14 034 Transfer Pricing Intra Group Financing Final Web

Transfer Pricing and Intra-Group Financing
Why this book?
Transfer Pricing and Intra-Group Financing is a practical guide that addresses the
transfer pricing issues related to intra-group financing transactions. Currently, tax
authorities and transfer pricing professionals are focusing on these transactions – and
the application of the arm’s length principle. This growing attention is largely dictated by
two factors: (i) the relative importance that financial transactions have in multinational
groups and the significant amounts involved; and (ii) the increased awareness of
tax authorities (and taxpayers alike) who, having for many years primarily dealt with
transfer pricing issues related to goods and services, are now being confronted with the
complexity of the pricing of these financial transactions. The so-called “credit crunch”,
which began in late 2007 and in mid-2008 exploded on the financial services industry
and the global economy, has also heavily influenced this field of application of the arm’s
length principle. The impact of the financial markets on this area of transfer pricing
continues today.
Title: Transfer Pricing and Intra-Group Financing

Editor(s): Anuschka Bakker, Marc M. Levey
Date of publication: September 2012
ISBN: 978-90-8722-152-2
Type of publication: Print Book
Number of pages: ± 580
Terms: Shipping fees apply. Shipping information is
available on our website
Price: EUR 120 / USD 150 (VAT excl.)

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Table
Tableof
of Contents
contents
Foreword v
Acknowledgements ix
Chapter 1: Introduction 1
1.1. General considerations: The change in (market)

circumstances 1
1.2. The OECD framework and selected international
developments 4
1.3. Typical types of intercompany financial transactions 7
1.4. The treasury functions: Typical characterization of
the treasury department 8
1.5. Intercompany loans, the issue of hidden capitalization
and the arm’s length principle: Theory and practice 10
1.5.1. Hybrid financing 30
1.6. Financial guarantees and performance guarantees 32
1.7. Cash management and optimization 39
1.8. Factoring 45
1.9. Foreign exchange and commodity risk management 49
1.10. Captive insurance 51
1.11. Establishing an intra-group policy 53
Chapter 2: Australia 57
2.1. Corporate income tax framework 57

2.1.1. Corporate income tax system 57
2.1.2. Taxable entities 57
2.1.3. Taxable income 58
2.1.4. Tax losses 58
2.1.5. Tax rates 58
2.1.6. Interaction of thin capitalisation and transfer pricing
legislation 59
2.2. Overview of intra-group financing in Australia 59
2.2.1. Historical context 59
2.2.2. Recent developments 60
2.2.3. Proposed legislation rewrite 63
2.3. Intercompany loans 64
2.3.1. Loan or equity 65
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2.3.1.1. Transfer pricing considerations in relation to debt

and equity 66
2.3.2. Profit participating loans (PPLs) and hybrid debt
instruments 68
2.3.3. Interest charged 69
2.3.3.1. Arm’s length pricing considerations arising from
TR 92/11 69
2.3.3.2. Considerations arising from TR 2010/7 70
2.3.4. Transfer pricing approach 72
2.3.4.1. Steps in the application of the above approach 72
2.3.4.2. Impact of ordering of the above steps 75
2.3.4.3. Potential adjustments when the financing
transactions produce non-commercial outcomes 75
2.3.5. Example 76
2.4. Guarantee fees 77
2.4.1. A parent company funding a subsidiary unable to
borrow the funds it needs on a stand-alone basis 78
2.4.1.1. Example 78
2.4.2. A parent or offshore associate provides debt funding
to a group company that has the financial strength to
be able to borrow the debt funding it needs without
support from its parent company 79
2.4.2.1. Example 79
2.4.3. A parent guaranteeing the debt of a wholly owned
group company that is unable on a stand-alone basis
to borrow the debt funding it needs 80
2.4.3.1. Example 81
2.4.4. A parent company provides a guarantee to a
subsidiary that is able to borrow the funds it needs
on a stand-alone basis, to allow the subsidiary to
access funding at the lower cost available to the
parent 83
2.4.4.1. Example 83
2.4.5. Transfer pricing methods 84
2.4.6. Use of a range of results 85
2.5. Cash pooling 86
2.5.1. Interest 86
2.5.1.1. Cash pooling for administrative convenience 86
2.5.1.2. Operation of an in-house “bank” 87
2.5.2. Remuneration CPL 88
2.5.2.1. Cash pooling for administrative convenience 88
2.5.2.2. Operation of an in-house “bank” 89
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2.5.3. Allocation of cash pool benefit 89

2.5.4. Documentation 89
2.5.5. Advance pricing arrangements (APAs) 89
2.6. Factoring 90
2.7. Leasing 90
2.8. Other forms of financing and credit risk arrangements 91
2.9. Branches 91
2.10. Documentation 91
2.10.1. Overview of documentation requirements 92
2.10.1.1. Application of the four-step process for financing
transactions 93
2.10.2. Contemporaneous documentation 94
2.10.3. Timing aspects 94
2.10.4. Penalty aspects 94
2.10.5. Burden of proof 95
2.10.6. Further exceptions 95
2.11. Recommendations 96
Chapter 3: Brazil 97

3.1.5. Tax rates 100
3.1.6. Interaction of thin capitalization and transfer pricing
legislation 101
3.2.2. Profit participation loans (PPLs) 103
3.2.3.1. Historical background 104
3.2.3.2. Indexes, concepts and acronyms 105
3.2.3.3. Interest range scenarios 112
3.2.4. Transfer pricing (TP) methods 115
3.2.5. Thin cap rules 120
3.2.6. Exchange controls and Central Bank registration 122
3.2.7. IOF tax 125
3.2.8. Disguised distributions of profits 126
3.2.9. Intercompany back-to-back loans 128
3.2.10. Interest on net equity 129
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3.2.11. Subordinated loans 130

3.2.12. Hedging 130
3.2.13. Withholding income tax 131
parent 132
3.3.6. Use of range of results 133
3.3.7. Requirement for outcomes to make commercial
sense 133
3.4.1. Interest 135
3.4.4. APA 135
3.5. Factoring 135
3.6. Leasing 136
3.8. Sectors 138
Chapter 4: Canada 141

4.1.2. Transfer pricing 142
4.1.2.1. Relevant legislation 142
4.1.2.2. Applicable jurisprudence 144
4.1.2.3. Transfer pricing methods (TPM) 145
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4.1.2.4. Documentation requirements 148

4.1.2.5. Advance pricing arrangements 149
4.1.5. Ordinary tax losses 152
4.1.7. Interaction between thin capitalization and transfer
pricing 154
4.2.2. Profit participating loans 157
parent 159
4.3.6. Use of a range of results 162
4.3.7. Requirement for outcomes to make commercial sense 163
4.4.1. Interest 164
4.4.2. Remuneration – Cash pool leader 164
4.4.4. APA 165
4.5. Factoring 165
4.6. Leasing 166
4.7.1. Derivatives 167
4.7.2. Foreign exchange 168
4.7.3. Hybrid financial instruments 168
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4.8. Sectors 169

