Transfer Pricing Aspects of Financing (Treasury) Activities

1. Transfer Pricing Aspects of Financing (Treasury) Activities Dr. Vikram Chand Executive Director, Executive Tax Education, University of Lausanne vikram.chand@unil.ch

2. Intra Group Treasury Activities Co A State A • Credit rating • Intra group lending • Provision of guarantees Treasury entity • Cash pooling Low tax country • Factoring • Derivatives State B Co B

3. Framework common to most financing transactions

4. Credit ratings • Credit ratings • What are credit ratings? • Who provides credit rating services? • How do these service provider provide credit ratings? • How is a credit rating given? • Should credit ratings be adjusted for implicit support?

5. Transfer Pricing aspects of Intercompany financial guarantees

6. Guarantee fee recognition • Facts: • The credit rating of Co B is C. Banks provide loans to such entities on an standalone basis @ 9% • However, as Co B is related to Co A group, whose credit rating is A, the bank agrees to provide the loan at the same terms it extends to borrowers with a credit rating of B • The bank provides a loan to Co B at an interest rate @ 7% • Issue: • Should Co B pay a guarantee fee to Co A? • Question to be analyzed: • Is there an intra group service? – The benefit test • Incidental benefit vs deliberated concentrated action • Revised Para 1.167 Co A Implicit support Guarantee fees? State A State B Loan BANK Co B Interest

7. Guarantee fee recognition • Facts: • The credit rating of Co B is C. Banks provide loans to such entities on an standalone basis @ 9% • However, as Co B is related to Co A group, whose credit rating is A, the bank agrees to provide the loan at the same terms it extends to borrowers with a credit rating of B. The bank provides a loan to Co B at an interest rate @ 7% • Nevertheless, if a formal guarantee is in place, the bank is ready to lend to Co B at the same rates it applies to companies with a A credit rating ie @ 5% • Issue: • Should Co B pay a guarantee fee to Co A? • Question to be analyzed: • Is there an intra group service? – The benefit test • Incidental benefit vs deliberated concentrated action • How much fee should be paid? • Revised Para 1.167 Co A Explicit support Guarantee fees? State A State B Loan BANK Co B Interest

8. Arm’s length fee CUPs • Internal CUPs • External CUPS • Credit default swaps • Yield method or benefit approach • Insurance method = Actuarial method • Cost of capital Other methods

9. Transfer Pricing aspects of Intercompany loans

10. Loan recognition Step 1 • Is it a loan for domestic law purposes? Analysis of loan terms and conditions Yes Step 2 • Does the borrowers relevant economic circumstances support the loan ? Undertake could and would analysis to understand borrowers debt capacity – Essentially a credit rating analysis Yes Step 3 • Is there a commercial rationale to borrow the funds? Yes • Recognize the loan for TP purposes

11. Loan recognition – Is it a loan? • Facts: • Co A, a leading pharmaceutical company, infuses funds via equity and debt in the financing entity • The financing entity, legally set up in an EU jurisdiction funds Co B, a State S company, via an interest bearing loan of AUD 100 Million @ 8% • The loan is given on the following terms: • The loan is given for a tenure of 100 years with no repayment clauses for the principal amount • Co B is required to pay interest only if it makes profits • Issue: • Is it a loan for State S domestic law purposes? • The Dutch Practice Co A State A Financing entity State B Low tax country Interest Australia Co B

12. Loan recognition – borrowers borrowing capacity? • Facts: • Co A, a leading pharmaceutical company, infuses funds via equity and debt in the financing entity • The financing entity, legally set up in an EU jurisdiction funds Co B, an Australian company, via an interest bearing loan of AUD 150 Million @ 8% • The credit rating and financial analysis of Co B indicates that, at arm’s length, a third party lender would lend only AUD 100 Million @ 8% • Issue: • Does Article 9 permit re-characterization of the loan arrangement? If yes, is it automatic or should a reference be made to the domestic law? • Can AUD 50 Million be re-characterized? If yes, as what? Co A State A Financing entity State B Low tax country Interest Australia Co B

13. Loan recognition – commercial rationale? • Facts: • Co A, a leading pharmaceutical company, infuses funds via equity and debt in the financing entity • The financing entity, legally set up in an EU jurisdiction, funds Co B, an Australian company via an interest bearing loan of AUD 100 Million @ 8% • The credit rating and financial analysis (could analysis) of Co B indicates that, at arm’s length, a third party lender would lend only AUD 100 Million @ 8% • So far, Co B has drawn down only AUD 60 Million for undertaking commercial activities. The un used arm’s length borrowing capacity amounts to AUD 40 Million • Co B draws down AUD 40 Million and deposits the cash in a bank. The bank pays interest @ 1% • Issue: • Is it commercially rationale to draw down the loan? • Can AUD 40 Million be re-characterized? If yes, as what? Co A State A Financing entity State B Low tax country Interest Australia Co B

