Switzerland Update: OECD publishes transfer pricing guidelines on financial transactions

On February 11, 2020, the OECD published the final version of the Transfer Pricing Guidelines for Financial Transactions (FT Guidelines). These are to be added to the OECD Transfer Pricing Guidelines as a new Chapter X in the future and contain guidelines for setting transfer prices for intra-group financing transactions. Although this is the first time that the OECD has issued guidelines for financial transactions, the published FT Guidelines are primarily a confirmation of existing practice. In addition to the general principles for transfer pricing of intra-group financial transactions, the FT Guidelines specifically address common financial transactions such as loans, cash pools and hedging as well as financial guarantees.

Principles

As with all intra-group transactions, it is also necessary in the case of financial transactions to examine whether a transaction would also have been concluded under these conditions between independent third parties. As always, the arm’s length principle is decisive. In order for an arm’s length comparison to be made, there must first be an analysis of the financial transaction, i.e. an analysis of the commercial and financial relationships between the parties involved as well as the terms and economically relevant surrounding circumstances; this includes an examination of the contracts governing the financial transaction, the functions performed, the assets used and risks assumed, the characteristics of the financial instruments, the economic circumstances of the parties involved and the relevant market, as well as the business strategies of the parties involved. [1] The crucial question, however, is whether the financing chosen by the parties makes any economic sense at all. [2] In addition to analyzing the financial transaction itself, this also requires the parties to the contract to weigh up realistically available alternatives. In doing so, alternative investment options from the perspective of the capital provider, and alternative financing options or the need for additional financing per se from the perspective of the capital borrower must be examined. [3]

The group companies involved in a financial transaction must therefore always be able to demonstrate to the tax authorities the economic sense of the transaction, the arm’s length nature of the contractual terms, the appropriateness of the capital structure and the transfer prices applied. The FT Guidelines contain specific recommendations for common financial transactions such as loans, cash pools and hedging as well as financial guarantees.

Loan

In a first step, it must be examined or demonstrated whether the loan even qualifies as debt capital from an economic perspective. As mentioned above, both the financial transaction itself and possible alternatives must be examined. A loan may be deemed to be simulated or be reclassified as equity if, from the outset, the borrower would not have been able to repay the loan within a reasonable period of time and at the same time service the interest on the loan on the basis of liquidity planning. It is therefore important that, in the case of intra-group loans, careful consideration is given to whether the loan is a loan at all and whether the borrower is solvent.

If the loan qualifies as debt capital, the creditworthiness of the borrower must be determined and, based on this, the appropriate interest rate in an arm’s length comparison. The rating can be determined either top-down, i.e. from the group’s credit rating (Group Rating), or bottom-up, i.e. by the borrower itself (Standalone Rating). There is no automatic application of the Group Rating to the group companies. Passive group membership advantages must be taken into account when determining the borrower’s credit rating. If, for example, the borrower is a strategically important group company or if a default by the borrower would be associated with reputational damage for the entire group because it acts externally under the group name, it must be assumed that the borrower benefits from implicit support from the group. This implicit guarantee increases the borrower’s credit rating. However, as it is not an explicit, specific guarantee, no remuneration should or may be paid for it. [4]

In addition to the creditworthiness of the borrower, the interest rate for the loan must also take into account the other terms and conditions of the loan, i.e. its term, currency, seniority, hedges and guarantees. Based on this, according to the FT Guidelines, the amount of the interest rate should then be determined primarily on the basis of the price comparison method and taking into account loan fees customary in arm’s length transactions (administration fees, commissions, etc.). If there are no comparable arm’s length transactions, the interest rate can also be determined based on the cost of funds for the lender (cost of funds approach) or by applying economic models (modeling approach). Under the modeling approach, the interest rate is calculated by combining a risk-free interest rate with premiums for various loan characteristics – e.g. default risk, liquidity risk, inflation expectations or maturity. Furthermore, the FT Guidelines provide that the spread, i.e. the risk premium that a third party would demand on the capital provided, can be determined under certain circumstances using credit default swaps of financial instruments traded on the market. However, it is clear that information from banks (bank offers) in which the banks state the interest rate at which they would grant a comparable loan to the company in question is not to be regarded as evidence of an arm’s length interest rate. In the opinion of the OECD, these do not represent a real loan offer and are therefore not based on a comparison of actual business transactions.

In addition to the creditworthiness of the borrower, it must be further examined whether the lender is economically capable of bearing and controlling the risks associated with the loan. If this is not the case, for example because the lender lacks the financial resources to do so, the lender may not receive more than a risk-free return on the loan granted. [5] The borrower may still claim an interest expense up to the arm’s length amount. The difference between the arm’s length interest payable and the risk-free rate of return is attributable to the entity that exercises and bears control over the investment risk under the FT Guidelines. [6] Only if the lender exercises control over and bears the financial risks associated with the provision of the financing itself can the lender expect a risk-adjusted return on its financing in accordance with the FT Guidelines.

