Companies within the same multinational group often lend money to one another instead of borrowing from a bank. These loans may be used to build factories, expand operations, or meet working capital needs. The interest rate and loan terms should be similar to those offered by independent lenders.
Suppose ABC Manufacturing Inc. is a U.S. parent company that lends $5 million to its Hong Kong subsidiary. The Hong Kong subsidiary uses the loan to help build a new manufacturing facility.
Because the loan is between related companies, the interest rate charged on the loan is an important transfer pricing issue.
Under the arm’s-length principle, the interest rate and other loan terms should generally be comparable to those charged by an independent bank or lender for a comparable loan.
Suppose an independent lender would charge 6% annual interest on a similar $5 million loan.
The annual interest would be: $5,000,000 × 6% = $300,000 (A)
Therefore, at the arm’s-length rate, the Hong Kong subsidiary would pay $300,000 of interest to the U.S. parent each year.
Now suppose the U.S. parent charges its Hong Kong subsidiary only 1% interest.
The annual interest would be: $5,000,000 × 1% = $50,000 (B)
The difference between the two interest amounts from arm’s length and the actual price charged is as follows:
$300,000 (A) − $50,000 (B) = $250,000
So, the Hong Kong subsidiary pays $250,000 less interest than it would have paid at the 6% arm’s-length rate. Because the subsidiary has $250,000 less interest expense, it retains an additional $250,000 of profit.
At the same time, the U.S. parent receives $250,000 less interest income.
In simple terms, $250,000 of profit has shifted from the U.S. parent to the Hong Kong subsidiary.
Let’s understand this in the following simple table:
Interest Income Comparison
| Arm’s-Length Rate: 6% | Actual Rate: 1% | |
| Loan amount | $5,000,000 | $5,000,000 |
| Interest rate | 6% | 1% |
| Interest paid by Hong Kong subsidiary | $300,000 | $50,000 |
| Interest income received by U.S. parent | $300,000 | $50,000 |
| Additional profit retained in Hong Kong | $0 | $250,000 |
Now let’s see how the different interest rates affect the group’s taxes.
For this simplified example, assume:
U.S. corporate tax rate = 21%
Hong Kong profits tax rate = 16.5%
These rates are used only to illustrate the potential effect of allocating more profit to a lower-tax jurisdiction.
As discussed above, if the Interest Rate Is 6%, the U.S. parent receives $300,000 of interest income.
$300,000 × 21% = $63,000
Therefore, the simplified combined tax shown here is: $63,000
If the Interest Rate Is 1%
The U.S. parent receives only $50,000 of interest income.
$50,000 × 21% = $10,500
The Hong Kong subsidiary pays $250,000 less interest than under the 6% rate. This amount becomes additional taxable profit in Hong Kong:
Additional Hong Kong profit = $250,000
$250,000 × 16.5% = $41,250
Therefore:
$10,500 U.S. tax + $41,250 Hong Kong tax = $51,750 combined tax
Let’s understand this in the following simple table format:
Simple Tax Comparison
| Line | Calculation | 6% Interest | 1% Interest |
| A | Interest rate | 6% | 1% |
| B | Loan amount | $5,000,000 | $5,000,000 |
| C = A × B | Interest income to U.S. parent | $300,000 | $50,000 |
| D | U.S. tax rate | 21% | 21% |
| E = C × D | U.S. tax | $63,000 | $10,500 |
| F | Additional profit retained in Hong Kong | $0 | $250,000 |
| G | Hong Kong tax rate | 16.5% | 16.5% |
| H = F × G | Hong Kong tax on additional profit | $0 | $41,250 |
| I = E + H | Combined tax shown in this example | $63,000 | $51,750 |
The difference in combined tax is:
$63,000 − $51,750 = $11,250
Therefore, under these simplified assumptions, charging 1% instead of the 6% arm’s-length rate shifts $250,000 of profit from the U.S. parent to the Hong Kong subsidiary. This results in $11,250 less combined tax in this simplified comparison.
The U.S. tax decreases by:
$63,000 − $10,500 = $52,500 (A)
The Hong Kong tax on the additional $250,000 of profit is:
$250,000 × 16.5% = $41,250 (B)
Therefore:
$52,500 (A) − $41,250 (B) = $11,250 less combined tax.
This shows that by charging a 1% interest rate, the U.S. company can shift the profit to Hong Kong and pay less U.S. taxes.
This example shows why intercompany financing and interest rates are important transfer pricing issues. When related companies operate in countries with different tax rates, the interest rate can affect the profit reported in each country.
However, a multinational group cannot simply choose an interest rate that produces the lowest tax. The interest rate and other loan terms should generally be supported by the arm’s-length principle and the facts of the particular loan, such as the borrower’s creditworthiness, loan amount, maturity, currency, security, and other relevant terms.
If the IRS determines that the intercompany loan terms do not reflect an arm’s-length arrangement, it may adjust the transaction under IRC Section 482. The U.S. parent could also face additional tax, interest, and potentially penalties, depending on the circumstances.