For related party debt arrangements, the manner in which key terms are documented could have a substantial impact on arm’s length pricing.
As an example, where a borrower under a fixed rate loan has the right to prepay at any time without penalty, transfer pricing issues emerge. A third party borrower would utilise such a right to seek to refinance should interest rates fall materially (or renegotiate a lower rate with the original lender).
Practically, from a transfer pricing perspective, this means that the interest rate needs to be re-benchmarked over the life of the loan, with the arm’s length rate potentially reducing if market rates have fallen (but with no corresponding potential for increase).
An attempt to remedy this situation on an existing loan by simply amending the agreement could be problematic. The amendment could be viewed as giving rise to the disposal of a valuable right without consideration.
The above issues would not arise if the loan had been floating rate or, if fixed rate, the borrower had been required to indemnify the lender’s reasonable break costs in relation to early prepayment (as is typical in third party fixed rate debt arrangements).
It is worth undertaking a review of all current and proposed related party financing documentation and assessing whether the terms and conditions are reflective of those that might be expected to exist in arrangements with an independent lender. To the extent that the conditions differ, then the arm’s length pricing implications should be further considered.