The financing of companies operations using both equity and related party loans is a prevalent structure, for obvious reasons though, as unlike dividends paid to the shareholders, interest paid on related-party loans is, subject to Rwanda’s thin capitalisation rules, tax-deductible. Related party lending transactions must, however, be consistent with the arm’s length principle (ALP) in that they must be entered into on conditions that are not different from those that would have been applied between independent persons in comparable transactions carried out under comparable circumstances. The application of the ALP is generally understood as requiring that interest applied in a related party lending transaction be within the same range as that that would be charged by an independent lender lending to the borrower in comparable circumstances. There is however another facet of the ALP consisting of assessing whether the advance of funds by a related party to the borrower can be regarded as a loan or should be regarded as some other kind of payment, in particular a contribution to the borrower’s share capital, and this aspect will be the focus of this article. The applicable laws are not prescriptive on the factors to be taken into account in delineating transaction involving advance of funds between related parties, but according to the 2020 OECD Transfer Pricing Guidance on Financial Transactions, various economically-relevant characteristics such as the presence or absence of a fixed repayment period; the obligation to pay interest; the existence of financial covenants and security; the ability of the borrower to obtain loans from unrelated lending institutions or general creditworthiness or repayment capacity of the borrower are (depending on the circumstances/facts) critical in that regard. For instance where a loan from a related party is interest-free and does not have a fixed repayment period, the chances are that such loan may be re-characterised as equity on the ground that no independent lender would extend an interest-free loan and without a fixed repayment period. The re-characterisation of a related party loan (or at least part thereof) may also be considered in in light of the creditworthiness of the borrowing entity. For instance if an entity receives a loan from a related company which is stated to be repayable in 10 years, but in light of all good-faith financial projections of the borrowing entity, it is clear that the latter would not be able to service such loan amount within a period of 10 years, a conclusion may then be reached that no independent lender would have been willing to extend such loan amount to the borrowing entity owing to its limited repayment capacity. The assessment of the borrower’s creditworthiness or repayment capacity must however take into consideration idiosyncratic aspects of intra-group financing transactions such as the fact that the borrower is a member of a multinational group which may have a higher credit rating and that the parent or other group companies may be reasonably expected to support the borrower in its financial needs (i.e. ‘stewardship by the parent company’ or ‘implicit support’) as this is something an independent lender would also consider. The view of the United Nations Committee of Experts on International Cooperation in Tax Matters in the 2021 UN Practical Manual on Transfer Pricing for Developing Countries, which is shared by the writer, is that where the borrowing entity is of a strategic importance to a multinational enterprise (MNE) (i.e. integral to the MNE’s current identity and future strategy), the rest of the MNE is likely to support the borrowing entity under any foreseeable circumstance. This suggests that the repayment capacity of a borrower that is a member of an MNE group should not be assessed on a standalone basis, but must also factor-in group synergies. Factors like existence or absence of security and financial covenants are relevant to unrelated lenders, but it cannot be always the case in related party lending transactions as the risk they seek to hedge is taken away by the fact that the borrowing entity is related to and/or controlled by the lender. According to the OECD guidance referred to above, the fact that the lender has control and ownership of the borrower makes the granting of security less relevant to its risk analysis as the lender has control over the assets of the borrower. The same position is taken by the OECD in relation with financial covenants where it states that intra-group lenders may choose not to have covenants on loans to related parties, partly because they are less likely to suffer information asymmetry and it is less likely that one part of an MNE group would seek to take the same kind of action as an independent lender in the event of a covenant breach. The above discussion of transfer pricing considerations for related party lending transactions indicates that when accurately delineating transactions involving advance of funds, funds extended to related companies as loans may be re-characterised as equity. The consequences of this cannot be overstated as all costs relating to a re-characterised related party loan (including interest and other costs) would be rejected by the tax administration. The re-characterisation risk is not merely perceived as the tax administration has (in a number of transfer pricing audits) re-characterised related party loans as equity based on some of the features considered above and rejected all costs associated therewith. Taxpayers (particularly those that are members of MNE groups and receiving debt funding from related parties) are advised to ensure that their related party borrowings and relevant agreements (these must be put in place if they do not exist) are reviewed from a transfer pricing perspective to avoid the risk of subsequent re-characterisation and its tax implications. The views contained herein are those of the author and do not constitute legal or tax advice. The writer is a corporate commercial and tax lawyer, and senior associate at ENSafrica Rwanda.
