In the first part of this two-part series, we went over the June 2022 amendments to the Transfer Pricing Administrative Guidelines on financial transactions. In this part, we will discuss how to efficiently manage intercompany loan interests and the potential issues that arise as a result of the amendments.
The most significant change made in the amendments was that taxpayers must now determine an appropriate intercompany interest rate based on the borrower’s (typically, the subsidiary’s) creditworthiness. Therefore, let’s first go over what interest rates are comprised of and how they are determined.
- What Determines an Interest Rate?
Loan interest rates consist of i) a risk-free interest rate, which typically refers to government bond yield or interbank lending rates and ii) a credit spread. The risk-free interest rate depends on country risk, a country’s monetary policy, and the supply-demand balance of the specific currency. Thus risk-free interest rate varies from currency to currency. The credit spread, on the other hand, is the return earned by the lender on the borrower’s default risk and depends on the borrower’s specific creditworthiness. However, it can also be affected by market liquidity. Interest rates vary by maturity and are typically categorized as short, medium, or long term, all of which are affected by economic conditions and monetary policies.
- How to Set and Manage Intercompany Loan Interest Rates
Given the above structure and influencing factors, interest rates depend on many things, such as the type of loan and when the loan is made. This makes it administratively burdensome for taxpayers to calculate interest rates every time an intercompany loan is made.
In order to efficiently manage intercompany loan interests, we recommend evaluating and calculating a specific related-party borrower’s credit spread once a year for each currency and maturity (short, medium, and long term), and use the same credit spread throughout the year. As for the risk-free interest rate, the most up-to-date interest rate at the time of the loan should be used. Since a credit spread depends on the borrower’s financial standing and the market liquidity at a specific time, we recommend updating a related-party borrower’s credit spread annually.
In general, a credit spread can be benchmarked by referring to publicly traded comparable bond yields on loans between unrelated parties. Factors such as currency, credit ratings, collaterals, and maturity are used to find comparable financial transactions.
Example of How to Manage Intercompany Loan Interests
|Credit Rating||Subsidiary||Once a year|
|Credit Spread||Subsidiary / Currency|
Term (Short, Mid, and Long)
|Once a year|
|Risk-free Interest Rate||Currency|
Term (Short, Mid, and Long)
- Trends and Issues
Now let’s take a look at the recent trends in risk-free interest rates and credit spreads. The following bar charts show the yields on US dollar-denominated corporate bonds by credit ratings. The chart as of December 31, 2021 represents yields before the FRB began tightening its monetary policy, and the chart as of February 22, 2023 represents the yields. Corporate bond yields are useful references in benchmarking interest rates (risk-free rate plus credit spread.) Credit rating categorization is based on the Standard & Poor’s credit ratings (AAA, AA, A, BBB, BB, B), and the U.S. Treasury bond were used as a reference for risk-free interest rates. Note that BBB and higher is considered investment grade.
- Risk-free interest rates have risen significantly due to FRB’s tightening its monetary policy, which began in January 2023. On the other hand, since early 2023 the market has been anticipating a decline in inflation rate and a corresponding drop in interest rates. This resulted in an inverted yield curve, which is a state in which mid- and long-term bonds have a lower yield than short-term bonds.
- Credit spreads have not risen much and have in fact lowered in a relative term (i.e., credit spread as a percentage of total interest rate.) This is likely due to the increased liquidity in the bond market as more money flowed in to bonds.
As funding needs grow due to inflation and supply chain issues, many companies are at the same time affected by rising interest rates. The challenge for the companies is therefore not just to calculate appropriate interest rates, but to reduce foreign subsidiaries’ interest expenses. Following are some examples of how companies can deal with such circumstances, but careful consideration is required since each method has its pros and cons.
- Reduce foreign subsidiary’s debt ratio.
- Debt/equity swap
- Debt forgiveness
- Change loan durations based on interest rate predictions.
- Change loan currency from USD to JPY to take advantage of a lower risk-free interest rate.
- Review your transfer pricing policy to check if there are any incorrectly priced intercompany transactions that could offset interest payments. (e.g., royalty)
Hotta Liesenberg Saito LLP provides transfer pricing advice tailored to your specific needs and situation. If you have any questions regarding transfer pricing, please feel free to contact us.
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