Transfer Pricing Guidelines for Financial Operations

Transfer Pricing Guidelines for Financial Operations [1]

Background

The 11 of February of 2020, the Organization for Economic Co-operation and Development (OECD) published transfer pricing guidelines aiming to regulate financial operations between related parties[2]. The publication of said guidelines conforms to actions 4 (reducing base erosion limiting interest deductions and other financial payments) and 8 to 10 (alignment of transfer pricing outcomes with value creation) of the BEPS plan. The most relevant aspects of the guidelines are the following:

Identification of commercial and financial relationships, accurate delineation of the operation.

From the OECD’s point of view, the transfer pricing analysis for financial operations must start with a broad based analysis of the internal and external factors affecting the transaction. Such analysis must address the circumstances affecting the parties involved (taking into account their best available economic alternatives), and should be guided by the elements of the conventional comparability analysis proposed in the Chapter III of the Guidelines. The expected outcome is a “characterization” of the transaction as a loan (or as any other financial instrument), and not as a contribution to equity.

Treasury function

After emphasizing the need to accurate delineate the transactions, the transfer pricing guidelines address specific situations starting with the treasury function. The OECD highlights that treasury functions are organized considering the financial strategy of the multinational group from the macro/micro context that it may face. In this sense, the new guidelines require a precise analysis of the functions performed by the treasury and not simply a general description that prevent its correct remuneration. For example, activities like debt management (emission of bonds, loans, etc.), capital, managements of relationships with financial institutions and rating agencies, monitoring of returns on investment, reduction of the volatility of cash flows, maintenance of balance ratios, etc. would have to be evaluated on their own merits and eventually would have to be assigned an arm´s length consideration . Moreover, it is necessary to mention that the guidelines establish that the treasury function should normally be considered as a service (and therefore remunerated considering the market price of the activity deployed or simply considering the transfer of the costs of the function plus a margin determined by the market), always considering the complexity of the activities carried out and the inherent risks of said activities.

Intercompany Loans

Within the treasury function, one of the main activities, if not the most important of them, is the financing of operations to entities of the group. The transfer pricing guidelines mention that the arm’s length analysis for this kind of operation should consider both the perspective of the lender as well as the borrower . Important considerations (in attention to the accurate delineation of the actual transaction) for the lender when making a loan are: the amount, terms, what are the implied risks and how will they be monitored, and what measures will be taken before their eventual realization.

From the borrowers perspective, the risks derived from receiving financing must be evaluated, particularly the availability of alternatives to the acquisition of intercompany financing (for example, debt emission, loans from third parties, convertible obligations, commercial role, etc.), its real possibilities to satisfy the credit terms on time and form, as well as its capacity to face external circumstances that may affect its ability of payment.

Once the operation has been contextualized, and with the purpose to confirm the arm’s length nature of the same, the guidelines suggest the use of the Comparable Uncontrolled Price Method (CUP), considering the availability of financial information regarding uncontrolled financial transactions (without rejecting the possibility of analyzing the operation through the use of internal comparable transactions – similar operations that the taxpayer may have carried out with independent third parties –).

The use of the CUP method would require the elaboration of an accurate reference parameter. The definition of what is or what is not comparable depends mostly on the credit risk, and therefore such credit risk must be taken into account to establish any arm´s length parameter. The credit rating can be obtained from opinions emitted from an external agency (where generally it is the group that is being rated and not the particular credit) or by rating models that determine the credit risk. Regarding the use of credit ratings, the guidelines highlight that even if these are useful instruments, they must consider certain aspects that may eventually distort the analysis. In case of credit ratings, the different methodologies employed by each rating agencies (and taking into account the quantitative and qualitative factors) may have an effect in obtaining ratings that are not necessarily homogeneous.

The guidelines also stressed out that merely belonging to the group– an incidental activity – does not warrant a return, and that while the group does not actively grant explicit guarantees for a financial transaction, in these circumstances a return should not be considered. Lastly, the guidelines emphasize the preliminary analysis of the arm’s length condition of additional intercompany operations to the finance operation being analyzed (sales, purchases, services, royalties, etc.) so that the same does not negatively impact the analysis.

