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Tax and fiscal enviroment in Puerto Rico today

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Kevane Grant Thornton Conference: Tax and fiscal enviroment in Puerto Rico today. December 13, 2016

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Tax and fiscal enviroment in Puerto Rico today

  1. 1. © 2016 Kevane Grant Thornton. All rights reserved. Conference - Tax and fiscal environment in Puerto Rico today December 13, 2016 Caparra Country Club San Juan, Puerto Rico
  2. 2. @2016 Kevane Grant Thornton LLP. All rights reserved. Disclaimer DISCLAIMER: These presentations and their content do not represent a consulting. Participants should not act solely on the basis of this material and its content. Its usefulness is for information only and should not be used as a specific consulting. In addition, you must obtain the consultation of an expert before acting or taking a decision on any topic addressed in this presentation.
  3. 3. @2016 Kevane Grant Thornton LLP. All rights reserved. Our Values are CLEARR unite through global Collaboration demonstrate Leadership in all we do promote a consistent culture of Excellence act with Agility ensure deep Respect for people and actively communicate take Responsibility for our actions and demonstrate integrity
  4. 4. © 2016 Kevane Grant Thornton. All rights reserved. Fiscal and financial oversight in Puerto Rico Ojel Rodríguez Advisory partner CPA/ABV, CVA, CIRA, CISA, CIA, CFE Marta Rodríguez Advisory manager CPA/CVA, CGMA
  5. 5. © 2016 Kevane Grant Thornton LLP. All rights reserved. Governance and management aspects of the Puerto Rico Oversight Board Requirements of fiscal plan Economic growth under PROMESA Infrastructure revitalization Public debt restructuring and issuance Agenda 1 2 43 5
  6. 6. © 2016 Kevane Grant Thornton LLP. All rights reserved. Overview of PROMESA • Signed into law by President Obama on June 30, 2016 • Creates a structure for exercising federal oversight of the fiscal affairs of Puerto Rico • Establishes an oversight board with plenary authority over Puerto Rico's financial, budgetary, and legislative processes • Provides relief from creditor lawsuits through the enactment of a temporary stay on litigation • Creates two alternative methods to adjust unsustainable debt • Expedites approvals of key energy projects and other "critical projects" in Puerto Rico
  7. 7. © 2016 Kevane Grant Thornton LLP. All rights reserved. Overview of PROMESA Title I • Establishment & Organization of Oversight Board Title II • Responsibilities of Oversight Board Title III • Adjustment of Debts Title IV • Miscellaneous Provisions Title V • Puerto Rico Infrastructure Revitalization Title VI • Creditor Collective Actions Title VII • Sense of Congress Regarding Permanent, Pro-Growth Fiscal Reforms
  8. 8. © 2016 Kevane Grant Thornton LLP. All rights reserved. Eligibility and requirements of Board members • PROMESA requires the Board's members to meet the following criteria: – has expertise in finance, municipal bond markets, management, law, or the organization or operation of business or government – is not a candidate for elected office – is not an elected or appointed official – is not an employee of the territorial government – is not a former elected official of the territorial government • Tenure of members: – the term of a member of the Board shall be three (3) years beginning the date of appointment – the term of the Chair will be two (2) years or until a successor is appointed Reference: Section 101
  9. 9. © 2016 Kevane Grant Thornton LLP. All rights reserved. Board's composition Speaker of the House of Representatives Speaker of the House of Representatives Senate Majority Leader Minority Leader of the House Minority Leader of the Senate President’s discretion Nominee 1 Nominee 2 Nominee 3 President of the United States Governor or his/her designee Nominee 1 Nominee 2 Nominee 3 Nominee 1 Nominee 2 Nominee 3 Nominee 4 Nominee 1 Nominee 2 Nominee 3 Nominee 1 Nominee 2 Nominee 3 Member 1 Member 2 Member 3 Member 4 Member 5 Member 6 Member 7 Member 8 (non-voting) Reference: Section 101
  10. 10. © 2016 Kevane Grant Thornton LLP. All rights reserved. Board's composition (continued) Republican Nominees Democratic Nominees Carlos García former president of the Puerto Rico Government Development Bank President of the United States Arthur González former chief judge of the US Bankruptcy court in Manhattan, NY José Carrión III insurance executive based in San Juan Andrew Biggs American Enterprise Institute fellow Ana Matosantos California's finance director from 2009 to 2013 José González chief executive of the Federal Home Loan Bank of New York David Skeel law professor at the University of Pennsylvania Reference: https://juntasupervision.pr.gov/ Governor's designee Elias Sánchez
  11. 11. © 2016 Kevane Grant Thornton LLP. All rights reserved. Executive Director and Staff • Appointed by the Chair with the consent of the Board members • Will execute the instructions of the Board and be subject to the supervision and control of the Board • Will have general supervision and direction of the business affairs of the Board • Subject to the approval of the Board, may enter into and execute on behalf of the Board contracts as he/she deems appropriate • The Board is responsible for establishing the salary compensation (no ceiling or limits are established) • The Executive Director may hire and fix the pay of, and remove additional personnel employed by the Board, as he/she deems appropriate Reference: https://juntasupervision.pr.gov/
  12. 12. © 2016 Kevane Grant Thornton LLP. All rights reserved. Board's bylaws • The Board's bylaws were approved on September 30, 2016 during the Board's first meeting in New York – the bylaws are based on PROMESA's sections • All actions of the Board shall be taken by an affirmative vote of no fewer than four (4) members and in accordance to section 206(v) of the Act, an affirmative vote of no fewer than five (5) members is required to issue a restructuring certification • Board must meet at least quarterly • To the greatest extent possible, the Board shall produce all of its written materials in English and Spanish • The Board shall submit and make public an annual report which will include audited financial statements and adopted budget Reference: https://juntasupervision.pr.gov/
  13. 13. © 2016 Kevane Grant Thornton LLP. All rights reserved. Scope of the Board • 63 public entities are covered under PROMESA's dispositions and therefore under the supervision of the Fiscal and Oversight Board, among them: – PR Aqueduct and Sewer Authority (PRASA) – PR Electric Power Authority (PREPA) – Fiscal Agency and Financial Advisory Authority (AAFAF) – PR Sales Tax Financing Corporation (COFINA) – Puerto Rico Industrial Development Company (PRIDCO) – University of Puerto Rico – Governmental Development Bank for PR (GBD) – Public Corporation for the Supervision and Deposit Insurance of Puerto Rico Cooperatives (COSSEC) Reference: https://juntasupervision.pr.gov/
  14. 14. © 2016 Kevane Grant Thornton LLP. All rights reserved. Procedures on Transactions Involving Covered Entities • On a letter dated November 23, 2016, the Board shared additional procedures regarding transactions involving covered entities • The Board stipulated that: – transactions of covered instrumentalities that are subject to Approval under PROMESA, must be submitted to the Board no less than 15 calendar days prior to its required approval – the clock for such 15 days will start when the Board confirms it has received all the information required for its review – the Board can delay the transaction and take additional time for its review in the case of complex transactions or in the case the Board believes it requires additional information Reference: https://juntasupervision.pr.gov/
  15. 15. © 2016 Kevane Grant Thornton LLP. All rights reserved. Procedures on Transactions Involving Covered Entities (continued) • In addition, the approval request must include at least the following information: – a detailed memorandum explaining all the details of the transaction including purpose, reasons why the transaction is the best public interest, financial resources required and summary of all principal legal documents required to execute – letter evidencing approval by the Fiscal Agency and Financial Authority of Puerto Rico and its rationale for approval – letter from the Office of the Governor of Puerto Rico endorsing the transaction and rationale – legal opinion supporting why the transaction is covered under PROMESA and under what legal basis the transaction can be approved by the Board Reference: https://juntasupervision.pr.gov/
  16. 16. © 2016 Kevane Grant Thornton LLP. All rights reserved. Litigation stay • PROMESA suspends certain legal actions against Puerto Rico for debt payments and remedies allowing Puerto Rico to: – address its immediate fiscal crisis – negotiate with creditors instead of defending itself against multiple lawsuits – improve its governance – pursue debt restructuring and liability adjustments – resolve long-standing fiscal issues so it can return to economic growth • The stay would remain in effect until February 15, 2017 or six months after the Board is established Reference: Section 405
  17. 17. © 2016 Kevane Grant Thornton LLP. All rights reserved. Who will pay for the Board? • Members shall serve without compensation but may be reimbursed for reasonable and necessary expenses • Puerto Rico Government shall designate a dedicated funding source within 30 days of the enactment of the bill • The Board may use its powers to ensure that there are sufficient funds to cover its operation $370 million* over a 5 year period (FY2017-FY2022) * CBO estimate Reference: Section 107; Congressional Budget Office
  18. 18. How powerful is the Oversight Board? How powerful is the Oversight Board?
