The OECD published a new chapter of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Authorities (“the OECD Guidelines”). The new chapter provides guidance on the transfer pricing for loans, guarantees, cash pools, hedging and captive insurance transactions.
The new chapter is the first OECD guidance on transfer pricing for financial transactions issued in final form and will be the main reference point for pricing and auditing related party financial transactions in most countries going forwards.
Loan, guarantee and cash pool policies that Swiss groups apply across their international operations should be reviewed and updated to ensure compliance with the new guidance.
Amongst the highlights of the new OECD chapter:
- Loan terms. The OECD explains that loan terms should be examined at the start of any transfer pricing analysis but where the agreements are insufficiently detailed, or where they deviate from the actual conduct of the parties, the loan agreement terms may be disregarded in a transfer pricing analysis. This powerful provision might allow tax authorities, for example, to disregard long term (more expensive) intra-group debt and assert that short term (cheaper) debt would have been advanced at arm’s length. This provision will be particularly relevant for all groups that use very concise agreements for internal loans and for groups where the terms of internal financing transactions differ significantly from the terms of external financing.
- Functional analysis. A functional analysis must be performed for all types of financial transactions as part of the OECD’s framework for accurate delineation of the transactions. For example, if the functional analysis shows that a related party lender does not perform the expected functions, then the interest payments it receives might be reassigned to the group company that does perform these activities. Many group transfer pricing policies do not currently include a functional analysis for financial transactions. These policies will need to be updated so that they fulfil the new OECD guidance.
- Interest rate benchmarking. The OECD discusses a number of common approaches to benchmarking interest rates and notes that in most situations it should be possible to identify either internal or external CUP data to price related party transactions. The OECD’s rejection of the use of bank quotes as a reliable source of evidence was well previewed in the July 2018 discussion draft but it is nonetheless relevant for many groups here in Switzerland. Also relevant for many Swiss groups is that the OECD guidance implies that benchmarking by reference to yield curves is insufficient.
- Credit rating. The OECD provides detailed commentary on calculating credit ratings, including confirming its previous draft guidance on the importance of assessing the impact of group membership on credit rating. The paper simultaneously outlines many of the weaknesses of commercially available quantitative credit rating estimation tools. These comments suggest that the OECD expects groups to apply more rigour to establishing credit ratings for use in intra-group transactions. Many Swiss groups will want to review and upgrade their approach to assessing the credit standing of intra-group borrowers.
- Cash pooling. The OECD states that the leaders of cash pools will generally be entitled to only a limited remuneration and not to a significant spread between deposit and draw interest rates. The guidance does allow for certain circumstances where the cash pool leader may earn a more significant return. Important in the determination of whether a limited return or spread is appropriate will be a functional analysis of the cash pool leader, examination of the alternatives available to the parties, and consideration of whether the cash pool leader is both legally exposed to credit and liquidity risk – and whether in practice it has the financial capacity and functional capability to manage/bear those risks.
- Guarantees. The OECD explains that where one group company provides a legally binding financial guarantee that benefits another group company then there should be a guarantee fee, but where there is anything less than an explicit guarantee, or whether the guarantee does not provide a benefit, a fee should not be charged. The OECD provides guidance on a number methods for establishing guarantee fees.
- Loan Volume. The OECD paper allows for the disallowance of interest where a group company borrows more from a related party than the group company could/would have borrowed at arm’s length from a third party. This provision will be less relevant to Swiss group companies since the deductibility of debt here in Switzerland is primarily governed by Circular 6, 1997, but this provision will be very relevant to Swiss groups with subsidiaries in other countries that borrow from related parties.
- Captives. The paper states that a critical element of pricing any captive insurance transaction will be the determination of whether the transaction should be respected or not – based on a factual and functional analysis of the transactions and the insurer, and the consideration of a number of key factors that the OECD lists and explains. The OECD also provides expanded guidance on how captive insurance premiums may be set by reference to benchmarking combined ratios and the investment returns achieved independent insurance groups.
Related topic: The 2020 Swiss safe harbour interest rates were published last week.
- The guidance will have immediate (and possibly retrospective) effect in most countries
- Swiss taxpayers with multinational operations should:
- Review and update their loan, cash pool and guarantee transfer pricing policies and benchmarks to ensure compliance with the new standards
- Upgrade the approach taken to credit rate group companies for transfer pricing purposes
- Perform functional analyses as part of the pricing of all large or recurring financial transactions
- Utilise sufficiently detailed agreements for all related party financial transactions and be able to evidence that the terms of the agreements are commercial
- Include a debt quantum analysis when pricing any new loan to/between foreign group companies
- Taxpayers with captive insurers in place should perform a functional analysis of the captive, review substance in light of the new OECD guidance and revisit premium pricing
In case of any questions, please reach out to David McDonald, firstname.lastname@example.org.