On 3 July 2018 the OECD released a discussion draft on financial transactions in relation to BEPS actions 8 to 10 (ensuring that transfer pricing outcomes are in line with value creation). This has been issued as part of the follow-up work on the transfer pricing aspects of financial transactions requested by the 2015 BEPS report. The discussion draft aims to clarify the application of the principles resulting from the BEPS reports and included in the 2017 edition of the OECD transfer pricing guidelines.

The discussion draft looks at the accurate delineation of financial transactions and invites comments on the factors specific to financial transactions that need to be taken into account in delineating the transaction. Views are invited on situations in which a lender would be allocated risks with respect to an advance of funds within a multinational group.

Risk-free return

Where the accurate delineation of the actual transaction shows that a funder lacks the capability, or does not perform the decision-making functions, to control the risk associated with investing in a financial asset, it will be entitled to no more than a risk-free return as an appropriate measure of the profits it is entitled to retain. A risk-free rate of return is the hypothetical return which would be expected on an investment with no risk of loss. Ultimately there is no investment with zero risk, and the reliability of available proxies for approximating a risk-free rate of return will depend on prevailing facts and circumstances. An approach which is widely used in practice is to treat the interest rate on certain government issued securities as a reference rate for a risk-free return, as these securities are generally considered by market practitioners not to carry significant default risk.

To serve as an approximation to risk-free rates of return, government issued securities are not the only reference, and other alternatives may be considered on prevailing facts and circumstances of each case. Commentators are invited to describe financial transactions that may be considered as realistic alternatives to government issued securities to approximate risk-free rate of returns. The risk-free rate of return may be relevant, for example, as a component in calculating a risk-adjusted rate of return on an investment or as the return allocable to an investor who has provided funding but has not assumed any of the risks related to the funding.

Risk-adjusted rate of return

The OECD Guidelines state that where a party providing funding exercises control over the financial risk associated with the provision of funding, without the assumption of, including the control over, any other specific risk, it could generally only expect a risk-adjusted rate of return on its funding. Therefore, in determining the risk-adjusted rate, it is important to identify and differentiate the financial risk which is assumed by the funder in carrying on its financing activity, and the operational risk that is assumed by the funded party and is connected to the use of the funds.

In general, the expected risk-adjusted rate of return on a funding transaction can be considered to have two components, these being the risk-free rate and a premium reflecting the risks assumed by the funder.

The risk-adjusted rate of return can be determined under a number of different approaches, for example based on the return of a realistic alternative investment with comparable economic characteristics. A reasonable indicator of a risk-adjusted rate of return could be found using comparable uncontrolled transactions or considering realistically available alternative investments reflecting the same risk profile. Realistic alternatives to an intra-group loan could be bond issuances or loans which are uncontrolled transactions. Another approach to determining the risk-adjusted rate of return would be to add a risk premium to the risk-free return, based on the information available in the market on financial instruments issued under similar conditions.

Views are invited from interested parties on the guidance on determining the rate of return and its interaction with other sections of the discussion draft.

Other issues covered

The draft also looks at specific issues such as the treasury function, intra-group loans, cash pooling, hedging, guarantees and captive insurance.

Comments from interested parties are requested on or before 7 September 2018.