Overall, the criteria to be taken into account are quite comprehensible. In practice, however, it is not always easy to apply them consistently.

Cash pool

Multinational companies often resort to cash pools to make their liquidity management more efficient; this involves the balances of several individual bank accounts being pooled either physically or notionally at one company. Depending on the circumstances of the individual case, a cash pool enables companies to manage liquidity more effectively and reduce the need for external borrowing or – in the case of liquidity surpluses – to generate higher returns thanks to the pooling of balances. [7] Before the interest rates used within the cash pool and the remuneration of the company leading the cash pool can be determined, it must be examined whether the companies gain an advantage from participating in the cash pool, taking into account the next best options. Only in this case would arm’s length companies participate in the cash pool. In addition to the advantage of favorable interest rates, advantages of cash pools include, for example, a permanent source of financing or access to liquidity that would otherwise not be available. In any case, cash pool participants should at least not be placed in a worse position compared to the next best alternative course of action and should in any case participate in the benefits of cash pooling to the appropriate extent. The benefits from the cash pool, i.e. above all the interest rate advantage, must not only accrue to the cash pool leader.

The appropriate remuneration of the cash pool leader depends on the functions performed, assets used and risks assumed. Generally, according to FT Guidelines, a cash pool leader only performs a coordination or intermediary function and does not bear any increased risk. Given this limited scope of function, the cash pool leader’s compensation as a service provider is generally limited to compensation for costs plus a profit margin. The company that exercises and bears control over the risks of the cash pool within the group is to be compensated for this. Only if the cash pool leader assumes additional functions such as a fully-fledged treasury center or strategic functions, or bears the risks associated with the cash pool, such as credit and liquidity risk, and has the ability to control these risks, is this to be additionally compensated. Additional compensation requires that the cash pool leader has the necessary personnel and financial substance to do so.

If it becomes apparent that individual debit or credit positions of participants in a cash pool are of a longer-term nature, it should also be examined whether these positions should be treated as something other than short-term cash pool balances, e.g. as longer-term deposits or term loans, and as such should also be subject to interest. If Swiss companies are involved in cash pools, the issue of deposit return must always be kept in mind.

Here, too, the mechanisms can be described as useful; even if the practical application is demanding.

Hedging

Hedging involves the transfer of risks within a group. Hedging is often used to hedge risks such as exchange rate or commodity price fluctuations. If hedging within a group is centralized in a treasury function, which arranges the hedging contracts entered into by the operating companies, this should be remunerated as a service, i.e. on the basis of the costs plus a profit mark-up, in accordance with the FT Guidelines. In these cases, compensation based on the amount hedged should be waived. However, if the treasury unit or other group companies enter into the hedging contracts in their name, they are to be compensated on the basis of an analysis of the functions assumed and risks assumed.

Financial guarantees

As mentioned above, implicit financial guarantees that result from the group membership of a company are not to be remunerated according to the FT Guidelines. [8] Only if a group company grants an explicit, legally binding guarantee and this guarantee offers the guarantee-accepting companies an economic benefit that goes beyond an implicit group guarantee is this to be remunerated. [9] Benefits of such a guarantee may be the receipt of more favorable interest rates on loans or a higher permissible level of debt at a bank – i.e. ultimately an improvement in the borrower’s credit rating.

If an explicit guarantee is granted, it must therefore be determined what advantage it offers over the implicit group guarantee. Only this additional advantage is to be compensated. According to the FT Guidelines, the amount of compensation for the granting of a guarantee can be determined using various methods. If data on the compensation of guarantees among independent third parties are available, the price comparison method is again likely to lead to the most reliable values. However, there is hardly any publicly available information on credit enhancing guarantees under third party guarantees. For cases without a third-party comparison, the FT Guidelines primarily refer to the interest rate-based approach (“yield approach“). Under this approach, the benefit accruing to the guarantee holder as a result of the guarantee is quantified on the basis of the reduction in interest rates made possible by the guarantee.[10] In a first step, therefore, the interest rate that a borrower would have to pay on the basis of its own characteristics is determined, taking into account the effect of the implicit backing it has through its group membership. In a second step, the interest rate to be paid under the explicit guarantee is determined. The difference between these two interest rates is then the maximum fee that an independent third party would pay for the guarantee. However, a borrower only has an incentive to pay a fee for a guarantee if the combined bank interest rate and guarantee fee are lower than the interest rate he would have to pay to the bank without a guarantee. Thus, the borrower must have a benefit from the guarantee. Therefore, in the absence of evidence of unequal bargaining power, the benefit from the guarantee is usually split 50/50 between the guarantor and the guaranteed party. [11] The FT Guidelines cite a cost-based approach (“cost approach“) and loss-based and capital-based approaches, respectively, as other ways to determine the amount of the guarantee fee. In these methods, the additional risk borne by the guarantor is quantified by estimating the amount of the loss that the guarantor must expect to incur as a result of the guarantee provided if the borrower defaults (“loss given default”). Alternatively, the expected costs could be determined by reference to the capital required to cover the risk assumed by the guarantor. [12]

