Transfer pricing of intra-group financial transactions
Intra-group financial transactions are an essential part of the operations of multinational enterprises. From the perspective of transfer pricing, it is important to ascertain that the contractual terms of intra-group financial transactions are similar to those that would apply between independent, unrelated companies and that the revenues received by the participating group companies are similar to those that unrelated companies would receive. The OECD Transfer Pricing Guidelines – Chapter X discussing intra-group financial transactions provides guidance and instruction on the subject of appropriate transfer pricing.
The transfer pricing of intra-group financial transactions can relate to many different specific issues. Such transactions as loans, guarantees, collateral, intercompany cash pooling arrangements and different types of hedging instruments are typical examples of intra-group financing. In addition to the above, the OECD’s guidance also offers an in-depth discussion of the transfer pricing related to captive insurance arrangements of MNE groups.
The essential requirement in intra-group financing is that the group companies that act as lenders get an arm's length return on the lending and the borrowing companies pay an arm’s length interest.
Different financing arrangements have special characteristics that play a role when arm's length prices are determined. The following pages deal with some of the frequently occurring transfer pricing issues:
- Intra-group loans
- Transfer pricing of cash pooling arrangements
- Transfer pricing of intra-group financial guarantees
Financing arrangements must be on an arm's length basis
In financing arrangements between unrelated parties, the type and contractual terms of all kinds of financing are agreed on a case-by-case basis in accordance with the goals and needs of both parties. The approach must be the same when intercompany arrangements are agreed upon within an MNE group.
When evaluating whether the arm’s length principle has been adhered to, all the facts and circumstances of the participating group companies should be taken into account. From the lender’s perspective, this may mean that the borrowing company’s creditworthiness, solvency and future prospects are examined in greater detail or from the borrower’s perspective that the purpose of the borrowing should be evaluated thoroughly.
The differences between the financial instruments available in the market may have an essential effect on the pricing of products or services. In transfer pricing, not only the business transaction at hand (e.g. its contractual terms, the business reasons), but also other factors may have an impact on pricing; these factors may include e.g. the line of business, varying economic cycles, and government regulatory activity. Besides conducting a functional analysis of the group’s business, and delineating the transactions accurately, there should also be a precise documentation of the transactions that were carried out. Later, the documentation may serve as evidence to prove the arm’s length pricing of a financial transaction.
MNE groups often have a centralised treasury function that obtains financing for the needs of the group’s business, identifies financial risks, evaluates the risks, etc. Typically, the treasury function is also in charge of the necessary arrangements: it manages the group’s cash pooling arrangement; it oversees the loans to be issued between group entities, etc.
In conclusion, the role of the treasury function may be quite significant. The way a particular MNE group has organised its treasury function may vary. This is affected by factors like group structure and the complexity of its business operations. There are MNE groups with a centralised treasury function and others with a more decentralised form.
When evaluating the transfer pricing issues related to treasury activities, as with any case, it is important to accurately delineate the actual transactions and determine exactly which functions an entity is performing rather than relying to any extent upon a general description such as “treasury activities”.
In transfer pricing it is important to evaluate the functions actually performed by the treasury company and the risks to which it is exposed to. After analysing the case, it is possible to make conclusions about the proper arm’s length level of remuneration for the functions performed and risks assumed. Depending on the situation, pricing can be based on the services provided – on the other hand, there may be a more complicated intra-group activity going on. In the latter case, the pricing must additionally reflect the risks, including a credit risk that the treasury company has taken.
Other issues to be considered in the transfer pricing of financial transactions
The following matters should also be considered:
The separate entity approach
The arm's length principle is based on an approach that focuses on every group company as a separate entity. This means that each group company is considered as a separate actor, independent of the group. However, when determining the creditworthiness of a group company, the effect of group membership should also be taken into account. This incidental benefit that the MNE is assumed to receive solely by virtue of group affiliation, is referred to as implicit support.
From the lender’s perspective, the credit rating of a group company can improve by virtue of the implicit support. In this case, the results of an analysis would indicate that such a group company, if it were to default on its debt repayments, would receive support from the remaining MNE group members even if no legal guarantee commitment is made.
Written agreements and up to date comparability analysis
The matters agreed between the parties in intra-group transfer pricing situations should be laid down in written agreements stating clearly the parties to the agreement, the purpose of the agreement and the rights and obligations of the parties.
Whether or not financial transactions are arm’s length is generally verified by comparing the used intercompany pricing with the pricing of comparable business transactions between unrelated parties. Suitable business transactions in this regard may be for example loan contracts. For this purpose, the comparability analysis and searches for comparables must be based on up-to-date data similarly as unrelated parties would act when determining the pricing of their transactions.
For more information, see the OECD Transfer Pricing Guidance on Financial Transactions.