When debt stops behaving like debt: transfer pricing in distressed group financing

Corporate distress rarely begins with an insolvency. It begins when a capital structure that was manageable under one set of market conditions must be refinanced under another, and the group must decide whether to fund a subsidiary that no longer has credible market access or allow it to fail. That decision sits at the intersection of commercial reality, legal constraint, and the arm’s-length principle. Those considerations do not always point in the same direction, which is why the transfer pricing analysis must explain not only the price but the business judgement behind the group’s response.

The market backdrop makes this issue more urgent. In 2025, 59% of European leveraged loan issuance was used for refinancing rather than new investment (AFME, European High Yield, Leveraged Loan, and Private Credit Report, Q4 2025). The International Monetary Fund has also highlighted that firms with higher refinancing needs may face greater challenges rolling over debt in an environment of higher interest rates (Corporate Sector Vulnerabilities and High Levels of Interest Rates, January 2025), and the European Central Bank has noted that higher financing costs can weaken a firm’s ability to service and roll over debt (“Corporate Debt Service and Rollover Risks in an Environment of Higher Interest Rates”, May 2024). The population of intercompany financing arrangements now under strain, and therefore under audit scrutiny, is growing.

A strong position in this environment starts with sequencing. The first step is to diagnose the nature of the distress and the commercial response it supports. The next is to determine what the group has actually created: debt, a guarantee, equity support, or something closer to shareholder conduct. Even where the instrument is respected as debt, domestic interest limitation rules may still deny the deduction, and regulated sectors add another layer of constraint through capital and resolution requirements. If more than one jurisdiction is involved, the analysis must also anticipate how any disagreement will be managed through an advance pricing agreement (APA) or mutual agreement procedure (MAP). In that sequence, pricing remains important, but it should follow from the underlying character and legal consequences rather than sit apart from them.

The commercial response to a liquidity shortfall is not the same as the response to a balance sheet that can no longer support its leverage. A short-term refinancing gap, a loss of market access, and a permanent debt-capacity problem each point to a different arm’s-length inquiry. Four pressure types are worth distinguishing.

This distinction appears across sectors, although the indicators differ. In real estate, a delayed sale may indicate timing pressure if rental income is stable, while falling valuations point to a capacity problem. In software, cash burn into a credible path to profitability may be financeable, while funding a business with declining retention may not be. The diagnosis determines the appropriate commercial response, and the supporting analysis must explain why the chosen response fits that pressure type.

The commercial response in distress rarely stops at repricing an existing facility. Each tool in the restructuring toolkit produces different transfer pricing consequences.

Covenant waivers, amend-and-extend arrangements, additional security, and partial repayments are designed to maintain creditor alignment while the borrower stabilises. The transfer pricing question is whether the waiver reflects creditor confidence in recovery. If it does, ordinary debt analysis applies. If it does not, the waiver may evidence continued group support that an independent creditor would have refused or converted into equity.

Super-senior facilities, payment-in-kind (PIK) options, preferred equity, and hybrid instruments raise some of the hardest transfer pricing questions in distressed financing. A rescue facility carrying a PIK feature and equity warrants is not economically equivalent to a term loan. Pricing the rate without addressing the warrant produces only a partial answer. The combined instrument must be analysed as such: what portion is arm’s-length debt, how is the warrant priced separately, and does the aggregate return resemble debt or equity participation?

Cash pool arrangements under stress raise a distinct set of questions that bilateral loan analysis does not address. When a distressed entity becomes a structural net borrower from the pool, the pool leader is effectively providing rescue funding. The question is whether the rates, guarantees, and risk allocations within the pool still reflect arm’s-length behaviour.

The Spanish Supreme Court addressed the credit rating question directly in July 2025 through judgment 985/2025: the applicable rating for pool participants should reflect the group’s consolidated creditworthiness, not the standalone borrower’s rating. In a distressed context, the ruling cuts both ways. It may limit how high a rate the pool leader can charge a distressed participant, because the group rating may be above the standalone rating. It also removes the argument that implicit group support justifies a below-market deposit rate for stronger entities funding the pool. A further practical risk is that authorities may classify structural cash pool overdrafts as long-term intercompany loans, triggering full transfer pricing documentation and thin capitalisation analysis.

Distressed groups often move assets and businesses alongside the financing, and the two are rarely separable in substance even when they are documented separately. Examples include a carve-out of the distressed activity into its own entity, a disposal at nominal or negative value where the buyer assumes future funding obligations, or a transfer of the operating business to a stronger group entity while liabilities remain behind. Each of these is, from a transfer pricing perspective, a transaction with its own valuation question, sitting on top of whatever financing analysis is being run in parallel. An analysis that treats the loan and the carve-out together is well placed to explain why the lending continued, or stopped, exactly when it did.

