Information from the Directorate-General for Finance on transfer pricing guidelines for financial transactions
On 4 August 2021, the Directorate-General for Finance issued a document briefing on the content of the Transfer Pricing Guidelines for Financial Transactions, which were published on the OECD website already in spring 2020 ("OECD Guidelines for Financial Transactions"). A translation of the Guidelines into Czech is attached to the Information.
We consider the information issued during the summer holiday season to be important, as it confirms the previously published intention of the Tax Administration to focus attention on the true nature of financial transactions and the conditions under which these transactions are carried out.
Prioritising the substance of the transaction over the formal contractual arrangement is an approach that the Tax Administration has generally long applied to any other group transaction in transfer pricing tax audits, but in the case of financial transactions, until recently the OECD Transfer Pricing Guidelines did not contain any specific recommendations that both taxpayers and tax administrations could follow in setting and controlling the prices of financial transactions and that would help prevent disputes in this area.
The OECD Guidelines on Financial Transactions define several absolutely essential categories of financial transactions. These are intra-group lending, cash-pools, hedging and financial guarantees, addressing in detail for each of them the circumstances under which the price was determined.
A very common example of an intra-group financial transaction is an intra-group loan. It can be assumed that an independent lender would first check the borrower's risk of insolvency before providing funds. There are currently several commercial database offerings on the market containing tools that can determine a "rating" using a mathematical model and data from published financial statements. The borrower's rating is one of several comparability criteria that should be considered when determining the market-based intra-group interest rate. Note that the borrower's rating may be significantly affected by the ability of local management to exercise control and management functions related to the use of the funds provided if control and management of the local company's activities has been taken over by a controlling person.
The interest rate on an intra-group loan should ideally be within the range of interest rates on loans to independent borrowers on comparable terms. The term comparable terms includes, for example, the maturity of the loan, subordination, collateral, the amount advanced, etc. To find data on comparable interest rates for loans granted to independent borrowers under the above-mentioned comparable circumstances (the so-called CUP method), it is usually necessary to use a paid-for commercial database containing the necessary data. In addition to the CUP method, the General Financial Directorate information allows for the possibility of using methods based on financing costs or economic modelling methods. The services of a valuation firm may be used here. The principle of balancing the costs incurred in documenting the transaction against its significance should be respected in the preparation of transfer pricing documentation.
As regards the course of tax audits focused on financial transactions, in practice, one can encounter an approach where the Tax Administration scrutinises in detail the circumstances of financial transactions formally based on a contractual relationship bearing the defining characteristics of a loan, the contractual terms of which regarding the maturity or the amount and frequency of repayments are not actually fulfilled and for which the risk of the debtor's insolvency is not checked. Consequently, the possibility of early repayment of the loan could be exercised when the indicators that are normally checked in the case of a loan granted between unrelated parties are not met.
In the case of foreign tax administrations, it is not an exception when, based on a tax audit, a part of interest related to a loan granted by a Czech parent company to a foreign subsidiary is reclassified as a hidden dividend payment and tax is subsequently assessed on the unrecognised interest costs. In such cases, the question arises as to how and whether it is possible to achieve such a solution where the reclassification of interest is accepted by the Czech Tax Administration to avoid double taxation of the amount that was already taxable income on the Czech side. Recall that as of 15 September 2020, the Act on International Cooperation in the Resolution of Tax Disputes in the European Union has entered into force, which should harmonise the procedure of both tax administrations in resolving such cases.
Financial transactions are a separate category of related-party transactions where the context in which the transaction takes place is important. Our experience in tax audits to date suggests that to properly define the category to which the financial transaction under review actually belongs and to demonstrate the actual risks associated with the transaction on the part of the lender or guarantor, it is necessary to describe and explain the basic principles of the financial strategy of the group as a whole. The group's financial strategy should be described in the section of the transfer pricing documentation referred to as the MASTERFILE.