Transfer Pricing challenges in Private Debt structures: navigating arm’s length principles in a non-traditional market

Private debt has become a significant alternative financing source, particularly in Europe and Luxembourg. While offering flexibility, these structures introduce complex transfer pricing challenges due to bespoke terms, contingent features, and limited market comparables. This article examines key issues in applying the arm’s length principle in relation to intra-group financing in the context of private debt transactions, outlines practical approaches for compliance, and provides a case study illustrating a typical benchmarking in a Luxembourg fund structure. It also explores emerging trends, regulatory scrutiny, and the role of technology in shaping future best practices.

The rapid growth of private debt markets has reshaped corporate financing strategies. Unlike traditional bank loans, private debt instruments (such as uni-tranche facilities, mezzanine loans, and hybrid instruments) are often negotiated privately and tailored to specific borrower needs. 

Private debt is not merely a niche product; it represents a structural shift in global capital markets. Institutional investors, including private equity funds and alternative asset managers, increasingly favor private debt for its yield potential and flexibility. However, this evolution introduces complexities that demand a multidisciplinary approach including transfer pricing, tax and regulatory aspects.

When carrying out private debt transactions, Luxembourg investment funds generally finance debt acquisitions via Luxembourg holding companies (“SPVs”). The financing provided by the fund to SPVs in the form of debt is considered a transaction between related parties and should be carried out in line with the arm’s length principle.

However, contrary to other industries (such as real estate and private equity), the characteristics of the third-party receivable instrument and the return expected complicate the transfer pricing analysis on the related party transaction, particularly under the Organisation for Economic Co-operation and Development (“OECD”) Transfer Pricing Guidelines (OECD, 2022), which emphasize accurate delineation and risk allocation. 

Regulatory Context for Transfer Pricing

The OECD’s Chapter X on Financial Transactions provides a framework for pricing intra-group financing arrangements. Tax authorities across Europe, including Luxembourg, have intensified scrutiny of financial transactions following the OECD’s Base Erosion and Profit Shifting (“BEPS”) project. Mispricing can result in significant tax adjustments, double taxation, and reputational risk for multinational enterprises and asset managers. Luxembourg, as a leading hub for investment funds, faces heightened expectations for robust transfer pricing documentation. Authorities increasingly require granular evidence of arm’s length pricing, including credit risk analysis, functional profiles, and economic substance assessments. Therefore, the Draft Law (Bill No. 8186) and Grand-Ducal Regulation implementing it aims to modernize transfer pricing compliance and introduce documentation obligations in line with OECD BEPS Action 13 on Transfer Pricing Documentation and Country-by-Country Reporting.

While it is not expected that private debt structures will be impacted by the provisions to be introduced by Bill No. 8186, there is significant push in terms of transfer pricing compliance in Luxembourg which can potentially increase the scrutiny also in structures where one side of the transaction is not with related parties. This trend is already visible since many market players in the private debt industry are receiving inquiries from the Luxembourg tax authorities in relation to their transfer pricing documentation.

Key Transfer Pricing Challenges for Private Debt

In the context of other industries and intra-group funding, it is often possible to rely on third-party transactions that can be used (at least partially) as comparable transactions. This is particularly true in the context of the selection of the intra-group payable instruments (such as interest-bearing loans with or without specific features). 

However, third-party transactions in the private debt markets lack transparency. Increased complexity in the instrument features such as payment-in-kind (PIK) interest, equity kickers and contingent clauses affect pricing and risk but are rarely reflected in standard databases. These features blur the line between debt and equity, increasing questions about characterization and tax implications, thus creating additional complexity from a transfer pricing point of view.

Unlike syndicated loans, private debt deals are bespoke, limiting the availability of reliable Comparable Uncontrolled Prices (CUPs) to price the related party transactions used to finance them. This scarcity forces practitioners to rely on more complex intra-group payable instruments (such as derivatives) to mirror, as much as possible, the intra-group instruments used to fund the third-party transactions. This increases the need to use different methods than the transfer pricing methods presented in the OECD Guidelines and entails synthetic benchmarking or alternative data sources to price them at arm’s length conditions. 

