Intercompany Financing: Transfer Pricing of Risk, Credit and Guarantees Liga Hoy, Principal Economist, DLA Piper San Francisco June 3, 2014 *This presentation is offered for informational purposes only, and the content should not be construed as legal advice on any matter.
Agenda Relevant authority on intercompany financing transactions Regulations: Section 482, BEPS OECD and other US proposals Recent case law: The GE case, among others Characterization of debt Technical analysis: when is debt bona fide? Financial ratios and comparables Overview of tax authority activities Arm s length charges on intercompany financing transactions Technical discussion and analysis Key takeaways 2
Authorities on transfer pricing of financing transactions: relevant regulations and case law OECD BEPS Update June 3, 2014 3
Relevant regulations: intercompany financing US IRC 1.482 Treasury Reg. Section 1.482-1(b) / (c): The arm s length standard applies to inter-company financial transactions Determination of true taxable income of a controlled taxpayer, the standard applied is that of a taxpayer dealing at arm s length with an uncontrolled taxpayer. However, because such transactions can rarely be located, an arm s length result will generally will be determined by reference to the results of comparable transactions under comparable circumstances. The preamble of Regs 1.482-9 states that the Treasury and IRS plan to issue additional guidance for guarantees. Financial transactions are explicitly excluded from SCM eligibility. [1.482-9(b)(3)(ii)(H)] Treasury Reg. Sec. 1.482-2(a): Determination of taxable income in specific situations loans or advances General case Funds obtained at situs of borrower Applicable federal rates (AFR) safe haven 4
Relevant regulations: intercompany financing OECD and BEPS Both the OECD Report on Attribution of Profits to Permanent Establishments and the new BEPS Action Plan establish a distinct role for the financial risk management function Action 9. Transfer Pricing for risks and capital (Sept. 2014) Action 4. Deductibility of interest and other financial payments (Sept. 2015/Dec. 2015) Risk associated with financial assets or instruments can be transferred among affiliates (OECD Report, Part II, para. 21) Risk management capabilities at the transferee location need to be identified and assigned (OECD Report, Part II, para. 182) Contracts and contractual terms need to clearly identify and assign risk management capabilities at the transferee location (OECD Report, Part II, para. 182) 5
Relevant regulations: intercompany financing BEPS OECD The OECD Business Restructuring Paper and BEPS Action Plan similarly both recognize that financial risks and assets are transferrable and their management is a key entrepreneurial risk-taking (KERT) function Management of risk and financial assets is assumed by unrelated or related parties for a price The transfer of financial risk and associated financial assets are not generally recognized unless the functional management of the financial asset is also transferred. Business purpose and substance is critical Redeployment of key financial risk management functions may needed to evaluate, monitor and oversee financial capital and related risk regionally or globally Optimizing intercompany financing can be a key source of tax-driven value creation Restructuring financial risk management globally can optimize ROI A new and enhanced corporate treasury function can rely on the following accepted market-based instruments to manage the firm s financial risks among affiliates: Credit default swaps and credit guarantees to reduce intercompany borrowing costs, indemnification of parts of the company against risk of loss by the counterparty, cash pooling and optimizing banking relationships are all market-based instruments used to manage financial risk and costs 6
Regulatory developments: intercompany guarantees and passive association A loan or credit guarantee is an agreement by the parent co (guarantor) to pay any missing payments to an unrelated third-party lending in the event its subsidiary (borrower) defaults on its loan obligation. The key transfer pricing issue is whether the sub-borrower should pay a guarantee fee (or other compensation) to its parent co, since the guarantee helped it obtain the third-party loan on favorable terms Guaranteeing a subsidiary s loan provides an economic benefit to the subsidiary since it helps the subsidiary finance and undertake core business functions Passive or implicit association may improve the potential creditworthiness of the subsidiary and reduce the value of the guarantee fee Role of implicit group financial support and passive association July 13 2013 OECD draft Intangible Regulations (para. 24) include implicit association as a benefit with positive value that can reduce the value of the guarantee fee Views differ across tax jurisdictions; a recent survey found 11 of 23 jurisdictions, including Australia, include implicit association as a benefit Differing views are a source of potential bilateral disagreement on an already contentious issue Various transfer pricing methodologies can be applied to determine the value of a credit guarantee 7
Recent case law: recap of GE capital guarantee fee litigation (2006-2009) GECC (USP) guarantees GE Capital Canada third-party debt 1989-1995 1995 1995-2000 1998 Guarantee in place, no fee charged A guarantee fee of 100 bps is charged Guaranteed debt rises 3x from $2.5B to $8.0B CRA Canadian audit of guarantee fee and 2004 CRA assessment disallows entire guarantee fee of USD $48M 2006-2009 GE files notice of appeal, trial commences 2009 Dec GE Cap Canada Guarantee fee deduction is upheld 100% Credit Ratings AAA AA+ AAA AA- A+ A A- BBB+ BBB BBB- Assume 20 bps loan cost for each increased risk level GE CAP CANADA Borrower (BBB) 100 bps Guarantee fee Loan GECC (USP) Guarantor (AAA) 3 rd party Lender Credit Guarantee 1) Rating impact of Guarantee (from BBB to AAA) = 120 bps 2) Guarantee fee price < Interest Savings (BBB to AAA) 8
