The OECD clearly outlines the preferred approach towards credit ratings. In the context of pricing intercompany financial transactions, subsidiary-specific credit ratings are frequently required. Without an automated process, this can be a cumbersome process for corporates. This article will elaborate on the compliance challenges of subsidiary-specific credit ratings and how to tackle those from a practical point of view. Replace shortcut methods by technology!
Many treasury and tax departments face a high number of subsidiaries. Many of these entities are impacted by intercompany financial transactions which require subsidiary-specific credit ratings. Without automation in place, treasurers sometimes revert to shortcut methods in order to save time. Unfortunately, this creates unnecessary tax risk as auditors can re-assign a different credit rating more easily.
Corporates are advised not to apply the public credit rating of the group for its entities. Subsidiaries do not, by definition, have the same credit rating as the group. Most subsidiaries will actually have a lower credit rating. This shortcut method opens the door for tax auditors to put forward a subsidiary-specific credit rating and thereby dismissing the subsequent pricing outcome as well. Note that exceptions exist, for example when explicit guarantees are in place.
Some multinationals will categorize similar entities into credit rating buckets. It should be noted that this approach is also a shortcut approach relative to the most recent OECD guidance. However, the level of compliance largely depends on how the rating buckets are defined and created. The more granular the rating buckets, the better. Additionally, it is important to follow the OECD guidance when determining the rating of each bucket. More information on the credit rating best-practices can be found in the next section.
Best-practice principles for a defendable credit rating
Creating credit ratings requires specific knowledge and data. It is therefore often challenging for corporates to comply with the subsidiary-specific credit rating requirements. Having a solid framework in place will assist corporates in significantly lowering the compliance burden.
The first step would be to create a financial assessment of the subsidiary based on its financial statements. Ideally, such analysis would incorporate a point-in-time, i.e. last fiscal year, as well as a trend analysis across the last fiscal years in order to be complete. Subsequently, the financial rating should be complemented by qualitative information that is not incorporated in the analysed financial statements. This information could, for example, be segmented into country risk, industry risk and business risk. Business risk may include entity-specific information such as a high dependency on one supplier, particular riskiness of its activities, etc.
The above-mentioned two steps will result in a stand-alone credit rating of the entity. Lastly, the corporate may need to revise this rating by factoring in group support. The OECD distinguishes between explicit support, provided through formal guarantees, and implicit support. More information of the various level of group support can be found in our related articles: various types of guarantees and how to price them and how corporates can document implicit support.
Practical hurdles faced by corporates
Setting a transfer pricing policy in line with the OECD requirements is often not the most challenging part. Implementing the framework in a feasible and economic fashion is. Two practical tasks prevail: the readiness of credit rating models and dealing with a large number of credit ratings.
Creating a credit score based on the financials of an entity is subject to model risk. In order to mitigate the model risk, practitioners rely on data. Data on corporate financial statements and their resp. defaults may help to understand which financial ratios are leading. Data also helps to understand the correlations between the ratios. Unfortunately, most corporates would not have direct access to such data nor the in-house knowledge to perform a rating model calibration. Therefore, corporates seeking compliance may consider to outsourcing these tasks to third-party credit rating tools. It should be noted that corporates are advised to choose those providers that show transparency on the methodology. Black box models may lead to even more discussions with tax authorities.
Secondly, many corporates have practical doubts around repeating the credit rating process for each entity as this may require a significant time investment. Fortunately, technology may bring relief!
Technology as an alternative for shortcut methods
Repetitive processes are ideal for automation. The OECD lays out the principles for a best-practice rating process. Once a corporate defines their interpretation, the framework can be applied uniformly across all entities within the group. It would be a cumbersome and error-prone task to execute this yearly process manually for each subsidiary. Selecting a credit rating tool that offers a high level of end-to-end automation may help corporates to lower the compliance burden, reduce errors and illustrate consistency. Shortcut methods may save time initially, i.e. when establishing the credit rating, but may lead to lengthy audit discussions later on.
The latest regulatory guidance helps corporates to define a compliant credit rating framework by providing more details on each step. On the other hand, it also imposes a significant compliance burden. Smaller corporates may not have access to the appropriate tooling. Larger multinationals may face a high number of subsidiaries that require a credit rating. Lowering the compliance burden via technology is preferred to relying on shortcut methods.