In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible. For example, treasury may act as the contact point to centralize 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. In considering the commercial and financial relations between the associated borrower and lender concerning intra-group loans, both the lender’s and borrower’s perspectives should be taken into account. In particular, it is important to consider the risks that the funding arrangements carry for the party providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of related party transactions. Arm’s length interest rates can be sought based on consideration of the credit rating of the borrower or the rating of the specific issuance, taking into account all of the terms and conditions of the loan and comparability factors. The widespread existence of markets for borrowing and lending money and the frequency of such transactions between independent borrowers and lenders may make it easier to apply the CUP method to financial transactions than may be the case for other types of transactions.
Background. In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation.
The Guidance is divided into several parts. First, the Guidance elaborates on how “accurate delineation” analysis applies to the capital structure of a Multinational Enterprise (“MNE”), which was the subject of a prior post. Regarding accurate delineation, the Guidance makes clear that it does not seek to prevent countries from implementing approaches to address capital structure and interest deductibility under domestic legislation. Subsequent sections of the Guidance address specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, guarantees, and captive insurance. Those issues will be the subject of separate posts. This post covers pricing of intra-group loans.
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, and currencies of operation, among other factors. Different treasury structures involve different degrees of centralization. In the most decentralized form, each MNE within the group has full autonomy over its financial transactions. At the opposite end of the scale, a centralized 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 corporate treasury may be to optimize 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. Other activities that 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. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible. For example, treasury may act as the contact point to centralize 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.
Intra-group loans. In considering the commercial and financial relations between the associated borrower and lender concerning intra-group loans, both the lender’s and borrower’s perspectives should be taken into account. In particular, it is important to consider the risks that the funding arrangements carry for the party providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient. These risks will relate to repayment of the amount transferred, compensation expected for the use of that amount over time, and compensation for other associated risk factors. The lender’s perspective in the decision of whether to make a loan, how much to lend, and on what terms, will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of funds. When an enterprise is making a loan to an associated enterprise, it will not necessarily follow all of the same processes as an independent lender. For example, it may not need to go through the same process of information gathering about the borrower’s business. However, in considering whether the loan has been made on conditions which would have been made between independent enterprises, the same commercial considerations such as creditworthiness, credit risk and economic circumstances are relevant. A lender will also consider the potential impact of changes which could happen in economic conditions affecting the credit risk it bears, not only in relation to the conditions of the borrower but in relation to potential changes in economic conditions, such as a rise in interest rates, or the exposure of the borrower to movements in exchange rates. Borrowers seek to optimize their weighted average cost of capital and to have the right funding available to meet both short-term needs and long-term objectives. In respect of collateral, this might mean secured funding ahead of unsecured funding.
Security. In the case of a loan from the parent entity of an MNE group to a subsidiary, the parent already has control and ownership of the subsidiary, which would make the granting of security less relevant to its risk analysis as a lender.
Use of Credit Ratings. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of related party transactions. The credit rating of an MNE or MNE group (“issuer credit rating”) is an opinion about its general creditworthiness. Such an opinion is usually premised on the MNE or MNE group’s capacity and willingness to meet its financial obligations in accordance with the terms of those obligations. Information is readily available in many lending markets on the different rates of interest charged for differently rated enterprises and such information may usefully contribute to performing comparability analyses. When making comparisons between borrowers using the kind of financial metrics typically seen as important to lenders, such as debt-equity ratios or debt-earnings ratios, it is important to note that the same financial metrics will not necessarily result in the same credit rating if there are other differences between the rated parties. It is important that the MNE group appropriately documents the reasons and selection of the credit rating used for a particular MNE when pricing intra-group loans and other financial transactions.
The credit rating of a particular debt issuance (“issue rating”) is an opinion about the creditworthiness of the issuer with respect to a specific financial instrument. The issue rating considers specific features of the financial instrument, for instance, guarantees, security and level of seniority. When both an issuer and issue ratings are available, the issue rating of the particular debt issuance would be more appropriate to use to price the controlled financial transaction. In most cases, publicly available credit ratings are only available for the MNE group. An approach often used for a specific MNE is to apply quantitative and qualitative analyses of the individual characteristics of the MNE using publicly available financial tools or independent credit rating agencies’ methodologies to seek to replicate the process used to determine the credit rating of the MNE group. This approach also involves improvements in creditworthiness that the specific MNE would be assumed to receive as a result of being part of the MNE group. Broadly, publicly available financial tools depend on approaches such as calculating the probability of default and of the likely loss should default occur to arrive at an implied rating for the borrowing. This can then be compared to a market database in a search for comparables to arrive at a price or price range for the borrowing. In conducting a credit analysis, it is important to note that the financial metrics may be influenced by current and past controlled transactions.
