Transfer Pricing, Treaty Benefits Reshaped by OECD’s Tax Update

The most recent update to the OECD Model Tax Convention marks a watershed moment for multinational enterprises and their capital structures.

For years, a tension has existed between multinationals using cross-border debt financing to optimize global effective tax rates and tax authorities deploying anti-avoidance rules to protect their domestic tax bases.

The November 2025 update to Article 9 bridges the gap between international tax treaties and Chapter 10 of the Organization for Economic Cooperation and Development’s transfer pricing guidelines by formally elevating the “accurate delineation” of financial transactions into the treaty network.

This development matters because it provides tax authorities with a robust, treaty-sanctioned framework to attack excessive debt financing.

By endorsing the accurate delineation of transactions under Article 9, tax authorities can recharacterize excessive debt as equity. It will allow authorities to aggressively apply the anti-avoidance provision of Article 11(6)—which denies treaty benefits on excessive interest—to the volume of debt. This solves a historical limitation that had restricted authorities from applying the provision to excessive interest rates.

For tax directors and practitioners, understanding this intersection is no longer optional—it’s a mandatory prerequisite for defending global capital structures.

Formalizing Chapter 10

To appreciate the gravity of the update, practitioners must look at the specific language added to the Commentary on Article 9 (associated enterprises). The new guidance incorporates the concepts of the OECD transfer pricing guidance on financial transactions (the FT report), which was consolidated into Chapter 10 of the transfer pricing report.

The update clarifies that countries may take different views on applying Article 9 to determine the balance of debt and equity funding of an entity within a multinational enterprise group. The commentary notes that while some contracting states use the accurate delineation of the transaction in the OECD transfer pricing guidelines to determine if or how much a purported loan should be regarded as a loan for tax purposes, other contracting states address the issue of the balance of debt and equity under their domestic laws, including judicial doctrines.

Under both approaches, determining whether a purported loan should be respected as a loan precedes any attempt to price the transaction. This is a sequential mandate: Characterization comes first and pricing comes second. Once a transaction is respected as a loan, the guidance in chapters one, two, three and 10 of the OECD transfer pricing guidelines must be followed to price the controlled transaction.

This linkage clarifies that Article 9 doesn’t merely govern the arm’s-length pricing of the interest rate; it governs the arm’s-length nature of the capital structure itself. It also clarifies that Article 9 doesn’t deal with whether expenses are deductible when computing the taxable income of either enterprise because conditions for deducting expenses are determined by domestic law.

Examples of domestic rules that can deny a deduction for expenses include thin capitalization rules and interest stripping rules, such as the fixed ratio and group ratio rules recommended in the final report on BEPS Action 4.

‘Excessive Debt’ Dilemma

The most profound impact of the update lies in its intersection with Article 11(6) of the OECD Model. Historically, tax authorities faced a dilemma when attempting to deny treaty benefits (such as reduced withholding tax rates) on interest payments arising from heavily debt-laden subsidiaries.

Article 11(6) stipulates that the treaty’s withholding tax limitations apply only to the arm’s-length amount if there is a special relationship between the payer and the beneficial owner that causes the amount of the interest to exceed the amount which would have been agreed upon in the absence of such relationship.

The traditional interpretation of this provision was constrained by its precise wording. Article 11(6) typically restricts treaty benefits “having regard to the debt claim for which it is paid.” Because of this phrasing, Article 11(6) generally doesn’t apply to an excessive amount of debt. It historically was applied to scenarios where the interest rate itself was excessive compared to the open market.

If a multinational company capitalized a subsidiary with an astronomically high volume of debt but applied a perfectly arm’s-length interest rate to that debt claim, an arm’s-length interest rate, calculated with the transfer pricing approach, normally wouldn’t be considered excessive under a strict reading of Article 11(6).

The endorsement of the accurate delineation of transactions bridges this historical gap. By applying Chapter 10 principles under Article 9, a tax authority can accurately delineate the financial transaction based on its economic substance. If the economic reality reveals that an independent party wouldn’t have produced that volume of debt, the tax authority can recharacterize the excessive portion of the debt claim as an equity contribution.

Once the underlying “debt claim” is recharacterized as equity, the payments made on that excessive portion are no longer considered interest on a debt claim. As a result, the tax authority gains a robust treaty basis to use Article 11(6) (in conjunction with Article 9 and domestic rules) to deny the withholding tax benefits originally claimed on the recharacterized interest, treating it instead typically as a hidden dividend distribution.

‘Substance Over Form’

Classifying transactions as loans or equity impacts multinational taxpayers, especially when purported loans exhibit equity-like features. Tax authorities normally will seek to recharacterize a controlled transaction when its economic substance differs from its legal form, applying a strict “substance over form” approach.

