Financing costs
Introduction
The recent credit crunch has presented more than its fair share of challenges to companies exposed to the international capital markets. Unfortunately for multinational enterprises, inappropriate transfer pricing policies could add tax adjustments to overall exposures.
Cross-border financings form a substantial part of total associated party dealings by New Zealand members of multinational groups. Key issues arising include the pricing of interest and guarantee fees at market rates and capital structuring within New Zealand’s thin capitalisation rules. New Zealand-owned multinationals also need to account for the very same issues in their outbound financing activities.
Over the last 18 months, we have reviewed over 70 large international intercompany financings. Although on the whole we have found compliance to be high, this may have been more the result of good luck than necessarily sound tax management - in particular, a general lack of scientific benchmarking has been apparent.
Some basic principles
Most interest rate analyses begin with an appropriate reference rate or base indicator. For variable rate loans, this is typically the bank bill rate; for fixed rate loans, usually swap rates are applicable. Essentially these base indicator rates provide reasonable proxies for a commercial bank’s marginal cost of funds.
Financing is mostly about margins. The key factor in determining interest rate margins is credit risk or the probability of default (which includes term to maturity). Factors such as liquidity, ranking (senior or subordinated) and early repayment have only limited impact compared with credit risk. Thus the margin added to the base indicator in order to arrive at an interest rate is almost entirely compensation for credit risk.
The margin over the base indicator is best determined by reference to credit ratings. In our experience, by far the most common credit rating for foreign-owned subsidiaries in New Zealand is the Standard & Poor’s rating of “BBB”. This probably reflects today’s optimal capital structure, effectively the best mix of debt and equity to produce the lowest sustainable weighted average cost of capital, with interest being a tax shield in this equation.
Stand alone entity approach usually applied
In determining an appropriate interest rate, we generally evaluate the credit risk of the company in question on the basis that it is a stand alone entity, rather than an inseparable part of a single unified business. Well-performing subsidiaries may be more robust financially than their wider multinational groups, therefore notching down subsidiary credit ratings should be done with some care.
Is the entity too important to be allowed to fail?
Some subsidiaries in a multinational are so central (or core) that, even absent any formal financial guarantees, if the subsidiary should be unable to repay its debt, the parent will intervene with the necessary financial support. This parental intervention will occur either due to reputation concerns or in order for the parent to ensure that its own credit rating is not jeopardised by the rumour mill.
The following factors need to be weighed up:
- relative size and profitability of the New Zealand operation compared with the global group
- whether the New Zealand operation is strategic to the global group
- whether the New Zealand operation is part of a wider integrated supply chain, and
- whether the same name flows through the group.
The arm’s length principle which underpins international transfer pricing practice does not operate in a vacuum. Would bank credit approvals of a subsidiary in the local New Zealand market take into account the wider multinational group’s creditworthiness? If so, then this market condition must be factored into the transfer pricing analysis, in just the same way as third party banks and rating agencies do currently in their decision-making.
Compliance costs
From their inception, in enforcing New Zealand’s transfer pricing rules, we have endeavoured to strike a balance between protecting the tax base and containing compliance costs. Our approach to financing costs is no different. For small value loans (i.e. less than NZ$1 million principal), our experience suggests 150 basis points (1.5%) over the relevant base indicator is broadly indicative of an arm’s length rate, in the absence of a readily available market rate for a debt instrument with similar terms and risk characteristics.
For loans up to NZ$10 million principal, independent banker quotes are generally acceptable, but once again considerable care is required. In particular, such quotes are generally accepted as indicative only and do not involve a full due diligence process nor is the bank making any funding commitment. For all loans in excess of NZ$10 million principal, we expect far more science and benchmarking to support interest rates applied.
Major current tax risks
In our current programme of work, we are paying close attention to the following:
- all inbound loans over NZ$10 million
- outbound loans of all sizes - we still see such oversights as low or no interest loans from New Zealand corporates to their foreign associates and no fees charged for guarantees
- appropriateness of Non-investment grade credit ratings (i.e. Standard & Poor’s “BB” or lower) - interest rates move exponentially higher once the “Investment grade divide” is crossed, so companies must be prepared to substantiate these ratings.
Emerging tax risks
Widening credit spreads and general volatility in rates due to the credit crunch mean we need to be more vigilant during this period to ensure associated party interest rates and guarantee fees are not exploited.
The great majority of multinational financings in New Zealand are plain vanilla loans. In general, they are current account recallable at two days’ notice or term loans with provisions to alter rates during the course of the loan (for example, annual interest rate reviews). Consequently, we pay special attention to more exotic financings, such as hybrid instruments and long-term subordinated debt facilities.
We will certainly examine closely any capital restructurings which result in major reductions in New Zealand tax paid. Depending on the facts and circumstances of the case, it may be appropriate to consider an upward movement in operating margins to account for the increased risk brought about by greater gearing.
Some errors to avoid
The following errors have been identified in the course of our examinations of associated party financings:
- Internal comparables readily available but ignored
- Wrong geographic market data applied
- Selection of base indicators and/or credit spreads that do not match the terms and conditions or the timing of the loans in question
- Inappropriate use of the Reserve Bank “base lending rate” (i.e. weighted average of rates for banks lending to small-sized businesses without too much credit standing) in preference to the bank bill rate as a base indicator
- No regard paid to early repayment clauses when an arm’s length party would exercise such a clause at a time of declining interest rates
- Not all financing costs captured (arrangement/commitment/facility fees, etc) in the pricing analysis
- Additional cost of non-resident withholding tax gross up clause not captured in the pricing analysis, and
- Failure to use the credit rating of a lesser developed country for outbound loans where the country credit rating is lower than that of the stand alone borrower entity.
Guarantees
In common with generally accepted international practice, we require an explicit written guarantee in the form of a letter of guarantee or irrevocable letter of credit before a guarantee fee will be recognised. We do not accept that any financial service has been received merely because the credit rating of a subsidiary is higher by reason of affiliation alone. Letters of comfort are also not sufficient to create legal obligations.
We will as a matter of course check the financial capacity of the offshore guarantor to meet its obligations in the event of a default. We will verify that there is sufficient capital available to support the risk guaranteed.
Our preferred approach to pricing guarantee fees is based on interest rate savings, with the interest spread (pre-guarantee less post-guarantee) quantifying the total benefit from the financial service provided. In theory, arm’s length parties would look to share the economic benefit of this interest rate reduction according to their relative contributions. In practice, we have seen non-bank guarantors generally sharing such savings on a 50/50 basis, which is also consistent with economic game theory.
Other related tax issues
With any economic downturn, there will be pressure on balance sheet asset values. It would pay to double check the thin capitalisation calculations, especially if the group’s gearing ratio is nudging the 75% mark. Note that non-resident withholding tax still applies to interest paid, even if a deduction is not available under the thin capitalisation rules.
Where interest has been paid to a branch without any non-resident withholding tax impost, we will check the bona fides of the branch to ensure the substance truly matches the form.
Although the 2% approved issuer levy is not available to associated parties, unfortunately this mistake does occur and can be very costly.
Date published: 19 Feb 2009
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