With its latest release in October 2015, the Organisation for Economic Co-Operation and Development (OECD) delivered more guidance on economic substance and value creation with a proposed comprehensive, coherent and co-ordinated reform of the international tax system. Many of these action points are also directly or indirectly affecting intragroup financing transactions.
Action Points Leading to Action?
From an immediate impact perspective, the revised Action Points 8 – 10 (”Aligning Transfer Pricing Outcomes with Value Creation”) will have the strongest influence on the structure and setup of intercompany financing going forward.
The general objective is to create outcomes in line with value creation and risk allocation. This shall be achieved by an accurate delineation of the transaction, promoting the focus on actual contributions rather than contractual arrangements, i.e. “substance over form”. The guidance authorizes tax authorities to disregard transactions which actually lack commercial rationality.
Beyond the potential for wide interpretation of function vs. control and allocation of risk in general, company-specific structures might further complicate the alignment of contractual obligations with economic reality. In today’s environment many multinational enterprises (MNE) have created entities only focusing on financing activities. In addition to the provision of simple and complex group loans, these services might include the provision of explicit guarantees or cash pooling activities. Adding a complex non-local matrix management structure on top might make the actual allocation and determination of value creation, as well as risk-taking and risk control at these entities, debatable. Accordingly, “cash box” entities, which are not performing relevant economic activities, shall be entitled to retain no more than a risk-free return on intercompany financing.
Given the far-reaching consequences and their potential for interpretation, it is important to monitor the approaches tax authorities are following while applying this guidance locally. While most OECD Actions are designed to achieve coherence for Government Agencies, Actions 8-10 could actually lead to less coherence in the short- to medium-term, at least.
BEPS and the Reality
If rules in line with the new BEPS Action Points are adopted in local law – and some are already – they will have a significant impact on intercompany financing – transfer pricing. Not least due to court rulings a lot of uncertainty still prevails.
Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [(2015) FCA 1092] and Canada v. General Electric Capital Canada Inc. [(2010) FCA 344 (CanLII)] are two remarkable cases in that regards, though just the tip of the iceberg. Both cases actually confirmed, among other issues addressed, the concept of an “Implicit Support” provided by the parent company, though avoided being too specific with regards to the application of an analytical framework. More guidance from the OECD is expected to come soon and is necessary as tax authorities are still having a very divergent view on the incorporation of a parental affiliation while pricing intercompany financing transactions.
Even though quantitative credit risk models incorporating the potential parental and government support are available, there is still uncertainty around how to actually price that risk.
The aforementioned Chevron Australia Holdings court case highlighted the very high, though potentially unrealistic standards of comparability expected by courts applying the concept of “comparable uncontrolled transactions” or “comparable uncontrolled prices”. Benchmark loan agreements which were put forward by both the Australian Taxation Office and Chevron were rejected due to different reasons of incomparability, e.g. based on differences with regards to covenants, different tenors, and different industries.
Due to the lack of directly comparable loan market information in many cases, secondary corporate bond market aggregates - specific to tenors, industries, currencies and credit risk - have been leveraged by transfer pricing practitioners to ground their analysis on a defendable, transparent, and readily available market source. Best practices to adjust these senior unsecured benchmark rates to reflect certain financing conditions (e.g. collateralizations, optionality’s) are emerging.
Questions about the capitalization structure, as well as the ability to service its intercompany financing debt obligations, are already regulated by “thin capitalization” rules in various countries. Nevertheless, the prevailing weak economic environment has potentially eroded the profitability of some MNEs and consequently their perceived ability to service its current debt obligations. A weaker debt capital structure following further refinancing rounds is a logical consequence. Therefore transfer pricing practitioners should not only analyse new intercompany financing agreements, but should also review their existing debt positions. These highly leveraged entities might require a reset in terms of levels and conditions of these transactions.
The mixture of regulatory uncertainty, coupled with missing clear guidance, different best practices across tax jurisdictions, different levels of sophistication of tax authorities, different analytical approaches, limited unrelated transaction information, and case law decisions makes transfer pricing, especially - but not limited to - intercompany financing related, a challenging field of work for all practitioners.
The bottom line is that tax authorities, corporates and auditors alike are looking for a common ground that is consistent and transparent when creating an arm’s length intercompany loan pricing model. The sole purpose of that is to avoid cherry picking or inconsistent approaches, which can lead to debatable pricing strategies. There is no perfect framework or one-model-fits-all as in many other tax discussions, but a well-documented, clear, and transparent internal transfer pricing policy at the corporate level can go a long way in avoiding any reasonable doubts from any tax authority in the world.
As a general guideline for transfer pricing analysis, it might help to remember an often overlooked statement: “Transfer pricing is largely a matter of facts and circumstances coupled with a high dose of common sense.” [Justice Robert Hogan in Canada v. General Electric Capital Canada Inc. [(2010) FCA 344 (CanLII)]
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 “Cash boxes” are entities typically located in low-tax jurisdictions that are highly capitalized, have few employees and little economic activities.