Some practical thoughts (and a few unpractical ones) about debt
Debt is one of the most contentious and emotive issues there is. In some cultures and religions debt is tightly restricted, or at least strongly discouraged, and there are hundreds of proverbs and quotes on the subject dating back centuries. While some are amusing (such as Earl Wilson’s, “If you think nobody cares if you're alive, try missing a couple of car payments”) the general mood is summed up in the famous words of Polonius in ‘Hamlet’: “Neither a borrower, nor a lender be.”
In the modern commercial world, of course, that’s not an option. And when it comes to documenting and pricing intercompany debt for transfer pricing and other purposes, there is a particular challenge that must be dealt with.
You might start by asking which is more important: the commercial terms of the debt (contractual provisions such as repayment date, fixed or floating interest rates, currency interest payment dates and security) or the economic substance (such as the borrower’s credit rating and any implicit group support), but that’s the wrong question.
It’s not a matter of ‘form over substance’ or ‘substance over form’: they are intrinsically connected, and both must be aligned in order for an MNE’s position to be robust from a transfer pricing perspective. This is for two main reasons.
First, it is arguably impossible to delineate financial transactions through an analysis of the parties’ conduct and the credit rating of the borrower. Fundamental terms such as repayment dates, interest rates (fixed or floating) and security or ranking cannot be deduced from merely observing the actions of the respective parties. Second, from a legal entity perspective, corporate governance issues tend to be more transparent and immediate for financial transactions than for other transaction types. That means that directors need to be clear on the contractual terms of intercompany debt in order to show that they have complied with their duties.
In addition to considering the appropriate commercial terms and economic substance of intercompany debt, there’s a third factor which MNEs need to consider: the legal form of the debt. (Note that the legal form of the debt will not necessarily affect the commercial terms or the allocation of risk. In other words, it is usually possible to give effect to any given set of commercial terms, irrespective of the legal form.)
Common options as regards the legal form of intercompany debt include:
- Loan agreements (including a bilateral loan agreements between a single lender and a single borrower, as well as a multi-party loan agreements which document the terms of multiple loans between different parties)
- Loan notes or bonds (these terms are often used interchangeably)
- Deep discount bonds (also known as zero coupon bonds)
- Deeds of acknowledgment of debt
- Promissory notes
- Terms incorporated into trading agreements / transactional documents.
By the way, an important point about the legal term ‘promissory note’: terms such as this may have very different meanings and legal implications, depending on the applicable law. For example, under English law, a promissory note is regarded as a type of ‘negotiable instrument’ which is transferable by delivery and ‘endorsement’. The relevant formalities may create unnecessary complications and administration if used in an intra-group context.
The legal form of the debt can affect many things, including:
- The impact of withholding taxes on interest
- Corporation tax treatment
- Regulatory treatment
- The legal formalities required for the documentation of advances, repayments and assignment.
On reflection, maybe Polonius had a point. But this is the world we live in, and it’s our job to help the multinational groups that we work for and advise to operate in it successfully, without incurring unnecessary risks. And, as another Shakespeare character pointed out, “Things done well, and with a care, exempt themselves from fear.”
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