Centralized treasury (cash pooling)

The guidelines begin the analysis of this type of operations emphasizing that normally this type of structures allow for better short-term cash management in the group, reduce external loans, increase returns and eventually eliminate excessive financing costs. The guidelines distinguish among “physical cash pooling” and “notional cash pooling”. With respect to physical cash pooling, the cash accounts of each member are directly transferred to a sole account managed by the centralized treasury leader. Any deficit in the account is taken to an objective balance (normally zero) with a transfer from the master account to a subaccount. Depending on whether there is a deficit or a surplus, the leader might request a loan or make investments.

In notional cash pooling, the benefits are obtained without balance transfers. – Even if the bank may require additional gains -. The bank will pay or charge interest as a function of the net sales reported by the entities participating in the centralized treasury, whether it is to the leader of the treasury or to each one of the members according to the pre-agreed upon formulas.

Having identified the types of centralized entities, the guidelines warn that “the accurate delineation of the [arm’s length condition] of the cash pooling may be complex as ‘independent third parties do not normally carry out these types of operations’”.

With respect to, and for the analysis of these type of operations, the guidelines stressed out additional considerations. For example, if the participants of an agreement obtain benefits through the deliberate actions of the group, these must be sufficiently detailed in the functional analysis. The functional analysis must also explain the nature of the advantages or disadvantages, the amounts of the generated benefits or loses and how is it that these will be distributed among the members of the group (previous remuneration to the cash pooling leader in attention to the functions, risks and assets carried out and assumed by the leader). The guidelines also emphasize that in case that the treasury creates synergies that may lead to future benefits, these must be assigned to the members of the agreement (and not retained by the treasury leader).

Additionally, the guidelines make reference that in general treasury leaders do not carry out more than one of the following functions coordination or agency, and therefore their remuneration should be limited to one corresponding to one of these activities. Additional remunerations should be based on greater functions, risks or assets that the leader may carry out or assume.

Hedging

Finally, regarding the treasury function, the guidelines address hedging activities, emphasizing that in order to mitigate certain risks, for example FOREX risk or fluctuations in the price of commodities, it is common to carry out these activities. They also state that said activities should be considered as a service and consequently remunerated with an arm’s length return.

At the conclusion of the function transfer price analysis for the treasury function, the guidelines suggest further items to consider with regards to additional transactions such as financial guarantees, captive insurance and the use of both risk-free and risk-adjusted interest rates. The comments are the following.

Financial Guarantees

The new guidelines provide certain rules regarding the use of guarantees in intragroup operations (the guidelines state that a guarantee should be understood as “guarantee is 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 transfer pricing analysis for financial operations requires an accurate delineation of the characteristics of the operation. In the case of financial guarantees, the first consideration is the identification of economic benefits obtained by the related parties beyond the passive association to the group, including “letters of comfort” that could be extended to express the intent to guarantee an obligation.

For the receiver of the guarantees, the existence of these will grant it access to the best financial conditions. The guidelines state that the existence of a remuneration due to the offer of guarantees should only exist if said guarantees in effect contribute to better conditions compared to when the original financing was offered, otherwise perhaps it one could only consider the existence of an administrative service with the consequent effect that this may cause on the return.

The transfer pricing guidelines propose the use of the Comparable Uncontrolled Price (CUP) method for these type of operations in attention to the existence of internal and external comparables, and require the review of the credit profile of the debtor, the terms and conditions of the guarantee, the terms of the guaranteed credit (amounts, term, rate, currency, maturity), credit spread between the guarantor and the debtor, market conditions, etc. The guidelines propose several approaches to establish the compensation for these operations; the yield approach, cost approach, valuation of expected loss approach and the capital support method.

Captive insurance

In some cases, a multinational group may opt for the internalization of insurance functions through a subsidiary created solely for these effects – ‘a captive insurer’ – . Among the potential commercial reasons are the possibility to standardize paid premiums by the multinational group, benefit from tax and regulatory arbitration, obtain access to reinsurance markets, make a profit from the retention of risk within the group, or simply because of the difficulty in obtaining insurance coverage for certain risks.

The guidelines stressed out that this type of operations involve only the management of risks and does not imply their control, and also that the risks arisen from assuming the insurance function differ from insured risk. In this sense, the guidelines also require the identification of how the risk is assumed and how it is diversified, and if the insurance function is subcontracted. They also touch on the subject of fronting in captive insurance schemes.

