Implicit Support or Arm’s Length? The Ambiguity of Transfer Pricing for Intercompany Loans and Guarantees

Originally published on LinkedIn by Bram Isgur, Principal at Keystone Strategy.

Some areas of the law are largely straightforward and settled. With a given set of facts, the outcome is fairly predictable. But other areas of the law are anything but settled and predictable, such as transfer pricing of intercompany loans and guarantees within multinational corporations.

An important topic with huge financial impacts for many organizations, transfer pricing for intra-group finance has gained special attention following the recent release of new guidelines from the Organisation for Economic Cooperation and Development (OECD). Recently, I was a guest on a webcast series hosted by Skadden entitled “Arm’s Length Principle vs. Implicit Support: What’s the Way Forward?”

Those two terms — arm’s length vs. implicit support — reflect different legal frameworks for determining an appropriate interest rate for a loan to a subsidiary. Strictly interpreted, the arm’s length standard applies the rate a third party would charge the subsidiary if it stood “at arm’s length” from the rest of the multinational with no expectation of a “bail-out” from its parent company. The implicit support theory assumes that indeed if the subsidiary were in trouble, the parent company would step in. As such, the implicit support standard could result in a lower rate than the arm’s length standard.

The OECD has endorsed the implicit support standard. However, no transfer pricing case in the United States has tested this theory.

Significant tax consequences for companies and countries

The differences have significant consequences for the countries in which the affiliated lender and borrower are situated. If the subsidiary is paying back the loan at a higher rate, that surplus represents greater taxable income for the corporation’s country. Tax officials in the lender’s country thus would prefer to apply the stricter arm’s length standard while tax officials in the borrower’s country would prefer the implicit support standard.

Complicating the issue is the complexity of measuring how much (if any) the interest rate should be reduced by implicit support. Applying the implicit support theory requires careful consideration of the factual permutations of each case:

• How dependent is the rest of the group on the borrower?
• How severable is the borrower from the group?
• How likely is the parent to be able to support its subsidiary?

In short, there is no simple formula to apply to come up with an objective answer.

Determining an independent lender’s likely judgment and rate

To settle the matter, the parties might seek an independent opinion about the interest rate a subsidiary could obtain on its own. Often a company will offer as supporting evidence a quote from its bank. However, the OECD guidelines and many tax authorities question the value of bank quotes without the extension of an actual loan.

At Keystone, we help clients provide viable answers to such matters by finding experts who can provide a realistic vantage point that others might lack. In this case, that group may include industry experts who have made their living valuing, buying, selling, and placing corporate debt.

The reason is that the industry experts have had real-world experience dealing with thorny issues involving debt capital markets and the complex questions of trust involved in implicit support. From that perspective, they can evaluate how an unusual transaction would be perceived by the lending market in practice. Because true third-party loans to subsidiaries are rare and the answer depends so heavily on the idiosyncrasies of each particular case, experts with real depth of experience in the debt market will be critical to resolving controversies.

To learn more about how Keystone can help you or your organization with a transfer pricing matter, contact us. In the meantime, use this link to watch the webinar with Skadden representatives and me.