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The importance of selecting the appropriate capital structure

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Arendt & Medernach
A four-step analysis can be derived in order to price an intra-group transaction

The OECD has released its long-awaited transfer pricing guidance on financial transactions. Danny Beeton and Alain Goebel of Arendt & Medernach review the guidance and suggest the best approaches for pricing and documentation.

Thin capitalisation and interest limitation rules are well known and widely spread techniques to avoid excessive indebtedness of a company and to limit the deduction of interest expenses.

The OECD has addressed the issue several times, for example, in its report on thin capitalisation (1987), in a discussion paper on thin capitalisation legislation (2012) and more recently in Action 4 of its base erosion and profit shifting (BEPS) report (2016) and its February 2020 transfer pricing guidance on financial transactions report. It seems that, so far, the OECD has distinguished between the arm's-length approach and the ratio approach.

Under the arm's-length approach, the maximum amount of debt needs to be justified by reference to the amount that the borrower could have borrowed and the amount the said borrower would have borrowed.

Under the ratio approach, the maximum amount of debt is determined by a pre-established ratio that does not reflect the arm's-length principle.

Although the OECD seems to favour the arm's-length approach, several countries used to accept debt-to-equity ratios in their administrative practices, most likely for simplification purposes or because of the absence of reliable comparables.

In Luxembourg, for example, a debt-to-equity ratio of 85:15 for the financing of participations qualifying for the participation exemption regime was traditionally considered as a safe harbour, provided that the interest rate on the debt complies with the arm's-length principle.

Similarly, under the old Circular of 2011, a company engaged in intra-group financing transactions was considered as being sufficiently capitalised with 1% equity, capped at €2 million ($2.2 million) until December 31 2016. Other countries like the UK, the Netherlands and Switzerland had adopted similar formal or informal approaches.

Nowadays, and in particular with the adoption by the OECD of the final transfer pricing (TP) guidance on financial transactions, it is questionable whether taxpayers could still rely on such financing safe harbours. One of the key messages of the new TP guidance from the OECD seems to be that the balance of debt and equity funding of an entity must be accurately delineated and comply with the arm's-length principle to be justified in appropriate TP documentation. Obviously, the right capital structure will vary depending on the nature of the investment that is being financed.

This seems to imply that capital structures should be determined by legal analysis of the investment documents, financial analysis of the risks and TP analysis of the equity required to cover the risks and/or the maximum debt that could and would have been obtained from an arm's-length lender.

This article will explain the concepts, review the new guidance and suggest approaches for pricing and documentation. Regulated institutional entities, such as banks and insurance companies, being subject to specific capitalisation requirements, are excluded from the analysis.

The importance of transfer pricing in capital structures

Guidance on the arm's-length capital structure is sparse and may be found to some extent in the 2017 OECD TP Guidelines (guidelines):

  • According to paragraph 1.38, a transaction (including financial transactions) must be at least as economically beneficial as any other transaction to both parties;

  • Paragraphs 1.122 to 1.128 analyse the circumstances in which transactions between related parties may be disregarded, including a possible imputation of a different (e.g. smaller) loan; and

  • Paragraphs 1.164 to 1.167 provide practical examples in this respect.

At the national level, the UK's HM Revenue and Customs' (HMRC) international manual guidance on thin capitalisation discusses the 'could' versus 'would' decision for the borrower (i.e. as to whether it would choose to borrow up to its full borrowing capacity given that this might reduce its credit rating and leave it with inadequate liquidity).

Meanwhile, the Australian Taxation Office's draft guidance on thin capitalisation of August 2019 also points to a reduction of a borrower's credit rating to below that of its group as a risk assessment issue, and that any covenants in a related party loan agreement (such as maximum gearing) should reflect those that parties acting at arm's length would reasonably be expected to have entered into, and that a loan should not be so large as to prevent the borrower from providing the market rate of return to its equity investors.

