On February 11, 2020, the OECD issued its final Transfer Pricing Guidance on Financial Transactions, of which Chapters A through E will be incorporated as Chapter X of the OECD Transfer Pricing Guidelines (Chapter X). The report was developed as part of Actions 4 and 8-10 of the BEPS Action Plan and represents the OECD’s first finalized guidance on transfer pricing for financial transactions. The report retains many of the themes from its non-consensus Discussion Draft on Financial Transactions (the Discussion Draft) published in July 2018, while also making some notable changes. In light of Chapter X, taxpayers engaging in intercompany financing transactions (e.g., loans, cash pool and guarantees) in countries that follow the OECD Transfer Pricing Guidelines (OECD Countries) may need to make significant changes to the way these transactions are structured, priced and documented.
Expanded Scope of Intercompany Financing Evaluations
Chapter X includes a framework that guides countries that use the accurate delineation principle under Chapter I, to determine whether a purported loan should be regarded as a loan for tax purposes. This could mean that where in the past, tax authorities in OECD Countries may have focused time and resources on the arm’s-length nature of interest rates and governed debt characterization questions, solely through non-transfer pricing measures (e.g., thin capitalization rules), they may now apply the guidance in Chapter X to employ a more holistic debt characterization analysis. Chapter X interprets this principle by guiding tax authorities to determine whether entities engaging in intercompany financing activities are acting as “independent entities behaving in a commercially rational matter.” (Paragraph 10.7).
It is notable that Chapter X also leaves room for individual countries to set their own rules to answer these questions (Paragraphs 10.8 and 10.9). This is an important caveat in Chapter X as OECD Countries may employ differing approaches regarding how financial transaction characterization is evaluated under domestic law.
Potential for Recharacterization of Intercompany Debt
Section B of Chapter X provides guidance on how to apply the accurate delineation principles to determine whether an intercompany advance of funds should be regarded as a loan for tax purposes. Specifically, if financial transactions that multinationals claim to be debt do not carry the characteristics of debt in practice (both in substance and form), they could be regarded as another type of financial instrument such as equity. This would impact the ability for intercompany borrowers to treat payments made under these financial instruments as deductible interest for tax purposes.
Paragraph 10.12 of Chapter X lists characteristics of a financial instrument that may be useful indicators of whether it should be accurately delineated as debt:
“…the presence or absence of a fixed repayment date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the advance is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement.”
It’s also important to note that the actual conduct of borrowers or lenders (e.g., whether contractual terms are followed as written) is mentioned as a consideration.
Potential for Tax Authorities to Recast the “Type” of Intercompany Financing Transaction
Throughout Chapter X, there are examples given where tax authorities may change the classification of an intercompany financing transaction (and in turn the appropriate interest rate) if it can be determined that either—a) a different type of transaction would have been a more likely result had the entity been operating at arm’s-length, given the facts and circumstances; or b) the behavior of the borrower and lender reflected a different classification ex-post transaction.
As an example of the first scenario, Chapter X notes in Paragraphs 10.36 and 10.37 that intercompany loans should take the multinational’s business strategy into account and, in particular, the multinational group’s global financing policy. It provides an example where an intercompany ten-year loan is issued for short-term working capital purposes. However, it’s the overall multinational group’s established policy to use one-year revolvers to manage its short-term working capital needs. In the example, there is a conclusion that the borrowing subsidiary would not have entered into a ten-year loan for short-term working capital at arm’s length, and the loan could be recast by the taxing authority of the borrower as a one-year revolver, making appropriate adjustments to the interest rate.
In a similar example for cash pools, Chapter X notes in Paragraph 10.122 that if a cash pool balance has been maintained for a long enough time, it may be appropriate to treat these balances as “something other than a short-term cash pool balance, such as a longer term deposit or a term loan.”