In practice, determining adequate compensation will be difficult to implement even with these guidelines because, as mentioned, the relevant comparative values are often missing or difficult to obtain.

Effects on companies domiciled in Switzerland

The explanations on transfer pricing in financial transactions are not fundamentally new; they confirm the internationally applicable practice. It is to be expected that through the concretization in the FT Guidelines, the tax administrations will exert more pressure with regard to their application in financial transactions between Switzerland and foreign countries. [13] Switzerland is a member of the OECD and the Swiss Federal Tax Administration (FTA) has officially stated that the transfer pricing principles of the OECD should be taken into account when determining arm’s length prices. [14] Thus, from Switzerland’s perspective, the FT Guidelines must also be applied in bilateral financial transactions. It should be noted that the interest rates for advances or loans to related parties in Swiss francs or in foreign currencies published by the FTA in its annual circulars, as well as the minimum capitalization rules mentioned in Circular No. 6 of June 6, 1997 “Concealed Equity”, only reflect the practice of the FTA and the cantonal tax administrations and are thus considered a safe haven only vis-à-vis the domestic tax authorities. However, the application of other interest rates or other financing in a third party comparison is always possible also vis-à-vis the Swiss tax authorities. The application or acceptance of other arm’s length compensation will probably be increasingly necessary after the publication of the FT Guidelines. This is because the “safe haven” rules will not be appropriate in certain situations from the perspective of foreign tax administrations. For example, the circulars on recognized interest rates do not take into account the creditworthiness of the borrower, nor the term of the loan. Additionally, the interest rates published in them are adjusted only once a year. It would be desirable if the FTA would take into account the FT Guidelines when setting the safe haven rules.

Since companies cannot rely on these “safe haven” rules vis-à-vis foreign tax administrations in international financial transactions, the third-party comparison will become increasingly important. This third party comparison must comply with the FT Guidelines. Thus, the transfer price must take into account the characteristics of the financial transaction, the characteristics of the companies involved, as well as the functions assumed, risks controlled, and assets used by the companies. These considerations, as well as the economic rationale behind the financial transaction, must be documented. This is the only way to reduce the risk of international double taxation. This is all the more true since the EU, with the introduction of the Anti-Tax Avoidance Directive (ATAD), limits the deductibility of interest to a maximum of 30% of taxable earnings before interest, taxes, depreciation and amortization (EBITDA), and individual EU countries, such as Germany, are using the introduction of ATAD to introduce additional conditions for the recognition of transfer prices on financial transactions.
 

[1] See para. 10.17 of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[2] See on this and the following: Transfer Pricing for Financial Transactions, Nicolas Bonving/Fabian Berr/Marc-Antoine Chevalley, in Expert Focus 6-7/2020, p. 384 et seq.

[3] See para. 10.19 of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[4] See also the comments on financial guarantees

[5] The risk-free return consists of a risk-free interest rate plus costs incurred by the lender in providing the funds. The borrower may claim a deduction for operating expenses in connection with the financing received up to an arm’s length amount, subject to the fulfillment of further conditions.

[6] See on this and the following: Point 1.108 et seq. of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[7] See on this and the following: Point 10.109. of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[8] See comments under Loans above.

[9] See on this and the following: Point 10.156 of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[10] See on this and the following: Point 10.174 of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[11] Transfer Pricing for Financial Transactions, Nicolas Bonving/Fabian Berr/Marc-Antoine Chevalley, in Expert Focus 6-7/2020, p. 388

[12] Point 10.178 of the Transfer Pricing Guidelines on Financial Transactions of February 11, 2020, OECD.

[13] See Transfer Pricing for Financial Transactions, Nicolas Bonving/Fabian Berr/Marc-Antoine Chevalley, in Expert Focus 08/2020, p. 517.

[14] See Circular No. 4 “Service Companies” dated March 19, 2004 and Circular No. 49 “Evidence of Business-Related Expenses for Foreign-Foreign Transactions” dated July 13, 2020.

By Adrian Briner, Vischer, Switzerland, a Transatlantic Law International Affiliated Firm.

For further information or for any assistance please contact switzerland@transatlanticlaw.com

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