OVERVIEW: Interest rates on intragroup loans for real estate assets: the end of mezzanine debt?
Funding is crucial for the real estate industry. Following the financial crisis, loans from non-financial institutions and investors with shareholder loans have increased. Indeed, the banks, which previously provided significant amounts of debt, reduced their commitment. While loans from third-party non-financial institutions to real estate groups are inherently arm’s length, shareholder loans (SHLs) are not and require transfer pricing analysis.
Due to the difficulty in obtaining external financing, investors in the real estate sector often depend on SHLs to finance their real estate acquisitions. In today’s market, senior lenders make up no more than 60% of the loan-to-real estate asset value ratio. And in recent years, as recourse to self-financing has increased, the level of control by tax authorities and the Organization for Economic Co-operation and Development (OECD) over transfer pricing analysis for financial transactions increased.
Taxpayers face more inquiries and challenges from tax authorities. While it is understandable that there are disputes around the arm’s length nature of intragroup debt instruments in countries that have recently implemented transfer pricing rules, the same trend is observed in countries like Australia and Germany with entrenched transfer pricing regimes.
Recent decisions to reduce the interest rates of real estate structures
As illustrative examples, I draw attention to two recent decisions of the German and Luxembourg courts (Finanzgericht Köln, June 29, 2017, N ° 10 K 771/16, and TA du Grand Duchy of Luxembourg, October 22, 2018, No. 40348). In both cases, the German and Luxembourg judges rejected the agreements concluded between related companies to acquire real estate assets, arguing that they did not comply with the arm’s length principle.
This means that excessive interest is treated as a hidden distribution of profits or a hidden distribution of dividends, potentially subject to withholding tax.
While the two decisions have common factors (the acquisition of real estate assets), they are structured differently. The German case concerns the purchase of a real estate company (PropCo) by a German acquisition company (GermanCo) from a third party seller.
The structure after the acquisition was as follows:
The financing instruments used in the structure were as follows:
A comparative study was carried out by a transfer pricing advisor two years after the transaction. However, the court ignored the comparative study on the grounds that it was not prepared at the time the transaction was completed.
The Luxembourg case is simpler. There was only one debt instrument in the structure: an SHL used to finance the acquisition of real estate in France. The SHL was not guaranteed with a fixed interest rate of 12%.
The structure can be summarized as follows:
The Luxembourg tax administration reduced the interest rate to 3.57% and 2.52% and ignored the two comparative analyzes prepared by two different advisers. Local tax authorities have considerable leverage because although the OECD has established the arm’s length principle, it has not provided any practical guidance for intragroup lending.
Use of an uncontrolled comparable internal price without possible adjustment
Applying the arm’s length principle to intragroup debt amounts to considering the lender and the borrower as separate parties. The OECD Transfer pricing guidelines provide five different methods for determining the arm’s length nature of related party transactions. For financing agreements, the methods commonly used are the internal or external Uncontrolled Comparable Price (UPC).
Internal CUP means reviewing loans that related parties have with third parties. In real estate, it is generally a bank loan or a loan granted by a non-financial institution third to the transaction. This third party loan can be used as a comparable.
However, in most cases, the interest rates charged on a third party loan cannot be applied without adjustments. The main reason for this is the difference in nature between the two types of loans. Bank loans are different from SHL in terms of maturity, priority and security. Bank loans are generally senior and secured / asset-backed and often have a shorter maturity (less than 10 years and around five years).
Therefore, even though the interest rate charged on the bank loan could potentially be comparable, it still requires comparability adjustments. As recommended by the OECD Transfer Pricing Guidelines, comparability adjustments are necessary because they “increase the reliability of the results”.
The adjustments to be made must take into account that:
- the intra-group debts are not senior and are subordinated to the bank loan;
- intra-group debts do not include any pledge or guarantee;
- the maturity of intra-group debt is longer than that of bank debt.
To take into account the difference in priority, maturity and / or security, a premium or margin is added to the interest rate of the bank loan.
In the German decision, the financial court ruled that the recognition of a loan relationship between affiliated companies does not require the provision of a guarantee by the related borrowing company.
Surprisingly, the court added that neither the lack of collateral nor the subordinate nature of SHLs can justify a risk premium when performing benchmarking of interest rates. For the court, if the purchase value corresponds to the real value of the real estate assets, in the event of default, the third bank is not able to withdraw the full amount of the pledge. The excess between the maximum that the bank can withdraw on the collateral and the collateral constitutes a security on the SHL. Thus, the interest rate on the SHL is capped at the level of the bank loan without any possible adjustment.
This is in line with the position taken by other tax authorities such as the Australian authorities, and with the current trend observed in Germany.
On December 11, 2019, the German Ministry of Finance released a draft law on the implementation of the EU Anti-Avoidance Directive. Under the new rules, interest rates are capped at what a third-party lender would have offered to the multinational group. Taxpayers always have the option of demonstrating that the arm’s length interest rate is different, but it becomes a difficult exercise.
If adopted, this measure should represent a fundamental change in the real estate sector.
Difficulty finding a comparable uncontrolled external price
An alternative to the internal CUP is the external CUP. However, it is difficult to find comparables, because when government bonds are issued in a primary market and then traded in a secondary market, private placements and bank loans are generally not traded after issuance. This means that information on private placements of third parties or bank loans, which can be used as comparables, is scarce.
An alternative to a loan search is a bond search. The following information is used for the search:
- the main;
- duration or maturity;
- interest rate: this can be the yield to maturity, the worst-case yield and the current margin. The yield to maturity is the percentage rate of return paid if the security is held to its maturity date. The calculation is based on the coupon rate, the term to maturity and the market price. It assumes that coupon interest paid over the life of the security is reinvested at the same rate. The worst-case yield on a corporate bond is the lowest yield a buyer can expect among reasonable alternatives, such as yield to maturity, redemption yield, and redemption yield. The current margin is the current or last known spread above the benchmark used to determine the coupon for the current period;
- call clause (for bonds) or reimbursement clause.
Although databases such as Bloomberg have yield curves, geographic location and available currencies are limited to the US market. For example, on Bloomberg there are yield curves for US real estate investment trusts with credit ratings between BBB + –B-. Regarding BBB ratings, interest rates are lower, between 2% and 4%; while for B ratings, yields range from 8% to 13%, depending on maturity.
For borrower credit ratings, the databases used for the analysis of credit risk on European private companies exclude the real estate sector. Indeed, “the annual accounts of real estate development and investment companies only give a partial description of the dynamics of these companies and therefore of their probability of default, because their financial health often depends on a particular development such as project financing. “This makes it difficult to calculate the probability of default of a mortgage company.
To improve the reliability of such databases, it is important to take into account elements such as rental income or the experience of the management team.
For real estate groups, this prompts us to make a New Year’s resolution: when organizing new transactions, transfer pricing reports should be prepared at the same time. The transfer pricing study should always first consider the internal debt of third parties, and then reject or adjust it as necessary, to produce a solid conclusion that can survive the scrutiny of the tax administration.
Andrea Leho is a transfer pricing specialist at Macfarlanes.
The author can be contacted at: [email protected]
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.