Transfer Pricing implications of increase in market interest rates

The current macroeconomic landscape is marked with high inflation as a result of increased consumer demand post-Covid and a rise in energy prices. Inflationary pressures were further accentuated by political turmoil in Eastern Europe and supply chain issues caused by lockdowns in China. To counter the rise in prices, central banks such as the Federal Reserve and the Bank of England have been increasing their benchmark interest rates. Although in a slower tempo, the European Central Bank has also increased interest rates with further increases likely to follow. These developments have a direct impact on the arm’s length pricing of certain types of intra-group transactions which have been briefly discussed below:

Intra-Group Financing

From an arm’s length standpoint, it is critical that the terms and conditions of intra-group transactions reflect third party dealings and market circumstances. Due to the increase in benchmark rates, the funding cost has risen and this ideally should also echo in intra-group loan arrangements. Therefore, it is important that current market interest rates are reflected in the arm’s length interest rates of new transactions. In addition, one should also assess whether embedded options such as a “demand option”, if included in the current agreements, could be exercised or not. In any event, it is advisable to document the reasons for exercising or not exercising the option. Such a document could be useful when dealing with audits in the future.

The rise in market interest rates will also impact the arm’s length pricing of cash pooling transactions as interest rates on deposits and loans are dependent on market rates. Further, one should also review the options realistically available to cash pool participants to ensure that being part of the cash pool is still the most beneficial option for them. There could be a scenario where the deposit rates in local countries have increased significantly more than the deposit rates being offered in the cash pool. This would then raise the question of whether being in the cash pool would make sense for the participants. A cost benefit analysis could be undertaken to conclude on the most beneficial option, which could then be documented for internal files.

Finally, the rising cost of debt may also result in an increased difficulty to access funds in local markets from third party banks. In such a case, parent entities may have to provide financial guarantees to banks for the local entities to receive funding at favourable rates. These financial guarantees need to be evaluated from an arm’s length perspective and if a benefit has been received by the local entity, then an arm’s length guarantee fee may be applicable.

Asset Valuations

When reliable comparable uncontrolled transactions involving asset transfers cannot be identified, income based valuation methods are generally used to determine an arm’s length value of an asset. These valuation methods are based on discounting projected future income streams or cash flows using an appropriate discount rate and calculating the net present value of those cash flows.

One of the most important inputs in such a valuation exercise is the discount rate, which captures the risk associated with the future cash flows related to the asset. The discount rate calculation takes into account the current market circumstances, with the rise in interest rates and the current reduced equity returns having an impact on the discount rate and accordingly on the value of the asset. Therefore, it is crucial that the timing of intra-group asset transfers are considered carefully as it can have a significant impact from a tax standpoint.

Arm’s Length Return for Limited Risk Activities

The Organisation for Economic Cooperation and Development Transfer Pricing Guidelines 2022 support the application of comparability adjustments when it enhances the accuracy and reliability of the results. Comparability adjustments are designed to eliminate differences that may arise from differing accounting practices between the controlled and uncontrolled transactions, or differences in the allocation of functions, assets and risks. One such comparability adjustment is the working capital adjustment, which is undertaken to account for differences in working capital (accounts receivable, accounts payable and inventory) between the tested party and the comparables.

When carrying out working capital adjustments, the time value of money is calculated using an appropriate interest rate. The increase in market interest rates would generally enhance the adjustment, potentially resulting in a reduced return for limited risk activities vis-a-vis returns in a lower interest rate environment. Such variation could lead to an inconsistency between the transfer pricing policy of a set targeted return (based on prior benchmarking analysis) and the results using the latest data. Therefore, it is essential that the transfer pricing policy is updated, if required, to ensure consistency with market conditions and the arm’s length principle.

Key Takeaways

The recent increase in interest rates present a number of facets that need to be carefully considered when analysing a transaction from an arm’s length perspective. As outlined above, possible areas where higher interest rates could impact transfer pricing arrangements include:

• Intra-group Financing Transactions: it is important to ensure that current market circumstances are reflected in intra-group financing arrangements and the pricing is adjusted accordingly.
• Asset Valuations: discount rates used in valuation might be affected, which in turn could impact the asset value and therefore timing of the transaction is critical.
• Limited Risk Activities: working capital adjustments could be larger meaning that the set target return including the transfer pricing might need to be updated.

It is important to identify and adequately address these areas to ensure consistency with the arm’s length principle and in certain instances, mitigate tax audit risks in the future.