1. Introduction

The concept of transfer pricing addresses the global enterprises creating an international chain of sold and bought products and services. The price may be manipulated to shift the profits between the jurisdictions and minimize the amount of taxes paid. According to the UN, intra-group trade may account for more than 30 percent of all international transactions. The OECD reported that profit shifting practices cost 100-240 billion USD in lost income tax revenue annually. The importance of transfer pricing grew since the fiscal authorities tried to combat profit shifting, which makes transfer pricing a significant tax compliance issue. Some well-established methods were developed to define if the transfer price declines from the market one, in cases of intra-group selling of goods and services. The detailed regulating of transfer prices on capital – which may occur in quite typical and frequent intra-group financial transactions – is novel. Since both the UN and the OECD introduced new guidelines for international corporations and national governments addressing the transfer pricing of financial transactions, previously only in few jurisdictions represented regulating practices in that fiscal area are expected to be spread worldwide.

The paper aims to analyse the OECD proposal on the transfer pricing of financial transactions and the implementation level in the national legislation on an example of three jurisdictions: one high-tax OECD jurisdiction (Germany), one low-tax OECD jurisdiction (Hungary), and one non-OECD country (Russian Federation). Such analysis is relevant for any multinational company with subsidiaries in those jurisdictions, which wants to ensure its compliance and optimise its financing structure facing taxation challenges.

2. Terminological clarifications

The transfer pricing regulation aims to determine a company's income and expenses that are a part of an MNE group attributable within the jurisdiction. This shall, from one side, secure the appropriate tax base in each jurisdiction and, from the other side, help avoid double taxation. The separate entity approach and the arm's length principle are used to achieve those goals, which are realized through the Model Tax Convention and tax treaties but are also presented in the harmonising guidance. Further, some basic terminological concepts will be given.

Associated enterprises

The subjects of the transfer pricing regulation are the associated enterprises. Two enterprises are associated enterprises concerning each other if one of the enterprises meets the conditions of Article 9, sub-paragraphs 1a) or 1b) of the OECD Model Tax Convention relating to the other enterprise:

1a) "an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State, or"

1b) „the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State".


The arm's length principle

The "arm's length principle" represents the international consensus regarding the valuation of profit distributed between associated enterprises in their cross-border transactions. It is outlined in Article 9 of the actual OECD Model Tax Convention as follows:

where "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, because of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly" .

Comparability analysis

Comparability analysis is essential for the defining of the hypothetical market price (in one uncontrolled transaction) to be compared with the used transfer price (in a controlled transaction). It is defined in the OECD Guidance as follows:

"Controlled and uncontrolled transactions are comparable if none of the differences between the transactions could materially affect the factor being examined in the methodology (e.g., price or margin), or if reasonably accurate adjustments can be made to eliminate the material effects of any such differences."

Appropriate comparables can be divided into "internal comparable" transactions - between one party of the controlled transaction and an independent party –, and "external comparable" – transactions between two independent parties.

Transfer pricing methods

After accurately delineating the transactions and the depiction of the participating parties, the appropriate method to price the transaction must be defined. The different levels of involvement in value creation require different methods to verify if the prices are in line with the arm's length principle. Transfer pricing methods are divided into the traditional (comparable uncontrolled price method, resale price method, cost plus method) and transactional profit methods (net margin method, profit split method).

3. Intra-group financing operations in the transfer-pricing context

Treasury function

The goal of the treasury is to achieve efficient financing of the commercial business of the MNE group. The approach adopted by the enterprise may differ depending on the business model, the strategy, the role of the entity in the business cycle, the industry, the operating currencies, etc. Various treasury structures require different levels of centralisation. A centralised treasury has complete control over the financial transactions of the MNE group, with subsidiaries within the group responsible for the operational but not the financial matters. In the decentralised treasury entities are more independent in their financial strategies (that may occur, for example, in MNE groups with several operating divisions in discrete industrial sectors).

The treasury function usually supports the core value-creating activity and can include such schemes as intra-group loans, cash pooling, covenants, guarantees, hedging, and captive insurance. Based on the conditions of each case, that activities may be object to the transfer pricing control, where the treasury reward is expected to be on the arm's length.

Intra-group loans

Financing operations within the MNE-Group can be structured as debt or as equity financing. Sometimes there are hybrid forms e.g., mezzanine capital or convertible loans. Commentary to Article 9 of the OECD Model Tax Convention notes in paragraph 3(b) that Article 9 is relevant "not only in determining whether the rate of interest provided for in a loan contract is an arm's length rate, but also whether a prima facie loan can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to equity capital."

Cash pooling

Cash pooling means bringing together, either physically or notionally, the balances on several separate bank accounts of the subsidiaries in the frame of one MNE group. That centralised cash management strategy aims to achieve more efficient liquidity management. The financial costs (bank fees) and the reliance on external borrowing can be reduced or, where there is a cash surplus, an enhanced return may be earned on the aggregated cash amount. Cash pool arrangements are complex contracts that may involve controlled and uncontrolled transactions, e.g., an unrelated bank. As cash pooling is often an intra-group loan, legal requirements as to shareholders' loans should therefore be considered, and the arm's length principle can apply to the interests' rates, but also for the cash pool leader rewarding.

Covenants

The use of covenants in a loan contract helps to limit the lender's risk. There are generally two forms: incurrence covenants and maintenance covenants. Incurrence covenants require or prohibit specific actions by the borrower without the lender's approval (e.g., banning the borrower from taking additional debt). Maintenance covenants include financial indicators which must be met and can be controlled during the loan period, they play a role of an early warning system so in the case of financial difficulties on the borrower's side both counterparties can take corrective action at an early stage. Since the risk level must be considered for the pricing of financial operations, the covenants clauses in loan contracts are significant for the comparability analysis.

