Transfer Pricing Update
Transfer pricing continues to be one of the leading topics in the tax world. Tax jurisdictions everywhere are looking to increase revenues. Changes brought about by U.S. tax reform and the Organization for Economic Co-operation and Development (OECD) are being addressed in various foreign jurisdictions by the enactment of lower, competitive tax rates and the implementation of the Base Erosion and Profit Shifting (BEPS) Action items, specifically, Country-by-Country reporting and the requirement of a transfer pricing master file and local file. Further, the catastrophic impact of the global COVID-19 pandemic will continue to have serious implications for many multinational groups’ (MNEs) transfer prices, and taxing authorities will be looking for more ways to increase the deficit in tax revenue.
TRANSFER PRICING UNDER U.S. TAX REFORM
The Tax Cuts and Jobs Act of 2017 (“TCJA”) continues to have both direct and indirect effects on global inter-company transactions. Several aspects of TCJA upended the way in which MNEs evaluate tax structuring and transfer pricing.
- Corporate tax rate reduction. One of the main purposes of the reduction in the corporate tax rate was to make the U.S. competitive with foreign jurisdictions that offer lower tax rates and other tax incentives. The reduction in the tax rate from 35%, formerly one of the highest global tax rates, to 21% encouraged MNEs to re-evaluate the location of business activities, including the location of valuable intellectual property (IP) and services such as research and development. While some countries already had low tax rates at the time of TCJA enactment, other higher taxed countries lowered their tax rates in response to the U.S. 21% rate.
- Global Intangible Low Taxed Income (“GILTI”). The GILTI applies to controlled foreign corporation (CFC) income that exceeds a 10% return on tangible assets of CFCs. This tax only applies to CFCs and presents a new stand-alone anti-deferral regime. It applies in addition to the existing subpart F regime. Foreign tax credits can offset up to 80% of the GILTI tax. The GILTI tax was designed to discourage the offshoring of valuable IP, as it taxes certain offshore income in a manner similar to the taxation of subpart F income. An indirect effect of the GILTI on transfer pricing is that it is based on a formulaic calculation that calls into question the traditional arm’s length principle used to evaluate the appropriateness of transfer pricing applied to inter-company transactions for MNEs. The final GILTI regulations were released in July 2020. The final regulations allow taxpayers to elect to exclude GILTI that is subject to an effective foreign income tax rate exceeding 90% of the maximum U.S. corporate rate (currently 21%) or 18.9%.
- Foreign Derived Intangible Income (“FDII”). Section 250 of the TCJA lowers the revised 21% corporate tax rate to an effective rate of 13.125% for foreign-use intangibles held by U. S. taxpayers (“FDII eligible income”). FDII eligible income relates to excess returns derived from foreign sources, which include income from the sale of property, services provided, and licenses to non-U.S. entities/persons. The lower tax rate applicable to FDII income was designed to encourage U.S. entities to develop technology or intangibles in the U.S. and to license such IP to overseas affiliates. Further, it encourages U.S. entities to provide corporate support or other services to foreign affiliates. Similar to the GILTI, the indirect effect on transfer pricing is that the FDII calls into question the arm’s length principle used to evaluate the transfer pricing of MNEs. The final FDII Regulations were released in July 2020 and provided some favorable guidance for taxpayers.
- Base Erosion and Anti-Abuse Tax (“BEAT”). The BEAT is a minimum tax charged on payments to related foreign affiliates. Like the former corporate Alternative Minimum Tax (“AMT”), this is a parallel tax system that applies when the BEAT is in excess of the regular tax liability. Unlike the former corporate AMT, there is no credit to offset future regular tax liabilities. The BEAT specifically targets payments for services, royalties and interest to foreign affiliates. The BEAT is calculated by increasing taxable income by deductions taken for related-party transactions and taxing the modified taxable income at 5%. The BEAT only applies to MNEs with revenues in excess of $500 million. Further, it only applies if payments to foreign affiliates equal or exceed 3% of total tax deductions. The direct impact of this tax is that it is aimed at transfer pricing payments made by U.S. entities to foreign related parties. It ignores traditional transfer pricing principles based upon the arm’s length method and seeks to broaden the tax base through the creation of a modified taxable income taxed at a lower rate. Also, the BEAT potentially creates double taxation since transfer pricing examinations are based on the calculation of the regular tax liability, and there is no mechanism for foreign entities to counteract the BEAT. The final BEAT regulations were issued on September 1, 2020, which provided additional guidance on its application.
OECD BEPS INITIATIVES
The OECD continues to play an integral role in providing transfer pricing guidance to its 37 member states, including the U.S.
- The OECD published 15 action items addressing base erosion and profit shifting (BEPS) by taxpayers reporting in multiple taxing jurisdictions. The focus of these actions was to ensure that profits are taxed in the jurisdictions where they are earned. One of these action items introduced CbC reporting, which provides increased transparency of global transfer pricing. CbC reporting is required for MNEs with global revenues in excess of $850 million. Similarly, the same action item introduced the concept of transfer pricing documentation master file and local file. Since the release of these action items, many less sophisticated foreign taxing jurisdictions have implemented the requirement for CbC reporting and transfer pricing master file and local file, and thus further increased the compliance burden on MNEs and the possibility of more audit activity by the taxing authorities.
The COVID-19 pandemic has had far-reaching consequences beyond the spread of the disease itself and efforts to quarantine. As the virus spread around the globe, concerns shifted from supply-side manufacturing issues to decreased business in the services sector. The pandemic caused the largest global recession in history, with more than a third of the global population at the time being placed on lockdown.
