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Mylan Australia Intercompany Financing: Thin Cap or Pricing?

Intercompany Agreements

23 August 2023

This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (One of several that he has written for us.) He considers some ongoing litigation in Australia – Mylan Australia Holding Pty Ltd v. Commissioner (FCA 672 2023) – and highlights two critical issues.

On June 21, 2023 the Federal Court of Australia issued a procedural decision in Mylan Australia Holding Pty Ltd v. Commissioner (FCA 672 2023). The ongoing litigation involves an intercompany loan from Mylan Luxembourg to the Australian affiliate Mylan Australia Pty Ltd. This article looks at two key issues which may affect the outcome of the litigation, namely the quantum of the debt (thin cap issue) and the pricing of the debt (interest rate), taking into account the selection of floating verses fixed interest rates, and the potential impact of implicit support.

The background to the litigation is that on October 2, 2007 Mylan Inc. acquired Merck’s generic pharmaceutical group, which included the Australian entity Alphapharm Pty Ltd. The value of the assets of this entity were approximately A$1.2 billion, of which 75% was financed by an intercompany loan. The interest rate was originally floating, but was later fixed at 10.15% per annum with retroactive effect from October 2, 2007.

In an April 14, 2023 LCN Legal Podcast entitled “Ongoing TP Litigation in Australia” Paul Sutton interviewed Andy Bubb, who noted how the Australian Tax Office (ATO) was attempting to deny some of the intercompany interest rate deductions:

“Its main arguments point to the debt levels that the whole global group had after that transaction, which were closer to 50 or 60%. And so the ATO is seeking to knock out the additional deductions that were taken up to 75%. And, as I mentioned, arguing either that the TP rules apply and parties operating independently wouldn't have geared up to a 75% level, they would have only geared up to the global group level. Or alternatively, based on the General Anti-Avoidance Rule, essentially arguing that the dominant purpose of that aspect of the structure was to obtain a tax benefit, being the extra interest deductions that were claimed in Australia.”

Reducing the debt/asset ratio from 75% to 60% would lower the principal from A$ 923.25 million to A$738.6 million, which would lower annual interest deductions from approximately A$94 million to A$75 million as noted in table 1 under “Thin Cap”. While it is unclear whether the ATO will pursue the pricing of the intercompany loan, we shall argue a case can be made that the arm’s length interest rate is only 7.7%. Even if the debt/asset ratio remained at 75%, the reduction of the interest rate to the arm’s length standard would lower annual interest deductions from approximately A$94 million to A$71 million as noted in table 1 under “Pricing”. If both the Thin Cap and Pricing were proposed and sustained, annual intercompany interest deductions would be approximately A$57 million.

Table 1: Interest Rate Reductions Under Alternative Challenges

Item (millions)TaxpayerThin CapPricingBoth
Interest rate10.15%10.15%7.70%7.70%
Interest expenseA$93.71A$74.968A$71.09A$56.872


Floating versus Fixed Interest Rate

The Federal Court noted that the ATO had been exploring two potential pricing issues, including whether the original intercompany contract, which was a floating rate arrangement, should have been maintained. We briefly address this issue before turning to the issue of whether the 10.15% fixed interest rate was above the arm’s length standard. The Federal Court order noted:

“The Commissioner emphasised that MAHPL’s Appeal Statement positively contends that, on or before 31 December 2007, the decision was made to (inter alia) amend PN A2 to establish a principal of AUD923,205,336 and to fix the interest rate at 10.15% with retroactive effect to 2 October 2007. The Commissioner submitted that when the fixing of the interest rate with retroactive effect occurred was a matter that was in dispute.”

The order also noted that the expert witnesses for the taxpayer:

“... explained why it was sensible to have a fixed rate for an intercompany loan, and that a fixed and floating interest rate are economically equivalent at the time they are chosen because they are chosen by reference to the future curve and looking at where the market thinks interest rates will go.”

