Arm’s length intra-group loans – 10 things to know
Financing arrangements are a key consideration for multinationals (MNEs) growing their businesses, whether through acquisition or organic growth. This can include financing arrangements within a multinational group.
Regardless of the complexity of these financing arrangements, an area often overlooked by multinationals when structuring their financial affairs is that of transfer pricing of intragroup loans. The risks of being wrong about transfer pricing aspects could result in non-deductible interest charges, double taxation, penalties or other more severe penalties.
While the OECD released a draft discussion on this issue for public consultation on July 3, unilateral steps have already been taken by countries to challenge transfer pricing aspects of intragroup loans, which has given rise to some cases. historical courts, such as the Chevron cases in Australia and the GE Capital cases in Canada, and specific guidelines have been issued by the Dutch, Australian and UK tax authorities.
Below, we highlight 10 important things to know in order to significantly reduce the risk of exposure to sanctions:
- Look at the loan from both angles. Any analysis of transfer pricing of intragroup loans should be undertaken from the perspective of both the lender and the borrower. A bilateral analysis involves an examination of the risks borne by the lender when lending money and requires taking into account the cost of obtaining these funds by the borrower. Analysis based on a solitary point of view carries significant risks of controversy.
- Take into account the borrower’s debt capacity. An analysis of debt capacity determines how much debt the borrower can repay without defaulting on obligations. This is important because any excess debt incurred by the borrower will be considered non-arm’s length, and interest deductions on that portion of the debt may be denied for tax purposes. An analysis of debt capacity is usually undertaken by analyzing the borrower’s liquidity and solvency ratios.
- Make sure the terms and conditions of the agreement are at arm’s length. Legal agreement is the starting point for any transfer pricing analysis and economic and legal realities must be aligned. Additionally, arm’s length pricing is dictated by the agreement, and if the terms and conditions do not reflect third party behavior and actual economic circumstances, there may be a risk that the transaction will be requalified by the tax authorities.
- Think about withholding taxes. From an economic point of view, it is important to consider which party will bear the withholding taxes and then consider its impact on the pricing of the interest rate. This consideration must take into account the fact that treaty protection is only available for the interest component which conforms to the arm’s length principle and is not unduly influenced by the special relationships between the parties.
- Make sure the interest rates are based on the terms and conditions of the agreement. The interest rate is the lender’s rate of return for lending money to the borrower and is determined by pricing the risks borne by the lender. It is therefore important that each risk can be clearly identified from the intra-group agreement. Often times, the most overlooked items are the built-in options such as a prepayment option, a conversion option, and an on-demand option (among others) that provide flexibility to parties to a loan. Certain integrated options can have a significant impact on interest rates, in particular the value of the intra-group loan. Thus, it is important that these options, including all risks, are identified and priced appropriately, and comply with the arm’s length principle.
- Take into account the implicit support when determining the borrower’s risk profile. Implicit support refers to the benefit the borrower derives from belonging to a larger group. The OECD and a number of tax administrations advocate the application of implicit support adjustments to determine the borrower’s risk profile. Thus, interest rates on intragroup loans that do not take into account the implicit support would carry the risk of controversy. One approach to account for implied support is to adjust the borrower’s credit rating, taking into account the borrower’s importance within the group.
- Make sure the lender has adequate substance. An important principle emerging from the international fight against tax evasion is the requirement of substance for entities involved in financing agreements. Under this principle, lenders must have the management and control of the risks associated with the intragroup transaction. In case of inadequate substance, access to double taxation treaties could prove difficult and could have an impact on the arm’s length pricing of interest rates.
- Ensure loan asset transfers are at market value. In an intra-group framework, there are cases where a loan or a portfolio of loans is transferred between entities. Such transfers must take place at market values to reflect the behavior of third parties, since values can change over time as interest rates change. To do this, all the relevant terms and conditions of the loan should be taken into account, as they can have a significant impact on the value of the loan. A general approach is to perform a discounted cash flow analysis to value a loan or loan portfolio.
- Determine arm’s length interests before the interest cap rules are applied. Many countries have introduced stricter interest limitation rules in their national tax laws following the OECD recommendation in Action 4 of the OECD Base Erosion Action Plan and profit shifting (BEPS). These rules limit interest deductions to an amount equivalent to between 10% and 30% of earnings before interest, taxes, depreciation and amortization. However, this does not imply that interest deductions up to the predefined threshold are automatically allowed. These deductions must be justified from an arm’s length perspective, otherwise there is a risk of challenge by the tax authorities.
- Develop a coherent financing policy. As intragroup lending operations within a multinational group increase, it is essential that a coherent funding policy is developed and followed. Such a policy defines the parameters, processes and approaches of intra-group lending from a transfer pricing perspective. A strategic approach to develop such a financing policy offers an opportunity to involve all internal stakeholders in treasury, legal, tax and operations. A consistent funding policy is important, as a description of the overall funding policy must now be included in the documentation of a group’s transfer pricing master file.
As the global tax environment evolves, it is essential to ensure that financing arrangements within multinational enterprise groups comply with the arm’s length principle in order to mitigate the potential for controversy. In this regard, taking these 10 points into account could prove useful in minimizing the exposure of MNEs to sanctions on intragroup loans. In order to proactively mitigate risks and reduce uncertainties about the tax treatment of intragroup loans, it may also be useful to explore the use of advance price agreements or mutual agreement procedures as tools that reinforce the loan strategy. multinational group transfer pricing.