Is Your Hedge Program at Risk Due to OECD’s BEPS Action Program?
Cost-plus tax strategies are under fire. And in Australia they may be faced with extinction. What might that mean for your hedge program? The impact will depend on your current structure and hedge program.
If you have a USD functional entity (e.g., Singapore) that “owns” the AUD revenues and pays the Australian entity a cost-plus reimbursement, there could be big changes coming soon – in fact, the change might be effective retrospectively to the start of this year. This may, in turn, mean that all of your buy-forward contracts hedging AUD costs could be associated with “remote” of occurring activity (loss of hedge accounting and recording of P&L impacts). And as the USD functional entity replaces AUD third-party revenue with intercompany transfer price sales to the Australian subsidiary, the hedging entity might find itself overhedged (notionals may exceed interco revenues), or worse, the exposure may not be adequately covered in the designated hedge definition – potentially causing a loss of special hedge accounting.
How did this happen? For the past three years, the Organisation for Economic Co-operation and Development (OECD) has been studying base erosion and profit shifting (BEPS). This hot-button tax topic has not been hitting the radar screen in many treasury organizations … and the ramifications may devastate existing hedge programs.
The BEPS project is a wide-ranging and far-reaching effort to, in OECD’s words, give “countries the tools they need to ensure that profits are taxed where economic activities generating the profits are performed, and where value is created.” Again, per OECD, “estimates conservatively indicate annual losses of anywhere from 4-10% of global corporate income tax (CIT) revenues, i.e., USD 100-240 billion annually.”
The BEPS project also seems to be addressing the financial reporting optics of countries’ GDP (Gross Domestic Product) reporting. In a cost-plus scenario, a country reports GDP on the cost-plus revenues it receives (the amount they spend locally on expenses plus a profit margin). These same countries historically reported GDP on the revenue for the goods/services provided in GDP. So in the move to the cost-plus tax structure, the GDP of Australia, for example, drops from the revenue value of goods and services sold in Australia to the local costs of delivering those services plus a small spread.
Meanwhile, the GDP of the country where the tax entity that owns the revenue is domiciled balloons to include all the revenue generated in Australia. As you imagine, the politicians are having difficulties explaining to their constituents that Australia’s economy is vital and growing when their GDP reporting is tanking. Add the drop in commodity pricing over the past year and the political pressure is on the Australian Taxation Office.
While we do not offer an opinion on BEPS or the ATO’s actions to combat it, the fact remains that recent happenings could have dramatic effects on your cash flow hedge program, with AUD hedges being the first victims.
What are the action items for Treasury? If you’re not hedging AUD, take this as a warning and revisit your hedge program in conjunction with your tax department or advisors. If your cost-plus strategies are at risk, consider that in your required probability assessment for current hedges at period end and consider the impact before implementing future hedges. Consider hedging lesser amounts of revenue (reflecting a possible transfer price) and defining the exposures as “third-party or intercompany” revenues. If you do hedge AUD for an entity that is not Australian yet owns AUD revenues, run, don’t walk, over to tax, understand what BEPS means for your company and effective when, then start taking remediation actions immediately.
As always, if you need a hand, we’re happy to help. Contact Hedge Trackers today, or call us at 408-350-8580.