MNEs are under pressure as the BoE raises interest rates

Tax authorities have cautioned that the most recent hikes in UK interest rates might further harm MNEs, who are already having difficulty.

According to tax experts, the Bank of England's decision to raise interest rates by 0.5%, to 2.25%, would put further transfer pricing pressure on multinationals, who are already under pressure from high debt levels and more restrictive financing terms.

The BoE Monetary Policy Committee's rate increase continues a worldwide trend of central banks using forceful monetary policy instruments to attempt and rein in inflation that has gotten out of control.

The US Federal Reserve hiked rates by 0.75% just yesterday, September 21, marking the fifth rise this year. Rates also increased this month in Sweden and Canada, by 0.75% and 1%, respectively.

The intra-group and inter-company funding are expected to be the major targets of the rate rises, according to Marc Mokrab, group tax director of the international security business Verisure in Geneva.

"Higher rates on higher debt with inflation and a looming energy crisis will put MNEs in a difficult situation," predicts Mokrab.

After being compelled to use their credit facilities during the COVID-19 outbreak, many firms are under stress.

According to Mokrab, "They were in distress requiring urgent cash injections and remediation."

He claims that a combination of rising borrowing prices, more expensive inter-company financing, and limited corporate interest deductions would certainly put further pressure on firms.

These are a result of anti-tax avoidance regulations, such as the EU Anti-Tax Avoidance Directive II (ATAD II). To accommodate enterprises, he continues, governments must exhibit unprecedented flexibility on interest deductions and thin capitalization limits.

The shift in prices, according to Michael Vorndran, CEO of TP Accurate in Oslo, would probably prompt corporations to reassess their inter-company agreements.

"Groups will review their portfolio of loans, guarantees, as well as their cash pooling arrangements since their structuring was predicated in part on the prevailing interest rates," according to Vorndran.

The occasionally adversarial nature of the interaction between taxpayers and tax officials may also impede effective communication.

It is reasonable to argue that more might be done to strengthen the relationship of trust between tax authorities and multinational corporations, particularly in regards to compliance difficulties. Arm's-length trades are one of these areas.

"There is always suspicion of non-arm’s-length transactions, whereas MNEs are just reflecting market conditions they are facing," claims Mokrab.

According to him, firms are subject to more scrutiny when interest rates rise when they try to account for intra-group financing arrangements.

When it comes to intra-group finance, "you feel sometimes that whatever the quality of the analysis and evidence gathered, the audit would be difficult," adds Mokrab.

This makes finance compliance more difficult and creates businesses problems. Additionally, as businesses restructure their related party financing contracts, authorities' concerns regarding the rationale of new contracts and rates are raised.

Any renegotiation of related party agreements or transactions, according to Vorndran, will need to be supported by a legal analysis that complies with OECD standards and takes interest rates into account.

"Multinational groups may be concerned about increased tax authority scrutiny in specific cases in which high interest rates disadvantage their tax jurisdiction," according to Vorndran.

Inter-company contracts are not expected to be affected uniformly by the BoE's rate increase, according to tax authorities. The contracts that were signed before to the change in the base rate are probably still in effect, but new contracts will need to be negotiated at the new rate.

One of the main advantages of TP debt, according to Tom Heal, an in-house TP manager in the UK, is that it is frequently based on important market measures, data, and indications at a certain period..

Heal explains that, "generally, you’re looking at interest rates, debt capacity and loan terms based on a snapshot in time and what terms the borrower as well as the lender would transact on if they were third parties."

Unless the loan may be later refinanced for less money or on better conditions, he claims that once an interest rate is agreed upon by the parties, it often remains in place for the length of the loan.

Companies do have the ability to modify their funding agreements, according to Mokrab.

Regarding the tranche of senior secured credit facilities, he states, "When market conditions permit, a debt renegotiation such as term loan B [TLB] extension or fixed rate loan may be an option."

The short-term effect of the interest rate increase will be a rise in the price of debt and the expense of servicing it.

Heal continues, "Companies will have to take higher borrowing costs into account when looking at things like their interest coverage ratio, the amount they can borrow and their ability to service such debt."

Interest rates are projected to climb more in the near future due to geopolitical uncertainties and rising inflation.

Companies can take efforts to mitigate the effects of these policies, though. Before a rate increase is anticipated to be announced, for example, intercompany loans should be swiftly agreed upon. Other strategies include employing a combination of stock and debt, or, if necessary, borrowing from foreign financial institutions rather than British lenders.

According to Heal, "UK companies could look at borrowing from European entities that may have lower base rates, and which don’t rely on the Bank of England – if it makes commercial sense."

He emphasizes the requirement that tax and finance teams maintain compliance by making sure that their agreements are made at arm's length, that they include commercial conditions, and that they are in accordance with the letter of the law.

It is crucial to follow both UK legislation and OECD recommendations, especially when it comes to internal tax operations and the advisers who support them.

Heal contends that companies must take care to avoid unilaterally taking on excessive related party debt at exorbitant rates in order to obtain an advantage over other group members, since this would violate TP regulations and the arm's-length principle.

Part 4 of the Corporate Tax Act of 2010 states that businesses should consider the UK regulations prohibiting interest deductions on excessive debt that they would not get if they entered into an arrangement with a third-party lender.

According to UK legislation, in particular, you are not allowed to burden your business up front with debt that it is unable to take on and pay off on its own, according to Heal.

Companies could also think about a variety of financing choices, such as changing their financial structures to include more ownership and less borrowing.

Companies would be wise to think about whether they have enough revenue to support their interest expenses. In related party agreements, HM Revenue and Customs may also examine this.

Heal advises internal tax and finance teams to follow OECD recommendations while also making sure they adhere to UK laws both legally and in accordance with the letter of the law.

Similar to most of the rest of the globe, the UK has seen severe inflation; at 9.9%, it is at a 40-year high. Both corporations and politicians have been caught off guard by this spike in prices for products and services, and many households are currently experiencing a cost-of-living crisis.

Heal says in relation to the central bank's goal range for inflation that "a few businesses may have had measures in place to account for average annual inflation increases every year, but probably not on this scale, where it is nearly five times more than the 2% target rate."

Additionally, businesses have measures to lessen the effects of increasing inflation. These options can include adjusting their supply chains to include more affordable suppliers, simplifying operations into a single service function, or just passing the costs forward to customers.

For most businesses, it may be dangerous to pass on increasing expenses to clients when interest rates and inflation rise. In many economies, a pricing spiral could already be in motion.

Even while it is clearly a challenging moment for most organizations, multinational corporations benefit from having more control over their finances and supply chains because of their size and intra-group activities.

Despite these benefits, companies confront difficult times as a potential global recession becomes more real. Effective tax directors may be priceless in these circumstances.

By fLEXI tEAM