Financial Transactions Transfer Pricing August 2010

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Iris McLaughlin
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1 Financial Transactions Transfer Pricing

2 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

3 Transfer Pricing for Financial Transactions - Why is this relevant today? 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 Slide 65

4 The Global Scenario Canada: GE and HSBC cases on implicit support Sweden: contemporaneous documentation and comparables Netherlands: Focus on arm s length nature of terms and conditions Austria: Incorporating Passive Association GSK case on interest deductibility Spain: focusing on participative loans UK: new regulations on interest capping Singapore: guidance issued on loans and thin cap Australia: ATO publication on intra-group finance guarantees and loans Slide 66

5 Impact of the credit crunch Explosion of credit risk premiums B Credit rating Credit margin in percent (%) Jan Jul Nov Mar Duration in years Specific characteristics of debt instruments could manifest this further Slide 67

6 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 68

7 Setting arm's length interest rates on inter-company loans Step 1. Determine the Level of Risk for the Borrower (credit rating on a stand-alone basis) Step 2. Adjust the Risk for Specific Debt Characteristics (e.g. term of loan, currency, rate base (fixed/ flexible), convertibility, options (call/ pre-pay), collateral, debt risk rating) Step 3. Determine Interest Rate Based on Market Sources (Comparable Uncontrolled Price (CUP) Analysis/ Benchmarking ) Slide 69

8 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: Borrower: Foreign Sub Currency: Amount: USD USD 100 mio Intra-Group Loan Indian Parent Company Issue Date: 1-May-07 Maturity Date: 31-Dec-10 Term / Maturity 3.7 years Rate (Long term) Rating: 5%, fixed Not rated Foreign Sub Repayment: On Maturity Slide 70

9 Setting arm's length interest rates on inter-company loans Case study (Contd..) Step 1: Credit Rating 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 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 Determine Interest Rates 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 bps Benchmarking data demonstrates that the credit spread of 100 bps is consistent with the spreads on comparable debt Slide 71

10 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 72

11 Setting fees for Guarantee transactions Case study Guarantee to : Foreign Sub Currency: USD Guarantee Indian Amount: USD 100 mio Parent Company Issue Date: 1-May-07 Maturity Date: 31-Dec-10 Unrelated Party Lender Term / Maturity 3.7 years Rate (Long term) 5%, fixed Rating: Not rated Foreign Sub Repayment: On Maturity Loan Slide 73

12 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 74

13 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 75

14 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 76

15 Thank You All rights reserved., a registered trademark, refers to Private Limited (a limited company in India) or, as the context requires, other member firms of International Limited, each of which is a separate and independent legal entity.

Seventh INTERNATONAL TAX PLANNING CONFERENCE-2001 OF BOMBAY MANAGEMENT ASSOCIATION. T.P.Ostwal Mumbai. 8th Dec 2001 T.P.

Seventh INTERNATONAL TAX PLANNING CONFERENCE-2001 OF BOMBAY MANAGEMENT ASSOCIATION By By T.P.Ostwal Mumbai fca@vsnl.com 8th Dec 2001 T.P.Ostwal 1 The process of fixation of Pricing of any Transaction between