OECD has just released its long-awaited guidelines for pricing financial transactions (OECD report). The report is intended to form a new chapter X to the OECD transfer pricing guidelines.
This report broadly covers:
- Intercompany loans
- Treasury functions
- Cash pooling
- Captive insurance
We summarise below some of the key matters raised in the report as concerns loans and guarantees.
OECD emphasises the importance of accurately delineating the transaction and taking into account the options realistically available to both borrower and lender. That analysis may suggest that all or some of an intercompany debt should not be respected as debt (but rather as equity).
For example, if the facts suggest a borrower could not fully service the loan and an independent lender would not lend that amount, some of the loan could possibly be reclassified as equity. Another example is that a long-term loan could be delineated as being an in-substance series of short-term loans. Furthermore, if Co A is lending to related Co B, but Co A is not exercising control over the risks of that lending or has no capacity to take on the risk, it may justify only a risk-free return to Co A.
The comparable uncontrolled price (CUP) method is endorsed for interest rate pricing. The report reminds us to consider the possibility of an internal transaction that may be sufficiently comparable (at least with some adjustments). Other approaches are not dismissed- the cost of funds approach (i.e. the lenders cost of borrowing plus cost of arranging the loan and a risk premium), use of credit default swaps and economic modeling. But the guidance notes potential issues using these alternatives. Bank quotes are ruled out as reliable evidence.
Credit worthiness (and hence credit ratings) is acknowledged as an important factor that lenders take into account. When working out the implied credit rating of the borrower:
- The issue rating is more relevant than the issuer rating. Consider the particular loan features.
- Use of credit rating agency methodologies and proprietary tools to calculate an implied credit rating are considered useful but be aware of limitations and need to consider qualitative factors.
- Support that a parent may provide to the borrower in distress, in the absence of an explicit guarantee (i.e. implicit support of ‘halo’ effect), needs to be taken into account. Factors such as the relative importance of the borrower and linkages with the rest of the group and stated credit policies, are relevant factors. The assessment of implicit support is a “matter of judgment”.
- Typically, the standalone borrower rating is relevant where little implicit support is limited. The group credit rating could be appropriate where implicit group support of the borrower is strong.
When benchmarking an interest rate, the report suggests that a range is more likely rather than a single specific rate. Comparability adjustments may be required to gain greater reliability (e.g. tenor, currency, security).
Guidance is also provided on financial guarantee arrangements- typically, where one company in a group provides a financial guarantee for lending by an independent person to another group company. In the absence of a reliable external CUP, a guarantee benefit is typically measured by the difference between the borrower’s interest rate with the guarantee and the rate without a guarantee (but accounting for implicit support). Both borrower and guarantor should benefit from the guarantee arrangement, but unfortunately, no guidance is given on how to measure the sharing of the benefit between the parties.
An important factor is whether the guarantor has the financial capacity to take on the guarantee. The absence of such capacity may undermine the substance of any real guarantee at arm’s length.
A guaranteed benefit could be an increase in borrowing capacity. That may suggest pricing a standalone loan amount to the borrower, but the excess loan amount could be treated as a loan to the guarantor and equity contribution to the borrower.
See our follow-up article here: https://www.tpts.co.nz/blog/2020/02/19/new-zealand-is-out-of-sync-with-oecds-new-guidelines-on-financial-arrangements/