Financial transactions

Financial transactions: The elephant in the room

In our fast growing and ever changing economy, businesses frequently resort to borrowing in order to meet investment capital requirements and manage cash flows. When faced with the decision of choosing a lender, companies often resort to borrowing from related parties/ group entities rather than third parties such as banks for a number of factor such as favourable terms of the loan, grace periods and the lack of a collateral requirement.

Although the commercial need for funding is easily understood, complexity and related risk does arise from a transfer pricing perspective as not only is the interest rate, but also all the terms of the loan, scrutinised under a microscope to ensure the arm’s length nature thereof.

A company is typically financed through a mixture of debt (with interest being tax deductible) and equity (with dividend not being tax deductible). Where the debt is from a related party, there is a need to consider (i) whether the full amount of funding is accepted as “debt” for tax purposes, and (ii) whether the interest on such debt is a market value interest rate.

The acceptable level of debt is determined by thin capitalisation rules introduced in the income tax legislation in 2010, and which replaced predecessor “interest cover” provisions. Thin capitalisation refers to a situation where a borrower is financed through a relatively high level of debt compared to equity. Any commercial lender will want to determine whether a prospective borrower is thinly capitalised, because this might indicate that it would be more risky to make further loans to the prospective borrower. The rules limit eligible debt (namely debt on which interest can be claimed) by reference to a debt to equity ratio of 7 to 3. Therefore, any interest expense on debt that exceeds the allowable ratio is disallowed for tax purposes.

Once the thin capitalisation test is passed, from a transfer pricing perspective it is then necessary to show that the interest rate meets the arm’s length test. To determine the appropriate commercial interest rate, two components are considered: (i) a component of interest to reflect the use of money (base rate) and (ii) a margin added on top of the base rate to reflect the additional reward required by the lender to compensate for the risk taken (i.e. that the borrower might default).

There are a number of factors that determine the base rate, such as: currency, term of the loan, whether it is a fixed or variable rate, and liquidity in the market. It is usually relatively straightforward to determine the arm’s length base rate as this is set by reference to an internationally recognised basis such as the Bank of Tanzania base rate for the Tanzanian Shilling or the London Interbank Lending Rates (LIBOR) for the United States Dollar.

Determining the margin is often more challenging because it is more subjective as account must be taken of both the creditworthiness of the borrower (as a standalone entity) and the macroeconomic conditions affecting the credit spreads. There are a number of credit rating methodologies, tailored for separate industries that have been developed by credit rating agencies such as Standard & Poor's (S&P), Moody's, and Fitch Group that provide guidance on how to determine the credit worthiness of a company. Once a credit rating/worthiness is determined, a search is conducted to ascertain the interest rate that borrowers have obtained as corporate bonds/ loans based on that credit rating.

The Tanzania Tax Administration (Transfer Pricing) Regulations, issued in November 2018, provide that a person who provides or receives intra group financing directly, with or without consideration, shall determine the arm’s length interest rate for such assistance. However, there is no further guidance, and so suggests that one must then revert to the international standards / best practice in determining the arm’s length interest rate for a intra group financial transaction. In July 2018 the Organisation for Economic Co-operation and Development (OECD) issued a discussion draft on financial transactions which attempts to provide further guidance on the transfer pricing of financial transactions including in relation to financial transactions such as treasury function, cash pooling, hedging, guarantees and captive insurance. It is expected that when the draft is finalised, it will be added into the 2017, OECD Transfer Pricing Guidelines.

Complicated? Yes. Might there be a simpler approach? Possibly - and here I am thinking of application of the so called “interest cover” approach (removed in 2010). But that can be a subject for another day.

By Vivian Mbowe Senior Associate at PwC - Tax Line of Service

The views expressed do not necessarily represent those of PwC. For PwC updates on tax and other matters do follow @pwc_tz or visit our website www.pwc.com/tz

Article first published in The Citizen (14.02.2019).