Episode 3 – Interest Free Loans between Related Parties

02 August 2022

Interest free loans are a concern to most groups of companies. Groups of companies have a tendency to lend to companies that are loss-making, normal companies, and other companies which hold long-term assets sometimes land on an interest-free basis.

But as far as the law is concerned under Section 140 (a), you can’t have that situation. There is no provision for interest free loans. Whenever you lend money to one another, there needs to be an arm’s length rate of interest. Inevitably interest has to be charged.

However, there are exceptions. The exceptions are when you have a situation where the money is actually funded – you’re funding your related companies on the assumption that it’s equivalent to equity. In that situation, interest need not be charged because it is no longer a loan. It is a form of equity. 

Although you call it a loan, the economic circumstances under which you lend that is the economic you know the substance of the terms of the agreement. The fact that you actually don’t expect a repayment. The fact that has been invested on a long-term asset like a fixed asset in the company that is borrowing the money actually provides you support for not charging interest and arguing that it is equity.

Therefore, the basic argument is back to the equity argument. You’ve got to build up the necessary features in such a way that it remains equity. The other thing that can also happen is a situation where at certain points in time, your loan or your instrument can even change its nature. At some point, you’ll be charging interest. At another point, you may not be charged interest. Now it depends on whether at that point in time, it is a loan and at the subsequent point, it’s equity. This is the fundamental thing that you have to build up if you want to justify the interest rate. 

The tax authorities have not issued any guidance on the subject matter. This is actually guidance that we have picked up overseas, especially in places like Australia where there is some guidance on the matter of interest free loans. 

Interest free loans as a matter of principle, interest has to be charged. There’s no such thing as interest free loans. However, there are exceptions and it should not be used on a generic basis. Ladies and gentlemen, be careful when it comes to interest free loans. The tax authorities are now beginning to look at it. We have got instances where the tax authorities are now saying they have to impose interest on an interest free loan. This is already beginning. It’s happening. Make sure you’re prepared if you have interest free loans. Be prepared to defend yourself.

Thank you very much.

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