Other recent case law: HSBC Canada is appealing a CA$90M tax adjustment, which relates to the Canada Revenue Authority (CRA) partially disallowing parental guarantee fees deducted between 1996 and 2000 CRA takes the position that a non-resident parent would provide a guarantee of a subsidiary regardless of whether a formal arrangement exists (passive association argument). Therefore, the guarantee fee should be very low or there should be no fee. This position appears at odds with the arm s length principal. Container Corp v. Comr, 134 T.C. No. 5 (2010): US Tax Court focus on the character of the payment for US income sourcing purposes The court finds guarantee fees are more analogous to services than to interest, assisting to address the issue of characterization of a guarantee transaction Guarantee fees were determined to be foreign-sourced, rather than US-sourced, and therefore not subject to US withholding tax Two key points for transfer pricing purposes: US Tax Court implicitly recognized: 1. the payment of intercompany guarantee fees (averaging 150 basis points annually or 1.5%) and 2. the economic substance of the transaction 9
Characterizing debt technical background and analysis OECD BEPS Update June 3, 2014 10
Technical background: demonstrating that debt is bona fide The quantum of debt directly impacts creditworthiness, which then impacts the interest rate The overall objective is measuring debt capacity of a company. Key factors include: Can the company borrow the quantum of debt given current market conditions? Is the company capitalized consistent with the arm s length principle? Relative to comparable companies? (debt / capital, debt / equity ratios) Will the company be able to service its debt obligations interest payments and principal over the term of the loan? (debt service coverage and interest coverage ratios) Interest rates are determined by various factors, including overall capital market conditions 11
Technical background: is borrower capitalized consistent with arm s length standard? Identify comparable companies within the industry Evaluate relevant financial ratios Debt service and interest coverage ratios (i.e., determine minimum coverage ratios, EBIT / interest expense > 1.0 + ) Cash-flow ratios (i.e. total debt / EBITDA) Profitability ratios (i.e. return on assets) Leverage ratios (i.e. debt to capital, debt to equity) Adjustments to financial statements Operating leases Securitizations 12
Technical background: confirm debt capacity of borrower Complete an evaluation of the intercompany borrower s financial metrics over the term of the loan in comparison to: Financial market covenants (loan requirements and restrictions) Comparable companies in similar industry Demonstrate the ability of the borrower to service the debt through positive discretionary cash flow and a reasonable repayment period 13
Indicators related to the form and terms of financial instrument Debt Indicators Labelled as loan, debt, debenture Fixed rate of interest No participation in business upside or downside Not convertible into stock Right to enforce payment Fixed date for repayment Term of advance reasonably short No subordination to outside lenders Additional features such as (i) security; (ii) sinking fund (to cover lump-sum principal repayment); and/or (iii) warranties, covenants, other creditors rights Equity Indicators Label as equity, stock, capital No fixed rate of interest Payments dependent on earnings or discretionary board action Participation in business upside or downside Convertible into stock No right to enforce payment No fixed date for repayment Term of advance unreasonable long Sub ordination to outside lenders No additional risk management features (e.g., no security, warranties, no convenants or other creditor s rights) 14
Indicators related to circumstances at time of advance Debt Indicators Reasonable debt/equity ratio (compared to industry average) Able to obtain similar amounts on similar terms from outside lenders Projected cash flows sufficient to pay interest and principal, taking into account needed capital expenditures Funds used for working capital No identity of interest of shareholders and creditors Equity Indicators Unreasonably high debt/equity ratio (compared to industry average) Unable to obtain similar amounts on similar terms from outside lenders No evidence of sufficient cash flows to pay interest and principal Funds used to acquire capital assets or start new businesses Identity of interest of shareholders or creditors 15
Indicators related to subsequent actions of the parties Debt Indicators Interest is paid when due out of borrower s earnings (rather than new loans) Principal paid when due out of borrower s cash flow (rather than new loans) Instrument not modified (except to grant extra creditor s rights) Consistent treatment of advances as loans in financial statements, board minutes, etc. No evidence of intent not to repay when due Equity Indicators Interest not paid when due (e.g., capitalization of interest) Principal not paid when due (e.g., extensions of terms of advance) Instrument modified to relax terms, remove creditor s rights Any treatment of advances as capital or equity in financial statements, board minutes, etc. Evidence of intent not to repay when due 16
