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1 transfer pricing insider tm onesource transfer pricing Volume 3, issue 1 April 2009 Author: J. Harold McClure, Senior Manager onesource Transfer Pricing The Implications of the Credit Crunch for Intercompany Loans Source: J. Harold McClure, Senior Manager, onesource Transfer Pricing In a recent speech, Federal Reserve chairman Ben Bernanke described the ramifications of the abrupt end of the credit boom thusly: 1 Rising credit risks and intense risk aversion have pushed credit spreads to unprecedented levels, and markets for securitized assets, except for mortgage securities with government guarantees, have shut down. Heightened systemic risks, falling asset values, and tightening credit have in turn taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity. While the recent recession has led to losses for many U.S. companies which would tend to increase their need to borrow funds if they wished to maintain current operations, the credit crunch has made obtaining third party loans more difficult. Consider the case of a U.S. subsidiary, which desires to obtain credit by undertaking intercompany debt issued by its foreign parent. While interest rates on U.S. federal debt have dramatically declined during recent months, interest rates on third-party corporate debt have increased. The rise in interest rates on corporate debt is reflected in Bernanke s observation that credit spreads have risen to unprecedented levels. We shall note that while many The Implications of the Credit Crunch for Intercompany Loans Credit Spreads: 1994 to 2008 Effective Use of Section (a) s Safe Haven for Intercompany Loans in Early 2007 Safe Haven Does Not Provide Comfort for Intercompany Loans Made in Early 2009 Estimating the Arm s Length Interest Rate Setting and Documenting the Arm s Length Nature of Intercompany Interest Rate Figure 1 Figure 2 Footnotes About OneSource Transfer Pricing Tax & Accounting

2 multinational corporations with inbound intercompany loans may have relied on the Applicable Federal Rate (AFR) safe haven of section (a) for previous intercompany loans, reliance on this safe haven is not likely to address the need to comply with both U.S. transfer pricing regulations and the expectation of the foreign tax authority that the interest rate on the intercompany loan be consistent with market interest rates for comparable loans. This paper s discussion begins by noting the credit spreads on long-term AAA and BBB government debt over the 1994 to 2008 period. The discussion next considers how the tax director for a hypothetical U.S. subsidiary that had incurred an intercompany loan two years ago might have successfully managed transfer pricing exposure by the use of the safe haven provision. The paper concludes by considering a situation where this U.S. subsidiary wishes to raise funds in today s market through the use of an additional intercompany loan. We shall note why the safe haven provision will not successfully manage the transfer pricing exposure for this new transaction. And we shall - also address how to evaluate an arm s length interest rate. Credit Spreads: 1994 to 2008 The Federal Reserve publishes historical information on long-term corporate bond rates, which are rated Aaa and Baa by Moody s. The Moody s ratings correspond to the AAA and BBB ratings by Standard & Poor s. Figure 1 shows the reported average monthly rates from January 1994 to December Credit spreads are often calculated as the difference between the interest rate on some form of private debt of a particular maturity and the interest rate on federal government bonds for the same maturity. Figure 1 also shows the monthly average interest rate for 20-year Federal government bonds. Figure 2 calculates the credit spread for AAA debt (AAA-s) as the difference between the interest rate on long-term AAA corporate debt and the interest rate on 20-year federal government bonds. Figure 2 also calculates the credit spread for BBB debt (BBB-s) as the difference between the interest rate on long-term BBB corporate debt and the interest rate on 20-year Federal government bonds. Over the period from January 1994 to December 2008, the mean AAA spread was 81 basis points, while the median AAA spread was 67 basis points. Over this period, the mean BBB spread was 170 basis points, while the median BBB spread was 149 basis points. 2 These spreads, however, vary over time and were above their average values during the period from early 2000 to early During the recent recession, which started in December 2007, these spreads have increased reaching the unprecedented levels mentioned by the Federal Reserve chairman by late Effective Use of Section (a) s Safe Haven for Intercompany Loans in Early 2007 Section (a) of the U.S. transfer pricing regulations allows a U.S. entity engaged in intercompany loans to provide evidence that the intercompany interest rate meets the arm s length standard, that is, is consistent with the market rate for a comparable loan. This section also allows for a safe haven if the loan is dollar denominated and if the interest rate is not less than the Applicable Federal Rate (AFR) and not greater than 1.3 times the AFR. AFRs are established by the Internal Revenue Service for: short-term loans defined as being equal to less than three years; mid-term loans defined as being greater than three years but not more than nine years; and long-term loans defined as being greater than nine years. As an example, suppose that a U.S. subsidiary borrowed $500 million from its foreign parent where the contract stipulates a term greater than nine years and the currency of denomination is U.S. dollars. If the long-term AFR for the month when the loan was made were 5 percent, then the IRS cannot challenge the intercompany interest rate as long as it is not greater than 6.5 percent. In early 2007, the interest rate on 20-year federal government bonds was almost 5 percent, while credit spreads on BBB debt were just under 150 basis points. If the AFR were 5 percent, the multinational could have established a 6.5 interest rate on its intercompany loan and be protected from IRS scrutiny by the section (a) safe haven. While safe havens are generally not provided by foreign tax authorities, the tax authority for the foreign parent might accept the 6.5 interest rate unless it had evidence that the credit rating for the U.S. subsidiary would be worse than BBB. If the credit standing of the U.S. subsidiary were clearly such that any debt that it issued would be considered investment grade, this multinational would not likely need to produce an analysis of what the arm s length rate should have been. Safe Haven Does Not Provide Comfort for Intercompany Loans Made in Early 2009 If the AFR were only 3 percent rather than 5 percent, the upper end of the safe haven range would be only 3.9 percent. Recently, interest rates on government bonds have dramatically declined, which would also suggest that the implied spread between the AFR and 1.3 times AFR would not be as high as it was a few years ago. In fact, the implied spread is less than 100 basis points for long-term loans made during February Spreads for even AAA-rated long-term corporate debt, however, have recently been higher than 100 basis points, while spreads for borrowers with lower credit ratings have been much higher. 2