To determine the arm’s length insurance or reinsurance premium as the brokerage or fronting fee the analysis should prioritize the use of the Comparable Uncontrolled Price (CUP) method through the premise that “the remuneration between related parties is carried out in arm’s length conditions, being aligned with the performance benchmark of insurers that assume similar risks, assigning an appropriate benefit ”. The method may be used with external comparables (operations carried out among independent third parties) or when there is existence of uncontrolled operations, with internal comparables (transactions carried out by the taxpayer with independent third parties). The calculation of the arm’s length remuneration should take into account the particular issues when fixing the price of premiums like the possibility of the use of combined financial decisions relating to the profitability of the claims and returns on capital as well as considering the possible existence of synergies within the group, also taking into account that the captive insurer must receive an adequate return for the services provided to the group, and the remainder of the synergy benefits should be distributed among the insured based on the determined premiums. Finally, relating to the commission for sales agents, the guidelines suggest that when an insurance agreement is not sold directly from the insurer to the insured, there should be a return assigned to the agent that made the sale in function of the returns that would have been obtained by third parties in these specific circumstances.

Risk-free and risk-adjusted rates of return

The last section of the transfer pricing guidelines for financial operations has to do with the arm’s length analysis of risk-free and risk-adjusted rates of return. The guidelines state that when the creditor of a financial operation among related parties does not have the capacity or does not have control on any risk associated to the investment in the financial asset, this company will not obtain a greater return than that of a risk-free return. In this regard, as an approximation of these rates, one may consider as an example the use of government bonds.

The risk-free rate makes reference to the hypothetical return of an asset that does not have risk of loss. In reality there is no asset free of the risk of loss but it is common to use of government debt instruments as a good estimation of this risk-free rate. Even, depending on the circumstances, the use of interbank rates, interest rate swaps or government repurchase agreements may also be admissible.

In the cases where an entity controls the financial risk of an investment but does not any other, one should consider the risk-free rate, plus a premium for the assumed risk, as a renumeration. The guidelines suggest the use of indicators of transactions among independent third parties with the same risk that could be comparable to this risk-adjusted rate, for example corporate bonds or loans. Another alternative is the use of available financial information to calculate the risk and add it to the risk-free rate.

New transfer pricing guidelines for financial operations and its impact on Mexican legislation

The transfer pricing guidelines on financial operations, as their name imply, are geared to routine intercompany financial operations so that these are consistent with the arm’s length principle – in other words, that said operations conform to the negotiation dynamic that would have taken place among independent third parties in comparable operations –. As it effects domestic legislation, it is necessary to take into account that the last paragraph of article 179 of the Mexican Income Tax Law states: “for the interpretation of that stated in this Chapter, the Transfer Pricing Guidelines for Multinational Entities and Tax Administrations approved by the Council of the Organization for Economic Co-operation and Development in 1995, or those that take their place, to the extent that the same are congruent with the [Mexican] Law, and the treaties agreed to by Mexico”. As a result, these guidelines on financial operations, that would modify the current guidelines of 2017, would be effective immediately (fiscal year 2020) with regards to operations with foreign related parties (Section V, Chapter III). However, it is also important to mention that Mexican legislation, in virtue of article 76-I, XII and 28-I of the Fiscal Code of the Federation, conforming to the criteria 32/ISR/N, equates transfer pricing obligations for domestic and foreign transactions, so that even operations among domestic related parties would have to be evaluated in light of these new provisions.

Conclusion

The release of new transfer pricing guidelines on financial operations are without a doubt an important development to the transfer pricing regime. Once incorporated to the current text of the transfer pricing guidelines we could likely expect a great number of reviews on this subject, as has already happened with the items addressed in actions 8-10 of the BEPS plan, particularly in the subject of intangibles and unique and valuable contributions. Given the previous, we urge you to conduct an immediate review of the effects these guidelines will have in your financial operations, as well as the interaction of these with other practices such as thin capitalization and the still very recent limits to interest deductions as a function of the adjusted profit for the exercise (action 4 of the BEPS plan).

[1] Jesús Aldrin Rojas. Lead Partner. QCG Transfer Pricing Practice

[2] https://www.oecd.org/tax/beps/oecd-releases-transfer-pricing-guidance-on-financial-transactions.htm

[3] Aprecio la colaboración de José Chamorro y Esteban Ollervides en la discusión de las secciones de aseguramiento cautivo y tasas libres de riesgo.