Overview
As some officials had previewed in recent public statements, the IRS (through Chief Counsel) issued a memorandum (AM 2023-008) on what has emerged as a contentious transfer pricing issue with respect to intercompany loans. The crux of that issue is whether, in pricing loans between related parties, the IRS can treat the borrower as benefitting from the “implicit support” of its controlled group (i.e., the fact that if the borrower were unable to pay, the group might step in to help, even without a contractual promise to do so) while ignoring the lender’s costs for providing that support.
This is a thorny issue that implicates hard questions about the nature of the arm’s-length standard, including questions about the facts that taxpayers and the IRS may consider (or ignore) in applying that standard. The memorandum concludes that the IRS can consider facts that empower the IRS to minimize interest rates on intercompany loans and ignore facts that imply a higher interest rate on those loans.
Taxpayers with this issue may have to wait for pending disputes to move forward (like the Tax Court litigation in Eaton Corp. v. Commissioner, No. 2608-23) to get some answers about the finer points of the IRS’s position. With a little time to consider the memorandum, we wanted to highlight some notable aspects of the memorandum and some of the questions that the memorandum raises but does not answer.
A Quick Overview
The memorandum poses a relatively simple hypothetical: A foreign parent (FP) makes a bona fide loan to its US subsidiary (USSub) but makes no express guarantee or other legally enforceable financial commitment to support USSub. In pricing that loan, the memorandum concludes that the arm’s-length standard permits the IRS to consider the “implicit support” that FP would provide to USSub, even where doing so serves to “improve the debt terms available to” USSub in a loan from FP. At the same time, the memorandum rejects the notion that the arm’s-length price should reflect the cost that the implicit support imposes on the lender.
The memorandum does not conclude that the implicit support gives USSub the same credit rating as FP. To put it in the credit-rating parlance, the memorandum does not conclude that the implicit support results in “equalization.” Nevertheless, the memorandum concludes that FP’s implicit support diminishes the arm’s-length interest rate from a “standalone” rate (i.e., the rate that USSub would have paid without implicit support) of 10% to an implicit-support rate of 8%.
The memorandum offers at least three different reasons to justify this 200-basis-point drop in the interest rate; we examine each reason in turn. It is worth noting that in addition to these three reasons, the memorandum asserts (in a footnote) that this pricing approach conforms to the OECD Transfer Pricing Guidelines. Although the IRS routinely insists that the Treasury Regulations are consistent with those Guidelines, those OECD Guidelines are not US law.
The Arm’s-Length Standard
The first reason that the memorandum offers for its position is an interpretation of how the arm’s-length standard applies here. And the first premise for this interpretation is hard to dispute: If USSub were to borrow from an unrelated lender, that unrelated lender would consider FP’s implicit support and price the loan accordingly. The memorandum couches this premise in terms of the borrower’s credit rating: “Because an uncontrolled commercial lender would charge interest based on the borrower’s credit rating, factors that inform the borrower’s rating, including the borrower’s role, level of integration within the group, and implicit support from affiliates, all inform the arm’s length rate of interest.”
But this unremarkable premise is difficult to reconcile with the rest of the argument in the memorandum. The memorandum insists that while the arm’s-length standard permits the IRS to consider the benefit that FP’s implicit support confers on USSub’s borrowing, that same standard permits the IRS to ignore FP’s costs for providing that implicit support. It is not enough, however, to consider only the rate that the borrower could get from a lender at arm’s-length. The IRS must also consider the rate at which the lender would be willing to make the loan to the borrower. And in this circumstance, it is not only true that USSub may benefit from FP’s implicit support. It is also true that the lender bears the cost of that implicit support.
The memorandum recognizes this issue and considers the argument that “FP, as the source of USSub’s implicit support … is … entitled to a higher interest rate to compensate its greater risk,” i.e., the risk of providing that implicit support. The memorandum insists that the arm’s-length standard means that the premise of this argument, “that the controlled lender is the borrower’s parent, is assumed away.” Here, however, the memorandum’s version of the taxpayer’s argument is a straw man. The taxpayer would not argue that the lender would demand a higher rate because it is the borrower’s parent. The taxpayer would argue that the lender would demand a higher rate because it is the lender who, in this circumstance, is called upon to provide implicit support.
This is worth unpacking a bit more. One version of the taxpayer’s argument is that the IRS must consider the cost of implicit support in these circumstances because the party providing that support is the lender. In this version, the taxpayer would maintain that the identity of (1) the lender and (2) the party providing implicit support is just another fact about the circumstances in this transaction. And the taxpayer would argue here that this identity—between the lender and party providing implicit support—does not presume that the lender is the borrower’s parent. It merely presumes that the lending transaction to be priced here is a unique lending transaction—one where the party making the loan is also the party who would have to step in and provide support if the borrower were unable to pay.
