Transfer pricing in a high interest rate environment

TaxTalk - April 2024

read timeRead time: 28 mins

Soaring UK inflation and interest rates, the highest for over a decade, mean cost of living pressures and economic uncertainty. What’s the impact for businesses and their financing arrangements from a transfer pricing perspective?

Businesses and their intra-group arrangements should comply with transfer pricing rules, which adhere to the arm’s length principle. This means that intercompany financing arrangements should be based on terms and pricing which would be agreed between independent parties, based on the prevailing economic conditions. Otherwise intercompany transactions can breach transfer pricing rules and be adjusted by HMRC, with potential exposure to interest, penalties, and economic double taxation.

In a high interest rate environment, UK companies should proactively review, and update where appropriate, their intercompany financing arrangements. We outline below the key transfer pricing and Corporation Tax implications that businesses most commonly encounter.

Thin capitalisation rules

High interest rates have placed greater importance on the pricing of new intercompany debt, including debt pushdown after refinancing of external borrowing.

Thin capitalisation rules look at whether a UK company has more debt than it either could or would borrow without group support, when acting in its own interests in the open market. This can lead to disallowance of any excessive interest deductions claimed by the UK borrower.

Businesses which provide asset-backed lending are particularly affected. In the commercial property investment sector, legacy financing structures with high loan-to-value ratios (that were set up during much lower market interest rates) are difficult to extend on similar terms. Investors are currently placing higher deposits to reduce interest repayments on asset purchases, reducing comparable independent loan-to-value ratios as a result.

What’s more, maintenance of debt covenants, such as interest cover ratios, has placed pressure on businesses to reassess their financing arrangements.

Financial and performance guarantees

Financial institutions are exposed to various levels of credit risk when lending based on the financial security of a borrower. This is typically determined by the borrower’s credit rating.

A UK company with a weak credit rating may facilitate a financial or performance guarantee from a group affiliate (typically a parent company) with a stronger credit rating. This can take the form of a comfort letter, keep-well agreement, or explicit credit guarantee. Each can secure a lower interest rate on external borrowing with significant savings to the UK borrower (or alternatively result in third party costs where a UK company is the guarantor).

Businesses should consider the pricing of intercompany guarantees carefully to avoid the pitfalls. As these arrangements are often complex, it’s important to be clear on the specific guarantee, quantify the level of actual benefit, and calculate the arm’s length price of guarantee fees based on the economic conditions.

Early repayment and termination clauses in loan agreements

Loan agreements typically include clauses on early repayment and termination, which can be exercised by one or both parties. Following the advance of funds, a UK lender at arm’s length may seek to renegotiate to take advantage of an increase in market interest rates. Similarly, a UK borrower on a floating interest rate may want to renegotiate to secure a fixed rate for future certainty.

It’s crucial for businesses to review intercompany agreements and consider whether, and to what extent, to re-price or amend their terms and conditions to reflect the current economic circumstances. New loan agreements should also contain relevant fallback provisions.

Business restructuring and asset valuations

As well as financing arrangements, high interest rates can impact other business activities like asset valuations on transfers between companies. In the absence of direct comparables, asset valuations are typically calculated on an income-based valuation method, such as discounted cash flows.

A key component here is the discount rate to apply, which considers the time value of monies. This is directly affected by high interest rates. So, it’s important for businesses to assess the economic conditions and effects of timing of intra-group asset transfers.

What should you do now?

High interest rates can have major transfer pricing implications for businesses. These can be complex, so should be considered carefully.

As the first quarter of 2024 ends, multinationals should decide whether any transfer pricing adjustments are needed for financial reporting (for calendar year-end companies) or tax return purposes. In our December issue, we discussed the importance of making appropriate transfer pricing adjustments.

Businesses should constantly review whether, and to what extent, the high interest rate environment impacts their existing intercompany financing arrangements. This may suggest a defence requirement for retaining the existing position, the need to reprice, or the setting up of new (and unwinding of outdated) internal financing-related flows.

Any revised intercompany financing arrangements should reflect the latest economic conditions and business facts, supported by transfer pricing analysis and documentation.

For further guidance, please contact Farhan Azeem and Kiran Rai