Global Transfer Pricing Conference

www.pwc.com/tp Managing multiple stakeholders in the new economy Global Transfer Pricing Conference Financial transactions in a changing world

Today s presenters Jeff Rogers Arthur Mendoza Krishnan Chrandrasekhar Michel van der Breggen Slide 2

Agenda Setting the scene Inter-company loans Intercompany guarantees Cash pooling arrangements Accounts Receivable Factoring Documentation and Risk Slide 3

Setting the scene Slide 4

Setting the scene ACTION 4 Limit base erosion via interest deductions and other financial payments Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments. The work will evaluate the effectiveness of different types of limitations. In connection with and in support of the foregoing work, transfer pricing guidance will also be developed regarding the pricing of related party financial transactions, including financial and performance guarantees, derivatives (including internal derivatives used in intra-bank dealings), and captive and other insurance arrangements. The work will be coordinated with the work on hybrids and CFC rules. Slide 5

Current FT developments around the world Canada: Changes to Thin Cap Requirements and Court Cases on Financial Transactions US: IRS increased Scrutiny of Inbound Intercompany Loans and Their Characterization as Bona Fide Debt Netherlands: Court Decision on Intercompany Loan Interest Treatment Luxembourg: New Intercompany Lending Guidance Sweden: New Interest Stripping Regulations Belgium: Changes to Thin Cap Requirements Finland: Court Decision Intercompany Loan s Interest Rate South Africa: Changes to Thin Cap Requirements China: Increased Tax Audit Focus on Capitalization Australia: Guidance on Interaction of Thin Cap and Transfer Pricing Slide 6

What we typically hear from companies Our treasury team knows what to do Although treasurers may have an in-depth understanding of financial transactions, they may not be aware of or interested in transfer pricing risk and compliance. We have bank quotes supporting our pricing Bank quotes are typically not accepted by tax authorities as reliable comparable data. Of course, we rely on the average cost of funds for the group The parent company raises all third party debt great comparable data We have many examples of third party funding from the early 2000 s The marginal cost of funding approach does not consider differences in creditworthiness of the borrower and in the terms and conditions applied. Are the transactions really comparable (terms and conditions, volume, creditworthiness)? Times have changed! Slide 7

Inter-company loans Slide 8

Building blocks of an arm s length loan Creditworthiness To determine an arm s length range of interest rates it is first necessary to understand the creditworthiness of the borrowing entity on a stand alone basis. Terms and Conditions In accordance with the OECD guidelines, it is necessary to ensure that the terms and conditions associated with the transaction are set in accordance with the arm s length principle. Volume In addition to the interest rate, consideration should also be given to whether the borrowing entity could have raised equivalent debt from a third party and also whether the borrowing entity would have entered into the transaction. Interest rate Often seen as the most important building block, establishing a robust range of arm s length interest rates is critical, taking into consideration the creditworthiness of the borrower, the terms and conditions and the volume of the loan. Slide 9

Debt vs. equity and the issue of characterization How to support capital structure? What do you need to address? And, how may you do it? Can the borrower be expected to service its obligations (including repayment of interest as well as principal) for the stated level of debt? The fundamental test around ability to repay, evaluating projected availability of free-cash flows and considering anticipated capital expenditures, etc. Would the borrower want to capitalize itself with the stated level of debt, considering its financial competitiveness against peers? This involves an evaluation of the borrower against comparable peers, considering measures of profitability, leverage, coverage, and cash flow Could the borrower obtain the level of financing contemplated under current market conditions? This requires a lender-oriented analysis of current debt market conditions, such as the consideration of existing lending multiples based on recent market transactions Supporting characterization as debt requires (1) a direct consideration of debt market conditions from the perspective of a lender as well as (2) considerations around the resulting arm s length nature of the capital structure of the borrower, along with the more traditional (3) debt servicing analysis. Slide 10

Intra-group loans The impact of terms and conditions Impact on interest rate Higher Bullet Long term Mezzanine On maturity Unsecured Higher risk currency Prepayment Unguaranteed Nonconvertible Junior Lower Capital & interest Demand Guaranteed Short term Senior Quarterly (regular) Secured Lower risk currency Convertible? Impact of covenants?? Commercial & economic rational?? Impact on fixed vs. floating loans? Slide 11

