Surviving the Storm: Strategies for Managing Financial Transactions in a Volatile Economic Climate
During 2022 international businesses continued to be exposed starkly to changing macroeconomic conditions, with Europe now battered by war after recovery from Covid-19. Compared to the preceding roughly 10 years of low interest rates and relatively stable economic conditions, the situation in January 2023 in the Euro Area is marked by rising inflation, rising interest rates, and a tanking business and consumer confidence (see graphs below).
Harmonized Index of Consumer Prices (HICP), Eurostat (Dec 2022), sourced from European Central Bank Inflation Dashboard, January 4th 2023
Euro Short-Term Rate (EST) — Overnight borrowing of financial corporations at 25th percentile of volume, sourced from European Central Bank, January 4th 2023
Consumer Confidence Index (CCI) for Euro Area countries, sourced from Business Tendency and Consumer Opinion Surveys, OECD (2023), January 4th 2023
The graphs reflect what is happening in the real world with recent developments causing dire impacts on lives, jobs, prices, supplies, etc. It seems subordinate to talk about corporate compliance and only makes sense because work is necessary to abide by the rules that we have set internationally and fulfill the function we have assigned to compliance in society (stability, predictability, trust, etc.).
In this post, we will review the specific economic variables affecting financial transactions and provide practical suggestions on analyzing and responding to these changes to ensure your transfer pricing is still compliant with the arm’s length principle.
So let’s get started. First, we need to review which of the current changing market variables impact existing group financial transactions (FT) or the group policy. Below is a list of economic variables that will impact certain aspects of your comparability analysis for transfer pricing purposes.
1) Rising central bank lending rates and interbank reference rates
- Rising base rates directly impact the price of FTs that contain a variable interest component (floating interest rates). Scan your FTs that move relative to interbank offering rates (IBOR) or alternative reference rates (ARR), considering the phase-out of IBORs.
- Assess the analyses of the group’s FTs for conclusions made on financing options realistically available. Consider whether previously opted out financing options are now considerably more attractive from the lender’s or borrower’s perspective.
- Intercompany financial agreements may include clauses that are triggered when certain levels of reference interest rates are hit.
- Some intercompany agreements reserve the right to renegotiate the pricing and terms and open up planning opportunities to benefit from changing market conditions.
2) Reshuffling of prices in markets for fixed income (bonds, loans, etc.), foreign exchanges, financial swap agreements, etc.
- The pool of potentially comparable financial instruments can be significantly altered, which is the most significant factor affecting your interest rate range.
- Changes in benchmark curves (such as Bloomberg’s corporate sector curves), currency and interest rate swaps, etc., impact comparability adjustments that shape your interest rate range.
- Reshuffling of markets may indirectly open new options realistically available. For example, the Swiss Franc is around its all-time high against the Euro, which warrants a review of regional financial conditions.
3) Deteriorated business financials and weakened economic outlooks
- Check Moody’s, S&P, and Fitch for any updates on the group’s (parent) rating, which affects notching for implicit support and instrument rating.
- Your issuer credit rating analysis may be revised in hindsight for different reasons. Where this might be the case, a risk exposure analysis can help assess how current market circumstances alter, for example, the borrower’s projections. This especially applies where historic years have been (partially) used to compute an issuer rating.
- Similarly, the debt capacity analysis may be revisited in light of changed business financials. Your tested party may stack up differently to the computed ratios of your comparables. This may affect the characterization of your FT and, in a worst-case scenario, lead to a full or partial re-characterization for transfer pricing purposes from intercompany debt to equity.
- In cases where you are using a simplified credit rating to interest matrix as a starting point to compute an arm’s length range, all of the above factors should measurably impact the updated rates on the matrix.
- Check group financing agreements and term sheets for any thresholds that may be reached because of changed business financials. Staying on top and following contractual terms reduces the exposure to related transfer pricing adjustment risks.
Once all market variables impacting FTs have been identified, the second step is to assess the impact or the materiality of the effects on the transfer pricing comparability analysis.
Transfer pricing software can help in this regard. Get in touch with AIBIDIA to assess whether our FT modules fit your purposes.
About the author
Max Stobbe worked on transfer pricing structures for Silicon Valley-based multinationals and today empowers innovative businesses with digital solutions.