In Transfer Pricing, concerning the Arm’s Length Principle, related parties must operate similarly to independent parties in comparable circumstances. In this regard, when the terms and conditions of the financial markets change, financial transactions between related entities will be affected.
1. Background
In 2022, inflation forced central banks to raise interest rates. Such a trend has been noted in financial institutions such as the European Central Bank or the U.S. Federal Reserve up to the present day.
Somehow, central bank interest rates determine the cost of funding for commercial banks. Rising central bank interest rates result in a parallel increase in commercial bank interest rates, which affects private entities seeking funding.
2. Multinational Group Value Chains
Within multinational groups, it is common for an entity to centralize funding with independent financial institutions and then provide funding to related entities. For this purpose, an independent institution would only grant funding to its borrowers if this operation would result in a positive margin for the lender.
If financing costs were to increase, it would be necessary to review the value chains of multinational groups in terms of financing to ensure their viability.
3. Borrower’s treasury
Due to the rising interest rates, financial institutions have resumed the remuneration of corporate bank deposits. Previously, when interest rates were low, such deposits were not remunerated, or negative interest rates were applied thereon.
Thus, in the current market context, an independent entity would presumably grant funding only if the expected return exceeds its available investment opportunities, or this, with a cash position2, might have incentives to amortize debt instruments.
4. Capital-aggressive Balance Sheet Structures
Given that high-interest rates reduce the attractiveness of debt, borrowers prefer capital-intensive balance sheet structures, i.e., funding in the form of equity will prevail over debt funding.
A company can be financed with its resources (capital) or borrowed resources (debt). The proportion between the two amounts is known as the capital structure.
Therefore, it is necessary to understand that the market nature of a transaction is measured not only by its interest rate but also by the totality of the terms and conditions of the transaction.
Source: Legal Today 30/03/23
