. First, a stand-alone credit rating can be used where the borrower is considered as independent and credit risk is determined based on this principle. An example is deriving the credit risk of a borrower by looking at its financial ratios.
Alternatively, a group credit rating can be employed, which takes into the “halo effect” of belonging to a group. This analysis takes into account any “implicit support” from the group, as later discussed in this article, and thus will improve the borrower’s credit rating. The amount of the improvement will depend upon the level of strategic importance that the associated enterprise has within the group, the manual says.
Controversially, the new chapter states that, in the delineation of the intra-group financing, consideration should be given not only to the debtor’s credit rating but also to the issuer’s. This is correlated with the specific features of the financial instrument and the relation of this instrument to other transactions (both financial and non-financial) between the borrower and both related and third parties.
Usually, the credit rating is notched down from the credit rating of the borrower based on methodologies provided by credit rating agencies.
Most appropriate transfer pricing method
According to the UN manual draft chapter, the most commonly used method in identifying comparable transactions to controlled transactions is the comparable uncontrolled price (CUP) method via the use of either internal or external comparables.
Apart from the CUP method, a cost-based method (on gross or on net) could be applied in treasury service cases as, for example, when funds are transferred by a lender (cost center) to group members. In these cases, besides the costs incurred in servicing the loan, a risk premium is charged plus a profit margin on costs, the draft states. This method requires considering other options realistically available to the parties and especially to the borrower.
However, if a financing entity provides funds to group members and there is a mismatch in timing and/or currencies as well as exposure in creditworthiness, the cost-plus method might not be the appropriate transfer pricing method for that financing transaction, the chapter says.
The chapter mentions that the transactional profit split method can be used, though it is of limited application.
Some countries, such as Brazil, apply a transfer pricing method referred to as the “sixth method,” usually for commodities transactions.
This method considers as sufficiently comparable – without the need to identify comparable transactions – interest rates of international or national public bonds, such as US bonds, LIBOR, etc. On the other hand, Singapore, Serbia, China and other countries, have introduced in their local laws interest rate safe harbors to simplify the determination of arm’s length prices in intra-group loans, the chapter notes.
Intra-group financial guarantees
The UN draft chapter on financial transactions states that there is a need to assess the underlying reason for a financial guarantee and whether there is indeed any benefit created by it.
Thus, a guarantee would be considered to create commercial value if obligations of the borrower have been transferred to the guarantor under the circumstances defined in the financial guarantee; an independent party would be willing to pay for the intra-group financial guarantee; and the guaranteed entity achieves a better price for the intra-group loan because of the intra-group financial guarantee.
By contrast, the draft chapter mentions that a financial guarantee would not provide benefits to the borrower and, therefore, would not be chargeable when the guaranteed entity is perceived as having better creditworthiness only because of the implicit support from its group.
According to the new chapter, in market conditions, an independent borrower would not be willing to pay for implicit support even though the borrower may be able to obtain more favorable financing terms.
There have been different case laws that have considered such implicit support as relevant and have recognized a guarantee fee between the borrower and its related party guarantor (e.g. General Electrics vs. the Queen, 2009).
Also, guarantees do not provide benefits to a borrower when the debtor has no debt capacity or credit status and, therefore, would not be able to access the capital market without the intercompany financial guarantee.
In such situations, the tax authorities could recharacterize the transaction as a shareholder service or classify the guarantor himself as the direct borrower followed by an equity contribution from the guarantor to the former borrower of the loan.
Further, a financial guarantee would not benefit the borrower if it has been requested by the creditor only to avoid that the parent company diverts the funds of the financed company, the manual states.
Most appropriate transfer pricing method
The UN’s draft chapter and the OECD discussion draft on financial transactions have different views regarding the most appropriate transfer pricing method.
The UN manual affirms that the most commonly used method for determining the arm´s length nature of intra-group financial guarantees is the CUP method, and suggests reviewing the banker´s acceptances, credit default swap fees, letter of credit fees, commitment fees, various types of insurance, and put options.
Apart from the CUP method, the new chapter considers the yield approach and the cost approach as a means to calculate an arm´s length guarantee fee.
The yield approach estimates the maximum potential interest rate savings achieved by the guaranteed entity when receiving an explicit guarantee from a related party. The spread between the interest rate received and that which would have been received by a borrower/guaranteed entity with no explicit support is then calculated. This spread is then divided among the guarantor and the borrower. This approach is also known as the interest savings approach or the cost benefit approach.
The draft chapter’s cost approach calculates a minimum guarantee fee by identifying the capital required to support the risks of the guarantor considering the value of expected losses.
Financial transactions have a significant impact on international trade and cross-border transactions because of their high frequency and amounts, the facility to shift profits and to erode taxable bases using such transactions, and their peculiar characteristics.
While the OECD and the UN Committee of Experts on International Cooperation in Tax Matters proposals have their differences and similarities, both share the same goal of tackling tax issues, specifically regarding financial transactions. These are both excellent initiatives that put us closer to a multilateral consensus.