Presumably, the IRS’s response is that no lender would, at arm’s length, provide such support to the borrower. In other words, the IRS would argue that implicit support obtains only between related parties. The memorandum suggests as much when it considers whether taxpayer can ignore the benefits of implicit support “because the lender does not benefit from its own support.” The memorandum rejects that notion as “contrary to the arm’s length standard” because “it assumes … that the controlled lender would provide financial support to the controlled borrower, whereas no unrelated lender would.”
Perhaps the memorandum is correct and implicit support is not something observable in transactions between unrelated parties. But this is a tricky argument for the IRS to make while also arguing that it can consider implicit support in pricing the loan under the arm’s-length standard. Taxpayers will almost certainly observe that the plain language of the foundational regulation on the arm’s-length standard—Treas. Reg. § 1.482-1(b)(1)—provides that “[a] controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.” If the arm’s-length standard requires hypothesizing that the parties to the transaction are uncontrolled, then it follows that the IRS cannot consider implicit support at all because on the IRS’s own account, implicit support is not something that obtains between uncontrolled parties.
There is, however, a deeper problem with the reasoning in the memorandum. It cannot be the case that the IRS can simply ignore important facts about the transaction at issue (i.e., that the lender is also providing implicit support) because those facts would not obtain in transactions between unrelated parties. Many of the difficult questions in transfer pricing involve transactions that would not happen at arm’s length. This is certainly true where parent companies license hard-to-value, crown-jewel intangibles to their affiliates. It is indeed difficult to price a loan where the lender is also the party providing support to the borrower because that transaction is either uncommon or nonexistent between unrelated parties. But that difficulty inheres in most transfer pricing disputes; it cannot be the reason for ignoring important facts about the subject transaction.
The memorandum’s discussion of the arm’s-length standard thus leaves a host of unanswered questions. The IRS wrote the regulation that requires hypothesizing that the parties to the transaction are uncontrolled. Should a court consider the IRS’s authorship when construing that regulation in this context? The memorandum distinguishes facts that the IRS can consider because FP and USSub are related (like implicit support) and the facts that the IRS can ignore because FP and USSub are related (like the FP’s cost for providing that support). What is the principled basis for that distinction? To what extent, if at all, can the IRS ignore facts about a related party transaction simply because those facts do not occur in transactions between unrelated parties?
Realistic Alternatives Principle
The second reason that the memorandum offers in support of its 200-basis-point adjustment raises other questions. The memorandum asserts that the realistic-alternatives principle applies here to reduce the subject interest rate by looking to the realistic alternatives available to USSub. If USSub could get a better interest rate from an unrelated lender because that unrelated lender would consider the implicit support that FP provides to USSub, the USSub would borrow at that lower rate (rather than at a higher rate from the related lender).
But the memorandum omits any discussion of the realistic alternatives available to the lender. Presumably, FP could lend to a standalone entity with the same credit rating as USSub’s standalone credit rating. If FP could lend at a higher rate without incurring the costs associated with providing the borrower its implicit support, isn’t that what FP would do? And if so, what does the “realistic alternatives” principle tell us about how FP would price its loan to USSub if it were made at arm’s length? The memorandum does not explain why the borrower’s realistic alternatives matter and the lender’s realistic alternatives do not.
Passive Association Benefits
The third reason that the memorandum offers for its conclusion is that the lender’s implicit support of the borrower is just a benefit of USSub’s “passive association” with its controlled group. The memorandum correctly observes that in the context of pricing controlled services transactions, the transfer pricing regulations recognize that group membership confers some benefits on group members that need not be compensated at arm’s-length. Specifically, Treas. Reg. § 1.482-9(l)(3)(v) provides that “a controlled taxpayer generally will not be considered to obtain a benefit where that benefit results from the controlled taxpayer’s status as a member of a controlled group.”
But the memorandum does not answer an important question here. The Treasury Regulations on intercompany services recognize noncompensable passive association benefits and the Treasury Regulations on intercompany lending make no mention of passive association benefits. Isn’t the better interpretation of the Treasury Regulations that there are noncompensable passive-association benefits in the context of intercompany services but not in the context of intercompany lending? If the IRS thought that there were noncompensable passive association benefits in the context of intercompany loans, they could have said as much in the relevant Treasury Regulations. The fact that they did not implies that this memorandum is incorrect to treat implicit support as a noncompensable benefit of passive association.