  19. 19. © 2016 Kevane Grant Thornton LLP. All rights reserved. Powers of the Board Section 104 of PROMESA describes the Board's broad powers. The Board has the power to: • hold hearings and seek testimony, and receive evidence • obtain information and records from federal agencies, Puerto Rico and its creditors • issue subpoenas for testimony or records • enforce a law that prohibits public sector employees from participating in a strike or lockout • ensure the electronic payment and administration of taxes • seek judicial enforcement of its authority • investigate and publicize disclosure and sales practices related to bonds purchased by retail investors • accept gifts, bequests and devises of services or property, as long all gifts and donors are disclosed within 30 days Reference: Section 104
  20. 20. © 2016 Kevane Grant Thornton LLP. All rights reserved. What does the Board's fiscal plan entails? • The Board requires the Governor to develop compliant five-year fiscal plans (at least) • If the government fails to develop a compliant fiscal plan, the Board shall develop and certify a fiscal plan Development and submission Review by Board Notice of violation Revision by Governor Approval Reference: Section 201
  21. 21. © 2016 Kevane Grant Thornton LLP. All rights reserved. Means to approve the fiscal plan • Submitted by the Governor and approved by the Board – the plan meets the 14 requirements outlined in PROMESA • Developed and approved by the Board – if the Governor fails to take corrective actions on the recommendations of the Board • Jointly developed by the Board and the Governor – the bill allows the Board and the Governor to work collaboratively to develop a consensus plan Reference: Section 201
  22. 22. © 2016 Kevane Grant Thornton LLP. All rights reserved. PROMESA – Fiscal Plan Requirements 1. Provide for estimates of revenues and expenditures in conformance with agreed accounting standards and be based on (i) applicable laws, or (ii) specific bills that require enactment in order to reasonably achieve the projections of the Fiscal Plan 2. Ensure the funding of essential public services 3. Provide adequate funding for public pension systems 4. Provide for the elimination of structural deficits 5. For fiscal years covered by a Fiscal Plan in which a stay under titles III or IV is not effective, provide for a debt burden that is sustainable 6. Improve fiscal governance, accountability and internal controls 7. Enable the achievement of fiscal targets 8. Create independent forecasts of revenues for the period covered by the Fiscal Plan Reference: Section 201
  23. 23. © 2016 Kevane Grant Thornton LLP. All rights reserved. PROMESA – Fiscal Plan Requirements cont’d 9. Include a debt sustainability analysis (“DSA”) 10. Provide for capital expenditures and investment necessary to promote economic growth 11. Adopt appropriate recommendations submitted by the Oversight Board (under Section 205(a) of PROMESA) 12. Include such additional information as the Oversight Board deems necessary 13. Ensure that assets, funds, or resources of a territorial instrumentality are not loaned to, transferred to, or otherwise used for the benefit of a covered territory, unless permitted by the constitution of the territory, an approved plan of adjustment under title III, or a Qualifying Modification approved under title VI 14. Respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreements of a covered territory or covered territorial instrumentality in effect prior to the date of enactment of PROMESA Reference: Section 201
  24. 24. © 2016 Kevane Grant Thornton LLP. All rights reserved. Puerto Rico Government Fiscal Plan • Governor Garcia Padilla formally presented Puerto Rico's Fiscal Plan on October 14, 2016 • On November 9, 2016, the Board open an invitation to comment on the Fiscal Plan (November 23 was the extended its due date for comments submission) – A total of 114 comments were received, fifty percent coming from Puerto Rico residents. Made public by the Board on December 8. • On November 23, 2016, the Board issued an assessment of the fiscal plan in which the following was addressed: – convey the reasons why the Board rejected the fiscal plan submitted by Governor García Padilla – provide a timeline for the Board to certify a fiscal plan • The Board understand that "more policy adjustment, particularly with respect to structural reforms, is necessary for the Puerto Rico economy to return to sustainable growth“ Reference: https://juntasupervision.pr.gov/
  25. 25. © 2016 Kevane Grant Thornton LLP. All rights reserved. Rebuttal of fiscal plan – evaluation principles • The Board established five (5) principles, in addition to the criteria set forth in PROMESA Section 201(b), which the plan must meet in order to be accepted: • Cover at least the next 10 fiscal years with meaningful progress in the next five (5) • Meet the standards set forth in the law (14 requirements) • Achieve the Board's main objective • Assume no additional federal support beyond that which is already established by law (e.g. no Affordable Care Act support extension and no reliance on Act 154 revenues) • Include an appropriate mix of structural reform, fiscal adjustment, and debt restructuring supported by the relevant analytical tools (e.g. debt sustainability analysis and a detailed economic projection) Achieve the following: • stabilize current economic situation • increase the economy's resilience • shore up public finances • support long- term growth • meet basic needs of citizens • Must include relevant operational plans that show the Government will achieve the changes and reforms it proposes Principle Principle Principle Principle Principle Reference: https://juntasupervision.pr.gov/
  26. 26. © 2016 Kevane Grant Thornton LLP. All rights reserved. Fiscal Plan certification timeline Publication of Baseline Projections for the Fiscal Plan and principles for achieving balance December 9th Working Session on Fiscal and Economic Plan Fiscal and Economic Plan Draft presented Meeting to discuss revised version of Fiscal Plan Distribution to the public of revised Fiscal Plan and invitation to open good-faith negotiations with creditors Week of December 19th December 12th December 15th Revised version of Fiscal Plan to be submitted to the Board Week of January 16th January 31st Target Date for Certification of Fiscal Plan Reference: https://juntasupervision.pr.gov/
  27. 27. © 2016 Kevane Grant Thornton LLP. All rights reserved. Annual and quarterly budgets • Once a fiscal plan is approved, the governor shall submit annual and quarterly budgets compliant with the fiscal plan – the Board will be submitting revenue estimates for the period covered by the budget – approval process is similar as the one for the fiscal plans • The Governor would also be required to submit quarterly "budget vs actual" reports in the following areas: revenues expenditures cash flows Reference: Section 202
  28. 28. © 2016 Kevane Grant Thornton LLP. All rights reserved. Inconsistencies in the budget vs actual reports • Inconsistencies would require explanation and corrective action by the Governor – if the Governor fails to take corrective action, the Board would be required to notify the US House and Senate – the Board has the powers to address directly the inconsistencies identified Reference: Section 203
  29. 29. © 2016 Kevane Grant Thornton LLP. All rights reserved. Financial stability and management responsibility • The Board may submit recommendations, at any time, to address fiscal and management matters, e.g. – privatization of public entities – alternatives for paying employee pensions – performance-based personnel systems – modification or transfers of the type of services delivered by governmental entities – reduce government's non-debt expenditures – implement hiring freezes / layoffs in the public sector • The government would have to adopt the recommendations within 90 days – if rejected, the governor must submit a statement to the President and Congress explaining why the recommendations were rejected Reference: Section 205
  30. 30. © 2016 Kevane Grant Thornton LLP. All rights reserved. Review of laws, contracts and executive orders • Under PROMESA, the Governor would be required to prepare and maintain a public registry of all contracts executed • New contracts must be reviewed and approved by the Board – the Board may enter into new contracts without Governor's approval • Board may revoke any existing contract • For any newly enacted law, the Governor shall submit a formal cost estimate – the Board has the power to certify and amend any proposed or new law – also has the power to revoke or amend any existing law, regulation or executive order Reference: Section 204
  31. 31. © 2016 Kevane Grant Thornton LLP. All rights reserved. Tax abatements and relief agreements • PROMESA requires the Governor to submit a report documenting all existing tax abatement or similar tax relief agreements • The Board reserves the power to execute or modify any tax abatement or relief agreement without limits to what constitutes the limit of power • This report would not be disclosed to the public in order to comply with regulation regarding confidential taxpayer information Reference: Section 208
  32. 32. © 2016 Kevane Grant Thornton LLP. All rights reserved. For how long would the Board operate? • The Board would be operating until it determines and certifies that Puerto Rico has achieved the following: – obtained access to short-term and long-term credit markets at reasonable rates of interest, and – balanced budgets for four (4) consecutive fiscal years Reference: Section 209
  33. 33. © 2016 Kevane Grant Thornton LLP. All rights reserved. Detroit vs Puerto Rico Fiscal Boards Reference: Dentons
  34. 34. © 2016 Kevane Grant Thornton LLP. All rights reserved. Detroit vs Puerto Rico Fiscal Boards Reference: Dentons
  35. 35. Economic growth under PROMESAEconomic growth under PROMESA
  36. 36. © 2016 Kevane Grant Thornton LLP. All rights reserved. Overview of Puerto Rico's economy 2.7% 1.9% 0.5% -1.2% -2.9% -3.8% -3.6% -1.7% 0.5% -0.1% -1.7% -0.6% -2.2% -2.8% -3.3% -1.7% -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Annual Real GNP Growth • The local economy has experienced secular deceleration in economic growth since the mid 1970s • GNP growth has been negative every year since 2007 with the exception of 2012 (0.5%) • Significant decrease in investment weakened the economy – investment in construction fell from nearly $7.0 billion (1999) to around $3.4 billion (2014) Reference: Government Development Bank for Puerto Rico
  37. 37. © 2016 Kevane Grant Thornton LLP. All rights reserved. • Government overspending lies at the root of the current the fiscal crisis – from 2001 to 2013, accumulated budget deficits exceeded $20 billion. During the same period $42 billion in debt was issued, half of which was used to cover budget deficits Overview of Puerto Rico's economy 463.9 1,671.6 201.3 937.6 1,013.0 1,855.8 844.6 965.0 3,180.1 2,651.9 2,464.7 3,298.6 1,322.8 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Fiscal deficits Reference: Office of Management and Budget
  38. 38. © 2012 Kevane Grant Thornton LLP. All rights reserved. • Outmigration reached historical levels with the loss of approximately 331,000 people or 9% of the total population in the period between 2006 and 2015. This has led to an aging of the remaining population, a decreased net birth rate and declines in Puerto Rico’s tax base. – Recent data also suggest that the rate of outmigration continues to increase Overview of Puerto Rico's economy Reference: Office of Management and Budget - 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000 3.4 3.45 3.5 3.55 3.6 3.65 3.7 3.75 3.8 3.85 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 (inmillions) Total population and outmigration Population Annual outmigration Source: U.S. Census Bureau
  39. 39. © 2016 Kevane Grant Thornton LLP. All rights reserved. Overview of Puerto Rico's economy • Puerto Rico and its various government instrumentalities owe around $68.7 million in debt – extraordinarily complex • 18 different issuers, including the Commonwealth itself, financing entities, and operating entities that provide essential public services – debt is held by countless and diverse creditors, including retail holders (both on- and off- island), hedge funds, mutual funds, local credit unions and mainland institutional investors, each with different interests and motivations in a potential restructuring Reference: PROMESA Overview Presentation – Government of Puerto Rico
