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NERA has used economic tools such as Monte-Carlo simulations of expected income streams – a probabilistic analysis model – to identify value drivers for companies |
Finance companies are an important commercial tool for multinational enterprises to manage their internal financing. However, companies in low-tax jurisdictions have come under particular scrutiny due to the OECD's Base Erosion and Profit Shifting (BEPS) Action Plan. Tax authorities in various countries have begun to challenge multinational groups in recent months.
On the one hand, the increased scrutiny will be somewhat painful to many taxpayers as substance and documentation requirements increase and questions are raised in field audits. On the other hand, the OECD now provides better guidance that will help taxpayers and advisers to plan their structures and formulate their defence.
Finance centres have frequently been challenged based on either the interest rate charged (discussed in a future article), or alleged missing 'substance'. Substance indicates the level of economic activity in the FinCo. Now the OECD has refined that definition. With this new definition at hand, a proper economic analysis is now possible and should be used to document and defend internal financing.
The OECD has established two broad categories which can be analysed: the financial capacity to assume risks, and the ability of the personnel to make informed decisions about risks. Finance companies have to actually bear the risks they are remunerated for (paragraph 1.64); they have to perform the activities associated with the risk-taking (paragraph 1.65); a pure formalisation of the outcome of decisions is not sufficient (paragraph 1.66); and there need to be sufficient capital buffers in the finance entities (paragraph 1.64).
As can often be seen in the financial industry, it does not necessarily require a lot of personnel to make decisions and to take on, layoff or decline risk-bearing opportunities. The same holds for being capable of mitigating financial risks – as long as the staff is competent and has sufficient access to finance knowledge and intangibles. An economic analysis can identify the presence of finance intangibles, such as financial know-how, databases, rating methodologies, market studies, or trading strategies. In particular, the value-added of these items can be quantified and translated into arm's-length profits for the finance company. However, a concrete economic valuation is required to demonstrate the commercial benefits.
Notably, the finance company can purchase some of the services and intangibles (for example, buy credit ratings and hedges) from other sources, such as intercompany resources or third parties. But the company must still have a meaningful degree of control, know-how, and management in selecting such a service provider. All these steps should be well-documented.
Secondly, the finance company must have the financial capacity to assume risks that give rise to its expected earnings. Therefore, these risks must be quantified and the capital must be sufficiently and demonstrably in accordance. The capital does not necessarily have to be provided as equity, but in specific economic circumstances a company might also be able to take on risks if it has principal access to further funding, for example through credit lines.
The role of economic analysis for finance companies is therefore to identify the value drivers of the specific company and quantify their respective contributions through financial modeling. Depending on the case at hand, we have been using a variety of economic tools, such as option-pricing, Monte-Carlo simulations of expected income streams, or surveys of decision-makers.
We have used these techniques to set up a number of new structures, written expert reports for tax lawyers to defend old structures in audits, and acted as expert witnesses in court. Our economic analysis has successfully strengthened the arguments of taxpayers in several large defence cases.
