The purpose of this Chapter is to provide guidance for determining whether the conditions of certain financial transactions between associated enterprises are consistent with the arm’s length principle.
Section B describes the application of the principles of Section D.1 of Chapter I to financial transactions. Section C provides guidance on determining the arm’s length conditions for treasury activities including intra-group loans, cash pooling and hedging. Section D examines financial guarantees, and Section E outlines the analysis of captive insurance companies.
The conditions of financial transactions between independent enterprises will be the result of various commercial considerations. In contrast, an MNE group has the discretion to decide upon those conditions within the MNE group. Thus, in an intra-group situation, other considerations such as tax consequences may also be present.
It may be the case that the balance of debt and equity funding of a borrowing entity that is part of an MNE group differs from that which would exist if it were an independent entity operating under the same or similar circumstances. This situation may affect the amount of interest payable by the borrowing entity and so may affect the profits accruing in a given jurisdiction.
Commentary to Article 9 of the OECD Model Tax Convention notes at paragraph 3(b) that Article 9 is relevant “not only in determining whether the rate of interest provided for in a loan contract is an arm’s length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital.”
In the context of the preceding paragraphs, this subsection elaborates on how the concepts of Chapter I, in particular the accurate delineation of the actual transaction under Section D.1, may relate to the balance of debt and equity funding of an entity within an MNE group.
Where it is considered that the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, the guidance at Section D.2 of Chapter I may also be relevant.
Although this guidance reflects an approach of accurate delineation of the actual transaction in accordance with Chapter I to determine the amount of debt to be priced, it is acknowledged that other approaches may be taken to address the issue of the balance of debt and equity funding of an entity under domestic legislation before pricing the interest on the debt so determined. These approaches may include a multi-factor analysis of the characteristics of the instrument and the issuer.
Accordingly, this guidance is not intended to prevent countries from implementing approaches to address the balance of debt and equity funding of an entity and interest deductibility under domestic legislation, nor does it seek to mandate accurate delineation under Chapter I as the only approach for determining whether purported debt should be respected as debt.
Although countries may have different views on the application of Article 9 to determine the balance of debt and equity funding of an entity within an MNE group, the purpose of this section is to provide guidance for countries that use the accurate delineation under Chapter I to determine whether a purported loan should be regarded as a loan for tax purposes (or should be regarded as some other kind of payment, in particular a contribution to equity capital).
Particular labels or descriptions assigned to financial transactions do not constrain the transfer pricing analysis. Each situation must be examined on its own merits, and subject to the prefatory language in the previous paragraph, accurate delineation of the actual transaction under Chapter I will precede any pricing attempt.
In accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances: the presence or absence of a fixed repayment date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the advance is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement.
For example, consider a situation in which Company B, a member of an MNE group, needs additional funding for its business activities. In this scenario, Company B receives an advance of funds from related Company C, which is denominated as a loan with a term of 10 years. Assume that, in light of all good-faith financial projections of Company B for the next 10 years, it is clear that Company B would be unable to service a loan of such an amount. Based on facts and circumstances, it can be concluded that an unrelated party would not be willing to provide such a loan to Company B due to its inability to repay the advance. Accordingly, the accurately delineated amount of Company C’s loan to Company B for transfer pricing purposes would be a function of the maximum amount that an unrelated lender would have been willing to advance to Company B, and the maximum amount that an unrelated borrower in comparable circumstances would have been willing to borrow from Company C, including the possibilities of not lending or borrowing any amount (see comments upon “The lender’s and borrower’s perspectives” in Section C.1.1.1 of this chapter). Consequently, the remainder of Company C’s advance to Company B would not be delineated as a loan for the purposes of determining the amount of interest which Company B would have paid at arm’s length.
In determining the arm’s length conditions of financial transactions, the same principles apply as described in Chapters I-III of these Guidelines for any other controlled transaction.
As with any controlled transaction, the accurate delineation of financial transactions requires an analysis of the factors affecting the performance of businesses in the industry sector in which the MNE group operates. Because differences exist among industry sectors, factors such as the particular point of an economic, business or product cycle, the effect of government regulations, or the availability of financial resources in a given industry are relevant features that have to be considered to accurately delineate the controlled transaction. This examination will take account of the fact that MNE groups operating in different sectors may require, for example, different amounts and types of financing due to different capital intensity levels between industries, or may require different levels of short-term cash balances due to different commercial needs between industries. Where the relevant MNEs are regulated, such as financial services entities subject to regulations consistent with recognised industry standards (e.g. Basel requirements), due regard should be had to the constraints those regulations impose upon them.
