Intra group debt: loan agreements vs loan notes

From a transfer pricing perspective it’s almost impossible to ‘delineate’ intra group debt without reference to the legal terms. One financial instrument cannot be compared with another for pricing purposes unless there is clarity on the associated legal rights and obligations of the respective parties. Here we’re talking about basic terms such as currency, tenor, interest rates (fixed or floating), interest payment dates, acceleration, prepayment rights etc. And following the BlackRock case (the subject of a recent episode of our podcast) we also need to look carefully at security and third party covenants.

That much is clear.

But debt can have different legal forms, and one of the basic distinctions is between ‘conventional’ loan agreements on the one hand, and debt in security form (e.g. loan notes) on the other.

The choice of legal form is independent of the selection of commercial terms – because any given commercial terms can be implemented just as fully in loan notes as they can in ‘conventional’ loan agreements, and vice versa.

In some situations, there’s a clear preference for loan notes, such as where the debt is to be listed as a ‘quoted eurobond’ on a recognised stock exchange.

But if there isn’t a clear driver like that, my view is that you should think twice before using loan notes.

The reason for this is that although the commercial effect may be the same when the debt is first put in place, the ongoing corporate administration of the debt is very different.

As illustrated in the slide above, if loan notes are used then matters such as additional advances, repayments of principal and capitalisation of interest need to be documented in a very different way.

This may not seem like a major issue. But if the legal administration of loan notes is not kept up to date, then you end up with a set of legal documents which doesn’t align with the reality.

In which case you’ve failed one of the key objects of the exercise: audit-ready documentation to substantiate your TP policies.