4.8.1. Natural resource industry 169
4.8.2. Financing start-ups 170
4.8.3. Automotive 170
Chapter 5: China 173

5.1.6. Transfer pricing and thin capitalization legislation 177
5.2.2. Profit participating loans (PPLs) 181
5.2.4. Transfer pricing methodologies 183
5.2.4.1. Acceptable transfer pricing methods 183
5.3.1. A parent company that guarantees the debt of a fully
owned company that is unable to obtain the finance
itself that it needs 186
5.3.2. A parent or offshore associate provides funding to a
group company even though it is capable and has the
financial strength to borrow the funding it needs 186
5.3.3. Parent company provides funding to a subsidiary
that is unable to borrow the funds it needs 186
5.3.4. A parent company becomes a guarantor for a
on a standalone basis, but does so in order for the
subsidiary to gain funding at the lower cost available
only to the parent 186
5.3.7. Requirement for outcomes to make commercial sense 188
5.4.1. Interest 190
5.4.2. Remuneration of CPL 191
5.4.3. Transfer pricing treatment on cash pooling 191
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5.5. Factoring 194

5.6. Leasing 195
5.7. Other forms of financing and credit risk
arrangements 197
5.7.4. Transfer pricing for other financing and credit risk
arrangements 199
5.8. Sectors 202
5.8.1. Financial services industry 202
5.8.2. Oil and gas industry 204
5.8.4. Financing and leasing in the automotive industry 206
5.9. Transfer pricing documentation 207
5.10. Recommendation 208
Chapter 6: France 209

6.1.5.1. Income 211
6.1.5.2. Capital gains 212
pricing legislation 212
6.1.6.1. Maximum interest rate and thin capitalization rules 212
6.1.6.1.1. Shareholder loans and current accounts 213
6.1.6.1.2. Interest served to related parties 213
6.1.6.1.3. Thin capitalization rules 214
6.1.6.1.4. Limitation of interest expenses deduction linked to
the acquisition of participation shares 215
6.1.6.2. Transfer pricing rules 216
6.1.6.3. Anti-abuse provisions 217
6.1.6.4. Interaction between thin capitalization rules and
transfer pricing rules 219
6.1.6.4.1. Interest rate 219
6.1.6.4.2. Debt-to-equity ratio 219
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6.2.2. Profit participating loans (PPLs) and hybrid
instruments 221
6.2.3. Illustration of relevant case law on characterization
of debt or equity 223
6.2.3.1. Foreign legal characterization 223
6.2.3.2. Substance requirements 224
6.2.4.1. Perspective of a French borrower 225
6.2.4.2. Perspective of a French lender 226
6.2.5. Debt waivers by a parent company to its subsidiary 227
6.3.1. Should the guarantee be remunerated? 228
6.3.2. Determination of an arm’s length remuneration for
the guarantees 229
6.3.3. Withholding tax issues 229
6.4.1. Interest paid under cash-pooling arrangements 229
6.4.1.1. Deductibility of interest payments 229
6.4.1.2. Withholding tax on interest payments 230
6.4.2. Interest received under cash pooling 231
6.4.3. Remuneration of the cash-pooling entity 231
6.4.4. Allocation of cash-pool benefit 231
6.4.5. Transfer of the cash-pooling activity 232
6.5. Factoring 233
6.6. Leasing 235
arrangements 236
6.8. Sectors 236
Chapter 7: Germany 241

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legislation 243
7.2.5. Case study 250
parent 254
7.4.1. Interest 258
7.4.5. Advance pricing agreements (APA) 261
7.5. Factoring 262
7.6. Leasing 266
arrangements 266
7.8. Specific industries 267
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Chapter 8: India 271
8.1. Introduction 271

8.2.1.1. Introduction 272
8.2.1.2. Transfer pricing framework 272
8.2.1.3. Transfer pricing methodology 273
8.2.1.4. Applicability of transfer pricing provisions to
specified domestic transactions 273
8.2.1.5. Transfer pricing documentation requirements 274
8.2.6. Withholding tax on interest payments to
non-residents 276
8.2.7. Thin capitalization 277
8.2.8. General anti-avoidance rules 277
8.2.9. Advance pricing agreement 277
8.3.3. TP methods 281
8.3.4. Interest-free loans 281
8.3.4.1. Attribution interest income on a notional basis when
there is no real income 282
8.3.4.2. Rulings on benchmarking of interest-free loans 283
8.3.4.3. Rulings on attribution of interest income on
long-outstanding trade receivables 285
8.3.5. Relevance of exchange control caps in the context of
transfer pricing benchmarking 288
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parent. 292
8.6. Factoring 295
8.7. Leasing 296
arrangements 297
8.9. Sectors 297
8.10. Conclusion 298
Chapter 9: Ireland 299

9.1.6. Application of transfer pricing legislation to
intra-group financing activities 302
legislation 304
9.2.2. Profit Participating Loans (PPLs) 309
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parent 318
sense 319
9.4.1. Interest 321
9.4.2. Remuneration of cash pool leader 321
9.4.5. Advance pricing agreements (APAs) 322
9.5. Factoring 323
9.6. Leasing 325
arrangements 327
9.8. Sectors 327
Chapter 10: Japan 331

10.1.5. Tax rates 333
legislation 334
10.1.7. Recent changes in the transfer pricing taxation 334
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parent 346
sense 349
10.4.1. Interest 350
10.5. Factoring 353
10.6. Leasing 353
arrangements 354
10.8. Sectors 354
Chapter 11: Luxembourg 361

11.1.1. Corporate income tax system and taxable entities 361
11.1.2. Tax rate – Corporate income tax – Municipal
business tax 362
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11.2. General transfer pricing rules 364
11.2.1. Overview of legal sources 364
11.2.2. Article 56 LITL – Transfer of profits to a
non-resident 365
11.2.3. Article 164(3) LITL – Hidden distributions 365
11.2.4. Circulars L.I.R. 164/1 367
11.3. Transfer pricing rules applicable to intra-group
financing transactions 368
11.3.1. Scope of the circular 369
11.3.1.1. An intra-group financing activity 369
11.3.1.2. A Luxembourg company whose principal activity
consists in intra-group financing 372
11.3.2. Obligations under the circular 373
11.3.2.1. Reinforced substance 374
11.3.2.2. Equity at risk 375
11.3.2.3. Transfer pricing report and margin requirement 377
11.3.3. Advance pricing agreement (APA) 380
11.3.3.1. Submission of an APA: An option for the taxpayer 380
11.3.3.2. Content of the APA 380
11.3.3.3. Validity of the APA 381
11.4. Conclusion 382
Chapter 12: Mexico 383
12.1. Mexico overview 383

12.2.4. Tax rates 387
12.2.5. Interaction of thin capitalization and TP legislation 388
12.3.1. Interest and derivative financial transactions
covering debt 392
12.3.3. Back-to-back loans in terms of MITL 393
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parent 398
12.4.5. Direct explicit credit support and implicit credit
support 398
12.5. Use of range of results 399
12.6. Requirement for outcomes to make commercial
sense 400
12.7.5. Advance pricing agreement (APA) 405
12.8. Factoring 406
12.9. Leasing 407
arrangements 407
12.11. Sectors 409
12.12.1. Statutory requirements/regulations 411
12.12.2. Documents required 412
12.12.2.1. Transfer pricing documentation – Requirement 412
12.12.2.2. Information return 412
12.12.2.3. Statutory audited tax report (Dictamen Fiscal) 413
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12.12.3. Timing 414

12.12.4. Penalty 414
12.12.5. Burden of proof 415
12.12.6. Small and medium-sized enterprises 415
12.12.7. Multilateral rules or guidance 416
Chapter 13: Netherlands 417

