Intra-Group Treasury Operations Seen Through Tax Glasses

On 11 February 2020, the Organisation for Economic Co-operation and Development (OECD) published, as part of its Base Erosion and Profit Shifting (BEPS) project, the final guidance on transfer pricing aspects of intercompany financial transactions (the Report). For the first time ever, the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD TP Guidelines) includes nearly 40 pages of groundbreaking guidance related to structuring and pricing of intercompany financial transactions. As the Report has been approved by the 137 member countries of the Inclusive Framework, its importance stretches beyond the OECD countries and will have significant impact on intra-group treasury operations of multinational companies from both non-financial and financial sectors. Here Krzysztof Łukosz, Associate Partner and his colleague Martin Druga, Manager, both from Transfer Pricing & Operating Model Effectiveness Group of EY Netherlands, provide an overview of the Report – with both the ‘good and bad news’.

The OECD TP Guidelines become relevant for corporate treasurers

The OECD Guidelines are intended to help tax administrations (of both OECD member countries and non-member countries) and multinational companies to evaluate whether the conditions of commercial and financial relations between associated entities satisfy the arm’s length principle. As Sections A-E of the Report are added to the OECD Guidelines as Chapter X, whereas the guidance on the determination of risk-free and risk-adjusted rates of return (Section F) is included in Chapter I, it is highly relevant for corporate treasurers to read through and understand the new OECD guidance. Treasury departments should subsequently evaluate existing group policies for intercompany financial transactions to see if they are in line with the arm’s length principle. Otherwise, the group’s exposure to transfer pricing disputes and double taxation is likely to increase.

Over recent years, transfer pricing of intra-group financing arrangements has remained an important area of tax controversy. This is expected to intensify, as less-developed countries have elevated their knowledge and experience by being part of this specific OECD workstream, and have already started applying the new concepts and approaches in practice. In many jurisdictions the guidance included in the Report will be directly applicable to both existing and new intercompany financial transactions.

The scope of the Report is quite broad, covering various types of intercompany financial transaction

The Report is divided into five main sections, including:

For many jurisdictions, especially those in emerging markets and those that historically followed a more ‘legalistic’ rather than ‘economic’ approach to transfer pricing, the new guidance is expected to have far-reaching consequences. This is due to the fact that until recently local tax examiners may not have been familiar with specific definitions, concepts, economic approaches and market trends around financial transactions, especially those displaying complex attributes and characteristics.

By issuing the final guidance in its current form, the OECD recognises that the topic of financial transactions is important in the transfer pricing landscape and that it deserves additional clarifications as to how the principles outlined in the 2017 edition of the OECD TP Guidelines should be applied to various types of intra-group financing arrangements. It is noted that it took the OECD nearly seven years to release this guidance since it was announced for the first time as part of the BEPS Action Plan in 2013.

Given the extensive scope of the Report, those countries that were previously primarily focusing on intercompany loans are now expected to also scrutinise cash pool arrangements and current account structures, financial and performance guarantees, intercompany hedging, and other types of intercompany financial transactions (e.g., leasing, factoring).

Transfer pricing analysis is broader than just pricing

One of the main takeaways is that a transfer pricing analysis of intra-group financial transactions should consist of two main steps:

The first step (delineation exercise) is expected to create a significant compliance burden for taxpayers, nevertheless it is extremely important. Historically, multinationals and transfer pricing practitioners focused merely on pricing, under the assumption that the way the transaction was structured, including its terms and conditions, would be respected by tax administrations. However, the most recent tax controversy around intra-group financing arrangements clearly evidence that this assumption is no longer valid.

Following the 2015 BEPS guidance, tax authorities have successfully been challenging pricing of financial transactions by first delineating and re-characterising financial transactions. This also entails reassessing the contractually agreed terms and conditions, effectively resulting in a new ‘term sheet’ for transfer pricing purposes. In this respect, the Report indicates that while the conditions of financial transactions between independent entities are the result of various commercial considerations, in an intra-group context certain conditions may by influenced by tax considerations.

