EU court rules Romania can impute interest on intercompany loans, but what should the rate be?

By Dr. Harold McClure, New York City

The Court of Justice of the European Union (CJEU) ruled on October 8 that Romania’s tax authority can require arm’s length interest rates on intercompany loans made by a Romanian branch to its Italian parent.

The case involved Impresa Pizzarotti, which is the Romanian branch of SC Impresa Pizzarotti. The Romanian branch extended to its parent an €11.4 million loan on February 6, 2012, and another €2.3 million loan on March 9, 2012.

No interest was paid to the Romanian branch for what were effectively two-year loans. While interest rates were low in Europe during this period, the arm’s length interest rate was certainly above zero.

Romania’s tax authority objected to this arrangement, and the dispute ended up in court. As a part of these proceedings, the CJEU was asked to rule on the legality of Romanian law. The CJEU concluded that EU concepts of freedom of establishment did not preclude the application of Romanian transfer pricing law that imputed a market-rate interest on the loan between the parent and the branch.

Now that it is confirmed that the Romanian tax authority can impute a market rate interest to the Impresa Pizzarotti loans, the question becomes how much interest should, in fact, be applied  – this is an economic issue.

Determining arm’s length interest

A standard model for evaluating whether an intercompany interest rate is arm’ s-length has two components: the intercompany contract and the related party borrower’s credit rating.

Properly articulated intercompany contracts stipulate the date of the loan, the currency of denomination, the term of the loan, and the interest rate.

The first three items allow the analyst to determine the market interest rate of the corresponding government bond. This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.

The information provided by the CJEU in the Impresa Pizzarotti case specified the date of the loans and the currency of denomination.

While the term of the loans was ambiguous, it is reasonable to assume a term of two years.

The European Central Bank provides daily information on Euro area yield curves. On February 6, 2012, the 2-year yield was only 0.38 percent. On March 9, 2012, the 2-year yield was only 0.34 percent.

If the appropriate credit spread were 0.6 percent or less, the arm’s length interest rate would be less than 1 percent.

The information provided by the CJEU ruling did not specify the credit rating for SC Impresa Pizzarotti. If its credit rating were AAA, then the credit spread should be less than 0.6 percent.

Of course, the appropriate credit rating is a difficult and controversial issue, so the Romanian tax authority might argue for a higher credit spread and hence a higher intercompany interest rate.

Italian interest deduction

During the period in question, Italy’s corporate profits tax rate was 31.4 percent, while the corporate profits tax rate for Romania was 16 percent.

 A higher interest rate would lower the group’s worldwide taxes if the Italian tax authorities accepted the intercompany interest rate deduction. Given this tax differential, one might wonder why this multinational did not charge interest on these intercompany loans.

The modest size of these intercompany loans may have discouraged the multinational’s representatives from spending the effort to determine and document the arm’s length interest rate.

The Italian tax authorities can challenge if not deny any intercompany interest expenses without proper and convincing documentation.

Given the recent efforts from the Romanian tax authorities to assert an arm’s length interest rate, such an evaluation is warranted.