Intra-group financing: Transfer pricing and intra-group financing
As energy firms discover and exploit new reserves which require significant amounts of financing, tax authorities have increased their focus on the intra-group financing transactions of such companies. Randy Price, Nadim Rahman and Bill Yohana of Deloitte investigate why the materiality of these transactions may have also increased taxation authority interest in the intra-group financing transactions of energy firms.
The arm's-length principles for pricing their intra-group debt are complex in their application and are therefore difficult to comply with. One significant source of uncertainty regarding these transactions relates to the process for estimating the credit quality of a given project or business in a certain country. Estimating the credit risk associated with such transactions can be an involved exercise. A second source of uncertainty for taxpayers, but particularly for those in the energy sector, relates to how transfer pricing principles specifically should be applied to the pricing of intra-group debt.
The need for multi-billion dollar investment and the resulting transfer pricing issues
The oil and gas (O&G) industry is paramount to the movement of goods and capital, including human capital. The vast majority of transportable goods and associated logistics infrastructure is moved around and across economies and geographies primarily using the energy generated from either oil or gas. Tax authorities from both developed and emerging countries are trying to increase their knowledge and understanding regarding this global movement of goods and the associated profits.
Unlike many other industries, the O&G industry is a capital-intensive sector with a need for significant funding. Exploration and production (E&P) projects involve substantial capital investments with long-term contracts and relatively uncertain long-term returns. E&P companies engage in drilling and evaluation, along with completion and production. These activities can have time horizons from a few years up to a decade before a well may start to show a return and up to quarter of a century or more for the overall lifespan of some projects.
To receive the required financing, E&P companies may need to seek significant funding from a variety of resources. Some funding is extended through financial institutions that are sophisticated enough to evaluate the project risk and have the capital to manage the risk. E&P firms may also access the public bond market, the market for privately-placed debt, as well as more narrow markets for project finance. However, given the long time horizons for these projects, the difficulty in predicting recoverable reserves, the challenge in projecting revenues/profits, complexities/uncertainties of the analysis and inexperience of financial institutions to properly evaluate the risk, it is often the case that an E&P firm (or the E&P subsidiary of a larger concern) may experience significant costs in obtaining adequate project financing from third-party sources. Therefore, the local E&P affiliate (or its ultimate parent) may decide to secure a portion of its required financing from related entities within its group, including the parent company. Such transactions create potential transfer pricing considerations.
Determination of credit quality of the borrower
The credit quality of a borrower is a specific determinant of the interest rate of a loan or the yield on a bond issued by an E&P firm. However, credit analysts do not use uniform approaches to evaluate the credit quality of a given borrower in the E&P sector. While credit analysts might broadly rely on metrics relating to interest coverage, leverage, the quality and amount of reserves and the like, the emphasis placed by a credit analyst on each factor (and how each factor maps to a given credit quality) can vary.
Furthermore, when creditors look to fund O&G projects, they need to focus on the fact that these, especially those involving E&P, are long-term projects that will span over a decade, rather than using a typical one to two year financials projections, or extrapolating historical data to reflect future performance. When assessing a potential borrower's credit quality, such data is adjusted to create a post-loan effect on the financials. However, for an E&P borrower, it is necessary to have reliable projections of the financial profile of the project over its lifetime.
Creditors typically adjust their interest rates to reflect the inherent risk in lending O&G companies such funds, and with the knowledge that, in certain instances, the borrower may not generate substantial revenue until they begin production of oil and/or gas. Thus, in determining credit ratings in the energy sector, some creditors might also account for the credit quality of the borrower, as well as any potential credit support that the legal borrower may receive from its ultimate parent and that corporate parent's credit quality to determine what credit risk rating to grant the subsidiary. The potential for such adjustments raise various transfer pricing issues as to whether creditors should account for the fact that an O&G subsidiary is in fact part of a larger corporate group, which adds on to the existing inherent inaccuracy in determining the stand-alone credit quality of the borrower in this industry owing to the issue of steady-state point of view alluded to before.
The role of the OECD guidelines
Another specific source of uncertainty for E&P firms relates to available transfer pricing guidance – in other words, how a taxpayer or a taxation authority should attempt to evaluate a given transaction, particularly given that a credit analyst may account for the fact that a subsidiary is part of a larger group (even though it appears counter to arm's-length principles to do so for transfer pricing purposes).
