DEBT TRANSFER PRICING AND RELATED DEVELOPMENTS SYDNEY, MONDAY 26 FEBRUARY 2018

Transcription

1 DEBT TRANSFER PRICING AND RELATED DEVELOPMENTS SYDNEY, MONDAY 26 FEBRUARY 2018

2 SPEAKERS 1. Shahzeb Panhwar, Assistant Commissioner, Public Groups and International, ATO 2. Greg Johnson, Managing Director, Global Capital Advisors, LLC 3. Julian Pinson, Director, Greenwoods & Herbert Smith Freehills Q&A panel session 2

3 ATO s Approach to Cross-Border Related Party Financing Presented by Shahzeb Panhwar, Assistant Commissioner Public Groups and International Australian Taxation Office

4 PCG Update Material Changes >Bifurcation >Arm s length vs actual conditions >ICR >Currency/lender s jurisdiction 4

5 PCG Transition Period Transitioning to the green zone >18 month period >Penalties & interest >Treatment of back years Types of products 5

6 PCG White Zone White zone >What is it? >How do you get into it? 6

7 Understanding the ATO s Approach Global bond issues Foreign Parent Global credit facility ATO Approaches >PCG lens >Audit lens Related party loan Financiers Senior debt Aus Co 7

8 Understanding the ATO s Approach Commercial paper Foreign Pension Fund ATO Approaches >PCG lens >Audit lens Related party loan Financiers Senior debt Aus Co 8

9 Understanding the ATO s Approach Global bond issues for acquisition Global credit facility Foreign Parent ATO Approaches >PCG lens >Audit lens Related party loan Bid Co Target Co Equity 9

10 Guidance Product Update Related party derivatives Interest free loans Other Thin capitalization >Safe harbor >Arm s length debt test 10

11 GREG JOHNSON MANAGING DIRECTOR, GLOBAL CAPITAL ADVISORS, LLC

12 Greenwoods Herbert Smith & Freehills Corporate Tax Association Debt Transfer Pricing and Related Developments Seminar February 2018 Global Capital Advisors, LLC 1 (888)

13 DEBT TRANSFER PRICING SERVICES Global Capital Advisors, LLC Scrutiny of multinational companies ( MNC s ) intercompany loans and associated interest expense deductions has increased, as evidenced by OECD BEPS recommendations, the ATO s PCG covering related party financings, new US Treasury regulations and ongoing litigation. Global Capital Advisors, LLC ( GCA ) professionals bring decades of credit rating and capital markets expertise to evaluating the appropriateness of related party debt amounts and interest rates. GCA professionals are proficient at replicating the methodologies actually employed by the major rating agencies and debt capital market desks. GCA s familiarity with real world attributes of corporate debt can be critical to validation of a transaction, from the variances in rating agencies methodologies to the high standard deviation in credit spreads for a given rating category. GCA s professionals deliver unbiased and independent perspectives and have successfully provided expert witness services with respect to litigation involving intercompany debt. 13

14 DEBT TRANSFER PRICING SERVICES Global Capital Advisors, LLC GCA delivers debt transfer pricing reports that are in-depth and highly substantiated evaluations of specific intercompany debt issuances and associated interest expense. This documentation generally includes: A stand-alone Implied Credit Profile ( ICP ) of the Issuer and the specific debt instrument, including a full credit analysis using Moody s and/or S&P s industry specific methodologies and rated comparable credits, and An Indicative Pricing Report that considers the specific characteristics of the financing likely to impact pricing, including the amount, maturities, covenants, ranking and call features of comparable financings for similar credits at the time. GCA specialists are neither tax accountants nor tax lawyers, and work collaboratively with Issuers and their accounting, tax, and legal advisors with respect to optimal intercompany debt structures and strategies. 14

15 WHY IS RELATED PARTY DEBT A PROBLEM? Perceived overleverage of multinationals subsidiaries in high tax rate jurisdictions, including use by inverted companies. Debt market aggressiveness proving viability of debt structures well in excess of thin capitalization limits. Tax authorities have difficulty in proving debt should be considered equity. Tax authorities believe that implicit support should result in similar borrowing costs for parent and subsidiaries, while corporations believe subsidiaries should be treated as stand-alone entities. Subjective nature of credit analysis remains a major obstacle to agreement between taxpayers and tax authorities, High variances in the cost of debt for borrowers of similar credit rating creates additional room for disagreement on the borrowing costs of a given entity. Use of hybrid structures has resulted in significant interest expense deductions in one jurisdiction without resulting in interest income in another jurisdiction. 15

