A Large Accounting Firm Automates Its Credit Assessments for Transfer Pricing

Multinational enterprises (MNE) account for large portions of world production, employment, investment, trade and R&D. While some see them as monopolizing markets, others see them as the epitome of modern capitalism, doing cutting-edge R&D, innovating production and spreading economic benefits around the world.^[1] Whatever one's view, governments need to ensure that the taxable profits of MNEs are properly reported in the country where economic activity is undertaken. The OECD Transfer Pricing Guidelines ("Guidelines") provide guidance on the application of the arm's length principle, which is the international consensus on the valuation of cross-border transactions between associated enterprises. Essentially, this requires two related companies to set the same transfer price as if bargaining in a competitive market. As markets shift and experience volatility, it is even more critical for MNEs to adapt and transform their transfer pricing workflows to minimize tax risk.

The tax and transfer pricing team ("pricing team") at this large global accounting firm advises clients on the debt rates to charge subsidiaries when loaning money. Clients, in turn, need to justify these rates to tax authorities by showing the risk level they have assigned to the subsidiary and what that would mean if sourcing funds in the open market. Given the large size of the accounting firm and the volume of ongoing work, its executives wanted to provide the pricing team with a more automated and efficient way to support their workflows.

Pain Points

Members of the pricing team were using several third-party and internal capabilities for their transfer pricing assessments, which was inefficient and increased the time involved to come up with a recommendation. They wanted to find an integrated and automated solution that would:

• Deliver a comprehensive — yet transparent and streamlined — way to assess the risk level of a subsidiary.
• Provide an integrated end-to-end offering that would calculate a risk rating plus price debt instruments.
• Meet the OECD Guidelines.
• Be applicable to multiple markets around the world, including emerging markets.
  
  

Given the importance of transfer pricing and the need to stand up to the close scrutiny of tax authorities, it was also essential to work with a well- recognized and respected firm. The team reached out to S&P Global Market Intelligence ("Market Intelligence") to learn more about capabilities in this area.

The Solution

Specialists from Market Intelligence discussed Credit Risk Pricing, a robust solution to assist with transfer pricing workflows available as part of the Credit Analytics suite of models on the S&P Capital IQ Pro platform. The approach lets users easily assess a company's creditworthiness, create a stand-alone credit score^[2] and find comparable yields and a defensible interest rate in a manner that aligns with the OECD Guidelines.

The specialists then discussed the need to go beyond the solution in the case of emerging markets and build two customized features:

1. An interest rate model to reflect an emerging country's actual risk rate. The interest rate from Credit Risk Pricing is comprised of a risk-free rate and a corresponding spread attributed to company-specific credit risk. In certain cases, the instruments used in standard corporate yield curves are not representative of the niche instrument being priced in Credit Risk Pricing. In these cases, custom searches are compiled to locate more representative samples to create a custom yield curve.
2. A debt capacity analysis to assess the debt level of a subsidiary or affiliate. Once scored, users can view capitalization and leverage ratios of the subsidiary/affiliate alongside ratio values of peers in the same risk category. This enables users to understand how much additional leverage a subsidiary can take on without seeing credit deterioration.
   
   

With these capabilities, the transfer pricing team would be able to:

	Quicky assess the creditworthiness of subsidiaries	Users can access financial data for millions of companies or use their own financials in conjunction with Market Intelligence models to generate issuer and issue credit risk assessments. The Premium Financials Dataset provides standardized data for 5K+ financial, supplemental and industry-specific data items for 150K+ companies globally, including 95K+ active and inactive companies across multiple industries. Data is available at numerous frequencies and point-in-time representations of a financial period include press releases, original filings and restatements. The Private Company Dataset covers 52M+ private companies around the globe, 10M with financial statements, and 500K+ early-stage companies supported by data from Crunchbase. Credit Analytics blends sophisticated models with robust data to help users reliably score and efficiently monitor potential risk exposure of companies across the globe.
	Add qualitative insights	Adjustments and Overlays enable users to incorporate qualitative insights, parental support, macroeconomic stress and Loss Given Default (LGD) factors to add a layer of sophistication to the analysis.
	Determine appropriate interest rates	The solution provides an intuitive Interest Rate Calculation and also enables users to drill into the yield curve construction and credit risk components to understand how the final values for the intercompany loan obligations were calculated. Corporate Yield Curves offer broad and consistent coverage of credit term structures (one month to 30 years) across four currencies($,€,£, A$) and every GICS sector, as well as a broader non-financial corporates sector and seven rating categories (AAA- CCC) or aggregates with investment grade and high-yield categories. Data is sourced directly from major buy-side firms, credit trading desks and trade reporting venues. This provides robust and transparent data to drill down and view the underlying bond constituents and prices used in the construction of each curve.
	Monitor companies on an ongoing basis	A credit risk dashboard lets users monitor a portfolio of companies and generate alerts according to their preferences. An export function downloads a report in PDF format.
	Receive training and ongoing support	Market Intelligence specialists are located around the world and are available for training sessions and to provide ongoing support as clients utilize different solutions and the S&P Capital IQ platform.

