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INTERNATIONAL

Intercompany Loans:
Observations from a Transfer Pricing Perspective
Michel E.P. van der Breggen1
1. INTRODUCTION
Over the years, transfer pricing has become a standard
item on the agenda of tax directors and controllers of
multinational enterprises (MNEs). The introduction of
transfer pricing documentation requirements in many
countries has been a contributing factor in this regard,
as has been the fact that transfer pricing is currently a
more or less recurring issue in tax audits. Until now,
the preparation of transfer pricing documentation and
discussions with tax authorities have typically centred
around transfer pricing within the context of the intercompany supply of goods, the provision of services
and intangible property (IP) transactions. Due, in part,
to their often complex nature and specific characteristics, intercompany financing transactions have had a
relatively low profile so far.
Judging from an increasing interest in intercompany
financial transactions from the business community
and tax authorities alike, this lack of attention seems to
be changing. In this regard reference is made to the
adjustments to the French thin capitalization rules that
are set to take effect on 1 January 2007 and which contain explicit requirements for the arms length nature
of interest on intercompany loans. Reference is also
made to the audit that the New Zealand tax authorities
have announced with respect to the intercompany
finance expenses of 50 multinationals.
Given this increasing interest in intercompany financial transactions, the present article will discuss some
observations with respect to the transfer pricing
aspects of intercompany loans.2

The OECD Transfer Pricing Guidelines (1995-1999)

(OECD Guidelines) further flesh out Art. 9 of the
OECD Model Treaty in offering an extensive description of the different methods for determining arms
length transfer prices and when to apply these methods. Due to their extensive nature and given the fact
that the OECD Guidelines have been established as a
joint effort between the OECD member countries, the
OECD Guidelines have been declared directly applicable by many countries. The OECD Guidelines place
relatively much focus on the substantiation of the
arms length nature of transfer prices used for the intercompany supply of goods and the provision of services. In addition, the OECD Guidelines separately
address the position of IP within a group.3
Remarkably, the OECD Guidelines merely touch upon
the application of the transfer pricing methods in determining an arms length fee for intercompany financing
activities, such as establishing interest rates on loans
provided to group companies.4 This means that for the
determination of interest rates on intercompany loans
one must focus primarily on specific domestic transfer
pricing rules (if any), which increases the risk of disputes on the interest rates applied (as the domestic
rules may vary from one country to the next).
Despite this lack of explicit guidance by the OECD
Guidelines, the discussion below will address what, in
the authors opinion, could be a common approach in
setting arms length interest rates on intercompany
loans within the framework of the OECD Guidelines.

2. RELEVANT RULES AND REGULATIONS

Thanks to their association within a group, MNEs are
able to manipulate transfer prices and hence the allocation of taxable profits within the group. In order to prevent such arbitrage, many countries have implemented
specific transfer pricing rules in their domestic legislation, including the arms length principle. The arms
length principle is rooted in Art. 9 of the OECD Model
Treaty and stipulates that associated companies should
deal with each other as if they were acting with unrelated third parties. In many cases the domestic transfer
pricing rules also include specific documentation
requirements, which stipulate that companies should
provide evidence for, and document, the arms length
nature of their transactions with associated companies.
This is to reduce the information deprivation that often
characterizes the position of local tax authorities relative to a taxpayer.

1. Senior manager, Transfer Pricing Group, PricewaterhouseCoopers,

Amsterdam. The author specializes in financial services and financial transactions.
2. This article will not address other intercompany financing activities,
such as conduit activities, guarantees and cash pools. For details on conduit
activities, see Arnout van der Rest and Michel van der Breggen, Intercompany Finance Activities Structured via the Netherlands: Time to Act, 12
International Transfer Pricing Journal 2, at 81.
3. See Chapter 6 OECD Guidelines.
4. The OECD publication Discussion Draft on the Attribution of Profits
to Permanent Establishments (PEs): Part II (Banks) of March 2003
addresses the functions performed, risks assumed and assets used in the
banking industry. This analysis is relevant for the separate entity
approach proposed by the OECD, under which profit is allocated to a permanent establishment through the analogous application of the OECD
Guidelines. The draft does not provide specific guidance for the application
of transfer pricing methods to financial transactions between head offices
and permanent establishments.

