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August 6, 2013

2013-Issue 32—You are the U.S. tax director of a global multinational's U.S. subsidiary. One day you get a call from the global CFO at the foreign parent, who tells you they want to issue intercompany debt to the tune of $500 million. As you run a quick calculation on the back of an envelope, the mechanical test of IRC Section 163(j) does not, on its face, seem to create a limitation on this type of debt planning. You find that your interest expense is under 50 percent of adjusted taxable income, and you're comfortably below the 1.5:1 debt-to-equity ratio that 163(j) prescribes. But what about the more esoteric tests that have to be performed and issues that need to be vetted? For example, IRC Section 385 provides that certain questionable indebtedness could be reclassified as equity ownership, if the nature of the loan fails to resemble an arm's-length debtor-creditor relationship. Plantation Patterns expands on 385, and prevents the deduction of guaranteed debt interest if the likelihood of repayment without such a guarantee is slim. Instead, those payments are reclassified as dividends, more accurately reflecting the guarantor's intent to put its money at risk in the debtor's business.

As a result of these and other considerations, debt planning requires a prudent CFO or VP of tax to perform a further assessment of market principles, as the ultimate treatment of such debt will likely be subjected to an intense review of the facts and circumstances by the IRS. In our experience, it isn't the mechanical analysis under IRC Sec. 163(j) that will be the deciding factor on how much debt the company can take on. Instead, a more market-driven analysis will determine what is a "reasonable" amount of debt.

Companies that have in place, or are considering issuing, intercompany debt should be mindful of ensuring they have appropriate support for their intercompany financing arrangements. In the following narrative, we outline some of the key factors associated with intercompany financing, discuss how a valuation can play an integral role in the process, and provide insight into some of the nuances — and the pitfalls to avoid — relative to intercompany financing for U.S. tax purposes. While this article focuses on intercompany debt that is inbound to the U.S., the same principles can apply to non-U.S. tax jurisdictions as well. 

Current Environment 

Taxing authorities, both state and federal, are increasingly scrutinizing intercompany financing arrangements, with the Internal Revenue Service paying particularly close attention to intercompany debt issued to a U.S. subsidiary by a foreign parent company. This environment necessitates a well-supported analysis that includes documentation. To frame out the situation, it is worthwhile to first identify the various factors considered in the characterization of intercompany financing as debt or equity. 

A Tax Court memorandum of opinion released in NA General Partnership & Subsidiaries v. Commissioner (T.C. Memo. 2012-172) provides insight into the Tax Court's current approach to intercompany financing considerations, highlighting 11 key factors that the Tax Court considered:

  1. The name given to the documents evidencing the indebtedness;
  2. The presence of a fixed maturity date;
  3. The source of the payments;
  4. The right to enforce payments of principal and interest;
  5. Participation in management;
  6. A status equal to or inferior to that of regular corporate creditors;
  7. The intent of the parties;
  8. "Thin" or adequate capitalization;
  9. Identity of interest between creditor and stockholder;
  10. Payment of interest out of only dividend money; and
  11. The corporation's ability to obtain loans from outside lending institutions.

The corporation's ability to obtain loans from outside lending institutions can be viewed as a central theme throughout an intercompany financing analysis. The factor that is the most subjective — and which we discuss in further detail in this article — is the "thin" or adequate capitalization.

Thin Capitalization

A thinly capitalized entity is one that holds too much debt relative to its enterprise value. Two key indicators among several provide insight into supportable capitalization levels:

  1. Leverage ratios — debt to equity and debt to total capital; and
  2. The entity's ability to service the debt obligation.

Key Factors Relative to Thin Capitalization

Ascertaining a reasonable level of debt encompasses analysis of a number of variables while remaining cognizant of how a lending institution would approach the situation. The factors include:

  1. The enterprise value of the entity;
  2. The interest rate charged on the debt;
  3. The ability to service the interest expense payment and repay the debt over the term; and
  4. Comparable indications including interest rates, leverage ratios, public debt yields, etc.

Enterprise Value

The enterprise value reflects the total fair market value of the entity, thus is the base at which thin capitalization is measured. Given that equity value is equal to enterprise value less debt, the higher the enterprise value, the more debt that can be borrowed.

Is Net Book Value Appropriate?

