Key takeaways

• The GLAM reflects understood IRS and OECD positions regarding implicit support.
• The degree to which implicit support applies to a subsidiary depends on its importance to the group.
• Additional factors should be considered in comparing reasonable alternatives.

More detail

Arm's length standard and realistic alternative principle

Under the arm’s length standard, the interest rate charged on a related party loan should align with the interest rate that would be charged if the loan transaction were entered into between uncontrolled taxpayers. The GLAM states that if a third-party lender considers implicit support due to association with a corporate group, this should also be considered for pricing intercompany loans. In this context, implicit support refers to the possibility that another group member would provide financial support to the borrower entity, even if not required to do so by any formal commitment or obligation. The GLAM goes on to state that based on the realistic alternatives principle, a taxpayer would not engage in a transaction if doing so would make them worse off than if they would be under a realistically available transaction. In other words, holding all other loan terms equal, if the taxpayer could use its group membership to obtain a lower interest rate from an unrelated lender, the taxpayer would reject a related party loan with a higher interest rate in favor of the third-party loan.

Example

The GLAM illustrates this point through an example where a foreign parent issues a loan to a US subsidiary. The GLAM walks through the analysis to reach the conclusion that the intercompany interest rate should align with a credit rating that considers group membership.

In the example, a foreign parent (FP) owns 100% of the equity of a US subsidiary (USSub). Given that USSub is essential to the group’s financial performance, FP would be expected to provide financial support to fulfill USSub’s financial obligations to unrelated parties. USSub plans to obtain capital through an intercompany loan from FP. An independent rating agency rated both FP and USSub. FP is rated A. USSub is rated BBB considering group association and rated B as an independent entity. FP lends to USSub at an interest rate consistent with a B rating (10%).

According to the GLAM, the IRS may adjust the interest rate to be consistent with a BBB rating (8%) because USSub would have been able to borrow from an unrelated lender that would have taken into account USSub’s group membership. Given that USSub has a realistic alternative of entering into a loan with a lower interest rate, it would not accept a higher interest rate.

The example is also used to address the argument that the benefit of implicit support should be disregarded in cases where the source of the implicit support is the lender. It could be argued that FP should consider the standalone credit rating of B for USSub given that it will not be able to benefit from the support given that it is also the lender. The GLAM concludes that this argument should be dismissed given that under the arm’s length standard intragroup transactions must be considered as if they were between unrelated parties engaged in the same transaction under the same circumstances. In all cases, a related party lender may not charge a higher interest rate to a related party borrower, because an unrelated borrower would not accept a higher interest rate than it could obtain from an unrelated lender.

Compensation for passive association benefits

The GLAM states that consistent with the services regulations (see Treas. Reg. § 1.482-9(l)(3)(v)), no compensation is owed for a passive association benefit in an intragroup lending context. Absent a guarantee or other legally binding credit support, a borrower is entitled to retain the benefit it receives solely from its group membership without compensating any affiliate. The GLAM also notes that this is consistent with the OECD Transfer Pricing Guidelines (paragraph 7.13).

Observations and practical considerations

Implicit support may not always apply

In its analysis, the GLAM starts off with the assumption that implicit support exists. However, group association does not always mean that implicit support applies and results in a lower arm’s length interest rate. Whether or not a borrower will benefit from implicit support generally depends on the importance of that subsidiary to the group.

As specified in Treas. Reg. § 1.482-2, 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. In determining the arm’s length interest rate, all relevant factors are to be considered, including the principal amount, duration of the loan, credit rating of the borrower, and interest rates for comparable loans between unrelated parties.

The credit quality of a borrower is an important factor in determining an arm’s length interest rate given that the better the credit rating, the lower the perceived risk and therefore the lower the interest rate that a lender would demand. In most cases, if there is an available credit rating from an independent credit rating agency, this is used for benchmarking an applicable interest rate for an intragroup loan. Usually, aside from the overall public credit rating for the group, rating agencies do not assign a credit rating to a particular subsidiary. In these cases, further analysis must be performed to determine a synthetic or shadow credit rating for the borrowing subsidiary. It is during this portion of the benchmarking analysis that the consideration of group association becomes relevant. Credit rating tools and rating methodologies from rating agencies are commonly used to determine standalone credit ratings for specific subsidiaries. Certain taxpayers rely on these standalone credit ratings as-is while others also consider implicit support. In practice, implicit support is considered by reference to guidance issued by rating agencies. Most major rating agencies, in their rating methodology whitepapers, lay out the framework for notching up or increasing the credit rating of a subsidiary based on its importance to the group. Therefore, it is not always the case that the standalone credit rating should be notched up. The applicability of implicit support needs to be evaluated based on the facts and circumstances relevant to the borrower and its overall importance to the group. The rationale for considering or not considering implicit support needs to be adequately documented.

GLAM consistent with IRS position and OECD guidelines

Although the GLAM is recent guidance from the IRS, it is consistent with the IRS’s existing position on determining the credit quality for a related party borrower. Guidance provided in the form of a GLAM is considered by the IRS as clarifying existing law and not new law. Therefore, this guidance can be regarded as applying retroactively to intragroup loans in open years.

Also, the GLAM is consistent with the discussion of implicit support in Chapter X of the OECD Transfer Pricing Guidelines (paragraphs 10.76-80). It is often the case that intragroup loans involve a US taxpayer and a taxpayer in an OECD jurisdiction or jurisdiction that aligns its transfer pricing rules with the OECD Transfer Pricing Guidelines. Therefore, the consideration of implicit support is not a new factor in benchmarking the interest rate on an intragroup loan. Taxpayers typically consider the transfer pricing rules of both the lender’s and borrower’s jurisdiction.

Realistic alternatives

Many taxpayers review the interest rate from the perspective of whether either party is worse off than it would have been otherwise. To further exemplify this, consider that Treas. Reg. § 1.482-2 allows for the use of safe harbor interest rates based on the applicable federal rate (AFR) provided that certain conditions are met. The AFR generally does not align with market rates and is not linked to a particular credit rating. Therefore, taxpayers generally elect to use the safe harbor rates only in cases where the foreign related party is not worse off as a result of using the AFR.  This approach aligns with the GLAM’s view that a party’s realistic alternatives must be considered.

The realistic alternatives principle is not unique to the IRS, and many tax authorities prefer to evaluate intragroup transactions based on realistic alternatives available. Evaluating multiple realistic alternatives should consider all factors and not simply look at the interest rate differential. For example, companies may decide not to refinance an existing loan for a lower interest rate given the administrative burden of the refinance process or the fees that may need to be incurred.