Multinationals Beware: The Surge in Transfer Pricing Regulations and Enhanced IRS Oversight
As the dust settles on a post-pandemic world, 2023 reveals a landscape where economic certainties have been upended, with ripples of recessionary forces challenging nations’ fiscal policies and regulations. Chief among these challenges is the field of transfer pricing, as multinationals grapple with an evolving regulatory environment. Transparency and reporting emerge as vital tools as governments seek to safeguard their tax bases amid inflationary pressures and dwindling revenues.
2023 has also been a substantive year in pushing forward the OECD’s Pillar One and Pillar Two initiatives.1 Although these initiatives are focused on large multinational entities engaged in significant digital commerce, there is a general awareness that local government regulations on this matter are likely, which will most likely impact mid-market multinationals as well.
It is not surprising that during 2023, Transfer pricing remained a top tax concern for multinational entities (MNEs), not only because it can result in multimillion-dollar adjustments but also because of its complexity. In 2022, the Internal Revenue Service (IRS) received funding to hire approximately 87,000 new IRS agents to support its review and enforcement objectives. In April 2023, the IRS issued an ambitious strategic operating plan for spending $80 billion in additional funding provided by the Inflation Reduction Act.2
During a conference in May 2023, the acting deputy commissioner of the IRS, Jennifer Best, stated that transfer pricing fits within the stated goals of the IRS and now has the funding for the right data analytics tools and the ability to hire specialized staff to increase the scope of transfer pricing reviews.3 Half of the additional $80 billion in funding for the IRS is expected to be dedicated to compliance enforcement, specifically focusing on MNEs’ transfer pricing activity. Internal sources at the IRS confirmed that additional resources would be used to expand the capabilities of the Large Business and International division (LB&I) to bring advanced data analysis technology to enhance and accelerate their risk assessment process. The recent investments in the IRS will enhance their enforcement capacity in the shorter term, which is of particular concern for middle-market multinationals. Large multinationals have always faced a greater risk of transfer pricing audits than middle-market multinationals. However, a better-equipped IRS during recessionary times expands the net of transfer pricing audits to include middle-market multinationals engaged in high-risk intercompany arrangements. Such arrangements include financial transactions involving the transfer/sale of intellectual property, among others.
In particular, middle-market multinationals operating in the cryptocurrency and cannabis industries or similar sectors must navigate constantly changing regulatory environments, which can have real and significant effects on how intercompany arrangements must be structured to comply with the regulations and ensure the optimization of the intercompany transaction flows.
In all cross-border transactions, there are at least two tax administrations with an interest in ensuring an arm’s length allocation of income and expenses to the respective jurisdictions. Consequently, in addition to the US transfer pricing regulations, rising multinationals must consider the transfer pricing regulations in all jurisdictions they operate. Developing a harmonized transfer pricing regime that considers US transfer pricing regulations, the 2022 OECD Transfer Pricing Guidelines, and applicable local requirements is necessary to meet the compliance requirements and implement an optimized structure that allows the group to benefit from the tax attributes in each jurisdiction.
Relevant Legislative Updates
On March 9, 2023, the Biden Administration released the Fiscal Year 2024 Budget and the “General Explanations of the Administration’s Fiscal Year 2024 Revenue Proposals,” commonly called the “Green Book.” The Green Book summarizes the Administration’s tax proposals contained in the Budget. The Green Book is not proposed legislation, and each of the recommendations will have to be introduced and passed by Congress. The main issues as they relate to international tax and transfer pricing are further discussed below.4
- The Budget includes an increase to the rate corporations pay in taxes on their profits. Corporations received an enormous tax break in 2017, cutting effective U.S. tax rates for U.S. corporations to a low of less than 10 percent. The Budget would set the corporate tax rate at 28 percent, still well below the 35 percent rate that prevailed before the 2017 tax law. This tax rate change is complemented by other proposals to incentivize job creation and investment in the United States and ensure large corporations pay their fair share.
- The Budget Stops the Race to the Bottom in International Corporate Tax and End Tax Breaks for Offshoring. For decades, countries have competed for multinational business by slashing tax rates at the expense of having adequate revenues to finance core services. More than 130 nations signed on to a global tax framework to finally address this race to the bottom. Building on that framework, the Budget proposes to reform the international tax system to reduce the incentives to book profits in low-tax jurisdictions, stop corporate inversions to tax havens, and raise the tax rate on U.S. multinationals’ foreign earnings from 10.5 percent to 21 percent. These reforms will ensure that profitable multinational corporations pay their fair share.
