In recent years, tax authorities have focused their attention on transfer prices charged in intercompany financial transactions.
In this regard, on February 11 2020, the OECD published Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10, the contents of which have been transposed to Chapter X and paragraphs 1.107 to 1.126 of Chapter I of the OECD Transfer Pricing Guidelines (the Guidelines).
This is because multinational groups now often centralise the treasury function with the aim of efficiently managing a group's financial resources, minimising financial risks, and managing cash flows. The Guidelines recognise that the organisation and level of centraliation of the treasury function can vary considerably depending on the structure of the individual group and the complexity of the operations put in place.
Factors in determining the characterisation of intercompany loans
With reference to intercompany loans, the first issue is to assess whether what the parties have defined as financing can actually be considered as such and should not, instead, be recharacterised as an equity contribution. In fact, as pointed out in Section 10.4 of the Guidelines, any differences between the financial structure (the balance of debt and equity funding) of the affiliate obtaining the financing compared with that in place if that organisation had been an independent entity operating under similar conditions could affect the amount of interest payable by it and, consequently, the profits generated in a given jurisdiction.
Although each financial transaction must be analysed individually on the basis of its unique circumstances, the Guidelines list a number of characteristics that may be relevant in determining whether a loan can actually be considered as such. In particular, these include:
The presence or absence of fixed maturities for the repayment of principal;
An obligation to pay interest;
The right to compulsorily demand the payment of principal and interest in the event of default;
The status of the lender in relation to the enterprise's ordinary trade creditors;
The presence of financial covenants and guarantees in the loan agreement;
The source of interest payments;
The ability of the borrower to borrow from independent lending institutions;
The use of the financial resources obtained in the purchase of capital assets; and
Failure to repay the loan at maturity or a request for an extension of the repayment term.
Non-interest-bearing financing
In Italy, another issue is related to intercompany non-interest-bearing loans.
On this point, there is a long-standing position of the tax administration, which, in Circular Letter of September 22 1980 No. 32, had deemed the provision of an interest-free loan incompatible with the arm’s-length principle, on the assumption that independent parties would hardly have agreed to a free loan. In particular, in the case of a loan granted to a foreign company by its Italian subsidiary, it had been affirmed that there was no suitable economic justification to legitimise its gratuitousness.
In the first respect, the Supreme Court had initially held that the transfer pricing rules could not be applied in the case of non-interest-bearing loans, as the operability of this provision was subject to the condition that positive or negative income components were derived for the taxpaying company from the intra-group negotiated transaction.
However, in recent years, the Supreme Court has repeatedly stated that transfer pricing regulations apply not only in relation to intra-group financing granted for consideration, but also in cases of non-interest-bearing financing.
Therefore, to be compliant with the Italian transfer pricing rules, it is necessary to show that in non-interest-bearing intra-group financing, deviation from the arm's length-principle depended on "commercial reasons" internal to the group, related to the role the parent company takes in supporting other group companies.
The comparable uncontrolled price method and alternatives
Considering the widespread availability of information on market data and financial products, the Guidelines recognise that the comparable uncontrolled price (CUP) method is generally more usable, in the internal and external versions, in relation to financial transactions than other types of intercompany transactions.
The application of the CUP method, in the external version, can be performed first by comparing the interest rate charged in the intercompany transaction with that inferable from publicly available data for other borrowers with the same credit rating for loans with sufficiently similar terms and conditions and other comparability factors.
In the absence of comparable transactions that allow the application of the CUP method, the selection of alternative methods can be evaluated (for example, the cost of collection, or the ‘cost of funds’).
Specifically, the cost of funds reflects the costs incurred by the lender in raising the funds to lend. To these are added the organisation and related costs incurred in servicing the loan, a risk premium, plus a profit margin, which will generally include the incremental cost of equity capital required by the lender to support the loan.
Another method that can be used in the absence of comparables is based on so-called credit default swaps, which are derivatives that hedge the credit risk of an underlying financial asset assumed to be comparable. Specifically, the spread that such a financial instrument assumes can be used to estimate the risk premium associated with an intercompany loan. Credit default swaps, however, should be used with caution given their high volatility, driven primarily by the absence of trading in regulated markets.
The Guidelines exclude the usability of so-called bank opinions; i.e., written opinions from independent banks stating what interest rate the bank would apply were it to make a comparable loan to that enterprise.
