Transfer pricing has always been a challenging exercise, in particular in regard to intra-group financial transactions. It was not until February 2020 that the OECD eventually published specific guidance on financial transactions, namely the “Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8-10”.[1]
In the context of intra-group loans, to provide administrative simplicity for both the taxpayers and the tax authorities, safe harbour (or safe haven) rules are often used by tax authorities in determining arm’s-length interest rates. Such rules are usually optional (i.e. the taxpayer can elect to either apply the safe harbour rule or follow the country’s domestic transfer pricing guidelines).
For example, in the context of intra-group loans, a safe harbour rule could be a pre-determined rate that is typically published by the tax authorities and such a rate may be amended from time to time. However, certain tax risks may arise, on both domestic tax law and at tax treaty level.
Safe harbour rules and intra-group loans: Cyprus as a case study
As noted above, tax policy-makers are inclined to introduce safe harbour rules to provide (for both tax administrators and taxpayers):
Increased administrative simplicity;
Lower tax compliance burden;
Minimised transfer pricing disputes; and
Certainty for taxpayers.
Presumably, with all these merits in mind, in mid-2017 the Cypriot tax authorities (CTA) introduced a safe harbour rule with respect to intra-group loans. In brief, taxpayers that entered into intra-group loans (specifically back-to-back loans) have the option to either prepare a transfer pricing study and therefore apply the arm’s-length interest rates or apply a pre-determined rate that is 2% profit margin (i.e. the difference between loan payable and loan receivable).
Practical application and planning points
Despite the above advantages, in practice, several issues have arisen. To begin with, the outcome of using the safe harbour rule (i.e. 2% profit margin) may be contrary with the arm’s-length principle (i.e. the guidelines provided in the FT Report). For example, assume that a Cyprus tax resident company borrowed funds from its parent at 2% and on-lend such funds to its wholly-owned foreign subsidiary bearing interest at 4%.
Assume further that the arm’s-length interest rate is 3.2 %. As a result, the taxpayer is found to report income above arm’s-length level. It is worth mentioning that tax authorities would not provide for a downward adjustment, that is to refund the difference of 0.8%. On the other hand, the foreign tax authorities would be inclined to challenge the high safe harbour rule as it may lead to less taxable income reported by the foreign subsidiary.
Furthermore, the foreign tax authorities – where the subsidiary is considered to be tax resident – may challenge the amount of interest expenses paid. In such a case, provided that the foreign tax authorities follow the OECD TPG (i.e. the FT Report), in order to accurately delineate the intra-group loan, they must take into consideration the commercial rationality of the transaction from both perspectives, that is the Cyprus company as a lender and the foreign subsidiary as a borrower.
At least two tax risks may arise. In case the Cyprus company is found to be a limited risk financing entity, typically earning a handling fee (i.e. the functional analysis concludes that the company performs limited functions and has limited risks) and not a fully-fledged financing entity.
First, according to the FT report on paragraph 10.8, in case the transaction is found to be commercially irrational then the foreign tax authorities may disregard the transaction and therefore disallow the interest expense. The same result would be achieved in case the foreign tax authorities decide to re-characterise the transaction/payments thereunder, normally from interest to dividends.
Second, the Cyprus company would typically not be entitled to tax treaty benefits. This is because a handling fee earning type of entity may, depending on the facts of the case, also not be considered as the beneficial owner of the income nor fulfil the requirements of the principal purposes test. As a result, the generally lower tax treaty rate for interest income (i.e. Article 11 of the OECD Model) would not apply, and therefore the source country will have an unlimited taxing right to apply its domestic withholding tax rate imposed on interest paid to non-residents.
In light of the above, taxpayers entering in cross-border intra-group loans, when following the safe harbour rule in Cyprus would not be in a position to analyse their capital structure (i.e. the balance of debt and equity funding), in order to ensure that they comply with the FT Report. However, by performing a transfer pricing study, the taxpayer will be able to identify any tax risks and therefore be in a position to minimise such risks by planning their cross-border activities depending on their capital structure, and their specific set of facts and circumstances.
[1] There were brief country notes on financial transactions relevant to transfer pricing in the Transfer Pricing and Multinational Enterprises Report of 1979, repealed by the OECD's Council in 1995, and in the Thin Capitalization Report of 1987.
Christos Theophilou
T: +357 22 875 720
Demis Ioannou
T: +357 22 875 720
