CFO Insights Taxing matters: Assessing the risks in corporate financings

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1 CFO Insights Taxing matters: Assessing the risks in corporate financings As they gear up for what hopefully will be an economic recovery, many CFOs are contemplating how to fund growth in a low cost and tax-effective way. Indeed, while multinationals make investment decisions for strategic reasons and commercial upside, tax is an ever-present consideration. So much so that in our Q CFO Signals survey, nearly 70 percent of CFOs said that corporate tax policies significantly impact their investment decisions. And given the likelihood of corporate tax reform in the next few years (something 65 percent of CFOs expect, according to the same CFO Signals survey), it appears that companies will have to delicately balance their need for growth with an eye on the changing tax landscape. In this issue of CFO Insights, we examine the tax risks associated with internal and external financings and outline some questions CFOs should ask of their tax directors. Internal vs. external debt For CFOs, staying on top of tax changes is challenging particularly those related to financings. Consider, for example, President Obama s current proposal to defer interest deductions on international operations until the income is subject to U.S. taxation a move that would have far reaching effects on cross-border financings. 1 Meanwhile, the issue of whether the Internal Revenue Code provides too many incentives for accumulating debt over equity the subject of last summer s rare joint hearing of Congress two tax-writing committees is far from resolved. 2 Plus, numerous proposals to lower the corporate tax rate will fundamentally change the value of interest deductions and impact where and when financings should be done. Although a change in tax law is one risk, the existing body of tax law as it relates to the tax aspects of corporate financing is already complex. To better understand and address those risks, let us break down the tax considerations according to the type of debt issued: External debt When raising capital, companies generally seek financing with a low effective cost measured on an after-tax basis. Since interest is deductible and dividends are not, debt financing is usually deemed less expensive. But since debt financing carries with it other risks, such as liquidity and bankruptcy risks, companies typically seek to favorably balance their mix of debt and equity in the capital structure or issue individual securities that blend the elements of debt and equity. These considerations have set the stage for the development of hybrid securities (e.g., convertibles, bond/warrant investment units) that combine elements of both, and as a result, blur the distinction between debt and equity. However, there is still no bright-line test for determining whether a given instrument is debt or equity. 1

2 Tax considerations have certainly been a significant factor in the evolution of such hybrid securities. Similarly, the rating agencies process for evaluating the creditworthiness of securities issuers has also driven financial innovation. Tax and credit-enhancing considerations can actually drive the evolution of similar or dual-purpose structures, although the perspectives of the two organizations (i.e. IRS and rating agencies) are very different. If tax authorities challenge the characterization of a purported debt instrument as in substance equity, it is an all or nothing risk. If the challenge is sustained, tax benefits from the interest deductions arising from the hybrid security will be lost in the entirety. But the adverse tax treatment is unlikely to impact other securities in the issuer s capital structure. In contrast, the rating agencies do not attempt to classify a hybrid security as either all debt or all equity. A debt security can be given partial benefit or equity credit if it includes terms, such as the ability to defer interest payments in times of cash flow difficulties. However, rating agency considerations can impact other securities in the issuer s capital structure. For example, an issuer may have debt where the interest rate is expressed as an objective interest index (e.g., LIBOR or U.S. Treasuries) plus a spread reflecting the creditworthiness of the issuer. Therefore, the rating on one security may impact the creditworthiness of the issuer that may, in turn, have a synergistic effect on the pricing of other debt issues that reference the creditworthiness of the issuer. The problem is that an innovation or structure that may serve dual purposes or even one that predominantly increases the credit rating may be misconstrued by the taxing authorities as predominantly tax-motivated and generate a negative response. The following table illustrates that some hybrid securities terms fulfill both a tax- and a credit-enhancing purpose. Whenever a tax-effective financial instrument innovation is perceived as too aggressive, the courts, the IRS, and ultimately Congress respond in one of two ways. The first is to establish a bright line where boundaries were previously uncertain. The second is to amend the rules in a manner that may adversely impact the tax advantage, although such changes generally are made effective on a prospective basis. This scenario sets the stage for a fast follower advantage. Whereas a first mover may obtain tax benefits, but end up on the wrong side of the boundary when the rules are clarified, a fast follower can benefit from letting the tax-effective financial innovation evolve. But the followers cannot wait too long or there is a possibility that the benefits will be lost entirely. A brief listing of tax-effective financial instrument innovation and the U.S. government s response is listed below. Table 1. Securities features that enhance creditworthiness and are tax effective Instrument (or Term) Credit Enhancement Tax Effective TaxDual-Purpose Zero Coupon Bonds Interest payment deferral Deduction ahead of payment (e.g., OID) Payment-in-Kind Interest Option (and other deferral provisions) Optional interest payment deferral Deduction ahead of payment (e.g., OID) Trust Preferred Subordinated to more senior debt; synergistic benefits on other securities Issuing debt in lieu of a preferred offering 2