16 IS THE ARM S LENGTH STANDARD DYING? Tax authorities and legislators are embracing formulaic approaches to address the perceived abuses in related party financings. PCG ties pricing of subsidiary debt to parent cost of debt regardless of the credit quality of the subsidiary. New US tax rules limit deductibility of interest expense to 30% percentage of EBITDA (or EBIT beginning in 2022). BEAT provisions of new US tax laws apply a tax on intercompany payments including interest expense, intangibles and services. Uncertainties about how to apply the arm s length standard to related party debt include implicit support vs orphan treatment of subsidiaries. Diverted profits tax rules imposing significant penalties on structures that deliver tax advantages even if proven to be arm s length. 16

17 CREDIT RATING CATEGORIES Long-term debt ratings are forward looking estimates of default probability and are therefore subjective in nature. Comparison of industry specific historical and projected key credit ratios generates a quantitative view of a credit. Rating agencies emphasize the importance of an analyst s subjective judgment, which factors in qualitative measures including future performance expectations. 17.

18 CREDIT RATINGS Using Historical Data to Estimate Credit Quality Moody s only provides methodologies and industry metrics every few years GCA s analysis of 944 companies in 36 industries concluded: It is easy to measure the degree to which quantitative measures alone do not correspond with ratings In the past three years, final ratings failed to correlate with numerical indicators roughly two thirds of the time Over same period, final rating was off two or more notches 20% of the time Analysis of S&P ratings based on equal weighting of their key quantitative measures yielded similar findings 18

19 CREDIT RATINGS Investment Grade Size Thresholds Credit analysis by companies and transfer pricing advisors is often undertaken without consideration of size thresholds, that although not officially recognized as such by Moody s and S&P, clearly exist. S&P data reflects that of 925 US companies, none with less than $1.3 billion in assets were rated investment grade. Similar thresholds exist for revenue and EBITDA, and for international companies. 19

20 CREDIT RATINGS The subjectivity of credit ratings is evident in how often the two major agencies, Moody s and S&P, differ in their assessments, as they disagree on the rating of a company more often then they agree and disagree by two notches or more nearly one in every eight times. Data Source: Bloomberg Nov 14,

21 PRICING CONSIDERATIONS Even within one rating notch, significant pricing variance Total interest expense can vary dramatically within a given credit rating, even within one standard deviation of the mean. As an example, the data below reflects a $100 million, 10-year bond at a 10-year Treasury level of 1.90%, as based on 1,285 secondary bond trading levels per Bloomberg on February 4, Another third of the bonds would price outside these ranges. Std Rating OAS Dev Coupon Total Interest Expense BBB % $32.0mm - $46.6mm BBB % $30.6mm - $66.0mm BBB % $35.6mm - $84.0mm BB % $42.0mm - $89.4mm BB % $52.2mm - $103.2mm BB % $50.6mm - $93.6mm B % $48.3mm - $93.1mm B % $52.5mm - $117.5mm B % $63.5mm - $117.1mm 21

22 PRICING CONSIDERATIONS Effect of out-of-favor industries can be significant The data on the previous page changes dramatically when Exploration and Production, Metals and Mining, Oil Services and Pipelines are excluded, resulting in 1,020 secondary bond trading levels and underscoring the importance of understanding forces that influence such data Std Rating OAS Dev Coupon Total Interest Expense BBB % $31.6mm - $46.0mm BBB % $33.2mm - $49.8mm BBB % $36.2mm - $56.4mm BB % $44.6mm - $64.2mm BB % $48.0mm - $82.4mm BB % $49.3mm - $90.9mm B % $48.0mm - $91.4mm B % $54.2mm - $99.6mm B % $59.6mm - $111.6mm 22

23 RELATED PARTY DEBT IS A PROBLEM Related party debt under the arm s length standard is likely to remain a contentious area due to the room for disagreement about The credit quality of any given borrower, whether based primarily on historical quantitative credit ratios or qualitative considerations The impact of implicit support The significant variances in the cost of debt for borrowers of the same credit quality The perceived ease of using debt to alter tax obligations of an entity It seems likely that legislators and tax authorities will continue to seek formulaic limits to related party debt concerns given the above concerns The three-eyed tax monster (Intangibles, Interest, and Inversions) is difficult to control with just the arm s length standard 23

