INSIGHT: Interest Rate on Intra-Group Loans for Real Estate Assets—the End of Mezzanine Debt?

Financing is crucial to the real estate sector. Following the financial crisis, lending from non-financial institutions and investors with shareholder loans has grown. This is because banks, which previously provided significant amounts of debt, have decreased their engagement. While loans from third-party non-financial institutions to real estate groups are per se at arm’s length, shareholder loans (SHLs) are not, and require a transfer pricing analysis.

Due to the difficulty in obtaining external funding, investors in the real estate industry are often reliant on SHLs to finance real estate acquisitions. In the current market, senior lenders represent no more than 60% of the loan-to-value of the real estate asset. And in recent years, as the use of self-funding has increased, so has the level of scrutiny from tax authorities and the Organization for Economic Co-operation and Development (OECD) on transfer pricing analysis for financial transactions.

Taxpayers face more inquiries and challenges from tax authorities. While it is understandable to have disputes around the arm’s-length nature of intra-group debt instruments in countries with recently implemented transfer pricing rules, the same trend is observed in countries such as Australia and Germany with well-entrenched transfer pricing regimes.

Recent Decisions Reducing Interest Rates for Real Estate Structures

As illustrative examples, I would draw attention to two recent decisions from the German and Luxembourg courts (Finanzgericht Köln, June 29, 2017, N°10 K 771/16, and TA du Grand Duché de Luxembourg, October 22, 2018, N°40348). In both cases, the German and Luxembourg judges rejected arrangements made between related companies in order to acquire real estate assets, arguing that they were not in line with the arm’s-length principle.

This means that the excessive interest is treated as hidden profit distribution or hidden dividend distribution, potentially subject to withholding tax.

While the two decisions have common factors (the acquisition of real estate assets), they are structured differently. The German case is about the purchase of a real estate company (PropCo) by a German acquisition company (GermanCo) from a third party seller.

The structure after the acquisition was as follows:

The financing instruments used in the structure were as follows:

A benchmarking study was prepared by a transfer pricing adviser two years after the transaction. However, the court disregarded the benchmarking study on the basis that it was not prepared at the time that the transaction was carried out.

The Luxembourg case is simpler. There was only one debt instrument in the structure—an SHL used in order to finance the acquisition of a property in France. The SHL was unsecured with a 12% fixed interest rate.

The structure can be summarized as follows:

The Luxembourg tax authorities have reduced the interest rate to 3.57% and 2.52% and ignored the two benchmarking analyses prepared by two different advisers. Local tax authorities have considerable leverage because although the OECD set the arm’s-length principle, it has not provided any practical guidance for intra-group loans.

Use of Internal Comparable Uncontrolled Price with no Adjustments Possible

Applying the arm’s-length principle to intra-group debt means considering the lender and the borrower as separate parties. The OECD Transfer Pricing Guidelines provide five different methods to determine the arm’s-length nature of related parties transactions. For financing agreements, methods commonly used are the internal or external Comparable Uncontrolled Price (CUP).

Internal CUP means looking at loans that the related parties have with third parties. In real estate, there is generally a bank loan or a loan provided by a non-financial institution third party to the transaction. This third-party loan can be used as a comparable.

However, in most cases, the interest rates applied on a third-party loan cannot be applied without adjustments. The main reason for this is the difference in nature between the two types of loans. Bank loans are different to SHLs in terms of maturity, priority and security. Bank loans are typically senior and secured/asset-backed and often have a shorter maturity (below 10 years and around five years).

Therefore, even if the interest rate applied on the bank loan could potentially be comparable, it nevertheless needs comparability adjustments. As recommended in the OECD Transfer Pricing Guidelines comparability adjustments are required because they “increase the reliability of the results.”

The adjustments that need to be performed should account for the fact that:

• intra-group debts are not senior and are subordinated to the bank loan;
• intra-group debts have no pledge or guarantees;
• intra-group debts’ maturity is longer compared to the bank debt.

To account for the difference in priority, maturity and/or security, a premium or margin is added to the bank loan interest rate.

In the German decision, the financial court ruled that the recognition of a loan relationship between affiliated companies does not require collateral to be provided by the related borrowing company.

Surprisingly, the court added that neither the lack of collateral nor the subordinated nature of SHLs can justify a risk premium when performing interest rate benchmarking analyses. For the court, if the purchase value corresponds to the actual value of the real estate assets, in case of default, the third-party bank is not able to withdraw the total amount of the collateral. The excess amount between the maximum the bank can redraw on the collateral and the collateral constitutes a security on the SHL. Therefore, the interest rate on the SHL is capped at the level of the bank loan without possible adjustment.

This is in line with the position taken by other tax authorities such as the Australian authorities, and with the current trend observed in Germany.

On December 11, 2019, the German Ministry of Finance published a draft bill on the implementation of the EU Anti-Avoidance Directive. Under the new rules, interest rates are capped at the level of what a third-party lender would have offered to the multinational group. Taxpayers still have the possibility to demonstrate that the arm’s-length interest rate is different, but this is becoming a challenging exercise.

If adopted, this measure should represent a fundamental shift in the real estate sector.

Difficulty in Finding External Comparable Uncontrolled Price

An alternative to internal CUP is the external CUP. However, it is difficult to find comparables, because where public bonds are issued on a primary market and then traded in a secondary market, private placements and bank loans are, in general, not traded after their issuance. This means information on third party private placements or bank loans, which can be used as comparables, is scarce.

An alternative to a loan search is a bond search. The following information is used for the search:

• the principal;
• the term or maturity;
• interest rate: this can be the yield to maturity, the yield to worst and the current margin. The yield to maturity is the percentage rate of return paid if the security is held to its maturity date. The calculation is based on the coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid over the life of the security is reinvested at the same rate. The yield to worst on a corporate bond is the lowest yield that a buyer can expect among the reasonable alternatives, such as yield to maturity, yield to call, and yield to refunding. The current margin is the current or last known spread above the benchmark used in determining the current period’s coupon;
• call provision (for bonds) or repayment clause.

Although databases such as Bloomberg have yield curves, the geographic location and the available currencies are limited to the U.S. market. For example, on Bloomberg there are yield curves for U.S. real estate investment trusts with credit ratings between BBB+–B-. Regarding BBB ratings, interest rates are lower, between 2% and 4%; while for B ratings, yields vary from 8% to 13%, depending on the maturity.

For borrower’s credit ratings, databases used for credit risk analysis on European private companies exclude the real estate sector. This is because “the annual accounts of real estate development and investment companies provide only a partial description of the dynamics of these firms and, therefore, their likelihood of default, as their financial health often hinges on a particular development such as in project finance.” It is therefore challenging to calculate the probability of default on a real estate borrowing company.

To improve the reliability of such databases, it is important to take into account elements such as the rent income or the experience of the management team.

For real estate groups, this prompts us to take on a New Year’s resolution: when arranging new transactions, transfer pricing reports should be prepared contemporaneously. The transfer pricing study should always first consider the internal third-party debt, and then reject or adjust it as appropriate, to produce a robust conclusion which can survive tax authority scrutiny.

Andrea Leho is a transfer pricing specialist with Macfarlanes.

The author may be contacted at: andrea.leho@macfarlanes.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.