The OECD’s concept of accurate delineation of a transaction refers to establishing economic substance of the transaction, rather than relying on its legal form. To ensure that a transaction was both structured and priced consistent with a third-party behaviour, taxpayers should consider and properly document the following five economically relevant characteristics:

With respect to the contractual terms, it is acknowledged in the Report that, between associated entities, the contractual arrangements may not always provide information in sufficient details or may be inconsistent with the actual conduct of the parties or other facts and circumstances. As such, it is therefore necessary to look to other documents, the actual conduct of the parties, and the economic principles that govern the relationship between independent parties in comparable circumstances. This obviously creates additional complexity and administrative burden in terms of transfer pricing compliance.

The new OECD guidance also emphasises the importance of analysing the group’s policies, as they may inform the accurate delineation of the actual transactions through consideration of, for instance, how the group prioritises funding needs among different projects, whether the group is targeting a specific credit rating or debt-equity ratio, whether the group is adopting a different funding strategy from the one observed in the industry sector, etc.

Last, but not least, taxpayers should always keep in mind the two-sided perspective and options realistically available to the parties (e.g., an independent borrower would not enter into a subordinated loan, if it could still attract senior debt).

If a taxpayer fails to support contractually agreed terms and conditions of, for example, an intercompany loan, tax authorities may hypothesise collateral for an unsecured loan, assume presence of financial covenants, deem a subordinated loan as senior, adjust tenor, currency, and repayment terms, etc., and subsequently determine new arm’s length interest rate.

Loan or equity?

The OECD guidance supports the notion that it is possible to determine an arm’s length capital structure (balance of debt and equity) of a borrowing group entity. In practice this means that tax authorities may attempt to re-characterise part or the whole amount of an intercompany loan into equity, denying interest deduction. As such taxpayers should be prepared to present a debt capacity analysis and a cash flow analysis, both aimed at supporting the borrower’s ability to service interest payments and repay the outstanding debt amount when due.

It also appears that taxpayers may need to consider the arm’s length debt structure (e.g. the most appropriate mix of senior secured, senior unsecured, and subordinated debt, if any), as the OECD stipulates that independent borrowers seek to optimise their weighted average cost of capital. This entails that group borrowers are expected to first attract senior secured debt funding.

Certain corporate treasury practices applied to intra-group treasury operations may not work any more

Based on our experience, certain standard approaches adopted by corporate treasurers to structure and price intercompany financial transactions are not necessarily in line with the arm’s length principle. The list below provides the most important transfer pricing considerations, in addition to those addressed in the previous sections, that corporate treasurers should be aware of and consider going forward:

Good and bad news: alternative views are possible

Before the BEPS era, tax legislation was less extensive and clearer. Today, there is a large variety of tax rules, which are often ambiguous and open to interpretation. The new OECD guidance on transfer pricing aspects of financial transactions follows this trend.

Specifically, the guidance introduces various alternative methods for determining arm’s length prices of loans, guarantees, and cash pool arrangements, which are likely to result in different outcomes. Also, in terms of accurate delineation of actual transactions, there are vast possibilities as to how to structure respective types of financial transactions, and the guidance contained in the report lists many areas that are subjective and dependent on judgment.

Since the OECD does not force ‘one-size-fits-all’ approaches, on the one hand multinational companies may welcome the flexibility offered by the Report. On the other hand, such flexibility and the non-prescriptive nature of the OECD guidance pose significant threats to corporates. For example, as two reasonable and rational parties (a taxpayer and a tax administration) may arrive at completely different and opposite conclusions while following the OECD TP Guidelines, there is the likelihood of transfer pricing disputes and controversy.

Next steps

Multinational groups should ideally assess whether their transfer pricing policies for intra-group financial arrangements are aligned with the new guidance and ensure they have required transfer pricing documentation in place to support both the structure and the price of individual transactions.