  40. 40. © 2016 Kevane Grant Thornton LLP. All rights reserved. Congress's point of view • Section 701 expresses Congress's point of view regarding fiscal reforms for Puerto Rico: “any durable solution for Puerto Rico’s fiscal and economic crisis should include permanent, pro-growth fiscal reforms that feature, among other elements, a free flow of capital between possessions of the United States and the rest of the United States.” Reference: Section 701
  41. 41. © 2016 Kevane Grant Thornton LLP. All rights reserved. Congressional Economic Task Force • Composed of eight (8) members, this task force is responsible of issuing a report by December 31, 2016, that would examine: – the relation of federal laws and economic growth in Puerto Rico; – economic consequences of a Puerto Rico Department of Health Regulation 346, which relates to natural products, natural supplements, and dietary supplements; and would – recommend changes to federal laws to spur sustainable, long-term economic growth; – recommend changes to federal law and programs that would reduce child poverty; and – include additional information as deemed necessary Reference: Section 409
  42. 42. © 2016 Kevane Grant Thornton LLP. All rights reserved. Congressional Economic Task Force (continued) • On September 15, 2016, the Task Force issued its first status update in which the Task Force highlighted its concerns regarding "the relative lack of reliable data pertaining to certain aspects of the economic, financial, and fiscal situation in Puerto Rico" • They received over 335 proposal submissions from individuals and organizations regarding economic growth initiatives for Puerto Rico • The Task Force would be terminated once the report is issued by December 31, 2016 Congressional Task Force members Congressional Task Force members are: 1. Senator Orrin Hatch (R-UT) 2. Senator Robert Menéndez (D-NJ) 3. Senator Marco Rubio (R-FL) 4. Senator Bill Nelson (D-FL) 5. Representative Tom MacArthur (R-NJ) 6. Resident Commissioner Pedro Pierluisi (PR) 7. Representative Sean Duffy (R- WI) 8. Representative Nydia Velázquez (D-NY) Reference: https://pierluisi.house.gov/
  43. 43. © 2016 Kevane Grant Thornton LLP. All rights reserved. Economic growth proposals (most discussed) Reference: http://pierluisi.house.gov/; Private Sector Coalition; US Department of Health and Human Services Health • Parity in Medicare and Medicaid Federal funding • Elimination of HIT Tax in Puerto Rico • End the exclusion of territories from Part D of Low-Income Subsidy Program Jones Act and Maritime Transportation Reform • Reform or modification of the Jones Act • Amend Section 808 of Law 108-176 of December 2003, also known as the Stevens Amendment (United States presence in global air cargo industry) Energy • Extend the authority of the Federal Energy Regulatory Commission to review and regulate local energy industry • Extend the Investment Tax Credit for Renewable Energy in Puerto Rico until 2018 Social Security • Implement a 50% reduction in the social security tax for workers, employers and the self-employed for a period of six (6) years
  44. 44. © 2016 Kevane Grant Thornton LLP. All rights reserved. Economic growth proposals (most discussed) Reference: http://pierluisi.house.gov/; Private Sector Coalition; US Department of Health and Human Services Other exemptions • 85% exemption on dividends (or repatriation payments) from eligible Puerto Rico companies, as defined • Reduction in half of the full US statutory tax for active Puerto Rico source income on the remaining 15% Medicaid • Lift the Federal cap on Medicaid funding to Puerto Rico and other US territories • Raise the Federal Medicaid share from 55% to 83% over time • Expand eligibility of Medicaid program to anyone who is earning less than 100% of the Federal poverty level Medicare • Improve hospital payments related to low income patients and uncompensated care • Increase payment rates for hospitals Extend the Earned Income Tax Credit to Puerto Rico Extend the Child Tax Credit to Puerto Rico
  45. 45. © 2016 Kevane Grant Thornton LLP. All rights reserved. An opportunity for growth – HUBZone • Designed to encourage economic development and job creation in historically underutilized business zones through a certification and designation process • Companies and small businesses that become HUBZone-certified by the SBA receive preferential treatment in Federal government contracting over regular businesses • HUBZone program requires that 3% of all Federal government's contracting dollars be assigned specifically to HUBZone certified businesses Reference: Section 412; SBA.gov
  46. 46. © 2016 Kevane Grant Thornton LLP. All rights reserved. An opportunity for growth – HUBZone • Section 412 of PROMESA eliminates the 20% restriction from the qualified census tract definition (for Puerto Rico only) until the first of the following events occur: – 10 years after the date that the SBA Administrator implements the amendment; or – the date on which the Board ceases to exist • With this amendment, more areas could now qualify for the HUBZone designation providing local small businesses the chance to benefit from federal contracting opportunities Reference: Section 412
  47. 47. © 2016 Kevane Grant Thornton LLP. All rights reserved. Other provisions Reference: Title IV • PROMESA allows Puerto Rico (with the Board's approval) to establish a $4.25 minimum wage for employees younger than 25 • The rate could last as long as four years or until the board terminates • Current federal minimum stands at $7.25 an hour for non-exempt employees ($15.00 in some states) • The bill won't restrict Puerto Rico's right to determine its future political status by plebiscite • PROMESA excludes PR from the USLD's overtime pay rule which is scheduled to take effect on December 1, 2016 • The rule would raise the salary threshold for white- collar workers (exempt workers) from $23,660 to $47,476 • Employees who earn less than the threshold amount would be eligible for overtime pay • The exemption would be in effect until GAO determines that the rule wouldn't negatively affect the island's economy Minimum wage Exemption from Overtime Pay Political status
  48. 48. Infrastructure revitalizationInfrastructure revitalization
  49. 49. © 2016 Kevane Grant Thornton LLP. All rights reserved. How will infrastructure be revitalized? • Title V of PROMESA establishes a process to accelerate the development of infrastructure projects that provide essential services or address threats to public health or safety • Creates the position of "Revitalization Coordinator" and grants it the following powers: – a role in reviewing and permitting critical projects – establish an expedited review process for such projects – add related provisions intended to ease the permitting process and increase the federal oversight role • Critical project is defined by section 503 as: – one that is intimately related to addressing an emergency whose approval, consideration, permitting and implementation shall be expedited and streamlined Reference: Section 502 and 503
  50. 50. © 2016 Kevane Grant Thornton LLP. All rights reserved. How will infrastructure be revitalized? (continued) • Physical infrastructure could involve projects related to: • Projects could be proposed by a Puerto Rican agency or private entity • The application would have to describe how the project addressed an emergency, provide for estimated costs and the availability of funds to support the project energy water & sewage roads telecommunications other systems Reference: Section 503
  51. 51. Public debt restructuring and issuance
  52. 52. © 2016 Kevane Grant Thornton LLP. All rights reserved. Summary of Debt Outstanding Issuer Total Bonds and Private Loans (000's) GO $12,896 COFINA 17,294 HTA 4,317 PBA 4,005 GBD 4,015 ERS 3,141 PRIFA 2,158 PFC 1,147 UPR 496 PRCCDA 386 PRIDCO 159 AMA 28 Other Central Gov't Entities 242 Plus/Less: Missed bond interest, GBD and MFA Bonds 1,635 Total debt outstanding $68,707
  53. 53. © 2016 Kevane Grant Thornton LLP. All rights reserved. How will the debt be restructured? • PROMESA contains two methods (Title VI and Title III) to adjust Puerto Rico's debts: • As long as the Board remains in place, the territory including all of its instrumentalities are prohibited of issuing new debt without the Board's approval • Streamlined process to achieve modifications with the consent of a supermajority of creditors • Benefits such as potential speed relative to a traditional restructuring through a formal in-court process Voluntary adjustments • Court-supervised debt-adjustment process modeled after Chapter 9 • Includes "cram-down" power which may provide Puerto Rico with flexibility in debt adjustment • Gives Board total control over the adjustment process • Includes certain provisions designed to protect creditor interests Court reviews Reference: Title III, Title VI
  54. 54. © 2016 Kevane Grant Thornton LLP. All rights reserved. Title VI and Title III Overview Comparison Chart Reference: Title III, Title VI Area Title VI Title III Application • Bonds, loans, or other borrowings predating enactment of the Act • Substantially all liabilities predating the petition Eligible issuers • The Commonwealth and also any covered territorial instrumentality explicitly authorized by the Board • The Commonwealth or covered territorial instrumentality for which Board files a petition Prerequisites to relief • There is no prerequisite to entry, but a successful Title VI modification requires that the modification satisfy certain conditions • Board determines, among other things that the debtor made good-faith efforts at consensual restructuring, adopted procedures to provide timely audited financials, published draft financial statements and other information required to assess restructuring, and adopted a fiscal plan Proposals • The debtor or the Oversight Board makes the restructuring proposal • Only the Board may file a petition or a plan of adjustment
  55. 55. © 2016 Kevane Grant Thornton LLP. All rights reserved. Title VI and Title III Overview Comparison Chart (continued) Reference: Title III, Title VI Area Title VI Title III Process • Issuer or holders propose a Modification and the Board places affected bonds in pools based on their priority and security features; with limited exceptions, the proposed modification must provide all holders in all pools the same consideration pro rata • The Board certifies that the modification is consistent with the fiscal plan or, if no fiscal plan exists, that it provides sustainable debt • In order to become effective and bind non- consenting holders, holders of at least two- thirds in amount of the outstanding principal amount of the bonds that vote consent, provided further that such two-thirds must also constitute a majority in outstanding principal amount (for any secured bonds, non- consenting holders either retain their liens or receive property of a value at least equivalent to the value of the lesser of their bond claims or the collateral securing such bond claims) • A federal court approves the binding modification • Board files petition and plan • The process and substance otherwise generally follows Chapter 9 of the U.S. Bankruptcy Code, except that confirmation standards include a modified “best interests of creditors” test and require that the plan of adjustment must be consistent with the fiscal plan (which must “respect” priorities and liens existing under relevant constitution, law or agreement, but such determination will be made by the Board)
  56. 56. © 2016 Kevane Grant Thornton LLP. All rights reserved. Questions & feedback
  57. 57. © 2016 Kevane Grant Thornton. All rights reserved. Accounting issues resulting from the actual fiscal environment in Puerto Rico: Accounting Estimates Angiee Chico, CPA, CIA, CGMA Audit partner
  58. 58. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting Issues Related to Accounting Estimated - Accounts Receivable and Bad Debts Expense An accounting estimate impacted by the current economic environment is the collectability of receivables. Global and local economic downturn and fiscal crisis have put at risk accounts receivable and constrained cash flows.
