The Internal Revenue Service (IRS) recently issued a nonbinding Generic Legal Advice Memorandum (GLAM) that provides advice on Internal Revenue Code Section 482 and so-called implicit parental support. Consistent with prior IRS positions advanced in the examination phase, at the IRS Independent Office of Appeals, and in an ongoing litigation, the GLAM concludes that the IRS may consider group membership in determining the arm’s length rate of interest chargeable for intragroup loans.
Because the guidance[1] was issued in nonbinding form and is consistent with the IRS’s recent position in prior matters, this guidance will likely have little effect on taxpayers facing this issue. The IRS may have issued this guidance simply so that all Examination teams apply what has become their already standard position uniformly.
Below we examine the GLAM and provide our views on potential areas to which taxpayers should pay particular attention.
BACKGROUND
Section 482 seeks to ensure that “taxpayers clearly reflect income attributable to controlled transactions” by determining the “true taxable income” of controlled taxpayers. The Treasury Regulations under Section 482 provide guidance for determining arm’s length charges on intragroup lending arrangements. The Section 482 transfer pricing regulations currently do not expressly address whether implicit parent support must be considered in pricing intercompany debt. The regulations provide:
Where one member of a group of controlled entities makes a loan or advance directly or indirectly to, or otherwise becomes a creditor of, another member of such group and either charges no interest, or charges interest at a rate which is not equal to an arm’s length rate of interest (as defined in paragraph (a)(2) of this section) with respect to such loan or advance, the district director may make appropriate allocations to reflect an arm’s length rate of interest for the use of such loan or advance.
The regulations under Section 482 define an arm’s length rate of interest as 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.” The regulations explain that “[a]ll relevant factors shall be considered, including the principal amount and duration of the loan, the security involved, 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.”[2]
Taxpayers and the IRS have long contested whether the “credit standing of the borrower” includes the borrower’s standing and position within a multinational group. This concept of considering a borrower’s position within a group of related entities is known as implicit parental support (IPS). According to the IRS,[3] taxpayers must evaluate whether IPS applies to its intracompany lending under Section 482. This implicit support generally reflects the expectation that a parent or affiliate company will step in to support a subsidiary in the event of the subsidiary’s financial difficulty and help the subsidiary meet its debt obligations.
In other words, “implicit support” is the assumption that a corporate parent or affiliate would perform the same role as an explicit guarantor despite the fact that no explicit, legally binding guarantee exists. Because interest rates are generally tied to the riskiness of any lending, if IPS applies to a particular loan, that loan may be considered less risky based on these facts and circumstances, and the lending entity may be entitled to a lower interest rate.
Since 2021, the IRS has included in its Priority Guidance Plan a regulatory project to “clarify[] the effects of group membership (e.g., passive association) in determining arm’s length pricing, including specifically with respect to financial transactions.” In recent webinars, the IRS previewed that it planned to issue advice on this issue in subregulatory guidance before being able to propose or finalize any regulations on the topic.[4] On December 29, 2023, the IRS issued the promised subregulatory guidance.
GLAM AM 2023-008 addresses whether group membership could be considered in determining the arm’s length rate of interest chargeable for intragroup loans. Under the fact pattern, a foreign parent directly owned 100% of the equity of a US subsidiary, which owned “operating assets and operates businesses essential to the group’s financial performance.” Because of the essential nature of the subsidiary, the IRS explained that the foreign parent would be likely to provide financial support—by either contributing capital to the subsidiary or forgiving debt owed to it by the subsidiary—if the subsidiary’s financial condition deteriorated.[5]
Under the fact pattern, the IRS treats the loan as bona fide debt. An independent rating agency[6] has rated the foreign parent with a credit rating of A, the subsidiary with a standalone credit rating of B, and, when IPS is considered, rated the subsidiary with “a one-notch lower credit rating of BBB [from its parent], reflecting both its standalone credit profile and the group’s group credit profile.”
