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Transfer Pricing

Why Do I Need a Debt Capacity Analysis for My Loan?


Recently, a number of countries have either indicated or adopted requirements that transfer pricing reports documenting loans include debt-capacity analyses as an integral part of proving those intercompany loans are arm’s-length arrangements. But what is a debt-capacity analysis and why is it important? 

Believe it or not, you’re already familiar with a debt-capacity analysis. Think about taking out a loan to purchase a car. The lender will need to evaluate you as a borrower, and the general first step is checking your credit rating. Let’s say you happen to have a score of 800 out of a possible 850, so you look good as a buyer.  You will also be asked about your employment and how much you earn, and it is usually a very simple process to buy the car. 

Now let’s take it up a notch and instead of buying a car, let’s say you want to buy a house.  The process is similar to buying a car but with some additional work.  Of course, your credit rating is important but now the questions about your employment and earning are more focused.  The table below shows a very simplistic calculation of three different potential purchase options and does not reflect any specific down-payment requirement or other criteria.   

Cost                                              250,000       500,000        1,000,000

Down Payment                                50,000      100,000            200,000

Mortgage Principal                      200,000       400,000           800,000

Mortgage term in years               30                   30                      30

Interest rate                                  6.46%              6.46%                6.46%

Payment                                        ($1252.14)       ($2504.28)         ($5,008.56)

1 yr of mortgage payments         $15,026             $30,051             $60,103

Borrower’s annual income            100,000          100,000            100,000

Arbitrary bank earnings rule         25%                  25%                    25%

Borrower qualifies?                        yes                    no                       no

Just as our hypothetical banker doesn’t want the borrower overextended on taking out a mortgage, so too are the tax authorities concerned with the ability of a company to repay a commercial loanThe concern is twofold: First, the authorities do not want a situation where the carrying cost of the loan creates a loss position for the company, which would eliminate any taxes payable on income.  Secondary to this is the impact consistent losses could have on both employees and creditors of the company.  The authorities do not want to encourage risky behavior that would adversely impact others within the local economy.