  59. 59. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting Issues Related to Accounting Estimated - Accounts Receivable and Bad Debts Expense Inevitably, no matter how good the credit department and policies are, a company will have a customer that does pay its debts. This is simply part of doing business.
  60. 60. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting Issues Related to Accounting Estimated - Accounts Receivable and Bad Debts Expense General Facts Receivables represent oral promises of the purchaser to pay for goods and services sold Short-term extension of credit Classify as either current – expect collection within one year or non-current and trade or non-trade receivables Normally collected within 30 to 60 days Largest uninsured asset on a company’s balance sheet.
  61. 61. © 2016 Kevane Grant Thornton LLP. All rights reserved. What Do You Do if You Are Having a Hard Time Collecting the Accounts Receivable? Every company needs a formal system to account for, age, follow up and collect receivables. Companies should assess more directly and timely the collectability of their receivables. Some accounts that don’t get paid require more persuasive techniques, such as a call from you, an attorney or a collection agency.
  62. 62. © 2016 Kevane Grant Thornton LLP. All rights reserved. What Do You Do if You Are Having a Hard Time Collecting the Accounts Receivable?  Invoicing – establish a billing process that ensures accurate invoices are sent on a timely basis. Ask about payment at that time.  Aging Accounts Receivable - age your accounts starting with the project completion date, sale or service date. Choose a payment date or payment terms. If you don’t receive payment in that time, send a reminder or past-due reminder. Keep a record of the age of each account that isn’t paid under its terms. Accounts older than the required payment terms need your personal attention.
  63. 63. © 2016 Kevane Grant Thornton LLP. All rights reserved. What Do You Do if You Are Having a Hard Time Collecting the Accounts Receivable?  Calling Your Customer – effective communication, proactive approach; this gesture might be enough to get payment and avoid a collection agency or attorneys’ fees.  Using Collection Agency or Attorney – should be considered. Many small-business owners choose not to file suit on receivables under a certain amount and write off the transaction as uncollected. You'll save time and keep the transaction out of the public records.
  64. 64. © 2016 Kevane Grant Thornton LLP. All rights reserved. Collectability and estimates for allowance for doubtful accounts • Watch for trends in accounts receivable. Companies should assess more directly and timely the collectability of their receivables, as write-offs or additional reserves may be necessary. • Losses from uncollectible receivables shall be recorded if, based on current information and events, it is probable that the company will be unable to collect all amounts according to the contractual or business terms of the receivable.
  65. 65. © 2016 Kevane Grant Thornton LLP. All rights reserved. Collectability and estimates for allowance for doubtful accounts • Companies should consider to tighten the credit policy and review regularly. • Evaluate each individual customer. Consider prior periods' experience and ability to pay. • Negotiate payment plans to align to corporate collection policies.
  66. 66. © 2016 Kevane Grant Thornton LLP. All rights reserved. Collectability and estimates for allowance for doubtful accounts After proper evaluation and discussion, determine adjustments required or estimate for uncollectible accounts receivable. • Direct Write-Off vs. Allowance Method The company needs to determine how it will report the money it will not collect. Companies use either the direct write-off method or the allowance method to record defaulted sales.
  67. 67. © 2016 Kevane Grant Thornton LLP. All rights reserved. Collectability and estimates for allowance for doubtful accounts • Estimating Uncollectible Balances Determine how to calculate the portion that is likely to be uncollected. Allowances or adjustments should be recorded in the correct period. Be realistic!
  68. 68. © 2016 Kevane Grant Thornton LLP. All rights reserved. How Accounts Receivable Impact the Rest of Accounting This estimate and corresponding analysis is critical because of its impact in the rest of accounting.  Affects working capital or free capital  Limit investments and growth opportunities  Limit shareholders payouts  Inability to invest in new equipment or introduce new products or services
  69. 69. © 2016 Kevane Grant Thornton LLP. All rights reserved. How Accounts Receivable Impact the Rest of Accounting  Accounts Payable and Additional Debts o Cash flow directly impacts the company's ability to pay short-term liabilities, including any current portion of long-term debt. o May require to obtain additional financing or lines of credit  Results are reflected in the financial statements and related disclosures, as applicable
  70. 70. © 2016 Kevane Grant Thornton LLP. All rights reserved. How Accounts Receivable Impact the Rest of Accounting  Budgeting Implications o Accounts receivable can impact the future expected income used to make budgeting decisions o If receivables included in income expectations are not paid as expected, budgets can quickly become underfunded  Collection Approach o A higher percentage of overdue receivables can distract limited accounting personnel from their daily routines in small businesses, decreasing departmental productivity o Aging of receivables can also increase the loss a company takes due to bad debts write-offs or selling them to third-party collections agencies
  71. 71. © 2016 Kevane Grant Thornton LLP. All rights reserved. How Accounts Receivable Impact the Rest of Accounting  Ratio Valuations o Oversight and monitoring of metrics and financial covenants by banks, investors and creditors are more tough when making lending or investment decisions. o Since receivables are assets, account balances impact any financial ratio based on assets, including the debt-to-assets and assets turnover ratios. o Because of its impact on cash flows, receivables also impact liquidity ratios such as the current, quick and cash ratios. o The receivables turnover ratio is directly affected by the average maturity of accounts receivable as well.
  72. 72. © 2016 Kevane Grant Thornton LLP. All rights reserved. What is the next step? Managing the company’s accounts receivable should be one of its priorities. Create a plan! Work as a team. Business owners, senior managers and key personnel should be highly involved on a day-to-day basis. In good times and bad times the company needs to ensure the accounts receivable are as current as possible.
  73. 73. © 2016 Kevane Grant Thornton. All rights reserved. Impairment of investments Johanna Pérez, CPA, CFE, CAMS, CGMA Audit partner
  74. 74. © 2016 Kevane Grant Thornton LLP. All rights reserved. Agenda • Impairment definition • Impairment indicators • Accounting for other-than-temporary impairment of investments • Example • Disclosure requirements • New accounting standards
  75. 75. © 2016 Kevane Grant Thornton LLP. All rights reserved. What is an Impairment of Investments? • If, on each reporting date, a security is impaired because its fair value is less than its amortized cost basis, management must decide if the impairment is either temporary or other than temporary. • An other than temporary impairment does not mean the investment has been permanently impaired, but that the carrying value is not expected to recover through the holding period of the security.
  76. 76. © 2016 Kevane Grant Thornton LLP. All rights reserved. Impairment Indicators • Significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the investee; • Significant adverse change in the regulatory, economic, or technological environment of the investee; • Significant adverse change in the general market condition or either the geographic area or the industry in which the investee operates; • A bona fide offer to purchase, an offer by the investee to sell, or a completed auction process for the same or similar security for an amount less than the cost of the investment; • Factors that raise significant concerns about the investee’s ability to continue as a going concern; • Among others.
  77. 77. © 2016 Kevane Grant Thornton LLP. All rights reserved. Impairment Indicators Applicable to Puerto Rico investments • Overall shrinkage of Puerto Rico's economy • Default of bond payments by Puerto Rico Government • Degraded rating of Puerto Rico bonds by principal credit rating agencies: Fitch, Standard & Poor and Moody's • Among others.
  78. 78. © 2016 Kevane Grant Thornton LLP. All rights reserved. Impairment Indicators Applicable to Puerto Rico investments Rating Agency Date Rating Outlook Standard & Poor's October 1983 A N/A April 2016 CC Negative Moody's September 1970 A N/A April 2016 Caa3 Negative Fitch January 2011 BBB+ Stable April 2016 CC Rating Watch Negative sources: http://www.gdbpr.com/investors_resources/ UBS Municipal Brief April 7, 2016
  79. 79. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments Guidance on other than temporary impairments is prescribed by ASC 320-10-35 “Investments – Debt and Equity Securities – Overall – Subsequent Measurement”
  80. 80. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • For equity securities, an other-than-temporary impairment loss should be recognized in earnings for the difference between the amortized cost and fair value of the security at the balance sheet date. The fair value becomes the new amortized cost and should not be adjusted for subsequent recoveries in fair value. (FASB ASC 320-10-35-34)
  81. 81. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • For debt securities, the recognition of an other-than temporary impairment loss depends on whether the entity intends to sell the security (or whether it is more likely than not it will be required to sell the security) before recovery of the amortized cost basis less any current-period credit loss.
  82. 82. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • If the entity intends to sell the security (or more likely than not will be required to sell the security), the other-than-temporary impairment should be recognized in earnings for the entire difference between the amortized cost and fair value at the balance sheet date.
  83. 83. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • If there is no intention to sell the security or it is not more likely than not the entity will be required to sell, the other-than-temporary impairment should be separated into amounts pertaining to (a) the credit loss and (b) all other factors. The amount relating to the credit loss should be recognized in earnings and the remaining amount should be recognized in other comprehensive income (net of taxes).
