The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
The author explores how finance companies are reacting and adapting to the new transfer pricing documentation requirements and guidance on risk from the OECD.
By Omar Moerer, PwC
Omar Moerer, CFA, is a director with PwC Netherlands and a member of the transfer pricing team. Please provide comments to Omar.Moerer@nl.pwc.com. Any errors or omissions are the author's, and this article is written in his personal capacity.
The past years have witnessed increased attention on the transfer pricing aspects of intercompany finance transactions—even as those transactions have become more sophisticated. One can cite numerous developments to explain this trend: increased use of financial transactions by multinational corporations, enhanced understanding and knowledge of such transactions by advisers and tax authorities and large court cases that significant attracted media attention (at least in the world of tax and transfer pricing). The recommendations developed under the Organization for Economic Cooperation and Development's Action Plan on Base Erosion and Profit Shifting (BEPS) are likely to further increase the scrutiny multinational companies face regarding their intercompany financing transactions and to require more substantiation of the arm's-length nature of those transactions. Multinationals have been reacting to these developments and are increasingly adopting in-house transfer pricing financing policies to ensure compliance with strengthened transfer pricing rules and guidance. This article will address two of the BEPS action items that have an immediate impact on the transfer pricing aspects and requirements of group financing arrangements. It also will describe a high-level structure of a financing policy that can be put in place to ensure that the structuring and pricing of financing transactions, including the substance of the parties involved, remains at arm's length.
Intercompany financing within a multinational—such as issuing intercompany loans, treasury activities, managing the group's cash pool, issuing guarantees and foreign exchange risk management—has historically been, and still is, the domain of the treasury department. In recent years, however, tax departments are increasingly interested in the activities of their treasury colleagues from a desire to ensure that the financing transactions entered into are conducted at arm's length.
When treasury takes the lead on the relevant processes and transactions, it might sometimes consult other departments. For instance, it might consult the legal department on agreements that are in place or documented transactions, or the tax department, which might provide input on applicable interest deduction thresholds or perhaps transfer pricing issues.
For multinationals, intercompany financing can be used to optimize liquidity, reduce external financing costs and reduce the tax burden. The last point has caused tax authorities worldwide to pay attention to these transactions and the relevant aspects to consider for transfer pricing purposes. Where in the past there was an absence of formal guidance on intercompany finance transactions, and the transactions may have been considered too complex to focus on, this is no longer the case, as evidenced by court cases in various jurisdictions around the world and an increase in local tax and transfer pricing audits.
Some of the historic reluctance to target financial transactions might have come from the lack of guidance on this topic, with only limited references provided in the OECD transfer pricing guidelines. Limited guidance could be found in paragraph 7.13 of the guidelines, which deals with credit ratings, including the impact of group affiliation, and guarantee fees, and paragraph 7.15, which includes language on the form of compensation for financial services such as loans, foreign exchange and hedging. New Chapter 1 of the guidelines, updated with recommendations in the final reports on OECD BEPS Actions 8, 9 and 10, provides a bit more guidance in that regard. However, formal guidance from the OECD on the transfer pricing aspects of intercompany finance transactions is still forthcoming. It is expected that draft guidance will be issued by the OECD in the course of 2017.
Although the OECD's formal guidance is still to be published, the organization has issued final reports under its Action Plan on Base Erosion and Profit Shifting (BEPS) that are relevant for multinationals and their intercompany finance activities. These are the reports on:
For transfer pricing purposes, Action 13 and Action 9 directly affect how multinationals conduct and document their intercompany financing transactions.
Action 13 provides guidance on transfer pricing documentation and introduced a new three-tiered transfer pricing documentation template that has already been adopted by numerous jurisdictions worldwide, consisting of a master file, a local file and a country-by-country report.
Without going into great detail on the new OECD documentation requirements, one of the elements introduced is an obligation for multinationals to detail how they are financed. Specifically, a description of the multinational's financial activities is to be included in the master file. The required information includes how the group is financed (for instance, with external creditors), but also the intercompany financing arrangements present within the group including information on centralized treasury activities and the transfer pricing policies in place in relation to the intercompany financing transactions.
Also, the local file requires a detailed analysis and description of the intercompany finance transactions entered into by entities in the local jurisdictions, including support for the arm's-length nature of the prices applied, copies of the relevant agreements and an overview of payments made by the local entity—for example, interest payments on a loan—and to which jurisdiction such payments are made.
The new documentation template thus requires multinationals to disclose their intercompany financing arrangements and describe the policies used to structure and price these arrangements at arm's length. The immediate impact of Action 13 will be company-specific. For some multinationals it might be as straightforward as having to document their finance arrangements and policies in place, while others might find that the intragroup financing transactions entered into aren't subject to a coherent transfer pricing policy or structured approach. Clearly, the new transfer pricing documentation requirements will make it easier for tax authorities to identify taxpayers in the latter situation.
