Published: November 01, 2014
This article describes the OECD’s new recommendations on Base Erosion & Profit Shifting (BEPS) and to what extent these new rules, if they are adopted by the various states, will impact the day-to-day work of corporate treasurers. Can taxes and the treasury function still go together well? BEPS will be certainly be THE next regulatory challenge that corporate treasurers will have to confront. The tax landscape seems to be coming under ever greater fire from governments. Looking for the lowest tax charge is becoming a minefield for multinational corporations. Things will never again be what they were; we can take that for granted, so we need to be ready to document intragroup transactions.
Transfer pricing has always been given special attention by the tax authorities. However, since the financial crisis, the G20 has added to its long regulatory wishlist measures for preventing tax avoidance through transfer pricing between entities of the same group. Clearly, excesses must have been committed. They used to be tolerated. But the bailout of the banks and the sovereign debt crisis which arose from it have forced states to look for new sources of funds to wipe out their deficits. The natural idea was to look for money wherever it happened to be and to curb the excesses made possible by incorporating exaggerated margins into transfer prices. What could be simpler than transferring income or margin within your group, from a country in which deductions are available to another country in which there are no, or fewer, deductions. Simple and effective, but indefensible. The idea, then, is to ensure that these abuses should not be committed and that the substance should not be transferred from one country to another, thus depriving certain states of badly needed revenue. The G20 has recently reaffirmed its support for the OECD project on that subject, and also for the Action Plan that it has put forward. The OECD itself has given the Global Forum on Transparency and Exchange of Information for Tax Purposes the task of working out the bases of this new regulation.[[[PAGE]]]
The three key words proclaimed by the G20 are these: ‘substance’ (which should take precedence over form, following the sacrosanct principle of ‘substance over form’, particularly as regards intellectual property with the expansion of digital businesses and an increasingly virtual economy); ‘transparency’ (all the post-financial crisis measures and regulations have the overarching objective of absolute transparency); and finally ‘consistency’ (consistency between governments is required to avoid leaving loopholes that could lead to loss of tax and loss of taxable income for states). It has been found that the practices of MNCs (multinational corporations) had become increasingly aggressive over the years. The difficulty then arises of being able to demonstrate and substantiate the appropriateness of the transfer prices used. What the G20 is trying to achieve is to align transfer prices with the value actually created (and not with an artificial value). The price (or margin) applied to transfers needs to be at arm’s length and at the price at which a similar transaction would have been carried out on a stand-alone basis.
The question we need to ask ourselves is this: is the price or margin applied to intergroup financing, for example, equivalent to the price at which the transaction could have been carried out by the subsidiary itself without the support and help of its parent company, given the specifics of the local market in question? And local specifics can indeed have an impact on price. It is not a matter of applying the same margins to each and every country, but of tailoring them to the specifics of each individual counterparty. The major principle of BEPS, that of using an arm’s-length margin is also applied in the USA in US Transfer Pricing section 482 of the Internal Revenue Code.
BEPS is yet another of these mysterious acronyms that we are going to have to learn to live with. It is not short for Black Eyed Peas * but for the new concept of Basis Erosion and Profit Shifting worked out by the OECD. The central idea of BEPS is to tax a group in the place in which the economic substance and its operational activity are located. One of the threads of this huge project will be to eliminate arrangements put in place to reduce taxable profits, either by complex or hybrid structures, or by evading withholding taxes through abuses of treaties between countries. The goal is to prevent abusive interpretation of bilateral treaties to find tax loopholes in them. Benefiting from favourable tax regimes will be possible provided that at least some minimum of operational activities takes place in that country (the concept of economic substance).
For hybrid structures, the idea is no longer to tolerate the deduction of interest on a loan if the recipient is not taxed on the interest income that it generates. It is about absolute fairness in tax pushed to the extreme. This is, furthermore, what France has just introduced. This trend could become more widespread. We may look forward to various Discussion Papers in 2015 to refine these ideas and to develop them. Approaches such as these could have an impact on treasurers in the future.