These credit ratings reflect the following potential commercial market interest rates, which are generally determined based on a suitable analysis depending on the date of issuance and debt terms:[7]
The foreign parent lends to its subsidiary at an interest rate of 10%. Under the IRS’s analysis, the subsidiary’s “credit rating of BBB reflects a two-notch increase over the rating it would have if it were an independent entity, which increase is based on the implicit financial support” of the group. As such, under these facts and circumstances, the IRS concluded that it could adjust the interest rate of the foreign parent’s loan to its subsidiary to 8% based on a rating of BBB.
INITIAL THOUGHTS
‘Formalizing’ the IRS’s Position
Based on our experience with Examination and Appeals, the IRS is merely “formalizing” its litigation position with respect to implicit parental support that it is applying retroactively to related-party loans made in prior years. The IRS has made clear in each forum that implicit parental support should be considered, and no compensation is due to the group based on the principles of passive association. This is similar to positions explained by the IRS during public webinars[8] and therefore does not trod much new ground.
Nevertheless, while taxpayers continue to wait on Treasury Regulations to address this issue,[9] it is important to recall that the GLAM is merely “non-binding subregulatory guidance.” This means that, generally, the IRS will not rely on a GLAM to seek deference for this position.[10]
Its import in litigation thus is modest at best. In ongoing exams and litigation,[11] then, this “formalization” should not be seen as an additional arrow in the IRS’s quiver. Instead, because this guidance is from James Kelly, Chief Counsel for Controversy and Litigation, it is almost certainly the position of the IRS National Office and thus provides insights in the IRS’s current analysis of this issue.
Commercial Lenders Consideration of Credit Profiles
The IRS only lists two items that credit rating agencies may take into account in determining both standalone and group credit profiles: (1) the relationship of the entity’s businesses and assets to the overall group and (2) the likelihood that another group member would provide financial support if the entity were in financial distress.
As an initial matter, neither of these considerations is relevant to the standalone credit profile of a subsidiary.[12] Instead, both relate to considerations with respect to the effect and magnitude, if any, of IPS. Moreover, while these are two items that credit rating agencies, such as S&P’s and Moody’s, may take into account when deriving a credit rating, there are many other items that are also taken into account.[13]
If the IRS is attempting to analyze what commercial lenders would do when determining the risk involved in extending credit, these two items are not an exhaustive list for group support and lack any helpful guidance in first determining a standalone credit profile or rating.
As it relates to group support, S&P’s and Moody’s criteria generally requires assessment of the strategic importance of the subsidiary to evaluate the parent’s economic incentives and ability to provide support.[14] The criteria expressly listed in the GLAM focuses more on the parent’s economic incentive to provide support, but not on the parent’s ability to provide such support.
The IRS’s Position Potentially Contains Internal Inconsistencies
Similar to prior cases that we have dealt with, the IRS’s position contains internal inconsistencies: the IRS contends that the hypothetical pricing structure involves a loan from an unrelated lender but, at the same time, suggests that the loan at issue would—or could—be forgiven by the group if faced with future financial duress.
On one hand, the IRS rejects the hypothetical scenario that the foreign parent should be treated as the creditor for purposes of pricing under Section 482. In the IRS’s view, “that the controlled lender is the borrower’s parent, is assumed away, as the central hypothesis of the arm’s length standard is—‘uncontrolled taxpayers . . . engaged in the same transaction under the same circumstances.’” Thus, the debt from the controlled transaction must be treated as coming from an unrelated lender.
On the other hand, the IRS contends that when determining the riskiness of the loan, the group may provide assistance to a distressed subsidiary by forgiving debt, potentially including the debt from the controlled transaction. The guidance provides that the foreign parent “might contribute capital to USSub or forgive debt owed to it by USSub.” On its face, it is unclear whether “debt forgiveness” could—or should—include the debt from the controlled transaction.[15]
Following the IRS’s central hypothesis that the creditor in this hypothetical is an uncontrolled party, then it should be without controversy that an unrelated lender would not consider itself forgiving the debt at issue when determining the likelihood of a group member providing financial support.
