Intercompany financing is where transfer pricing and the interest rules meet, and it is one of the most exposed areas for a group with debt on its own balance sheet. When one group company lends to another, the interest has to be arm's length, both in its rate and in whether the loan makes commercial sense at all. On top of that, the interest deduction faces the general limitation. A shareholder loan is therefore tested more than once, and a casual approach to it is a reliable way to lose a deduction.
The rate has to be arm's length
The interest charged on a related-party loan must be what an independent lender would have charged the borrower for a comparable loan. That depends on the borrower's own creditworthiness, the amount, the term, the currency, the security, and the conditions in the market at the time. A parent cannot simply pick a rate. A rate set too high shifts profit to the lender through interest, and a rate set too low does the reverse. Either way, the Authority can adjust it to the arm's length figure, so the rate needs support, ideally benchmarked.
Would the loan have happened at all?
Arm's length is not only about the rate. It is also about whether an independent borrower would have taken the loan on those terms, and whether an independent lender would have made it. A loan far beyond what the borrower could service, or with no realistic prospect of repayment, may be re-characterised, so that some or all of the interest is denied. The commercial rationale for the financing, not just its price, is part of what has to be defensible.
The interest limitation on top
Even where the rate and the loan are arm's length, the deduction still runs into the general interest limitation, which caps net interest by reference to earnings, with a safe harbour below which the cap does not apply. Related-party interest also faces additional scrutiny where the borrowing funds particular transactions, such as a dividend, a capital contribution, or an acquisition within the group. So intercompany interest can be arm's length and still be restricted or deferred by the limitation rules. The two regimes stack.
Documentation and agreements
A defensible intercompany loan has a proper loan agreement, terms that match how it actually operates, and support for the rate, typically a credit assessment of the borrower and a benchmark of comparable lending. A loan recorded only as a movement on an intercompany account, with no agreement and no rationale for the rate, is weak on every front. As elsewhere in transfer pricing, the evidence is not optional. It is what makes the interest deductible.
What to do about it
Benchmark the rate on each related-party loan against what an independent lender would charge that borrower, and keep the analysis. Test whether the loan itself is commercially sensible, not just its price. Model the interest limitation and the related-party interest rules on top, because arm's length does not exempt you from them. And put real agreements in place that reflect the actual terms. Intercompany financing is legitimate and often necessary, but it is tested on the rate, the substance, and the limitation, and it earns its deduction only when all three hold.
This article is general information on UAE transfer pricing and is not tax advice. The rules on related-party financing and interest should be confirmed against current legislation. We would be glad to review your intercompany financing.