On February 11, 2020, the Organization for Economic Cooperation and Development (OECD), issued the final report of the Transfer Pricing Guidelines in relation to financial transactions between related parties.
This report was developed to follow up on Action 4, 8 and 10, of the BEPS (Base and Erosion and Profit Shifting) Plan, which refer to the delimitation that the deduction of interest on loans should have and the alignment of transfer pricing results with the creation of value.
This is of utmost importance, since it represents the incorporation of a new Chapter in the Transfer Pricing Guidelines published in 2017, which would be oriented for the first time to transfer pricing aspects in relation to financial transactions.
The purpose of this chapter is to seek consistency in the interpretation of the arm’s length principle with respect to such transactions.
Among the main aspects addressed in this Guide is the correct delimitation of financial transactions, intra-group loans, cash pooling, guarantees, among others.
Delineation of the Financial Operation
The first section of this Guide indicates that the loan must be defined precisely, since with a correct characterization of the loan, it will be possible to determine a remuneration that respects the principle of full competition.
To this end, it suggests certain factors to be taken into consideration for the characterization of the loan, which will make it possible to distinguish it from other forms of financing, such as a capital contribution.
Among these factors are the obligation to pay interest, the absence of a repayment date, the existence of financial agreements and guarantees, the source of payment of interest, among others.
It also points out that in order to precisely delimit the operation, an exhaustive analysis of those economic characteristics that are relevant should also be taken into consideration, such as an evaluation of the contractual terms, the review of the characteristics of the financial products or services; the functions, assets and risks involved in the operation and the economic circumstances of the parties involved and the market.
If, according to the above, the borrower’s capital and debt structure would not correspond to that agreed upon by independent parties, the borrower should categorize such transaction as a capital contribution.
With respect to the treasury functions, the second section of the Guide states that this will depend on the structure of the group and the complexity of its transactions.
The main treasury functions covered in this section are:
- Intra-group loans: In relation to this, the Guide indicates certain factors to be taken into consideration when establishing an interest rate for these loans, such as.
- Lender’s perspective: In order to do so, the recipient of the financing must be evaluated credibly.
- Group influence: The effect of being part of a group, also called implicit support, should be taken into consideration, possibly impacting on the ability of the member of the multinational group to borrow.
- Convenant: Financial commitments are usually made between independent parties to provide security for the loan, including duration and repayment terms.
However, many times these are not included in intra-group financing operations, so the implicit agreements in these must be analyzed.
- Perspective of the operation: These loans must be analyzed from both the debtor and creditor perspective, in order to evaluate the risks of each in the operation.
Likewise, this report indicates the methodology that can be followed for the analysis of the interest rate:
- Uncontrolled Comparable Price Method: For which the credit rating of the debtor and the conditions of the mutual company will be taken into consideration, in order to look for comparable operations.
- Financing cost: The OECD points out that in case comparisons are not obtained, the lender’s financing cost can be taken as a reference, to which a risk premium and a markup will be added.
- Credit Default Swaps: It is pointed out that swaps, by reflecting a credit risk based on an underlying asset, can be used in the absence of information on this asset, as a comparable transaction.
For this purpose, the differential of credit default swaps may be used to calculate the risk premium associated with intra-group financing.
- Economic Models: It is based on economic models that calculate the interest rate using risk-free interest rates and a series of premiums associated with different aspects of the loan.
- Bankers’ Letter: Also known as “bankability opinion”, it seeks to demonstrate that the agreed rate is in accordance with the principle of full competition, based on written opinions of independent banks, in which the latter indicate what would be the applicable interest rate in a comparable loan.
- Cash Pooling: Also known as centralized treasury, it is a method used for financing purposes between related parties, which can be physical or notional.
The Guide states that in order to determine the consideration that complies with the arm’s length principle, in cash pooling transactions the consideration paid to the cash pool leader, the cash pool member or the cash pool guarantees should be analyzed.
- Hedging: The Guide indicates that intra-group financial transactions may include instruments through which risk is transferred between the various entities comprising the group, such as a hedging agreement or Hedging.
Therefore, it will be important that the hedging entity receives consideration at market value.
Section D of the Guidelines provides information on how to price financial guarantees.
As in the case of loans, methodologies have been established to be used to establish the consideration, such as the comparable uncontrolled price, yield approach, cost approach, expected loss valuation and capital support method.
Captive Insurance Companies
There are ways in which multinational groups can manage risk, one of which is by consolidating certain risks through a captive insurance entity.
The Guide indicates as relevant points regarding these, the financial capacity that the insurer must have to assume the insured risks and the capacity of control of the insurer.
Therefore, when it cannot be determined that the insurer exercises this risk control, but that the risk is controlled by another entity of the group, the performance should be assigned to the latter.
Free Risk Interest Rate
Section F of the Guide outlines how the risk-free interest rate and the adjusted rate of return should be determined, a section added to Chapter I, Section D 1.21 of the Transfer Pricing Guidelines.
The Guide refers that if the entity making the loan does not have a risk for the investment, the interest rate should be the free risk rate, for which purpose, among others, government bonds may be taken as a reference.
However, if the leader assumes a risk associated with the loan, but not other specific risks, only an interest rate adjusted to the financing risk should be agreed upon, for which the risk-free rate and a risk premium should be considered.
Conclusion and Recommendation
This new Transfer Pricing Guide establishes parameters to be followed regarding financial transactions between related parties. Multinational groups should review these types of transactions in order to analyze if they comply with the criteria established in this report, which in turn should be taken into consideration for future transactions.