As described in Chapter I, the process of accurate delineation of the actual transaction also requires an understanding of how the particular MNE group responds to those identified factors. In this regard, the MNE group’s policies may inform the accurate delineation of the actual transaction through the consideration of, for instance, how the MNE group prioritises the funding needs among different projects; the strategic significance of a particular MNE within the MNE group; whether the MNE group is targeting a specific credit rating or debt-equity ratio; or whether the MNE group is adopting a different funding strategy than the one observed in its industry sector (see Section B.3.5).
In accordance with the guidance established in Chapter I, the accurate delineation of the actual transaction should begin with a thorough identification of the economically relevant characteristics of the transaction – consisting of the commercial or financial relations between the parties and the conditions and economically relevant circumstances attaching to those relations –, including: an examination of the contractual terms of the transaction, the functions performed, assets used, and risks assumed, the characteristics of the financial instruments, the economic circumstances of the parties and of the market, and the business strategies pursued by the parties.
In common with the analysis of any other transaction between associated enterprises, in applying the arm’s length principle to a financial transaction it is necessary to consider the conditions that independent parties would have agreed to in comparable circumstances.
Independent enterprises, when considering whether to enter into a particular financial transaction, will consider all other options realistically available to them, and will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives (see paragraph 1.38 of Chapter I). In considering the options realistically available, the perspective of each of the parties to the transaction must be considered. For instance, in the case of an entity that advances funds, other investment opportunities may be contemplated, taking account of the specific business objectives of the lender and the context in which the transaction takes place. From the borrower’s perspective, the options realistically available will include broader considerations than the entity’s ability to service its debt, for example, the funds it actually needs to meet its operational requirements. In some instances, although an entity may have the capacity to borrow and service an additional amount of debt, it may choose not to do so to avoid placing negative pressure on its credit rating and increasing its cost of capital, and jeopardising its access to capital markets and its market reputation (see comments upon “The lender’s and borrower’s perspectives” in Section C.1.1.1 of this chapter).
In an ideal scenario, a comparability analysis would enable the identification of financial transactions between independent parties which match the tested transaction in all respects. With the many variables involved, it is more likely that potential comparables will differ from the tested transaction. Where differences exist between the tested transaction and any proposed comparable, it will be necessary to consider whether such differences will have a material impact on the price. If so, it may be possible, where appropriate, to make comparability adjustments to improve the reliability of a comparable. This is more likely to be achievable where the adjustment is based on a quantitative factor and there is good quality data easily available (e.g. on currency differences) than, for instance, in trying to compare loans to borrowers with qualitative differences or where data is not so readily available (e.g. borrowers with different business strategies).
To inform an analysis of the terms and conditions of a financial transaction as part of the accurate delineation of the actual transaction or seeking to price the accurately delineated actual transaction, the following economically relevant characteristics should be considered.
The terms and conditions of a financial transaction between independent enterprises are usually explicitly stated in a written agreement. However, between associated enterprises the contractual arrangements may not always provide information in sufficient detail or may be inconsistent with the actual conduct of the parties or other facts and circumstances. It is therefore necessary to look to other documents, the actual conduct of the parties – notwithstanding that such consideration may ultimately result in the conclusion that the contractual form and actual conduct are in alignment – and the economic principles that generally govern relationships between independent enterprises in comparable circumstances in order to accurately delineate the actual transaction in accordance with Section D.1.1 of Chapter I.
In accurately delineating the actual financial transaction, a functional analysis is necessary. This analysis seeks to identify the functions performed, the assets used and the risks assumed by the parties to that controlled transaction.
