Intragroup financing is one of the most sensitive areas in contemporary international taxation. In a context of increased scrutiny by tax authorities and the implementation of BEPS standards, the interaction between thin capitalization rules and the arm’s length principle in transfer pricing takes on strategic importance.
Although both disciplines pursue different objectives—limiting tax base erosion through excessive interest and the correct valuation of transactions between related parties—in practice they converge on a common technical point: the economic validation of intragroup indebtedness.
It is not enough to comply with a legal deductibility ratio. It is essential to demonstrate that the debt is consistent with what independent parties would have agreed in comparable circumstances.
From an international perspective, this analysis operates on two complementary levels:
(i) the application of domestic interest limitation rules (thin capitalization or interest limitation), and
(ii) the verification, under transfer pricing rules, that the debt and its remuneration are in line with what independent parties would have accepted.
Consequently, compliance with a legal ratio does not replace the need for economic justification and arm’s length comparability.
Economic nature of financing: debt or equity
The first level of analysis is not quantitative, but qualitative. Before discussing interest rates or percentage limits, it must be determined whether the intragroup financial instrument has economic substance as debt.
A genuine loan implies, among other elements:
- A real obligation to repay.
- Reasonable ability to pay on the part of the borrower.
- Remuneration commensurate with the risk assumed.
- Contractual terms consistent with market practices.
When an entity has levels of leverage that would not be acceptable to an independent lender, the supposed loan may lose its economic nature. In such cases, partial or total recharacterization as a capital contribution becomes a specific technical risk.
Here we see the first intersection with thin capitalization rules: debt that exceeds market economic limits may be questioned even if it formally complies with domestic deductibility regulations.
Debt capacity and credit profile
Determining the amount of debt that is defensible under the arm’s length principle requires proving that an independent third party would have granted—and the borrower would have been able to assume—an equivalent level of financing. This analysis is based on the entity’s actual cash flow generation capacity, the stability of its business model, and its operational risk profile. It is not consistent to attribute high levels of leverage to entities with limited functions or routine margins if their economic substance does not support such financial exposure.
In particular, if reasonable financial projections show that the entity does not have the capacity to service the loan on its terms, an independent lender would not have granted that amount. In such cases, the analysis may conclude that only part of the financing can be treated as debt for arm’s length purposes, with the excess remaining outside the amount to be remunerated as interest.
A central element is the estimation of the standalone credit rating, which allows for an approximation of how the entity would be evaluated in the market without automatic support from the group. Based on this rating, both the reasonable volume of indebtedness and the financial conditions consistent with the market are determined. The possible implicit support of the group must be rigorously analyzed and cannot be presumed to justify excessively leveraged structures.
In this context, the analysis is not limited to setting an arm’s length rate, but requires validation of the overall consistency of the capital structure. When the level of debt responds mainly to fiscal objectives and not to solid financial fundamentals, the risk of adjustments and recharacterizations at the fiscal level increases significantly.
Determination of the arm’s length interest rate
Once the nature and amount of the debt have been validated, the remuneration commensurate with the risk assumed must be established.
The interest rate should reflect:
- The borrower’s credit profile.
- The currency and term of the instrument.
- The existence of guarantees.
- Comparable conditions observable in the market.
- Any implicit support effects from the group.
However, even a correctly determined rate may be irrelevant if the level of debt is excessive from an economic perspective. In other words, transfer pricing analysis cannot compensate for an artificial capital structure.
The interaction with thin capitalization is evident: while domestic regulations may allow a deduction of up to a certain percentage of EBITDA, arm’s length analysis may require an additional reduction in the amount financed.
Risks arising from an inconsistent structure
When the intra-group capital structure is not properly aligned with the arm’s length principle, the tax risks go beyond mere deductibility limitations and can have structural impacts on the group’s tax position. In audit scenarios, tax authorities do not limit themselves to verifying formal compliance with legal ratios, but also analyze the economic rationality of the debt, the financial substance of the borrowing entity, and the overall consistency of the financing policy.
In this context, the main risks include:
- Reclassification of debt as equity:
- When the level of leverage would not be accepted by an independent financier, the authority may consider that the alleged loan lacks substance as debt, reclassifying it wholly or partially as a capital contribution. This implies the loss of interest deductibility and the alteration of the tax base.
- Primary adjustments to deductible interest:
- Even if the debt is recognized as such, the principal amount or interest rate may be adjusted if they are not considered arm’s length. This generates direct increases in the taxable income of the borrowing entity.
- Secondary adjustments:
- Derived from the primary adjustment, deemed dividends or hidden distributions may be configured, generating additional withholdings or collateral tax effects in other jurisdictions of the group.
- Double taxation:
- If the lender’s jurisdiction does not recognize the adjustment made in the borrower’s jurisdiction, the same financial flow may end up being taxed twice, affecting the consolidated tax burden.
- Increased risk of international disputes:
- Discrepancies in the characterization or valuation of intra-group financing can lead to mutual agreement procedures (MAP), arbitration, or protracted litigation, with significant financial and reputational costs.
Experience shows that a financially inconsistent structure not only increases immediate tax exposure but also weakens the group’s technical position in the face of complex audits and multilateral reviews.
Comprehensive technical approach
A robust approach requires integrating both analyses:
- Prior economic assessment of the optimal level of capitalization.
- Determination of individual credit ratings.
- Comparative market analysis for interest rates.
- Contemporary documentation to support financial decisions.
- Periodic review in light of changes in the economic environment or group structure.
Consistency between corporate financial discipline and transfer pricing policy is the main defense mechanism against potential tax challenges.
Strategic approach to intragroup financial structures
Thin capitalization and transfer pricing are not isolated disciplines, but complementary dimensions of the same analysis: the economic validation of intragroup financing. The international standard requires demonstrating not only that the agreed rate is arm’s length, but also that the volume of debt responds to financial parameters that an independent third party would have accepted in comparable circumstances.
In an environment of greater scrutiny and technical sophistication, consistency between financial policy, economic substance, and transfer pricing documentation becomes critical to mitigating contingencies and avoiding international disputes.
At TPC Group, as a company specializing in transfer pricing, we assist multinational groups in the comprehensive evaluation of their capital structures, the analysis of borrowing capacity, and the technical documentation of intra-group financing, strengthening their position in the face of complex tax reviews and demanding international standards.
Source: OECD-Transfer Pricing Guidance on Financial Transactions (Section B – C)