Credit Rating vs Quotation: Should We Choose One?

Domestic financial markets have been facing considerable pressure recently. Issues relating to downgrades in the government’s debt rating, along with concerns about the credit profiles of a number of corporations, have weighed on market sentiment. The impact is clear: bond market yields increase and borrowing costs increase even higher. 

For many companies, this is not merely a macroeconomic issue. Higher yields can also affect how companies determine loan interest rates, including in intercompany loan transactions within a group. 

When market interest rates surge due to short-term sentiment, an important question arises. Should intercompany loan interest rates adjust to the elevated market conditions? Or should companies continue to rely on their internal fundamentals? 

In transfer pricing practice, this dilemma usually comes down to two main approaches for testing whether a loan interest rate is arm’s length, namely the credit rating approach and the quotation approach. Both are commonly used for transfer pricing compliance purposes, but they reflect different perspectives. Which approach, then, is actually more appropriate? 

Different Approaches, Different Perspectives 

The credit rating approach starts from the internal condition of the borrowing company. The analysis focuses on the debtor’s financial capacity to repay the debt. 

Typically, the analysis examines various financial ratios, such as the interest coverage ratio and the debt-to-equity ratio. Those ratios derive a synthetic credit, for example, stating equivalence to BBB or BB, as used by international rating agencies. 

In other words, this approach seeks to answer one central question: how risky is the company as a borrower? 

By contrast, the quotation approach places greater emphasis on market conditions. Practitioners generally refer to loan interest data available in the market as comparables. In Indonesia, this approach often relies on aggregate data, such as the Indonesian Economic and Financial Statistics (SEKI) published by Bank Indonesia.  

The quotation approach has the advantage of reflecting actual market conditions. However, the approach often represents only the industry average rather than a company’s specific circumstances. This creates a common dilemma in practice. 

Different Results 

The difference between these two approaches is not merely a matter of methodological preference. The difference arises because each views risk from a different angle. 

The credit rating approach views risk from inside the company, whereas the quotation approach views risk from the market’s perspective. In Indonesia, this condition raises several practical issues. 

First, most companies in Indonesia, especially subsidiaries of multinational groups, do not have an official credit rating from a rating agency. An analysis that solely relies on market data, such as SEKI, implicitly assumes that the company bears the same level of risk as the industry average. In reality, however, the situation may be very different. 

Second, volatile market conditions may cause quotation data to become excessively high. In times of crisis or negative sentiment, market lending rates can rise sharply. In such circumstances, the credit rating approach tends to produce more stable results because the basis is on the company’s financial statements. 

Third, the market often penalises companies perceived as lacking transparency. Companies with weaker disclosure quality are typically charged a higher risk premium by the market. However, internal analysis based on financial statements may not fully capture that sentiment. 

The differing characteristics often cause the two approaches to produce differing interest rates as well. 

Finding a Middle Ground 

In this situation, relying exclusively on one approach is not the best solution. Instead, a more rational approach is to combine both. 

However, before conducting an interest rate analysis, one step is often overlooked, namely confirming that the transaction is factually a loan in substance. This is in line with PMK 172/2023, which emphasizes the importance of the delineation of the transaction. 

In other words, loan characteristics such as tenor, currency, and repayment capacity must first be tested substantively as a loan transaction. Without this step, any interest analysis becomes less relevant, regardless of the method used. 

Once the transaction has been established as a valid loan, the two approaches can then be applied sequentially. 

The first step is to assess the debtor’s risk profile independently through a synthetic credit rating analysis. From the financial ratio analysis, the company can determine whether the profile is equivalent to an AA, BBB, or even lower rating. 

The second step is to consider implicit support from the group. In business practice, subsidiaries often benefit from the reputation of their parent company. The OECD has even acknowledged that this implicit support can improve a subsidiary’s creditworthiness. 

The third step is to translate that credit rating into an interest range by using external comparable data. 

At the final stage, the result can be calibrated against market data through the quotation approach. This way, the company does not rely solely on market statistics, but also has a strong rationale grounded in the internal risk profile. 

If the interest derived from the internal analysis is lower than the market average, the company can explain that this is reasonable because the risk profile is better than the industry average. Conversely, if the risk is higher, a more expensive rate may also be justified. 

More Than a Matter of Choosing a Method 

Ultimately, the debate between the use of credit rating and quotation is not really about choosing the best method. Both methods are analytical tools that view risk from different angles. 

What matters more is whether a company can build a consistent and reasonable line of proof, starting with understanding the substance of the transaction, followed by a credible risk analysis, and validated against market data. 

Such an approach not only produces stronger transfer pricing documentation but also helps bridge the perspective difference between taxpayers and the tax authority. 

In an increasingly complex transfer pricing environment, a balanced, analysis-based approach is often far stronger than merely choosing one method while disregarding the other. (ASP) 

Disclaimer! This article is a personal opinion and does not reflect the policies of the institution where the author works.