Issues with Securing Effective Tax Relief for Financing Costs

The question as to whether or not a group is securing effective tax relief for its financing costs is not a new issue. In fact, treasurers and finance professionals spend many hours locked up with their tax advisers with the precise aim of ensuring that effective tax relief is secured. Furthermore, in an increasingly complex tax environment, the raft of thin capitalisation, transfer pricing and anti-avoidance often makes this a difficult and arduous process, but again this is nothing new.

So why is the position any different in the current economic environment?

To understand why, we need to take a look at the two key group funding scenarios: first, the group company requiring the funds borrows directly from third party lenders; and second, the group parent or finance company borrows from the third party lenders and on-lends to the group companies requiring funds.

With the first scenario there isn’t too much to say in the context of this article. If a company’s business performance has deteriorated to a level where full tax relief isn’t being secured for its financing costs then tax relief will be the least of its worries.

With the second scenario, however, there is much to consider.

In recent years, international groups have become increasingly sophisticated in terms of their intra-group financing arrangements. In this regard the balance sheets of group companies are invariably arranged to ensure that the maximum level of debt is ‘pushed-down’ to companies with sufficient tax capacity to absorb the associated financing costs.

In a normal economic environment, such intra-group structures require little maintenance: profits remain stable or grow and financing costs are paid to the group parent or finance company, which in turn makes payments to the third party lender.

In the current economic environment, however, the position can be very different with the following three issues being of particular relevance.

First, trading results are likely to be highly volatile (with the level of volatility depending on markets, jurisdiction, etc), thus potentially putting previously secure tax deductions at risk if the company suffers a major drop in profits or makes a trading loss.

Second, the balance sheet of the group company could deteriorate to such an extent that the debt:equity ratio no longer satisfies the local thin capitalisation and transfer pricing criteria, whether the criteria is statutory or set out in an advanced agreement with the local tax authorities. Again, previously secure tax deductions may now be at risk.

Third, cash flow could be such that a group company is not able to pay the financing costs to the group parent or finance company as they fall due. If the group company had borrowed directly from the third party lenders, in many cases this shouldn’t give rise to a tax issue on the basis that most European jurisdictions provide for tax relief for financing costs to be given on an accruals basis, i.e. as charged in the accounts. With intra-group debt, however, this is not necessarily the case and there are a number of instances where relief for financing costs arising on intra-group loans is only given on a paid basis. So, again, previously secure deductions may now be at risk.

So, given this, what action should treasurers and finance professionals be taking?

Treasurers and finance professionals should be reviewing their intra-group financing structures to ensure that in a volatile environment the group’s intra-group financing structure continues to be effective. Failure to do this could result in tax relief not being secured for financing costs and ultimately this may result in higher cash tax payments being made than were expected.