Intercompany Financing: When Intra-Group Loans Are Recharacterised

Intercompany loans usually start as a practical call. Capital is raised at the holding level and pushed into operating entities as debt. It keeps things flexible, helps with cash flow, and interest deductions make the structure look efficient early on.

The problem is, nothing really tests this setup in the beginning. The pressure comes later. Typically during investor diligence, refinancing, or a tax audit. And when that happens, the conversation shifts quickly. It is no longer about whether a loan agreement exists. The question becomes much simpler and harder at the same time. Would an independent lender have done this on the same terms?

That is where many structures start to come apart.

The Regulatory Lens: How Intercompany Financing Gets Tested

Intercompany financing is not looked at through a single rule. It is tested through multiple frameworks that overlap and reinforce each other.

At the centre is the arm’s length principle. The idea is straightforward. Would a third party have agreed to this loan on similar terms?

Even if that holds, BEPS Action 4 steps in to limit how much interest you can actually deduct. In most cases, this is capped at 30 percent of EBITDA, which means even commercially valid debt can stop being tax efficient.

Then there are BEPS Action 2 anti-hybrid rules, which deal with mismatches across jurisdictions. If a payment is deducted in one place but not taxed in another, the deduction can simply be denied.

On top of that, thin capitalisation rules look at whether the level of debt itself is excessive. Ratios like 2:1 or 3:1 debt-to-equity are commonly used as reference points, especially where interest flows into lower-tax jurisdictions.

And finally, treaty benefits are not automatic. Under the Principal Purpose Test (PPT), they can be denied if the structure looks primarily tax-driven.

All of these rules are essentially asking the same thing from different angles. Does this financing reflect commercial reality, or just its form?

The Real Test: Commercial Reality

This is where most founders underestimate the issue. Having a loan agreement in place is not enough. Authorities look at how the arrangement actually behaves over time.

In practical terms, a few questions keep coming up:

●      Can the borrower realistically service the debt based on its cash flows?

●      Is interest being paid, or just building up on paper?

●      Are repayment timelines meaningful, or constantly pushed out?

●      Does the lender actually have capital at risk and make real decisions?

If the answers start to feel stretched, the classification becomes difficult to defend.

Where Structures Start Failing

1.    Leverage that does not match reality

One of the first things that draws attention is how debt is distributed within the group.

When operating entities in relatively lower tax jurisdictions carry high levels of debt, it raises a clear question. Is this funding business risk, or is it structured to maximise deductions?

Certain patterns tend to trigger review:

●      Debt-to-equity ratios moving beyond 2:1 or 3:1

●      Interest being paid to related parties taxed below 10%–15%

●      One entity carrying significantly more leverage than the rest of the group

At that point, the structure starts looking deliberate rather than incidental.

2.    Interest limitation under BEPS Action 4

Even if the loan itself is accepted, interest deductibility is not guaranteed.

Most jurisdictions aligned with BEPS Action 4 cap deductions at 30% of EBITDA. Some operate within a 10%–30% range, but the effect is similar.

In practice, this creates a mismatch. Interest continues to accrue, but the tax system does not fully recognise it. For early-stage or fast-scaling businesses with low EBITDA, this becomes particularly visible.

Over time, what looked like a tax advantage starts increasing the effective tax rate instead.

3.    When loans stop behaving like loans

Recharacterisation rarely happens because of one issue. It builds over time.

You start seeing patterns like:

●      Interest being booked year after year without actual payment

●      Repayment timelines quietly extended beyond 3–5 years

●      Borrowers with weak cash flows and interest coverage below 1.0x

●      Additional funding going in despite limited ability to repay

Individually, these may not seem alarming. Together, they tell a different story.

At that point, the question becomes hard to answer. Why would any external lender continue under these conditions?

If recharacterisation follows, the impact is immediate:

●      Interest deductions are denied

●      Payments may be treated as dividends

●      Withholding tax applies, often in the 5%–15% range

●      Transfer pricing adjustments and penalties can follow

This is where the structure starts working against itself.

4.    Hybrid mismatch exposure

Cross-border structures often introduce hybrid instruments without it being immediately obvious.

Under BEPS Action 2, mismatches are neutralised. If income is not taxed somewhere, or deductions are claimed twice, the benefit is removed.

These issues usually do not show up when each country is looked at in isolation. They emerge when the structure is viewed as a whole.

When It Gets Picked Up

Intercompany financing does not get examined continuously. It gets tested when something brings it into focus.

That typically happens during:

●      Statutory audits, once companies meet size thresholds such as 2 out of 3 tests on turnover, assets, or employees over consecutive years

●      Transfer pricing reviews under BEPS Action 13, where documentation requirements kick in

●      Refinancing discussions, where lenders reassess leverage and repayment capacity

●      Investor diligence, where assumptions are tested under downside scenarios

These are the moments where the structure is looked at commercially, not just legally.

Why It Surfaces Late

This issue builds quietly.

In the early stages, speed matters more than precision. Loans are set up quickly, interest accrues without pressure to service it, and documentation is rarely revisited.

Over time, however:

●      Leverage builds without matching cash flow

●      Intercompany balances keep rolling forward

●      Financial reality drifts away from what the documents say

By the time scrutiny begins, it reflects years of accumulated behaviour. That is what makes it harder to defend.

Substance, Control, and Treaty Position

Financing structures are never looked at in isolation. They are tied closely to where control and decision-making sit.

Authorities expect the lending entity to show real substance. That includes:

●      Sufficient capital at risk relative to the loans it has given

●      Decisions being taken where the entity is resident, aligned with POEM-type principles

●      Actual treasury or risk management activity, not just passive holding

Structures become more vulnerable where the lender sits in a low-tax jurisdiction with an effective rate below 10%–15%, but without meaningful operations.

In such cases, treaty benefits may not hold. Under the PPT, authorities can deny them if the arrangement appears primarily tax-driven. The entity may then be treated as a pass-through rather than a genuine lender.

How This Affects Transactions

These issues become very real when external stakeholders get involved.

During refinancing or investor diligence:

●      Related-party debt is often treated as quasi-equity

●      Leverage is recalculated based on what is economically sustainable

●      Interest deductions are tested rather than assumed

This directly feeds into valuation, deal terms, and borrowing capacity.

Founder Reality, Not Theory

A founder expanding globally funded subsidiaries through intercompany loans. Interest accumulated over several years while cash was reinvested into growth. During investor diligence, it became clear that the subsidiaries could not service the debt independently. The financing was treated as equity, and past interest deductions were questioned.

In another case, a group set up a financing entity in a favourable jurisdiction to centralise lending. It worked quietly for years. The issue surfaced during refinancing, when lenders and tax authorities both questioned whether the entity had real decision-making capacity. Treaty benefits were challenged, and the structure had to be reworked under time pressure. These are not unusual situations. They are how these issues typically surface.