When the economy is unfavourable, it’s time to review your intra-group debt financing.
In the current economic climate, commercial property groups have been impacted by declining valuations and high interest rates. As a result, intra-group property financing structures with UK debt owned to an offshore company can be severely affected because of transfer pricing and thin capitalisation rules. So this means property groups should be reviewing and updating their internal debt financing arrangements.
Intra-group financing arrangements
Intra-group financing is a complex area of transfer pricing for commercial property groups. Property financing structures typically consist of bank debt, intra-group debt in the form of shareholder loans, and equity reserves.
Shareholder debt is normally an attractive option (more so than equity) to fund the acquisition or refinancing of a property. Loan interest expense can reduce the amount of tax payable on the profits generated from rental of the property, thereby increasing the investment return to shareholders.
Many countries like the UK have rules to limit the reduction of taxable income through inter-company interest expenses on loans from both offshore and domestic related parties.
Transfer pricing rules specify that a related-party debt arrangement should be priced based on, and have terms consistent with, comparable third-party debt arrangements. Among other provisions, the UK has thin capitalisation rules to assess whether the borrower has more debt than it could, or would, borrow without group support when acting in its own interests in the open market.
The impact of tax rules
Decreasing market valuations and high interest rates have put pressure on existing financing structures, especially those set up during a low interest rate and high loan-to-value environment.
Such structures are becoming difficult to support and should not simply be rolled forward on identical terms. It’s important to review the terms to reflect current economic circumstances. Otherwise it may be difficult to comply with transfer pricing and thin capitalisation rules. And failure to do so may mean excessive interest deductions are disallowed in tax returns.
Credit metrics are useful to evaluate shareholder loans for commercial property, to assess the riskiness of a loan or general creditworthiness of the borrower.
LTV and ICR
The loan-to-value (LTV) ratio is based on the fair market value of the property and compares this to the amount of the loan. The LTV is calculated by dividing the amount of the loan by the property’s market value. Borrowers with lower LTVs will usually qualify for more favourable interest rates.
The interest coverage ratio (ICR) measures a borrower’s ability to service its debt from the income derived from a property. The basic calculation is EBIT divided by the total interest expenses. Lenders will generally prefer higher ICRs to be confident the borrower can service its debt.
One of the reports providing data on typical LTVs for commercial property is the Cass Commercial Real Estate Lending Survey, published by Cass Business School.
We recommend shareholder debt structures are reviewed regularly, including an assessment of key credit metrics, including the LTV and ICR. It’s also worth checking the terms and conditions of clauses, such as maturity date and early repayment, to ensure arm’s length behaviour between related parties. And, as third-party financing arrangements are being renegotiated, intra-group financial arrangements should be reviewed at the same time.
Next moves
Commercial property groups should regularly review whether, and to what extent, the economic environment is impacting their existing intra-group debt financing arrangements. The priorities should be to ensure:
- Robust comparability and benchmark data. Update pricing and terms of intercompany debt financing based on fresh analysis of comparable transactions, with robust economic analysis and potential adjustments
- Implementation, documentation and compliance. Thorough execution of revised inter-company debt interest expenses, maintenance of proper records and preparation of transfer pricing documentation can be crucial for demonstrating arm’s length compliance.
Given current conditions, commercial property groups that review and update their intra-group financing arrangements will be more likely to avoid unwanted financial and tax compliance consequences.
For more information or guidance on issues raised in this article, please contact Farhan Azeem.