One of the measures recommended by the OECD is to document all intragroup transactions. This is already in itself a worry for (all too) many MNCs who just do things verbally and have no written documentation. Some will be starting from rock bottom. For the others, their documentation will unquestionably have to be improved and constantly updated. Furthermore, the documentation will have to be prepared before the event (before the transaction and not just if required for tax audit). This will be the crucial point of impact of these new measures, and a considerable amount of work for treasurers. Were you worrying about being bored after EMIR? Don’t worry about that, the OECD has been thinking about you! Agreements on prices (Advanced Pricing Arrangements – APAs) will have to be disclosed. This will be on a country by country approach. They will have to be analysed case by case, by country and by country specifics, and by precise and detailed financial ratios. The consistency of treasury transactions will be dissected under the microscope.
Some companies think that, since the measures put forward by the OECD are only recommendations and are not mandatory in nature, they will not be obliged to follow them. It would be naive to think that major governments worldwide would not adopt the recommendations into national law, in the manner of European Directives (which by contrast are indeed mandatory). Transposition into international law will happen, and countries not adopting BEPS will be accused of being soft on tax avoidance. Be sure that if the USA adopts BEPS, the whole world will have to fall into line. So it would be best to see this as just a matter of time and to start preparing ourselves. However, the fact that it is a recommendation in nature (and not concerted) could create differences and distortions that we could well do without. Aggressive rulings will come under fire and some countries will have to make sure they avoid excesses. Besides, the European Commission has already started to investigate some possible excesses.
Tax competition between countries will become an ever more delicate issue and the harmonisation of taxes and tax practices will force countries to use other criteria to differentiate between themselves. Corporate communications by MNCs will be crucial to avoid risk to reputation. C level management needs to be fully aware of that. Are you aware of the BEPS risk and the potential impact on your business? Perhaps not! The treasury environment is changing rapidly but the tax environment appears to be following close on its heels. We may well fear that the treasury function will not be immune from international tax changes and the consequences of globalisation of the economy.
With BEPS, it is the tax authorities rather than the regulators that we need to fear. We have to meet reporting obligations on substantiating the transfer prices used. This substantiation will be neither painless nor easy. They are looking for a truly structured approach, documented and elaborate. In addition, we will have to provide them with details on its sources, the risk measurement techniques used for calculating spreads, etc. A whole slew of details which cannot be found either on the internet or on Wikipedia, I fear. Not having extensive, special-purpose documentation could cost the company dear, through possibly having its intragroup transactions reclassified and taxed differently. The preparation and structuring of the approach will be cornerstones in facing up to BEPS. Optimists will naturally tell you that here is another opportunity to organise your activities better, and consign to writing that much loved treasury department oral tradition with its all too frequent approximations. Too many treasurers rely on a tribal-type oral tradition where everything is relatively well organised but nothing is clearly or formally documented.
BEPS is not an isolated case of tax impact since FATCA, the Foreign Account Tax Compliance Act, is in force and a financial transactions tax (FTT) is still on the drawing board (even if currently applied by only two out of the eleven countries that were considering it). In the future, tax could play a predominant role in our day-to-day treasury activities and have an impact on how our organisational structures work. Thinking along the same lines, the European Commission has launched an enquiry and investigations into potential disguised state aid by means of over-generous or unduly advantageous rulings. The general principle underlying this process would be to establish fair tax competition between states, the fundamental basis of a single market (European single market).
The centralisation of treasury activities forces international groups to act as banks in financing their subsidiaries. Unfortunately, the transfer pricing structure used for these intercompany transactions is often poorly documented and short on back-up, and even where there is documentation and back-up it is not effective in proving that the prices used are consistent. The difficulty for companies that are less well equipped in resources, systems, models and techniques, will lie in evaluating the right margin to apply, as a function of the entity and the country concerned. It is a tricky business even for large MNCs to set up an elaborate model with comparative data to set such margins, all of which have to be different and specific to the entity that is the counterparty to the transaction. A country’s tax audit authorities can demand an objective evaluation based on a database that is sufficiently comprehensive and wide-ranging to reflect the process of setting transfer prices. They will be looking for robust and comprehensive documentation, based on economic, statistical and historical facts and reasons to justify the prices charged by group central treasury to its subsidiaries.[[[PAGE]]]
As if this were not already complicated enough, we have to add a national and local dimension. The probability of default of a construction company of less than €50 m turnover is not the same in Holland as it is in Greece or in the UK, nor the same as that for a retail company of the same size. For each country and/or region the company must therefore decide on the ratios to be used (for example liquidity, probability, debt coverage, leverage, growth, business, etc.). The business can then use this data and its model to set the margin to be used in each individual instance. Here again, the figure for the probability of default, the track record, by business sector, the credit rating, changes over time (because nothing stays the same), the credit cycle, the predictability of future default risk, etc. will be data that have to be calculated precisely using reliable and credible sources and procedures that remain constant over time. In practice, this is a real challenge for treasurers. It looks as if they will have to turn to external sources to be able, if and when required, to provide evidence and substantiation of the rates used.