Need to Demonstrate Ability for Borrower to Repay Intercompany Debt
Another consideration that Chapter X introduces regarding the accurate delineation of a financial transaction is whether, based on available good faith projections for the borrowing entity, it would be reasonably expected that the borrower would be able to repay the loan or seek a postponement (see Paragraph 10.12). This would suggest that a repayment analysis demonstrating the borrower’s projected ability to service or refinance the loan would be a prudent exercise for any material intercompany loan.
The example in Paragraph 10.13 illustrates this framework. It notes that if an analysis shows that a proposed loan amount exceeds the maximum amount an arm’s-length lender would have agreed to, then that excess may not be treated as debt for tax purposes by the tax authority in the borrower’s jurisdiction. This could mean that Chapter X espouses bifurcation, where the characterization of a financial instrument as debt or equity is not treated as an all-or-nothing exercise. Instead, parts of a loan can be recast as equity, and parts can remain debt.
Analysis of Reasonable Alternatives – for both Lenders and Borrowers
Chapter X suggests that the accurate delineation of a financial transaction should take into consideration “the conditions that independent parties would have agreed to in comparable circumstances” (Paragraph 10.18). As Paragraph 10.19 notes, independent parties “will consider all options realistically available to them, and will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives.”
Chapter X recommends that any analysis of realistic alternatives be considered from both the lender’s and borrower’s perspective. For a lender, the financial instrument under review would have to be a more attractive investment than other comparable investing opportunities. From a borrower’s perspective, one should consider whether, for example, the amount of debt being borrowed is more than needed to meet their funding goals and whether the amount borrowed could lead to pressure on their credit rating or capital markets reputation.
The Concept of Accurate Delineation Can be Used to Determine Financial Transaction Income (which Could Differ from Arm’s Length Interest)
The concept of accurate delineation is expounded upon throughout Chapter X and also discussed with respect to the functions performed, the assets used, and the risks assumed by the entities involved in the financial transactions, and how that might impact the compensation they earn for their respective contributions to the transactions.
Building on concepts elaborated in BEPS Action 8 concerning the control of risk, Chapter X poses an example stating that if a lender “lacks the capability or does not perform decision-making functions, to control the risk associated with investing in a financial asset,” then that lender is not entitled to earn more on that loan than a risk-free return (Paragraph 1.108). In the intercompany context, legal entities that actually issue funds (e.g., serve as lenders) to related parties are in some cases not the entities that are making decisions about the multinational’s intercompany financing policy. For example, those decisions might be made by tax or treasury departments that sit in a jurisdiction separate from the lender. According to Chapter X (and expanded on in Chapter F of the Transfer Pricing Guidance on Financial Transactions, which will become part of Chapter I of the OECD Transfer Pricing Guidelines), the lending entities in such structures may no longer be permitted to earn more intercompany interest than the risk-free rate. The borrowers in such cases are still able to deduct the entire arm’s length interest rate, but importantly, the balance between the full interest amount and the risk-free rate is allocated to the entity with control over the risks related to the financial transaction in question. It remains to be seen how OECD Countries will implement and enforce this guidance. However, this would appear to be materially impactful for multinationals that advance funds from legal entities, which do not have control or evidence of control over their decision to enter into such financial transactions.
Another example relates to cash pools, where Chapter X suggests restricting the income that can be earned by cash pool leaders to an arm’s length return for services performed, which it suggests that in many cases is a routine administrative function (Paragraphs 10.129 through 10.142). This contrasts with, for example, cash pool headers retaining as income the spread between the rates at which they borrow funds from a bank and the rates paid by related parties to cash pools for funds.
Chapter X Stops Short of Providing Hard Rules or Rebuttable Presumptions on Implicit Support
In discussing the impact of group membership on the credit rating of individual borrowers, the Draft Guidance proposed the introduction of a rebuttable presumption that the credit rating for all legal entities of a multinational be equal to that of the overall multinational (e.g., the multinational’s public third-party credit rating). This rebuttable presumption was not included in Chapter X, as the OECD opted for a less prescriptive stance on implicit support. Instead, Chapter X notes that implicit support from the group “may affect” the credit rating of the borrower, but the extent of the impact will depend on factors such as the importance of the entity to the multinational group and the strength of the link between the entity and the multinational group. This would seem to endorse a case-by-case determination of the appropriate credit rating uplift for implicit support, based on relevant facts and circumstances. Taxpayers engaging in intercompany financial transactions should be prepared to explain to taxing authorities on both sides of a given transaction how the impact of group membership (i.e., implicit support) was considered.
