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Danny Beeton and Murray Clayson, Freshfields Bruckhaus Deringer LLP
The GE Capital Canada case is not a binding authority in UK tax law, but a view could be taken that it should be accorded persuasive weight as regards recognition of the economic impact of implicit support. Such a view would be supported by the recognition of the impact of implicit support in the OECD's latest draft paper on transfer pricing aspects of intangibles.1 Example 1 at page 9 of the draft paper explains the impact that this kind of group relationship can have on the amount independent lenders are willing to make available to a borrower:
On a stand-alone basis, however, the strength of S's balance sheet would support a credit rating of only Baa. Nevertheless, because of S's membership in the P group, large independent lenders are willing to lend to it at interest rates that would be charged to independent borrowers with an A rating, i.e. a lower interest rate than would be charged if S were an independent entity with its same balance sheet, but a higher interest rate than would be available to the parent company of the MNE group.
Example 2 considers the same situation, but where the parent company P extends a guarantee to its subsidiary S to bring its creditworthiness up to P's own level. The level of the guarantee fees which can be charged at arm's length must be calculated on the basis of increasing the company's credit rating from A to AAA, since the company's stand-alone credit rating is already increased from Baa to A due to implicit support. In our view this example clearly intends to reflect the facts of, and decision in, the GE Capital Canada case. These examples would become part of chapter 1 of the OECD Transfer Pricing Guidelines (TPG), as things stand, although they may be removed and the issue dealt with in the separate OECD Base Erosion and Profit Shifting workstream on financial transactions.
In our view, acceptance of the economic significance of implicit support is already consistent with the TPG, noting that section 164 Part 4 Taxation (International and Other) Act 20102 requires, broadly speaking, consistency between the application of key provisions of the transfer pricing regime in Part 4 TIOPA 2010 and the OECD TPG; the TPG (e.g. at para 1.33) require that all comparability factors should be adjusted for, and as per the ratings agencies, potential group support can clearly be a major comparability factor.
HMRC recognise that implicit group support can have an influence on interest rates in the open market. INTM501050 states that “it is a matter of weighing up the likelihood of an implicit guarantee being honoured and the effect that would have” - in other words, it is a question of degree, not whether implicit support adjustments should be made at all.
We understand HMRC's view to be that a ratings agency's classification of a subsidiary as, for example, “strategically important”, and statements from the parent company to this effect, are not decisive and that HMRC do not feel bound to accept the size of credit rating adjustment that is implied by a ratings agency model.
“The ratings agencies produce various credit rating models which businesses and financial institutions can run to quickly and cheaply estimate credit ratings. These models are based on similar factors to those which the agencies themselves will consider in arriving at a rating, but do not take account of the qualitative issues which are important in the independent rating process…While these models do not provide the depth and breadth of analysis which an independent, participatory exercise can produce, they will - if properly applied - produce a fairly accurate 'ball park’ estimate of the rating…”
“The ratings agencies are generally held to have a very good record of predicting the likelihood of default on particular rated instruments, but on occasions they have faced heavy criticism from a number of reputable sources… independent credit ratings, while they may be able to contribute to the assessment of creditworthiness, cannot determine it on their own.”
It is relevant first of all to note the UK tax legislation on the effect of related party guarantees. The general transfer pricing rule permitting tax calculations to be based on the arm's length, not the actual, provision is set out at section 147(1) TIOPA 2010 as follows:
For the purposes of this section “the basic pre-condition” is that:
(a) provision (“the actual provision”) has been made or imposed as between any two persons (“the affected persons”) by means of a transaction or series of transactions,
(b) the participation condition is met (see section 148),
(c) the actual provision is not within subsection (7) (oil transactions), and
(d) the actual provision differs from the provision (“the arm's length provision”) which would have been made as between independent enterprises.
Section 147(1)(d) is to be read as requiring that, in the determination of any of the matters mentioned in subsection (6), no account is to be taken of (or of any inference capable of being drawn from) any guarantee provided by a company with which the issuing company has a participatory relationship.
The matters are:
(a) the appropriate level or extent of the issuing company's overall indebtedness,
(b) whether it might be expected that the issuing company and a particular person would have become parties to a transaction involving:
- (i) the issue of a security by the issuing company, or
- (ii) the making of a loan, or a loan of a particular amount, to the issuing company, and
- (c) the rate of interest and other terms that might be expected to be applicable in any particular case to such a transaction.
