How does the ‘arm’s length’ test work in intercompany lending?

Intercompany lending arrangements within multinational enterprises are at record levels, and are coming under increasing scrutiny from tax authorities across the world. Silvina Aldeco-Martinez and Ernest Breitschwerdt explain why

For large multinational enterprises, intercompany lending offers the possibility of an ideal allocation of debt versus equity within the wider group to support shareholder value creation, an optimal capitalisation of entities within that group to meet investment requirements and the opportunity of leveraging these various entities’ different levels of funding access.

However, the lack of a formalised framework for assessing and reporting intercompany financing has led tax authorities to identify a major risk stemming from it: that corporations are organising these transactions in ways that could be interpreted as ‘thin capitalisation’, ‘profit shifting’ or other tax-avoidance practices.

Although various national authorities have taken different approaches to such transactions, and there is a lack globally of a formal framework for their assessment, one common theme emerging, certainly in the advanced economies, is that such arrangements ought to be arranged according to the ‘arm’s length principle’. In other words, the aim is that the financing in question is conducted in the most objective way possible.

In showing that this is indeed the case, corporate groups in developed-economy jurisdictions are increasingly expected to demonstrate their compliance with two subsidiary principles.

The first is that the borrowing entity could and would potentially get access to a similar level of debt, with similar terms and conditions, from a third-party lender. The second is that the interest rate is priced in accordance with arm’s length transactions in which comparable, unrelated parties would enter into similar agreements.

The benefit of such an approach is noted in the 34-nation Organisation for Economic Co-operation and Development consultation paper published in December 2014*: “An arm’s length test… allows a tax administration to focus on the particular commercial circumstances of an entity or a group.” The arm’s length principle has therefore been found to be the most complete approach to formalise a framework for intercompany financing.

Risk assessment

Passing this arm’s length test is a two-part process. Firstly, the enterprise concerned has to show that its credit risk assessment of the affiliated company is transparent, objective and comparable to that which would have been conducted by an unrelated third-party lender. Secondly, and assuming that the financing is then approved in principle, the enterprise concerned then has to show that its pricing of the loan also meets these criteria.

The question is how multinational enterprises can best fulfil these requirements.

Firstly, the credit risk analysis. One simple way to arrive at a risk assessment is to calculate different financial ratios based on interest expenses, debt, equity, depreciation and amortisation (EBITDA), or assets in varied combinations. It is then possible to compare these ratios to aggregated ratio data based on those of publicly rated companies, and gauge the credit risk.

But this approach typically results in a flawed outcome. To start with, the publicly rated companies are likely to be of a different size and scale from the subsidiary or affiliate with whose financial ratios they are being compared to. Similarly, ratios are likely to vary across different industries and regions.

As a consequence of these issues, auditing firms and corporations have begun to incorporate a second approach, namely quantitative credit risk assessment models – effectively treating the affiliate as an entirely independent entity from the multinational business – to arrive at a far more credible credit rating.

 Assessing the credit risk and the appropriateness of the associated pricing is not without its challenges 

Increasingly, auditors and companies have shifted to examining credit risk ‘in the round’ rather than focusing on financial ratios, with the most effective models looking at measures such as ‘probability of default’ and credit scores through the business cycle. These measures are more likely to produce robust and provably independent risk assessments of the sort that would emerge were the subsidiary or affiliate to be entirely unconnected to the main group.

The key role played by credit risk assessment in satisfying the arm’s length criterion increasingly insisted upon by tax authorities is underlined by our own research into the risk landscape of the top 15 subsidiaries or affiliates of the five largest corporations, measured by revenue, with their headquarters in Luxembourg. These are ArcelorMittal, Tenaris SA, RTL Group SA, Regus plc and Eurofins Scientific SA.

These companies’ interests range across five main industry groups: materials, energy, ‘consumer discretionary’, industrials and healthcare. These subsidiaries operate in at least two of these sectors and in a minimum of seven national markets.

Further approaches

This industrial and geographical variety can be shown when using a quantitative credit-risk assessment model calculating ‘through-the-cycle’ metrics in the form of probabilities of default or credit scores (typically in lower-case nomenclature to distinguish them from public credit ratings) trained on observed defaults or ratings dispersion. These approaches enable a holistic assessment of financial and business risks altogether, rather than focusing on ratio analysis alone.**

The dispersion of the stand-alone credit-risk assessments we found in our research (ranging from credit scores of A- to CC) in conjunction with some substantial deviations from those of the parent companies is a clear illustration of the need to analyse each subsidiary or affiliate as an individual business in order to properly fulfil the arm’s length requirement. Depending on the tax jurisdiction, the additional consideration of a potential support structure might be necessary, based on qualitative and/or quantitative elements.

After the risk assessment follows the question of pricing the loan. That pricing needs to comply with the principle that the cost ought to be comparable with the rate that would be charged by an unrelated third party. Central to establishing this is ensuring that the price is similar to that charged in the open market to independent companies with comparable credit assessments and operating in similar business sectors and geographical areas.

  Increasingly, the requirement is that such financing will be conducted in a manner comparable to lending to an entirely unconnected company of the same size and creditworthiness 

The public bond market, for instance, provides a valuable starting point to credit-risk pricing because of the availability of up-to-date price references (given the existence of a deeper secondary market), the depth of available coverage in terms of geographical and industry representation, and the full transparency of the comparable debt instruments, given their public nature.

Such a transparent, accurate and objective source of information is useful for establishing benchmark rates to be charged on loans. But a caveat is that publicly quoted bond rates tend to not reflect the extra risk premium that an independent private company would be expected to pay to lenders. It is here that an additional source of information can be brought into play: the secondary market in private loans. It is at the interstices of the public bond markets and the private loan markets where such a premium can be empirically quantified and estimated.

In conclusion, the rising use of intercompany financing and heightened scrutiny from tax authorities across the world have gone hand in hand. Increasingly, the requirement is that such financing will be conducted in a manner comparable to lending to an entirely unconnected company of the same size and creditworthiness.

Assessing the credit risk and the appropriateness of the associated pricing is not without its challenges. By leveraging sophisticated independent credit-risk assessment tools and mechanisms to compare observed prices for entities sharing the same credit risk, sector and country exposure, maturity and specific debt characteristics will help to ensure transparency, objectivity, consistency and speed, and therefore will limit potential conflicts with tax authorities.

Loan rates

Our own researches show interesting regional divergences in the spread between loan rates and bond rates. In the eurozone, the spread of loan rates over bond rates has risen markedly since the end of 2012, while the US markets display practically no mark-up in terms of loan rates over bond rates. One explanation is that the greater involvement of American companies of all sizes in the bond market has resulted in more competitive prices for loans.
What is certain is that the private-company loan premiums vary greatly over both different regions of the world, as has been seen inside the eurozone.

*OECD BEPS Action 4: Interest deductions and other financial payments (Published 18 December 2014)

**The globally comparable output of these quantitative tools is typically considered independent and objective credit risk assessments, where judgement and therefore disagreement between multinational enterprises and tax authorities, is minimised

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About the authors

Silvina Aldeco-Martinez is managing director; and Ernest Breitschwerdt, CFA, is application specialist at S&P Capital IQ

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