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3. ARMS LENGTH INTERCOMPANY LOANS

3.1. Introduction
As indicated above, as a result of domestic transfer pricing rules and documentation requirements, in many
cases companies need to substantiate and document
that the terms of an intercompany loan (specifically,
the interest rate applied) are arms length. In practice,
it turns out that many companies are not sufficiently
familiar with this requirement, if they are aware of it at
all. Upon being questioned about their substantiation
of the interest rate associated with intercompany loans,
many companies refer to quotes obtained from banks
or to the market interest rate in general. The majority
of companies are surprised to learn that such evidence
will in most cases not be sufficient.5

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example is the situation where a group company issues

a credit facility to another group company with, say, a
cap of EUR 250 million and a commitment fee7 of 20
basis points. Based on the scale of the debtors activities, it is clear, however, that the debtor will never
draw any more than EUR 100 million from the facility
during its effective period. It could be argued that in
this situation applying a commitment fee on the
undrawn amount lacks economic substance.
The dividing line between the application of profit
adjustments on account of the non-arms-length nature
of some terms and full reclassification of an intercompany loan into capital due to the lack of economic substance of the loan as a whole is not always clear and
should be reviewed on a case-by-case basis. In practice, therefore, discussions about the arms length
nature of an intercompany loan in many cases eventually focuses on the interest rate applied.

3.2. Arms length terms

In practice, it turns out to be quite difficult to provide
evidence regarding the arms length nature of intercompany loans, as companies do not usually have
access to information about whether or not an independent third party would be prepared to issue a loan
under similar circumstances. It is therefore useful to
look at what the consequences actually are of nonarms length terms. In such a situation, could the arms
length principle serve as an independent criterion for
the reclassification of a group loan into a capital contribution?
Under Sec. 1.37 of the OECD Guidelines, this is
indeed the case, which is to say that there can be circumstances in which it is appropriate and legitimate
for tax authorities to consider disregarding the structure adopted by the taxpayer. An example of such a circumstance is if the economic substance of a transaction
differs from its form. An example of this circumstance
mentioned in the OECD Guidelines is that of:
an investment in an associated enterprise in the form of
interest-bearing debt when, at arms length, having
regard to the economic circumstances of the borrowing
company, the investment would not be expected to be
structured in this way. In this case it might be appropriate for a tax administration to characterize the investment in accordance with its economic substance with
the result that the loan may be treated as a subscription
of capital.

If and to what extent such a reclassification will indeed

be the consequence of non-arms length terms, will
ultimately depend on domestic legislation.
The next question is whether the arms length principle
can also cause profit adjustments as a result of the fact
that certain terms of a loan differ from what would
have been agreed between independent third parties,
without this leading to an overall reclassification into
capital. In accordance with the OECD Guidelines, the
author believes that this can indeed be the case if a specific term lacks economic substance and a comparability adjustment can be made.6
The economic substance of a specific term is lacking,
for example if a loan has been subordinated to other
creditors under the loan agreement while in fact the
debtor does not have any other creditors. Another

3.3. Arms length interest rate: the underlying

theory
Assuming that an intercompany loan itself is arms
length, an arms length fee must be determined for that
specific loan. According to the OECD Guidelines, an
arms length remuneration should be established based
on the functions performed, risks assumed and assets
used. Where a group companys functions are comprised mainly of issuing loans, the functions performed
and risks assumed by this company are in essence
comparable to the functions performed by independent, centrally regulated, financial institutions. Application of the arms length principle implies that the fee
for these activities must be based on the fees that such
institutions charge for similar transactions.
Financial institutions generally weigh four elements in
determining whether or not to issue loans and, if so, at
what conditions and fees:
financial risk. In order to gauge the financial risk
incurred by the lender, the debtors financial position is reviewed based on its balance sheet and
income statement;
credit risk. In order to gauge the credit risk, three
elements are weighed, namely the availability of
guarantees, the purpose of the loan and the loans
term to maturity;
business risk. The lenders views on the industry in
which the debtor operates its business is reflected
in this risk; and
structural risk. In gauging this risk, the qualifications of external rating agencies awarded to the
debtor are weighed.8

5. In the Netherlands, for example a reference to bank quotes is generally

not sufficient to substantiate an interest rate. See the answer to question 32
in the Question and Answer Decree with respect to the Decree on Service
Providers and Transitional Ruling Policy, Netherlands Ministry of Finance,
IFZ 2004/127M (11 August 2004).
6. See Sec. 2.9 OECD Guidelines.
7
A commitment fee is due on the undrawn portion of a facility. This fee
compensates the lender for the fact that the lender is required to keep this
undrawn portion of the facility available for use at short notice and cannot,
therefore, use it for other (long-term) investments.
8. Well-known rating agencies include Moodys, Standard & Poors and
Fitch.

