Intra-group financial transactions and the arm's length principle: a comparative and normative analysis

Acknowledgements / 13
List of abbreviations / 15

Part I – Introductory chapters / 19

1 Introduction / 21
1.1 Background / 21
1.2 An introduction to the studied intra-group financial transactions / 23
1.2.1 Introduction / 23
1.2.2 Thin capitalization / 23
1.2.3 Intra-group loans / 24
1.2.4 Intra-group financial guarantees / 25
1.2.5 Intra-group cash pooling / 26
1.3 State of the art / 27
1.4 The study’s objective, research question and relevance / 29
1.5 Research methodology / 30
1.6 Scope of the study: the application of arm’s length reasoning to thin capitalization, intra-group loans, guarantees and cash pooling / 33
1.7 Some critical reflections on the study / 35
1.7.1 The choice of countries and representativeness of the studied domestic source materials / 35
1.7.2 The risk of misinterpreting foreign languages / 36
1.7.3 The benchmark to determine what constitutes correct arm’s length reasoning / 36
1.8 Some remarks on terminology / 37
1.9 Overview of OECD guidance, EU source materials and country reports / 38
1.9.1 Introduction / 38
1.9.2 OECD / 40
1.9.3 European Union / 42
1.9.4 Australia / 43
1.9.5 Austria / 45
1.9.6 Belgium / 46
1.9.7 Canada / 47
1.9.8 Denmark / 48
1.9.9 Finland / 49
1.9.10 France / 49
1.9.11 Germany / 51
1.9.12 India / 52
1.9.13 Luxembourg / 53
1.9.14 The Netherlands / 53
1.9.15 New Zealand / 55
1.9.16 Norway / 56
1.9.17 Singapore / 57
1.9.18 South Africa / 57
1.9.19 Sweden / 58
1.9.20 Switzerland / 59
1.9.21 United Kingdom / 60
1.10 Overview of the book / 61

2 Topics generally relevant to the application of arm’s length reasoning to intra-group financial transactions / 63
2.1 Introduction / 63
2.2 High-level overview of the transfer pricing process / 64
2.3 Transfer pricing methods / 66
2.4 Types of transfer pricing adjustments / 67
2.5 The requirements of control over risk and financial capacity to assume risk / 73
2.6 Transfer pricing safe harbours / 76
2.7 Determining a borrower’s credit rating for transfer pricing purposes / 78
2.7.1 Introduction / 78
2.7.2 External rating approach / 79
2.7.3 Commercial rating tools approach / 82
2.7.4 Publicly available rating methodologies approach / 84
2.7.5 Internal rating approach / 85
2.7.6 The impact of (potential) implicit support on a borrower’s credit rating / 86
2.8 Relevance of bank offer letters and quotation letters for determining arm’s length terms / 90
2.9 The arm’s length amount of profit of a group finance company / 96
2.9.1 Introduction / 96
2.9.2 Arm’s length amount of profit of a low-substance group finance company (cash box) / 97
2.9.3 Arm’s length amount of profit of a non-cash box group finance company / 99
2.10 Interest-free intra-group loans and intra-group guarantees without charge / 110
2.10.1 Introduction / 110
2.10.2 General rule: an intra-group loan must be interest-bearing and an intra-group guarantee must be remunerated by a guarantee fee / 111
2.10.3 Exception 1: additional relations between the lender/guarantor and the borrower / 114
2.10.4 Exception 2: different arm’s length reasons than additional relations between the lender/guarantor and the borrower / 119
2.11 Conclusion / 128

