Transfer pricing

Tax uncertainty in intercompany financing transactions

Žygintas Starkus
By:
Whenever financing needs to be granted between associated companies, either belonging to a same group or associated by other criteria, tax authorities can challenge the interest rate as being too high, or too low, and accordingly calculate additional corporate income tax. The methodology of setting arm’s length pricing for tax purposes in transactions between associated companies is called transfer pricing, and set mostly in the OECD’s guidelines. However, guidelines are “soft law”, and local “hard law” is lacking, making it quite difficult for companies to decide on what interest rate to apply.
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But firstly, can there be no interest rate at all? In transfer pricing, the notion of an interest-free loan was always perceived as precarious with most entities avoiding such risk-prone models, as for 99,99% of cases such interest-free loans would most likely fall. This comes from the long lived notion that no loan must go without interest as interest free loan arrangements usually do not occur between independent parties. In real life group relations, interest free loans can be justified under certain legitimate business reasons but historically a significant portion of such cases were challenged by tax authorities demanding that the unpaid interest to be treated as deemed revenue.

One such example was a famous Statoil case whereas Statoil ASA, a Norwegian company, granted an interest-free loan to its wholly owned subsidiary Statoil Angola. Statoil Angola had previously received interest-bearing loans from Statoil SCC (a Belgian company with no ownership interests in Statoil Angola) which fully exploited Statoil SCC 's borrowing capacity, therefore, Statoil ASA did not calculate interest on their loan granted after, as the loan capacitance was already exceeded. Norwegian tax authorities reasoned that Statoil Angola’s borrowing capacity should have been split between the two loans and insisted that interest revenue should be deemed on Statoil ASA’s part of the loan. Statoil ASA appealed the allegations by stating that Statoil Angola did not have the financial capacity to carry larger interest-bearing loans than the loans taken out from Statoil SCC which means that it would not have been possible for Statoil Angola to obtain the loan from an independent lender. In such case, the interest-free loan is not a result of the partnership between Statoil ASA and Statoil Angola, but it is commercially justified as Statoil ASA’s choice to operate Statoil Angola with low equity and use capital grants in the form of interest-free loans provide greater flexibility regarding repayment as opposed to riskier return on capital investment. In the end, The Supreme Court concluded the case agreeing that Statoil’s allocation of the full borrowing capacity of Statoil Angola to the loan from the sister company in Belgium was based on commercial reasoning and is compliant with the arm’s length principle. The Court discerned that Statoil Norway – unlike Statoil Belgium – had a 100% ownership of Statoil Angola, and the lack of interest income would therefore be compensated through the benefit of an increased value of its equity holding in Statoil Angola.

Beyond interest free loans there are numerous other intragroup financing transaction pricing nuances, that cause disagreements during tax audits and later in courts. Recent German Federal Fiscal Court rulings gathered exceptional attention as one after another three rulings presenting quite differing outcomes were released. On the first one the Court released a ruling that concluded that the fact of an unsecured loan being subordinated does not by itself contradict charging a risk premium on interest. This was widely received as a more economic logic based view of risk compensation that is taken by most taxpayers and is now strengthened by this new ruling. The new ruling was a contrast to the former Finance Court of Cologne decision which stated that difference in interest premium between a senior secured and junior unsecured loan was deemed a hidden profit distribution. The last of the three rulings strengthened the position that other corporate debt instruments (e.g., alternative revenue from fixed deposits or cost of market rate bonds) can be used as arm’s length comparables to price intercompany loans. Moreover, this ruling come to an understanding that the fact of unrelated lenders granting unsecured loans to a parent company is not a sufficient argument to state that granting of an unsecured intercompany loan to a subsidiary is a completely incomparable case, i. e. the absence of only one condition from a comparable transaction should not by default mean that the intercompany loan is not at arm’s length.

More localised transfer pricing practice in terms of the Baltics is very scarce, so it is very likely that in case of court proceedings, local Courts would “take a look” at foreign Courts practices. This means that such historical foreign rulings can be used as an indicator of what to expect when implementing policies and partaking in risk-prone intercompany engagements. If business operations lead to high-risk intercompany financing engagements, it is always highly recommended prior to concluding such transactions to consult with specialised transfer pricing professionals.

 

OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022, available https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm

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