Basic information on intra-group financing

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Intra-group financing

Introduction

The purpose of the second chapter is to present the background of intra-group financing and the surrounding issues. Since Sweden has no restrictions on how thinly capitalized a corporation can be, i.e. there are no thin capitalization rules, these rules have been desc-ribed in order to demonstrate how other countries have chosen to counter the problems related to the pricing of intra-group loans. Furthermore, credit rating and credit risk is explained as it is an important part of the pricing of loans and is discussed in case law.

 Basic information on intra-group financing

 General information

Intra-group financing is a general term for a wide range of intra-group transactions whe-re credit guarantees and loans are included.20 Loans between group entities are common in multinational groups and are carried out in the same way as between independent par-ties. The loan can be both short-dated such as accounts receivable or payable or on long-term, such as capital placements. Loans and credit guarantees are often connected where one group entity borrows external debt and another group entity acts as guarantor.
When group entities arrange financing between them it is often quite challenging since there is little public data on financial transactions and on interest rates on intercompany loans. Lending institutions, usually banks are not keen to publish detailed information on interest rates and credit ratings which could have been used as a benchmark in the pricing of financial transactions.21 Furthermore, there is little support regarding the re-solving of transfer pricing issues relating to financing transactions. The reason is that fi-nancial transactions often have unique characteristics. 22 When companies arrange intra-group financing they often rely on rules of thumb, internally set department rates or in-dicative quotes from bankers to establish the transfer pricing policies with respect to such transactions.23 The different financing transactions often require an assessment in casu and ideally from a third party standpoint.
The OECD, who is the initiator and author of the TP guidelines, define loans in the transfer pricing context as a term used in a broad sense that applies to all forms of in-debtedness. 24 It includes all advances of money, whether or not evidenced by a written instrument. The OECD remarks on the financial aspect of debt financing and point out that tax costs usually are lower for a group with debt financing, then with equity finan-cing.25 The transfer pricing issues relating to loans are, according to the OECD, based on the fact that debt servicing can provide opportunities for shifting profit between members of a multinational group for tax purposes.26 In the latest edition of the TP gui-delines, the OECD has included loans between intra-group members in the context of intra-group services. The recommended approach is to examine whether an intra-group service has been rendered or not and then applying the most appropriate transfer pricing method in order to establish the correct price of the loan. The CUP method is, according to the OECD, the most appropriate method when a comparable transaction can be found.27

General problems

Apart from the lack of information regarding the structuring of a transfer pricing policy on intra-group financing, there are other issues regarding intra-group financing. Besides the pricing of the loan there are further financial transactions associated with the loan that can fall under the scope of the arm‟s length principle. As the financing involves two related entities entering into arrangements to provide finance it is not uncommon that assistance is provided by one of the related entities, indirect or directly, in securing loans from third parties.28 These loan guarantees affect the credit rating of the borrowing entity, which in the end affect the interest rate. In loans between associated entities, the-re is usually no need for a guarantee as the lending entity has better insight of the finan-cial status of the borrowing entity. Furthermore, there are major differences between lo-ans within a group and loans between independent parties.
Usually, loans are transaction based. When conditions are changed between unrelated parties this usually implies a change in the loaning agreement. However, in a group, other conditions become applicable. Loans within a corporate group are usually establi-shed between a parent company and its subsidiary.29 Since the two parties act under other commercial conditions, this can influence the process of establishing an arm‟s length price of a loan.

