How to determine the market value of interest on loans to associated companies

 

Associated companies frequently issue loans to each other, which must, like other transactions between associated companies, conform to market value. Currently, this issue has received additional topicality due to the fact that interest payments that exceed their market value are considered to be equivalent to dividend payments. This means that the issue of determining the market value of interest rates will become more topical.

There is no single “correct” approach to evaluating the market value of the interest rate. In our practice of interest rate research, we have used commercial data bases (for instance, Bloomberg), as well as publicly available statistical data (statistics of the Bank of Latvia).

In theory and in practice, the method of comparative uncontrolled prices by using either internal comparative data or external comparative data is used to substantiate the conformity of the interest rate to the market value.

The analysis of factors that affect pricing policy must be made first to identify comparable transactions, i.e. transactions that are similar enough to prevent the possibility of their differences affecting the price, or transactions, where the effect of differences could be corrected by means of mathematical calculations. In the event of a loan contract, the most significant parameter of comparison is the credit capacity (rating) of the borrower, however, the evaluation of the time of loan issue, the sum of the loan, the collateral, the period of the loan, etc., is also important.

So far the theory is clear, however practice poses difficulties; first of all – in determining the credit capacity of the tested company and secondly – in obtaining the data from comparable companies.

During the first step, the methodologies developed by international credit rating agencies that enable the analysis of the credit rating (for instance, Moody’s, Standard & Poor’s) are usually used to determine the credit capacity.

During the second step, the comparable data are sought, by using commercial data bases that either contain data on, for example, corporate bonds (for instance, Bloomberg data base), or on interest rates on the loans (for instance, Bureau van Dijk data base).

  1. A case example. A Latvian company has received a loan from a Cyprus-based parent company. The interest rate is 3% or lower.

In this situation, the simplest method involves analysis of the statistical data of the Bank of Latvia. Although, in terms of transfer price theory and methodology, the comparison of interest rates on the loans issued by intermediary companies and credit institutions is not correct, in practical terms such data are usually sufficient, especially, if the loan is not too big.

However the condition that the lender (Cyprus-based company) must perform certain functions and assume certain risks associated with the issue of such loan must be taken into consideration. If the issuer of the loan fails to perform functions and assume risks, they can only claim a risk-free interest rate. Thus, if the lender is, as it is popular to call them nowadays, “a shell company”, a 3% interest rate may also be above the market level.

  1. A case example. A Latvian company has received a loan of  1,000,000 euros from a Cyprus-based parent company. The interest rate is 8%, namely – 80,000 euros per annum

This is definitely a high-risk transaction that needs to be evaluated. The excess interest rate over the, for instance, statistical rate of 3%, namely, 50,000 euros can be considered a hidden dividend and respectively corporate income tax amounting to 20/80 x 50,000 = 12,500 euros would be payable, or the interest rate must be substantiated.

Is it possible to substantiate an 8% interest rate? This depends on multiple factors. Inter-company interest rates will be higher than interest rates on bank loans due to several reasons, but mainly due to the existence of functional differences – banks grant loans to companies with higher credit rating, etc.

Probably, in this case the information on corporate bonds with the coupon rate reaching and exceeding, for example, the 10% mark, could be used to substantiate the 8% interest rate.

  1. A case example. A Latvian company has received a loan of 1,000,000 euros from a UK-based parent company. The interest rate is 15%, namely – 150 000euros per annum. Can this rate be substantiated?

Most probably, this rate cannot be substantiated, unless the business specialises in the issuing of consumer loans, namely has a very high risk of bad debts.

  1. A case example. A Latvia-based company is a lender. This is not a frequent situation, however, here we face a different problem. It is not uncommon for Latvia-based companies to issue loans at a low interest rate, for example 1%. In practice, there have been situations, where attempts were made to compare the issued loans with deposit rates, which have not received the support of the State Revenue Service (SRS). Here we must agree to the tax administration that inter-company loans cannot be compared to deposits merely for the reason that the acceptance of deposits is the service provided by credit institutions and that companies do not have the right to provide this service. Meanwhile, the OECD transfer pricing guideline provides that capital without functionality may generate no more than a risk-free return, ensuring that the cash box must not receive an additional return without appropriate justification. Thus, in my opinion, if a Latvia-based company has free funds that they would gladly lend to an associated foreign company, this argument can serve as the point of reference to analyse situations, where free cash is lent to associated companies. I also hold the opinion that this norm of OECD guideline can be used to substantiate the low interest rate in cash-pool transactions by the company that invests their free funds (or simply allows one to consolidate them for the needs of the group).

 

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