OECD BEPS Action 9 also will affect intercompany finance transactions (as well as most other intercompany transactions)—specifically, where it deals with the contractual allocation of risks, the related activities carried out (conduct, management and control) and the resulting allocation of expected returns to those risks.
In general, the BEPS project emphasizes the importance of substance and people functions in relation to profit allocation, and also in relation to the allocation of risks. These developments might become particularly relevant for intercompany finance transactions. The pricing of these transactions typically deals with the pricing of risks identified within the transaction. These risks could be the credit risk of the counter-party, the terms and conditions applied in the agreement or market circumstances. Accurately pricing the risks identified in an intercompany transaction often means relying on finance techniques. As a result of Action 9, multinationals now have to ascertain that the contractual allocation of risks is consistent with the actual conduct of the parties, and, specifically, that the party allocated a risk has both the financial capacity to bear the risk and the ability to manage and control the risk.
In that regard, the final BEPS Action 9 report indicates that risk management consists of both the capability to perform and the actual performance of the following functions:
As mentioned, because risks are a major component in intercompany finance transactions and their pricing, the OECD's emphasis on the analysis of risks is something multinationals should consider in assessing—or reassessing—their intragroup financing arrangements. The OECD introduces a six-step framework for ensuring that the risks are allocated to the party that can actually manage and control the risks.
Specifically, multinationals will need to assess whether the relevant risk management and control functions are performed by the entity that is contractually allocated these risks and, for instance, issues the loans and receives the related returns. The new Action 9 guidance is relevant for multinationals to ensure that their intragroup financing remains at arm's length and that risks and expected returns are allocated in accordance with the actual conduct of the parties.
These developments may have an impact on so-called cash box entities—capital-rich entities without any other relevant economic activities. These entities have neither substance nor the ability to control and manage any of the risks embedded in the investments made with their capital. Therefore, the profits the cash box entity is entitled to retain might be equivalent to no more than a risk-free return, and the entity might not be entitled to any additional return.
The direct impact of Action 9 could be that a multinational simply has to document and support that the contractual allocation of risks in its intercompany finance transactions is consistent with the actual conduct of the parties involved. However, for some multinationals it might become apparent that the contractual allocation of risks is not aligned with the conduct of the parties, potentially requiring adjustments to be made in the overall treasury set-up, in addition to the documentation that should be prepared.
Faced with an increasingly sophisticated tax and transfer pricing environment, more audits, more comprehensive documentation requirements and a new formal compliance burden regarding the group's finance policy, intercompany finance arrangements are, or should be, on the radar of any multinational company's tax department, as it needs to ensure that transactions are structured and entered into at arm's length and that supporting documentation in place.
Multinationals are increasingly establishing transfer pricing finance policies that strive to fulfill these requirements. The policies aim to not only price the group's finance transactions at arm's length, but also to ensure that the structure of, for instance, a loan, the volume thereof, the terms and conditions applied, the substance, conduct, risk allocation and control related to such transactions are at arm's length. This typically requires that all relevant stakeholders (for example, the tax, treasury and legal departments as well as management of borrowing entities) are involved in the process and that the policy has the necessary checks and balances to ensure that it is properly implemented and maintained and that the relevant risks are indeed managed and controlled in line with the contractual allocation thereof.
Generally, the day-to-day activities of such a finance policy are managed and controlled by the treasury department. The design of the policy should be consistent with the internal treasury policy in place at the multinational. Treasury policies and financial risk management policies might, among others, deal with interest rate management, foreign exchange risk management, credit risk, liquidity and capital. The transfer pricing policy should ideally be structured so that it falls within the general treasury policy, but changes to these internal processes might be required.
In basic terms, the policy would consist of a framework, with specific steps and procedures, that ensures the group's intercompany finance transactions are structured and priced at arm's length and that the process and transactions are documented. Ideally, the policy would cause little interference with the treasury department's day-to-day activities. Finance policies can be structured in such a way that they can be operated and maintained completely in-house based on the resources and databases available within the multinational or, where needed, with periodic input from an adviser.
Below is a generic framework for how such an arm's-length finance policy could be structured and the various phases and analyses that it might entail. To be clear, this basic framework won't suit every multinational, and will need to be designed on a case-by-case basis, but it lays out the relevant aspects and phases that one might consider.
Setting up a finance policy will require taxpayers to determine what should be included in the policy before they can start with the actual design. This not only involves reviewing and assessing the intercompany transactions to be covered, but also identifying the stakeholders. This objective could be achieved by means of three distinct sub-phases.
