Funding of corporate operations using both equity and related party loans is a popular structure, for obvious reasons, however, unlike dividends paid to shareholders, interest paid on related party loans is, subject to Rwanda thin capitalization rules, tax deductible.
Lending transactions between related parties must, however, comply with the arm’s length principle (ALP) in that they must be concluded on terms which are not different from those which would have been applied between independent persons in comparable transactions carried out. in comparable circumstances.
The application of ALP is generally understood to require that the interest charged in a related party lending transaction be in the same range as that which would be charged by an independent lender lending to the borrower under comparable circumstances.
There is, however, another facet of the ALP consisting in assessing whether the advance of funds by a party related to the borrower can be considered as a loan or should be considered as another type of payment, in particular a contribution to capital. social responsibility of the borrower, and this aspect will be the focus of this article.
The applicable laws are not prescriptive on the factors to be taken into account in the delimitation of transactions involving a cash advance between related parties, but according to the OECD 2020 Transfer pricing guide to financial transactions, various economically relevant characteristics such as the presence or absence of a fixed repayment period; the obligation to pay interest; the existence of financial and security clauses; the borrower’s ability to obtain loans from independent credit institutions or the borrower’s general creditworthiness or repayment capacity are (depending on the circumstances / facts) critical in this regard.
For example, when a loan from a related party is interest-free and has no fixed repayment period, it is likely that that loan could be recalculated to equity on the grounds that no independent lender would make a loan without interest and no fixed repayment period.
The requalification of a related party loan (or at least part of it) may also be considered in light of the creditworthiness of the borrowing entity. For example, if an entity receives a loan from a related company that is expected to be repayable in 10 years, but in light of all the good faith financial projections of the borrowing entity, it is clear that the borrowing entity would not. able to service these loan amounts over a period of 10 years, it can then be concluded that no independent lender would have been willing to provide this loan amount to the borrowing entity due to its limited repayment capacity.
The assessment of the borrower’s solvency or repayment capacity must, however, take into account the idiosyncratic aspects of intra-group financing transactions such as the fact that the borrower is a member of a multinational group which may have a rating. higher credit level and that the parent company or other group It can reasonably be expected that the companies will support the borrower in his financial needs (i.e., “management by the parent company” or ” implied â), as this is something an independent lender would consider as well. The perspective of the United Nations Committee of Experts on International Cooperation in Tax Matters the 2021 United Nations Practical Handbook on Transfer Pricing for Developing Countries, what is shared by the author, is that when the borrowing entity is of strategic importance to a multinational enterprise (MNE) (i.e. it is an integral part of the current identity and future strategy of the multinational enterprise), the rest of the MNE is likely to support borrowing the entity under any foreseeable circumstance. This suggests that the repayment capacity of a borrower who is a member of an MNE group should not be assessed on its own, but should also take into account group synergies.
Factors such as the existence or absence of guarantees and financial covenants are relevant for unrelated lenders, but this may not always be the case in related party lending transactions because the risk they seek to hedging is removed by the fact that the borrowing entity is related to and / or controlled by the lender.
According to the OECD guidelines mentioned above, the fact that the lender has control and ownership of the borrower makes the granting of the collateral less relevant for its risk analysis because the lender has control over the assets. of the borrower.
The same position is taken by the OECD with respect to financial covenants where it states that intragroup lenders can choose not to have covenants on related party loans, in part because they are less likely suffer from information asymmetry and that it is less likely that a part of an MNE group would seek to take the same type of action as an independent lender in the event of a breach of an undertaking.
The above analysis of transfer pricing considerations for related party lending transactions indicates that when one accurately delineates transactions involving cash advances, funds extended to related companies in the form of loans may be reclassified as equity.
The consequences of this cannot be overstated as all costs associated with a recalculated related party loan (including interest and other costs) would be rejected by the tax administration. The risk of requalification is not simply perceived as the tax administration has (in a number of transfer pricing audits) reclassified related party loans to equity based on some of the characteristics discussed above and rejected all associated costs.
Taxpayers (especially those who are members of multinational enterprise groups and who receive debt financing from related parties) are advised to ensure that their borrowing with related parties and the relevant agreements (these should be set in place if they do not exist) are examined from a transfer pricing perspective. to avoid the risk of subsequent requalification and its tax implications.
The opinions contained herein are those of the author and do not constitute legal or tax advice.
The author is a corporate commercial and tax lawyer and senior partner at ENSafrica Rwanda.