September 2019

SGV thought leadership on pressing issues faced by chief executives in today’s economic landscape. Articles are published every Monday in the Economy section of the BusinessWorld newspaper.
30 September 2019 Reynante M. Marcelo

Transfer pricing audit issues requiring attention Part 2

(Second of two parts) In the previous article, we discussed the salient points of RAMO No. 1-2019, the Transfer Pricing (TP) Audit Guidelines and the urgent need to have a TP documentation to prepare for the TP audits. These guidelines also provide the audit procedures to be applied to specific TP issues that are quite common to groups of companies today. These issues relate to intra-group services, intangible assets and interest payment transactions. Under the RAMO, intra-group services are activities undertaken within a group that provide benefits for one or more other members in the group. Intra-group services may take the form of management, administration, technical, support, purchasing, marketing, distribution and other commercial services provided in connection with the group’s business. Of the above forms of intra-group services, the most common are the management services for which a parent company or another company within the group charges a management fee, and the “shared services,” which include non-core or other support services that are centralized into and provided by a shared service center within the group. Under the guidelines, it is not enough that an arm’s-length fee is charged for these services. It is equally important to prove that the other party receiving the service has derived economic benefit from the service. Such benefit is derived by considering whether an independent party in similar circumstances would be willing to pay another independent party for the service or would just perform the services itself. There are also certain kinds of services that cannot be considered intra-group services because there is no economic benefit to the service recipient. These services include shareholder activities, duplicative services, those that provide incidental benefit, and on-call services. In such a case, such services do not justify a charge to the service recipient. Thus, the possible risk is a total disallowance or the downward adjustment of the service charge to the service recipient, insofar as it pertains to the excluded services, resulting in deficiency income tax from the additional income arising from a disallowed or lowered service fee. Given all these considerations, it is, therefore, important to revisit management and shared services agreements and the TP documentation itself. These agreements must be closely examined to ensure that the services described in the agreements fall within the category of intra-group services and not under the exclusions. The RAMO also provides procedures for identifying intangible assets in the conduct of functions, asset and risk (FAR) analysis of the parties to the related party transaction (RPT). Intangible assets are those that are neither physical nor financial assets. A higher profitability level than the average for the industry is a factor that may establish the existence of an intangible asset. It is not necessary that such intangibles be recorded as an asset in the balance sheet or registered with the Intellectual Property Office. Even costs or expenses incurred in connection with research and development and the marketing of a product may indicate the existence of an intangible asset. In transfer pricing, the existence of an intangible asset is an indication that the owner is engaged in high-value functions in its transaction with affiliates. In such a case, the owner of such an intangible asset should be compensated with more than a mere routine return for its functions. The owner must be remunerated at a higher return that will allow it to recover the costs incurred for the development of such an intangible asset. In addition, a company that owns an intangible asset cannot, in most cases, be selected as a comparable for a company that performs routine manufacturing or distribution functions. Thus, as part of the TP documentation, an analysis has to be made on whether a company, by the nature of its functions, owns such intangible assets. Finally, the RAMO also prescribes audit procedures on intra-group loan transactions. The two areas of focus are the arm’s-length nature of the debt-to-equity ratio and the reasonableness of the interest rate and other expenses for the intra-group loan transaction. In testing the interest payments, an analysis must be made of the need for the debt and the market conditions at the time the loan is extended. In determining the need for the debt, the level of debt held by the borrower of the affiliate should be considered. The debt-to-equity ratio of the borrower is also benchmarked against the debt and equity of similar companies, although the purpose for determining such ratio is unclear in the regulations. In other countries or jurisdictions, the debt-to-equity ratio is a factor that is taken into account in determining if a company is thinly capitalized, that is, whether the higher level of related-party debt than equity is intended to take advantage of the interest deductions that comes with financing with debt rather than with equity. Where a company is thinly capitalized, its interest deduction attributable to the higher debt-to-equity ratio may be disallowed. In the TP documentation covering the interest payments on intra-group loans, it is, therefore, important to establish what is an acceptable debt-to-equity ratio within the industry and to ensure that related-party debt is within the benchmarked ratio. Given the complexity of TP audits and the preparations being undertaken by the Bureau of Internal Revenue, it is now more vital than ever that companies consider the factors we presented when establishing a pricing policy for intra-group services, intangible assets and interest payment transactions. Companies with foresight will make advance work, prepare TP documentation or revisit an existing one, to be better positioned in managing risks brought on by a TP audit. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co. Reynante M. Marcelo is a Partner for International Tax and Transaction Services of SGV & Co.