13.1.2. General overview of the corporate income tax
system 417
13.1.3. Specific rules on loans 418
13.1.3.1. Interest in connection with certain tainted
transactions (article 10a CITA) 418
13.1.3.2. Interest recharacterized as dividend (article 10(1)(d)
CITA and the Supreme Court case, BNB 1988/217) 419
13.1.3.3. Long-term loans with an interest rate substantially
lower than the arm’s length interest rate (article 10b
CITA) 420
13.1.3.4. Acquisition debt (article 15ad CITA) 420
13.1.4. Specific TP rules 421
13.1.4.1. Specific guidance on financial services 422
13.1.4.2. Relevant case law 423
13.1.5. Interaction between thin capitalization and
TP legislation 425
13.2. Intra-group loans 426
13.2.2. Profit participating loans 427
13.2.4.1. Credit rating 429
13.2.4.2. Setting the interest rate 430
13.2.5. Back-to-back loans 431
13.3. Guarantees 432
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13.3.4. Pricing a guarantee 434
13.4.1. General 435
13.4.2. Setting the debit and credit rates 436
13.4.3. Remuneration for the cash pool leader 437
13.4.4. Allocation of the cash pool benefit 438
13.4.6. Substance 438
13.5. Factoring 439
13.6. Leasing 439
arrangements 439
13.7.1. General 439
13.7.4. Captives 440
13.8. Sectors 441
13.9.1. General rule 441
13.9.2. Documenting intra-group financial transactions 442
13.9.3. APA 444
13.9.3.1. General 444
13.9.3.2. Advance pricing agreements for intra-group financial
transactions 444
Chapter 14: South Africa 447

14.1.5. Tax rates 448
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14.1.7. Transfer pricing framework 450

14.1.7.1. Transfer pricing legislation 450
14.1.7.2. Affected transactions 450
14.1.7.3. Consequences – General circumstances 452
14.1.7.4. Consequences – Special circumstances 452
14.1.7.5. Exemptions 453
14.1.7.6. Discussion 453
14.1.7.7. The arm’s length concept 454
14.1.7.8. The independent persons requirement 455
14.1.7.9. The mandatory nature of the transfer pricing
adjustment 457
14.1.7.10. The nature of a tax benefit 457
14.2.4. Transfer pricing method 461
14.3.1. A parent typically guarantees the debt of a wholly
owned group company when it is unable on a
stand-alone basis to borrow the debt funding it needs
to be able to borrow at reasonably commercial rates 463
parent 465
sense 466
14.5. Factoring 467
14.6. Leasing 468
arrangements 470
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14.7.1. General 470

14.7.2. Transfer pricing method 471
14.8. Sectors 471
14.8.4. Mining 473
Chapter 15: Switzerland 477

15.1.5. Tax rates 479
pricing (TP) legislation 480
15.2.1. General 482
15.2.2. Profit participation loans (PPLs) 483
parent 491
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15.3.7. Requirement for outcome to make commercial sense 493

15.4.1. General 494
15.5. Factoring 500
15.6. Leasing 501
arrangements 502
15.8. Sectors 503
Chapter 16: United Kingdom 505

16.2. Taxable entities 506
16.2.2.1. Ordinary losses 507
16.2.2.2. Carry forward 507
16.2.2.3. Carry back 507
16.2.2.4. Capital losses 508
16.2.3. Tax rates 508
16.2.3.1. Income 508
16.2.3.2. Capital gains 508
16.2.4.1. UK thin capitalization rules 509
16.2.4.1.1. Interest served to related parties 509
16.2.4.1.2. Thin capitalization rules 509
16.2.4.1.3. Advance thin capitalization agreements 510
16.2.4.2. Transfer pricing rules 511
16.2.4.3. Anti-abuse provisions 512
16.2.4.4. Interaction between thin capitalization rules and
transfer pricing rules 512
16.2.4.4.1. Debt-to-equity ratio 512
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16.6. Factoring 521
16.7. Leasing 522
arrangements 522
16.9. Sectors 522
Chapter 17: United States 527

17.1.5. Tax rates 529
17.1.6. Interaction thin capitalization and TP legislation 529
17.3. Introduction to guarantees 536
17.3.1. Financial guarantees in the context of transfer
pricing 536
17.3.1.1. Guarantees and their impact on determining entity
credit ratings 538
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17.3.1.1.1. Transfer pricing methods for benchmarking

guarantees 540
17.3.1.2. Market approach 541
17.3.1.3. Yield/spread (credit enhancement) approach 541
17.3.1.4. Put option approach 542
17.3.1.5. Loss given default (LGD) framework 542
17.3.2. Performance guarantees 543
parent 544
sense 545
17.4.1.1. Creditworthiness of cash pool participants and leader 547
17.4.1.2. Implicit guarantees 547
17.4.2. Remuneration of cash pool leader 548
17.5. Factoring 550
17.5.1. Overview 550
17.5.2. Transfer pricing 551
17.5.2.1. Estimating the profit element 552
17.5.2.2. Estimating the amount advanced to the assignor 552
17.5.2.3. Estimating the factoring discount 552
17.6. Leasing 553
17.6.1. Safe haven lease charge 553
17.6.2. Subleases 553
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arrangements 554
17.8. Sectors 554
17.9.1. Penalty provisions 555
17.9.2. Contemporaneous documentation exemption for
penalties 556
xxxiii
Chapter
Sample 2
chapter
Australia
Paul Balkus and Melissa Heath*
This chapter is based on information available up to 2 March 2012.
2.1. Corporate income tax framework
2.1.1. Corporate income tax system
An Australian resident company is subject to Australian income tax on its

non-exempt worldwide income. A non-resident company is subject to Aus-
tralian tax only on Australian-sourced income.1
Companies incorporated in Australia are residents of Australia for income

tax purposes, as are companies carrying on business in Australia with either
their central management and control in Australia or their voting power
controlled by Australian residents.2
For transfer pricing, Division 13 of Part III of the Income Tax Assessment
Act 1936 (ITAA 1936) provides a mechanism by which Australia adopts the
arm’s length principle for taxation purposes as the basis for ensuring that
Australia receives its fair share of tax.
2.1.2. Taxable entities
Australian resident companies and individuals are generally subject to Aus-

tralian income taxation on their non-exempt worldwide income. There are
* Paul Balkus, Partner; Melissa Heath, Executive Director; both with Ernst & Young,
Australia. The views expressed in this chapter are the views of the authors, not Ernst &
Young. This chapter provides general information, does not constitute advice and should
not be relied on as such. Professional advice should be sought prior to any action being
taken in reliance on any of the information. Liability limited by a scheme approved under
Professional Standards Legislation.
1. Section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997).
2. See the definition of “resident or resident of Australia” in section 6(1)(b) of the
Income Tax Assessment Act 1936 (ITAA 1936).
57
Chapter 2 - Australia
also specific rules about the treatment of certain entities, such as trusts,
partnerships, etc.3
2.1.3. Taxable income
Taxable income is calculated as assessable income less allowable deductions.