The Reserve Bank of Australia provides historical data on the interest rates for Australian government bonds including short-term bonds, five-year bonds, and ten-year bonds as well as historical data on the interest rate for 6-month interbank rates. On October 2, 2007 the term structure was inverted with the interest rate on short-term bonds being 6.47%, interest rate on five-year bonds being 6.4%, and the interest rate on ten-year bonds being 6.16%. The interbank interest rate was near 7%.

The Federal Court order did not state what the original intercompany loan margin was, but let’s assume the original intercompany contract set the interest rate at the interbank rate plus a 4% loan margin. The original interest rate would be 11%, which was higher than the 10.15% long-term fixed rate in the revised contract. Note, however, an inverted term structure is often a signal that the market expects short-term interest rates to fall in the future. Interbank rates remained near 7% or higher for the next twelve months but dramatically fell in late 2008.

Arm’s Length Interest Rate for a Long-term Fixed Interest Rate Arrangement

While the ATO could challenge whether the intercompany loan contract could retroactively be recast as a fixed interest rate contract signed on October 2, 2007, we shall pose the question as to whether a 10.15% interest rate was arm’s length if a ten-year fixed interest rate contract denominated in Australian dollars was signed on that date. Table 2 summarizes the terms of this hypothetical loan contract and provides the interest rate on ten-year Australian government bonds (GB). The difference between the 10.15% intercompany interest rate and the 6.16% interest rate on ten-year Australian government bonds implies a credit spread very close to 4%. Such a high credit spread would be reasonable only if the credit rating of the Australian borrowing affiliate were BB-.

Table 2: Credit Spreads for Intercompany Loan and Two Third Party Debt Issuances

DateAmount (millions)Term (years)Interest rateGB rateCredit spread


The Federal Court order notes this explanation for the 10.15% by the representatives of Mylan:

“Mylan Group Treasury was responsible for determining appropriate fixed interest rates for all promissory notes based on the cost of external debt and an appropriate spread for the currency of the note. The fixed interest rate of 10.15% was determined and set by Mylan before 31 December 2007.”

The interest rate on ten-year U.S. government bonds on October 2, 2007 was 4.54%, so the appropriate spread for the currency of the loan could be seen as the difference between the 6.16% interest rate on ten-year Australian government bonds and the 4.54% interest rate on ten-year U.S. government bonds. What was meant by the cost of external debt, however, is unclear. Table 2 provides certain key data on corporate bond issuances both before and after the date of the intercompany loan. On January 29, 2013, Mylan issued $2 billion in corporate debt with $500 million in the form of ten-year debt with an interest rate = 4.27%. The interest rate on ten-year U.S. government bonds on this date = 2.75% so the credit spread = 1.55%. If this same credit spread was applied to the ten-year Australian government bond rate, the implied arm’s length interest rate would be 7.7%.

This position relies on the premise that Mylan’s group credit rating was BBB and that the appropriate credit rating for the Australian borrowing affiliate is this group credit rating. Transfer pricing advisors in 2007, however, were relying on estimated standalone credit ratings for borrowing affiliates. It is plausible that Mylan’s Treasury Group estimated that the standalone credit rating for the borrowing affiliate was BB-, which allowed them to conclude that a 4% credit spread was reasonable.

Transfer pricing practitioners in light of recent decisions in both Australia and Canada consider implicit support considerations. Weak implicit support would start with the standalone credit rating and then notch up the credit rating. Strong implicit support would start with the group rating and then notch down the credit rating. We should also note that Mylan’s group credit rating for late 2007 may have been different from the group credit rating for early 2013. Table 2 considers the evidence from the $500 million in corporate debt offerings on July 21, 2005 of which $350 million represented ten-year corporate debt with an interest rate = 6.38%. The interest rate on ten-year U.S. government bonds for that date = 4.11% so the credit spread = 2.27%. This credit spread was consistent with a group credit rating at the time of BB+.

Whether the ATO raises the issue of this 10.15% intercompany interest rate is unclear. We have suggested that the arm’s length rate might be as low as 7.7%. The appropriate evaluation of this issue would require a thorough analysis of the role of implicit support and an analysis of the group credit rating for Mylan at the time of acquisition.

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