Structuring intercompany loans that pass an audit

A tax authority auditor doesn't start with your revenue line or your cost of goods sold. They start with intercompany transactions, and loans between related parties sit right at the top of that list. The reason is simple: intercompany loans are one of the easiest ways to shift profit between jurisdictions, and auditors know it. Whether you're lending from a UAE parent to a UK subsidiary or funding a new entity within a free zone group, getting the loan structure wrong can trigger reassessments, denied deductions, and penalties that dwarf whatever tax saving you thought you were achieving. The frustrating part is that most of these problems are preventable. They come from sloppy documentation, unrealistic terms, or a complete absence of the commercial logic that a third-party lender would demand. If you're running a multi-entity group and money moves between your companies, you need intercompany loans structured to withstand audit scrutiny, not just ones that look tidy in your accounting software. Here's how to build them properly.

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Why intercompany loans are the most audited line in your group

Tax authorities globally have gotten significantly better at spotting intercompany financing that lacks commercial substance. The FTA in the UAE, HMRC in the UK, and virtually every OECD-aligned jurisdiction now use algorithmic risk-based selection to flag related-party loan transactions. What triggers the flag? Loans with no interest charged. Loans that never get repaid. Loans where the terms shift every quarter with no written amendment.

The core issue is that intercompany loans create a direct mechanism for profit shifting. A parent company in a zero-tax jurisdiction lends to a subsidiary in a taxable jurisdiction at an inflated interest rate, and suddenly the subsidiary's taxable income shrinks while the parent collects tax-free interest income. Auditors are trained to look for exactly this pattern. The OECD's Transfer Pricing Guidelines set out the international framework that most tax authorities follow when scrutinising these arrangements, and the principles around financial transactions were tightened substantially in the 2020 OECD report on transfer pricing guidance for financial transactions.

Even if your intent is completely genuine, a poorly documented related-party loan will look suspicious under scrutiny. The burden of proof sits with you, not the auditor. If you can't demonstrate that the loan reflects what two independent parties would have agreed, you'll lose the argument. The UAE FTA's transfer pricing guidance makes this explicit: the standard applies to all related-party transactions, and financing is among the categories examined most closely.

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The arm's length test in plain English

The arm's length principle is the single most important concept in transfer pricing for group financing. It asks one question: would an independent lender have offered this loan on these terms to this borrower?

That means you need to think like a bank. A bank wouldn't lend AED 10 million to a company with no revenue, no assets, and no repayment plan at a 2% interest rate. A bank wouldn't lend without security. A bank wouldn't agree to a loan with no maturity date. If your intercompany loan has any of these characteristics, it fails the arm's length test before the auditor even opens the file.

The practical application involves benchmarking. You compare your intercompany loan terms against what the borrowing entity could realistically obtain from an unrelated third-party lender. This comparison covers the interest rate, tenor, covenants, security, and repayment schedule. Transfer pricing documentation should include this benchmarking analysis, ideally prepared before the loan is disbursed, not retroactively when an audit notice lands on your desk. The OECD's guidance under BEPS Action 10 specifically addresses how the arm's length principle applies to intragroup financial transactions, including the question of whether a transaction should be characterised as a loan at all.

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Interest rate: how to set one you can defend

Setting the right interest rate on an arm's length intercompany loan is where most groups either overthink or underthink the problem. The answer isn't to pick a rate that "feels reasonable" or to copy whatever your bank charges on your operating facility.

Start with the credit profile of the borrower, not the group. Your subsidiary might sit within a strong group, but if it's a standalone entity with limited assets and thin margins, its standalone credit rating is what matters. A common mistake is applying the parent's borrowing rate to a subsidiary that, on its own merits, would be rated three notches lower.

From there, build the rate using comparable data:

• Check published loan databases like Bloomberg or Refinitiv for comparable third-party loans to similarly rated borrowers
• Add a spread that reflects the specific risk of the borrower: industry, geography, currency of the loan
• Factor in the loan's tenor, because a five-year unsecured loan carries more risk than a twelve-month revolving facility
• Reference a recognised risk-free benchmark rate. For USD-denominated intercompany loans, SOFR (the Secured Overnight Financing Rate) has replaced LIBOR as the standard reference. For GBP loans, SONIA (the Sterling Overnight Index Average) serves the same function. Using the correct benchmark matters because auditors expect to see rates anchored to an observable market reference, not a number selected in isolation
• Document every assumption you make, because the auditor will ask about each one

If you're a smaller group without access to expensive databases, at minimum obtain indicative quotes from two or three commercial banks for a hypothetical loan to the borrowing entity. That gives you a defensible reference point. For UK-connected transactions, HMRC's International Manual sets out how HMRC approaches intercompany interest rate benchmarking in detail, and INTM is worth reading before you finalise any documentation you expect to defend before a UK inspector.

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Term, security and the credit rating you give your own subsidiary

Interest rate gets the most attention, but auditors increasingly focus on the non-price terms of intercompany loans. These terms reveal whether the loan has genuine commercial substance or whether it's really just an equity injection dressed up as debt.

Consider the term first. A loan with no fixed maturity date, or one that's been "extended" four times without any formal amendment, looks like permanent capital. An independent lender would never agree to that. Set a realistic repayment schedule, and actually follow it. If the subsidiary can't make repayments, that tells you the loan was probably too large or the entity isn't commercially viable: both of which an auditor will note.

