Intra-group loans
In the case of an intra-group loan, an associated lender will not necessarily perform all of the same functions at the same intensity as an independent lender. However, in considering whether a loan has been advanced on conditions which would have been made between independent enterprises, the same commercial considerations and economic circumstances are relevant.
Questions and answers in connection with intra-group loans
Here you will find information on various transfer pricing topics in connection with cross-border transactions. This information is intended to provide clarification on selected issues. It is general in nature and cannot be used as the sole basis for the tax assessment of a specific fact pattern.
Certain administrative instructions issued by the FTA are applicable to financial transactions. These are namely the circular letters published annually by the FTA on the interest rate recognised for tax purposes for advances or loans in Swiss francs or foreign currencies, and FTA circular no. 6 of 6 June 1997 on hidden equity in corporations and cooperatives. These administrative instructions represent "safe harbour" regulations which are not binding for foreign tax administrations.
Chapter X of the OECD Transfer Pricing Guidelines contains specific guidelines for applying the arm's length principle to intra-group financial transactions, in particular treasury activities, including intra-group loans.
The FTA circular letters on interest rates recognised for tax purposes on advances or loans in Swiss francs and foreign currencies contain interest rates for different categories of transactions, and are intended to simplify the application of the arm's length principle. If taxpayers decide to apply the safe harbour rates, they do not have to demonstrate that the interest rate applied to a transaction complies with the arm's length principle, and a transfer pricing analysis is not necessary, provided that the transaction in question falls under the scope of the circular and the applied interest rate is in line with the rates in the circular.
On the contrary, non-compliance with these interest rates creates a rebuttable presumption of non-compliance with the arm's length principle. In this context, taxpayers have the option to demonstrate that the transaction complies with the arm's length principle and they are expected to demonstrate through a transfer pricing analysis, that the applied interest rate reflects the market rate and thus complies with the arm's length principle.
A transfer pricing study can be provided to demonstrate whether an interest rate that deviates from the interest rates set out in the FTA circular letters is in compliance with the arm's length principle. In practice, such a study is expected to include at least the following elements:
- A detailed description of the relevant transaction's main characteristics that could impact the interest rate. This description is important in order to identify the main factors for comparability and to delineate the transaction. These factors include the term of the loan, the currency, the issue date, the borrower's credit rating and the existence of guarantees and/or collateral.
- An analysis of the borrower's credit rating.
- A search for comparable transactions, taking into account the most important comparability factors.
The choice of currency is assessed on a case-by-case basis. The circumstances at the time of the transaction should be taken into account. The choice of a foreign currency must not be based solely on tax considerations.
Taking out a loan in a foreign currency loan may be justified in the following cases in particular:
- The foreign currency is the enterprise's functional currency.
- The foreign currency allows the enterprise to achieve more favourable terms. However, the costs of hedging the exchange rate risk must be taken into account.
- The foreign currency is the main currency of the income resulting from the use of an asset financed by the loan.
When conducting a transfer pricing analysis, it is important to distinguish between the rating of a borrower (issuer credit rating) and the rating of a financial transaction (issue credit rating).
The main difference is that the issue credit rating, which is based on the issuer credit rating, takes into account the specificities of the transaction and their impact on the credit risk assumed by the lender. As a result, the issue credit rating may be higher than the issuer credit rating. For example, a loan agreement may provide for a guarantee or a senior/privileged repayment, which reduces the credit risk and hence improves the rating. However, in other cases, the issuer credit rating may be higher than the issue credit rating. This may in particular happen if a loan is subordinated, as the lender will not be repaid until other loans have been repaid.
It is recommended to use the issue credit rating (rather than the issuer credit rating) to determine an arm’s length interest rate.
If a rating from an independent rating agency is available for a borrower, such rating should be used.
If no such rating exists, the rating must be estimated. There are various approaches:
- Use of methods defined and used by rating agencies;
- Use of software which allows the rating to be estimated based primarily on statistical models.
It is recommended that the methods used by one of the rating agencies be applied. However, the use of financial software is not excluded, provided that the reliability of the results can be demonstrated.
The issuer credit rating is a measure for determining the borrower's future ability to pay. It is therefore important to consider the impact of future transactions on the borrower's balance sheet, profit and loss account, and treasury function.
Nonetheless, it is appropriate to take historical financial data as a reference point, if such data can be considered to be sufficiently representative of future financial data.
