Why is it important to apply interest on intercompany loans and shareholder loans in Denmark?

The Importance of Applying Interest on Intercompany Loans and Shareholder Loans in Denmark

In this blog, we examine why it is important to apply interest on intercompany loans and shareholder loans in Denmark in 2024.

Implications of Not Applying Interest on a Loan between Related Parties in Denmark

For loans between related parties, if the interest rate set does not correspond to the interest rate that independent parties would have set in a similar situation, the interest rate will be corrected during tax audit.

Applying proper interest on intercompany loans and shareholder loans in Denmark is also crucial for compliance with thin capitalisation rules in 2024, Transfer Pricing rules in 2024, as well as arm’s-length principles for 2024.

The following are examples of situations when interest corrections typically can occur during a tax audit

Non-Arm’s Length Transactions

Charging a lower interest rate on the loan than what is conventionally charged in a similar transaction between unrelated parties due to a close relationship between the lender and borrower (e.g. the lender is a shareholder of the borrowing company).

Tax Avoidance

Companies intentionally setting artificially low interest rates on loans to reduce their taxable income or to shift profits to jurisdictions with lower tax rates.

Lack of Documentation

Loans between related parties lacking proper documentation or having incomplete records of the terms and conditions.

Transfer Pricing Regulations

For compliance regulations in countries that have transfer pricing regulations that necessitate transactions between related parties at arm’s length.

Interest rate correction

A correction made by the Danish Tax Agency we call interest rate correction, interest rate fixing or fixation of interest.

If the Danish Tax Agency determines that the interest rate on a related party loan is in contrast with the arm’s length principle, then they have the power to impose an adjustment.

This denotes that if there is no interest charged at all, or if the rate is not comparable to what unrelated parties would have agreed upon, the Danish Tax Agency can impose a notional arm’s length interest rate.

Interest rate correction involves setting an interest rate corresponding to the market rate.

This implies that you should always set the interest rate to a level that two independent parties would have set in a similar loan relationship.

If a company fails to apply interest on a loan from a related party, such as a subsidiary, or a parent company, there can be significant tax consequences.

Consequences When Interest Corrections Are Made

The administrative practice for interest rate correction varies depending on the relationship in which the loan was granted.

It can either end up as a tax-neutral correction for both the lender and borrower, or, worse, end up with a taxable event at one of the involved parties.

Here it is important to understand and consider 2 principles:

Interest: The amount of corrected interest.

Interest advantage: The advantage the borrower had of not having to pay interest to the lender. Or in the case of the lender, the loss the lender had by never receiving the corrected interest. So in the case of the lender, it is more of a negative interest advantage, opposite of the borrowers advantage.

If the Danish Tax Agency makes an adjustment to impute arm’s length interest, the following are the typical possible consequences:

1: The lender is taxed on interest income

If an interest rate correction is made, the lender is generally taxed on the corrected interest as income.

Whether the lender is an individual shareholder or a company, this notional interest income is included in taxable income, increasing their Danish tax liability.

Despite the initial interest-free or non-arm’s length loan terms with the related borrower, the goal of the correction is to tax the lender appropriately.

2: The lender can only sometimes deduct interest advantage

Only in some situations will the lender be able to deduct the negative impact of the interest advantage (since the lender never actually gets paid from the borrower), making it a tax-neutral correction.

The tax qualification of the interest advantage also has a derived impact on whether the lender can deduct the interest advantage granted when calculating the taxable income.

The administrative practice for tax adjustments depends on the relationship in which the interest-free or low-interest loan was granted.

The practice is based on the assumption that there is some form of community of interest between lender and borrower.

We dive into this later in the blog.

3: The borrower can deduct interest

The borrower generally receives a corresponding tax deduction for the interest rate correction.

This prevents the case of double taxation and aligns with the borrower to pay a market rate from the start, even though they initially paid lower interest or none at all due to the non-arm’s length loan terms with the related lender.

4: The borrower is taxed on the interest advantage of not having paid interest

However, the borrower also received an interest advantage by not having paid the market interest rate to the lender.

Therefore, as a derivative effect of the interest correction, a tax assessment must also be made of the financial advantage that the interest-free or low-interest rate entails for the borrower.

The taxation of the non-paid interest advantage for the borrower depends on how the interest advantage is characterised for tax purposes by the Danish Tax Agency.

Interest advantage

Typically, the interest advantage can be characterised as a:

Grant

This may be considered as income subject to taxation for the borrower but potentially tax-exempt for the lender under Denmark’s legislation.

Dividend

The interest advantage is treated as a constructive dividend paid by the borrower to the lender. This can result in dividend withholding tax implications for the borrower.

Salary

The interest advantage could potentially be re-characterised as additional salary or compensation, taxable as personal income for the borrower when being a physical person.

Since the tax implications are different for these outcomes, some are taxable and others tax-neutral, and because taxation also depends on the relationship between the lender and borrower, it can have significant tax implications if the Danish Tax Agency makes a correction of interest rate.

