TP policies must not neglect financial transactions, say sources

Corporations that neglect financial transactions within their transfer pricing policies are putting themselves at risk of pricy and time-consuming audits as tax administrations are becoming more scrupulous in audits.

“Financial transactions are often ignored in TP policies. There are exceptions, but it is an area that is more neglected than supply chain transactions,” says a partner at a law firm in London.

“Smaller groups don’t want to spend money on it – TP advisers are excluded in financial transactions. That’s a trend that needs to change,” adds the partner.

Tax consultants say the recently raised interest rate by the Bank of England (BoE) has contributed to the strong focus on financial transactions in the UK. These transactions include interest deductions and other financial payments that need to follow the arm’s-length principle (ALP).

On November 3, the bank raised the base rate to 3% to continue to combat inflation. The biggest hike in 33 years has led multinationals to review their intra-group arrangements to ensure they reflect the new rate.

Companies with financial transactions that are benchmarked against the base rate will see their TP risk increase if they fail to review their intra-group arrangements. For those transactions, TP issues could become more visible to tax authorities.

Resources and tools made available by the OECD have also enabled tax administrations to seek further detail within TP documentation by looking at the risk areas of financial transactions, according to Laurence Field, partner at accountancy firm Crowe in London.

“Years ago, tax authorities paid a bit of attention – they might not have had all the tools, but a lot of TP challenges I recall were about interest deductibility.

“It perhaps hasn’t been as relevant, but now if you have to re-benchmark your borrowings, suddenly you will have provisions that you need to worry about because of the interest rate that goes up,” he adds.

“Financial transactions will be a bigger portion of the loss for companies. It’s a risk-based approach. Maybe you should be paying more attention,” he says of companies.

The post-BEPS era of further TP guidelines on financial transactions has also led to greater interest from tax authorities.

Guidance released by the OECD in February 2020 especially brought the topic to light. The TP guidance on financial transactions stated that taxpayers should not rely on data but on the functions and risks of lenders and borrowers to determine the arm’s-length interest deduction.

Chris Liu, managing director at advisory firm FTI Consulting in London, says the change in approach to financial transactions meant that tax authorities started looking into them more actively.

The UK’s new TP regime, set to commence on or after April 1 next year, could also be a game changer, as Field notes.

“We have a lot more focus on substance. There is a greater focus on understanding who, what, when, where, and how around those transactions. There may well be a revision [of financial arrangements].

“It’s about having everything well documented and understanding what the commercial teams are trying to achieve,” he adds.

In the UK, the introduction of master file and local file requirements, as well as country-by-country reporting, has shed even more light on companies’ transactions. Tax authorities are gaining more information by the day.

The case of Blackrock, which was resolved in July this year, shows that the UK tax authority is looking at financial arrangements with a closer eye.

The dispute between HM Revenue and Customs and the investment management company, which involved inter-company loans that were deemed non-compliant with the ALP, highlights again that TP can often be neglected in these types of transactions.

Financial arrangements will continue to be under scrutiny and could lead to expensive audits and disputes for businesses.

Field says the best way of avoiding this situation is for companies to recognise, at an early stage, the scale of their transactions and ensure the tax teams understand the consequences of long-term financing arrangements so they can document them efficiently.

The UK’s forthcoming TP regime and the increase of the BoE’s interest rate can only serve as a reminder that corporations need to monitor their TP policies closely.