This article was originally published 10 March 2020.
What is it all about?
The Australian Taxation Office (ATO) has in recent years issued a range of guidance concerning intragroup financing transactions and related issues following its win in the landmark transfer pricing case against Chevron. Meanwhile, international guidance from the Organisation for Economic Cooperation and Development (OECD) has been slower to materialise.
Now, more than 18 months after the publication of its non-consensus discussion draft on Financial Transactions (BEPS Actions 8 – 10), the OECD has released its ‘final’ report on the transfer pricing of financial transactions. The original draft contained some 25 areas of disagreement, representing a non-consensus position of the OECD’s Committee on Fiscal Affairs. While the guidance mostly resolves these areas, there are still some issues that have not been definitively addressed.
The guidance is significant because it is the first time the OECD Transfer Pricing Guidelines will be updated to cover the transfer pricing aspects of financial transactions. The guidance appears to have been in line with the general thinking of the ATO, and it addresses specific issues on:
- How the ‘accurate delineation’ of transactions advocated by the 2017 OECD Transfer Pricing Guidelines is to be applied to financial transactions (including to the capital structure of an entity itself within a multinational group)
- The effect of group membership on debt capacity and loan pricing, such as the value (if any) of formal guarantees and implicit support
- Standalone credit ratings of individual subsidiaries of a multinational group (and their impact)
- How to determine risk-free and risk-adjusted rates of return
- The transfer pricing of:
- Treasury functions
- Intra-group loans (including the fact that implicit guarantees from a group can and should be taken into account when pricing loans)
- Cash pooling
- Hedging
- Guarantees
- Captive insurance.
The application of the Australian transfer pricing rules generally follows the OECD guidelines where possible, so taxpayers with related party financial arrangements should take into account the new OECD guidance where relevant. We examine the impact of the newly published OECD guidance to Australian taxpayers in more detail below.
Good news, bad news
The OECD’s new guidance is designed to improve international consistency concerning the transfer pricing of financial transactions by promoting a set of common standards, thereby reducing the risk of double taxation. It should certainly reduce risk in many areas and is, therefore, to be welcomed.
Unfortunately, several countries have recently issued unilateral guidance or passed legislation in the area of financing, meaning inconsistencies between the OECD guidance and local approaches are highly possible.
The guidance is generally consistent with other OECD publications in a number of respects. For example, it highlights that taxpayers should consider the options realistically available to them when looking to enter into financing transactions, and sets the expectation that taxpayers would choose the option which best aligns with their commercial objectives. This language generally supports the application of Australia’s transfer pricing provisions, highlighting the need to consider the commerciality of the arrangement, alongside the pricing, so that an accurate delineation of the transactions can be performed.
While not explicitly focused on financial arrangements, it is relevant to note the ATO is also currently litigating a case against Glencore that has tested the ATO’s approach to reconstruction. The Federal Court decision (being appealed by the ATO) highlights that the threshold for the reconstruction of a transaction should be limited to exceptional circumstances. Regardless of the outcome, we expect the ATO will continue to seek to gain a holistic understanding of group treasury policies and funding arrangements, seeking to dig deeper to determine whether arrangements make sound commercial sense.
Still, there remain some contentious areas with scope for controversy between countries, leaving taxpayers with difficult choices to make regarding their approach to the pricing and structuring of financing transactions. In addition, following the new guidance will require a higher level of documentation and analysis than some groups might historically have expected. We address some of these challenges below.
Review of OECD and Australian guidance in detail
- Capital structure - Whilst the OECD guidance acknowledges that the structure and interest rate of a prima facie loan in a related party situation should be subjected to the arm’s length standard, the guidance leaves it open to the domestic legislation of countries to ‘address the balance of debt and equity funding of an entity and interest deductibility’. This allows individual jurisdictions to put aside an ‘accurate delineation analysis’ in favour of their own approach to determining the arm’s length mix of debt and equity. This leaves the potential for significantly different approaches (and tax misalignment) between different jurisdictions.
