New Transfer Pricing Directive

It has been more than three months since the OECD issued a new version of the Transfer Pricing Directive. How has the text of the Directive changed since the last update in 2017? Based on the information published by the General Financial Directorate, the most important changes can be summarised in the following three points:

• revision of the profit split method, including an annex containing examples of the application of the method;
• a new Chapter X containing guidelines on transfer pricing in the area of financial transactions; and
• a new Appendix to Chapter VI on the application of the approach to intangible assets that are difficult to measure

I consider it important to become more familiar with these changes, especially for Czech entities that have been mandated by a multinational group to undertake research and development of new intangible assets or to provide intangible assets created by them for further use within the group. For such companies, the profit split method might be an appropriate way to determine the price in related party transactions.

 

Revision of the profit split method

The objective of the profit split method is to distribute the profit among the entities involved in the transaction in a way that most fairly reflects the added value each of them has contributed to the common goal. It is not without significance that the profit split method can be applied to the allocation of losses in the same way as to the allocation of profits.

The Directive does not contain any prescriptive rules to help identify the cases for which the profit split method is most appropriate.

The advantage of the profit split method is the ability to resolve cases where each of the parties contributes to the transaction in a unique and valuable way. A limitation to the use of this method may be that it requires knowledge of the consolidated result of the entire transaction. In many cases, it is difficult to extract from accounting records maintained under different laws the costs and revenues incurred by all the entities involved in transactions leading to a common objective in a way that would enable the profit to be identified with sufficient reliability to be distributed as remuneration for the functions performed and the assets involved.

According to the Guidelines, one key that may be used for profit split purposes is the time spent by experienced professionals on a transaction resulting in a unique intangible asset. However, this assumes that there is a linear relationship between the amount of this time effectively spent and the value of the asset being developed. Closely related to this issue is also the new Annex to the Directive on the treatment of hard-to-value assets.

For the profit split method to be used effectively, contractual arrangements are needed that define the rules under which the profit will be split, as well as the duration of these rules. And it is written contractual arrangements clearly defining the set rules for pricing between related parties that are often forgotten in practice. The absence of written contractual arrangements often leads to a lack of evidence in the event of a tax audit, which may result in an additional tax assessment.

 

New Chapter X of the Directive

Czech entities that benefit from intra-group financing such as cash pooling should pay particular attention to the new Chapter X of the Directive containing guidelines on financial transactions. Chapter X contains a description of the stricter rules for testing financial costs and benefits linked to short-term intra-group financing transactions.

Short-termism is essential in cash pooling transactions. The average interest rates at which banks in the Czech Republic lend money to each other on the interbank market can be used to test the interest rates associated with cash pooling transactions. Such a rate is, for example, 3M PRIBOR.

The evaluation of the test results is based on the circumstances in which the financial transaction was negotiated. In the case of a cash pooling transaction, the desire for synergistic use of cash within the group is taken into account, one of the main advantages being easy access to a source of funding. A market-clearing interest rate is considered by the profession to be a situation in which the cash pooling borrower's interest rate is no higher than the rate that would have been negotiated with a banking institution. The cash pooling lender's rate, on the other hand, should be higher than what the bank would have offered for the funds provided.¹ Otherwise, the use of cash pooling would not provide the expected benefit/reward to all entities involved, including the entity responsible for maintaining the master account.

In a market environment, the amount of interest is determined by an agreement between the two parties which, among other things, reflects the risk of the debtor's insolvency. The rate at which the bank obtains the deposit in the interbank market is increased by this risk premium. According to the CNB's forecast published on 5 May 2022, the three-month PRIBOR rate could reach 7% in 2022. In the case of interest rate settings for intra-group financial transactions such as cash pooling, it is essential to monitor the rapidly changing rates on the interbank market.

Cash pooling operations may be subject to mandatory reporting, the scope of which is set by the CNB in a decree. ² This obligation may apply, for example, to companies whose annual volume of financial loans granted or received in relation to foreign countries at the end of the calendar year reaches CZK 100 million. ³