Intra-company financing is under growing scrutiny from tax authorities, with many arguing that certain capital transactions should only earn a ‘risk-free’ return. But is this realistic?

Economic theory, corporate finance principles, and commercial reality all suggest not (outside some extreme scenarios). Risk-free returns are rarely observed in practice.

The risk-free return argument

We have observed tax authorities referencing paragraph 1.108 of the OECD Transfer Pricing Guidelines to argue that if a funder does not manage financial risks, it should receive only a risk-free return. This interpretation suggests that when capital is provided without direct involvement in risk management, the return should be comparable to a government bond yield rather than a commercial rate.

While we have seen this position cited in tax disputes, this view is inconsistent with how investors and businesses would be expected to behave at arm’s length. In reality, investors always expect compensation for the risks they bear, and these risks are almost always greater than ‘risk free’.

Returns are rarely risk free at arm’s length

A risk-free return is an economic concept, with the rates of interest paid on government debt typically used as a proxy. Investors always demand compensation for the risks they bear, which is why:

• Capital providers expect returns above risk-free rates. Standard corporate finance models, such as the Capital Asset Pricing Model (CAPM), demonstrate that a business's cost of capital is linked to its risk level, not the lender's involvement in managing risks.
• Even passive investors earn market-driven returns. Pension funds, asset managers, and other institutional investors may play no active role in risk management, yet they still earn commercial returns on their investments.
• Businesses would not accept risk-free rates for their financing. If a company could only offer a risk-free return, capital would flow elsewhere to more attractive opportunities.

Risk control vs. capital returns: a false link?

Applying paragraph 1.108 by asserting or assuming that some form of risk management must be performed by the capital provider to justify a return above a risk-free rate would be open to robust challenge. In reality:

• Capital providers often delegate risk management but still expect competitive returns above the risk-free rate.
• Separation of risk control from capital raising does not imply a lower return to the capital itself. The cost of the capital is determined by the risks being borne. The price of the risk management is determined in the relevant markets for the inputs being used to manage the risks.
• The true test is whether an independent third party would accept a risk-free return on the capital it provides. Almost always, the answer would be no, given their capital is at risk.

Proceed with caution

In nearly all cases, capital providers demand returns above risk-free levels because businesses are inherently riskier than government bonds. Any analysis of capital returns should be undertaken with care, particularly in circumstances where paragraph 1.108 has been cited.

For businesses facing this argument, the best response is to put forward sound economic reasoning, clear commercial logic, and evidence from real-world financing transactions to explain the economic characteristics of the transaction, and to explain what an arm’s length transaction would therefore look like.

This is a shortened version of an article that previously appeared in Tax Journal: Transfer pricing: why returns are rarely risk-free