24 WHAT WE LEARNED FROM THE PCG While the ATO s PCG for Cross-Border Related Party Financings lacks legal basis for most measures, it effectively sends a message to clean up previous related party debt excesses by January 1, 2019 or face consequences. The ATO will remit penalties and interest for those companies that self identify excesses and takes steps to correct them. Three conditions will automatically result in very high risk (Red Zone) rating: Interest rate more than 200bps higher than referable debt Lender in a 0% tax jurisdiction (unless parent jurisdiction or finance sub) Hybrid arrangement Cliffs abound, such as 61% vs 60% leverage or a 15% vs 16% tax jurisdiction; or 20 versus 4 points for being over the edges. The PCG s pricing grid implies that a subsidiary is always within two or three credit notches of its parent given that more than a 100bp differential in pricing incurs at least 3 penalty points. 24

25 WHAT WE LEARNED FROM THE PCG Several pricing risk parameters (lack of appropriate collateral, subordination, exotic features) will not be held against the taxpayer if such characteristics did not effect the pricing of the transaction. The taxpayer is only penalized for self-inflicted wounds. The ATO intends to press taxpayers to borrow in the currency in which it earns the majority of its revenue (or at least enough to cover interest 1.5 times), despite the Chevron case findings. A 3-point penalty for EBITDA interest cover ratio of 1.4 to 4.2 corresponds to the new US level of 3.3 times (upper end of BEPS recommendation). A 10-point penalty for EBITDA interest cover ratio of less than 1.4 corresponds to a single B credit at best. Traceable third-party debt (i.e. how the lender finances itself before on-lending funds to a related party) will be a key consideration for the ATO. 25

26 LESSONS FROM CHEVRON Employ the most appropriate and reliable method(s) for justifying an arm s length transaction at the time it is completed. Think about the appropriate comparables and structure your transaction accordingly, not visa versa. The comparables chosen to defend the Chevron intercompany debt transaction were not similar enough in all meaningful respects to convince the Court of their appropriateness. Each side only produced four or five comparable transactions, and the Court found fault with the lack of similar Maturity Financial and operation covenants Security provisions Ranking (i.e. senior, subordinated, etc.) Industry and creditworthiness Amount/size of transactions Currency of the comparables 26

27 LESSONS FROM CHEVRON Arm s length pricing of debt is a highly subjective undertaking both when establishing a borrower s credit quality (experts were 8 notches apart) and when trying to agree on appropriate debt pricing comparables. A related party loan is subject to re-characterization by the ATO if its structure and terms cannot be defended with convincing comparables. The currency of the loan need not necessarily be in the same currency the borrower earns the majority of its revenue. How an entity funds itself before on-lending funds to a related party is a relevant, though not critical, consideration. A subsidiary of a multinational is not an orphan, but implicit support has serious limitations with regard to credit lift. The precedent of Chevron subsidiaries borrowing with a Chevron guarantee (and no fee) weighed heavily on what the court considered appropriate form. 27

28 POST PCG/CHEVRON QUESTIONS The circular aspect of the lift argument (which is most evident when a subsidiary s debt is directly held by the parent company) was not addressed. Should a parent company accept a below market interest payment from a subsidiary because it might be willing to assist the subsidiary in a stress situation? How will the parent company s tax authority view such an arrangement (i.e. less income revenue than one would expect)? Can subsidiaries borrowing with a parent guarantee deduct a guarantee fee paid to the parent if there is not a pattern of the parent charging other subsidiaries for such benefit? Does a true A$ bond market have to exist for an A$ transaction to be validated, or can an alternative market, such as the US bond market swapped back to A$, provide convincing proof that a transaction is appropriately priced. 28

