The COVID-19 crisis has severely impacted many businesses globally, resulting in disruption to supply chains and reduced profitability. Existing and new funding arrangements, including external banking facilities and intragroup loans, will be critical in supporting companies’ cash flow needs during the pandemic and beyond.
While the impact will vary across countries, industries and companies, many companies will have changes to their intercompany funding arrangements, either because the local affiliate requires new or additional intercompany funding, or because cash reserves of the local affiliate are used to support overseas affiliates. This creates transfer pricing risks and opportunities, which may call for a revaluation of existing intercompany policies relating to intragroup funding to meet the liquidity needs of the business.
Any new or extension of existing intercompany lending arrangements needs to have terms consistent with current market conditions. Ideally, the intercompany financing policy should be aligned with the group’s own external financing terms and conditions, where applicable. This situation happens especially if the group enters new lines of credit. It could be either because existing credit lines have matured or been exhausted or because there was a breach of financial covenants, triggering renegotiation with lenders.
Considerations for Interest Rates
While worldwide base rates are likely to stay for a while due to the easing of monetary policies by central banks, the collapse in revenues and fears over the economic impact of COVID-19 have encouraged many companies to max out their credit lines to keep large amounts of cash at hand. At the same time, banks have been hoarding cash as they worry about companies defaulting or drawing down on their credit lines. This has brought about an increase in credit spreads to levels unwitnessed since the 2008 global financial crisis, as credit risk has been significantly repriced since the beginning of the pandemic, especially for non-investment grade borrowers.
For example, when the U.S. Federal Reserve announced it would buy bonds in unlimited numbers and backstop direct loans to companies to calm markets and support the U.S. economy, the U.S. dollar corporate bond spreads increased significantly for all credit ratings. They even maxed out on March 23, 2020. Since then, spreads have come down but are still higher than levels before the onset of the pandemic.
The implication is that using historical rates to price new intragroup loans or reprice existing loans may be inappropriate. The volatility in current market interest rates makes the timing of intercompany loan transactions critical.
For companies operating cash pools, the deposit and borrowing rates might need to be adjusted to reflect current market conditions and in line with the rates under any linked external credit facilities, particularly as there may be increased reliance by participants on the cash pool to fund their working capital needs.
As creditworthiness may decline for many companies in the current environment, it’s important to consider how any changes in creditworthiness impacts the pricing of intercompany financing transactions. Credit rating estimation based on historical data (which does not reflect the impact of COVID-19) may overstate borrowers’ creditworthiness. Therefore, taxpayers should consider using forecast financials which consider the impact of the crisis.
It is also important to consider the options available and how independent borrowers and lenders in the industry are acting in the current environment. Early repayment or prepayment clauses in intercompany loan agreements designed to provide flexibility to the borrower or lender and avoid being locked into a high-interest rate or too high debt amount over time should be monitored regularly to determine if the option would reasonably be expected to have been exercised in the current environment. Failure to exercise such an option if it makes commercial sense to do so could result in the tax authority treating the loan as being refinanced at the prevailing market rate for transfer pricing purposes.
For taxpayers contemplating entering into new loan arrangements, floating rate loans or short-term loans may provide greater flexibility to renegotiate interest rates at a later date depending on how the situation plays out. Companies seeking to take advantage of higher interest rates in the current climate to increase tax deductions for an extended period are likely to attract tax authority scrutiny if there is no valid commercial reason for doing so.
Care should also be taken where there is existing third-party debt and a subsidiary draws down additional intercompany debt. The temptation is to automatically treat the intercompany debt as subordinated. In these circumstances, it is important to show that senior debt funding has been exhausted before drawing down on the more expensive subordinated debt and that there is evidence of subordinated debt lending in the taxpayer’s industry.
In addition to credit markets, COVID-19 is also introducing levels of volatility in foreign currency markets not seen since the 2008 global financial crisis. Typically, the intercompany loan will be either in the functional currency of the lender or borrower, or currency of any third-party funding within the group. Companies should consider hedging foreign exchange risk on intercompany loan transactions to mitigate foreign exchange gains/losses where there is no natural hedge.
Considerations for Debt Characterization
Under the recent Organization for Economic Cooperation and Development (OECD) transfer pricing guidance on financial transactions (OECD (2020), Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8-10, OECD, Paris) released on February 11, 2020, an “accurate delineation analysis” must be applied in determining the amount of debt to be priced for tax purposes. Issues relating to debt characterization and application of the OECD accurate delineation analysis was explored by Duff & Phelps in the Transfer Pricing Times article dated April 1, 2020, and in a recently published article for Bloomberg Tax.
Subsidiaries facing difficulties in servicing existing intercompany debt may give rise to questions about the existing capital structure for tax purposes. In these circumstances, a loan or part of the loan may be recharacterized as equity (or “quasi-equity”) under the local transfer pricing rules, where the borrower is unable to adequately service the debt.
Restructuring of intercompany loans in these circumstances may provide tax and cash optimization opportunities if the company is in losses or cannot deduct the interest for tax purposes due to thin capitalization or interest limitation rules as a result of reduction in cash balances or impairment of assets.
As an alternative to restructuring the intercompany debt, taxpayers might consider providing a payment holiday and extending maturity of the loan to reduce the impact on cash flows. Again, it’s important to consider and document market practices and what commercial lenders are doing to support any departures from existing contractual rights and obligations.
It is also relevant to consider if there is a potential force majeure event under the intercompany agreement and if so, what are the procedures and consequences provided for in such a situation. U.S. taxpayers need to consider the potential tax consequences of any debt restructuring, under Regs. Sec. 1.1001-3, and whether a significant modification of the debt terms may result in a deemed taxable exchange.
On the other hand, where there are intragroup payables, extension of trade credit beyond normal commercial terms could result in the payable being recharacterized as interest-bearing debt for transfer pricing purposes with interest imputed on the balance. Payment terms extended by suppliers or to customers may inform as to the appropriate treatment.
Finally, external lenders may require additional collateral pledges or financial guarantees from the parent or affiliates on new loans or in response to breaches of financial covenants for existing external loans. The first step to consider in supporting a guarantee fee is the ability of the subsidiary to borrow on a stand-alone basis without the guarantee. In other words, the guarantee provides a pricing benefit through enhancement of the borrower’s credit standing rather than acting as a substitution of capital.
