Why Debt-To-Equity Analysis Should Be On Your 'Black Swan' Radar?

What exactly is it?

A debt-to-equity (D/E) analysis determines if the forecasted debt level and capital structure of a company meet the arm's length standard. In other words, it aims to establish an approximation of conditions that are consistent with third-party behavior.

As a simplified illustration, here are just some of the typical transfer pricing (or D/E analysis) questions deliberated in an intra-group loan arrangement:

How much debt could the borrower (related party) have obtained from a third party and service without defaulting on its obligations? How much would a lender have charged? And how much would the borrower be willing to pay? In a nutshell, the arm's length principles should be respected when determining whether a loan is a loan for fiscal purposes. This is in line with Article 9 of the OECD Model Tax Convention, including the corresponding commentaries, and also referred to in the OECD discussion draft relating to the financial transactions issued during the summer of 2018 1.

Why is that important? Well, because any excess debt undertaken by a borrower could be considered non-arm's length and delineated as equity. What's more, interest deductions thereof could be denied for tax purposes.

The Luxembourg angle and the Black Swan theory

In principle, no thin capitalization rules are embedded in the Luxembourg tax laws. However, the current administrative market practice generally consists of the D/E ratio of 85-15 for intra-group financing of participations. 2

Not to be forgotten, the interest limitation rules in Luxembourg, effective from January 2019 and where taxpayers will be faced with a fixed ratio rule to determine tax deductible borrowing costs, do not eradicate D/E analysis requirements.

In the absence of domestic legislation addressing a company's capital structure, we cannot exclude the risk that the Luxembourg tax authorities may enhance their views in the future with respect to thin capitalization / D/E ratio approaches in Luxembourg. Obviously, the longstanding administrative practice based on the principle of legitimate trust and legality should and will, without any doubt, be used by taxpayers and their trusted advisors in the future to mitigate the risks of successful challenges by the tax authorities. However, under the Black Swan theory 3, it may be anticipated that, going forward, the local tax authorities seeks more information and focuses even more on these points (e.g. in tax audit reviews).

Holding...