INTM524060 - Thin capitalisation: practical guidance: the use of credit ratings: important factors to consider when benchmarking using credit ratings

Credit ratings are commonly used in transfer pricing cases to help demonstrate that the amount and maturity of an intra-group debt and the interest rate thereon should be considered to be at arm’s length.

It is important to separate the debt pricing from any consideration of whether the debt would or could have been made at arm’s length.

However, a credit rating approach may be used to support both of these goals (see INTM524080 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 amount and maturity of debt

A credit rating can be used to establish the amount and maturity of intra-group debt by analysing the amounts and maturities of similarly rated contemporaneous debt that have been issued in the marketplace. It is generally helpful to start with a broad brush approach to determine the amount and maturity that may have been available to the borrower under any structure of debt. At this stage, it is key that:

  • The issue credit rating of benchmarked debt should be the same as that of the tested transaction.
  • The currency of all benchmarks should be the same as the tested transaction.
  • The issue dates should be historically close to the tested transaction.
  • Government-backed securities should not be included (assuming the tested transaction is not government-backed).

Following the initial identification of the amounts and maturities potentially available, consideration should be given to other features of the debt that may, depending on the macroeconomic conditions and the credit risk of the borrower, affect that amount and maturity of the debt available. These may include the interest characteristics of the debt (e.g., fixed vs floating rate and discounted or zero-coupon debt) and any termination features (e.g., put and call options).

External evidence surrounding market coupons

Similarly, in debt pricing cases a credit rating should be accompanied by analysis of what the “par yield to maturity on new debt” is in the marketplace for similarly rated contemporaneous debt, with similar amounts and maturities. The key variables of benchmarks to consider here are that:

  • The issue credit rating of the benchmarked debt should be the same as that of the tested transaction
  • The currency of all benchmarks should be the same as the tested transaction.
  • The amount and maturity should be similar to the tested transaction.
  • Issue dates should be istorically close to the tested transaction.
  • Whether the interest rate is fixed or floating should be the same as the tested transaction.
  • Government-backed securities should not be included (assuming the tested transaction is not government-backed)

Each of these factors will affect the”par yield to maturity on new debt” issued in the debt capital markets by third parties, and if they are not identical to the tested party’s debt (or have not been sufficiently adjusted for) then this analysis may lead to an inappropriate debt price.

As when assessing the amount and maturity, consideration should also be given depending to other features of the debt that may, depending on the macroeconomic conditions and the credit risk of the borrower, affect the market yield. These may include further interest characteristics of the debt (discount or zero-coupon debt) and specific types of termination feature (e.g., put and call options).

The arm’s length principle

Each of the features of the debt in the tested transaction must be consistent with the arm’s length principle. The amount, maturity and interest rate should not be increased by terms that do not reflect the accurate delineation of the lending transaction of which would not have been agreed at arm’s length. As part of this, the terms must be consistent with those features and the other terms. For example, at arm’s length zero-coupon debt generally has short maturity (because of the risks associated with the lack of intermittent payments).