Assessable income consists of income as defined by ordinary concepts and
income that is specifically assessable under a statutory provision.4 Allow-
able deductions consist of general deductions (broadly losses or outgoings
incurred in gaining or producing assessable income) and deductions that are
specifically allowed under a statutory provision.5
2.1.4. Tax losses

Tax losses may be carried forward indefinitely against assessable income
derived during succeeding years, subject to certain limitations. To claim
a deduction for past losses, companies must satisfy either a continuity of
ownership test or a same business test. Losses may not be carried back.6
2.1.5. Tax rates
For the 2011 to 2012 tax year, resident companies are subject to Australian
income tax at a rate of 30% (the government has committed that the rate
will be reduced to 29%, effective from the 2013 to 2014 tax year).7 Income
of non-resident companies from Australian sources is similarly taxable at
30% if it is not subject to withholding tax or treaty protection.
3. See Divs. 5 and 6 ITAA 1936.

4. See Div. 6 ITAA 1997.
5. See Div. 8 ITAA 1997.
6. Division 36 of the ITAA 1997 provides an outline of the general rules regarding
the calculation and utilization of tax losses of earlier income years.
7. Press Release No. 13 of 2012 from the Deputy Prime Minister and Treasurer Mr
Wayne Swan. Note that for “small business” companies the 29% rate will apply from the
2012-13 income year.
58
Overview of intra-group financing in Australia
2.1.6. Interaction of thin capitalisation and transfer pricing

legislation
On 27 October 2010, the Australian Taxation Office (ATO) released its final
ruling (Taxation Ruling TR 2010/7) on the interaction of the thin capitali-
sation and transfer pricing provisions.8 The final ruling includes the ATO’s
observations on the application of appropriate transfer pricing methods to
determine the arm’s length consideration for cross-border intra-group debt
arrangements having regard to the interaction with the thin capitalisation
rules.
Broadly, TR 2010/7 indicates that the transfer pricing rules apply first to
determine the arm’s length interest rate applicable to a debt arrangement
entered into between international related parties. The thin capitalisation
rules are then applied to determine whether some portion of that interest is
not deductible. When determining an arm’s length interest rate, the taxpayer
must assess whether the existing level of debt provides an arm’s length
capital structure even though the level of debt complies with the thin cap-
italisation rules. If it does not, a hypothetical arm’s length level of debt,
which results in an arm’s length capital structure, will need to be used when
determining the arm’s length interest rate. The arm’s length interest rate
derived based on the hypothetical level of debt is then applied to the actual
level of debt allowed under the thin capitalisation provisions.
Section 2.3.3. of this chapter provides a more detailed commentary on TR

2010/7 and the interaction between the transfer pricing and thin capitalisa-
tion provisions.
2.2. Overview of intra-group financing in Australia
2.2.1. Historical context
The ATO released Taxation Ruling TR 92/11 in 1992 to deal with specific
issues in relation to interest payments, loans and equity contributions.9 In
particular, the ruling discusses the general approach accepted by the ATO in
pricing intra-group loans. This ruling also provides factors which should be
8. Taxation Ruling TR 2010/7, Income tax: the interaction of Division 820 of the
ITAA 1997 and the transfer pricing provisions.
9. Taxation Ruling TR 92/11, Income tax: application of the Division 13 transfer
pricing provisions to loan arrangements and credit balances.
59
considered in determining whether an arrangement should be characterized

as debt or equity. These factors are discussed at 2.3.1.1. below.
Prior to 2007, the transfer pricing legislation and the thin capitalisation
provisions were largely seen as operating independently of each other. That
is, when the level of debt was within the safe harbour threshold set out in
the thin capitalisation provisions, it was generally accepted that the funding
arrangement represented an arm’s length capital structure. Therefore, the
“safe harbour” capital structure could be used for the purposes of determin-
ing the arm’s length interest rate to be applied rather than the hypothetical
capital structure referred to above. The only clear distinction in the applic-
ation of transfer pricing principles was in the determination of an “arm’s
length” amount of debt (an alternative to using the “safe harbour” debt
amount for thin capitalisation purposes).
Although this analysis follows the broad transfer pricing principles in rela-
tion to what constitutes an “arm’s length” amount of debt, it forms part of
the thin capitalisation legislation and therefore includes a number of assump-
tions and adjustments in relation to the debt and assets of the taxpayer. Given
what is generally regarded as a relatively generous 3 to 1 debt to equity ratio
for non-authorized depositary institution (non-ADI) taxpayers (i.e. generally
taxpayers other than banks), the arm’s length debt amount under the safe
harbour provisions is used infrequently. The arm’s length debt test for thin
capitalisation purposes is therefore not discussed further in this chapter.
2.2.2. Recent developments
Commencing in 2007, the ATO began to officially indicate that intercompany

financing (and in particular the interaction between the transfer pricing and
thin capitalisation provisions) was becoming an increasing area of focus. The
ATO was concerned that taxpayers could have capital structures that were
within the thin capitalisation safe harbour, but resulted in such an adverse
impact on financial performance that the arm’s length basis on which the
related parties were dealing should be called into question. To clarify their
position and obtain feedback from the broader taxpayer community and their
advisers, the ATO released a draft Taxation Determination (TD 2007/D20)
in November 2007 outlining its view on the interaction between the transfer
pricing and thin capitalisation provisions, as well as a draft discussion paper
(ATO Discussion Paper: Intra-group finance guarantees and loans: Applic-
ation of Australia’s transfer pricing and thin capitalisation rules) in June
2008. These documents were subsequently withdrawn in December 2009,
60
when the ATO released the initial draft of a new Taxation Ruling (TR 2009/
D6), as well as a draft Practice Statement (PS LA 3187).10
Ultimately, these documents were replaced when the ATO issued Taxation
Ruling TR 2010/7 in October 2010, the finalized version of TR 2009/D6 (see
2.3.3.2. below). Although this is the only document which is binding on the
ATO, the earlier discussion documents are helpful in providing some indi-
cation of the ATO position regarding intra-group financing arrangements.
This is particularly relevant given the guidance included in TR 2010/7 is
less comprehensive than that which was previously provided, particularly in
relation to guarantee arrangements. Further, the binding part of TR 2010/7
does not provide any detail regarding how the transfer pricing principles
should be applied to debt arrangements; this exposition is instead included
in an Appendix to the ruling, which the ATO indicates is non-binding.
In summary, the guidance provided in this final ruling indicates the ATO’s
preference to adopt a “holistic” approach to funding arrangements, with a
focus on the following three key factors:
– parent affiliation: Whether the taxpayer’s relationship with its parent
company provides support that should be considered in determining an
arm’s length interest rate;
– financial independence: Whether the taxpayer’s capital structure is
consistent with that of a “financially independent” company (i.e. is it
an “arm’s length capital structure” when benchmarked against other
comparable companies); and
– commercial realism: Whether the taxpayer’s profit before tax (i.e. profit
after interest expense) makes sense in the context of other comparable
companies.
This holistic approach incorporating these elements is focused not only

on the pricing of the actual debt, but also on the economic context of the
intra-group funding arrangement. It is this broader context which makes the
ATO’s approach contentious when compared to what was previously seen
and generally accepted in practice. As outlined in 2.1.6. above, TR 2010/7
requires a taxpayer to have reference to an “arm’s length” capital structure in
determining an appropriate interest rate and provides that the taxpayer should
subsequently apply the interest rate so determined to the actual amount of
debt allowed under the thin capitalisation provisions. This raises an issue in
relation to whether Australia’s transfer pricing rules, contained in Division
10. PS LA 3187, A practical “rule of thumb” approach for the transfer pricing of interest
payable by a taxpayer on a cross-border related party loan, an interim measure to alleviate
uncertainty prior to the release of TR 2010/7.
61
13 of the ITAA 1936 (Division 13), allow the Commissioner to substitute

