Various economic, political and tax factors are increasing the need to consider financing arrangements for your business, coupled with significant recent changes in tax legislation in how these arrangements should be priced and supported. Below are some examples of how this may impact businesses and what needs to be evaluated in the near term.

Current environment

A multitude of factors in recent years, spanning the economic, political and tax environments, are putting a spotlight on and leading to increased scrutiny of, the transfer pricing aspects of intercompany financial transactions.

Here in Ireland, updated transfer pricing legislation was introduced – effective for accounting periods beginning on, or after, 1 January 2020 – which incorporates the most recent OECD Transfer Pricing Guidelines into Irish legislation. The updated legislation also specifically references assessing the underlying economic nature of transactions and expands the breadth of transactions within the scope of the Irish transfer pricing legislation (resulting in a number of intercompany financial transactions previously outside the scope of the Irish transfer pricing legislation now coming within the scope of the Irish transfer pricing legislation). This includes certain loans and guarantee arrangements.

It is helpful to note that the updated Irish transfer pricing legislation currently retains the exemption for SMEs from the specific transfer pricing requirements but does include a draft section to bring SMEs within the scope of the legislation in the future. In addition, the expanded scope of the transfer pricing legislation provides an exclusion for certain specific domestic non-trading transactions.

Together with the updated transfer pricing legislation, the Irish tax authority have actively increased their transfer pricing resources, with substantial growth in the transfer pricing audit team headcount. The Chairman of the Board of the Irish Revenue Commissioners has also recently spoken publicly about the planned focus on transfer pricing.

From a wider economic perspective, the impact of the COVID-19 pandemic on the global and local economies has put a significant strain on liquidity. Impacted groups are having to amend external financing arrangements. Within groups, treasury and tax teams are trying to optimise cash available and direct cash where it is most needed – often through intercompany loans.

From a political perspective, countries will continue to protect their tax base as evidenced through the Base Erosion and Profit Shifting (BEPS) project which began in 2013 focusing on specific base eroding transactions. The BEPS project has moved at considerable pace issuing the final BEPS papers for the original focus areas in 2015, and ultimately incorporating these into the updated OECD Transfer Pricing Guidelines in 2017. In the midst of a potential economic slowdown, this focus on a country’s tax base will only intensify.

A subsequent focus area coming out of the BEPS project was to address the transfer pricing aspects of financial transactions. In February 2020, the OECD issued the long-awaited final version of the financial transactions paper (FT Paper). This paper provides specific guidance on assessing the underlying economic nature of the transaction and pricing such intercompany financing transactions.

In addition, there has been an increasing number of significant court cases across the globe which have centred on the transfer pricing aspects of intercompany financial transactions. This trend is likely to continue given the impact of the current economic, political and tax factors on intercompany financing transactions noted above, not mentioning the abolition of LIBOR and introduction of interest limitation rules in 2021.

Financial transactions and the FT Paper

As a result of the changing environment, intercompany financial transactions are now a key focus area of tax authorities. The recent guidance on financial transactions could lead to some contention, particularly in the areas of intercompany lending and options realistically available. Therefore, the sections below focus on these topics and how they span across different disciplines within an organisation.

Intercompany lending

Intercompany lending is an important component of the treasury function of a group. The subsections below focus on some of the key aspects of intercompany lending that need to be considered:

Quantum of debt

The FT Paper discusses how intercompany loans need to be analysed to determine if under arm’s length conditions, the full amount of the intercompany loan would be considered debt or if a portion/all should be recharacterised as equity which would limit the interest deduction available to the borrower.

In performing the debt capacity analysis, it is important to consider a number of questions:

1. Would a lender be willing to lend this quantum of debt;
2. Should the borrower capitalise itself with the stated level of debt considering its financial competitiveness against peers; and
3. Could the borrower be expected to service its interest and principal obligations for this level of debt?

In addressing these questions coverage ratios, leverage ratios, serviceability and other considerations specific to your industry must be assessed.

