Prepayment options in loans from affiliates could cause tax problems if not exercised once it becomes economically beneficial to do so.

It is not unusual for a company investing in another country to form a blocker corporation in that country to hold the investment and to lend part of the capital needed to make the investment to the blocker corporation. This allows earnings from the investment to be “stripped” in the form of interest on the loan. The interest payments are deducted in the country where the investment is made, thereby reducing taxable income. A withholding tax may or may not be collected at the border on the interest payments, depending on whether any tax treaties apply and other factors.

Loans from related parties often give the borrower the ability to prepay the loan principal without having to pay the lender a penalty.

Tax authorities across Europe expect such prepayment options to be exercised when it is economically beneficial for the borrower to do so and, if not exercised, are likely to disallow interest deductions on the loan and possibly also not to view the loan as a real loan, according to Yanick Scheuerman, a tax lawyer in the Norton Rose Fulbright office in Amsterdam.

“If an intragroup loan has a prepayment option without substantial penalties, and the borrower fails to exercise the option to refinance at a point where it would be economically beneficial to do so, the tax authorities may consider the loan no longer arm’s length. This could lead to denial of interest deductions above the lower current market rate or potentially a re-characterization of the entire transaction,” Scheuerman said.