In this article, we will explore what debt capacity analysis is and why it is a critical component of financial analysis in the transfer pricing documentation of intercompany financial transactions.
As the name suggests, a debt capacity analysis examines a borrowing entity’s ability to service a certain level of debt. Among unrelated lenders and borrowers, a lender would conduct an analysis to determine the maximum level of debt a borrower can assume and service without defaulting. Debt capacity analysis is one of many assessments a lender performs to ensure proper debt servicing. The final loan amount, maturity, and interest rate depend on additional factors such as credit rating, collateral, industry, and market conditions.
Similarly, in the context of related entities, the borrowing entity must demonstrate its ability to repay an intercompany loan under specific conditions. The OECD guidelines on financial transactions state that each intercompany loan transaction must be clearly delineated and tested to ensure it meets the arm’s length standard. Failure to comply can result in tax authorities re-characterizing the transaction as a dividend payment rather than a loan. The consequences for the borrowing entity include non-deductibility of interest expenses and additional withholding taxes on perceived dividend payments, leading to double taxation.
Typically, a debt capacity analysis benchmarks the borrower’s leverage ratios, such as Debt/EBITDA, Debt/Equity, Debt/Total Assets, and EBITDA/Interest Expenses, against those of comparable companies within the same industry and credit rating. Moreover, many tax jurisdictions (i.e. UK, Ireland, Netherlands, Germany, US, India, Australia and many more) require taxpayers to provide a debt capacity analysis be provided as part of transfer pricing documentation of intercompany financial arrangements.
In conclusion, a debt capacity analysis is crucial to substantiate that an intercompany loan is indeed a loan and not recharacterized as an equity transaction. This analysis is becoming increasingly important as tax authorities target intercompany financing arrangements through debt re-characterization arguments.
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