handbook-tb

Peter A. BarnesFrom the perspective of the country in which the interestexpense arises, the key question is whether it is relevant that therecipient of the interest payment is related to the payer. The answermay be yes:‣ ¾ There is a potential for transfer pricing abuse, and disallowingsome or all of the interest paid to a related party is a preventivemeans of addressing that potential abuse;‣ ¾ Even if the amount of interest paid is appropriate (and wouldbe allowed if paid to a third party), there is a concern that theinterest may not be properly taxed in the hands of the recipient.To prevent base erosion on a global basis, the country of thepayer may limit the interest deduction.On the other hand, treating related-party interest less favourablycreates costs. In particular:‣ ¾ As discussed previously, there are non-tax reasons as well as taxreasons why an investor may choose to invest partially with debtand not wholly with equity. If tax rules impose additional costson the use of debt, that may affect investment decisions; not allinvestors will be willing to bear those additional tax costs;‣ ¾ Enforcing special rules on related-party lending creates administrativecosts because it can be difficult to define what a relatedparty is for purposes of the rule. For instance, a nominal lendermay be an unrelated party; however, the loan would not havebeen made but for a deposit with the lender from a party relatedto the borrower. Or a party related to the borrower may offera guarantee to the lender; such guarantees vary considerably,from formal and binding agreements to “comfort letters” thathave no legal consequences. If special rules are applied torelated-party lending, there will need to be anti-avoidance rulesto prevent abuse.Another factor to consider is whether the tax administrationof a country can minimize the risk that related-party lending wouldabuse the tax system. The risk of related-party lending being onnon-arm’s length terms can be addressed by stronger transfer pricingenforcement, including the possibility of published permissible178