5 minute read 15 Apr 2020
New OECD report on Financial Transactions, tax controversy in the new decade?

New OECD report on Financial Transactions, tax controversy in the new decade?

By Nicolas Gillet

EY Luxembourg Transfer Pricing Partner

Leader of one of the largest Transfer Pricing teams in Luxembourg. Passionate about ski and tennis.

5 minute read 15 Apr 2020

On 11 February 2020, the Organization for Economic Co-operation and Development (OECD) released its final report on transfer pricing guidance for financial transactions (the Report). 

he Report has been published as follow-up guidance to Base Erosion and Profit Shifting (BEPS) Action 4 and Actions 8-10. It aims to clarify how the principles included in the 2017 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG) should be applied, in particular, the accurate delineation analysis of financial transactions. The Report represents the first time that guidance on financial transactions has been included in the OECD TPG, which should contribute to consistency in the application of transfer pricing and help reduce transfer pricing disputes and double taxation.

The Report covers the accurate delineation of financial transactions with respect to the capital structures of multinational enterprises (MNEs). It also addresses specific issues related to the pricing of financial transactions such as treasury functions, intra-group loans, cash pooling, hedging, guarantees, and captive insurance.

We will focus on the main points of attention that are likely to drive tax controversy in the new decade.

Accurate delineation of transactions

To determine whether a loan should actually be regarded as a loan or rather as a capital contribution, the guidance elaborates on the relevance of the balance of debt and equity funding of an entity within an MNE. The guidance lends support to the notion that it is possible to determine what should be considered as an arm’s-length capital structure. Thus, the arrangements made in relation to a transaction, viewed in their totality, should not differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances.

The OECD report will likely put more emphasis on the amount of debt raised by Luxembourg entities, as well as the terms and conditions used in loan agreements, to ensure this commercial rationality test is met.

The economically relevant characteristics of financial transactions

Specific guidance in the context of financial transactions is provided for each of several economically relevant characteristics.

The Report states that in accurately delineating a specific financial transaction, a functional analysis is necessary and it provides an overview of the typical key functions performed by lenders and borrowers with respect to intra-group loans.

In the context of this overview, MNEs should evaluate whether the level of profit earned in a group entity from intra-group lending is in line with the people functions exercised in that entity to manage and control the financial risks. For example, a lending company that has no people to carry out these functions would be entitled to no more than a minimal remuneration (corresponding to a risk-free return); any additional return on lending would be allocable to the party exercising control over the investment risk.

Treasury functions

General principles

According to the new guidance, the treasury function is usually a support service to the main value-creating business operations. In other situations, the treasury function may be more complex and should be compensated accordingly. It is also recognized that treasury activities are closely linked to, and influenced by, the vision, strategy, and policies established by group management. As such, higher strategic decisions will usually be associated with policy-setting at the group level, rather than driven by the treasury function itself.

Hence, under the new OECD paper, a treasury company with limited substance and decision-making capability may be entitled to the equivalent of a risk-free return.

Intra-group loans

With regard to intra-group loans, a two-sided perspective (lender and borrower) should be considered when analyzing the commercial and financial relations as well as the economically relevant characteristics of intra-group financial transactions.

The Report acknowledges that the credit worthiness of the borrower is one of the main factors considered by independent lenders. In this respect, credit ratings are a useful measure of credit worthiness of a given borrower. The Report provides extensive guidance about both determining the stand-alone rating of group companies, and taking into account the benefit of group membership (“implicit support” or “halo effect”).

In some cases, the stand-alone credit rating of the borrower may prove to be better than the group rating. Therefore, the use of the group rating as a starting point and the application of a “notching down” approach does not always provide arm’s length results.

Companies should consider their group’s policies for determining credit ratings of subsidiaries in light of the Report and, in particular, consider the group’s view on its willingness and ability to support troubled group companies. Consequently, the use of the same group rating for all subsidiaries might not be appropriate. Ideally, the credit rating policy framework should be based on a combination of the “bottom-up” and “top-down” approaches, where both the stand-alone borrower’s rating and the group’s rating should be considered.

