OVERVIEW: Intercompany Financing: Does the Federal Safe Haven Line Bind State Tax Authorities?
State tax authorities have a mixed record in their attempts to challenge what they see as abusive business-to-business pricing. Many of the early litigation involved challenges from the New York Division of Taxation over intercompany royalty rates or gross margins received by distribution subsidiaries. The Indiana Department of State Revenue objected to the intercompany royalty rate paid by Rent-A-Center East and the gross margin received by the national sales subsidiary for Columbia Sportswear, but lost both disputes.
My examination of these two disputes revealed that the tax administration had not contested the analysis prepared by the representatives of the taxpayer. (“Rent-A-Centerv. Indiana: ColorTyme as CUT? “, Journal of Multistate Taxation and Incentives, May 2016) In light of these losses, the Indiana Department of State Revenue and other state tax authorities have established dedicated transfer pricing teams or are working with external transfer pricing experts.
Business-to-business financing issues have attracted the attention of both the OECD and the UN. The OECD released its transfer pricing guidelines for financial transactions on February 11, 2020. The pricing of B2B debt in the extractive industry was discussed at the United Nations Committee of Experts on International Cooperation in tax matters on May 3, 2020. The committee discussed a new chapter proposed in the manual on Questions chosen for the taxation of extractive industries by developing countries entitled Tax treatment of financial transactions in the extractive industries.
A standard model for assessing whether an inter-company interest rate is arm’s length can be viewed as having two components: the inter-company contract and the credit rating of the related borrower. Well-articulated inter-company contracts stipulate:
- the denomination currency;
- the duration of the loan; and
The first three elements allow the analyst to determine the market interest rate for the corresponding government bond. The intercompany interest rate minus the market interest rate for the corresponding government bond can be viewed as the credit spread implied by the intercompany loan agreement. The reasonableness of this implied credit spread depends on the appropriate credit rating. The OECD and UN discussions note the controversy over estimating credit scores, which are actually alphabetical ratings. This alphabetical note should also be translated into a digital credit spread. Government bond rates change over time, as do credit spreads.
Consider a hypothetical situation where a German-based multinational granted a 20-year fixed interest rate loan to its US subsidiary on March 18, 2020, with an interest rate equal to 5%. Oh on that date, the interest rate on 20-year government bonds was 1.6%, implying that the multinational would have to defend a 3.4% credit spread as being at arm’s length. If the IRS provided a reasonable estimate of the borrowing branch’s credit rating as BBB, then it could say that the appropriate credit spread should be lower. The initial fallout from the COVID-19 crisis, however, led to a surge in observed credit spreads similar to what we saw after the collapse of Lehman Brothers in the fall of 2008. The specific date for the B2B loan is important because interest rates were volatile. during this period.
EI Dupont de Nemours & Co. v. Indiana Department of State Revenue involved several questions, including whether the intercorporate interest rate on a substantial loan was at arm’s length. On August 31, 1995, DuPont Energy Company granted an $ 8 billion loan to EI DuPont De Nemours and Company, the loan of which was due on August 31, 2005. On August 31, 1995, the 10-year bond interest rate State was 6.28%. The interest rate on the intercompany loan was 8.528%. So, the implied credit spread on this intercompany loan was approximately 2.25%.
The Indiana Department of Revenue insisted that this intercompany interest rate was too high, but did not present evidence of what an arm’s length interest rate should be. The taxpayer’s expert did not present an economic analysis but relied on the safe haven provision of article 1.482-2 (a) (2) (iii), which defines the safe haven as being any interest rate between the applicable federal rate (AFR) and 1.3 times AFR. The AFR rate for August 1995 was 6.56% and 1.3 times that rate was 8.528%. The court decision noted:
“The Ministry maintains that the interest rates on the loans were ‘too high’ and should have been refinanced. (See Resp’t Br. At 4, 12.) Nonetheless, “DuPont’s current business practice [was] to ensure that all intercompany loans have been made[-]on a term basis, at market rates comparable to those which would have been available from external lenders. (Pfeiffer Aff. ¶ 42.) To this end, interest rates on loans have been set within the “safe haven range” prescribed by §482 of the Internal Revenue Code. (Assef Aff.¶¶ 5-9, Ex. C (indicating that with respect to related party transactions (e.g. intercompany transactions), IRC §482 indicates that an interest rate in the range of safe-haven value (i.e. between 100% and 130% of the applicable federal rate (“AFR”) is considered to be “arm’s length” and therefore at the market rate). In addition, the evidence designated by DuPont shows not only that DuPont was not required to refinance its loans during their term, but also that it would likely not have been able to refinance at rates lower than those already applied to the Loans. (Assef Af. ¶¶ 14- 27, 29.) ”
Any claim about market rates at the time without proof of what the borrower’s credit rating should be is premature at best. Credit spreads during this period were not particularly high. The credit spread for the BBB long-term corporate bond rate was only 1.3%. If we assumed this credit rating, the market rate for a 10-year loan as of August 31, 1995 would only be 7.6%. If one could make a credible argument that the credit rating should be BB +, then a credit spread of 2.25% would be reasonable.
