Intercompany Loans for State Purposes: Two Illustrations of Debt Push Downs and Pricing

Harold McClure
This is the guest post by Dr. J. Harold McClure, New York City
The November 2020 DHG webinar entitled “Overview and Considerations for Domestic Transfer Pricing” considered various tax planning strategies including debt push downs. Consider a holding company such as Berkshire Hathaway Energy that incurs third party debt on behalf of its operating affiliates. The holding company incurs interest expenses, while the operating profits are booked by the operating affiliates. The debt push down strategy allocates the interest expense to the operating affiliates.
We illustrate this strategy as well as the pricing issues for the evaluation of arm’s length interest rates using both recent financing for Berkshire Hathaway Energy and the financing of how Amazon acquired Whole Foods.

I. Berkshire Hathaway Energy
Berkshire Hathaway Energy is a holding company with the following operating affiliates: PacifiCorp, MidAmerican Energy, MidAmerican Funding, Nevada Power, and Sierra Pacific. These operating affiliates are regulated utilities providing energy such as electricity to their customers. These operating affiliates collectively own approximately $70 billion in fixed assets, which are financed with over $25 billion in third party debt. Table 1 shows the fixed assets and debt allocated to these operating affiliates as of December 31, 2019.

Between May 24, 2020 and October 29, 2020, Berkshire Hathaway Energy issues $5.25 billion in corporate bonds on various dates and various terms to maturity. Table 2 summarizes these corporate bond offerings including the interest rate. While the credit ratings for each operating affiliate were A, the interest rates on the debt issued in late March were quite high relative to the corresponding government bond (GB) rate.
A standard model for evaluating whether an intercompany interest rate is arm's-length can be seen to have two components — the intercompany contract and the credit rating of the related party borrower. Properly articulated intercompany contracts stipulate:
· The date of the loan;
· The currency of denomination;
· The term of the loan; and
· The interest rate.
The first three items allow the analyst to determine the market interest rate of the corresponding government bond. This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.
Table 2 calculates the credit spread on each of these corporate bond offerings. Credit ratings are letter grades, which require translating into a numerical credit spread. The fallout from the COVID-19 crisis includes volatile credit spreads almost reaching what we witnessed after the collapse of Lehman Brothers in the fall of 2008.
I discussed the spike in credit spreads during the period after the COVID-19 became evident.[1] These discussions focused on the difference between the interest rate on long-term corporate bonds rated BBB and the interest rate on 20-government bonds. The following figure shows these interest rates and the implied credit spread from February 3, 2020 to October 30, 2020. 
While the interest rate on long-term government bonds fell from 1.8 percent in early February to around 1 percent after the recognition of the COVID-19 crisis, interest rates on long-term corporate debt rose from around 3.6 percent to around 5 percent. The credit spread on corporate debt rated BBB spiked from around 1.8 percent in early February to near 4 percent as of March 23. This spike in the credit spread moderated over the rest of 2020 was only 2 percent by the end of October.
Miguel Faria-e-Castro, Julian Kozlowski, and Mahdi Ebsim noted this spike in credit spreads.[2] The rise in observed credit spreads began on February 28 and peaked on March 23, which was the date that the Federal Reserved announced measures to stem this financial crisis. These authors cited evidence on credit spreads for corporate bonds with credit rating A- and better, corporate bonds with credit ratings between BBB and BB-, and corporate bonds with credit rating B+ and below. The credit spreads shown in table 2 are consistent with their evidence on credit spreads for corporate bonds with credit ratings A- and higher. 

II. Amazon Acquisition of Whole Foods
Amazon purchased Whole Foods during the summer of 2017 for $13.7 billion. This purchase price represented a premium over the market value of Whole Foods at the time of the acquisition and was almost twice the book value of Whole Food’s assets.
Amazon also issued $16 billion in corporate bonds on August 22, 2017. Table 3 shows the key terms of these corporate bond issuances as well as the corresponding government bond rate for the various terms to maturity. The credit spreads for these corporate bonds were consistent with a credit rating of A. Some commentators were surprised that Amazon paid higher credit spreads than other high technology companies such as Apple. We should note that not all high technology companies are alike as Apple’s operating margins then to be several multiples of Amazon’s operating margins.
At the time of the acquisition Whole Foods had $1 billion in long-term debt from a corporate bond issuance on December 3, 2015. The terms of this corporate bond issuance is also shown in table 3 along with the interest rate on 10-year government bonds on that date. The credit spread was 2.87 percent, which was consistent with Whole Food’s BB+ credit rating.
If Amazon wished to push down some of this new financing as of August 22, 2017, two questions exist. One is how much debt could be pushed down in the form of intercompany loans from Amazon to its new Whole Foods operating affiliate? Amazon would not likely prevail in pushing down all $16 billion in debt but an intercompany loan equal to $1 billion would be reasonable if not conservative.
The other question is what should be the intercompany interest rate. Table 4 considers a 10-year intercompany loan of $1 billion issued on August 22, 2017 with three possible interest rates. Which interest rate represents the arm’s length standard depends on how one views the credit rating for the operating affiliate. If Amazon’s group rating of A is used for the analysis, then the arm’s length interest rate is the 3.15 percent third party rate paid by Amazon on the same date for the same term to maturity.
If Whole Food’s standalone credit rating of BB+ was seen as appropriate, then the December 3, 2015 third party loan might be seen as the appropriate comparable with one comparability caveat. Interest rates were slightly lower as of August 22, 2017 than they were as of December 3, 2015. Table 4 suggests that a 5 percent interest is consistent with a BB+ standalone credit rating.
Recent court decisions in other nations have suggest an intermediate position between using the group credit rating versus the stand alone credit rating. When the parent has a better credit rating than the borrowing affiliate, the implicit support controversy suggests that the appropriate credit rating be seen as stronger than the standalone credit rating but not as strong as the group rating. If the appropriate credit rating were BBB, then a credit spread near 2 percent would be appropriate. Table 4 reflects this intermediate view as a 4.25 percent intercompany interest rate under the arm’s length standard.
III. Concluding Remarks
We illustrated certain issues that require addressing in any intercompany debt push down tax planning. The first question is how much of the holding affiliate’s third party debt should be allocated to any particular operating affiliate. The OECD’s Action 4 of the Base Erosion and Profit Shifting effects on “Limitations of Interest Deductions” offers guidance which state tax authorities might consider.   
The other issue involves the appropriate intercompany interest rate under the arm’s length model. We have offered an economic approach consistent with the OECD’s recent “Transfer Pricing Guidance on Financial Transactions”. Our economic approach focuses on the terms of the intercompany agreement (date of loan and term to maturity) and the credit rating of the borrowing affiliates.
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[1] “Calculating Credit Spreads During A Pandemic”, LAW 360, April 27, 2020; “Translating Credit Ratings into Credit Spreads in Intercompany Financing, RoyaltyStat Blog.
[2] "Corporate Bond Spreads and the Pandemic," On the Economy Blog, April 9, 2020.

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