INTM501050 states quite plainly that “When considering borrowing capacity from a lender's perspective guarantees should not be taken into account; TIOPA10/S152(5) applies.” INTM586180 includes implicit support in the “influence” of an overseas parent that should be disallowed:
When considering whether a UK borrower is thinly capitalised, any support received from an overseas parent or any other overseas affiliate (apart from subsidiaries of the borrower) must be disregarded… The involvement of a parent, or other affiliates, can usually only be ascertained by looking at the detailed reports underlying the rating itself…These reports will typically give two or even three different ratings, only one of which (the one we need to consider for thin cap purposes) will be the rating for the UK borrower as a stand-alone entity. The others will be the ratings for other groupings, such as:
- the UK borrower where another party, most commonly the overseas parent, has guaranteed the bond or debt instrument (where the rating will be equivalent to that of the guarantor), or
- the UK borrower where the parent, say, has not provided a formal guarantee but is held to be likely to support its UK subsidiary in the event that the latter has difficulty meeting its interest payments. [our emphasis added]
It is possible to argue, however, that this guidance to tax inspectors could be at odds with the requirement in UK tax law to have regard to the arm's length principle as it is set out in TPG, at least as interpreted in the GE Capital Canada decision.
The lack (in our view) of complete clarity in this guidance reflects a potential ambiguity in UK tax law on this point: on the one hand sections 153-154(1) TIOPA 20103 extend the transfer pricing rules to non-legally binding arrangements or understandings which create a mere expectation of performance; on the other hand, UK tax law4 specifically requires that the transfer pricing code is to be construed in such manner as best secures consistency with the TPG, which at paragraph 7.13 observes that no service is received where an associated enterprise by reason of its affiliation alone has a credit rating higher than it would if it were unaffiliated. Paragraph 7.13 does not prohibit arm's length remuneration for positive parental (or indeed other affiliate) actions, for example even non-legally binding assurances; nor is it inconsistent with implicit support being taken into account as part of the overall factual matrix.
The UK has a relatively wide definition of “guarantee”, and the relevant factual test appears to be whether the possibility of group support could give rise to a “reasonable expectation” that payment will be made by another party if the borrower defaults. The fact that the ratings agencies do not advise their clients to assume that implicit support will have this effect should be significant here. There is no definition of “reasonable expectation” in HMRC's International Finance Glossary.5 However, its meaning has been considered in, for example, Regina (Bradley and others) v Secretary of State for Work and Pensions6 Chadwick LJ giving the leading judgment agreed with an assertion that a “'reasonable expectation’ would not ordinarily be understood to mean 'only a 50 percent chance’”. This could suggest that a reasonable expectation ordinarily means more than a 50 percent chance of an expectation being met.
Another possible way to test whether implicit parental support would result in a “reasonable expectation” of payment is by reference, for example, to Standard & Poor's (S&P's) “Guidelines for Evaluating Corporate Credit Risk: Parent/Subsidiary Relationships”. In this guidance S&P explain that an explicit guarantee relates to payments “on the date due” whereas an implicit support merely relates to there appearing to be a commercial benefit to a parent of providing vague “support”.
firms that are not core entities may find themselves on the front line during periods of adversity” because “core” subsidiaries will take precedence over them; in other words, in a crisis, the value of the implicit support for most group companies could disappear quickly.
It may therefore be, depending on all the facts and circumstances, that a lender should not have a 'reasonable expectation’ of payment when appraising implicit parental support (at least of the full amount, on the date due and in most circumstances).
It is our understanding that HMRC are prepared to accept that the effect of implicit support on interest rates and guarantees should be adjusted for in some circumstances. However, they appear reluctant to accept that there is a category of implicit support which falls short of generating a 'reasonable’ expectation of payment so that its effect on debt quantum would under sections 152(5)-(6) TIOPA 2010 be disregarded. It may be that it would need a taxpayer to take a case to the First-tier Tax Tribunal in order to have the matter considered there.
Danny Beeton is head of transfer pricing economics at Freshfields Bruckhaus Deringer LLP in London. Murray Clayson is a partner in Freshfields Bruckhaus Deringer LLP's tax practice group in London. They may be contacted at:
1 Discussion Draft on the Revision of Chapter VI of the OECD Guidelines on Intangibles, July 30, 2013.
2 TIOPA 2010
3 Sections 153-154(1) TIOPA 2010 extend the notion of guarantee to any “surety and to any other relationship, arrangements, connection or understanding (whether formal or informal) such that the person making the loan to the issuing company has a reasonable expectation that in the event of a default by the issuing company he will be paid by, or out of the assets of, one or more companies” [our emphasis added].
4 Section 164 TIOPA 2010.
6 Court of Appeal, February 21, 2008.
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