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Financial TransactionsTransfer PricingAugust 2010
Contents
• Background to inter-company financial transactions
• Inter-Company Loans
− Issues and pricing case study
• Guarantee Fees
− Issues and Pricing Methodologies
• Thin capitalisation
• Way Forward
PricewaterhouseCoopers
Transfer Pricing for Financial Transactions - Why is this relevant today?
Slide 65August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
• Robust economic growth in India leading to innovative inbound funding structures
• Indian MNCs expanding overseas through offshore debt and SPVs
• Large exposures mean increased need for sophistication in compliance
− Authorities have taken notice
− Ad-hoc approaches unlikely to remain sustainable
• Well conceptualised capital structures can play an important role in tax planning
PricewaterhouseCoopers
The Global Scenario
Slide 66August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
Sweden: contemporaneous documentation and comparables
Australia: ATO publication on intra-group finance guarantees and loans
Singapore: guidance issued on loans and thin cap
UK: new regulations on interest capping
Canada: GE and HSBC cases on implicit support
Netherlands: Focus on arm’s length nature of terms and conditions
GSK case on interest deductibility Spain: focusing
on participative loans
Austria: Incorporating Passive Association
PricewaterhouseCoopers
Impact of the credit crunch
Explosion of credit risk premiums
B Credit rating
0
2
4
6
8
10
12
14
16
0 1 2 3 4 5 6 7 8 9 10
Duration in years
Cred
it m
argi
n in
per
cent
(%)
01-Jan-0701-Jul-0828-Nov-0811-Mar-09
Specific characteristics of debt instruments could manifest this further
Slide 67August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Inter-company Financial Transactions-Issues which come up in practice
• Failing to document loan or credit guarantee agreements
• Loans without a final maturity date
• Using arbitrary interest rates/guarantee fees
• Basing interest rates/guarantee fees on casual analysis (e.g. high-level bank quotations)
• Failure to update interest rates (e.g. floating interest rate agreements with ‘stale’ rates)
• Failure to adhere to terms of credit agreements (e.g. not paying interest when due)
Slide 68August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Setting arm's length interest rates on inter-company loans
Step 1. Determine the Level of Risk for the Borrower
Step 2. Adjust the Risk for Specific Debt Characteristics
Step 3. Determine Interest Rate Based on Market Sources
(credit rating on a “stand-alone” basis)
(e.g. term of loan, currency, rate base (fixed/ flexible), convertibility,options (call/ pre-pay), collateral, debt risk rating)
(Comparable Uncontrolled Price (CUP) Analysis/ Benchmarking )
Slide 69August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Setting arm's length interest rates on inter-company loans:Case study
To finance its on-going business operations, Foreign Subsidiary received a loan from its Indian parent. The terms of the loan are the following:
Indian Parent Company
Foreign Sub
Intra-Group Loan
Borrower: Foreign Sub
Currency: USD
Amount: USD 100 mio
Issue Date: 1-May-07
Maturity Date: 31-Dec-10
Term / Maturity 3.7 years
Rate (Long term) 5%, fixed
Rating: Not rated
Repayment: On Maturity
Slide 70August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Setting arm's length interest rates on inter-company loansCase study (Contd..)
A credit rating analysis assigns a risk rating based on correlation between:• Operating financial ratios• Riskiness of the debt; while taking into acount other commercial factors• Impact of Group Rating (Single Entity Vs Member of Group approach)
Step 2: Debt Rating
Determine Interest Rates
Step 1: Credit Rating
• The debt taken by Foreign Sub is subordinate to any other obligations the company may have and the loan pricing should reflect the higher risk
• To reflect the lower recovery prospects on the debt, this debt should be rated two notches below the derived credit rating from “Ba1“, down to “Ba3” credit rating
• The base rate needs to be established for a 3.7 year USD denominated loan• The 4 yr SWAP rate on borrowing date was 4%• The benchmarking data for Ba3 rating category loans shows an inter-quartile
range of spreads from 90-120 bps • Benchmarking data demonstrates that the credit spread of 100 bps is
consistent with the spreads on comparable debt
Slide 71August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Guarantees
• Credit / Financial guarantee provides credit enhancement to the guaranteed party, either:
− to access cheaper funding or
− to access capital markets
• Types of guarantee in an inter-company context:
− Explicit Guarantee – direct benefits
− Implicit Guarantee – implicit benefits
Slide 72August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Setting fees for Guarantee transactions – Case study
Indian Parent
Company
Foreign Sub
Unrelated Party Lender
Guarantee
Loan
Guarantee to : Foreign Sub
Currency: USD
Amount: USD 100 mio
Issue Date: 1-May-07
Maturity Date: 31-Dec-10
Term / Maturity 3.7 years
Rate (Long term) 5%, fixed
Rating: Not rated
Repayment: On Maturity
Slide 73August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Approaches for determination of arm’s length price –Guarantee Fees
• No prescribed regulation across the world for benchmarking guarantee fees
• Most appropriate approach
− CUP Approach
− Risk of Loss Approach
− Valuation of benefit Approach / Interest Savings approach
Slide 74August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Thin Capitalisation
• Debt : Equity mix in relation to arm’s length borrowing capacity
• Revenue focus on gearing ratios and interest coverage
• Recharacterization of debt as equity in terms of OECD guidelines
• Tax Impact of Debt-Push down Structure
Slide 75August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
PricewaterhouseCoopers
Way Forward
• Global guidance and recent Indian rulings clearly emphasise the relevance of the subject
• The proposed Direct Tax Code contains anti avoidance provisions including re-Characterisation of transaction, leading to thin capitalization
• Robust analysis using scientific pricing models would be critical towards a defensible strategy in structuring financial transactions and planning
− India and overseas angles relevant to factor
Slide 76August 2010Thriving Through Challenging Times – An Interactive Session on Transfer Pricing
© 2010 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers”, a registered trademark, refers to PricewaterhouseCoopers Private Limited (a limited company in India) or, as the context requires, other member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.
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