What does it mean for Australian taxpayers?
While Australia’s thin capitalisation rules currently operate to limit the number of debt deductions available to Australian entities based on an assessment of overall gearing, a transfer pricing analysis of the underlying characterisation of related party financing arrangements should still be undertaken where the lines between debt and equity are blurred. This is especially true given the recent finalisation of TD 2019/10 (originally published in draft as TD 2018/D6), which clearly states that nothing in the Australian income tax legislation limits the ability of the transfer pricing rules to characterise a financing arrangement as debt or equity, regardless of what a standalone Division 974 analysis would say.
The ATO has also previously outlined its view on the factors to be considered as part of an analysis of whether a debt interest should be treaty as quasi-equity in TR 92/11. This ruling focused on a combination of quantitative and qualitative factors including the purpose of the arrangement, the legal terms of the loan, the ability to obtain finance from an unrelated party, and the debt to equity ratio of the entity itself.
The ATO has publically hinted there will be more guidance in this space, particularly in relation to interest-free loans. However, it is currently unclear when to expect this long-awaited guidance.
- Substance and allocation of risk – These are important factors underpinning the proper delineation of transactions and determining the characterisation of a given entity. However, the guidance states where a 'lender is not exercising control over the risks associated to an advance of funds', its return may still be (limited to) a risk-free return. This could lead to tax misalignment and challenging compliance issues.
The guidance highlights the importance of undertaking a detailed consideration of key functions, assets, and risks as part of an analysis of a multinational group’s financial arrangements. In keeping with the general theme of the OECD’s broader base erosion and profit shifting program (BEPS), the guidance continues to highlight the importance of underlying economic substance.
What does it mean for Australian taxpayers?
The Chevron decision showed the importance of properly analysing, documenting and evidencing intragroup financing arrangements from both an Australian and overseas perspective, having regard to commerciality, and ensuring the arrangements do not substantially deviate from Group policies.
An additional difficulty may arise for those Australian subsidiaries of a multinational group where access to information on group treasury policies is kept offshore. This will create practical issues where the ability to access this information when undertaking a local transfer pricing analysis is limited, due to either the size of the Australian subsidiary in the group context or due to group policy.
- Credit analysis of the borrower - The OECD guidance advocates the role of a credit rating analysis of the borrower in pricing intra-group loans, including the use of commercial hypothetical credit scoring tools and methodologies. It also emphasises the need to consider the ‘implicit support’ that an individual entity may derive from its membership of a multinational group. However, in some circumstances, the guidance anticipates the use of the credit rating of the multinational group as a whole to assist with determining the credit rating by its constituent entities (an approach commonly taken by many countries, including Australia) as opposed to standalone entity credit ratings. This leaves a lot of room for misalignment between tax authorities over the most appropriate approach to use.
What does it mean for Australian taxpayers?
Australian courts have previously considered the merits of parental affiliation in the ATO’s case against Chevron, with the Full Federal Court rejecting the ‘orphan theory’ put forward by Chevron, thus ruling the Australia subsidiary should not be assessed on a standalone basis where the facts indicate the wider group would be likely to provide support (whether explicit or implicit) to the local subsidiary in the event of default. This creates a potential difference with the OECD guidance.
- Cash pooling - The guidance requires an ‘accurate delineation analysis’ for cash pooling arrangements. This will inevitably lead to particular challenges in proving the appropriate characterisation of debit and credit balances in the cash pool. Issues appear due to the length of time loans, and deposits are left outstanding, the patterns of deposit and lending over time and the group’s overall funding policies, and in establishing the basis for allocating returns to the pool participants.
What does it mean for Australian taxpayers?
The guidance states that parties to a cash pooling arrangement should not be worse off than under other realistically available alternatives. This requires a careful analysis both at a global and local level. In Australia, this opens up support for the use of the Australian reconstruction provisions where a local subsidiary may be worse off for its participation in a cash pooling arrangement, despite potentially not having a say in the way in which its overseas parent entity structures this arrangement. We recommend an analysis of the benefit of the cash pooling arrangement to be included as part of the Australian documentation.
