By Anthony Diosdi
Cross-border lending is a common business practice with groups of related corporations. However cross-border lending requires attention be given to the transfer pricing and earnings stripping rules. The Internal Revenue Service (“IRS”) has broad powers to recharacterize “any multi-party financing transaction as a transaction directly among any two or more of such parties where the Secretary determines such recharacterization is appropriate to prevent the avoidance of any tax imposed by this title.” See IRC Section 7701(1). We will begin our discussion with a look at how the transfer pricing rules impact cross-border lending.
Transfer Pricing Rules for Cross-Border Lending of Related Parties
For transfer pricing purposes, controlled entities generally must charge each other an arm’s length rate of interest on any intercompany loans or advances. See Treas. Reg. Section 1.482-2(a)(1)(i). There is an exception, however, for intercompany trade receivables, which are debts that arise in the ordinary course of business and are not evidenced by a written agreement requiring the payment of interest. If the controlled borrower is located outside the United States, it is not necessary to charge interest on an intercompany trade receivable until the first day of the fourth month following the month in which the receivable arises. If the controlled borrower is located within the United States, the interest free period extends to the first day of the third month following the month in which the receivable arises.
Below please see Illustration 1 which demonstrates the practice of not charging interest on trade receivables.
Acme, a domestic corporation, owns 100 percent of Apex, a foreign corporation. On November 1, Apex purchased $1 million of inventory from Acme. The $1 million debt, on which Acme pays no interest, is still outstanding on December 31, which is the end of Acme’s taxable year. Since the $1 million intercompany trade receivable was outstanding for only two months, Acme does not have to recognize any interest income. However, if the $1 million debt was still outstanding on January 31 of the following year, Apex would begin owing Aceme interest.
Longer interest free periods are possible if the controlled lender ordinarily allows unrelated parties a longer interest free period or if a controlled borrower purchased the goods for resale in a foreign country and the average collection period for its sale is longer than the interest free period.
Intercompany debt other than a trade receivable generally must bear an arm’s length interest charge. To determine the arm’s length rate, the parties must consider all relevant factors, including the amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender for comparable loans between the uncontrolled parties. See Treas. Reg. Section 1.482-2(a)(2)(i). If an arm’s length rate is not readily determinable, the taxpayer can still protect itself against the Internal Revenue Service (“IRS”) by satisfying the requirements of a safe harbor provision. Under this safe harbor, an interest rate is deemed to be an arm’s length rate if it is between 100 percent and 130 percent of the applicable federal rate. See Treas. Reg. Section 1.482-2(a)(2)(iii)(B). The applicable federal rate is the average interest rate (redetermined monthly) on obligations of the federal government with maturities similar to the terms on the intercompany loans.
Below, please see Illustration 2 which demonstrates the safe harbor rule.
Apex, a foreign corporation, owns 100 percent of Acme, a domestic corporation. During the current year, Acme borrows $1 million from Apex. The loan is denominated in U.S. dollars and has a three year obligation of 8 percent. Under the safe harbor provision, an interest rate of between 8 percent (100% of the applicable federal rate) and 10.4 percent (130% of the applicable federal rate) is automatically acceptable to the IRS. A rate lower than 8 percent or higher than 10.4% can be used if the taxpayer can establish that it is an arm’s length rate, taking into account all of the relevant facts and circumstances.
The safe harbor is not available if the intercompany debt is denominated in a foreign currency or the controlled lender is in business of making loans to unrelated parties. See Treas Reg. Section 1.482-2(a)(2)(iii)(E). A special rule applies if the controlled lender obtains the funds to make the intercompany loan at the situs of the controlled borrower. In such cases, the controlled lender is treated as a mere conduit for the loan entered into with the unrelated lender. Therefore, the arm’s length rate on such pass through loans is assumed to be equal to the rate paid by the controlled lender of the original loan, increased by any associated borrowing costs, unless the taxpayer can establish that a different rate is more appropriate under the general rules. See Treas. Reg. Section 1.482-2(a)(2)(ii).
Below, please see Illustration 3 which demonstrates the special rule on pass through loans.
Acme, a domestic corporation, owns 100 percent of Paprika, a Hungarian corporation. During the current year, Acme borrowed $10 million from a U.S. bank at a 10 percent rate and then relends the funds to Paprika. The arm’s length rate on the intercompany loan is deemed to be equal to 10 percent plus any borrowing costs incurred by Acme in securing the original loan. A rate other than 10 percent also can be used if Acme can establish that such a rate is arm’s length, taking into account all of the relevant facts and circumstances.
The Application of the Earnings Stripping Rules of Section 163(j) to Cross-Border Lending Transactions of Related Parties
As discussed above, on most occasions, the transfer pricing rules require arm’s length interest rate to be on intercompany loans. The charging of an interest rate typically translates into a very beneficial tax deduction. Internal Revenue Code Section 163(j) operates to prevent U.S. and foreign owned companies from eroding the federal tax base through tax deductible interest payments to related parties. Section 163(j) provides that a deduction allowed for business interest expenses in any tax year generally cannot exceed the sum of 1) the taxpayer’s “business interest income” for the taxable year; 2) 30 percent of the taxpayer’s “adjusted taxable income” for the taxable year.
The term “business interest income” is defined to mean the amount of interest includible in gross income that is allocable to a trade or business, which does not include investment income. The term “adjusted taxable income” means the taxpayer’s taxable income computed without regard to any deductions allowable for depreciation, amortization, or depletion.
If the IRS disallows any portion of related party interest expense, the disallowed interest can be carried forward, but the utility of such a carry-forward is questionable. Anytime related parties engage in cross-border financing, the parties both the transfer pricing and earnings stripping provisions of Section 163(j) must be followed.
We devote a large part of our practice to the U.S. federal income tax rules applicable to U.S. businesses operating outside the United States, as well as foreign companies investing in the United States.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.