29 FORM OF RELATED PARTY DEBT Loans or bonds, which are better for intercompany debt? Amount, term or ranking of the borrowing may dictate form Different situations call for different solutions, but bond market data is generally much more robust, available and transparent Secondary bond trading data allows pricing based on current info Floating rate loans allow incremental additions over time and generally more flexibility with regard to repayment and refinance Long term fixed rate bonds have a higher interest rate and generally can be prepaid only upon payment of a Make-Whole amount Interest rate changes may negate perceived advantages of either form Lower issuers (Non-Investment Grade) who want to avoid giving security may only be able to do so the public high yield bond market Bank loan comparables often include the effects of long term relationships and ancillary business, which are nearly impossible to quantify and extract from pricing data 29

30 US SECTION 385 IMPACT Beginning January 1, 2019, an issuer of related party debt must provide documentation detailing both the commercial terms of the transaction and an analysis of the creditworthiness of the issuer before filing a return for the year in which the transaction took place. More specifically, the documentation must reflect: i. A legally binding obligation to repay the funds; ii. The creditor s right to enforce default terms (if borrower fails to pay or is unable to comply with covenants); iii. A reasonable expectation that the funds can be repaid (based on projections or other expected source of funds, including refinancing); iv. Evidence of timely payment of P&I and an on-going genuine debtorcreditor relationship. If an issuer is unable to provide evidence of any of the above, reclassification of the debt as equity is possible, further resulting in reclassification of the interest expense as dividends. These requirements become are subject to de minimis threshold limitations. 30

31 US REGULATIONS New Interest Expense Deduction Limitation Until recently, a corporation s interest expense deduction was subject to limitation under 163(j) only if: Debt to equity is greater than 1.5 times (similar to Australia s rule), and Interest expense is greater than 50% of Adjusted Taxable Income ( ATI ), which is usually roughly equal to EBITDA. With passage of the 2017 Tax Cuts and Jobs Act, the corporate interest expense deduction is limited to 30% of EBITDA, reducing to 30% of EBIT in This is true whether the interest is paid on true third party or related party debt. There is an unlimited carryforward provision for unusable interest expense. This provision will require company s to re-evaluate their debt levels and consider the impact any changes to their debt levels will have on their credit quality and future borrowing costs. 31

32 US REGULATIONS New Base Erosion Anti-Abuse Tax (BEAT) A minimum tax on US corporate income calculated by eliminating deductions of payments to foreign related entities for interest, services and intangibles. Applies to payments that are deductible or give rise to tax depreciation or amortization. Exempts payments for inventory, derivatives, and payments for services provided at cost without mark-up. Applies to corporations with revenues of USD 500 million and base eroding payments exceeding 3% of deductible payments for the year. The BEAT rate is 5% in 2018, increases to 10% in 2019 and plateaus at 12.5% in The BEAT rate for banks and securities dealers is 1% higher. May encourage companies to onshore or outsource certain services as well as reshape supply chains. Will require company s to re-evaluate their related party debt levels and consider the impact any changes will have on their credit quality and future borrowing costs. 32

33 RATING AGENCIES EXPLICIT / IMPLICIT SUPPORT Shared Rating Agency Views on Parent/Subsidiary Linkage 1 First step is to determine the standalone ratings of both the parent and subsidiary. Next step is to assess the potential for ratings lift from either explicit parent support, via a legally enforceable agreement, or implicit support based on factors specific to the parent/subsidiary relationship. There are various forms of explicit support, but if the explicit support is in the form of a fully enforceable and unconditional guarantee, agencies will rate the subsidiary the same as its guarantor. Absent explicit support, compelling reasons must exist to justify lift of the subsidiary s standalone creditworthiness based on the possibility of parent financial support during periods of distress. Each situation is viewed based on multiple factors, with no single, or even multiple factors, necessarily determining the value, if any, of implicit support. 1 Information extracted from Moody s article: Rating Non-Guaranteed Subsidiaries: Credit Considerations in Assigning Subsidiary Ratings in the Absence of Legally Binding Parent Support, December 2003; and S&P article: Parent/Subsidiary Links; General Principles; Subsidiaries/Joint Ventures/Nonrecourse Projects; Finance Subsidiaries; Rating Link to parent, October 28,

