This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (You may also remember him from another blog he wrote for us about the implications of the demise of LIBOR.) Here he examines the recent judgment in the case Sweden vs. Nobel Biocare Holding AB, and highlights its main implications.
Sweden vs. Nobel Biocare Holding AB (HFD 2016 ref. 45) involved a set of January 2003 intercompany loans from the Netherlands Antilles affiliate of Nobel Biocare Holding AG to Nobel Biocare Holding AB, a Swedish operating affiliate. The relevant agreements were long-term, with maturities ranging from 15 years to 30 years, but were also floating rate agreements. The original agreements were based on the Stockholm Interbank Offered Rate (STIBOR) plus a 1.5 percent loan margin.
The Swedish Tax Administration (STA) accepted this 1.5 percent loan margin as arm’s length, but objected to a June 2008 change in the agreements which increased the intercompany interest rate by 2.5 percent. Nobel Biocare appealed to an administrative court. It ruled in favour of the taxpayer, arguing that the 2008 agreement was consistent with market rates.
The STA appealed to the Court of Appeals, which upheld the STA’s original transfer pricing adjustment. The Court of Appeals stated the following:
When contracting parties who are close to each other have an agreement and renegotiate the terms of it or replace it with another, the examination against the correction rule shall refer to how independent parties had acted given that they had the contractual relationship of the related parties. The 2008 agreement meant that the company had to pay a higher interest rate than it would have had to do in 2003 agreements continue to apply. As far as can be seen, according to the 2003 agreement, there was no right for the lender to adjust the interest rate and the 2008 agreement was thus unfavourable for the company. There is nothing to show that the 2003 and 2008 agreements differ in such a way that it was commercial for the company to commit to continuing to pay a higher interest rate through the later agreements. The Swedish Tax Agency has thus shown that the company entered into an agreement with a related company which – in relation to the agreement that then ran between the parties – was unfavorable to the company, without other contract terms justifying it and without any compensation for the changed terms. An independent party had not agreed on such an amendment to the agreements.
The Supreme Court upheld the Court of Appeal’s decision on June 7, 2016. Mikael Jacobsen, Malin Andersson and Janina Hägg recently discussed this litigation in terms of the implications for intercompany agreements.
Market rates as of January 2003 and June 2008
The graph below shows the Swedish 3-month interbank interest rate (STIBOR) from January 2003 to June 2008. This rate was 3.65 percent as of January 2003. If the intercompany loan margin was 1.5 percent, then the original intercompany interest rate was 5.15 percent. Our graph shows the intercompany interest rate under the original intercompany agreement as the interbank rate plus 1.5 percent.
Over the next two years, market rates declined. From early 2005 through June 2008, market rates rose with STIBOR reaching 4.15 percent by June 2008. Under the original contract, the intercompany interest rate would be 5.65 percent as of June 2008.
The facts in this litigation suggest that under the new intercompany contract, the intercompany interest rate was 2.5 percent higher than the original intercompany interest rate or 7.65 percent. Note, however, that this higher intercompany interest rate represented a new loan margin: 3.5 percent. The STA position that the original contract should have been honoured would logically imply a 2 percent transfer pricing adjustment, and not the 2.5 percent adjustment proposed by the STA, as the original contract contemplated adjustments to the intercompany interest rate as short-term market rates adjust.
Swedish interbank rates and the implied intercompany rate: January 2003 to June 2008
Loan margins and credit ratings
The Court of Appeals decision notes the following controversy with respect to the appropriate credit rating for the Swedish affiliate.
The company argues that the crucial difference between the calculations is that PwC's comparative companies are companies with a relatively low credit rating, while the Swedish Tax Agency has compared the interest rate on corporate bonds for companies with significantly higher rankings. The company believes that the Swedish Tax Agency in its assessment incorrectly assumed that the current debt is equity and not foreign capital and that this has led the Swedish Tax Agency compared with the wrong company [sic]. The credit risk has – according to the company – been tested without taking into account the borrower's ability to pay the current interest on an ongoing basis and ability to repay or refinance the debt at maturity. In its assessment of market interest rates before lending, a bank would not disregard SEK 11 billion in debt. According to the company, such an approach is unreasonable and there is no support for this in current financing theory. The company's objections well illustrate the difficulties that exist with standardized interest calculations. The company has large debts to group companies and an external lender would of course have had to take these into account when the interest rate was negotiated. At the same time, in this context, one can not ignore the fact that it is a question of loans from companies that are completely under the Group's control. There are in principle no external loans and Group management has full transparency and control over several factors that are of crucial importance for the interest rate level. This applies, for example, to the collateral that must be provided for this loan andfor additional external loans or how the order of priority should be for future borrowing.
In summary, the Court of Appeal considers that the company has not shown that the interest rate according to the 2003 agreement was below the market interest rate. Previously stated information and how the company has been taxed in previous years speaks against the company's claim. The study carried out by PwC 2011 and the report on the Group's pricing of loans do not show with sufficient strength that the interest rate on the loans taken out in 2003 was not market-based. This investigation is further contradicted to a certain extent by the information provided by the Swedish Tax Agency.
The 1.5 percent loan margin stipulated in the 2003 intercompany agreement is consistent with arm’s length pricing if the credit rating for the borrowing affiliate was BBB. A 3.5 percent loan margin would be reasonable only if this credit rating were BB-. The appropriate credit rating is a particularly difficult factor in the pricing of intercompany loans under the arm’s length standard. While PwC provided an argument for a poor credit rating in its 2011 analysis, the STA provided its own analysis for a higher credit rating. Interestingly, Nobel Biocare’s initial position when the long-term intercompany loan agreement was established in 2003 was consistent with the position of the STA.
This litigation illustrates two key considerations. The arm’s length loan margin for a floating rate intercompany loan depends critically on the appropriate credit rating. The original intercompany loan contract was consistent with a BBB credit rating for the Swedish borrowing affiliate. Over five years later, however, the representatives of Nobel Biocare asserted that the appropriate credit rating was below investment grade. The STA disagreed with this subsequent analysis, preferring the original position of Nobel Biocare.
The other key consideration is the role of intercompany contracts. Jacobsen, Andersson and Hägg reviewed this litigation in terms of implications for intercompany contracts and suggest “always include an interest adjustment clause in loan agreements”. There are several problems with such a recommendation. If the interest rate adjustment clause allowed the lending affiliate to increase the intercompany interest rate, the tax authority could reasonably assert that borrowers would not agree to an option by the lender to increase its interest expense. The option to repay or refinance a loan before its maturity is often extended to the borrower. Claymont Investment v. Commissioner (Docket Nos. 14384-99, 9129-00) is an example where the IRS argued for a much lower intercompany interest rate based on the premise that the borrowing affiliate would exercise such an option if market rates fell.
An easier means for allowing a multinational more flexibility would have been to have the term of the intercompany loan be a five-year floating rate loan rather than a very long-term floating rate loan. If the credit rating for the borrowing affiliate were indeed lower in 2008 than it was in 2003, then the arm’s length loan margin may have indeed increased from 1.5 percent to 3.5 percent. A cautionary note, however, that the tax authority could challenge the premise that the appropriate credit rating should have been BB-.
 “Intra-group agreements may become a lock-in in Sweden”, International Tax Review, May 12, 2022.
 Organization for Economic Cooperation and Development, 3-Month or 90-day Rates and Yields: Interbank Rates for Sweden.
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