Debt has long been a favorite financing instrument of the tax departments of multinational enterprises because interest can be deducted. It also tends to be cheaper for MNEs, doesn’t require raising additional equity capital, and introduces leverage, which can increase returns for owners.
But to reap the potential benefits on a related party basis, MNEs must learn how to avoid various pitfalls associated with intra-group debt financing.
Finance departments of MNEs often jump quickly to determine (and support) the interest rate on intercompany debt. However, transfer pricing rules and regulations that are in force in most countries require MNEs to adhere to the arm’s-length principle. This principle requires the financial relations of related parties to be consistent with conditions on which independent enterprises under the same circ*mstances would have agreed.
The price of debt is commonly the rate of interest charged on the principal amount issued. Transfer pricing practitioners are tasked with supporting the arm’s-length nature of the proposed interest rate. An interest rate that isn’t arm’s length may lead to denied interest deductions on local tax returns.
Jumping to support the proposed interest rate often overlooks a few critical steps that can be more important to supporting the arm’s-length nature of the transaction.
Commercial Purpose
Considering whether the financing has a commercial purpose is the first step. Just as in other areas of tax, the business purpose for a transaction should be at the forefront of a MNEs thinking. This has become the default starting position for a tax authority when evaluating the merits of such a transaction.
Interest deductions are likely to be challenged in the absence of a clear commercial purpose (or if a tax authority can argue an unallowable purpose). The first Base Erosion and Profit Shifting report from the OECD—particularly Action Items 8-10—emphasized business purpose and substance.
Several countries have since issued their own anti-abuse and harmful tax practices rules, such as diverted profits taxes, following the conclusion of the Organization for Economic Cooperation and Development’s BEPS work.
More recently, and specific to intercompany financing, countries have issued rules that require taxpayers to prove commercial basis related to intercompany financing. Germany’s Growth Opportunities Act has added new conditions for taxpayers to get an interest deduction on related party loans.
One of these conditions is a business purpose test, in addition to a debt capacity and arm’s-length principle requirement. The onus will be on the taxpayer under audit to prove that the transaction has a business purpose. These rules are effective retroactively to Jan. 1.
An April appeals court decision in the UK rejected a claim by asset manager BlackRock Inc. for a deduction on an intercompany loan on the grounds that it was structured to secure a tax advantage. This followed revised and expanded guidance by His Majesty’s Revenue & Customs on whether a loan relationship has an unallowable purpose.
HMRC will challenge intra-group debt in the absence of a clear commercial nexus between the acquiring company and the target, and where the use of a UK entity is chosen largely due to the availability of loan relationship debits.
The BlackRock decision is just one example of why MNEs need to focus on the purpose and substance of intercompany financing beyond technical compliance.
Bearing the Debt
Supporting the capacity of the related party borrower to bear the debt that it’s issuing is another big step that shouldn’t be overlooked. These “thin cap” requirements are an important component of the new German rules on intercompany financing, as well as the rules of several other jurisdictions .
MNEs must ensure the borrower has the financial capacity to bear the debt. This can be demonstrated through suitable financial and transfer pricing analysis. An MNE tax department often must work closely with the finance department to get clarity on the borrower’s current and forecast financials. Unreliable forecasts may limit the analysis’s accuracy.
Robust transfer pricing analysis should demonstrate that the amount of debt is sustainable and in line with leverage ratios, covenants, guarantees, and other items that independent parties would have agreed to in similar circ*mstances. Some countries have introduced safe harbor rules for thin cap or debt capacity purposes, which also should be considered when appropriate.
Legal Support
MNEs’ finance departments must always have pertinent legal documentation to support intercompany financing, and make certain that the form and structure of the financing is clearly understood through these agreements.
The OECD was quick to explain the importance of accurately delineating the financing transaction in its recent guidance on the transfer pricing aspects of financial transactions. The form of the transaction will help determine the applicable interest rate, but it’s also often a primary defense to the extent that a tax authority challenges the substance or characterization of a transaction.
In the US, the form of the loan—and the agreement that is executed between the related parties to memorialize its terms—have helped shaped case law on this issue.
Outlook
Financing decisions are complex and often the subject of tax authority scrutiny. Taxpayers must have a clear and documented business purpose for any intercompany financing transaction they execute and conduct a holistic arm’s-length analysis that supports the amount of debt financing, the structure of the debt financing, and the proposed rate of interest.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Jon Morton is international tax services partner at Forvis Mazars.
Gabriel Fuenmayor is partner at Forvis Mazars in London and leads the firm’s transfer pricing team in the UK.
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