Transfer Pricing Guidance on Financial Transactions: my two cents

Intro

We are living a challenging time and the financial services industry is facing with several issues due to the uncertainty of the economy and some irrational decisions. Economic circumstances on one hand and government decisions / support on the other may have a massive impact on the industry.

It’s ironic that all the above is happening short after the OECD published the “Transfer Pricing Guidance on Financial Transactions”, providing – in line with Actions 4, 8 and 10 included in the OECD BEPS Action Plan – specific guidance on financial transactions. The Guidance, which will be included in OECD Transfer Pricing Guidelines as Chapter X, should contribute to consistency in the application of transfer pricing principles and help avoid double taxation.

It is worth to consider that OECD published the first guidance on financial transactions more than one year ago after the publication of the “non-consensus discussion draft” by the OECD Committee on Fiscal Affairs. Therefore, the Guidance represents a significant step towards the development of the 2017 version of the OECD Transfer Pricing Guidelines.

In a nutshell, the Guidance is divided into 5 sections and focuses on the concept of “accurate delineation” of financial transactions, related to transactions involving MNE groups. It also analyses legal aspects related to the organisation of the treasury function, to cash pooling, to risk coverage, to financial guarantees, as well as to captive insurance. The last paragraphs of the Guidance provide a thorough analysis on how to determine the risk-free and risk-adjusted rates of return.

Main updates

Section “B” of the Guidance elaborates the concept of “accurate delineation” related to financial transactions and establishes the principles to be applied in order to:

• assess when a transaction can be considered as intra-group loan or should be regarded as some other kind of payment, in particular a (hidden) contribution to equity capital;
• correctly define those factors that, in the light of the arm’s length principle, impact on intra-group relationships of MNE groups, in order to identify when operations should be considered as commercial or as financial: to this end, the contractual terms of the transactions, the functions performed by the parties involved and the risks borne should also be taken into account;
• carry out a functional analysis of the economically relevant characteristics of the financial transactions. On this topic, the Guidance provides that, among the factors to be considered, there are: (i) the contractual agreement regulating the transaction between the parties, (ii) the context in which the financial transaction is performed, and (iii) the behaviour of the parties involved with regard to the nature, purpose, and amount of the loan, as well as to its repayment schedule.

The second part of the Guidance provides instructions on the correct application of the principles contained in Section D.1 of the 2017 OECD Guidelines on transfer pricing to financial transactions. As a matter of example, it describes the relevant aspects in a MNE group related to the organization of treasury, to intra-group loans and to risk coverage.

Some highlights, as provided by the Guidance:

• the treasury function depends on the structure of the MNE group and on the level of complexity of its transactions. The degree of centralization is also directly influenced by the group business strategies;
• in an intra-group loan it is important to take into account the perspective of both parties involved in the transaction. Other relevant factors to be considered are creditworthiness, credit risk, economic circumstances, and – for the application of the arm’s length principle – credit rating. In fact, credit rating is one of the main factors that independent investors take into account. Also, in order for the financial transaction to be considered as compliant with the arm’s length principle, the Guidance provides that interest rates should be determined by applying the Comparable Uncontrolled Price (CUP) method;
• the accurate delineation of cash pooling arrangements would need to take into account not only the facts and circumstances of the balances transferred but the wider context of the conditions of the pooling arrangement as a whole. The reward of the cash pool leader will depend on the functions performed for the purposes of the transactions and the risks assumed in facilitating or allowing a cash pooling arrangement;
• financial guarantees should be divided in consideration of the economic benefit arising to the borrower. To this regard, if the guarantee leads to an enhancement of credit rating and a reduction in borrowing costs, for the purposes of arm’s length, the CUP method should apply. On the other hand, if the guarantees allows the borrower to increase its credit rating, the contract should be duly re-determined. The remaining amount, therefore, should be classified as capital contribution by the guarantor;
• insurance and reinsurance transactions performed by captive insurances (i.e. insurance or reinsurance companies belonging to the MNE group, which are not active and not operating in the insurance business) are regulated under letter E of the Guidance. The Guidance analyses the shift of the risk between the involved parties and identifies several indicators aimed at qualifying the transaction like an insurance or reinsurance activity;
• for the purposes of determining risk-free and risk-adjusted rates of return, the funder’s costs related to the borrowing associated to the funding should be taken into account, as well as the risks assumed by the funded party and connected to the use of the funds.

Conclusion

The Guidance on intra-group financial transactions has a considerable strategic relevance taking into account that, for the first time, it clearly defines some issues related to transfer prices which have always been unclear so far. Therefore, although the Guidance provides mere indications on the principles to be applied, allowing each Country to choose whether to implement the regulation on financial transactions transfer prices or not, MNE groups that carry out such transactions should consider whether their current transfer pricing policies are compliant with the new guidelines.

However, I cannot exclude the need, soon, for a further clarification due to the current environment since in some years, the Tax Administrations will be reviewing 2020 with a different perspective.