Beginning in 2024, Malta and the United Arab Emirates (“UAE”) will implement adopted transfer pricing legislation. Neither of these jurisdictions historically has had transfer pricing rules.
On November 18, 2022, Malta published legislation implementing formal transfer pricing rules. The rules will take effect on January 1, 2024, and will apply to arrangements that are between related parties and are cross-border in nature, in the sense that they take place between a resident company and a non-resident company or are effectively connected to a permanent establishment (PE) of a company outside of Malta and a resident company in Malta.
Per the new rules, the threshold for the transfer pricing requirements to apply is EUR 6 million in revenue and EUR 20 million in capital measured in the preceding financial year. The rules contain a carve-out for securitization transactions.
The introduction of transfer pricing rules means that entities with cross-border transactions that meet the defined thresholds will, from January 2024, have to comply with the arm’s length principle by demonstrating that such transactions generate income and expenses unrelated parties would generate under similar circumstances. In other words, related-party transactions must lead to arm’s length market prices. Transactions that fail to meet the arm’s length principle are not compliant and face potential adjustments and penalties.
United Arab Emirates (UAE)
On December 9, 2022, the UAE Ministry of Finance released the Federal Decree-Law No. 47 of 2022 on the taxation of corporations and businesses. It updated the related “frequently asked questions” (“FAQs”) section, which includes new transfer pricing rules as described below.
The law calls for introducing a corporate tax on businesses operating in the UAE for tax years starting on or after June 1, 2023. The law defines taxable persons and confirms that a UAE branch of a UAE taxable person should be treated as one taxable person (i.e., a single tax registration and return). Certain businesses and certain types of income may be exempt from corporate tax.
The law prescribes two rates of corporate tax:
- 0% for income below certain thresholds
- 9% above this taxable threshold
- 0% on qualifying income of free zone entities
All businesses will need to comply with the transfer pricing regulations set out in the Corporate Tax Law.5 Transfer pricing rules apply to UAE businesses that have transactions with related parties and connected persons, irrespective of whether the parties or connected persons are located in the UAE mainland, a Free Zone, or a foreign jurisdiction.
A taxable person will need to maintain a master file and a local file if either:
- Entity revenue in the relevant tax period is AED 200 million or more.
- The entity is part of an MNE group with a total consolidated group revenue of AED 3.15 billion or more in each financial period.
Brazil’s Alignment with the OECD Transfer Pricing Guidelines
As of June 15, 2023, Brazil’s legacy transfer pricing rules were replaced with ones drawn from the OECD Transfer Pricing Guidelines. Adopting the OECD-based rules will be mandatory as of January 1, 2024. However, Brazilian taxpayers can opt to apply the new rules as of January 1, 2023.
Implementing the new rules will significantly impact the tax environment of the largest economy of the Latin American (“LATAM”) region. The alignment of the transfer pricing rules with the OECD Transfer Pricing Guidelines may alleviate concerns with issues such as double taxation while promoting Brazil’s economic growth through more efficient integration into global value chains, thereby enhancing trade with and investment in the country.
Adopting the new transfer pricing rules will significantly impact taxpayers’ ability to claim foreign tax credits in the US for income taxes paid in Brazil.
US Foreign Tax Credit (FTC) final regulations, released on December 28, 2021, implemented a new attribution requirement to the “net gain” condition for determining whether a foreign tax is creditable in the United States. In case of foreign tax imposed on residents of a jurisdiction, the FTC regulations establish that a foreign tax will meet the attribution requirement solely when the allocation rules are followed in said tax jurisdiction and are consistent with the arm’s length principle (“ALP”) as stated in US transfer pricing regulations and OECD Transfer Pricing Guidelines.
In 2023, Canada’s Department of Finance released a consultation paper and accompanying legislative proposals that include changes to the Canadian transfer pricing rules, including amendments to the transfer pricing adjustment rule and possible revisions to certain administrative practices.
The consultation paper, which includes a series of questions for public comment, emphasizes that these proposals aim to clarify the technical aspects of applying the arm’s length principle and better align the Canadian transfer pricing rules with international standards and transfer pricing guidance published by the OECD.