  84. 84. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • Compare the present value of the expected cash flows versus the amortized cost – PV of expected cash flow < amortized cost = credit loss
  85. 85. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • When developing an estimate of cash flows expected to be collected, management should consider: – Past events, current conditions, and reasonable and supportable forecasts • Remaining payment terms of the security • Prepayment speeds • Financial condition of the issuer • Expected defaults • Value of any underlying collateral
  86. 86. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for Other-Than-Temporary Impairment of Investments • The prior amortized cost less the impairment loss recognized in earnings becomes the new amortized cost. This amount should not be adjusted for subsequent recoveries in fair value, but should be adjusted for accretion and amortization. (FASB ASC 320-10-35-34A through 34E)
  87. 87. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example A company has an investment portfolio on which management identified investments in debt securities (government securities – Puerto Rico) with a fair value significantly lesser than its amortized cost. Issuer Amortized Cost as of 12/31/2015 Coupon Rate Maturity Date Credit Rating (Moody's/S&P) Market Value as of 12/31/2015 Market Value as of 12/31/2015 Diff. between BV and MV % Government Development Bank for Puerto Rico (I) 5,000,000$ 4.150% 8/1/2017 CA/CC 28.244 1,412,200$ 3,587,800$ 72% Government Development Bank for Puerto Rico (II) 5,000,000$ 4.500% 8/1/2019 CA/CC 27.791 1,389,550$ 3,610,450$ 72% 10,000,000$ 2,801,750$ 7,198,250$
  88. 88. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example 0 50 100 150 2011 2012 2013 2014 2015 Market Value Bond #1 Bond #2 Source: Bloomberg
  89. 89. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example Circumstances for an OTTI have occurred and impairment analysis:  The entity intends to sell the security  It is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis  The entity does not expects to recover the entire amortized cost basis of the security
  90. 90. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example Management assumptions: Assumption Bond #1 Bond #2 Principal hair cut -20% -25% Coupon interest adjustment -10% -10% Maturity term extension (years) 5 5
  91. 91. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example Revised scenario based on management assumptions: New terms Bond #1 Bond #2 Adjusted principal obligation $4,000,000 $3,750,000 Adjusted coupon interest 3.735% 4.050% Monthly interest payments $12,450 $12,656 Term to maturity date (months) 79 103 New maturity date 8/1/2022 8/1/2024
  92. 92. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example Impairment calculation: Credit related impairment loss estimate for the Government Development Bank securities is based on the probability of default and loss severity in the event of default in consideration of the debt securities credit ratings and the latest available information about the Puerto Rico’s Government’s financial condition, including the Puerto Rico Government’s intention to restructure its outstanding bond obligations. Bond #1 Bond #2 Total Amortized cost $5,000,000 $5,000,000 $10,000,000 Present value of expected cash flows $3,904,517 $3,630,034 $7,534,551 Impairment amount (credit loss portion) ($1,095,483) ($1,369,966) ($2,465,449)
  93. 93. © 2016 Kevane Grant Thornton LLP. All rights reserved. Journal Entry Account Description Debit Credit Impairment losses - current earnings 2,465,449$ -$ Unrealized losses - other comprehensive income 4,732,801 - Impairment loss on investments - 7,198,250 7,198,250$ 7,198,250$
  94. 94. © 2016 Kevane Grant Thornton LLP. All rights reserved. Presentation of Other-Than-Temporary Impairment (Balance Sheet) Balance Sheet Investment in marketable securities 2,801,750$
  95. 95. © 2016 Kevane Grant Thornton LLP. All rights reserved. Presentation of Other-Than-Temporary Impairment (Income Statement) Income Statement Total other-than-temporary impairment losses (7,198,250)$ Portion of loss recognized in other comprehensive income before taxes 4,732,801 Net impairment losses recognized in earnings (2,465,449)$
  96. 96. © 2016 Kevane Grant Thornton LLP. All rights reserved. Disclosure Requirements • ASC 320-10-50 – Methodology and significant inputs used to measure the amount related to credit loss (recognized in earnings) • Performance indicators such as default rates, delinquency rates, percentage of nonperforming assets • Loan-to-collateral-value ratios • Third party guarantees • Geographic concentration • Credit ratings
  97. 97. © 2016 Kevane Grant Thornton LLP. All rights reserved. Disclosure Requirements • ASC 320-10-50 – Roll forward of the amount related to credit losses recognized in earnings • Beg. balance of credit losses for which a portion of an other-than-temporary impairment was recognized in other comprehensive income • Additions to the credit loss for which an other-than-temporary impairment was not previously recognized • Reductions for securities sold during the period (realized) • Reductions for securities for which the amount previously recognized in other comprehensive income was recognized in earnings because the entity intends to sell the security or more likely than not will be required to sell the security before recovery of its amortized cost basis
  98. 98. © 2016 Kevane Grant Thornton LLP. All rights reserved. Disclosure Requirements (cont.) • ASC 320-10-50 – Roll forward of the amount related to credit losses recognized in earnings (cont.) • If the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, additional increases to the amount related to the credit loss for which an other-than-temporary impairment was previously recognized • Reductions for increases in cash flows expected to be collected that are recognized over the remaining life of the security • The ending balance of the amount related to credit losses on debt securities held by the entity at the end of the period for which a portion of an other-than- temporary impairment was recognized in other comprehensive income.
  99. 99. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting Standards Update • ASU No. 2016-01 – “Financial Instruments – Overall: Recognition and Measurement of Financial Assets and Financial Liabilities” – which amends the guidance in U.S. GAAP on the classification and measurement of financial instruments. Changes to the current GAAP model primarily affects the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. In addition, the guidance related to the valuation allowance assessment when recognizing deferred tax assets resulting from unrealized losses on available-for-sale debt securities was clarified. The ASU is effective for public companies for years beginning after December 15, 2017 and for all other entities an additional year after that.
  100. 100. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting Standards Update • ASU No. 2016-13 – “Financial Instruments – Credit Losses: Measurement of Credit Losses on Financial Instruments” – which amend the guidance on the impairment of financial instruments. The new guidance introduces an approach based on expected losses to estimate credit losses on certain types of financial instruments. It also modifies the impairment model for available-for-sale debt securities and provides for a simplified accounting model for purchased financial assets with credit deterioration since their origination. ASU is effective for public companies for years beginning after December 15, 2019 and for non-public entities for years beginning after December 2021.
  101. 101. © 2016 Kevane Grant Thornton. All rights reserved. Troubled debt restructuring Kayra Rivera, CPA, CGMA Audit director
  102. 102. © 2016 Kevane Grant Thornton LLP. All rights reserved. Troubled debt restructuring • ASC 470-60 “Debt, Troubled Debt Restructurings by Debtors” establishes standards of financial accounting and reporting by the debtor for a troubled debt restructuring. • ASC 405-20 “Liabilities, Extinguishments of Liabilities” establishes standards of financial accounting and reporting for extinguishments of all liabilities.
  103. 103. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for debt modifications • Basic types of transactions:  Trouble debt restructurings  Modification of terms of an existing debt  Extinguishment of debt
  104. 104. © 2016 Kevane Grant Thornton LLP. All rights reserved. Definition of troubled debt restructuring • A restructuring of a debt constitutes a troubled debt restructuring if: (1) the borrower is experiencing financial difficulty, and (2) the lender grants a concession that it would not have otherwise considered
  105. 105. © 2016 Kevane Grant Thornton LLP. All rights reserved. Factors to determine a troubled debt restructuring • If a borrower's creditworthiness has deteriorated since its debt was originally issued, it should then assess all aspects of its current financial position to determine whether it is experiencing financial difficulty.
  106. 106. © 2016 Kevane Grant Thornton LLP. All rights reserved. TDR Identification – Two-Step Process Step 1: • Determine whether the borrower is experiencing financial difficulties. Indicators include the following:  the debtor is currently in default on any of its debt  the debtor has declared or is in the process of declaring bankruptcy  doubt about ability to continue as a going concern  currently, the debtor has securities that have been delisted, are in the process of being delisted, or are under threat of being delisted from an exchange.
  107. 107. © 2016 Kevane Grant Thornton LLP. All rights reserved. TDR Identification – Two-Step Process Step 1: • continuation -  the debtor forecasts that its entity-specific cash flows will be insufficient to service debt (both interest and principal) in accordance with the contractual terms of the existing agreement through maturity.  absent the current modification, the debtor cannot obtain funds from sources other than the existing creditors at an effective interest rate equal to the market interest rate for a similar debt for a nontroubled debtor.
  108. 108. © 2016 Kevane Grant Thornton LLP. All rights reserved. TDR Identification – Two-Step Process (cont.) Step 2: • Determine whether modification is a concession.  the effective borrowing rate on the restructured debt is less than the effective borrowing rate of the original debt. o the effective borrowing rate of the restructured debt is calculated by projecting all the cash flows under the new terms and solving for the discount rate that equates the present value of the cash flows under the new terms to the debtor's current carrying amount of the old debt.
  109. 109. © 2016 Kevane Grant Thornton LLP. All rights reserved. TDR Identification – Two-Step Process (cont.) Step 2: • Examples include the following:  Forgiving principal or interest  Modifying interest rate to a below-market rate  Deferring principal payments(e.g. interest only)  Extending the maturity date
  110. 110. © 2016 Kevane Grant Thornton LLP. All rights reserved. Troubled debt restructuring – Settlement of debt Involves most commonly the following: Full settlement with assets or equity – if the debtor transfers receivables from third parties or other assets or equity to the creditor to fully settle a debt, it should recognize a gain on the transaction in the amount by which the carrying amount of the payable exceeds the fair value of the assets transferred. Partial settlement with assets or equity – if the debtor transfers receivables from third parties or other assets or equity to partially settle a debt, it should only measure the transaction with the fair value of the assets transferred (not the fair value of the payable).
  111. 111. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a Settlement of debt – Example – Exchange of assets ABC, Inc. owes $300,000 plus $20,000 of accrued interest to PR Bank. The debt is a 10-year, 10% note. During 2015, ABC, Inc.’s business deteriorated due to a faltering regional economy. On December 31, 2015, PR Bank agrees to accept an old machine and cancel the entire debt. The machine has a cost of $490,000, accumulated depreciation of $321,000, and a fair market value of $290,000.