The more difficult problem is what the transaction does to the financing that survives it. If the real estate asset securing a loan is transferred to a different group entity as part of a restructuring, the borrower's debt capacity, and therefore the character of any continuing intercompany support, must be reassessed against the post-transfer balance sheet, not the one that existed when the loan was made.

The same applies in manufacturing where a carve-out separates a profitable division from a loss-making one: a loan made to the combined entity before separation has to be retested against the entity the borrower has become, so that its pricing and characterisation reflect the post-separation business rather than the one that no longer exists.

Operational restructuring works the same way over a longer period. Cost reduction and footprint rationalisation change the risk profile gradually, but the effect on what arm’s length means for the financing is the same.

The most common error, especially from a transfer pricing perspective, is starting at the end; i.e., with the margin. The correct order for a sound analysis is facts, character, price. The November 2025 update to the Commentary on Article 9 of the OECD Model Tax Convention reinforces this sequence at treaty level. The determination of whether a loan should be respected as debt precedes pricing in all cases. German law (Foreign Tax Act, Section 1(3d)) and financial transactions guidance from the UK’s HM Revenue and Customs (INTM414430 and INTM501050) reflect the same discipline domestically.

The analysis must reconstruct the commercial situation as it existed when the support was provided, not as it appears with hindsight. Key questions include:

• What external funding was sought and refused?

• What terms were offered?

• What did the group’s treasury and credit teams conclude?

• What did the board consider?

These questions are best answered contemporaneously and should not merely be an audit defence.

This is also where the ruling by the Full Court of the Federal Court of Australia in Chevron Australia Holdings Pty Ltd v Commissioner of Taxation (April 21 2017) becomes important. The analysis in that case did not stop at the interest rate. It looked at whether the instrument had the features an independent lender would have required, including security, covenants, and enforceable rights. In a distressed setting, that point is central: the commercial terms must be tested before the price can carry much weight.

A subsidiary that is structurally loss-making and survives only because the parent stands behind it fails the test an independent lender applies before any rate is discussed: can this entity service the debt from its own operations? If not, the ‘would and could’ analysis may not support debt characterisation at all, regardless of how carefully the rate is benchmarked. German and UK approaches both require this question to be addressed as part of the character and pricing analysis, rather than treated as a documentation point after the fact.

On guarantees specifically, if an explicit guarantee is relied on, the analysis must demonstrate that it created distinct value beyond the implicit support that already existed. Where the borrower’s standalone rating and its group-uplifted rating are close, the incremental value of an explicit guarantee is limited. The fee should reflect that, rather than the rate differential between the standalone borrower and a risk-free borrower.

The ruling by the Court of Justice of the European Union in Hornbach-Baumarkt AG v Finanzamt Landau (May 31 2018) is useful here because it recognises that shareholder-related commercial reasons may explain why a group supports a subsidiary. That rationale matters, particularly in distress, but it does not end the analysis. It helps explain why the group acted; it does not, by itself, determine whether the arrangement is debt, guarantee, equity, or shareholder support.

The Canadian Federal Court of Appeal’s ruling in Canada v Cameco Corporation (June 26 2020) provides the counterweight. It illustrates that recharacterisation is not a free-standing tool to replace the taxpayer’s chosen transaction with a more tax-favourable alternative for the authority; it must be grounded in the applicable legal test and the facts. In practice, that protection is strongest where the taxpayer has already addressed the character question carefully and can show why the instrument should be respected as structured.

Even where the transfer pricing analysis supports the instrument as arm’s-length debt, interest limitation rules may independently deny the deduction. Under Article 4 of the Anti-Tax Avoidance Directive and Section 4h of the German Income Tax Act, deductible net interest is capped at 30% of tax-adjusted EBITDA. In distress, EBITDA typically contracts precisely when interest costs are highest. The result may be a position where the transfer pricing analysis is correct, the rate is defensible, and the deduction is still denied. Therefore, performing the interest limitation analysis alongside the transfer pricing analysis helps provide the complete picture.

Pricing a distressed intercompany loan is harder than pricing an ordinary one because the comparable set is structurally thin. A genuinely distressed independent borrower may not obtain funding at all or may receive it only with protections such as security, covenants, seniority, monitoring rights, or upside participation. Healthy-borrower comparables do not capture that risk, while formal restructuring comparables, such as debtor-in-possession financing or distressed debt trades, often reflect a different legal and economic position.

