Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: important factors to consider when using credit ratings in loan pricing cases
Credit ratings are commonly used in transfer pricing cases to help demonstrate that a particular related party loan interest rate should be considered to be at arm’s length.
Interaction with thin capitalisation
As with other thin cap cases, there are two things to consider - whether the amount of the loan may be regarded as arm’s length in nature and whether the interest rate (and other terms) can be considered to be arm’s length. It is therefore important to separate the loan pricing from any consideration of whether a loan would or could have been made at arm’s length.
A credit rating approach may be used to support both of these goals (see INTM524180 below), and just because a credit rating approach provides only limited evidence to support the amount of debt, that does not necessarily mean it has no use in establishing whether an interest rate stands up as arm’s length (or vice versa), providing there is sufficient other evidence.
External evidence surrounding market yields
In loan pricing cases, a credit rating is often accompanied by analysis of what similarly rated debt yields in the marketplace. Apart from the obvious issue of how the rating is quantified, a number of variables are important to consider here:
- Is the maturity of the two debt obligations similar?
- How close in time are the issue dates?
- Is the currency the same?
- Are termination rights and obligations (put and call rights, etc) the same or similar?
- Are the interest characteristics the same or similar? For example, is one a discount bond with a reduced or nil coupon?
- How many other similar loans are there in the marketplace. In other words, what is market liquidity?
Each of these factors will affect the yield on publicly-traded debt, and if they are not identical to the tested party’s loan (or have not been sufficiently adjusted for) then this analysis may lead to an inappropriate loan price.