In July 2018, under the mandate of the Report on Actions 8-10 of the Base Erosion and Profit Shifting (“BEPS”) Action Plan (“Aligning Transfer Pricing Outcomes with Value Creation”), the OECD Working Party 6 published a non-consensus discussion draft on financial transactions. Although there were many comments and fundamental issues raised by various parties, the differences between the so-called non-consensus draft and the final report are rather limited (we refer in this respect to an article published by International Tax Review1). Furthermore, it was already clear back in 2018 that countries participating in the OECD Working Party 6 could not reach consensus, the release date of the public discussion draft being behind schedule provided an indication (please find our initial comments on that non-consensus draft here).
Now, the OECD provides for final guidance on financial transactions2, with the purpose to determine whether the conditions of certain financial transactions between associated enterprises are consistent with the arm's length principle, however, still including various options or leaving core topics blank – thereby avoiding the elephant(s) in the room. As a key example, we may refer to what the OECD states in paragraph 10.10: “Although countries may have different views on the application of Article 9 to determine the balance of debt and equity funding of an entity within an MNE group, the purpose of this section is to provide guidance for countries that use the accurate delineation under Chapter I to determine whether a purported loan should be regarded as a loan for tax purposes (or should be regarded as some other kind of payment, in particular a contribution to equity capital)” – i.e. this guidance is applicable for those jurisdictions who want it to be applicable, but not for those who don’t want it? Because of these options, tax administrations among the globe may apply standards in different ways. We believe this increases rather than reduces uncertainty.
In this article we will highlight the key issues with respect to the determination of arm’s length interest rates on intercompany loans only.
On credit ratings and credit scores
The creditworthiness of the borrower is one of the most important factors in the determination of an arm’s length interest rate. Indeed, while the interest rate ultimately applied will depend on the particular terms and conditions of the loan agreement (e.g. tenor, seniority, options included, guarantees/collateral provided, etc.), the economic analysis would typically start with the determination of the creditworthiness of the borrowing entity. Although, as the guidance also acknowledges, the particular terms & conditions could result in a credit rating of a debt issuance that deviates from the creditworthiness of the borrower, however the creditworthiness of the borrower still serves as starting point from which the debt issuance could deviate from (e.g. in case of subordination).
Therefore, in order to estimate the creditworthiness of a borrowing entity, and given that it will not typically have publicly available credit ratings (although it may be part of a group for which the ultimate parent entity may have publicly available credit ratings), publicly available financial tools are often used to assess credit worthiness which are then translated into so-called credit scores3.
However, the guidance now questions the reliability of those publicly available financial tools (which can be licensed from credit rating agencies) as they may differ significantly from the credit rating methodologies applied by independent credit rating agencies to determine official credit ratings. Obviously, we do not question the statement that official credit ratings are a result of far more rigorous analysis that includes quantitative analysis of historic and forecast entity performance as well as detailed qualitative analysis of, for instance, management’s ability to manage the entity, industry specific features and the entity’s market share in its industry. However, publicly available financial tools are used precisely to try to replicate as good as possible the official credit rating methodologies. Moreover, the qualitative analysis within an intragroup context probably will not be objective if performed by affiliated entities. Otherwise, if such qualitative analyses need to be performed by third parties to demonstrate, for instance, consistency of tools with those provided by independent credit rating agencies, the cost of debt issuances would increase significantly. Additionally, although these tools rely more on quantitative inputs rather than qualitative inputs and they are not transparent – a black box with respect to the underlying algorithms and processes, the 3 major independent credit agencies, i.e. S&P, Moody’s, and Fitch, all provide such financial tools. Therefore, we may expect that these tools provide credit scores on a consistent basis which at least are very directional for the more formal credit rating practices.
The alternative use of the group credit rating (or score)
Despite the considerations provided in the guidance, the use of such publicly available financial tools is accepted. However, the guidance explicitly mentions – and this is just one the biggest elephants in the room – that “a pricing approach based on the separate entity credit ratings that are derived from publicly available financial tools, the implicit support analysis, the difficulties of accounting for controlled transactions reliably and the presence of information asymmetry may pose challenges that, if not resolved, may result in outcomes that are not reliable” and therefore, the group credit rating may also be used.
The guidance later softens its language that such group credit rating (or scores) may be used where the facts so indicate, particularly in situations such as where the MNE is important to the group taking into account implicit group support (see below) and where the borrowing entity’s indicators of creditworthiness do not differ significantly from those of the group. Nevertheless, because of aforementioned “pre-requisites”, it can be expected that tax administrations in market jurisdictions of the borrowing entity could interpret the guidance that the use of publicly available financials tools is not really acceptable and that the group rating should be taken into account – most likely resulting in a lower interest rate applied / deducted – even merely on the basis of a perceived information asymmetry between them and the taxpayer concerned?
Of course, it has to be seen which line of argumentation the tax administration will follow. Certainly considering that a significant amount of groups do not have a publicly available group credit rating. Hence, in those cases the publicly available financial tools might be the only reliable indicator to produce a group credit score.
In any case, the fact that the guidance includes an option to use the group credit rating (although it refers to certain situations) is a move away from the separate entity approach which is fundamentally embedded in the arm’s length principle. Taking into account the latest developments in view of Pillar 1 and 2 with respect to the tax challenges of the digitalization of the economy, one could ask if the arm’s length principle will remain the standard in the (near) future.
Implicit group support
On the other hand, where the separate entity hypothesis can be retained to serve as a base principle underlying arm’s length pricing, we welcome the guidance on the effect of group membership. Group membership has an effect on the creditworthiness of a group affiliate. The so-called implicit support would not require a compensation or comparability adjustment.