Security matters too. If your subsidiary owns property, equipment, or receivables, a third-party lender would take security over those assets. Your intercompany loan should reflect the same logic. Unsecured lending between related parties isn't automatically problematic, but you need to justify why no security was taken and how that affected the interest rate.

The credit rating question is one that catches founders off guard. You need to assess your subsidiary's creditworthiness as if it were approaching a bank independently. This standalone rating, separate from any implicit group support, determines what terms are realistic. Ignoring this step is one of the fastest ways to fail a transfer pricing audit on group financing. The same substance disciplines that govern physical presence in a jurisdiction apply here: a holding company that functions as a genuine lender needs to demonstrate the capacity to bear the risk it's nominally accepting, not just hold a loan agreement on a filing shelf.

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The paperwork most groups never write

Here's the pattern I see repeatedly: a group transfers AED 5 million between entities, records it as a loan in the accounting system, and never produces a single document to support the transaction. No loan agreement. No board resolution. No evidence that anyone actually approved the terms.

This is the equivalent of handing an auditor a gift. Without documentation, the tax authority can reclassify the loan as equity, deny the interest deduction entirely, and impose penalties on top. The UK's transfer pricing legislation under TIOPA 2010 Part 4 gives HMRC wide powers to substitute arm's length amounts when documentation is absent or inadequate. The UAE Corporate Tax regime operates on the same principle.

The documentation you need isn't complicated, but it must exist before or at the time the funds move:

• A board resolution from the lending entity approving the loan and its terms
• A board resolution from the borrowing entity accepting the loan
• A signed intercompany loan agreement with all material terms specified
• A transfer pricing memorandum or benchmarking study supporting the interest rate
• Evidence of actual fund transfers matching the agreement
• Records of interest accrual and payment, even if payments are netted within the group

If you're operating in the UAE under the Corporate Tax regime, the FTA expects this documentation to be available on request. HMRC expects the same for UK entities. The cost of preparing these documents is trivial compared to the cost of defending an audit without them. If you're not certain your current arrangements would survive scrutiny, have them reviewed by a specialist now. The real cost of non-compliance in the UAE alone is substantial enough that the review cost is irrelevant by comparison.

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Thin capitalisation and the deductibility limit founders miss

Even if your intercompany loan passes the arm's length test with flying colours, you can still lose the interest deduction under thin capitalisation rules. These rules limit how much debt a company can carry relative to its equity, and they exist specifically to prevent groups from loading subsidiaries with excessive intercompany debt to strip out taxable profits. The OECD's BEPS Action 4 recommendations drove the adoption of interest limitation rules across member states, and the UAE and UK both implemented versions of the fixed ratio approach.

The UAE Corporate Tax framework includes a general interest deduction limitation. For most groups, net interest expense exceeding AED 12 million is subject to a cap of 30% of EBITDA. Smaller groups often assume this doesn't apply to them, but the threshold is lower than many founders expect when multiple intercompany loans are stacked across entities.

The UK applies similar restrictions through its Corporate Interest Restriction rules, which also use a 30% of EBITDA ratio but with additional group-level calculations. If your group spans both jurisdictions, you need to model the deductibility limits in each country separately. For groups with entities in Pillar Two scope, the interaction between interest limitation rules and the global minimum tax adds another layer of complexity that thin capitalisation analysis alone won't capture.

The practical takeaway is this: don't assume that just because you've set an arm's length rate, the full interest charge is deductible. Run the thin capitalisation numbers before you finalise the loan amount. Sometimes the right answer is to fund part of the investment as equity and part as debt, rather than structuring everything as a loan that creates a deduction the borrower can't actually claim.

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The intercompany loan template, and what should be in it

A strong intercompany loan agreement doesn't need to be 40 pages long, but it does need to cover specific terms that demonstrate commercial substance. Generic templates downloaded from the internet are dangerous because they rarely reflect the actual economics of your transaction, and an auditor will spot the disconnect immediately.

Your agreement should include:

• The principal amount and currency
• The interest rate, including whether it's fixed or floating, and the benchmark it references (SOFR, SONIA, or an equivalent published rate)
• The drawdown date and maturity date
• A repayment schedule with specific dates and amounts
• Security provisions, or an explicit statement explaining why the loan is unsecured
• Default provisions and consequences, because a real lender would include them
• Governing law and dispute resolution
• Signatures from authorised representatives of both entities

Beyond the agreement itself, keep a transfer pricing file that includes the benchmarking analysis, the credit assessment of the borrower, and any correspondence showing how the terms were negotiated. If the loan is modified at any point, document the amendment formally and update the transfer pricing analysis. The IRS applies the same discipline under Section 482 for any transactions involving US entities, so if your group includes a US subsidiary or parent, a consistent documentation standard across all jurisdictions avoids conflicts when multiple tax authorities review the same arrangement.

The difference between a loan that survives an audit and one that gets reclassified as equity almost always comes down to whether the documentation tells a coherent, commercial story. An auditor should be able to read your file and conclude that two independent parties could have reached the same arrangement. If that story doesn't hold together, no amount of post-hoc justification will fix it.

Getting intercompany loans right is one part of a broader group tax and accounting function. If you're building a multi-entity structure and need the financing to sit properly within it, how you set up the holding company and how you choose your holding jurisdiction are decisions that shape what loan arrangements are available and defensible. The time to structure intercompany loans properly is before the money moves, not after the audit notice arrives. If you're unsure whether your current arrangements would hold up, have them reviewed by a transfer pricing specialist now, while you still have time to fix them.