Among the various factors used to determine an arm’s length remuneration for intragroup financing, assessing the borrower’s credit rating is essential for qualifying the credit risk to which the lender is exposed.
Once the borrower’s rating is estimated—taking into account any group effects (i.e., implicit support)—it is crucial to focus on the credit risk specific to the intragroup loan itself. Often overlooked, this analysis is nevertheless indispensable for accurately assessing the arm’s length interest rate.
Understanding an Issue Credit Rating of an Intragroup Financing
The credit rating of a debt instrument reflects an opinion on the borrower’s willingness and ability to meet its financial obligations for a specific debt, considering the terms and conditions that may affect the level of losses suffered by the creditor(s) in the event of default.
As the OECD points out: “The credit rating of an MNE or MNE group may differ from an issue rating due to the fact that the credit risk of a financial instrument is linked to its specific features and not only to the risk profile of the borrowing MNE.”(OECD Transfer Pricing Guidelines 2022, §10.70)
The French tax authorities therefore require that: “One must seek not only the rating that the company might have been assigned by rating agencies, but also the rating that these agencies might have assigned to the intra-group loan itself.”(Methodological Note No. 3, Comparability – Methodological Publications of Rating Agencies and Credit Risk, 2021)
Why focus on this rating? Most often, when a borrower defaults on one obligation, it defaults on all. In such cases, the amount of loss suffered by the creditor depends on the existence of any payment priorities and the security provided. The expected loss in the event of default must be factored into the credit rating. Thus, for the same borrower rating, a debt instrument with a higher recovery rate—due to its seniority and/or security—will generally receive a better rating than another instrument with a lower recovery rate in the event of default.
For example, Électricité de France (EDF) is rated Baa1 by Moody’s for its senior unsecured financing, while its junior subordinated financing is rated Ba1.
Determining an Issue Credit Rating
To assess the credit risk specific to each debt instrument, each rating agency uses its own methodological framework, evaluating how the terms and conditions of the debt instrument affect expected losses in the event of borrower default.
For instance, Moody’s provides an analytical grid based on historical data of average losses according to the seniority of each obligation and the security provided (Moody’s Investors Service, Notching Corporate Instrument Ratings Based on Differences in Security and Priority of Claim, October 26, 2017). In summary, depending on whether expected losses increase or decrease based on the characteristics of the obligation, an adjustment of one or more notches to the rating must be made.
This adjustment is generally based on the rating applicable to a senior unsecured loan. Thus, a senior loan with security may be rated one or two notches above the borrower’s credit rating, while a subordinated loan may be rated one or two notches below.
This analysis will result in a credit rating for the intragroup loan, and it is this issue rating that must be used to determine the arm's length interest rate.