Japan Tax BulletinOECD Transfer Pricing Guidance on Financial Transactions
July 2020
On 11 February 2020, as part of tax base erosion and profit
shifting project, the OECD released final Transfer Pricing
Guidance on financial transactions. The Guidance mainly
addressed regarding the intra-group loans, cash poolingarrangements, financial guarantees, and captive insurance. This
article aims to summarize the key chapters of the Guidance and thepossible impact the Guidance may have on transfer pricing
arrangements for financial transactions within a multinational
enterprise group.
1.

Accurate Delineation

The accurate delineation of the financial transactions is one of
the key changes in the Guidance, which emphasized the importanceof determining whether a purported loan should be regarded as aloan for tax purposes or should be regarded as some other kind ofpayment, in particular a contribution to equity capital.
According to the Guidance, in order to price the accurately
delineated actual transaction, the following economically relevantcharacteristics should be considered.
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Contractual terms
Functional analysis
Characteristics of financial instruments
Economic circumstances
Business strategies.

With regards to characteristics of financial instruments, thefeatures may include but not limited to: the amount of the loan; its
maturity; the schedule of repayment; the nature or purpose of theloan; level of seniority and subordination, geographical location of
the borrower; currency; collateral provided; presence and quality of
any guarantee; and whether the interest rate is fixed or floating. The
Guidance suggested to document the transaction’s features andattributes.
Regarding economic circumstances, to achieve comparability
requires that the markets in which the independent and associatedenterprises operate do not have differences that have a material
effect on price. In this regard, macroeconomic trends factors andcurrency differences are considered to be important factors.
Macroeconomic trends factors include central bank lending rates
or interbank reference rates, and financial market events like a crisis.
Currency differences factors include growth rate, inflation rate, andthe volatility of exchange rates.

2.

Intra- group Loans

When considering the commercial and financial relations
between the associated borrower and lender, and in an analysis of
the economically relevant characteristics of the transaction, theguidance noted both the lender’s and borrower’s perspectives
should be taken into account.
The lender’s perspective in the decision of whether to make aloan, how much to lend, and on what terms, will involve evaluationof various factors relating to the borrower, wider economic factors
affecting both the borrower and the lender, and other options
realistically available to the lender for the use of the funds. In
contrast, from the borrower’s perspective, when considering
whether to enter into a particular financial transaction, will consider
all other options realistically available to them, and will only enter
into the transaction if they see no alternative that offers a clearly
more attractive opportunity to meet their commercial objectives
The creditworthiness of the borrower is one of the main factorsthat independent investors take into account in determining aninterest rate to charge. An approach often used is to apply
quantitative and qualitative analyses of the individual characteristicsof the multinational enterprise group using publicly available
financial tools or independent credit rating agencies’
methodologies to seek to replicate the process used to determine
the credit rating of the multinational enterprise group.
The CUP method is considered to be the most common method
to determine the arm’s length interest rate of intra-group loans.
Because the widespread existence of markets for borrowing andlending money and the frequency of such transactions between
independent borrowers and lenders, coupled with the widespread
availability of information and analysis of loan markets may makeit easier to apply the CUP method to financial transactions than
may be the case for other types of transactions. Alternatively, credit
default swap and economical modelling are considered to priceintra-group interest rate.

3.

Cash Pooling Arrangements

The use of a cash pooling is arranged within a multinationalgroup to ensure efficient cash management and achieve financing
cost efficiency.
A cash pooling arrangement refers to the pooling of debit andcredit balances of the separate bank accounts of cash poolmembers to arrive at a net balance. Interests will be paid or received
based on the overall balance. There are two type of cash poolingarrangements include physical and notional pooling.
To determine an arm’s length remuneration for a cash poolingarrangement, it is necessary to identify:

Nature of the advantage or disadvantage of a cash poolingarrangement;
Amount of the benefit or detriment provided; andHow that benefit or detriment should be divided among
members of the multinational group.

