Tax & Accounting Blog

Determine Whether Your Intercompany Interest Rates Are Arm’s Length As You Comply With Section 163(n)

Blog, ONESOURCE, Transfer Pricing April 11, 2018

The Tax Cuts and Jobs Act includes some key impacts to transfer pricing, including the limitations on interest expenses imposed by section 163(n). BEPS Action 4 proposed two types of limitations on intercompany interest deductions:

  • limits to intercompany debt where an affiliate’s debt to asset ratio mirrors the overall third party debt to asset ratio of the multinational; and/or
  • limitations to the ratio of interest expenses relative to operating profits such as a 30 percent limitation.

Under the old U.S. tax law, section 163(j) limited the ratio of interest expenses to operating profits before depreciation (EBITDA) to 50 percent, which was a generous upper bound in an era of low interest rates. The new tax law will reduce this limit to 30 percent and eventually use as the denominator operating profits after depreciation (EBIT). While many discussions of this new limitation are advising multinationals to reduce the intercompany debt of their U.S. affiliates, our view is that one should first evaluate whether the intercompany interest rate is excessive under section 1.482-2(a).

We illustrate this caveat using a hypothetical European-based shoe manufacturer that sells 30 million pairs of shoes at $100 per pair to U.S. customers via a U.S. distribution affiliate. Let’s also reasonably assume that this affiliate incurs various operating costs including cost of products from third parties, its own operating expenses, and intercompany payments to its European parent such that its total operating costs represent 97 percent of sales leaving the U.S. affiliate with a 3 percent operating margin. Let’s also assume that the intercompany policies with respect to operations has been defended using an application of the Comparable Profits Method.

Table 1 presents various scenarios with respect to its intercompany financing, where the original scenario involved a $600 million loan from the European parent on March 17, 2017 with an interest rate equal to 5 percent fixed for 10 years. Assume that the U.S. affiliate had $1 billion in assets, which implies equity = $400 million. As such, this affiliate had a debt/equity ratio equal to 60 percent but since its interest expenses were less than 50 percent of its EBITDA, section 163(j) was not binding. On January 1, 2018, section 163(n) would limit the interest expense to $27 million. Should the multinational adopt alternative A and reduce intercompany debt to $540 million maintaining the 5 percent interest rate as many advisers are recommending? We shall suggest that alternative B might be considered, which would maintain the original level of debt and lower the intercompany interest rate, if there is the possibility that the IRS would deem the arm’s length interest rate under section 1.482-2(a) to be lower than 5 percent.

Table 1: Alternative Means for Compliance with Section 163(n)

If the multinational has not performed an analysis of what would be the arm’s length interest rate, we strongly suggest that they should. Table 2 presents certain information that might be relevant to this exercise. The IRS might point to a third party loan that the parent incurred in October 2014 where Euro denominated debt in a 10-year loan with a fixed interest rate equal to 2.25 percent. The IRS might ask why the intercompany rate is more than twice this market rate. This third party loan differs from the controlled transaction with respect to some of the key comparability criteria. While both loans had the same term to maturity, the controlled transaction occurred almost 2.5 years later and was denominated in U.S. dollars. Our chart shows the interest rates on 10-year German and U.S. government bonds from 2006 to 2017. While the German government bond rate fell from 0.75 percent in October 2014 to only 0.35 percent as of March 17, 2017, the U.S. government bond rate was 2.5 percent on March 17, 2017.

Table 2: Key Information for the Evaluation of an Arm’s Length Interest Rate

The group rating for the parent corporation was BBB, which translates into a credit spread equal to 1.5 percent as credit spreads represent the difference between a corporate yield and the interest rate on the corresponding government bond. Table 4 considers four scenarios with respect to the controlled transaction. The 5 percent intercompany interest rate is based on the premise that the appropriate credit spread is 2.5 percent, which would be consistent with a BB+ credit rating. Let’s assume that the representatives of the multinational commissioned an estimate of the U.S. affiliate’s standalone credit rating where this evaluation concluded that the appropriate credit was indeed BB+. The evaluation of credit ratings is a current controversy among taxpayers and tax authorities. One can imagine that the European tax authority might argue for a 5.5 percent interest rate on the premise that the appropriate credit rating should be BB implying a credit spread equal to 3 percent.

If the IRS, however, adopts the implicit support view, which other tax authorities have argued, they could argue for a better credit rating. If the IRS took the extreme position that the group credit rating of the parent should be used in this evaluation of the credit rating for the U.S. affiliate, then the IRS might argue for a 4 percent interest rate. Table 4 presents a “settlement” position where the multinational and the IRS eventually agree that the appropriate credit rating under the implicit support standard should be BBB-, which implies a 2 percent credit spread and an arm’s length rate.

If the multinational and the IRS eventually settle on a 4.5 percent interest rate as being arm’s length under section 1.482-2(a), then the multinational would be in compliance with section 163(n) even if it maintained $600 million in intercompany debt. Our point is that multinationals should not rush to reduce its intercompany debt to be in compliance with the new provision of section 163(n) until they have done their analysis of what interest rate would be supportable under the arm’s length standard as expressed under section 1.482-2(a).

U.S. and German 10-year Government Bond Rates: 2006-2017

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