This content is from: Jurisdictions

The OECD releases final TP guidance on financial transactions

The OECD has published its long-awaited TP guidance on financial transactions that includes several new points on how to apply the arm’s-length principle (ALP) to credit default swaps and economic modelling.

The release of the TP guidance on financial transactions aims to reduce uncertainty about the transfer pricing rules for financial transactions, but adds a larger compliance burden for taxpayers.

Tomas Balco, who oversaw the OECD’s TP work on financial transactions for two years, described the paper as “one of the most difficult projects” the team has ever undertaken. Nevertheless, Working Party 6 (WP6) hopes the guidance will increase “consistency” across TP practices.

When the discussion draft was released in July 2018, it received a cold reception from some businesses at the time. The latest version intends to address some of that criticism, but there are still plenty of critics.

“What happened to proper public consultation?” asked Andy Neuteleers, partner at T/A Economics in Brussels. “Comparing the non-consensus draft with this final report, the amount of differences are quite limited in view of the many comments and fundamental issues raised by interested parties.”

Many TP professionals fear the guidance will not reduce the risks taxpayers face. The fact that the OECD guidance is soft law that is open to interpretation means tax administrations will apply standards in different ways.

“I am not a fan of guidance in excess of the core of the arm’s-length principle [ALP] that opens the path for many discussions because of the options provided,” said Neuteleers.

Neuteleers was also sceptical about the possibility of finding a uniform approach to group credit ratings. There is the risk that the separate entity approach fundamental to the ALP could be “overruled” by group ratings, he said.

First principles

The OECD report includes several points on the application of the ALP in pricing financial transactions, particularly the comparable uncontrolled price (CUP) method for inter-company loans.

“The arm’s length interest rate for a tested loan can be benchmarked against publicly available data for other borrowers with the same credit rating for loans with sufficiently similar terms and conditions and other comparability factors,” the report explained.

“In practice, however, there is unlikely to be a single ‘market rate’ but a range of rates,” the report said. “Although competition between lenders and the availability of pricing information will tend to narrow the range.”

Comparability is a key question in all of this. Multinational companies (MNEs) face the difficulty of assessing loans in certain markets if there is a lack of comparables. The OECD suggested MNEs can take a loan to a member of a different multinational group as a valid comparable – so long as all other economically relevant conditions are similar enough.

“Arm’s length interest rates can also be based on the return of realistic alternative transactions with comparable economic characteristics,” the report said. “Realistic alternatives to intra-group loans could be, for instance, bond issuances, loans which are uncontrolled transactions, deposits, convertible debentures, commercial papers etc.”

MNEs have to take into account the facts and circumstances of the comparables to eliminate differences between the controlled inter-company loan and the alternative comparable. This means taking into account differences of liquidity, maturity, collateral and currency.

One controversial point in the OECD guidance is the role of risk-free returns in certain cases. The report highlights cases where a funder cannot control the risk associated with investing in a financial asset.

The OECD concluded that the costs should be taken into account in determining the risk-free rate of return. “The funded party would still be entitled to a deduction up to an arm’s length amount in respect of the funding,” the report said.

“The difference between those amounts would be allocable to the party exercising control over the investment risk in accordance with the guidance in this chapter,” said the OECD.

This is a sticking point for TP specialists eager to keep to first principles.

“Certain parts of the guidance clearly deviate from the arm’s-length principle,” said Neuteleers. “Using risk-free returns can never be arm’s length by definition.”

“I hope that I am wrong, but this could just be the next step in the OECD’s move to promote global formulary apportionment,” he told ITR.

No surprises

There are few surprises in the report, but there were some noteworthy additions on how to apply the ALP to credit default swaps and when it comes to economic modelling.

“Credit default swaps reflect the credit risk linked to an underlying financial asset. In the absence of information regarding the underlying asset that could be used as a comparable transaction, taxpayers and tax administrations may use the spreads of credit default swaps to calculate the risk premium associated to intra-group loans,” the report said.

“As financial instruments traded in the market, credit default swaps may be subject to a high degree of volatility,” the report explained. “This volatility may affect the reliability of credit default swaps as proxies to measure the credit risk associated to a particular investment in isolation.”

Credit default spreads could reflect non-related factors, such as liquidity or the volume of contracts. These factors could distort the outcome. The OECD stressed the importance of “careful consideration” in calculating the risk premium on this basis.

Another notable addition was on economic modelling. “Certain industries rely on economic models to price intra-group loans by constructing an interest rate as a proxy to an arm’s length interest rate,” the report noted.

“However, in situations where reliable comparable uncontrolled transactions cannot be identified, economic models may represent tools that can be usefully applied in identifying an arm’s length price for intra-group loans,” the report explained.

This would be subject to the same constraints when it comes to markets. The cost of funds can vary between different lenders. Therefore, the lender cannot base its charges on the cost of funds, especially when there is a potential competitor who can obtain funds at a cheaper rate.

A highly competitive market would drive the prices down to the lowest possible rate. This would mean that lenders would be forced to drive operating costs as low as possible and seek to minimise the cost of obtaining funds to lend in the first place.

“In some circumstances taxpayers may seek to evidence the arm’s length rate of interest on an intra-group loan by producing written opinions from independent banks, sometimes referred to as a ‘bankability’ opinion,” the report continued.

“Such an approach would represent a departure from an arm’s length approach based on comparability since it is not based on comparison of actual transactions,” the report added.

These bank letters will not count as an offer to lend or evidence of terms and conditions in line with the arm’s-length principle. Therefore, this is not the best option for companies planning their transactions.

Many TP experts are still concerned about the future of the ALP in the debate on international tax reform. The OECD report may not please everyone, but the organisation has tried to keep first principles intact.

The material on this site is for financial institutions, professional investors and their professional advisers. It is for information only. Please read our Terms and Conditions and Privacy Policy before using the site. All material subject to strictly enforced copyright laws.

© 2019 Euromoney Institutional Investor PLC. For help please see our FAQ.

Related

Instant access to all of our content. Membership Options | One Week Trial