Intra-group loan agreements: what do finance lawyers need to know?
This article first appeared in the April issue of Butterworths Journal of International Banking and Financial Law.
In the current economic landscape, which is plagued with high inflation and interest rates, the legal agreements covering intra-group loan transactions are being reviewed with a fine-tooth comb from an arm’s length perspective. This is because loan agreements are a starting point for any transfer pricing analysis and if done properly (ie are arm’s length) can assist in justifying interest deduction locally ensuring that there is no, to limited, double taxation. The question is however – what does an arm’s length loan agreement entail? In this In Practice article, we explore this question and highlight the key aspects to consider with their potential repercussions.
The arm’s length principle is defined in the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) and is considered as the international guidance that is referenced and followed by taxpayers, practitioners, tax authorities and courts. The arm’s length principle requires that transactions between related entities should take place under conditions that are comparable to those that independent enterprises dealing with comparable transactions in comparable circumstances would accept. When this is not the case, the profits arising to one of the parties could be attributed to the other entity party to the transaction.
“[Where] conditions are made or imposed between two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”1
In other words, the arm’s length principle seeks to treat members of a multinational group as if they were independent entities in setting the price or value of any transaction(s) between them. According to the OECD Guidelines, an intra-group agreement is the starting point in delineating a transaction between related entities for a transfer pricing analysis and therefore it is important that an intra-group loan agreement serves the right purpose in setting appropriate terms and conditions of the loan between the two related parties, ie the lender and the borrower.
From a transfer pricing perspective, one of the most critical terms in any intra-group loan agreement is the “interest rate” applied to the loan transaction. Interest rate, in transfer pricing parlance, is the price of the loan transaction and needs to be arm’s length to ensure that the borrower can realise local interest deductibility. However, the interest rate is a result of other terms and conditions included in the loan agreement; and therefore, it becomes necessary that these reflect third-party behaviour and market circumstances. Each clause in the loan agreement can have a significant impact on the interest rate and therefore it is critical to consider a broader view and assess the reasonability of those terms and conditions from an arm’s length standpoint.
The “purpose” of the loan forms the basis of the transaction and the agreement, ie what is the reason for the borrower to borrow funds from the lender? As is the case between third parties, an intra-group loan agreement also needs to have a clear purpose. A loan could be provided for various purposes such as financing an acquisition, for working capital, for refinancing of an existing debt, etc. Stating the purpose is not only useful to assess the validity of the transaction, but it has a direct link with the interest rate too. Each purpose has a different risk profile that needs to be accounted for when determining or assessing the interest rate applied to the transaction. For example, the interest rate for a working capital loan will generally be lower than the interest rate on a loan for acquisition purposes due to lower risks involved with working capital financing. In case the intra-group loan is intended for non-commercial purposes or for no purpose at all, the tax authorities might assess the transaction to be non-arm’s length and accordingly re-characterise the transaction into equity and/or deny interest deductibility. Thus, it is important to understand the background and context to the transaction and that the purpose of the loan is included when drafting an intra-group loan agreement.
Another critical clause is the “term/maturity” of the loan. In a third-party context, a financial institution will not grant a loan without a set repayment date or a repayment schedule. Therefore, an intra-group loan agreement following the same principles requires a stated maturity date. An instrument with a longer maturity has a higher risk and would require a higher interest rate. On the other hand, there are instances where a roll-forward clause is included in an intra-group loan agreement, whereby the loan is extended automatically each year after the termination date, without adjustments to the interest rate. This does not reflect arm’s length behaviour as third parties would not agree to a similar arrangement. Therefore, if such a clause is included, then the possibility to adjust interest rates to reflect most recent economic circumstances should be provided as well to ensure that the clause showcases third-party behaviour.
