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New OECD Guidance on transfer pricing aspects of financial transactions and main take-aways for Luxembourg

On 11 February 2020, the Organisation for Economic Co-operation and Development (“OECD”) published the “Transfer Pricing Guidance on Financial Transactions” (the “Report”). 

The Report offers further guidance in relation to Base Erosion and Profit Shifting (“BEPS”) Action 4 and Actions 8-10. Its main purpose is to clarify the application of the principles included in the 2017 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD TPG”), in particular the accurate delineation analysis under Chapter I to financial transactions, and provide some information relating to the pricing of financial transactions and more precisely of loans, cash pooling, hedging, guarantees and captive insurance. A new Chapter X will be included in the OECD TPG.

This Report is the outcome of two years of intense debate over the treatment of the main types of financial intra-group transactions. Initial guidance on the topic – on which there was no consensus – was published in July 2018. The Report finally offers a common view on the treatment of certain financial transactions.

1. Key aspects of the report relating to the transfer pricing aspects of intra-group loans

A large part of the Report focuses on the transfer pricing aspects of intra-group loans.

1.1. Focus on the accurate delineation of the transaction

The Report first provides guidance on how to accurately delineate an intra-group financial transaction. The OECD TPG already contains some guidance on the delineation of a transaction (section D.1 of Chapter of the OECD TPG), but this is not specific to financial transactions.

(a) Debt qualification of the instrument, or when can a loan be considered a loan for tax purposes?

A transaction needs to be delineated in order to determine whether a prima facie loan can be regarded as a loan for tax purposes or whether it should be considered as some other kind of payment, such as a contribution to equity capital.

The typical scenario is an advance of funds (in the form, for instance, of a loan with a principal amount of EUR500 million and a maturity of 10 years) by a company to a related party. Based on financial projections, it is clear that the borrower will not be able to service that loan for such amount within the 10 year-maturity. In similar circumstances, would an unrelated party be willing to provide a loan with such terms and conditions? Probably not.

It is therefore key to determine the maximum amount that an unrelated lender would have been prepared to advance and the maximum amount that an unrelated borrower in comparable circumstances would have been willing to borrow. In other words, the analysis should be performed from both perspectives: borrower and lender and their respective options realistically available (“ORAs”).

The Report lists the following characteristics as economically relevant for delineating an advance of funds:

  • the presence or absence of a fixed repayment date
  • the obligation to pay interest
  • the right to enforce payment of principal and interest
  • the status of the funder in comparison to regular corporate creditors
  • the existence of financial covenants and security
  • the source of interest payments
  • the ability of the recipient of the funds to obtain loans from unrelated lending institutions
  • the extent to which the advance is used to acquire capital assets
  • the risk that the debtor does not repay on due date or seeks a postponement.

On that basis, tax authorities could conclude that the purported intra-group loan is not structured in an arm’s length manner and should in fact be regarded as a different financial instrument, which could possibly lead to a reclassification as equity with consequences in terms of taxation and withholding tax.

Finally, the Report helpfully clarifies that this guidance should not prevent countries from implementing in their domestic legislation other approaches to address debt and equity funding and interest deductibility.

(b) Identification of the commercial or financial relations

The accurate delineation of the financial transaction, as for any other intra-group transaction, starts with the identification of the economically relevant characteristics of the transaction, which includes an examination of:

  • the contractual terms of the transaction: this includes an analysis of the written agreements, and, in line with the principle of substance over form, the actual behaviour of the parties prevails if it differs from what has been put in writing. For instance, in the case of an intra-group unsecured loan, it should be checked whether assets are available to serve as collateral for the loan as this could have an impact on pricing.
  • the functions performed, assets used and risks borne: in addition to the functions and risks that are typically expected in the context of an intra-group financial transaction, the Report stresses that a lender must have control over the risks associated with the advance of funds and needs to have the financial capacity to assume these risks
  • the characteristics of the financial instruments: these may include the loan amount, maturity, schedule of repayment, nature or purpose of the loan, level of seniority and subordination, geographical location of the borrower, currency, collateral, fixed or floating interest rate
  • the economic circumstances of the parties and of the market: markets in which the uncontrolled transactions take place should be comparable to the market of the controlled transaction. In that respect, particular care should be given to currency differences and geographic location (due to specific regulations such as interest rate controls, exchange rates controls, etc., which could impact the pricing); and
  • the business strategies pursued by the parties: as different business strategies can have an effect on the terms and conditions of the financial transaction, these must also be examined. For instance, working capital requirements will not be financed in the same way as the acquisition of a company. 

