Why Corporations Are Refinancing Their Debt—Upwards

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.