Most business and individuals engaged in business activities are familiar with the concept of financing. This is because it is the most direct route of acquiring funds to support various aspects of their operations, be it daily activities or investments.
Like other organisations, those with established business relationships also engage in financing activities. The most common arrangement is whereby a parent company provides funds to its subsidiaries.
Parent companies are responsible for financing their subsidiaries either through subscription of equity and/or debt or arranging with external lenders such as banks to lend directly to their subsidiaries.
As a practice, parent companies often issue interest free loans to their subsidiaries. These loans are known as intragroup financing. Financing activities among related entities also occur among subsidiaries, sister companies and/or associates based on convenience.
Intra group financing is preferable because it is convenient, less risky and has favourable terms compared to acquiring funds from external sources. In some instances, the funds are provided without interest charges.
This way, the financier can support the related party without resorting to equity which would alter the shareholding structure.
Companies may also finance each other by incurring third party expenses on behalf of related entities. This is commonly known as recharge of costs among entities. This means that, the price charged between related entities is like that charged between unrelated entities for similar arrangements of transaction.
The conclusion may be based on the conformity of the loan to the definition of pass through as per the OECD Transfer Pricing guideline, 2021 as there is no interest charged among the related entities.
As correct as the analysis of the arm’s length nature of such transaction may be, taxpayers who enter in financing arrangement with their associates ought to consider the time lapse between issuance of funds and reimbursement of those funds.
Regulation 10(3) of the Tax Administration (Transfer Pricing) Regulations 2018 (TP Regulations), requires the determination of arm’s length interest rate for such financing whether the financing assistance is issued with or without consideration. Therefore, if interest is not charged on the transaction, the Tanzania Revenue Authority (TRA) during audit will determine the arm’s length interest rate that would have been charged for such financing by an independent party.
The determined interest is termed as deemed interest and will be subjected to 10 percent withholding tax as per the requirement of the Income Tax Act, 2004.
On the same note, the deemed interest will in turn result to penalty as per the requirement of Section 79(2)(c) of the Tax Administration Act, 2015 where any transfer pricing adjustment is subjected to 100 percent penalty of the tax shortfall.
It is important to note that determination of interest by the taxpayer or by TRA solely depends on the duration in which the financing assistance has been reimbursed by the lender to the borrower.
The tax laws and regulations are silent on how much time is long enough for the financing assistance to translate to interest free loan. However, one year has been used as the best practice for such a transaction.
Therefore, taxpayers should be aware of the arm’s length interest rate in their intragroup financing agreement as per the requirement of Regulation 10(3) of the TP Regulations, 2018 and whether the repayment period exceeds twelve months period to avoid non-compliance with tax laws and regulations and subsequent penalties and interests.
In analysing arm’s length nature of intragroup financing, the taxpayer should also consider three key factors provided under paragraph 13.6 of the Transfer Pricing Guidelines, 2020.
These factors include firstly consideration of conditions of the transaction such as the nature and quantum of the debt and interest, and the nature of the repayment of debt and interest.
Secondly, the circumstances surrounding the transaction, such as creditworthiness and how the economic condition of the jurisdiction affects both the lender and borrower, as well as the borrower’s ability to obtain finance from a third party.
Thirdly, the confirmatory test, which includes testing whether the loan was delivered and whether the loan and interest charged are at arm’s length.