A company's first approach is often to review debt-to-equity ratios based on the net book value of the equity, as this approach provides an easily measurable result by simply reviewing an entity's balance sheet. The upside is that there is minimal effort involved, as the figures can be easily gathered, thus not straining internal resources or incurring costs associated with a formal valuation. The downside is that net book value provides an accounting figure, thus in most cases not portraying the position of the business's true economic capitalization. The key term in the preceding sentence is economic, as the net book value of equity can have little or no bearing on a business's capability to borrow funds. Keeping consistent with the premise of how a third-party lender would measure the creditworthiness of a potential borrower, the lender will be much more interested in the debt-to-equity level of the borrower based on the fair market value of the enterprise and equity, not the net book value. Why? For starters, fair market value provides a window into the economic capitalization of the business and indicates the intrinsic strength of the business to raise capital (i.e., how much debt a lender would provide given the overall value of the business), the financial stability of the business, etc. Therefore, in most cases, it is preferable to use the fair market value of the enterprise rather than any book value measures.

Enterprise Valuation Approaches

Now that we have discussed the benefits of measuring debt-to-equity levels based on the fair market value of the enterprise instead of book value, we focus our attention on the approaches that should be considered when conducting a valuation for U.S. tax purposes:

  • The income approach uses a discounted cash-flow method, which measures fair market value based on the discounted future cash flows of the entity, including the outlook for revenues, cost of sales, operating expenses, taxes, depreciation, capital expenditures and working capital requirements.
  • The market approach estimates fair market value based on observed multiples, e.g., enterprise value to revenues, enterprise value to earnings before interest and taxes, etc. of the following:
    • The public stock price value of the subject company (if publicly traded); in this case, the borrowing entity is compared and contrasted with the overall company, and adjustments are made to the implied trading multiples for differences in geographic region, size, product mix, etc;
    • A comparison of the subject entity with comparable companies that are publicly traded; and
    • A comparison of the subject entity with comparable companies that have been acquired or sold.
  • The net asset value approach measures value based on the fair market value of the assets less liabilities, and is typically used in the valuation of holding companies and start-ups.

The results from the income and market approaches are then correlated to determine the fair market value of the enterprise on a controlling interest basis.

Nuances and Pitfalls

Rather than provide a detailed narrative on how to value a business, we focus our discussion on the nuances of fair market value in the context of a valuation as it pertains to U.S. tax purposes. Viewed through this lens, the first and often foremost issue is the treatment of intercompany transactions, which often appear in a few different forms:

  • Sale of goods: these typically are governed by an intercompany transfer pricing agreement and can range from a cost plus agreement, which is typical for a contract manufacturing arrangement, to a designated profit margin, which is common in the case of limited risk distributors, etc.
  • Use of intellectually property (IP): these are typically governed by intercompany transfer pricing agreements, with payments made in the form of royalty and/or cost-sharing payments.
  • Intercompany financing: long-term funding between related parties in the form of notes receivable or payable.

Since the topic of this article is the placement of intercompany financing, we will not address the third item above.

As many entities have significant levels of intercompany transactions, the vital question is whether intercompany transactions should be included or excluded. The answer is that intercompany transactions should in fact be included when valuing a business as part of an analysis for U.S. tax purposes. The need to include intercompany transactions in a valuation for U.S. tax purposes can be summed up in one word: consistency. The need for consistency enters the equation at many levels, and therefore must be considered not only in the context of the valuation.

While the need for consistency extends beyond the issue of inclusion of all intercompany transactions, we start with this topic, as it is a vital assumption that can send the valuation down the wrong path from the start, considering many entities generate all or a portion of their revenues from related parties. Some may approach the valuation and assume that the intercompany revenues and any borrowings or receivables should be excluded from the analysis; the premise is that a third-party buyer would not pay for a revenue stream associated with intercompany sales because of the uncertainty of continuation of the relationship, nor would this buyer expect to settle intercompany receivables or payables. However, this assumption is not valid, and can potentially cause significant issues for the company:

  • Intercompany transactions should have a commercial rationale. Excluding intercompany revenues would contradict this premise.
  • This assumption views fair market value strictly from the buyer's view in a hypothetical third-party transaction. However, one would expect the seller to maximize the value of the entity in the event of a sale of the entity to a third party.
  • Excluding intercompany revenues from the analysis could call into question the purpose of the entity if it is assumed revenues would not be present in a third-party scenario.
  • It contradicts transfer pricing that stipulates payment for goods, services and/or IP to or from the entity must be in the context of an arm's-length scenario.

Having addressed the vital issue of including all intercompany transactions, we can next focus on the need to ensure the assumptions used in the valuation consider the specific characteristics of the entity, and are consistent with the overall transfer pricing structure. We now examine in more detail the importance of transfer pricing and risk, how they are correlated, and why it is vital to ensure consistency across all variables.

