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Charging forward with chargebacks

AmyLynn Flood –PricewaterhouseCoopers, LLP Donald D’Anna – The Carlyle Group

Agenda Types of equity based compensation Securing a corporate tax deduction Cash repatriation and other issues Specific country issues Audit experience Questions

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Types of equity based compensation Nearly 85% of all publicly traded companies offer some form of equity based compensation

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Types of equity based compensation Most common stock settled arrangements are: • Stock options • Restricted Stock • Restricted Stock Units/Deferred Stock Awards • Stock Appreciation Right (equity settled) • Employee Stock Purchase Plan

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Typical structure

US - Parent Company (US - PC) 1. US - PC grants equity to employee of FS.

100% US Operating Company 100% Foreign Holding Company 100% Foreign Subsidiary (FS) 2. Employee provides services directly to FS Employee

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Atypical structure

Public Company (PC) 1. OpCo grants PC equity to employee of FS.

15% US Operating Company (OpCo)

Private Owners

85%

100% Foreign Holding Company 100% Foreign Subsidiary (FS) 2. Employee provides services directly to FS Employee

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Securing a corporate tax deduction – US • No corporate income tax deduction is allowed under US tax laws for equity transferred to employees of foreign subsidiary - Exception, ‘check the box’ entities which are treated as a branch of a US Company - Instead, US Parent Company is deemed to contribute cash (in the form of a capital contribution) to foreign Subsidiary - Foreign subsidiary is deemed to use that cash to buy shares from the parent - Foreign subsidiary is deemed to transfer those shares to employee for services ◦ Deduction in foreign subsidiary

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Securing a corporate tax deduction – Foreign • Deduction only available at foreign subsidiary level if permitted under foreign laws • With exception of the UK, most foreign jurisdictions require that an economic cost be incurred in order to secure a corporate deduction • To satisfy this “cost” requirement, parent can establish process to charge the subsidiary for the value of the equity delivered to their employees - Payment as a result of that process creates a local economic cost - This is typically called a “recharge agreement”

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Securing a corporate tax deduction – Structure

US - Parent Company (US - PC) Equity Award Recharge Agreement between US - PC and FS

100%

Foreign Subsidiary (FS)

Equity Award Grant Agreement between US - PC and FS employee

Employee

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Securing a corporate tax deduction – Structure

US - Parent Company (US - PC)

Stock

Cash

Foreign Subsidiary (FS)

Stock

Services

Employee

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Factors to consider in the recharge determination • Is a corporate tax deduction available? • Is foreign subsidiary profitable or expected to be profitable? • Is cash repatriation from subsidiary to parent desired? • Are there any corporate cost-sharing arrangements? • How does a recharge impact the employer’s social tax liability on the awards? • How does a recharge affect the withholding and reporting requirements imposed upon the employer? • How does a recharge impact employee’s income and social tax liability or timing on the awards? • Are there any other considerations (e.g., labor law, foreign exchange control)?

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Benefits of recharge strategy • Reduce cash tax expense at foreign subsidiary through corporate income tax deduction • Reduce income statement expense for equity awards by tax effect of future deduction - Deferred tax asset is established to reflect tax deduction value based upon accounting expense - Note: impact of transfer pricing agreements and valuation allowances

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Benefits of recharge strategy • Repatriate cash without dividend taint - A payment in return for shares is specifically protected from taxation under Section 1032 - Comment: payment of accounting value may not be Section 1032 protected • Difficult for IRS to challenge foreign tax credit utilization because company has taken steps to reduce non-US corporate income tax - Otherwise, foreign tax payments could be viewed as “voluntary”

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Recharge strategy – General • Execute Subsidiary Cost Sharing Agreement for equity based compensation awards • Agreement may cover all forms of equity (Option Rights, RSUs, etc.) • Agreement may extend over multiple equity compensation plans

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Recharge strategy – General • Create legal liability for subsidiary to pay US Parent Company at time of settlement for fair value of awards transferred to employees (or “spread” value of Option Rights exercised) - As soon as administratively practicable • Caution - Consider capital level of foreign subsidiary – may be important for regulated entities – consider “round tripping” cash

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Issues • Timing of agreement • Increased local compliance • Type of shares • Currency issues • Transfer Pricing/PE