Each rating agency applies its own standard. There are reliable comparison tables which can be used to convert a rating into one standard or another. The ratings of potential comparable transactions are mostly presented according to a standard set by one of the rating agencies.
It is therefore recommended that the standard of one of the rating agencies be used for a rating, although it is also possible to use other standards, provided that a reliable comparison or conversion table exists. However, the use of these other standards should make it possible to search for comparables without affecting the reliability of the results.
Banks are subject to special regulations to ensure their capital strength against certain risks and to protect customers from the risk of bank insolvency. They require an internal process for reliably assessing credit applications from enterprises. This internal process includes a financial rating system. Based on such rating system, banks set the conditions under which they will finance independent enterprises. Internal ratings of taxpayers in the banking sector can be accepted as comparables if it can be shown that they were estimated using the same methodology as the one used for their customers in calculating an interest rate.
The implicit support has an impact on the creditworthiness of a company, and hence on its credit rating. It must therefore be taken into account when estimating a borrower’s credit rating, as this rating determines to some extent the interest rate at which it can borrow.
Implicit support must be assessed on a case-by-case basis. It does not necessarily bring the same benefit to all companies in the group. If it appears that a borrower is receiving implicit support, its rating must be adjusted accordingly.
The rating of a company must be determined as if it were not part of the group (i.e. on a standalone basis). However, any implicit support must be taken into account.
In exceptional cases, the group credit rating may be used for the rating of a borrower. However, it must be demonstrated that it is the most reliable indicator in light of all the facts and circumstances. In particular, the company's creditworthiness indicators may not differ from those of the group (e.g. in the case of structures in which the group is owned by a succession of intermediate holding companies).
It is unlikely that there is only one interest rate on the market for a given transaction. It is therefore usual practice to set a range of arm's length interest rates. If the applied interest rate is within the interquartile range, it is usually accepted for tax purposes. The taxpayer must determine which specific interest rate he would like to apply and justify his choice. In this regard, it should be examined whether the chosen interest rate corresponds to the interest rate that an independent borrower (taking into account the terms of the transaction) would have received from a third party, and whether the taxpayer would have accepted it among other realistic options, based on the assumption that the borrower is seeking to optimise his weighted average cost of capital (WACC).
With regard to financial transactions, the OECD describes the specific methods which are used for determining an interest rate:
- The comparable uncontrolled price method (CUP method): according to the OECD, the CUP method is easier to apply for financial transactions than for other transaction types. This is due to the large number of markets and the availability of information for this type of transaction. The use of the CUP method is therefore widespread and is often preferred. The identification of internal or external comparables is a prerequisite for the use of the CUP method.
Depending on the conditions and circumstances, other methods may also be considered. In this regard, the OECD mentions the following methods:
- Cost of funds.
- Use of credit default swaps: credit default swaps are financial instruments comparable to insurance contracts for the assumption of credit risk in return for a risk premium. The results can be unreliable, as the limited degree of liquidity on the market for this kind of instrument leads to high volatility, as stated by the OECD. Thus, the spread applied to these financial instruments may partly reflect the liquidity problem observed on the markets for such instruments. In this case, it is not representative of market conditions. The use of credit default swaps is not recommended.
This is not an actual transaction, as the parties do not conclude a contract. The comparability criterion is therefore not met. Moreover, a bank opinion does not demonstrate whether an independent borrower would accept the same conditions or whether there would be other, more advantageous alternatives.
Against this background, a bank opinion can only serve as a starting point in exceptional cases, but is not sufficient to demonstrate compliance with the arm's length principle. As result, it is not recommended to use this method.
The application of the CUP method requires the identification of internal or external comparables. The FTA accepts bonds issued on the market and private financial transactions for which information is made available in databases as comparable transactions.
To identify comparable internal or external transactions, the selection criteria that have an influence on the interest rate must be defined based on the most important comparability factors. Key criteria are:
- Credit rating
- Effective (remaining) term
- Currency
- Issue date of the transaction
Once comparable transactions have been identified, it must be determined: i) which data should be used, and ii) whether an adjustment is necessary in order to determine an arm's length interest rate. Two types of data are relevant:
- The interest rate applied to comparable transactions: the interest rate is set at the moment when the relevant transaction is concluded. It corresponds to the markets' yield expectation at that time for this type of transaction, assuming a sale at nominal value. However, this interest rate does not reflect the market conditions at a later date. It is therefore not recommended to use interest rates of comparable transactions that were not executed close to the time of the transaction under review.
