The finance function has always been one of the center pillars for success of any business as financial transactions are the most critical and material transactions. In order to get funding across, service liquidity provision, and manage other operational and tax needs, financial transactions are central to financing multinational groups. Over the last few years, there has been an increased focus on financial transactions from a transfer pricing perspective with dwindling tax collection.
The deadly outbreak of COVID-19 led to dire consequences, including an increase in risk aversion in financial markets and other issues. In order to manage additional funding requirements, businesses may have to seek loans and guarantees from group entities, and it's imperative that these financing arrangements are in line with Transfer Pricing Guidelines.
On 11 February 2020, the OECD1 issued its final Transfer Pricing (TP) Guidance on Financial Transactions (FT Guidelines), of which Chapters A-E will be incorporated as Chapter X of the OECD TP Guidelines.
This report is a follow-up guidance on 'Aligning Transfer Pricing Outcomes with Value Creation' pursuant to BEPS Actions 8-10, and the 2015 report on 'Limiting Base Erosion Involving Interest Deductions and Other Financial Payments' pursuant to BEPS Action 4.2
The FT Guidelines aim to clarify the application of the principles of the 2017 OECD TP Guidelines, in particular the accurate delineation analysis, to financial transactions. It covers loans and guarantees and includes cash pooling, risk-free and risk-adjusted rates of return, and captive insurances.
The said guidelines cover the key intra-group financing arrangements in the nature of intra-group loans; guarantees, cash pooling and hedging. FT Guidelines also identify the factors to be considered while determining the arm's length pricing policy. Some of the essential characteristics of the intercompany financing arrangements are contractual terms, functional analysis, economic circumstances and business strategies, which are similar to assessing arm's length nature in the case of non-financial transactions.
This article mainly focuses on the key aspects of intra-group loans highlighted by the FT Guidelines.
According to the FT Guidelines, specific measures that are relevant in analyzing the arm's length nature of intra-group loan are:
- Analyzing lender's perspectives – The lender's perspective regarding the decision whether to grant a loan, how much to lend, and on what terms will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of the funds.
• Analyzing Borrower's perspectives – The borrowers seek to optimize their weighted average cost of capital and to have the right funding available to meet both short-term needs and long-term objectives. They also consider the potential impact of changes in economic conditions such as interest rates and exchange rates and the risk of not being able to make timely payments of interest and principal on the loan.
• Identifying commercial/financial relations – While accurately delineating financial transactions, one needs to analyze factors affecting the performance of businesses in its operational industry sector. Such factors may be in the nature of economic, business or product cycle, the effect of government regulations, or availability of financial resources in a given industry.
The pandemic may put subsidiaries under financial stress, as some may struggle to meet their payment obligations on intercompany loans. In such a case, it may be reasonable to renegotiate more favorable terms than usually available, delay interest payments temporarily, or re-characterize short-term loans as long-term loans. These measures would need to be well documented, demonstrating a close consideration of the options realistically available to both the borrower and the lender.
• Usage of credit ratings – The borrower's creditworthiness is one of the key factors that independent investors consider in determining an interest rate to charge. Credit ratings are a useful measure of creditworthiness, and these help identify potential comparables and applying economic models in the context of related party transactions. Due to the pandemic, there may be substantial changes to key ratios like liquid ratio, capital gearing ratio, etc., which will have a cascading effect on the entity's credit rating and, therefore, a need to revisit the credit rating may be required.
• Effect of group membership – The effect of group membership is relevant for taking into consideration the conditions under which an MNE would have borrowed from an independent lender at an arm's length. An implicit support from the group may affect the borrower's credit rating or the rating of any debt that it issues3.
On account of this pandemic, the financing costs are impacted, leading to higher interest rates and difficulty to obtain loans. To manage these increased costs when obtaining new loans or renegotiating the existing ones, MNEs may need to avail such implicit support of the group to meet their financial obligations. The implicit support may be reflected by an improved credit rating, more closely aligned to that of the MNE group. In the case of sourcing external funding, implicit support from the group could be combined by explicit intra-group guarantees, thus enabling the group entities to survive in this situation.
• Use of MNE group credit rating – The FT guidelines recommend that it may be appropriate to use the MNE group's credit rating for the purpose of pricing loan where the borrower entity is strategically important to the group and where the MNE's indicators of creditworthiness do not differ significantly from those of the group.
During the current pandemic, a parent may support its subsidiaries even more aggressively to obtain favorable financing terms. It may be appropriate to consider the group's credit rating instead of the subsidiary's stand-alone rating.
• Covenants – According to the FT guideline, generally, the covenants' objective in a loan agreement is to provide the lender a degree of protection to limit its risk. Over a period of time, MNEs have revamped their intercompany loan agreements to be in line with terms contained in third-party loan agreements.
While companies experiencing financial difficulties due to this pandemic may breach one or more covenants as mentioned in their inter-company agreements, it will be essential to consider the behavior of unrelated parties and take proactive steps to amend terms or refinance the intercompany debt, as allowed by law.
However, considering the current rate environment, there is a possibility that certain borrowers may be able to take advantage of significantly lower rates, and companies should consider the implications of considering realistic alternatives of refinancing the debt.
- Guarantees – A guarantee availed from the other party may be used as a support to the borrower's credit. A lender would have to evaluate the guarantor in a similar way in which it evaluates the original borrower while placing reliance on guarantees. While the lender takes such a guarantee into account in setting the terms and conditions of a loan, it would need to be reasonably satisfied that the guarantor would be able to meet any shortfall in a case if the borrower is unable to meet its obligations.
In light of the pandemic, there may be a need to reanalyze the guarantor's credentials and revisit the terms and conditions of the loan based on the current financial situation of the guarantor.
Arm's Length Pricing:
One of the most common financial transactions involves establishing the interest rate for an intercompany loan. However, this also involves determining the supportable 'arm's length' quantum of debt, i.e., pricing the loan terms as if they had been made at arm's length, for which a debt capacity analysis is commonly performed. While some jurisdictions may have a specific thin capitalization regime that sets these parameters more definitively, the tax regulations in other countries support a more flexible spectrum of acceptable debt-to-equity ratios, as long as the taxpayer has undertaken an appropriate analysis that establishes their leverage parameters.
The OECD has taken a significant step by issuing FT Guidelines. It is a move towards providing more comprehensive guidance on financial transactions. This step also highlights OECD's expectation to observe significant progress by multinationals in updating their existing transfer pricing policies on financial transactions to comply with the Guidance.
On the other hand, MNEs with intra-group financial transactions should ensure and retain sufficient documentation so as to demonstrate that their policies are aligned with the FT Guideline.
During this period, where tax treaties are changing at such a rapid pace, MNEs need to ensure that each transaction/arrangement includes both current and potential future treaty interaction, including known treaty changes as a result of the use of the OECD's Multilateral Instrument and continue to closely monitor related developments in this area at both, the country and OECD level. MNEs also need to consider Advance Pricing Agreements and other non-litigative rulings (bilateral or even multilateral) if available, to negate the impact of COVID-19 on the arrangements across MNE groups.
1. Organisation for Economic Co-operation and Development
3. The impact of implicit support of the group on the credit rating of a subsidiary was confirmed by the Federal Court of Australia in a landmark judgment delivered in the case of Chevron Australia and in the judgment of the Federal Court of Canada in the case of General Electric