On February 11, 2020, the OECD issued its final Transfer Pricing Guidance on Financial Transactions (the Final Guidance). The report was developed as part of Actions 4 and 8-10 of the BEPS Action Plan and represents the first time the OECD Guidelines will be updated to include guidance on transfer pricing for financial transactions. While the Final Guidance retains many of the themes from the July 2018 Discussion Draft on Financial Transactions (the Discussion Draft), it also makes some notable changes. In response to this new guidance, taxpayers engaging in intercompany financing transactions and related services in countries that adhere to the OECD Guidelines may need to make significant changes to the way these transactions are structured, priced and/or documented.
Below are five things you should know. While the focus here is primarily on intercompany debt, many of these concepts also apply to other types of intercompany financial transactions and treasury services (e.g., cash-pools, guarantees).
1. Debt Characterization is in Scope
While acknowledging that countries may continue to address debt characterization through domestic legislation, the Final Guidance outlines a framework to assess whether a purported loan is accurately delineated as debt for federal income tax purposes, essentially applying the Chapter 1 concept to capital structure. Below are a few consequences of this framework:
- If, when applying this framework, tax authorities deem that a purported intercompany loan is not structured in an arm’s-length manner, it can be regarded as another financial instrument. This could mean a reclassification as equity or as an intercompany loan with different characteristics.
- Analyses of whether the intercompany transaction would have occurred at arm’s-length should consider both the lender’s and borrower’s perspectives and all realistic alternatives to both parties.
- In determining whether a transaction can be characterized as debt, one should consider a repayment analysis (based on good-faith projections) as a way of demonstrating a borrower’s ability to meet its loan obligations.
2. Final Guidance Could Impact Allocation of Interest Income
Accurate delineation also requires an understanding of the functions performed and risks assumed by the entities involved in intercompany financing, and analysis of such could impact allocations of returns (e.g., interest income). In the case of an intercompany loan, if a lender “lacks the capability, or does not perform decision-making functions, to control the risk associated with investing in a financial asset”1 they are not entitled to earn more than a risk-free return. The differential between the risk-free return and the arm’s-length interest would be allocated to the entity that performs these functions and bears these risks (e.g., the parent, the treasury center, etc.). Borrowers in such cases would still be able to deduct the entire arm’s-length interest expense.
3. The Final Guidance Generally Endorses Consideration for Implicit Support, but Stops Short of Providing Hard Rules or Rebuttable Presumptions
The OECD opted against a rebuttable presumption of implicit support (such as those proposed in the Draft Guidance) and takes a less prescriptive stance in the Final Guidance. The guidance states that implicit support from the multinational group “may affect” the credit rating of a borrower, but that 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 borrowing entity and the overall multinational. Taxpayers should make a case-by-case determination of the role of implicit support based on relevant facts and circumstances.
4. The OECD Endorses a Comparable Uncontrolled Price Method (CUP Method) for Benchmarking Loans, Rejects Bank Opinions
The Final Guidance notes that the breadth and availability of market lending data make the CUP method easier to apply to financial transactions than to other transactions. It highlights that “…the possibility of internal CUPs should not be overlooked”2 while noting that it might be necessary to adjust the internal (or external) CUPs to improve comparability.
The Final Guidance also discusses potential issues with bank opinions concluding that “[s]uch letters would not therefore generally be regarded as providing evidence of arm’s length terms and conditions.”3
5. The Final Guidance Will Increase Documentation Needs around Intercompany Financing
Though the Final Guidance does not explicitly discuss specific documentation requirements, it brings light to many of the transfer pricing complexities of intercompany financial transactions that may not currently be addressed or considered by taxpayers. More detailed analysis and documentation may be warranted.
For example, to avoid recharacterization of intercompany loans as either equity or a different kind of debt instrument, it might be advisable to include the following in documentation reports going forward:
- Cash flow analysis demonstrating borrower ability to repay;
- An overview of the terms of the loan and how it appears to have debt-like characteristics;
- An overview of why a loan was structured a certain way (and why unrelated parties in similar circumstances would have structured it this way); and
- A discussion of realistic alternatives and why this was the best transaction for both the lender and borrower to enter into relative to the available alternatives.
There are also references to the level of detail that a tax authority might expect. To accurately delineate an intercompany financial transaction, the Final Guidance notes the need for a functional analysis to document the functions performed, assets used, and risks assumed by the parties to the transaction. For the lender, this could mean examining the terms at which they would choose to advance funds, and for the borrower, this could be analyses undertaken to ensure they are able to fulfill loan obligations. With respect to cash pools, the Final Guidance suggests “[i]t 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.”4
Duff & Phelps has assisted numerous taxpayers in preparing for the documentation for intercompany financial transactions. Our independence, world-renowned debt structuring and capital markets services, and deep expertise in valuation and transfer pricing provide us with a unique ability to assist taxpayers in this space.
1 Final Guidance, Paragraph 1.108.
2 Final Guidance, Paragraph 10.94.
3 Final Guidance, Paragraph 10.108.
4 Final Guidance, Paragraph 10.124.