S&P Global Market Intelligence: Intercompany financing - Ernest Breitschwerdt
With its latest release, the OECD delivered more guidance on economic substance and value creation with a proposed comprehensive, coherent and coordinated reform of the international tax system. Ernest Breitschwerdt, senior business development specialist at S&P Global Market Intelligence, discusses how some of these action points are also directly or indirectly affecting intragroup financing transactions.
From an immediate-impact perspective, the revised Action Points 8-10 ('Aligning Transfer Pricing Outcomes with Value Creation') from the OECD will have the strongest influence on the structure and set up of intercompany financing going forward. The general objective is to create outcomes in line with value creation and risk allocation. This shall be achieved by an accurate delineation of the transaction, putting the focus on actual contributions rather than contractual arrangements; for example, substance over form. The guidance authorises tax authorities to disregard transactions that actually lack commercial rationale.
Beyond the potential for wide interpretation of function versus control and allocation of risk in general, company-specific structures might further complicate the alignment of contractual obligations with economic reality. In today's environment, many multinational enterprises (MNEs) have created entities only focusing on financing activities. In addition to the provision of simple and complex group loans, these services might include the provision of explicit guarantees or cash-pooling activities. Adding a complex non-local matrix management structure on top might make the actual allocation and determination of value creation, as well as risk taking and risk control at these entities, debatable. Accordingly 'cash box' entities, which are not performing relevant economic activities, shall be entitled to retain no more than a risk-free return on intercompany financing. Given the far-reaching consequences and their potential for interpretation, it is important to monitor the approaches tax authorities are following while applying this guidance locally. While most OECD Actions are designed to achieve coherence for government agencies, Action Points 8-10 could actually lead to less coherence in the short to medium term, at least.
BEPS and the reality
If the rules that are in line with the new BEPS Action Points are adopted in local law - and some are already - they will have a significant impact on intercompany financing (transfer pricing). Not least due to court rulings - a lot of uncertainty still prevails.
For instance, previous court cases have confirmed the concept of an 'implicit credit support' provided by the parent company but simultaneously avoided being too specific with regard to an analytical framework. Additionally, very high, though potentially unrealistic, standards of price comparability were applied at the Chevron Australia Holdings court case were all benchmark loan agreements were basically rejected due to different reasons of incomparability.
Due to the lack of directly comparable loan market information, in many cases secondary corporate bond market aggregates - specific to tenors, industries, currencies and credit risk - have been leveraged by transfer pricing practitioners to ground their analysis on a defendable, transparent and daily available market source. Best practices to adjust these senior unsecured benchmark rates to reflect certain financing conditions (for example, collateralisations, optionality) are emerging.
Questions about the capitalisation structure as well as the ability to service its intercompany financing debt obligations are already regulated by 'thin capitalisation' rules in various countries. Nevertheless, the prevailing weak economic environment has potentially eroded the profitability of some MNEs and consequently their perceived ability to service its current debt obligations. A weaker debt capital structure following further refinancing rounds is a logical consequence. Therefore, transfer pricing practitioners should not only analyse new intercompany financing agreements but should also review their existing debt positions. These highly leveraged entities might require a reset in terms of levels and conditions of these transactions.
The bottom line
The mixture of regulatory uncertainty coupled with missing clear guidance; different best practices across tax jurisdictions; different levels of sophistication of tax authorities; different analytical approaches coupled with limited unrelated transaction information as well as case law decisions makes transfer pricing, especially - but not limited to - intercompany financing-related; present a challenging field of work for all practitioners.
The bottom line is that tax authorities, corporates and auditors alike are looking for common ground that is consistent and transparent when creating arm's length intercompany loan pricing. The sole purpose of that is to avoid cherry picking or inconsistent approaches, which can lead to debatable pricing strategies. There is no perfect framework or one model fits all as in many other tax discussions, but a well-documented, clear and transparent internal transfer pricing policy at the corporate level can go a long way in avoiding any reasonable doubts from any tax authority in the world.