Financial Instruments and Transfer Pricing A discussion of methodologies, practical challenges and comparability
Jeffrey Rogers, PricewaterhouseCoope...
Financial Instruments and Transfer Pricing A discussion of methodologies, practical challenges and comparability
Jeffrey Rogers, PricewaterhouseCoopers LLP Waël Tfaily Ernst & Young LLP
66th Annual Tax Conference | Vancouver 2014
Financial Instruments and Transfer Pricing
Outline Slide title
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Presenters
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Disclaimer
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Factoring transactions detailed
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Presentation objective
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Pricing factoring transactions
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Section 1: Overview
Factoring transactions
Transfer pricing documentation
Introduction
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The Environment
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Legal Agreements: The starting point….
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Lending transactions The capital perspective
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The transfer pricing perspective
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Practical challenges
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Country-by-country reporting
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Summary Presentation outline
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In summary
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Loan guarantees
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The economic rationale
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Transfer pricing methodologies
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Practical challenges
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66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
Disclaimer The content of this presentation is for general information purposes and should not be represent technical tax advice in the respective areas presented herein. All information presented in this presentation is the views of the authors only and do not represent the views of their respective firms. Any errors made or omissions are those of the authors only.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Presentation objective This session will examine transfer pricing methodologies that apply to loans, loan guarantees and factoring transactions. It will also examine practical challenges when unbundling financial instruments, and ways to identify and document appropriate comparables.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Section 1
Overview
66th Annual Tax Conference
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W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
Introduction > > > > > >
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Loans – interest rates, debt capacity; Guarantees – financial and operating/performance; Accounts receivable factoring; Leasing; Preferred shares; and Miscellaneous - securitizations and sales of financial instruments.
66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
The Environment > Tax audit disputes and litigation; > Action 2 – Neutralizing the impact of hybrid mismatch arrangements; > Action 4 – Limit base erosion via interest deductions and other financial payments; > Action 8 – Intangibles; > Action 9 – Risk and capital; and > Guidance on financial transactions transfer pricing?
Embedded options; Subordination; Security/collateral; and Compliance with covenants.
> Third-party > Unintended compensable benefits.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Section 2
Lending transactions 66th Annual Tax Conference
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W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
The capital markets perspective > Fundamental difference in perspective: > Credit, credit risk and the impact on monetary policies > Interest rates as a “currency” > Sensitive to terms and conditions; > Terms and conditions in turn impact borrower’s debt capacity; and > Most importantly, interest rates are set by the supply of and (to a lesser extent, the) demand for capital.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
The capital markets perspective (cont.) > Capital markets for lending take the form of: > Standardized (regulated) public bond markets including: > Sovereign financing; > Investment-grade corporate paper; and > High-yield debt. > Customizable OTC markets: > Bank debt; > Private financing; and > Mezzanine financing.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
The capital markets perspective (cont.) > Capital markets provide three-categories of lending: > Cash-flow-based lending (e.g. traditional senior debt); > Asset-based lending (e.g. asset-backed securities); and > Project-based lending aka Project Financing.
> Depending on the size of the principal, debt could be underwritten from: > A Single lender; > Multiple lenders (e.g. “club deals”); or > Syndicate.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
The transfer pricing perspective > Correct answer vs. defensible answer; > Applicable transfer pricing methods; > The implications of the “arm’s length” principle: > The stand-alone perspective; > The “halo” effect; and > The issue specific adjustments.
> The documentation requirement;
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66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
The transfer pricing perspective (cont.) > Unbundling: the identification of the benefits conferred in a given lending transaction and the separation of these benefits into separately identifiable transactions > Identifying the benefit providers; > Evaluating the value of these benefits; and > Imputing intercompany transactions on as required.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Practical challenges > > > > > > >
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‘Capital markets’ is only what’s “observable”; The analytical weight of “quotes”; The psychological traps of decision making; The debt-capacity conundrum; Where to identify comparables? Considerations for debt size: More premium? Credit risk: Backward-looking or forward-looking?
66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Practical challenges (cont.) > Debt covenants and implications on arm’s length behaviour; > Controlling the scope of quantitative adjustments; > The prepayment option and implication on penalty settings; > The special case of debt “facilities”; > The scope of the CUP method: What counts as one? > Decision making – How to choose from the results.
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66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
Section 3
Loan guarantees 17
66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
The economic rationale > Guarantees as a transaction: Explicit vs. implicit support; > Are all guarantees compensable? > Loan guarantees vs. operating guarantees.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Transfer pricing methodologies > The inapplicability of the traditional transaction methods; > The reliance on “other” methods; > Cost-based methods: > The insurance model; > The CDS model; > The RAROC method; and > The Letter of Credit method. > Benefit methods: > The yield-curve method; and > The “bank quotes” method.
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Practical considerations (cont.) > Limitation of the stand-alone approach > Does it lead to biased results?
> The importance of parties’ behaviour > The presence and enforceability of debt covenants > The presence of loss contingency reserves (for cost-based methods)
> The issue of a centralized treasury function > The importance of parent reputation > The issue of control in parent-subsidiary linkage > The strategic importance of the guaranteed entity
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66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
Practical considerations (cont.) > The top-down approach vs. bottom-up approach: > Top-down: Liberal bias? > Bottom-up: Too cautious?
> Risk-ratings: Model-driven vs. analysis driven and importance of qualitative considerations.
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Financial Instruments and Transfer Pricing
Section 4
Factoring transactions 22
66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Factoring transactions detailed > Transaction characteristics: > Recourse vs. Non-Recourse; > Notification vs. Non-Notification; and > Advance rates.
> Differences between accounts receivables factoring and securitization: > Market participants; and > Credit support.
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Financial Instruments and Transfer Pricing
Pricing an intercompany factoring transaction > AR portfolio characteristics used to estimate the Factoring Discount Rate using the “comparable uncontrolled price method” and securitization principles; > The pricing, terms and conditions for a factoring arrangement includes remuneration for: > > > > 24
Financing; Credit risk; Commission (including servicing costs and profit element); and Dilution. 66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
Section 5
Transfer Pricing Documentation 25
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Financial Instruments and Transfer Pricing
Country-by-Country Reporting > Three “levels” to document: > Master file: > High-level overview of the multinational entreprise; with > Specific requirements to disclose ALL financing arrangements (related and unrelated) including the details of their TP policies. > Local file: > Detailed information on specific group transactions. > Country-by-country report: > Aggregate, jurisdiction-wide information on global allocation of income, taxes paid, indicators of economic activity; and > Useful for transfer pricing risk assessment and for evaluating other BEPS-related risks. 26
66th Annual Tax Conference
W. Tfaily | J. Rogers
Financial Instruments and Transfer Pricing
Outro
Summary
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66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
In this presentation, we… > … presented the various types of financial transactions; > … discussed the recent changes in the legislative environment in this respect; > … explored the capital market perspective on intercompany lending, guarantee transactions and factoring arrangements; and > … contrasted it with the transfer pricing perspective; and > … discussed the documentation requirements for each of these transactions and the evolution of the C-b-C initiative in this respect. 28
66th Annual Tax Conference
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Financial Instruments and Transfer Pricing
In summary, > It’s all about the details! > Legal forms; > Analytical robustness; and > Factual support
> Increased attention by extra-jurisdictional and governments on these transactions; and > Documentation is critical, and trending!
