Note: This content originally appeared as a BDO Global Insight.
In this last quarter of 2020, multinational enterprises (‘MNEs’) are reviewing their financial statements and transfer pricing strategies. As part of this process, MNEs should document their intercompany loan transactions. As we noted in our previous article, Financial transactions: COVID-19-proof or audit-proof, planning and implementing appropriate interest rates, along with preparing debt capacity analyses, are important in supporting intercompany financial arrangements.
Why MNEs require intercompany loan analyses
In most countries, intercompany loan reporting is required as an element of corporate tax compliance, and transactions must take place on an arm’s length basis. Yet, often the transfer pricing of these transactions is not given the same attention as other intercompany transactions. For example, an intercompany loan analysis should include the same type of functional and risk analysis as other intercompany transactions. An understanding should be developed around how an entity structures its debt efficiently within a multinational group. Considerations may include whether a parent company should provide a financial guarantee to its subsidiary, or whether a parent should perform a capital injection instead of lending funds to the subsidiary for its operations. If a parent company decides to provide a loan to its subsidiary, the MNE should assess its debt-to-equity ratio to determine whether it meets any thin capitalisation requirements. Many banks and tax authorities around the world require MNEs to have thin capitalisation documentation in place when setting up an intercompany loan transaction.
Performing an interest rate determination analysis provides evidence to a tax authority that the intercompany loan was provided under bona fide business reasons with an arm’s length interest rate. This documentation is crucial for the borrowing entity. A detailed functional analysis, as part of a transfer pricing study, plays an essential role in demonstrating economic substance. By having formal transfer pricing documentation in place for financial transactions, an MNE can help protect itself against potential penalties in the event of an audit.
Renew current loan arrangements
For medium to long-term intercompany loan arrangements, renewing those arrangements may be warranted due to COVID-19’s impact on the economy. The pandemic has had a significant effect on many businesses financial metrics, which in turn affect credit ratings and resulting interest rates.
Companies operating in retail industries have been hit severely by the COVID-19 pandemic. As such, a typical retail borrower’s credit rating may have decreased, and the original interest rate determination analysis may no longer be applicable. Or, borrowers may not be able to repay interest, let alone principal, to the lender. In these cases, the lender should consider revisiting the terms of its intercompany loans, extending principle repayment periods, forgiving a portion of the loan, providing financial guarantees, injecting additional capital into the borrower, or lowering the interest rate charged. It is critical to document these changes to demonstrate compliance with the arm's length principle within the COVID-19 economic setting.
Separately, the COVID-19 pandemic may lead to higher risk premiums in evaluating an entity with respect to interest rates. As an increased number of companies file for bankruptcy, MNEs should look to external capital markets to determine the impact the pandemic is having on current borrowings in the market.
For MNEs with fixed interest rates in their intercompany loans, a thorough review should be undertaken. Financial forecasts and assumptions made at the inception of a loan have likely changed due to COVID-19. If business operations are undergoing significant changes, the MNE should consider updating its interest rate analysis and documentation to reflect such changes.
Separately, for MNEs that had established floating interest rates benchmarked to the London Inter-bank Offered Rate (‘LIBOR’), the interest rate analyses and documentation will need to be updated to determine an appropriate alternative, as LIBOR will no longer be usable as a benchmark.
Chapter X of the OECD Transfer Pricing Guidelines discusses intercompany financial transactions documentation. Given that different tax authorities can have slight differences in interpreting and implementing this guidance, it is also important to assess country-specific risks with respect to each lending and borrowing entity. For example, certain tax authorities may look to the full arm’s length range of interest rates in a typical benchmarking analysis, while other tax authorities may accept rates only within the interquartile range. To decrease country-specific risks, such nuances should be identified and respected. BDO’s Transfer Pricing team has a global network to help plan, analyse, document, and support the needs of MNEs in meeting such local country requirements.
A shift of one basis point could make a significant difference in the intercompany loan and operations of a business. With MNEs operating in a world of uncertainty, we encourage clients with financial transactions to perform a thorough intercompany loan analysis and reach out to their tax advisors for assistance.
If you need a hand reviewing your transfer pricing strategy, contact one of our Transfer Pricing specialists.