Steps for Applying Interest on Intercompany Loans in Denmark

This guide outlines the steps for companies to follow when setting and applying interest rates on intercompany loans.
Identify any loans between your company and other uncontrolled parties if possible, because these qualify as intercompany loans and can be used as comparables.

Gather relevant data on the loan itself to determine an appropriate interest rate. The information may be regarding the loan amount, terms, currency, and repayment schedule.

Conduct a benchmarking analysis to find similar loans between unrelated parties. This analysis should look into factors like borrower and lender creditworthiness, loan size and term, and current market interest rates. Various resources are helpful for this step, but you should remember that interest on intercompany loans must be comparable to market rates.

Set an interest rate on the intercompany loan based on the gathered data and benchmarking analysis. The rate should be at arm’s length. Document the process to justify the interest on the intercompany loan chosen and ensure it aligns with Danish transfer pricing regulations if this is applicable for your company.

Ensure all documentation related to the interest on intercompany loans is maintained as this can be scrutinised by the Danish Tax Agency.

If you are not able to find any comparable loans, you can read further in this blog on how to set the interest rate using a safe-harbour rate.

Loans in Group (holding and operating company) relationships

Loans from a Danish Parent Company to a Subsidiary and Loans between Sister Companies

When it comes to interest on intercompany loans in Denmark within a corporate group structure, the tax treatment is generally tax-neutral if certain conditions are met.

If the companies are covered by the conditions for joint taxation set out in SEL § 31 D, subsections 1 and 4, the principle of taxation of the interest advantage received by the borrower is waived.

The subsidiary shall, cf. SEL § 31 D, subsection 1, first sentence, not include the economic advantage received, just as the parent company shall not, cf. SEL § 31 D, subsection 1, first sentence.

In other words, if the interest advantage is given from a direct or indirect parent company to a subsidiary or the interest advantage is given between sister companies (companies with a direct or indirect parent company), the interest advantage received by the borrower will be tax-neutral, just as there will be no right of deduction for the interest advantage by the lender.

The net effect for the group companies will, therefore, be tax-neutral.

Loans from a Danish Subsidiary to a Parent Company

In the case of loans from a subsidiary to a parent company, any interest advantage will normally be regarded as a dividend, which may be tax-free for the borrowing company (the parent company) according to the detailed provisions in SEL § 13 or SEL § 17. See SKM2002.246.LSR, where a non-interest-bearing suspense account was established between a main shareholder and his company.

This treatment is based on rulings like SKM2002.246.LSR, where the lack of interest on an intercompany account was deemed a constructive dividend subject to adjustment under Section 2(1) of the Tax Assessment Act.

Effectively, this results in tax neutrality for the group overall:

Parent company claims interest deduction matching subsidiary’s interest income inclusion;
The subsidiary cannot deduct the constructive dividend paid to the parent company;
The dividend is tax-neutral for the parent company.

Loans in Majority Shareholder Relationships

The tax treatment is stricter when a majority shareholder (physical person) provides a loan to their company.

In order to prevent inappropriate profit shifting between the individual and corporate tax spheres, the lender is often denied a deduction for the interest advantage.

In the case of loans from a majority shareholder (physical person) to his/her company, an interest advantage that is not commercially justified is considered taxable for the borrowing company.

However, the borrowing company also normally gets a tax deduction for the corrected interest.

Therefore, for the borrowing company, the net effect is that there is no overall change in taxable income, as the taxable interest advantage is neutralised by the interest deduction allowed on the corrected interest.
For the majority shareholder as the lender, the net effect is a taxation of the corrected interest, as there is no deductibility for the interest advantage granted to the company for not paying interest.

This will, therefore, result in a tax liability for the majority shareholder (physical person).

This asymmetric treatment results in an incremental tax liability for the majority shareholder (physical person) on the corrected interest income they are deemed to have received from the related party loan.

So, while tax-neutral for the company, charging arm’s length interest is crucial from the majority shareholder’s perspective to avoid creating additional personal tax liability under Denmark’s rules for related party loans.

Read about the statuatory requirement in Denmark to declare controlled transactions like loans each year

What is The Arm’s Length Principle?

The arm’s length principle is used for determining prices and terms for transactions between related parties.

This principle ensures that transactions are conducted as if the parties involved were independent entities operating at arm’s length.

The arm’s length principle is designed to prevent skewed pricing or unfair terms that could be used for avoiding tax or shifting profit purposes.

It covers all relationships between the related parties, including interests and loans.

Main Applications of the Arm’s Length Principle

Transfer pricing: To determine arm’s length prices for the transfer of services, goods, and intangibles between related parties.

And, to ensure values are taxable on profits where it is generated;

Intercompany financing: To establish arm’s length interest rates for loans between related parties. Rates need to be comparable to those between unrelated Lenders and Borrowers;

Use of intangibles: To determine reasonable royalties and fees for related parties to use intangibles like patents, and trademarks;

Cost contribution arrangements: To allocate costs of joint development activities between related parties on an arm’s length basis;

Intercompany guarantees: To calculate arm’s length guarantee fees for assurances provided between related parties;

Business restructuring: To ensure arm’s length compensation to transfer profit potential during restructurings;

Intercompany agreements: To draft terms and conditions reflecting arm’s length behaviour and commercial rationally;

Intra-group services: To determine charges for services at arm’s length, such as administration and management provided within parties;

Intercompany financing: To evaluate the arm’s length nature of the related party’s loans and cash pooling arrangements.

