With recent news of limits on intercompany debt in Australia, China, New Zealand, and the UK, many U.S. affiliates in these countries incurred substantial debt. While U.S. tax law does not place formal limits on the extent of debt versus equity financing, section 482 requires that the interest rate on intercompany debt be consistent with the arm’s length standard.
Example: If over 60% of the assets of a U.S. affiliate are financed by debt, then section 163(j) of this law limits the deduction for interest expense to 50% of operating profits.
In our recent paper, Interplay Between Section 163(j) and Transfer Pricing, Nicole O. Lichtman and I note that the enforcement of section 163(j) requires a proper evaluation of various transfer pricing issues facing U.S. affiliates.
Two evaluations are required to calculate whether interest expenses exceed half of the operating profits of the affiliate.
- Evaluation of the arm’s length interest rate
- Evaluates whether operating profits are a clear reflection of the income attributable to the functions, assets, and risks incurred by the affiliate
Since the arm’s length interest rate depends on the credit rating of the affiliate, the level of operating profits under arm’s length pricing is key element in evaluating the intercompany interest rate.