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Loans – Intercompany loans are a common source of funding within financial services groups

Loans – Intercompany loans are a common source of funding within financial services groups

Intercompany loans are a common source of funding within financial services groups. Related parties would be expected to satisfy the FIRS that the remuneration being received or charged for the intercompany loans are appropriate. Common risks with intercompany loans include the risk that the interest rate is not appropriate and the risk that the interest could be re-characterised as dividends.

Risk of re-characterisation:  Groups in the financial services industry must investigate if the transaction meets the definition of a loan based on the law and accounting standards of the country of the borrowing company. Where the tax authority successfully argues that the loan does not meet the definition of debt, it can re-characterise the loan as equity and deem the interests paid as dividends. Ordinarily, interests paid on loans are tax deductible. However, if such loans are re-characterised as equity, the dividends will usually not be tax deductible.

Even where there are no express definitions of debt and equity in the tax law, tax authorities are still able to challenge the substance of the loans based on the nature of the transaction and the conduct of the parties. This is the case in Nigeria where the FIRS can rely on transfer pricing principles to challenge the substance of a related party loan and the resulting interest. In general, the risk of re-characterisation is relatively lower with banking groups compared to other businesses in the financial services industry. Some of the factors which could lead the tax authorities to challenge the substance of a related party loan include where: the borrower is very thinly capitalised, there is no specified tenure or repayment date in the agreement, the tenure of the loan is unusually long, repayments are not made when due and are outstanding for a long period of time, the loans come with voting rights, the loans are tied to profitability, the loan in not secure in spite of significant transaction risks etc. These conditions suggest that the lender is taking on significant risks which it is not likely to take if it were dealing with an independent party. The risks associated with the lending are therefore considered to be similar to the risks taken by an equity investor, hence the re-characterisation of the loan to equity.

Level of interest charged : The interest charged on a loan must reflect the risk associated with the borrowing. Transaction terms such as loan currency, tenor, interest type (floating vs. fixed), presence of collateral and security, restrictive covenants, seniority of the loan etc. are relevant for assessing the risk and consequently determining the arm’s length interest rate. Other factors such as the country of borrower, business of borrower, economic circumstances at the time of the borrowing etc. also play a role in establishing the arm’s length interest rate. Since the provision of loans is in the ordinary course of their business, banking groups have relatively more access to information that can be used to determine the appropriate interest rate for intercompany loans. This information includes information on internal comparables i.e. independent companies who they have similar transactions with. The interest charged on comparable transactions with independent companies can be used as a benchmark for setting the interest rate on the related party loans.

It will however be important to ensure that there are no material differences (between the third party and related party transactions) which could impact the interest rate. Where any material differences exist, appropriate adjustments should be made. Where internal comparables do not exist it will be necessary to search for similar loan transactions involving two independent parties (i.e. external comparables).

The first step will usually involve estimating the credit rating of the connected borrower and also identifying the material terms of the related party loan transaction (these steps are also applicable when internal comparables exist). The next step is to search for loan transactions between third parties where the borrower has a similar credit rating as that of the connected borrower. It is important to ensure that terms and conditions of the related party loan are similar to those of the third party loans. Where the transactions are considered similar enough, the interest rate applied on similar third party loans can be compared with or used as a basis to price the related party loan. Where there are material differences in transaction terms, adjustments will need to be made. Country risk, tenor risk and currency risk adjustments are some of the adjustments that are sometimes necessary to achieve comparability.

Conclusion

It is expected that groups in the financial services sector will be one of the targets of future TP audits. They must therefore be prepared and ensure that all intragroup transactions are priced appropriately and in line with the arm’s length principle. Group CFOs must be prepared for the future audits and should carry out reviews of their current TP practices and defence documentation to ensure that they are not exposed.

 

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