this hypothetical “arm’s length” capital structure for the actual amount of
debt when determining the interest rate.
The ATO contends that this approach is not new and that the approach out-
lined in TR 2010/7 is based on the guidance provided in TR 92/11 and is
representative of the historical ATO position. The ATO claims that any com-
ments presented in TR 2010/7 are simply a “clarification” of the guidance
previously provided by TR 92/11 and thus the ruling applies retrospectively.
The retrospective application of this ruling is also contentious given what
was considered to be the generally accepted approach and the judgments
set down in recent transfer pricing cases discussed below. These cases con-
cluded that the Australian transfer pricing provisions should be applied on
a transaction basis, i.e. the arm’s length or market price of the related party
transactions should be reviewed, not whether there is arm’s length behav-
iour or appropriate profits arising from such related party transactions. As
outlined below, the Australian Treasury is currently working on a rewrite
of the transfer pricing legislation that is expected to clarify the situation at
least on a prospective basis but may also apply retrospectively when treaty
countries are involved.
It is further noted that the wording of the tax treaties regarding the treatment
of international related-party dealings (as contained in the Business Profits
and Associated Enterprises articles) is different to Australia’s existing trans-
fer pricing provisions. In particular, the tax treaties provide that the profits
should be allocated in an arm’s length way. This wording may more readily
accommodate the hypothesizing of an “arm’s length” capital structure for
the taxpayer and support the ATO’s preference for financing arrangements
to result in a “commercially realistic” outcome.
The government intends to “clarify” that the transfer pricing rules in the
treaties allow the Commissioner to make adjustments independently of the
domestic transfer pricing legislation. Exposure Draft legislation which was
released on 16 March 2012 outlines that the new legislation will apply for
income years commencing on or after 1 July 2004.
The application of the “profits” approach outlined in the tax treaties on a

retrospective basis is highly contentious and may represent a significant
risk to taxpayers who have existing intercompany loan arrangements with
affiliates in treaty countries. This approach is most likely to affect companies
with high levels of debt and low levels of profitability, where the application
of the transfer pricing provisions using a transactional/market rate approach
62
may result in a different outcome to an approach that considers the overall

profitability of the entity after all international related-party transactions,
including debt.
2.2.3. Proposed legislation rewrite
The ATO has recently concluded two transfer pricing cases: Roche Products
Pty Limited v. Commissioner of Taxation [2008] AATA 261 in April 2008 and
SNF (Australia) Pty Ltd v. Commissioner of Taxation [2010] FCA 635 in June
2010. In both cases, the decision, and the reasons for the decision, brought
into question the approach taken by the ATO in determining an arm’s length
consideration and in particular whether the use of the transactional net mar-
gin method (TNMM) favoured by the ATO is appropriate under the existing
transfer pricing legislation. A summary of these cases and the decisions is
included in the Australian chapter of the IBFD Transfer Pricing Collection.
In part as a reaction to these decisions and the controversy surrounding

the issuance of TR 2010/7 on a retrospective basis, the Assistant Treas-
urer announced on 1 November 2011 that Treasury would be undertaking a
reform of Australia’s transfer pricing provisions.11
On 16 March 2012, Treasury released the first exposure draft which addresses
retrospective aspects of the rewrite of the transfer pricing provisions. These
amendments and clarifications are to apply from 1 July 2004 and will only
apply to foreign affiliates in treaty countries (i.e. those countries with which
Australia has a double tax agreement). Further exposure drafts are expected
to be released shortly that address the prospective aspects of the legislation
as well as the attribution of profits to permanent establishments, which will
apply to all taxpayers.
Based on the initial exposure draft, not only has TR 2010/7 been written
into the transfer pricing legislation but it is also clear that the Commissioner
intends to maintain and “clarify” his position that the treaties may be used
as a separate taxing power. The separate taxing power is perhaps the most
contentious aspect of the transfer pricing legislative rewrite as it provides
the Commissioner the potential to recharacterize transactions to reflect what
would be expected to occur between independent parties based on overall
profitability.
11. Available at: http://ministers.treasury.gov.au/DisplayDocs.aspx?doc=pressre-

leases/2011/145.htm&pageID=003&min=brs&Year=&DocType=.
63
For taxpayers with existing intra-group borrowing arrangements with affili-

ates in treaty countries it will be necessary to consider whether these arrange-
ments have resulted in an appropriate profit being retained in the Australian
entity for all financial years commencing after 1 July 2004, as under the
proposed new legislation the ATO will have access to a legislated “profits”
standard (through the Associated Enterprises and Business Profits articles
of the relevant double tax agreements) in assessing the arm’s length nature
of these international related-party transactions.
At present, there is some uncertainty regarding the content of the finalized

legislation; however, the approach to loans and guarantee fees is likely to
be similar to that already described in TR 92/11 and TR 2010/7. Specifi-
cally, it is envisaged that the new legislation will contain additional clarity
regarding the Commissioner’s ability to recharacterize a loan arrangement
and/or hypothesize an “arm’s length” capital structure for the purposes of
determining the arm’s length consideration.
2.3. Intercompany loans
This section discusses the current Australian approach to pricing intercom-

pany loans and is divided into three key sections:
– Loan or equity: Discusses the relevant debt/equity rules and economic

considerations that need to be taken into account in determining whether
an instrument will be considered debt or equity for Australian transfer
pricing purposes.
– Interest charged: Discusses the relevant considerations in relation to

intra-group financing from an Australian transfer pricing perspective
and is divided into two subsections:
– Arm’s length pricing considerations arising from TR 92/11: Out-
lines the key factors to be taken into account based on the guidance
provided in TR 92/11; and
– Considerations arising from TR 2010/7: Outlines the key factors to
be taken into account based on the guidance provided in TR 2010/7.
– Transfer pricing approach: Provides a broad outline of the application of

the comparable uncontrolled price (CUP) method to financing transac-
tions, in the light of the guidance provided by the ATO.
64
Intercompany loans
In addition to the above, reference is made to the pricing of profit partici-

pating loans (PPLs) and other hybrid instruments that include both debt and
equity components.
2.3.1. Loan or equity
Australia has debt/equity rules contained in Division 974 of the ITAA 1997
that apply for debt and equity interests issued from 1 July 2001 and, in lim-
ited circumstances, to certain interests issued before that date. The general
object of this division is to establish a test for distinguishing between debt
and equity interests with a focus on economic substance rather than on
legal form. The test is complex and extends well beyond an examination
of whether a borrower has a non-contingent obligation to repay an amount
of principal.
Broadly, the scope of the debt/equity rules may impact the following:
– the taxation of dividends (including the imputation requirements);
– the operation of Australia’s thin capitalisation rules; and
– the application of non-resident withholding taxes and related measures.
To address the interplay between Division 974 and Australia’s transfer pri-
cing regime,12 the ATO has issued Taxation Determination TD 2008/20.13
The determination outlines that when it is relevant to distinguish between
debt and equity in the application of Division 13, the characterization of
the transaction for Division 13 purposes is not affected by the classification
under Division 974. Here, the determination notes that Division 974 provides
a test for determining whether an interest is to be treated as a debt interest
or an equity interest for particular tax purposes that do not include the ap-
plication of Division 13.
12. Set out in Div. 13 ITAA 1936.

