Debt capacity – when is it worth considering in transfer pricing?

“Debt analysis,” “debt capacity,” “analysis of debt servicing ability” – many terms exist in the world of transfer pricing, but they all refer to the same issue. It is no longer a secret that tax authorities, when examining financial transactions, check not only the level of applied interest rates but also other conditions, including the ability to incur and subsequently service debt.

Among other things, scrutiny is applied to whether the borrower, at the moment of incurring the liability (and during its repayment), had the resources to service the debt on time. Simply put, it is analysed whether the entity would have a realistic chance to obtain and maintain financing on similar terms from an independent financial institution.

Is debt capacity analysis mandatory?

Polish transfer pricing regulations impose on taxpayers – in certain cases – the obligation to prepare transfer pricing analyses aimed at confirming the arm’s length nature of intra-group transactions. However, the regulations do not specify the form such analysis should take. As a result, debt capacity analysis is not formally a mandatory element of transfer pricing analysis.

Does this mean it can be omitted? In practice, this is decidedly not recommended. The mere fact that conducting such analysis is not explicitly required by law does not mean that tax authorities will not perform it themselves during an audit and draw conclusions from it. Therefore, it is worth treating it as a best practice when verifying the arm’s length nature of financial transactions.

Is the borrower’s rating sufficient on its own?

In market analyses concerning financial transactions, the borrower’s credit rating (i.e. credit standing) as a comparability criterion has become the market standard. Such a rating – assigned by rating agencies or calculated using specialised databases – informs about the creditworthiness of a given entity. Generally: the lower the rating, the higher the risk of non-repayment of the liability.

Does this mean that if the borrower’s rating is included in the transfer pricing analysis, it can be considered that the debt analysis has been analysed? Unfortunately, no. Although the rating and debt capacity analysis rely on similar data and measure credit risk, the rating does not replace a comprehensive debt capacity analysis. The latter is broader and also considers other factors, including the perspective of continued debt servicing in the future. Therefore, it should be treated as a complement to transfer pricing analysis.

Is a one-off analysis at the moment of obtaining financing sufficient?

The minimum option is to carry out the debt analysis at the time of obtaining financing. However, it is worth remembering that tax authorities may examine creditworthiness also in subsequent years, especially if the company’s financial situation deteriorates.

Therefore, we recommend updating the debt analysis at least once a year, particularly in the case of:

• high financing value,
• lack of collateral,
• deteriorating financial results of the company.

How to approach debt capacity analysis in the case of special purpose vehicles (SPVs)?

Special purpose vehicles (SPVs) operate under somewhat different rules than typical entities conducting operating activities. Often, at an early stage of their existence, they request financing even though they do not yet have a credit history or revenues from which to service liabilities.

How then to approach debt capacity analysis in their case? First, the specifics of the sector in which the company operates should be taken into account. SPVs may be characterised by unusual financial indicators – e.g. a very high level of indebtedness at the start or lack of revenues during the investment phase. For this reason, applying standard debt capacity analysis methodology may be inadequate – both in terms of assumptions and interpretation of results. In such cases, it is worth considering adjusting the analytical approach to the specific facts.

The purpose of this approach is not to circumvent the problem but to realistically assess the company’s ability to service debt in the context of its function and objectives – which is particularly important in assessing the arm’s length nature of intra-group financial transactions.

Why do banks not have to update analyses – but you should?

“But banks don’t do this…” is an argument often raised in discussions about intra-group financial transactions. The point of contention here is primarily the obligation to update transfer pricing analyses at least every three years and, as a result, if necessary, to adjust interest rates during financing, while banks do not carry out such analyses or interest adjustments after financing has been granted.

The situation is similar regarding debt capacity. So why the difference in transfer pricing regulations?

It should be remembered that:

• Banks, before granting financing, thoroughly verify the creditworthiness of the potential borrower, which often lacks in intra-group financing.
• Banks very often, if not predominantly, apply various types of collateral intended to secure repayment of liabilities by the borrower during the financing period.
• Intra-group transactions are often unsecured, which increases the risk borne by the lender in relation to the financing granted.

These differences, influencing the level of risks associated with intra-group financing, from the tax authority’s perspective further increase the need for a thorough debt capacity analysis.

Summary: why is it worth analysing debt capacity?

• Debt capacity analysis is not explicitly required by documentation obligations, but its absence may disadvantage the taxpayer during an audit.
• It can determine the arm’s length nature of the financial transaction and help avoid income adjustment.
• It is important for large loans, companies with unstable financial situations, or SPVs.
• It should be updated regularly, not just at the moment of the transaction.

Does the above apply to your company? Is there a risk related to the lack or reduction of the ability to incur or service liabilities by your company? If you do not know or are unsure, we encourage you to contact us.