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20 September 2019 Janice Joy M. Agati and Redgienald G. Radam

Preparing for the IBOR Transition part 1

(First of two parts) Financial markets globally are preparing the shift from referring to Interbank offered rates (IBORs) as a benchmark for financial products and services to alternative reference rates (ARRs). For decades now, IBORs have been the reference rates for variable-rate financial instruments with the London Inter-bank Offered Rate (Libor), the most widely used IBOR, underpinning trillions of dollars’ worth of financial contracts. Libor is referred to worldwide for many financial products — bonds, loans, derivatives, mortgage-backed securities, and others. It represents the average rate at which internationally active banks obtain funding from wholesale and unsecured markets. Libor is also used to gauge market expectations on central bank interest rates, liquidity premiums in the money markets, and even on the state of a banking system during periods of stress. In 2012, however, a group of banks was accused of manipulating their IBOR submissions during the financial crisis and a series of scandals ensued. In 2017, UK and US regulators simultaneously declared the uncertainty of the use of IBOR as a benchmark rate after 2021. Initiatives to reform the benchmark were made but actual transactions supporting Libor rates continued to dwindle and markets further questioned the integrity of the rates as a benchmark. Regulators proposed the solution to develop and adopt instead ARRs. These ARRs are believed to be more appropriate as reference rates as they are “near-risk free” and are based on actual transaction volumes. Regulators worldwide began laying down concrete policy steps for the transition. Relevant ARRs have been selected for major currencies with strategic transition plans to minimize market disruptions. The US Alternative Reference Rates Committee (ARRC), for example, has issued a 4-year timeline starting in 2018 for the transition from the US Libor to the Secured Overnight Financing Rate (SOFR). ARRs for other major currencies include the Reformed Sterling Overnight Index Average (SONIA) for GBP Libor, the Swiss Average Rate Overnight (SARON) for CHF Libor, and the Tokyo Overnight Average Rate (TONAR) for JPY Libor and JPY Tibor. As ARRs are selected and regulators provide for a transition procedure, financial institutions must assess early on the potential impact of the change of benchmark in order to re-assess their business strategies and make the uncertain, certain. As discussed in a recent EY publication titled End of an IBOR era, the top 10 challenges that banking, capital markets organizations, and other financial market participants will face in transition to the ARRs include: 1. Client outreach, repapering and negotiating contracts. Institutions should consider the necessity to re-negotiate existing contracts that will mature past 2021 based on the new reference rates. 2. High litigation, reputation and conduct risk. Spreads should be re-assessed based on the differences between the IBOR and the ARRs. 3. Market adoption and liquidity in ARR derivatives. The market must account for a transition in the adoption of ARR derivatives, thus affecting the liquidity in the market. 4. Absence of ARR term rates. As most ARRs will initially be an overnight rate, defining term rates for ARRs needs to be accelerated to facilitate the timely and smooth transition of cash products. 5. Differences in ARR and transition timelines across G5 currencies. There is also the need to harmonize the timing of the transition and publication of daily ARRs across the G5 currencies (dollar, euro, pound, Swiss Franc and yen) to address the impact on the FX swap markets. 6. Regulatory uncertainty. There is a need for regulatory guidance to be issued early on if only to allow markets to plan and work on their transition plans. 7. Operations and technology changes. As IBOR has already been embedded deeply in operational procedures and technological infrastructures, changes to systems may have to be planned early. 8. Valuation, model and risk management. A wide range of financial and risk models will have to be developed, recalibrated, and tested in order to incorporate the new reference rates. This poses a challenge given the lack of available historical time series data. 9. Accounting considerations. Financial institutions will need to review changes against accounting standards. 10. Libor may yet survive. The Financial Conduct Authority recently hinted at the potential use of synthetic Libor for existing contracts that may go beyond 2021. Additionally, the ICE Benchmark Administration also indicated the possibility that Libor may still be used for selected currencies and tenors. The lack of clarity and firm decision pose a challenge for institutions given the huge amount of “To Dos” needed to prepare the onset of year 2021. The Philippines should keep up with, if not be ahead of, these changes and prepare early as well. The domestic financial industry can see this as an opportunity to accelerate the Philippine Capital Market Agenda by establishing local reference rates. Regulatory guidance will play a crucial role at this point. Institutions also need to understand the structural differences between the IBOR and the ARRs and re-assess the impact to ensure their business models are abreast with the industry developments. In the next article, we will continue the discussion on expected IBOR transition, looking at some of the other business areas that institutions should start re-assessing, such as operations, risk management and regulatory frameworks, accounting and procedures that companies can adopt to ensure an efficient and effective transition. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co. Janice Joy M. Agati and Redgienald G. Radam are Senior Directors from SGV & Co.’s Financial Service Organization service line.

