Based on the arm’s length principle, all intra-group financing must be set at arm’s length for tax purposes. These are the terms and conditions under which independent third parties (eg banks) would provide funding. This article compares the loan approach and the bond approach, which are the most common open market price comparison methods for setting an arm’s length interest rate for intragroup financing. Although the OECD has concluded that both approaches can be valid and are to a large extent substitutes, the obligation approach appears to be the preferred alternative.
With the loan approach, an arm’s length interest rate is set by comparing interest rates on comparable loans between third parties that were set under similar circumstances. Key considerations for applying the lending approach are:
– A comparison between similar instruments, loans to loans, is usually the most accurate way to set an arm’s length interest rate, since it is the same instrument. A disadvantage, however, may be that the number of transactions available is limited compared to bonds, which may make it more difficult to find enough eligible comparables. For example, the number of outstanding loans available in Bloomberg is 65,310, while the number of outstanding bonds available is 406,917. 1
– For companies with a relatively low (bad) credit rating, there are relatively more loans available in commercial databases. For example, the number of lower quality loans currently available in Bloomberg is 4,199 out of 65,310 (6.4%), while the number of lower quality bonds currently available is 11,871 out of 406,917 (2. 9%). Indeed, companies with low credit ratings find it difficult to enter the public bond market. Thus, the spread of available transactions may be relatively lower for this category of companies.
With the bond approach, an arm’s length interest rate of an intercompany loan is set by comparison with the yield to maturity of bonds with similar volumes and other characteristics. The main considerations for applying the bond approach are:
– Many comparable bond data are available in databases, since bonds, unlike loans, are traded on the secondary market. As a result, a relatively large number of comparables are available to provide customization when setting an arm’s length interest rate. This can allow you to find comparable transactions within the same industry, volume, duration, credit rating, age, warranty, etc. – In addition, bonds better reflect the current market price than loans, since bonds are negotiable instruments. According to the OECD, information about the terms of similar transactions between third parties made during the same period as the related transaction is the most reliable information to use in a comparability analysis. Therefore, the bond approach is the best approach in a market where interest rates fluctuate widely, because it takes into account the most recent market conditions. – Regarding the bond yield to maturity, information is available, which de facto corresponds to the total remuneration. Therefore, when comparing bonds to a structured loan with a base rate and a margin (e.g. USD 12 month LIBOR + 2%), one must determine the base rate to determine a full interest margin. competetion. The latter is not applicable when the lending approach is followed. It is also possible to make comparability adjustments for currency differences with currency swap rates.
Despite the fact that the loan approach appears to be the most accurate way to set an arm’s length interest rate on a loan, there is much more comparable data available regarding bonds. In addition, bonds better reflect the current market price due to their negotiability. Therefore, it can be concluded that, especially in a very fluctuating market (due, for example, to Covid), the bond approach is the most reliable way to set an arm’s length interest rate for intragroup financing. . However, it depends on the details of the transaction and the parties involved what is the most appropriate approach in a specific case.