On 11 February 2020 the OECD released its first guidance on the transfer pricing aspects of financial transactions, constituting an important supplement and update to its 2017 Transfer Pricing Guidelines.
The guidance is divided into five main sections, namely:
- Interaction with the guidance provided in section D.1 of the 2017 guidelines (accurate delineation of the transaction)
- Treasury function (including loans, cash pooling and hedging)
- Captive insurance
- Risk-free and risk-adjusted rates of return
As with any area of tax compliance, transfer pricing policies are unlikely to be fully effective in managing tax risks unless they have been implemented legally. Financial transactions present a special challenge because they carry a greater risk of being recharacterized. A classic example would be funds advanced as a loan, which instead may be regarded as a contribution to equity capital.
Here is a brief summary of the key implications of the new guidance as regards the legal implementation of transfer pricing and corporate structures.
1. Contractual terms are a starting point for delineating financial transactions
The new guidance confirms that “in determining the arm’s length conditions of financial transactions, the same principles as apply … as for any other controlled transaction.” (Para 10.14) Therefore, "the accurate delineation of the actual transaction should begin with a thorough identification of the economically relevant characteristics of the transaction", including "an examination of the contractual terms of the transaction.” (Para 10.17)
2. The delineation of a transaction for transfer pricing purposes includes analysing the legal effect of relevant arrangements with third parties as well as the applicable regulatory framework
For example, as stated in para 10.154 of the new guidance:
“To consider any transfer pricing consequences of a financial guarantee, it is first necessary to understand the nature and extent of the obligations guaranteed and the consequences for all parties, accurately delineating the actual transaction in accordance with Section D.1 of Chapter I.”
See also paras 10.31 10.40 as regards the relevance of the regulatory framework within which the associated entities operate.
3. Pricing follows delineation, and not vice versa
As for any other transaction type, financial transactions can only be priced after they have been delineated. (Para 10.11) This is a common mistake we see in TP reports and policies.
4. Loan covenants may not be appropriate in intercompany agreements
Paragraphs 10.83 to 10.86 contain interesting commentary on whether it is appropriate for intercompany financing agreements to include negative covenants such as an obligation on the borrower not to incur additional debt (referred to in the guidance as ‘incurrence covenants’) and positive covenants to maintain certain financial indicators (referred to in the guidance as ‘maintenance covenants’).
The guidance states that since “[t]here may be less information asymmetry between entities (that is, better visibility) in the intra- group context than in situations involving unrelated parties”, therefore “[w]here there is an absence of covenants in any written agreement between the parties, it will be appropriate to consider under Chapter I guidance whether there is, in practice, the equivalent of a maintenance covenant between the parties and the consequential impact upon the pricing of the loan.” (Para 10.86)
This reflects what we consider to be best practice, namely to avoid unnecessary procedural provisions in intercompany agreements which may be difficult for groups to comply with in practice.
5. Convergence of two-sided transfer pricing analysis with legal and governance considerations
The new guidance confirms the general principle that the delineation and pricing of financial transactions should follow a two-sided consideration of the interests of the parties involved. This includes the principle that controlled entities should not be taken as entering into transactions which would leave them worse off than their “next best option”.
In many ways, this aligns with the legal and governance view of proposed intercompany transactions, namely the process for implementing intercompany transactions must respect the personal legal and fiduciary duties owed by the directors of each of the participating legal entities.
6. The terms documented must include all key features and attributes
The guidance reaffirms that, when pricing controlled transactions, it is important to document the transactions’ key features and attributes.
“For instance in the case of a loan, those characteristics may include but are not limited to: the amount of the loan; its maturity; the schedule of repayment; the nature or purpose of the loan (trade credit, merger/acquisition, mortgage, etc.); level of seniority and subordination, geographical location of the borrower; currency; collateral provided; presence and quality of any guarantee; and whether the interest rate is fixed or floating.” (Para 10.29)
Because many of the features mentioned above cannot be observed by a functional analysis alone, the documentation transactions through appropriate legal agreements is as important for financing transactions as for any other transaction.
7. Contents of master files and local files
The new guidance refers back to Annex I to Chapter V of the original 2017 Guidelines regarding the information to be included in transfer pricing master files.
As specified in Annex II to Chapter V, local files must contain “copies of all material intercompany agreements concluded by the local entity.” This includes copies of agreements documenting the terms of intercompany financing transactions.
'Fast track' intercompany agreements for financial transactions
To help tax and transfer pricing professionals protect the corporates they look after in the light of OECD guidance, LCN Legal has created a new 'fast track' service which facilitates the creation of effective intercompany agreements, including loan agreements and loan note instruments.
LCN Legal's 'fast track' service is powered by our proprietary document automation platform and our experience of working alongside leading transfer pricing professionals globally. It is an ‘execution only' service which enables non-lawyers to produce best-in-class intercompany agreements for the most common transaction types, quickly and efficiently.
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