In the pre-design phase, taxpayers should take inventory of the intercompany finance agreements in place and the typical funding needs of the relevant group entities—working capital, credit facilities, long term financing, credit enhancement (guarantees), foreign exchange, hedges and the like.
It is important to obtain a thorough understanding of the group's financing needs, the sources of funding and the common transactions entered into so the policy can be designed in such a way that it covers a majority of the gruop's common finance requirements.
Financing is typically the domain of the treasury department—with increased interest from the tax department. Additional stakeholders to consider when designing a financing policy for transfer pricing purposes are the tax department, the legal department and, where relevant, local management of group entities that engage in intercompany finance transactions.
Where the role of treasury is obvious, one shouldn't ignore the contributions of the tax department and the legal department in a transfer pricing policy. The tax department wants to ensure that the transactions entered into by group companies are conducted at arm's length. This means reviewing the interest rate, the nature of the transaction, the parties involved, the purpose of the transaction and the terms and conditions applied. The terms and conditions applied in the intercompany finance agreements are typically the domain of the legal department, and they need to reflect the terms and conditions that would be agreed upon between unrelated parties, including the appropriate risk mitigating measures, where appropriate. With the emphasis put by the OECD on two-sided analyses for transfer pricing purposes, the group companies engaging in finance transactions with treasury should be involved in the process to ensure that their financing needs, including options realistically available, are appropriately considered.
This phase of the policy typically consists of multiple steps with contributions of multiple stakeholders and allows for the structuring of the finance policy framework.
Structuring the policy means assessing the identified needs of the multinational and its reliance on intercompany financing, to ensure that the policy covers a majority of the intragroup financing transactions.
With regard to intercompany loans, for instance, one could consider the type of financing arrangements typically used—for example, term loans versus facilities, the purpose of the arrangement, the typical maturities and the most common currencies in which funds are transacted. For practical purposes one could consider establishing a policy that consists of elements that cover a majority of the group's financing transactions and treat the remainder on a case-by-case basis. With regard to intercompany loans, for instance, one could identify the following common elements:
The benefit of relying on a targeted set of terms and conditions is that the policy remains manageable and practical for all stakeholders, provides sufficient flexibility to tailor the transactions to the specifics needs of the parties involved, allows one to consider the options realistically available and ultimately ensures that they are structured at arm's-length terms. Clearly, the above overview is illustrative only and should ultimately be aligned with the financing needs and practice within the multinational. Other factors, such as security (collateral, guarantees), covenants, country specific risks, other type of options and the purpose of the loan will be relevant for a multinational depending on its financing needs.
For cash pool structures it will be relevant to also consider the terms and conditions mentioned above; the features of a cash pool will clearly affect some of them—for example, the maturity is typically short-term, and there may be demand options on deposits (that is, funds on deposit with the cash pool leader should be available for withdrawal on demand). Additional factors might be volume thresholds, maturity thresholds and the impact of guarantees from the parent or cross-guarantees.
A side benefit of having a targeted set of terms and conditions is that from a legal documentation perspective, this simplifies drafting the relevant loan agreements, allowing for standardization while ensuring that the relevant terms and conditions—and only the relevant terms and conditions—are included in the final loan agreement. This also makes the contributions of the legal department more structured, consistent and manageable.
Once the overall policy has been designed and the relevant parties and transactions have been mapped out, one can progress with the analytics phase. During this phase, it is typically the treasury department that will run all, or most, of the background analyses to ensure that all the transactions are structured and priced at arm's length. With regard to intercompany financing, such analyses could pertain, for instance, to credit rating analyses and interest rate and fee benchmark analyses.
One of the important elements to consider in pricing finance transactions regards credit risk—that is, the risk that a borrower will default on its payment obligations under a loan, or that such a default invokes a guarantee. A party's creditworthiness is often expressed through its credit rating.
Subsidiaries of multinational groups typically aren't rated by official credit rating agencies, such as Standard & Poor's and Moody's. Therefore, the policy requires an assessment of the credit ratings of the group entities. Such an analysis could be performed by the treasury department at the head office or by regional or local treasury departments—for example, conducted under service-level agreements.
In determining the credit rating of the relevant group entities, several approaches can be adopted. For instance, a “bottom up” approach, starting from the stand-alone rating of the relevant group companies and, if necessary, adjusting the rating for specific terms and conditions of the finance transaction or for implicit support (a potential beneficial impact on the perceived credit worthiness of a group subsidiary, from the perspective of a third-party creditor, resulting solely from group association), or a “top down” approach whereby the analysis starts from the rating of the group to which appropriate adjustments are subsequently applied to derive the ratings of the individual group entities or finance transactions. Clearly, the impact of explicit guarantees should also be considered in this phase.
