The Implications of the Credit Crunch for Intercompany Loans

THE IMPLICATIONS OF THE CREDIT CRUNCH FOR INTERCOMPANY LOANS J. Harold McClure, Senior Manager, ONESOURCETM Transfer Pricing ONESOURCE TRANSFER PRICING TAX & ACCOUNTING

THE IMPLICATIONS OF THE CREDIT CRUNCH FOR INTERCOMPANY LOANS In a recent speech, Federal Reserve chairman Ben transfer pricing exposure by the use of the safe haven provision. The paper Bernanke described the ramifications of the “abrupt concludes by considering a situation where this U.S. subsidiary wishes to raise end of the credit boom” thusly:1 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 Rising credit risks and intense risk aversion have pushed credit spreads to unprecedented levels, pricing exposure for this new transaction. And we shall also address how to and markets for securitized assets, except for evaluate an arm’s length interest rate. mortgage securities with government guarantees, have shut down. Heightened systemic Credit Spreads: 1994 to 2008 risks, falling asset values, and tightening credit The Federal Reserve publishes historical information on long-term corporate bond have in turn taken a heavy toll on business and rates, which are rated Aaa and Baa by Moody’s. The Moody’s ratings correspond consumer confidence and precipitated a sharp to the AAA and BBB ratings by Standard & Poor’s. Figure 1 shows the reported slowing in global economic activity. average monthly rates from January 1994 to December 2008. While the recent recession has led to losses for Credit spreads are often calculated as the difference between the interest rate on many U.S. companies which would tend to increase some form of private debt of a particular maturity and the interest rate on federal their need to borrow funds if they wished to maintain government bonds for the same maturity. Figure 1 also shows the monthly current operations, the credit crunch has made average interest rate for 20-year Federal government bonds. Figure 2 calculates obtaining third-party loans more difficult. Consider the credit spread for AAA debt (AAA-s) as the difference between the interest the case of a U.S. subsidiary, which desires to obtain rate on long-term AAA corporate debt and the interest rate on 20-year federal credit by undertaking intercompany debt issued by its government bonds. Figure 2 also calculates the credit spread for BBB debt foreign parent. (BBB-s) as the difference between the interest rate on long-term BBB corporate While interest rates on U.S. federal debt have debt and the interest rate on 20-year Federal government bonds. Over the period dramatically declined during recent months, from January 1994 to December 2008, the mean AAA spread was 81 basis points, interest rates on third-party corporate debt have while the median AAA spread was 67 basis points. Over this period, the mean BBB increased. The rise in interest rates on corporate spread was 170 basis points, while the median BBB spread was 149 basis points.2 debt is reflected in Bernanke’s observation that credit These spreads, however, vary over time and were above their average values spreads have risen to “unprecedented levels.” We during the period from early 2000 to early 2003. During the recent recession, shall note that while many multinational corporations which started in December 2007, these spreads have increased reaching the with inbound intercompany loans may have relied unprecedented levels mentioned by the Federal Reserve chairman by late 2008. on the Applicable Federal Rate (AFR) safe haven of section 1-482.2(a) for previous intercompany loans, Effective Use of Section 1-482-2(a)’s Safe Haven for Intercompany Loans reliance on this safe haven is not likely to address in Early 2007 the need to comply with both U.S. transfer pricing Section 1.482-2(a) of the U.S. transfer pricing regulations allows a U.S. entity regulations and the expectation of the foreign tax engaged in intercompany loans to provide evidence that the intercompany interest authority that the interest rate on the intercompany rate meets the arm’s length standard, that is, is consistent with the market rate loan be consistent with market interest rates for for a comparable loan. This section also allows for a safe haven if the loan is comparable loans. 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 This paper’s discussion begins by noting the credit Internal Revenue Service for: spreads on long-term AAA and BBB government debt over the 1994 to 2008 period. The discussion next • short-term loans defined as being equal to less than three years; considers how the tax director for a hypothetical U.S. • mid-term loans defined as being greater than three years but not subsidiary that had incurred an intercompany loan more than nine years; and two years ago might have successfully managed • long-term loans defined as being greater than nine years. 1 Stamp Lecture, London School of Economics, London, England, January 13, 2009. 2 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 2008. 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.