Effect of Group Membership. The effect of group membership is relevant for informing the conditions under which an MNE would have borrowed from an independent lender at arm’s length in two ways. First, the external funding policies and practices of group management will assist in informing the form and terms and conditions of the debt the MNE would have entered into with an independent lender. Second, the MNE may receive support from the group to meet its financial obligations in the event of the borrower getting into financial difficulty. In the context of intra-group loans, this incidental benefit that the MNE is assumed to receive, solely by virtue of group affiliation, is referred to as implicit support. The effect of potential group support on the credit rating of an entity and any effect on that entity’s ability to borrow or the interest rate paid on those borrowings would not require any payment or comparability adjustment, according to the OECD. Implicit support from the group may affect the credit rating of the borrower or the rating of any debt which it issues. The relative status of an entity within the group may help determine what impact, if any, that potential group support has on the credit rating of the issuer. Another key consideration would be the likely consequences for other parts of the MNE group of supporting or not supporting the borrower.
The credit rating of the MNE group may also be used for the purpose of pricing the accurately delineated loan where the facts so indicate, particularly in situations such as where the MNE is important to the group and where the MNE’s indicators of creditworthiness do not differ significantly from those of the group.
Covenants. The purpose of covenants in a loan agreement is generally to provide a degree of protection to the lender and so limit its risk. That protection may be in the form of incurrence covenants and maintenance covenants. Incurrence covenants require or prohibit certain actions without the consent of the lender. Maintenance covenants refer typically to financial indicators which have to be met at regular, predetermined intervals during the life of the covenanted loan to provide a degree of protection to the lender and so limit its risk. Intra-group lenders may choose not to have covenants on loans to associated enterprises, partly because they are less likely to suffer information asymmetry and because it is less likely that one part of an MNE group would seek to take the same kind of action as an independent lender in the event of a covenant breach.
Guarantees. A guarantee from another party may be used to support the borrower’s credit. A lender placing reliance on a guarantee or guarantees would need to evaluate the guarantors in a similar way to that in which it evaluates the original borrower.
Comparable Uncontrolled Price (“CUP”) Method. Once the actual transaction has been accurately delineated, arm’s length interest rates can be sought based on consideration of the credit rating of the borrower or the rating of the specific issuance, taking into account all of the terms and conditions of the loan and comparability factors. The widespread existence of markets for borrowing and lending money and the frequency of such transactions between independent borrowers and lenders may make it easier to apply the CUP method to financial transactions than may be the case for other types of transactions. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of related party transactions. The arm’s length interest rate for a tested loan can be benchmarked against publicly available data for other borrowers with the same credit rating for loans with sufficiently similar terms and conditions and other comparability factors. In practice, there is unlikely to be a single “market rate” but a range of rates, although competition between lenders and the availability of pricing information will tend to narrow the range, according to the OECD. Arm’s length interest rates can also be based on the return of realistic alternative transactions with comparable economic characteristics. Realistic alternatives to intra-group loans could be, for instance, bond issuances, loans which are uncontrolled transactions, deposits, convertible debentures and commercial paper. It may also be possible to identify potential comparable loans within the borrower’s or its MNE group’s financing with an independent lender as the counterparty.
Cost of Funds. In the absence of comparable uncontrolled transactions, the cost of funds approach could be used as an alternative to price intra-group loans in some circumstances. The cost of funds will reflect the borrowing costs incurred by the lender in raising the funds to lend. To this would be added the expenses of arranging the loan and the relevant costs incurred in servicing the loan, a risk premium to reflect the various economic factors inherent in the proposed loan, plus a profit margin, which will generally include the lender’s incremental cost of the equity required to support the loan. The application of the cost of funds approach requires consideration of the options realistically available to the borrower.
Credit Default Swaps. Credit default swaps reflect the credit risk linked to an underlying financial asset. In the absence of information regarding the underlying asset that could be used as a comparable transaction, taxpayers and tax administrations may use the spreads of credit default swaps to calculate the risk premium associated to intra-group loans.
Economic Modeling. Economic models calculate an interest rate through a combination of a risk-free interest rate and a number of premiums associated with different aspects of the loan for example default risk, liquidity risk, expected inflation and maturity. The economic model might also include elements to compensate the lender’s operational expenses. It is important to note that economic models do not represent actual transactions between independent parties and that, therefore, comparability adjustments may be required.
Bank Opinions. In some circumstances taxpayers may seek to evidence the arm’s length rate of interest on an intra-group loan by producing written opinions from independent banks, sometimes referred to as a “bankability” opinion, stating what interest rate the bank would apply were it to make a comparable loan to the enterprise. It is important to bear in mind that such letters do not constitute an actual offer to lend.
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