The COVID-19 pandemic creates uncertainty across the markets. It is likely that Cypriot multinational companies will be required to borrow additional funds to finance their operating expenses. Often, the source of borrowing would be a foreign related party that has necessary funds available. The other scenario, when a cash-rich Cypriot company lends money to its foreign related parties, is also possible.
From the transfer pricing perspective, any transaction between related parties should be aligned with the arm’s length principle. In light of the COVID-19 impact it will be more challenging to establish the arm’s length price for a loan transaction.
There are three key transfer pricing areas of attention for loans issued in 2020:
· Debt vs. equity considerations;
· Credit rating of the borrower;
· Lender’s perspective.
We describe these topics for Cypriot multinational companies in more details below.
I. Debt vs. equity considerations
For multinationals it is often possible to inject funds to a subsidiary either through debt or equity. If the group decides to proceed with debt, there is a risk that a loan would be considered as a non-arm’s length arrangement and recharacterised as a contribution to equity. This risk follows from the assumption that a company might not be able to borrow funds from an unrelated party in an uncertain business environment that we are currently experiencing. That said, it does not imply that borrowing is impossible in 2020. It is rather the case that a borrower should be able to demonstrate that it has reasonable expectations to return borrowed money under the conditions specified in the loan agreement. The proper way to do this is to prepare a transfer pricing study in advance, i.e. before the loan agreement is signed.
II. Credit rating of the borrower
Credit rating of the borrower is one of the key determinants of the interest rate. For transfer pricing purposes, it is often estimated using publicly available credit risk calculators and financial statements of the borrower for preceding reporting periods. However, it is obvious that financial statements for 2019 (or 2018, if recent financial statements are not available yet) do not take into account the impact of COVID-19. Because of this impact, actual credit rating of the borrower may be significantly different in 2020 compared to 2019, even if financial results were consistent in recent years. Thus, a corresponding adjustment to the calculated credit rating may be required.
III. Lender’s perspective
For transfer pricing purposes, a loan transaction should be considered from the perspective of the lender as well as the borrower. More often than not, a borrower’s perspective gets more attention, so it is hard to miss something from this side. From the lender’s perspective, it is always important to consider alternative instruments for a lender to invest. It might be the case that an independent lender chose not to invest the funds, to create a safety cushion. Besides that, it may be argued that an independent lender will demand a collateral for a loan and otherwise would not agree to give funds even for a much higher interest rate.
It is also worthwhile to mention that for existing loan agreements (signed before 2020) an independent lender would reassess existing loans to determine the impact of COVID-19 on the creditworthiness of the borrower.
The best way to manage these risks is to prepare a timely transfer pricing report that will allow to determine an appropriate arm’s length range.