External loans to be reclassified as internal loans

In the state budget, the proposed interest limitation will be extended in that external loans will be regarded as internal loans in a number of contexts.

In the state budget, the interest limitation rule was extended in that external loans can be regarded as internal loans in a number of contexts. If, for instance, a related party has provided security for the debt, the borrowing company's external loan is to be reclassified as an internal loan. In many industries, such as the energy industry and the real estate industry, cross-collateralization is a common way of financing the business. These group companies will be hit unreasonably hard with the new interest limitation rules. It is very unfortunate when the wording of an act as well as its legislative background allow for the provision of security, letters of comfort and positive or negative pledges to imply that an external loan might be reclassified as an internal loan.

LIMITATION OF THE DEDUCTABILITY OF INTEREST EXPENSES ON INTRA-GROUP LOANS – THE MAIN ASPECTS
As referred to in previous newsletters, it was proposed in the state budget to limit the deductibility of interest paid between taxpayers that are related parties (internal interest). The provision is adopted and will enter into force from 1. January 2014. The main aspects of the interest limitation rule are as follows:

  • The basic principle is that the interest limitation rule applies to loans between related parties, i.e. internal loans. In order to be regarded as a related party, ownership or control of at least 50 percent is required.
  • The rule allows for the provision of security, letters of comfort, positive or negative pledges, and back-to-back agreements to imply that an external loan might be reclassified as an internal loan.
  • Deduction of interest expenses exceeding 30 percent of the amount of a specifically defined result, is denied.
  • When calculating the interest deduction limit, the tax result before interest deduction limitation, is used as a basis. Net interest expenses and tax depreciations are to be re-allocated in such a basis. 
  • If the new interest expenses exceed NOK 5 million, the interest deduction limitation is to apply in full.
  • Denied interest deduction may be brought forward and deducted in the next ten income years.
  • The changes are given effect from the income year 2014.

RECLASSIFICATION OF EXTERNAL LOANS AS INTERNAL LOANS IF RELATED PARTIES HAVE PROVIDED SECURITY

Background

According to the rule, external loans in which "a related party has provided security for the debt" are regarded as internal loans. Reclassification of an external loan as an internal loan as a result of the provision of security was new in the state budget, and the provision of security from related parties was not mentioned in the consultation paper.

It was the Directorate of Taxes that proposed, in its consultation statement, that related party guarantees should imply that external loans were regarded as internal loans. The reason provided was related to aspects of evasion:

"The Ministry of Finance has assumed that some external loans are to be regarded as internal loans. In our opinion, it might be appropriate if this is also assumed for external loans for which a parent company guarantee exists, and possibly other intra-group loan guarantees. Without such an extension, the rule will be too easy to evade. In such cases, it is the internal guarantor that does in fact take the risk, meaning that the borrower in question may raise much higher external loans than what the borrower has the capacity to raise on its own."

The Ministry of Finance has provided the following reasons for the provision:

"Such security is provided in cases such as when a company receives a loan from an independent party, for example a bank, against a related company, typically the parent company, providing a guarantee for the debt. A guarantee from a parent company might give a subsidiary the opportunity to raise a higher loan with an independent lender than what the subsidiary would have received without the guarantee. Thus, the size of the interest expenses that are deductible upon the assessment of the subsidiary might increase. The increased debt could have been raised as an internal loan directly from the parent company, but not as external debt without a parent company guarantee."

The provosion in further detail. The Ministry of Finance rejects an intermediary solution

The interest limitation rule implies that the provision of security from related parties (often parent companies) means that all interest payments in relation to the loan are regarded as internal interest, even if a part of the loan could have been raised by the subsidiary on the same conditions without security.

However, the Ministry of Finance rejects an intermediary solution in which the loan is divided into an external and an internal part:

"If the security relates to the entire loan, all interest payments related to the loan will be regarded as internal interest, even if a part of the loan could have been raised by the subsidiary on the same conditions without security. A division of the loan, meaning that only the interest on the part of the loan that has been granted because of the parent company guarantee is to be regarded as internal interest, will be difficult to carry out in practice. The solution would also be poor in relation to the solution for actual internal loans. For the latter type of loans, all interest expenses are regarded as internal interest, even if the borrower could have raised a part of the loan externally on the same conditions."

