Intragroup financing arrangements are among the transactions most closely scrutinized during tax audits. Beyond the interest rate, the entire financing process is examined.
The latest version of the OECD Transfer Pricing Guidelines, supplemented by the 2020 OECD Guidance on Financial Transactions, provides a detailed framework for these issues.
This article identifies ten specific questions that every finance department should ask itself.
1. Is the choice of instrument appropriate for the purpose of the funding?
Cash pools, checking accounts, term loans, and capital contributions: each instrument serves a different economic purpose. The tax authorities expect consistency between the nature of the instrument and the use of the funds. Financing a long-term investment through a cash pool, or using a ten-year loan to meet working capital needs, creates a discrepancy that the tax authorities can exploit—including by reclassifying the transaction.
2. Would a bank have approved this loan?
It is common practice to provide financing to subsidiaries that would not have been able to obtain such a loan from a third party. This is not prohibited, but it shifts the focus: the issue is no longer whether the right rate is being charged, but rather justifying why the group has an economic interest in providing this financing and what it receives in return. Otherwise, the tax authorities may challenge the transaction as a whole, not just its price.
3. Are the terms of the loan consistent with the borrower’s ability to repay?
The amount and maturity of the loan must be analyzed in light of the borrower’s financial projections. If these projections indicate that the borrower will be unable to repay the loan, the amount recognized for transfer pricing purposes will be limited to what an independent lender would have agreed to lend. The excess amount may be reclassified as equity. This is an issue to which several tax authorities, particularly in the United States, pay close attention.
4. Is the credit rating used that of the borrowing entity?
Many groups use the group’s credit rating to set interest rates for all their intragroup loans. In most cases, the borrowing entity’s own rating should serve as the benchmark, estimated using the methodologies of credit rating agencies.
If necessary, this rating must incorporate two adjustments. First, the implicit support from the group, the extent of which depends on the subsidiary’s strategic status and the strength of its ties to the group. Second, the country risk cap, which limits the subsidiary’s rating when the sovereign rating of the borrower’s country is lower than that of the group. This is a point that is frequently overlooked.
5. Are there any internal comparables before looking externally?
A bank loan obtained by the borrower or by a group entity with a comparable profile is generally the most reliable comparable. Bonds issued by the group on the financial markets can also serve as a benchmark.
Many groups opt directly for the external CUP for convenience. If the tax authorities identify a relevant internal comparable that has not been taken into account, they have a strong basis for challenging the analysis.
6. Are the criteria for the external CUP sufficiently targeted?
The best practice is to use a funnel approach: start with restrictive criteria (same rating, same currency, same maturity, same sector) and then gradually broaden the scope if the number of comparables is insufficient. Each broadening of the scope must be justified and documented.
A panel constructed on overly broad criteria from the outset—extended rating universe, permissive maturity window—produces results whose economic relevance is questionable and provides fertile ground for the auditor.
7. Are comparability adjustments made when necessary?
Differences in currency, maturity, or type of rate (fixed/variable) between the loan under review and the comparables can have a significant impact on the rate. Currency and rate adjustments can be reliably performed using market instruments. Maturity adjustments can be made using yield curves, though their reliability decreases as the difference in maturity becomes larger.
Point of caution: an adjustment that is disproportionate to the comparable’s initial rate weakens the analysis. It is better to exclude the comparable than to make an unreliable adjustment.
8. Do intra-group financial guarantees bear interest?
The key distinction is between the implicit support associated with group membership—which does not give rise to compensation—and the explicit guarantee, which constitutes a legally binding commitment.
When an explicit guarantee provides the borrower with a benefit beyond the implicit support (a more favorable rate, access to a larger loan amount), it is likely to give rise to the payment of a commission. But if the formal guarantee merely reflects the support that the group would have provided anyway, no commission is due. A case-by-case analysis is essential.
9. Is the rate reviewed if there is a significant change in the loan’s terms?
A fixed-rate loan is not intended to be repriced every time the borrower’s credit rating or market conditions change—a bank would not do that either.
However, when the characteristics of the loan itself are modified—such as extending the maturity, increasing the amount, or changing the currency—this calls for a new analysis. Risk often crystallizes around maturity extensions without a rate review: a loan initially granted for 3 years and extended to 7 years without adjustment no longer reflects the conditions applicable to a loan of that duration.
10. Has the loan been formalized, and does the contract reflect standard practice?
The absence of a written contract, a provisional interest rate specified in the contract but never amended, a repayment schedule that was agreed upon but never adhered to, and the absence of financial clauses despite the borrower’s risk profile justifying their inclusion: these situations do not automatically lead to a reassessment, but they significantly weaken the group’s position.
The OECD Principles note that the administration is justified in looking beyond the contract to examine the actual behavior of the parties. Conversely, a well-drafted contract consistent with standard practice provides a first line of defense.
Conclusion
Securing intragroup financing depends not only on the interest rate but also on the consistency of the entire process: choice of instrument, analysis of repayment capacity, credit rating, identification of comparables, contractual formalization, and ongoing monitoring.
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