- COVID-19 created a sudden, unexpected supply chain disruption for MNEs. The virus shut down manufacturing in the heart of China and other North Asian countries and rapidly moved to impact manufacturing all over the world. Business closures across the globe had already impacted suppliers and customers, depending on the industry, and will likely to continue to impact more in the future as global consumers are required to stay home and unemployment continues to rise. MNEs were forced to review clauses in supply contracts and evaluate alternative means of performing contract obligations. Further, companies were forced to look at temporary supply options, including assessing whether to support their suppliers with advance payments or even acquisitions in order to keep them afloat. Pandemic travel restrictions continued to remain in force, and many business activities were put on hold or performed virtually. Inventory levels for both raw materials and finished goods were reassessed, required additional investment, or cut, to prepare for future shifts in demand. MNEs began to focus on responding to all of their specific issues and recalibrating their supply chains since COVID-19 became priority No.1.
- MNEs were forced to review their existing inter-company agreements for inter-company financing arrangements, inter-company services arrangements and inter-company royalty arrangements. Consideration on restructuring or re-pricing interest rates to be in line with third party interest rates and help to free up cash flow was front of mind. Many MNEs temporarily held off charging for intercompany interest, inter-company services and inter-company royalties.
- MNEs will be under more pressure in the future to defend their existing transfer pricing policies due to the economic downturn. One element of this is that adversely affected companies will be required to explain low operating profits or losses to tax authorities for both the current and coming years. It may be prudent for MNEs to model the impact of COVID-19 on operating results now, to help demonstrate in the future the commercial rationale for changes in transfer pricing and other planning decisions, and ultimately show that low profits or losses were not the result of non-arm’s length transfer pricing policies. The business impacts vary greatly by industry sector and geography. Moreover, the profit margin data often used for setting or testing transfer prices is generally only available with a lag of five to six months for North American databases and up to 18 months for some foreign databases.
- The catastrophic impact of the COVID-19 pandemic will be far reaching, and the serious implications for many MNEs’ transfer prices, analysis and documentation is yet another thing to consider.
THE CORONAVIRUS AID, RELIEF AND ECONOMIC SECURITY (CARES) ACT
The 116th U.S. Congress passed a $2.2 trillion economic stimulus bill on March 27, 2020, in response to the economic fallout from the coronavirus pandemic in the United States.
- The CARES Act temporarily suspended the 80 percent taxable income limitation on the use of a net operating loss (NOL) to offset taxable income for tax years beginning after December 31, 2017, and before January 1, 2021.
- The CARES Act further introduced temporary changes to the IRC business interest limitation. The CARES Act generally allows taxpayers to increase the 30 percent of adjusted taxable income (ATI) limitation on business interest expense to 50 percent of ATI for any tax year beginning in 2019 or 2020. Taxpayers could elect not to apply the higher 50 percent limitation. If the additional deduction yields negative tax consequences for another tax provision, such as the BEAT, taxpayers could decide not to elect to apply the increased limitation.
- MNEs should review their current transfer pricing positions in conjunction with carryback tax loss relief to maximize tax benefits. MNEs should further review any inter-company financing arrangements to maximize interest relief.
The TCJA changes related to the corporate tax rate and the imposition of FDII rules, GILTI and the BEAT require rethinking the approach to transfer pricing and intangibles ownership. A thorough modeling of these changes needs to be performed by MNE taxpayers to determine impact. Since this analysis is facts and circumstances-driven, there is no simple way to estimate the results or strategies that should be explored. Further, the impact of the COVID-19 pandemic and the CARES ACT stimulus should also be carefully considered to defend the transfer pricing position taken and maximize tax benefits. Marcum recommends that MNE taxpayers undertake a study to determine the impact of the TCJA on international structuring, transfer pricing policies, and global tax rates, and to defend their current transfer pricing positions due to the pandemic. The outcome of such a study will point out new strategies that should be explored to minimize global taxation for a MNE. Some possible new strategies could include the following:
- For FDII and GILTI
- Determine whether IP (intellectual property) is better located in the U.S. or abroad, including the costs of unwinding current structures and implementing new structures.
- For GILTI
- Maximize the exempt deemed tangible income returns on CFCs to minimize GILTI.
- Manage Foreign Tax Credit.
- Manage pre-tax income distributions.
- Consider non-CFC entities to house business operations, since the GILTI only applies to CFCs.
- For BEAT
- Review mark-ups on payments to foreign related parties.
- Review licensing arrangements related to foreign related party IP.
- BEAT related party payments do not include cost of goods sold or services eligible for the Service Cost Method; explore planning ideas related to these exceptions.
- Country-by-Country Reporting
- CbC reporting should continue to be a focus for MNE taxpayers. MNE taxpayers should continue to be diligent in preparing accurate CbC information and/or contemporaneous documentation, to provide penalty protection in the event of a transfer pricing adjustment upon examination.
- For COVID-19 and CARES ACT
- Review current supply chains and utilize transfer pricing planning in conjunction with commercial considerations to establish new structures. Review current transfer pricing position with respect to generated losses and support the loss position through transfer pricing documentation.
- Review the possibility of providing holidays on charging interest rates on inter-company financing and on charging for inter-company services and royalties.
- Review and update inter-company agreements for any legal clauses and align with third party agreements to support the transfer pricing position taken.
- Review transfer pricing in line with the CARES Act stimulus and determine if transfer pricing can be used to maximize deductions and minimize global effective tax rates.
While 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 MNEs to take a fresh look at their transfer pricing policies, not only to defend their current transfer pricing positions in response to the global pandemic, but also to identify new opportunities to further maximize deductibility and reduce global effective tax rates.