Principal Principal Intra-group loans The importance of terms and conditions Envisaged loan 5 years Bullet Prepayment option included High interest rate Due on the full principal How will excess cash be used? 100 M Alternative loan 5 years Term loan Fixed installments, no prepayment option Lower interest rate Due on a decreasing principal Overall interest burden significantly lower in this scenario 100 M Years 1 2 3 4 5 Years 1 2 3 4 5 Slide 12

Common pitfalls in practice 1 No stand alone credit rating of the borrower 2 Using one blended interest rate for all transactions 3 Including flexibility (call & prepayment options) without considering the impact on the interest rate 4 Using a one pager as loan documentation 5 Not addressing FX risks Also look out for the following: Transfer of loans against nominal value (vs. fair market value) Lack of consideration for withholding taxes (for who s account/impact on price) Interest free loans Long standing non-fluctuating current account balances Repayment schedule (interest & Capital) & accrual options Long term funding within cash pools Slide 13

Related party guarantees Slide 14

Related party guarantees The GE Capital Canada case A case on guarantee fees and implicit support Between 1996 and 2000, GE Capital Canada paid a guarantee fee to GE Capital USA for the provision of an explicit guarantee relating to capital market issues in the name of GE Canada. The guarantee allowed GE Canada to benefit from cheap debt associated with a AAA rating. CRA disallowed the deduction of the payments totalling approximately $136 million on the basis that GE Canada could have raised the funds on the same terms and conditions simply by virtue of its association with the GE Group ( Implicit support ). The Tax Court of Canada accepted GE s appeal and agreed that the guarantee fee was equal to or lower than an arm s length price. Case was appealed and dismissed by Federal Court of Appeal. Guarantee fee GE Capital Canada GE Capital USA Explicit guarantee This case has potentially wide reaching consequences: Court cases involving financial transactions involve capital market experts. Arm s length testimony in a non-arm s length world? Companies should be extremely cautious when using the assumption of implicit support when establishing and substantiating inter-company financial transactions. Slide 15

Related party guarantees What is the purpose of the transaction? What is it? Shareholder service? Beneficial service? A shareholder service? no service would be received where an associated enterprise by reason of its affiliation alone has a creditrating higher than it would if it were unaffiliated, but an intra-group service would usually exist where the higher credit rating were due to a guarantee by another group member, or where the enterprise benefited from the group's reputation deriving from global marketing and public relations campaigns. In this respect, passive association should be distinguished from active promotion of the MNE group's attributes that positively enhances the profit-making potential of particular members of the group. (OECD Guidelines, Para 7.13) Example A beneficial service? the question whether an intra-group service has been rendered ( ) should depend on whether the [guarantee] provides a group [company] with economic or commercial value ( ). This can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay for the [guarantee]. (OECD Guidelines, Para 7.6) Explicit support - Financial Examples - Operating/Performance Implicit support Slide 16

Related party guarantees What is the value of the transaction? What is the cost to the guarantor? An intercompany guarantee is a contingent liability that is off-balance sheet. Generally, no real cost to an intercompany guarantee. Possibly a reduction in debt capacity. What is the benefit conferred? Is the taxpayer able to borrow a quantum of funds that would have otherwise not been available? Is the taxpayer able to borrow at a lower cost with the guarantee than it would have been able to obtain without the guarantee? Is the taxpayer able to enter a transaction it otherwise would not have been able to? Recipient's bid price intercompany guarantee fee guarantor s ask price Bid price Ask price 1. Return on the on-balance sheet liability On-balance sheet liability = likelihood of having to pay x potential payment Earn a return on the on-balance sheet liability 1. Yield approach Price of credit guarantee = estimated arm s length interest rate without guarantee actual interest rate with guarantee 2. CUP approach Adjusted standby letters of credit / letters of credit Financial Transactions Webcast October 2011 Slide 17

