Bringing clarity to documenting intercompany financing during a pandemic

Dr. Harold McClure, New York, NY

These days, transfer pricing practitioners are rightfully advising clients to clearly document their intercompany financing, mostly for two different reasons.

One is the February 11, 2020, release by OECD of its transfer pricing guidelines on financial transactions. The other is the market volatility created by the pandemic.

Many US affiliates are facing at least temporary financing needs, which may require financial assistance from their foreign parents. While government bond rates have recently declined, credit spreads on corporate borrowings have increased.

Transfer pricing economists focus on the pricing issues in the OECD guidelines, but many practitioners have expressed concerns over the accurate delineation of the transaction.

Accurate delineation

Tax directors may wonder what accurate delineation of the transaction even means. As an economist, my natural response might simply be to have clear and consistent intercompany loan contracts. Much of the recent discussion adds confusion by questioning whether the intercompany financing represents debt versus equity and questioning whether the specific terms of an intercompany loan contract will be respected.

I will present some of these concerns before turning to the important pricing issues.

Much concern revolves around whether a tax authority will see intercompany financing as a vehicle to shift income towards tax havens.

While the OECD guidelines discuss whether a tax authority can deem intercompany financing as equity and not debt, many firms are seeking either third party debt or intercompany debt. We should note, however, that the practice of hybrid mismatches, where an intercompany loan for an affiliate is treated as equity for the parent is being challenged by tax authorities.

Multinationals should also be aware of any legal limitations to the percent of operating profits that can be included in interest deductions.

The other concern is whether the intercompany interest rate is above what the affiliate would have paid in a third party contract.

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

Properly articulated intercompany contracts stipulate the date of the loan, the currency of denomination, the term of the loan, and the interest rate.

The first three items allow the analyst to determine the market interest rate of the corresponding government bond.

This 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 contract.

While it used to be common practice to accept the first three terms of any clearly articulated intercompany loan contract, both the OECD guidelines are recent discussions give credence to tax authorities challenging these terms.

One of the issues in Chevron Australia Holdings Pty Ltd. v. Commissioner of Taxation was the attempt by the tax authority to recast the denomination of the intercompany loan from being in Australian dollars to US dollars.

At the time of the loan, interest rates on Australian financial instruments were higher than interest rates on US financial instruments. This difference in interest rates reflected the expectation of exchange rate changes such that the true cost of borrowing in US dollars was the same as the cost of borrowing in Australian dollars. The tax authorities attempted to argue it was cheaper to borrow using US dollars, which is a claim that ignores basic international finance.

Interest rates during periods of weak economic demand often are very low for short-term government bonds, while long-term government bonds tend to be somewhat higher. Intercompany loans with long-term fixed interest rates would tend to have higher interest rates than short-term or floating rate loans. Paragraph 10.37 of the OECD guidance presents this example:

Consider that Company A, a member of AB Group, advances funds with a term of 10 years to an associated enterprise, Company B, which will use the funding for short-term working capital purposes. This advance is the only loan in Company B’s balance sheet. AB Group’s policy and practices demonstrate that the MNE group uses a one-year revolving loan to manage short-term working capital. In this scenario, under the prevailing facts and circumstances, the accurate delineation of the actual transaction may conclude that an unrelated borrower under the same conditions of Company B would not enter into a 10-year loan agreement to manage its short-term working capital needs and the transaction would be accurately delineated as a one-year revolving loan rather than a 10-year loan. The consequences of this delineation would be that assuming the working capital requirements continue to exist, the pricing approach would be to price a series of refreshed one-year revolver loans.

Much recent transfer pricing practitioner commentary suggests that tax authorities can challenge the term of an intercompany loan as well as the date of the intercompany contract.

Some of this commentary has suggested that a third party would not borrow at all during periods when market interest rates were elevated, which is a striking suggestion given the fact we observed very high interest rates during the financial crisis after the fall of Lehman Brothers.

Interest rates were not artificially high during this period, as some have suggested. Interest rates were high simply because companies had serious financing needs when credit spreads were elevated. One could, however, suggest that during a temporary need for financing, borrowers would either borrow short-term or negotiate floating-rate agreements if they believed interest rates in the future would decline.

Pricing issues: credit ratings and market interest rates

The issue of what represents a reasonable credit rating has attracted a lot of attention in recent litigations in various jurisdictions.

The Chevron litigation was especially instructive given the taxpayer’s attempt to justify a high loan margin on a claim that the intercompany loan represented subordinated debt.

The court rejected this characterization and accepted the premise that a parent would grant a borrowing affiliate at least some degree of implicit support. The successful position of the tax authority was that the credit rating should be consistent with a BBB credit rating.

Interest rates vary over time for various reasons, which can be seen in terms of the two key components.

Government bond rates vary over time as do credit spreads. Our table presents information derived from the Federal Reserve for various key recent data on the interest rate on 20-year government bonds and the interest rate on long-term corporate bonds with a BBB credit rating.

At the beginning of the year, the corporate bond rate was 3.86 percent and the government bond rate was 2.19 percent.

The difference represents a 1.67 percent credit spread. By February 20, corporate bond rates had declined to 3.57 percent as the government bond rate had declined by almost 30 basis points while credit spreads rose by about ten basis points.

 

Long-term interest rates at various dates

Date	Corporate bond rate	Government bond rate	Credit spread
1/2/2020	3.86	2.19	1.67
2/20/2020	3.57	1.81	1.76
3/20/2020	5.15	1.35	3.80
5/15/2020	4.05	1.05	3.00
6/3/2020	3.81	1.32	2.49

 

A month later, corporate bond rates had increased to 5.15 percent even though government bond rates had declined to 1.35 percent because credit spreads had jumped to 3.8 percent.

Since then, credit spreads and corporate bond rates have moderated with the credit spread on long-term corporate bonds rated BBB being near 2.5 percent.

Credit spreads were elevated during the 2007 to 2009 credit crisis. Credit spreads also spiked in late March but have moderated to the levels witnessed during late 2001.

Two continuing litigations between the Canadian Revenue Agency (CRA) and ConocoPhillips involve whether a 0.5 percent intercompany guarantee fee was appropriate. Canadian affiliates collectively borrowed $6.5 billion using formal guarantees from the US parent.

In an earlier paper, I provide the contractual details (“Alberta v. ENMAX Energy: Shades of the Chevron Australia Intercompany Interest Issue,” Journal of International Taxation, April 2019). The 0.5 percent intercompany guarantee fees would be consistent with market pricing if a reasonable estimate of the credit rating for the borrowing affiliate was BBB.

These litigations, however, drag on as the CRA appears to be more focused with what was the purposes of this financing back in 2001 as opposed to addressing the intercompany pricing issue.

The parable for multinationals in today’s environment is that the original reasoning for intercompany financing, as well as the structure of that financing, should be documented at the time of the intercompany contract.

Transfer pricing economists can then focus on the intercompany contract in terms of the date of the loan, the currency of denomination, and the term of the loan.

The intercompany interest rate can be compared to the interest rate on the corresponding government bond to determine the credit spread implied by the intercompany contract.

Estimating credit rating for the borrowing affiliate is clearly the crucial, but also controversial, issue.

 Even with an agreed-upon credit rating, translating this letter grade into a numerical credit spread is an important step that requires market data at the time of the intercompany contract in light of the variability of observed credit spreads.