Some high profile international TP cases have also influenced the general approach to related party debt financing. For example:

  • In the Australian Chevron case decision of November 2014, it was ruled that a borrower would not want to reduce its credit rating and so increase its cost of capital by becoming too indebted (Chevron Australia Holdings Pty Ltd v Commissioner of Taxation [2017]);

  • In its Fiat state aid case decision of September 2019, the EU General Court concluded that the arm's-length amount of equity required by a lending intermediary could not be approximated by a general industry benchmark such as the Basel II ratio regulatory capital ratio (T-755/15 Luxembourg v Commission and T-759/15 Fiat Chrysler Finance Europe v Commission [2019]);

  • In a Spanish profit participating loan case decision of June 2018, the court ruled that as the shareholder already participated in the favourable economic performance of the borrower, the borrower's tax-deductible interest expenses should be limited to that which would have been incurred in a senior bank loan (Lidl Supermercados [2018]). In a similar decision in February 2019, all the variable interest was recharacterised as dividends and only an arm's-length amount of fixed interest was treated as deductible; (Emet La Salud [2019]); and

  • In a Swiss cash pooling case decision of September 2018, it was determined that the liquidity requirement of the borrower created a limit to its long term borrowing (Switzerland vs. A GmbH [2018]).

The new financial transactions chapter X of the OECD Guidelines, released on February 11 2020, included a discussion of when related-party debt can be treated as equity. It refers to the following situations:

  • When profit is not sufficient to service the loan (i.e. to pay the interest and repayments of principal on time);

  • If the debt worsens the borrower's credit rating below the group's target rating, or so much that it would significantly affect the borrower's access to the capital markets; and

  • If the lender could have found a more profitable use for the funds, or if the borrower did not actually need the funds.

As a simplified approach, particularly in the context of advance pricing agreements (APAs) concerning a large number of loans, some jurisdictions have accepted the Basel I and II regulatory capital ratios as an approximation of the maximum arm's-length ratio of debt-to-equity for non-banks. This approach was concluded to be incorrect by the EU General Court in the state aid case of Fiat's group treasury company in Luxembourg, although in the context of a treasury company which is involved in many loans it seems to be justified by the administrative simplicity/non-excessive benchmarking exceptions in the OECD Guidelines.

In years past, HMRC's informal rule of thumb for its inspectors to use was that debt should not exceed equity and that interest cover (operating profit to net interest expense) should be at least three to one.

However, it seems that tax administrations have been moving away from such safe harbours, for example:

  • In Luxembourg, the lump-sum 1% equity rule for companies engaged in intra-group financing transactions has been repealed via a 2016 Circular and replaced by a requirement to determine the appropriate capitalisation of the company on a case-by-case basis. In practice, such determination is made through a credit rating of the borrower and the application of the expected loss methodology;

  • In Spain, the treatment of profit participating loans for companies in the same mercantile group has been changed, and both the fixed and flexible interest on them is now non-taxable. However, the TP rules will continue to apply to related-party profit participating loans that are not within the same mercantile group; and

  • In Ireland, the arm's-length principle was extended to financing transactions through the Finance Act 2019, and recharacterisation is permitted.

With the threat that tax administrations may now requalify debt into equity more easily, triggering non-deductible interest and potential withholding or wealth tax issues, it seems advisable to adopt a prudent approach by including the determination of the appropriate capitalisation in the TP documentation.

Framework for determining the arm's-length capital structure

Both from an economic and a TP perspective, a general capitalisation formula applicable for all assets and activities seems to be excluded. Instead, the appropriate approach could adjust the capital structure for each of the main types of investments, as suggested below.

Financing activities

For intra-group financing activities, the technical approach to determine the minimum equity to cover the credit risk through a credit rating and the expected loss methodology seems to be in line with the new OECD guidance. A similar methodology could be applied for external financing or secondary market acquisition of claims, given that the risk and functional profiles are the same, with the difference that the interest rate on the third-party loan is per se arm's-length and does not need to be further justified.

Equity investments

Although, for now, most countries do not require any justification of the balance between debt and equity funding with respect to the financing of participations, this may change with the application of the OECD's new guidance on financial transactions.

