Blackrock’s transfer pricing battle with the UK: unexplored intercompany financing issues

By Dr. J. Harold McClure, New York City

The November 3 UK Tribunal decision favoring Blackrock in its dispute with the UK tax authority described transactions that pose interesting transfer pricing questions. Though not addressed in the litigation, it seems that the UK could have challenged the transfer pricing of Blackrock’s intercompany loans.

In the case, the UK tax authority – HM Revenue and Customs – attempted to deny in full interest deductions for $4 billion of intercompany loans from the group’s US affiliate to a UK affiliate, which were part of the financing when Blackrock acquired Barclays Global Investors over a decade ago.

The litigation involved the purpose of the intercompany loans. The UK tax authority attempted to assert they were designed solely for tax avoidance purposes.

Liz Hughes and Anthony Crewe discuss aspects of this litigation in their recent MNE Tax article. They note that there were two main purposes of the loan transaction – securing a tax advantage and the commercial purpose of acquiring Barclays Global Investors. The court ruled in favor of the taxpayer, emphasizing the commercial purpose of the intercompany loan.

Pricing for the intercompany loans

The pricing of these intercompany loans is a puzzling aspect of this case. The intercompany loans were issued on November 26, 2010, in four tranches summarized by the following table.

Tranche	Amount (millions)	Maturity date	Original rate	Revised rate	Government bond rate
1	$420	Short-term	2.20%	–	–
2	$1,680	9/30/2014	4.65%	3.08%	1.15%
3	$1,400	9/30/2016	5.29%	3.50%	1.87%
4	$500	9/30/2019	6.62%	4.40%	2.65%

The UK tax authority began questioning the purpose of these intercompany loans during an audit that began in 2012. Effective October 1, 2012, the intercompany interest rates for the loans under tranches 2–4 were revised downward.

The standard model for evaluating whether an intercompany interest rate is arm’s-length has two components: the intercompany contract and the related party borrower’s credit rating.

Properly articulated intercompany contracts stipulate the loan’s date, the currency of denomination, loan’s term, and the interest rate. The first three items determine the market interest rate of a corresponding government bond. The intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contracts.

Tranches 2 –4 in the table above represent fixed interest rate loans with terms of 4 years, 6 years, and 9 years.

On November 26, 2010, the interest rate on 3-year government bonds was 0.78 percent, while the interest rate on 5-year government bonds was 1.53 percent. Our table derives the interest rate on 4-year government bonds as 1.15 percent. The original intercompany interest rate implied a credit spread equals 3.5 percent.

On November 26, 2010, the interest rate on 7-year government bonds was 2.21 percent. Our table derives the interest rate on 6-year government bonds as 1.87 percent. The original intercompany interest rate implied a credit spread of 3.42 percent.

On November 26, 2010, the interest rate on 10-year government bonds was 2.87 percent. Our table derives the interest rate on 9-year government bonds as 2.65 percent. The original intercompany interest rate implied a credit spread of 3.97 percent.

Credit spreads ranging from 3.4 percent to 4 percent are high, indicating a credit rating of BB or worse.

While the Tribunal decision does not discuss the pricing issue, it is plausible that the UK tax authority raised this issue during its audit.

The revised interest rates are consistent with credit spreads ranging from 1.63 percent to 1.93 percent. These lower credit spreads are consistent with a BBB credit rating.

The question then becomes whether the appropriate credit rating was BBB given the underlying facts of the intercompany loans. As we note below, a lot of the expert testimony focused on the nature of the intercompany loans as compared to what would be observed in third party lending.

Structure of the intercompany loans and implications for the appropriate credit rating

Hughes and Crewe note testimony by the expert witnesses for the taxpayer and the UK tax authority concerning whether the UK affiliate could have borrowed $4 billion from a third party at the same conditions and terms in the intercompany loans.

The testimony, however, did not directly address the pricing issue noted above.

Both experts noted a third party lender would have required certain protective covenants. Both experts agreed that there was sufficient liquidity at the time such that independent enterprises could have entered into a $4 billion at the same (or at no lower) rates of interest if covenants were included to protect the position of the lender.

The experts disagreed as to whether a third-party borrower would have accepted such covenants. The taxpayer’s expert argued that a third-party borrower would have accepted covenants even though they limit the financial flexibility for the borrower. The tax authority’s expert disagreed, arguing that agreeing to these covenants would be too complex and costly to the borrower even though Blackrock had agreed to similar covenants in its third-party revolving credit facility.

For third-party loans, a lack of covenants places the lender at greater risk of default. Multinationals that wish to charge their related party borrowers higher intercompany interest rates have argued that a lack of covenants for the intercompany loan suggests a lower credit rating and hence a higher interest rate under arm’s length pricing.

For third-party loans, a lack of covenants places the lender at greater risk of default. Multinationals that wish to charge their related party borrowers higher intercompany interest rates have argued that a lack of covenants for the intercompany loan suggests a lower credit rating and hence a higher interest rate under arm’s length pricing.

This argument for high credit spreads is often challenged by tax authorities for reasons noted in the OECD transfer pricing guidelines on financial transactions. Credit rating issues are covered by paragraphs 10.62 to 10.86, which includes discussions of covenants and the effect of group membership. Paragraph 10.86 notes:

There may be less information asymmetry between entities (that is, better visibility) in the intragroup context than in situations involving unrelated parties. Intra-group lenders may choose not to have covenants on loans to associated enterprises, partly because they are less likely to suffer information asymmetry and because it is less likely that one part of an MNE group would seek to take the same kind of action as an independent lender in the event of a covenant breach, nor would it usually seek to impose the same kind of restrictions.

The tax authority’s expert argued that the lack of covenants would have meant that the parent would have had to issue a loan guarantee for this loan to be made by a third party. The taxpayer’s expert argued that no guarantee was needed because of the implicit support of the parent company.

The OECD’s transfer pricing guidance on financial transactions notes the role of implicit support.

The intercompany loans’ lack of covenants was not seen as a reason to disregard the intercompany loans by this court decision.

If the lack of covenants did not materially impact the appropriate credit rating for the intercompany loan, it would not likely impact our analysis of the arm’s length interest rate.

As such, the lack of covenants in the intercompany transactions would not necessarily imply a lower credit rating once the implicit support argument is considered.

The UK tax authorities’ attempt to disregard this intercompany loan entirely did not succeed given the ruling of this Tribunal. The ruling of the Tribunal does not indicate that the taxpayer agreed to lower intercompany interest rates after the transfer pricing audit started. It is entirely possible that this challenge by the UK tax authority succeeded in convincing the taxpayer to agree to lower its intercompany interest rates.