Facts – Belgian tax administration challenge intragroup borrower’s credit rating
This is the second recently published case dealing with intragroup financing (see Transfer Pricing – Belgian Case Law on Shareholder Loan Financing ) regarding the previous case). The case deals with the arm’s length nature of interest payments made by a Belgian company (BelCo) to a related Swiss lender under an intragroup loan (Loan) during FY2016.
The Loan had a floating interest equal to the EURIBOR base rate increased with a credit margin dependent on BelCo’s credit rating. BelCo’s stand-alone credit rating was assessed using the group’s credit rating policy based on Standard & Poor's ‘Corporate Methodology’ (S&P methodology). The S&P methodology evaluates the risk of a company based on its business risk profile and its financial risk profile based on financial information. This model calculates a borrower’s stand-alone credit rating based on a comprehensive scorecard, incorporating both qualitative and quantitative elements.
In the case at hand, BelCo's stand-alone credit rating was then notched up to account for the implicit support of which it benefited from the group, using S&P's ‘Group Rating Methodology’. BelCo was characterized as a ‘moderately strategic entity’ for which the S&P guidance suggests an upward adjustment of one notch to the stand-alone credit rating to reflect implicit group support.
The Belgian tax administration (BTA) argued that S&P methodology was not correctly applied. In particular, according to the BTA, not all qualitative elements were considered with respect to the business risk analysis. Furthermore, the BTA stated that the outcome of the financial risk analysis is unjustifiably influenced by BelCo’s high indebtedness, since this is a direct result of significant intercompany debt with high interest costs. The BTA, however, did not adjust the stand-alone credit rating of BelCo.
Instead, the BTA claimed that BelCo should in any case be considered a ‘core entity’ under the S&P Group Rating Methodology, as a result of which BelCo should have the same credit rating as the group to which it belongs. The BTA concludes that the credit rating of BelCo was understated resulting in excessive interest payments by BelCo to SwissCo.
Court determines borrower’s credit rating based on implicit support
The court first emphasizes that the burden of proof to demonstrate excessive interest payments lies with the BTA.
The court observes significant discrepancies in the stand-alone credit rating analysis of BelCo compared to the S&P methodology. First, the court notes that the business risk analysis focuses solely on the profitability of BelCo and ignores all other qualitative elements. Secondly, according to the court, the financial risk analysis exhibits a circular reasoning, wherein the quantitative credit rating is adversely affected by the level of intercompany debt and interest expenses. This results in BelCo being qualified as ‘highly leveraged’ resulting in a lower credit rating and increased interest costs.
The court subsequently assesses the criteria outlined in the S&P Group Rating Methodology to determine BelCo’s categorization within the group and thus how implicit group support should be taken into account. The court carefully evaluates each of the seven criteria that should be cumulatively met for BelCo to be a ‘core entity’, referring a.o. to BelCo’s relative profitability and the group annual reports.
The court then concludes that BelCo cannot be considered a ‘core entity’ nor a ‘moderately strategic entity’. With reference to the criteria of the S&P Group Rating Methodology, the court thus concludes that BelCo should be classified as a ‘highly strategic subsidiary’, and BelCo’s stand-alone credit rating should be one notch below the credit rating of Group.
Finally, the court establishes that BelCo has granted a non-arm’s length benefit to SwissCo as its credit rating was understated. The court rules that the excessive part of the interest must be recalculated taking into account the adjusted credit rating as calculated by the court.
- Accurate credit rating analysis is crucial – In practice, various methods can be used to assess credit ratings, encompassing both quantitative and qualitative approaches, or a combination of both. In the case at hand, the court does not express a preference for a specific methodology but instead scrupulously evaluates whether the chosen method is correctly applied. Therefore, it is crucial to rigorously apply the selected method by following all steps and criteria. Any unsubstantiated deviation may trigger suspicion from the BTA and the court. It is imperative for taxpayers to give proper diligence to this crucial starting point of loan pricing and to align qualitative assessment with publicly available information.
- Consideration for impact of intragroup leverage and interest rate on credit rating outcome - In case the credit rating analysis is dependent on financial parameters, such as a borrower's financial statements or leverage ratios, caution must be exercised to ensure that the parameters used are not unduly influenced by intercompany transactions that may not necessarily be arm’s length. In particular, it should be assessed whether the outcome of the (quantitative) credit rating analysis is not negatively impacted by the level of intercompany debt and interest expenses (which results in a circular reasoning according to the court). To address this concern, various scenarios can be simulated in a credit rating assessment to consider the impact of lower interest costs. Next to this, this case once again highlights the need to evaluate not just the price but also the terms and conditions of a financing transaction, with a particular focus on leverage.
- Burden of proof principles nuanced - The BTA bears the burden of proof to perform a transfer pricing correction. Leading case law confirmed that the burden of proof is twofold: the BTA should demonstrate that (i) the method applied by the taxpayer does not lead to an arm’s length outcome (either because the method is inappropriate or was incorrectly applied), and (ii) another method providing another price is appropriate. In the case at hand, the court concludes that the BTA successfully demonstrates that the taxpayer incorrectly applied the credit rating method but fails to prove the arm’s length interest underlying the tax correction (i.e. the second step in the burden of proof was not met). The court, however, did not end its assessment there but instead conducted its own analysis to come up with a different credit rating. The court then allows the BTA to determine a new interest rate based on the outcome of the court’s credit rating analysis and issue a new tax assessment on that basis. The court hereby brings some nuance to the (high) twofold burden of proof to the BTA by giving the BTA a second chance to come up with the correct price based on the court’s properly determined credit rating.
We will follow-up on this and report on subsequent developments.
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