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In addition to a credit risk uplift, independent financial

institutions determine the fee for the provision of loans
by adding uplifts for capital adequacy and currency
risk, if any, as well as a handling fee, to the funding
costs of the transaction. Therefore, in principle such
surcharges also need to be considered in determining
an arms length fee for intercompany loans.
3.4. Establishing an arms length interest rate in
practice
The most relevant information for determining an
arms length interest rate for an intercompany loan is
provided by the terms of loans that have recently been
issued to the same debtor by independent third parties
(the internal comparable uncontrolled price (CUP)
method). In applying the CUP method, it is important
that the transactions being compared are sufficiently
comparable. Where they are not, comparability adjustments need to be made.9 If such adjustments cannot be
made, there is no usable internal CUP and comparable
transactions that (recently) took place in the market
(so-called external CUPs) must be used as a reference
point.10
Based on Para. 3.3, the elements that play a key role in
this regard can be summarized as follows:
the debtors credit rating;
the loans term to maturity;
the purpose of the loan;
the currency in which the issued loan is denominated;
the securities provided;
the country in which the debtor is located; and
the industry in which the debtor operates.
From these elements it becomes clear that the search
for external CUPs should be based on the debtors
credit rating rather than the groups credit rating. After
all, the objective of the analysis is to determine an
arms length fee for a transaction between group companies, disregarding the fact that these companies are
members of the same group.
As a group company normally does not have its own
credit rating, the first step is to determine a stand-alone
credit rating based on the debtors financial information and using a credit-rating model. The outcome of
such a credit-rating model may need to be adjusted,
either upward or downward, based on factors such as
the (structural) subordination of the intercompany
loan, securities provided or the companies management structure, as these factors are not fully considered
by the credit-rating model.
The next step is to perform a CUP analysis based on
the credit rating and the available market information.
Market information can be obtained from databases
and real-time information sources such as Bloomberg
Professional, Thomson Financial and Reuters Web
Dealscan. A CUP analysis effectively boils down to an
analysis of loans between independent parties and of
market bonds, where the debtor has a similar credit rating and the terms of the loans and bonds are sufficiently comparable with those of the intercompany
loan.

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The outcome of such an analysis is an (inter-quartile)

range of credit spreads. A credit spread is that part of
the interest that, among other things, serves as a fee for
incurring the credit risk. Within this range, the credit
spread must be selected that is most appropriate for the
intercompany loan at hand, also having regard to factors such as payment instalments, prepayment options
and other elements that have not been considered in the
CUP analysis so far. This credit spread must then be
added to the underlying base rate11 (i.e. the risk-free
fee for the provision of capital) in order to arrive at an
arms length interest rate. The interest can then be designated as floating (e.g. three-months Euribor plus 175
basis points) or as a fixed interest rate.
4. POTENTIAL PITFALLS IN DETERMINING
AN ARMS LENGTH INTEREST RATE
Within a group, financing requirements are often coordinated by a centralized treasury department, which
tries to make the best possible use of the cash resources
that are freely available within the group, meaning that
intercompany loans are preferred over third-party
loans from (local) banks for example. This can lead to
interesting situations.
4.1. Group companys credit rating differs from
overall group rating
A groups credit rating is based on the creditworthiness
of all its members jointly, having regard to the fact that
the whole is larger than its separate parts. On a standalone basis, group companies will therefore often have
a credit rating that differs from the group rating.12 It is
relatively common in practice, e.g. within the scope of
an acquisition, that a loan is contracted from a bank at
a certain level within the group and that this loan is
subsequently re-lent within the group for the purposes
of financing (local) acquisitions. Interest on such a
bank loan will generally be based on the group rating.
The bank usually imposes the condition that, at the
groups lowest level, no loans may be contracted from
other third parties and that additional financing
requirements should be drawn under the facility with
the bank (either directly or through a group loan). The
group company that borrows the money from the bank
often re-lends the loan within the group on a back-toback basis, usually applying only a minor interest
spread.
Such a situation can result in a group company with a
higher credit rating than the group effectively having
to borrow funds at a higher interest rate than would
have been charged had a local bank issued the loan on
a stand-alone basis. At the same time, group companies with a worse credit rating than the groups will
9. See note 6.
10. In practice, the arms length nature of an interest rate can effectively
be determined only by using the CUP method, as insufficient relevant information is available for applying other transfer pricing methods.
11. An example of a base rate is the interbank interest rate (e.g. Euribor)
that applies to the term to maturity and currency denomination of the specific loan.
12. For example as a result of stringent domestic thin capitalization rules,
such as in Germany.