In addition, the OECD Guidelines require identifying which entity controls and assumes credit risk of the transactions. Intra-group arrangements often create ambiguity, necessitating detailed functional analysis especially in the context of private debt funding. Control over risk—not mere contractual assumption—determines entitlement to returns, which is the arm’s length remuneration that the SPVs in Luxembourg should earn. In particular, the transactions carried out by the SPVs will not fall into the scope of the Luxembourg Transfer Pricing Circular (Circular L.I.R. No. 56/1 – 56bis/1) since the transaction on the asset side is carried out between unrelated parties. This means that from a transfer pricing standpoint, the requirements might be less stringent. However, the pricing of the arm’s length remuneration is still key, and it can follow similar methodologies than the one used for Luxembourg companies falling into the scope of the Circular. In addition, depending on the underlying type of third-party debt, the arm’s length nature of the intra-group payable instrument should be monitored to avoid non-deductibility of the interest and possible withholding tax.

Practical Compliance Strategies

When evaluating whether intra-group transactions used to finance third-party debt comply with the arm’s length principle, it is crucial to go beyond a purely contractual review and consider the actual behavior of the parties involved, as well as their financial capacity to provide such funding. These elements should be continuously monitored to ensure that the arrangement reflects what independent entities would have agreed upon under similar circumstances.

In particular, when determining the financial capacity of the Luxembourg SPVs (which is linked with the arm’s length amount of debt that SPVs can borrow), a fundamental component is determining an indicative credit rating for the underlying investment. However, establishing such a credit rating in the context of private debt can be particularly challenging. Unlike public debt markets, where credit ratings and market benchmarks are readily available, private debt transactions often lack transparency and standardized data. As a result, commonly used approaches for intra-group transactions (such as relying on the group’s overall credit rating or performing a simple review of the borrowers’ financial statements) may not provide a reliable measure of creditworthiness.

To address these limitations, alternative methodologies should be considered. For instance, an analysis based on the internal rate of return (IRR) of the underlying investment can offer a more accurate reflection of expected performance and risk. Similarly, referencing the credit rating of the broader industry in which the borrower operates can provide useful context, particularly in sectors such as real estate debt funding where market dynamics significantly influence risk profiles. These approaches should be complemented by a detailed risk analysis, especially in situations where the financing structure involves not only intra-group loans but also additional third-party funding. Such complexity increases the need for a robust assessment of potential risks and the capacity of the parties to manage them.

Finally, all these considerations must be thoroughly documented in comprehensive transfer pricing reports. This documentation should go beyond simply presenting the pricing of the intra-group transaction. It should include a functional analysis of the parties involved, a clear explanation of the economic rationale behind the arrangement, and evidence supporting the chosen methodologies. By doing so, the documentation will not only demonstrate compliance with the arm’s length principle but also anticipate and address potential queries from tax authorities, thereby reducing the risk of disputes.

Outlook

Tax authorities are increasingly focusing on audits of financial transactions in Luxembourg and other European jurisdictions including private debt funding. AI-driven benchmarking tools and unconventional transfer pricing methods are emerging as a solution to mitigate data limitations and improve predictive accuracy in transfer pricing analyses even though a thorough transfer pricing functional analysis together with business rationale should be included in the transfer pricing documentation. 

Conclusion

Private debt structures require rigorous transfer pricing analysis, as their bespoke features make arm’s length assessments more complex and heavily reliant on robust documentation aligned with OECD Guidelines. Increasing scrutiny means that detailed functional analyses, clear business rationales, and careful characterization of hybrid or derivative based intra group instruments are now essential. The functional profile of Luxembourg SPVs must also be closely monitored and thoroughly documented to address potential queries from both local and foreign tax authorities. In a fast evolving market, assumptions that once supported an arm’s length position may no longer hold, making regular reviews and stress testing of transfer pricing policies indispensable.