IRS Transfer Pricing Memo on Implicit Support Has Legal Flaws

Intercompany loans within multinational enterprises continue to be targets for IRS transfer pricing adjustments, especially when it comes to whether and how group membership should influence interest rates. But MNEs facing adjustments based on the implicit support their group provides to related-party borrowers have credible legal arguments (in addition to whatever economic arguments they have) that they should make against those adjustments.

The IRS routinely takes the position that an MNE’s subsidiary should be deemed to have a better credit rating by virtue of its group membership and the presumptive implicit support that the group would provide. And the IRS rejects the standalone approach under which the subsidiary is treated as uncontrolled with a credit rating based solely on its discrete financials.

But nothing in the existing Treasury Regulations expressly requires taxpayers to consider implicit support in pricing loans. The arm’s-length standard articulated in 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 treating a borrower as uncontrolled, then it arguably requires pricing the loan under a standalone approach.

The IRS Chief Counsel issued a generic legal advice memorandum (or GLAM, designated as AM 2023-008) in December aimed at filling the gap in the Treasury Regulations. It poses a simple hypothetical: A foreign parent makes a bona fide loan to its US subsidiary but makes no express guarantee to support that subsidiary.

The GLAM says the arm’s-length standard permits the IRS to consider the implicit support that the foreign parent would provide to US subsidiary. But it doesn’t conclude that the implicit support gives the US subsidiary the same credit rating as the foreign parent. Nevertheless, the GLAM concludes that the foreign parent’s implicit support diminishes the arm’s-length interest rate from a standalone rate of 10% to an implicit-support rate of 8%.

For MNEs that have priced foreign-parent-to-domestic-subsidiary loans on a standalone basis, the GLAM signals that the IRS will likely disagree with their pricing. Even those MNEs that considered implicit support in pricing intercompany loans might face IRS arguments that implicit support has a larger effect and thus requires an adjustment to the MNE’s return position.

Taxpayers that accede to the IRS’s GLAM still have room to disagree with the IRS about the size of the effect that implicit support would have on pricing the loan. The determination of how the implicit support affects the interest rate is fact-specific, nuanced, and difficult.

But taxpayers should think hard before conceding that the IRS can consider implicit support, which isn’t precedent and doesn’t carry the force of law. Moreover, it has legal weaknesses. It offers at least three different reasons to justify its conclusion, all of which deserve scrutiny.

First, the GLAM reasons that if a US subsidiary were to borrow from an unrelated lender, that unrelated lender would consider the foreign parent’s implicit support and price the loan accordingly. But the GLAM concludes that while the IRS may consider that related-party implicit support under the arm’s-length standard, that same standard permits the IRS to ignore the foreign parent’s costs for providing that implicit support.

There is, however, an economic basis for arguing that the IRS shouldn’t ignore the cost that the lender bears for that implicit support. The GLAM recognizes this issue and considers the possible taxpayer argument that “as the source of USSub’s implicit support,” the foreign parent is “entitled to a higher interest rate to compensate its greater risk.”

The GLAM misconstrues the taxpayer’s argument, asserting that the foreign parent can’t earn a higher interest rate because the fact “that the controlled lender is the borrower’s parent” is, under the arm’s-length standard, “assumed away.” But the taxpayer wouldn’t argue that the lender would demand a higher rate because it is the borrower’s parent; the taxpayer’s argument is that the lender would demand the higher rate because it is the lender who is called on to provide implicit support.

The IRS’s response suggests that it can ignore that cost because no lender would, at arm’s length, provide such support to the borrower. The GLAM asserts that considering the lender’s cost would be “contrary to the arm’s length standard” because it assumes the controlled lender would support the controlled borrower financially, “whereas no unrelated lender would.”

This argument implies that the IRS can ignore important facts about the transaction at issue (for example, that the lender is also providing implicit support) where those facts wouldn’t obtain in transactions between unrelated parties. But many of the difficult questions in transfer pricing involve transactions that wouldn’t happen at arm’s length.

Second, the GLAM argues that the realistic-alternatives principle applies to reduce the US subsidiary’s interest rate. The GLAM reasons that if the subsidiary could get a better interest rate from an unrelated lender because of the parent’s implicit support, the realistic alternatives principle means the intercompany loan should be priced at that lower rate.

But it never considers whether the foreign parent could lend to another entity with the same credit rating as the US subsidiary’s standalone credit rating and charge a higher rate. The GLAM doesn’t explain why the borrower’s realistic alternatives matter and the lender’s do not.

Finally, the GLAM argues that implicit support is just a benefit of the US subsidiary’s “passive association” with its controlled group. In the context of services transactions, the regulations recognize that group membership confers some benefits on members for which they don’t owe compensation to the other group members under Section 482 of the tax code.

But those are the Treasury Regulations on intercompany services; the Treasury Regulations on intercompany lending make no mention of passive association benefits. Taxpayers might argue that implicit support isn’t the type of noncompensable passive-association benefit described in the regulations.

Although the IRS will defend the GLAM’s conclusion and adjust intercompany lending rates based on how the IRS thinks implicit support will affect those rates, the legal issues with the GLAM’s legal reasoning are intractable and taxpayers facing such adjustments would be wise to attack those issues.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Steven R. Dixon is partner at Steptoe and has represented corporate taxpayers in large-dollar transfer-pricing disputes in the US Tax Court, at IRS Appeals, and on audit.

Amanda Pedvin Varma is partner at Steptoe and advises clients on international tax planning, controversy, and policy issues.

Write for Us: Author Guidelines