3 Our hypothetical U.S. subsidiary likely needs to conduct a transfer pricing analysis to evaluate and defend its choice for the intercompany interest rate. If the interest rate were set so as to fall within the safe haven provisions of section (a), then the foreign tax authority could readily argue that the intercompany interest rate were too low. If the interest rate were set such that it was consistent with what a borrower with a BBB credit rating would have to pay, the IRS could suggest that the appropriate credit rating was higher, implying a lower interest rate. Given our assumption that the loan base is $500 million, each 1 percent (or 100 basis points) reduction in the interest rate would raise U.S. taxable income by $5 million. This taxpayer would therefore be potentially subject to section 6662 penalties if they did not conduct a contemporaneous documentation showing that its intercompany interest rate was consistent with the market rate on comparable debt. To avoid a possible double taxation dispute between the foreign tax authority, who will argue that the interest rate should be high, and the IRS, who will argue that the interest rate should be modest, taxpayers in this situation should analyze the credit rating of the U.S. subsidiary in order to both set a reasonable intercompany interest rate and to provide documentation that the interest rate that was selected is consistent with the arm s length standard. Estimating the Arm s Length Interest Rate The evaluation of what constitutes an arm s length interest rate depends on the terms of the intercompany loan as well as the credit rating of the borrower. The terms of the loan should be stipulated in an intercompany agreement between the related party lender and borrower that would describe the following features: date of the loan; term or duration of the loan; currency of denomination; and other features of the loan (if any). For simplicity, we shall assume a dollar-denominated 10- year fixed interest rate loan. Loan rates also vary because of differences in the credit risk. As an illustration, interest rates on 10-year federal bonds were only 2.76 percent as of February 2, 2009 but interest rates on long-term corporate debt rated AAA was 5.19 percent and interest rates on long-term corporate debt rated BBB was 8.09 percent. Credit spreads are often seen as the compensation for the lender bearing the downside risk from borrower s defaulting on loans. A simple model for the contractual interest rate (i) on loans was offered by Dwight M. Jaffee who assumed a one-period loan and an expected return equal to r: 4 r = i(1 p) p(1 c), where p = probability of default and c = the amount of the original loan principle that the lender can recover from provisions such as collateral. Option pricing models such as the seminal paper by Robert Merton are based on this simple premise that the difference between the contractual rate and the expected return represents the expected losses from default. 5 An alternative approach to estimating credit spreads is often used and represents a two-step process where the analyst: estimates the credit rating of the borrower; and evaluates market observations on interest rates paid by borrowers with the same credit rating for loans of the same duration made at the same time. The credit rating of the borrower is perhaps the most difficult feature to estimate and yet it represents a critical issue in evaluating whether a particular intercompany interest rate is arm s length. Credit rating agencies including Moody s, Standard & Poor s, and Fitch Ratings assign publicly traded debt ratings from as high as AAA (best quality borrowers, reliable and stable) to as low as D (has defaulted on obligations and will likely default on most or all obligations). Debt that has a rating of BBB or higher is often referred to as investment grade debt. Credit ratings are indications of the probability that a borrower will default on its loan obligations. When borrowers default, the lender will likely receive a return on its investment that is substantially less than the contractual rate. As such, lenders will adjust upwards the contractual rate to reflect the expected losses from default. Credit rating models often utilize certain income statement and balance sheet data of the borrower to access the borrower s ability to repay debt. While the credit rating agencies access the probability that the terms of publicly traded debt will either be honored by the borrower versus seeing the borrower default, the task of transfer pricing practitioners is to evaluate the credit worthiness of related party borrowers. They often evaluate the creditworthiness of the related party borrower on a stand-alone basis (that is, if the entity were assumed not to be part of the multinational group. Edward Altman developed one version for credit ratings in 1968 that estimated the probability of default based on a Z-score approach where the determinants were the following five financial ratios of the borrower: 6 working capital/total assets; retained earnings/total assets; operating profits/total assets; market value of equity/total liabilities; and sales/total assets. Practitioners that utilize this Altman Z-score approach must translate the derived Z-score into either a credit spread or a credit rating. While Gregory Eidleman 3