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18 September 2019 Janice Joy M. Agati and Redgienald G. Radam

Preparing for the IBOR Part 2

(Second of two parts) In the first part of this article, we highlighted the current state of Interbank Offered Rates (IBORs), the factors behind the shift from IBORs to Alternate Reference Rates (ARRs), and the top 10 challenges to be faced in transitioning to the ARRs. In this second part, we will delve into the key operational, financial and accounting considerations that come along with the imminent discontinuation of IBORs. It is expected that the broad impact of transitioning to ARRs will be felt not just by banking and capital market organizations, but also by corporates with significant exposures to IBOR-linked instruments. This impact will cut across various functions within an organization, including treasury, legal, finance and risk. Given this, it is imperative for market participants to quickly assess the cross-functional implications of the transition to their businesses and clients. Having an awareness of these implications early on will help an organization plan for an efficient transition. Here are some of the key considerations for organizations before the IBOR reform is implemented: Determining your exposure to IBOR — Developing a detailed inventory of IBOR-linked products and contracts will be cumbersome for many organizations with existing financial contracts that are not digitized. The organization will have to ensure that relevant contract terms, including any fallback provision, are captured so that all legal and financial risks are determined. Contract renegotiations — IBOR-linked products and contracts may need to be modified and renegotiated. While the International Swaps and Derivates Association provides protocols to facilitate amendments to contracts between counterparties, having a huge number of derivative contracts to be amended can be a tedious task. For cash products, the renegotiation may be more burdensome due to the non-standard nature of most of the contracts. Multilateral negotiations will also be required for bonds, syndicated loans and other securitized products. It will also be necessary to establish governance processes and controls to avoid any financial, legal and operational risks. Impact on IT systems and infrastructure — The shift to ARRs will require changes to various platforms (e.g., valuation, trading and risk management systems) within the organization’s IT systems. Recalibration or redevelopment of models — Organizations need to build an inventory of all its pricing, valuation and risk models that use IBORs as an input and assess the need for recalibration or redevelopment. Any change in the models will also impact the front (in terms of pricing strategy and new product offerings) and back-office processes of the treasury function and will warrant an update of the organization’s risk management strategy. Accounting and hedging — The transition to IBOR will have a significant impact on various aspects of accounting, more notably on the application of hedge accounting and derecognition assessment for any contract modification due to changes in reference rates. Although amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments are underway to address some problematic hedge accounting issues pre-IBOR transition, financial reporting issues post-IBOR transition are still to be dealt with by the International Accounting Standards Board (IASB). The pre-IBOR transition issues covered by the proposed amendments to IAS 39 and IFRS 9 relate to the assessment of the probability of the hedged forecasted IBOR cash flows occurring, assessment of effectiveness of hedging relationships and the immediate release of any amount lodged in equity to profit or loss if hedged IBOR cash flows will no longer occur. WHAT ORGANIZATIONS SHOULD START DOING NOW Given the various considerations discussed above and the impending completion of the IBOR reform by local jurisdictions, there is a need for organizations to plan and prepare for a smooth transition to ARRs. As discussed in a recent EY publication titled How will you respond to IBOR transition ($FILE/EY-end-of-an-ibor-era.pdf), organizations must establish an IBOR transition program as a necessary foundation upon which they can plan their transition strategy and implementation programs. Here are recommended steps in establishing an IBOR transition program according to the EY report: Assemble a broad-based IBOR transition team — Mobilize a formal IBOR transition program team with a strong governance framework and senior leadership appointed to oversee and report progress to relevant executive committees and the board. This program team should be cross-functional in nature, with business leaders represented from inception. Conduct a comprehensive impact assessment — The impact assessment should cover all areas of the business that are exposed to IBOR. This would include: (1) product assessment — categorize and quantify financial IBOR exposure by various parameters, including maturity, optionality, counterparty, client segment, business and jurisdiction; (2) legal contract assessment — extract and analyze the contractual language of the impacted products with a priority on positions that are due to mature beyond 2021; (3) risk assessment — analyze the potential impacts of transitioning to ARRs on the risk profile and financial resources of your organization; (4) operational assessment — identify impacted areas, including systems, models and processes that are linked to current IBORs; and (5) inventory management — establish and maintain an inventory of products and contracts linked to IBORs across jurisdictions. Develop a transition roadmap — A comprehensive implementation roadmap is needed for prioritized initiatives, including key workstreams, projects, milestones and ownership. A strategy for educating and communicating with both internal and external stakeholders should also be addressed, including clients, technology vendors, regulators and industry bodies. Launch the formal IBOR transition program — Publish a multi-year enterprise-wide transition program, including a program charter, a stakeholder map and resourcing requirements. As the pace of IBOR transition picks up, complacency will be detrimental to organizations with significant exposure to IBORs. Considering the complexity and wide-ranging scope of the transition, these organizations should initiate steps to prepare and make the most out of this exercise. A “wait and see” approach to implementation will not work with the overwhelming challenges that are expected to emerge when the IBOR is discontinued. At this point, an organization that can get ahead of the curve will have the advantage of identifying early market opportunities with the new ARRs. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co. Janice Joy M. Agati and Redgienald G. Radam are Senior Directors from SGV & Co.’s Financial Service Organization service line.