Part II – A comparative analysis of intra-group financial transactions / 133

3 Thin capitalization / 135
3.1 Introduction / 135
3.2 An overview of OECD guidance, EU guidance and domestic legal provisions approving the application of arm’s length reasoning in the context of thin capitalization / 141
3.2.1 Introduction / 141
3.2.2 OECD guidance on the application of arm’s length reasoning in the context of thin capitalization / 142
3.2.3 Domestic legal provisions and EU guidance which allow the application of arm’s length reasoning in the context of thin capitalization / 144
3.3 The characteristics of the borrower in an arm’s length debt test: the relevance of potential implicit support, the borrower’s subsidiaries and its risk attitude towards leverage / 148
3.3.1 Introduction / 148
3.3.2 The relevance of the characteristic of potential implicit support / 149
3.3.3 The relevance of the characteristic of the borrower having subsidiaries / 150
3.3.4 The relevance of the characteristic of the borrower’s risk attitude towards leverage / 151
3.4 The identity of the lender in an arm’s length debt test / 152
3.5 The arm’s length debt test: a ‘could interpretation’ and a ‘would interpretation’ of the arm’s length debt amount / 156
3.5.1 Introduction / 156
3.5.2 A could interpretation of the arm’s length debt amount / 156
3.5.3 A would interpretation of the arm’s length debt amount / 158
3.6 Approaches to determine the arm’s length debt amount / 161
3.6.1 Introduction / 161
3.6.2 Comparing the financial (debt) ratios or credit rating of a borrowing group company with the financial (debt) ratios or credit rating of comparable companies / 161
3.6.3 Accepting a specified, fixed credit rating as an arm’s length credit rating / 164
3.7 Moment(s) in time at which to apply the arm’s length debt test / 166
3.7.1 Introduction / 166
3.7.2 Applying the arm’s length debt test only at the moment an intra-group loan or external guaranteed loan is taken out / 166
3.7.3 Applying the arm’s length debt test both at the moment an intra-group loan or external guaranteed loan is taken out and at (specified) later moments / 167
3.7.4 Applying the arm’s length debt test each taxable year / 168
3.8 Satisfying the arm’s length escape under a domestic thin capitalization rule: a closer look at the requirements / 169
3.8.1 Introduction / 169
3.8.2 A stringent application of the arm’s length escape: all terms of the debt taken out by the borrower need to be at arm’s length / 170
3.8.3 A less stringent application of the arm’s length escape: not all terms of the debt (including the debt amount) taken out by the borrower need to be at arm’s length – the actual amount of debt is equal to or lower than the arm’s length debt amount / 174
3.8.4 A less stringent application of the arm’s length escape: not all terms of the debt (including the debt amount) taken out by the borrower need to be at arm’s length – the actual amount of debt exceeds the arm’s length debt amount / 175
3.9 Arm’s length pricing of a non-arm’s length debt amount / 176
3.9.1 Introduction / 176
3.9.2 Arm’s length pricing of a higher than arm’s length debt amount / 176
3.9.3 Arm’s length pricing of a lower than arm’s length debt amount / 179
3.10 Thin capitalization in the context of outbound loans and outbound guarantees / 180
3.11 Interest deduction at the level of the intra-group guarantor / 185
3.12 Conclusion / 187

4 Intra-group loans / 191
4.1 Introduction / 191
4.2 Transfer pricing approaches to determine an arm’s length interest rate / 193
4.2.1 Introduction / 193
4.2.2 Interest rate based on the intra-group borrower’s external debit interest rate / 195
4.2.2.1 Introduction / 195
4.2.2.2 Prototypical internal CUP: the interest rate which the intra-group borrower pays on an external loan / 196
4.2.2.3 Intra-group borrower’s external debit interest rate determined by means other than an external loan taken out by the intra-group borrower / 198
4.2.3 Interest rate based on the intra-group lender’s costs / 208
4.2.4 Interest rate based on the group’s external debit interest rate and/or credit rating / 214
4.2.5 Interest rate which exceeds the intra-group lender’s external credit interest rate and is lower than the intra-group borrower’s external debit interest rate / 222
4.2.6 Interest rate conforming to a safe harbour interest rate / 224
4.2.7 Other transfer pricing approaches / 226
4.2.8 Conclusion / 231
4.3 The impact of an intra-group loan’s structural terms on the arm’s length interest rate / 232
4.3.1 Introduction / 232
4.3.2 Term to maturity / 233
4.3.3 Type of interest rate / 235
4.3.4 Security/collateral / 238
4.3.5 Rank / 246
4.3.6 Currency / 249
4.3.7 Amount / 255
4.3.8 Principal repayment type / 255
4.3.9 Timing of interest payments / 256
4.3.10 Covenants / 256
4.3.11 Call and put options / 258
4.3.12 Conversion into shares / 259
4.3.13 Guarantee / 260
4.3.14 Conclusion / 261
4.4 The impact of (potential) implicit support on an arm’s length interest rate / 261
4.5 The consequences of an intra-group borrower not acting in an arm’s length manner after the conclusion of an intra-group loan / 267
4.5.1 Introduction / 267
4.5.2 An intra-group borrower does not act during the intra-group loan’s term to maturity, while doing so would be beneficial / 268
4.5.3 An intra-group borrower replaces an intra-group loan prior to maturity by another intra-group loan with worse terms / 270
4.6 Conclusion / 275

5 Intra-group financial guarantees / 279
5.1 Introduction / 279
5.2 Yield approach / 281
5.2.1 Introduction / 281
5.2.2 Full-yield-savings approach / 283
5.2.3 Part-of-the-yield-savings approach / 285
5.3 CUP method / 288
5.3.1 Introduction / 288
5.3.2 Bank guarantee fees / 288
5.3.3 Credit default swaps / 294
5.3.4 Financial guarantees provided by insurance companies / 297
5.4 Cost based approach / 297
5.5 Cost-benefit approach / 300
5.5.1 Introduction / 300
5.5.2 The guarantor’s minimum ask price / 301
5.5.3 The borrower’s maximum bid price / 302
5.5.4 Determining the arm’s length guarantee fee within the range between the guarantor’s minimum ask price and the borrower’s maximum bid price / 302
5.6 Put option approach / 304
5.7 Cost of capital approach / 305
5.8 Guarantee fee applied in previous case law approach / 306
5.9 Safe harbour guarantee fee approach / 308
5.10 Other approaches to determine an arm’s length guarantee fee / 308
5.11 Conclusion / 309

