Controversies in financial transactions: a closer look at cash pooling arrangements and upstream guarantees
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Controversies in financial transactions: a closer look at cash pooling arrangements and upstream guarantees

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Ariel Krinshpun and James Mahon, III of Deloitte US and George Galumov of Deloitte Switzerland analyse two areas of intercompany financing arrangements as transactions come under increasing scrutiny from tax authorities.

On February 11 2020, the OECD issued the final version of the Transfer Pricing Guidance on Financial Transactions (the FT Guidance). This has subsequently been implemented as the new Chapter X within the January 2022 version of the OECD Transfer Pricing Guidelines (the TPG).

OECD member countries broadly follow, or have rules that are generally consistent with, the transfer pricing (TP) principles in the TPG. Because local rules may not be as specific as the FT Guidance, tax authorities may be able to apply some of the ideas articulated in the FT Guidance as part of their examinations and audits. In addition, although local rules and practice in relation to financial transactions may vary, the FT Guidance will play a prominent role in the context of mutual agreement procedures and arbitration, because these proceedings are governed by OECD principles.

Ultimately, the purpose of the FT Guidance is to provide taxpayers and tax authorities with a consistent framework for assessing arm’s-length compensation of financial transactions and consequently to mitigate the risk of challenges when analysing and pricing these types of intra-group financial transactions.

As part of these developments, in recent years intra-group financial transactions have drawn increased scrutiny from tax authorities in various jurisdictions. This article provides an overview of two areas that have been the subject of focus and are under discussion with, and between, different tax administrations: cash pooling and upstream guarantees.

Cash pooling

Cash pooling has proven to be a complex area where a single arrangement can involve multiple tax jurisdictions. Cash pools combine the cash flows from multiple affiliates to efficiently manage short-term working capital needs for the group. Taxpayers can be subject to a variety of potential challenges, including:

  • The remuneration earned by the cash pool leader;

  • The short-term characterisation of seemingly longer-term balances; and

  • The rates charged to cash pool borrowers and paid to cash pool depositors.

Pursuant to the TPG, any analysis of a financial transaction should begin with an accurate delineation of what the transaction is in substance and the economic factors that would drive the analysis. Accurate delineation of a cash pooling arrangement requires a careful analysis given the variety of arrangements that are possible (for example, physical versus notional, and the range of possible function and risk profiles of the cash pool leader).

The FT Guidance emphasises the importance of performing an accurate delineation of a cash pool in supporting the results of any arrangement as arm's length. For example, the FT Guidance articulates that the appropriate remuneration for the cash pool leader depends on the functions that it performs and the risks that it assumes. In cases where the cash pool leader merely performs a coordination or agency function, the FT Guidance states that its remuneration as a service provider would be limited.

Similarly, the FT Guidance states that cash pooling arrangements are intended to fund short-term working capital needs. On accurate delineation, the facts and circumstances of the cash pool management would reflect the short-term nature of the funding arrangements. In cases involving balances that are outstanding for a substantial period, the FT Guidance encourages taxpayers to consider whether consideration would take the form of a long-term funding arrangement outside the cash pool.

Furthermore, accurate delineation of the cash pooling arrangement can also impact the appropriate rates paid to cash pool depositors and charged to cash pool borrowers because they depend in part on the remuneration of the cash pool leader and the short-term nature of the funding arrangements. Consideration should also be given to the form of the remuneration paid to the cash pool leader (for example, via a spread in the borrowing or via a mark-up on costs incurred) based on the nature of cash pooling arrangements and, specifically, the functions and risks borne by the leader.

The fact-driven nature of an accurate delineation of a cash pooling arrangement creates the potential for disagreement between taxpayers and tax authorities regarding the appropriate arm's-length result for cash pools. The multiple tax jurisdictions covered by any cash pooling arrangement further raises the spectre of tax controversy. Taxpayers can prepare for tax authority audits by generating contemporaneous annual TP documentation that establishes a baseline set of facts regarding the arrangement and management of their cash pools.

