When an entity is part of a multinational group, it can access better financing terms than it would if it operated completely independently. In Transfer Pricing, this effect may be due simply to the fact that the entity belongs to a financially sound group.
For instance, a bank may consider the entity to pose a lower credit risk, given its affiliation with a financially sound group, even if the parent company has not provided a formal guarantee.
The OECD Guidelines on Financial Transactions address this phenomenon under the concept of implicit group support or implicit support. The OECD recognizes that this effect can influence an entity’s credit rating and financing terms, but it also states that the benefit derived exclusively from belonging to the group does not generate remuneration by itself.
Implicit Support vs. Explicit Guarantee
The distinction between these two concepts is crucial.
Implicit support refers to the benefit an entity obtains simply by belonging to a business group. There is not necessarily a contractual commitment by the parent company or a legally enforceable obligation to back the subsidiary’s obligations.
In this scenario, the improved financing terms are considered an incidental benefit derived from the passive association with the group and not a controlled transaction that must be compensated.
The situation is different when an entity within the group provides an explicit guarantee—that is, it formally assumes a legally enforceable commitment regarding the borrower’s obligations.
However, the existence of a formal guarantee does not automatically mean that a fee must be charged. First, it must be analyzed whether such a guarantee provides the borrower with an additional economic benefit beyond what it would already obtain from the implicit support derived from its membership in the group.
When the guarantee effectively improves financing terms—for example, by allowing access to a lower interest rate or a higher level of indebtedness—arm’s-length compensation may be appropriate for that incremental benefit.
Why does this distinction matter for the analysis of interest rates?
Implicit support takes on particular significance when determining the interest rate applicable to an intragroup loan.
To establish an arm’s-length rate, it is necessary to analyze the borrower’s credit quality. However, this assessment should not necessarily be limited to a completely isolated or stand-alone rating.
Membership in the group may influence an independent lender’s perception of the borrower’s ability to meet its obligations.
Therefore, it is necessary to analyze the level of implicit support that the entity could reasonably expect to receive based on its specific circumstances and its position within the group.
Completely ignoring this effect could lead to assigning the borrower a credit rating lower than what the market would recognize and, consequently, result in an artificially high fully competitive interest rate.
Implicit support does not automatically equate to the group’s credit rating
Recognizing the existence of implicit support also does not mean automatically assigning the borrower the same credit rating as the group or its parent company.
The OECD notes that the impact of belonging to the group will depend on the specific circumstances of each entity.
Factors that may be relevant include:
- the entity’s strategic importance within the group;
- its degree of operational integration;
- the connection between its activities and the group’s main lines of business;
- the potential reputational consequences for the group in the event of a default;
- the history of support provided to other entities in similar circumstances; and
- the group’s general policies regarding financial support for its members.
A highly integrated and strategically relevant entity could receive a higher level of implicit support than one whose activities are less significant to the group.
Therefore, the adjusted credit rating should not be automatically equated with either the entity’s fully independent profile or the group’s consolidated rating.
How should implicit support be documented in practice?
An analysis of intragroup financing that takes implicit support into account should clearly explain how the borrower’s credit quality was determined and what effect its membership in the group had.
The documentation should support, among other things, the entity’s stand-alone credit rating, its relative importance within the group, the level of implicit support that can reasonably be expected, and the effect of such support on the rating used to determine the arm’s-length interest rate.
It is also important to avoid two extremes: completely ignoring the entity’s group affiliation or assuming that this automatically equates to an explicit guarantee from the parent company.
The analysis must reflect the actual economic circumstances of the transaction and the behavior that an independent lender would reasonably exhibit toward an entity with comparable characteristics.
A Key Consideration in Intragroup Financial Transactions
Implicit support demonstrates that determining an arm’s-length interest rate does not depend solely on the contractual characteristics of the loan.
It also requires analyzing the economic environment in which the borrower operates and the influence that its membership in a multinational group may have on its credit risk.
Properly identifying this effect helps avoid both overestimating and underestimating the entity’s risk and contributes to establishing an interest rate consistent with the arm’s-length principle.
At TPC Group, in every intragroup financing analysis, we assess the level of implicit support that should reasonably be recognized in the borrower’s credit rating, with the goal of supporting a technically defensible arm’s-length interest rate.
Source
OECD — Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022