Mexico has introduced new transfer pricing regulations, including significant changes to certain technical matters for taxpayers to consider when conducting a transfer pricing analysis.
- Article 76 (Section IX) of the Mexican Income Tax Law (“MITL”) requires taxpayers to include in their transfer pricing documentation all cross-border and domestic intercompany transactions.
- As part of the functional analysis process, taxpayers must perform an analysis on a “dual basis,” meaning that the functions, assets, and risks of the entity that records the income and the counterparty that books the expense must be fully described in the report.
- Taxpayers must file their transfer pricing information tax return (referred to as “DIM’s Appendix 9”) no later than May 15 of the following fiscal year.
- Taxpayers must file the Local File return by May 15 of the following fiscal year.
- Article 179 of the MITL clarifies that corporations and individuals must rely on the arm’s length principle when pricing-controlled transactions.
In 2023, the Netherlands adopted a new transfer pricing decree, including new guidance on financial services companies. The goal is to align the Dutch more closely with the OECD transfer pricing guidelines on financial transactions.6
2023 was a significant year for regulatory advancements in the cryptocurrency (“crypto”) industry. These advancements signal the need for greater reporting requirements for all companies operating in the crypto space. Given the US and international regulatory requirements, MNEs, such as global crypto exchanges, are organized across various jurisdictions. Given the cross-border nature of typical transactions such as management and research and development (“R&D”) services, transfer pricing analyses are critical to ensuring compliance with local requirements and optimizing intercompany transactions.
In recent years, cryptocurrency mining operations have experienced significant volatility related to the effects of the global pandemic, the ban of cryptocurrency mining operations in China since 2020, and the market drop of 2022 emanating from the collapse of FTX.
In response to the Chinese government’s crackdown on the crypto mining industry, operations have reduced significantly, with only 25 percent of mining operations active in the Chinese shadow economy. Currently, 65 percent of crypto mining operations are located in the US due to factors such as lower levels of political risk, appropriate climate, cheap and reliable power grid, as well as access to renewable energy sources. The US has become a top destination for relocated and new mining operations. On the other hand, these companies must now plan on managing the US tax implications. Although the US provides a suitable location for mining, it imposes significant taxes on realized cryptocurrencies, such as Bitcoin. As such, many cryptocurrency mining groups are not incentivized to receive cryptocurrency allocations in the US jurisdiction and opt for developing an international structure with intercompany arrangements that allow for cryptocurrency mining in the US and distributing crypto rewards to the foreign parent.
Multinational cryptocurrency industry players can achieve efficient business and tax structures by developing an intercompany value chain that allows for the compensation of value drivers consistent with the functions performed, assets used, and risks borne.
Given the regulatory microscope on cryptocurrencies, the best defense against an IRS transfer pricing audit is to become more proactive and prepare a transfer pricing study that can be used as an audit defense.
One of the primary challenges facing cannabis businesses is the lack of federal legalization in the US, which has led to different state-level regulations that can vary widely. Internal Revenue Code (“IRC”) Section 280E7 states,
No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.”
This treatment disallows marketing and advertising costs, selling expenses, research and development costs, and other general and administrative expenses unrelated to production or manufacturing operations. This means that only the cost of goods sold, or the adjusted basis in the inventory sold, is reduced from the business income. Consequently, many cannabis companies have become vertically integrated to better control the supply chain costs and the outlet of sale to the end consumer. The motivation is to increase the cost of goods sold for the resale or retail side to maximize deductions.
At times, the reallocation of costs can run afoul of the US transfer pricing rules, as it requires a clear reflection of income under the arm’s-length standard. The cannabis industry faces a difficult struggle, and it is unlikely that these strenuous tax provisions will change significantly soon. Further, with the infusion of funding to the IRS via the passing of the Inflation Reduction Act, we will more than likely witness an increase in audit activity for Cannabis companies. The best defense against an IRS transfer pricing audit is to become more proactive and prepare a transfer pricing study, which can be used as an audit defense.
