Family Loans & Shareholder Advances, Reducing Recharacterisation Risk in Cross-Border Groups

Family owned groups move money around for practical reasons. A shareholder covers payroll while a customer pays late. A holding company funds a new subsidiary until it can trade. A profitable business supports another entity through a weak period. These transfers are normal, but tax rules force them into categories. They’re either debt or equity, and the tax outcome changes sharply depending on which one an authority applies. This article explains the situations that usually trigger recharacterisation and the habits that tend to keep funding on the right side of the line.

What recharacterisation looks like in practice

Recharacterisation is when a tax authority decides that funding described as a loan isn’t really a loan. The label used internally stops carrying weight and the authority taxes the funding based on how it behaves.

The most common result is denied interest deductions, because equity doesn’t generate deductible interest. In cross-border cases the problem often doubles. Withholding tax may still be charged on interest that was paid or even just accrued, leaving the group with tax leakage and no corresponding deduction.

The reverse can also happen. A payment treated internally as equity can be viewed as debt in another country if it looks and behaves like debt. That can pull in interest limitation rules, deemed interest income or transfer pricing adjustments.

The situations authorities actually challenge

Challenges usually follow a small number of patterns.

One is the long-standing shareholder advance. A current account balance builds up over years with no interest, no repayment date and no clear plan to clear it. The business uses the funds as permanent working capital. On audit, the authority points to the history and concludes there was never a real expectation of repayment.

Another is the startup loan that can’t realistically be repaid. A parent lends to a newly formed subsidiary with no revenue, no external funding and no credible forecast. The agreement might say three years with low interest, but no independent lender would accept that risk at that price. Authorities often treat this as equity risk capital.

A third is late documentation. Funds move first, paperwork appears later and repayments only start once questions are raised. Even if the agreement is valid on paper, the earlier behaviour undermines it.

A fourth is inconsistent treatment. One country treats the balance as debt, another effectively treats it as equity through filings or accounts. That inconsistency signals that the group itself didn’t have a settled view.

What a loan has to look like

At its core, a loan needs three things.

There has to be a clear obligation to repay. There has to be a cost for using the money, usually interest. And there has to be a plausible route to repayment.

The last point is where many family arrangements fail. If repayment depends on “we’ll see how the year goes,” the funding behaves like equity. Profitable operating companies can support shorter terms. New or distressed companies usually can’t, unless the terms reflect that risk.

Documentation that actually helps

A loan agreement is essential, but it only helps if it matches reality.

A workable agreement sets out the amount, currency, interest rate, term and repayment schedule. It also deals with what happens if payments can’t be made on time. Board or shareholder approvals should show who decided to lend and why.

What really supports the position is evidence created at the time. Cash flow forecasts showing how repayment was expected to happen. Budgets that management actually used. Ledger entries showing interest accruals were posted consistently.

If terms change, amendments should be signed when the decision is made. Quietly ignoring the agreement and fixing it later rarely works.

Why behaviour carries so much weight

After the funds move, behaviour often matters more than the paperwork.

If interest is meant to accrue quarterly, the accounts should show that pattern. If principal repayments are scheduled, there should be a history of repayments, even if they’re adjusted from time to time.

When a borrower misses a payment, the response should look commercial. That might mean an extension supported by updated forecasts or a revised schedule. Doing nothing makes the balance look permanent.

This is why shareholder advances are risky. They often sit as running accounts with no trigger to force a decision. Even short-term support should come with a clear clean-up plan, settlement within a set period, conversion to equity or formalisation into a term loan.

Transfer pricing, stripped back

Cross-border loans between related parties have to be priced as if independent parties were dealing with each other. That’s the practical meaning of arm’s length pricing.

In simple terms, weaker borrowers pay more. Currency, term and security all affect the rate. Group support can reduce pricing, but it needs to be analysed, not assumed.

What usually works is a short transfer pricing memo explaining how the rate was chosen, including a basic credit assessment and comparable data. What doesn’t work is “we picked a rate that felt reasonable.”

Interest limits still apply

Even a genuine loan can produce a poor tax result if local interest limitation rules apply.

Many regimes cap net interest deductions based on earnings. The UAE Corporate Tax regime follows this approach, generally limiting net interest expense to 30 percent of tax adjusted EBITDA once the relevant threshold is exceeded, commonly referenced at AED 12 million.

That means funding design has to go beyond classification. Groups also need to ask whether interest will be deductible in practice and what happens if earnings fall.

A simple way to reduce risk

For many groups, the biggest risk sits in legacy balances.

If a shareholder advance has sat for years with no terms, decide what it really is. If it’s permanent capital, convert it properly. If it’s repayable, formalise it with terms the business can follow.

Then put one habit in place, an annual review of related party balances. Check that terms still fit performance, interest has been booked correctly, repayments are happening and pricing still makes sense. This alone often prevents funding from drifting into problem territory.

How The Knightsbridge Group can help

With over ten years advising international businesses and families, The Knightsbridge Group supports clients across the UAE and worldwide.

We combine legal, tax and immigration expertise to review family loans and shareholder advances in cross-border groups. We’ll map actual cash flows, compare them to what’s on the balance sheet and identify where funding could be attacked as equity or where interest deductions may be restricted.

We also coordinate with trustees, banks, regulators and overseas legal partners so loan terms, approvals, transfer pricing support and ongoing behaviour all line up in practice.

To review your current arrangements or plan new strategies, contact info@kbgroup.ae.