DEBT EQUITY CONSIDERATIONS AND RELATED TRANSFER PRICING IMPLICATIONS. August 1, 2012

Transcription

1 DEBT EQUITY CONSIDERATIONS AND RELATED TRANSFER PRICING IMPLICATIONS August 1,

2 PANELISTS Filiz Serbes, IRS Office of Associate Chief Counsel (Corporate) Carol Tan, IRS Office of Associate Chief Counsel (International) Brian Cody, KPMG LLP Richard Rozek, NERA Economic Consulting Sanford Stark, Bingham McCutchen LLP 2

3 DEFINITIONS OF DEBT AND EQUITY Currently no definition in the Code or Treasury regulations of debt or equity for tax purposes Substantial body of Federal common law is the principal source of guidance Courts have created lists of factors to distinguish debt from equity with no one factor controlling or more important than any other, including Fin Hay Realty Realty Co. v. United States, 398 F.2d 694 (3d Cir. 1968) (sixteen factors) Estate of Mixon v. United States, 464 F.2d 394 (5th Cir. 1972) (thirteen factors) 3

4 FIN HAY REALTY REALTY CO. V. UNITED STATES Sixteen factors for distinguishing debt from equity 1. Intent of parties 2. Identity between creditors and shareholders 3. Extent of participation in management by holder of instrument 4. Ability of corporation to obtain funds from outside sources 5. Thinness of the capital structure in relation to debt 6. Risk involved 7. Formal indicia of arrangement 8. Relative position of obligees as to other creditors regarding payment of interest and principal 9. Voting power of holder of instrument 10. Provision of fixed rate of interest 11. Contingency on obligation to repay 12. Source of interest payments 13. Presence or absence of fixed maturity date 14. Provision for redemption by corporation 15. Provision for redemption at the option of holder 16. Timing of advance with reference to organization of corporation 4

5 ESTATE OF MIXON V. UNITED STATES Thirteen factors for distinguishing debt from equity 1. Names given to certificates evidencing the indebtedness 2. Presence or absence of fixed maturity date 3. Source of payments 4. Right to enforce payment of principal and interest 5. Participation of management flowing as a result 6. Status of contribution in relation to regular corporate creditors 7. Intent of parties 8. Thin or adequate capitalization 9. Identity of interest between creditor and stockholder 10. Source of interest payments 11. Ability of corporation to obtain loans from outside lending institutions 12. Extent to which advance was used to acquire capital assets 13. Failure of debtor to repay on due date or to seek postponement 5

6 PRACTICAL CONSIDERATIONS OR ISSUES Documentation Intercompany loan agreements Records of payments Accrual schedules, etc. 6

7 PRACTICAL CONSIDERATIONS OR ISSUES (continued) Conduct of the parties Circular cash flows Dividends and other payments Netting of transactions (e.g., interest payments/charges) Settlement of accounts Replacement of third-party debt with related-party debt 7

8 ECONOMIC ISSUES Discount Rates NPV Analysis Relies on Accurate Measure of Risk WACC Reflects the Debt and Equity Data for a Specific Company Financing R&D with Debt and/or Equity Industry Differences (e.g., Pharmaceutical Firms Rely on Equity to Finance R&D) In Selecting Comparables, Examine Debt/Equity Structure Loans to Related Parties Interest Payments are Costs to One Party and Revenues to Another Party (possibly in different tax jurisdictions) GSK Terminated Loan to Luxembourg Subsidiary After Tax Authority Scrutinized Transaction 8

9 ECONOMIC ISSUES (continued) Guarantees on Loans Between Related Parties Credit Ratings of Related Parties GE Canada Case Affirmed a Guarantee is Acceptable Arm s Length Interest Rate for Loan Between Related Parties Reflect Risk of the Parties Identify Risks Measured by Various Market Rates Thin Capitalization OECD Identified Ongoing Debate on TP Issue or Anti-Avoidance Issue China and Netherlands Addressing the Issue Credit or Default Risk 9

10 MORE ON THIN CAPITALIZATION Debt/Equity May be Too High for the Related Party (Borrower) Not Based on Arm s Length Benchmark Tax Authorities May Disallow Certain Payments Possible Safe Harbor Rule Provide Guidance to Taxpayers Acceptable Debt/Equity Ratios Interest on debt in excess of 2:1 rate not deductible. Such rules do not take into account industry differences (across industries and within industry). 10

11 THIN CAPITALIZATION: INDUSTRY DIFFERENCES VARIATION IN DEBT-TO-EQUITY RATIOS ACROSS INDUSTRIES Industry Mean Debt-to- Equity Ratio Interquartile Range (1) (2) Heavy Construction Drugs - Generic Conglomerates Chemicals - Major Diversified Beverages - Soft Drinks Drug Manufacturers - Major Specialty Chemicals Food - Major Diversified Independent Oil & Gas Auto Parts Diversified Utilities Auto Manufacturers - Major Shipping Wireless Communications Housewares & Accessories Major Airlines Source: Ycharts 11