Implicit Support Group

Lost (at least by me) amid the year-end shuffle, the Internal Revenue Service Office of Chief Counsel released in December a legal advice memorandum on intercompany lending. Specifically, it concerns “implicit support,” the idea that interest on an intercompany loan should be priced taking into account the borrowing entity’s involvement in a larger corporate structure. Since a company that’s part of a giant conglomerate would probably be a safer bet to repay than a standalone entity, that usually means a lower interest rate would be justified, resulting in a lower tax deduction.

“If an unrelated lender would consider group membership in establishing financing terms available to the borrower, and such third-party financing is realistically available, then the Service may adjust the interest rate in a controlled lending transaction to reflect group membership,” the memo states.

Many tax experts disagree, claiming this logic violates the arm’s-length standard–the foundational principle of global taxes, that intercompany transactions should be priced at what independent parties would pay. How can that be consistent with looking at the company as a whole to determine the price? Especially when it’s that same company doing the lending?

It’s a debate that I find both interesting and beguiling. And while I think there’s something uniquely paradoxical about intercompany debt, the larger issue here spreads to other aspects of transfer pricing, including intangible assets. It forces you to confront the core nature and purpose of the arm’s-length standard and the international tax system.

Not everyone likes to put it this way, but the arm’s-length standard is about pretending. You pretend that two subsidiaries are actually things they aren’t, and then price accordingly. After that, the fiction becomes the reality. But ask any actor or role-playing game enthusiast–when it comes to make-believe, there can be potentially significant disagreements and misconceptions about where exactly the pretending begins and ends.

You can see that as the memorandum elaborates, and gets into logical puzzles that are even more dizzying. The IRS anticipates a counter-argument that some have already made–if the intercompany loan has to take into account the larger organization, shouldn’t it also take into account the lender’s extra risk, as part of that corporate group which could have to bail the borrowing entity out?

The IRS notes that its regulations already explicitly state that intercompany payments can’t be made to compensate for “passive association.” (Which confuses me a bit, because implicit support and passive association almost seem like the same thing, and the former is being incorporated into the price.) More fundamentally, it argues that considering the lender’s risk would be a violation of the arm’s-length standard–it would mean you’re no longer pretending that the two entities are independent. 

In one way this makes perfect sense–in another, it can seem to be circular logic, only going in one direction. Why does implicit risk have to be assumed away, but implicit support doesn’t? 

From the lender’s point of view, a big advantage to lending within the group, rather than outside, is control. The fact that the borrower, lender, and the overall corporate group are all controlled by the same people would greatly reduce the risks of default. Control is pretty important to lenders–indeed, they’ll often insist on a greater degree of control over a borrower's operations as a condition of a loan, if that borrower poses an extra degree of risk.

I guess it’s pretty clear that arm’s-length pricing shouldn’t take into account control. “Uncontrolled parties” is right there in the rule. But can you really separate the control aspect from the implicit support of being part of a larger organization?

It reminds me a bit of some ideas that the Organization for Economic Cooperation and Development tossed around, as it considered new rules for pricing valuable intangible assets as part of the Base Erosion and Profit-Shifting project in 2015. Intangibles like intellectual property are often fundamental to complex tax structures that shift profits to low-tax jurisdictions–they’re easy to move, difficult to value and often can reap huge amounts of income. 

One concept that the OECD considered was to price in “moral hazard,” the economic principle that a party will engage in riskier behavior if they do not bear the costs. In this case, the idea was that a gigantic corporation wouldn’t ever sell its “crown jewel” IP to an unrelated party, in part because that would mean it has less control over how it was used. The buying entity would have a valuable piece of the business, but wouldn’t be fully invested in the business’s long-term health. 

The OECD ultimately dropped this idea, probably because it’s hard to square with arm’s-length transfer pricing. But there are hints in its final product on hard-to-value intangibles of taking an entity’s role in the overall corporate group into account. The rules state that tax authorities and taxpayers should look beyond the arm’s-length price of the asset itself, and consider factors like where those assets are developed and maintained. (The “DEMPE Functions.”)

In both cases, the rules are stating that in order to truly understand the arm’s-length price, you need to look at the buying and selling entities’ places in the overall corporate chain. You're doing a bit less pretending than you would if you just looked at the asset and what price it would get on the open market.

The IRS memo doesn’t have the legal force of law, but it presumably indicates current agency thinking. If so, it’s another indication (along with increased use of the the economic substance doctrine) that the IRS and the U.S. Treasury Department are getting more aggressive and creative about how to use some of the fundamental international tax rules.

I think there are interesting arguments in favor and against the IRS position. But critics of the arm’s-length standard might claim it reveals all of this transfer pricing as a farce. What’s the point of using economics to find supposedly objective prices of completely uneconomical transactions? Can transactions that are entirely theoretical ever be reliably priced?

I think it forces you to really evaluate what the purpose of the arm’s-length standard is. It’s intuitive to think that the goal of arm’s-length pricing is to arrive at economically realistic results. But is it? The value of the arm’s-length standard may not be its economic accuracy, but the fact that it’s the standard that everyone has agreed to. Fulfilling it is the goal in and of itself–even if its results can be pretty loopy.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

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Note: I've been writing this newsletter for more than two years, without needing to post a correction. But I want to be as up-front as I can with readers, including when I goof. Last week's newsletter stated that Bermuda enacted a qualified domestic minimum top-up tax along with other parts of Pillar Two. In fact, it has not–it enacted a 15% corporate income tax but declined to do a QDMTT, for reasons it outlined here. I know that my readers expect a high degree of accuracy and it's a responsibility I've accepted–I sincerely apologize for falling short in this case.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

• While the OECD’s Two-Pillar project enters more extra innings–what, the 25th? 39th?–the global tax discussion has started to shift to wealth taxes. In the latest development, progressive tax superstar Gabriel Zucman unveiled a report, commissioned for the G-20 coalition of nations, for a “a coordinated minimum effective taxation standard for ultra-high-net-worth individuals.” The idea is that countries would commit to ensuring that those with a net worth over a billion dollars pay 2% of their assets annually, through whatever combination of wealth or income taxes achieve that result. This is in contrast to Biden’s billionaire minimum tax, which taxes both realized and unrealized income, but doesn’t tax assets outright. Zucman implies that this could get around the constitutional issues with a wealth tax in the U.S., but I’m not sure–a wealth tax is still a wealth tax, no matter how it’s triggered. That’s not even taking into account the extra questions that the recent Supreme Court Moore decision raised.
• In the meantime…Canada has shown no signs of hesitating with its 3% digital services tax, despite significant pressure from its neighbor to the south. And, on Thursday, it became law, after receiving “royal assent” and being passed by both houses of Parliament. Business groups reiterated their opposition to the idea, and Republicans such as U.S. House Ways & Means Chairman Jason Smith blasted the tax. As the OECD could release text for a Pillar One treaty any moment (maybe by the time you’re reading this), the situation continues to be evolving and chaotic.
• During the worst days of the coronavirus pandemic, would you have guessed that government revenues in the Asia/Pacific region would have returned to their pre-2020 levels within a few years? That’s what a new OECD report, released Tuesday. The turnaround was driven by both tourism and rising commodities prices.

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Every week, a new character from the Golden Age of Superheroes who's fallen out of use.

Strongman, first appearing in Strongman #1 in 1955. An orphan of fallen trapeze artists (like Robin), he was raised in the circus and became, allegedly, the strongest man alive. He uses his strength as well as other skills of showmanship to fight evil and crime.

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