TRANSFER PRICING OF RELATED PARTY LOANS

1.0 Background
This tax guide has been drawn based on the Ugandan Transfer Pricing Regulations, 2011 and the OECD Transfer Pricing guidelines on the application of the arm’s length principle to related party loans. Taxpayers, either through their tax agents or by themselves, are responsible for managing their own tax exposures, including the risks of transfer pricing adjustment for cross-border related party transactions. Transfer pricing adjustments made by tax authorities for cross-border related party transactions might result in double taxation. It is, thus, in the best interest of taxpayers with related party transactions in goods, services and intangibles to minimize the incidence of double taxation by ensuring that they establish arm’s length transfer pricing policies and maintain adequate documentation to demonstrate compliance with these policies.
The arms-length (AL) principle is the internationally accepted standard for determining transfer prices for related party transactions. While mechanical application of the arm’s length principle could give rise to difficulties and concerns for taxpayers, the conduct of a comprehensive analysis for the purpose of demonstrating compliance with the AL principle might be impractical. In principle, the tax body would accept practical alternatives to assist taxpayers comply with the AL principle.
2.0 Application of the AL Principle to Related Party Loans
It’s important to determine what would be considered a loan and when it does arise if the AL Principle is to be of any use in availing under-or over-taxation. A loan would arise when there is money lent in one form or another, irrespective of whether or not the loan is made through a written agreement. It may include credit facilities or inter-company credit balances arising from the normal course trading which are left uncollected over a substantial period of time beyond, which a third party trade creditor would not typically accept. For example, if parent company A renders management services to its subsidiary company B and the management fees amount remains unpaid by company B beyond a period of time considered reasonable (this is of course subject), company A may be deemed as having extended a loan to company B.

A related party loan can arise where there is (a) “Related domestic loan” and/or (b) “Related cross-border loan”. With the former a domestic entity lends to, or borrows from, a related domestic entity while in the latter instance, a domestic entity lends to, or borrows from a related foreign entity.
In complying with the AL principle, an entity that makes a loan to, or otherwise becomes a creditor of, another related entity should charge the related entity for the use of funds at a rate that reflects an AL interest rate. The AL interest rate is the rate of interest which should have been charged , at the time the indebtedness arose, between independent parties under similar circumstances. In other words, the AL rate of interest is the interest rate that the lender of the funds would charge to provide funds to borrowers that are independent of lender. The entities extending interest-free loans or interest bearing-loans at rates that are not supported by transfer pricing analysis to related party entities are required to adopt the typical methodology of charging an AL interest rate.
To facilitate compliance with the AL standard, the tax body makes interest adjustments on lenders who make loans to related entities, which are interest-free or otherwise at interest rates not supported by transfer pricing analysis. This practice ordinarily applies to related domestic loans and where the lender concerned is also not in the business of borrowing and lending funds e.g. banks or other financial institutions. A domestic lender that extends a loan to foreign related entity which is interest-free or otherwise at an interest rate not supported by transfer pricing analysis must restructure their loans to reflect commercial conditions and obtain AL interest rate.
3.0 Determination of the AL Interest rate
During a comparability analysis, all facts and circumstances relating to the loan must be considered, and these may include factors such as:
? Nature and purpose of the loan;
? Market conditions at the time the loan is granted;
? Principal amount, duration and terms of the loan;
? Currency in which loan is denominated;
? Exchange risks borne by the lender or borrower;
? Security offered by the borrower;
? Guarantees involved in the loan;
? Credit standing of the borrower; and
? Interest rate prevailing for comparable loans between unrelated parties.

The comparable uncontrolled price (“CUP”) method is the preferred method for determining the arm’s length pricing for related party loans, not only because of its conceptual superiority compared to other methods, but because it is often found to be the most suitable method for loan transactions. However, if circumstances render another method to be more appropriate, taxpayers could rely on that method, and maintain documentation to justify why consider that method is more suitable.

Practical guidance for the arm’s length analysis for loans: It is generally accepted that taxpayers can rely on a suitable reference rate, such as the BOU Inter Bank Rate, the London Inter Bank Offered Rate (“LIBOR”), prime rates offered by banks or specific rates quoted by banks for similar loans. Adjustments, where necessary can then be made to the reference rate, based on the outcome of the comparability analysis undertaken, to arrive at the appropriate AL interest rate or range of interest rates.
4.0 Conclusion
Observance of the AL length standard is part of Uganda’s tax treaty obligations. The AL principle is also the internationally adopted standard. The adoption and compliance with this AL principle helps (a) reduce the incidence of transfer pricing adjustments, (b) improve the resolution of transfer pricing disputes and (c) reduce the potential risk of double taxation in the case related party loans. As a result, taxpayers who extend interest-free cross-border loans or interest-bearing cross-border loans not supported by transfer pricing analysis to related parties should recognize that when such loans are subjected to transfer pricing audits and/or adjustments, there may be a higher risk of unresolved disagreement over the adjustments and hence double taxation.

Disclaimer: It should be noted that in Uganda, transfer pricing taxation is at its young stage, and specific and practical guidance on most issues is yet to be developed. Meantime, the interpretation and application of the regulations is likely to vary from tax officer/taxpayer/tax practitioner to tax officer/taxpayer/tax practitioner. Nonetheless, it is important to consult the Uganda TP regulations in Income Tax Act and the OECD guidelines and myself before applying this interpretation. I take no responsibility for any loss/liability resulting from the application of this advice without due reference to myself.