The court ruling in this litigation did not discuss any analysis of what an appropriate credit rating should be by the taxpayer’s experts or the tax authority. The parent company carried out two bond issues between August 29, 1995 and September 11, 1995. Our table provides key information on the two bond issues. The first issue was five-year corporate bonds with an interest rate = 6.63%. The interest rate on the corresponding government bond (GB) was 6.15%, so the credit spread was 0.48%. The second issue consisted of 10-year corporate bonds with an interest rate = 6.6%. The interest rate on the corresponding government bond (GB) was 6.24%, so the credit spread was 0.36%. If we add the average of these two credit spreads (0.42%) and the interest rate of 6.28% on 10-year government bonds at August 31, 1995, the interest rate of Full competition estimate on the intercompany loan would be 6.7%. An interest rate of 6.7% matched the market interest rates at the time for borrowers with a AAA credit rating.
Issuance of EI Du Pont de Nemours corporate bonds
The argument of the Ministry of Revenue according to which the borrowing entity would have refinanced this loan is based on two questionable assumptions. The first is whether the intercompany loan agreement contained provisions that would have allowed the borrower to refinance if their cost of borrowing declined during the term of the intercompany loan. The other assumption is that the cost of borrowing in the market significantly decreased after the initial 10 year loan was issued. Our figure presents certain market data for the period from August 1995 to August 2005 which calls into question this second presumption.
Key market data from August 1995 to August 2005
While it is true that interest rates on short-term government bonds fell dramatically during the 2001 recession, the interest rate on 10-year government bonds (GB10) has failed. also dropped dramatically. Our figure also shows a measure of the credit spread on long-term BBB-rated corporate bonds during this period. This credit spread remained above 2% from April 2000 to March 2003 and was around 2.5%
Thus, the modest decline in the government bond rate was probably offset by the increase in credit spreads. The suggestion by the taxpayer’s representatives that the borrower was not required to refinance misses the point that refinancing clauses in loan agreements give the borrower the option of refinancing if interest rates fall by the following. Their argument as to whether a borrower could have refinanced at a lower rate was a more compelling position, as our presentation of market evidence during this period demonstrates.
The court ruling briefly noted another business-to-business loan:
On August 31, 2005, the 1995 loan expired. (Resp’t Des’g Evid., Ex. 2J to DIN 2027.) On the same day, DGOI loaned DuPont $ 12.2 billion (“2005 loan”), which is equivalent to the total value of the principal and total interest due on the Loan — at an interest rate of 5.64%.
This 5.64% interest rate was above the AFR safe-haven range, which was 3.92% to 5.1%. However, being outside the safe haven range has little to do with whether an intercompany interest rate is arm’s length. As of August 31, 2005, the interest rate on 10-year government bonds was 4.02%, so the credit spread implied by this second B2B loan was only 1.62%. If the borrower’s credit rate was still AAA, that intercompany interest rate is somewhat in the arm’s length range. If it could be argued that the appropriate credit rating should have been BBB, then that interest rate would be defensible.
The Indiana Department of State Revenue claimed that the initial intercompany interest rate was too high, but provided no analysis to support this claim. We have discussed a standard model for the appropriate valuation of intercompany interest rates under the arm’s length standard in the hope that tax authorities and taxpayer representatives can present more convincing evidence on issues such as this. this.
This column does not necessarily reflect the opinion of the Bureau of National Affairs Inc. or its owners.
Harold McClure has been involved in transfer pricing as an economist for 25 years.