- The yields calculated for the comparable transactions: it is recommended to use yields that are calculated at a point in time close to that of the transaction under review. These yields reflect the current market conditions, regardless of when the comparable transactions were issued/executed. Due to the volatility of the markets, these yields should be calculated over a certain time period and an average should be used, in order to increase the reliability of the results.
It is not easy to find comparables in Swiss francs. Comparables in other currencies may therefore also be used. Given the proximity and economic interdependence between Switzerland and the EU, the use of comparables in Euros is recommended.
In this case, a reliable adjustment of the results is necessary to improve comparability. In practice, in most cases to make an adjustment it is appropriate to make an adjustment corresponding to the difference between a swap interest rate in Swiss francs and a swap interest rate in Euros for the same term.
Parties that have concluded a loan agreement can include a clause which entitles them, under certain conditions, to repay all or part of the loan before maturity.
The impact of early repayment clauses on the arm's length interest rate should be taken into account. It is therefore necessary to determine which party benefits from the clause and whether an actual benefit exists. In doing so, various factors such as the economic environment should be considered. If, for example, the markets expect a significant rise in interest rates, it is likely that the lender will activate the repayment clause and derive a benefit from this. Consequently, in such a context, the lender will probably be more inclined to accept a lower interest rate for the amount of the reduction in the risk associated with the loan. Conversely and under the same circumstances, a borrower would be more reluctant to negotiate such a clause. Finally, repayment clauses appear to be unrealistic for short-term, variable rate loans, as the risk associated with the interest rate volatility is lower in this context. A clause protecting against this risk does not seem appropriate.
Despite the end of the LIBOR, banks are continuing to grant variable rate loans. Thus, the use of a variable interest rate complies with the arm's length principle, provided that the interest rate applied also complies with the arm's length principle.
It is important to use a reference interest rate that is equivalent to those used in practice by financial institutions as a replacement for the LIBOR. These rates are determined according to new market standards that are set by stock exchange institutions or central banks that manage them. For the Swiss franc, this is the SARON (Swiss Average Rate Overnight). The LIBOR can be stated for various maturities (e.g. one day, one week, three months), whereas the alternative rate that was selected is a daily (overnight) rate. For this reason, methods exist for deriving a longer-term rate from this overnight rate, and these should be taken into account. For intra-group loans in Swiss francs, the option "last recent" and the SARON Compound Rate were selected.
The reference rate must be in line with the new market standards that are set by the stock exchange institutions or central banks that manage them. In particular, the following should therefore be considered:
- The new reference interest rates set for each currency;
- The duration of the LIBOR rate that was originally intended to be used for calculating the variable rate;
- The method for calculating longer-term reference rates from the new daily reference rates (e.g. SARON);
- Spreads that are calculated by the International Swaps and Derivatives Association (ISDA) according to a specific method and are supported by the banking sector. These spreads should ensure that the new reference interest rates are equivalent to the LIBOR rates with regard to risk.
Any change in the terms and/or conditions of an intra-group loan must comply with the arm's length principle. In this regard, it should, in particular, be assessed whether:
- revisions to the terms of the loan (e.g. duration, risk premium, use of a fixed interest rate) that were performed under the pretext of the end of the LIBOR were actually changed in compliance with the arm's length principle; [example 1]
- the possible termination of an agreement following the end of the LIBOR is in line with the original contractual terms and is justified on economic grounds; [example 2]
- the interest rates applicable from 1 January 2022 onwards were correctly calculated. On this assumption, an adjustment of the risk premium is in principle not justified. [example 3]
These different situations are illustrated with the following examples:
Example 1: Change in the terms of an intra-group loan
Background:
In 2021, the subsidiary of the ABC group (company A), based in Switzerland, receives a five-year loan of CHF 1 billion from another subsidiary (company B) of the ABC group. Based on a transfer pricing study, the contractually fixed interest rate for the loan between company A and company B is a variable rate corresponding to the three-month LIBOR plus a spread of 100 basis points (bps). Following the end of the LIBOR in 2022, the interest rate for the intra-group loan in question must be changed. For this purpose, a new transfer pricing study is performed on the basis of data that was available at the time when the loan was agreed between A and B in 2021. Based on this new study, from 2022 onwards, a fixed interest rate of 3% will be applied to the intra-group loan contracted in 2021.