14. Arm’s length interest Step 1 • Establish relevant economic characteristics of the borrower: Credit rating analysis Step 2 • Understand the terms and conditions at which the related party loan was provided The amount and loan tenure, currency, seniority or subordination, fixed or floating interest, loan repayment schedule, security provided by the borrower etc • Understand the controlled transaction and apply internal or external CUP’s to justify the arm’s length charge

15. Arm’s length interest Internal CUP’s • The related borrower would have borrowed from third parties • Third parties would have provided loans to other members of the multinational group • Suitable adjustments would be required • Use of bank quotes? • Database search with appropriate screening criteria • Fair value Curves External CUP’s

16. Transfer Pricing aspects of Cash pooling arrangements

17. Physical pooling with external bank structure Master Account with bank A Co • A Co is a service provider External bank • Related party loans • Cross guarantees Loan Interest Interest Loan Loan Interest Co B Co C Co D Sub Account with bank Sub Account with bank Sub Account with bank

18. Physical pooling with in house bank structure Master Account • Related party loans • Cross guarantees A Co Treasury • A Co is an entrepreneur acting as a bank Loan Interest Interest Loan Loan Interest Co B Co C Co D Sub Account Sub Account Sub Account

19. Recognition of the arrangement • Should you recognize cash pooling arrangements? • Arrangement should be respected when • Form = substance • The arrangement is commercially rationale • How would you prove commercial rationality?

20. Arm’s length analysis • Loans have to be at arm’s length • Guarantees fees may have to be paid on cross guarantees that enhance an entities credit rating over and above implicit support • Cash pooling benefit has to be allocated on an arm’s length basis: • In house bank structure – Cash pool leader should be entitled to the benefit (interest spreads) as it undertakes more risks • External bank structure – Cash pool leader should be entitled to a service fee. Balance benefit should be allocated among the participants. Ideally using the PSM

21. Notional pooling with external bank structure External bank • No physical flow of funds • Cross guarantees • Pooling benefit paid to A CO A Co • Service provider Co B Co C Co D

22. Arm’s length analysis • Guarantees fees may have to be paid on cross guarantees that enhance an entities credit rating over and above implicit support • Cash pooling benefit has to be allocated on an arm’s length basis: • Notional structure – Cash pool leader should be entitled to a service fee. Balance benefit should be allocated among the participants using the PSM

23. Transfer Pricing aspects of captive insurance arrangements

24. Insurance or Reinsurance – Basics • What is insurance? • Who are the parties to an insurance arrangement? • What are the main revenue and expense items for the insurance business? • What are the functions, assets and risks of an insurance business? • What is reinsurance?

25. Captive insurance • What is captive insurance? • What is the commercial rationale to enter into captive insurance arrangements? • What are the various types of captive insurance arrangements? • Direct insurance • Reinsurance • In which jurisdictions are captive insurance entities set up? • What types of risks do they insure?

26. Captive providing direct insurance Captive Entity • Captive acting as a direct insurer Low tax jurisdiction State A State B Premium Insurance Insurance Insurance Premium Premium Sub I Parent Sub

27. Captive providing reinsurance Captive Reinsurer • Captive acting as a reinsurer Insurance Premium Low tax jurisdiction Fronting Insurer State A State B Insurance Premium Insurance Premium Premium Insurance Sub I Parent Sub

28. Captive recognition – Form vs substance • Facts: • Insured (Parent) and captive reinsurer (owned by the Parent) are related parties • Insured enters into an insurance arrangement with fronting insurer for protection against business interruption • Fronting reinsurers 100% of the risks with the captive reinsurer • The captive is legally formed with two board of directors. These directors are residents of State B. They fly to State A once a year to formalize decisions taken by an independent captive management company • The captive does not have its own employees that undertake underwriting activities • Issue: • Should the arrangement be respected in the sense that the premium (and investment income) be allocated to the captive reinsurer from a TP perspective? Services Captive reinsurer Management Company Fees Insurance Premium State A Low tax country Fronting State B Insurance Premium Insured

29. Arm’s length pricing of the insurance policy CUP’s • Internal CUPs • External CUPS such as broker quotes for actual transactions • Captive is the tested party • Return on capital for the captive • Alternate: apply the insurance method TNMM • Opinions of actuaries • Opinions of economists Other methods