Intercompany Loans Amid Virus Invite Scrutiny by Tax Authorities

Multinationals that loan money among their entities or rework existing loans to boost liquidity during the pandemic could end up attracting the attention of tax authorities.

In the current climate of market volatility, tax authorities will likely pay special attention to companies taking advantage of higher interest rates during the crisis that they typically wouldn’t do under normal circumstances, tax practitioners warn.

Intercompany loans help companies bolster their reserves during economic downturns, and higher rates can benefit a company by increasing the amount of interest expense it can deduct from its tax bill, practitioners said. They advise companies to be prepared to back up their decisions and to document them to avoid tax disputes later with tax authorities.

“The current volatility in yields could lead tax authorities to later argue that taxpayers took advantage of extraordinary economic circumstances to maximize the interest rate on an intercompany loan,” said Sherif Assef, principal in KPMG’s Washington National Tax Practice based in New York.

For instance, a company subject to a 21% tax rate that borrows $100 million at a rate of 5% would get to deduct $5 million per year and reduce its tax liability by just over $1 million. If the interest rate is instead 8%, the deduction grows to $8 million and tax owed is reduced by nearly $1.7 million, Assef said.

Tax authorities are likely to ask whether an independent borrower would borrow cash when interest rates are arguably artificially high, practitioners said. Multinationals must value the transactions between their entities as if they were unrelated, a principle known as the arm’s length standard under transfer pricing rules. To determine how unrelated parties would act, companies base those transactions on comparables, or real-world examples.

Comparable interest rates for third party loans are likely “going to be all over the place, given the unique circumstances,” said Friedemann Thomma, chair of the international tax practice at Venable LLP in San Francisco.

And tax authorities will be scrutinizing these arrangements as they face pressure to boost tax revenues post Covid-19, said Henric Adey, transfer pricing practice leader at EisnerAmper LLP in New Jersey.

Deductions Questioned

With profits in certain industries in decline, historical high interest rate arrangements likely will be questioned, said Glen Marku, transfer pricing managing director and Midwest leader at Grant Thornton LLP. The accurate characterization of transactions and deductibility of interest expense may be scrutinized, he said.

If a borrowing entity with a debt at 6% can now pay it down early and refinance at 2%, chances are the company would do that, Marku said in an email. If tax authorities see a company paying 6% while the prevailing market rates are far lower, it may raise questions, he said.

Lower credit ratings and higher interest rates based on financial forecasts assuming a steep decline in profits because of the pandemic may ultimately be proven wrong if it was just a short-term dip or if the company was otherwise able to weather the storm without significant financial downside, according to Marc Alms, a managing director with Alvarez & Marsal Taxand in New York. In this case, a tax authority may argue that the company over-relied on a snapshot view of the economic circumstances and that the borrower should have actually been rated with a higher credit rating and a lower interest rate, he said.

There is no better indication of a market interest rate for a company on an intercompany debt basis than the terms on which a third party lent to the overall company, Philip Antoon, a managing director with Alvarez & Marsal in New York, said.

“In the current environment, it’s vital that companies that have third-party debt react to what is happening with that debt,” Antoon, said. When estimating an intercompany debt interest rate, the starting point should always be the terms for any third-party debt if it provides an arms-length view, he said.

“Now is not the time to be taking short cuts on interest rate analyses,” Alms said

Document, Document

Companies sometimes aren’t diligent enough with documenting intercompany financing transactions, Marku said. This leaves them room to tweak the arrangement over time. But in the current environment, changes to historical arrangements without proper support could stand out and be challenged, he said.

The Internal Revenue Service released informal guidance in April addressing in question-and-answer format what it wants to see in companies’ transfer pricing documentation. The move sends a clear signal that the agency will be increasing its scrutiny of such documentation, and may seek to assess penalties more frequently, according to practitioners.

The IRS didn’t respond to a request for comment.

A company’s best defense is a contemporaneous analysis to show a tax authority that the transactions were at arm’s length, Adey said.

Financing is no different than other intercompany transactions, said Barbara Mantegani, a tax attorney and founder of Mantegani Tax PLLC in Washington. “You have to explain what you’re doing and it has to make sense,” she said. “Make sure that the transfer pricing tail isn’t wagging the business dog.”

—With assistance from Isabel Gottlieb.