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 Organisation 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, the country-by-country report and the requirement of a transfer pricing master file and local file.
Recent changes in the U.S. tax administration and the announcement by the House Ways and Means Committee (“HWMC”) on September 15, 2021, provide further details of proposed changes that may come into effect as of January 1, 2022. The catastrophic impact of the global pandemic of COVID-19 also continues to have serious implications for many multinational enterprises’ (MNE’) transfer prices, and taxing authorities will be looking for more ways to reduce their deficits with tax revenue.
TRANSFER PRICING UNDER U.S. TAX REFORM AND PROPOSED CHANGES UNDER THE BIDEN ADMINISTRATION
The Tax Cuts and Jobs Act 2017 (“TCJA”) continues to have both direct and indirect effects on global intercompany transactions. Several aspects of TCJA upended the way in which MNEs evaluate tax structuring and transfer pricing. Further, proposed changes announced by the HWMC on September 15 may update certain provisions of the TCJA. A final bill, if any, has not passed at the time of this writing.
- 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. The HWMC proposal introduces a graduated corporate tax rate for certain corporate taxpayers, with a top rate of 26.5%.
- Global Intangible Low Taxed Income (“GILTI”). The final GILTI regulations were released in July 2020. The GILTI currently applies to controlled foreign corporation (“CFC”) income that exceeds a 10% return on a CFC’s tangible assets. This tax only applies to CFCs. It applies in addition to the existing subpart F regime. The changes to the proposed tax rates, as described above, along with a reduction in the deduction for GILTI, may result in a higher effective tax rate on GILTI. In addition, under the HWMC proposal, GILTI will be applied on a country-by-country basis including net CFC-tested income, net deemed tangible income return, Qualified Business Asset Investments (QBAI) and interest expense. The HWMC proposal also allows for carryforward of GILTI Foreign Tax Credits (FTC), a major complaint from taxpayers uner the current rules. Allowing carryforward of GILTI FTCs would substantially affect transfer pricing and international tax planning strategies that were needed in light of the current rule.
- Foreign-Derived Intangible Income (“FDII”). Section 250 of the TCJA lowered 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”). The final FDII Regulations were released in July 2020 and provided some favorable guidance for taxpayers. FDII-eligible income relates to excess returns derived from foreign sources, including 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. The new proposals by the HWMC intend to raise the rate on FDII-eligible income.
- Base Erosion and Anti-Abuse Tax (“BEAT”). The final BEAT regulations were issued on September 1, 2020, providing additional guidance on their application. 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 HWMC proposal accelerates the rate increases under BEAT, but despite early proposals by the Biden administration to replace BEAT with a new regime, the HWMC proposals do not propose a repeal of BEAT. 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 HWMC proposal removes the 3% threshold. 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 on 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.
- Additional changes in the HWMC proposal that will interact with transfer pricing planning include the following:
- The disallowance of FTC carrybacks. FTC carryforwards will still be allowed for 5 years under the proposal. FTCs (except those in the GILTI basket) can currently be carried forward for up to 10 years. Ability to carry forward FTCs can affect transfer pricing planning strategies that include relocating taxable income and/or taxes.
- FTCs and associated limitations would be calculated country-by-country. Transfer pricing planning strategies will need to account for a country-by-country approach to FTCs.
OECD BEPS INITIATIVES
The OECD continues to play an integral role in providing transfer pricing guidance to its 38 member states, which includes 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 a 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 of CbC reporting and transfer pricing master file and local file, thus further increasing the compliance burden on MNEs and the possibility of more audit activity by the taxing authorities.
- In February 2020, the OECD released guidance on financial transactions. The release of this report was significant because it was the first time that the OECD Transfer Pricing Guidelines included guidance on the transfer pricing aspects of financial transactions. The main goals of this report are to provide more consistency in the interpretation of the arm’s length principle and help avoid transfer pricing disputes and double taxation.
The COVID-19 pandemic has had far-reaching consequences, beyond the spread of the disease itself and efforts to quarantine it, and continues to do so. 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 continue to impact more in the future as global consumers are required to stay home and unemployment has been on the rise. The discovery of vaccines came as a sigh of relief but also divided many, where individuals were not willing to take the vaccine. Many different variants of the virus mutated and caused further widespread disruption and restrictions on travel. Although most schools reopened and many companies reopened their offices, many employees continued working remotely. 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. The 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, and required additional investment, or cuts, to prepare for future shifts in demand. MNEs began to focus on responding to all of their specific issues and recalibrating their supply chains as COVID-19 became priority number one.
