Transfer pricing perspectives: Winds of Change - PwC

During the course of recent transferpricing audits, the Indian tax authoritieshave sought to challenge interest freeloans, particularly in an outbound loancontext. Adopting scientific approachesto credit rating and benchmarking is anincreasing expectation of the Indian taxauthorities from Indian tax-payers wishingto develop sustainable positions in the areaof intra‐group loans. Similarly, intra‐groupguarantees have also been a matter ofintense discussion in India, necessitatinga careful and detailed approach towardssuch arrangements.In Australia, the ATO has recently issuedfinal guidance on the interaction of transferpricing and thin capitalisation. The taxruling reiterates that transfer pricingrules apply first to determine an arm’slengthinterest rate for a related partyloan, which is then applied to the actualamount of the debt. The thin capitalisationprovisions then operate to determinethe debt deductions based on prescribedratios. Australian taxpayers (includingbranches) are generally restricted underAustralia’s thin capitalisation rules to 3:1measured with reference to eligible assetsnet of eligible non‐debt liabilities. Alldebt is included, whether from related orunrelated parties. It is also possible to relyon an ‘arms‐length debt’ test to support ahigher level of debt. Australian financialentities (including branches) are restrictedto a 20:1 ratio measured in basicallythe same way but with concessions foron‐lending and borrowing against cashand certain highly‐rated assets (e.g. REPOsecurities, A‐rated subordinated debt andBBB-rated senior debt).While the thin capitalisation provisionscontinue to govern the actual amount ofdebt, in the ATO’s view, the arm’s-lengthinterest rate must ‘produce an outcome thatmakes commercial sense’.Interest ratesLocal transfer pricing rules across Asiarequire that interest rates on intercompanyloans should be consistent with the arm’slengthprinciple. Typically, in order todetermine the arm’s-length rate on arelated party loan, taxpayers need to gothrough the following steps:• Compare the loan parameters ofthe tested transaction to the loanparameters of transactions betweenthird parties• Assess the stand alone credit rating ofthe borrower• Substantiate the economic rationaleof the terms and conditions ofthe transaction• Where there are no internalcomparables, determine the pricethrough a robust economic analysis andbenchmarking of external comparableinterest rates or credit spreads for thegiven credit rating of the borrower andthe specific terms and conditions ofthe transaction• Document the arrangement withtransfer pricing documentation andretain agreements, calculations, etc• Review and monitor the arrangementregularly (especially in casethe transaction includes call orprepayment options).Although this process appearsstraightforward, there is little guidanceon how it should be applied in practiceeither from the OECD or from most localtax authorities.Loan guaranteesA loan guarantee is a binding arrangementwhere one party, the guarantor, assumesthe debt obligation of a borrower in case ofdefault. Many subsidiaries relying on localfinancing from third parties face demandsfor such guarantees. Where an explicitguarantee is made by the parent or anothergroup company and the benefit of providingthe guarantee (in terms of interest saved)can be clearly demonstrated, a guaranteefee should generally be charged for transferpricing purposes. For branches however,it is generally not appropriate to charge aguarantee fee as, in accordance with theOECD Guidelines, a branch is deemedto have the same credit rating as itshead office.Local transfer pricing rules across Asiarequire that inter company guarantee feesshould be set at levels that are consistentwith the arm’s-length principle.Transfer Pricing Perspectives. October 201167