On the 11th of February OECD released the final Transfer Pricing guidance on financial transactions (the Report). The existing OECD TP Guidelines ( the Guidelines) will be updated to include these new guidelines which are expected to contribute to the avoidance of transfer pricing disputes and double taxation.
The Report in general describes the transfer pricing aspects of financial transactions, and also provides a number of examples to illustrate the principles discussed. The Report is focused on the following 5 sections:
Identifying the commercial or financial relations
This section of the Report concentrated on whether a prima facie loan should be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity. It also clarifies that the guidance included in this Report does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation.
Further, the report stresses the importance of accurate delineation of financial transactions and outlines five economically relevant characteristics that form the analysis of the terms and conditions of financial transactions. These economically relevant characteristics are:
- Contractual Terms
- Functional Analysis
- Characteristics of Financial Instruments
- Economic Circumstances
- Business Strategies
In this section the Report analyses the Treasury functions performed within a MNE group and outlines the considerations which arise from three treasury activities that are often performed within MNE groups.
- Intra-group loans
- Cash pooling
It is important to note that under intra-group loans OECD acknowledges that it is easier to apply the CUP method to financial transactions than may be the case for other types of transactions due to the widespread availability of information.
This section of the Report considers financial guarantees on certain intra group transactions. It stresses the importance of accurately delineating the transaction by identifying the commercial or financial relations before considering any transfer pricing consequences on a financial guarantee.
The guidance also provides for 5 pricing methods that can be used in cases where, after accurately delineating the transaction, a guarantee exists.
- CUP method
- Yield approach
- Cost Approach
- Valuation of expected loss approach
- Capital support method
An MNE group may choose to consolidate risks through a so called “captive insurance”.In this Report the term captive insurance refers to an insurance undertaking or an entity which belongs to a MNE group and substantially all of its insurance business is to provide insurance policies to the group. Under this section OECD provide guidance on intra group reinsurance as well, which is distinguished from captive insurance.
The Report provides guidance as to how to determine whether the captive insurance undertakes and controls risks and once more stresses the importance of identifying the relevant commercial and financial relations between associated enterprises and the conditions which are economically relevant before determining whether transfer pricing implications exists.
In relation to the pricing of a transaction the report analyses several approaches that can be taken on a case by case basis. The report acknowledges the difficulties of applying the CUP method in some cases and analyses potential alternatives.
Risk free and risk adjusted rates of return
In this section OECD provides guidance on how to determine a risk free rate of return and a risk adjusted rate of return in those situations where an associated enterprise is entitled to any of those returns.
The risk free rate of return is considered as an appropriate remuneration for a funder who lacks the capability or does not perform decision making functions to control the risk associated with investing in financial assets. The risk adjusted rate of return is considered an appropriate remuneration for a funder that exercises control over the financial risks associated with the provision of funding without assuming or control any other specific risk.
The risk free and risk adjusted rates of return guidelines will be added to section D.1.2.1 in Chapter I of after paragraph 1.106 and the rest will be included in as Chapter X.
This Report was published after a consensus between the OECD members was achieved. It is expected that some non-OECD members will also follow these guidelines therefore it is important MNE’s to assess the impact of this Report on their intra group financial transactions.
Our office will make new publications providing more in depth technical analysis on these guidelines using practical examples.
Marios Palesis (Partner – Tax Department)
This publication has been prepared as a general guide and for information purposes only. It is not a substitution for professional advice. One must not rely on it without receiving independent advice based on the particular facts of his/her own case. No responsibility can be accepted by the authors or the publishers for any loss occasioned by acting or refraining from acting on the basis of this publication.