To better streamline transfer pricing regulations, the OECD has issued guidelines that are recommendations providing principles and standards for responsible business conduct for multinational corporations. Tax authorities throughout the world follow these guidelines and apply their principles to their own legislation (though how they do so may differ by country). In particular, the OECD guidelines are based upon an arm's-length principle when dealing with intra-group transactions. The arm's-length principle is designed to prevent income shifting between different taxing jurisdictions. The OECD guidelines, under article 9, paragraph 1, allow tax authorities to reserve the right to make the appropriate adjustments to the profits between two related enterprises to more accurately reflect a transaction that would have occurred between two unrelated parties. In particular, the OECD guidelines note:
[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations, which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
This is especially important when considering how to evaluate credit risk in the context of multinational groups in the O&G industry. Financial transactions in the O&G industry, including intra-group loans and credit guarantee arrangements, allow O&G parent companies to finance their global businesses. However, the OECD has provided little specific guidance regarding how arm's-length principles should be applied to intra-group financial transactions. This lack of concrete guidance has made it difficult for taxpayers to determine that they are appropriately applying the arm's-length standard to their intra-group financial transactions and thereby managing their transfer pricing compliance and potential exposures. Taxation authorities have been adopting views inconsistent with one another regarding how intra-group financial transactions should be transfer priced by taxpayers. To make matters worse, individual authorities have not necessarily adopted consistent positions between their own taxpayer cases.
Separate entity versus group affiliation precept
Based upon the guidance in the OECD guidelines, taxation authorities, taxpayers, and tax advisers have broadly adopted two separate (and generally incompatible) approaches towards evaluating intra-group financial transactions. We describe these two approaches below.
Separate entity precept
Under the separate entity precept, for transfer pricing purposes, creditors analyse the credit risk profile for the loan solely based on the subsidiary's risk profile, and do not take into consideration the parent company's credit ratings or any contingent credit support that a member of a multinational group might provide to a related party. This approach might be argued with reference to how credit analysts might evaluate the credit quality of a borrower, how the OECD guidelines apply to a given financial transaction, or both. Some argue that, unlike the contingent credit support precept, a subsidiary should be viewed as a separate entity from the corporation, and it is not appropriate to assign any credit enhancement to a subsidiary of a multinational, absent formal and legally binding credit support from the subsidiary's parent. The creditor, when lending to the subsidiary as a separate entity, is taking on more of an inherent risk when the corporate parent is not involved in the transaction. Thus, the subsidiary should be charged a higher interest rate to compensate the lender for this inherent risk.
The tax authorities that have adopted the separate entity precept rely heavily on paragraph 1.3 of the OECD guidelines which indicates:
By seeking to adjust the profits by reference to the conditions which would have obtained between independent enterprises in comparable circumstances (i.e., in 'comparable uncontrolled transactions'), the arm's-length principle follows the approach of treating the members of a multinational enterprise ("MNE") group as operating as separate entities rather than as inseparable parts of a single unified business.
Based upon this language, it would appear as though the OECD would prefer the separate entity precept; however, this language is found in the first paragraph of article 9 of the OECD Model Tax Convention, which defines transfer pricing concepts, in general. It does not specifically address the type of precept to apply when dealing with intra-group credit risk evaluations.
Group affiliation precept
Legally, a subsidiary is a separate legal entity from its parent. However, this does not deter some creditors from adjusting their credit evaluations of O&G subsidiaries based on the credit rating of their parent corporations. Creditors perform these adjustments to account for the fact that a parent corporation may provide credit support (as in, an implicit guarantee) to one of its subsidiaries even if they had no legal or explicit obligation to do so. Thus, this credit adjustment may reflect a situation in which a creditor analyzes the risk of the loan based on the subsidiaries' corporate group affiliation.
Certain tax authorities argue that, because the market takes into account the credit quality of a broader multinational when considering the credit quality of a subsidiary, it is appropriate to do so within a transfer pricing context. For example, if the market lowers the subsidiary's credit risk rating based on the assumption that the parent company will guarantee the debt, then it is reasonable for the parent corporation to also lower the credit risk, and thus the interest rate, when establishing an intra-group loan to its subsidiary.
In support of the group affiliation precept, many tax authorities consider the fact that the global reputation of the parent corporation can affect the subsidiary reputation in other foreign jurisdictions. Likewise, one subsidiary can affect the global credit rating of the entire group. For example, if a subsidiary in one jurisdiction defaults and the parent company fails to "bail" them out, since there is no contractual obligation to do so, this default can affect the perceived credit quality of other entities within the group. Similarly, if a subsidiary in a jurisdiction is responsible for environmental damages, it can reduce the entire group rating. Since no subsidiary is totally independent from its own group, some tax authorities deem it reasonable to adjust credit risk ratings of the group as a whole.
Incidental benefits and passive association
The transfer pricing of intra-group funding and the pricing of credit risk ratings represent differing points of view among tax authorities. Unfortunately, the OECD has provided very little guidance regarding how the arm's-length principles should be applied to intra-group loans. Since the OECD has not offered any concrete guidance cross-border financial transactions have become a key risk area for major O&G companies.
