Financial transactions – risks of non-arm’s length terms in transfer pricing

What are financial transactions in the context of transfer pricing?

Financial transactions encompass a wide range of intercompany activities, including loans, credit facilities, financial guarantees, bond issues, and other financial instruments. These are among the most common categories of related party transactions.

To minimize the risk of income adjustments by tax authorities, the terms of financial transactions should accurately reflect market conditions. Companies engaging in financial transactions with related parties must therefore prioritize proper structuring, accurate valuation, and comprehensive documentation for transfer pricing purposes.

What are the risks associated with non-arm’s length financial transaction terms?

Non-arm’s length conditions in financial transactions can stem from faulty assumptions—not just regarding interest rates, but also concerning inadequate collateral or improperly assessed risk. The key risks include:

• Incorrect remuneration – setting an interest rate that is too high or too low in related party transactions may prompt tax authorities to adjust taxable income (for example, by reducing deductible expenses or increasing taxable income).
• Lack of commercial rationale – financing arrangements without a clear commercial rationale, repayment plan, or appropriate lender response to missed payments can trigger scrutiny from tax authorities. If the terms of the financing wouldn’t be acceptable between independent parties, authorities may reclassify the transaction—for example, treating a loan as an equity contribution—and adjust the tax liabilities of all parties involved accordingly.
• Inadequate credit risk assessment – failure to assess the true credit risk, such as the counterparty’s solvency or history of late payments, can lead tax authorities to question the arm’s length nature of the transaction. For example, they may argue that unrelated parties would not agree to defer interest payments without capitalising them, and consequently change the tax treatment of the transaction.
• Insufficient collateral – a lack of adequate collateral for intragroup transactions or failure to reflect existing collateral in the pricing of a financial transaction may also be considered non-arm’s length and result in negative tax consequences. For example, providing substantial financing to a related party without standard guarantees—which would not be acceptable under market conditions—may trigger tax scrutiny.

Non-arm’s length financial transactions may result in adjustments to taxable income, penalty interest, and administrative sanctions, which in some cases can amount to PLN 41 million under Polish tax law.

How to ensure financial transactions align with the arm’s length principle?

To mitigate risks in financial transactions, companies should adopt market-based transfer pricing principles from the outset. Key steps in which we can support you include:

• Proper structuring of financial transactions – ensuring that all terms (not just interest rates, but also interest accrual frequency, capitalisation, repayment schedules, and default provisions) align with market conditions.
• Benchmarking analysis – conducting a comparability study to determine an arm’s length interest rate, ensuring all relevant comparability factors and transaction terms are appropriately considered to defend the market alignment of the transaction.
• Robust documentation – preparing thorough transfer pricing documentation to support the arm’s length nature of the transaction in the event of a tax audit.
• Ongoing audit & review – periodically assessing whether transaction terms need to be adjusted due to significant changes in economic conditions.

Don’t take unnecessary risks – ensure compliance with the arm’s length principle. Remember that the pricing of financial transactions is not just about interest rates, but encompasses all commercial terms.

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