As an example, suppose that a U.S. subsidiary U.S. taxable income by $5 million. This taxpayer would therefore be potentially borrowed $500 million from its foreign parent where subject to section 6662 penalties if they did not conduct a contemporaneous the contract stipulates a term greater than nine years documentation showing that its intercompany interest rate was consistent with and the currency of denomination is U.S. dollars. If the market rate on comparable debt. To avoid a possible double taxation dispute the long-term AFR for the month when the loan was between the foreign tax authority, who will argue that the interest rate should be made were 5 percent, then the IRS cannot challenge high, and the IRS, who will argue that the interest rate should be modest, taxpayers the intercompany interest rate as long as it is not in this situation should analyze the credit rating of the U.S. subsidiary in order to greater than 6.5 percent. 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. In early 2007, the interest rate on 20-year federal government bonds was almost 5 percent, while credit Estimating the Arm’s Length Interest Rate spreads on BBB debt were just under 150 basis The evaluation of what constitutes an arm’s length interest rate depends on the points. If the AFR were 5 percent, the multinational terms of the intercompany loan as well as the credit rating of the borrower. The could have established a 6.5 interest rate on its terms of the loan should be stipulated in an intercompany agreement between intercompany loan and be protected from IRS the related party lender and borrower that would describe the following features: scrutiny by the section 1.482-2(a) safe haven. While safe havens are generally not provided by • date of the loan; foreign tax authorities, the tax authority for the foreign • term or duration of the loan; parent might accept the 6.5 interest rate unless it had • currency of denomination; and evidence that the credit rating for the U.S. subsidiary • other features of the loan (if any). would be worse than BBB. If the credit standing of the U.S. subsidiary were clearly such that any debt For simplicity, we shall assume a dollar-denominated 10-year fixed interest rate that it issued would be considered investment grade, loan. Loan rates also vary because of differences in the credit risk. As an illustration, this multinational would not likely need to produce interest rates on 10-year federal bonds were only 2.76 percent as of February 2, an analysis of what the arm’s length rate should 2009 but interest rates on long-term corporate debt rated AAA was 5.19 percent have been. and interest rates on long-term corporate debt rated BBB was 8.09 percent. Safe Haven Does Not Provide Comfort for Credit spreads are often seen as the compensation for the lender bearing Intercompany Loans Made in Early 2009 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 If the AFR were only 3 percent rather than 5 percent, assumed a one-period loan and an expected return equal to r:4 the upper end of the safe haven range would be only 3.9 percent. Recently, interest rates on government r = i(1 – p) – p(1 – c), bonds have dramatically declined, which would where p = probability of default and c = the amount of the original loan principle also suggest that the implied spread between the that the lender can recover from provisions such as collateral. Option pricing AFR and 1.3 times AFR would not be as high as it models such as the seminal paper by Robert Merton are based on this simple was a few years ago. In fact, the implied spread is premise that the difference between the contractual rate and the expected return less than 100 basis points for long-term loans made represents the expected losses from default.5 during February 2009.3 Spreads for even AAA-rated long-term corporate debt, however, have recently An alternative approach to estimating credit spreads is often used and represents been higher than 100 basis points, while spreads a two-step process where the analyst: for borrowers with lower credit ratings have been • estimates the credit rating of the borrower; and much higher. • evaluates market observations on interest rates paid by borrowers with the Our hypothetical U.S. subsidiary likely needs to same credit rating for loans of the same duration made at the same time. conduct a transfer pricing analysis to evaluate and defend its choice for the intercompany interest rate. The credit rating of the borrower is perhaps the most difficult feature to estimate If the interest rate were set so as to fall within the and yet it represents a critical issue in evaluating whether a particular intercompany safe haven provisions of section 1.482-2(a), then interest rate is arm’s length. Credit rating agencies including Moody’s, Standard the foreign tax authority could readily argue that the & Poor’s, and Fitch Ratings assign publicly traded debt ratings from as high as intercompany interest rate were too low. 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 If the interest rate were set such that it was of BBB or higher is often referred to as investment grade debt. Credit ratings are consistent with what a borrower with a BBB credit indications of the probability that a borrower will default on its loan obligations. rating would have to pay, the IRS could suggest that When borrowers default, the lender will likely receive a return on its investment that the appropriate credit rating was higher, implying a is substantially less than the contractual rate. As such, lenders will adjust upwards lower interest rate. Given our assumption that the the contractual rate to reflect the expected losses from default. Credit rating models loan base is $500 million, each 1 percent (or 100 often utilize certain income statement and balance sheet data of the borrower to basis points) reduction in the interest rate would raise access the borrower’s ability to repay debt. 3 Rev. Ruling 2009-5 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).

