OECD Issues It’s Final Transfer Pricing Guidance On Financial Transactions

Robert Bachmann On Transfer Pricing Guidelines

On February 11, 2020, the OECD issued its final Transfer Pricing Guidance on Financial Transactions in a 46 page document which the OECD widely disseminated and which can be found on the OECD website. The report builds on the discussion contained in the non-consensus Discussion Draft on Financial Transactions published in July 2018 (“2018 Discussion Draft”). As the guidance is final, it will likely be heavily relied upon by many tax authorities when scrutinizing financial transactions.

The guidance contains five sections:
1. Interaction With Guidance In Section D.1 of Chapter 1
2. Treasury function
3. Financial Guarantees
4. Captive Insurance
5. Risk-Free And Risk-Adjusted Rates of Return

1. Interaction With Guidance In Section D.1 of Chapter 1
Much of this section relates to methods to determine whether a purported loan should be regarded as a loan for tax purposes. At a high level the guidance is for tax authorities to determine whether entities engaging in intercompany financing activities are acting as independent entities would if they were behaving in a commercially rational matter. They note that tax authorities may benefit from applying a multi-factor analysis of the characteristics of the instrument and the issuer. In addition, the guidance lists characteristics of a financial instrument that may be useful indicators of whether it should be accurately delineated as debt, including the obligation to pay interest, the right to enforce payment of principal and interest and the source of interest payments among others. Lastly, the guidance also notes that individual countries may use their own techniques in the delineation of debt as truly debt or as equity and do not have to be tied to what is described in this guidance.

2. Treasury Function
The treasury function section discusses intra-group loans, cash pooling and hedging. At a high level this section covers the circumstances necessary for these types of transactions to be arm’s length and the treasury’s role in setting and maintaining these policies. The notion of implicit support is also discussed at length. Implicit support is the concept that the borrower is part of a group and would receive support from the group if it were to be in a position where it may not be able to satisfy the loan terms. Therefore the borrower may have a higher credit rating or ability to pay due to this implicit support than it would receive on its own. The concept of implicit support is discussed in other portions of the guidance and not only in the Treasury function section. In addition, implicit support was discussed extensively in the 2018 Discussion Draft.

3. Financial Guarantees
The financial guarantee section covers some of the key aspects to determine if a financial guarantee is properly priced. One key aspect for a financial guarantee to be characterized as a financial guarantee is that it must provide economic benefit to the borrower. Methods for determining the arm’s length price of guarantees are also discussed. These methods include the CUP method, the yield approach, the cost approach, valuation of expected loss approach and capital support method.

4. Captive Insurance
Captive insurance refers to “an insurance undertaking or entity substantially all of whose insurance business is to provide insurance policies for risks of entities of the MNE group to which it belongs.” This section covers the accurate delineation of captive insurance and reinsurance and the pricing of captive insurance and reinsurance. Methods of determining an arm’s length price for captive insurance discussed in the guidance include pricing of premiums, the combined ratio and return on capital, group synergy and agency sales.

5. Risk-Free And Risk-Adjusted Rates of Return
This section provides guidance on how to determine a risk-free rate of return and a risk-adjusted rate of return. For determining approximate risk-free rate of returns, the guidance notes that highly rated government issued securities are not the only reference, and that other alternatives may be considered. For determining a risk adjusted rate of return several methods are noted. The standard method in practice of adding a premium to a risk-free rate of return to reach a risk adjusted rate of return is discussed as a likely method for practitioners to utilize.

Have a question? Contact Robert Bachmann, CFA.

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