The accurate delineation of financial transactions also requires an analysis of the factors affecting the performance of businesses in the industry sector in which the group operates. Thus, a greater emphasis is put on the industry of the borrowing company.

The comparability analysis will then enable the identification of financial transactions between independent parties, which should match as closely as possible the tested transaction. In line with the OECD TPG, the Report further confirms that comparability adjustments can be performed if required to improve the reliability of the comparables.

1.2. Pricing of intra-group debt

The Report also provides guidance for determining whether the interest rate provided for in the loan agreement is an arm’s length rate. 

(a) Lender’s and borrower’s perspectives

Again, the Report stresses the fact that the analysis should be performed both from the lender’s and the borrower’s perspectives:

  • On the lender’s side, the decision to grant the loan, how much and on what terms, involves the evaluation of various factors relating to the relevant borrower, in particular the credit assessment of the borrower, and the lender’s ORAs for the use of the funds.
  • On the borrower’s side, ORAs will have to be considered as well (e.g. a bank loan instead of an intra-group loan) as an independent borrower would in principle seek the most cost-effective solution.

Fortunately, the Report acknowledges that in the context of an intra-group financing, the parties would not necessarily go through the exact same process as independent parties when analysing the risks associated with the grant of a loan.

(b) Determination of the credit rating

The OECD defines the credit rating as “an opinion about a company’s general creditworthiness”, which is a combination of quantitative and qualitative factors. It is intended to reflect a company’s capacity to meet its financial obligations in accordance with the terms of those obligations. The credit rating is a useful measure for identifying potential comparables when determining what would constitute arm’s length interest.

The credit rating can be determined by reference to the overall creditworthiness of the group or on a stand-alone basis (i.e. at the level of a single group entity).

For credit ratings determined on a stand-alone basis, interestingly the Report considers the use of publicly available financial tools or methodologies as not always sufficiently reliable due to a “lack of clarity” as to what these processes actually involve when compared to the assessment by independent credit rating agencies.

(c) Effect of group membership

The Report acknowledges that the implicit support from the borrower’s group may affect the credit rating of a borrower, resulting in possible adjustments to the stand-alone credit rating of the borrower.

(d) Use of group credit rating

It should not be assumed that the group rating applies de facto to the borrower unless the borrower is an important asset of the group. Thus, preference seems to be given to a stand-alone approach.

(e) Covenants

Covenants enable the limitation of risks in a given financial transaction. In an intra-group transaction there is less asymmetry between entities than in a transaction between unrelated parties. As a consequence, intra-group lenders may choose not to have covenants in loans to associated enterprises.

According to the Report, it would nevertheless be appropriate to consider whether there is, in practice, the equivalent of a maintenance covenant between the parties and its impact on the pricing of the loan.

(f) Guarantees

Guarantees provided by a group company can also impact the pricing of the loan and could be subject to a guarantee fee.

(g) Determination of the arm’s length interest of intra-group loans

Unsurprisingly, the Report confirms that the CUP method would generally be considered as the most appropriate approach in the context of intra-group loans, not least due to the large public data available on such transactions. Even if the arm’s length interest rate for a tested loan can be benchmarked against publicly available data for other borrowers with the same credit rating and with loans having similar features, it has first to be checked whether an internal comparable is available (the internal comparable does not necessarily need to be at the level of the lender or the borrower).

Interestingly, the Report rejects the use of bank opinions as providing evidence of arm’s length terms and conditions.

1.3. Risk-free rate of return in cases where there is no control over the risk

The Report states that if a lender lacks the capability or does not perform decision-making functions to control the risk associated with investing in a financial asset, it is not entitled to earn more than a risk-free return. The difference between the risk-free return and the arm’s length interest would be allocated to the entity that actually performs these functions and bears these risks. Borrowers in such cases would still be able to deduct the full amount of arm’s length interest expenses.

2. Other financial intra-group transactions

The Report also provides guidance on other types of financial transactions such as cash pooling, hedging, financial guarantees or captive insurance.

2.1. Cash pooling

Two types of cash pool arrangements can be distinguished: (i) physical, i.e. the actual transfer of funds, and (ii) notional, i.e. the bank involved settles the accounts without cash pool participants transferring funds.

Cash pooling arrangements are usually implemented by groups to ensure efficient cash management and cost efficiency. Thus, according to the Report, for the determination of the arm’s length remuneration it is necessary to identify:

 the nature of the advantage or disadvantage

 the amount of the benefit provided

 how that benefit should be divided among members of the group

 the control and capacity related to the risks, such as the liquidity risk and credit risk.

