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How do you align intercompany loan terms with arm's length principle?

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Intercompany loans and transfer pricing are two key aspects of cash management for multinational enterprises (MNEs). They involve the movement of funds and the allocation of profits among different entities within the same group. In this article, you will learn how to align intercompany loan terms with the arm's length principle, which is the international standard for transfer pricing.

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Inam-Ur- Rehman

Lead Taxation - Pakistan & Middle East Cluster at Roche Pakistan Limited

1 What is the arm's length principle?

The arm's length principle is the basis for determining the transfer prices of goods, services, and intangibles between related parties. It states that the transfer prices should reflect the conditions that would apply if the parties were independent and acted in their own interest. The arm's length principle aims to prevent MNEs from manipulating their profits and taxes by shifting income and expenses among different jurisdictions.

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Karim Farah

Accounts payable Team lead at CMA CGM
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Aligning intercompany loan terms with the arm's length principle involves ensuring they match what unrelated parties would agree upon, often using transfer pricing methodologies for assessment.

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2 Why is it important for intercompany loans?

Intercompany loans are a common way of financing the operations and investments of MNEs. They can provide liquidity, flexibility, and risk management benefits for the group. However, they can also pose transfer pricing challenges, as the interest rates and other terms of the loans can affect the taxable income of the borrower and the lender. Therefore, it is important to ensure that the intercompany loan terms are consistent with the arm's length principle and reflect the market conditions.

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Inam-Ur- Rehman

Lead Taxation - Pakistan & Middle East Cluster at Roche Pakistan Limited
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Following steps to align intercompany loan terms with the arm's length principle: Conduct a Comparable Uncontrolled Price (CUP) Analysis: Determine the Appropriate Transfer Pricing Method: Consider Economic and Financial Conditions: Document the Loan Terms and Rationale: Consider the Creditworthiness of the Borrowing Entity: Use External Benchmarks: Consider the Currency and Duration: Involve Financial Experts: Regularly Review and Adjust Terms: Document Comparable Transactions: Comply with Local Transfer Pricing Regulations: Consider Thin Capitalization Rules: Involve Legal and Tax Advisors:

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3 How to determine the arm's length interest rate?

One of the main factors that affect the arm's length interest rate is the credit risk of the borrower. This is the risk that the borrower will default on the loan or fail to pay the interest. The higher the credit risk, the higher the interest rate that an independent lender would charge. To assess the credit risk of the borrower, you can use various methods, such as credit ratings, credit default swaps, or financial ratios.

Another factor that affects the arm's length interest rate is the currency and maturity of the loan. Different currencies have different interest rates, depending on the supply and demand, inflation, and exchange rate expectations. Similarly, different maturities have different interest rates, depending on the time preference, liquidity, and uncertainty. To determine the arm's length interest rate for a specific currency and maturity, you can use market benchmarks, such as interbank rates, government bonds, or corporate bonds.

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4 How to document the arm's length loan terms?

In order to support arm's length loan terms, you need to document the process and rationale behind them. Doing so can help you comply with the transfer pricing rules and regulations of the relevant jurisdictions, as well as avoid potential adjustments or penalties. To accomplish this, you may need to prepare a loan agreement that specifies the amount, currency, maturity, interest rate, repayment schedule, and security of the loan. Additionally, a transfer pricing report should explain the method and data used to determine the arm's length interest rate and other terms. Furthermore, a functional analysis should describe the functions, assets, and risks of both the borrower and the lender. Lastly, a comparability analysis should identify and adjust any differences between the intercompany loan and market benchmarks.

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5 How to monitor and review the arm's length loan terms?

The arm's length loan terms are not static and may change due to changes in the market conditions or in the circumstances of the borrower or the lender. It is important to monitor and review the loan terms periodically and make any necessary adjustments to reflect the arm's length principle. This could be triggered by a significant change in the credit risk of either party, interest rates or exchange rates of the relevant currency, business strategy or financial performance, or renegotiation or termination of the loan agreement. Intercompany loans and transfer pricing require careful planning and management, and by aligning with the arm's length principle, you can optimize your cash flow, tax position, and avoid potential disputes and adjustments.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Gale Carter

Senior Loan Review Officer at Cadence Bank, N.A.
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Consolidating financial statements prepared according to GAAP. Prohibition on inter-company loans or distributions without prior consent. Evaluate each entity’s existing loan agreements for compliance. Incorporate an inter-creditor agreement in event of covenant waivers, default, etc..

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Chris Shultz

?? Global Treasury Leader with a History of Operational & Strategic Successes ?? Drives Teams to Exceed Targets ? Treasury ? Cash Management ? Banking ? Capital Markets ? FP&A ? Forecasting ? Treasury/Banking Systems
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Question, if the parent is lending to its subsidiary, and 1) the sub has no credit rating, 2) the sub is guaranteed by the parent (lender), can you use the parent’s borrowing rate plus a service spread for the I/C loan?

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How do you align intercompany loan terms with arm's length principle?

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1 What is the arm's length principle?

2 Why is it important for intercompany loans?

3 How to determine the arm's length interest rate?

4 How to document the arm's length loan terms?

5 How to monitor and review the arm's length loan terms?

6 Here’s what else to consider

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