This article was first published in Tax Journal
The OECD/G20 BEPS programme acknowledged the potential impact of financing arrangements on multinational groups, with a potential for the erosion of tax bases resulting in the Action 4 recommendations to introduce limitations on interest deductibility. This action specifically sidestepped the question of transfer pricing. However, in doing so, it highlights some views that transfer pricing can be relatively hard to understand and police.
Even in the face of the prevalence of mechanical interest barriers, such as the UK's corporate interest restriction, transfer pricing remains a potent tool and at the heart of how tax treaties allocate taxing rights on related party interest amounts.
With this in mind, it is critical to understand the financing arrangements of a group and its interaction with the transfer pricing rules. This will enable businesses to set robust transfer pricing policies for financing arrangements and gain comfort from its supporting documentation. In this article, we outline the types of financing arrangement commonly found and the various factors and approaches that should be considered in dealing with them.
Financing arrangements: what, how and why?
Groups may find themselves with related party financing relationships in all manner of situations. Sometimes these arise entirely unintentionally; for example, if trading balances accumulate without payment or offset, as part of group structuring — for instance, an acquisition or reorganisation — or from commercial need. We examine the following in this article:
- Leveraged corporate acquisitions
- Real estate backed loans
- Intragroup working capital loans
- Cash pooling arrangements
- Guarantees, and
- On-lending arrangements.
Most of these are self-explanatory. Cash pools are arrangements that seek to make efficient use of a group's cash balances by balancing credit and debit positions across the group, and minimising external borrowing costs. They typically combine types of lending but are worthy of separate consideration due to the potential complexity of the overall arrangements.
Regardless of how a loan balance arises, the transfer pricing considerations are typically framed by the following questions:
- Would this amount of debt (or some of it) have been agreed between an independent lender and borrower?
- How much would a lender have charged and how much would the borrower be willing (and able) to pay?
- What terms would have been agreed for this arrangement?
These questions are specifically enshrined in UK legislation. As with other transfer pricing areas, there is a broad consistency of approach globally. However, some countries will typically place more emphasis on assessing the pricing of a loan than the quantum, especially if other rules limit the amount of debt that can be taken into account (often referred to as thin capitalisation rules). Other countries tend towards fixed levels of permitted interest expense with less acceptance of an arm's length position.
OECD guidance and tax authority positions
The OECD transfer pricing guidelines provide the basis on which the UK and a significant number of countries globally interpret the application of the arm's length principle, but these guidelines do not currently contain considerations specific to financing arrangements.
The interpretation of how the arm's length principle applies for financing arrangements still benefits from many of the general aspects of this guidance, such as the need to consider various facts and comparability factors in the analysis of how independent parties might have acted. However, given that many transfer pricing methods do not naturally translate to this type of transaction, businesses and tax authorities typically resort to a range of 'other methods' and approaches.
The OECD has been working on updated guidance to include this area since the BEPS programme, but publication has been repeatedly delayed. This has led to suggestions that when guidance is eventually published, it may reflect a non-consensus view with some nations expressing reserved positions.
Potentially controversial areas may include the impact of intragroup guarantees: authorities and case law in some territories take the view that a subsidiary should expect to benefit from anticipated support from its parent company; others exclude any parental support to reflect a fully standalone position. The UK is, currently at least, in this latter position with legislation excluding the impact of related party company guarantees.
HMRC has had published guidance in place and a well embedded unilateral advance pricing agreement programme (the advance thin capitalisation agreement (ATCA) programme), which has primarily dealt with leveraged buyouts sponsored by private equity houses. Recently, additional guidance has been issued in relation to cash pooling and HMRC has increased its activity in investigating how these arrangements are structured.
Independence in a financing context
The UK transfer pricing rules have a significantly wider ambit in relation to financing arrangements than other types of transaction.
The reason for this is that it is quite feasible that a shareholder can influence the terms on which a lender might be prepared to offer finance by providing a guarantee or otherwise through wider relationships between the lender and the shareholder and/or its other investments.
In most cases, any independent lenders seen as 'acting together' with a shareholder in respect of financing can be clearly identified as not having their financing terms affected, allowing the lending terms to be waved through as 'arm's length'. It is, however, important to remember the reasons for this step and be alert to any factors that may cause apparently unconnected lenders to offer different terms.
Timing of analysis
An independent lender will consider the circumstances of the borrower ahead of advancing finance and will then commit funding for a period agreed under the loan terms, which may be a short term facility or a multiple year agreement. This leads to the key point in time for assessing a loan under the transfer pricing rules often being the inception of the financing, based on forecasts and other information that would have been available at that time.
Hindsight should not be used and so lower than expected results should not necessarily automatically result in the conclusion that less debt should be in place. However, conversely actual results are important in several ways.
Firstly, most long term loans at arm's length will have a series of financial conditions that alter the terms of the loan if breached. This can involve provisions to maximise the lender's ability to sweep cash from the borrower including penalty interest rates or mandatory repayment of some or all of the loan. There is not a single answer that represents what would happen for all loans in a default position and careful consideration is needed.
The position can be particularly awkward to unpick if an independent lender acquires some or all of the shares in a business as part of a severe default, leaving it to a potential adjustment under the transfer pricing rules on existing debt in place. (This is contrasted with the arm's length position that might arise where a new hypothetical lender considers whether to advance any funds at all and, if so, on what terms.)
Secondly, the use of hindsight can have some validity in providing a sense check as to whether the original forecasts were robustly prepared. Lenders are expected to be wary of overly optimistic forecasts and to form reasonable judgments for themselves, although of course this may be easier said than done. A significant variance from forecasts without identifiable and unforeseeable causes can lead to the conclusion that different figures would have been used in an arm's length assessment.