This information could open up markets for ratings agencies such as Moody’s, Standard & Poor’s, Fitch Ratings and others, or to financial analyst companies or credit risk companies. Their vast databases give them the ability to generate the information necessary and helpful to preparing such models and for evaluating margins. Given the enormity of the task and the cost, using a subcontractor would seem to be the most obvious solution. The evaluation must be both quantitative (as described above) and qualitative. This is why independent companies, with their knowledge and in-house data, could help set prices using robust tried and tested methods. The credit rating agencies could offer, and are offering, this service to some companies via their analytics or services entities. For example, by inputting some dozen basic financial figures from the financial report into RiskCalcPlus, the financial model developed by Moody’s, you can calculate the expected default frequency, the implicit rating (if the subsidiary does not have its own rating from a credit rating such as S&P, for example) and finally, depending on the maturity used (for example 1, 2, 3 or 10 years), set the spread to be applied to the interest rate on the loan. For example, your subsidiary ABC in Italy, with an estimated stand-alone credit rating of Baa3 based on its results, would see a margin of 218 basis points (bps) applied on a four-year loan. The Agency’s grid will then give you a benchmark from which you must/should not deviate too much. In our example, ABC’s parent company (treasury centre) can maintain that a 225 basis point spread is acceptable and is defensible against the tax authorities. The external source is credible, reliable and robust. It would therefore seem that the cost of such a service would be less than using your own model developed in-house or based on burdensome IT resources.
1. Quantitative evaluation to establish the credit risk figure for the group’s internal counterparty, based on a robust financial model.
2. Qualitative evaluation incorporating more subjective elements, based on standard questions, benchmarks, comparatives, stability of management teams, business stability, reputation, government support and whatever else. This second evaluation is somewhat like the process practised by the ratings agencies. The weighting of the second evaluation is lower and counts for one third, against two thirds for the quantitative evaluation, approximately. Based on this evaluation, the implicit rating may be increased or decreased slightly (an adjustment of one or two ‘notches’ up or down).
3. The (possible) Implicit Guarantee is/would be the final concept to be incorporated in the view of certain tax authorities. This aims at incorporating into the stand-alone concept the possible effect of an implicit parent company guarantee and, where one exists, ensuring it is taken into account, thereby improving the subsidiary’s credit rating. This evaluation can be done using standard questionnaires.
We can therefore see that this evaluation is far from being a simple formality knocked together in two shakes of a lamb’s tail, based on flimsy documentation. It is no longer enough to find a friendly bank that will do you a favour and give you an idea of the order of magnitude of the margin that it itself applies on a stand-alone basis. The tax office will be looking for coherence and consistency over time in this demanding set of back-up documentation. Perhaps the banks will offer this service, although we may well doubt it. Using an expert subcontractor would seem to be unavoidable. This will come at a cost for which you are fervently recommended to prepare yourself.
The treasurer is about to become a true documentation professional who, in each Master Agreement with subsidiaries, must provide evidence of the services rendered, the fees, royalties and other margin calculations, and the methods for evaluating and setting margins following the methodology recommended and worked out by the OECD. He will cover the structuring of cash pooling and term loans. The choice of the location of the lender entity will not be without impact. We may hope that the country from which we operate to finance our group will be one of those that has adopted BEPS (even though this is only an OECD recommendation) and has transcribed it into its own legal system. Some countries have also let it be known that they will adopt BEPS into their own legal systems, for example Luxembourg. The adoption of such a law will give the country credibility and will give the tax authorities in the countries in which the subsidiaries are established (incorporated) the impression that tax obligations are being checked in both countries.
Being soft on taxes now seems to be something out of the past, and things will never be the same in the future. Transfer pricing will impose a huge amount of work on every treasurer in terms of documentation and recurring evaluation, resulting in additional costs and requiring additional resources. It will cause credit margins for intragroup transactions to narrow and will thus restrict the tax optimisation potential by comparison with the past. Tee-Pee or transfer pricing will be one of the main challenges on the treasurer’s roadmap for 2015. It seems to us a very good idea to start preparing for it right now.
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