In a world economy where multinational enterprises (MNEs) play a prominent role, the governments ensure that taxable profits of MNEs are not artificially shifted out of their jurisdiction. Also, the tax base reported by MNEs in their country should reflect economic activities. The Organization of Economic Co-operation and Development (OECD) guides the application of the "arm's length principle". This usually represents the international consensus on the valuation of income tax processes, or cross-border transactions between associated enterprises. On 20th January 2022, the OECD released the most recent version of its Transfer Pricing Guidelines for Multinational Enterprises and the Tax Administrations.
The updates target improving on the 2017 edition by clearly incorporating the guidance on the transactional profit split method, hard-to-value intangibles, and financial transactions. Further, the 2022 transaction processing group (TPG) revises Chapter I to offer the much-anticipated clarity on the returns.
The guidance on the application of the transactional profit split method was previously issued in 2018. Further, the objective of the guidance was to clarify that the transactional profit split method is the most appropriate. It helps various tax administrators to apply the approach to hard-to-value intangibles, under BEPs Action 8. Here is everything you need to know about OECD's latest version of its transfer pricing guidelines.
Changes to Chapter I for Transfer Pricing
1. Risk-Free Rate Return Interpretation
The 2017 transfer pricing guideline on Chapter I states that an entity that funds an investment but does not control its associated financial risks or other involved risks is granted a risk-free rate of return. This guidance aims at limiting the return that a multinational enterprise can offer to a cash-box type. There was no particular definition of the risk-free rate of return.
The 2022 version of TPG clearly states that a risk-free rate of return means a measured risk of loss. The new guidance also states the risk-free rate of return measures about the yield curve. Details of a transaction can potentially influence most of the reliable data used in the construction of a yield curve.
2. Risk-Adjusted Rate of Return Interpretation
The 2017 transfer pricing guideline on Chapter VI states that an institution that funds investment and also controls its related financial risk, and no other significant economic risks, only permits a risk-adjusted rate of return. This guidance aims at limiting the return that a multinational enterprise can offer a "financial investor-type entity". It also contributes to the funding of the intellectual property of an MNE. This guideline did not explain the meaning of a risk-adjusted rate of return.
The 2022 TPG has added new paragraphs that clearly explain that a risk-adjusted rate of return measures default risk. This essentially means that the uncontrolled comparable transactions can potentially offer a measure of a risk-adjusted return. According to the new paragraphs, the alternative would be to calculate a risk-adjustable return by adding a risk premium.
What This Means to the U.S Multinationals
The released updates and clarifications on risk-free and risk-adjustable rates of return confirm that the inclusive framework (IF) on BEPs is not interested in providing any level of default risk premium to low-substance entities. While few US MNEs operate through institutions without financial control, many MNEs usually operate this way. There is also minimal control over operational economic risks. These MNEs only entitlement remains to a risk-adjustable rate of return.
New Chapter X Transfer Pricing
The OECD also released its final transfer pricing guidelines on the financial transactions. These have been developed as a direct follow-up to the actions stipulated under sections 4 and 8-10 of the BEPs action plan. Section B of 2022 TPG offers guidance on the application of the principles that are established in Section D.1 of Chapter 1 of the transfer pricing guidelines for financial transactions. The section categorically explicates the ways that the accurate delineation analysis contained in the chapter with proper application.
The new Chapter X also makes it clear that the guidance doesn't stop countries from adopting other methods to address capital structures as well as the interest deductibility that is under their domestic legislation. Section B of the chapter outlines the characteristics that are economically relevant. Additionally, it informs the analysis of terms and conditions that inform financial transactions. Section C, D, and E of the 2022 TPG look into certain challenges related to the treasury functions, such as hedging, loans, and cash pooling.
The guidance given in Chapter X does not necessarily impose stringent new documentation requirements in regard to financial transactions. Nevertheless, taxpayers should carefully evaluate their transfer pricing policies and the associated documentation. Thus, addressing any daylight that could possibly exist. In order to avoid the recharacterization of debt as equity, factor in information about debt characteristics.
