Transacting with Connected Parties
Most developed tax systems contain provisions that allow the tax authorities to increase the taxable profit, or reduce the allowable loss, of an entity which has entered into transactions with affiliates on non-arm’s-length terms. In some jurisdictions, including the United Kingdom, this now includes domestic transactions as well as cross-border items. The concern for tax authorities is that profits are artificially moved between countries and, in particular, from a high tax area to a lower tax area.
Transfer pricing rules concern the provision of services as well as goods, and so they affect not only intragroup funding and hedging arrangements but also the provision of centralized treasury services. From a practical perspective, this means that apart from keeping contemporaneous documentary evidence of group transactions:
all intercompany loans should carry a market rate of interest or other finance charge;
commercial foreign exchange rates should be used when transacting between group companies;
central treasury services should be recharged among those group members that benefit from them.
In-house re-invoicing and factoring centers usually receive particular scrutiny from the tax authorities of all the countries where participating group members are based.
A company is said to be “thinly capitalized” where it is particularly highly geared. The tax authorities are concerned to ensure that companies do not receive debt funding from affiliates at levels that mean their profits are largely sheltered by interest expense. Many jurisdictions have now passed rules that set out what they consider to be an acceptable level of gearing for tax purposes. In some cases, for example in the United States, Germany, or Australia, the rules prescribe a maximum debt/equity ratio or required interest cover, and in others, such as the United Kingdom, the rules restrict finance charges by reference to the company’s capacity to borrow from a third party on a stand-alone basis. Where the acceptable level of debt is based on subjective tests, it is frequently possible to secure advance clearance from the fiscal authorities on the proposed level of gearing.
In the UK a new debt cap takes effect for accounting periods beginning on or after 1 January 2010, running in parallel with the arm's length principle. The debt cap applies to limit the tax deduction for finance expense payable by UK group companies by reference to the consolidated worldwide gross finance expense of that group. This is intended to counter the risk that groups with little or no external debt may nevertheless leverage their UK operations to reduce UK corporate taxes. There is a risk that interest deductions on intragroup loans could be denied in the UK, while the corresponding receipt remains taxable in a foreign country.
For companies, the downside is that if transfer pricing or thin cap rules are breached a tax deduction for interest expense may be denied, while at the other end of the transaction the lending company is still taxed on the interest income.