The remuneration for the cash pool leader’s activities depends on the type of cash pooling arrangement and the activities performed. For instance, the performance of a coordination or agency function will generally be rewarded with a limited remuneration. An internal CUP may be available for the cash pool members (i.e. banking arrangement between the bank and the cash pool leader), subject to relevant adjustments.

2.2. Hedging

Hedging arrangements are a means of transferring risk within the group by mitigating exposure to certain risks, such as foreign exchange or commodity price movements.

In the context of international groups, the risk mitigation strategy, such as hedging, is often centralised. As such, a hedging contract provided by one group member to other members may be seen as a service, which should be remunerated at arm’s length.

2.3. Financial guarantees

There is a wide spectrum of financial guarantees which can be provided by one group company to another, ranging from the implied support stemming from mere membership in the group (passive association) to the formal written guarantee.

The existence of a guarantee may affect the terms and conditions of the borrowing as the borrower may obtain better terms or borrow a more important amount. Thus, it is important to analyse all the facts and circumstances relevant to the provision of the financial guarantee and in particular, to determine whether the guarantee does in fact reduce the cost of the debt funding for the borrower, in which case the borrower should pay for such a guarantee.

The Report provides further guidance on how to properly delineate the transaction and to determine the arm’s length price of a guarantee.This may turn out to be a complex exercise as it is necessary to determine the impact of the guarantee on the loan amount and on the interest rate, and take into account any implicit support resulting from the group membership.

The Report acknowledges that the CUP method will often not be applicable and mentions several other approaches such as the yield approach, the cost approach, the valuation of expected loss approach and the capital support method.

2.4. Captive insurance

The Report finally provides guidance on the transfer pricing aspects in cases where a multinational group has chosen to consolidate certain risks through a “captive” insurance scheme.

3. Main take-aways for Luxembourg

The Report seeks to clarify certain transfer pricing aspects relating to financial transactions to reduce the risk of double taxation for the taxpayers. However, when comparing the Report to the first draft published by the OECD a couple of years ago, the differences seem rather limited. The Report still leaves a number of questions unanswered, and some points are subject to interpretation by the taxpayers and the tax authorities, which could in fact lead to even more challenges and disputes.

However, one thing is already clear, the Report increases the compliance burden on taxpayers. The Report does not set out de minimis thresholds for which financial intra-group transactions need to be documented, but in this regard we can rely on the general principles of the OECD TPG according to which taxpayers should not be expected to incur disproportionately high costs and burdens in producing documentation[1] . In other words, the documentation efforts should be proportionate to the facts and circumstances.

Luxembourg has already included the comparability analysis in its domestic legislation (article 56bis of the Luxembourg Income Tax Law). The new guidance simply provides further clarification as to how this applies in the context of financial transactions. Therefore, in practice, no big changes are expected for the comparability analysis.

However, a more detailed approach will be required for other aspects and in particular in light of the risk of the characterisation of debt into equity. Thus, going forward, the transfer pricing analysis of financial activities would have to include, for instance, a cash flow study demonstrating the borrower’s ability to repay the loan, explanations of the terms and conditions of the loan and a discussion of the ORAs from a lender’s and borrower’s perspective.

In Luxembourg, the OECD TPG are usually considered soft law, but the tax authorities are likely to apply this guidance in the future. For instance, the Luxembourg tax authorities have already started to requalify any excess interest as a hidden dividend distribution[2] with the application of a 15% withholding tax. The Luxembourg tax authorities are also increasingly focusing on debt-to-equity ratios, and one cannot exclude that, in the future, the quantum of the loans would be challenged as well, under the new framework included in the Report.

The Report places emphasis as well on the importance of control over the risks relating to a financial transaction and the company’s (financial) ability to assume such risks. This type of analysis is already included in the Circular L.I.R.56/1 – 56 bis/1 dated 27 December 2016 issued by the Luxembourg tax authorities on the tax treatment of companies carrying out intra-group financing transactions applicable since 1 January 2017 (“Circular”) so that the impact should again be rather limited.

Finally, the Report criticizes the use of publicly available financial tools for the determination of credit risk. It is true that such tools are largely used in Luxembourg for the determination of the expected loss (or equity at risk) in the context of the intra-group financing activities within the scope of the Circular. Therefore, we suggest contemplating corroborative approaches whenever possible to mitigate any risk relating to the use of such tools. 



  1. TPG, §5.28
  2. Court of Appeal, 17 July 2019, 42043C



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