—–For general audience—-–
In a global economy where multinational enterprises (MNEs) play a prominent role, governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. Also see: Do you pay your fair share of Taxes? For taxpayers, it is essential to limit the risks of economic double taxation.
The OECD Transfer Pricing Guidelines provide guidance on the application of the “arm’s length principle”, which is the international consensus on the valuation of cross-border transactions between associated enterprises.
The last year’s edition includes the revised guidance on the application of the transactional profit method and the guidance for tax administrations on the application of the approach to – so called – hard-to-value intangibles. This has been incorporated into Chapter 1 (new Section D.1.2.2) and in a new Chapter 10.
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Chapter 10.
The purpose of this chapter is to provide guidance for determining whether the conditions of certain financial transactions between associated enterprises are consistent with the arm’s length principle, e.g. treasury activities including intra-group loans, cash pooling and hedging in section C, and financial guarantees in section D. In contrast, an MNE group has the discretion to decide upon those conditions within the MNE group. Thus, in an intra-group situation, other considerations such as tax consequences may also be present:
In conducting a TP analysis for a cash pool structure a couple of elements are to be considered:
• Accurate delineation of the cash pool and transactions;
• Accurate delineation of the cash pool leader and its remuneration;
• Arm’s length interest rates (borrowing and deposits); and
• Cash pool synergies shared appropriately among cash pool participants.
The cash pooling transactions should first be accurately delineated by looking at the functional and risk profile of the parties involved, particularly the cash pool leader. This is especially important for cash pooling transactions since independent enterprises seldom undertake transactions of this type. As such, there is little or no direct evidence of what conditions would have been established by and between independent enterprises. This step entails developing a thorough understanding of the nature of the cash pool and its relevant economic characteristics (is it a physical pool, currencies involved, involvement of the cash pool leader, the overall cash position of the pool, etc.)
Another important aspect of a transfer pricing analysis relating to cash pooling is the concept of “options realistically available.” The lender’s perspective in the decision of whether to make a loan, how much to lend, and on what terms, will involve evaluation of various factors relating to the borrower, wider economic factors affecting both the borrower and the lender, and other options realistically available to the lender for the use of the funds. In other words, no member of the pooling arrangement would participate in the transaction if it made him or her any worse off than his or her next best option. As such, an MNE needs to ensure that cash pool participants benefit from being a member of the cash pool. The OECD refers to the cash pool (and any benefits derived therefrom) being the result of a concerted group action. In doing so, it links it to the guidance on synergies in Chapter I of the OECD Guidelines, which states that any benefit derived therefrom should be passed back to the entities that contributed thereto.
Any cash pool policy applied should thus ensure and demonstrate that the synergies achieved are appropriately identified and shared with the members of the pool, including the cash pool leader, where appropriate. A cash pool leader should be rewarded in accordance with its functional and risk profile.
Risk; An independent lender will carry out a thorough credit assessment of the potential borrower to enable the lender to identify and evaluate the risks involved and to consider methods of monitoring and managing these risks. That credit assessment will include understanding the business itself as well as the purpose of the loan, how it is to be structured and the source of its repayment which may include analysis of the borrower’s cash flow forecasts and the strength of the borrower’s balance sheet.
Function; In most cases, a cash pool leader performs no more than a coordination or agency function and, hence, it would be entitled to a service like remuneration. Only when the cash pool leader performs additional functions, controls and bears the financial risks contractually allocated to it, particularly credit, liquidity and FX risk, and has the financial capacity to bear those risks, a risk related return would be appropriate.
Finally, the remuneration of the cash pool participants should be calculated through the determination of the arm’s length borrowing and deposit rates within the cash pool, which should ideally allocate the synergy benefits arising from the cash pool arrangement among the pool members.
Credit rating determinations.
Particular considerations should be borne in mind when determining a credit rating for a specific MNE within an MNE group for the purpose of assessing controlled transactions. Where an MNE has a publicly available credit rating published by an independent credit rating agency, that rating may be informative for an arm’s length analysis of the MNE’s controlled financing transactions.
However, in most cases, publicly available credit ratings are only available for the MNE group. An approach often used for a specific MNE is to apply quantitative and qualitative analyses of the individual characteristics of the MNE using publicly available financial tools or independent credit rating agencies’ methodologies to seek to replicate the process used to determine the credit rating of the MNE group. This approach also involves taking into account improvements in creditworthiness that the specific MNE would be assumed to receive as a result of being part of the MNE group.
