Most treasurers support their business units through a wide range of intercompany loans. The terms and conditions of these loans as well as the creditworthiness of the borrowing subsidiaries may be very different. Therefore, it may not be straight-forward to determine the arm’s length pricing for the various loan types. This article will support treasurers on determining the accurate pricing methodology.
Pricing driven by the risk profile of the loan
The arm’s length principle states that the pricing of intercompany transactions should be in line with market conditions. Intercompany loans are subject to this rule as well. Bank pricing of loans may entail numerous insights on how to price intercompany loans. Aside from commercial incentives, bank pricing is mainly driven by the credit risk profile of the loan. Empirical data supports that those riskier transactions, e.g. loans and bonds, are priced with a higher margin. This is in line with the capital requirements to which banks are subject.
Both transfer pricing guidance and capital requirements point towards the same loan characteristics that contribute to the risk profile, and thus pricing, of the loan. First, the creditworthiness of the borrowing entity is an important characteristic. This is often expressed by a credit rating or score. The better the credit rating, the lower the risk profile. Secondly, the terms and conditions are important for the pricing. The shorter the maturity or the more collateral, the lower the risk profile. The repayment schedule can also influence the risk profile through the amount outstanding. Each multinational is advised to create a list of loan characteristics to take into account for each intercompany loan, regardless of the type of loan.
Do’s and don’ts: bank quotes and cost of funds
In the past, relationship banks would be asked to provide an unofficial quote for an intercompany loan. This quote was then stored as documentation for the internal interest rate. The OECD has now officially dismissed this practice. It is stated that bank quotes do not represent actual market transactions and can therefore not be used to substantiate a proposed arm’s length interest rate. Continuing to use bank quotes thus creates a very high degree of tax risk for each corporate.
An alternative approach to the arm’s length pricing of intercompany loans is through the so-called cost of funds method. This method will use the external cost of funding of the lender as the starting point of the analysis. In some scenarios an additional mark-up could be added to represent costs incurred with providing the funds, a risk premium and a profit margin. However, it is noted that this method is only ideal when the risk profile of the intercompany loan is (merely) identical to external funding. This requirement may, in practice, only be fulfilled when pricing pass-through loans.
A scalable method: comparable uncontrolled pricing
The above-mentioned methods do not provide a solution when pricing a wide range of different loans. Therefore, the comparable uncontrolled pricing (CUP) method is often preferred. The methodology allows to substantiate internal interest rates by directly comparing them to the most relevant external transactions or market transaction done by the group, i.e. internal comparables.
Following this method, the practitioner should first select the most comparable market transactions. These are often bond transactions with a similar credit rating and terms and conditions. The market spreads are adjusted to account for every difference between the internal loan and the resp. comparable. After these comparability adjustments, statistical methods can give a measure of dispersion around the prevailing arm’s length interest rate. For example, the interquartile range of the adjusted spreads of the most comparable transactions may give both the taxpayer as well as tax authorities more insight compared to a simple average.
The CUP method allows for a scalable pricing method across various loan types as it can be applied to all types of risk profiles as long as market data is available. Learn more about this method in our related article: Common pitfalls: how to correctly apply the CUP method for intercompany loans.
Conclusion
Although loan pricing is intuitively driven by the risk profile, it is often not straight forward how the financial markets would price a similar loan. The OECD strongly encourages to abandon pricing methodologies that are based on bank quotes. Additionally, the cost of funds methodology does not prevail as a suitable approach for most loan types. Therefore, multinationals are often advised to use the CUP method for intercompany loans. It allows for a uniform methodology that can be applied on various loan types across the organization.