Intercompany loans were not respected by Chinese law until new rules from the Supreme People’s Court of China known as provision 18. Provision 18 set fixed ranges for interest rates under private loans. Initially a private loan agreement with an annual interest rate of 24% or less would be regarded as valid by Chinese courts. Moore MS Advisory on August 14, 2020 discussed intercompany loans in its “Intercompany Loans: Shareholder Loans to Chinese Subsidiaries," noting:
Because the Chinese State Administration of Foreign Exchange (SAFE) strictly controls foreign exchange in China, the amount that can be borrowed by a Chinese subsidiary is limited to the so-called foreign debt quota.
For a Chinese affiliate with assets in excess of $10 million, debt can be at most 60% of assets. Their discussion also notes:
When an intercompany loan is initiated and a foreign loan agreement is prepared, it is important for the companies to establish an interest rate based on the Loan Prime Rate (LPR) as published by the National Interbank Funding. LPR is equal to the most preferential lending rate offered by commercial banks at that period in time … The LPR is published every 20th day of each month. For example, on July 20, 2020, the 1-year LPR stood at 3.85% and the 5-year LPR stood at 4.65%.
The 5-year LPR was 4.85% as of August 2019 and declined over time as market rates fell. As of December 2022, the 5-year LPR was 4.3%. While the 24% interest rate under provision 18 was substantially above the interest rates on Chinese government bonds, these LPR rates may be closer to what would be expected under the arm’s length standard. Using the LPR may be seen as relying on a safe harbor for yuan- denominated intercompany loans to Chinese borrowing affiliates. If the credit rating for the borrowing affiliate is below investment grade, LPR likely understates the arm’s length interest rate. If the credit rating for the borrowing affiliate is investment grade, LPR likely overstates the arm’s length interest rate.
Practitioners at Lee & Ko discuss how intercompany loans are addressed in South Korea:
In 2017, a safe-harbor rule for intercompany loan transactions was introduced to the LCITA by a Ministerial Regulation. It stipulates that 4.6%, which is the overdraft lending rate, shall be applied for outbound transactions (where a Korean tax resident lends funds to its foreign related party(ies)) and a rate equal to the 12-month LIBOR plus 1.5% shall be applied for inbound transactions (where a Korean tax resident borrows funds from its foreign related party(ies)). The safe-harbor provision was designed to enhance the convenience of taxpayers and is still valid under the current version of the LCITA and its subordinate regulations. However, the safe-harbor rule has the following problems: The overdraft interest rate of 4.6% stipulated under the LCITA and the Korean Corporate Tax Law is relatively high in the current era of low interest rates. Korean tax residents could possibly charge a high interest rate of 4.6% in an effort to avoid any challenges by Korean tax authorities, but this may be an issue for the contracting state where the borrower is domiciled. Particularly this may be the case when the borrower could have secured a loan from a local independent financial institution at a much lower interest rate. In addition, a Korean tax resident applying the 4.6% interest rate to a loan made to a foreign related party with a low credit rating who, had they been independent parties, the Korean tax resident might not have lent to, or, even if they had been willing to lend, would have charged a much higher interest rate than 4.6%, might be at risk of not receiving adequate interest and/or a return of the principal of the loan. Notwithstanding the benefits of the safe-harbor rule—namely simplicity and convenience for taxpayers—its application without any further consideration of the commercial rationality concept and the two-way approach that the OECD Guidance introduced has the potential to trigger transfer pricing issues in jurisdictions where the other contracting related parties are domiciled.
The South Korean 10-year government bond rate was near 2.7% at the beginning of 2022, which is when this Lee & Ko discussion was published. If a 4.6% interest rate was required by the Korean National Tax Service (KNTS) on an outbound intercompany loan, the implied credit spread would be 1.9%. If the foreign tax authority asserted that the credit rating for the borrowing affiliate was investment grade, then their warning of double taxation has merit. Interest rates during 2017 were generally lower and dropped to only 1.17% as of August 17, 2019. This interest rate in early January 2017 was near 2.1% so this 4.6% rate would be consistent with a credit spread = 2.5%. The South Korean 10-year government bond rate was 4.655% as of October 23, 2022 and was near 3.6% at the beginning of 2023. As such, the credit spread implied by this 4.6% rate would be very low for recent periods.
Illustration of the Chinese Approach Applied to Shanghai Columbia Sportswear Commercial
We illustrate how the arm’s length standard may apply to Chinese affiliates of foreign parents by evaluating an intercompany loan briefly mentioned in the Columbia Sportswear 10-K filing for fiscal year ended December 31, 2014. Swire Resources is a Hong Kong distributor of sports apparel and footwear, which began serving as the exclusive distributor of goods designed by Columbia Sportswear in in Hong Kong and Macau in 2002, and in China in 2004.
As of January 1, 2014 Shanghai Columbia Sportswear Commercial (SCSC) was a joint venture 40% owned by Swire Resources and 60% by Columbia Sportswear that became the exclusive distributor of Columbia Sportswear in China. As of January 1, 2019 SCSC has been 100% owned by Columbia Sportswear. Before the joint venture was formed, sales of Columbia Sportswear products exceeded $125 million and were expected to grow rapidly under this joint venture arrangement. While the worldwide operating margin for Columbia Sportswear was near 12%, let’s assume that the distribution affiliate’s operating margin = 5.2%. As such, SCSC would likely generate annual profits near $6.5 million per year. We shall reasonably assume that the value of its assets would have been $65 million or 390 million yuan at the time of the formation of the joint venture.