BEPS 2.0: Pillar I And II Updates
Building on the OECD’s Base Erosion and Profit Shifting (“BEPS”) plan, in 2019, the OECD launched a two-pillar solution to the tax challenges arising from the digitalization of the economy aimed at modernizing international tax systems. This initiative, referred to as BEPS 2.0, consists of two pillars:
- Pillar I proposes a new taxing right for the digital economy. It could allocate a percentage of large and highly profitable MNEs’ residual profits to end users or customers’ jurisdictions where they have generated significant sales and may not have a traditional taxing presence. This solution considers two parts: Amount A is calculated by applying a formula to an MNE’s global profits that meet certain revenue thresholds. Amount B provides a simplified and streamlined approach to using the arm’s length principle for in-country baseline marketing and distribution activities.
- Pillar II proposes a minimum global corporate tax to MNEs with profits in each country or jurisdiction subject to an effective tax rate lower than the minimum rate. In that case, those profits will be taxed at a minimum rate of 15%.
It is important to note that Pillar I and Pillar II provisions apply to MNEs with global revenues greater than EUR 20 billion and EUR 750 million. However, this does not mean these initiatives do not have trickle-down effects for smaller and middle-market MNEs. Once Pillar I and Pillar II provisions are finalized, it is anticipated that many countries will adopt modified rules for companies engaged primarily in the digital economy.
The most recent public consultation on Pillar 1, launched in July 2023, provides a framework for the simplified and streamlined application of transfer pricing rules to specific marketing and distribution activities under Amount B while proposing two options for the scoping criteria of Amount B. The OECD has announced that the final agreements on Amount B intended by the end of 2023 will be a key content to be incorporated into the OECD Transfer Pricing Guidelines by January 2024.
The latest guidance on Pillar 2 addresses, amongst other subjects, the treatment of tax credits and a transitional undertaxed profit rule (“UTPR”) safe harbor, which are considered to be the most relevant measures affecting U.S. MNEs.8 Although the United States is not anticipating implementing the GloBE rules any time soon, the adoption by important trade partner countries will impact U.S. MNEs operating in those countries.
Transfer Pricing Dispute Resolution Updates
Dispute Resolution Alternatives
Transfer pricing disputes are on the rise due to tax policy and administration developments around the world. The number of audits and the aggressiveness of tax authorities, particularly in the United States, have surged. These tax controversies provoking double taxation are not only costly, time-consuming, and disruptive but can also have a significant impact on MNEs’ performance. More than ever, transfer pricing is considered a leading tax audit concern.
Advanced Price Agreements (APAs) have been the tool available to MNEs to increase transfer pricing certainty. The OECD recently established a new program to assist MNEs in managing transfer pricing risk under the International Compliance Assurance Program (ICAP). Similarly to APAs, ICAP is a voluntary program intended to help MNEs manage transfer pricing risks proactively.
New APA Filling Procedures in the US
In April 2023, the Director of the IRS Treaty and Transfer Pricing Operations (“TPPO”) issued to the division employees a memorandum titled “Interim Guidance on Review and Acceptance of Advance Pricing Agreement (APA) Submissions.” This memorandum details a new process in which taxpayers may engage before filing for an APA, which can be time-consuming and costly. Under this new approach, the IRS will review the taxpayer’s APA request and, based on the review, will recommend the taxpayer to either move forward with applying for the APA or suggest alternative solutions, including the International Compliance Assurance Programme (“ICAP”) or joint audit procedures. The IRS is expected to soon release the highly anticipated revised APA revenue procedure.
ICAP Alternative to an APA Procedure
The OECD ICAP was launched as a voluntary risk assessment and assurance program that helps MNEs obtain increased certainty over their transfer pricing and other international tax issues. The first roll-out of ICAP was announced in December 2020, following two pilots initiated in 2018 and 2019.
OECD ICAP’s primary goals include being a faster and clearer route to multilateral tax certainty for MNEs and an effective and collaborative alternative to dispute resolution to reduce the inventory of Mutually Agreed Procedure (“MAP”) cases. It also aspires to prevent unnecessary tax disputes while using tax authority resources efficiently.
The IRS showed its support for this alternative option soon after the OECD adopted the ICAP alternative. The IRS provided additional guidance recommending that taxpayers start with an initial consultation before submitting the application package, which typically includes the MNE Group’s most recent country-by-country report (“CbCR”), master file, transfer pricing reports, and financial statements. The IRS will review all transfer pricing transactions in which the United States is a counterparty, even if the jurisdiction in which the counterparty is located is not participating in the ICAP.9
In general, “the IRS anticipates that the learnings from ICAP will facilitate more efficient dispute resolution processes outside of ICAP.”
