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Arm’s Length Interest Rates

Arm’s Length Interest Rates

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The Ministry of Finance published, at the end of -March 2023, its eleventh Regulation on interest rates which are considered to be in line with the "arm’s length" principle. The Ministry of Finance, i.e. the Minister issues this Regulation every year and it pertains to the interest rates for that year.

As a reminder, the Corporate Income Tax Law gives the Minister the right to prescribe interest rates that are considered to be in line with the "arm’s length" principle. The law also gives the taxpayer the right to apply general rules for calculating the price of a transaction in accordance with the "arm’s length" principle, instead of the interest rates prescribed by the Minister. If the taxpayer exercises this right, it must apply the general rules to all loans or credits with related parties, and the tax administration in that case is not bound by the interest rates specified in the Minister's regulation during the tax control procedure.

Therefore, if the Minister exercises his right and issues a regulation, as it has been done every year since 2013, the interest rates prescribed by the regulation are primarily binding for everyone, but the taxpayers have the right to apply the appropriate method prescribed by the law for determining the "arm’s length" price instead of those interest rates. A classic example would be a taxpayer who takes loans from both banks and related parties and uses the rate it has in a comparable loan with banks to determine the "arm’s length" rate for loans with related parties.

Let us now look at the movement of interest rates prescribed by regulations in the last five years and put them in relation to changes in the reference interest rate of the National Bank of Serbia (“NBS”).

As stated on the NBS website, the reference interest rate has a role of signaling the monetary policy stance, as well as the role of benchmark interest rate because the level of money market interest rates i.e. interest rate corridor, is set with reference to this rate. Therefore, this rate cannot be an "arm’s length" rate, but these interest rates would have to be higher than the reference interest rate. And that was indeed the case until the Regulation for the year 2023, as can be seen from the chart below:

Short-term credits/loans in RSD                   

2019 - 4.98%              

2020 - 4.71%              

2021 - 3.69%              

2022- 3.12%               

2023 - 3.88%

Long-term credits/loans in RSD                    

2019 - 5.69%              

2020 - 5.55%              

2021 - 3.9%                

2022 - 3.39%‚             

2023 - 4.74% 

Short-term credits/loans in EUR                  

2019 - 2.71%              

2020 - 2.64%              

2021 - 2.32%              

2022 - 2.25%              

2023 - 2.98%

Long-term credits/loans in EUR                   

2019 - 2.90%‚             

2020 - 2.87%              

2021 - 2.83%              

2022 - 2.73%              

2023 - 3.22%  

Change in the ref. interest rate

of the NBS (Jan-Dec)  

2019 - 3%-2.25%        

2020 - 2.25%-1%        

2021 - 1%                   

2022 - 1%-5%             

2023 - 5.25%-6%

The chart leads us to two conclusions. The first is that administratively prescribed "arm’s length" interest rates that are applicable for a whole year penalize those who enter into a loan agreement with a related party after an abrupt increase in the reference interest rate in the year in which abrupt increase of the reference interest rate occurs, as well as those who enter into a loan agreement before a significant decrease in this interest rate in the year in which a significant decrease of this rate occurs.

This means that a taxpayer in the year 2020 could have treated as an "arm’s length" interest rate the rate of 4.7% even if the contract was executed at the moment when the reference interest rate had dropped from 2.25% to 1%. Likewise, in the year 2022, the taxpayer could still treat only 3.12% as an "arm’s length” interest rate even though it was impossible to obtain such a low rate from the bank, given that the reference rate was already at 5%.

The second conclusion is that in the year 2023, the ministry has deviated, for the first time, from the principle that "arm’s length" interest rates are higher than the reference interest rate. The same applies to EUR interest rates, although the table does not show the rates of the European Central Bank. Such deviation is not justified, as the transfer pricing rules should only help with determining the “arm’s length” prices, and “arm’s length” prices are the ones that can be achieved in a transaction between unrelated parties, whichever such prices are. Instead, this solution puts those who do business with their related parties in a less favorable position, in terms of applicable interest rates, than in the case of doing business with unrelated parties, which is not the purpose of the “arm’s length” principle.

By Nikola Poznanovic, Partner, and Marija Vukcevic, Senior Associate, JPM Jakovic Popovic Mitic

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