Cash pooling Slide 18

Cash pooling arrangements Tax considerations Permanent establishment: Will the participants have a permanent establishment in the country of the cash pool leader Withholding tax: What is the character of the payment and who is the beneficial owner? Thin capitalization: Are interest payments to the cash pool leader or the participants non-deductible or recast as a constructive dividend? VAT: If a service is being supplied by the pool leader, will there be VAT implications on charge flows? Long term positions in cash pool How to allocate the cash pool advantage? Slide 19

Cash pooling Practical example 3P bank Guarantees 3P bank - 2.5 Interest Interest - 6 3-3 - 50 Cash pool leader bank account??? Entity bank accounts - 100 100-50 - 100 100-50 Entity bank accounts Co 1 (NL) Co 2 (FR) Co 2 (GER) Co 1 (NL) Co 2 (FR) Co 2 (GER) Debit interest rate: 6% Credit interest rate: 3% Net position: - 6 Debit interest rate: 5% Credit interest rate: 4% Net position: - 2.5 Slide 20

Accounts receivable factoring Slide 21

Section 5 Where to start Factoring OpCo Funds Less Factoring Discount 2 Sale of Accounts Receivable FactorCo 1 Sales Accounts Receivable 3 Customers Payments on Accounts Receivable Slide 22

Invoice Face Value Accounts receivable factoring (continued) Breakdown of the factoring price Servicing Costs include administrative, legal, bookkeeping, and dunning expenses. Default/Dilutions reflect the risk of nonpayment of the invoice. Dilutions may occur as a result of rebates or charge backs. Financing Costs are borne by the factor for providing the assignor with upfront cash. Profit Element is the factor s earnings. It reflects returns on the costs/expenses mentioned. Servicing Costs Default/Dilutions Financing Costs Profit Element Amount Advanced to Assignor Discount TNMM/CPM: May be used to analyze the profit element that the factoring entity earns. Constructed CUP method: May be used to analyze the factoring discount. Discounted Cash Flow ( DCF ): An unspecified method that may be used to analyze the actual amount advanced to the assignor. Slide 23

Documentation and risk management Slide 24

Questions to ask yourself Would unrelated parties want to act in this way? Would unrelated parties be able to act in this way? Does the economic substance of the transaction match the legal form? What is the economic rational behind the transaction (lender & borrower perspective)? Is there a potential tax advantage arising from the transaction? Slide 25

Documentation and risk management Developing a financial transactions policy Typical transactions Intercompany short-term and long-term funding transactions The provision of guarantees FX transactions Organisation Centralised versus Decentralised Objective To provide an overall framework to document and substantiate inter-company financial transactions and to ensure a consistent approach is being applied throughout the company Introduction Company background Organisation of the Treasury department/treasury business model Functional analysis Industry analysis Transfer pricing method selection Loan pricing policy Typical policy components Short term loans/cash pool Long term loans Guarantees FX transactions Other transactions Documentation procedures Slide 26

Documentation and risk management Developing a financial transactions policy A general policy describing how the company ensures that its inter-company financial transactions are carried out at arm s length. It typically describes the processes through which the important elements (credit rating, volume, terms and conditions etc.) are addressed in practice Underlying legal documentation, i.e., the actual agreement concluded between both sides of the transaction (borrower/lender) Information substantiating the economic rationale for the borrower and lender. e.g., local board minutes of the borrower and the lender explaining the reasons why to accept internal debt funding or participating in a cash pool A file which contains information used to establish the arm s length interest rate (e.g., print screens from financial databases, information used to establish a stand-alone credit rating) The policy also describes what documentation should be maintained by whom and for how long (e.g., in view of local statute of limitations) Documentation Framework What TP rules to take as a basis: OECD Guidelines? How to act in case local legislation deviates? Use the policy to also formalise the internal departments involved in the various steps (i.e., legal, tax, treasury accounting) In case certain options are being used, it is also relevant to include procedures on how financial transactions are being monitored (so not only focus on origination) Are the relevant financial information systems available? If not, where to retrieve the relevant information from Consider using thresholds above which financial transactions will be dealt with on a more tailor made basis Slide 27

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