Transfer Pricing

Transfer pricing could be considered to play the most important role in valuing an entity with intercompany transactions, as the revenues and profit margins — two key variables in a valuation — will be based on the terms of intercompany transfer pricing agreements. One could readily state that the valuation of the entity will only be as good as the transfer pricing for that entity, given its effect on the entity's revenues, expenses, profit margins and capitalization. To ensure the valuation doesn't contradict the transfer pricing structure, as discussed previously, the revenues must include all sales — including those between related parties — and the profit margin must be consistent with the transfer pricing agreement. For example, if the entity is compensated pursuant to a transfer pricing agreement at a fixed return of 5 percent of revenues, the profit margin applied in the valuation should be 5 percent. It's a simple example, but one that could be easily overlooked if a review of the transfer pricing is not undertaken.

Risk

Capturing risk in a valuation using a discounted cash flow approach is typically encompassed in the discount rate, which is used to estimate the present value of the future cash flows associated with the entity. The higher the risk associated with the cash flows, the higher the discount rate, all else held constant, as the discount rate increases the fair market value decreases, and vice versa.

The selection of a discount rate cannot be performed in a vacuum. It must consider the nature of the operations, functions and rights of the entity, transfer pricing, and profit margins, among other factors. Correlating the risk with the other key factors is vital, both in capturing the appropriate value of the entity and in ensuring consistency with other positions, i.e., transfer pricing.

Interest Rate

In addition to estimating how much debt can be borrowed based on the enterprise value of the entity, the interest rate that is charged is also a key variable, given that it affects how much interest expense is paid annually over the term of the debt. The following issues should remain in the forefront when ascertaining a reasonable interest rate:

  • In keeping with one of the 11 factors as outlined in T.C. Memo. 2012-172 — the corporation's ability to obtain loans from outside lending institutions — the interest rate should be consistent with a rate that would be provided by an independent lender;
  • As the interest rate in part drives the annual interest expense, the rate should be at a level that ensures the borrower has the financial capability to satisfy the interest payments; and
  • The interest rate should be consistent with the risk inherent in the entity, the terms of the debt and the financial condition and expectations of the entity.

Cash Flows

The final step in the analysis is to ensure that the entity has sufficient cash flows to both pay the annual interest expense and repay the debt principal over the term of the loan. Reviewing the future cash flows is a "sanity check" of the intercompany financing, as it measures the reasonableness of the entity's ability to service the debt.

On an annual basis, the entity should have a reasonable level of cash flow remaining after payment of the interest expense. Taking into consideration a sufficient level of cash flow to reinvest in the business, etc., interest expense as a percent of earnings before interest and taxes should reasonably remain below 50 percent. The entity must also demonstrate the financial capability to service the debt principal, whether that encompasses annual payments towards the principal or a balloon payment at the end of the term. Regardless of the pattern of the principal repayment, the entity must demonstrate it has enough cash flow to pay the interest expense and repay the principal over the term, while retaining sufficient excess cash flows for investment in the business, etc.

Alvarez & Marsal Taxand Says:

After considering all the factors mentioned above, companies typically issue debt up to a ratio of approximately 3 to 1 of debt to equity. While this level can be viewed as a reasonable ceiling, it is important to note that there are circumstances and specific industries in which a supportable debt-to-equity ratio is above or below this level. This is not a cookie-cutter analysis, and one size does not fit all.

When exploring the possibility of intercompany debt planning, the take-away should be — when valuing an entity for U.S. tax purposes — the company must first gather information about any analyses, tax positions, etc. that could influence (or be influenced by) the valuation of the entity. Starting off on solid ground by including all revenues — both intercompany and third party — will be very helpful in supporting the methodology used to value the company. Being mindful of the transfer pricing structure, the organization of the legal entities, the rights and functions of the entity being valued, and its interrelationship with related entities will also go a long way in preparing a supportable valuation analysis. That in turn provides the foundation for a supportable analysis and decision as to how much debt is reasonable through an intercompany financing.

Author:

Philip Antoon
Managing Director, New York
+1 212 763 9830

Gwayne Lai, Senior Director, contributed to this article.

For More Information:

Juan Carlos Ferrucho
Managing Director, Miami
+1 305 704 6670

Albert Liguori
Managing Director, New York
+1 212 763 1638

Kristina Dautrich Reynolds
Senior Director, Washington D.C.
+1 202 688 4222

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer. 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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