Recent (court) developments and challenges on intercompany financial transactions
In the past few years, financial transactions have become an important topic for tax authorities, especially when it comes to audits. In the wake of the BEPS-project, the OECD has devoted a great deal of attention to this topic. Most importantly, in February 2020, the new Chapter X of the Transfer Pricing Guidelines was released, providing specific guidance on financial transactions. Additionally, CFC-rules and earnings stripping measures were introduced as general anti-abuse rules.
With increased attention and the new Transfer Pricing guidance, intercompany loans are increasingly scrutinized. This has led to an increase in disputes regarding financial transactions. Some examples are the BlackRock-case in the UK, as well as Dutch cases regarding the qualification of perpetual securities and regarding interest rates charged.
It is strongly recommended that you review the transfer pricing aspects of your financial transactions, preferably before implementing the transaction. Quantera Global has a dedicated team of experts in this field. If you have any questions regarding this topic, feel free to contact us.
Below are some points to consider regarding intercompany financial transactions.
First Question: Debt or Equity?
When looking at the Transfer Pricing aspects, the first question to ask is whether the loan is in reality a loan for tax purposes or should be considered as equity. Although the contractual agreement might classify a transaction as a loan, an agreement is only the starting point of the accurate delineation process. As there are a wide variety of financial instruments, the terms and conditions of a specific transaction should be carefully considered. The same goes for the business rationale of the transaction, the borrowing company’s debt capacity and the economic conditions that may have a material effect on the price.
Further analysis, including a functional analysis of the borrower and lender, will have to determine whether the agreement is also followed by these parties. Special attention must be paid to the entity assuming the risks. This party must both be in control of the risks and have the financial capacity to bear the consequences of materializing of these risks.
A recent case highlighting the importance of a thorough analysis is the Blackrock case in the United Kingdom, which raised the question of whether a comparable third party would have the availability to such a large amount of debt in the open market. In addition, the question was raised whether the main purpose of the transaction was to obtain a tax advantage and therefore no attributable interest should be awarded.
Second Question: An Arm’s Length Remuneration
To determine an arm’s length remuneration on a financial transaction, it is important to consider both the perspective of the lender and the borrower. A third-party lender would pay close attention to the borrower’s creditworthiness to determine the credit risk of a loan. A credit rating is usually determined by both qualitative (e.g., strategy of the company and industry) and quantitative factors (e.g., financial information). Determining a borrowing company’s creditworthiness can be challenging, also given the implicit support effect that must be taken into account. In summary, this means that a company that is part of a Multinational enterprise also benefits indirectly from being part of that group.
Based on the credit rating of the borrowing company and the relevant terms and conditions of the financial transaction, it is possible to find comparable transactions in databases such as Bloomberg and Thomson Reuters. This is something we do often for our clients/partners and requires careful consideration of the relevant terms and conditions and well-documented substantiation of the steps taken.
In the Netherlands, two recent court cases have challenged the interest rates on intercompany loans. In the most recent case, based on the contractual agreement the interest rate was set between 11.5% and 14%. However, the court agreed with the tax inspector that an interest rate of 2.5% would be more appropriate and limited the deduction of interest charged to the company. This shows the importance of substantiating the interest rate on your intercompany loans with proper transfer pricing analysis and documentation.
How can Quantera Global help you?
Governments around the world have incurred significant costs in coping with the COVID-19 pandemic, which is why an even further increase in tax audits is expected. With this, as well as the increased importance of transfer pricing on financial transactions, it becomes crucial for MNEs to make sure their intercompany financing is at arm’s length. This drastically improves the level of control when tax authorities start their audit.
At Quantera Global we have a lot of experience with the arm’s length principle for intercompany transactions. With our strong track record in topics such as intercompany loans, cash pools, guarantees and captive insurances, we can help you from the start with the design through to the implementation and documentation process.
If you would like to know more about the Transfer Pricing aspects of financial transactions, please feel free to contact us.