Applying default prediction models to determine credit ratings for transfer pricing purposes in a group of companies

Abstract

Along with the new transfer pricing documentation requirements, large corporations in Finland have had to pay more attention to terms of internal loans. In practice, the Finnish Tax Administration requires that the borrower has to be rated. Due to this requirement, many companies purchase a license to rating softwares provided by credit rating agencies or outsource the rating evaluation to consultancies. Another alternative for companies could be to find or build their own rating models for internal use, which would provide cost savings. In addition, this alternative would enable companies to better explain how the credit ratings have been determined. This study investigates which kind of rating models there are and whether the models could be used in transfer pricing of long-term loans.

The research problem of this study is to find the most suitable credit rating models for the case company and to evaluate the ratings for nine group companies. Previous accounting research has showed hundreds of default prediction models and studied, for example, financial ratios' ability to predict failure. The studies have mainly focused on producing models that could discriminate between defaulted and non-defaulted companies as reliably as possible. Taxation research, on the other hand, has mainly paid attention to transfer pricing requirements from a legal point of view. However, the previous research has not combined the perspectives of accounting and taxation.

This study consists of a literature review, interviews and the determination of credit ratings. The material used in the literature review consists of journal articles and books from the fields of accounting and taxation. The interviews were carried out either in a semi-structured or an unstructured form. The interviewees included employees working for the case company, a representative of the tax administration, and a consultant specialized in rating models. With the help of the literature review and interviews, potential models to be used in rating determination were found. As a solution to the research problem, the thesis also shows credit ratings for the nine group companies.

The study contributes to accounting research by tying together credit ratings and transfer pricing requirements. By combining the perspectives of accounting and taxation, a solution for a real-world problem - credit rating determination for internal loan pricing - is been proposed to be solved. The study also provides new and valuable information about internal loans to taxation professionals. Based on the study, it can be concluded that it is possible to find applicable rating models for transfer pricing purposes from literature and journals.