A closer look at debt transactions in practice
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A closer look at debt transactions in practice

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Ariel Krinshpun, James Mahon and Mo Malhotra of Deloitte explain why taxpayers may wish to review intra-group financing arrangements, and significant financing transactions in particular, for controversy risk.

Financial transactions have been a growing area of focus for tax authorities. In landmark cases over the last 15 years, tax authorities have challenged the intra-group financing arrangements of taxpayers on the basis of pricing and characterisation and have made arguments regarding credit ratings and passive association, cash pooling, realistic alternative transactions, and economic substance, where formal transfer pricing (TP) guidance in many countries has been relatively thin.

Taxpayers face potentially large consequences from this controversy activity because the emphasis on economic substance tends to result in challenges to the whole financial transaction, as opposed to debates over discrete elements of the transaction (e.g. pricing).

Furthermore, the formal incorporation of many of the issues raised by tax authorities into a new Chapter X of the OECD Transfer Pricing Guidelines (OECD TP Guidelines) in early 2020 may result in increased controversy activity.

In preparation for potential scrutiny of financial transactions, taxpayers may wish to review their intra-group financing arrangements for potential controversy risk and take action to formalise and document intra-group financing policies.

Global trends in financial transactions controversy

Financial transactions continue to be an active area of TP controversy for tax authorities. Between 2017 and 2020, according to a third party website, there have been 68 court decisions involving financial transactions globally.

Figure 1: Number of court decisions involving financial transactions

Nearly half of these cases appear to include a focus on the economic substance of inter-company financing arrangements. Using keywords that the website ‘tpcases.com’ attributes to each court case, almost half of all court decisions involving financial transactions during the 2017–2020 period had been flagged as including an economic substance element.

Figure 2: Percentage of court decisions on financial transactions involving economic substance

Globally, Europe has accounted for a large share of the recent TP controversy in financial transactions. Activity in the rest of the world suggests other jurisdictions could follow Europe’s lead in this area. For example, the recent Carbis Bay G7 Summit Communiqué from June 5 2021 indicate that G7 negotiations could result in greater cooperation on international tax policy.

In addition, the FY2022 US Treasury Revenue Proposals released in May 2021 proposes significant increases to the amount of funding available for US tax enforcement. We anticipate that greater international tax cooperation and tax enforcement funding could both have implications for controversy risk.

Common themes in financial transactions controversy

Over the last 15 years, courts have reviewed various challenges despite lack of formal TP guidance on many issues involving financial transactions. The objections raised by tax authorities have included arguments regarding credit rating enhancement given implicit support from passive association, cash pooling, realistic alternative transactions, and economic substance arguments that challenge the pricing and characterisation of intra-group financing arrangements.

Implicit support from passive association, or the attribution of the group credit rating to a local entity by virtue of its group affiliation, has been a particularly recurrent issue in tax controversy cases on financial transactions.

In one example, a tax authority challenged payments from a subsidiary to its foreign parent for a contractual financial guarantee on the basis that the subsidiary did not receive any benefit from the formal guarantee because, by virtue of its group affiliation, it already benefitted from passive association from the parent. The court decided that passive association is a factor in determining the appropriate level of a guarantee fee. However, in this case, the amount of implicit support enjoyed by the subsidiary was only partial and not complete.

Passive association is a complex issue for taxpayers to grapple with because its presence/absence and the degree of impact can be difficult to conclusively substantiate and because varying tax jurisdictions have tended to have competing views of whether it is more appropriate to assess the credit quality of the local entity on a group or on a stand-alone basis.

Cash pooling, which pools the cash flows of multiple affiliates to efficiently manage short-term working capital needs of group affiliates, has been another point of frequent contention between taxpayers and tax authorities. In one example, a tax authority challenged the allocation of the cash pooling benefit among cash pool participants because it was not based on the relative risks and contributions of the participants.

In another case, the differentiation of credit risk was a key consideration. The tax authority argued that, because deposits with the cash pool were unsecured, the deposit rate paid to cash pool participants did not reflect the greater credit risk associated with in-house cash pool deposits.

Cash pooling has proven to be a complex area where a single arrangement can involve multiple tax jurisdictions and taxpayers are subject to a variety of potential challenges including the rates charged/paid to cash pool participants, the margins earned by cash pool headers, and the short-term characterisation of seemingly longer-term balances.

The concept of realistic alternative transaction, which involves an evaluation of the transaction(s) that a taxpayer could have alternatively adopted as compared to what they actually did, has also been used by tax authorities to challenge the reasonableness of some intra-group financing arrangements.

In one case, a tax authority sought to rebut arguments from a taxpayer that an inter-company interest rate was reasonable because the inter-company loan lacked security on the basis that, at arm’s-length, a similarly situated taxpayer would provide security to a third-party lender in order to obtain a reduced interest rate.