While such a position may seem obvious based on the IRS’s Section 482 construct, the IRS has argued in prior cases that both the debt is from an unrelated lender and that the parent would forgive the debt at issue in times of distress.
‘Essential’ Subsidiary and Notching
Under the facts, the US subsidiary owns operating assets and operates businesses essential to the group’s financial performance. Such a factual finding can be important in determining the strategic importance of the subsidiary and evaluating the parent’s economic incentives to provide support. In such a scenario, a parent and group may have a strong incentive to provide support (if possible) to the distressed subsidiary. Based on this factual finding, the IRS contends that the subsidiaries standalone rating of B should be increased “two-notches” to BBB so that it is “one-notch-lower” than its foreign parent’s rating.
The “essential” designation does not directly map to either S&P’s or Moody’s guidance, however. But an estimate can be deduced based on the notches. For example, the primary S&P’s guidance on group support that was effective during many years under Examination by the IRS was released in 2013.
Under that guidance, S&P defines five categories of group status from “nonstrategic” to “core.” These categories indicate S&P’s views of the likelihood that an entity will receive support from the group.
Based on the IRS’s view that the subsidiary is “essential” and is notched to a level one below its parent, we can surmise that the IRS views this type of subsidiary as “highly strategic” based on S&P’s categories—“Almost integral to the group’s current identity and future strategy. The rest of the group is likely to support these subsidiaries under almost all foreseeable circumstances.” As a consequence, S&P’s guidance provides that this subsidiary may be one notch below the group credit profile. On the other end of the spectrum, a “nonstrategic” subsidiary will generally retain its standalone credit rating despite being part of a larger group.
Finally, based on our past experience in this area and prior IRS positions during Examination and Appeals, the notching regime used in the GLAM is inconsistent with published S&P’s and Moody’s guidance. As noted previously, the IRS contends that, based on an independent credit rating agency’s analysis, the subsidiary’s standalone rating is a B, the subsidiary’s rating taking IPS into account is BBB, and the parent’s credit rating is an A. Under the IRS’s regime, the increase from a B to a BBB is “two notches” and the notch from BBB to A is only a single notch. This approach is inconsistent with our experience with notching used by commercial lenders applying S&P’s and Moody’s guidance and is also inconsistent with how IRS and their experts have applied the notching regime in prior cases.
For S&P and Fitch, each credit rating includes a “+” and a “-” for each letter.[16] For example, a credit rating of B would also include a credit rating of B+ and B-, with each rating qualifying as a single notch. In the GLAM, the IRS disregards these additional ratings for simplification. However, in prior cases, the IRS has treated an increase from a B to BBB as six notches instead of two.[17] Such a difference in credit ratings (six notches up instead of two) may have a material impact on the corresponding interest rates applicable to the intragroup debt.
The IRS attempts to justify its notching approach in a footnote by explaining without citation or justification that “[u]nder these facts, the one-notch difference disregards that certain ratings may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.” However, this simplification is potentially (if unintentionally) misleading, and taxpayers will need to gird themselves for the reality of the IRS’s notching application as compared to its hypothetical application.
IPS Should Require Compensation
The GLAM concludes that similar to controlled services transactions—where no compensation is owed for any benefit arising solely from passive association—in the intragroup lending context, absent a guarantee or legally binding credit support, the borrower is not required to compensate any affiliate.[18]
In total, the two-sentence explanation does not provide adequate support for this proposition given longstanding, compelling arguments from taxpayers that providing implicit support utilizes a parent’s finite credit profile, which is a detriment to the parent, distinguishing it from passive association.[19] Ignoring IPS in the intragroup lending context eliminates this “free rider” problem and produces essentially the correct economic result as the standalone credit rating would compensate the parent lender for any potential IPS through a higher interest rate.
CONCLUSION
Because the IRS proposed this guidance in nonbinding form and it is generally consistent with prior positions, it is unclear what immediate impact it will have. For the IRS, hopefully it will receive and implement feedback from taxpayers in any future regulations on this topic. As for taxpayers, they should continue to track this issue moving forward, consider this guidance when issuing new intracompany debt, and provide any additional feedback if and when proposed regulations are issued.
