Arm’s length principle of loan is not only about the interest rate

Financial transactions are one of the most common transactions between related parties and also most frequently controlled by the tax authorities. Due to the an extensive catalogue of financial transactions and their level of complexity, taxpayers often face problems in justifying the arm’s length nature of these transactions. In addition, the unfavourable approach to taxpayers by tax authorities and courts that we have seen recently does not make this task any easier for taxpayers.

Currently, tax authorities are not only focusing on the amount of interest and the interest rate but also other relevant conditions from the perspective of assessing their arm’s length nature, e.g. the capacity to service the financing. Significantly, the tax authorities, as a result of a detailed analysis of the contractual provisions for the controlled financial transaction, may find that unrelated parties would not have agreed to conclude a similar transaction – as the taxpayers were convinced in the 2023 judgments.

What did the court find?

The rulings issued last year confirm how important it is to define the terms of financial transactions correctly and specifically from the perspective of justifying their arm’s length nature. In the mentioned judgments, the court questioned the content of the financing transaction agreements on the grounds that the provisions contained therein, or lack thereof, did not confirm the arm’s length nature of the transaction. In addition, the court considered whether the terms of the taxpayer’s intra-group financing agreements lead to a deterioration of the financial condition of the parties to the transaction. As a result, the court found that unrelated parties would not have agreed to provide financing in the amount as in the controlled transaction.

Extended benchmarking analysis – a valuable tool in defending the validity of a financial transaction

Qualitative benchmarking plays a key role from the perspective of justifying the terms of a financing transaction. In addition to the interest rate, the taxpayer should include in the benchmarking analysis all relevant factors that could potentially influence the unrelated party’s decision to provide financing, including the borrower’s ability to incur and repay liabilities.

Such a comprehensively prepared benchmarking analysis, extended by an analysis of the ability to incur and service debt, can be helpful during a tax audit. An extended benchmarking analysis will increase tax security and reduce the risk of disputes with the authorities.

Conclusions for taxpayers

Taxpayers conducting financial transactions should verify whether the content of the agreements contain clauses confirming the market nature of the transaction (e.g. financing period, interest repayment schedule) and whether these contractual provisions were or are in fact complied with. It is important to include all aspects relevant from the perspective of the transaction in question in the contract to avoid negative consequences from the tax authorities.

It can also be helpful to compare the terms of financing agreements with offers from independent financial institutions to verify whether the terms of the deal being pursued meet market standards. However, it should be borne in mind that offers from external financial institutions will not always be the best comparable. The safest way to verify the arm’s length principle of financing is to conduct a benchmarking analysis, which will include verification of the interest rate and analysis of the ability to incur and service the debt. A reliable benchmarking analysis will provide evidence of the market nature of the transaction. It is also worth considering the development of a transfer pricing policy for financing transactions, which can provide an additional tool to ensure market conditions in the transaction.