  112. 112. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a Settlement of debt – Example (cont.) Journal entries to be recorded: ABC, Inc: Notes Payable 300,000 Interest Payable 20,000 Accumulated Depreciation 321,000 Machine 490,000 Gain on Disposition of Machine 121,000 (a) Gain on Debt Restructuring 30,000 (b)
  113. 113. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a TDR involving modification of terms • When a borrower has a troubled debt restructuring (TDR) in which the terms of its debt are modified, it should analyse the future undiscounted cash flows to determine appropriate accounting treatment. • If the future undiscounted cash flows under the new terms is lesser than the adjusted net carrying value of the original debt -- a gain is recorded on the transaction. • If otherwise, no gain would be recorded.
  114. 114. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a TDR involving modification of terms • In calculating the future undiscounted cash flows specified by the new terms: All payments under the new terms should be included Any contingent payments should be included without regard to the probability of those payments being made If the number of future payment periods may vary because the debt is payable on demand, the estimate of future cash payments should be based on the maximum number of periods that could be required under the terms of the revised debt agreement
  115. 115. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a TDR involving modification of terms (cont.)
  116. 116. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a TDR involving modification of terms (cont.)
  117. 117. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example of Modification of terms – Gain recorded • On December 31, 2012, ABC Bank enters into a debt restructuring agreement with DEF Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.  Reduce principal obligation from $2,000,000 to $1,300,000.  Extend the maturity date from December 31, 2012, to December 31, 2015.  Reduce the interest rate from 12% to 10%. • DEF Company pays interest at the end of each year. On January 1, 2016, DEF Company will pay $1,300,000 in cash to ABC Bank.
  118. 118. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example of Modification of terms – Gain recorded (cont.) Journal December 31, 2012: Note Payable 310,000 Gain on Debt Restructuring 310,000 Total future cash flows after restructuring: Principal 1,300,000$ Interest ($1,300,000 x 10% x 3) 390,000 1,690,000 Total pre-restructuring carrying amount of note (principal): 2,000,000 Gain ($2,000,000 - $1,690,000) 310,000$
  119. 119. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example of Modification of terms – No gain recorded • On December 31, 2012, ABC Bank enters into a debt restructuring agreement with DEF Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, $2,000,000 note receivable by the following modifications.  Reduce principal obligation from $2,000,000 to $1,600,000.  Extend the maturity date from December 31, 2012, to December 31, 2015.  Reduce the interest rate from 12% to 10%. • DEF Company pays interest at the end of each year. On January 1, 2016, DEF Company pays $1,600,000 in cash to ABC Bank.
  120. 120. © 2016 Kevane Grant Thornton LLP. All rights reserved. Example of Modification of terms – No gain recorded (cont.) • Under this example, no gain is recorded by DEF Company since total future cash flows after restructuring exceed total pre-restructuring carrying amount of the note (principal): Total future cash flows after restructuring: Principal 1,600,000$ Interest ($1,600,000 x 10% x 3) 480,000 2,080,000$ Total pre-restructuring carrying amount of note (principal): 2,000,000$
  121. 121. © 2016 Kevane Grant Thornton LLP. All rights reserved. Extinguishment of liabilities- ASC 405-20 General • ASC 405-20-40-1 provides guidance on when a reporting entity should extinguish a debt. • A liability has been extinguished if the debtor either: the debtor pays the creditor and is relieved of its obligation for the liability the debtor is legally released from primary obligation under the liability, either judicially or by the creditor
  122. 122. © 2016 Kevane Grant Thornton LLP. All rights reserved. Extinguishment of liabilities- ASC 405-20 What is considered? • an exchange of debt with substantially different terms • a substantial modification of terms If the difference between the present value of the cash flows of the new debt and the present value of the remaining cash flows of the original debt is……
  123. 123. © 2016 Kevane Grant Thornton LLP. All rights reserved. Extinguishment of liabilities- Measurement of debt extinguishments • For all debt extinguishments, the difference between the reacquisition price and the net carrying amount of the debt extinguished (which includes any deferred debt issuance costs) should be recognized as a gain or loss when the debt is extinguished. – Extraordinary item – new guidance effective • Transaction with related parties - recognition of gain or loss may not be appropriate (such a restructuring may be in essence a capital transaction).
  124. 124. © 2016 Kevane Grant Thornton LLP. All rights reserved. Accounting for a Debt extinguishment
  125. 125. © 2016 Kevane Grant Thornton LLP. All rights reserved. Troubled debt restructuring Chapter 11 bankruptcy proceedings • since debtor would be restating its liabilities generally, this subtopic would not apply to the debtor's accounting for such reduction of liabilities. • this subtopic would apply to an isolated TDR by a debtor involved in bankruptcy proceedings if such restructuring did not result in a general restatement of the debtor's liabilities.
  126. 126. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-14 Taxation of income due to debt forgiveness • Section 1031.01 (a) (6) of the 2011 Puerto Rico Internal Revenue Code, as amended (the "Code"), provides that, as a general rule, the income or benefit derived from the forgiveness of a debt is considered as part of the gross income subject to income tax.
  127. 127. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-14 Taxation of income due to debt forgiveness Certain amounts are excluded: • The cancellation is the result of filing an application for bankruptcy in an action under the provisions of Title 11 of the United States Code. • Student loans, in whole or in part • Reorganization of a mortgage loan guaranteed by the qualifying residence of the taxpayer, provided that the original mortgage loan amount does not exceed $1,000,000. • Insolvency of the taxpayer
  128. 128. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-14 Taxation of income due to debt forgiveness This Administrative Determination establishes the rules to determine the amount exempt from debt forgiveness under the following exclusions and also establishes the way to report the income for debt forgiveness under such circumstances: – reorganization of a mortgage loan guaranteed by the qualifying residence of the taxpayer; – when the taxpayer is insolvent • Agreed upon procedures required
  129. 129. © 2016 Kevane Grant Thornton. All rights reserved. Francisco Luis, JD, CPA Tax partner Recent tax legislation affecting multinational organizations
  130. 130. © 2016 Kevane Grant Thornton LLP. All rights reserved. Topics 01 Act 40-2013 02 Circular Letters 03 Act 72-2015 04 Wal-Mart Case 05 Where are we now?
  131. 131. © 2016 Kevane Grant Thornton LLP. All rights reserved. Background – Act 40-2013 • Act 40-2013 was enacted to impose, among others, important limitations to Puerto Rico taxpayers that had transactions with related parties not engaged in a trade or business and not subject to tax in Puerto Rico, as follows: • established certain disallowance of expenses incurred or paid to a related person ; and • added new components to the Alternative Minimum Tax ("AMT") computation.
  132. 132. © 2016 Kevane Grant Thornton LLP. All rights reserved. Non-Deductible Expenses • for ordinary tax purposes, Act 40-2013 established a disallowance of 51% of the expenses incurred with a related party that is not engaged in a trade or business or subject to taxes in Puerto Rico (section 1033.17)
  133. 133. © 2016 Kevane Grant Thornton LLP. All rights reserved. Alternative Minimum Tax • the AMT of a corporation is the excess of, if any, the tentative minimum tax over the regular tax. • important changes: 2011 PR Internal Revenue Code Act 40-2013 AMT Tax Rate 20% 30% Book Income Adjustment 50% 60% NOL Limitation 90% 80%
  134. 134. © 2016 Kevane Grant Thornton LLP. All rights reserved. Alternative Minimum Tax the tentative minimum tax is composed of the greater of: • 30% of the alternative minimum net income, or • the sum of the following two items: 1. 20% of the expenses incurred or paid to related parties and/or the expenses allocated from a home office to a branch located in Puerto Rico, if such payments were not subject to tax in Puerto Rico during the tax year 2. up to 2% on the purchases of tangible personal property from a related person
  135. 135. © 2016 Kevane Grant Thornton LLP. All rights reserved. Authority to the Secretary of Treasury • Act 40-2013 provided authority to the Secretary of Treasury to approve waivers to exclude expenses subject to the disallowance of 51% and the 20% charge in the AMT. It was also authorized to waive also the AMT on the transfer of personal property – the Secretary was requested to issue guidelines on the procedures to request such waivers
  136. 136. © 2016 Kevane Grant Thornton LLP. All rights reserved. Waiver for expenses • Circular Letter 13-06 was issued providing the procedures to request the exclusion of certain expenses incurred or paid to a related person with regards to: – deduction of said expenses with regards to the 49% limitation imposed for income tax purposes – 20% tax under the AMT calculation • under these sections, the Secretary may grant an exclusion upon assessment of the nature of the expenses or costs paid to related person or office
  137. 137. © 2016 Kevane Grant Thornton LLP. All rights reserved. Waiver for expenses • Circular Letter 13-06 required that among others a Memorandum in support of the waiver should be filed together with certain “Agreed Upon Procedures” covering the 4 taxable years prior to the year for which the waiver was being requested. – the waiver, if granted would have been valid for 2 taxable years
  138. 138. © 2016 Kevane Grant Thornton LLP. All rights reserved. Waiver for transfers of personal property • Circular Letter 13-07 was issued to provide the procedure for requesting a partial or total waiver from inclusion in the AMT calculation of the purchase value of property acquired from a related person or transferred from home office • Secretary may grant a partial or total waiver to reduce the tax rate limited to .2% when it is determined that the value of the purchased property or transferred property to the taxpayer was the same or substantially similar to the value under which said related person sells the property to an unrelated party. • Pursuant to Act 40-2013, a transfer price study is required.
  139. 139. © 2016 Kevane Grant Thornton LLP. All rights reserved. Circular Letter No. 13-23 • it was issued to clarify the term "eligible charges" to be excluded from the 51% disallowance for ordinary tax purposes and the AMT 20% charge. – “eligible charges” are those that are expenses or directs costs that are essential and meet the following criteria: 1) should be directly related to the operation of the industry or trade or business in Puerto Rico 2) should be indispensable to make the operation viable in Puerto Rico It also indicated that the “eligible charges” should be those that although paid to a related party, they are truly reimbursements of expenses paid to non related third parties
  140. 140. © 2016 Kevane Grant Thornton LLP. All rights reserved. Act 72-2015 changes • Act 72-2015 brought the following significant changes to the rules for related party transactions: – it limited the amount of the expenses that the Secretary could waive to 60% from the 51% disallowance for ordinary tax purposes and from the 20% tax for AMT; and – it also eliminated the waiver process for the purchases of personal property and provided an increase on the tax over those purchases from 2% to 6.5%, depending on the taxpayer's gross revenues
  141. 141. © 2016 Kevane Grant Thornton LLP. All rights reserved. Act 159-2015 Technical amendment to Act 72-2015 Waiver on Expenses with Related Parties • it provides that the waiver request to exclude 60% of the expenses incurred with a related party that is not engaged in trade or business in Puerto Rico from the 51% disallowance for ordinary tax purposes and from the 20% tax for AMT, should be made within the first taxable year for which such waiver is being requested. If granted, the waiver will be valid for a maximum of 3 taxable years.