13. TD2008/20, Income Tax: where a taxpayer has supplied or acquired property under
an international agreement and that gives rise to a debt interest or an equity interest as
defined for the purposes of Division 974 of the ITAA1997, does Division 974 bear upon
the characterization to be adopted for the purposes of the application of Division 13 to
the transaction?
65
2.3.1.1. Transfer pricing considerations in relation to debt and

equity
TR 92/11 discusses the treatment of certain funding as debt or equity, which

relates solely to the treatment of funding for the purposes of determining the
arm’s length consideration to be paid and received between the parties (i.e.
the characterization for transfer pricing purposes does not affect the broader
characterization under the debt/equity rules).
Specifically, it is noted that an interest-free outstanding balance may be

considered arm’s length. Predominantly, these situations exist when the
balance is to be treated as equivalent to a contribution to equity. The Com-
missioner quoted the statement in the 1979 Report of the OECD Committee
on Fiscal Affairs, entitled Transfer Pricing and Multinational Enterprises,
which provides that:
Since for tax and other reasons equity contributions may be disguised as loans,
a distinction has to be made between the two. Where it is determined that a
financial transaction is a contribution to the equity of an enterprise, it follows
that no interest is due.
The factors that will be considered by the ATO in determining whether a

particular loan agreement should be treated as equivalent to a contribution
of equity include:
– The legal relationship that is established between the provider of funds

and the recipient. If the legal relationship is that of a creditor and a
debtor, it could generally be expected that Division 13 would be ap-
plied to impute arm’s length interest. If the rights and obligation of the
provider of funds are similar to that of a shareholder (e.g. voting rights,
returns dependent upon profits, etc.), the funds could be treated as equity.
– If the agreement provides for the payment or accumulation of interest,

the agreement would generally be treated as a loan.
– If the loan is repayable upon demand or within a short period of time,

the funds will generally be treated as a loan unless other facts indicate
otherwise.
– If the claim for repayment is not effectively subordinated to the claims

of other creditors, the contribution may be considered as equity.
66
Intercompany loans
– Use of the funds to invest in fixed assets of a long-term nature for use
as core assets of the business may be an indication that the contribution
is by way of equity.
– If the debt/equity ratio is very high compared to the average for the par-
ticular industry or in the country of investment, this is one of the factors
that might indicate that a part of the debt may be equivalent to equity.
– If the funds are contributed by way of a “loan” because of factors affect-

ing the term of investment in the country of investment (e.g. the need
for flexibility due to barriers on repatriation of equity, minimum share-
holdings by domestic investors), the funds may be considered as equity.
– Where, at a particular time, the activity of a business is such that no arm’s

length lender would lend to that business at that time, even on deferred
interest terms, this may indicate that the amount in question could be
equity (e.g. prospecting or exploration). In cases where an affiliated
entity other than the parent is the lender, the question will depend on
whether the non-arm’s length lender was as fully informed as the parent
company and on the security and consideration offered for the loan.
– The absence of a written loan agreement is not an indication that the

contribution is by way of equity.
These are not the only factors that will be taken into account. TR 92/11
outlines that while these and other factors will be relevant, what is important
is the total picture that emerges from the transaction. The taxpayer would
have to establish that the transaction that bears the legal character of a loan
is equivalent to a contribution to equity.
Additionally, during a start-up or market penetration period, it may not

be possible to obtain financing from an unrelated party due to the lack of
security or lack of income flow. Here, the granting of an interest-free loan
may be acceptable and there may be commercial or regulatory reasons as
to why any contribution is structured as a loan versus share capital. An ex-
ample is in the mining and resources industry in the exploration phase where
upfront cash is required, but where third-party loans would generally not be
available due to no income being derived. The funds may be contributed as
an interest-free loan rather than capital as the local regulatory environment
may restrict the ability of the parent entity to recover an equity investment,
but where repayment of debt (including interest free debt) is not subject to
similar restrictions.
67
There is no definition of start-up period; nor is there a provision regard-

ing the length of a start-up period. There is also no requirement that the
lender also supply goods or services to the borrower. The onus would be on
the taxpayer to prove that the amount was akin to equity. Also, it may be
considered whether the arrangement should contain some form of deferred
interest payment.
During financial difficulties, it may not be possible to obtain loans from

independent lenders and pay interest due to the lack of an income flow. Here,
depending on the facts and circumstances, the granting of an interest-free
loan may be accepted. However, the ability of the borrower to obtain fin-
ancing from an unrelated party is only one of the factors to be taken into
account. The possibility of an interest deferral arrangement would also need
to be considered.
2.3.2. Profit participating loans (PPLs) and hybrid debt

instruments
PPLs and hybrid debt instruments differ from “vanilla” loan arrangements
in that they include some component of (usually variable) equity return to
the lender. As discussed above, it is necessary to consider whether such
instruments are characterized as debt or equity from both a transfer pricing
and tax perspective.
As outlined in TD 2008/20, the classification of the arrangement as debt

or equity under Division 974 does not affect the characterization of the
arrangement for transfer pricing purposes.
Where an arrangement is characterized as debt for transfer pricing purposes,

all of the considerations outlined in 2.3.3. below would apply to the pricing
of such instruments. However, as outlined in TR 92/11, if the arrangement,
or some part of the arrangement, is classified as equity or “quasi-equity”,
then the “interest” associated with the arrangement or part of the arrange-
ment should not be charged. As discussed below, TR 2010/7 sets out the
possibility that some part of the arrangement may be treated as “hypothetical
equity” for purposes of pricing the overall arrangement (i.e. interest is not
specifically disallowed but the quantum of interest that may be charged on
the overall arrangement is reduced).
68
Intercompany loans
2.3.3. Interest charged
2.3.3.1. Arm’s length pricing considerations arising from TR 92/11
Further to the above considerations regarding the characterization of an

outstanding intercompany balance as debt or equity for transfer pricing pur-
poses, TR 92/11 provides an overview of the key considerations to be taken
into account in determining arm’s length pricing in relation to an outstanding
intercompany balance. To determine an arm’s length interest rate, all the
relevant facts and circumstances surrounding the loan will be considered.
As outlined in TR 92/11, these include:
– nature and purpose of the loan;
– market conditions at the time the loan was granted;
– amount, duration and terms of the loan;
– currency in which the loan is provided and the currency in which repay-
ment has to be made;
– security offered by the borrower;
– guarantees involved in the loan;
– credit standing of the borrower;
– situs of lender and borrower; and
– prevailing interest rates for comparable loans.
The preferred method for determining the arm’s length consideration in

relation to loan agreements is the CUP method.
For Australian dollar-denominated loans, the appropriate reference rate will

