Limiting the transfer pricing burden for the insurance industry
Insurers face a growing transfer pricing compliance burden as industry-specific elements increase complexity. However, regulatory compliance remains key to limit tax and reputational risks. In this regard, it is of paramount importance to be aware of potential pitfalls for the insurance industry, as well as to analyze how technology may assist insurers to navigate through the changed regulatory landscape.
Financial transactions transfer pricing has been a topic much discussed by practitioners in recent years. Little practical guidance on the correct determination of arm’s length interest rates for intercompany loans and cash pools was available as local regulators and case law often used different concepts and principles.
In February, the OECD published the long-awaited and first ever consensus document on financial transactions transfer pricing. It outlines the high-level principles and best practices when determining an arm’s length interest rate. The document reduces the uncertainty but imposes strict compliance measures on all multinationals.
Corporations active in the financial services industry, such as insurers, are however still subject to industry-specific characteristics. The OECD document recognizes these challenges but does not specify any practical guidance. Consequently, there are several hurdles for insurers on their road to compliance. Technology and process automation may be leveraged in order to limit the compliance burden by reducing the required time and resources for these compliance processes.
Where the relevant MNEs are regulated, such as financial services entities subject to regulations consistent with recognized industry standards (e.g. Basel requirements), due regard should be made to the constraints those regulations impose upon them as stated in the OECD Transfer Pricing Guidelines on financial transactions (2020), §10.15.
Entity-specific credit ratings
The OECD document clearly formalizes the need for user entity-specific credit ratings when pricing an intercompany financial transaction. In other words, the credit rating of the borrowing subsidiary should be assessed rather than using the group rating. This borrower-specific credit rating should be determined based on both financial as well as qualitative information.
The financial credit rating will be based upon the stand-alone financial statements of the borrowing entity. This financial credit should be complemented with qualitative information that is not (yet) captured in the financials. One critical element that should be considered is implicit group support. Should the borrowing entity not receive a formal guarantee, the level of affiliation with the group should be assessed to predict the likelihood of group support. A high level of implicit group support will have a positive impact on the credit rating of the subsidiary.
The challenge for insurers lies within the financial assessment of the entity. As the balance sheet and P&L structure of insurers is likely to differ from most other industries, an appropriate credit rating model should be used. Such credit rating model may not be readily available.
In contrast to the financial analysis, insurers are likely to follow the same processes to determine the impact of qualitative elements as multinationals in other industries. For insurers, the regulation may have an impact on the level of group support, for example.
Comparable uncontrolled transactions
The main method used to determine an arm’s length price for financial transaction is the comparable uncontrolled pricing (CUP) method. This method relies on comparable market transactions in order to determine an arm’s length interest rate. In general, the yield on bonds in the secondary market is used, as this data is available in a structured manner from market data providers. When selecting the bonds, it is key that these market transactions are comparable to the terms and conditions of the intercompany loan. Therefore, the insurer will focus on selecting bonds with a similar credit rating, maturity, currency, etc. Should there be any differences between the comparable bond and the intercompany loan, a comparability adjustment should be made.
Most transfer pricing analyses will filter on corporate bonds to be used in the CUP method, specifically filtering out financial institutions and insurers due to these industries’ particularities. Contrary to corporates, insurers should focus on bonds issued by other insurers in order to reflect their industries’ particularity in their own transfer pricing analysis. This may impose limits on the availability of bond data in scope.
The determination of internal interest conditions for cash pool participants has also been formalized by the February document. The OECD outlines a three-step approach. First, the multinational should calculate the overall benefit generated by the pooling structure for the group. This benefit may arise from the offsetting of debit and credit balances, as well as more favorable interest conditions for the participating subsidiaries.
Secondly, the functional analysis of the cash pool will determine the functions performed and risks assumed by the cash pool leader. The renumeration for this entity would need to be defined as a portion of the total benefit and should in line with its functional profile.
Lastly, the remainder of the benefit would need to be allocated to the participating subsidiaries. By enhancing their interest conditions, the group creates the necessary financial incentive for them to participate. Effectively, the arm’s length interest rates within a pooling structure will incorporate a pooling discount for pooled withdrawal rates and a pooling premium for pooled deposit rates. This complex process should be put in place by all multinationals, including insurers.
Technology as a remedy?
The new OECD transfer pricing guidelines for financial transactions trigger many multinationals to evaluate their current processes. Regulatory compliance is a key consideration in order to limit tax and reputational risks. The new guidance is also an opportunity for insurers to rethink the operational processes around these compliance topics. Many calculations (such as determining a credit rating, calculating comparability adjustments, calculating the pooling synergy, etc) are complex and error-prone. Introducing automation in this area may improve the reliability of the results and reduce time spent on transfer pricing processes. It may also increase auditability during e.g. tax audits.
Wondering how the Zanders Inside Transfer Pricing Solutions may help you to facilitate compliance in a cost-effective manner? Please do not hesitate to reach out to us to discover how automation may help your organization!