For leasing companies, adhering to and documenting arm's-length pricing and profitability have not been straightforward. This is partly due to a confluence of factors that have particular significance for the industry, especially high interest rates and the current difficult economic climate. Nevertheless, for the most part, leasing companies do have some common related-party transactions, and it is our objective in the balance of this paper to highlight these transactions, possible approaches for their supporting documentation, and some of the pitfalls to avoid.

In more detail

Loans from related parties

Capital is one of the key economic inputs in the leasing business and, in some cases, may be derived from loans extended by a related group member. Related-party loans come with transfer pricing issues that require some consideration. One of these issues is how to derive an arm's-length interest rate for a related-party loan. The approved method is no different from how independent commercial lenders set interest rates for loans to their unrelated clients.

Factors including the credit-worthiness of the borrower, the loan principal, loan maturity, collateral, subordination level, and market risk premium above a reference rate must all be taken into account when determining the interest rate for each borrower. Credit-worthiness can be established through credit scoring with a method or software from rating firms such as Moody's or Standard & Poor's. We caution that the credit score should be pertinent to the borrowing group lease company. Using the group parent's credit score is an inappropriate shortcut.

Generally speaking, market interest rates have roughly tripled since early 2022. Hence, it is important for both related lenders and borrowers to regularly update their transfer pricing analysis to ensure that any new loan advanced is accompanied by an updated transfer pricing analysis that is reflective of the higher rates. In addition, borrowers may be affected by the prevailing challenging economic climate, hence an updated credit score may need to be obtained.

Purchase of products from related manufacturers

A captive leasing company ("Group Lease Co") usually form part of vehicle maker group, hence any dealings with the group's vehicle manufacturing entity ("Group Manufacturer") need to be at arm's-length. In most situations, the Group Manufacturer will also sell to unrelated parties such as final vehicle owners, dealers, or other leasing companies. If Group Lease Co purchases vehicles from Group Manufacturer, the purchase price in these related-party transactions need to take into consideration the purchase price for unrelated parties.

However, factors such as a long-term business relationship, purchase quantity, purchase period, and accompanying services may result in material differences between the purchase price paid by Group Lease Co and unrelated customers. It is therefore important to document and quantify factual differences and their effect on the related-party purchasing price. Otherwise, it would be difficult for the tax authority to understand the differences between related and unrelated purchases (especially if the physical products are similar).

Guarantees

A Group Lease Co may also borrow from arm's-length parties through the issue of corporate bonds to the public or loans from commercial banks. In many such instances, the Group Lease Co may obtain a guarantee (usually from its well established and financially sound group parent) to reduce its cost of funding. As the guarantee creates a potential risk for the related guarantor, it is usual for the guarantor to receive some remuneration from the borrower – usually as a percentage of the sum guaranteed.

As a starting point, there may be some comparable data on guarantee fees charged by arm's-length insurance companies. As the circumstances surrounding commercial guarantees may be materially different from related-party guarantees, some adjustments will be needed. One consideration is to discern what Group Lease Co's interest payable would have been, in the absence of the parent's guarantee. The most that any arm's-length party would pay for the guarantee is an amount equivalent to the interest saved.

How are taxpayers responding?

With transfer pricing prominent on every tax authority radar screen, it is important for taxpayers to start with a coherent and consistent transfer pricing approach. Thereafter, it is just as important to support the approach taken, and ensure that transfer prices are utilized with appropriate, adequate, and up-to-date transfer pricing documentation. The last item is especially important to the leasing industry, given the interest rates and economic situation over the past two years. This documentation will demonstrate compliance and, with well-thought-out analysis, may even push the onus of proof back to any challenging authority.