While the credit rating agencies access the probability Moody’s RiskCalc draws on the KMV-Merton model to estimate the credit rating for that the terms of publicly traded debt will either be private firms. Eric Falkenstein, Andrew Boral, and Lea V. Carty provide a discussion honored by the borrower versus seeing the borrower of various approaches to estimating credit ratings including the RiskCalc model for default, the task of transfer pricing practitioners is estimating the credit rating.8 The model uses as inputs the following 10 financial to evaluate the creditworthiness of related party ratios in a probit model to estimate the Expected Default Frequency (EDF) at borrowers. They often evaluate the creditworthiness 1-year and 5-year horizons: of the related party borrower on a stand-alone basis • assets/CPI; (that is, if the entity were assumed not to be part of the • inventories /COGS; multinational group). • liabilities/assets; Edward Altman developed one version for credit • net income growth; ratings in 1968 that estimated the probability of • income/assets; default based on a “Z-score” approach where the • quick ratio; determinants were the following five financial ratios • retained earnings/assets; of the borrower:6 • sales growth; • cash/assets; and • working capital/total assets; • debt service coverage ratio. • retained earnings/total assets; • operating profits/total assets; The model also estimates a credit rating based on the 5-year EDF. • market value of equity/total liabilities; and • sales/total assets. 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 Practitioners that utilize this Altman Z-score approach loans. Comparability includes both the actual date of the loan as well as the must translate the derived Z-score into either a credit term of the loan. The arm’s length interest rate can be derived as the sum of: spread or a credit rating. While Gregory Eidleman notes the use of the Altman approach, he cautions • interest rate on government bonds for loans issued on the same day practitioners who utilize this approach, or any other and for the same term; and of the many alternative models, as to not naively • credit spread appropriate for the date of the loan and its term. trust the results from the application of any particular model. Any model of a company’s credit rating can As our historical charts indicate, both factors can vary substantially over time. produce misleading results when applied naively. Both factors also depend on the term of the loan. The term structure of interest Untrained users should recognize that these models rates often refers to the relationship between interest rates on government bonds only take us one step beyond the accounting data with different terms. The credit spread may also depend on the term of the loan that represents the inputs of the model. As such their so that a term structure of credit spreads exists. Recent papers have examined apparent accuracy and sophistication should not blind the factors that determine the term structure of credit spreads.9 While these the user as to how imprecise what might appear to be papers suggest that the term structure of credit spreads may be either upward exact information often is. As such, the output from sloping or downward sloping, transfer pricing practitioners often note that the these credit rating models must be seen as, at best, an credit spread for shorter-term loans is lower than the credit spread for longer-term estimate of the credit rating of the borrower.7 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 The KMV-Merton model applied the framework of Rob- might be lower than the credit spread for longer-term loans, as they note that ert Merton who argued that the equity of a company is issuers of debt may have embedded options such as call provisions:11 a call option on the underlying value of the company with a strike price equal to the face value of its debt. One example of an embedded option is a call provision, which allows the issuer While neither the underlying value of the company nor 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. its volatility are directly observable, the model postu- lates that both can be inferred from the value of equity, Since the value of an option tends to increase with its term, the additional yield the volatility of equity and several other observable on a loan with default risk would tend to be higher if the term of loan was longer. variables. The model specifies that the probability of Given the tendency for both government bond rates and credit spreads to vary default is the normal cumulative density function of a both across the term of the loan and across time, any analysis of the arm’s length Z-score depending on the firm’s underlying value, the rate must be able to examine market data not only for various credit ratings but firm’s volatility and the face value of the firm’s debt. also for various terms to maturities and various dates. Various sources exist Moody’s uses an extension of this KMV-Merton model for reviewing market information on third-party interest rates on loans including to estimate the credit rating for publicly traded firms. Dealscan, which is a service offered by Thomson Reuters. 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/16641886.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 Eco- nomic Models Can Fill the Guidance Gap”, BNA Tax Management Transfer Pricing Report, February 28, 2008. 11 “Credit Spreads and Subordinated Debt”, Economic Commentary (Federal Reserve Bank of Cleveland, March 1, 2007).

Setting and Documenting the Arm’s Length Nature of Intercompany Interest Rate Long-term interest rates Given the simultaneous recent decline in government 10.00 bond rates and the rise in credit spreads, we have 9.00 argued that U.S. entities that choose to borrow funds 8.00 from related party entities would be ill advised to 7.00 rely simply on the safe haven provisions of section 6.00 1.482-2(a). In order to manage transfer pricing risk 5.00 that may exist with respect to an IRS inquiry, the 4.00 taxpayer would need to ensure that they can defend 3.00 their choice of intercompany interest rates against a 2.00 claim that the arm’s length rate is too high. In order 1.00 to manage transfer pricing risk that may exist with 0.00 respect to a foreign tax authority inquiry, the taxpayer Jan-93 Oct-95 Jul-98 Apr-01 Jan-04 Oct-06 Jul-09 Apr-12 GB20 AAA BBB would need to ensure that they can defend their choice of intercompany interest rates against a claim Figure 1 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 Credit Rate Spreads spread depends on the credit rating, the taxpayer 6.00 must evaluate what would be an appropriate credit rating for the related party borrower. Even if the 5.00 U.S. entity’s credit rating would place its debt in the 4.00 category of investment grade, the intercompany interest rate would likely contain a significant credit 3.00 spread in today’s marketplace. 2.00 In order to have protection against section 6662’s 1.00 penalties from an IRS challenge to the chosen intercompany interest rate, the taxpayer should 0.00 produce documentation that the interest rate chosen Jan-93 Oct-95 Jul-98 Apr-01 Jan-04 Oct-06 Jul-09 Apr-12 for the intercompany loan was consistent with the AAA-s BBB-s arm’s length standard. This documentation would Figure 2 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.

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The Implications of the Credit Crunch for Intercompany Loans

by Thomson Reuters Tax & Accounting on Jul 28, 2009

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The Implications of the Credit Crunch for Intercompany Loans — Document Transcript