An Intercompany Loan Is Priced Off the Borrower, Not the Lender

Intercompany lending is the transaction most likely to be priced by habit. A rate gets set once, often by reference to what the parent pays its own bank or to a figure that looks reasonable, and it is carried forward for years. The FTA transfer pricing guide builds the number from a different starting point, and the difference usually moves the rate.

First, characterise what the treasury entity is actually doing

The guide asks a preliminary question before any pricing. It is important to accurately characterise and understand the actual transactions, and to determine what the treasury functions an entity is carrying out really are, before moving to pricing.

Its distinction is between two very different businesses that look similar on a group chart. A central treasury function is often performing routine services without bearing or managing significant risks, in which case the guide points to its section on remunerating centralised services. That is a different exercise from one where the treasury is acting as an in-house bank, bearing and managing significant contingent liability risk arising from related party loans, cash pooling or guarantees.

Intra-group loans are not only a treasury phenomenon. The guide lists loans from a parent to an operating subsidiary, loans between operating subsidiaries, and shareholder loans made by investors to portfolio companies — the last of which is the common shape in UAE holding structures.

The method is usually CUP, and the guide sets out the steps

Given the abundance of data on third-party loans, the guide says it is often the case that the comparable uncontrolled price method can be applied. It then breaks the application into three steps.

1. Analyse the terms of the loan relating to factors that may affect pricing, including issue date, tenor, country of the borrower, currency, options such as a pre-payment option, and interest rate type such as fixed versus floating.
2. Analyse the borrower's credit rating to understand the credit risk borne by the lender in extending the loan, factoring in implicit support from the group.
3. Search for third-party loans with a similar credit rating and terms.

Credit ratings: whose, and at what level

The guide treats creditworthiness as one of the main factors independent lenders consider when setting the terms of a borrowing, and credit ratings as a useful measure of it — helping identify potential comparables or apply economic models.

Ratings can be determined at two levels: the overall creditworthiness of a multinational group or its ultimate parent, or a specific issuance of debt. That distinction has a stated preference attached to it.

Determining a rating requires both quantitative factors, such as the financial information of the borrower, and qualitative ones, such as the industry and the jurisdiction in which the borrower operates. An approach often used is to replicate the process by which the group's own rating was determined, applying that analysis to the individual characteristics of the entity using publicly available financial tools.

A warning about the tools most groups actually use

The guide attaches a caution to that approach which is easy to skim past and expensive to ignore. The credit rating methodology used in publicly available financial tools may differ significantly from the methodologies applied by independent credit rating agencies to determine official ratings, and the impact of any such differences should be carefully considered.

In practice that means an output from a subscription scoring tool is a starting point rather than a conclusion. Where the resulting rating drives the interest rate on a material loan, the file should show why the tool's methodology was appropriate for this borrower, not merely what number it produced.

Implicit support, which cuts against the taxpayer more often than for

The guide is explicit that the analysis factors in implicit support from the group, and refers to the enhanced creditworthiness an entity may receive from being part of a multinational group.

That is worth stating plainly, because groups tend to reach for a standalone rating when it produces the higher rate. Implicit support generally improves the borrower's rating, which lowers the arm's length interest rate, which lowers the deduction in the borrower and the income in the lender. It is a factor to be applied honestly in both directions.

Where the rate is only half the exposure

Pricing the loan correctly does not settle the deduction. The interest deduction limitation applies separately, so a rate that is arm's length can still produce interest that is not fully deductible in the borrower.

And where the lender or borrower is a free zone company, this stops being a computation question. Compliance with the arm's length principle is a condition of Qualifying Free Zone Person status, so an unsupported intercompany rate puts the 0% at risk rather than producing an adjustment.

What to check

1. Characterise the lender first: is it providing routine services, or bearing genuine credit and liquidity risk as an in-house bank?
2. Price lending separately from any service the same entity provides, rather than in one blended margin.
3. Record the loan terms that drive pricing — issue date, tenor, currency, borrower jurisdiction, fixed or floating, and any options.
4. Establish the borrower's credit rating on quantitative and qualitative factors, and document how implicit group support was reflected.
5. Where a rating tool was used, note why its methodology was appropriate rather than relying on the output alone.
6. Use an instrument-level rating in preference to a group rating where both are available and the debt is comparable.
7. Check the interest deduction limitation separately, because an arm's length rate does not guarantee a full deduction.

The FTA Transfer Pricing Guide (CTGTP1) is guidance rather than legislation; the underlying obligation is in Articles 34 and 55 of the Corporate Tax Law. Confirm the position for your own facts before relying on it.