Global Transfer Pricing Conference...2 Using one blended interest rate for all transactions 3 Including flexibility (call & prepayment options) without considering the impact on the

Global Transfer Pricing Conference Financial transactions in a changing world

October 2013

www.pwc.com/tp

Managing multiple stakeholders in the new economy

Today’s presenters

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October 2013 Global Transfer Pricing Conference

Jeff Rogers

Arthur Mendoza

Krishnan Chrandrasekhar

Michel van der Breggen

PwC

Agenda

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Setting the scene

Inter-company loans

Intercompany guarantees

Cash pooling arrangements

Accounts Receivable Factoring

Documentation and Risk

PwC

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Setting the scene

PwC

Setting the scene

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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 co-ordinated with the work on hybrids and CFC rules.

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October 2013

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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

China: Increased Tax Audit Focus on

Capitalization

Australia: Guidance on Interaction of Thin Cap and

Transfer Pricing South Africa: Changes to Thin Cap

Requirements

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What we typically hear from companies

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.

“Our treasury team knows what to do”

Bank quotes are typically not accepted by tax authorities as reliable comparable data.

“We have bank quotes supporting our pricing”

The marginal cost of funding approach does not consider differences in creditworthiness of the borrower and in the terms and conditions applied.

“Of course, we rely on the average cost of funds for the group…”

Are the transactions really comparable (terms and conditions, volume, creditworthiness)?

“The parent company raises all third party debt – great comparable data”

Times have changed! “We have many examples of third party funding from the early 2000’s”

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PwC

Inter-company loans

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October 2013 Global Transfer Pricing Conference PwC

Building blocks of an arm’s length loan

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.

Creditworthiness 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.

Terms and Conditions 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.

Volume

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.

Interest rate

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Could the borrower obtain the level of financing contemplated under current market conditions?

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?

Would the borrower want to capitalize itself with the stated level of debt, considering its financial competitiveness against peers?

The fundamental test around ability to repay, evaluating projected availability of free-cash flows and considering anticipated capital expenditures, etc.

This involves an evaluation of the borrower against comparable peers, considering measures of profitability, leverage, coverage, and cash flow

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.

Debt vs. equity and the issue of characterization How to support capital structure?

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Intra-group loans The impact of terms and conditions

Higher

Lower

Impact on interest

rate

Bullet Pre-

payment Un-

guaranteed Long term Mezzanine

On maturity Unsecured

Higher risk currency

Non-convertible

Capital & interest

Demand Guaranteed Short term

Senior Quarterly (regular)

Secured Lower risk currency

Junior

Convertible

? Impact of covenants ? ? Commercial & economic rational ? ? Impact on fixed vs. floating loans ?

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Envisaged loan

• 5 years

• Bullet

• Prepayment option included

High interest rate

Due on the full principal

How will excess cash be used?

Intra-group loans The importance of terms and conditions

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

P

rin

cip

al

100 M

Years 1 2 3 4 5

Pri

nci

pa

l

100 M

Years 1 2 3 4 5

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Common pitfalls in practice

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

• 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

Also look out for the following:

1 No stand alone credit rating of the borrower

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October 2013

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Global Transfer Pricing Conference

Related party guarantees

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Related party guarantees The GE Capital Canada case

A case on guarantee fees and implicit support

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.

• 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

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Related party guarantees What is the purpose of the transaction?

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)

A shareholder service?

“…no service would be received where an associated enterprise by reason of its affiliation alone has a credit-rating 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)

What is it?

Beneficial service?

Shareholder service?

Example

• Implicit support

Examples

• Explicit support

- Financial

- Operating/Performance

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Related party guarantees What is the value of the transaction?

Financial Transactions Webcast October 2011

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

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

“Ask” price

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

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Cash pooling

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• 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?

Cash pooling arrangements Tax considerations

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Cash pooling Practical example

Co 2 (FR)

Co 1 (NL)

3P bank

Co 2 (GER)

- 100 - 50 100 Entity bank accounts

Interest - 6 3 - 3

Debit interest rate: 6% Credit interest rate: 3% Net position: - 6

Co 2 (FR)

Co 1 (NL)

3P bank

Co 2 (GER)

- 100 - 50 100 Entity bank accounts

Interest

?

- 50

- 2.5

Cash pool leader bank account

? ?

Guarantees

Debit interest rate: 5% Credit interest rate: 4% Net position: - 2.5

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Accounts receivable factoring

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OpCo FactorCo

Customers

Funds Less Factoring Discount

Sale of Accounts Receivable

Payments on Accounts Receivable

Sales Accounts Receivable

1

2

3

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Section 5 – Where to start Factoring

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

Disco

un

t In

vo

ice

Fa

ce V

alu

e

• 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.

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Documentation and risk management

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Questions to ask yourself

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?

Would unrelated parties want to act in this way?

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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

• Introduction

• Company background

• Organisation of the Treasury department/Treasury

business model

• Functional analysis

• Industry analysis

• Transfer pricing method selection

• Loan pricing policy

• Short term loans/cash pool

• Long term loans

• Guarantees

• FX transactions

• Other transactions

• Documentation procedures

• Typical policy components

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

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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)

• 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

Documentation Framework

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Thank you

This publication has been prepared for general guidance on matters of interest only, and does

not constitute professional advice. You should not act upon the information contained in this

publication without obtaining specific professional advice. No representation or warranty

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members, employees and agents do not accept or assume any liability, responsibility or duty of

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© 2013 PwC. All rights reserved. PwC refers to the PwC network and/or one or more of its

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further details. This content is for general information purposes only, and should not be used

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Global Transfer Pricing Conference...2 Using one blended interest rate for all transactions 3 Including flexibility (call & prepayment options) without considering the impact on the