3 Table 2. Government responses to selected financial instruments Tax-effective Innovation Exchangeable Notes Contingent Convertibles Prepaid Cash Settled Forward Trust Preferred Trade Name DECS New LYONs ELKs MIPS, TOPrS Government Response Limits (e.g., Section 163(l)) 3 Bright line (e.g., Rev Rul ) 4 Limits (e.g., Section 1259) 5 Court Challenge (e.g., Enron) 6 The table demonstrates that the tax laws are not static with respect to financial innovation. However, what is not readily apparent is that certain companies were able to utilize financial instruments before adverse legislation became effective, while others faced challenges from taxing authorities. This creates a dilemma for a CFO when selecting newer tax-effective financial instruments. So what is a CFO to do? If you are going to structure your external financing with plain vanilla instruments, there really is not much to be concerned about. However, if you want to achieve a lower cost of financing through altering the mix of debt and equity in your capital structure, which includes the judicious use of hybrid securities to execute a chosen strategy, here are some suggestions: Develop a network. Other CFOs, investment bankers, lawyers, accountants, and auditors who regularly encounter sophisticated financial structures can keep you informed about developments in the marketplace. Do not be the first. (but don t be the last). Your network will help you here. Let the marketplace test the structure before you do. Get good counsel. Often, the tax treatment of items turns on factors not readily apparent to nontax professionals. Be well advised on the transaction. Internal debt CFOs are continually faced with decisions about how to manage internal movements of cash and structure internal funding of operations. Taxes can either be a detriment or a benefit on these financings. For example, although international tax arbitrage may be misunderstood by some parties, it is a reality for many multinational businesses. Basically, the term refers to arrangements that utilize meaningful differences between the tax consequences of the same item in two or more jurisdictions. Take statutory tax rates. Some countries, such as Ireland or Luxembourg, set their rates low, and others, such as the U.S. or Japan, set their rates high. It is this disparity that sets the stage for international tax arbitrage, such as crossborder financing, which is a tax-rate arbitrage. Such tax-rate arbitrage can facilitate significant reductions in the overall global tax burden for a company. The essence of the approach is to shift income from high-tax jurisdictions to low-tax jurisdictions via the interest deductions on the intercompany debt. The interest expense deductions generate a tax benefit for the operating companies that may average between approximately 30 percent and 40 percent in their home jurisdictions. The off-setting interest income recorded at the finance companies may be subject to, essentially, a low or no tax pursuant to tax rulings negotiated with the respective taxing authorities. While this is customary tax planning for multinational companies, it is often an area of dispute between taxpayers and taxing authorities. Most nations, in fact, have enacted limitations on related-party interest deductions. Thin capitalization rules are intended to limit interest deductions for highly leveraged companies for interest payments made to related parties. A comprehensive analysis of foreign taxation of debt is beyond the scope of this paper, but here is a selected overview of those thin cap rules. Seek an external opinion. If necessary, obtain an opinion from a reputable firm that is knowledgeable and experienced with financial instruments. 3

