New IRS Guidance on Arm’s Length Interest Rates on Inbound Intercompany Loans
While there are numerous structures by which foreigners may invest in U.S. real estate, the use of intercompany debt is ubiquitous in these ventures. In a typical structure, the foreign parent lends an amount to its U.S. subsidiary which in turn makes periodic interest payments to the foreign parent. For the U.S. subsidiary holding the real estate, its operational income (e.g., rental revenue) will be heavily offset by depreciation deductions and interest payments. With these deductions for interest and depreciation oftentimes completely eradicating taxable income, the U.S. subsidiary consequently has no tax liability (and likely has net operating losses).
The mechanics of the debt in leveraged transactions is a critical component in such transactions. For example, if the debt fails to qualify as debt for U.S. tax purposes, the debt is likely recast as equity. Consequently, the payments which were supposed to be deductible interest payments will subsequently be classified as nondeductible dividends paid to the foreign parent.
The IRS employs a 2-step methodology to analyze a financing arrangement. First, the IRS gauges if the financing arrangement is debt or equity. Second, if the financing arrangement is determined to be bona fide debt for U.S. tax purposes, the IRS then determines if the intercompany interest rate meets the arm’s length standard for bona fide debt.
For the first part, the debt-vs. -equity analysis, the IRS will consider the following factors:
- Intercompany loan agreement;
- Duration of the loan;
- Business purpose of the loan;
- Actual principal repayments and interest payments;
- Source of the principal repayment and actual interest payments (it may involve tracing all the payments over the life of the loan);
- Repeated loan extensions;
- Debtors' financial risk, credit risk, and debt/equity ratios;
- Code Sec. 385 (guidance on the treatment of certain interests in corporations as stock or debt); and
- Debt-vs.-equity established under case law (including name of the financing arrangement, presence or lack of a maturity date, principal repayment, source of payments, subordination, thin capitalization, and independent creditor test, among other things).
For the second part, the IRS must determine if an arm’s length interest rate has been charged. In general, an arm’s length interest is the rate of interest that would have been charged, at the time of debt formation, in an independent transaction with or between unrelated parties in a similar situation. In a new International Practice Unit (“IPU”), the IRS has issued guidance to its examiners on this issue. Specifically, the IPU addresses whether the interest on a loan or advance from a foreign parent corporation to a U.S. subsidiary meets the arm’s length standard for U.S. tax purposes.
In the IPU, IRS offers 3 potential methods to determine whether interest on an intercompany loan or advance is at an arm's length rate:
- Method 1: Funds obtained at situs of borrower. If the foreign parent borrows money from an independent third party in the U.S. (“third party loan”) to fund its loan to the U.S. subsidiary (“intercompany loan”), the interest rate on the intercompany loan must equal the interest rate on the third party loan, increased by other costs or deductions incurred by the foreign partner on the third party loan.
- Method 2: Safe haven interest rates. The interest rate on an intercompany loan may fall within a safe haven range, defined as not less than 100% or not greater than 130%, of the applicable federal rate (“AFR”). This method may not apply in certain cases, including if Method 1 above applies.
- Method 3: Interest rates on unrelated transactions. If the U.S. subsidiary uses neither Method 1 nor 2, it must substantiate that the interest rate on the intercompany loan is arm's length in the manner set forth under the applicable regulations. For this method, all relevant factors must be considered, including the principal amount and duration of the intercompany loan or advance, the security involved, the credit standing of U.S. subsidiary, and the interest rate prevailing at the situs of foreign parent for comparable loans between unrelated parties (e.g., a transfer pricing study).
If none of these methods are able to establish that the interest rate in question is arm’s length, the IRS will adjust the interest rate to reflect an arm's length rate, said the IPU.
While IPUs are not official pronouncements of law or directives and cannot be used, cited, or relied upon as such, they do provide insight on how IRS examiners may conduct their analysis during an audit