In the first series of TP Insights, we focused on Reacting to the COVID-19 pandemic. During this time, companies were primarily focused on survival - dealing with immediate issues such as cash flow, liquidity management, and related intra-group transactions.
With this Insight, we move to the Resilience phase, when companies consider how to maintain business continuity and ride the wave of COVID-19 challenges by improving efficiencies where possible and minimizing costs where practicable. The variety of issues is vast and includes addressing increased finance-related costs, fluctuating general commercial costs, the potential need to restructure supply chains, and a myriad of other business issues. This Insight specifically addresses the transfer pricing challenges of COVID-19-related financial transactions which/that may not have been a part of a company’s prior intercompany landscape. Future Insights will examine other medium-term issues.
Intra-group financial transactions quickly became a crucial tool in managing liquidity during the first phase of the COVID-19 pandemic. Now, financing transactions are expected to come under increasing scrutiny by tax authorities due both to an increasing level of unilateral legislation and to the relatively new, specific OECD guidance on financial transactions. Can the new guidance help companies deal with the business and economic effects of COVID-19 in the medium term, or does it merely increase administrative compliance burdens?
While companies may have entered into intragroup transactions broadly comparable to unrelated party transactions observed in the market during the initial phase of the crisis, relatively few resources may have been available to structure or document those intragroup transactions completely consistently with tax authority guidance. As rapid and unforeseen changes in the economic environment occurred during the early stages of COVID-19, there was an increased need for quick access to funding, mainly driven by liquidity pressures. In the context of cross border arrangements, this translated into an increased level of intragroup funding being accessed, and the rise in demand for parental or cross-guarantees on third-party lending in industries most impacted by the crisis.
It seems ironic that right in this moment, long expected guidance on transfer pricing aspects of financial transactions was published by the OECD on 11 February 2020 (‘OECD guidance’). This guidance is a big breakthrough in the transfer pricing world, as it is the first time that specific guidance on the transfer pricing aspects of financial transactions (related-party loans, treasury functions, cash pooling, hedging, guarantees and captive insurance) will be included in the OECD Transfer Pricing Guidelines. Click here for a summary of the new guidance on financial transactions.
Is it possible to deal to immediate COVID-19 challenges by making financing available to entities in need but at the same time meet the stricter compliance requirements? Below, we discuss medium-term actions that groups can take in response to COVID and how the OECD guidance should be considered in this respect.
Accurate delineation of the transaction
The OECD Guidance addresses how financial transactions, including the capital structure of an entity itself within a multinational group, should be analyzed. The OECD guidance generally puts emphasis on the fact that both the lender’s and the borrower’s perspective should be considered when analyzing the arm’s-length character of financial transactions. Since management and Boards face decision points at quarter and year ends and the preparation of financial statements, timely analysis will be key in the medium term to document the nexus between balance sheet items, the impact of COVID-19 on the company’s financial position, and a company’s tax position. With respect to transfer pricing documentation, tax authorities generally still expect taxpayers to timely meet their annual contemporaneous documentation compliance requirements, including those related to financial transactions, despite the challenges being faced as a result of COVID-19.
Related party loans
The current crisis and the increase in risk aversion in financial markets can have a significant impact on intragroup financing. Challenges and questions are arising from these developments. Questions include how to establish an arm’s length interest rate in the current economy, with its abundance of government support and seemingly cheap debt. Should companies take the current situation into account when determining lending policies? And should interest rates on existing intercompany loans be reviewed and amended?
Prevailing interest rates can change significantly over a relatively short period of time due to market perception of risk. When group entities struggle to meet their payment obligations on intercompany loans, it may be defensible to renegotiate the terms, for example, agreeing to temporary delay interest payments and / or postpone repayments. It is imperative to find market examples or comparables to document that this has also occurred in similar circumstances (comparability analysis). Documentation is required regarding the changes in terms and the options realistically available, commercial rationale and market perspectives.
Explicit intragroup guarantees could also be a useful tool during the current crisis. Explicit support could help parties obtain larger loans or gain access to more favorable terms. When a guarantee provides a benefit, an arm’s length guarantee fee should be paid to the guarantor. The OECD guidance outlines several different methods with which guarantee fees can be priced. It must be noted here that not every country allows for a guarantee fee to be deductible and that careful analysis is required to reach a balanced approach.
Intragroup financing policies rely on historical credit ratings. The current pandemic may lead to widespread changes to credit ratings, and we have already witnessed that it affected the credit outlook of certain countries. Reconsidering a group or entity’s credit rating in the light of the current economic conditions could impact the arm’s length interest rate. The OECD guidance has a significant focus of the importance of appropriately documenting the reasons behind selected credit ratings. Also, the OECD also provides guidance on how implicit support of group members may impact the credit rating to be applied (stand-alone or group credit rating).
Cash pooling is an efficient way of managing cash within a group. Especially during the current crisis, this could be a means for moving cash between group entities. For a cash pool to be implemented and priced, the cash pool transactions and the functions of the cash pool leader need to be accurately defined and delineated. The arm's length remuneration of a cash pool leader depends on the facts and circumstances and should be decided on a case-by-case basis. While establishing a formal cash pool is time and cost-intensive, a quick response to the pandemic crisis and liquidity issues may be a temporary framework agreement within a group of companies that sets certain terms and conditions at which group members may obtain access to intragroup funds. The terms and conditions should consider the new OECD guidance. More comprehensive documentation may be prepared some months down the road when the economic storm has moderated.
Interaction with other areas of tax
In addition to transfer pricing, many jurisdictions now use prescriptive (and often mechanical) tax rules reflecting BEPS Action 4, such as the interest limitation rules tied to local profitability that have appeared in many jurisdictions. These can potentially give rise to situations where a lender in one country will be taxed on arm’s length interest income but, due to a mechanical limit, the related-party borrower in another country will not be able to deduct the associated interest expense. Therefore, a holistic approach to the analysis of the characterization and pricing of financing transactions is critical to preserve overall group profitability.
The new OECD guidance on transfer pricing for financial transactions acknowledges that different views on the topics are possible. We expect that this new guidance will apply to both new and current intercompany financial transactions and will increase the focus of tax authorities globally on these transactions. Therefore, we recommend reviewing current intragroup financing positions both as a result of the COVID-19 disruption and in light of OECD guidance.
We are, unfortunately, still in the middle of this crisis and some businesses still need to make ad-hoc financing decisions. Those companies are advised to keep their administrative and documentation efforts to a minimum but structure their intra-group transactions with the new OECD guidance in mind and with the ability to formalize their structures and documentation when required to do so under OECD and local guidance.
For other companies, now is the time to revisit intragroup policies on financial transactions in light of this new guidance and to carry out risk mitigation initiatives. These companies should document the impact of COVID-19 on their balance sheets and profit and loss statements, explain whether variances are the result of COVID-19 or other events, document governance decisions, support assumptions used for valuation purposes and document all actions, including write-down decisions.
While it is a statutory requirement to create and maintain records in relation to the arm’s-length character of a company’s intra-group transactions, tax authorities should consider easing the compliance burden. (This intention has already been announced by some countries.) In situations where the use of certain measures is not contentious, or is widely accepted and understood, less extensive comparables analysis should be permitted. Tax authorities are generally open to proactive discussion around certain issues and may provide guidance on their view on whether an intra-group arrangement would be high or low risk. In some cases, such consultation can take place on a no-name basis.
For more information visit our Global Transfer Pricing webpage or get in touch with one of the team directly.
 Government support measures related to COVID-19 need to be considered and whether changes with respect to transfer pricing policies would have an impact on subsidies received.
 This may vary per country.