US Transfer Pricing Rules for Intercompany Loans - A Practical Overview for SMEs

Intercompany loans are a frequent and relatively straightforward area of challenge in US transfer pricing audits. Unlike more complex transfer pricing issues, related-party debt arrangements lend themselves to mechanical adjustments when basic legal, pricing, or behavioral requirements are not met.

This note summarizes the key US transfer pricing rules that apply specifically to intercompany loans and highlights how the IRS approaches these arrangements in practice, particularly in an SME context.

Core Legal Framework: IRC §482

The primary legal authority governing intercompany loans is Internal Revenue Code §482. This provision empowers the IRS to reallocate income, deductions, credits, or allowances between related parties where necessary to clearly reflect income or prevent tax avoidance. Intercompany loans and advances are explicitly within the scope of §482, and interest income and expense are common targets for adjustment where the IRS considers the arrangement non-arm’s length.

What Constitutes a Controlled Loan

A controlled loan exists where one related party advances funds to another with the expectation of repayment and where the parties are under common control, whether direct or indirect. In assessing whether a controlled loan exists, the IRS applies a substance-over-form approach. Merely labeling an advance as a “loan” is not sufficient; the arrangement must behave like debt in practice. The IRS places significant weight on how the parties actually conduct themselves.

Debt Versus Equity: A Threshold Determination

Before addressing pricing, the IRS first determines whether the arrangement qualifies as debt at all. This debt-equity analysis is often the first and easiest adjustment the IRS makes. Factors commonly considered include the existence of a written promissory note, a fixed maturity date, an obligation to pay interest, actual payment of interest, repayment of principal, creditor remedies upon default, subordination to third-party debt, and whether the balance is long-term or effectively perpetual.

If the arrangement fails to exhibit sufficient debt-like characteristics, the IRS may recharacterize it as equity. In such cases, interest deductions may be denied, and payments may instead be treated as dividends or capital contributions, irrespective of the stated form of the transaction.

Arm’s-Length Standard for Interest

Where an arrangement qualifies as debt, the interest rate must satisfy the arm’s-length standard under Treasury Regulations §1.482-2(a), which governs loans and advances. The regulation requires that the interest charged on a controlled loan reflect the rate that would have been charged between unrelated parties under similar circumstances. This assessment takes into account factors such as the loan amount, term, currency, credit risk, security, and repayment terms.

Applicable Federal Rate (AFR) as a Practical Reference

The IRS provides the Applicable Federal Rate (AFR) as a practical benchmark for intercompany loans. AFRs are published monthly and vary by short-term, mid-term, and long-term maturities. While AFR is not mandatory, interest rates below AFR are a clear audit trigger. For small and mid-sized groups, interest charged at or above AFR is commonly accepted as defensible, provided the loan otherwise behaves like debt.

Imputed Interest Rules

If a related-party loan charges no interest or charges interest below a market level, the IRS may apply the imputed interest rules under IRC §§482 and 7872. These provisions allow the IRS to impute interest income to the lender and deny corresponding interest deductions to the borrower. Zero-interest intercompany loans are therefore considered high-risk arrangements and are routinely challenged.

Consistency Between Legal Terms and Actual Conduct

US transfer pricing rules place strong emphasis on actual conduct. Written loan agreements that are not followed in practice carry limited weight. Where interest is never accrued or paid, repayment schedules are ignored, or maturity dates are routinely extended without enforcement, the IRS may disregard the written agreement altogether. In such cases, income may be adjusted based on how the arrangement actually operates rather than how it is documented.

Documentation Expectations Under US Rules

Unlike many non-US jurisdictions, the United States does not require OECD-style master files or local files. Nevertheless, taxpayers are expected to maintain contemporaneous documentation sufficient to support their transfer pricing positions. For intercompany loans, this includes evidence of the existence of a loan, the interest rate applied, and consistency with arm’s-length behavior. Failure to maintain adequate documentation increases both adjustment risk and potential penalty exposure under IRC §6662.

Withholding Tax Considerations for Cross-Border Loans

Transfer pricing compliance does not override US withholding tax rules. Interest paid by a US borrower is generally treated as US-source income and subject to 30 percent withholding unless reduced by an applicable tax treaty. The IRS expects taxpayers to assess treaty eligibility, retain appropriate documentation (including W-8 forms), and comply with relevant reporting obligations, such as Forms 5471 and 5472.

IRS Audit Focus in Practice

In practice, the IRS tends to focus on a small number of core questions when reviewing intercompany loans: whether the arrangement is truly debt, whether interest is charged at all, whether the rate is at least AFR, whether the parties follow the agreement, and whether balances are rolling or effectively permanent. For SMEs, complex credit modeling is rarely the starting point for an audit.

Practical Bottom Line for SMEs

Under US transfer pricing rules, intercompany loans most often fail scrutiny because they resemble permanent capital, lack documentation, carry zero or below-AFR interest, or are ignored in practice. The IRS does not require sophisticated arguments to make adjustments in these circumstances. Addressing the fundamentals—documentation, interest charging, and consistency of behavior—remains the most effective way for SMEs to manage transfer pricing risk related to intercompany loans.