The OECD’s Transfer Pricing Guidelines have been amended.

How to apply the arm’s length principle to financial transactions

As was already written in an earlier issue of our newsletter, in 2020 the OECD amended its Transfer Pricing Guidelines with guidance on the intra-group financial transactions. In our present newsletter we would like to highlight the essential points of applying the arm’s length principle to financial transactions. 

• A loan or a contribution to equity capital?

In the case of related party transactions, it is often arguable whether an intra-group financing should be regarded, wholly or partially, as a loan or a contribution to equity capital. Depending on that are the interest deductibility and the profits accruing in a given country. The OECD Guidelines do not intend to prevent countries from implementing approaches to address this problem, but at the same time they set out that financial transactions should not be examined based on particular labels or descriptions assigned to them, but each transaction should be qualified based on its own characteristics. Therefore, it is recommended to examine the presence or absence of a fixed repayment date; the obligation to pay interest; the right to enforce payment of principal and interest; the existence of financial covenants and security; the source of interest payments; the failure of the purported debtor to repay on the due date or to seek a postponement etc.

• Identifying the commercial or financial relations

It is required to analyse the industry sector factors affecting the performance of the MNE group (e.g. the particular point of an economic, business or product cycle, what amounts and types of financing may be necessary to a business operating in that particular industry etc.) and understand how the MNE group responds to those identified factors (e.g. how it prioritises the funding needs among different projects; whether a specific credit rating or debt-equity ratio are targeted etc).

Independent enterprises, when considering whether to enter into a particular financial transaction, will only enter into it if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives. If we examine the position of the parties from this perspective, it is more likely that potential comparables will differ from the tested transaction. In such cases it will be necessary to consider whether such differences will have a material impact on the price. If so, it may be necessary to make adjustments.

The economically relevant characteristics of actual financial transactions and specific related issues which the OECD guidance provides recommendations for, are the following:

Contractual terms:

• may be missing or inconsistent with the actual conduct of the parties or other facts and circumstances;

Functional analysis:

• an associated lender does not necessarily perform ongoing monitoring and periodic review of the loan, or not at the same intensity as an independent lender;
• the lender is not exercising control over the risks associated to an advance of funds, or does not have the financial capacity to assume the risks;

Characteristics of financial instruments:

• as there is a wide variety of financial instruments with very different features and attributes, which may substantially affect the pricing;

Economic circumstances:

• currencies, geographic locations, local regulations, the business sector of the borrower and the timing of the transaction;
• macroeconomic trends (central bank lending rates or interbank reference rates) and financial market events (e.g. a credit crisis);

Business strategies:

• independent lenders may be prepared to lend on terms and conditions to a borrower undertaking a merger or acquisition which might otherwise not be acceptable to the lender for the same business if it were in a steady state; effectively the business plans of the borrower are being factored in;
• particular transactions are not in line with the MNE group’s financing policy and demonstrated practice (e.g. a 10-year loan is granted to a group member company for short-term working capital purposes, where the MNE group normally uses one-year revolving loans to manage such financing needs). 

It is important that companies review their transfer pricing policy and align it with the issued guidance, which may also substantially affect their intra-group financing policy. A review of the transfer pricing documentation of the financial transactions that has been prepared earlier is also indispensable

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The transfer pricing specialists of VGD Hungary constantly monitor the latest developments and provide effective assistance in the appropriate documenting of the financial transactions and preparation of transfer pricing documentation.

Should you have any questions regarding this newsletter, the tax experts of VGD Hungary will be pleased to assist you.