A cash pool leader performs no more than a co-ordination or
agency function with the master account being a centralized point
for a series of book entries to meet the pre-determined target
balances for the pool members. Given such a low level offunctionality, the cash pool leader’s remuneration as a service
provider will generally be similarly limited.
The remuneration of the cash pool members will be calculated
through the determination of the arm’s length interest rates
applicable to the debit and credit positions within the pool. This
determination will allocate the synergy benefits arising from thecash pool arrangement amongst the pool members and it will
generally be done once the remuneration of the cash pool leader
has been calculated.
However, to determine the arm’s length interest rates for thecash pool intra-group transactions may be a difficult exercise dueto the lack of comparable arrangements between unrelated parties.
4.

Financial Guarantees

A financial guarantee provides for the guarantor to meet
specified financial obligations in the event of a failure to do so by
the guaranteed party. From the borrower perspective, a financial
guarantee may affect the terms of the borrowing. From theperspective of a lender, the consequence of one or more explicit
guarantees is that the guarantors are legally committed; the lender’srisk would be expected to be reduced by having access to the assetsof the guarantors in the event of the borrower’s default.
To determine the arm’s length price of guarantees, the Guidanceillustrated 5 methods as below.
1) CUP method
The CUP method could be used where there are external orinternal comparable; independent guarantors providing guarantees
in respect of comparable loans to other borrowers or where thesame borrower has other comparable loans which areindependently guaranteed. The difficulty with using the CUP

method is that publicly available information about a sufficientlysimilar credit enhancing guarantee is unlikely to be found between
unrelated parties given that unrelated party guarantees of bankloans are uncommon.
2) Yield approachThis approach quantifies the benefit that the guaranteed party
receives from the guarantee in terms of lower interest rates. The
method calculates the spread between the interest rate that wouldhave been payable by the borrower without the guarantee and theinterest rate payable with the guarantee.
3) Cost approachThis method aims to quantify the additional risk borne by theguarantor by estimating the value of the expected loss that theguarantor incurs by providing the guarantee. Alternatively theexpected cost could be determined by reference to the capitalrequired to support the risks assumed by the guarantor.
4) Valuation of expected loss approach
The valuation of expected loss method would estimate the valueof a guarantee on the basis of calculating the probability of default
and making adjustments to account for the expected recovery ratein the event of default. This would then be applied to the nominal
amount guaranteed to arrive at a cost of providing the guarantee.
The guarantee could then be priced based on an expected returnon this amount of capital based on commercial pricing models suchas the Capital Asset Pricing Model (CAPM).
5) Capital support method
The capital support method may be suitable where the difference
between the guarantor’s and borrower's risk profiles could beaddressed by introducing more capital to the borrower's balance
sheet. It would be first necessary to determine the credit rating forthe borrower without the guarantee (but with implicit support) andthen to identify the amount of additional notional capital required
to bring the borrower up to the credit rating of the guarantor. The
guarantee could then be priced based on an expected return on thisamount of capital to the extent that the expected return so usedappropriately reflects only the results or consequences of theprovision of the guarantee rather than the overall activities of theguarantor-enterprise.
5.

Captive Insurance Companies

Captive insurance entities are defined as entities whose primaryfunction is to insure risks of entities belonging to the samemultinational group. In order to accurately delineate a captive
insurance, it is important to determine whether the insurance isgenuine, whether a risk exists and whether the risk is allocated tothe captive insurance.
Some indictors of genuine insurance are as follows:• There is diversification and pooling of risk in the captive
insurance;• The economic capital position of the entities within the MNEgroup has improved as a result of diversification and there is
therefore a real economic impact for the MNE group as a whole;• Both the captive insurance and any reinsurer are regulated entities
with broadly similar regulatory regimes and regulators that require
evidence of risk assumption and appropriate capital levels;• The insured risk would otherwise be insurable outside the MNEgroup;• The captive insurance has the requisite skills, including investment
skills, and experience at its disposal; and• The captive insurance has a real possibility of suffering losses.
Also, the Guidance discussed two methods as appropriate for
pricing intra-group transactions that involve captive insurance andreinsurance premiums: CUPs and actuarial analysis.

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