CORPORATION TAX | 02/28/2024
Key insights
- The IRS can consider group membership when determining the arm’s length rate of interest for intragroup loans (both in solely U.S. and cross-border scenarios).
- Regardless of how group membership impacts the debt terms for a controlled borrower based on financial support expected from another group member, the IRS will still consider group membership.
- Companies must verify the interest rate charged for intragroup loans reflects market realities, and the financial strength of the parent company matters.
Businesses must carefully evaluate loans between related companies so interest rates charged comply with the federal income tax rules.
The IRS recently issued Advice Memorandum AM-2023-008, shedding light on treating intercompany interest rates in the context of group membership. Overcharging affiliates could lead to IRS scrutiny and potential adjustments.
Let’s delve into the memo’s key points and implications.
Background
Commercial lenders evaluate credit risk when extending loans to borrowers. The credit rating systems used by commercial lenders assess potential borrowers based on their creditworthiness.
When analyzing a corporate group, rating agencies consider both the standalone credit profile of individual entities and the group credit profile.
Section 482 details
The Section 482 regulations state the arm’s length standard applies to the interest charged between related parties for the “use of such loan or advance.” An arm’s length standard requires the pricing of transactions between related parties to reflect pricing between unrelated parties under similar circumstances.
Additionally, the regulations specify “an arm’s length rate of interest shall be a rate of interest which was charged, or would have been charged, at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances. All relevant factors shall be considered, including the principal 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 or creditor for comparable loans between unrelated parties.”
The issue
The memo addresses whether the IRS can consider group membership when determining the arm’s length rate of interest for intragroup loans. In other words, does group membership impact the interest rate charged between related entities?
The conclusion
The memo provides a clear answer: Yes.
Under the Section 482 regulations, the arm’s length rate of interest on an intragroup loan to a controlled borrower is generally the rate where that borrower could realistically obtain alternative financing from an unrelated party.
If an unrelated lender would consider group membership in establishing financing terms available to the borrower, and such third-party financing is realistically available, then the IRS may adjust the interest rate in a controlled lending transaction to reflect group membership.
Implicit support and expectations
Here’s where it gets interesting. Even if group membership improves debt terms for a controlled borrower based on financial support expected from another group member (even if that group member is the lender), the IRS will still consider group membership as a factor in evaluating the arm’s length nature of the transaction.
In other words, the IRS’s position is a borrower cannot argue for a higher interest rate on an intercompany loan on the theory the related party lender cannot benefit from credit support such lender (or other related party) provides on its own loan.
The regulations disregard the ownership relationship between the controlled lender and borrower for this purpose. Instead, the controlled lender must enforce repayment of the debt according to its terms, just as in an arm’s length bona fide lending scenario.
Practical implications
Create consistency with external financing
The IRS expects intragroup loans should align with what an unrelated lender would offer, considering the borrower’s creditworthiness and group membership.
Avoid overcharging (or undercharging) affiliates
Companies must charge interest rates reflecting market realities for intragroup loans (especially between parent companies and affiliates). Overcharging affiliates could lead to IRS scrutiny and potential adjustments.
Remember financial strength matters
The parent company’s financial strength matters. The interest rate should be comparable to what the affiliate would receive from an outside lender, considering the parent company’s financial standing.
Consider your intercompany loan arrangements
The memo emphasizes the importance of treating intercompany transactions as if they were arm’s length transactions with unrelated parties. Group membership should not distort the pricing of intragroup loans.
Carefully evaluate your intercompany borrowing and lending arrangements so interest rates comply with the arm’s length standard. Although this summary is largely portrayed as applicable in cross-border scenarios, this can also apply in a purely domestic arrangement.
Remember, this memo provides nontaxpayer-specific legal advice and should not be cited as precedent. However, it offers valuable insights into the IRS’s perspective on intercompany interest rates.
How we can help
You need confidence your intercompany and cross-border transactions are not putting your business at risk. Chartered can assist with interest rate benchmarking on intercompany loans.