Rise in interest rates also relevant for intra-group financing

Application of the correct reference interest rate

Transfer pricing rules require that intra-group loan agreements be entered into on market-based terms. These are terms consistent with the terms that independent parties would agree to under similar circumstances. Due to the successive increases in benchmark interest rates by central banks, the financing costs of businesses are rising. Often, the interest rate on an intra-group loan is determined based on a reference interest rate (e.g., 3m EURIBOR) increased by a premium primarily compensating for credit risk. With these reference interest rates fluctuating more, it is important to closely monitor that the correct reference rate is applied for each loan agreement.

Is the risk premium still appropriate?

In some cases, interest rate increases can also impair the repayment capacity of the debtor. This is especially true in groups that utilize debt financing from various group entities while operational margins remain stagnant. An increase in financing costs in such structures can result in group entities no longer having positive results or generating insufficient cash flow to cover the heightened interest expenses, consequently increasing the risk of the company being unable to meet its debts. In such instances, it is necessary to assess whether the risk premium applied on top of the reference interest rate is still appropriate. It may need to be increased. An independent party such as a bank would indeed expect a higher premium when exposed to a higher credit risk.

Impact on tax deductibility of interest expenses

In more extreme cases, the loan may no longer be repaid. The revised OECD guidelines on transfer pricing include rules that determine when financing constitutes a loan or has characteristics more akin to equity. If, for transfer pricing purposes, financing is considered as equity, then the interest cost is no longer tax-deductible. When it becomes highly unlikely that the loan can be repaid or if repayments never occur, it may indicate that, for transfer pricing purposes, the loan is more appropriately characterized as capital. This results in the interest costs no longer being tax-deductible.

Additionally, various tax rules limiting interest deductibility exist (known as 'thin cap' rules), primarily relevant to large enterprises. For instance, interest deduction for all loans, whether intra-group loans or external or bank loans, is generally limited to EUR 3 million or 30% of the operational profit (EBITDA), whichever amount is higher. These rules are applied on a Belgian (ad hoc) consolidated basis. Rising interest costs can lead to surpassing these thresholds, rendering interest expenses non-deductible.

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