In February 2020, the Organization for Economic Cooperation and Development (“OECD”) released Transfer Pricing Guidance on Financial Transactions (“Guidance”). The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions.

According to the OECD, before attempting to apply the pricing guidelines that are the primary topic of the Guidance, it may be necessary to determine whether a purported loan should be regarded as a loan, since the balance of debt and equity funding of a borrowing entity that is part of an Multinational Enterprise (“MNE”) group may differ from that which would exist if it were an independent entity operating under similar circumstances. In accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances: the presence or absence of a fixed maturity date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the loan is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement. The accurate delineation of financial transactions may require an analysis of the factors affecting the  performance of businesses in the industry sector in which the MNE group operates. The contractual arrangements between independent enterprises may not always provide information in sufficient detail, and it may therefore be necessary to look to other documents and the actual conduct of the parties to define the relationship. Accurate delineation of the transaction may include an identification of the economically relevant characteristics of the transaction, including the functions performed; assets used and risks assumed; the characteristics of the financial instruments; the economic circumstances of the parties and of the market; and the business strategies pursued by the parties.

Background. In February 2020, the OECD released Transfer Pricing Guidance on Financial Transactions. The Guidance is significant because it is the first time that the OECD’s Transfer Pricing Guidelines have been updated to include guidance on the transfer pricing aspects of financial transactions. The OECD expects that the Guidance should contribute to consistency in the application of transfer pricing and help to avoid transfer pricing disputes and double taxation.

The Guidance is divided into several parts. First, the Guidance elaborates on how “accurate delineation” analysis applies to the capital structure of a MNE, which is the subject of this post. The Guidance makes clear that it does not seek to prevent countries from implementing approaches to address capital structure and interest deductibility under domestic legislation. Subsequent sections of the Guidance address specific issues related to the pricing of financial transactions, such as treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance. Those issues are the subject of separate posts.

Identifying the Financial Relations. According to the OECD, before attempting to apply the pricing guidelines that are the primary topic of the Guidance, it may be necessary to determine whether a purported loan should be regarded as a loan, since the balance of debt and equity funding of a borrowing entity that is part of an MNE group may differ from that which would exist if it were an independent entity operating under similar circumstances. The Guidance reflects an approach of accurate delineation of the actual transaction to determine the amount of debt to be priced. A number of approaches may be taken to address the issue of the balance of debt and equity funding of an entity. These approaches may include a multi-factor analysis of the characteristics of the instrument and the issuer. In accurately delineating an advance of funds, the following economically relevant characteristics may be useful indicators, depending on the facts and circumstances: the presence or absence of a fixed maturity date; the obligation to pay interest; the right to enforce payment of principal and interest; the status of the funder in comparison to regular corporate creditors; the existence of financial covenants and security; the source of interest payments; the ability of the recipient of the funds to obtain loans from unrelated lending institutions; the extent to which the loan is used to acquire capital assets; and the failure of the purported debtor to repay on the due date or to seek a postponement. These factors are generally consistent with long-standing case law in the United States.

Business and Economic Factors. The accurate delineation of financial transactions may require an analysis of the factors affecting the  performance of businesses in the industry sector in which the MNE group operates. Because differences exist among industry sectors, factors such as the particular point of an economic, business or product cycle, the effect of government regulations, or the availability of financial resources in a given industry are relevant features that may need to be considered to accurately delineate the controlled transaction. This examination will take account of the fact that MNE groups operating in different sectors may require, for example, different amounts and types of financing due to different capital intensity levels between industries, or may require different levels of short-term cash balances due to different commercial needs between industries. The MNE group’s policies may also inform the accurate delineation of the actual transaction through the consideration of, for instance, how the MNE group prioritizes the funding needs among different projects; the strategic significance of a particular MNE within the MNE group; whether the MNE group is targeting a specific credit rating or debt-equity ratio; or whether the MNE group is adopting a different funding strategy than the one observed in the industry.

Contractual Terms. The terms and conditions of a financial transaction between independent enterprises are usually explicitly stated in a written agreement. However, between associated enterprises the contractual arrangements may not always provide information in sufficient detail. It may therefore be necessary to look to other documents, the actual conduct of the parties (notwithstanding that such consideration may ultimately result in the conclusion that the contractual form and actual conduct are in alignment), and the economic principles that generally govern relations between independent enterprises in comparable circumstances in order to accurately delineate the actual transaction.

Functional Analysis. Accurate delineation of the actual transaction may include an identification of the economically relevant characteristics of the transaction, consisting of the commercial or financial relations between the parties and economically relevant circumstances attaching to those relations, including an examination of the contractual terms of the transaction, the functions performed, assets used, and risks assumed, the characteristics of the financial instruments, the economic circumstances of the parties and of the market and the business strategies pursued by the parties. In accurately delineating the actual financial transaction, a functional analysis may be necessary. In the case of an intra-group loan, the key functions performed by a lender to decide whether and under what terms to advance funds would typically include an analysis and evaluation of the risks inherent in the loan, the capability to commit capital of the business to the investment, determining the terms of the loan and organizing and documenting the loan. Such a functional analysis is likely to include consideration of similar information to that which a commercial lender or ratings agency would consider in determining the creditworthiness of the borrower. An associated lender will not necessarily perform all of the same functions at the same intensity as an independent lender. From the perspective of the borrower, the relevant functions usually refer to ensuring the availability of funds to repay the principal and the interest on the loan in due time; providing collateral, if needed; and monitoring and fulfilling any other obligation derived from the loan contract. There is a wide variety of financial instruments in the open market that present very different features and attributes, which may affect the pricing of those products and services. Consequently, when pricing controlled transactions, it is important to document the transactions’ features and attributes.

To achieve comparability requires that the markets in which the independent and associated enterprises operate do not have differences that have a material effect on price or that appropriate adjustments can be made. Macroeconomic trends, such as central bank lending rates or interbank reference rates, and financial market events such as a credit crisis, can affect prices. Currency differences are another potentially important factor. Business strategies must also examined in accurately delineating the actual transaction and in determining comparability for transfer pricing purposes. For example, independent lenders may be prepared to lend on terms and conditions to an enterprise undertaking a merger or acquisition which might otherwise not be acceptable to the lender for the same business if it were in a steady state. The analysis of the business strategies will also include consideration of the MNE group’s global financing policy and the identification of existing relationships between the associated enterprises such as pre-existing loans and shareholder interests.