Debt financing requires a level of repayment certainty which is not the case with equity financing and that is the reason why equity attracts a higher return than debt. However, there are different levels of repayment certainty within debt financing and this is captured through ranking of the instrument, ie whether the loan is senior, subordinated, junior or mezzanine. A senior loan can involve securities, guarantees or collaterals: these are legally binding promises (sometimes tied to an asset in the case of collaterals) whereby one party, or the guarantor, provides a deed for repayment in case the borrower is not able to meet its repayment obligations or is in default. A subordinated loan is riskier and requires a higher compensation as opposed to a senior secured loan, which is ranked higher. When assessing the risk associated with a particular debt instrument, the ranking should be considered as it has an immediate bearing on repayment prioritisation in case of insolvency: senior loans would be repaid before subordinated loans. Hence, including a clause that ranks the loan appropriately is important for the correct risk assessment and determination of the interest rate that is aligned with the arm’s length principle.
Another consideration for managing and ascertaining repayments is whether the intra-group loan agreement includes embedded options. Embedded options allow for additional protection and provide flexibility to the party that owns the option with a corresponding downside to the counterparty. For instance, if a put/demand option is included in the loan agreement, the lender can demand repayment of the whole or part of the loan, thereby increasing its ability to obtain funds prior to the stated maturity of the loan. On the other hand, if the agreement has a call/prepayment option giving the borrower the option to repay without notice or penalty, the lender must deal with the reinvestment risk as it might be required to reinvest the excess funds received before the agreed maturity. Generally, a put/demand option for the lender tends to reduce the interest rate whereas the call/ prepayment option for the borrower tends to increase the interest rate, highlighting the direct linkage between embedded options and the interest rate.
One final aspect to consider are the covenants. A covenant is a contract between two parties where they agree that certain actions will or will not be carried out. There are various types of covenants such as affirmative or positive covenants, negative covenants, and numerical or financial covenants. Affirmative and negative covenants require the borrower to perform (or refrain from performing) certain specific actions. Some common examples include maintenance and disclosure of proper financial data, adequate levels of insurance, or restrictions from issuing dividends. These covenants provide an additional layer of certainty that the borrower will not deteriorate its credit standing and will not undertake activities that could affect its ability to service its obligations under the loan. A financial covenant is tied to a specific numerical metric, such as the borrower’s profitability or solvency. In a recent case, His Majesty’s Revenue and Customs (HMRC) have been able to make successful claims against the taxpayer where the interest expenses on an intra-group loan were disallowed based, inter alia, on the fact that the intra-group loan did not include any covenants. According to the BlackRock case,2 HMRC argued that independent parties would not have entered a loan transaction without specific covenants. This article does not aim to detail the facts and analysis of this case, but rather highlight the importance of considering inclusion of covenants in the intra-group loan agreement and how the tax authorities can view them.
In conclusion, for an intra-group loan agreement to be in line with the arm’s length principle, it should reflect conditions that would have prevailed between independent parties. Therefore, when drafting such agreements, it is essential that each clause is reviewed and assessed from an arm’s length perspective including its impact on the interest rate applied. From a theoretical standpoint, any clause that increases the risk for the lender will increase the interest rate whereas any clause that decreases the risk will decrease the interest rate. In addition, options realistically available to parties entering the transaction, ie options available to both the lender and the borrower, should also be considered such that entering the loan transaction does not result in either of the parties being worse off. For example, if the interest rate applied to the intra-group loan with the purpose of refinancing is higher than the interest rate on external financing, then the intra-group loan will make the borrower worse-off, and a third party would not enter such a transaction. This can deem the intra-group loan transaction to be considered as non-arm’s length. Arm’s length interest rates are determined based on the terms and conditions included in the intra-group loan agreement, and where they do not reflect third-party behaviour and genuine economic circumstances, there is a risk that tax authorities might re-characterise the loan transaction and/or deny interest deductions thereby increasing the taxable income in the borrower’s jurisdiction.
1 Article 9 of the OECD Model Tax Convention as incorporated into the OECD Guidelines, para 1.6.
2 UK vs BlackRock, July 2022, Upper Tribunal, Case No  UKUT 00199 (TCC).