Electricité de France v. France: pricing of intercompany convertible and vanilla debt

By Dr. J. Harold McClure, New York City

The French Court of Appeal decided in favor of the multinational in a somewhat involved intercompany financing pricing issue in a January 25 decision denoted as case number 20VE00792. SAS Electricité de France International (SAS EDFI) is France’s largest electricity provider and owns the UK affiliate EDF Energy UK Ltd (EDFE).

On October 16, 2009, SAS EDFI issued €3314.25 million in intercompany debt in the form of convertible debt. The term of this financing was five years and the interest rate was equal to 1.085 percent, which was below even the interest rate on five-year German government bonds. While this interest rate would have been below the arm’s length standard had the debt been vanilla debt, the multinational asserted that this low interest rate was reasonable given the upside potential for the holder of the debt given its right to convert the debt into equity. The French tax authorities, however, argued that this conversion right had no value and preferred to treat the intercompany financing as vanilla debt. The tax authorities under this view asserted that the arm’s length interest rate should have been 4.41 percent.

This review of this litigation begins with a review of the convertible debt argument. This review will also assert that the asserted 4.41 percent interest rate may have been in excess of the arm’s length standard even if the intercompany financing were vanilla debt.

The multinational’s position

The multinational reviewed certain corporate bond issues by third parties which they deemed to be comparable to the position of the UK borrowing affiliate. The Court of Appeals decision noted:

SAS EDFI determined, on the basis of a panel of bond issues of independent comparables, the arm’s length rate that should be applied to conventional bonds, i.e. 4.41% (mid-swap rate and premium of 1.70%)

In other words, the five-year swap rate was 2.71 percent and the multinational’s analysis suggested a credit spread equal to 1.7 percent. Below, we assert that the multinational’s analysis may have overestimated the arm’s interest rate for vanilla debt.

The Court of Appeals decision also noted that the multinational used the Tsiveriotis and Fernandes model to determine the value of the right to convert debt into equity. A convertible bond gives the holder the option to exchange the bond for a specified number of shares. The number of shares for which the bond can be exchanged is given by the conversion ratio, which is usually stated at bond issuance. While the investor holds the bond and does not exercise their option to convert, they will receive periodic payments at the stated coupon level. A convertible bond can be thought of as a regular bond with an embedded equity call option. The main advantage to the issuer of a convertible bond is that the bond will usually be issued with a lower coupon rate than the equivalent non-convertible bond. This is because the holder of the convertible bond is compensated with the right to convert the bond into equity.

Tsiveriotis and C. Fernandes modeled the pricing of such instruments by noting they have two components, an equity component and a debt component, and these components have different default risks. The equity component has no default risk, since the issuer can always issue its own stock. This equity component should be discounted at the risk-free rate. The debt component involves credit risk and

should be discounted at the risk-free rate plus a credit spread. To split the convertible bond (CB) up into its components, a new hypothetical security is defined, called the “cash-only part of the convertible bond” (COCB). This hypothetical security is defined as follows: “The holder of a COCB is entitled to all cash flows, and no equity flows, that an optimally behaving holder of the corresponding convertible bond would receive.” Since the convertible bond is a derivative of the underlying equity, the COCB must also be a derivative on the underlying equity, and the value of both should follow the standard option pricing model.

A corporate bond with face value equal to €3314.25 million that pays interest equal to 1.085 percent for five years would have a market value equal to €2829.26 million if the market interest rate for its credit rate is equal to 4.41 percent. In other words, the convertible bond would have to provide additional consideration equal to €484.99 million for the 1.085 percent interest rate to be considered arm’s length. If the value of the option to convert debt into equity represents €484.99 million or 14.63 percent of the face value of the debt, then the pricing of this convertible debt would be arm’s length.

The financial economics involving convertible debt is involved. The original paper by Tsiveriotis and Fernandes was published in 1998. Victor Gushchin and Erwan Curien provide an overview of the literature and empirical work in 2008. The complexity of the financial economics raises potential double tax dispute possibilities as the French tax authorities could have argued that the value to the debt holder from the prospect of conversion to equity was lower than the multinational’s estimate, while the UK tax authorities might argue for a higher conversion value and hence an interest rate less than 1.085 percent.

