The recent debt-equity conundrum in transfer pricing

By Samwel Ndandala and Waziri Jumanne

All investors are, to some degree, tax sensitive. Whether investing in a start-up, or taking over a brownfield investment, smart investors consider how they will eventually exit their investments. The tools they use to deploy finance will therefore differ, and so would the tax implications of such financing. For example, debt is easier to inject to extract that equity. So short term investors may opt for debt instruments as opposed to equity.

Debt agreements are also easier to execute, allowing fluidity and speed to capture opportunities; and also provides certainty of repayment because debt repayments are not pegged to profitability.

On the other hand, equity instruments are more patient investing tools as returns come only when the company is profitable. However, equity injections have the benefit of not imposing interest costs on the company, giving it a longer runway to achieve profitability.

Equity is also harder to extract as the company needs to go through legal processes to either wind down the company or reduce its equity. Unlike debt, there are no restrictions on how much equity one can have before they are subject to anti-tax avoidance rules such as thin-capitalisation rules.

In other words, the less leveraged the company, the less likely it will be to pay extra tax as a result of anti-avoidance restrictions.

That seemed to be the common understanding. But recently, there has been an increased scrutiny over how companies are financed and the tax implications of the same.

Some large companies have been subjected to revenue authority audits that have questioned their balance sheets and the characterization of debt or equity that they are reporting.

We have seen revenue authorities attempt to recharacterize debt and equity or vice versa. This is not a Tanzanian phenomenon alone, but rather a global international tax phenomenon. The result of such characterization often is significant taxes and associated penalties.

In order for a taxpayer to be on the right side of the law, and of this conundrum, three things are important.

Demonstrate commercial rationale

A company must pick a financing instrument that makes commercial sense. You do not want to put the tax cart before the business and commercial horse. The business has to decide if the best instrument for it is debt or equity.

Factors to consider may include the tenure of the required financing. For example, you do not want to inject equity to cater for short-term financing needs. Other factors may be the nature of the financier, and the nature and stage of the investment.

A new business that needs a bit of a runway to mature into a cashflow positive venture may not be able to afford debt with tight repayment schedules, but a mature one with positive cashflow may.

Another component to think about is what the financing is for and the capacity for the entity to carry the resultant financing costs. The terms of such financing instruments are also important. Both equity and debt instruments can impose challenging conditions that may hamper the performance of the business. The key issue here therefore is that the commercial considerations of the business must be the guiding yardstick used to choose from the financing options available, not the tax advantages.

Demonstrate provable substance

Once the commercial rationale is locked in, one must show that it was the commercial factors that dictated the financing options chosen. Substance in this case means that what is on paper aligns with the actual realities of the business. When an instrument is chosen, the actual implementation of it must reflect that choice.

If debt is chosen for example, there must be a formal loan agreement, with defined terms of payment, interest rates and tenor. Because some of these transactions happen between related parties, some of these details are often passed-over or relegated.

It is crucial to remember that tax authorities do not have the benefit of inside information of your company, so before executing a loan arrangement, an agreement must be in place, central bank notifications / registrations must be made and all internal processes must align, in substance, to the agreement that has been signed between the parties. Conversely, if the loan requires monthly payments, one expects that those payments are made and reported accordingly, with exceptions being addressed through the legal process as you would in a commercial agreement.

In transfer pricing parlance, substance means the delineation of the actual financial transaction. Is there a presence or absence of fixed repayment dates? Is the obligation to pay interest enforced or enforceable? Does the funder maintain a status similar to regular corporate creditors? Are other financial covenants and securities present with the lender? What about the ability of the lender to repay the principal, interest and what are the source of such payments? And is the borrower able to source funding of similar nature (loans) from an unrelated lending institution? Is there a credible justification for getting that loan? Did the borrower actually receive the funds? All these questions buttress or weaken the substance of the transaction being reported.

In recent transfer pricing audits, most of the businesses having debt financing arrangements with related parties have been subjected to the delineation tests mentioned above, and failure of the debt arrangement between two related parties to qualify the above tests would always result into a recharacterization of the debts to equity followed by disallowances of the full interest expense thereon.

One would quickly think that to avoid challenges in debt financing, they should probably enter interest free loan arrangements or agree to defer repayments of the principal and interest either to the maturity date or any future date. In absence of proper reasons for these kinds of arrangements, this option runs into challenges.

It is easy for the revenue authority to deem interest and impose a 10% withholding tax on the deemed interest. Whilst this is still a contentious practice, it is important to consider in determining the financing structure of your investments.

Document defensively

At this point, your commercial rationale is credible, and so is your substance. The next step is to document both in a way that defends your position.

Remember, it is the paper trail that wins the case for you in the end. The obvious starting point is that the agreements creating debt or equity instruments should be clear and reflective of the operational substance.

But more than that, the transfer pricing documentation should also be clear and comprehensive in explaining the functional profile of both the lender and borrower. In addition to that, the supporting information should be available and accessible in case they are required.

One challenge that taxpayers have is around maintaining sufficient information both at the time the instrument is created but also during the time the instrument is executed. It follows therefore that when subjected to audit, the taxpayer is unable to defend its position due to limited information.

This is why it is important to think defensively. Information that is often not retained such as negotiation positions, minutes of meetings where financing conditions are agreed, cases where third party lenders provide terms for comparative financing all can be useful to make a case that the financing arrangement should pass the anti-tax avoidance test.

With transfer pricing, you do not document to put something on record, you document to defend a position from the inevitable future audit.

This article was co-written by Samwel Ndandala (Tax & Legal Partner) and Waziri Jumanne (Tax & Legal Senior Manager) with Deloitte Consulting Limited. The views presented are their own and not necessarily those of Deloitte. They can be reached at [email protected] or [email protected].