In order to apply implicit support, we would recommend to apply the guidance provided by independent credit agencies, such as S&P’s group rating methodology papers. Combined with the use of publicly available financial tools provided by independent credit agencies, we firmly believe that groups can develop a robust finance policy based on the separate entity approach.
Furthermore, the proper application of implicit group support would typically diminish the need to use publicly available financial tools for every group affiliate within the group, as at least for group affiliates that are considered to be vital for the business their credit scores would be equal or close to the group credit rating.
The appropriate application of implicit group support within such a finance policy will typically be the last step in the determination of the issuer’s credit score. However, as the guidance also acknowledges, the credit score of a specific debt instrument may differ still due to the particular terms and conditions included in the agreement.
Transfer pricing method(s)
Even though a move away from the arm’s length principle towards global formulary apportionment might be on its way, the determination of interest rate on intercompany loans given a certain credit rating is probably still to be based on the (modified) CUP method. Indeed, the widespread availability of information makes it easier to apply the CUP compared to other transactions, the OECD claims. Additionally, the unexpected movement of the financial market makes it harder, again, compared to other transactions to apply a formulaic approach.
With the above in mind, we welcome the guidance that arm’s length interest rates can also be based on the return of realistic alternative transactions with comparable economic characteristics. While, in order to determine an arm's length interest rate a benchmark analysis can be used based on publicly available data for other borrowers with the same credit rating for loans with sufficiently similar terms and conditions and other comparability factors (i.e. the direct CUP method), we believe that in a substantial amount of cases significant comparability adjustments are required or that no (potential) comparable loan transactions can be found. Indeed, in order to find potential comparable loan transactions, often the search criteria (such as start date, tenor, creditworthiness) are stretched.
Therefore, in the context of financial transactions, the application of significant comparability adjustments, in our view, would not be sufficiently accurate (taking into account that due to stretching the search criteria the necessary adjustments sometimes result in wide interest rate ranges) and, therefore, we usually do not use the direct CUP method. Indeed, seemingly minimal differences in terms and conditions could lead to significant different results. In addition, the timing of the transaction is important given the constant fluctuations of the financial market. Finally, if comparable loan transactions can be found, they need to be adjusted (unless they take place really close to the effective start date of the controlled transaction) such that the correct yield-to-maturity can be calculated. Hence, yield curves are required.
Consequently, interest rates based on return of realistic alternative transactions with comparable economic characteristics, such as yield data based on bonds can be used. Such (option-free) fair market yield curves are constituted of data points of underlying comparable uncontrolled transactions. Furthermore, yield curves are available per sector, currency, tenor, start date, credit class. Moreover, they are stripped from all sorts of options (any options that are included in the controlled transaction can be valued separately if required).
Essentially, such yield curves represent the CUP-method on which statistical measures have been applied to make comparability adjustments automatically (i.e. building a full term structure for a given dataset of underlying uncontrolled transactions, on any given date for a remaining tenor) and offering a basis of comparability for the most significant comparability factors – being timing, currency, rating, tenor and sector – on which basis then fewer comparability adjustments are required. This promotes objectivity, and it should therefore be noted that it consists of underlying real instruments. In essence this is a modified CUP analysis where we do not need to do the statistics ourselves.
Another advantage of this approach in view of the arm’s length principle is that these yield curves are used continuously by fixed income investment professionals globally for effectively pricing and trading fixed income securities, and are therefore an effectively used means for price setting between third parties.
In addition, the guidance mentions the use of the cost of funds approach in absence of comparable uncontrolled transactions, which reflect the borrowing costs incurred by the lender in raising the funds to lend added the expenses of arranging and servicing the loan, a risk premium and a profit margin, which will generally include the lender’s incremental cost of the equity required to support the loan. However, with the application of the modified CUP method, there will be no absence of comparable uncontrolled transactions. Thus, the need to apply a method such as the cost of funds approach disappears4. However, wouldn’t the end game be a sort of global cost of funds apportioning as the pressure (at least from an inbound perspective) seems to increase to use group ratings and the matching of all internal lending indentures, including timing with those of the group externally?
Although the guidance published by the OECD in some points makes clear clarifications. With respect to intercompany loans, such clarifications are for instance the valid use of implicit group support in determination of the creditworthiness of the borrowing entity or the use of yield curves in application of the modified CUP method. On the other hand, the guidance offers a lot of options such as when determining the creditworthiness of the borrowing entity or transfer pricing methods to determine an arm’s length interest rate (CUP, cost of funds, credit default swaps, economic modelling). These ‘options’ may lead to divergencies in usage by countries around the globe, or – as we are incrementally experiencing - even within a jurisdiction on the basis of whether they are dealing with the inbound or the outbound side of the transaction.
Therefore, we wonder whether it would not have been a better option to add another public consultation round before publishing final guidance to be included in the OECD Transfer Pricing Guidelines. In our view, it seems they could not reach consensus and, therefore, they included this range of options, which in the end will not help avoid transfer pricing disputes and double taxation.
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3 Note that credit rating agencies distinguish between credit ratings they formally assign based upon their own analysis, and credit scores that are derived from such financial tools they license.
4 In our view, in line with the pure application of the arm’s length principle which is based on the separate entity hypothesis, the sole time the cost of funds approach may be used to price loans is where capital is borrowed from an unrelated party which passes from the original borrower through one or more associated intermediary enterprises, as a series of loans, until it reaches the ultimate borrower. In such cases, where only agency or intermediary functions are being performed, as noted at paragraph 7.34, “it may not be appropriate to determine the arm’s length pricing as a mark-up on the costs of the services but rather on the costs of the agency function itself”.