Transfer pricing and the impact of rising interest rates

April 2023

During 2022, central banks around the world such as the US Federal Reserve and European Central Bank introduced successive increases in base interest rates. This tendency has continued in 2023, and further increases are expected to help curb rising inflation.

Interest rates that central banks control determine the rate at which commercial banks can borrow. When these interest rates rise, commercial banks tend to pass on the increase to their own borrowers in the form of higher interest rates. This raises an important and specific question: how does this affect transfer pricing? In this article we consider some of the potential implications for financial transactions between related parties.

The arm’s-length principle

The overarching principle of transfer pricing is that related parties involved in controlled transactions shall conduct themselves in the same way that third parties would behave in similar circumstances. Therefore, if external influences such as interest rates are changing, it follows that there might be implications for the arm’s-length nature of financial transactions between related parties. This is true for both new and existing transactions.

New and existing financial transactions

Generally, the arm’s-length nature of financial transactions should be evaluated every time a financial instrument is granted or amended.

In this context, any financial agreement that carry tacit or automatic renewal capability merits close attention, particularly if any of the parties can oppose the extension of the agreement. At arm’s length, third parties would aim to renegotiate the terms and conditions, considering current costs as well as available funding and investment opportunities.

Funding value chain

In multinational groups it is usual to centralise third-party debt and then grant intercompany funding to related parties. At arm’s-length, a lender would only lend if the financial transaction produces a positive outcome. Consequently, in the context of rising debt costs, multinational groups should analyse their funding value chains to ensure they are feasible for transfer pricing purposes.

Further, transfer pricing policies should avoid increasing intercompany interest rates to a point where they exceed those available on the open market.

Borrower’s cash position

Intercompany financial transactions must align with transactions that third parties would undertake in similar circumstances. This means considering both a lender’s and a borrower’s circumstances.

In recent years, low interest rates have led to bank deposits receiving little interest, having a direct impact on the related parties’ opportunity costs. With interest rates rising, banks are beginning to offer returns on deposits. This creates an expectation that a borrower with significant cash deposits might partially or totally repay a debt (if allowed under the agreement). Similarly, at arm’s length, a company might only be willing to lend to a related company  where the return exceeds the expected return of alternative investments.

Debt capacity and balance structure

Higher interest rates can make borrowing less attractive, leading borrowers to prefer equity intensive funding structures. Therefore, it is important to understand that it is not only interest rates that drive the arm’s-length nature of an intercompany financial transaction but all conditions of the funding agreement. This includes any debt-to equity proportion or interest coverage ratio.

Following OECD guidance

In view of the OECD’s Base Erosion and Profit Shifting project (BEPS), most jurisdictions have incorporated interest-capping, thin capitalisation and earnings stripping rules. Rising interest rates may affect a borrower’s capacity to comply with these regulations, making intercompany debt less attractive than other funding alternatives.

The January 2022 edition of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrators incorporates the report Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10, issued in February 2020.

While most jurisdictions follow, directly or indirectly, the OECD transfer pricing guidelines, local practice or regulation may also prevail. This means it’s not possible to be definitive and the advice of local transfer pricing experts is invaluable.

About the author

Airam González San Fiel
Madrid, Spain

Airam joined Russell Bedford in Spain in 2022, following eight years in the Global Transfer Pricing Services practice of KPMG Spain. During this time, Airam did a secondment in KPMG’s New York office.

Airam has wide experience managing and leading global transfer pricing documentations covering more than 30 jurisdictions. He has also been involved in the design and implementation of transfer pricing policies, as well as in restructuring and M&A projects. With regards to tax audits and agreements with and between tax authorities, such as Advance Pricing Agreements (APA) and Mutual Agreement Procedures (MAP), Airam has worked with the tax and competent authorities in multiple jurisdictions.

agonzalez@gnlrussellbedford.es