What makes these issues even more prominent is the fact that the OECD has previously attempted to develop guidance specifically addressing intra-group loan financing issues, but it has failed to reach the consensus necessary to publish any relevant recommendations. During these negotiations, the OECD addressed benefits that naturally derive from being a member of a group:
… an associated enterprise should not be considered to receive an intra-group service when it obtains incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity being performed. For example, no service would be received where an associated enterprise by reason of its affiliation alone has a credit-rating higher than it would if it were unaffiliated, but an intra-group service would usually exist where the higher credit rating were due to a guarantee by another group member, or where the enterprise benefitted from the group's reputation deriving from global marketing and public relations campaigns. In this respect, passive association should be distinguished from active promotion of the MNE group's attributes that positively enhances the profitmaking potential of particular members of the group. Each case must be determined according to its own facts and circumstances.
Since a contingent credit support is not attributed to any activity of the parent, it is not a service warranting compensation. Accordingly, the benefit derived from contingent credit support is to be subtracted from the transfer pricing of a loan. The US Treasury Regulations Section 1.482-9 stipulates that:
A controlled taxpayer generally will not be considered to obtain a benefit where that benefit results from the controlled taxpayer's status as a member of a controlled group. A controlled taxpayer's status as a member of a controlled group may, however, be taken into account for purposes of evaluating comparability between controlled and uncontrolled transactions.
This language indicates that the US will readjust credit risk valuations as though the subsidiary was not to receive contingent credit support from its parent company.
In addition, different tax authorities have been adopting views inconsistent from one another regarding how intra-group financial transaction should be transfer priced by taxpayers. O&G companies are also involved in O&G exploration activities in unsophisticated tax regimes, which have also not come to a conclusion on these issues; thus, making implementation that much harder. These inconsistent views among tax authorities have just led to further confusion among O&G companies as to what guidance to follow, and potentially have increased their transfer pricing exposure.
Source of tax risk
Many tax authorities have recently been focused on the credit risk ratings of intra-group loan financing transactions, both in the O&G and other industries. The pricing of a loan impacts both the borrowing jurisdiction (in terms of the deductions that it can claim) and the lending jurisdiction (by virtue of the income that it receives.) Absent global consensus on this issue, combined with additional guidance that can be applied to financial transactions, we can expect this area within transfer pricing to remain a specific source of tax risk for multinationals and tax controversy.
OECD Guidelines, Art. 9, ¶ 1.6
OECD Guidelines, Art. 9, ¶ 7.9.
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Randy Price is the leader of Deloitte Tax's transfer pricing practice for the Houston office. His transfer pricing practice involves client projects spanning the entire energy value chain. Randy's primary area of focus is helping energy related clients address global transfer pricing planning, documentation, and tax controversy matters. In addition to his core energy related experience, he has significant experience with transfer pricing issues involving the cost sharing of intangibles and related buy-in payments for technology focused industries.
Before joining Deloitte, Randy spent more than 10 years as an international tax/transfer pricing executive for a Fortune 500 multinational company where he developed, implemented, and ultimately defended multiple transfer pricing transactions from the Internal Revenue Service exam phase through appeals. In addition, he has experience with transfer pricing planning and controversy matters in multiple jurisdictions outside of the US. Given Randy's experiences both within industry and Deloitte Tax, he provides the key practical and technical transfer pricing skills sets that clients' appreciate in today's complex transfer pricing environment.
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Nadim is a senior manager and an economist in Deloitte Tax's US transfer pricing practice and has seven years of transfer pricing experience working in both the Dallas and Houston markets. During his tenure with Deloitte Tax, he has managed various projects for large Fortune 500 clients, overseeing work related to global documentation, cost sharing, intangible valuation, headquarter cost allocation, intercompany financing, planning studies, competent authority assistance, and audit defence. He has developed relationships with clients in the US, Europe, Asia, and Latin America. Nadim works on a variety of diverse industries and has a focus on energy and oilfield services industries.
Nadim has an MSc degree in economics from Texas A&M University, was a Visiting Student in the MBA programme at the Indian Institute of Management, Ahmedabad and has a bachelors of technology degree in mechanical engineering from the Indian Institute of Technology in Mumbai.
Nadim is a member of the American Society of Mechanical Engineers and the American Bar Association.
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Bill is a director in Deloitte's transfer pricing practice in New York. Bill has been providing clients with transfer pricing advice for the past 14 years, with a focus on addressing financial transactions transfer pricing issues across industries, including the pricing of related-party loans, credit guarantees, the development of global loan, and guarantee pricing policies and the evaluation of thin capitalisation issues. He also has experience in financial services transfer pricing, as an adviser to commercial and investment banks, asset managers, finance companies, and insurers.
Bill has an MBA from Johnson School of Management, Cornell University; a BA in economics from the University of Chicago and was a visiting student in philosophy and economics at Jesus College, Oxford.
He is a chartered financial analyst from the CFA Institute.
The authors would like to thank Lani Payne, a consultant with Deloitte's global transfer pricing services, for her significant contributions in assisting with the research and drafting of this article.