Fixed-Rate Intercompany Loans and Currency Denomination

John Hollas recently addressed how to make a comparability adjustment for the difference in the currency of the tested loan and the currency of the comparable loan transaction using one-year floating rates loans as his illustration. This post extends this discussion in two ways. First, we address this adjustment using longer term fixed interest rate loans, and then we discuss past litigations and regulatory guidance that touch on this issue.

Hollas notes that the Interest Rate Parity (IRP) theorem states:

... that in a market without arbitrage, the expected change in the exchange rate between two country’s currencies (i.e., forward premium or discount to the spot exchange rate) is equal to the percentage difference between the risk-free nominal interest rate between the two countries. Therefore, the IRP theorem is the basis upon which to estimate the interest rate adjustment, if any, for differences in the currency of the comparables, which are usually in US$, to the non-US$ currency of a particular tested intercompany loan.

His illustration assumes a borrower with a BBB- credit rating that borrowed $100 million on July 23, 2021 with a term of one year. The interest rate on 12-month LIBOR loan denominated in dollars was 0.25%, while the loan margin for borrowers with a BBB- credit rating was 1.5%. As such, the arm’s length margin for this intercompany loan should be 1.75%.

If the intercompany loan was denominated in Euros, the corresponding 12-month LIBOR denominated in Euros was negative 0.55%. If the appropriate loan margin was 1.5%, then the arm’s length interest rate would be 0.95% as the expected appreciation of the Euro with respect to the dollar was 0.8%.

A standard model for evaluating whether an intercompany interest rate is arm's-length can be seen in terms having a clearly articulated intercompany contract that stipulate:

• The date of the loan;
• The currency of denomination;
• The term of the loan; and
• The interest rate.

The first three items allow the analyst to determine the market interest rate of the corresponding government bond. This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.

Coca Cola borrowed €150 million Euros on November 5, 2021 using 10-year fixed interest rate bonds with an interest rate equal to 0.4%. On that date, the yield for 10-year German government bond (GB) yield was negative 0.25%. As table 1 notes, the credit spread was 0.65%, which is consistent with Coca Cola’s A+ credit rating.

Table 1: 10-year Intercompany Loans Issued on November 5, 2021

The interest rate on 10-year US government bonds was 1.45% on November 5, 2021. If a 10-year intercompany loan was issued on November 5, 2021 that was denominated in US$, the arm’s length interest rate would be 2.1%. The interest rate on 10-year Canadian government bonds was 1.6% on November 5, 2021. If a 10-year intercompany loan was issued on November 5, 2021 that was denominated in CA$, the arm’s length interest rate would be 2.25%. The higher arm’s length interest rates on intercompany loan denominated in US$ or CA$ reflects the market’s expectation of depreciation of these currencies with respect to the Euro.

Prior Litigations

In an earlier discussion of a Canadian intercompany interest rate litigation, I noted two past litigations that involved the difference between interest rates on US$ denominated loans versus interest rates on loans denominated in either Australian dollar (AU$) or New Zealand dollars (NZ$).[1]“ Shell Canada Limited v. Her Majesty The Queen represented a challenge from the Canadian Ministry of Revenue to a 15.4% interest rate used in determining the interest deduction on a NZ$150 million five-year fixed interest rate loan, which was issued on May 10, 1988. At the time, the interest rate on five-year US government bonds was 8.55% and the interest rates on five-year New Zealand government bonds as of May 10, 1988, was 13.2%. The higher interest rates on New Zealand government bonds likely reflected the market's expectation that the NZ$ would devalue. The position of the Minister of Revenue should be only 9.1%. This position rested on two premises: the appropriate currency of denomination should be US$ rather than NZ$, and the appropriate credit spread should be 0.55%, consistent with an AAA credit rating.  While the 15.4% interest rate suggests a credit spread equal to 2.2%, which appears to be high given an AAA credit rating, IRP would suggest the taxpayer’s position with respect to the currency of denomination. If the appropriate credit spread were 0.55%, then the appropriate interest rate would be 13.75%.

