OECD’s Chapter X: Three key areas of impact for Luxembourg
Dinko Dinev and Mariana Cohen Margiotta of Deloitte Luxembourg analyse the key takeaways from the OECD’s recent TP guidelines targeted at MNEs and tax administrations.
On February 11 2020, the OECD released the new Chapter X of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Chapter X marks a significant breakthrough for the transfer pricing analysis of financial transactions, as it is the first-ever specific guidance that the OECD has provided on the topic.
The publication of Chapter X marks an important development for local transfer pricing (TP) practices in Luxembourg. This development gains additional significance given the country’s role as a global financial centre through which many multinational enterprise (MNE) groups’ financial transactions take place.
This briefing discusses three issues on which Chapter X will likely have an impact in Luxembourg: debt-to-equity ratio, intragroup financing, and cash pool arrangements.
Chapter X provides guidance on the application of the arm’s-length principle to analyse the debt-to-equity ratio of a borrowing entity. The guidance reshapes the traditional assessment of financial transactions, because it addresses the overall rationality of the transaction, as opposed to addressing only the remuneration set for the transaction.
Common approaches for the economic analysis of debt-to-equity ratios include: peer analysis, projected cash flow analysis, and expected loss analysis. Chapter X refers to the projected cash flow analysis approach by way of an illustrative example, but does not conclude on any specific methods to assess debt-to-equity ratios.
Given the absence of domestic thin capitalisation rules, the guidance provided by Chapter X is expected to become an authoritative reference framework in Luxembourg for the TP assessment of debt-to-equity ratios.
Luxembourg has put in place a specific administrative circular to address intra-group financing companies. However, the circular does not elaborate on the methodologies to be applied for the TP assessment of these companies.
Local TP practices developed based on the circular approach the assessment of the remuneration of these companies by building up on the cost of equity related to their financing activity to estimate an arm’s-length return.
These practices may be framed under the ‘cost of funds’ approach elaborated on in Chapter X, reflecting borrowing costs and adding certain elements to these costs to estimate an arm’s-length return. One such element is a risk premium to reflect the risks directly inherent to the financing transaction.
This element is relevant to Luxembourg intra-group financing companies within on-lending structures involving the flow of funds through different group entities. Specifically, when differences in the terms and conditions of the agreements linked to these flows result in additional risks being assumed by the Luxembourg company.
Chapter X’s clarifications regarding the ‘cost of funds’ approach will likely be incorporated into local TP practices, particularly in regards to the assessment of additional risks by Luxembourg financing companies within on-lending structures.
Cash pool arrangements
Different approaches have been applied by local TP practitioners to assess the arm’s-length nature of cash pool arrangements, which address the rewards of both the members and the leader of the cash pool.
Under these approaches, the allocation of the cash pool benefits has been assigned either through the interest rates of the arrangement or through a separate transaction. However, the chapter clarifies that the means for allocating the benefits of the arrangement are the interest rates applicable to the positions of the cash pool members, after rewarding the cash pool leader.
As regards the treatment of cash pool leaders, their functionality has sometimes been framed under an entrepreneurial role and remunerated accordingly. In this respect, Chapter X sets a relatively high functionality threshold for this consideration to be accurate, and envisages no more than a service provider profile, and consequent remuneration, to cash pool leaders that do not meet this threshold.
Chapter X will likely have an effect on local TP practices addressing cash pool arrangements, especially in regards to the mechanisms by which the allocation of benefits is carried out as well as to the characterisation and remuneration of cash pool leaders.
The chapter’s impact
The impact of Chapter X on the three areas discussed – debt-to-equity ratio, intra-group financing, and cash pool arrangements – will likely be significant. A question that remains open is the pace at which the Luxembourg and other tax authorities will adopt the guidelines of Chapter X in tax laws, regulations, jurisprudence, and audits.
Overall, the inclusion of Chapter X in the OECD TP guidelines highlights the need for Luxembourg taxpayers to review their policies, agreements, and documentation to address any ambiguity in how tax authorities might interpret (or reinterpret) their financial transactions.
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Mariana Cohen Margiotta