  142. 142. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – First Instance • on December 4, 2015, Wal-Mart initiated legal action against the Secretary to challenge the changes brought by Act 72-2015. • the main focus of Wal-Mart's claim was particularly with the AMT imposition on the purchases of personal property as it is the area in which it received the most impact.
  143. 143. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – First Instance • Wal-Mart requested an injunction against the continued enforcement of the AMT provisions sustaining that they were unlawful under the following: – Dormant Commerce Clause – Equal Protection Clause – Bill of Attainder Clause – Federal Relation Acts
  144. 144. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – First Instance • on March 28, 2016, the district court issued an order stating its findings of fact and conclusions of law. It held that: 1) it had jurisdiction under the Butler Act because of the lack of a "plain, speedy and efficient remedy" in Puerto Rico courts; 2) the AMT violates the Dormant Commerce and the Equal Protection Clause; 3) the AMT violates the Federal Relations Act; 4) the AMT does not violate the Bill of Attainder Clause
  145. 145. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – The Court of Appeals determination • the Court of Appeals affirmed the District Court's decision, therefore the injunction against the enforcement of the AMT against Wal-Mart continues. • it indicates that the District Court had jurisdiction over Wal-Mart claims.
  146. 146. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – The Court of Appeals determination – Remarkable points • the decision states that the AMT dispositions of Act 72- 2015 are discriminatory as it taxes only cross border transactions between a Puerto Rico corporate taxpayer and a related entity outside of Puerto Rico. • furthermore, the Appeal's Panel concluded also that if Act 72-2015 would have been valid, it would prevent multistate corporations from enjoying the functional integration, centralization of management, and economies of scale associated with their interstate business model.
  147. 147. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – The Court of Appeals determination – Remarkable points • the decision mentions that Act 72-2015 is based on the incorrect presumption that all intercorporate transfers to a Puerto Rico branch from a related party are fraudulently priced to evade taxes. • it says that there are alternatives to validate if there is an undue profit shifting as it is the case with "the already existing set of regulations that authorize the PR Treasury to conduct a traditional transfer pricing audit of interstate transactions between related parties and to adjust specific transfer prices … to recapture improperly shifted profits."
  148. 148. © 2016 Kevane Grant Thornton LLP. All rights reserved. Wal-Mart Action – The Court of Appeals determination – Remarkable points • certainly, the Appeals Court decision reaffirms, not only the unconstitutionality of these arbitrary impositions on related party transactions, but emphasizes the fact that Puerto Rico has regulations to review transactions among related parties, similar to those in the Federal Tax System.
  149. 149. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-11 • the Secretary of Treasury issued the AD 16-11 to clarify the applicability of the AMT after the resolution of the case with Wal-Mart – for taxable years beginning after January 1, 2016, the AMT computation will not include the charge on the transfer of personal property and the 20% charge on expenses with related parties not engaged in a trade or business in Puerto Rico
  150. 150. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-11 • provides rules stating that if the amount of tax for taxable year 2016, without considering the AMT charges on transfer of personal property and expenses, is already covered with the estimated tax payments made, no additional estimated tax payments are necessary.
  151. 151. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-11 • what about taxable year 2015? – the AD 16-11 indicates that the taxpayer may amend its 2015 tax return to eliminate the tax portion that was attributable to the AMT computations on personal property and expense, if any. • the excess tax paid should be claimed then as a credit of income taxes or as an AMT credit for future years. • it specifically states that any excess tax paid can not be requested as a refund.
  152. 152. © 2016 Kevane Grant Thornton LLP. All rights reserved. Administrative Determination 16-11 • what about the 51% disallowance? – the Secretary indicates that even though the AMT charges on transfers of personal property and expenses with related parties not engaged in trade or business in Puerto Rico were declared unconstitutional, the 51% disallowance continues to be valid.
  153. 153. © 2016 Kevane Grant Thornton. All rights reserved. Transfer Pricing Isabel Hernández, CPA Tax partner
  154. 154. @2016 Kevane Grant Thornton LLP. All rights reserved. Agenda • Overview • Arm's Length • History • US Regulation • OECD Guidelines • PR Regulation • Transfer Pricing Study • BEPS
  155. 155. @2016 Kevane Grant Thornton LLP. All rights reserved. What is Transfer Pricing? • The pricing of transactions between related parties, such as a parent and a subsidiary. • Companies undertaking transactions with unrelated companies in the marketplace must set competitive prices for goods they sell, services they provide, or the use of intangibles, but companies transferring goods or services between entities do not have to set competitive prices.
  156. 156. @2016 Kevane Grant Thornton LLP. All rights reserved. • Deals with the evaluation of prices charged in transactions between RELATED PARTIES • Parties: Owned or controlled directly or indirectly by the same interests • Transactions: – Sale, lease, use of tangible property – Sale, license, use of intangible property – Services – Loans Scope of Transfer Pricing
  157. 157. @2016 Kevane Grant Thornton LLP. All rights reserved. • Multinational companies operate in different countries with different tax laws/tax rates • Large companies can have difficulty determining where income is earned • Companies have incentives to transfer income to lowest tax jurisdictions • Companies can use transfer pricing as a planning opportunity to reduce taxes • In many countries, enforcing transfer pricing regulations is perceived to be a significant revenue raising strategy used by the local tax authorities • In many countries, the local tax authority imposes significant penalties for noncompliance with the transfer pricing regulations Importance of Transfer Pricing
  158. 158. @2016 Kevane Grant Thornton LLP. All rights reserved. • Any multinational company that has intercompany transfers of tangible property, services or intangibles • Multi-state companies with intercompany pricing issues • Companies with management objectives of determining intercompany prices • Companies whose transfer pricing policies are being audited • Companies who have related party transactions involving entities not part of a consolidated tax return • Companies which require an analysis of the value of certain functions and risks (ex: value of intangible property) Types of Companies that Benefit from a Transfer Pricing Analysis
  159. 159. @2016 Kevane Grant Thornton LLP. All rights reserved. • There are two options for meeting regulatory requirements: annual report and Advance Pricing Agreements (APA) Meeting Regulatory Requirements • This is typically considered to be the standard way to meet regulatory compliance • Companies must annually document their activities (documentation requirements vary by country) and be ready to support a tax return filed • This approach to regulatory compliance is most common among the clients as it is still the dominantly chosen means for compliance • An APA is an agreement between the taxpayer and the Tax Authorities concerning the methods the taxpayer will use to set its transfer prices over some specified period of time • The main advantage of an APA is that it reduces uncertainties both for taxpayers and tax authorities, reducing the threat of penalties • The main obstacle to an APA is the cost of time and resources involved in negotiating one successfully • Under an APA, a company must still carry-out the agreed methodology in order to determine the appropriate allocation of profits APAANNUAL REPORTING
  160. 160. @2016 Kevane Grant Thornton LLP. All rights reserved. • The arm’s-length standard is the fundamental basis of worldwide transfer pricing regulations. • A transaction is at arm’s-length if the transaction is consistent with results of uncontrolled taxpayers engaged in comparable transactions. • Specific methods for analyzing intercompany transfers of tangible goods, services and intangible goods are outlined in regulations under Section 482 of the US IRC and Section 1040.09 of the PRIRC. • When two or more transfers occur within the same company, the use of more than one transfer pricing method may be needed. • The arm’s-length standard is accepted by most developed and many developing nations for intercompany transfers of goods, services, and intangibles. The Arm’s-Length Standard
  161. 161. @2016 Kevane Grant Thornton LLP. All rights reserved. General Overview of the Arm's Length Standard…
  162. 162. @2016 Kevane Grant Thornton LLP. All rights reserved. • Arm’s-length Range: In most cases it is not possible to identify a single price that would occur between unrelated parties. Several comparable transactions can define an arm’s-length range of possible results within which the related party transaction to be priced should fall. • Interquartile Range: When there are significant functional and operational differences between the comparable firms and the taxpayer, the interquartile range is used to eliminate any outlying results. • A transfer pricing method may produce a single reliable result, or a range of reliable results. The Arm’s-Length Range
  163. 163. @2016 Kevane Grant Thornton LLP. All rights reserved. Let’s talk about history
  164. 164. @2016 Kevane Grant Thornton LLP. All rights reserved. • Starting in 1920, countries began debating about the consequences of double taxation • In 1943 the first models of bilateral agreements were created • In 1960 the US, Canada and 18 European countries joined to create the Organization for Economic Cooperation and Development (OECD) Where does transfer pricing come from?