4 notes the use of the Altman approach, he cautions practitioners who utilize this approach, or any other of the many alternative models, as to not naively trust the results from the application of any particular model. Any model of a company s credit rating can produce misleading results when applied naively. Untrained users should recognize that these models only take us one step beyond the accounting data that represents the inputs of the model. As such their apparent accuracy and sophistication should not blind the user as to how imprecise what might appear to be exact information often is. As such, the output from these credit rating models must be seen as, at best, an estimate of the credit rating of the borrower. 7 The KMV-Merton model applied the framework of Robert Merton who argued that the equity of a company is a call option on the underlying value of the company with a strike price equal to the face value of its debt. While neither the underlying value of the company nor its volatility are directly observable, the model postulates that both can be inferred from the value of equity, the volatility of equity and several other observable variables. The model specifies that the probability of default is the normal cumulative density function of a z-score depending on the firm s underlying value, the firm s volatility and the face value of the firm s debt. Moody s uses an extension of this KMV-Merton model to estimate the credit rating for publicly traded firms. Moody s RiskCalc draws on the KMV-Merton model to estimate the credit rating for private firms. Eric Falkenstein, Andrew Boral, and Lea V. Carty provide a discussion of various approaches to estimating credit ratings including the RiskCalc model for estimating the credit rating. 8 The model uses as inputs the following 10 financial ratios in a probit model to estimate the Expected Default Frequency (EDF) at 1-year and 5-year horizons: assets/cpi; inventories /COGS; liabilities/assets; net income growth; income/assets; quick ratio; retained earnings/assets; sales growth; cash/assets; and debt service coverage ratio. The model also estimates a credit rating based on the 5-year EDF. Once a credit rating is established, the transfer pricing analyst should also review market data on interest rates paid by third-party borrowers for comparable loans. Comparability includes both the actual date of the loan as well as the term of the loan. The arm s length interest rate can be derived as the sum of: interest rate on government bonds for loans issued on the same day and for the same term; and credit spread appropriate for the date of the loan and its term. As our historical charts indicate, both factors can vary substantially over time. Both factors also depend on the term of the loan. The term structure of interest rates often refers to the relationship between interest rates on government bonds with different terms. The credit spread may also depend on the term of the loan so that a term structure of credit spreads exists. Recent papers have examined the factors that determine the term structure of credit spreads. 9 While these papers suggest that the term structure of credit spreads may be either upward sloping or downward sloping, transfer pricing practitioners often note that the credit spread for shorter-term loans is lower than the credit spread for longer-term loans. 10 The discussion of credit spreads by Joseph G. Haubrich and James B. Thomson may suggest one reason why the credit spread for shorter-term loans might be lower than the credit spread for longerterm loans, as they note that issuers of debt may have embedded options such as call provisions: 11 One example of an embedded option is a call provision, which allows the issuer to buy a bond back at a previously set price. The issuer pays for this provision by offering a higher yield on the bond issue. Since the value of an option tends to increase with its term, the additional yield on a loan with default risk would tend to be higher if the term of loan was longer. Given the tendency for both government bond rates and credit spreads to vary both across the term of the loan and across time, any analysis of the arm s length rate must be able to examine market data not only for various credit ratings but also for various terms to maturities and various dates. Various sources exist for reviewing market information on third-party interest rates on loans including Dealscan, which is a service offered by Thomson Reuters. Setting and Documenting the Arm s Length Nature of Intercompany Interest Rate Given the simultaneous recent decline in government bond rates and the rise in credit spreads, we have argued that U.S. entities that choose to borrow funds from related party entities would be ill advised to rely simply on the safe haven provisions of section (a). In order to manage transfer pricing risk that may exist with respect to an IRS inquiry, the taxpayer would need to ensure that they can defend their choice of intercompany interest rates against a claim that the arm s length rate is too high. In order to manage transfer pricing risk that may exist with respect to a foreign tax authority inquiry, the taxpayer would need to ensure that they can defend 4