Where direct loan or bond comparables are limited, credit default swap spreads, standalone credit ratings, and credit modelling can help infer a market-implied spread. These are not first-choice benchmarks, but they can bridge the gap where observable transactions do not exist. If such data is used, the analysis should explain why the proxy is reasonable, including sector, leverage, size, geography, maturity, and liquidity.

The same approach is needed for blended instruments. If a rescue facility combines debt, a warrant or conversion feature, and shareholder support, it should not be priced as a single coupon. The debt-like portion is priced by reference to credit risk and lender protections. The equity-like element is valued using equity or option valuation methods. Any shareholder support element is addressed through characterisation, not by finding a higher interest rate. Step 4 is therefore not simply about finding a rate; it is about identifying what is being priced and applying the right method to each component.

During a tax audit, the tax authorities will have access to documentation beyond the transfer pricing analysis. They are likely to compare the analysis with the documents that explain how the group understood the situation at the time, including:

• Board papers;

• Treasury materials;

• Lender communications;

• Accounting assessments; and

• External disclosures.

That comparison can be helpful where the records tell the same narrative. For example, the transfer pricing documentation may describe the loan as a temporary bridge with a credible repayment path, while the board minutes explain the same funding decision as a measure to preserve value during a difficult period. The issue arises where different records point in different directions, such as where the transfer pricing analysis treats the funding as debt, but going concern papers, rating agency correspondence, or financial statement disclosures suggest that the borrower depended on continuing parent support.

This makes internal consistency necessary, but not a ‘good to have’. A transfer pricing position can be coherent on its own terms, with facts, character, and price aligned, and still be vulnerable if the board papers, auditor’s going concern assessment, rating commentary, or public disclosures describe the same period differently. These materials carry weight because they were not prepared for the transfer pricing analysis. Any divergence may become the starting point for the audit discussion.

The practical objective is not to force every workstream into identical language. Treasury may focus on liquidity, legal enforceability, accounting on going concern and classification, and tax on deductibility and arm’s-length character. The stronger approach is to identify these perspectives early, explain how they fit together, and make sure the legal agreements, board papers, valuation work, solvency analysis, and accounting treatment support a coherent overall position.

The timing of the analysis therefore matters. Documentation prepared and dated in the same period as the board papers, going concern assessment, and rating commentary is more likely to reflect the facts as they were understood at the time. Documentation reconstructed later is more exposed to hindsight, and hindsight can create a gap between the transfer pricing narrative and the contemporaneous record.

For regulated entities, the same point extends to supervisory correspondence. Communications with regulators on capital adequacy, recovery planning, or total loss-absorbing capacity and minimum requirements for own funds and eligible liabilities compliance describe the same underlying facts through a different framework. A transfer pricing position for a regulated borrower is stronger when it can be reconciled with what the group has told its regulator about the entity’s standalone viability.

The cross-border risk in distressed financing is often not a simple disagreement over the interest rate. The more difficult case is where one jurisdiction respects the instrument as debt, while another treats part of the same support as equity, guarantee support, shareholder contribution, or non-deductible funding. At that point, the issue is whether both jurisdictions are looking at the same transaction. That is why the dispute path should be considered while the support is being structured, not only after an adjustment is proposed.

The practical takeaway is to identify early what kind of disagreement the group is trying to prevent. If the likely issue is the arm’s-length rate on a continuing loan, an APA may be useful because the competent authorities can engage on the same prospective fact pattern before positions harden. If the likely issue is character, the preparation has to be more deliberate. The group should be able to show the treaty route, the competent authorities that may need to engage, the evidence supporting the original characterisation, and the accounting and legal consequences of any possible adjustment. In distressed financing, APA and MAP planning is not a procedural afterthought. It is part of the design and planning that helps prevent a commercial rescue from becoming a double taxation dispute.

Distressed group financing is most effective when it is treated as a design exercise, not a narrow pricing exercise. The practical question for tax, treasury, legal, accounting, and restructuring teams is how to reach a position that is commercially credible, legally coherent, and capable of being explained consistently if conditions deteriorate further.

The useful takeaway is to make the key judgements early. Identify what type of distress the group is responding to, decide what the support is intended to achieve, test whether the instrument still behaves like debt, and document the commercial rationale while the facts are fresh. That does not remove complexity, but it turns the analysis into a managed process rather than a reconstruction exercise.

For groups facing refinancing pressure, this is also an opportunity. A well-structured response can preserve value, support the business through a difficult period, and reduce avoidable controversy later. The strongest outcomes come from aligning the financing decision, the evidence base, and the cross-border strategy before the transaction becomes difficult to explain.

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