34 DEBT TRANSFER PRICING SERVICES Disclaimer - Notice to Recipient These materials have been prepared by Global Capital Advisors, LLC ( GCA ) for the Recipient only and for whom such materials are directly addressed and delivered in connection with a possible engagement to provide Transfer Pricing Advisory services and may not be used or relied upon for any purpose other than as specifically contemplated by a written agreement with us. No representation or warranty, express or implied, is made as to the accuracy or completeness of any information and nothing contained herein is, or shall be relied upon as, a representation, whether as to the past, the present or the future. These materials were designed for use by specific persons familiar with the business and affairs of their enterprise and are being furnished and should be considered only in connection with other information, oral or written, being provided by us in connection herewith. These materials are not intended to provide the sole basis for evaluating, and should not be considered a recommendation with respect to, any transaction or other matter. These materials do not constitute an offer or solicitation to sell or purchase any securities and are not a commitment by GCA to arrange any financing for any transaction or to purchase any security in connection therewith. We assume no obligation to update or otherwise revise these materials. These materials have not been prepared with a view toward public disclosure under state or federal securities laws or otherwise; and are intended for the benefit and use of the recipient, and may not be reproduced, disseminated, quoted or referred to, in whole or in part, other than as specifically contemplated by a written agreement with us. Global Capital Advisors is a Limited Liability Corporation organized under the laws of the State of New York and is engaged in the provision of corporate finance and ratings advisory services to issuers and prospective issuers of public and private debt securities as well as debt transfer pricing advisory services to multinational companies with existing and prospective intercompany debt. In the provision of these services, there may arise the perception of a conflict of interest by virtue of the firm providing multiple advisory services to any one client. In the ordinary course of its corporate finance advisory activities, GCA may be simultaneously engaged in multiple roles as Investor Relations Advisor, Independent Private Placement Advisor, Advisor on Amendments/Waivers and/or as Credit Ratings, Transmittal Advisory, or Debt Transfer Pricing Advisor. GCA has adopted policies and guidelines designed to preserve the independence of our analytical research.. These policies prohibit our analysts from offering research coverage, a favorable research rating or a specific price target or offering to change a research rating or price target as consideration for, or an inducement to, obtain business or other compensation. GCA provides neither tax nor accounting advice. Accordingly, any statements contained herein as to tax or accounting matters were neither written nor intended by us to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on such taxpayer. If any person uses or refers to any such tax statement in promoting, marketing or recommending a partnership or other entity, investment plan or arrangement to any taxpayer, then the statement expressed herein shall be deemed not to have been delivered to support the promotion or marketing of the transaction or matter addressed and the recipient should seek advice based on its particular circumstances from an independent tax advisor. Global Capital Advisors, LLC 34

35 JULIAN PINSON DIRECTOR, GREENWOODS & HERBERT SMITH FREEHILLS

36 36

37 CHANGES FROM DRAFT PCG More complicated (pricing + motivational factors) Can be easier to end up in the red zone e.g. interest rate >200 bps over cost of referable debt gets you there alone Implicit threat of applying diverted profits tax if outside green zone Consortium / JV arrangements and global group concept References to compliance with this Guideline, amending prior year assessments to be in green zone sounding less and less like an ATO risk assessment tool Are we applying factors based on actual conditions or assumed arm s length conditions? GREENWOODS.COM.AU 37

38 TRANSITIONING ARRANGEMENTS INTO GREEN ZONE Taxpayers wishing to modify their financing arrangements on a prospective basis are required to provide us details regarding: existing financing arrangements including how those arrangements comply with this Guideline proposed financing arrangements and their compliance with this Guideline how the transition will be executed and any tax consequences associated with the transition, and any proposal for resolution of relevant open years Where we reach agreement with you on your transitional arrangements that agreement will be executed by way of deed and will apply for the duration of the new financing arrangements, subject to any critical assumptions agreed to as part of the deed. GREENWOODS.COM.AU 38

39 SCENARIO 1 PARENT credit rating: A3/A- Can borrow AUD at BBSW basis points p.a Overseas Australia 100% shares (A$400m) ONE OR MORE THIRD PARTIES A$600m debt interest: BBSW basis points p.a. SUBSIDIARY credit rating: Ba2/BB Total cost to Subsidiary: BBSW basis points p.a. GREENWOODS.COM.AU 39

40 SCENARIO 2 PARENT Credit rating: A3/A- Can borrow AUD at BBSW basis points p.a ONE OR MORE THIRD PARTIES 100% shares (A$400m) Overseas Australia interest: BBSW basis points p.a. A$600m debt SUBSIDIARY credit rating: Ba2/BB Total cost to Subsidiary: BBSW basis points p.a. GREENWOODS.COM.AU 40