[1] AM 2023-008 (Dec. 29, 2023).
[2] The IRS contends that its position is generally consistent with the OECD Transfer Pricing Guidelines. See OECD, Transfer Pricing Guidance on Financial Transactions (February 2020).
[3] Taxpayers have a myriad of counterarguments, including that treating the foreign parent as related to the US subsidiary and potentially providing support is contrary to the arm’s length standard that treats the parties as unrelated. As many of these counterarguments have been covered at length in various public papers, they are not rehashed here. See, e.g., American Bar Association, Comments and Recommendations for Guidance to the Transfer Pricing of Related Party Guarantees (Sept. 13, 2012).
[4] Transfer Pricing Developments and Planning, Practicing Law Institute Webinar (Sept. 13, 2023); APAs/MAPs and BEPS 2.0, Public Country-by-Country Reporting and Implicit Parental Support...Hot Transfer Pricing Topics Examined!, American Bar Association Webinar (Oct. 16, 2023).
[5] The IRS concludes that the same analysis would apply to lending between corporations in a brother-sister relationship.
[6] As noted in the GLAM, where ratings are not actually obtained by an independent rating agency for the borrower, a taxpayer and Exam may conduct “shadow ratings.” Because an independent rating agency has rated the relevant entities under this fact pattern, there is no need to conduct full “shadow ratings.” However, a taxpayer should consider how the debt from the controlled transaction may affect the rating from the independent rating agency: if the borrower was rated before the debt at issue, there should be consideration if the new debt would change the assigned rating, and, if the borrower was rated after the debt at issue, it should be understood how the rating agency treated the debt at issue to make sure it was consistent with the IRS’s central hypothesis of debt between unrelated parties.
[7] Generally, both the IRS and taxpayers apply a CUT-like approach to price intracompany debt by locating comparable debt. This comparable debt will result in a range of interest rates for the same credit rating because different lenders apply different subjective factors to the same ratings in determining their required interest rates. Arm’s length behavior therefore leads to a range, not a point; as such, a range of interest rates could satisfy the arm’s length standard.
[8] See supra n.4.
[9] See, e.g., David Stewart, Officials Engage Practitioners on Pricing of Guarantee Fees, Tax Notes Today (May 10, 2010); 2021-2022 Priority Guidance Plan (Sept. 9, 2021).
[10] Policy Statement on the Tax Regulatory Process (March 5, 2019).
[11] See Eaton Corp. & Subsidiaries v. Commissioner, Docket No. 2608-23.
[12] See, e.g., S&P Global Ratings, Corporate Methodology (Nov. 19, 2013). In a recent PLI presentation, which included an IRS speaker, some of the criteria for determining a credit rating of the borrower were discussed. See PLI’s Application of the Arm’s-Length Standard to Related Party Debt, slide 9 (Jan. 8, 2024).
[13] See, e.g., S&P Rating Services, General Criteria: Group Rating Methodology (Nov. 19, 2013).
[14] The credit profile evaluation for both the standalone and group rating may require the testimony of an expert witness to evaluate the facts and circumstances surrounding a given loan.
[15] For example, the IRS states that the “controlled lender is expected to enforce repayment of the debt according to its terms as in an arm’s length bona fide lending.” This suggests that the IRS does not believe the group may forgive the debt at issue.
[16] Moody’s has a different designation but includes the same number of ratings as S&P and Fitch.
[17] This would include going from B to (1) B+, (2) BB-, (3) BB, (4) BB+, (5) BBB-, and finally (6) BBB.
[18] The final 2009 service regulations, which include the passive association provisions, explained that “financial transactions” were excluded from coverage. See 74 FR 38830-01, 38835-36.
[19] American Bar Association, Comments and Recommendations for Guidance to the Transfer Pricing of Related Party Guarantees at 56 (Sept. 13, 2012) (“The ‘no affiliation’ model addresses the free rider problem.”).
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