The reasons to assess the loans for related companies, according to the Transfer Pricing Regulation
What is the market interest rate to be agreed upon in financing among member companies of the same Multinational Economic Group?
What factors must be considered within a regulating Transfer Pricing scope?
This item aims to clarify these questions that, generally, member companies of the same Multinational Economic Group face before the liquidity needs for the working capital or other objectives the Group can establish within its policies.
The Arm’s Length Principle, which the Transfer Pricing regulation is subject to, establishes that all transactions must be performed at market values or price as independent companies do in business relations.
According to this principle, establishing the market interest rate for financing between related companies can be quite complex than the mere evaluation of the debtor’s risk, the currency, the amount of the principal, and the agreed term.
Due to the power of Multinational Economic Groups to decide on loan conditions to be agreed upon, these must consider the tax results, some of which are included within the international Transfer Pricing regulations.
Currently, tax administrations focus on tax audits related to inter-company financing especially. Hence, authorities adjust the agreed interests and even tend to reclassify transactions recorded as capital contributions to loan accounts, depending on the context of the transaction and analyzing both lenders and debtors. Due to tax audits, the taxable base is adjusted, requiring participants the due recognition of taxes by those transactions that determined the tax loss, if applicable. Depending on the nature of transactions, it does not only possibly affect the liquidity of companies but may turn into long and costly litigation for the Multinational Economic Group.
Regarding the financing within the Transfer Pricing regulations, the following questions are answered: Under common market conditions, what is the maximum amount a third party would lend if the borrower cannot pay, may merge, is in a country with unstable policies, or the industry in which operates is highly regulated? What is the quantity in a rate to be agreed upon considering these risks? May the rate agreed between related parties assume the parent companies or companies with greater financial stability as implicit guarantors? among others?
Answering these questions implies performing an accurate functional analysis to identify the functions performed, assets used, and risks assumed by the related parties in the controlled transaction.
Thus, according to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (Section B.3.2. – Functional Analysis), Company A, a disbursement lender, does not have control over the granted fund, but a parent company P, which has financial capacity, actually does it. Hence, the company A would be only entitled to a risk-free yield.
On the other hand, being a member of an economic group could also consider the transfer of a possible implicit risk of the group due to the level of subordination of the company, which implies assessing the credit rating of the company and the group belonging to it.
This type of assessment requires that documentation and technical reports supporting the loan transactions between related companies have been agreed upon, thus complying with the Arm’s Length Principle. These studies and documents will be periodically prepared for each loan transaction performed among several companies of the group.
Concluding the aspects addressed herein, companies must include the following actions in their policies or procedures:
- Quarterly monitoring of the loan accounts granted/received with related parties.
- Detailed contract on the conditions of the financing granted, specifying the market rate, term, currency, and guarantees (if applicable), among others.
- The contractual terms and conditions should provide detailed information consistent with the actual conduct of the parties involved or other facts and circumstances.
- Specialized external advice on market interest rates to be considered, which will depend on the type of financing.
- Monitoring tax projections before the closing of the accounting year to provide for the calculation of presumed interest for direct tax recognition in the income tax return, if necessary.
- Functional analysis to identify the functions, assets, and risks associated with the controlled transaction.
- Establishment of intra-group financing policies and identification of the companies exercising the centralizing function of these financings.
Source: OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. January 2022
