Related party loans in a recession
Transfer pricing refers to the prices at which related companies trade with each other across borders. The purpose of transfer pricing regulations is to ensure a fair allocation of profits across territories by requiring that related parties transact with each other on an arm’s length basis. It should therefore come as no surprise that transfer pricing has become an area of increased focus for tax authorities during the recession, write KPMG's Dan McSwiney and Michelle Louw
One area receiving particular attention from transfer pricing specialists and tax authorities alike is the area of related party loans. Transfer pricing regulations generally determine that a loan is at arm’s length if the interest rate charged would have been one agreed by unrelated parties. Therefore related parties will often rely on publicly available information as a means of determining arm’s length interest rates. In the current environment however, when the financial markets are in a state of turmoil, this becomes challenging because the third party data that related parties have traditionally relied upon can be unpredictable.

Consequently whilst the parties may have intended to transact at arm’s length, it may be difficult to evidence this to tax authorities where they are required to do so. This can lead to uncertainty, and if prices are not determined to be arm’s length, a significant risk of penalty exposures exists.

Determining an arm’s length interest rate
In order to determine an arm’s length interest rate for a related party loan the “Comparable Uncontrolled Price” (“CUP”) method would generally be used, using either internal comparables (e.g. a loan extended to the borrower by a third party bank) or external comparables with reference to the capital markets.

For third party loans to be considered comparable, various factors are taken into account such as issue date, duration and currency of the loan and the credit rating of the borrower.

The most critical of these factors is the borrower’s credit rating. Generally borrowers must be benchmarked on a standalone basis, absent guarantees from the parent. Therefore, group credit ratings only serve as a guide. Individual companies generally won’t have a public credit rating. There are a range of approaches which can be utilised to determine a credit rating, including using credit score models such as those used by Moody’s and Standard and Poor.

Once the borrower has been rated, this allows the specialist to perform a search for comparable debt issued to companies with the same credit rating and to determine a range of risk premiums that could be considered to be arm’s length for purposes of the related party loan. The arm’s length interest rate is then determined as the sum of a standard borrowing benchmark (e.g. government bonds or Libor) and the risk premium determined by the comparable debt search.

The effect of volatile financial markets
When markets are stable, determining an arm’s length interest rate can be relatively straightforward. However, when financial markets are in turmoil this exercise becomes more challenging. Benchmark rates have generally declined during the recession. On the other hand, investors are now demanding a higher return on funds, resulting in higher risk premiums. Since an arm’s length rate is usually determined by adding the risk premium to the benchmark rate, determining an arm’s length rate becomes difficult when these two rates are in a constant state of flux.

In certain jurisdictions, if the interest rate falls within a predetermined range, the taxpayer may not be required to justify the interest rate chosen. This is known as a “safe harbour”. For instance, the US allows for a safe harbour on Dollar loans if the interest rate is not less than the Applicable Federal Rate (“AFR”) or more than 1.3 times the AFR. These AFR rates have been declining during the recession, but credit spreads have been increasing. For example, the rate for 130% AFR monthly mid-term was 6.28% in July 2007 compared to 3.53% in July 2009. Consequently, interest on related party loans which previously fell within the safe harbour parameters may now be at risk of breaching these parameters. To stay within the parameters the lender may be forced to reduce the interest rate on loans, which could have the effect of placing it in a loss making position if it is paying interest on a third party loan at a higher interest rate. Alternatively, the borrower may be forced to find other support for the interest rate chosen.

Mitigation of risk
The effect of volatile financial markets makes it critical for taxpayers to actively manage the transfer pricing risks associated with related party loans.

Active management entails more than putting transfer pricing documentation in place as may be required by the taxpayer’s local tax authority but should also include active planning and management of the rate throughout the life of the loan. Transfer pricing documentation should be robust and should clearly justify the interest rate applied. The documentation should include comparable market data which supports the interest rate chosen. This might include a credit rating analysis and a search for comparable third party loans which support the risk premium applied. Where loans are covered by safe harbour provisions, companies should ensure that they are aware when the upper limits are breached to enable them to put corrective steps in place. Where related parties decide to refinance loans it is important that parties are able to evidence that unrelated parties would also have renegotiated the loan in the circumstances. Where loans are renegotiated, fresh benchmarking should be performed and documented.

The current environment makes compliance with transfer pricing rules applicable to related party loans challenging. However, the active and regular management of related party loan arrangements together with appropriate benchmarking should go a long way towards mitigating this risk. Whilst this may represent an added compliance burden on companies, this should be far outweighed by the benefit of protecting the company from possible penalties imposed by local tax authorities if the pricing cannot be justified.
Dan McSwiney is a tax director and Michelle Louw is a tax manager at KPMG.