Intra-group funding: financial transactions are under scrutiny

Authorities around the world are increasingly scrutinizing the nature of intra-group loans

We observe that tax authorities and courts are more frequently recharacterizing loan transactions, challenging their substance and arm’s length nature. Authorities are now examining not only the market terms of the interest rate but also the underlying substance of the transaction.

They are investigating whether the borrower and lender may have inadvertently sought to gain a tax advantage. They verify whether the taxpayer had the capacity to service the financing at the time it was obtained. It is advisable to prepare for such a situation by conducting an analysis of the ability to service the debt, even before signing the financing agreement.

Which countries have the highest number of such cases?

Judgments on recharacterization in financial transactions are most frequently seen in OECD countries, including Germany, the UK, the Netherlands, Belgium, Denmark, Sweden, and Finland. However, this issue also arises outside the OECD, in countries like Argentina and South Africa. We have analyzed verdicts and cases still pending before courts of second instance, revealing that courts are increasingly challenging the inclusion of interest on borrowed funds as a deductible expense. This approach reduces the tax base and increases the amount of tax due.

What specifically are the authorities questioning?

(i) the marketability of the interest rate

Very often, it is the marketability of the interest rate and the fees associated with the intra-group financing that attract the attention of the authorities. They assess whether the entity has conducted a benchmarking analysis and whether the selected sample of comparable transactions aligns with the characteristics (terms and conditions) of the transaction under review, including factors such as credit rating (risk), lending date, and maturity.

(ii) purpose and reasonableness of the loan

The authorities contend that a third-party would not have been willing to provide financing under the given circumstances. They argue that the intra-group loan was granted to an enterprise solely to secure a tax benefit, such as deducting interest from the tax base. The authorities maintain that the transaction lacked a genuine or reasonable business purpose.

(iii) failure to secure the transaction

The authorities often argue that in the situations under review, unrelated parties would not have provided financing without adequate collateral. They also scrutinize the contract provisions concerning the repayment schedule for principal and interest, frequently concluding that repayments are not being made as stipulated in the contract. In such cases, the authorities may recharacterize the intra-group loans as equity.

Recharacterization of debt into equity

Here foreign authorities often refer to Article 9(1) of the OECD Model Convention. They argue that, under the circumstances, an independent company would not have granted the loan in question and, on that basis, they can adjust the tax in their transfer pricing audit.

How to be on the safe side?

The key to safeguarding intra-group financial transactions is a robust benchmarking analysis. It is also crucial to include an analysis of debt capacity and debt service at the time of financing.

Therefore, it is best to conduct this analysis before entering into a financing transaction. Calculating and comparing debt and liquidity ratios with industry peers will help verify the taxpayer’s financial capacity. This approach enhances tax security and minimizes the risk of recharacterization by tax authorities.

Leverage the expertise of transfer pricing professionals. Contact us to prepare all the necessary documents and analyses.