Transfer Pricing and Intra-Group Financing: Tap Dancing in a Minefield?

April 10,2017
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Anuschka Bakker (Manager Transfer Pricing and Specialist Knowledge Group, IBFD)

Introduction

Intra-group financial transactions attract the attention of tax administrations because they are increasingly perceived to lead to base erosion and profit shifting (BEPS), for example through the use of excessive interest payments on related-party or third-party debt.

The existing guidance on transfer pricing aspects of financial transactions is relatively limited. The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) do not yet include a separate chapter on financial transactions. However, the general transfer pricing principles outlined in the OECD Guidelines do apply to financial transactions. In order to determine the consequences of intra-group finance transactions, countries use, among others, the following rules: (i) thin capitalization rules, (ii) debt-to-equity ratios and (iii) guidance on when capital should be regarded as debt or equity or when interest should be reclassified as a dividend. Each of these rules is applied alongside the general or specific transfer pricing rules.

In response to the problems posed by BEPS, the OECD published its OECD BEPS Action Reports. In one way or another, the reports on Actions 2, 4, 5, 6, 9 and 13 may impact MNEs who deal with intra-group financing transactions. A number of these final reports relate directly or indirectly to transfer pricing. The author will deal with Actions 9 and 13.

Action 9

The report on Action 9 of the BEPS project seeks to ensure that transfer pricing outcomes are in line with value creation. Action 9 provides guidance with respect to the allocation of risk. The OECD introduced, among others, the following six-step approach with regard to risk:

(1)identification of economically significant risks with specificity;

(2)determination of contractual assumption of the specific risk;

(3)functional analysis in relation to risk;

(4)interpreting Steps 1 through 3;

(5)allocation of risk; and

(6)pricing the transactions, taking into account the allocation of risks.

Step 1 concerns the identification of economically significant risks. The significance of a risk depends on the likelihood and size of the potential profits or loss arising from the risk.

Step 2 relates to the contractual assumption of risks. The type of risk that is assumed and the party or parties assuming the risks would typically be laid down in a contract. This must be in line with the relevant substance and people functions. The contract should, for example, provide the relevant details to this arrangement and how particular risks are managed and mitigated by the treasury company and for the local entity, potentially in combination with agreements with other related or unrelated parties.

Step 3 concerns the functional analysis with regard to risk. It is important to understand the roles and people functions undertaken at the level of the parent, the subsidiaries and the treasury company, especially as they relate to control over risks. Further, it is important to examine which party to the transactions has the financial capacity to assume the risks identified in Step 1 (this could, for example, be market price risk, counterparty credit risk, liquidity risk and settlement risk).

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