Six strategies for restructuring intercompany loans

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Large multinational enterprises (MNEs) often finance operational and capital expenditures of their foreign affiliates through intercompany loans. As a result of the credit market turmoil and liquidity crunch, MNEs are considering restructuring or renegotiating intercompany loans to repatriate cash and achieve tax efficiency. While today’s scarcity of credit and capital availability means companies stand to benefit from factoring in a liquidity premium when pricing their intercompany lending transactions, loan characterization continues to be a thorny issue.

Below are six key issues companies should consider when restructuring intercompany loans.

1. Ensure interest on intercompany loans is consistent with the arm’s length standard. Under Treas. Reg 1.482-2(a), the interest rate on intercompany loans should be consistent with the arm’s-length standard. While companies often rely on the safe haven provision, which uses the applicable federal rates to calculate interest rates, this method fails to capture the true credit risk associated with the subsidiaries. The associated liquidity premium and default risk premium, which are contingent on the maturity (or duration) of the loan, must be appropriately considered. As a result, the credit risk present in lending transactions cannot be accurately captured under current market conditions without carefully considering the effect a liquidity-constrained economy would have on the pricing of loans of various maturities.

2. Be aware that newly negotiated loans may come with unfavorable interest rates and stringent financial covenants. In the past, companies typically refinanced loans to obtain better interest rates and relaxed covenants. The current economy has prompted companies to restructure debt for different reasons, such as avoiding bankruptcy or managing cash-flow problems. Many companies have found that newly negotiated loans are requiring increased interest rates and stricter terms.

3. Carefully document renegotiated terms, and update loan terms periodically to reflect market changes. Taxpayers should carefully document that all terms and conditions of the loan – not just the interest rate – are factored in appropriately. For example, loans allow the borrower to pre-pay the loan without incurring any penalty. Tax authorities question this option if the borrower does not exercise this term even when favorable rates are available.

4. Consider all material characteristics of the loan when undertaking any benchmarking analysis. Under Treas. Reg. 1.482-2(a), an arm’s-length interest rate should reflect the interest rates on loans between unrelated parties with similar terms, including duration and credit standing of the borrower. While the borrower’s credit rating has been the most critical determinant of the interest rate on any loan, it is critical that other loan characteristics be evaluated. These include term, currency denomination, level of subordination, collateralization and other embedded options, such as pre-payment options.

5. Do your homework when determining debt versus equity characterization. Loan restructuring leads to issues involving thin capitalization, debt versus equity characterization and interest deductibility. When considering restructuring a loan that involves a US borrower, taxpayers should consider the rules under Section 385, which authorizes the Treasury Department to issue regulations to determine whether an instrument is debt or equity. This classification is a fundamental issue for federal income tax and transfer pricing purposes because the taxation of interest payments and dividend distributions differs. While the Treasury initially issued regulations under Section 385, it later withdrew them. In the absence of regulatory guidance, the characterization of an instrument as debt or equity is determined primarily by reference to case law. Over the years, US courts have developed factors they use to characterize an obligation as debt or equity for US federal income tax purposes; these are generally consistent with Section 385. However, case law in this area is complex, and it is difficult to determine with certainty whether any particular court would characterize a given instrument as debt or as equity for US federal income tax purposes.

6. Consider metrics that will be the most accurate predictors of the borrower’s ability to pay its interest expense. A company’s capacity to take on additional debt may be assessed in several ways. Evaluation may include the company’s debt-to-equity ratio and its interest coverage ratio; whether the borrower has a high percentage of intangibles and goodwill included in its balance sheet; and the borrower’s profitability, operational structure or expansion strategy.

For additional news about the transfer pricing, download our March FSTP Worldwide newsletter.