Rent arrears converted to loan

Whenever associated parties enter into a loan agreement, the fiscal profit calculation is based on an arm’s length interest rate the level of which will depend inter alia on the security having been put up by the borrower and on the term of the loan. The loan will be regarded as non-arm’s length where no interest rate can be fixed for which an unrelated third party would be willing to grant the loan under the same terms and conditions, and the lender will then be presumed to have taken on the sort of credit risk no third party would have settled for. A loss on the loan will not be charged to the lender’s profit. The assessment as to whether or not a loan qualifies as non-arm’s length has to be made at the time the loan is entered into. It should moreover be borne in mind that unbusinesslike actions on the part of the lender may cause a loan which started out as arm’s length to become non-arm’s length while it is under way.

The Arnhem Court of Appeal branded a loan having come about from the conversion of rent arrears between two associated private limited-liability companies as non-arm’s length. The lessee’s shareholders’ equity ran to some € 200,000 at the time its rent arrears were converted to a loan, in addition to which it was also indebted to its bankers. The lessor’s loan to its lessee was subordinate to the lessee’s bank loan. The lessee had put up no security whatsoever. Redemption of the loan was scheduled to occur at maturity. The lessee paid the interest on the loan from its current-account relationship with the lessor. All in all the Court considered it plausible that an unrelated third party would not have settled for a bad debt risk of this magnitude, and ruled against write-down against the lessor’s profit.