In general, interest rates in loan contracts between MNE group companies must be based on the rates that would be charged in similar circumstances in loan arrangements between independent, unrelated parties. Normally the arm’s length nature of the interest rate is determined by comparing intra-group loans with similar loan arrangements between independent parties. This transfer pricing method is called the comparable uncontrolled price method (CUP).
The applicable comparables can be internal as well as external. If the group company taking out the loan has an internal comparable (a loan contract with similar kind of terms and conditions with an independent lender) – or if another group company has such a comparable – the arm’s length nature of the intra-group interest rate may be evaluated by comparison with that comparable contract. Attention must be given to the fact that creditworthiness and the bargaining power for loan terms with lenders may differ between group companies. For this reason, the terms that the parent company – or one of its subsidiaries – is able to secure for its financing are not directly applicable to the intra-group financing provided to other group companies.
If there are no internal comparables, the search for comparability data can be made using commercial databases so that an arm's length interest rate can be determined. Using different search criteria, information on loans between independent companies can be searched in the databases. Among the search criteria that can be recommended are the key facts of the loans and the borrowing companies. The comparable companies’ credit ratings should be similar to those of the borrowing company. Additionally, comparable loans should be on such contractual terms that are as identical as possible with those of the intra-group loan under review.
It is a good practice to take into account e.g. the following aspects of contractual terms that may affect the pricing of a loan:
- The amount of the loan;
- Its maturity;
- The repayment schedule;
- The nature and purpose of the loan (such as working capital, acquisition loan );
- Level of seniority and subordination;
- The borrower company’s geographical location;
- The currency;
- Collateral provided;
- Presence and quality of any guarantees;
- Whether the interest rate is fixed or floating.
In practice it may be necessary to modify some of the search criteria. Otherwise, it may be difficult to find any comparable loan contracts in the databases. After sufficiently comparable loans have been found, it is possible to determine an interest rate that reflects the arm’s length principle.
Evaluating the borrowing company’s creditworthiness
Determining the borrowing company's creditworthiness is an essential part of determining the arm's length interest rate. Separate ratings can be made for the entire MNE group, for any particular group company or subsidiary, or for a specific loan issuance. The most appropriate type of credit rating that suits the particular needs under the circumstances that prevail should be selected.
The sources of information may be the publicly available credit ratings, the methodologies employed by credit institutions, or the use of publicly available tools designed for credit rating calculations. When analyses are carried out, both the qualitative factors (such as the company’s line of business, the geographical area of activities) and quantitative factors (such as the profit-and-loss account and the balance sheet) should be examined.
The effect of being a member company of an MNE group, also known as “implicit support” plays a role when evaluating creditworthiness. The practical meaning of implicit support from the group is the difference in the outcomes of credit rating evaluations, conducted by an outside funder, if in one scenario the borrower company is under evaluation as a member of the group, and in the other scenario, evaluated as an independent company that does not belong to the group. In general, the group companies that are considered as being strategically important from a group business strategy perspective are assumed to receive support from other group companies. As a result, such a group company may enjoy a credit rating that approaches that of the entire MNE group.
Finding comparables and implementing other methods
When applying the comparable uncontrolled price method, possible comparables may include not only loan contracts between unrelated companies but also bonds or debentures, certificates of deposit, convertible promissory notes, and commercial papers issued by specific companies. Comparability relating to the instrument under evaluation is essential to facilitate the comparability. It may be necessary to make appropriate adjustments to improve comparability.
It is additionally worth noting that the average rate of interest that prevails for the MNE group’s financing from outside does not usually fulfill the comparability requirements. This is due to the fact that the need for financing experienced by the entire MNE group is not similar to the needs of a particular group company. In the same way, the interest rates found in the loan offers received from commercial banks are generally not comparable, i.e. not acceptable as indications of arm’s length levels of interest rates.
Other additional methods of transfer pricing analysis may be implemented if no comparables are found in order to apply the CUP method appropriately. It is important to perform a thorough analysis of the different transfer pricing methods before deciding whether they are applicable. One of the OECD methods is the Cost of Funds method. When this method is employed, it is important to emphasize the borrowing company’s circumstances and to keep in mind that the lenders' cost of funds should be similar to that of other lenders in the market. Do not hesitate to contact the Finnish Tax Administration to discuss the applicability of different transfer pricing methods.
For more information on intra-group borrowing and lending, see the OECD Transfer Pricing Guidance on Financial Transactions.