5 their choice of intercompany interest rates against a claim that the arm s length rate is too low. We have also noted that the arm s length interest rate can be seen as the sum of the government bond rate for the term of the loan and the date it was issued and the appropriate credit spread. Since the credit spread depends on the credit rating, the taxpayer must evaluate what would be an appropriate credit rating for the related party borrower. Even if the U.S. entity s credit rating would place its debt in the category of investment grade, the intercompany interest rate would likely contain a significant credit spread in today s marketplace. In order to have protection against section 6662 s penalties from an IRS challenge to the chosen intercompany interest rate, the taxpayer should produce documentation that the interest rate chosen for the intercompany loan was consistent with the arm s length standard. This documentation would begin by describing the terms of the loan including the date of the loan and the term or duration of the loan. The documentation would also describe how the estimated credit rating for the related party borrower was determined as well as market evidence for credit spreads on loans made by borrowers with similar credit ratings on or near the date of the intercompany loan and for the same term or duration. Figure 1 Figure 2 5

6 footnotes 1 Stamp Lecture, London School of Economics, London, England, January 13, Financial economists pose a credit spread puzzle, which is defined as the large difference between observed credit spreads and the average default loss on corporate debt. This puzzle has been recently discussed in Long Chen, Pierre Collin-Dufresne, and Robert S. Goldstein, On the Relation Between the Credit Spread Puzzle and the Equity Premium Puzzle, January Explanations for this puzzle include the possibility that lenders require a premium in the expected return for bearing certain types of risk. If credit spreads include compensation for bearing risk, then option pricing models that assume away such premium will lead to estimates for the credit spread that will tend to underestimate market spreads. 3 Rev. Ruling states that the long-term AFR is 2.96 percent and 130 percent of this AFR is 3.86 percent, which represents an implied spread of only 90 basis points. 4 Money, Banking, and Credit (Worth Publishers, 1989). 5 On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, Journal of Finance (1974). 6 Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance (September 1968). 7 See the discussion at nysscpa.org/cpajournal/old/ htm. 8 RiskCalcTM for Private Companies: Modeling Methodology (May 2000). 9 Mascia Bedendo, Lara Cathcart, Lina El-Jahel, The Shape of the Term Structure of Credit Spreads: An Empirical Investigation, 2004; and C. N. V. Krishnan, P. H. Ritchken, and J. B. Thomson, On Credit Spread Slopes and Predicting Bank Risk. 10 See the table entitled AFR Compared with Market Rates in Rob Plunkett and Larry Powell, Transfer Pricing of Intercompany Loans and Guarantees: How Economic Models Can Fill the Guidance Gap, BNA Tax Management Transfer Pricing Report, February 28, Credit Spreads and Subordinated Debt, Economic Commentary (Federal Reserve Bank of Cleveland, March 1, 2007). 6

7 KEEP TRANSFER PRICING PENALTIES AT ARM S LENGTH! Important Guidance from WG&L! The United States has targeted transfer pricing as an issue of major importance, for both inbound and outbound investments. Therefore, one of the most crucial business and tax considerations for any multinational corporation is how it prices goods, services, and intangibles. WG&L s U.S. International Transfer Pricing examines the case law and regulations and applies those principles to such topics as: Transfer planning studies Presenting positions in the context of litigation or controversy Obtaining an advance pricing agreement (APA) Responding to a summons or examination It explores transfer pricing at work under the constraints of state taxation, customs laws, and other relevant areas. U.S. International Transfer Pricing includes detailed coverage of: The arm s-length standard Essential premises of transfer pricing law The transfer pricing penalty APAs IRS examination and controversy process Don t get caught in the web of complex regulations, risking huge penalties for noncompliance. Let the expert authors of U.S. International Transfer Pricing help you through the planning processes to make the right decisions. Call or visit ria.thomson.com now to learn more about this critical guidance. About the Authors: Sewell, LLP. Associates, New York, New York. Wynne Sewell LLP. INTP6/ Thomson Tax & Accounting. Checkpoint, RIA, PPC and WG&L are registered trademarks of Thomson Professional & Regulatory Inc. Other names and trademarks are properties of their respective owners. TAX & ACCOUNTING

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