The still-fresh guidance on cross-border intercompany financial transactions originally published by the Organisation for Economic Co-operation and Development (OECD) in 2020 represents an exciting new chapter in transfer pricing.
Four years after its publication, the transfer pricing community has distilled the guidance into several new practices and notable considerations that every multinational enterprise (MNE) tax and treasury leader should know.
In light of increasing tax audit activity, and growing importance of the treasury function given the changing capital markets and interest rate environment, MNEs should examine intercompany financial transactions according to the new guidance to mitigate potential transfer pricing risks and identify potential planning opportunities. Among the transactions that should be examined are loans, guarantees, cash pooling arrangements, and insurance arrangements.
Formalized guidance on intercompany financial transactions was first published in February 2020 as an additional chapter to the OECD's 2017 Transfer Pricing Guidelines and subsequently incorporated in the OECD's 2022 Transfer Pricing Guidelines as Chapter X and certain paragraphs in Chapter I. The guidance addresses interaction with guidance in Chapter I, Section D.1, the treasury function (including intra-group loans, cash pooling, and hedging), financial guarantees, and captive insurance.
The guidance presents a framework for tax authorities and MNEs to identify and price intercompany financial transactions by confirming certain practices, such as considering implicit support when estimating creditworthiness, and introduces nuances and complexities further described below. As governments continue to seek out tax revenues, tax authorities, particularly those in jurisdictions that adopt the OECD in law or in practice, now have a tool to evaluate intercompany financial transactions for consistency with the arm’s length principle.
One of the key takeaways from the guidance is that intercompany financial transactions should be actively monitored and tested to be compliant with the arm’s length principle, similar to the requirements for other intercompany transactions, such as services and sales of goods. This is particularly important for intercompany financial transactions with embedded derivatives, such as prepayment options, which have historically been one of the preferred structures for intercompany loans.
What can MNEs do?
To comply with the OECD’s guidance, tax leaders at MNEs should have an understanding of all intercompany financial transactions and how changing conditions might affect the lender and borrower behaviours at arm’s length.
Best practices for MNEs to consider include:
- Inventory of intercompany transactions: Prepare an inventory of intercompany financial transactions and summarize the terms and conditions as evidenced in an intercompany legal agreement or in books/records. These include identifying transactions that may be non-interest-bearing, whether those transactions were originally exempt of transfer pricing requirements or were mispriced at the onset.
- Inventory of arm’s length transactions: Prepare an inventory of arm's length financial transactions, including any co-borrowing arrangements and multi-party guarantee and security/collateral arrangements which may be relevant for “hidden” intercompany financial transactions, and summarize the terms and conditions as evidenced in the credit agreement and related documents. During a transfer pricing audit, tax authorities may request an understanding of global arm’s length financing arrangements, particularly those arm’s length transactions that the taxpayer under audit is party to (e.g., as a co-borrower, guarantor, or collateral party that could result in additional intercompany income for the taxpayer). Further, an arm’s length transaction may form a reasonable internal comparable for benchmarking purposes.
- Revisit terms and conditions: Review and, as necessary, refresh the terms and conditions for intercompany financial transactions. Historically, only material intercompany financial transactions were generally scrutinized by tax authorities. However, with the formal guidance, tax authorities may challenge simpler intercompany financial transactions, especially if the terms and conditions were not clearly established with the arm's length principle in mind. For instance, long maturities that are uncommon in the industry or for the transaction type.
- Monitor and document changes: Establish a mechanism with the relevant functional teams to actively monitor and document any changes to the intercompany financial transactions, arm's length financial transactions, and general capital markets. Examples include credit profile changes to the MNE (which may, for example, impact implicit support considerations) or the borrower of the intercompany financial transaction (especially if the borrower has a prepayment option which could be leveraged to obtain cheaper funding), benchmark rate changes (such as when USD LIBOR transitioned to SOFR), and availability of cash of the lender of the intercompany financial transaction should the borrower require additional funding.
- Year-end support: Prepare year-end support to document compliance with the terms and conditions of the intercompany financial transaction, such as interest calculations, settlement of interest and other payments, and financial covenant calculations, and the arm's length behaviour of the lender and borrower, such as the rationale explaining why any embedded derivatives were not exercised throughout the year.
Additional nuances and complexities that the new guidance introduces include:
- Financial and operational changes: Changes to the financial position and operations of the borrower in intercompany financial transactions should trigger a significant review of the transaction. Examples of such a change include asset impairment, loss of an important arm’s length arrangement, such as distribution rights or a government contact, and restructuring of a borrower's transfer pricing profile, such as the sale of valuable intangibles to an affiliate as part of a broader global transfer pricing restructuring. In the circumstance of a borrower divesting material or strategic assets to an affiliate or third party, an automatic cash sweep of the proceeds may be appropriate as that is common in arm's length financial transactions.
- Arm's length amendments: For an intercompany financial transaction structured in reference to an arm's length transaction within the group, an amendment to the arm’s length transaction may warrant a similar amendment to the intercompany financial transaction, or, at the very least, consideration of amending the intercompany financial transaction. Examples include changes to the interest rate, amortization, maturity, and financial covenants. Whether or not an intercompany financial transaction is structured or benchmarked in reference to the arm's length transaction, an amendment may also be informative for other purposes, such as identification of new guarantors and collateral pledges and pricing the transition to a new benchmark rate.
- Additional changes to an arm’s length financial transaction: Changes to arm's length financial transactions that may not be formalized in an amendment, such as making an optional prepayment and hedging the floating benchmark rate component, may suggest a similar change should be made to the intercompany financial transaction, especially if the intercompany financial transaction was structured and benchmarked in reference to the arm's length financial transaction.
- Issuance of new arm's length debt: As the group issues new arm’s length debt, the mechanism to actively monitor and test the intercompany financial transaction should be enhanced to incorporate the new arm’s length debt. For example, should the new arm’s length debt have cheaper interest rates and include new collateral and guarantee obligations, an amendment to the intercompany financial transaction may be warranted.
The message of the OECD guidance is clear: treat intercompany financial transactions more like arm's length transactions. With this higher bar and increasing tax audit activity by tax authorities, MNEs need to revisit their intercompany financial transactions before year-end, implement mechanisms to actively monitor the transactions, and prepare robust year-end transfer pricing support for the transactions.
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Grant Thornton LLP was recently named as the International Tax Review’s Transfer Pricing Advisory Firm of the Year (Canada, 2023) based on recent case experience and credentials in the financial transaction transfer pricing space. As innovators in the industry, our award-winning transfer pricing team can help your organization address the new guidance and position and establish best practices for 2024 and beyond. Contact one of our Advisors today.
About the author
Matthew is a Chartered Financial Analyst (CFA) and assists multinational enterprises with planning, implementing, documenting, and defending intercompany financial transactions, including loans, cash pooling arrangements, and guarantee fees. Matthew also has experience supporting MNEs with defending transfer pricing policies under audit, implementing intangibles-related transfer pricing structures, and addressing due diligence matters. In addition, Matthew assists the Complex Financial Instrument Pricing (CFIP) team with valuing financial instruments for financial reporting, tax reporting, and strategic business planning purposes.
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