A structured approach to pricing

The importance of a structured and consistent approach towards setting interest rates for inter-company loans.

A structured approach to pricing

Multinational companies are increasingly faced with regulatory requirements from tax authorities worldwide regarding the pricing of inter-company loans. This article looks at the importance of a structured and consistent approach towards setting interest rates for inter-company loans – an area with which many companies struggle.

Due to the financial crisis, the corporate finance function of companies has been increasing its focus on the optimization of external funding sources. However, one should not neglect the importance of the internal corporate finance function. The internal corporate finance function is defined as the process of optimizing the financial resource allocation within an organization. The internal corporate finance function is responsible for the way that an organization funds its operating companies.

Many companies finance the operations and capital expenditures of their operating subsidiaries through inter-company loans. Inter-company loans offer companies possibilities to optimize the capital allocation process by transferring profits from one tax jurisdiction to another. In the past few years, tax authorities have been increasingly focused on the different aspects of the armÕs length principle and thin capitalization rules in combination with the interest deductibility of intercompany loans. The effects of the economic crisis, which have resulted in a steep spike in credit spreads, will mean that the determination and documentation of interest rates for intercompany loans will receive even more attention from tax authorities.

Currently, many companies struggle to properly document how to determine the interest rate of their inter-company loans. Many companies still use, a simple (rating) grid approach in which operating companies are categorized into a limited number of risk categories. Each risk category has a static risk premium and loan pricing does not take into account the characteristics (terms and conditions) of these inter-company loans. Those companies are exposed to considerable risks of transfer pricing adjustments by tax authorities, even for loans provided several years ago.

“arm’s length” principle

Transfer pricing refers to the pricing of assets, funds and services transferred within a company and should be based on the so-called Arm’s Length Principle (ALP), which is documented in Article 9 of the OECD Model Tax Convention. However, in this article we focus on the transfer pricing regarding inter-company loans. Regulatory tax authorities require that pricing of these internal loans are set at arm’s length, as if they were provided to an independent market party. Therefore, an adequate assessment of the credit rating of the subsidiary and related, consistent pricing of the loan is required by national tax authorities.

To support the ALP, the company must show that inter-company loans between armÕs length parties (holding or financing company and its affiliates), with terms and conditions comparable to external loans, carry comparable interest rates. An example of a definition of the arm’s length principle for

“Many companies finance the operations and capital expenditures of their operating subsidiaries through intercompany loans.”

inter-company loans is given below (US Section ¤ 1.482 Transfer Pricing Regulation): “The arm’s length rate of interest shall be a rate of interest which was charged, or would have been charged, at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances. All relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.

In general, it should be noted that:

  • documenting the determination of inter-company interest rate on inter-company loans becomes more important;
  • next to interest rates, other characteristics and terms and conditions of the inter-company loan also need to comply with the ALP;
  • corporates more often use external or internal credit rating models to determine the armÕs length interest rate for each individual inter-company loan.

credit risk analysis

Credit risk can be expressed in the following three ways:

  • Probability of Default (PD) is the likelihood that the borrower will default within 12 months;
  • Exposure at Default (EAD) is the expected outstanding amount of a loan at the time of a default;
  • Loss Given Default (LGD) is the expected loss on the intercompany loan as a percentage of the EAD, if the company defaults.

Most inter-company rating models are only based on an assessment of the PD of the counterparty. Including the EAD and LGD in the assessment, can be regarded as a best in class’ approach, however, this is more complicated. A PD rating methodology, or model, should generate ratings which are linked to senior unsecured debt. A rating model is often based on a financial analysis and a business analysis. The financial analysis focuses on quantitative variables related to the company’s operations, liquidity, capital structure and debt service. Therefore, the values of the quantitative variables of an obligor should be compared with its industry peer group. The business analysis can consist of different factors such as industry sector and country risk, year of incorporation, legal structure, number of FTEs, etc. However, for the purpose of the assignment of an independent, objective credit rating only quantitative information should be used.

credit spread

Generally, market observations are evaluated on reference interest rates, or spreads, applicable to borrowers within the same industry with the same credit rating on loans with equal or similar conditions. All underlying loan characteristics, such as the date and term of the loan, repayment schedule or more exotic features, need to be taken into account to determine the interest rate or spread. Credit spreads for all rating categories can be determined by using information of data vendors, CDS levels or bond yields. The interest rate on the inter-company loan is calculated by looking up credit spreads based on the internal rating.

documentation

The rating and pricing assessment must be documented in a transparent, consistent and detailed ‘Obligor Rating and Pricing Report’ to respond to the requirements of tax authorities. The documentation should, at least, include the following:

  • short company description; overview of financial figures;
  • description of the rating methodology deployed;
  • credit rating analysis;
  • inter-company loan characteristics;
  • explanation of the pricing methodology and interest rate spread.

Next to that, the inter-company loan itself needs to be documented using ‘standard’ inter-company loan documentation which can also be used for third-party agreements.

Different solutions

Depending on the number of subsidiaries, loan agreements and data available, different solutions can be distinguished. In case of only a relatively limited number of subsidiaries and loan agreements, the documented analysis is preferably done based on a quantitative assessment of financial ratios which are benchmarked to the subsidiary’s industry peers. In case of many loan agreements to a large set of subsidiaries, a customized rating model could be considered. This kind of rating model can be based on internal and/or external data. The preferred solution should always be customized to the companyÕs needs and must always be based on a consistent subsidiary rating and pricing approach for the companyÕs internal and tax purposes. The self explanatory subsidiary rating and pricing matrix depicted before shows an overview of several distinctive situations and possible solutions.