To manage the risk of multi-country controversy, transfer pricing documentation should be consistent throughout the group.

Cash pooling

The Report states that the accurate delineation of cash pooling arrangements needs to consider not only the facts and circumstances of the relevant balances, but also the context of the arrangements as a whole.

The appropriate reward of the cash pool leader will depend on the facts and circumstances, the functions performed, the assets used, and the risks assumed in facilitating a cash pooling arrangement. Where a cash pool leader performs no more than a coordination or agency function to meet a pre-determined target balance, its remuneration as a service provider should be in line with these routine functions.

The remuneration of cash pool members will be calculated according to arm’s-length interest rates applicable to the debit and credit positions within the pool.

All cash pool participants are expected to be better off than in the absence of the cash pool. Benefits for cash pool participants can take the form of enhanced interest rates to debit and credit positions, but also qualitative benefits such as access to a permanent source of financing, reduced exposure to banks, or access to liquidity that may not be available otherwise.

The Report infers a general expectation that cash pooling is a routine function that should receive a cost-plus based return. Cash pooling operations set-up as in-house banks, with high profits reported by the cash pool leader, are likely to be challenged and scrutinized and should therefore be thoroughly supported in documentation.

Financial guarantees

The accurate delineation of financial guarantees requires initial consideration of the economic benefit arising to the borrower beyond that derived from passive association, that is, through implicit support. Two types of economic benefit may arise, the first being a guarantee that enhances the borrower’s conditions. The pricing for such guarantees would follow the same principles and methodologies as described for loan pricing.

Secondly, there are guarantees that allow the borrower to increase its borrowing capacity and enhance its credit rating. In such cases, if a portion of the loan from the lender to the borrower is to be delineated as a loan to the guarantor followed by an equity contribution by the guarantor to the borrower, the guarantee fee is limited to a fee on the portion that has been accurately delineated as a loan.

In delineating such transactions, companies should assess if the intercompany guarantee can be considered as an intra-group service that justifies an arm’s length guarantee fee.

Overall, if the combination of the interest rate and any guarantee fee exceed an arm’s-length, all-in finance cost the deduction is likely to be challenged. The transaction and related fees are also likely to be challenged if the guarantor does not have the capacity to stand behind the guarantee. Moreover, it should be highlighted that the cost versus benefit of the guarantee needs to be adjusted for implicit support.

Captive insurance

The Report seeks to establish a threshold for determining whether the captive has assumed, and is capable of controlling, the insurance risk contractually transferred to it. The OECD TPG analysis of risk applies equally to an associated enterprise’s insurance and reinsurance business. Specifically, if certain underwriting functions are outsourced, special consideration is required to ensure the control functions can be allocated to the captive insurance. The Report further elaborates on the importance of risk diversification within the insurance business and describes various ways in which diversification can be realized. The guidance discusses a number of indicators, all or substantially all, of which would be met if the captive insurance was found to undertake a genuine insurance business, including diversification of risk. Lack of sufficient reserves may also indicate that the captive insurance is operating a business other than insurance.

The Report infers a general expectation that captives provide a routine function that should receive a routine return. In any case, it is recognized that fully-fledged substance exists when captives have sufficient functional and financial substance to control and assume relevant risks.

Remuneration of the captive insurance company that exclusively covers internal risks might be lower than when risk diversification is achieved by insuring external, non-group risks, or by reinsuring a significant proportion of the group’s risks outside of the group.


In summary, whilst the Report is a welcome clarification on the OECDs transfer pricing guidelines to date, it contains a number of principles that are in the process of being, if not already, implemented within OECD countries and that are unlikely to remain without controversy.

About this article

By Nicolas Gillet

EY Luxembourg Transfer Pricing Partner

Leader of one of the largest Transfer Pricing teams in Luxembourg. Passionate about ski and tennis.