41 SCENARIO 3 PARENT Credit rating: A3/A- Can borrow AUD at BBSW basis points p.a ONE/MORE THIRD PARTIES 100% shares (A$400m) Overseas Australia interest: BBSW basis points p.a. A$600m debt SUBSIDIARY guarantee fee of 175 basis points p.a UNRELATED GUARANTOR* credit rating: Ba2/BB Total cost to Subsidiary: BBSW basis points p.a. *Provides a guarantee for the third party borrowers from subsidiary GREENWOODS.COM.AU 41

42 SCENARIO 4 guarantee by Parent of Subsidiary s debts PARENT Credit rating: A3/A- Can borrow AUD at BBSW basis points p.a Overseas Australia ONE/MORE THIRD PARTIES guarantee fee of 175 basis points p.a. 100% shares (A$400m) interest: BBSW basis points p.a. A$600m debt SUBSIDIARY credit rating: Ba2/BB Total cost to Subsidiary: BBSW basis points p.a. GREENWOODS.COM.AU 42

43 SCENARIO 5 Overseas Australia FINANCE SUBSIDIARY OF PARENT guarantee by Parent of Subsidiary s debts guarantee fee of 175 basis points p.a. PARENT 100% shares (A$400m) Credit rating: A3/A- Can borrow AUD at BBSW basis points p.a interest: BBSW basis points p.a. A$600m debt SUBSIDIARY credit rating: Ba2/BB Total cost to Subsidiary: BBSW basis points p.a. GREENWOODS.COM.AU 43

44 JV/CONSORTIUM DEBT Third party debt Investor 1 and 2 third party debt INVESTOR 1 INVESTOR 2 Loan Loan 50% 50% BID CO TARGET Investor 1 10% AUD equivalent Investor 2 5% AUD equivalent PCG: Where a JV partner or consortium member with more than 20% direct or indirect interest in the entity has provided capital by way of debt, that particular instrument is assessed against the global group of that particular joint venture partner or consortium member GREENWOODS.COM.AU 44

45 DPT AND THIN CAPITALISATION DPT EM para 1.30: The thin capitalisation modification (s.177j(4)), which preserves the role of Division 820 in respect of its application to an entity's amount of debt, applies if: the thin capitalisation provisions (Div.820) apply to the taxpayer for the relevant income year; the DPT tax benefit includes all or part of a debt deduction; and the calculation of the amount of the DPT tax benefit involves applying a rate to a debt interest 1.31 In these circumstances, for the purposes of calculating the amount of the DPT tax benefit, the rate should be applied to the debt interest actually issued (rather than to the debt interest that would have existed if the scheme had not been entered into or carried out): s.177j(5) GREENWOODS.COM.AU 45

46 DIVERTED PROFITS TAX PARENT 28% tax rate Sub 1 no treasury/other significant functions FOREIGN SUB $100m 5% (arm s length rate) Diverted profits tax (EM example 1.1) Alternative postulate is Parent lends to Sub 2 0% tax rate Sub 1 lack of substance important 30% tax rate $100m 8% AUS SUB GREENWOODS.COM.AU 46

47 EXPECTED HYBRIDS INTEGRITY RULE PARENT 28% tax rate Hybrid mismatch integrity rule FOREIGN SUB $100m 5% (arm s length rate) Target: achieving same outcome as hybrid instrument/entity mismatch by interposing entity in low-tax jurisdiction 0% tax rate 30% tax rate $100m 8% Will substance of Sub 1 be irrelevant? Purpose requirement? AUS SUB GREENWOODS.COM.AU 47

48 WHAT S STILL COMING ATO Expected timing Transfer pricing and debt equity (Tax Determination) March 18 does Div 974 prevail over Subdiv 815-B Interest free loans (Tax Determination) March 18 when considered an equity contribution Additional schedules to related party financing PCG derivatives March 18 interest free loans March 18 guarantee fees March 18 Chevron Decision Impact Statement? TR 92/11 changes / new TR on debt transfer pricing?? GREENWOODS.COM.AU 48

49 WHAT S STILL COMING (CONT) Treasury Revised anti-hybrids legislation branch mismatches integrity rule Expected timing Feb/March 18 OECD TP guidance for related party financial transactions (including guarantees) originally part of BEPS due 2015 deadline extended to 2017 but missed Expected timing? GREENWOODS.COM.AU 49