Nor does the Ministry of Finance allow for an intermediary solution in which an external loan is regarded as having been raised partly by the borrower and partly by the guarantor. Instead, the draconic solution of regarding the entire loan as an internal loan is chosen.

In our opinion, the provision is way too extensive. The starting point for the limitation rule is that internal loans are to be affected. Undoubtedly, an external loan means interest expenses for the borrower and should be fully deductible. It is important not to lose sight of this in the eagerness to secure the Norwegian tax base.

The Ministry of Finance's comparison with internal loans that could have been financed externally is not very relevant. In case of an external loan, with security provided in the group, an external loan has in fact been raised. Thus, it is documented that the group has borrowing capacity.

If an external loan has been granted against the provision of security, the aspects of evasion cannot indicate that the external loan must be reclassified. As emphasised by the Directorate of Taxes itself, the risk, if any, is that one group company raises a higher loan than the lender has the capacity to raise on its own, and that it might be the guarantor that actually undertakes the risk. The only consequence of reclassification, if any, is division of the loan, in which the loan is regarded as having been raised partly by the borrower and partly by the guarantor. Regarding the entire loan relationship as an internal one, with access to deny all interest, extends far beyond the interests invoked by the Directorate of Taxes and the Ministry of Finance.

Instead of proposing interest limitation rules per company, the rules should relate to the entire group, in which the borrowing capacity of the group as a whole is decisive for the right of deduction. However, this is not taken into account by the adoption of rules.

Letter of comfort

Based on the interest limitation rule, the provision of security or a guarantee from the parent company implies that the interest is deemed internal. In the legislative background of the act, the ministry also allows for informal security, such as a so-called "letter of comfort", to be regarded as security under the provision, the consequence being that the loan is deemed internal, ref. proposition 1 LS, p. 127:

"The security must be based on a legally binding agreement with the lender. In a group it is common that the parent company provides statements etc. on financial support to the subsidiary's lenders (letters of comfort etc.). Based on a specific interpretation, such provision of security may be regarded as provision of security under this rule, and imply that an external loan is deemed to be have been granted from a related company. Nevertheless, this only applies if the provision of security has affected the subsidiary's borrowing opportunities compared to what could have been achieved in the market if such security had not been provided."

Based on the preparatory work, it seems as if the subsidiary's borrowing opportunities in the market must be assessed on the basis of discretion. If such assessments are to be the main rule, we are again left with what the ministry states that it wants to avoid by introducing such a limitation rule: that an arm's length assessment must be made.

Security provided by a subsidiary

A subsidiary's provision of security/a guarantee for the loan of a parent company will also be covered by the interest limitation rule, the consequences being that the parent company's loan is deemed to be internal, and that interest is denied under the interest limitation rule.

However, security provided by a subsidiary is to a certain extent exempted from this regarding to supplementary regulations on the limitation of the deduction of interest expenses in communities of interest. The regulations govern cases in which security may be provided from underlying companies / subsidiaries without the loan being considered to be an internal loan.

Read more about this exemption in our newsletter here.

BACK-TO-BACK LOANS

A loan between related parties that is granted indirectly through an independent party (a so-called "back-to-back" loan) will also be regarded as an internal loan. For instance, a company may raise a loan in an independent bank. At the same time, the parent company of the company deposits an equivalent amount in the bank. In such a situation, the loan to the bank is to be regarded as an internal loan under the interest limitation rule. However, this does not apply if there is no connection between the lending and the borrowing, meaning that a third-party loan does in fact exist.

It is assumed that a specific assessment must be made as to whether there is an adequate "link" between the parent company's deposit in the bank and the bank's lending to the subsidiary.

Published in October 2013 (edited December 2013)