4 Table 3. Similarities and differences for thin cap rules in selected countries 7 Country Australia France Germany Mexico Japan UK Brief Description Limits when worldwide debt-to-equity ratio ( DTER ) exceeds 3:1 Limits when related borrowing exceeds 1.5 times equity and interest exceeds 25% of operating profits Interest only deductible up to 30% of EBITDA. Exceptions may apply. Limits on related party debt that exceeds 3:1 DTER Limits on related party debt that exceeds 3:1 on related party equity Thin cap (per above); Anti-arbitrage (financings using hybrid instruments or entities) and worldwide debt cap To avoid problems with taxing authorities, companies typically obtain a tax opinion prior to executing an internal financing. But unlike external debt, the specific risks related to internal debt occur before and after it is issued. Specifically, they include the robustness of the cash flow projections used to set the original terms of the debt; the credit scoring of the debt at the time of issuance; and the follow-on adherence to the stated terms of the instrument. When questions do arise in these areas, the IRS or other taxing authorities are not likely to compromise. Take, for example, projections that fail to properly analyze the projected cash flows. One might argue that the appropriate analysis of the flawed projections was that the debt issuer was in fact a weaker credit, and therefore, the appropriate remedy was that the interest rate should be increased to compensate the holder for the additional risk. But that is not how the IRS or other taxing authorities will respond. Instead, they may attempt to invalidate the debt in its entirety with the result that the interest deductions will be lost. In financial vernacular, this is a classic asymmetrical pay-off profile, but the common vernacular expresses it best: Heads I win; tails you lose. It is a similar story with adherence to terms. As the taxpayer, you must adhere to all the third-party protocols to sustain the tax benefits of the internal debt on examination. But if some third-party protocols would actually increase your benefits, the IRS (and other taxing authorities) may use them as a lever to invalidate your debt in the entirety. Your response may be to pursue legal action, but keep in mind that tax litigation of a factual nature (as this is) is very expensive. More important, the courts may rule in favor of the IRS where the adherence to the terms of the instrument have been systematically ignored (e.g., failure to pay interest and principal when due). So, again, what is a CFO to do? Here are some suggestions for safeguarding an internal financing at different stages: Before issuance. The amount of debt that a foreign subsidiary can carry is a function of its debt-carrying capacity at the desired credit rating. Of the two main components needed to justify a particular financing projections and credit scoring projections are more important. At a minimum, there should be a calculation of the expected free cash flow on a legal-entity basis demonstrating that the new internal debt can be serviced and retired at maturity by that cash flow pursuant to the terms of the new debt. The projection growth rates and assumptions should be consistent with other projections used by the company for other purposes (e.g., impairment testing). And while a full explanation of credit scoring is beyond the scope of this paper, the goal is to determine that the interest rate is not chosen arbitrarily and is commensurate with the issuer s creditworthiness. At issuance. The terms of most intercompany debt will be pretty plan vanilla. That is, it will not usually be linked to equity (e.g., convertible or exchangeable); it will not usually provide for interest deferral; and it usually will have a relatively short maturity (e.g., 7-12 years). Although it is important to get an opinion from a knowledgeable tax advisor, keep in mind that your main risks arise before and after the debt is issued. 4

5 After issuance. The internal administration of the debt going forward is key to avoiding future adverse tax consequences. Confirm that your treasury group scrupulously adheres to all the stated terms of the intercompany debt. Do not allow them to skip interest payment dates or just roll-over debt when it becomes due. In addition, determine that your treasury and tax departments work together to sustain the tax benefits of intercompany debt. You might also consider expanding the scope of your internal audit group to confirm that covenants are being followed and payments settled on time. Whether embarking on an internal or external financing, the final question a CFO should always ask is what is the potential cost of unwinding a transaction? In any deal, you should determine an exit strategy if the tax structure proves unwieldy or alternatively, structure the transaction with the minimal tax consequences in mind. Endnotes 1 U.S. Department of the Treasury, General Explanations of the Administration s Fiscal Year 2013 Revenue Proposals, February Joint Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCX-41-11), July 11, Internal Revenue Code: Section 163(l) 4 Internal Revenue Code: Rev Rul Primary contacts Richard Spears Tax Partner Deloitte Tax LLP rspears@deloitte.com Edmund Outslay Endowed Professor of Accounting Michigan State University outslay@bus.msu.edu This Deloitte CFO Insights article was developed with the guidance of Dr. Ajit Kambil, Global Research Director, CFO Program, Deloitte LLP, and Lori Calabro, Senior Manager, CFO Education & Events, Deloitte LLP. Deloitte s CFO Program harnesses the breadth of our capabilities to deliver forward-thinking perspectives and fresh insights to help CFOs manage the complexities of their role, drive more value in their organization, and adapt to the changing strategic shifts in the market. For more information about Deloitte s CFO Program visit our website at 5 Constructive sales treatment for appreciated financial positions: Internal Revenue Code; Section 1259; Treasury Notice , I.R.B. 252 and Rev. Rul , I.R.B First Supplemental Stipulation of Settled Issues; Enron Corp. vs. Commissioner, Doc , filed December 24, 1998; See also Counsel Settlement Memorandum, MIPs Issues, In re: Enron Corporation and Consolidated Subsidiaries, Docket Number , approved July 26, Joint Committee on Taxation, Present Law and Background Relating to Tax Treatment of Business Debt (JCX-41-11), July 11, This article contains general information only and Deloitte is not, by means of this article, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network of member firms, each of which is a legally separate and independent entity. Please see for a detailed description of the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting. Copyright 2012 Deloitte Development LLC. All rights reserved. Member of Deloitte Touche Tohmatsu Limited 5