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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. The use of a cash pool is popular among multinational enterprises as a way of achieving more efficient cash management by bringing together, either physically or notionally, the balances on a number of separate bank accounts. In a typical physical pooling arrangement, the bank account balances of all the pool members are transferred daily to a single central bank account owned by the cash pool leader. In a notional cash pool, some of the benefits of combining credit and debit balances of several accounts are achieved without any physical transfer of balances between the participating members’ accounts. As cash pooling is not undertaken regularly, if at all, by independent enterprises, the application of transfer pricing principles requires careful consideration. According to the OECD, a cash pool is likely to differ from a straightforward overnight deposit with a bank in that a cash pool member with a credit position is not depositing money as a transaction with a view to a simple depositor return. Rather, the cash pool member is likely to be participating in providing liquidity as part of a broader group strategy, in which the member can have a credit or debit position. The appropriate reward of the cash pool leader will depend on the functions performed, the assets used and the risks assumed in facilitating a cash pooling arrangement. A cash pool leader may perform no more than a coordination or agency function with the master account being a centralized point for a series of book entries to meet predetermined target balances of pool members. Under these circumstances, the cash pool leader’s remuneration as a service provider will generally be limited. Where a cash pool leader is carrying on activities other than coordination or agency functions, the pricing of such transactions would be adjusted appropriately. The remuneration of the cash pool members will be calculated through the determination of the arm’s length interest rates applicable to the debit and credit positions within the pool. This determination will allocate any synergy benefits arising from the cash pool arrangement amongst the pool members and it will generally be done once the remuneration of the cash pool leader has been calculated.
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Continue Reading OECD on Cash Pooling

Global Economics

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. In general, a financial guarantee provides for the guarantor to meet specified financial obligations in the event of a failure to do so by the guaranteed party. There are various terms in use for different types of credit support from one member of an MNE group to another. At one end of the spectrum is the formal written guarantee and at the other is the implied support attributable solely to membership in the MNE group. Here we use guarantee to mean a legally binding commitment on the part of the guarantor to assume a specified obligation of the guaranteed debtor if the debtor defaults on that obligation. The situation likely to be encountered most frequently in a transfer pricing context is that in which an associated enterprise (guarantor) provides a guarantee on a loan taken out by another associated enterprise from an unrelated lender. From the borrower perspective, a financial guarantee may affect the terms of the borrowing. For instance, the existence of the guarantee may allow the guaranteed party to obtain a more favorable interest rate since the lender has access to a wider pool of assets, or to increase the amount of the borrowing. From the perspective of the lender, the consequence of an explicit guarantee is that the lender’s risk would be expected to be reduced by having access to the assets of the guarantor in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed rating. A number of methods can potentially be used to value guarantees. The yield approach calculates the spread between the interest rate that would have been payable by the borrower without the guarantee and the interest rate payable with the guarantee. The interest spread can be used in quantifying the benefit gained by the borrower as a result of the guarantee. The cost method 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. Popular pricing models for this approach work on the premise that financial guarantees are equivalent to another instrument and pricing the alternative, for example treating the guarantee as a put option and using an option pricing model to price the put option. The valuation of expected loss method would estimate the value of a guarantee on the basis of calculating the probability of default and making adjustments to account for the expected recovery rate in the event of default.
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Continue Reading OECD on Financial Guarantees

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. Generally, the treasury function is part of the process of making the financing of the MNE group as efficient as possible. For example, treasury may act as the contact point to centralize the external borrowing of the MNE group. External funds would then be made available within the MNE group through intra-group lending provided by the treasury. In considering the commercial and financial relations between the associated borrower and lender concerning intra-group loans, both the lender’s and borrower’s perspectives should be taken into account. In particular, it is important to consider the risks that the funding arrangements carry for the party providing the funds, and the risks related to the acceptance and use of the funds from the perspective of the recipient. The creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of related party transactions. Arm’s length interest rates can be sought based on consideration of the credit rating of the borrower or the rating of the specific issuance, taking into account all of the terms and conditions of the loan and comparability factors. The widespread existence of markets for borrowing and lending money and the frequency of such transactions between independent borrowers and lenders may make it easier to apply the CUP method to financial transactions than may be the case for other types of transactions.
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Continue Reading Intra-Group Loans

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.

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Continue Reading Accurate Delineation of Financial Transactions

Businessman signed a contract agreement to invest together

Just as with debt instruments between unrelated parties, the current economic downturn may cause related parties to want to modify the terms of debt instruments existing between them. And as with debt instruments between unrelated parties, modification of debt instruments between related parties may have a number of tax consequences. Certain “significant modifications” of a debt instrument will result in a deemed exchange of the unmodified instrument (“old debt”) for the modified debt instrument (“new debt”). The old debt will be treated as redeemed for an amount equal to the “issue price” of the new debt. The new debt will be treated as a newly issued debt instrument with a new issue price. If the debt instrument is not publicly traded, then the issue price of the new debt instrument is generally equal to the principal amount, provided that the debt instrument bears stated interest at least equal to the “Applicable Federal Rate.”

What constitutes a “modification” and the determination of when a modification is “significant” are the subjects of this blog post.

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Continue Reading Modification of Intra-Group Debt Instruments