Application of transfer pricing to financial transactions

Applying transfer pricing principles to related party financial transactions is a challenging area for businesses, and one where they will frequently seek specialist advice. It is essential to carefully evaluate the terms of such transactions to ensure they align with the arm’s length principle, and that this is documented to withstand potential challenge. In this blog we explore considerations for related party loans, cash pooling arrangements and other treasury activities.

Related party loans

The risk of a tax authority recharacterising a financial transaction is higher than a trading transaction, due to the subject matter of financial transactions making them easier to manipulate.

When evaluating related party loans, one must consider what other options were realistically available to both the lender and the borrower:

For the borrower, third party loans may have been an option, or delaying investment until it could be funded from accumulated reserves.
For the lender, they could have chosen to invest the same funds in external investments (eg new acquisitions, or shares/debt which would generate passive income).

If it is determined that both the lender and the borrower might reasonably have entered into the transaction under normal circumstances, it is unlikely that a tax authority would seek to recharacterise it (for example, as a capital contribution).

Key factors to consider

There are some important points to bear in mind in establishing the arm’s length price for related party loans:

If the group is already party to third party loans

Depending on how the credit rating of the group compares to that of individual constituent entities, it may be appropriate to use those third party loans as an internal Comparable Uncontrolled Price (“CUP”) to establish arm’s length terms for the related party loans. Sometimes, a subsidiary’s credit rating may match the group’s overall rating if there is a significant degree of implicit support, especially if the subsidiary’s performance is crucial to the group’s success.

If the credit rating is not suitably comparable, it may be possibly to establish a “synthetic” credit rating for the individual subsidiaries.

This would allow a search for similar third party loan agreements in a commercial database to establish both the quantum and rate which would have been proposed at arm’s length.

If loans have caused a borrower to breach domestic “safe harbours” this does not categorically mean the loans are not arm’s length.

Safe harbours are an administrative simplification, and just because a loan does not fall within those safe harbour parameters does not mean it is not arm’s length. Depending on the nature of the subsidiary’s business, it may have significant tangible assets it could pledge security over, or may own for example natural resource exploitation rights which will give rise to significant future profits, and either of these may support a significant debt investment from a third party.

Cash pooling

Cash pooling occurs within groups of companies, where bank balances – both credit and debit – are offset between group members. The goal is the reduce overall external exposure to interest or maximise opportunity to earn interest income.

Cash pooling can include:

Physical cash pooling: involving the actual transfer of funds between companies
Notional cash pooling: the offsetting may just be a book offset.

The arm’s length reward for participating in a cash pool depends on the specific arrangements in place.

The cash pool lead is the co-ordinating entity: the cash pool lead will manage the cash pool relationship on behalf of the group with a third party bank, and are performing a service function only. In this case, they should be rewarded as such, and a cost plus mechanism may be appropriate.
The cash pool lead is making daily decisions: if the cash pool lead is taking a more active role in managing the surplus/deficit, for example, deciding which institutions to put amounts on overnight deposit with, then their reward may be significantly more as they are taking a greater risk, and perhaps entitlement to the residual profit after a fixed reward to the pool members may be appropriate

For the cash pool members, on arm’s length terms, companies would not participate in such an arrangement unless they expected to be better off as a result. Consequently, the cash pool members will expect to participate in the reduced interest cost/increased interest income as a result of being in the pool. This saving might be allocated between group members based on the relative quantum of their average daily balance for example.

Other treasury activities

The reward that a group treasury company earns depends on the functions it performs, and the risks it assumes.

Low-risk activities: A treasury company’s role may be more day-to-day eg managing liquidity, for example, via co-ordinating factoring on behalf of group entities with a third party, to take advantage of economies of scale. In this case, the treasury company is providing a service and should receive a modest reward, possibly based on the costs it incurs.
Higher-risk treasury activities: On the other hand, if the treasury company is involved in more complex activities—such as creating and managing hedging strategies where the hedge isn’t directly tied to the risks of the individual operating companies—it’s taking on more risk. These activities might justify a higher reward.

Closing thoughts

Transfer pricing for financial transactions requires consideration of additional factors to ensure compliance with the arm’s length principle, and is a complex and specialist area. With proper evaluation and documentation however companies can mitigate the risk of tax authority challenge and potential recharacterisation.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.