Solution:
The primary criterion is what independent enterprises would have agreed in comparable circumstances. In this case, an independent bank would merely have informed its customers of the end of the LIBOR and the need to use an alternative interest rate for the outstanding loan agreement, with the alternative rate being the reference rate validated by the central bank. In addition, the bank would also apply the spread validated by the central bank, in order to ensure equivalence with the LIBOR rate.
Although a transfer pricing study was carried out, the interest rate applied from 2022 onwards (fixed rate of 3%) for the loan negotiated in 2021 does not comply with the arm's length principle. Under similar circumstances, independent enterprises that were previously bound by such a contract would have agreed to use an interest rate in line with the SNB's recommendations. This interest rate would correspond to the sum of the following rates/spreads:
- The alternative interest rate chosen by the SNB (SARON). An illustrative interest rate of 0.90% is used for the example.
- A spread adjustment as set by ISDA and recommended by the SNB. The spread of 0.0031% in the table corresponds to the spread calculated by ISDA for a three-month interest rate in CHF.
- The contractual spread (100 bps) to be applied to the reference rate, and originally agreed by the parties when signing the contract in 2021.
On the basis of the above, an arm's length interest rate is lower than the fixed rate of 3% applied from 2022 onwards. Consequently, from the 2022 tax period onwards, some of the recognised financial expense is not justified. This results in a hidden profit distribution, which needs to be determined on the basis of the following calculation:
Example 2: Termination of the intra-group loan agreement and issue of a new loan (early loan replayment)
Background:
Based on the same facts as in example 1, company A decides in 2022 to terminate the loan contract with company B following the end of the LIBOR. There is no compensation for this termination. A new five-year loan contract is agreed upon by the same parties. This new contract sets a fixed interest rate of 3%. This interest rate was calculated as part of a transfer pricing study based on data for comparable five-year loans that were negotiated between independent enterprises in 2022.
Solution:
In this case, several aspects have to be taken into account. Firstly, it must be examined whether the contract clauses permit early contract termination and, if so, under what conditions. As a rule, the end of the LIBOR is not one of the conditions that can lead to early termination of the loan. Secondly, in the conditions agreed between third parties, banks usually include compensation in the event of early contract termination, in order to ensure that they are not disadvantaged. Thirdly, it must be ascertained whether early termination is economically justified. In this regard, it can reasonably be assumed that the borrower would not terminate the contract if the current market rates, after taking into account any compensation due, were less favourable than the interest rate fixed at the time the contract was concluded. Based on these different elements, it can be inferred that a third party would not have terminated the contract early under similar circumstances. Therefore, company A's decision to prematurely terminate its contract with company B does not stand up to a third-party comparison.
Thus, in light of the above discussion, the financial expense recognised for tax purposes must correspond to that calculated on the basis of the interest rate provided for in the original contract, as early termination is not justified. After the end of the LIBOR, this interest rate corresponds to the interest rate calculated in example 1 in line with the SNB's recommendations (0.90% + 0.0031% + 1.00% = 1.9031%). The amount of the hidden profit distribution thus comes to CHF 10,969,000 (CHF 1 billion x (3% - 1.9031%)).
Example 3: Use of an alternative interest rate which is not in line with the SNB's recommendations (alternative interest rates)
Background:
Based on the same facts as in example 1, company B decides to replace the LIBOR rate with an alternative rate corresponding to the one-year interest rate swap (IRS) rate in its contract with company A. In 2022, this IRS rate was 2%, whereas the alternative rate recommended by the SNB (SARON) after adjustment to a variable three-month rate is 1.5%. The interest rates provided in this example are purely illustrative.
Solution:
In this case, an independent bank would have followed the SNB's recommendations, and would thus have calculated an interest rate based on the SARON and the 100 bps spread that was agreed between the parties when the contract was concluded in 2021. The interest rate that should be used from 1 January 2022 onwards is 2.5% (i.e. 1.5% + 100 bps). Consequently, for the 2022 tax period, part of the recognised financial expense is not a business-related expense and must be corrected. The hidden profit distribution amounts to CHF 5 million (i.e. 0.5% x 1 billion), as the interest rate paid by company A was 3% instead of 2.5% in accordance with the SNB's recommendations.
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