For instance, in the particular case of an intra-group loan, the key functions performed by a lender to decide whether and under which terms to advance funds would typically include an analysis and evaluation of the risks inherent in the loan, the capability to commit capital of the business to the investment, determining the terms of the loan and organising and documenting the loan. This may also include any ongoing monitoring and periodic review of the loan. Such a functional analysis is likely to include consideration of similar information to that which a commercial lender or ratings agency would consider in determining the creditworthiness of the borrower. An associated lender will not necessarily perform all of the same functions at the same intensity as an independent lender. However, in considering whether a loan has been advanced on conditions which would have been made between independent enterprises, the same commercial considerations and economic circumstances are relevant (see comments on “The lender’s and borrower’s perspectives” and “Use of credit ratings” in Sections C.1.1.1 and C.1.1.2 of this chapter).
When, under accurate delineation, the lender is not exercising control over the risks associated to an advance of funds, or does not have the financial capacity to assume the risks, such risks should be allocated to the enterprise exercising control and having the financial capacity to assume the risk (see paragraph 1.98 of Chapter I). For instance, consider a situation where Company A advances funds to Company B. Consider further that the accurate delineation of the actual transaction indicates that Company A does not exercise control functions related to the advance of funds but that Company P, the parent company of the MNE group, is exercising control over those risks, and has the financial capacity to assume such risks. Under Chapter I analysis, Company P will bear the consequences of the playing out of such risks and Company A will be entitled to no more than a risk-free return (see Section D.1.2.1 in Chapter I).
From the perspective of the borrower, the relevant functions would usually refer to ensuring the availability of funds to repay the principal and the interest on the loan in due time; providing collateral, if needed; and monitoring and fulfilling any other obligation derived from the loan contract (see comments upon “The lender’s and borrower’s perspectives” in Section C.1.1.1 of this chapter).
In some instances, the functions of the lender and the borrower may be undertaken by the same entity in different transactions. That could be the case, for example, of centralised treasury activities within an MNE group where the treasury entity raises and provides funds to other members of the MNE group. In those circumstances, the functional analysis should consider the applicability of the guidance in Section C of this chapter, and, in particular, paragraphs 10.44 and 10.45.
There is a wide variety of financial instruments in the open market that present very different features and attributes, which may affect the pricing of those products or services. Consequently, when pricing controlled transactions, it is important to document the transactions’ 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.
To achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect on price or that appropriate adjustments can be made.
The prices of financial instruments may vary substantially on the basis of underlying economic circumstances, for example, across different currencies, geographic locations, local regulations, the business sector of the borrower and the timing of the transaction.
Macroeconomic trends such as central bank lending rates or interbank reference rates, and financial market events like a credit crisis, can affect prices. In this regard, the precise timing of the issue of a financial instrument in the primary market or the selection of comparable data in the secondary market can therefore be very significant in terms of comparability. For instance, it is not likely that multiple year data on loan issuances will provide useful comparables. The opposite is more likely to be true, i.e. that the closer in timing a comparable loan issuance is to the issuance of the tested transaction, the less the likelihood of different economic factors prevailing, notwithstanding that particular events can cause rapid changes in lending markets.
Currency differences are another potentially important factor. Economic factors such as growth rate, inflation rate, and the volatility of exchange rates, mean that otherwise similar financial instruments issued in different currencies may have different prices. Moreover, prices for financial instruments in the same currency may vary across financial markets or countries due to regulations such as interest rate controls, exchange rate controls, foreign exchange restrictions and other legal and practical restrictions on financial market access.
Business strategies must also be examined in accurately delineating the actual financial transaction and in determining comparability for transfer pricing purposes since different business strategies can have a significant effect on the terms and conditions which would be agreed between independent enterprises.
For example, independent lenders may be prepared to lend on terms and conditions to an enterprise undertaking a merger or acquisition which might otherwise not be acceptable to the lender for the same business if it were in a steady state. In this kind of scenario, the lender may take a view over the term of the loan and consider the borrower’s business plans and forecasts, effectively acknowledging that there will be temporary changes in the financial metrics of the business for a period as it undergoes changes. Section D.1.5 of Chapter I gives other examples of business strategies that must be examined in accurately delineating the actual transaction and determining comparability.
The analysis of the business strategies will also include consideration of the MNE group’s global financing policy, and the identification of existing relationships between the associated enterprises such as pre-existing loans and shareholder interests (see Annex I to Chapter V of these Guidelines about the information to be included in the master file).
