In addition to providing guidance on a number of transfer pricing related issues relating to aligning transfer pricing outcomes with value creation, the 2015 final report on Base Erosion and Profit Shifting - Actions 8 to 10 mandated follow-up work on the transfer pricing aspects of financial transactions. The Organisation for Economic Co-operation and Development's ("OECD's") Committee on Fiscal Affairs Working Party No. 6 has produced a discussion draft that aims to clarify the application of the principles relating to intra-group financial transactions. The discussion draft was finally published on 3 July 2018. The OECD invites interested parties to submit any comments on this discussion draft by 7 September 2018.
The purpose of the discussion draft is to provide guidance for determining whether the conditions of certain financial transactions between associated enterprises are consistent with the arm's length principle ("ALP").The discussion draft highlights that, in determining the arm's length conditions of financial transactions, the same principles apply as described in the OECD Transfer Pricing Guidelines ("OECD Guidelines").
The discussion draft includes important guidance for multinationals on general pricing issues in relation to intra-group loans as well as on specific pricing issues regarding treasury activities, cash pooling, guarantees and reinsurance.
The first part of the discussion draft provides guidance on the application of principles surrounding the identification of commercial or financial relations as discussed in the OECD Guidelines. Specific pricing issues related to the pricing of financial transactions such as treasury function, intra-group loans, cash pooling, hedging, guarantees and captive insurance are addressed in the second part of the discussion draft.
The discussion draft is divided into four sections, namely:
- Section B describes the application of the principles of the identification of commercial or financial relations as provided for in 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.
Each section is also sub-divided into different sections. Section B.1 of the discussion draft elaborates on how the accurate delineation analysis, which requires an analysis of the factors affecting the performance of businesses in the industry sector in which the Multinational Enterprise ("MNE") group operates, applies to the capital structure of a MNE within a MNE group. The discussion draft clarifies that the guidance included in this section does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation.
Section B.2 outlines the economically relevant characteristics of actual financial transactions and includes discussions on the analysis of the terms and conditions of a financial transaction, a functional analysis which seeks to identify the functions performed, the assets used and the risks assumed, the different characteristics of financial products or services which may affect the pricing of those products or services, the economic circumstances that needs to be considered in achieving comparability and the business strategies which could have a significant effect on the terms and conditions which would be agreed between independent enterprises.
Prior to determining what an arm's length interest rate would be, an analysis should be done to establish the loan amount between an unrelated lender and an unrelated borrower in comparable circumstances. Section C.1 deals with intra-group loans and determining an arm's length interest rate on these loans. In the discussion it is noted that the Comparable Uncontrolled Price ("CUP") method may be easier to apply to financial transactions due to a widespread existence of markets and the frequency of financial transactions between independent borrowers and lenders, coupled with the widespread availability of information and analysis of loan markets. Section C.2 explains the benefit of a cash pool and focus on the importance of appropriate allocation to various participants.
Intra-group financial transactions may include instruments by which risk is transferred within the MNE group, Section C.3 of the discussion draft demonstrates the treasury function in hedging contracts which is essentially seen as providing of services and an arm's length price is therefore required.
Section D differentiates between explicit guarantees, implicit guarantees and cross-guarantees and provides an understanding on determining an arm's length guarantee fee which would essentially take into account the benefit gained by the borrower as a result of the guarantee.
Finally, there are many ways that MNE groups may manage risks within the group and Section E of the discussion draft elaborates on one such option namely, the consolidation of certain risks through a so-called "captive" insurance company and provides guidance on how an arm's length price in these circumstances should be determined. Sections E.1 to E.4 provide some background on insurance and re-insurance captive and Section E.6 deals with agency sales of insurance contracts. Section E.5 outlines the different approaches to pricing intra-group transactions involving captive insurance. It remains important that the economic rationale to use a captive should be properly substantiated and differences between third party (captive) insurance companies and group insurance companies should be properly taken into account in determining prices.
Reviewed by Jens Brodbeck, an executive in ENSafrica's tax department.
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