Maximizing the Benefits of Intracompany Financing: What You Need to Know

Intercompany financing is an area within transfer pricing that has faced increased scrutiny by tax authorities in recent years, primarily due to higher interest rate environments. As part of the Base Erosion and Profit Shifting (BEPS) project, the OECD issued its final guidance on financial transactions on February 11, 2020. This guidance provided recommendations on the arm’s length treatment of various financial transactions between related entities, including loans, guarantees, cash pools, debt capacity, hedging, and captive insurance.

Multinational enterprises (MNEs) widely use intercompany financing for various purposes. Among the most common transactions are intercompany loans, cash pools, and guarantees. Cash pools are mainly used to reduce the group’s overall banking costs, lower interest rates, improve cash management, and hedge foreign currency exposures. Additionally, intercompany loans are primarily used to fund entities that cannot generate sufficient cash, support mergers and acquisitions, and optimize taxes. The OECD guidelines require that intercompany financing transactions be priced at arm’s length and that entities demonstrate financial capacity, which may necessitate a debt capacity analysis to prove their financial soundness to borrow or lend funds.

Intercompany Loans

The most common transfer pricing method used to set arm’s length interest rates is the Comparable Uncontrolled Price (CUP) method. When using the CUP method, several comparability factors should be considered. The key factors include: 1) principal amount, 2) loan duration, 3) type of collateral, 4) currency, 5) borrower’s credit rating, and 6) market conditions. Determining the borrower’s credit rating is crucial in setting arm’s length interest rates. It is possible to determine a range of arm’s length interest rates by calculating the yield to maturity of comparable debt instruments. After establishing the range of yields to maturity, a fixed-to-float swap analysis can be performed to establish an arm’s length range of spreads. It is worth noting that databases such as Bloomberg perform swap analyses, but the calculations are not transparent. Some tax authorities refuse to accept swap analyses without seeing the calculations, so it may be necessary to perform such analyses manually.

Implicit Support

The OECD guidelines acknowledge that an entity’s credit rating can be influenced by passive association with its parent company. Implicit support means that, depending on the subsidiary’s importance, the ultimate parent company may provide financial support in case of defaulting on interest payments. Such support can result in favorable borrowing terms, such as lower interest rates, and positively impact the subsidiary’s (borrower) credit rating. Any credit rating analysis should be transparent and consider the passive association element. Moreover, the IRS issued a memorandum in December 2003 addressing the issue of passive association, noting that the IRS may consider implicit guarantees to US subsidiaries from foreign parent companies, even without explicit guarantees. However, implicit guarantee arguments challenge the nature of the arm’s length principle by not considering the borrowing entity on a standalone basis, as it would be compared to an unrelated third-party borrower under the arm’s length standard.

Cash Pools

Cash pools can be both physical and notional. Physical cash pools involve daily sweeps of cash into a central account, while notional cash pools combine credits and debits without physically involving cash. As mentioned, cash pools play an important role in many MNEs, and it is important to delineate the functions and risks of the cash pool leader (CPL) and the participants. Cash pools are specific to MNEs and do not occur among unrelated third parties. Transfer pricing considerations for cash pools depend largely on the functions, risks, and assets of the CPL and the participants. CPLs can function similarly to a bank, risking their capital and making a profit from lending and borrowing activities. Alternatively, a CPL can function as a coordinator and facilitator with minimal risks, earning a routine profit. Therefore, it is important to document the functions, risks, and assets of cash pool arrangements to support the remuneration of the CPL. Moreover, a cash pool is typically regarded as a short-term financing arrangement between participants, and it is necessary to monitor balances to ensure they are not regarded as long-term loans, which would have different characteristics and pricing.

Guarantees

In some cases, entities may acquire an explicit guarantee from the ultimate parent. A third-party lender or lenders may request an explicit guarantee from a borrower, ensuring that if it defaults, the parent company would assume the debt. An explicit guarantee allows the borrower to borrow at a lower interest rate than it would be able to without a guarantee from the parent company, which ultimately bears the risk of default on the debt. The most common method to price explicit guarantees is to measure the differences in the yield to maturities between the guarantee and guarantor, given their different credit ratings.

Conclusion

In conclusion, intercompany financing plays a vital role in the financial strategies of multinational enterprises, offering benefits such as cost reduction, improved cash management, and tax optimization. However, the increased scrutiny from tax authorities and the guidance provided by the OECD necessitate careful consideration of arm’s length principles. By understanding and applying the guidelines, maintaining proper documentation and intercompany agreements for intercompany loans, cash pools, guarantees, and implicit support, MNEs can ensure compliance and favorable financial arrangements. Proper documentation and transparent analysis are essential to support these transactions in order to withstand transfer pricing audits.