What exactly is it?
A debt-to-equity (D/E) analysis determines if the forecasted debt level and capital structure of a company meet the arm's length standard. In other words, it aims to establish an approximation of conditions that are consistent with third-party behavior.
As a simplified illustration, here are just some of the typical transfer pricing (or D/E analysis) questions deliberated in an intra-group loan arrangement:
- How much debt could the borrower (related party) have obtained from a third party and service without defaulting on its obligations?
- How much would a lender have charged? And how much would the borrower be willing to pay?
In a nutshell, the arm's length principles should be respected when determining whether a loan is a loan for fiscal purposes. This is in line with Article 9 of the OECD Model Tax Convention, including the corresponding commentaries, and also referred to in the OECD discussion draft relating to the financial transactions issued during the summer of 2018 1.
Why is that important? Well, because any excess debt undertaken by a borrower could be considered non-arm's length and delineated as equity. What's more, interest deductions thereof could be denied for tax purposes.
The Luxembourg angle and the Black Swan theory
In principle, no thin capitalization rules are embedded in the Luxembourg tax laws. However, the current administrative market practice generally consists of the D/E ratio of 85-15 for intra-group financing of participations. 2
Not to be forgotten, the interest limitation rules in Luxembourg, effective from January 2019 and where taxpayers will be faced with a fixed ratio rule to determine tax deductible borrowing costs, do not eradicate D/E analysis requirements.
In the absence of domestic legislation addressing a company's capital structure, we cannot exclude the risk that the Luxembourg tax authorities may enhance their views in the future with respect to thin capitalization / D/E ratio approaches in Luxembourg. Obviously, the longstanding administrative practice based on the principle of legitimate trust and legality should and will, without any doubt, be used by taxpayers and their trusted advisors in the future to mitigate the risks of successful challenges by the tax authorities. However, under the Black Swan theory 3, it may be anticipated that, going forward, the local tax authorities seeks more information and focuses even more on these points (e.g. in tax audit reviews).
Holding and Financing activities
For intra-group financing of participations, rendering a D/E analysis could be done by analyzing market conditions, cash flows and financial ratios of the borrower that basically measure risk of loss of investment (e.g. by analyzing liquidity and solvency ratios including 'total debt to EBITDA', 'EBIT to interest expense', 'free cash flow to total debt' and 'funds from operations to total debt').
Notably, with regards to the related party financing of shareholdings / participations, experts at KPMG Luxembourg have since developed a methodology analyzing the range of debt to equity ratios based on investment risk analysis model, a common method in the financial industry that measures the risk of loss of an investment. Each investment risk method analysis is sensitive to inputs / working assumptions that need to be factored in and include the industry comparables that need to be carefully selected and reviewed in terms of general industry, functional/operational and geographic comparability.
Contextually, the expected loss method currently applied to intra-group financing transactions falling in the scope of the 2017 transfer pricing circular, could be seen as a pragmatic approach compared with the D/E analysis. Why? Because it is easier to apply and demands less resources. Whereas the results of the expected loss method may be regarded as an approximation of the minimal capital requirements in alignment with the credit risk profile of the investments of a borrowing entity, the method may not directly apply to intra-group financing of participations, notably because of the general absence of the credit risk when making investments into participations.
For practical reasons the D/E analysis is not often carried out for Luxembourg tax and transfer pricing purposes. With the changing landscape around this topic, however, Luxembourg taxpayers engaged in intra-group financing should stay on their toes in case they need to undertake a D/E analysis for their capital structures on a case-by-case basis – especially in situations which involve high volumes and complexities of related party financing.
Sounds complicated? KPMG can help
Conducting a D/E analysis is no walk in the park! It usually isn't a straightforward cut-and-paste process as it requires transfer pricing economic skills and access to appropriate data and comparable.
1. Transfer pricing aspects of capital structure was a subject kept aside for further clarification under last version of OECD discussion draft. More structured and clear guidance is awaited from OECD to address this either towards end of 2019 or by early next year, 2020.
2. In fact the thin capitalization rules should be considered on a country by country basis. For instance in The Netherlands, until 1 January 2013, contained thin capitalization rules restricting certain interest due to related parties if the taxpayer was considered to have been excessively financed with debt. While these rules have now been abolished, there is an expectation to support the capitalization from an economic / transfer pricing perspective. In the USA, Internal Revenue Code1 Section 385 was dealing with documentation requirements for certain related-party interests in a corporation to be treated as indebtedness (the Section 385 rules are currently being modified in the USA).
3. In principle, the black swan theory is a metaphor that describes an event that comes as surprise and occurrence of which may have significant effects.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.