January 5, 2024
Generic Legal Advice Memorandum says IRS can consider implicit support to price intercompany loans
In generic legal advice memorandum AM 2023-008 (GLAM), issued December 29, 2023, the IRS stated that it may consider group membership and potential implicit support in determining the arm's length rate of interest on intragroup loans.
The GLAM is addressed to the Director of Treaty and Transfer Pricing Operations in the IRS's Large Business and International Division from the IRS Deputy Associate Chief Counsel (International). Although a GLAM cannot be used or cited as precedent, it reflects the position of the IRS Office of Chief Counsel.1
Currently, US transfer pricing regulations do not expressly require companies to consider implicit support when pricing intercompany debt under Treas. Reg. Section 1.482-2. In the GLAM, the IRS outlines a fact pattern with a foreign parent that provides implicit support to a subsidiary and how that support affects the interest rate of an intercompany loan.
Arm's-length rate of interest
Treas. Reg. Section 1.482-2(a)(1)(i) states that the arm's-length standard applies to the interest charged between related parties for the "use of such loan or advance." Additionally, Treas. Reg. Section 1.482-2(a)(2)(i) specifies that an "an arm's length rate of interest shall be a rate of interest which was charged, or would have been charged, at the time the indebtedness arose, in independent transactions with or between unrelated parties under similar circumstances." For this purpose, under Treas. Reg. Section 1.482-2(a)(2)(i), "[a]ll relevant factors shall be considered, including … the credit standing of the borrower, and the interest rate prevailing at the situs of the lender or creditor for comparable loans between unrelated parties."
In the GLAM, the IRS states its position that an uncontrolled commercial lender would charge an interest rate in the market based on the borrower's credit rating. Factors that contribute to the borrower's credit rating include the borrower's role, level of integration within the controlled group and implicit support from affiliates. This approach is consistent with the Transfer Pricing Guidelines of the Organisation for Economic Co-operation and Development (OECD).2
According to the GLAM, the "realistic alternatives principle" recognizes that an uncontrolled taxpayer would not engage in a transaction under certain conditions if doing so would leave the taxpayer worse off than the taxpayer would be under a realistic alternative course of action. The IRS may consider realistic alternatives when evaluating arm's-length pricing, specifically, "whether the terms of [a] controlled transaction would be acceptable to an uncontrolled taxpayer." The IRS also "may adjust the consideration charged [between controlled entities] … based on the cost … of an alternative as adjusted to account for material differences."3 It should not, however, restructure the transaction based on the application of a realistic alternative.
A borrower's options are dictated by its credit rating, which are informed by the corporate group's credit profile and the implicit support available to the borrower from the group, according to the GLAM. To the extent that the borrower could use its group membership to procure a favorable interest rate from a third party on a loan with the same terms, the borrower would reject a loan at a higher interest rate from the group in favor of the third-party loan. Under Treas. Reg. Section 1.482-2(a)(2)(i) and Treas. Reg. Section 1.482-1(f)(2)(ii)(A), the IRS may adjust the interest rate charged to reflect the borrower's membership in the group and the implicit support received.
EY observes: Nevertheless, the overall benefit of one realistic alternative over another should be broad and holistic, including consideration of other benefits, such as ease of access to capital and less administrative burdens.
The GLAM addresses a factual scenario where a foreign parent (Foreign Parent) wholly owns a US subsidiary (Subsidiary). Subsidiary owns certain assets and businesses necessary for the business of the controlled group. In this example, if Subsidiary experienced economic hardship, it is assumed that the Foreign Parent would likely provide financial support to prevent a default on Subsidiary's economic obligations. Subsidiary plans to obtain financing through an intragroup loan from Foreign Parent.
Foreign Parent has a credit rating of A. Subsidiary has a credit rating of BBB informed by the assumed implicit support, which Foreign Parent would provide to Subsidiary in the event of default. Otherwise, Subsidiary would have a credit rating of B. The BBB credit rating would provide an interest rate of 8% on intragroup financing, whereas it would be 10% under a B credit rating without the implicit support.
Foreign Parent lends to Subsidiary at 10%. However, the GLAM asserts that the IRS may adjust the interest rate to 8% to reflect an arm's-length rate of interest that Subsidiary would pay based on a credit rating of BBB. This is the rate that Subsidiary could receive from a third-party lender in the market. When considering the arm's-length price, the IRS evaluates the interest rate as if the parties were unrelated. The borrower would not accept an interest rate higher than it would receive in the market. The GLAM indicates that the lender may not charge a higher interest rate based on a controlled relationship with the borrower because an uncontrolled borrower outside the controlled group would not accept such an interest rate.
The GLAM states that, under the services regulations in Treas. Reg. Section 1.482-9, no compensation is owed for a passive association benefit. In the intragroup lending scenario, absent a guarantee or legally binding credit support, the borrower is evaluated for an interest rate based on the benefit it receives from its group membership without compensation to any group member (i.e., Foreign Parent). This principle is consistent with paragraph 7.13 of the OECD Transfer Pricing Guidelines.
The GLAM concludes that the arm's-length interest rate of Subsidiary's loan from Foreign Parent is 8% and is informed by the implicit support Subsidiary receives from Foreign Parent and potentially other group members. Subsidiary's credit rating, received through implicit support from Foreign Parent, does not alter this determination, and Foreign Parent is not entitled to separate compensation.
EY observes: The GLAM example is simplistic for illustrative purposes and does not necessarily reflect a full analysis. It will therefore be important to consider several other facts in evaluating a subsidiary credit rating. For example, the role and reputational importance of the borrowing subsidiary within the group would affect the extent of implicit support, as would industry sector and the creditworthiness of the ultimate parent entity.
The GLAM is consistent with the IRS's position from the past few years. Taxpayers should remain vigilant about pricing on intercompany loans because the borrower's relationship in a controlled group may be evaluated for purposes of arm's-length pricing.
Additionally, the potential retroactive application of the guidance may present difficulties for intercompany financing. The IRS considers the GLAM as clarifying the application of Treas. Reg. Section 1.482, consistent with its stated objectives in its priority guidance plans for 2021-22, 2022-23 and 2023-24. However, the IRS has not fully addressed the absence of implicit support in Treas. Reg. Section 1.482-2 for financial transactions. Making the necessary amendments likely would require a change in the regulations.
Although Treas. Reg. Section 1.482 applies a subtly different definition of the arm's-length standard for financing transactions, the OECD Transfer Pricing Guidelines4 and Treas. Reg. Section 1.482-9(l)(3)(v) are consistent with the GLAM. As such, taxpayers should evaluate outstanding loans and may consider a borrower's membership in a controlled group as a factor when evaluating arm's-length interest rates.
1 IRC Section 6110(k).
2 The GLAM indicates in footnote 8 that considering group membership in determining the interest chargeable for intragroup loans is consistent with the current OECD Transfer Pricing Guidelines, paragraphs 10.76-10.80.
3 The GLAM cited Treas. Reg. Section 1.482-1(f)(2)(ii)(A) and "Realistic Alternatives and Tax Considerations in the Application of Sections 482 and 367(d)," AM 2022-006 (Nov. 9, 2022).
4 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, January 2022, paragraphs 10.76 to 10.80.