Thin Capitalization rules

Since enterprises within a group are associated they have the ability to arrange transfer prices and control the allocation of taxable profits. This can also be carried out through a loan. The parties can set an interest rate, high or low, transferring capital between them depending on what jurisdiction has the most favorable tax rate. Interest rates are usually a deductible cost for the borrowing party in a financing transaction.30 Some countries have implemented rules limiting or reclassifying the deductibility of interest rates in order to prevent such arbitrage. The rules vary from country to country.31 If the capital of the company paying the interest rate is thinly capitalized, meaning that its ca-pital is made up of a much greater proportion of debt than equity, i.e. its gearing, or le-verage, is too high.
Thin capitalization rules have been instituted in many countries as a way to prevent companies from making loans to subsidiaries and then reducing overall corporate tax payments by charging interest on those loans.32 From a tax perspective these arrangements can be very advantageous to corporate groups as it is a way to transfer capital, moving it to another jurisdiction with a lower tax rate on corporate income. The entity lending the capital, and which probably has its residence in a jurisdiction with a higher tax rate, could most likely deduct the interest payments associated with debt. The thin capitalization rules have thus been implemented in many countries in hope to discoura-ge this kind of behavior. Generally, tax authorities establish a threshold for debt-to-equity ratios, above which interest would be disallowable when calculating corporate income tax liability.33 Companies could, however, obtain tax advantages either by inc-reasing the rate of interest to the associated entity or by manipulating the ratio of debt to equity in their capital structure.34 That is why tax authorities also wish to apply the arm‟s length test on the rate of interest charged.35 There are no thin capitalization rules in Sweden, which means that there are no restrictions on how thinly capitalized a corpo-ration can be. Furthermore, the deduction right on interests is not limited.36 Therefore, Sweden has favorable conditions that may be abused for the benefit of multinational corporations. Since there are no thin capitalization rules the owners can finance a Swe-dish subsidiary entirely with debt instead of financing it with shareholder‟s equity and then debiting the interests to the subsidiary, which are deductable. The interest revenues are sometimes subject to withholding tax, but the tax rates of interest are usually lower than the tax rate of dividends.37 This could be arranged instead of distributing the net profit as dividends, which is constituted of already taxed revenues.38
Since Sweden does not have thin capitalization rules, the tax authorities must rely on the arm‟s length principle in order to discourage structures made by multinational corpora-tions in order to obtain fiscal advantages. However, even in cases where thin capitalized subsidiaries borrow funds from a parent company, the Correction rule has not been regarded as applicable.39 This means that the size of a loan, not in general, but in relation to its capital, cannot be questioned and resolved by applying the Correction rule. That is the reason why it could be even more complex to set an appropriate interest rate on int-ra-group loans.

Credit risk and credit rating

Credit rating is a fundamental element when pricing a loan. The higher credit rating an entity has, the lower interest rate it will have to pay and vice versa.40 Credit rating can be decided with different methods, but there are credit rating companies like Standard& Poor or Moody‟s that conduct recognized credit ratings. Credit ratings are often divided in different scales such as AAA, AA; BBB, BB and C in the case of Standard & Poor‟s, AAA being the highest and C the lowest.41
Credit risk drives the pricing of debt instruments and is considered to be an important search criterion when selecting available market data for a benchmark analysis. Usually, the credit risk profile of the related entity borrower has been identified by an estimated credit rating.42 If the borrower has an estimated credit rating, a search is then carried out for comparables within the whole letter credit rating category of the level of the borro-wer.43
There are however, some issues surrounding the credit rating procedure. Since credit ra-tings presented by external credit rating agencies are not always ideal when gathering benchmark data of third-party debt for the use of comparable uncontrolled transactions. One issue is that the external credit rating may be too static to be used as a common credit risk measure in a way that it does not reflect the true status of the credit risk at the time the loan transaction is executed.44 The arm‟s length solution to each case is a function of intrinsically unique economical facts and circumstances in the pricing of an int-ra-group loan.45
Even though the data from credit rating companies might provide the basis for the typi-cal sort of rate suitable for less assertive planning, it is still difficult to obtain informa-tion of the right type of sufficiently good quality. This is because credit institutes, such as banks, do not wish to publish detailed interest rates and credit rating information on which a specific taxpayer‟s circumstances can be applied.

 Summary

Since there are no thin capitalization rules in Sweden and no restrictions on how thinly capitalized a company can be, there are no other regulations to rely on except the TP guidelines of the OECD.
Even though the TP guidelines include methods to apply when establishing the price of a loan, it can be complicated to find similar transactions to compare with as most finan-cial transactions such as loans have unique characteristics. One of the factors that are important when determining the interest rate of a loan is the credit rating of the borro-wing party. The credit rating has had importance when determining the arm‟s length price on intra-group loans in case law, even though the rating does not always display the true status of the credit risk. The arm‟s length rate is often a result of intrinsically unique economical facts and circumstances.

1 Background 
1.1 Introduction
1.2 Background
1.3 Purpose and approach
1.4 Method
1.5 Delimitations
1.6 Outline
2 Intra-group financing 
2.1 Introduction
2.2 Basic information on intra-group financing
2.3 Thin Capitalization rules
2.4 Credit risk and credit rating
2.5 Summary
3 Swedish law 
3.1 Introduction
3.2 The Correction rule
3.3 Deduction right of interest rates
3.4 Interest-rates on intra-group loans according to SKV
3.5 Summary
4 International guidelines 
4.1 Introduction
4.2 Guidance of the OECD
4.3 Explicit and implicit Guarantees
4.4 Summary
5 Case law 
5.1 Introduction
5.2 Swedish case law
5.3 Foreign case law
5.4 Summary
6 Analysis 
6.1 Introduction
6.2 The influence of the parent-subsidiary affiliation
6.3 Loans without interest
6.4 Thin Capitalization rules – a solution?
6.5 Do the TP guidelines give enough guidance?
7 Conclusion 
7.1 Introduction
7.2 Concluding remarks
8 List of references
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