Accurate delineation requires a deep commercial analysis that considers the economic reality of the financial instrument and its terms and conditions. When analyzing these structures, tax authorities evaluate a matrix of practical indicators. Does the instrument feature an indefinite maturity or lack fixed repayment dates? Are there standard commercial covenants in place? Is the debt subordinated to other creditors? Does the borrower possess the ability to obtain third-party loans of a similar volume from an independent bank?

If tax authorities challenge an intragroup loan, the outcomes of recharacterization from the borrower’s jurisdiction generally fall into two categories:

• Full Recharacterization: The entire loan amount is considered equity. In this punitive scenario, all interest expense claimed by the borrower is disallowed as a deduction, and the entire stream of payments can be recharacterized as dividend distributions.
  
• Partial Recharacterization: Only a part of the loan amount is treated as equity. Under this approach, the tax authority determines the maximum arm’s-length amount of debt the borrower could have sustained. Only the interest expense on the excessive portion of the funding is disallowed, while the arm’s-length interest rate remains deductible on the portion of the funding that is respected as a loan.

While much of the focus rests on the borrower’s jurisdiction (where the interest deduction is claimed), the OECD update creates significant challenges from the lender’s jurisdiction.

The accurate delineation of transactions is a two-sided coin. If the borrower is deemed to have received an equity injection rather than a loan, the lender may face characterization of the instrument as quasi-equity. This can lead to complex anti-hybrid rules or treaty disputes, particularly if the lender’s jurisdiction continues to impute interest income on the transaction while the borrower’s jurisdiction denies the corresponding deduction, resulting in economic double taxation.

Furthermore, Chapter 10 of the transfer pricing guidelines requires an analysis of whether the lender has the financial capacity to assume the risk of the loan and whether it exercises control over those risks.

Planning Points

The abundance of specific anti-avoidance rules—including transfer pricing rules, earnings stripping rules, and domestic thin capitalization safe harbors—raises the critical question of how multinationals can minimize their tax exposure.

A taxpayer’s ability to meet the predetermined mechanical ratio of an earnings stripping rule or a thin capitalization safe harbor (such as a 1.5:1 debt-to-equity ratio) doesn’t mean that it will comply with the transfer pricing rules provided in Chapter 10 and the updated Article 9 commentary.

All these approaches may apply at the same time, meaning interest expense could be allowed under the Earnings Before Interest, Taxes, Depreciation, and Amortization rules but disallowed under the transfer pricing accurate delineation rules.

That means complying with the transfer pricing approach upfront provides the most robust defense. Multinationals that are bulletproof from a transfer pricing perspective—meaning they rigorously follow the guidance of Chapter 10—can minimize the risk of interest expense being disallowed by tax authorities under any of the other statutory approaches.

To defend their capital structures against the enhanced scrutiny brought by the OECD update, tax directors and advisers must build comprehensive transfer pricing documentation that establishes undeniable commercial rationality. This defense hinges on two interconnected concepts.

The “Would” Argument From the Borrower’s Perspective: Taxpayers must document whether the borrower would have entered the loan from a third party under these exact terms and conditions. This requires a detailed behavioral and economic analysis of the borrower: Would an independent enterprise, acting in its own best commercial interest, saddle itself with this level of fixed-interest obligations?

Multinationals must prepare cash flow projections, debt service coverage ratios, and commercial viability studies showing that the borrowing entity projected enough operational cash flow to service the debt without relying on continuous financial bailouts from the parent company. If the borrower is structurally loss-making or relies on the parent’s financial strength to survive, the “would” argument collapses, and the debt is ripe for recharacterization as equity.

The “Could” Argument From the Lender’s Perspective: Taxpayers also must document whether the borrower could have accessed similar debt from an independent bank, and whether the lender could reasonably expect a return commensurate with the risk. This requires establishing a shadow credit rating for the standalone subsidiary and using third-party banking criteria to prove that commercial lenders would have extended the funds.

The lender must be shown to have the substance, personnel, and financial capacity to manage and bear the risk of a potential default. It’s no longer enough to merely paper an intercompany loan through a cash-rich but substance-empty holding company.

Looking Ahead

The OECD’s 2025 update to the model tax convention’s commentary on Article 9 signals a paradigm shift in the international taxation of financial transactions. By tethering Article 9 to the accurate delineation principles of Chapter 10 of the transfer pricing guidelines, the OECD has handed tax authorities a sophisticated mechanism to bypass traditional treaty limitations.

Tax authorities no longer are restricted to merely adjusting the interest rate under Article 11(6); they can deconstruct and recharacterize the underlying capital structure, transforming excessive debt into equity and neutralizing withholding tax benefits in the process.

For multinationals, the days of relying solely on mechanical thin capitalization safe harbors are over. Tax directors must engage in forward-looking planning, ensuring that every intercompany financial transaction is backed by rigorous “would” and “could” analyses.

In the post-2025 landscape, defending a global capital structure requires proving not only the arithmetic of an interest rate, but also the commercial bedrock of the transaction itself.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Christos Theophilou is a tax partner at STI Taxand in Cyprus.

Write for Us: Author Guidelines