The OECD Endorses a CUP Approach for Benchmarking Loans, Rejects Bank Opinions
Chapter X provides some guidelines for performing CUP analyses to benchmark intercompany loans and notes that the large amount and availability of market lending data make the CUP easier to apply to financial transactions than to other transactions. It goes on to state that the possibility of internal CUPs should not be overlooked, though noting that it might be necessary to adjust internal (or external) CUPs to improve comparability. (Paragraphs 10.89 through 10.95).
Chapter X also provides guidance on a cost of funds approach (whereby interest rates would be a function of lender costs to raise funds and service the loans, a risk premium and a profit margin) but not without caveats and a note that this approach should be done “in the absence of comparable uncontrolled transactions” (Paragraph 10.97). Credit default swaps and economic modeling are also posited as potential approaches but with caveats around the reliability and sensitivity of inputs (Paragraphs 10.101 through 10.106).
Finally, Chapter X discusses bank opinions, which are written opinions from independent banks stating what they believe would be an appropriate interest rate, if such banks were to make a loan to that entity. These approaches are dismissed by Chapter X, which states “such letters would not therefore generally be regarded as providing evidence of arm’s-length terms and conditions” (Paragraph 10.108).
Revisions Around Evaluations of Guarantee Fees
Chapter X dedicates a section to guarantee fees, applying many of the common themes discussed throughout the chapter. Much of the discussion focuses on ensuring a guarantee fee is beneficial from the perspective of the borrower, or in other words, evaluating whether the borrower is in a better position paying both interest and a guarantee fee than it would be from just paying interest. Thus, a guarantee fee is only appropriate if it improves the borrower’s economic position (e.g., a lower interest rate such that the guarantee fee and interest rate are lower than would have been achieved otherwise (Paragraph 10.159) and/or that the borrower received some other benefit such as access to a larger amount of borrowing than would have been achieved otherwise (Paragraph 10.161). Chapter X also states that implicit support needs to be considered when evaluating the interest rate a borrower would have gotten without the guarantee. So if, for example, an evaluation of the borrower’s membership in a group has already uplifted its creditworthiness to be equal to that of the overall group, it might be the case that a guarantee fee provides no benefit.
Chapter X also suggests an examination of the financial capacity of the guarantor (Paragraphs 10.166 through 10.168), noting that a guarantee may not be accurately delineated as such if a guarantor, in practice, would be unable to fulfill its financial obligations in the case of default of the borrower.
Increased Documentation Burden
Although Chapter X does not provide significant detail on documentation requirements for financial transactions, it appears clear that there are many components of intercompany lending that multinationals might feel compelled to proactively defend, in light of Chapter X discussed above. For example, it might be advisable to include in documentation reports:
- Cash flow analysis demonstrating borrower ability to repay
- An overview of the terms of the loan and how it has debt-like characteristics (both contractually and in practice)
- An overview of why a loan was structured a certain way (and why this is how a borrower and lender at arm’s length would have structured it)
- A functional analysis noting which entities in the organization have the decision-making authority, concerning the financial transactions and evidence thereof
- An analysis of any potential internal CUPs within the organization and why those were rejected or, if accepted, what adjustments were considered
- A discussion of reasonable alternatives from the borrower’s and lender’s perspectives
Finally, Chapter X also suggests in the cash flow section that “it would be of assistance to tax authorities if [multinationals] would provide information on the structuring of the pool and returns to the cash pool leader and the members in the cash pool as part of their transfer pricing documentation” (Paragraph 10.124).