Guarantees

Guarantees are relevant for the transfer pricing of financial transactions because they can be provided from one associated enterprise to another for consideration, and such consideration will be a controlled transaction. Further, the guarantees are usually used to support the borrower's loan and, therefore, are essential for defining the loan's risk and price (rate).

Hedging, and captive insurance

The hedging instruments are commonly used to minimise risks such as foreign exchange or commodity price movements. An independent entity has its own policies regarding risk management and hedging. On the contrary, in an MNE group, risks might be treated according to the MNE group's approach to risk management and hedging. The treasury of the MNE group might centralize the risk management functions. The individual entities might therefore not contractually enter into hedging arrangements, but their risk might be hedged from the point of view of the MNE as a group.

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.

5. Methodological and practical aspects of transfer pricing of financial transactions

Comparability and functional analysis, accurate delineation

That section follows the main recommendations, contained in the OECD Guidance regarding the financial transactions. OECD Guidance suggests that the accurate delineation of the actual transaction should start with a careful identification of the economically relevant characteristics of the transaction. Para 10.15 of the OECD Guidance advise that the accurate delineation of financial transactions requires an analysis of the factors such as the economic, business or product cycle, the government regulations, or the availability of financial resources in the industry have to be considered.

According to the OECD Guidance, to inform an analysis of the terms and conditions of a financial transaction, the following characteristics should be considered:

- Contractual terms,
- Functional analysis (functions performed, the assets used, and the risks assumed by the parties to the controlled transaction),
- Characteristics of financial instruments,
- Economic circumstances (incl. precise timing),
- Business strategies.

One of the highlighted in the Guidance issues is the determination of whether a purported loan should be regarded as a loan. As stated by the OECD Guidance, it may be the issue that the balance of debt and equity funding of a borrowing entity differs from that which would exist if it were an independent enterprise operating in the similar conditions. This may affect the amount of interest payable by the borrowing entity and so may affect the profits taxable in each jurisdiction. The following characteristics of financial instruments can be used for accurately delineating:

- 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;
- and the failure of the purported debtor to repay on the due date or to seek a postponement.

The OECD Guidance argues that the pricing of intra-group loans should consider the perspectives of both borrowers and lenders. It was emphasized by Deloitte professionals because „in practice, more focus has often been placed on the circumstances of borrowers. It means, when an enterprise provides a loan to an associated enterprise, it may not follow the same procedures as an independent lender. For example, it may not necessary undertake the same due-diligence process or gathering information, as the required knowledge may already be available within the MNE group. Nevertheless, in considering whether the loan has been made on conditions that would have been made between independent parties, the same commercial matters such as creditworthiness, credit risk, and economic circumstances must be considered.

Use of credit ratings

The use of the credit ratings to define the arm's length interest rate is addressed in the OECD Guidance in detail. Such ratings can be used since they reflect the creditworthiness of the borrower and are one of the main factors that independent investors consider in determining an interest rate. A lower credit rating will signal a greater risk of default and be expected to result in a higher rate of return for the lender. There is Information available in many lending markets on the different rates of interest charged for differently rated enterprises and may be used for comparability analyses or help to identify potential comparables. The credit rating methodology usually combines the quantitative and qualitative factors. Because of that, variances in creditworthiness between borrowers with the same credit rating usually occure.

Additional available proxy to define the arm's length interest rate can be the credit rating of specific debt issuance (so called „issue rating"). Such rating gives an opinion about the creditworthiness of the issuer concerning a specific financial instrument.

If an MNE has a publicly available credit rating published by an independent credit rating agency, that rating may be helpful for the transfer pricing analysis of the MNE's controlled financing transactions. However, quite often, such ratings are only available for the MNE group. To resolve that issue the quantitative and qualitative analyses of the individual characteristics of the MNE-entity can be applied, using publicly available financial tools or independent credit rating agencies' methodologies. This approach also involves considering adjustments in creditworthiness that the specific MNE would be assumed to improve because of being part of the MNE group.

In case the MNE decided to define the entity's individual rating using the public available financial tools, the OECD Guidelines warns that the reliability of results are questionable. That can be solved if the analysis reproducibly demonstrates the consistency of ratings tools methodology with the methodology used by independent credit rating agencies.

The OECD Guidelines also emphasized, that in conducting a credit rating analysis, the financial metrics may be influenced by current and past controlled transactions (for example, sales or interest expenses). If those controlled transactions are not in accordance with the arm's length principle, the credit rating derived considering such intra-group transactions may not be reliable. If there is no possibility to use reliable alternatives, the MNE group rating can be used for the separate group entity, particularly if the MNE is valuable to the group.

Effect of group membership

According to the para 10.76 of the Guidance, incidental benefit arising solely by virtue of group affiliation, i.e., passive association (implicit support) not require any payment or comparability adjustment. The factors defining the likelihood the entities of an MNE group will receive group support are the following:

- the strategical value of the entity to the MNE group and the connections between the entity and the rest of the MNE group, either factual or strategically planned,
- consequences for other parts of the MNE group of supporting or not supporting the borrower.

The OECD Guidance suggest that the assessment of implicit support is a matter of judgment. The past behaviour of an MNE group may be an indicator of likely future behaviour but a proper analysis must be provided whether different conditions take plays.

Covenants and guarantees

OECD Guidance mentions that there may be less information asymmetry between entities in the intra-group context than in situations involving unrelated parties. Intra-group lenders may refuse to have covenants on loans or require the guarantees, since they are less likely to face information asymmetry. Where there is an absence of covenants or guarantees, it will be appropriate to consider whether there is the equivalent with the consequential impact upon the pricing of the loan.