Both Swire Resources and Columbia Sportwear extended 5-year loans to SCSC in early 2014 with interest rates = 7%. We shall assume that the total principle of these intercompany loans represented 60% of asset value or 234 million yuan (equivalent to $39 million). Could China’s State Taxation Administration (STA) challenge this intercompany rate? What would be a reasonable interest rate if Columbia Sportswear issues a new intercompany loan as of January 1, 2019?
A standard model for evaluating whether an intercompany interest rate is arm's-length can be seen to have two components — the intercompany contract and the credit rating of the related party borrower. Properly articulated intercompany contracts stipulate:
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. We have assumed a 5-year intercompany loan denominated in Chinese yuan issued on January 1, 2014. At the time, the interest rate on 5-year Chinese government bonds was only 4%. The 7% intercompany interest rate would be reasonable only if the credit spread was reasonably 3%.
Estimating credit spreads for borrowing affiliates is a more difficult and controversial issue. Credit ratings are letter grades, which require translating into a numerical credit spread. For example, if the taxpayer could reasonably assert that the credit rating should be BB, then this 3% credit spread would be reasonable. If the STA, however, could assert that the credit rating should be A, then the credit spread would be only 1% implying an arm’s length interest rate.
An important issue for the evaluation of credit ratings is the role of implicit support. Let’s assume that the group rating for Columbia Sportwear were A, while the standalone credit rating for SCSC were BB. The taxpayer’s position rests of the premise that implicit support provides no benefit to the borrowing affiliate. The STA position on the other hand rests of the proposition that implicit support is so strong that the appropriate credit rating should be the group rating. An intermediate position that assumes neither extremely strong implicit support nor extremely weak implicit support might be that the appropriate credit rating should be BBB. In this case, the credit spread would be 1.5% which would imply an arm’s length interest rate equal to 5.5%.
If Columbia Sportwear as the 100% owner of this Chinese distribution affiliate decided to issue new intercompany debt on January 1, 2019, then an analysis of the arm’s length interest rate for the new loan should be conducted. Let’s assume that the new loan was denominated in yuan with a 5-year term. The interest rate on 5-year Chinese government bonds was only 3% as of January 1, 2019. An analysis of the borrower’s credit rating with an appropriate understanding of the role of implicit support would be a key issue. If the appropriate credit rating were BBB, then one could justify a 4.5% interest rate as being arm’s length.
Illustration of an Intercompany Loan from SK Hynix to a Chinese Manufacturing Affiliate
Intel sold its NAND and SSD flash-memory business to SK Hynix for $9 billion on December 29, 2021. The transaction included Intel’s Dalian memory manufacturing facility, which likely was valued at $2 billion. Let’s also assume that the Korean parent corporation financed the acquisition Dalian facility with a 10-year 1.25 trillion Korean Kwon intercompany loan, which was equivalent to $1 billion.
The South Korean 10-year government bond rate was near 2.4% so this 4.6% rate would be consistent with a credit spread = 2.2%. This would be consistent with a BB+ credit rating for the Chinese borrowing affiliate. The group credit rating for SK Hynix, however, was BBB. If the STA asserted that the appropriate credit spread should be equivalent to this group rating, then the appropriate credit spread would be only 1.5%, which implies an arm’s length interest rate = 3.9%. The KNTS, however, may object to the use of the group rating preferring on the use of an estimated standalone credit rating for the Chinese affiliate. If this standalone credit rating were BB+, then the KNTS would likely insist that the 4.6% interest rate was arm’s length. An intermediate position based on a modest version of implicit support might support a credit rating of BBB-
Let’s also explore the implications of having this intercompany loan be denominated in yuan where a 6.9 billion yuan loan would be consistent with $1 billion in intercompany financing. The interest rate on 10-year Chinese government bonds at the beginning of 2022 was 2.8%. The implied credit spread would then be only 1.8%, which would be consistent with a BBB- credit rating. If the STA, however, insisted on the BBB group credit rating, then the credit spread would be only 1.5%, suggesting an arm’s length rate = 4.3%. We should note, however, that China’s 5-year PLR for early 2022 was 4.6%, which just happens to be consistent with the South Korean expectations.
China’s current 5-year PLR is 4.3%, while the interest rate on 5-year Chinese government bonds is near 2.7%. If a foreign parent extended a 5-year fixed-interest rate loan denominated in yuan, relying on this PLR would be consistent with a 1.6% credit spread. As long as the credit rating for the Chinese borrowing affiliate were BBB or better, the tax authority for the foreign lending affiliate would likely accept this interest rate. If the foreign tax authority asserted a below investment grade credit rating, then it might insist on a higher intercompany interest rate. South Korea insists on 4.6% interest rates on outbound intercompany loans. If the intercompany loan were denominated in Kwon, current South Korean government bond yields would suggest a very modest credit rating under this 4.6% rate.
Such safe harbors, however, do not always correspond to arm’s length rates. The evaluation of whether an intercompany interest rate depends both on contractual features including the date of the loan, the term of the loan, and the currency of denomination and on the appropriate credit rating. The recently released
OECD transfer pricing guidance on financial transactions extensively discusses the various aspects of evaluating an appropriate credit spread. While our two examples note the role of credit ratings and credit spreads, neither the KNTS nor the STA have provided much guidance as to how these two tax authorities will address such issues.
Tom Kwon, Steve Minhoo Kim, and Gijin Hong, “Intercompany Loan Transactions: Recent Developments in South Korea’s Transfer Pricing Regime,” Bloomberg Tax, February 18, 2022.