Arm’s length pricing means using market rates

Related parties that enter into intercompany financing (or other) transactions with each other must pay taxes as if they were independent parties. Consequently, their related party financial transactions need to be structured and priced on an arm’s length basis. This requirement applies not only to short-term and long-term loans but also to cash pooling, hedging, and guarantees. While these requirements have existed for a number of years, there is currently an added layer of scrutiny on intercompany financial transactions following the introduction of a dedicated chapter on financial transactions in the latest OECD Transfer Pricing Guidelines.  This guidance is focusing the attention of tax authorities on how to challenge the transfer pricing of financial transactions. 

The pricing of intragroup loans depends on various factors, and rates or margins vary across sectors and currencies. In 2022, however, we have observed a consistent upward shift in interest rates.  . Iin some cases, the increase is higher than in others – but in almost all areas the increases in 2022 were significant.

For instance, as outlined in our chart, one-year USD loans for industrial companies with investment grade (A) yielded 0.62 percent at the beginning of 2022, but at the end of December, they stood at 4.75 percent. Over the same time period, yields on B-rated industrials in USD climbed from 2.21 to 6.42 percent for one-year loans and from 3.79 to 7.51 percent for five-year loans.

_{Figure 1: USD industrial yields 2022 (Source: MSCI Inc.)}

While market changes happen fast, company practices can be slow to catch up. From an arm’s length standpoint, it is important that the terms and conditions of intercompany transactions reflect third party dealings and market rates. Accordingly, new loans need to be priced at current market rates and existing loans may need to be updated (or even refinanced) to reflect the conditions of third-party arrangements. Failure to respond to the changing market environment can result in non-arm’s length transactions, which can in turn lead to negative consequences such as lengthy audits, tax adjustments, and even litigation. Moreover, it can also adversely impact other aspects of financial transactions, such as debt quantum and terms.

Close the risk gap

When it comes to intercompany financial transactions, MNEs need to act strategically based on the magnitude of the deal at hand. This may include reviewing policies and pricing, assessing risks, evaluating the options realistically available to the parties, and possibly updating/refinancing arrangements. And let’s not forget about compliance – proper documentation and dispute resolution mechanisms like advance pricing arrangements and rulings are non-negotiable.