- Financial guarantees - The guidance states that a guarantee should provide a benefit, and in pricing a benefit an adjustment should be made for implicit support. This is expected to be a less than straightforward exercise as there is little direct guidance on how to measure this impact in the OECD material. The guidance also outlines a number of different methods with which guarantee fees can be priced.
An important complication highlighted by the guidance is what to do in the case where a parental guarantee results in an entity being able to borrow an additional funding amount greater than it could have otherwise obtained on a standalone basis. A question remains whether a portion of the loan could potentially be treated in substance as a loan from the subsidiary to the parent, and a subsequent capital contribution from the parent back to the subsidiary.
What does it mean for Australian taxpayers?
Where a financial guarantee is present, it will raise not only the question of whether this guarantee has a value which should be compensated, but also whether the guarantee changes the classification of the loan balances entirely. This will especially be of importance for companies with significant debt balances resulting in losses in light of TD 2019/10 noted above.
- Treasury function – The guidance suggests group treasury functions are likely to fall within the realm of ‘support services’, with the responsible party deserving a cost-plus reward. There is some acknowledgment that there would be some instances, for example, concerning capital raising functions, where remuneration is likely to be higher where linked to third party comparables. There is potential for dispute in this area, given that historically (especially in cash pooling scenarios) multinational groups often saw treasury functions as value-adding units.
Once again, the question of how group treasury functions should be remunerated will likely come down to an evaluation of the underlying economic substance, and the nature and value of activities performed.
What does it mean for Australian taxpayers?
The OECD approach is not expected to be out of line with the general approach expected from the ATO. Still, this raises a question around the accessibility of group information to provide appropriate evidence for local Australian subsidiaries.
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 interest limitation rules tied to local profitability have appeared in many overseas jurisdictions, and anti-hybrid mismatch provisions have been embraced both in Australia and overseas. These can potentially give rise to situations where a company in one country will be taxed on arm’s length interest income but the borrower in another country will not be able to deduct the associated interest expense due to a mechanical limit. Therefore, a holistic approach to the analysis of the characterisation and pricing of financing transactions is critical to map the impact on group profitability.
Why look at this issue now?
The emphasis that the guidance places on risk management within a financial structure and the economic rationale could cause some practical challenges with establishing and supporting appropriate pricing and will increase the level of analysis required in documenting financial transactions.
However, the expectations outlined by the guidelines set a clear standard for taxpayers, and for the first time, provide tax authorities with reasonably clear guidance on how to scrutinise the transfer pricing of financial transactions. As a result, we expect tax authorities around the world to increasingly challenge groups’ financial arrangements.
As a result of the guidance, we recommend that:
- Taxpayers should consider whether any existing analysis performed in relation to their financial arrangements is consistent with the new guidance, or if a fresh look is required.
- Taxpayers keep a log of affected transactions together with an assessment of the risk of potential adverse adjustments. This will especially be important when considering the impact of IFRIC 23 and reportable tax position schedule disclosures.
- Australian entities lending funds overseas should begin preparing for increased scrutiny now to avoid the risk of potential tax adjustments and penalties (as well as double taxation) both in Australia and overseas.
- Given the increase in unilateral actions taken by overseas tax authorities to limit interest deductions, the tax impact of both sides of a financing arrangement be considered.
Failing to prepare appropriately can expose the business to increased pressure to try and solve potential issues in a short period of time when questions are raised, and the reputational risks that can easily arise from major tax disputes and financial adjustments.
How BDO can help you?
Our experts have in-depth experience in dealing with financing arrangements and can assist you to assess your position against the new guidance as well as the Australian specific expectations. For example, we frequently assist new clients in taking a ‘fresh look’ at their existing and proposed financing arrangements to ensure they are fit for purpose given the significant changes in the landscape that have, and continue to occur in the financing space.
Please contact a member of BDO’s Transfer Pricing team if you require assistance.