The impact of parent affiliation is consistent with how market participants price intercompany loans and guarantees.

Summary: Whether or not an affiliate should be given an enhanced credit rating due to its affiliation with a more highly rated parent is causing controversy among transfer pricing practitioners.

Should parent company’s rating influence any of its subsidiaries?

The question of whether an affiliate should be given an enhanced credit rating due to its affiliation with a more highly rated parent is causing controversy among transfer pricing practitioners, and the issue has become more prevalent because of the decision in the General Electiric (GE) Canada case.

The subsidiary’s credit rating may be improved as a result of its affiliation with a parent company with a higher credit rating or larger asset base. This concept is illustrated in the diagram below.

Based on its stand-alone credit rating, the affiliate would be able to borrow at 6% (Rating 3). However, due to its affiliation with a parent whose credit rating is stronger, the view of the affiliate is enhanced so that it can borrow from a third party at 5% (Rating 2).

At the same time, the parent could access the capital markets based on its own credit rating and borrow at 4% (Rating 1).

Parent affiliation — two positions to consider

There are two alternate schools of thought as to how the impact of parent affiliation should be accounted for when determining the appropriate pricing for intercompany funding and guarantees:

1. The impact of parent affiliation is inconsistent with the arm’s length principle and should therefore be ignored when pricing intercompany funding or guarantees.
2. The impact of parent affiliation is consistent with the way market participants price intercompany loans and guarantees and should therefore be taken into account.

Awareness of the impact of parent affiliation has increased since the recent decision in the GE Canada case,¹ which focused on implicit parental support when determining an arm’s length price for an intercompany guarantee. Several tax authorities have also issued preliminary guidance on this issue, however, there is no clear consensus on what approach should be taken.

Does the arm’s length principle apply?

Many transfer pricing practitioners and tax authorities believe that the impact of parent affiliation is inconsistent with the arm’s length principle.

This view is based on paragraph 7.13 of the OECD Guidelines,² which states that “no service would be received where an associated enterprise by reason of its affiliation alone has a credit rating higher than it would if it were unaffiliated, but an intra-group service would usually exist where the higher credit rating were due to a guarantee by another group member.”

Therefore, where there is implicit support provided, the result is incidental benefits only, which should not be taken into account when pricing intercompany funding and guarantees involving the subsidiary.

The starting point for pricing the relevant funding or guarantee should be the stand-alone credit rating of the subsidiary.³

This being the case, many transfer pricing practitioners argue that a “box” should be drawn around the subsidiary and its creditworthiness be determined in isolation based on the quantitative and qualitative aspects of the subsidiary and ignoring any implicit parental support.⁴

The counterargument

A counterargument can be made that determining a credit rating (and associated interest rate) on a pure stand-alone basis may result in the facility being priced more expensively than the market interest rate. This is because the market interest rate offered by third-party banks will give due consideration to any implicit support provided by the parent.

When determining the creditworthiness of a subsidiary, credit rating agencies generally consider implicit parental support. For example, A.M. Best may deem that a subsidiary receives an “enhancement” of its credit rating based on either an explicit guarantee or implicit support. Such a determination is a facts and circumstances analysis for A.M. Best.⁵

The argument is that some subsidiaries in a multinational group are so integral to the group that even absent any formal financial guarantees, if the subsidiary should be unable to repay its debt, the parent will always, and unconditionally, intervene with the necessary financial support because it may receive a benefit.

This parental intervention will occur either for reasons of reputation or for the parent to ensure that its own credit rating is not jeopardized by any uncontrolled rumors or information spillovers. Thus, the view is that a core subsidiary has the same credit rating as the parent.

The credit rating of a strategically important subsidiary is notched up or enhanced to get it closer to that of the parent, but the credit rating of a non-strategic subsidiary will not be notched up based solely on implicit support.

The level of implicit support provided by the parent company is generally considered to be linked to the value of the group’s brand. If the group trades globally under one brand, then the implicit support provided by the parent will generally be taken to be higher, and vice versa.

Litigation and tax authority guidance

The GE Capital Canada case⁶ focused on the deductibility of guarantee fees paid by the Canadian company to its US parent for guaranteeing its third-party obligations. The court ruled that the implicit support provided by the parent company should be taken into account when pricing the guarantee.

Specifically, the price of the guarantee should be based on the explicit benefit only, and any increase in the creditworthiness of GE Canada due to its association with GE Inc. should not be taken into account when pricing the guarantee.

We are also aware of other court cases in the Nordics, based on similar fact patterns, in which tax authorities have argued that affiliation with a parent leads to an increase in an entity’s stand-alone credit rating. In a case from Eidsivating Lagmannsrett (the Appellate Court) in Norway, the court agreed with the tax authority that the borrowing company’s actual position as a subsidiary could not be ignored.

In contrast to HMRC’s thin capitalization guidance, the Australian Tax Office (ATO) released a draft ruling that states, “taking account of parental affiliation is consistent with the arm’s length principle embodied in the transfer pricing provisions where, in determining the creditworthiness of a borrower, it is a feature of the market to take account of any affiliation the borrower has.”⁷

What positions do tax authorities take on parent affiliation?

Our experience indicates that tax authorities around the world are more frequently looking to reduce interest rates on intercompany debt by arguing for an increase in a subsidiary’s credit rating due to its affiliation with a stronger parent. However, given that such challenges are still in the early stages, it is not yet clear if they reflect a shift in tax authorities’ official policy or are isolated actions driven by the views of local tax auditors.

While there are valid arguments on both sides, the issue can no longer be ignored when pricing intercompany funding and guarantees. Given the large sums of tax at stake, tax authorities are likely to continue taking alternate positions with respect to applying the halo effect on opportunistic grounds. We recommend that the OECD provide guidance on this complex issue, which reaches to the core of the arm’s length principle.

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¹ General Electric Capital Canada Inc. v. The Queen (2009 TCC 563).
² Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations issued by the Organization for Economic Co-operation and Development.
³ Compare, Treas. Reg. Sec. 1.482-2(a)(2)(i) which provides: “In general. For purposes of section 482 and paragraph (a) of this section, an arm’s length rate of interest shall be a rate of interest which was charged, or would have been charged, at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances. All relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties.”
⁴ Compare with the OECD’s Report on the Attribution of Profits to Permanent Establishments, 17 July 2008, which allows the host country to use any capital attribution method that is consistent with the arm’s length standard. The report envisages with respect to financial services companies that a stand-alone approach (“thin capitalization”), a shared capital approach or a minimum capital approach (“quasi-thin capitalization”) may be appropriate depending on the facts and circumstances.
⁵ “Rating Members of Insurance Groups, Methodology” 31 January 2005.
⁶ We note that the case is being appealed by the CRA.
⁷ Income tax: the interaction of Division 820 of the Income Tax Assessment Act 1997 and the transfer pricing provisions in relation to costs that may become debt deductions, for example, interest and guarantee fees, Australian Tax Office, p.10.