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02 September 2019 Cecille S. Visto

Redefining corporate rules Part 2

Second of two parts In the first part of this article, we covered Republic Act 112321 or the Revised Corporation Code of the Philippines (RCC), which redefined the corporate rules to promote ease and flexibility in doing business, as well as take full advantage of technological innovation. We also discussed the first two key provisions in the RCC, which make it relevant for the changing global business landscape. These were: (1) the relaxation of the minimum number of incorporators, and the residency requirement for incorporators and directors; and (2) the introduction of the One-Person Corporation (OPC). We will now continue with the other provisions in the RCC which are considered by many as significant changes highly beneficial to the Philippine business community. ALLOWING PERPETUAL EXISTENCE AND REVIVAL OF CORPORATIONS Under the old rules, the maximum corporate term is 50 years, unless extended for a maximum of 50 years (or sooner dissolved). The RCC, however, now allows companies to exist in perpetuity, unless majority of the stockholders elect to retain its specific term pursuant to the Articles of Incorporation (AoI). Corporations with expired terms may also be revived under the RCC. The revival applies to their corporate existence, all their rights and privileges under the certificate of incorporation, and their existing duties and liabilities prior to the revival. Certain types of companies, such as banks, pre-need and insurance, pawnshops and other financial intermediaries need favorable recommendation from the appropriate government agency for the revival. While the RCC does not provide any exception to the revival of a corporation whose corporate life has expired, it appears that the SEC proposes to exclude the benefit of revival to corporations whose registration were revoked for reasons or causes other than the non-filing of reports. Based on the draft rules on revival of corporations that the SEC has circulated, the regulatory body clarified that the revival applies only to corporations with expired terms, not to those whose registrations have been revoked due to fraud or continuous inoperation. We hope that the final regulations will specifically address issues on corporate revival to erase any doubt on the ability of corporations whose registrations have been revoked to avail of the benefit of revival under the RCC. INTRODUCING MEANS FOR DISPUTE RESOLUTION AND EMERGENCY ACTION Intra-corporate disputes are inevitable but the RCC provides stop-gap measures to minimize, if not totally prevent, long-drawn intra-corporate disputes in court. Companies now have the option to include an arbitration clause in the AoI. Arbitration is an option to resolve issues between the corporation and its stockholders arising from the implementation of AoI or By-Laws or from intra-corporate relations. With this new provision, all controversies can be referred to arbitration. However, the SEC still needs to formulate the governing rules, including the organization of an arbitral board. The board of directors has also been given the prerogative to constitute an emergency board to undertake any emergency action sought to prevent grave damage to the corporation. Vacancy in the board may be filled temporarily when the vacancy prevents the remaining directors from constituting a quorum and the remaining directors voted unanimously. The action of the temporary director shall be limited to the emergency action necessary and his or her term shall cease within a reasonable time from the termination of the emergency or upon the election of the replacement director. The SEC is expected to clarify in a separate issuance what may constitute grave, substantial, and irreparable loss or damage to the corporation that will necessitate the appointment of an emergency board. TAKING ADVANTAGE OF TECHNOLOGY From filings to notices to attendance in board meetings and voting, the law takes full cognizance of advances in technology. AoIs and their amendments may now be filed electronically, fortifying the already established Company Registration System of the SEC. The RCC allows written notices to be sent to regular stockholders through e-mail or such other means that the SEC will allow under its guidelines. A corporation may also specify in its By-Laws the manner of communication through notices of meetings are sent, including the extension or shortening of corporate term, increase or decrease of capital stock, and sale or other disposition of assets. Notably, shareholders may vote through any forms of remote communication such as videoconferencing or teleconferencing using available systems and computer applications or even in absentia. Voting in absentia may be done using any electronic voting platform that may be established. Similarly, directors can remotely participate in meetings, provided they are given reasonable opportunities to participate. In corporations vested with public interest, stockholders entitled to elect directors may do so either in absentia or remotely, even without specific provisions in the By-Laws authorizing such voting. THE FUTURE OF THE BUSINESS LANDSCAPE Aside from the ease of doing business, the RCC seeks to address various reform clusters, such as prioritizing corporate and stockholder protection, instilling corporate and civic responsibility, and strengthening the country’s policy and regulatory corporate framework. As the law is new and regulations have yet to be fully formulated, the role of the SEC will be crucial in its proper implementation. The SEC has already informed registered companies that it will come up with piecemeal rules implementing the provisions of the RCC in lieu of consolidated guidelines. The passage of the law brings much optimism and rightfully so. However, only time can tell how the RCC will be able to transform the business landscape in the short term and the whole economy in the years to come. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co. Cecille S. Visto is a Tax Senior Director of SGV & Co.

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