Thin capitalisation: practical guidance: loan pricing and the use of credit ratings: in-house credit ratings
Approach to take with in-house ratings
Credit rating arguments which are put to HMRC are not usually no independent credit rating, certainly not on one that is specific to the borrowing unit. Instead, an in-house “synthetic” rating is presented as equivalent to an independent rating, often in support of a claim that a particular interest rate represents an arm’s length return.
The ratings agencies produce various credit rating models which businesses and financial institutions can use themselves to quickly and cheaply estimate credit ratings. These models are based on similar factors to those which the agencies themselves will consider in arriving at a rating, but do not take account of the qualitative issues which are important in the independent rating process. It is crucial to understand the source of the data being used - published accounts may be a trustworthy source but any ‘management forecasts’ may lead to a rating which simply reflects optimistic assumptions about future performance.
While these models do not provide the depth and breadth of analysis which an independent, participatory exercise can produce, they can - if properly prepared - produce a reasonable ‘ball park’ estimate of the rating.
Many companies take the view that synthetic credit ratings represent a cost effective way of meeting their documentation obligations. In most instances the size of the loan and the resources available to the company in question may not be sufficient to warrant the commissioning of a full external rating (an expensive process) to support inter-group borrowing.
As with other evidence, an in-house rating should be examined and tested to see whether the method, data and assumptions produce a result on which sufficient reliance can be placed.
The Transfer Pricing Team at CTIS Business International can advise in particular cases.