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be able to benefit from cheaper loans at the group level

without an adequate fee being paid. The question is
how to approach such situations from an arms length
perspective.
Although the local management of a group company
for which a loan is more expensive than would be
expected on the basis of the companys stand-alone
credit rating is usually not involved in the negotiations
with the bank, it is bound by the agreement with the
bank. In such cases, local tax authorities may take the
view that local management has agreed with the interest rate (which is too high) because of the shareholding
structure and that only part of the interest which the
group company would have paid on a stand-alone basis
qualifies for tax relief.
At the same time, the tax authorities in the country in
which the group company is resident that re-lends the
bank loan, may take the view that too little interest is
charged to the group companies that have a worse
credit rating than the group, and decide to adjust the
interest accordingly. If the interest is adjusted, it will
usually be difficult to get the tax authorities of the
other country to allow a corresponding adjustment, so
that double taxation may arise for the group as a whole.
These type of situations can be easily avoided by considering the credit ratings of the different group companies and aligning interest rates accordingly when
bank loans are re-lent within a group.
4.2. Implicit parent guarantee
In determining the terms of a loan, independent third
parties regularly make allowance for the fact that the
debtor belongs to a group that has a better credit rating
than the debtor itself, without a formal guarantee having been issued (a so-called implicit parent guarantee).
The idea behind this is that an MNE will not let a group
company go into bankruptcy and that, for that reason,
the credit risk associated with the loan can be based on
the group rating. Based on the OECD Guidelines, in
such a situation group companies are not deemed to
have procured a service for which a fee should be
paid.13,14 Effectively, as a result of this implicit parent
guarantee, it is more cost effective for the group company to contract a loan from an independent third party
than would have been expected from its stand-alone
credit rating.
The question is how this implicit parent guarantee
should be dealt with in setting an arms length interest
rate on an intercompany loan. First, it obviously
remains to be seen whether a group company can
indeed contract loans at more favourable conditions
from an independent third party than was to be
expected based on its own credit rating. In any event, it
cannot be expected from a group company that wishes
to lend funds to the group company in question that it
makes allowance for an implicit parent guarantee, as it
(partly) furnishes the securities for that guarantee. This
will especially not stand if it is the ultimate parent
company that issues the group loan. In other words, the
issuing group company will want to apply an interest
rate that is based on the credit rating of the borrowing
group company itself.

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What one group company will want to charge in interest may on occasion therefore be higher than what the
other group company will want to pay in interest. In
such a situation, in theory no group loan is expected to
be contracted because the parties are unable to agree
on a price. Nevertheless, in practice, loans will be contracted anyway, simply because on a group level it is
more cost effective to provide intercompany financing.
As the shareholding structure is apparently decisive in
this regard, the non-collecting tax authorities may take
the view that the companies have agreed on a nonarms length interest rate that needs to be adjusted.
4.3. Prepayment of intercompany loans
In practice, it is common, for example within the scope
of a major acquisition, that temporary intercompany
loans are used and that, after the course of time, mostly
after the acquisition structure has been fully implemented, loans are repaid and refinanced early. The
question of whether such a repayment is permitted
under the contractual terms of the loan and whether
this constitutes an arms length transaction, considering the terms of the repayable loan and of the new loan,
is often disregarded.
Assuming that the market interest rate has developed
in a certain direction in the time frame between the
contracting of the intercompany loan and the time of
early repayment, it will often be an interesting option
for one group company to repay the loan early,
although this will have adverse consequences for the
other. It is important in this regard to substantiate that
the entity taking the initiative for the repayment has an
economic interest in doing so (e.g. the debtor, because
a lower interest rate is available elsewhere) and that
this party also has the legal option under the contract to
terminate the loan early (and that not only the creditor
for instance, for whom early repayment will have
adverse consequences, may terminate the loan early).
In this process, regard must also be had to the costs that
might be associated with the early repayment of the
loan.
If the arms length nature of an early repayment is not
sufficiently substantiated and the refinancing effectively results in higher expenses or lower income in a
certain jurisdiction, the company involved might run
the risk of adjustments. In practice, this can usually be
avoided by proactively approaching the loan as a temporary form of financing when intercompany loans are
concluded.
5. OPTIMIZATION OF THE ARMS LENGTH
INTEREST RATE
Based on the OECD Guidelines and local transfer pricing requirements, the terms of an intercompany loan

13. See Sec. 7.13 OECD Guidelines (No service has been procured, for
example when an associated enterprise, merely based on its association, has
a higher credit rating than it would have had without any association).
14. If a formal guarantee is issued, a guarantee fee will in principle be due
to the issuer of the guarantee, as a result of which the finance costs for the
debtor are as high on balance as they would have been had the debtor contracted the loan on a stand-alone basis.

