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)
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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
Guarantee in place, no fee charged
 1995
A guarantee fee of 100 bps is charged
 1995-2000
Guaranteed debt rises 3x from $2.5B to $8.0B
 1998
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-
GECC (USP)
Guarantor
(AAA)
100 bps
Guarantee fee
Credit Guarantee
GE CAP CANADA
Borrower
(BBB)
Loan
3rd party
Lender
1) Rating impact of Guarantee (from BBB to AAA) = 120 bps
• Assume 20 bps loan cost
for each increased risk level
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
Equity 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
• 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
Equity 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
• 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
Equity 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
• 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
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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
Key Industrial Financial Ratios,
Long-Term Debt
Standard
and Poor’s
3-yr metrics
AAA
AA
A
BBB
BB
B
CCC
EBIT Interest
Coverage (%)
23.8
13.6
6.9
4.2
2.3
0.9
0.4
EBITDA Interest
Coverage (%)
25.3
17.1
9.4
5.8
3.1
1.6
0.9
Free Op CashFlow /
Total Debt (%)
104.1
41.1
25.4
16.9
7.9
2.6
0.9
Total Debt /
EBITDA (%)
0.2
1.1
1.7
2.4
3.8
5.6
7.4
Return to Capital
(%)
29.1
25.9
16.8
13.4
10.3
6.7
2.3
Total Debt / Capital
(%)
6.2
34.8
39.8
45.6
57.2
74.2
110.2
Source: Standard & Poor’s
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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)
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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
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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