Transfer Pricing Spotlight: Cryptocurrency
By Farnaz Amini, Director, Tax & Business Services
2023 saw significant regulatory advancements in the cryptocurrency industry. These advancements signal the need for greater reporting requirements for all companies operating in the crypto space. Given the U.S. and international regulatory requirements, multinational enterprises (MNEs), such as global crypto exchanges, are organized across various jurisdictions. The cross-border nature of typical transactions, such as management and research and development (R&D) services, makes transfer pricing analyses 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 and the ban on cryptocurrency mining operations in China. The market drop in 2022 triggered the collapse of FTX. In response to the Chinese crackdown, mining operations were significantly reduced, with only 25 percent of mining operations active in the Chinese shadow economy. Currently, 65 percent of mining operations are located in the U.S. due to factors such as lower levels of political risk, appropriate climate, a cheap and reliable power grid, and access to renewable energy sources. Consequently, the U.S. has become a top destination for relocated and new mining operations.
On the other hand, these companies must now plan on managing the tax implications of a U.S.-based business. Although the U.S. 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 allocations of cryptocurrency in the U.S. jurisdiction and opt for developing an international structure with intercompany arrangements that allow for the mining of cryptocurrency in the U.S. while the allocation of crypto rewards a foreign parent.
To achieve efficient business and tax structures, multinational players can develop an intercompany value chain that allows for the compensation of value drivers consistent with the functions performed, assets used, and risks borne.
Considering the increased scrutiny on cryptocurrencies, being proactive and preparing a transfer pricing study can serve as a defense against an IRS transfer pricing audit.
One of the primary challenges facing cannabis businesses in the U.S. is the lack of federal legalization, resulting in state-level regulations that vary widely. Internal Revenue Code (IRC) Section 280E1 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 disallows deductions for marketing, advertising, 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 (COGS), or the adjusted basis in the inventory sold, is reduced from the business income. Consequently, many cannabis companies have become vertically integrated so they can better control the costs of the supply chain and the outlet of sale to the end consumer. The motivation is to increase the COGS for the resale or retail side to maximize deductions.
However, reallocating costs in this manner can run afoul of U.S. transfer pricing rules, which require 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 in the near future. 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 affecting Cannabis companies. Again, being proactive and preparing a transfer pricing study is the best audit defense.
- 26 U.S. Code § 280E – Expenditures in connection with the illegal sale of drugs