Transfer pricing of intra-group financing
Intra-group financial transactions are an essential part of the operations of multinational enterprises (MNEs). From the perspective of transfer pricing, it must be ensured that the terms and conditions applied on the intra-group financial transactions correspond to the terms and conditions that would have been agreed on by independent enterprises and that the profits accrued to the related party correspond to the profits that would have accrued to an independent enterprise in similar situation.
The return on the lender's investment must be at arm's length
Transfer pricing matters concerning intra-group financing may involve a broad range of different areas. For example, loan arrangements, collateral and guarantee arrangements, intra-group cash pools and different types of hedging mechanisms and instruments are typical parts of intra-group financing arrangements.
The most pivotal aim in the transfer pricing of financing-related transactions is to ensure that the terms and conditions for intra-group financing correspond to those that independent enterprises would have agreed on in similar situation. In intra-group financing it is essential to assure that the lender will receive an arm's length return on their investment in all situations.
Different areas of financing have their own special characteristics that play a role when arm's length prices are determined. A debt relationship between group companies is the most common financing-related transfer pricing matter. Therefore, in this connection, the focus is on the pivotal issues concerning the determination of the arm’s length interest rates on intra-group loans.
Financing arrangements must be at arm's length
In financing arrangements between independent enterprises, the form and terms and conditions of financing are agreed on a case-by-case basis according to the aims and needs of both parties. The same approach should be applied when intra-group loans are agreed on. When it is assessed whether the interest rate of an intra-group loan is at arm's length, consideration should be given for example to such issues as the functions, assets and risks of the company borrowing the money. In practice, this could mean that the creditworthiness, solvency and future prospects of the borrower are examined more closely.
As a rule, the poorer the solvency, the weaker the balance sheet and the poorer the future prospects of the borrowing company are, the higher is the risk the lending company is assuming when lending the money. Correspondingly, the higher the risk assumed by the lender is, the higher the interest and the stricter the loan conditions are.
The creditworthiness of the borrower can be examined based on its cash flow and assets and the solvency consisting of these factors. When the creditworthiness is assessed, consideration can be given to, among other things, the following matters:
- Are the business operations profitable or loss-making?
- How will the borrower manage to pay the interest payments and loan instalments after all the expenses arising from its business operations?
- Does the company have assets that can be used as loan collateral?
- What kind of future prospects does the company have?
- Are the business operations stable, on a growth path or highly sensitive to business cycles?
The creditworthiness of the company can be determined more closely by generating a credit rating of the borrowing company. The purpose of the credit rating is to measure the likelihood of the company becoming insolvent. There are a number of different ways to determine a credit rating of a company. In practice, however, the most common solution is to use the services provided by commercial credit rating agencies (such as Moody's or Standard & Poor's).
The interest of intra-group loans must be determined according to the arm's length principle
There are number of different methods for verifying that transfer pricing is at arm's length. The different methods are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted and an important source of interpretation when the arm's length principle is applied.
OECD Transfer Pricing Guidelines (www.oecd.org)
When determining the arm's length level of the interest rate the basis must be the interest rate charged in loan arrangements between independent enterprises in similar circumstances. The arm's length nature of the interest rate is usually assessed by comparing intra-group loan arrangements with corresponding loan arrangements between independent enterprises. This transfer pricing method is called the comparable uncontrolled price method (CUP).
If the borrowing company has an internal comparable (similar loan agreement with a third party lender) the arm's length nature of the interest on the loan between related parties must be primarily assessed based on this agreement. Generally, the creditworthiness of the parent company of the group and its ability to negotiate the terms and conditions of the loan with the lender differ from those of an individual group company. Therefore, the terms and conditions that the parent company is able to negotiate for its financing are not directly applicable to the intra-group financing provided to other group companies. Should there be no internal comparables, a search for comparables is required to be performed using commercial databases so that the arm's length interest rate can be determined. Applying different search criteria, details of loans between independent enterprises can be searched in the databases.
Typically, a broad range of different search criteria concerning the loans and the borrowing company can be entered into the databases. The terms and conditions of the comparable loans should be as identical as possible with the terms and conditions of the intra-group loan under review. The most essential search criteria include the credit rating of the borrower, ranking of the loan in relation to other loans, signing date of the loan agreement, maturity of the loan, size of the loan, currency of the loan, possible collateral and the market area. In practice, some of the search criteria may have to be left out in order to identify comparable loans in the database, in the first place. The comparable loans identified in the database indicate the arm's length range of interest margin within which the loan interest should be set between group companies.
Other matters to be considered in the transfer pricing of financial transactions
The following matters should also be considered in the transfer pricing of financial transactions:
Separate entity approach
The arm's length principle is based on the separate entity approach. This means that each related party is assessed as a separate entity being independent of the group. For example, a borrowing subsidiary is assessed as a party that is independent of the parent company when an arm's length interest on the loan is determined. Strong solvency position and assets of the parent company do not directly impact on the solvency and collateral of the subsidiary, meaning that they do not determine the arm’s length interest charged from the subsidiary either.
Insolvency of the borrower
If the group company is effectively insolvent, it cannot normally borrow money from third parties on standard terms. Financing such a company with borrowed capital through intra-group loan arrangements and on standard terms is not necessarily consistent with the arm's length principle.
The matters agreed between the parties in intra-group transfer pricing situations should be confirmed in written agreements stating clearly the parties to the agreement, the purpose of the agreement and the rights and obligations of the parties. At least the signing date of the loan, amount of the capital borrowed by the group company, the applied interest terms, the payment method of the interest and the conditions under which the loan falls due should transpire in the financing agreements.