Credit ratings

Ensuring the interest rate applied to an intercompany loan is arm’s length is still an important factor of intercompany lending. In this regard, the credit rating of the borrower has a significant influence on the arm’s length interest rate.

When determining the credit rating of the borrower, the FT paper notes the preference for starting at a standalone borrower rating. There are various methodologies and tools for determining this rating however there is a preference for using an open methodology which looks at both quantitative and qualitative factors.

Group membership

The incidental benefit that a borrower is assumed to receive due to being part of a wider group is referred to as implicit support. Implicit support may affect the standalone credit rating of a borrower to different degrees depending on the strength of such implicit support. The relative status of an entity within a group can help to analyse this strength.

The recent guidance could be read as attributing more weight to implicit support than was previously the case. This could have considerable knock-on consequences for the credit ratings of borrowers. We have seen this primarily in recent work when pricing intercompany loans and guarantee fees.

It is also important that careful consideration is given to group policies with respect to third party loans viz-a-viz intercompany lending policies. These third-party policies may provide a point of reference for the terms and conditions which should be applied on intercompany loans.

Options realistically available

A key term discussed across various sections of the FT Paper is “options realistically available”. The FT Paper notes that independent entities will consider all other options realistically available before entering into a financial transaction. Therefore, in a related party context, all partiesto a financial transaction should consider if there are any other options available that offer a more attractive opportunity to meet their specific needs.

For example, in the context of a cashpool participant who has excess cash, they may receive a better return on this cash by investing in a money market fund rather than placing the cash on deposit with the cashpool leader. Other factors may also need to be considered to determine if this alternative option works for the entity and the group, particularly in terms of access to the funds and compliance with the group’s investment objectives.

The options realistically available should be assessed for all intercompany financial transactions being entered into and for each party involved.

Interaction – tax, treasury and finance

The transfer pricing of financial transactions has significant implications across an organisation, particularly in the areas of tax, treasury and finance.

As discussed earlier, debt capacity ratios, credit ratings, interest rates and options realistically available are key factors when analysing financial transactions. At a group level, the tax, treasury and finance teams need to work together to ensure that the factors above are analysed in a way that is in line with the strategic objectives of the group as a whole.

For specific transactions, interaction between these teams is needed to ensure that transactions are planned and executed in an efficient manner that complies with the necessary regulations. As part of this process, the documentation prepared by each department should be consistent.

Key takeaways/considerations

The current economic, political and tax environments are putting a spotlight on the transfer pricing aspects of intercompany financial transactions.

Careful consideration needs to be afforded to the transfer pricing aspects of intercompany financial transactions as treasury and tax teams try to optimise cash available and direct cash where most needed within the group during the current economic environment. It is also important to assess the impact of the current economic environment on existing intercompany financial transactions, the ability of borrowing entities to service these arrangements, and any impact on the nature or pricing of such arrangements.

In light of the recently issued OECD financial transactions paper, groups are being encouraged to review their current transfer pricing policy for financial transactions for consistency with the guidance and considerations set out in the paper, as tax authorities begin to implement and apply this new framework and the principles within.

In addition, the interaction between the OECD financial transactions paper and the Irish transfer pricing and corporation tax rules is a developing topic and one that needs to be considered carefully.

For many taxpayers, who are now in Q3 of the financial year, thought needs to be given to these significant changes and transactions to be considered as a result of the developing financial transactions transfer pricing environment. Now is the time to start reviewing and understanding them. We are seeing greater pressure on interest rate deductions through the changes to credit rating approaches (implicit support), debt capacity and guarantee fees. As a result, these changes could have a bearing on your anticipated tax charge for the year.

Aoife Harrison Transfer Pricing Partner, PwC Ireland

Email: aoife.harrison@pwc.com

Dáire Corcoran Transfer Pricing Senior Manager, PwC Ireland

Email: daire.corcoran@pwc.com

Michael Douglas Transfer Pricing Manager, PwC Ireland

Email: michael.k.douglas@pwc.com