Intercompany funding – Pricing & Regulations

Having debt in one place, and cash in another, is not only expensive, due to the bid/offer spread, but it increases pressure on leverage calculations and credit ratings. Cash is a precious – and often rare – asset: it is vital to use it as well as possible.

Recent rises in interest rates, and pressure on lending sources due to Basel III and stress in banking systems have increased reliance on these essential tools.

But there is a problem: tax. With BEPS and increased co-operation between tax authorities around the world, many companies are re-visiting their approach to intercompany funding, to make sure they are above any reproach.

But this is easier said than done. There are no clear rules, and it can be challenging to implement the basic principle of arm’s length pricing. Of course, not all arms are the same length, so some judgment is always involved. But, with intercompany funding, the same group is both borrowing and lending, so at least one side has to be off market. Even if an in-house bank gets involved, it is not subject to the same regulations as a real bank, so its pricing is different to the market.

In this call we discussed:

If you would like commentaries like this on direct to your in box along with access to 145+ further commentaries – please register here.

• Actual tax investigations:
  • No-one has yet seen significant pressure from tax authorities on pricing intercompany loans. One participant used to work for a tax authority which looked at the question.
  • The consensus is that the amount of intercompany interest is unlikely to lead to any material change in tax due or paid. It is also a complex area, so difficult for the authorities to challenge.
  • Of course, internal tax departments are still very anxious to be able to defend any potential investigation – which may come after several years.
  • Some of the concerns may be caught by other tax regulations, such as thin capitalisation rules.
• General principles:
  • As always in transfer pricing, it is important to have a consistent approach, which is applied whether the result benefits the company or not.
  • It is important to have a clear, well documented, well reasoned approach.
  • Arm’s length: to the extent possible, benchmarking against real third party transactions helps. Some participants do their pooling through commercial banks: this may increase cost, but it guarantees arm’s length.
• The issues:
  • Credit rating: many companies now differentiate the rate they charge on their intercompany loans according to the credit rating of the subsidiary. Some do it based on the balance sheet of the subsidiary; some based on the importance to the group.
    • The balance sheet structure is determined by the group, so this can be a circular argument. No-one has yet had any issues with this.
    • Some companies deem that there is an implicit parent guarantee to the subsidiary, and now include this in their pricing. This is important to the lender’s jurisdiction.
    • This can result in different pricing for loans to different entities: some have individual rates; others have up to five risk categories
    • The resulting complication does not seem to be causing any issues.
  • Tenor: cash pooling and short term loans are valid for funding short term working capital. If these loans are never repaid, they become structural, so possibly exposed to challenge: participants regularly review their pools, and implement term loans or equity for structural deposits or loans.
  • Deposits: increasingly, the interest on these varies according to the duration.
  • In house banks: generally, these can be benchmarked against third party banks. However, as they do not have the same regulatory costs, this will leave them with a higher profit. One participant felt the need to pass the benefit of pooling and in house banks on to the subsidiaries.
  • Alternative structures:
    • Leading and lagging intercompany payments is effective. However, actual payment behaviour must be in line with commercial practice.
    • Intercompany factoring: the sale of receivables to head office or an in-house financing company removes a lot of the concerns above – provided the pricing is arm’s length.
    • Limited risk distributor: a couple of participants use this business model. As profit is always brought back to the target level, the pricing of any intercompany funding is a moot point. Of course, it is essential to make sure the distribution margin is acceptable to the authorities.
  • One participant uses intercompany loans to push group debt down to the subsidiaries. Authorities may challenge the need for these loans.

In all cases, it is essential to have a clearly defined, documented, policy, and to follow it consistently. The few cases where companies have been challenged by tax authorities have generally been settled by demonstrating this. Of course, the policy has to be reasonable – and there is always the concern that tax audits may happen several years after the event. Increasingly, corporates are making efforts to match the funding and tenor (and therefore rate!) to the business structure – this is where most challenges come.

Bottom line: intercompany funding is an essential tool. It presents tax challenges – but, generally, these can be managed by using a reasonable approach, documenting it, and following it consistently. Different companies apply different levels of sophistication: that depends on the size of the operations.