This content is from: France

French Tax Authority must change interest rate audit policy

Gianmarco Monsellato and William Finan, at TP Week sponsor Taj, argue for a policy change on intra-group interest rates

Recent experience with the French Tax Administration (FTA) on audits of internal or intra-group loans suggests that the FTA’s auditing methodology is inconsistent in several important aspects with generally accepted principles of finance and the international rules which apply to these transactions.

Like other tax administrations in the European Union (EU), the French government recently issued updated regulations regarding what are called thin capitalisation or thin cap rules. The standard approach to setting an interest rate in the open market is for potential lenders to determine a borrower’s creditworthiness. In the intra-group context this translates into determining the market risk spread over a base lending rate based on the standalone creditworthiness of the affiliate, considering the maturity of the loan and other conditions.

Included into the credit scoring process is the amount of debt being borrowed. This approach to setting the intra-group lending rate can be called the separated approach, meaning that that affiliate is reviewed on a stand-alone or separate basis with no guarantee, implicit or explicit, from the parent company.

The FTA, however, seems to have adopted an alternative approach to determining the intra-group lending rate based on what can be called the integrated approach. This approach treats all the members of a multinational group as a single, integrated economic unit. In applying this approach the FTA implicitly creates a guarantee from the lending parent to its affiliate in order to justify artificially reducing the credit risk spread hence lowering the intra-group lending rate.

In some instances the FTA has even gone further in seeking ways to lower the intra-group lending rate by arguing that the credit risk spread should be determined even before the loan amount is considered. Such an approach is obviously inconsistent with how the credit scoring process works where the ability of the borrower to bear additional debt is considered in establishing the creditworthiness of the borrower and hence is factored into setting the market interest rate on the loan. (Imagine if you or I walked into our local bank and asked to borrower 100M euros and the bank evaluated our creditworthiness before considering the amount of loan – this effectively is what the FTA approach does.)

If the FTA’s integrated approach to setting intra-group interest rates, even absent carrying it to the extreme of ignoring the borrower’s ability to bear the additional debt, to setting intra-group interest rates becomes widely adopted in the EU and elsewhere, then a French group parent lenders would generally have to lend to their affiliates at interest rates inconsistent with the independent risk profile of the borrowing affiliate. Thus, French group lenders would then be caught in a situation where, per the FTA’s methodology, they cannot charge market interest rates on their intra-group loans and French tax revenues would be lower.

This outcome illustrates one important reason why the separated approach is the prevailing one in determining the results for intra-group transactions. The separated approach is also preferred over the integrated approach from the standpoint of being consistent with the generally accepted international norm, the arm’s length principle. The arm’s length principle would evaluate a groups’ affiliates a standalone basis.

Now is the time for the administration to carefully reflect on how intra-group interest rates should be audited in France. Considering generally accepted principles of finance and international rules, the answer is quite evident -- applying the separated approach as the basis for its auditing methodology leads to the right answer. Once having validated this approach, it would be helpful to French groups if the FTA when take the lead in aligning other EU member states’ audit practices to follow apply the same approach. It would be in France’s economic interest to take this step.

Gianmarco Monsellato, managing partner, and William Finan, transfer pricing partner, Taj, a member of Deloitte Touche Tomhatsu

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