Key trends and focus areas on the assessment of intercompany financial transactions

Tax authorities are sharpening their focus on intercompany financial transactions from a transfer pricing (TP) perspective.

In brief

• Tax Authorities are examining intra-group debt levels, focusing on arm’s length principles, economic rationale, and the borrower’s debt capacity to secure a similar loan.
• Arm's length interest rates and the fair allocation of benefits in cash pooling and guarantees are being increasingly scrutinized to ensure they reflect independent terms.

Over recent years, there has been a noticeable increase of interest from Tax Authorities for intercompany financial transactions from a transfer pricing (TP) perspective. This growing attention reflects the evolving regulatory landscape, the increasing sophistication of Tax Authorities, and the recent massive surge of yield curves. Consequently, financial transactions are being examined in greater detail than ever before. Where in the past Tax Authorities focused mostly on interest rate benchmarking, their field of interest has rerouted towards a multitude of other transversal and complex considerations.

Below is a summary of the key trends and focus areas that can be currently observed.
 

1. Intra-group debt level and business rationale

It can be observed that Tax Authorities closely examine whether the levels of intra-group debt are justifiable from an economic perspective, and whether there is a sound business rationale supporting the intercompany loan existence. Tax Authorities also now focus on ensuring if the debt’s quantum as such is also consistent with arm's length principles, and if the transaction has a clear economic purpose aligned with the borrower's business strategy and purpose.

When assessing intercompany loans, it is essential therefore to assess whether the debt materiality also aligns with arm's length principles. This involves evaluating, from a stand-alone perspective, whether the borrower — should it be an independent entity — could and would similarly secure a similar loan. The key emphasis is on whether the borrower has an arm's length debt capacity, meaning whether a third party, such as a bank, would realistically consider the loan under comparable terms. Taxpayers are expected to conduct a thorough analysis of the potential impact of the debt quantum associated with an intercompany loan. Additionally, a sound business rationale should be established and ideally documented to demonstrate its validity. These considerations go much beyond more ‘classic’ aspects like EBITDA rules limitations e.g., but call for a standalone economic analysis.
 

2. Arm’s length pricing of intra-group loans

Conjunctly, there is obviously still a specific focus on whether arm’s length interest rates are applied to related-party loans. Tax Authorities have not stopped to also consider the arm’s length character of pricing of intercompany interest rates, but are increasingly applying the arm’s length principle more rigorously, utilizing detailed comparability analyses to determine whether the terms and conditions of intra-group loans align with what would have been agreed upon between independent parties, considering both qualitative and quantitative assessment, taking into account factors such as the borrower’s credit rating, the purpose of the loan, and prevailing market conditions. Tax Authorities expect that the determination of the borrower’s credit rating aligns with the group's transfer pricing policy. Consistency with internal comparable (external sources of funds conditions) is also more and more scrutinized or considered as a starting point.

Therefore, the pricing of financial transactions is increasingly transversally examined, and request a very robust and consistent examination.
 

5. Functional capacity

Functional capacity is crucial in assessing whether financial arrangements within MNEs adhere to the arm’s length principle. Tax Authorities are increasingly focused on whether the entities involved in these transactions possess the actual capacity to control, understand and manage the associated financial risks. This assessment extends to evaluating whether the entities have the necessary personnel, expertise, decision-making authority, as well as financial capital in place. Additionally, it involves verifying that the financial and operational characteristics of the entities justifies the terms of the arrangements. Financing decision-making and risk-taking entities, therefore, more than ever, need to be properly equipped with the right operating financial substance.
 

6. Impact of economic uncertainty and volatility

The recent economic volatility, driven by factors such as the COVID-19 pandemic and geopolitical tensions, leading to material inflation and surge in yields, has further complicated the landscape of financial transactions. Tax Authorities are increasingly vigilant about the impact of these uncertainties on financial arrangements.

They are examining whether MNEs have adjusted their financial transaction terms to reflect the changed economic conditions and whether such adjustments are documented and justified appropriately. Tax Authorities are particularly interested in the renegotiation of intra-group loans, the reassessment of credit risks, and the adjustments in interest rates to align with the new market realities. General terms and conditions misalignments are also high on their agenda.
 

Key takeaways and considerations

• Have a critical look at the potential impact of an intragroup leverage. In case the credit rating analysis is dependent on financial parameters such as leverage ratio, it should be assessed whether the results of the quantitative credit rating analysis are adversely impacted by the level of intercompany debt and interest expense. A robust debt capacity will help in supporting the debt leverage of the borrowing entity.
  
  
• Verify the interest rates for deposits and borrowing in the cash pool and assess the balances and options realistically available to cash pool participants. It is vital to substantiate that being cash pool participants is still the most favourable option, which would typically come from volume and netting synergies created via the cash pool.
  
  
• In the case of intercompany financing transactions, have a clear economic rationale and, where necessary, adequately demonstrate the expected benefits of leverage.
  
  
• Prepare transfer pricing documentation before engaging in any intercompany financing arrangement, as substantiating the arm’s length nature ex-post could be more challenging. Said documentation should embrace not only pure quantitative elements but should also have a close look at qualitative elements.