Credit Ratings: what to consider?

Quantera Global

 

Introduction

In the July published discussion draft, the OECD recognizes the use of credit ratings as an important tool to determine whether the conditions of intra-group loans are comparable to third party conditions. A credit rating serves as an assessment tool of the creditworthiness of a borrowing company, in general terms or in relation to a particular debt or financial obligation. A high credit rating signals that there is less risk for the lender that a (specific) loan will not be repaid, whereas a low credit rating depicts a greater probability that the borrower will default on paying back its financial obligations.

The relative ranking provided by credit rating agencies (CRAs) reduces the information asymmetry in the credit markets. This determines a judgment that summarizes both qualitative and quantitative information available. There are three main CRAs that control nearly the entire market – Moody’s, Standard & Poor and Fitch. CRAs use an alphabet-based rating scale, which is shown in the table below.

 

Main Attention Points

Main items include:

  • A credit rating provided by one of the three main CRAs will be the most robust defence line towards tax authorities. However, this option is quite burdensome and expensive and is used only by large MNEs. But even then, this will be performed for other purposes than solely transfer pricing and may only be used to determine the overall group credit rating (and not the credit rating for specific local entities).
    • Alternatively, commercially available databases such as Bloomberg or Credit Catalyst may be used to determine the credit rating of the group or of a specific entity / financial obligation within the MNE.
    • Furthermore, some MNEs develop inhouse commercial tools. A main challenge for inhouse statistical models, which are usually mainly focused on quantitative measures, is to also take into account qualitative factors, such as industry, strategy and the risk profile of the MNE’s management.
  • Determining credit ratings for special purpose vehicles (“SPVs”), start-ups or companies that have recently been part of a merger or demerger, may be challenging.
    • SPVs: as SPVs own underlying assets, the credit assessment needs to be based on the collateral for issued securities and not on the credit quality of the SPV itself.
    • Start-ups: newly established firms do not have a financial track record, thus publicly available information for a reliable credit rating establishment is rarely available.
    • Merger/Demerger: recent M&A transactions will influence the creditworthiness of a company by adjusted pro-forma credit measures, reduced free operating cash flow, and concerns about the business risk profile of a combined enterprise.
  • In case of start-ups and M&A transactions, it may be necessary to consider cash-flow and earnings projections for the period of the loan.
  • Paragraph 65 of the discussion draft states, freely translated, that if your Transfer Pricing on other intercompany transaction is incorrect your credit rating is unreliable.
    • This measure may result in more in-depth discussions between tax authorities and MNEs, as corrections applied on intercompany transactions on an EBIT-level, may also influence the interest that has to be applied.
      • For example, a higher remuneration for routine activities (imposed by tax authorities) may result in lower interest rates for that local entity due to a better credit rating.
    • It is stated that a “proper comparability adjustment” should be made on your credit ratings if your Transfer Pricing was incorrect. Overall this may lead to challenging discussions.
  • The effect of group membership will also influence the credit rating of an individual entity (implicit support effect). For this implicit effect, no separate remuneration has to be determined as it results from mere group membership (see below).
  • If a stand-alone credit rating of an entity is higher than that of the group, it is common practice to cap the rating of the stand-alone entity at the group level. This is based on the assumption that the parent company would be able to impose requirements that would undermine the existing rating, for example upstream dividends.

Our answers to OECD’s questions

The effect of group membership

The OECD asks whether it would be useful for the purpose of tax certainty and tax compliance if an independently derived credit rating at group level may be taken as credit rating for each group member, in order to determine the interest rate of an intra-group loan. The discussion draft mentions this as a rebuttable presumption subject to the right of the taxpayer or the tax administration to determine a different rating for individual group members.

The use of the group rating instead of individual ratings could in our view be a welcome solution if the tax payer could opt for this possibility. I.e., in principle the individual rating would be applicable, unless the tax payer opts for the application of the group rating.

If the tax administration were to be given the right to determine a different rating for particular members (as suggested in the discussion draft), the burden of proof should in our view be shifted to the tax administration.

The possibility to use the group rating as a starting point to determine individual ratings to which adjustments can be made, can also be useful. We would like to point out that in that case it would be important that the OECD provides clear guidance in respect of how adjustments should be made.

In respect of the reliability of (group) credit ratings that are not determined by a rating agency, we believe that credit ratings that are determined using commercially available databases can be reasonably accurate for transfer pricing purposes. Ratings will in that case be mostly determined using publicly available quantitative data, with qualitative adjustments if certain characteristics of the individual tax payer will have to be taken into account. In this respect, we would also like to point out that the use of such databases will from a practical and cost-effective point of view in most cases be the only viable option for tax payers and the tax administration alike.

 

The effect of implicit support

Independent lenders will normally take the benefit of group membership into account in determining the terms and conditions of a loan to an entity that is part of an MNE. The perspective of both parties should be taken into account. As this benefit arises from the mere group membership (and the assumption that the group as a whole will make sure that the company will fulfil its obligations), there is no contractual relationship between the individual group company and any other group company. Therefore, it does not result from a service provided by the parent company or any other group company. From transfer pricing purposes, such implicit guarantee should therefore not be remunerated as intercompany service.

As implicit support may affect the credit rating of a particular member, it is important to distinguish the effect from implicit support from the effect of an explicit guarantee (or other forms of support that can be considered as intercompany services).

The actual effect of implicit support on an individual entity’s credit rating may differ according to the relative importance of an entity within the group. In our experience, it is however also possible that a group decides to treat all its subsidiaries equally and considers the position of each entity of equal importance. That way, the parent company intends to assure lenders that the group will never let any of its subsidiaries fail. In that case, the level of implicit support granted by the parent company will be equal. It is likely that the rating of group companies will in that case be close to the group rating.

 

Our experience 

Quantera Global has access to the relevant databases (for example Bloomberg and credit rating models) to determine credit ratings for transfer pricing purposes. Our team also has the relevant in-depth experience to look also at the bigger picture from both a technical and practical point of view.

Quantera Global has assisted various small and large MNEs in setting up individual credit ratings, but also credit rating models which can be used by the MNE’s treasury department to efficiently determine credit ratings of all the relevant entities within the MNE.

If you have any questions or remarks, please feel free to give us a call or send an email.

 

Quantera Global Finance Team

Theo Elshof       
Managing Director
t.elshof@quanteraglobal.com

Enrico De Angelis    
Managing Director
e.deangelis@quanteraglobal.com

Arnas Laurynas    
Executive Director UK
a.laurynas@quanteraglobal.com

Stefan Ubachs    
Senior Manager
s.ubachs@quanteraglobal.com

Maikel Verhoeven    
Manager
m.verhoeven@quanteraglobal.com

Adriaan van der Heijden  
Junior Manager
a.vanderheijden@quanteraglobal.com

Nard Donders    
Analyst
n.donders@quanteraglobal.com