Tax Treatment of Interest-Free Loans Between Related Parties

Corporate Clients, Banking & Finance, Private companies

Interest-free loans between related parties are common practice in the corporate world, but they carry specific tax risks and requirements regulated by the Corporate Income Tax Act 2007 (CITA). In this context, it is crucial for companies to understand and comply with the tax rules to avoid penalties and adverse consequences.

Definition and scope of related parties

CITA does not contain a definition of related parties, but refers to the detailed enumeration in § 1, item 3 of the Additional Provisions of the Tax and Social Security Procedure Code 2006 (TSSPC). According to the TSSPC, related parties are a wide range of entities and individuals that have influence over each other. The control may be both direct and indirect, and the influence may be exercised variously, for example, through participation in the management or share capital of a company orthrough family and kinship ties with persons exercising such influence. CITA also provides for strict rules on transfer pricing, including for interest-free loans. 

Market conditions 

One of the main requirements of CITA is that transactions between related parties must be carried out at arm’s length. Where related parties carry out their commercial and financial relationships under conditions different from those between unrelated parties that affect the amount of the tax base, the tax base is determined and taxed under the conditions that would arise for unrelated parties. Here again, CITA refers to the TSSPC with respect to the definition of market price,that is, the amount, exclusive of value added tax and excise taxes, that would be paid under the same conditions for an identical or similar good or service in a transaction between unrelated parties.

Market conditions valuation methods

The valuation of market conditions for these loans is generally based on comparable arm’s length transactions. This includes an analysis of interest rates, terms and other conditions of the loan. In international practice, several methods for determining market price have been established, including the comparable uncontrolled price method (CUP), the cost-plus pricing method, the profit margin method, among others. TSSPC explicitly provides for the applicable methods. These are:

• the method of comparable uncontrolled price between independent traders; 
• the arm’s length method, where the arm’s length price is the price used in the process of selling goods and services in unchanged form to an independent counterparty, less the trader’s costs and the normal profit; 
• the mark-up method, in which the normal market price is determined by increasing the cost of production by the normal profit; 
• the transactional net margin method; 
• the profit sharing method.

In the context of interest-free loans, the method of comparable uncontrolled price between independent traders is most commonly used as it allows a direct comparison of loan terms.

Documentation and evidence 

Taxable persons should be prepared to provide evidence and documentation to prove that their interest-free loans do not result in a deviation from market conditions. This documentation may include the loan agreements themselves, an analysis of market interest rates, internal policies for related parties’ management and other relevant documents. Documentary evidence is of vital importance as tax authorities often require detailed information on related party transactions.

Potential tax risks and penalties when providing interest-free loans to related parties 

Failure to comply with the requirements of CITA regarding interest-free loans between related parties may result in tax audits and the imposition of adjustments, which may include the imposition of additional taxes, interest for delay and financial penalties.

This means that interest-free loans between related parties may trigger tax adjustments if they are considered to be a deviation from market conditions. In the case of an interest-free loan, the tax authorities may impose a conditional charge of interest based on the market value, resulting in an increase in the taxable profit of the borrowing company.

If the interest rate is lower than the market rate, this may be an indication of  hidden distribution of profits, as the borrower is saving costs equal to the  difference with market rates, which they can then distribute to shareholders. If it is established that there is such a hidden profit distribution and this fact is not disclosed in the borrower’s tax declaration, a penalty of 20% of the amount constituting the hidden profit distribution may be imposed.

In order to avoid such consequences, the parties to the loan relationship should carefully examine what the market interest rates are and take them into account when arranging the loan. 

Tax planning and strategies

In conclusion, the tax treatment of interest-free loans between related parties under CITA is a complex process that requires careful planning and compliance with the legislative requirements. Companies should be aware of the risks and take proactive measures to ensure compliance with the tax rules. This will not only help them avoid penalties but also improve their financial and tax reporting.