2023 Case Law Update
3M v. Commissioner
On February 9, 2023, the Tax Court provided its ruling in the transfer pricing case between 3M and the IRS, with the IRS emerging victorious. The primary issue centered on a 2006 Brazilian industrial property law that prevented the payment of select royalties by a Brazilian subsidiary of 3M to its US parent. As a result, the IRS determined that 3M in Brazil made an underpayment of royalties to its US parent. The IRS determined that the royalty payment should be increased by USD 23.65 million to become consistent with the arm’s length standard. The adjustment determined by the IRS did not reflect the legal restrictions borne by 3M in Brazil. Given the size of the adjustment and the presence of local legal regulations, it is anticipated that this decision will be appealed to the US Court of Appeals for the Eighth Circuit.
Argentinian Customs Authority v. Materia Pampa S.A.
The Argentinian Tax Court confirmed the transfer pricing adjustment conducted by the Customs Authority to the Argentinian company Materia Pampa S.A. In this case, the Customs Authority challenged the triangulation scheme used by the Argentinian company under which it exported products to a Brazilian company, Companhia De Bedidas Das Americas in Brazil (Ambev), via a related party located in Uruguay, Maltería Uruguay S.A. The Argentinean taxpayer failed to explain the economic reasons behind the significant differences between the price declared on exports to Uruguay and the price used for the subsequent final shipment to Brazil. The Customs Authority applied the ALP to redetermine export prices between related parties. This case illustrates the interplay between customs valuation and transfer pricing.
Commodity trading is an important economic activity for several countries in the world, to the extent that the BEPS Action 10 dealing with high-risk transactions included a deliverable dedicated to cross-border commodities transactions whose recommendations were incorporated into the OECD Guidelines.
While all these recent changes in the tax environment introduce new complexity to transfer pricing, they also create international tax and transfer pricing planning opportunities. Now is the time for large MNEs, as well as small and mid-sized MNEs, to take a fresh look at their transfer pricing policies and to identify new opportunities to maximize deductibility further and reduce global effective tax rates.
Marcum offers a full range of assurance, tax, and advisory services to clients operating businesses abroad who seek financing in the U.S. markets. From international business structuring to complex tax and transfer pricing matters, our professionals bring the Marcum standard of best-in-class service and a depth of knowledge to the international arena. Marcum’s International Tax Services group provides a broad range of international tax services to both domestic and foreign clients with global operations. Our international tax team has extensive experience in tax planning, cross-border transactions, and international tax compliance. Likewise, Marcum’s International Tax Services Group has the technical knowledge and skill to assist in transfer pricing support for clients, including planning, preparation of documentation to confirm with IRS and OECD requirements, and assistance in defending tax return positions in the event of a tax audit.
- Pillar one (Pillar I) establishes new nexus and profit allocation rules for large multinational enterprises meeting certain revenue and profitability thresholds. Pillar two (Pillar II) establishes mechanisms to ensure large multinationals pay a minimum 15% tax.
- In August 2022, President Biden signed into law the Inflation Reduction Act of 2022 (the Act), which addressed climate change, healthcare, inflation, and taxes. The Act applied a 15% minimum tax on corporations with over $1 billion in revenue; a 1% excise tax on corporate share buybacks; and about $80 billion of additional funding over 10 years for the Internal Revenue Service (IRS). Changes introduced were applicable to taxable years beginning after 2022
- Gottlieb, Isabel. 2023. IRS to Boost Transfer Pricing Focus with some of its new funding. 18 May. https://www.bloomberglaw.com/product/tax/bloombergtaxnews/daily-tax-report-international/X819M840000000?bna_news_filter=daily-tax-report-international#jcite
- Chapter X of the OECD Transfer Pricing Guidelines.
- 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs
- The latest guidance of July 2023 covers: 1. Additional administrative guidelines on: i. Currency Conversion Rules; ii. Tax Credits; iii. Substance Base Income Exclusion (SBIE); iv. Qualifying Domestic Minimum Top-up Tax (QDMTT); v. QDMTT Safe Harbor and vi. Transitional UTPR Safe Harbor; 2. GloBE Information Return; 3. Subject to Tax Rules (STTR) and 4. Implementation Support Measures.
- Excludes transactions that are a part of pending APAs and completed bilateral APAs.