50 WHAT TO DO NOW WITH EXISTING DEBTS Self-assess under TP rules remember normal TP documentation requirements still apply Self-assess risk zone under PCG (whether or not going to disclose) consider flow on accounting disclosures re: uncertain tax positions If high risk zone (and staying there) consider: compiling additional evidence now to justify position - strong evidence at review stage to avoid costly litigation pre-emptive engagement with ATO If high risk zone (and do not want to stay there) consider: 18 month transitional window to bring into green zone with no penalties now more onerous process repay/restructure debt flow on consequences? flow-on implications in other countries GREENWOODS.COM.AU 50

51 Q&A PANEL SESSION

52 CROSS-BORDER RELATED PARTY DEBT: PRACTICAL COMPLIANCE GUIDELINE 2017/4 A BRIEF OVERVIEW

53 OVERVIEW What is the PCG? ATO tool to assess risk and tailor our engagement with you according to the features of your related party financing arrangements not a ruling, not binding on ATO; not an interpretation of the law so, no legal protection for taxpayers by being in the White or Green zone still need to do proper transfer pricing analysis and prepare documentation PCG is silent on comparables : but still need to consider for TP purposes What to do now? identify relevant arrangements and undertake/document self-assessment of risk assess in light of PCG and Chevron (the PCG is silent on the Chevron case) make a voluntary disclosure within an 18 month transitional window? communicate assessed risk position to internal stakeholders GREENWOODS.COM.AU 53

54 BACKGROUND AND DATE OF EFFECT ATO regards interest on cross-border related party debt (especially excessive deductions on inbound debt) as the largest risk to the Australian corporate tax base PCG has been under development for a couple of years: prior to Chevron case Draft PCG 2017/D4 released in May 2017 Lots of consultation and submissions, e.g., our effort: Final PCG 2017/4 issued 18 December 2017: quite a few changes between draft and final PCG: not all of them favourable! PCG applies from 1 July 2017 to existing and new cross-border debt But: only debt entered into since 1 January 2015 should be reported for Reportable Tax Position schedule reporting purposes (para 39 of PCG) 18 month period (from 18 Dec 2017) to transition existing debt to the Green zone GREENWOODS.COM.AU 54

55 WHAT THE PCG COVERS At this stage, only related party debt funding, but may be extended in due course to cover other related party transactions, including: guarantees (currently not dealt with at all, despite comments in Chevron) interest-free loans related party derivatives Applies to inbound and outbound debt Only applies to risks arising from transfer pricing and not other tax issues such as thin capitalisation, debt/equity rules, interest withholding tax Exclusions: ADIs e.g. banks groups containing an Australian resident securitisation vehicle or s entity taxpayers applying the simplified transfer pricing rules in relation to loans Islamic finance GREENWOODS.COM.AU 55

56 WHAT DOES THE ATO EXPECT? Para 52: Generally, we expect pricing of a related party debt to align with the commercial incentive of achieving the lowest possible all in cost to the borrower. We also expect in most cases, the cost of financing to align with the costs that could be achieved, on an arm s length basis, by the parent of the global group to which the borrower and lender both belong. The indicators in this Schedule and their weighting have been developed with this expectation in mind. Para 68: This indicator requires a comparison of the all in cost of debt and the related party financing arrangement to the cost of debt issued to an unrelated third party. All in cost is all the cost associated or connected to the pricing of the debt. For example, guarantee fees, associated hedging cost, line fees and any anticipated foreign exchange gains or losses. GREENWOODS.COM.AU 56

57 RISK ZONES AND WHAT TO EXPECT FROM THE ATO Risk Zone ATO Treatment White (already reviewed) No review other than to confirm on-going consistency with the agreed/determined approach. Green (low risk) If there have been no material changes, then minimal ATO activity. Blue (low to moderate risk) We will actively monitor your arrangements using available data and will review arrangements by exception. Alternative dispute resolution (ADR) might be effective in resolving any areas of difference. Yellow (moderate risk) We will work with you to understand and resolve areas of difference. ADR might be effective in resolving any areas of difference. Amber (high risk) Reviews are likely to be commenced as a matter of priority. We will work with you to understand and resolve areas of difference. ADR might be effective in resolving any areas of difference. Red (very high risk) Reviews are likely to be commenced as a matter of priority. Cases might proceed directly to audit. You will not be eligible to access the APA program. We are likely to use formal powers for information gathering. Practically, it will be more difficult to resolve disputes through settlement or ADR. You might face an increased prospect of litigation. GREENWOODS.COM.AU 57