The court agreed with the tax authority that offering security was a realistic alternative and accordingly upheld the TP assessment on the inter-company loan arrangement. In jurisdictions that embrace the concept of realistic alternatives, taxpayers need to consider not only whether or not a party could have entered into a specific transaction, but also would have done so, in view of its specific facts and circumstances and the alternatives realistically available.

A challenge to economic substance, or the bona fide nature of inter-company debt, is another source of risk to taxpayers that can result in significant tax assessments.

In one example, a tax authority attempted to re-characterise the repayment of principal on an upstream inter-company loan from a foreign subsidiary to its parent as a dividend. The court presented a 14-factor analysis on this issue and upheld that the instrument was debt. In particular, the court noted that there was a legally binding agreement that had the conventional terms typically observed in commercial loan agreements; the lender could reasonably expect repayment at the time of issuance given that the borrower had the capacity to service the debt with internally generated cash flow; and both parties treated the transaction as debt, as demonstrated by conduct consistent with that of a borrower and lender.

In February 2020, the OECD formally incorporated many of the issues raised by tax authorities when it issued its Transfer Pricing Guidance on Financial Transactions. In a concise 44 pages, the OECD addressed concepts such as accurate delineation, which describes an exercise in determining what transactions actually are in substance – notwithstanding the formal legal documents defining them.

Such exercises should consider strategy and purpose, functions and risks, economic substance, and contractual terms (or lack thereof). The guidance also provides pricing methodologies, to be deployed once transactions have been accurately delineated.

This guidance has provided tax authorities with a roadmap with which to assess and potentially challenge the nature and pricing of financial transactions. The formal adoption of these concepts into the OECD TP Guidelines, as Chapter X, seems to be another indication that financial transactions will continue to be an area of focus for tax authorities.

Priorities for taxpayers to manage controversy risk

Taxpayers need to be aware that tax authorities may now look to the OECD Guidance on Financial Transactions for direction in order to evaluate and assess the appropriateness of intra-group financing arrangements. TP assessments in this area can be significant because tax authorities tend to challenge the overall characterisation of financial transactions based on their economic substance.

Taxpayers may wish to review their intra-group financing arrangements, and significant transactions in particular, for controversy risk. It is best practice to establish policy guidance and internal methodologies to determine pricing and leverage for financial transactions that is aligned with tax and TP rules. It is also an opportunity to evaluate intra-group finance as part of the overall group strategy and to develop robust inter-company financing arrangements.

Click here to read Deloitte's TP Controversy Guide 2021

Ariel Krinshpun



Deloitte Tax LLP

T: +1 212 436 2206

E: akrinshpun@deloitte.com

Ariel Krinshpun is a TP principal in Deloitte’s Washington National Tax Practice. He is Deloitte’s Americas leader in the TP of financial transactions such as debt, equity and hybrid securities.

Ariel has advised multinational corporations in connection with planning, compliance, audit and litigation support in a variety of industries. He has extensive experience in structuring and valuing debt transactions, as well as performing enterprise, equity and asset valuations, including intangible property. He also has extensive experience in treasury operations; supply chain and capital structure optimisations; M&A due diligence, planning and post-merger integration; and providing economic analyses supporting legal tax opinions on the characterisation of financial products and transactions.

Ariel holds a master’s degree in international economics and finance from Brandeis University, and a bachelor’s degree in business administration from Baruch College.

James Mahon


Senior manager

Deloitte Tax LLP

T: +1 347 224 3962

E: jmahoniii@deloitte.com

James Mahon is a senior manager in the New York office of Deloitte’s TP group. He primarily serves clients with intra-group financing or in the financial services industry.

James’ project work includes documentation, planning, and tax controversy for intra-group debt, preferred shares, cash pooling, and credit guarantees. He also advises on TP issues in financial services for commercial and investment banks, asset managers, and finance companies.

James holds a doctoral degree in political economy and government from Harvard University and a bachelor’s degree in economics and political science from Columbia University.

Mo Malhotra



Deloitte UK

T: +44 07 5536 11111

E: mmalhotra@deloitte.co.uk

Mo Malhotra is an international tax partner, who leads Deloitte’s global financing and treasury tax competency. He provides tax advice to multinationals to ensure that their acquisitions and disposals, restructurings, domestic and cross-border financing, intellectual property considerations, TP and tax compliance happen efficiently and effectively. As part of this, he regularly leads a global network of partners on complex projects for clients.

Mo has an advisory and disputes focused practice, and has gained significant experience in negotiating tax clearances and TP agreements with taxation authorities, as well as working with taxpayers in the contemplation of litigation. His experiences have exposed him to a vast range of tax work, particularly around financing transactions, and he is known for combining his technical expertise with an understanding of a client’s commercials to deliver practical and implementable advice.

Mo is a member of the Institute of Chartered Accountants in England and Wales, and the Chartered Institute of Taxation.

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