In an interconnected business world, intra-group transactions such as inter-company loans are under increasing regulatory scrutiny. For startups and established companies alike, borrowing from related entities is often a more accessible alternative to traditional financing options.
However, ensuring these transactions meet international arm’s length standards presents a unique set of challenges. This is why transfer pricing documentation and benchmarking have become pivotal elements of global business management, serving as crucial tools for compliance with international tax regulations.
What is transfer pricing?
Transfer pricing is the accounting and taxation practice that allows for pricing transactions internally within businesses and between subsidiaries.
Because transfer pricing expands the potential for cross-border transactions to distort taxable income for the holding company, tax authorities across jurisdictions require documentation to prove that transfer pricing transactions comply with the arm’s length principle. Transactions that are at arm’s length maintain terms that would exist between unrelated parties (e.g., loan interest charged at the market rate).
The importance of transfer pricing documentation
The issue of transfer pricing is complex, as intra-group loans have become a vital source of alternative financing within corporate groups. As interest rates have skyrocketed, intra-group loans have provided easier access to much-needed capital.
But these transactions can attract regulatory scrutiny if they aren’t properly documented and justified. Justifiable transfer pricing ensures that internal dealings between related entities are conducted at arm’s length, comparable to transactions that would occur between independent parties.
The benefits of documenting transfer pricing transactions include:
- Providing rationale for an enterprise’s pricing strategies
- Offering a paper trail for national tax authority investigations
- Ensuring compliance with international guidelines, such as those established by the Organisation for Economic Cooperation and Development (OECD)
OECD guidelines and benchmarking financial transactions
The OECD’s transfer pricing guidelines are designed to ensure that financial transactions are executed at market value, regardless of whether they occur between related or unrelated entities. While the term is inherently vague, “market value” is equivalent to what independent parties would have agreed under similar circumstances.
Benchmarking is typically done to determine whether a financial transaction is truly conducted at arm’s length. The process includes:
- Comparing the terms and conditions of the transaction with similar transactions between independent parties
- Analysing the functions performed, assets employed, and risks assumed by the parties involved
- Ensuring that any deviations from market conditions are justified and documented appropriately
Innodis and other cautionary tales
Although Mauritius does not have prescriptive transfer pricing legislation, tax authorities actively assess intra-group transactions to ensure they adhere to arm’s length principles. The landmark Supreme Court judgment in the case of Innodis highlights the strict Mauritian approach to transfer pricing assessments.
In 2023, the Mauritius Supreme Court ruled that the zero-interest loan terms Innodis had granted to its subsidiaries were not justifiable. Although the OECD transfer pricing guidelines recognise the practical difficulties in applying the arm’s length principle to transactions that independent parties would not likely undertake, Mauritius authorities took a stricter view.
Despite Innodis’s argument that the loans were given based on internal business needs and conditions similar to what OECD guidelines suggest could be justifiable, the court ruled that the loans should have interest applied at a market rate.
This case shows a strict interpretation of the arm’s length principle by Mauritius authorities and underscores the need for companies to exercise caution in documenting and justifying the terms of their transactions with related parties.
At IQ-EQ, we supported a client who had a similar battle with the Mauritius Revenue Authority (MRA) after extending an interest-free loan to a subsidiary. The tax authority raised an assessment and ascribed an interest rate of 15%.
After performing a thorough benchmarking exercise, IQ-EQ demonstrated that this rate was excessive and not reflective of an arm’s length transaction. Ultimately, the assessment was settled at a rate of 6%.
The key takeaway? The effectiveness of well-prepared transfer pricing documentation cannot be overstated.
How IQ-EQ can help
Transfer pricing documentation is more than a compliance requirement; it’s a strategic business tool that ensures the success of intra-group transactions. As global business complexities continue to grow, it is paramount to ensure these transactions can withstand the scrutiny of local and international tax authorities.
Contact our team today to ensure the compliance and strategic management of your transfer pricing documentation.
