On July 1, 2022 The Dutch Ministry of Finance published its new transfer pricing decree, replacing the previous transfer pricing decree (published in April 22, 2018). A previous article Transfer Pricing re-calibrated: “Value creation”. The new Dutch TP Decree. provides insights on how the previous Dutch TP Decree scrutinizes intercompany transactions by assessing the value creation and the relevant economical characteristics.
By Shining Lin (l) and Jiaxin Huang (r)
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In the new decree, the biggest changes are included in the section of financial transactions (such as intercompany loans, Cash Pooling and guarantees), to reflect the Chapter 10 of OECD’s guidelines on financial transactions. Overall, there is a significant emphasis on control over risks and having sufficient financial capacity, especially for financial intermediaries. This article specifically focuses on the decree’s high-level guidance relevant with intercompany loan and Cash Pooling. Although it is Dutch interpretation of transfer pricing, the general approach across different jurisdictions across the globe would be identical.
Old problem and new approach
Certain intercompany loans are designed to (aggressively) shift profit. This is undesirable and is what the new decree tries to tackle. Multinational enterprises usually purely focus on benchmarking interest rate for intercompany transactions. The benchmarking approach, in view of policy makers, is not comprehensive enough. Although it may not be realistic to apply the same level of scrutiny for the process of intercompany loan as compared with that of 3rd party loan, the new decree pointed out that it should, to some extent, mirror the 3rd party loan process. Several steps to analyse the process of intercompany loan, are generally accepted. The steps include: (1) substantiate commercial rationale; (2) assessment of financial capacity of borrower; (3) monitoring of the credit risk; (4) benchmarking analysis of interest rate.
The commercial rationale mainly refers to the business purpose of the loan, for example, the reason to give a loan to a low-rated affiliate. In the situation of a 3rd party loan, the rationale can be justified by certain incentives such as the borrower paying higher interest rate (leading to a higher return on investment for the lender) or agreeing to financial ratio targets etc.
Financial capacity relates with the repayment capability of the borrower. Size of the loan, lending terms and financial projections may need to be considered to match with borrower’s financial capacity. In addition, the role and position of the entity within the group shall be considered in determining the degree of implicit support from the group. The group usually provides more support to strategical subsidiaries, like a treasury centre. And the credit rating of that entity could vary by the level of group support. Most of rating agencies take parent support as one of influencing factors to the rating.
To better control the credit risk (or probability of default), it requires a continuous monitoring process. Not only at the time the loan is issued but also throughout the duration of the loan. For 3rd party lenders, periodical review such as covenants review plays important role to keep track of the financial capacity of the borrower and control credit risk. In post transaction monitoring, intercompany loan lenders are advised to follow the same practice.
Only after the abovementioned examination, a benchmarking analysis of interest rate can be performed. Thus, simply applying interest rate benchmarking will not make the regulators “happy”. It is important to document the decision-making trail to demonstrate to the regulators that the required aspects have been considered and put in written for future reference and to address potential questions from the regulators.
The market conditions/issuance timing may be critical when substantiating below-investment grade intercompany debt.
Cash Pooling
The new decree emphasis that Cash Pools, regardless of the structures (i.e., ZBA, single entity Cash Pool, multi-entity notional Cash Pool) should operate as short-term financing. Besides, if the Cash Pool is categorized as intercompany arrangement, companies must make efforts to address the element of transfer pricing.
- The tax impact of cross guarantee
Cross guarantee is one or several types of the collateral required in Cash Pool agreements whereby the participants act mutually as guarantor for each other. It is observed that, in most cases, the participating companies have no influence whatsoever on guaranteed party as well as for how much they guarantee. More importantly, no guarantee-fee is paid among group companies. Therefore, in the event of default, guarantees arising from supporting Cash Pool participating group companies, should be regarded as an act in the capital domain, which means the cost is not tax deductible.
- Tenors of Cash Pool transactions
Balances in Cash Pool are in general intended to support working capital needs of the Cash Pool participants. If one or multiple participants hold cash positions (in the pool) for an extended period, the decree states that it will be necessary to check whether the financial transactions should be recharacterized as a different type of transactions, for example, a deposit with a longer term or a loan. The analysis around longer-term outstanding balances should be different and thus, based on the arm’s length principle, result in a different remuneration (e.g., a higher interest rate) compared to that for a short-term position of the participant(s) in the pool.
- Functionality of a pool leader when allocating Cash Pool benefits
The decree holds the view that compared to that of a zero balancing Cash Pool, the functionality of a notional Cash Pool leader is more limited with less value creation. This is expected to be also reflected in the remuneration for the Cash Pool leader. If a Cash Pool leader is basically considered as merely performing routine activities, it should get limited or routine cost-plus-type remuneration. In that case benefits should be more allocated to the Cash Pool participants, such as according to the credit or debit balances of the participants.
What are the takeaways?
A tightening of policy seems noticeable from the changes of the decree in terms of analysing the intercompany loan. The new guidelines focus more on financial capacity and control of risk. For multinationals this means take a step back, not only focusing on benchmarking the interest rate, but also paying more attention on the risks the business is facing. It is critical to revisit the policies for financial transactions and to document the thinking and rationales behind the decisions.
Regarding Cash Pool, the short-term feature of the funds in Cash Pool was emphasized. Companies should also pay attention if balances in Cash Pool are static and should manage the pool balances to serve short-term characteristics. Longer-term outstanding balances should result in a different remuneration from arm’s length pricing perspective. Besides, legal instruments such as cross guarantees, when enforced in the event of default, will have tax impact since the cost incurred for supporting the default participants is not tax deductible as an expense.
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Featured image: 15th-century “De Waag” (The Weigh-house), Amsterdam’s oldest remaining non-religious building (now a restaurant). Originally a city gate and part of the walls of Amsterdam, but re-purposed as a weigh house in 1617, i.e the place where the “value” of goods was determined (also for tax purposes).
The views in this post solely reflect the opinions of the author and not necessarily those of the institutions with which he/she is affiliated.
In the posts the author(s) express(es) personal insights, expert views, and opinions with respect to the topic(s) discussed. Due to differences in interpretation, insights may (and will) differ.
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