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must in principle be arms length. Nevertheless, as

long as the terms have economic substance and the
intercompany loan is not reclassified as a capital contribution, there is certain flexibility in determining the
terms of a loan (i.e. for optimizing the interest rate).
For example a longer term to maturity or subordination
to the other creditors will generally lead to a higher
interest rate for the debtor, while Euro-denominated
loans are currently more cost-effective than US dollardenominated loans. The use of prepayment clauses15 or
credit facilities (with the aforementioned commitment
fee) might affect the interest rate as well. From the perspective of the group, it is appealing therefore, to set
the terms of intercompany loans such that they achieve
the best possible results, making allowance for the tax
climate and the tax position of the group companies
involved. However, in doing so, it should be remembered that adjustments to the terms of an intercompany
loan affect the creditors risk profile with respect to the
loan, and that losses might be incurred if these risks
actually materialize.
The possibility to optimize interest rates on intercompany loans offers interesting opportunities with respect
to the group interest regime which has recently been
proposed in the Netherlands and which will have an
effective corporate tax rate of 5% on the net intercompany interest received.16 The introduction of this group
interest regime will create an appealing tax climate in
the Netherlands for group financing activities, which,
in combination with the now well established advance
pricing agreement practice of the Netherlands tax
authorities, is expected to attract many group financing
companies to the Netherlands.
6. DOCUMENTING GROUP LOANS: LOAN
PRICING POLICY
As a result of the documentation requirements which
are now applicable in a significant number of countries, in many cases the arms length nature of each
loan must be documented and substantiated. Depending on the scale and the complexity of the intercompany loans, this may constitute a considerable administrative burden. In practice, therefore, particularly
significant loans and high-interest loans are being documented.17 In order to ensure that the documentation
requirements are met and that the interest on intercompany loans is determined in a consistent manner, the
establishment of a loan pricing policy can be considered.
A loan pricing policy determines how, within the
group, interest rates are set for each new intercompany
loan. In a loan pricing policy, regard is had to the credit
rating of the group companies by classifying them
annually into credit categories based on their financial
ratios. By using a limited number of terms to maturity
only (e.g. shorter than one year, three years and five

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years) and by restricting the currency denomination of

the group loans to, for example US dollars, Euro and
British pounds only, a matrix of credit spreads can be
prepared based on which the interest on intercompany
loans can be determined. In addition, the other terms of
the intercompany loans must be identical and
allowance must be made for specific rules in the countries in which the group companies are resident. Furthermore, the credit spreads in the matrix must be regularly adjusted to the market situation.
7. CONCLUSION
Clearly, it becomes increasingly important for MNEs
to consider the arms length nature of their intercompany loans. This is caused by a step-up in transfer pricing rules and the specific documentation requirements that have now been imposed in many countries.
In addition, tax authorities are operating with an
increasing degree of sophistication and no longer
accept reference to the market interest rates or bank
quotes as substantiation for the interest rate used.
The merits of each intercompany loan must be
reviewed based on the arms length principle, and the
interest rate must be substantiated with reference to
similar transactions that have been conducted in the
market, making allowance for the debtors own credit
rating. Moreover, specific situations are deserving of
special attention, such as the on-lending of funds
within a group and the prepayment of intercompany
loans.
On the other hand, interest rates on loans can be optimized by varying the terms of the intercompany loans.
The best possible results are achieved for the group if
the terms of a loan make allowance for the tax climate
and the tax position of the group companies involved.
The introduction of the proposed group interest regime
in the Netherlands, for example, might make it attractive for MNEs to establish their group financing companies in the Netherlands and to avail themselves of
this facility as best they can by optimizing the interest
rates applied. The documentation requirements can
subsequently be fleshed out in a loan pricing policy.

15. The prepayment option on a fixed-term loan.

16. The group interest regime, together with other major changes to the
Netherlands corporate income tax act, was proposed on 24 May 2006 by the
Netherlands government and was adopted by the Second Chamber of Parliament on 3 October 2006. The proposed legislation still needs to be discussed and approved by First Chamber of Parliament and the implementation of the group interest regime is ultimately subject to the outcome of
negotiations with the European Commission, which are currently still ongoing. The Netherlands Minister of Finance, Mr Zalm, has announced that the
group interest regime will be introduced as per 1 January 2007, even if no
formal approval has been given by the European Commission yet.
17. Examples include mezzanine financing and shareholder loans. The
interest rate on such loans is often over 10%. These types of transactions are
used regularly in acquisitions by private equity funds.

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