Financial and Tax Wisdoms

It is a well established fact that tax authorities globally are paying more attention to transfer pricing on all aspects of international trade including inter-company loans. Tax authorities have regard to all aspects of inter-company loans when assessing the arm's length nature thereof for transfer pricing, not just the interest rate.

t is a well established fact that tax authorities globally are paying more attention to transfer pricing on all aspects of international trade including inter-company loans. Tax authorities have regard to all aspects of inter-company loans when assessing the arm's length nature thereof for transfer pricing, not just the interest rate.

Recent audits by revenue authorities have reassessed taxpayers on the basis that the terms and conditions of intercompany debt instruments, other than the interest rate, were not the terms and conditions that unrelated parties would have negotiated with each other.

This is perfectly within in the letter of the law in most tax jurisdictions as even the tax jurisdictions that place reliance on general anti-avoidance legislation to enforce transfer pricing adjustments, make provision for an adjustment on a transaction between related parties if the terms and conditions of a transaction differ from those that would have been entered into had the parties been dealing at arm’s length.

Some recent audit findings made the following adjustments:

• The taxpayer treated and priced an intercompany loan as subordinated when there was no other debt in the borrowing entity. The adjusted terms of the loan reflected senior debt instruments the borrower would likely have been able to get in the market. This investigation resulted in a downward adjustment of the interest rate.
• The borrower had the option to repay an instrument early without penalty on a fixed rate, medium term loan and did not exercise that option, even though interest rates declined significantly over time. The adjustment imputed a new interest rate as if the borrower had exercised the option at an appropriate time and entered into a similar arrangement at a lower rate.

This discussion indicated that tax jurisdictions are continuously moving towards a greater consideration of substance over form.

How can a taxpayer defend itself?

• Review existing inter-company agreements on a periodic basis to ensure that all the terms and conditions of the loan remains arm’s length.
• Ensure that the loan agreement is reflective of the capital structure and the availability of capital to the borrower.
• Ensure that all the terms and conditions of new debt instruments are consistent with the arm’s length principle at the execution of the agreement.

Written by Marike Grove, adapted from global communications by Kevin Gale and Muris Dujsic in Toronto. This article was published in the March issue of the Business Day Review.

 Marike Grove, Tax Associate, Deloitte
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magrove@deloitte.co.za

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