Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: what is a credit rating?
A credit rating is a financial report prepared by an independent party (the rating agency) which attempts to assess credit risk, that is, the ability of the subject of the report to meet its financial obligations on a timely basis. This may relate to:
- the likelihood of default of a debt issuer (borrower) in relation to a specific financial obligation (usually a bond or other financial liability). This is called an issue credit rating.
- the general credit worthiness of the subject entity.
- the credit worthiness of a country. This is a measure of a country’s ability to provide a secure environment for investment. Warnings and downgrading at this level are not as rare as they were, and changes are sometimes headline news because they have a significant influence on the price of sovereign debt and the return on government securities.
Credit ratings are not the same thing as credit references. The latter represent a summary of an individual or a business’s credit history rather than an explicit assessment of future risk.
Credit rating agencies
The best-known agencies are Standard & Poor’s (S&P), Moody’s and Fitch Ratings. These and other such companies are paid by the debt issuer, and offer different types of rating services: public ratings; private ratings for internal or regulatory purposes; shadow ratings - again for private consumption; model-based ratings, etc, involving differing degrees of evaluation.
The financial obligation to which a rating refers is usually a bond or similar debt instrument. The company wishing to raise money by issuing a bond relies on an independently-verified credit rating (in many cases more than one) to inform potential investors of the company’s ability to meet its financial commitments. Credit rating agencies only look at credit risk and are not in the business of recommending the purchase or sale of the security.
There are two types of issue credit ratings - long-term issue and short-term issue credit ratings. Which classification is appropriate will depend on the length of time the financial obligation will be in issue. A short-term issue credit rating is appropriate for financial obligations with a maturity of less than 365 days.
Ratings may be public or private and provide opinions not recommendations. They are derived from both audited and unaudited information.
How ratings are expressed
The long-term credit rating system used by S&P is as follows:
|AAA and AA:||High credit-quality investment grade|
|A and BBB:||Medium credit-quality investment grade|
|BB, B, CCC, CC, C:||Low credit-quality (non-investment grade), known as “speculative grade bonds”|
|D:||Bonds in default for non-payment of principal and/or interest|
Independent credit ratings are widely used in Europe and the United States, where there is an established tradition of issuing bonds and other forms of commercial paper as a means of raising money.
It is important to appreciate that credit ratings are tailored to particular sectors. Ratings should be comparable across different sectors, but a rating may serve a very specific purpose in, say, the banking or insurance sectors; for example, to indicate the likelihood of a bank running into serious financial difficulty where it would require support, and whether it would get external support in such an event.
Debt instruments with the lowest credit ratings carry the highest level of risk of default by the borrower, and therefore offer the greatest reward. An investor must balance risk against the expected reward.
It is important for thin cap purposes to distinguish independent credit ratings commissioned from a ratings agency from internally-produced ratings (see INTM524180). An independent credit rating is highly unusual in cases seen by HMRC, except occasionally for cases within the financial or public utility sectors. This is because the UK borrower is usually part of a larger grouping, and UK borrowing will be intra-group or subject to group guarantees. This means the UK group has no reason to commission an independent rating, because the strength of the UK group is not the main consideration. Nevertheless, the borrower may operate in a regulated industry where having an investment grade rating is a requirement for obtaining or retaining a licence to carry on the regulated business, or the company may actually be issuing traded debt, in which case an independent credit rating may be required. Outside these specific circumstances, it is highly unlikely a full independent evaluation will have been carried out, as the process is costly and time-consuming (see INTM524190).
What are credit ratings used for in a transfer pricing context?
With any enquiry into the transfer pricing of debt there are two factors to consider:
- Does the debt borrowed match what would and could be obtained at arm’s length?
- Are the terms and conditions such as would apply at arm’s length?
Borrowers have been known to use credit ratings to support both these positions, but they are most commonly used in pricing loans rather than in establishing the arm’s length amount of borrowing. Each application of the credit rating concept is explained further below.
Use as evidence in potential thin capitalisation cases
The taxpayer may use a credit rating (whether externally or internally generated) to support the proposition that the amount of inter-group debt is equivalent to what could be borrowed at arm’s length.
The argument will normally proceed as follows:
X Ltd borrows £100m from a lender who is a related party. After the hypothetical or actual addition of the debt into the accounts of X Ltd, an internal or external rating is performed which concludes that the company (together with its subsidiaries) would be likely to receive a stand-alone credit rating of, say, BBB. Evidence is then obtained from market sources of instances where companies rated BBB issued debt to third parties at around the same time as the inter-company issue, and it is thereby concluded that a particular amount of the related party loan may be considered to be at arm’s length. The specific application of credit ratings in this context is discussed further at INTM524180.
Application to loan pricing
The more common approach is to apply the credit rating methodology to loan pricing. In these cases it may already have been established (perhaps through ratio analysis or some other means) that the company could have taken on all or part of the related party loan. The credit rating is then used to set the price of the loan.
In this instance the argument will normally be as follows:
Y Ltd borrows £100m from lender, a related party, and this debt is again rated BBB. A search of the yields of BBB-rated debt being traded in the marketplace reveals that on average they are yielding, say, 5.5% and as such it is concluded that this yield is a reasonable arm’s length interest rate to apply to the debt in question.