Related-party debt pricing is coming under growing scrutiny from tax authorities.
Governments around the world need to recoup their pandemic spending, and rising interest rates have made borrowing the funds they need more expensive. So tax authorities are having to become more aggressive – and more inclined to investigate debt transactions as a result.
And in the UK specifically, recent case law has motivated HMRC to look more aggressively at intra-group financing arrangements.
So what do organisations need to know about the landscape for internal debt financing? And what should they do about it?
Eye off the ball
Like other internal transactions, intra-group debt must be charged for on an arms-length basis. That means in line with the terms and interest rates that would have been set on the external market.
But since 2017, when Corporate Interest Restriction rules came into force in the UK, firms have been less attentive to debt pricing. Some now only assess the arms-length principle in retrospect, or fail to keep adequate documentation.
Of course, that’s because above a certain threshold, the debt no longer attracts interest relief. So there’s an assumption that regulators aren’t concerned about how it was priced.
But a less than rigorous approach can still lead to problems. During transfer pricing audits, tax authorities want to see that debt pricing reflects the current market (more on which below).
Debt pricing
There are two key aspects to consider when pricing internal debt: tax authorities’ priorities and current market conditions.
Tax authorities’ priorities
The OECD’s Transfer Pricing Guidelines deal with related-party debt in Chapters IX (on restructuring) and X (on financial transactions). When examining financing arrangements, tax authorities will demand evidence that firms have followed the principles set out in the Guidelines. To some extent, that’s good news for organisations. The principles reflect best practice and a common-sense approach to pricing, based on sensible reasoning. The ability to confidently demonstrate this should satisfy most authorities – though not all jurisdictions fully endorse the OECD approach.
Market conditions
Recent economic turbulence has severely disrupted debt-market and credit-risk dynamics. The inflationary climate has driven interest rates up, causing a contraction of lending appetites and maturity limits. These tightened even further following the Truss administration’s mini-budget in autumn last year.
Inevitably, these conditions have affected how firms should structure and charge for related-party debt, as interest rates reflect the much-changed market context.
Cash pooling
We’ve seen an increase in the use of cash-pooling arrangements, as market participants respond to economic headwinds.
The higher inflation and interest rates climb, the greater the appetite for optimising interest expense within large organisations. What’s more, cash pools also help to redistribute excess cash within a group of related entities to where it’s most needed.
The key considerations when operating a cash pool are its eligibility, structure and reward calculations:
Eligibility
It’s important to understand from the outset whether the substance of an internal financing arrangement actually qualifies it as a cash pool, or as an intra-group loan.
It may sound obvious, but in essence, a cash pool should be a short-term, flexible arrangement. Yet it’s not uncommon for organisations to treat loans as cash pools or vice versa.
Structure
Setting up a cash pool means making certain decisions about its structure. How many groups of depositors and borrowers will be involved? Who will the pool leader be, and how will they be rewarded? How will the benefits from the pool be distributed between the leader and its participants? (See below for more on reward.)
And importantly, should the interest rate be fixed or floating? Fixed rates are generally less expensive, and less risky, than floating rates, which can quickly spiral in inflationary times.
Reward
Calculating an arms' length reward for participants in a cash pool can be a key arena of complexity and so a potential target for audit by HMRC.
There are a number of alternative allocation systems that can be applied to analyse such rewards and are driven by the facts and circumstances of each case.
Funding frameworks
Some firms’ documentation of internal debt pricing has been less than robust in recent years.
Large, global organisations typically carry out large volumes of multi-currency, multi-maturity transactions – far too many to document every one. A funding framework is a pragmatic, modular way to reflect them: it’s a simple, decision-tree matrix, explaining how you set the interest rates applied.
Funding frameworks will vary greatly from business to business, and from sector to sector. The modules they consist of will depend on how the company runs its finances, and what drives its transactions. That will look very different in, say, an engineering multinational with expensive assets, compared to a global financial services provider.
