Transfer pricing of intra-group financing
Intra-group financial transactions are an essential part of the operations of international companies. From the perspective of transfer pricing, it is important to ascertain that the contractual terms of intra-group finance transactions are similar to those would apply between independent, unassociated companies and that the revenues received by the participating group companies are similar to those that unassociated companies would receive. The OECD’s transfer pricing guide – chapter 10 discussing intra-group finance contains guidelines and instruction on the subject of appropriate transfer pricing.
In intra-group financial transactions, the related transfer pricing issues can involve a broad range of different sectors. Such items as loans, guarantees, collateral, intercompany cash poolings and different types of hedging instruments are typical intra-group financing arrangements. In addition to the above, the OECD’s guidance also offers an in-depth discussion of the transfer pricing related to insurance arrangements based on captive insurance by MNE groups.
The essential requirement in financing is that the group companies that take the role of lenders get an arm's length return on the money they lend out, and that the borrower companies make interest payments that are arm’s length.
Some financing sectors have special characteristics that play a role when arm's length prices are determined. The following tax.fi pages deal with some of the frequently occurring transfer pricing issues:
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 we evaluate whether the arm’s length principle has been adhered to, we take account of the full facts and circumstances of all participating subsidiaries and other group entities. From the lender’s perspective, this may mean that the borrower company’s creditworthiness, solvency and future prospects are examined in greater detail. It can also mean that the borrower’s perspective should be evaluated by looking into the borrowed amount’s purpose of use.
Because there are differences between the financial instruments available in the market, the pricing of products or services may vary greatly. Not only the business transaction at hand (e.g. its contractual terms, the business interests that are involved), but also other factors have impact on pricing; these factors include the line of business, varying economic cycles, and government regulatory activity. After conducting an analysis of the group’s business, and after identifying the business transactions adequately, there must 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.
The group’s consolidated finance function
MNE groups often have a centralized finance department that obtains financing for the needs of the group’s business, identifies financial risks, evaluates the risks, etc. Typically, group finance also makes the necessary arrangements: it manages the group’s shared “intercompany” account, it oversees the loans to be issued between group entities, etc.
In conclusion, the role of the finance function may be quite significant. The way a particular MNE group has organised its finance may vary. This is affected by factors like group structure, lines of business, and others. There are MNE groups with a centralised finance function and others with a less centralised one. Importance is attached to proper identification of the business transactions and the full facts and circumstances when the transfer pricing of intra-group financial services is under our review. From this, it follows that it is not enough that merely the “finance function” name is used for identifying a certain activity.
To evaluate pricing, we must know how to identify the real transactions that take place. In addition, the risks to which the financial-services company is exposed to must be identified correctly. After we have analysed the case, we can make conclusions as to the proper arm’s-length level of compensation for the services rendered. Depending on the situation, pricing can be based on the financial-services company’s service offerings – 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 financial-services company has taken.
Other issues to be considered in the transfer pricing of financing
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 subsidiary as a separate entity. This means that each group company is considered as a separate actor, independent of the group. However, if we are reviewing the issue of creditworthiness, all member companies of an MNE group are affected by the fact that they are group members, i.e. by the “implied support” they receive from the MNE group.
From the lender’s perspective, the credit rating of a group member company can improve by virtue of the implied support. In this case, the results of an analysis would indicate that such a group member company, if it were to default on its debt repayments, would receive backing from the remaining MNE group members even if no legal guarantee commitment is made.
Written agreements and analyses of comparable contracts
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 paid price with the prices of comparable business transactions between unrelated parties. Suitable business transactions in this regard are loan contracts. For this purpose, whenever we prepare comparisons to work with various analyses or when we conduct searches for comparables, they must focus on updated data. This approach is similar to what unassociated parties would do, because they would also rely on updated data from the market when they determine their pricing.
For more information, see the OECD’s Transfer Pricing Guidance on Financial Transactions.