IRS Issues Important Transfer Pricing Guidance for Intracompany Loans

With IRS scrutiny of transfer pricing seemingly on the rise, corporate groups need to pay attention to new developments. The IRS recently released some guidance that provides valuable insights on how it applies the arm's length standard when evaluating interest rates on intracompany loans. This includes the role of a group's creditworthiness.

Transfer Pricing Basics

Transfer pricing generally refers to the price that one affiliate charges another for tax purposes in an intragroup (or "controlled") transaction involving the transfer of goods, services or intangible assets. Transfer pricing also can arise in the context of interest rates on intragroup loans to a "controlled borrower."

Internal Revenue Code Section 482 empowers the IRS to distribute, apportion or allocate gross income, deductions, credits or allowances between or among related parties to prevent evasion of taxes or to clearly reflect the income of any parties. Related regulations require that a transfer price yield results consistent with an arm's length transaction between unrelated parties. In a loan transaction, the arm's length interest rate to a controlled borrower generally is the rate at which that borrower could realistically obtain alternative financing from an unrelated party.

Issue at Hand

The recent guidance was released as an IRS memorandum. It addressed whether the IRS is allowed to consider group membership when determining the arm's length rate of interest chargeable for intragroup loans and make a Sec. 482 adjustment.

The memo notes that commercial lenders may offer more favorable loan terms to a group member (versus a standalone entity) based on "implicit support." That term refers to the likelihood that another group member would provide financial support (for example, via an equity contribution or debt forgiveness) if the borrower were in financial distress, even without an explicit guarantee or other formal commitment to do so.

Hypothetical Example

The memo outlines an example where a foreign parent company owns 100% of the U.S. subsidiary that owns operating assets and operates businesses essential to the group's financial performance. The parent company likely would provide financial support to prevent a potential default on the subsidiary's obligations to unrelated parties. The subsidiary's credit rating (BBB) reflects implicit support from its corporate group. Thus, the credit rating is higher than its standalone rating would be (B). The parent makes a loan to the subsidiary at a 10% interest rate.

The IRS has taken the position that, if an unrelated lender would consider group membership in establishing the financing terms for the borrower, and such third-party financing is realistically available, the IRS also may consider the group membership to adjust the interest rate. It could then adjust the interest rate to the 8% arm's length rate the subsidiary would pay to an unrelated lender based on its BBB credit rating.

Sec. 482 regulations state that an arm's length interest rate is that which would have been charged in independent transactions between unrelated parties under similar circumstances. Relevant factors include the:

• Borrower's credit standing, and
• Prevailing interest rate for comparable loans between unrelated parties.

The memo explains that, because an unaffiliated commercial lender would charge interest based on the borrower's credit rating, factors that affect the rating inform the arm's length rate. Those factors may include the borrower's role in the group, the level of integration within the group and implicit support from affiliates.

Additional Insights

In addition, the memo cites the "realistic alternatives" principle as support for its position. This principle is a corollary of the arm's length standard. It recognizes that an uncontrolled taxpayer wouldn't engage in a transaction on certain terms if it would leave them worse off than under a realistically available alternative. So the IRS can consider such alternatives when assessing whether a controlled transaction's terms would be acceptable to an uncontrolled taxpayer and adjust the interest rate based on the alternative's rate. And, to the extent that a borrower's group membership reduces the interest rate available from third-party lenders, the borrower would reject a loan with the same terms but a higher interest rate.

The IRS acknowledged the argument that a related lender, as the source of the borrower's implicit support, wouldn't benefit from that support as a creditor and, therefore, is entitled to a higher interest rate than an uncontrolled lender. But the IRS must treat the parties as unrelated for purposes of determining if an interest rate is arm's length. In other words, the related lender can't charge a higher rate based on a controlled relationship with the borrower because an uncontrolled borrower wouldn't accept a higher rate than it could obtain from an uncontrolled lender.

The memo further clarifies that controlled borrowers don't owe compensation for the implicit support because, under the regulations, no compensation is owed for any benefit arising solely from passive association. Without a guarantee or other legally binding credit support, a borrower can retain passive association benefits received solely from its group membership without compensating any affiliate.

Got Questions?

The IRS memo provides nontaxpayer-specific legal advice on applying Sec. 482. The analysis applies equally in the context of loans between controlled parties with other relationships (for example, sister subsidiaries). For more information on controlled loan arrangements or transfer pricing in general, contact your tax advisor.