Transfer pricing issues of intra group loans

The government introduced transfer pricing legislation on 1 January 2016 in order to regulate transactions involving members of the same group (subsidiaries and associates) within Zimbabwe or across the border. The rules require these transactions to be conducted at arm’s-length. A transaction is deemed to be at arm’s length if its price is similar to the one charged between independent enterprises in similar circumstances. Transactions that are under the spot light include the sale of tangible goods, provision of services, licensing of intangible and financial transactions. However, the focus of this article are financial transactions (intra-group loans). There are no specific rules for testing whether financial transactions are at arm’s length, in fact the general rules for testing arm’s length would apply. We fully explain the methodology for testing arm’s length financial transaction below:

The two components that are important in testing whether a loan or financial transaction is at arm’s length are the interest rate and the quantum of the loan. The interest rate refers to the charge the borrower is willing to pay for the funds advanced to it and this should be comparable between related parties versus that chargeable between independent parties in similar circumstances. The rate should incorporate the compensation required by the lender for the use of his money known as the base rate (risk free interest) and the premium chargeable by the lender for the risk of default imposed on the borrower of not paying payback the loan.  The risk free interest is the rate applicable when lending to the government or State because the chances for a government or State defaulting on loan obligations are next to nothing.  This rate depends largely on the currency of the loan, its tenure, the date the loan is made and whether the interest rate if fixed or floating rate. The relevant currency is that of the lender and the longer the term the higher the interest rate to compensate for the long use of money.  The risk premium is meant to compensate the lender for probability of the borrower defaulting on his/her loan. The key considerations are the creditworthiness of the borrower and the macro environment.  The borrower can bargain for a better risk premium if he has security, collateral, asset backing, interest cover, comfort letters, cashflow, covenants, guarantees, good track record, good business project etc.  The macro economic environment is also a key input in coming up with the risk premium. In a volatile environment such as that of Zimbabwe lenders would charge high interest rate because the risk of borrowers defaulting is very high and would to be compensated for taking this risk. Nevertheless, government may through the central bank regulate interest rate, again this a key input for both risk free interest and risk premium interest.  It is therefore expected that in commercial transactions between private players, the interest rate should exceed the base rate because some level of default will always exist.  Therefore as starting point, in fixing the interest rate for financial transactions related parties should consider the base since independent lenders to independent borrowers are more than willing to charge interest rate in excess of that charged to governments or States.   

Before concluding on this subject matter, whether or not a financial transaction is at arm’s length regard must have been made to quantum of the loan versus the capacity of the borrower. Any commercial lender would want to determine whether a prospective borrower is thinly capitalised, because this might indicate the capacity of the borrower to pay the debt. It is necessary to determine how much the borrower could have borrowed on a stand-alone basis. In testing this, the comparability factors for testing the credit worthiness of the borrower should be considered in order to determine how much debt would be appropriate and viable for the borrower if it were an independent company. Meanwhile, Zimbabwe has thin capitalisation rules for regulating intra group loans which provides for a debt to equity ratio of 3:1. Interest charge on excessive debt is disallowed when computing income tax. Although these rules are not transfer pricing rules per se, they constitute a key consideration in evaluating the capacity of the borrower to repay the loan.

In summary, related parties must consider factors highlighted in this document when fixing interest rate on intra group loan in order to stay within the arm’s length range. The interest rate and the quantum of the loan should be comparable to those in transactions between independent parties.  The analysis should be undertaken from both the lender’s and the borrower’s perspective. A two-sided analysis involves a review of risks borne by the lender when lending monies and requires consideration of the cost of obtaining these funds by the borrower. The analysis must also take into consideration the debt capacity of the borrower. A debt capacity analysis ascertains how much debt the borrower can service without defaulting on its obligations. This is important because any excess debt undertaken by the borrower will be considered at non-arm’s length, and interest deductions on that part of the debt could be denied for tax purposes. This analysis is generally undertaken by analyzing the liquidity and solvency ratios of the borrower. In light of the harsh penalties imposed by the government for failing to comply with the transfer pricing laws, related parties must exercise care when fixing the interest rate on intra group loans. Excessive interest could lead to non-deductible interest expense, double taxation, penalties or other more serious sanctions imposed on them by the government. On the other hand inadequate interest charge may result in the ZIMRA imputing income on the lender which action has almost the same implication as the charging of excessive interest rate.

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