How Credit Risk Pricing works - a four-step process:

Step 1: Input financial data for the subsidiary or affiliate

The analysis starts by leveraging Market Intelligence's comprehensive database of company financials to automatically create company credit scores in the credit scoring interface. Alternatively, users can manually input their own proprietary financials. This section of the interface also provides risk factors by country and industry to capture any country-industry combination being analyzed. These inputs can be adjusted if users have an alternative perspective.

Step 2: Input additional information as desired.

Four areas are considered here that can positively or negatively impact the credit score:

Qualitative Factors: The Guidance suggests adding qualitative information, where available. For example, this could include how diversified a subsidiary is by country/product line/customer base, the quality of its management and its payment behavior.

Parental & Government Support (PGS): The Guidance acknowledges that PGS can affect the creditworthiness of the borrower, and this feature factors in the financial health of the parent company.

LGD: The Guidance states that when both an issuer and issue rating^[4] are available, the issue rating is more appropriate to price the transaction. This can require looking at the LGD for the issuance and factoring that into the credit score. The solution features the LossStats approach, which returns loss and recovery estimates for companies' debt obligations globally. It takes into account the seniority structure (i.e., senior secured, unsecured, subordinated loans or the actual capital structure characteristic), including potential collateralizations and industry riskiness, which are factored into an LGD-adjusted credit score.

Macroeconomic Factors: The solution provides current data on a wide range of economic factors, and a stress-testing capability offers the opportunity to look at a range of situations to see how a positive or negative environment could impact credit risk.

Step 3: Click to generate a stand-alone credit score.

Once the financials and optional adjustments have been entered, users simply click to generate a probability of default in percentage terms and the associated letter grade credit score, which are generated using Market Intelligence's Credit Analytics models. In addition, if information mentioned in Step 2 is entered, users will receive an LGD-adjusted credit score along with macroeconomic impacted values for the subsidiary or affiliate.

Step 4: Construct a yield curve and produce the final interest rate.

The final credit score is utilized to determine the Comparable Uncontrolled Price (CUP), which is considered to be the most appropriate approach in the context of intercompany loans.

Use the final Credit Risk Score along with our Credit Risk Pricing tool, to calculate the All-In Yield and calculate the All-In Yield Curve, leveraging from two complementary approaches.

Our methodologies harness comprehensive datasets to construct robust Corporate Yield Curves.

The first approach taps into data directly from major buy-side firms, credit trading desks, and trade reporting venues, ensuring broad coverage across various credit term structures, currencies, sectors, and rating categories. The second methodology utilizes data from the GSAC Bond Sector Curve Pricing Data, offering a broader universe of underlying bonds and extensive coverage across sectors, tenors, and currencies in North America, Europe, and Asia Pacific regions.

Key Benefits

Members of the pricing team were impressed with the demonstration of the Credit Pricing Risk solution and the flexibility and transparency of the offering. The team is now using it throughout the organization and is benefiting from having access to:

• An integrated, step-by-step approach to assess transfer prices that follows the OECD Guidelines.
• Credit scores that broadly align with credit ratings from S&P Global Ratings that can stand up to close review by tax authorities.
• Extensive data and analytical tools on the S&P Capital IQ Pro platform to quickly screen companies on a specific set of criteria for benchmarking purposes.
• Expertise of Market Intelligence specialists to develop customized models where needed to ensure that findings reflect situations in local markets.
• Detailed user guides and technical documentation to fully understand the data and methodologies used for the calculations.
• Unrivalled training sessions and 24x7 support to meet the needs of the pricing team across its multiple global locations.
  
  

Click here to explore our transfer pricing solutions in more detail.