Various tools and models are available for these analyses, all with different degrees of granularity, complexity and reliability. Irrespective of the model relied upon, it is important to consider whether implicit support (as is to be introduced in Chapter 1 of the OECD transfer pricing guidelines is appropriately reflected and documented in the rating assessment and, of course, the impact of any parent and cross-guarantees.
Furthermore, it would be prudent to illustrate, based on forecasted financials, that the group entities borrowing under the policy generate sufficient cash flow to service their debt obligations over the lifetime of the loans (and to avoid discussions about potential requalification into equity).
The analyses performed in the previous phases—identifying the parties involved, supporting and structuring the type of financing or credit enhancement needed, establishing the appropriate terms and conditions to be used and determining the credit ratings to be applied—provide all the necessary elements to identify the economically significant risks in the finance transactions that are to be remunerated through the interest rate or fees applied and for which benchmarks are to be performed.
Again, having a targeted set of terms and conditions allows for a standardized benchmarking approach to be developed and used by treasury or advisers, which ensures that all the necessary factors are considered in a structured manner, ideally using tools and models that will extract the necessary information from the relevant databases.
In benchmarking interest rates, be it for intercompany loans or cash pool structures, it is important to consider all the relevant risk factors, either by benchmarking transactions that have comparable characteristics and terms and conditions or by constructing an arm's-length interest rate through pricing the individual risk components. Similarly, for guarantee fees, the relevant credit ratings of the parties involved and the specific terms and conditions (including the specifics of, and terms and conditions applied in the transaction that is guaranteed) should be considered.
Once the arm's-length interest rates and fees have been established, one should consider involving the other stakeholders again, communicating and validating the results and reaching agreement on them, updating any relevant analyses and documents necessary and ensure that the necessary approvals are obtained before the transactions are entered into.
The final phases of the policy aim to ensure that the framework developed is appropriately applied during the year and that the parties involved keep each other informed of all the necessary developments and changes, as you would expect in a third party arrangement. It also allows for the identification of any changes or inconsistencies that would require an update of the policy, ensuring that the policy is in fact a “live” policy that evolves in line with the evolvement of the multinational and the market.
Throughout the year, or cycle, it will be important to actively maintain, manage and control the policy. This is likely to be the domain of the treasury department, which for example will periodically monitor and examine the status of the intercompany loans issued or cash pool balances, as well as the actual development of the group companies' financials and how they compare with budgets relied upon, options included, market interest developments, hedging specific risks (such as foreign exchange) and financial covenants applied in the loan agreements, informing group companies of interest changes and payment receipts, or reviewing the need for external funding.
During this phase the legal and tax departments, as well as local management of group companies, would want to ensure that all relevant documentation is put in place, including, for instance the loan agreements and the relevant transfer pricing documentation.
Any issues or inconsistencies identified during the cycle will need to be addressed with the relevant stakeholders to ensure future compliance with the policy, and, potentially, to perform the necessary adjustments during the financial year.
During the last phase, the policy's periodic (for example, annual) performance is reviewed and, when appropriate, positions are settled. This closing and evaluation phase ensures that treasury validates the applicability of the finance policy used, that it still matches the needs of the group and that its application is still in accordance with the original policy. Observations and deviations, as well as changes made to the policy, are again to be communicated to and approved by the relevant stakeholders.
In maintaining the policy the above sub-phases 2-7 are typically part of a periodic, mostly annual, cycle that ensures that the policy captures the relevant and updated market circumstances, that the parties remain informed and in control of their financing and any changes in the group's situation.
Clearly each and every policy should be tailored to the specific needs and capacity of the multinational, and some policies will be much more granular and detailed than others. However, the over-arching aim and objective of such policies is to ensure that the group is in control of the intercompany finance transactions it enters into, both from a treasury as well as a tax and transfer pricing perspective. In addition, it would provide multinationals with a policy that is consistent with the current transfer pricing requirements and the policy documentation can be used to fulfill transfer pricing documentation requirements. Both elements are of crucial importance in the current transfer pricing environment of increasing transparency and sophistication.
Based on the developments at the OECD and local levels, it is clear that intercompany financial transactions will face increased scrutiny in the near future and the changes resulting from the OECD's BEPS actions warrant a careful review of multinationals' financing transactions and how they are structured, priced, supported and documented. Multinational companies are reacting to these increased requirements for, among other things, substance and documentation of such transactions, by setting transfer pricing policies whereby their tax and treasury departments devise a framework and policy for the multinational's intragroup financing. These policies aim to ensure that the financing transactions are structured and priced at arm's length and that there is supporting documentation available, including parts that can be included in the multinational's transfer pricing documentation. The OECD BEPS actions thus seem to have caused certain reactions at the level of multinationals. Whether they are “equal and opposite” to the original action remains to be seen.
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