Implicit group support has been a popular discussion topic between transfer pricing professionals over the last years. The OECD has now taken a clear position by requiring an implicit group support analysis for each subsidiary-specific credit rating. Which factors should be taken into account to determine the level of implicit support? Additionally, how to translate the level of implicit support towards a number of notches as an adjustment? This article aims to provide answers on many practical questions raised by corporates.
Implicit support as per the OECD
The OECD guidance is transparent on the high-level credit rating process for subsidiaries. Each credit rating should incorporate both financial as well as qualitative information to create a stand-alone rating of the entity. This rating may be adjusted to reflect the level of group support. More information on these processes can be found in our related article: a best-practice framework to determine subsidiary-specific credit ratings.
Unfortunately, many corporates would welcome additional guidance on the leading indicators for implicit support. The OECD lists the following indicators:
- Strategic importance and operational integration
- Shared name and reputational risk
- Historical group support and group policy
- Legal obligations
Although these criteria seem to provide a good indication of implicit support, they can be interpreted in different ways. In order to better understand the common interpretation of these criteria, practitioners often rely on case law.
Implicit support as per case law
Two landmark cases on implicit support help corporates to better understand the details of implicit support: the GE Capital case and the Chevron Australia case. The criteria of the GE Capital case largely overlap with those set out by the OECD. It mainly gives practitioners more insight on how to interpret the ‘strategic importance and operation integration’ of the entity. During the case, it is concluded that this is linked to the size of the subsidiary, the longevity of the subsidiary as well as the financial and managerial integration with the group.
The Chevron Australia case also deals with the definition of ‘strategically important’ entities. Corporates should therefore be aware that the OECD’s definition of strategic importance is not per se identical to the S&P definition as it categorizes subsidiaries by core, highly strategic, strategically important, moderately strategic and nonstrategic. However, the major issue addressed in this case is how to translate the level of implicit support into an upward adjustment of the stand-alone rating in terms of notches.
How to account for implicit support
Corporates are encouraged to create a implicit support framework. The framework typically includes a questionnaire that outlines a set of statements that can be linked back to the OECD criteria. Should some of these statements be subjective, it would be beneficial to document the interpretation of the statement, e.g. which corporate actions define historical group support.
The implicit group support would also include a mapping of each level of implicit support to a number of notches as upwards adjustment on the stand-alone subsidiary credit rating. It could be argued that this adjustment is dependent on both the level of group support as well as the gap between the stand-alone and group rating. For example, a medium level of group support may only lead to an adjustment if the gap between both ratings is large enough. As there is not a fixed approach that guarantees tax certainty, it is key to document the implicit group support framework and apply it consistently.
Special considerations
The group support analysis may be helpful in certain circumstances. For example, should the taxpayer not possess the subconsolidated financials for a certain holding. A financials-based rating may not be representative as the financials do not accurately represent the strength of the entity. The group support may lead to a significant upward adjustment of the rating to account for the strategic importance of the holding.
Special considerations should also be given to ring-fenced entities. Certain entities are ring-fenced due to regulatory requirements or recent M&A activity. These entities would not be subject to group support of the ultimate parent company.
Conclusion
Although the OECD puts forward an implicit group support analysis as part of a best-practice credit rating analysis, many details are lacking. This leads to a significant transfer pricing risk. However, the risk can be mitigated by developing a group support framework. Typically, the framework would consist out of questionnaire to determine the level of group support as well as a mapping towards the rating adjustment. Consistently applying this framework is the best option for corporates to mitigate tax risk.