We asked one of our sponsors from TP Minds Asia 2017 to talk through the implications and practical approaches towards intra group financing. Here, Zara Ritchie and Nick Drizen from BDO Australia lay out the basics for Asian groups.
Why is debt funding important?
Financing is one of the most crucial areas for business to consider. Funding is key to providing working capital to meet a business’s daily operations and to grow and allow for acquisition of assets and other investments.
There are different ways of meeting these funding needs, through internal cash generation, equity funding or debt funding. Independent businesses may find access to equity difficult or expensive even if they are listed on leading stock markets. Equity holders will expect a good return in terms of dividends and capital growth which can impact the investment decisions of a business to meet these needs. From a control perspective, issuing equity can dilute the ownership of the business making it less attractive.
There are a number of factors which can make debt a more attractive and practical way of financing a business, for example, debt:
- Offers greater flexibility in relation to repayment terms and other conditions
- Is generally cheaper than equity
- Does not dilute ownership control and
- Is usually tax deductible in most countries.
What is the ‘mischief’ with intra group financing?
In an intra group context, financing can be one of the most material items from a transfer pricing perspective. Where a large acquisition is financed by intra group debt, the interest costs can be significant and wipe out a significant amount of local taxable profits. In addition, from an international tax perspective, historically intra group financing has been associated with sophisticated financing structures such as hybrid financing (where there is an interest deduction in the borrowing company/one country, but no interest pickup in the lending company/other country) or where the lender provides funds from a low or no tax jurisdiction. Given the materiality of the transactions and perceived motivation of taxpayers to avoid or reduce tax through planning structures, financing is attracting a greater level of attention amongst Tax Authorities, Governments and at the OECD level.
Limited transfer pricing guidance is available in relation to intra group funding
From a technical stance, the challenge for multinational groups is how to deal with intra group funding arrangements. Historically, there has been very limited guidance from an OECD transfer pricing perspective and international case law compared with other contentious areas such as intellectual property. In practice, MNEs will often adopt different approaches in setting their financing arrangements.
Some groups may set intra group lending terms based on external borrowing facilities at the parent level. Other groups may rely on credit worthiness of the borrowing entity and set an appropriate interest rate based on this rating either with or without adjusting for parental affiliation (taking into account the better credit rating of the parent entity.) Both approaches have their pros and cons in terms of practicality, technical rigour and cost of implementation.
Whilst there has been limited technical guidance to date, the updated OECD guidelines issued in July 2017 include two examples on intra group funding. These examples suggest that intra group funding arrangements should be priced based on the credit rating of the borrower, but adjusted for parental affiliation. The OECD is currently in the course of drafting more comprehensive transfer pricing guidelines on financing. These guidelines are long overdue and are expected towards the end of 2017.
In the absence of more specific OECD guidance, from a practical perspective, we are seeing Tax Authorities across Asia Pacific taking markedly different approaches to intra group funding which are likely to give rise to increased disputes and potentially double taxation. The Chevron Case was recently decided in Australia in favour of the Australian Taxation Office (“ATO”). The final judgement ruled that commerciality of funding arrangements must be considered as well as parental affiliation, therefore, disregarding the “orphan” concept historically considered to be paramount under the arm’s length principle which traditionally has been followed by many jurisdictions.
The ATO has formed strong views about how groups should price debt funding and the Chevron decision has reinforced their position. Since the judgement the ATO has issued guidance on how they will risk assess and challenge funding arrangements. The approach relies on a traffic light risk assessment (where red equals highest risk) to encourage behavioural changes and influence groups to restructure their cost of intra group funding closer to the average external cost of funding of the group. Adopting the approach of a common group interest rate and taking into account “group synergies” is likely to reduce the supportable interest rate that can be charged within the group.
Other tax authorities such as India are taking a sophisticated benchmarking approach to intra group funding by using an independent external agency to credit rate borrowers on intra group transactions and to set the pricing on that basis. This seems quite different from the ATO approach which appears to disregard credit rating methodologies. Other Asian tax authorities are likely to follow OECD guidelines when they become available.
In addition to these different approaches, groups have to contend with other rules such as BEPS Action 4 that can limit interest deductions to a percentage of taxable profits or a safe harbour level of gearing. A number of Asian countries also have safe harbour interest rates, particularly for lower value transactions.
The picture in Asia is one of inconsistency making the landscape difficult for multinationals in a policy setting perspective as satisfying the needs of one tax authority can raise risk elsewhere. It also provides for uncertainty in dispute resolution.
Managing a group’s cross border funding is complex and requires careful management. However, as with any area of transfer pricing, adopting a systematic and structured approach can be the best way of managing risk, albeit not eliminating all risk. For example, MNEs may consider the following approach:
- Assessing their most material intra group funding transactions;
- Determining the approach of their local tax authority so it’s possible to identify any potential inconsistencies between the borrower and lender country;
- Considering whether there are any safe harbour positions which could be adopted (bearing in mind the risk of taking a one sided approach if the safe harbour favours one jurisdiction over the other); and
- Based on this information, deciding on an appropriate transfer pricing methodology to minimise adjustment risk. In some cases, this may require a comprehensive analysis addressing the commerciality of debt levels as well as interest rate benchmarking. In other cases, the analysis may require less work.
- Considering the following steps for a low dollar/low risk intra group loan:
I. Consider whether there are any local safe harbours available
II. Assess whether there are any external loan arrangements as a guide
III. If these steps not available, use general industry yield curves from Bloomberg
- Applying a similar process for high dollar/high risk intra group loans that might include:
I. Consider commerciality of the arrangement
II. Assess the credit rating of the borrower based on Moody’s/S&P Papers
III. Adjust credit rating for parental affiliation
IV. Price intra group loan using Bloomberg/Dealscan/other tool
V. Consider transfer pricing rules of borrower and lending country to ensure rate can be supported in both countries
Whichever the case, it will often be a matter of finding the right ‘balance’ in managing risk, penalty exposure and undertaking and documenting sufficient analysis to defend an enquiry from a local Tax Authority if (or more likely when) it arises.
Zara Ritchie and Nick Drizen
Zara is the leader of BDO’s Global transfer pricing practice as well as the Australian leader based in Melbourne.
Zara has over 20 years’ Transfer Pricing experience covering the areas of controversy/dispute resolution, planning and restructuring, compliance and developing transfer pricing policies and frameworks.
Nick Drizen is a transfer pricing director in BDO Australia's transfer pricing team. He has over 15 years of experience of working on transfer pricing matters. Nick has extensive experience in assisting groups in transfer pricing planning for finance, intellectual property and global tax optimisation planning.