How does the rising cost of debt impact transfer pricing?

Recent increases in interest rates are bringing transfer pricing for financial transactions into sharper focus.

Interest rate rises bring transfer pricing for financial transactions into sharp focus.

Following the recent decisions of the Bank of England and the Federal Reserve to hike interest rates by a further 0.75 percent, and the recent turmoil in the UK Gilt market, it is important that businesses assess the transfer prices for existing related party funding arrangements against the arm’s length standard. Similarly, when new debt is being created it will be important to ensure the transfer pricing analysis is informed by current market conditions. As ever, taxpayers should look to stay on the front foot by ensuring the contractual terms for related party borrowing are properly documented.

The low interest rate environment of the last 15 years, coupled with more recent changes in tax laws implementing OECD BEPS Actions Two (Neutralising the Effects of Hybrid Mismatch Arrangements) and Four (Limiting base erosion involving interest deductions and other financial payments), may have reduced taxpayers’ and tax authorities’ perception of the transfer pricing risks associated with financial transactions.

Recent surges in interest rates and volatility in financial markets have changed the risk equation and potential transfer pricing risks relating to financing arrangements between related parties are likely to attract greater attention over the next few years, with further rate increases expected. Groups can put themselves on the front foot with audit readiness by ensuring they have reviewed the transfer pricing policies for their financial transactions and captured this in detailed contemporaneous documentation.

We have given a flavour below of some of the possible considerations for groups arising from the rising interest rate environment:

Arm’s length debt capacity (thin cap)

Rising interest expense makes debt financing less attractive than before. We are seeing third party transactions place more emphasis on equity funding, which means that the amount of intercompany debt that could be supported as arm’s length will reduce accordingly. Given pressure on EBITDA from rising inflation, it will also be more difficult to meet notional maintenance covenants for existing debt arrangements, increasing the risk of tax authority challenge. The pace of change means it is more important than ever to ensure the analysis is informed by current market conditions, including lender appetite, which is increasingly variable depending on factors such as industry sector and the size of the borrower.

Financial guarantees

Parental or other intra-group guarantee arrangements that maintain access to the lowest interest rates from third party lenders may become more beneficial in a higher interest rate environment. This will lead to complex considerations around the arm’s length amount of a fee for such a guarantee.

Early repayment/refinancing

Where a loan carries interest at a fixed rate but is repayable on demand, a lender (particularly one funded by floating rate debt) may at arm’s length initiate a renegotiation of the interest rate to mitigate the risk of a loss. It is therefore crucial to understand what the legal agreements say for each of your loans, and decide whether to reprice or amend any terms to mitigate the impact of the rate rises.

Profitability of finance companies

Where a finance company is funded with floating rate debt (internal or external), rises in interest rates will raise its interest costs. If the finance company lends to affiliates on a long term fixed rate basis (e.g. a five year term loan), the finance company cannot increase its interest income, resulting in a loss which is likely to be scrutinised from a transfer pricing perspective. Conversely, if the finance company raises the rate on the intercompany lending, a tax authority could challenge whether this is arm’s length for the borrower. Contractual terms are an important aspect of the analysis but other factors such as how financial risks are controlled within the group and the extent of the group’s exposure should be considered. This includes whether the benefits of any external hedging arrangements (e.g. swap contracts) are recognised in the entity where the exposure sits.

Tax relief under Corporate Interest Restriction (CIR)

Interest rate rises may mean interest expense is more susceptible to being restricted under the CIR rules. For example, with a higher interest rate, more debt arrangements will exceed the £2 million de minimis interest expense threshold requiring a CIR analysis to be performed.

Cash pooling

The low interest rate environment in previous years has meant it is common to see a nil rate applied to deposits in GBP and EUR. Deposit and overdraft rates for cash pools in many currencies will need to be revisited in light of rising interest rates. If the intra group deposit rate does not match the ongoing rate rise, this could create a risk exposure from a transfer pricing perspective.

Other transactions

Groups should also consider the impact of higher interest rates on the pricing of other transactions, for example asset valuations based on discounted cash flows, working capital adjustments for distribution entities and risk-free returns where entities lacking substance have funded intangible development costs.

With year-end approaching for many groups now is the time to be considering the above issues, how they will impact on related party transfer pricing arrangements and make sure they are taken account of in year-end transfer pricing reviews and prospective transfer price setting processes.

We have experience with a number of clients in helping them re-price their related party debt to take account of market changes, so please reach out to your usual KPMG in the UK contact if you would like to discuss.