Upstream guarantees

Transactions involving guarantees – and, in particular, guarantees issued by parent companies on behalf of subsidiaries, or brother/sister entities on behalf of affiliates – have historically been the focus of many controversies. In the context of the new TPG, additional guidance is aimed at reducing subjectivity. Nevertheless, there are a growing number of challenges, and disagreements between the tax authorities of different tax jurisdictions (including OECD jurisdictions), in relation to the treatment of guarantees.

More recently, upstream guarantees have also been a focus of attention for tax authorities. The term ‘upstream guarantee’ refers to a guarantee provided by a subsidiary (direct or indirect) company to a lender on behalf of an affiliate that is upstream within the ownership structure of its group. This is typically done when an entity of a multinational group borrows funds from a third-party lender, which may require guarantees from affiliates, including direct and indirect subsidiaries.

The main purpose of this type of guarantee is to effectively render the lender’s receivable pari passu with certain obligations of the borrower’s affiliated companies and reduce the administrative burden related to the recourse of the lender in relation to group assets in the event of default.

One common area of controversy results from the discrepancy between the two methods for assessing the price of guarantees under the FT Guidance:

  • The yield approach – this aims to quantify the benefit that the guaranteed party receives from the guarantee in terms of lower interest rates, and calculates the spread between the interest rate payable by the borrower as a result of the guarantee and the interest rate that would have been payable without the guarantee (TPG, Chapter X, Section D.2.2); and

  • The cost approach – this aims to quantify the additional risk borne by the guarantor by estimating the value of the expected loss that the guarantor incurs by providing the guarantee (TPG, Chapter X, Section D.2.3).

As such, the yield approach represents the benefit derived by the guaranteed entity and the cost approach represents the risk, or expected costs, undertaken by the guarantor.

In the case of downstream guarantees (guarantees issued by a parent for the benefit of a subsidiary), there is typically a discrepancy in credit quality between the borrower and guarantor, which results in a positive measurement of value for the two aforementioned approaches.

In the case of upstream guarantees, however, the benefit of value with respect to the yield approach may not be obvious, since subsidiaries cannot generally be rated higher than their parent(s) (and in many cases, subsidiaries are rated lower). Furthermore, any existing debt at the subsidiary level, which would be structurally senior aside from the upstream guarantee, may not be significant enough relative to the parent's guaranteed borrowing to have a measurable effect from a yield approach perspective.

The FT Guidance also indicates that in cases where the beneficiary is not obtaining a benefit from the guarantee for which an independent party would be willing to pay, no guarantee fee should be paid by the guaranteed party. According to the FT Guidance, “analysis may indicate that the purported financial guarantee is not providing any benefit to the borrower but merely recognising the benefit that the guaranteed party would have obtained in any case by being part of the MNE group. In such situations, based on facts and circumstances, an unrelated enterprise in comparable circumstances would be unwilling to pay for the provision of a financial guarantee [emphases added]” (TPG, Chapter X, Section D, paragraph 10.160).

Furthermore, the FT Guidance states that a “borrower would not generally be prepared to pay for a guarantee if it did not expect to obtain an appropriate benefit in return. Even an explicit guarantee will not necessarily confer a benefit on the borrower [emphasis added]” (TPG, Chapter X, Section D, paragraph 10.164).

Notwithstanding the above guidance, tax authorities in numerous jurisdictions that provide upstream guarantees have asserted that a fee is payable on the basis of the cost approach, even when the yield approach results in no measurable benefit, leading to disputes in this area.

Final thoughts

Intercompany financing arrangements continue to attract tax authority scrutiny due to the challenges in establishing an accurate delineation and measurement of the risks involved. The variety of potential financing arrangements and methodological approaches to supporting an arm’s-length result provides ground for potential disagreement between taxpayers and tax authorities.

Taxpayers can best mitigate potential risks and vulnerabilities with robust policies and procedures and contemporaneous TP documentation of their intercompany financing transactions.

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