How will the UK transfer pricing rules apply to energy companies’ financing arrangements?

19 July 2023

With the rising cost of debt, RSM UK’s transfer pricing specialists offer guidance for energy companies regarding the transfer pricing treatment of their new, existing and refinanced debt arrangements.

Higher borrowing costs are impacting the level of interest on connected party debt which may be deductible for tax purposes. This applies to new lending, refinancing and ongoing arrangements. We recommend that businesses keep their connected party debt under review to ensure any interest deductions remain robustly supportable based on current market data.

On the back of the global economic and political turbulence throughout 2022, the European corporate debt market has followed global trends in terms of stark increases to the price of new debt and tightening of financial covenants applied by third party lenders restricting some borrowers’ access to funding. These trends reflect an increased level of risk associated with corporate lending and will impact how UK borrowers are able to fund their operations and the associated tax treatment of funding costs. 

The energy sector is heavily geared and characterised by long-term, high-value debt instruments that underpin significant capital and operating expenditure requirements. This makes it particularly sensitive to how this higher risk lending environment influences the operation of UK transfer pricing rules. In addition to their earnings being impacted by inflationary pressures and higher interest rates, large energy groups financing their UK operations with a combination of third-party and related-party debt (most commonly shareholder loans) may also be facing a reduced level of interest deductions in their annual income tax returns. This is due to the application of UK transfer pricing rules. 

These rules are based on the arm’s length standard, requiring UK companies borrowing from related parties to only include interest deductions that would have been available to them if they had borrowed the relevant funds on arm’s length terms. The rules will impact new and existing arrangements (including those arrangements being re-financed) in different ways, we have highlighted these below.

  • Interest deductions in relation to new related party lending arrangements must be assessed against current market data, and companies are unlikely to be able to rely on broad indicative financial metrics to support deductions ( eg ‘rule of thumb’ metrics regarding expected leverage, interest cover, capital structure, etc.).

    Market data relating to UK transaction activity suggests that UK borrowers will be able to support a lower level of related party debt but at a higher interest rate when compared to lending conditions in previous years. Whether or not this materially impacts borrowers’ access to interest deductions depends on the financial strength of each specific borrower. It should be noted that by operating in a cost-intensive industry, the financial strength of borrowers in the energy sector may have been more exposed to inflationary pressure than borrowers in the wider corporate debt market.
  • Companies refinancing their wider debt arrangements will likely need to refresh their existing assessment of the deductibility of related party interest.

    New third-party debt may be tied to a base rate that has increased substantially over the past year. This includes a higher margin than previous third-party arrangements may have included, or be a fixed rate instrument that reflects the higher level of market risk associated with corporate lending.

    Put simply, if new third-party debt is more expensive, it may absorb a borrower’s capacity to pay related party interest. This leads  to a greater proportion of the related party interest being disallowed than in the original arrangements.
  • Existing, on-going arrangements must also be tested on an annual basis in line with UK borrowers’ obligation to ensure that the related party interest deductions disclosed in their UK income tax return are supportable, particularly with reference to the financial capacity of the borrower to service and repay related party debt.

    Even where companies have previously assessed the deductibility of their related party interest expense, macroeconomic conditions may have impacted companies ongoing ability to service their related party debt and meet the financial covenants that a third-party lender would implement to a comparable arrangement.

    For example, borrowers in the energy sector that generate income from purchase price agreements may have seen material variations in their cash flows against their historic forecasts where purchase prices are fixed and / or do not increase commensurate to escalating operating costs or inflation. This variation from forecasts may mean that borrowers cannot support the same level of related party deductions as previous years.

Although stability in the European debt market may seem a far-away future, changes in market conditions present an opportunity for energy companies to review the transfer pricing treatment of their new, existing and refinanced debt arrangements. This ensures  that their annual interest deductions are robust and supportable.

In such a heavily leveraged sector, a practical, well-documented transfer pricing analysis can ensure that UK energy companies’ related party deductibility positions are commercial and supportable. This reduces the likelihood of transfer pricing adjustment by HMRC and mitigating the risk of penalties in the event of an adjustment. 

Kaila Engelsman
Transfer Pricing Associate Director
Kaila Engelsman
Transfer Pricing Associate Director