  165. 165. @2016 Kevane Grant Thornton LLP. All rights reserved. • In 1979 the OECD published “Transfer Pricing and Multinational Enterprises” • In 1995 the OECD published "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations", which is what we have today as amended in 2010 • OECD Member countries are: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States. OECD Member Countries
  166. 166. @2016 Kevane Grant Thornton LLP. All rights reserved. • U.N. members like China, India, and Brazil have adopted positions that would seem difficult to reconcile with the OECD TP Guidelines and the US TP Regulations. • The U.N. manual published on October 15, 2012 confirms that developing countries have acquired independent views on transfer pricing, presumably to ensure that a larger share of the profits of multinational enterprises are subject to taxation in developing countries. This was a sign that “the U.N has abandoned the neutral position toward the OECD TP Guidelines.” Non-OECD Member Countries
  167. 167. @2016 Kevane Grant Thornton LLP. All rights reserved. • The goal of transfer pricing, for tax purposes, is to prevent income shifting through inter-multinational companies’ transactions. The arm’s length principle is the standard used for that purpose. • Historically speaking, the arm’s length principle was first stated in US Regulations under §482 (“US TP Regulations”) of the IRC code in 1934. In this regard, the U.S. was the first promoter of the adoption of the arm’s length standard in the first OECD Model Income Tax Convention released in 1963. • Thus, the OECD guidelines on transfer pricing (“OECD TP Guidelines”) matter was influenced deeply by the US. The arm’s length principle has since gained acceptance in all OECD members as a fundamental principle governing international transfer pricing. Background
  168. 168. @2016 Kevane Grant Thornton LLP. All rights reserved. Transfer Pricing Legislation
  169. 169. @2016 Kevane Grant Thornton LLP. All rights reserved. • I.R.C. Section 482, Treasury Regulations 1.482 • Transfer Pricing Guidelines of the Organization for Economic Cooperation and Development (“OECD Guidelines”) (revised 2010) • U.N. Practical Manual on Transfer Pricing (2009) • PR Section 1040.09 and Proposed Regulation 8049 Transfer Pricing Legislation (cont.)
  170. 170. @2016 Kevane Grant Thornton LLP. All rights reserved. U.S. Regulation
  171. 171. @2016 Kevane Grant Thornton LLP. All rights reserved. • Section 482 authorizes the IRS to reallocate income among related parties in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. • In the case of any transfer (or license) of intangible property the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. Treasury Regulation §1.482
  172. 172. @2016 Kevane Grant Thornton LLP. All rights reserved. • Section 482 of the Internal Revenue Code (IRC) – Reaffirms the arm’s-length standard – Establishes that there is a range of arm’s-length prices – Establishes the “best method rule” – Distinguishes product comparability from functional comparability U.S. Regulations Addressing Transfer Pricing
  173. 173. @2016 Kevane Grant Thornton LLP. All rights reserved. • Section 6662 of IRC -- Issued Feb. 1996 – Requires documentation which: • Demonstrates an arm’s-length result • Justifies the use of a “best method” • Outlines pricing policies • Describes international operations U.S. Regulations Addressing Transfer Pricing (cont.)
  174. 174. @2016 Kevane Grant Thornton LLP. All rights reserved. OECD guidelines
  175. 175. @2016 Kevane Grant Thornton LLP. All rights reserved. • The main objective of the OECD is to promote policies that will improve the economic and social well-being of people around the world. The OECD provides a forum in which governments can work together to share experiences and seek solutions to common problems. • Contribute to international commerce in a multilateral, non- discriminatory basis. • Provide member countries with transfer pricing guidelines; however, these are non-binding guidelines and may be overridden by domestic law. Organization for Economic Cooperation and Development (OECD)
  176. 176. @2016 Kevane Grant Thornton LLP. All rights reserved. • OECD Transfer Pricing Guidelines – Part I: Principles and Methods – Part II: Applications • Revision of the Guidelines presented in 1979 • Part I issued and approved by OECD Council in July 1995 • Part II approved by OECD Council in March 1996 OECD Guidelines: Part I and Part II
  177. 177. @2016 Kevane Grant Thornton LLP. All rights reserved. • Reduce incidence of double taxation • Do not override domestic law • Do not bind OECD members: limited acceptance • Framework for international cooperation • Framework for development: conformity The OECD Revised Transfer Pricing Guidelines
  178. 178. @2016 Kevane Grant Thornton LLP. All rights reserved. • Covers transfers of tangible property • Reconfirmation of arm’s length principle • Review and approval of transaction methods – Comparable Uncontrolled Price (“CUP”) – Resale Price (“RPM”) – Cost Plus • Review and approval of profit methods (Profit Split and Comparable Profits Method) Part I OECD Transfer Pricing Guidelines
  179. 179. @2016 Kevane Grant Thornton LLP. All rights reserved. • Profit Split • Transactional Net Margin Method (TNMM) – Similar to the Comparable Profits Method (CPM) – Examines net margin for controlled transaction – Applied in manner consistent with Resale Price Method (RPM) and Cost Plus Method – Uses comparable uncontrolled transactions with no comparison of global profit Part I Profit Methods
  180. 180. @2016 Kevane Grant Thornton LLP. All rights reserved. • Burden of proof – problem of divergent rules between countries – both taxpayer/tax authority should be prepared to make good faith showing regardless of burden of proof • Penalties – sizable “no fault” penalties considered unduly harsh • Simultaneous tax examinations recommended • Advanced Pricing Arrangements (“APAs”) approved – strong emphasis on bilateral agreements • Safe harbors rejected Part I Recommended Compliance Practices
  181. 181. @2016 Kevane Grant Thornton LLP. All rights reserved. Comparison of US transfer pricing to the OECD transfer pricing guidelines
  182. 182. @2016 Kevane Grant Thornton LLP. All rights reserved. Comparison - Methods
  183. 183. @2016 Kevane Grant Thornton LLP. All rights reserved. • There is significant similarity between the OECD methods and the US methods, with as main exception the Services Cost Method (SCM). SCM is an elective method allowing taxpayers to charge out services at cost if the services are either on a list of routine and non-core services published by the IRS (e.g. HR, tax, legal, AP/AR services), or if they have a median comparable markup of 7% or less. These are referred to as covered services. Taxpayers must also determine that these services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in their business. Comparison – Methods (cont.)
  184. 184. @2016 Kevane Grant Thornton LLP. All rights reserved. Puerto Rico regulation
  185. 185. @2016 Kevane Grant Thornton LLP. All rights reserved. • In any case of two or more organizations, trades, or businesses, whether or not incorporated, whether or not organized in Puerto Rico, and whether or not affiliated, owned or controlled directly or indirectly by the same interests, the Secretary is authorized to distribute, apportion, or allocate gross income and deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or to clearly reflect the income of any of such organizations, trades, or businesses. 2011-PRIRC §1040.09 - Allocation of income and deductions
  186. 186. @2016 Kevane Grant Thornton LLP. All rights reserved. • The Secretary is also authorized to impute income by reason of interest, dividends, compensation or for any other concept or nature in transactions, trades or businesses when it is necessary to avoid tax evasion or to clearly reflect the income of any of such organizations, trades or businesses. 2011-PRIRC §1040.09 - Allocation of income and deductions (cont.)
  187. 187. @2016 Kevane Grant Thornton LLP. All rights reserved. • Articles 1040.09-1 to 1040.09-22 • Will effectively grant Puerto Rico businesses with official Transfer Pricing guidelines Proposed – Regulation 8049
  188. 188. @2016 Kevane Grant Thornton LLP. All rights reserved. • Current version presents a mix of guidelines from: – US Treasury Regulations – OECD Transfer Pricing Guidelines • Only technical guidelines available. – No administrative procedures – No filing or evidence requirements yet • Current version states it will apply to controlled organizations in which at least one member of the group is: – A large taxpayer (section 1010.01 (a)(35), or – In the previous year had gross sales volume or average assets of $10M or more. Proposed – Regulation 8049 (cont.)
  189. 189. @2016 Kevane Grant Thornton LLP. All rights reserved. • The Secretary has the authority to request a transfer pricing study to other taxpayers below the established threshold • Control for transfer pricing purposes is a much wider concept than for income tax • Regulation is not tied to 51% disallowance provision in the law • Time table: – will be sent for signature to Department of State by December 19th – will not be effective until administrative provisions are published Proposed – Regulation 8049 (cont.)
  190. 190. @2016 Kevane Grant Thornton LLP. All rights reserved. The transfer pricing study
  191. 191. @2016 Kevane Grant Thornton LLP. All rights reserved. • Determines compliance of intercompany pricing policies with local country regulations • Review and analysis of a company’s current pricing of intercompany transfers of tangible property, services, or intangibles • Establishment of a policy, support of a current policy, or proposal of changes in current policy • Establishes transfer pricing policies that can benefit corporate planning by determining a company’s worldwide tax liability Transfer Pricing Studies Types - Transfer Pricing Study
  192. 192. @2016 Kevane Grant Thornton LLP. All rights reserved. • The purpose of benchmarking studies is to determine the general conditions surrounding the transactions conducted by third parties on a given market. Such studies help elicit a range of values, i.e. the so-called arm's length range or mark-up range. Transfer Pricing Studies Types - Benchmarking Study
  193. 193. @2016 Kevane Grant Thornton LLP. All rights reserved. • Statement of Facts and Functional Analysis – Industry Overview – Overview of the Company and it’s Role in the Industry – Discussion of Relevant Company Operations - Functions Performed, Risks Borne, and Assets Employed – Description of Organizational Structure for Relevant Entities – Overview of the Subject Intercompany Transactions Components of a Transfer Pricing Study
  194. 194. @2016 Kevane Grant Thornton LLP. All rights reserved. • Economic Analysis – Restatement of the Subject Intercompany Transaction – Overview of Relevant Regulations – Description of Method Selection/Rejection – Description of Analysis Performed • Application of Regulatory Tests • Selection of Tested Party and Years of Comparison • Selection of Comparable Companies / Comparable Transactions • Step-by-Step Detailed Discussion of Analysis Performed – Statement of the Results of the Analysis Components of a Transfer Pricing Study (cont.)
  195. 195. @2016 Kevane Grant Thornton LLP. All rights reserved. Base erosion and profit shifting (BEPS)
  196. 196. @2016 Kevane Grant Thornton LLP. All rights reserved. • On October 5, 2015, the OECD issued its final reports on the 15 focus areas identified in its Action Plan on BEPS. These were discussed and endorsed at the G20 Finance Ministers' meeting on October 8, 2015. • The recommendations range from new minimum standards to reinforced international standards to common approaches and best practices. BEPS

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