After a long period of low-interest rates, the era of cheap financing is over. The steep rise in interest rates in Q3 and Q4 2022 has direct consequences for the intercompany transactions, meaning that the Transfer Pricing approaches have to be more accurate and sharper than ever.
Which areas of financing are affected?
The change in interest rates may have an impact on the following:
- intercompany loans;
- cash pools;
- provision of collateral;
- supplier loans;
- early loan repayments;
- financing companies; and
- interest deduction restrictions.
Intercompany financing should be negotiated in line with market conditions and in accordance with the arm’s length principle. Central banks worldwide have increased their reference interest rates, which, in general, increases financing costs. If the interest rate for an intercompany loan is based on a reference interest rate (i.e., EURIBOR), this must be adjusted accordingly or considered for new contracts concluded from 2023 onwards.
According to Chapter 10 of the OECD Transfer Pricing Guidelines 2022, it is necessary to differentiate between a loan as debt or equity. Higher interest rates lead to a decrease in the economic capacity of the borrower to repay the loan and to an increase in the default risk of the lender. We advise an analysis and documentation, according to which the borrower will be still economically able to service the loan. Otherwise, there is a risk that a loan will be re-qualified as equity and the interest expense deduction will be denied.
A decrease in the borrower’s credit rating due to rising financing costs may have to be reflected in a risk surcharge on the interest rate. The credit rating of a group of companies may deteriorate as a result of rising interest rates. A poorer group rating has a direct impact on affiliated companies, in case when the individual rating is identical to the group rating (implicit group support).
In the case of a cash pool, interest rates are relevant for the provision or drawdown of funds. Contrary to the background of available options for the individual participant in a cash pool, it should be discussed whether participation in a cash pool is the best option. Depending on the region, it may be more advantageous for the individual participant to invest available funds locally, taking advantage of the higher deposit spreads currently on the market. Conversely, it may be easier and more efficient to finance locally than via a cash pool arrangement, especially in the short-term view. In this case, a cost-benefit analysis must be conducted to determine whether it is beneficial for the individual to participate in a cash pool arrangement or not.
Provision of collateral
Rising financing costs make it increasingly difficult to cover local financing requirements on a stand-alone basis, i.e., attractive conditions are only granted by means of guarantees from the parent company. Such guarantees must be analyzed from an arm’s length perspective and appropriately remunerated.
Supplier loans within the group (i.e., from sales companies) should be checked as far as the agreed conditions and their actual implementation are concerned and, if necessary, compared with the procedure vis-à-vis external customers. In times of zero interest rates, exceeding payment terms without interest may still have been accepted as a financing instrument by the tax authorities, an approach that is not accepted any more.
Early loan repayments
With an early repayment agreement, a loss situation may arise for the lender, in the case of a fixed interest rate with simultaneous variable rate refinancing. Such agreements should be reviewed for possible adjustments needed.
Financing companies may find themselves in a loss situation if the interest income from internal fixed-rate agreements (i.e., fixed rate over 3 years) with affiliated borrowers no longer matches the rising external refinancing rates. In this case, it is highly likely that such a situation will be picked up by a tax audit.
Interest deduction restrictions
Increasing interest expenses, due to higher interest rates, lead to an increased number of transactions falling under the local interest deduction restrictions.
Take-Away and Recommendations
It is expected that an increasing number of intercompany transactions will be under tax scrutiny soon. It is recommended to review the existing financing agreements for any adjustment required. In addition, the contractual gaps must be closed, and the new financing transactions shall be concluded based on current market and capital conditions. If you have identified adjustment risks or mismatches and gaps as a result of current interest rate developments, it is advised to supplement your Transfer Pricing documentation.
For further consultation on the different approaches to taxation and financial regulation of each jurisdiction, please contact us.