The IRS has indicated that it is considering the overarching issue of whether intercompany debt should be priced solely on the borrower's credit rating or using a group approach where a parent would support the borrower if a financial need existed (i.e., implicit support).1
During a Practising Law Institute event, Kate Kerrigan, an attorney at the IRS's Office of the Associate Chief Counsel (International), said that the IRS is considering issuing a regulation that would clarify that parental support of a subsidiary's intercompany loan must be considered when pricing the loan.2 In addition, the IRS's priority guidance plan for 2022/23 listed a project on clarifying the effects of group membership (e.g., passive association) on arm's-length pricing for financial transactions.3
The United States (US) transfer pricing regulations employ a definition of the arm's-length standard that is subtly different from the Organisation for Economic Co-operation and Development (OECD) definition and does not support an adjustment for implicit support. Treas. Reg. Section 1.482-1 contains the general provisions that apply to all types of transactions, unless modified by more specific provisions. Treas. Reg. Section 1.482-1(b)(1) includes a general assumption that arm's-length conditions consist of uncontrolled transactions between uncontrolled entities. Treas. Reg. Section 1.482-2 governs financial transactions and does not include any specific exception to the general rules outlined in Treas. Reg. Section 1.482-1 on implicit support. Thus, both the general provisions under Treas. Reg. Section 1.482-1 and the specific provisions under Treas. Reg. Section 1.482-2 are inconsistent with the concept of implicit support.
Kerrigan pointed to passive association language for services (not financial) transactions that would validate the concept of implicit support. While Treas. Reg. Section 1.482-9(l)(3)(v) indicates that a related party does not receive a benefit from merely being a member of a controlled group, Treas. Reg. Section 1.482-9(l)(5), example 16, states that issuing a performance guarantee should be considered a compensable service if it enables an affiliate to secure a contract under materially better conditions than it would have without the guarantee.
Possible clarifying regulation
Kerrigan said a clarifying regulation could require taxpayers determining the interest rate on an intercompany loan to account for a parent's implicit support when rating a subsidiary borrower, just like a credit agency would, even if that support does not entitle the parent to a corresponding fee. This would align with the OECD transfer pricing guidelines.4 Kerrigan further explained that the likelihood that parental support might increase the credit rating of a borrower should be considered in pricing the loan, acknowledging that such an impact varies based on the relative importance of the borrower to a group or to the parent.
Generally, implicit support might affect an affiliate's ability to borrow or the interest rate at which a loan is extended to that affiliate. However, as Kerrigan mentioned, that is not always the case, as the likelihood that a parent (or the group) supports an affiliate might depend on the relative status of the entity within the group. Specifically, a group member with a strategic position (e.g., one that operates in the group's core business) might have greater chances of being supported by the parent, whereas an entity that is not integral to the group's identity or future strategy might be less likely to receive such support. In the latter case, the OECD guidelines suggest looking at the entity on the basis of its stand-alone abilities to repay, rather than the group's.
Kerrigan also stated that the Internal Revenue Code Section 482 regulations require everything impacting the pricing of intercompany debt to be considered for transfer pricing purposes, so a potential future regulation accounting for implicit support would only clarify the existing law and not qualify as a new one. Kerrigan expects such a regulation would apply retroactively to all pre-existing intercompany debt or guarantees (i.e., no grandfathering).
Taxpayers should closely monitor any development as any future regulation likely will impact the general approach to pricing intercompany debt when there is implicit support. Furthermore, the potential retroactivity of the clarifications could conflict with foreign jurisdictions, as they may not accept a new pricing approach for transactions already in place.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), National Tax Department, International Tax and Transaction Services, Transfer Pricing
Ernst & Young LLP (United States), FSO – International Tax and Transaction Services
Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor
Alexander F. Peter, Parent's Implicit Debt Support Doesn't Warrant Guarantee Fee, Tax Notes Today (Feb. 1, 2023).
See EY Tax Alert 2022-1704. The IRS's priority guidance plan for 2021-22 had identical language.
Par. 10.76 et seq.