Intercompany financing: overview of tax authority activity IRS has raised numerous debt v. equity issues recently (since financial meltdown). The most common scenario is when the foreign parent advances funds to the US subsidiary IRS industry counsel is involved and often controls development of the issue; IDRs are very detailed and extensive. Section 163(j) allows for disqualification and disallowance of interest expense Financial ratios are given a great deal of weight and heavily anlayzed Often, there is difference of opinion about how to compute certain ratios Tax authority decides how much weight to give each ratio Substance v. form: IRS claims substance of the transaction and not form controls, especially where the debtor and creditor are jointly controlled because the parties can mold the transaction to their will 17
Intercompany financing transactions and arm s length charges OECD BEPS Update June 3, 2014 18
Intercompany financing transactions: a diverse spectrum Common transactions Related party Loans Credit guarantees Factoring arrangements Cash-pooling arrangements Less common Performance guarantees Redeemable reference shares Credit risk transfer arrangements Interest rate swaps, cross-currency swaps and other derivatives 19
Arm s length charges: intercompany financing Interest rate theory Promised interest rate = time premium + default risk premium + market risk premium Capital market approach to price a financial transactions is normally based on three steps: Step 1: Establish a credit rating based on the bank lending or rating agency (Bloomberg, S&P, Fitch) scores or based on synthetic or shadow ratings Step 2: Identify specific characteristics of debt Step 3: Determine interest rates by reviewing comparables with the credit rating and characteristics as identified 20
Arm s length charges: step 1 credit rating analysis Bank lending industry and bond markets are based on analyses to assess credit risk (incl. security or assets, cash flows, leverage, and future liabilities) the results determine the amount and terms of available debt Rating agencies publish relevant data and state principals behind their rating approach Application of these methods for tax purposes has strong support and acceptance by tax authorities globally Standard and Poor s 3-yr metrics AAA AA A BBB BB B CCC EBIT Interest Coverage (%) EBITDA Interest Coverage (%) Free Op CashFlow / Total Debt (%) Total Debt / EBITDA (%) Return to Capital (%) Total Debt / Capital (%) Key Industrial Financial Ratios, Long-Term Debt 23.8 13.6 6.9 4.2 2.3 0.9 0.4 25.3 17.1 9.4 5.8 3.1 1.6 0.9 104.1 41.1 25.4 16.9 7.9 2.6 0.9 0.2 1.1 1.7 2.4 3.8 5.6 7.4 29.1 25.9 16.8 13.4 10.3 6.7 2.3 6.2 34.8 39.8 45.6 57.2 74.2 110.2 Source: Standard & Poor s 21
Arm s length charges: revenue authority perspectives on creditworthiness Two common approaches: Single entity approach the implied credit rating reflects the capital market s view of the entity s creditworthiness as if it operated on a standalone basis Member of the group approach the implied credit rating is a function of the entity s group affiliation As an example, an implied credit rating of BBB- may be upgraded to BBB or BBB+ on account of the affiliate being a member of the group without any legal authority for the entity to financially support its related party or because of its passive association with the group 22
Arm s length charges: step 2 Identify specific debt characteristics Attributes of debt instruments affect their rates in the market: Debt Characteristics Interest Rates Long-term/fixed rate Subordination Including preference shares Emerging market borrowers Loan fee structures BB 5yr @ 3.932 Callable fixed-rate loans BBB+ 5yr @ 2.392 Duration or term F/X denomination Convertibility (embedded equity call options) Seniority /collateral / guarantees Source: Bloomberg Professional (2014) OECD BEPS Update June 3, 2014 23
Intercompany credit guarantees or credit enhancement Credit guarantees are often required for the following purposes - Financial - Operating Potentially a contentious inter-company transaction - Canada GE Capital case, among others Demonstrate an economic benefit has been conferred - Credit enhancement, risk reduction, indemnification A range of arm s length prices are possible - Letters of credit - Agency credit ratings are not uniform - Thin capital markets may result in few data points - Reference rates non uniform: LIBOR, WIBOR, etc. Financial markets impact prices for credit enhancement or guarantee fees - the price of credit enhancement from BB to AA/A credit ratings changed markedly between 2006-2008 (financial meltdown) 24
Key takeaways and conclusions OECD BEPS Update June 3, 2014 25
Conclusions and key takeaways Economic and financial analysis - Credit rating/scoring of operational subsidiaries - Thin capitalization / optimized leverage ratios - Apply specific debt characteristics - Benchmark and Set interest rates - Evaluate potential for guarantee fees based on interest rate theory - Evolution of capital markets overtime may impact pricing of credit guarantees in past years. Documentation - Sign and file intercompany loan documentation agreements - Prepare a contemporaneous transfer pricing defense file - Enhance tax compliance forms Operations - A practical and easy to implement financing approach is needed - Viability and sustainability are key - Minimize business disruptions from intercompany financing transactions - Simplify implementation 26
Speaker contact information Liga Hoy DLA Piper 555 Mission Street, Suite 2400 San Francisco, CA 94105 Office phone: 415.836.2568 Cell: 415.297.0973 liga.hoy@dlapiper.com www.dlapiper.com Circular 230 Notice: In compliance with U.S. Treasury Regulations, please be advised that any tax advice given herein (or in any attachment) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another person any transaction or matter addressed herein. OECD BEPS Update June 3, 2014 27