4. International „soft law" for the transfer pricing of financial transactions OECD Model Tax Convention
Model tax conventions aim to help one state to develop and to negotiate tax treaties with other states. The definitions of the associated enterprises and the arm's length principle can be found in the OECD Model tax convention. According to the Article 7 "Business profits" which regards the permanent establishment "The profits that are attributable in each Contracting State to the permanent establishment referred to in paragraph 1 are the profits it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise".
That norm allows applying the arm's length principle to the distribution of profit between the enterprise in one state and its permanent establishment in another state.
Para 2 of Article 9 (Associated enterprises) not only gives the definition of associated enterprises, that was introduced in the previous sections, but also includes the norm to address the transfer pricing of its profits: "<…>and in either case conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."
Article 11 of the Convention foresees the application of the arm's length principle to the interest income (paragraph 6), which is especially relevant for the transfer pricing of financial transactions: „6. Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention." Framework on BEPS
According to the OECD website, 141 countries and jurisdictions are currently working together in the OECD Framework on BEPS (Base Erosion and Profit Shifting). The project includes 15 Actions and aims to combat the tax avoidance and improve the consistency of international tax regulation, contribute to a more transparent tax environment, and address the tax challenges arising from the digitalization.
The Action 4 recommendations aim to limit base erosion using interest expense and resulted in the 2015 OECD report "Limiting Base Erosion Involving Interest Deductions and Other Financial Payments
." According to the report, multinational groups may avoid taxation by varying the amount of debt in a group entity, which may appear in three basic situations:
- Groups can place higher amounts of third-party debt in high tax countries;
- Groups can use intragroup loans for interest deductions;
- Groups can take advantage of third-party or intragroup financing to generate the tax-exempt income.
The impact of those considerations for transfer pricing of financial transactions results in the concept of accurate delineation, which will be addressed further in the section 4 of this paper.
Work under BEPS Action 9 is especially relevant for transfer pricing of financial transactions, since it reflects the contractual allocation of risks and profits to these risks, which may be inconsistent with the performed activities. Furthermore, Action 9 focuses on the level of funding returns received by a capital rich MNE group member, where those returns do not correspond to the level of the carried-out financing activity.
The latter novel of the transfer pricing regulation is the BEPS Action 13. Under that Action all large multinational enterprises are required to prepare so-called country-by-country reporting.
That report aggregates statistics on the global distribution of income, profit and taxes paid among tax jurisdictions in which the MNE group operates. It helps tax administrations in the assessment of the high-level transfer pricing and BEPS risks. According to the OECD website, over 100 jurisdictions have already introduced legislation to impose a filing obligation on MNE groups, covering almost all MNEs with consolidated group revenue at or above the EUR 750 million threshold.
The work on the BEPS project resulted, inter alia, in the publication of the OECD Transfer pricing guidelines, which are the most important sources of information and a base for the development of the national legislation in this area. They are discussed in the next paragraph. The OECD Transfer Pricing Guidance
In 1979 the OECD introduced its Report "Transfer Pricing and Multinational Enterprises", which was elaborated to the first OECD Transfer Pricing Guidance approved in 1995. The Guidance was significant updated in 2010, 2016, and 2017. In February 2020 the OECD released "Transfer Pricing Guidance on Financial Transactions".
The guidance is important because, as it was formulated by Deloitte: "This is the first time that specific guidance on pricing intra-group financing transactions has been included and represents a big step forward in preventing and resolving disputes in this area."
In 2022 that Guidance became a part of the comprehensive OECD Transfer Pricing Guidance (further – the OECD Guidance) as a Chapter X. This chapter includes several examples to illustrate the principles and has a following scope:
- explains the application of the principles contained in Chapter I of the OECD Transfer Pricing Guidelines to financial transactions;
- elaborates the accurate delineation analysis;
- outlines the economically relevant characteristics that inform the analysis of the terms and conditions of financial transactions;
- address specific issues related to the pricing of financial transactions (e.g. treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance);
- instruct on how to determine a risk-free rate of return and a risk-adjusted rate of return. The UN Practical Manual on Transfer Pricing for Developing Countries
The UN introduced its Practical Manual on Transfer Pricing for Developing Countries
in 2013, with an update in 2017. In 2020 the Manual was extended with Chapter 9, which addresses the issues of transfer pricing of financial transactions. The OECD and the UN Guidance have some differences, but both keep the same goal to make the transfer pricing regulation clearer and more consistent, specifically regarding financial transactions.