Arguably, there is no credit risk when investing in a participation, to the extent that there is no loan to be repaid. It would follow that it is not appropriate to calculate the equity at risk when making such a loan.

However, there is a theoretical case for using the financial projections for an equity participation to make an investment risk calculation and infer a debt/equity ratio from it in order to achieve the required return on equity because of the level of debt and the interest rate on that debt.

As a result, both a justification of the capital structure and the arm's-length interest rate would need to be provided.

Investments in real estate

The same principles for equity investments may possibly apply to real estate investments.

In this case, the arm's-length ceiling on debt financing is usually determined by referring to the maximum loan-to-property value covenants in comparable third-party real estate loans (e.g. unsecured loans to acquire similar properties in terms of primary/secondary property, location and tenants). A variation – loan-to-acquisition cost – is usually used for loans to finance real estate development projects.

For cross-border real estate investments, the issue may be less relevant in the state of residence if the real estate benefits from an exemption under an applicable double tax treaty, although a possible requalification of excessive interest into dividends may trigger withholding taxes.


If the company does not bear the risks of the underlying investment and limits its activity to intermediary functions, it seems that it should be treated as a mere agent of a principal. In this situation, no minimum equity should be required because no risks need to be covered and the agent should be remunerated by a risk-free return, most likely based on a cost plus with a profit mark-up of 5-10%.

Vanilla loans for a general business purpose

For other loans, a possible approach may be to consider the maximum gearing and minimum interest cover by reference to the financial statements of similar borrowers or the financial ratio covenants in recent loans to similar borrowers, provided such data is publicly available.

Lessons to be learned

Through the new TP guidance on financial transactions, the OECD seems to have handed yet another tool to the tax administrations to challenge lending transactions of the taxpayer. In addition to the interest limitation rules included in Action 4 of the BEPS report, it seems that both the terms and conditions of a debt instrument (i.e. interest rate) and the capital structure (i.e. amount of the debt) of the entity may be questioned, potentially resulting in a requalification of debt into equity.

For the taxpayer, this seems to give rise to a further layer of justifications to be included in its TP documentation, namely a financial analysis of the maximum amount of debt and the maximum amount of interest which would have been foreseen in a similar unrelated transaction.

Obviously these rules will significantly influence entrepreneurs in their choice of funding operations or transactions and one may wonder how much is left of their freedom to manage the affairs of their business according to their commercial priorities.

Alain Goebel



Arendt & Medernach

Tel: +352 40 78 78 512

Alain Goebel is a partner in the tax law practice of Arendt & Medernach. He advises international clients on the tax and transfer pricing aspects of Luxembourg and cross-border transactions, focusing on corporate reorganisations, acquisitions and financing structures.

He has been a member of the Luxembourg Bar since 2002. He acted as president of the Young IFA (International Fiscal Association) Network from 2013-2016 and as Luxembourg's national representative for the International Association of Young Lawyers (AIJA) from 2012-2015.

He has worked as a lecturer in business taxation at the University of Luxembourg from 2009-2016 and is a regular speaker at tax seminars. He has published several papers on tax law, including national reports for IFA and AIJA.

Danny Beeton


Of Counsel

Arendt & Medernach

Tel: +352 62 13 95 102

Danny Beeton is an of counsel in the tax law practice of Arendt & Medernach, where he is the senior economist in the transfer pricing practice.

He advises clients on the determination of arm's-length prices for all types of related-party transactions, including goods, services and intellectual property, but with a special focus on financial transactions such as loans, guarantees, group treasury policies and asset management fees.

His assistance is often sought in the context of transfer pricing compliance and reporting, controversy and planning, and he has provided expert reports in the context of litigation.

He has been a member of two Her Majesty's Revenue and Customs (HMRC) advisory committees, and committees of the Confederation of British Industry and the Chartered Institute of Taxation. Until recently, he was editor-in-chief of the journal, Transfer Pricing Forum.

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