On 11 February 2020, the Organization for Economic Co-operation and Development (OECD) published its final guidelines on financial transactions as part of a newly added Chapter X. The first draft was published on 7 September 2018 in light of the 2015 report on BEPS Actions 8-10, which mandated follow-up to the transfer pricing aspects of financial transactions. This latest OECD publication represents a significant milestone because, to date, financial transactions have received little guidance.
Implications of the new guidelines
While they are considered “soft law” and, therefore, nonbinding for tax authorities, they play an important role in the regulation of international tax matters. Luxembourg’s tax authorities generally follow OECD transfer pricing guidelines. In this sense, the new guidelines could hold significant implications for companies in Luxembourg that perform financial transactions.
The new guidelines cover the following types of financial transactions: intra-group loans, treasury, financial guarantees, captive insurance and risk-free and risk-adjusted rates of returns.
The key takeaways
The new guidelines recognize that a borrowing entity’s balance of debt-to-equity funding impacts the amount of interest paid by the borrower and may affect profits. Article 9 – covering associated enterprises and the arm’s length principle – is relevant, “not only in determining whether the rate of interest provided for in a loan contract is an arm’s length, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital,” stated the Commentary to Article 9 of the OECD Model Tax Convention. Applying the principle of accurate delineation of actual transactions results in multiple examples of debt being recharacterized as equity. As a result, the new guidelines outline that the debt-to-equity balance should be analyzed on a case-by-case basis.
2. Emphasis on the Comparability Factors
The accurate delineation of each transaction is based on five economically relevant characteristics: contractual terms, functional analysis, characteristics of the financial instruments, economic circumstances and business strategies. During the functional analysis, weight should be given to both the lender’s and the borrower’s perspectives.
3. Treasury functions
A distinction is made between simple coordination functions (e.g. day-to-day operations, such as the contact point that centralizes the external borrowing of a multinational enterprise) and more complex functions (e.g. corporate financial management, which involves identification, responses and analysis of financial risk). Remuneration should be in line with the treasury services function performed.
4. Credit rating estimation
The OECD recommends relying on credit ratings, which are based on both quantitative and qualitative data. The publicly available credit rating of the group can be used as a proxy for the delineated transactions. Credit rating analyses based on financial metrics can be used as well, as long as the credit rating is not derived from intra-group transactions, which are unreliable. Passive association and support from the group should also be considered when determining a subsidiary’s credit rating.
5. Financial guarantees
The publication mentions two methods for pricing the guarantees: the yield approach and the cost approach. The first 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 second approach quantifies the additional risk borne by the guarantor by estimating the expected loss for providing the guarantee.
6. Captive insurance
Emphasis is placed on the characteristics that a captive insurance company should possess in order to perform “genuine insurance business,” as well as on the assumption and diversification of its risk. Additionally, in order to determine the arm’s length remuneration for captive insurance, two options are proposed: the combined ratio and the return on capital.
7. Risk-free and risk-adjusted rates of return
Only a risk-free rate of return should be applied to a funder who lacks the ability to control the risk associated with investing in a financial asset or who simply does not perform the decision-making functions to do so.
On the other hand, a return higher than the risk-free rate should be applied proportionally to a funder who possesses the ability to assume the risk of a transaction (i.e. on a loan granted).
KPMG Luxembourg comment
As per Luxembourg’s transfer pricing practices, it is likely that the new guidelines will be taken as a reference for developing future transfer pricing framework in the Grand Duchy.
KPMG Luxembourg’s transfer pricing team is here to help you assess if your intra-group financial transactions comply with the arm’s length principle given these latest developments. We are equipped to support you with robust TP documentation.