The trial court accepted the argument of the French tax authorities that the right to conversion had no value to the French parent. The Court of Appeal summarized the tax authority’s position:

 

The tax authorities considered that the “conversion” component had a zero value for SAS EDFI and that, given the terms of the loan – in this case, via the OCA mechanism – and the context of the issuance transaction, the reduction in the interest rate applied compared with the arm’s length rate of 4.41% to which SAS EDFI was entitled, made it possible to achieve a transfer of profits, In the case of SAS EDFI, the difference between the interest rate of 4.41% and the rate corresponding to the actual remuneration recorded had to be reintegrated in order to determine its taxable income. Before the appeal judge, the Minister of Action and Public Accounts contested any value to the “conversion” component on the double ground, on the one hand, that the OCAs issued by EDFE having been subscribed by its sole shareholder, the financial profit that SAS EDFI can hope to make by subscribing and then converting the OCAs into new shares mechanically has a value of zero, since it would be offset by a loss of the same amount on the value of the EDFE shares held prior to this conversion, and on the other hand, that since the OCAs issued by EDFE were subscribed by its sole shareholder, the financial benefit that SAS EDFI can hope to make by subscribing and then converting the OCAs into new shares has a value of zero, since it would be offset by a loss of the same amount on the value of the EDFE shares held before this conversion, on the other hand, since the objective sought by SAS EDFI was not that of a “classic” financial investor and the decision to convert or not the OCAs into new shares will not be taken solely in the interest of the subscriber with a view to maximising his profit, the valuation of the “conversion” component of the OCAs based solely on such an interest is not relevant and, since the financial impact of a conversion was then random, this component must necessarily be given a value close to zero.

 

The Court of Appeals, however, rejected this argument and found in favor of the multinational.

A revised analysis assuming vanilla debt

Had the trial court’s ruling been accepted by the Court of Appeals, we shall assert that this 4.41 percent interest rate was likely above the arm’s length standard by challenging some of the premises used in the multinational’s original documentation. A 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.

On October 16, 2009, the interest rate on five-year German government bonds was only 2.48 percent and not the 2.71 percent swap rate used by the multinational as its base rate. Swap rates represent the interest rates that banks can borrow at and not the risk-free rate. In this case, the swap spread was 0.23 percent. Using a swap rate in lieu of the government bond rate would have led to an overstatement of the arm’s length interest rate even if the credit spread should have been 1.7 percent.

A credit spread equal to 1.7 percent would be appropriate if the borrowing affiliate’s credit rating were BBB-. It is not clear how the multinational arrived at this asserted credit spread. The UK tax authority, however, could assert a higher credit rating and hence a lower credit spread. The group credit rating for this multinational over time has ranged from A to BBB. While the appropriate credit rating for a borrowing affiliate need not be the same as the group rating—even under implicit support—one could make the case for a BBB credit rating, which would imply a credit spread of only 1.5 percent.

If we combine the five-year German government bond rate with the credit spread for a borrowing affiliate with a BBB credit rating, the appropriate interest rate under the arm’s length standard should be 4 percent rather than 4.4 percent. Such potential disagreements over the appropriate credit rating between the French and UK tax authorities could lead to double taxation even under the simpler case of vanilla debt.

Double taxation issues for convertible debt

Intercompany convertible debt poses three different means for tax authorities having divergent views that could lead to double taxation. Even vanilla intercompany debt runs the risk that the tax authority for the lending affiliate would argue for a higher credit spread than the tax authority for the borrowing affiliate given the possible controversy over the appropriate credit rating, We also noted the possibility that the two tax authorities could disagree on the value to the lending affiliate with respect to the option of converting debt into equity.

Convertible debt has equity-like features, which may lead to a denial of intercompany payments by the tax authority for the borrowing affiliate on debt versus equity grounds. While the French tax authority in this particular litigation tried to raise the intercompany interest rate from 1.085 percent to 4.41 percent, the UK tax authority might have denied all intercompany payments on the grounds that this intercompany financing represented equity and not debt.