Earlier this week the OECD released a non-consensus discussion draft (the Draft) on the transfer pricing aspects of loans, cash pooling, guarantees, hedging transactions and captive insurance structures. This blog provides our initial reactions to the first three of these areas.
Accurate delineation of the transaction
The Draft begins by noting that before transfer prices can be set on a related party financing transaction, the transaction has to be accurately delineated. This means that before moving to setting an interest rate the taxpayer has to consider and demonstrate the arm´s length nature of:
- The terms of the transaction. For example, at arm´s length would the loan have similar duration, be unsecured, utilize a fixed interest rate and be denominated in that currency?
- The volume of the loan. Could and would the borrower have funded their business in the same way if they were not borrowing from a group company – for instance would they have utilized more equity and less debt.
- The economic context of the transaction. For example, did the Lender have investment opportunities that would have yielded a higher return and at arm’s length would it have pursued those rather than lending to the Borrower or would it have demanded that the Borrower pay a higher interest rate than would otherwise have been the case.
These OECD observations are very important. Many Swiss MNE´s do not currently have a process in place to evaluate the arm´s length nature of terms/quantum and to consider the delineation of transactions - so many groups will need to take action to update their pricing policies and processes.
The Draft steps through the activities performed by treasury functions on an intra-group basis and the different ways that treasury functions might be organized.
Perhaps most interestingly, the OECD comments note that in most instances treasury activities should be characterized as a support service, which might be read as implying that they should be remunerated on a cost plus or in some other way that results in a relatively low profit margin.
The Draft includes important guidance on core aspects of intra-group loan pricing:
- Use of credit ratings – the OECD notes the importance of credit ratings and describes a number of approaches that might be applied to estimate the credit rating of a borrower. The OECD notes some of the weaknesses of black box rating tools, but does not preclude their use.
- Effect of group membership - the Draft notes that in some circumstances it will be appropriate to calculate a credit rating for an intra-group borrower purely on the basis of its standalone circumstances. However in other cases it notes that it will be appropriate to take into account the assumption that a Group would support its subsidiaries in the absence of a formal guarantee (so called implicit support from passive association) and to adjust the credit rating accordingly.
- Pricing approaches - the Draft considers three specific pricing approaches (Comparable Uncontrolled Price, Cost of Funds and Bank letters/opinions). The Draft notes bank quotes should generally not be accepted as reliable evidence of arm´s length pricing, and notes limitations in the Cost of Funds approach.
The OECD comments are again important for Swiss MNE´s since they will require many to rethink their approach to credit ratings and/or to revisit their pricing methodology.
The Draft outlines that cash pool arrangements create synergies or savings for groups – for example because they eliminate the spread that banks charge between depositing and borrowing rates. The OECD notes that these savings are typically the result of ‘deliberate concerted action’ of all the members, and focuses its guidance on how those synergies should be shared between the cash pool leader and cash pool participants. The Draft observes that in many/most instances it will not be appropriate for the cash pool leader to retain a significant part of these savings.
The Draft then discusses three mechanisms for sharing cash pool synergies between participants. None of the three mechanisms is common in the Swiss market.
The OECD comments will be relevant for all Swiss MNE’s that operate cash pool structures and will be particularly relevant for Swiss MNE’s whose cash pool structures allocate a significant spread to the cash pool leader.
The Draft defines a financial guarantee as a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the latter were to default on that obligation, and indicates that anything less than a legally binding commitment (e.g. a “letter of comfort”) would not require the payment of a guarantee fee. This is largely consistent with the practical approach currently taken by most Swiss MNEs.
The Draft outlines five alternative approaches for pricing guarantees, including the ‘yield approach’ which is most common in this market. The Draft nonetheless includes important comments on how the approach should be applied in pricing a guarantee fee – in particular around how to deal with the issue of implicit support from passive association.
Despite being a non-consensus discussion draft, the OECD paper outlines a pricing framework that taxpayers should not ignore. At a minimum taxpayers are advised to review their existing policies in light of this publication.