This site uses cookies. By continuing to browse the site you are agreeing to our use of cookies.
When you lock down a great interest rate on a mortgage or loan, the whole idea is to hang onto it, right?
For you and I, average homebuyers, yes. But for multinational corporations, not always.
That’s a seemingly bizarre new arrangement that some multinational companies are beginning to engage in, according to one official with the Internal Revenue Service. The catch is that the companies are making the loans to themselves. Such intercompany debt, sometimes termed earnings stripping, is often used to create tax-deductible interest payments to a subsidiary or parent company in a low-tax jurisdiction.
Bao Ho, a senior economist with the IRS, explained the apparently new phenomenon during a conference sponsored by the National Association for Business Economics in Washington, D.C. on July 24.
She described the basics of the transaction: When a company borrows from a related party, transfer pricing principles require that the intercompany debt be structured and priced like loans entered into by independent parties. The IRS is encountering situations where the borrowing entity elects to pay the loan off well before the term ends—thus triggering a prepayment penalty. Such penalties are common, in loans between both related and unrelated parties as a protection for the lender, which stands to lose substantial interest income if the loan is paid off early.
Except, in this case, the related parties then enter into a larger loan with an even higher rate—justifying it, perhaps, by changes in business conditions.
“Are there any economists in this room who will say that makes economic sense?” Ho asked, to some laughter from the room full of tax experts.
Intercompany debt is often criticized as one of the most pernicious forms of corporate tax avoidance. The issue came into sharp focus last year, during the high-pitched public debate over inversions. Several iconic American companies, such as Burger King, used mergers to reorganize outside of the United States, at least partially for tax reasons. Inversions are almost always connected with intercompany debt, because often the goal is to become a foreign parent organization that can use related-party loans to strip earnings out of the U.S. (Current laws effectively block U.S.-based companies from using the same maneuver.)
Defenders say that intercompany debt is one of the main ways companies finance investment into the U.S., and to restrict related-party lending would have a detrimental effect on the economy. Nevertheless, proposals to tighten limits on intercompany debt batted around Congress last year during the furor over inversions. One former Treasury official claimed that the administration already has the power to restrict intercompany debt with existing laws—but, a year later, it has not yet done so. Meanwhile, the Organization for Economic Cooperation and Development is looking into new guidance to deal with the issue as part of its global Base Erosion and Profit Shifting project.
Debt is easily moved around the globe—it doesn’t have to be tied to a product or asset. But, through transfer pricing standards, the loan rates are still tied to what is documented in the market. Just as homeowners have an incentive to refinance their mortgages when interest rates go down, corporations have a reason to refinance their intercompany loans when the rates go up. The off-shore lender receives more income subject to little or no tax, and the U.S. borrower ratchets up the interest expense deduction.
Panelists at the D.C. conference agreed there might be some limited situations where an independent party would refinance at higher rates—perhaps, for example, when it has come across a new opportunity for investment, but the terms of the old loan prohibit taking on new debt. But tax practitioners at the panel also agreed this strategy could be playing with fire.
“Optically, it looks really bad. And practically speaking, on audit, you’re going to have a lot of explanations to do,” said Vinay Kapoor, of KPMG in New York.
The transaction also ought to trigger some questions on the lending side—but they might never be asked.
“What we’ve generally found is that usually the lending company, let’s just say, it’s not usually in a country that’s very robust in its transfer pricing rules,” Kapoor said.
Ho said that the IRS was considering ways to deal with these new transactions, including regulations which instruct tax examiners to consider “alternatives realistically available to the buyer or seller” when considering the economic conditions for finding comparable transactions.
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to books@bna.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to research@bna.com.
Put me on standing order
Notify me when new releases are available (no standing order will be created)