Cash pooling is an outstanding instrument to achieve more effective liquidity management. Nevertheless, it is important to properly structure the pool (and to document its particulars) in a way that mitigates risk of examination by the relevant tax authorities. In this respect, it is important to review the following:
Structural balances.
Also called perpetual or long-term. Requalification can occur when liquidity arrangements that are treated and valued as short-term (i.e. a pool of cash) remain outstanding (or appear to be) for a longer term. This can happen unintentionally and can even be caused by transfer pricing applied to other business-to-business transactions, for example when a cash-generating (profitable) entity gradually increases its excess cash on deposit in the cash pool which, over time, could have been in circulation for longer-term, while being remunerated at a short-term rate. This could be challenged and potentially such a position could be reclassified as a long-term financial instrument and priced accordingly. Before reaching such a conclusion, however, details are needed on how these positions have evolved as well as the business rationale for holding cash or cash over a number of years. In general, 12 months is considered the boundary between the short and the long term.
Re-evaluation.
The borrowing and deposit rates applied within the cash pool should be subject to a regular update to take into account market prices. In practice, the use of floating rate notes might capture market developments, albeit that interest spreads applied do need to be periodically re-set. Any changes in the facts and circumstances of the cash pooling arrangement require a re-evaluation of the cash pooling intra-group arrangement as a whole.
Delineation: The role of the cash pool leader can range from a service provider (starting premise) to an inhouse bank. Accurate delineation of the cash pool leader’s role is crucial in determining the arm’s length return it is entitled to (which might range from a service like return to the interest spread achieved). If a risk related return is considered, this requires a detailed functional and risk analysis to support said higher remuneration.
Guarantees.
In today’s market, collateral is a common element of cash pooling arrangements. Given the complexity of dealing with guarantees, it is important that the tax, treasury, accounting and legal departments of multinational groups regularly align and review intercompany financing structures, identify and monitor whether and by which entity a guarantee is provided, and conclude on the arm’s length nature including whether the security provided would be compensable for transfer pricing purposes. Guarantees can be distinguished in different ways, mainly depending on their nature, characteristics and purpose. Warranties can be very specific or very broad. In the context of intergroup guarantees, the most common are the following:
Cross guarantee.
Two or more related companies guarantee the obligations of the other. This mechanism secures the banking arrangement and by nature benefits all the entities of the multinational group that participate in the pool. As such, it is common practice for the parent company of the multinational to charge a guarantee fee to the other group entities participating in the pool.
When such a guarantee is identified, it is prudent to assess its transfer pricing implications and understand whether an arm’s length guarantee fee might be due. The OECD has clarified that only formal written guarantees that constitute a legally binding commitment on the part of the guarantor to assume a specific obligation of the secured debtor are relevant for transfer pricing purposes. The analysis therefore starts from a careful examination of the guarantee provided and the legal agreements relating to it.
A careful assessment of the rationale behind the guarantee, the reason it is provided, the economic impact of such guarantee on the related financing transaction and the parties involved are all relevant to the analysis of the guarantee. In general, there are several business motivations for providing financial security. For example, if a guarantee results in an economic or commercial advantage for the borrower, an arm’s length guarantee fee may be reimbursed. However, if the guarantee leads to an increase in borrowing capacity or allows the borrower to tap borrowing capacity that would otherwise not be available without the guarantee (on a stand-alone basis), the OECD proposes to re-qualify the additional capacity by means of a loan to the guarantor, followed by a contribution from the guarantor to the guarantor. The guarantee fee should then apply only to the part precisely defined as debt. From there, the focus is on confirming that the warranty fee reflects an arm’s length price. An arm’s length guarantee fee may be determined using the various methodologies offered under applicable transfer pricing regulations (e.g., comparable uncontrolled price (CUP), yield approach, or cost approach). Once the methodology has been selected, a benchmarking analysis should be performed to determine the correct price for the guarantee fee.
Conclusion.
The OECD transfer pricing guidance on financial transactions provides taxpayers and authorities with a roadmap for establishing and examining transfer pricing policies with respect to cash pooling. Proper documentation, updates and management of a transfer pricing policy for cash pool structures is therefore strongly advisable. While this documentation exercise requires attention, it does allow the MNE to benefit from the many efficiencies created by a cash pooling arrangement while simultaneously mitigating tax risk.
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Featured image: The China Central Television Headquarters in Beijing. (Photo Norbert Braspenning)
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