By Dr. J. Harold McClure, New York City

The British court of November 3 decision favoring Blackrock in its litigation with the UK tax administration has described transactions that raise interesting transfer pricing issues. While this was not addressed in the litigation, it appears the UK could have challenged the transfer pricing of Blackrock’s intercompany loans.

In this case, the UK tax administration – HM Revenue and Customs – attempted to deny full deduction of interest on $ 4 billion of intercompany loans from the group’s US subsidiary to a UK subsidiary, which were part of the financing when Blackrock acquired Barclays Global Investors Plus a decade ago.

The dispute revolved around the subject matter of the intercompany loans. The UK tax administration has attempted to claim that they were designed purely for tax evasion purposes.

Liz Hughes and Anthony Crewe discuss aspects of this litigation in their recent report MNE tax article. They note that the loan transaction had two main objectives – to obtain a tax advantage and the business objective of acquiring Barclays Global Investors. The court ruled in favor of the taxpayer, emphasizing the commercial purpose of the intercompany loan.

Pricing of business-to-business loans

The pricing of these business-to-business loans is a confusing aspect of this business. The intercompany loans were issued on November 26, 2010, in four tranches summarized in the following table.

The UK tax administration began to question the purpose of these intercompany loans during an audit that began in 2012. As of October 1, 2012, the intercompany interest rates on Tranche 2-4 loans have increased. been revised downwards.

The standard model for assessing whether an intercompany interest rate is arm’s length has two components: the intercompany contract and the credit rating of the related borrower.

Properly articulated business-to-business contracts stipulate the date of the loan, the currency of denomination, the length of the loan and the interest rate. The first three elements determine the market interest rate for a corresponding government bond. The intercompany interest rate minus the market interest rate for the corresponding government bond can be viewed as the credit spread involved in intercompany loan agreements.

Tranches 2 to 4 of the above table represent fixed interest rate loans with a term of 4 years, 6 years and 9 years.

On November 26, 2010, the interest rate on 3-year government bonds was 0.78%, while the interest rate on 5-year government bonds was 1.53%. Our table calculates the interest rate on 4-year government bonds at 1.15%. The original intercompany interest rate implied a credit spread equal to 3.5%.

On November 26, 2010, the interest rate on 7-year government bonds was 2.21%. Our table calculates the interest rate on 6-year government bonds at 1.87%. The original intercompany interest rate implied a credit spread of 3.42%.

On November 26, 2010, the interest rate on 10-year government bonds was 2.87%. Our table calculates the interest rate on 9-year government bonds at 2.65%. The original intercompany interest rate implied a credit spread of 3.97 percent.

Credit spreads ranging from 3.4% to 4% are high, indicating a credit rating of BB or worse.

Although the Tribunal ruling does not address the issue of pricing, it is plausible that the UK tax administration raised this issue during their audit.

The revised interest rates are compatible with credit spreads ranging from 1.63% to 1.93%. These lower credit spreads conform to a BBB credit rating.

The question then becomes whether the appropriate credit rating was BBB given the facts behind intercompany lending. As we note below, much of the expert testimony focused on the nature of business-to-business loans versus what would be seen in third-party lending.

Structure of B2B loans and implications for appropriate credit rating

Hughes and Crewe note the testimony of expert witnesses from the taxpayer and the UK tax administration regarding whether the UK subsidiary could have borrowed $ 4 billion from a third party on the same terms and conditions as the intercompany loans.

The testimony, however, did not directly address the pricing issue mentioned above.

The two experts noted that a third-party lender would have required certain protection clauses. The two experts agreed that there was enough liquidity at the time that independent companies could have taken out $ 4 billion at the same (or no lower) interest rate if covenants had been included to protect the position of the lender.

Experts disagreed on whether a third-party borrower would have agreed to such clauses. The taxpayer’s expert argued that a third-party borrower would have accepted commitments even if they limit the borrower’s financial flexibility. The tax administration expert disagreed, arguing that accepting these covenants would be too complex and costly for the borrower even if Blackrock had accepted similar covenants in its revolving credit facility of third.

For loans to third parties, the absence of restrictive covenants exposes the lender to a greater risk of default. Multinationals wishing to charge their related borrowers higher intercompany interest rates have argued that the absence of covenants for intercompany lending suggests a lower credit rating and therefore a higher interest rate under credit terms. full competition.

For loans to third parties, the absence of restrictive covenants exposes the lender to a greater risk of default. Multinationals wishing to charge their related borrowers higher intercompany interest rates have argued that the absence of covenants for intercompany lending suggests a lower credit rating and therefore a higher interest rate under credit terms. full competition.

This argument in favor of high credit spreads is often contested by tax authorities for reasons mentioned in the OECD guidelines on transfer pricing in financial transactions. Credit rating issues are covered by paragraphs 10.62 to 10.86, which include discussions of covenants and the effect of group membership. Paragraph 10.86 notes:

There may be less information asymmetry between entities (i.e. better visibility) in the intragroup context than in situations involving unrelated parties. Intragroup lenders may choose not to have commitments on loans to associated companies, in part because they are less likely to suffer from information asymmetry and because a party is less likely to a multinational group seeks to take the same type of action as an independent lender in the event of a breach of an undertaking, and it would generally not seek to impose the same type of restrictions.

The expert from the tax administration argued that the absence of covenants would have obliged the parent company to issue a loan guarantee for this loan to be granted by a third party. The taxpayer’s expert argued that no collateral was needed due to the implicit support of the parent company.

The OECD guidance on transfer pricing for financial transactions emphasizes the role of implicit support.

The absence of inter-company loan covenants was not seen as a reason for disregarding inter-company loans by this court ruling.

If the absence of covenants did not materially affect the appropriate credit rating for the intercompany loan, it likely would not affect our analysis of the arm’s length interest rate.

As such, the absence of covenants in intercompany transactions would not necessarily imply a lower credit rating once the implicit support argument is taken into account.

The UK tax authorities’ attempt to completely ignore this intercompany loan was unsuccessful given the court ruling. The Tribunal’s decision does not indicate that the taxpayer agreed to lower the intercompany interest rates after the start of the transfer pricing audit. It is entirely possible that this challenge by the UK tax administration was successful in convincing the taxpayer to agree to lower their intercompany interest rates.