Table 2: Five-year Fixed Interest Rates for May 10, 1988

Chevron Australia Holdings Pty Ltd. v. Commissioner of Taxation involved a June 6, 2003, intercompany loan to an Australian affiliate where the intercompany interest rate was based on the one-month LIBOR rate denominated in AU$ plus a 4.14% loan margin. The ATO also challenged the 4.14% loan margin, arguing that it should be substantially lower. The ATO's expert witnesses argued for a 1.44% loan margin based on its view that the appropriate credit rating for Chevron Australia should be BBB. The 4.14% loan margin, however, would have been consistent with a credit rating of CCC.

Even though the intercompany loan was denominated in AU$, the ATO argued that the loan should be treated as denominated in US$ because interest rates were approximately 2.5% lower in the US than in Australia during this period. I critiqued that ATO's fallacious economic reasoning in my draft paper “The Currency of Denomination Issue in Recent ATO Challenges to Intercompany Interest Rates,” noting that the expected cost of borrowing in a foreign currency must include not only the difference between the foreign and domestic interest rates, but also the expected change in the exchange rate of the currency borrowed over the life of the loan. The Canadian government’s position in the Shell Canada litigation and the ATO's position in Chevron Australia both ignore the role of expected exchange rate changes even though the IRP is a well-recognized aspect of international financial economics.

Regulatory Guidance

The Organization for Economic Cooperation and Development (OECD) released its transfer pricing guidance on financial transactions on February 11, 2020. This guidance noted the important of the currency of denomination of the intercompany loan. It also state that adjustments for difference in the currency of denomination should be made but gave no insights about how to do these adjustments.

Chapter 9 of United Nations Practical Manual on Transfer Pricing for Developing Countries includes sixteen examples illustrating the determination of intercompany interest rates and loan guarantees. Example 5 highlights the issues that can arise when the currency of denomination is not clear:

Borrowing Company, BCo, pays loan interest to Lending Company, LCo. BCo and LCo are associated enterprises. The loan agreement specifies that the advance is denominated in currency X. On further examination, it is found that the advance was made in currency Y, and regular interest payments have been made in currency Y computed on the outstanding balance expressed in currency Y.

To illustrate the issues, consider a US parent that wishes to extend 10-year fixed interest rate loans to each of its foreign affiliates in Australia, Canada, and Europe where the loan agreements were all signed on January 1, 2014 and the loans were issued in the local currency of the borrowing affiliates. Table 3 presents the interest rate on 10-year government bonds for Australia, Canada, Germany, and the US If the credit ratings for each of these affiliates were BBB, the appropriate credit spread would be 1.5%. Table 3 presents the arm’s length interest rate given this credit rating as the sum of the corresponding government bond rate plus a 1.5% credit spread.

Table 3: Illustration of UN Example 5

The arm’s length interest rate for the loan to the Australian affiliate = 5.8% if the currency of denomination were the AU$. The ATO, however, asserted in Chevron Australia v. Comr. that it had the right to alter the intercompany contract such that the currency of denomination would be US$. In our example, the implication would be to lower the intercompany interest rate to only 4.5%. The IRS, however, would likely disagree with this aggressive approach and would expect the interest rate to remain at 5.8%.

This assertion that the currency of denomination should be altered to US$ would lower the intercompany interest rate for the other two intercompany loans. The IRS would likely prefer the 4.5% interest rate to the 4.25% interest rate for the intercompany loan to the Canadian affiliate and the 3.5% interest rate for the loan to the European affiliate. The Canadian Revenue Agency, however, would likely insist on the lower 4.25% interest rate since the intercompany loan contract specified that the currency of denomination was CA$. Similarly, the European tax authority would note that the intercompany loan contract specified that the currency of denomination was the Euro implying an arm’s length interest rate of 3.5%.

Multinationals that want tax authorities to respect its choice of currency denomination must execute a clear intercompany contract that identifies the terms of the loan. The multinational should also make sure its behavior in repaying the loan follows its intercompany contract.

References

John Hollas, "Tutorial: Currency Adjustments in Intercompany Financing," EdgarStat Blog. 

Harold McClure, Alberta v. ENMAX Energy: Shades of the Chevron Australia Intercompany Interest Issue,” Journal of International Taxation, April 2019.