For example, consider that Company A, a member of AB Group, advances funds with a term of 10 years to an associated enterprise, Company B, which will use the funding for short-term working capital purposes. This advance is the only loan in Company B’s balance sheet. AB Group’s policy and practices demonstrate that the MNE group uses a one-year revolving loan to manage short-term working capital. In this scenario, under the prevailing facts and circumstances, the accurate delineation of the actual transaction may conclude that an unrelated borrower under the same conditions of Company B would not enter into a 10-year loan agreement to manage its short-term working capital needs and the transaction would be accurately delineated as a one-year revolving loan rather than a 10-year loan. The consequences of this delineation would be that assuming the working capital requirements continue to exist, the pricing approach would be to price a series of refreshed one-year revolver loans.
In any case, the reliability of results is generally improved to the extent comparable borrowers pursue similar business strategies to the tested borrower involved in an intra-group transaction.
For MNE groups, the management of group finances is an important and potentially complex activity where the approach adopted by individual businesses will depend on the structure of the business itself, its business strategy, place in the business cycle, industry sector, currencies of operation, etc.
The organisation of the treasury will depend on the structure of a given MNE group and the complexity of its operations. Different treasury structures involve different degrees of centralisation. In the most decentralised form, each MNE within the MNE group has full autonomy over its financial transactions. Decentralised treasury structures may be present, for instance, in MNE groups with multiple operating divisions that operate in discrete industries or with regional hub structures, or in MNE groups required to comply with specific local regulations. At the opposite end of the scale, a centralised treasury has full control over the financial transactions of the MNE group, with entities within the MNE group responsible for operational but not financial matters.
A key function of a corporate treasury may be, for example, to optimise liquidity across the MNE group to ensure that the business has sufficient cash available and that it is in the right place when it is needed and in the right currency. In general, efficient management of MNE group liquidity is driven by considerations above the level of individual entities, and acts to help mitigate risk across a number of entities.
Whilst the treasury’s cash and liquidity management function is concerned with day-to-day operations, corporate financial management is concerned with development of strategies and planning for investment decisions in the longer term. Financial risk management requires identification and analysis of, and responses to, the financial risks to which the business is exposed. By identifying and taking action to address financial risk, treasury can help to optimise the cost of capital to the advantage of the users of the MNE group’s treasury services.
Other examples of activities which the treasury may have responsibility for include raising debt (through bond issuances, bank loans or otherwise) and raising equity, and managing the relationship with the MNE group’s external bankers and with independent credit rating agencies.
When evaluating the transfer pricing issues related to treasury activities, as with any case, it is important to accurately delineate the actual transactions and determine exactly what functions an entity is carrying on rather than to rely to any extent upon a general description such as “treasury activities”.
Generally, the treasury function is part of the process of making the financing of the commercial business of the MNE group as efficient as possible. As such, the treasury function will usually be a support service to the main value-creating operation as in the case, for example, of the services provided by a cash pool leader (see Section C.2.3). Depending on the facts and circumstances of each case, such activities may be services in which case the pricing guidance on intra-group services at Chapter VII applies.
Similarly, the treasury may act as the contact point to centralise the external borrowing of the MNE group. External funds would then be made available within the MNE group through intra-group lending provided by the treasury. On prevailing facts and circumstances, guidance in paragraph 1.168 of Chapter I would apply to these situations and the treasury would be expected to receive an arm’s length fee for its coordination activities.
In other situations, the treasury may be found to perform more complex functions and, therefore, it should be compensated accordingly.
Another key concern regarding treasury activities is the identification and allocation of the economically significant risks in accordance with Chapter I.
The activities of the treasury function take into account issues at a group level and follow the vision, strategy and policies set out by MNE group management. Accordingly, the approach of the treasury to risk will depend on the MNE group’s policy where certain objectives may be specified, such as targeted levels of investment return (e.g. the yield must exceed the cost of capital), reduced cash flow volatility, or targeted balance sheet ratios (e.g. assets to liabilities). Therefore, it is important to note that usually the higher strategic decisions will generally be the result of policy set at group level rather than determined by the treasury itself.
The following sections outline the transfer pricing considerations which arise from some relevant treasury activities that are often performed within MNE groups, i.e. the provision of intra-group loans, cash pooling, and hedging activities.