The impact of rising interest rates on transfer pricing

Tue 16 May 2023

With rising inflation and multiple key interest rate increases, multinational enterprises should consider reviewing the prices of their intercompany financing transactions, which may no longer align with the arm’s length principle.

The quick rise in interest rates may have created significant divergence between the prices applied by a multinational enterprise on its intercompany financing transactions and the current market prices.

To mitigate the risk of dispute and challenges, taxpayers should perform regular reviews of their transfer pricing policies and consider the following points:

Intercompany financing

The rising cost of debt may affect companies which provide group financing through external debt funding. These companies should particularly pay attention to divergence that may happen if using both fixed and floating interest rates. Adjustments in transfer pricing policies may be necessary to ensure that the arm’s length principle is being met.

Companies using debt funding to finance their investments should consider the lender’s and the borrower’s objectives closely. There will need to be a commercial rationale for a transaction. For example, a lender may want to request an early repayment on an existing debt to a related borrower to grant a new debt at a higher interest rate. However, it would not make economic sense from the borrower’s perspective. Equally, tax authorities could challenge the arm’s length nature of a refinancing on this basis, as it is unlikely to have occurred between unrelated parties. As always, the arm’s length nature and economic rationale of any intercompany financing transaction should be properly documented to mitigate the risk of questions from domestic tax authorities.

Cash pooling

The significant increase in short-term interest rates may have created a divergence with rates for multinational enterprises still using 0% interest deposits or overdrafts in their cash pool structures. Tax authorities will expect that the cash pool leaders and participants are adequately remunerated in light of current market conditions. This will, without doubt, increase the complexity of existing cash pooling arrangements.

Capital structure and amount of debt

The rising cost of borrowing makes it harder for companies to raise debt financing on public markets. In an intragroup context, the balance of debt and equity plays an integral part in whether a loan should be regarded as debt or equity for transfer pricing purposes. We expect tax authorities to put this under further scrutiny and challenges may arise regarding the tax deductibility of interest on excessive amounts of debt.

Take the example of a company’s financing resources that are composed of 20% equity and 80% intercompany debt and, based on current market conditions, the company could only raise 70% debt through external financing. Tax authorities could consider that the portion of debt in excess of market conditions should be regarded as equity for tax purposes. Consequently, any interest expense paid on this portion of debt would be considered a dividend distribution which could trigger adverse tax consequences.

Combined with interest deduction limitation rules, this can create significant issues if not monitored and anticipated properly. Analyses should therefore be performed to ensure that companies’ level of indebtedness aligns with market reality.

Guarantees

The economic benefits of intercompany guarantees are especially noticeable with the increase in interest rates, as the beneficiaries of a guarantee can access a larger amount of financing at a lower cost without the guarantee. The complexity associated with determining appropriate guarantee fees will make their justification essential in case of questions from tax authorities.

Risk-free return

Multinational enterprises should keep in mind that the increase in interest rates also implies an increase in the risk-free return of lenders not bearing any significant risks in a financial transaction. Tax authorities would therefore expect a positive interest income adjustment for lenders in this position. 

The current interest rate climate has opened the door to new challenges from the tax authorities and complicated the application of the arm’s length principle for multinational enterprises. Taxpayers should ensure that their transfer pricing policies are periodically reviewed to reflect the increasing volatility of interest rates. In addition, applicable tax laws and regulations and Chapter X of the OECD Transfer Pricing Guidelines should be considered to establish the arm’s length price of any financing transaction.