Alain Goebel, Partner and Danny Beeton (Arendt & Medernach): Untangling COVID-19 complications for treasury transfer pricinG
Alain Goebel, Partner and Danny Beeton, Of Counsel in Arendt &Medernach’stransfer pricing team suggest how tax administrations expect treasurers to respond to the current challenging environment.
How is COVID-19 affecting treasury transfer pricing?
The economic disturbance caused by Covid-19 has created serious transfer pricing dilemmas for treasurers, such as:
borrowers defaulting on their loans or breaking their financial covenants;
borrowers whose credit rating no longer justifies the interest rates or guarantee fees which they have been paying;
in-house banks, cash pool leaders or guarantors whose credit rating no longer justifies the interest rates which they have been paying on credit balances or charging for guarantees;
“implicit group support” declining in value such that formal guarantees would be needed to maintain credit ratings;
whether government financial support which would restore the creditworthiness of one group company should be shared with other group companies and thereby diluted (where this is not prevented by the terms of that support); and
whether new loan agreements should feature stricter financial covenants, higher interest rates and other measures to protect the lender.
How should treasurers respond?
The treasury response should be determined by the following considerations:
the terms and conditions of existing transfer pricing agreements and in particular whether they entitle one of the parties to refuse changes in prices(such as the interest rate) during the course of the agreement, or to terminate the agreement;
whether the company is agreeing changes to its interest rates, etc. with unrelated companies or has evidence of other independent parties doing so, despite the terms of contracts which don’t oblige one the parties to do this; and
whether, notwithstanding the terms of the related party agreements or what is happening between independent parties, it is in the longer-term interests of the related parties to agree to a change in interest rates or to defer payments of interest and or principal, etc.(for example, so as not to push a borrower into bankruptcy).
This approach could apply to existing loan agreements, for example, where the borrower is breaking its financial covenant ratios, or the lender is now receiving too low an interest rate for the heightened risk of the borrower and arguably should consider exercising an option to demand repayment.More generally, the standard components of the group treasury policy document could need reviewing, for example the adjustments made for liquidity for short term balances. It may also be that new related party loan agreements should feature stricter financial covenants and other measures to protect the lender.
In any case, lenders are advised to take action and document that they tried to enforce their rights or to find a solution going forward in order to avoid any requalification of their debt claims into hidden equity. Also, any reductions or waivers or other benefits would need to be carefully documented, in particular the decision-making process and the “arm’s length” motivation of the lender to accept any of those (most likely to avoid a lengthy insolvency procedure with an uncertain end and a competition with other creditors). One should keep in mind that when the related lender does not enforce its rights under the financial arrangement (e.g. not claiming the effective payment of interest or reimbursement of the nominal amount), this may lead to the reclassification of such arrangement into equity with all the tax consequences associated therewith.
How should treasurers record these decisions?
In Luxembourg the period allowed for handing over transfer pricing documentation when requested is not fixed by law but is normally between two and six weeks (including one or more extensions if the taxpayer is fortunate). The burden of proof is on the taxpayer to show that their transfer pricing is in line with the arm’s length principle, and recent Luxembourg case law stresses the importance of having appropriate transfer pricing documentation in place from the outset.
Given this need to be able to hand over explanations for decisions to change or not change transfer pricing arrangements now, the effect of the crisis on group treasury matters should be reviewed, decisions made about whether and how policies should be changed and what to do about specific problematic loans, etc., and this process should be recorded in a document to answer any future tax administration questions.
Quotation: “In Luxembourg the period allowed for handing over transfer pricing documentation when requested is not fixed by law but is normally between two and six weeks.”
Alain Goebel, Partner, Arendt &Medernach Luxembourg
Danny Beeton, Of Counsel, Arendt &Medernach London