- MNEs were forced to review their existing agreements for intercompany financing arrangements, intercompany services arrangements and intercompany royalty arrangements. Consideration of 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, intercompany services and intercompany 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 any 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 guidance issued by the OECD was welcomed, as many taxing authorities and taxpayers continued to face uncertainty about the treatment of operating losses and taxing of incentive schemes. 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.
- Since the COVID-19 crisis started, the OECD has been providing data, analysis, and recommendations on the pandemic’s impact on health, the economy, employment, and society. The OECD features a dedicated COVID-19 section on its website to share its latest insights on the crisis.
- The catastrophic impact of the COVID-19 pandemic continues to 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 the $2.2 trillion economic stimulus bill called the CARES Act, signed into law by President Donald Trump on March 27, 2020, in response to the economic fallout of the COVID-19 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 Section 163(j) 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 can elect not to apply the higher 50 percent limitation. If the additional deduction yields negative tax consequences for another tax provision, such as IRC Section 59A (BEAT), taxpayers can decide not to elect to apply the increased IRC Section 163(j) limitation.
Since Marcum’s 2020 Year-End Tax Guide, two major transfer pricing controversy cases reached major milestones: Altera Corp. v. Commissioner and Coca-Cola v. Commissioner.
The Supreme Court declined to hear Altera’s appeal of the Ninth Circuit’s decision in Altera v. Commissioner. The Ninth Circuit upheld the rule under Treasury Regulation Section 1.482-7(A)(d)(2), which requires the inclusion of stock-based compensation in the calculation of intangible development costs for cost-sharing arrangements. The Supreme Court’s denial was Altera’s last point of appeal in the case. However, the issue could still be presented in future court cases.
In Coca-Cola v. Commissioner, the tax court ruled in November 2020 in favor of the IRS, resulting in an additional USD 3.3 billion tax liability for Coca-Cola. The case centered on the ownership of marketing intangibles, which Coca-Cola claimed were partially owned by its foreign affiliates known as “supply points.” The tax court opinion relied on the lack of support in the intercompany agreements for the allocation of intangible property rights, and the observation that Coca-Cola could not indefinitely rely on a closing agreement with the IRS from a 1996 audit to provide certainty on its transfer pricing methods. In addition, the tax court showed surprising support for the application of the “comparable profits method” for intangible property transactions.
Some possible new strategies could include:
For FDII and GILTI
- Determine whether IP is better located in the U.S. or abroad, including the costs of unwinding current structures and implementing new structures.
- Maximize the exempt-deemed tangible income returns on CFCs to minimize GILTI.
- Manage FTC.
- Manage Previously Taxed Income (“PTI”) distributions.
- Consider non-CFC entities to house business operations, since GILTI only applies to CFCs.
- Review mark-ups on payments to foreign related parties.
- Review licensing arrangements pertaining 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.
- Review planning strategies in light of potential elimination of FTC carrybacks.
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.
- If the taxpayer is required to file the CbC report for Country A, but is filing the report in Country B, the taxpayer may also need to notify Country A that the report will be filed in Country B. In some jurisdictions, this notification is due before the end of the taxable year for the CbC report.
- Some jurisdictions do not have agreements in place to exchange CbC reporting information. In this case, multiple filings may be required.
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 positions 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 intercompany financing and on charging for intercompany services and royalties.
- Review and update intercompany 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 see if transfer pricing can be used to maximize deductions and minimize global effective tax rates.
- Review transfer pricing in line with the guidance released by the OECD on the tax treatment of certain items such as operating losses and incentives.
- Review transfer pricing in line with proposed changes announced by the Biden Administration to minimize global effective tax rates.
For Controversy Updates
- For Altera
- Continue to review cost-sharing arrangements for inclusion of stock-based compensation in the intangible development costs paid by each participant.
- Review intercompany agreements to ensure they align with current functions, risks, and assets assumed by the parties to the transactions.
- Review transfer pricing policies that rely on previous agreements with the IRS (of all forms) for continued applicability.
While all of 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 a time for large MNEs, as well as small and mid-sized MNEs, to take a fresh look at their transfer pricing policies, not only to defend their current transfer pricing position caused by the pandemic, but also to identify new opportunities to further maximize deductibility and reduce global effective tax rates.
Marcum offers a full range of assurance, tax, and advisory services to clients operating businesses abroad as well as those headquartered 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 that have 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 experience 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.
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. Further proposed changes by the Biden Administration and Congress should also be considered. A thorough modeling of these changes needs to be performed by MNE taxpayers to determine their 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 positions taken and maximize tax benefits. Marcum recommends that MNE taxpayers undertake a study to determine the impact of the TCJA and proposed changes by the Biden Administration on international structuring, transfer pricing policies and global tax rates, and to defend 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.