58 WORKING OUT YOUR RISK ZONE A risk zone is determined by combining outcomes under the pricing and motivational risk scoring tables according to the following matrix: N G 1 2 MOTIVATIONAL A B C P R I C I An explanation of each of the 11 risk indicators is given at paragraphs 65 to 121 of the PCG, including two worked examples GREENWOODS.COM.AU 58

59 THE 11 RISK INDICATORS Pricing risks: 1. Price vs traceable 3 rd party debt; 3 rd party group debt; or global group cost of debt 2. Appropriate collateral (inbound only) 3. Subordinated/mezzanine debt (inbound only) 4. Currency of debt not consistent with operating currency 5. Presence of exotic features or instruments (inbound only) 6. Sovereign risk of borrower entity (outbound only) Motivational risks: 7. Leverage of borrower (inbound only) 8. Interest coverage ratio (inbound only) 9. Applicable tax rate of lender entity jurisdiction (inbound only) 10. Involves an arrangement covered by a taxpayer alert 11. Involves a hybrid arrangement GREENWOODS.COM.AU 59

60 DOING A RISK ASSESSMENT; OR NOT Need to separately self-assess and document the risk from each cross border debt with a non-resident, having regard to each of the 11 risk indicators: for existing arrangements either : o at the start of each income year, with subsequent reviews during the year where additional info becomes available; and o before income tax returns are lodged for the relevant year where more up to date info is available for new arrangements entered into during a year: when entered The overall risk zone reflects the debt with the highest risk Need to disclose self-assessed risk on Reportable Tax Position (RTP) schedule It is not a requirement for you to self-assess your risk rating, but if you are unable to (or choose not to) you will need to disclose this on the RTP schedule [where required to be lodged] GREENWOODS.COM.AU 60

61 CHANGES FROM DRAFT TO FINAL PCG INCLUDE: Only modest changes to the 11 risk indicators, but having two classes of risk (pricing and motivational) makes the overall exercise more complicated More clarity/definitions for some of the risk indicators Easier to end up in the Red zone /very high risk: any 1 of these gets you there: interest rate more than 200 basis points over cost of referrable debt lender in a 0% tax rate jurisdiction involves use of a hybrid arrangement (instrument or entity) Only arrangements entered into since 1 January 2015 need to be reported for Reportable Tax Position schedule reporting purposes PCG now says: We may review and modify the indicators contained in this Schedule to align it with changes in Australian debt market conditions. Our review will be contingent on the movement of certain indicators contained in the Aggregate Measures of Australian Corporate Bond Spreads and Yields statistical table maintained by the Reserve Bank of Australia. GREENWOODS.COM.AU 61

62 ACTION: WHAT TO DO NOW 1. Decide whether to self-assess risk per the PCG: not doing so will be problematic! 2. Apply the 11 risk indicators now to each current and former loan to: determine/document overall risk zone ascertain likely Reportable Tax Position schedule disclosures consider flow-on financial accounting disclosures re uncertain tax positions month transitional window to try(!) and bring existing/prior debt arrangements into the Green zone: no penalties and SIC remitted to base rate for back years Or accept implicit offer to reach a compliance review-based resolution, possibly with mediation-type ADR, if in Blue, Yellow or Amber zones Threat of full audit and litigation if stay in Red zone 4. Review/update transfer pricing documentation: especially if outside Green zone 5. Keep all internal stakeholders, including overseas parent/subs, informed of developments/risks in accordance with internal governance procedures 6. Consider flow-on implications in other countries of any adjustments in Australia GREENWOODS.COM.AU 62

63 SYDNEY ANZ Tower, 161 Castlereagh Street Sydney NSW 2000 T F MELBOURNE 101 Collins Street Melbourne VIC 3000 T F PERTH QV.1 Building, 250 St Georges Terrace Perth WA 8000 T F The contents of this publication, current at the date of publication set out in this document, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication Greenwoods & Herbert Smith Freehills Pty Limited ABN