6 Intra-group cash pooling / 313
6.1 Introduction / 313
6.2 Arm’s length allocation of the netting benefit and the volume benefit / 318
6.2.1 Introduction / 318
6.2.2 Arm’s length allocation of the netting benefit / 319
6.2.3 Arm’s length allocation of the volume benefit / 323
6.3 Arm’s length credit and debit interest rates within a cash pool / 325
6.3.2 Arm’s length credit interest rate / 326
6.3.3 Arm’s length debit interest rate / 331
6.4 Arm’s length remuneration of the cash pool leader / 334
6.5 Arm’s length credit interest rate for structural deposits / 336
6.6 A pool participant having simultaneous deposits and borrowings within a cash pool / 343
6.7 Notional cash pooling / 344
6.8 Conclusion / 346

Part III – A conceptual analysis of arm’s length reasoning in general and of the preferable application of arm’s length reasoning to intra-group financial transactions / 349

7 A conceptual analysis of arm’s length reasoning in general / 351
7.1 Introduction / 351
7.2 Objectives of arm’s length reasoning / 354
7.3 Applying arm’s length reasoning to the terms of a controlled transaction / 357
7.4 Establishing the terms of the reference transaction, that is the transaction to which the examined transaction must be compared / 358
7.4.1 Introduction / 358
7.4.2 Arm’s length reasoning is hypothetical by its very nature / 358
7.4.3 The characteristics of the parties in the reference transaction: a diverging interest but otherwise the same characteristics as the parties in the examined transaction / 360
7.4.4 Determining the terms of the reference transaction: hypothesizing a bargain between the parties in the reference transaction / 363
7.5 Adjusting the terms of the examined transaction if they differ from the terms of the reference transaction / 364
7.6 Conclusion / 366

8 Arm’s length reasoning and intra-group financial transactions: a preferable approach / 369
8.1 Introduction / 369
8.2 Why is it impossible to apply what constitutes a theoretically correct application of arm’s length reasoning in general to intra-group financial transactions? / 373
8.2.1 Introduction / 373
8.2.2 Determining the arm’s length debt amount: the impossibility of identifying the amount of debt which the RT borrower is willing to take out / 375
8.2.3 Determining the arm’s length interest rate and the arm’s length guarantee fee: the impossibility of determining whether a bargaining range exists / 378
8.2.3.1 Introduction / 378
8.2.3.2 Differences between the characteristics of the lender/guarantor in the reference transaction and the characteristics of an external lender/guarantor / 379
8.2.3.3 Consequence of the differences in characteristics: the impossibility to determine whether an arm’s length price for the examined intra-group financial transaction exists / 387
8.2.4 Conclusion / 389
8.3 The preferable (‘second best’) approach to determining arm’s length terms for an intra-group financial transaction: the group credit rating approach / 390
8.3.1 Introduction / 390
8.3.2 The group credit rating approach best fulfils the objectives of arm’s length reasoning / 394
8.3.2.1 Introduction / 394
8.3.3 The group credit rating approach fits best with the Ottawa taxation framework principles / 398
8.3.4 Other arguments in favor of the group credit rating approach / 400
8.3.5 Conclusion / 402
8.4 Applying the group credit rating approach / 403
8.4.1 Introduction / 403
8.4.2 Determining the arm’s length debt amount under the group credit rating approach / 403
8.4.3 Determining arm’s length terms for an intra-group loan under the group credit rating approach / 404
8.4.4 Determining the arm’s length guarantee fee under the group credit rating approach / 406
8.4.5 Cash pooling under the group credit rating approach / 406
8.5 Issues regarding the determination of arm’s length terms for intra-group loans which do not relate specifically to the group credit rating approach / 407
8.5.1 Introduction / 407
8.5.2 The arm’s length return to a lender which does not control the lending risk / 407
8.5.3 Acting in a non-arm’s length manner after the conclusion of an intra-group loan / 408
8.6 Conclusion / 409

Part IV – Summary, conclusion and recommendations / 415

9 Summary, conclusion and recommendations / 417
9.1 Introductory remarks / 417
9.2 The descriptive/comparative component of the study: how do the OECD, the EU and selected countries apply arm’s length reasoning to intra-group financial transactions? / 418
9.2.1 Thin capitalization / 418
9.2.2 Intra-group loans / 421
9.2.3 Intra-group financial guarantees / 424
9.2.4 Intra-group cash pooling / 426
9.3 The normative component of the study: how can arm’s length reasoning best be applied to intra-group financial transactions? / 428
9.3.1 A conceptual analysis of arm’s length reasoning in general / 428
9.3.2 Arm’s length reasoning and intra-group financial transactions: a preferable approach / 429
9.4 Conclusion / a succinct answer to the research question / 435
9.5 Recommendations / 437
9.5.1 Introduction / 437
9.5.2 Recommendations to the OECD, the EU and tax administrations, courts and lawmakers / 437
9.5.3 Recommendations for further research / 439

Wetenschappelijke samenvatting / 441
Scientific summary / 457
Bibliography / 471