depend on the facts and circumstances of the particular case, however, com-
mon reference rates include the Australian dollar (AUD) London Interbank
Offered Rate (LIBOR), the Bank Bill Swap rate (BBSW) and the AUD
swap rate.
For euro currency and Asian currency loans, the LIBOR and the Singapore
Interbank Offered Rate (SIBOR) may, respectively, be taken as indicative
of the risk-free interest rate. Appropriate margins will be added to this base
rate to reflect the specific terms and conditions of the loan and the credit
risk of the borrower.
To determine the appropriate margin to include on the base interest rate for
related-party loans, the credit rating of the borrowing entity is generally
reviewed absent comparable unrelated-party loans. Where an independent
rating agency has determined a credit rating of the entity this may be used.
However, where an independent rating agency has assigned the credit rating,
69
it is important to consider whether this has been determined on the basis of

the entity being a stand-alone entity or if it has considered that it is part of a
global group. In general, this type of credit rating information is not readily
available and it is therefore necessary to make an independent assessment of
an indicative credit rating (or score) for the borrowing entity. Ratings agen-
cies such as Standard & Poor’s and Moody’s have models available which
determine an indicative credit rating based solely upon various quantitative
factors (e.g. financial performance indicators based on various information
included in the entity’s income statement and balance sheet). This rating
may need to be adjusted in light of various qualitative factors (e.g. market
position, stability of earnings, etc.).
Once a credit score has been assessed, this can then be used to benchmark
appropriate interest rates or margins. Data is available from information
providers such as Reuters and Bloomberg of average bond rates for each
credit score, e.g. A+, A-, etc. Given the small size of the Australian market,
for lower credit scores, information may not be available for the relevant time
period. In this instance, information may be sourced from another market
(most commonly the United States) and foreign exchange swap rates used
to provide an Australian equivalent interest rate.
2.3.3.2. Considerations arising from TR 2010/7
TR 2010/7 indicates that when pricing cross-border intra-group debt, tax-

payers should follow existing ATO guidance, most relevantly TR 92/11 and
Taxation Ruling TR 97/20 (which deals with arm’s length transfer pricing
methodologies). The ruling does not mandate any particular approach; rather,
it stresses the overriding criteria that the taxpayer’s associated enterprise debt
arrangements must reflect a commercially realistic outcome.
A taxpayer must assess whether the pricing of its intra-group debt makes
commercial sense in the taxpayer’s circumstances. When it is considered
that the intra-group debt pricing results in financial costs that do not leave a
commercially realistic return for the taxpayer’s relevant business activities,
the Commissioner contends he has the power to look beyond the usual trans-
fer pricing methods and substitute an arm’s length capital structure when
determining the arm’s length interest rate. This is an issue that is subject to
contention and will hopefully be clarified, at least on a prospective basis,
with the issuance of revised transfer pricing legislation.
70
Intercompany loans
It is not acceptable to the Commissioner for taxpayers simply to determine a

market price for the actual level of intra-group debt. Rather, an assessment is
required as to whether the level of funding costs result in an overall financial
outcome that is commercially realistic for the individual taxpayer.
The ruling outlines two relevant considerations which may be appropriate

to ensure that the outcomes are commercially realistic, while noting they
are not necessarily the only considerations:
– The first is the “financially independent” or “arm’s length capital struc-

ture” consideration. This consideration requires an assessment of the
level of debt the taxpayer would have borrowed if it were acting as a
financially independent entity.
– The second, generally known as “parental affiliation” consideration,

looks at whether the credit rating of the parent is relevant for setting the
interest rate payable by a subsidiary entity on the debt.
While the ruling stresses that it does not require a taxpayer to work out an
arm’s length amount of debt to demonstrate that the pricing of its debt is
consistent with the transfer pricing provisions, it does state that taxpayers
must always assess whether the associated enterprise debt arrangements
reflect a commercially realistic outcome. It would appear that the only way
this can be done is for a taxpayer to assess what an arm’s length capital
structure would be for the entity if it were acting financially independently.
In general, the ATO would expect to see some indication of the process un-
dertaken in determining whether the actual capital structure is arm’s length.
One method would be to benchmark the actual capital structure of the tax-
payer against that of comparable entities operating in the same industry,
for example by comparing the debt to equity ratios of the relevant entities.
Based on recent experience, the ATO approach is also likely to involve a
determination of whether the borrower’s profit before tax is also commer-
cially realistic when benchmarked against other comparable companies.
This profits based approach can raise significant issues with the relevant
treaty partner where a transactional or market-based approach would support
the interest deduction. This approach is more likely to be pursued by the
ATO given the recent exposure draft, which specifically provides for such
a profits-based approach.
Further, the ruling notes that when the operations of the borrower are core
to the group, “in the sense that its functions are a vital part of an integrated
71
business”, it would generally be expected that the borrower company would

have the same credit rating as its parent. Accordingly, most taxpayers will
now be required to assess whether their cross-border intra-group debt fits
within an arm’s length capital structure and whether its operations are so core
to the global group that the parent company credit rating is the appropriate
rating to apply to the borrowing. These considerations exist even if the debt
levels fall within the thin capitalisation safe harbour amounts.
Notwithstanding the above, TR 2010/7 indicates that it is not intended to

override the thin capitalisation rules. Rather, the ruling suggests that any debt
deductions which need to be considered for thin capitalisation purposes must
previously have been concluded as being deductible under all other parts of
the tax legislation. The ruling suggests that this indicates that any amounts
considered as debt deductions under the thin capitalisation rules must have
already been determined as deductible under the transfer pricing rules; i.e.,
the amounts for which a taxpayer seeks to claim a deduction must have been
determined at arm’s length. Therefore, although it is necessary to apply the
transfer pricing rules in advance of the thin capitalisation rules to determine
an arm’s length outcome (e.g. interest rate), the amount of debt to which
such an outcome applies is determined under the thin capitalisation rules.
This is detailed in the example at 2.3.5. below.
2.3.4. Transfer pricing approach
Further to the above considerations, the following section includes a detailed

step plan indicating how the CUP method may be applied in practice.
2.3.4.1. Steps in the application of the above approach
The CUP method is generally preferred in assessing intra-group financing

arrangements. The CUP is applied based on either internal or external com-
parable data.
To consider all the principles outlined in TR 2010/7, taxpayers will need

to address the following steps when pricing cross-border intra-group debt.
Step 1: Determination of legal entity – For the purpose of the analysis, it

is important to determine the legal entity that has undertaken the borrow-
ing. Consideration also needs to be given as to whether there are financial
guarantees provided by other group members in the group in respect of the
72
Intercompany loans
borrowing. If so, it may be appropriate to analyse the consolidated Australian

group’s financial position, or some other entity combination, rather than just
the borrowing entity.
Step 2: Comparable uncontrolled transactions – Has the group entered

into any comparable independent party transactions? In this analysis it is
important to consider carefully the terms and conditions of the debt and the
relevant borrowing entity. We often find that external-party debt is senior to
any related-party debt. The different levels of subordination means the exter-
nal interest rate is not an appropriate arm’s length rate for the internal debt
unless appropriate adjustments can be made. Also, if a different entity has
undertaken the external versus internal borrowing then a direct comparison
of interest rate is not appropriate either. A letter from a bank offering a par-
ticular interest rate is not considered robust evidence of an independent-party
transaction by the ATO. This is because these letters rarely represent a bind-
ing contract and the terms and conditions of the actual related-party borrow-
ing have usually not been adequately considered in the bank’s offer letter.
Step 3: Establish stand-alone credit rating of borrower – Where an indepen-