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Timing • Should be in place at time of grant – but agreements executed after the grant date of awards may be respected • Requires periodic cash settlement via inter-company accounts • Requires proper accounting at foreign subsidiary level in statutory books and records

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Employer compliance – Local employees • While reporting and withholding is required in most countries, the addition of a chargeback may trigger these requirements in some jurisdictions - Mexico - Belgium - Thailand - Colombia - Poland - Czech Republic - Greece

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Employer compliance – Local employees • May change the timing or character of the income - Brazil - Indonesia • May create a direct link between the equity award and the Foreign Subsidiary resulting in acquired rights and other labor law complications • No deduction may be allowed - Canada - Netherlands

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Types of shares • Use of treasury shares (re-acquired from the open market) is recommended in some locations to secure a corporate tax deduction abroad because such shares demonstrate that a “cost” was incurred • Countries where treasury shares are required and/or recommended include: - France - Japan - Germany - Singapore

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Currency issues • Exchange controls may prevent cash reimbursement (e.g., China, Brazil and South Africa) • New developments in China - Notice 40 (effective September 1, 2013) provides guidance for certain outbound remittances with the aim of generally simplifying the tax remittance process - Local entities wishing to settle a cost recharge need to file documentation with the in-charge tax bureau in order to remit payments exceeding US$50,000 › Documentation includes: explanation letter regarding the remittance; related contract/agreement with foreign entity; invoice; a reconciliation between between amounts remitted and amounts subject to IIT, if applicable - Formal tax clearance certificates are no longer required; remittances can be processed upon submission of the necessary documents.

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Transfer pricing/PE issues • Transfer pricing considerations - “cost plus” arrangements are common, where the foreign subsidiary is reimbursed all its costs plus a percentage mark-up by another group company - Xilinx case: equity-based compensation is a cost for transfer pricing purposes - OECD’s view is consistent with the U.S. view that equity-based compensation is a cost to the employer issuing the equity and intercompany service agreements must incorporate such costs when reflective of the arm’s length price for the service [2004 OECD report “Employee Stock Option Plans: Impact on Transfer Pricing”] • Permanent Establishment (PE) issues - Equity compensation must be a cost of the entity for which the services are provided, or a dependent agency relationship could result ◦ Generally not a problem in traditional “corporate” structures with self-sufficient foreign subsidiary businesses ◦ Need a recharge agreement in place when subsidiaries are limited local service platforms but business is run from US parent

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Example – Impact of transfer pricing/cost-plus

Background: •

FS is reimbursed by FHC at costs plus 10%

•

FS and FHC are not necessarily in the same tax jurisdiction

US - Parent Company (US - PC)

US Operating Company 1. US - PC grants equity to employee of FS

4. US-PC charges FS $20 under the chargeback arrangement 5. FS receives $22 reimbursement by FHC at cost plus 10%

Foreign Holding Company (FHC) 2. Employee provides services directly to FS

3. Employee makes gain of $20 from equity grant

Net Tax Impact:

Foreign Subsidiary (FS)

•

US-PC receives $20 tax-free

•

FHC has $22 expense which is likely tax deductible –FHC is likely to be in a low or no tax jurisdiction

•

FS has $2 profit which is taxable

Employee

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Audit experience • Deduction generally allowed upon audit if documentation is in place • Treasury shares/cost of shares usually questioned • Need to show employees recognized ordinary income at stock transfer date, where applicable • Need to show wage withholding and/or information reporting at employee level, where applicable • Special consideration for employees who relocate internationally between grant and vesting/exercise date of the awards • Recent tax authority guidance in Hong Kong, India and Spain

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Appendices

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Tax compliance & planning Prevalence of Chargeback Arrangements to Obtain Corporate Tax Deductions

16%

41% 19%

24%

Not at all

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In selected locations

In a majority of locations

All locations

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Tax compliance & planning Reasons to Start Charging Back Equity Plan Costs

7% 18% To mitigate costs associated with expensing To secure local tax deductions 36%

Both of the above Other 39%

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Tax compliance & planning

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Tax compliance & planning

*Note:

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Top 10 countries for 2012 are shaded in orange

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Questions AmyLynn Flood PwC, LLP [email protected] (267) 330 -6274 Don D’Anna The Carlyle Group [email protected] (202) 729-5554

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