Ways to Determine an Arm’s Length Interest Rate in Denmark

The interest rate must be determined individually, taking into account factors such as the size of the loan, its term, the collateral provided and the borrower’s creditworthiness.

Several factors that should be considered

Loan size – The principal amount being borrowed;
Term – The duration/tenor of the loan;
Collateral – Any assets or guarantees securing the loan;
Borrower creditworthiness – the financial strength and ability to pay.

The amount of interest that an independent lender might require is influenced by these commercial characteristics.

Benchmarking an arm’s length range can be facilitated by carrying out a comprehensive comparison analysis using third-party loan data.

The Importance of Transfer Pricing Studies

One of the key reasons it is vital to apply proper interest rates on shareholder and intercompany loans is to comply with transfer pricing regulations. Transfer pricing is the pricing of transactions between related parties, like companies within the same corporate group or between a company and its shareholder.

Companies undertaking comprehensive transfer pricing studies ensure that intercompany loan and shareholder loan transactions are conducted at arm’s length as required by Danish tax laws. These studies involve analysing comparable third-party transactions and applying accepted methods to establish arm’s length interest rates for their related-party loans.

Read more about which companies are required to submit Transfer Pricing documentation in Denmark in 2024

Transfer Pricing Methods for Intercompany Financing

The Danish Tax Agency recognises several transfer pricing methods that can be used to determine arm’s length interest rates for shareholder and intercompany loans.

The most commonly used methods are:

Comparable Uncontrolled Price (CUP) Method

Involves identifying and analysing interest rates charged on comparable third-party loans with similar terms, conditions, and risk profiles. This method is the most direct and reliable when reliable comparables are available;

Cost Plus Method

Involves determining the costs incurred by the lender in providing the loan and adding an appropriate markup to arrive at an arm’s length;

Transactional Net Margin Method (TNMM)

Involves analysing the net profit margins earned by comparable third-party lenders engaging in similar financing transactions. The arm’s length interest rate is then determined based on the range of profit margins observed in the comparables;

Other Methods

In certain cases, companies may need to use other methods like the Profit Split Method or the Residual Profit Split Method. The application of any of these depends on the specific circumstances and the availability of reliable comparable data.

The Consequences if an Arm’s Length Interest Rate Cannot Be Determined

The Danish transfer pricing guidelines clearly state that taxpayers should make every effort to analyse comparable third-party loan data and determine an arm’s length interest rate through standard transfer pricing methods.

Only if – in exceptional cases – it is not possible to determine such an arm’s length interest rate with reasonable certainty, the official Danish “Diskonto” interest rate plus 4% p.a. can be used.

You can find the current “Diskonto” interest rate here

Reference is made to court cases SKM2009.567.VLR and SKM2010.135.BR, where the High Court and the City Court fixed an interest rate on loans between related parties at the official interest rate (called “diskonto”) + 4% p.a.

Where the courts determined this interest rate for related party loans in the absence of clear arm’s length evidence.

However, the Danish tax authorities emphasise that this 4% premium approach is not automatically accepted.

Taxpayers must:

Demonstrate thorough efforts to identify comparables through a proper transfer pricing analysis;

Provide documentation supporting the inability to reliably determine an arm’s length rate.

Justify why the “Diskonto” + 4% p.a. premium is appropriate given the facts and circumstances.

Even when applying the safe harbour rate, the onus remains on the taxpayer to prepare robust transfer pricing documentation explaining why standard arm’s length principles could not be reliably applied.

Proper analysis, documentation and due diligence can help mitigate potential transfer pricing disputes over intercompany financing transactions.

The Consequences of Having Already Applied Interests but These Are Below Market Interest Rate

In a situation with a loan from a parent company to a subsidiary (covered by the conditions in SEL § 31 D) where the self-declared interest rate is below the market interest rate, the parent company’s tax assessment pursuant to LL § 2 will be increased by the difference between the self-declared interest rate and the market interest rate (+R), while the corresponding reduction of the subsidiary’s taxable income will be -R.

The net effect for the group will, therefore, also be tax-neutral.

Thin capitalisation

It is important to note that in Denmark, there are rules that limit how much interest expense a company can deduct on loans from related parties if the company’s debt is too high compared to its equity – this is called “thin capitalisation”.

These rules aim to prevent multinational companies from using debt to shift profits to low-tax countries.

The thin capitalisation rule targets companies with controlled debt over 10 million DKK and where the equity is less than 20% of assets.

Our recommendation

Based on what we have discussed in this blog, our recommendation is always to calculate and apply interest on all loans between related parties.

Especially for loans between physical shareholders and their companies.

Do you need assistance?

If you need assistance ensuring compliance with your intercompany loans and shareholder loans with interest application, then call us at: +45 70272713 or schedule a meeting here.

(This blog was updated last time: 16.5.2024)

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