The Bank of England's interest rate hike necessitates an intra-group review

The greatest increase in 33 years has prompted multinational corporations to assess the TP risks associated with financial market volatility.

Companies must ensure that intra-group agreements continue to reflect the Bank of England's interest rate hike on November 3 – the largest increase in 33 years – or risk transfer pricing concerns.

"For most companies, it will be bad news," says Ben Henton, worldwide head of transfer pricing (TP) at Computershare in Bristol.

“Unless your profits are increasing as much as interest rates are, your ability to borrow will decrease, and that also applies when you’re borrowing within your group,” he adds.

In an effort to combat inflation, the bank increased the interest rate by 0.75 percentage points in early November, bringing the base rate to 3 percent. Current inflation in the United Kingdom is 10.1%.

This change in monetary policy would inevitably influence the TP policies utilised by multinational companies (MNEs) in financing arrangements. When the cost of debt increases, so does the TP risk associated with intra-group debt.

According to Henton, it might become a big concern for businesses with limited borrowing capacity, especially if the borrowing company is already overextended. Higher interest rates reduce the ability to borrow.

If multinational corporations' balance sheets are not increasing at a rate sufficient to withstand the higher cost of borrowing, TP regulations could limit interest payments.

“The deductibility for your debt starts to be called into question. When companies make decisions around borrowing, you assume they will have a tax deduction to their debt,” explains Henton.

As laws regarding the deductibility of interest have become increasingly stringent over time, it may be more difficult to claim the interest deduction.

“The rules weren’t as bad in the previous financial crisis. Now we are facing an inflation crisis,” says Henton.

Spillover impact

Existing loans with variable interest rates and new loans with either fixed or variable interest rates will be impacted by the increase in interest rates. This covers short-term and long-term loans, financing activities, cash pooling, as well as transactions involving hedging and guarantees.

Andrius Tamosiunas, TP manager at the professional services business TMF Group in Luxembourg, explains that the increase in interest expenses for loans denominated in British pounds affects the debt service coverage ratio for fixed earnings before interest, taxes, depreciation, and amortisation.

"This could result in a spillover effect, wherein a decreasing implied credit rating of the borrowers could lead to higher interest rates on intra-group loans in the future," he says.

“The base rate hike will increase the UK risk-free rate, therefore increasing the required return on capital to be realised by entities performing intra-group on-lending activities that are pound-denominated or are financing UK-based investments,” adds Tamosiunas.

These many risks to which MNEs are exposed as a result of the BoE's interest rate hike will necessitate solid long-term corporate treasury policies and distinct risk management techniques.

“The way currencies are moving quite dramatically, companies should get stability around that risk caused by the pound collapsing and interest rate hike,” says Henton.

Compliance is crucial

Tom Heal, a UK-based TP manager for a gambling company, is most concerned about the requirement for corporations to comply with TP regulations regarding corporate funding.

"There may be a desire to attempt to obtain lower or higher interest rates. In a similar vein, tax officials will increase their scrutiny of business credit in the future.

“I’ve seen more TP in debt than earlier on in my career,” he explains.

While adhering to local regulations and best practises, multinationals will need to guarantee their benchmarking is current with the new debt. They risk being scrutinised by tax officials if they do not comply.

With successive base rate adjustments, multinational enterprises will need to closely monitor their TP arrangements.

Phil Roper, TP partner and technical lead at 'big four' firm KPMG in the United Kingdom, asserts that the qualitative aspect and lender appetite inside a TP study, where arm's length is assessed, are frequently overlooked.

“We talk to our debt specialists at KPMG to see what they are seeing in the market, and they are seeing significant changes in lending appetite, not necessarily in high street banks,” he says.

“We’re going to see shifting trends in the debt market, and as TP specialists we need to stay connected as much as we can now. Old data is quite risky,” adds Roper.

Document changes

The current market volatility strengthens the necessity for multinational corporations to clearly disclose their inter-company loan agreements.

According to Ivan Hanna, partner at the London law firm LCN Legal, the term or maturity dates, currency, the applicable interest rates – fixed or variable – and how they are computed, as well as the repayment and prepayment arrangements, must be specified.

“The analysis in some circumstance will be similar to a domestic mortgage: if you’re a borrower on a five-year fixed interest rate mortgage, you would not agree to a higher interest rate just because base rates have increased,” he says.

 “This was the message of the 2016 Swedish case involving Nobel Biocare, where the taxpayer purported to adjust interest rates with a fixed term, without any clear explanation, commercial rationale or adequate documentation,” he adds.

Moving markets

Following the change in monetary policy, Tamosiunas believes connected parties will need to confirm that their intra-group arrangements reflect or continue to reflect market realities.

The primary worry, according to Gaspar Lopes Dias, a partner at the London-based advice firm Taxand, is the reform of intra-group arrangements.

“This could affect more than bonds and loans. If you have intra-group loans, all the assets that are being valued and transferred would have pressure on their transactions because the discount rate would be higher,” he explains.

The Bank of England's top economist, Huw Pill, indicated on November 8 that interest rates will be raised soon; JP Morgan is rumoured to have forecast a base rate increase of about 6 percentage points in 2024.

It is difficult for businesses to balance the current economic climate with day-to-day operations. Future intercompany agreements and loans with variable interest rates will undoubtedly be impacted by the bank's decisions.

The directors of TP continue to believe that inter-company debt is an appealing source of financing. In the interim, multinational enterprises must monitor market changes.

By fLEXI tEAM