dent rating agency has determined a credit rating of the borrowing entity
this may be used. However, this will only be useful if the independent rat-
ing agency has assigned the credit rating on the basis of the entity being
a stand-alone entity having regard to adjustments that may be required to
comply with TR 2010/7. In general, this type of credit rating information is
not readily available and it is therefore necessary to make an independent
assessment of an indicative credit rating (or score) for the borrowing entity.
Ratings agencies such as Standard & Poor’s and Moody’s have models
(available for external license) which determine an indicative credit rating
based solely upon various quantitative factors. This rating may need to be
adjusted in light of various qualitative factors, e.g. market position, stability
of earnings, etc.
The determined credit rating can then be applied to the terms and conditions
of the loan and an appropriate interest rate determined. Prior to the finali-
zation of the ATO’s views in TR 2010/7, it was considered that this interest
rate would then represent an arm’s length rate. However, the final ruling
(and the draft ruling before it) have now outlined that the ATO considers
the following additional steps are also necessary.
Step 4: Financial independence criteria – An analysis is now required as

to whether the capital structure adopted by the taxpayer may be considered
arm’s length in light of its specific facts and circumstances (e.g. maturity,
73
industry, etc.). To make this assessment, taxpayers will need to benchmark

how independent parties in their industry structure their financial arrange-
ments, and make an assessment of what constitutes an arm’s length capital
structure. If it is determined that the actual level of debt is above an arm’s
length amount, then an arm’s length capital structure needs to be substituted
when performing the analysis in Step 3. This will then result in a higher
credit rating and thus lower interest rate being determined in respect of the
borrowing.
Step 5: Parental affiliation criteria – An analysis of the relative importance of

the borrowing entity to the global group is now required. If it is considered
that the operations of the borrower are core to the group, in the sense that
its functions are a vital part of an integrated business, the ATO considers
that the global group would not let the borrowing entity default on its debt
obligations. Therefore, the ATO considers in this circumstance that the bor-
rowing entity effectively shares the same credit rating as its parent or global
group. There is also the potential for partial notching of the stand-alone
credit rating determined up to Step 4, if the borrowing entity is considered
strategically important to the group, but not core. Again, this step has the
impact of improving the borrowing entity’s credit rating and thus decreasing
the determined interest rate.
Additional consideration is necessary when the parent entity has assumed

some portion of the default risk of the subsidiary, e.g. through the provision
of a performance guarantee. This is relevant for limited risk distribution
arrangements when the parent entity provides a guaranteed return to an oper-
ating subsidiary. Here, there is likely to be a stronger argument for notching
the subsidiary credit rating up towards the parent rating, as the default risk
of the parent entity (in relation to the intercompany performance guarantee)
may be a more accurate indication of the credit risk of the subsidiary.
If the parental affiliation criterion is the dominant factor in determining a

credit rating for the borrowing entity, then it is possible to skip Step 4 and
move straight to the parent or global group’s credit rating, as this will gen-
erally be a higher rating than the local borrowing entity.
Step 6: Application of credit rating to terms and conditions of borrowing –

The resultant credit rating is then applied to the specific terms and conditions
of the loan to determine an arm’s length interest rate. As outlined above, this
rate is then applied to the actual amount of debt allowable under the thin
capitalisation provisions. The terms and conditions to consider include: time
to maturity, currency, fixed or floating rate, level of subordination, security
74
Intercompany loans
provided and payment in kind (most commonly the ability to capitalize

interest).
2.3.4.2. Impact of ordering of the above steps
When no one factor is dominant in determining a credit rating for the borrow-
ing entity, the order of application of the above steps may have a substantial
effect on the final determined arm’s length credit rating and interest rate.
For example, first notching the credit rating of the subsidiary based on paren-
tal affiliation may result in a credit rating which is subsequently considered
representative of an arm’s length capital structure (e.g. if the credit rating
is notched from BB to BBB). In such a case, it may be concluded that an
arm’s length interest rate may be determined based on a credit rating of BBB.
By contrast, first notching based on financial independence may then require

additional notching to address the parental affiliation criterion (e.g. notching
from BB to BBB- based on financial independence and subsequently notch-
ing up again to A- based on parental affiliation). That is, based on the same
facts, applying the steps in a different order may result in a different conclu-
sion as to the arm’s length credit rating (in this case, A- compared to BBB).
Therefore, in the absence of specific guidance from the ATO specifying the
order of application of the three key considerations, there is potential for
controversy in the way in which a taxpayer applies the principles outlined
in TR 2010/7, even when each principle is applied appropriately.
2.3.4.3. Potential adjustments when the financing transactions

produce non-commercial outcomes
When the Commissioner concludes that the financing transactions in their

totality result in a non-commercial outcome for the business (as represented
by the overall profitability of the controlled entity), the Commissioner may
seek to apply the additional powers granted under the transfer pricing pro-
visions to adjust the other international related-party transactions (IRPT) of
the taxpayer to ensure the pre-tax outcome is “commercially realistic”. Here,
we have summarized below four possible scenarios and the likely position
of the Commissioner in relation to the Australian taxpayer’s transfer pricing
arrangements.
75
Notes
Notes
Notes
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Transfer Pricing and Intra-Group Financing

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Title: Transfer Pricing and Intra-Group Financing

• IBFD Print books

IBFD, Your Portal to Cross-Border Tax Expertise

1.1. General considerations: The change in (market)

2.1. Corporate income tax framework 57

2.3.1.1. Transfer pricing considerations in relation to debt

2.5.3. Allocation of cash pool benefit 89

3.1. Corporate income tax framework 97

3.2.11. Subordinated loans 130

Chapter 4: Canada 141

4.1. Corporate income tax framework 141

4.1.2.4. Documentation requirements 148

4.8. Sectors 169

Chapter 5: China 173

5.1. Corporate income tax framework 173

5.5. Factoring 194

Chapter 6: France 209

6.1. Corporate income tax framework 209

6.2.1. Loan or equity 220

Chapter 7: Germany 241

7.1. Corporate income tax framework 241

7.1.5. Tax rates 242

Chapter 8: India 271

8.1. Introduction 271

8.4.4. A parent company provides a guarantee to a

Chapter 9: Ireland 299

9.1. Corporate income tax framework 299

9.3.4. A parent company provides a guarantee to a

Chapter 10: Japan 331

10.1. Corporate income tax framework 331

10.3. Guarantee fees 340

Chapter 11: Luxembourg 361

11.1. Corporate income tax framework 361

11.1.3. Taxable income 363

Chapter 12: Mexico 383

12.1. Mexico overview 383

12.4.1. A parent guaranteeing the debt of a wholly owned

12.12.3. Timing 414

Chapter 13: Netherlands 417

13.1. Corporate income tax framework 417

13.3.2. A parent or offshore associate provides debt funding

Chapter 14: South Africa 447

14.1. Corporate income tax framework 447

14.1.7. Transfer pricing framework 450

14.7.1. General 470

Chapter 15: Switzerland 477

15.1. Corporate income tax framework 477

15.3.7. Requirement for outcome to make commercial sense 493

Chapter 16: United Kingdom 505

16.1. Corporate income tax framework 505

16.3.1. Loan or equity 512

Chapter 17: United States 527

17.1. Corporate income tax framework 527

17.3.1.1.1. Transfer pricing methods for benchmarking

17.7. Other forms of financing and credit risk

Paul Balkus and Melissa Heath*

This chapter is based on information available up to 2 March 2012.