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 are being addressed in various foreign jurisdictions by the enactment of lower, competitive tax rates. The European Union’s (“EU”) antitrust regulator, the European Commission (“Commission”), continues to pursue multinational entities (“MNEs”), asserting that certain member states of the EU have gained an unfair competitive advantage resulting from government tax incentives and agreements, in certain cases disregarding conventional transfer pricing regulations and agreements between and among MNEs and tax authorities. The Organization for Economic Cooperation and Development (“OECD”) is advocating for a global consensus on the establishment of new tax rules addressing the rapid digitalization of the global economy. Concurrently, certain European states have enacted their own digital services taxes.
All of these global tax issues are converging at the same time. Action Items adopted by the OECD and largely followed by the Internal Revenue Service (“IRS”) under the Base Erosion and Profit Shifting (“BEPS”) initiative — most notably country-by- country (“CbC”) reporting — are creating transparency with respect to global transfer pricing that did not exist before. Further, new information reporting on U.S. tax return forms has resulted in transfer pricing coming into sharper focus.
With all of this change, the IRS reorganized its transfer pricing unit and is addressing transfer pricing with a view towards identifying high compliance risks. A series of IRS campaigns has targeted issues representing a risk of non- compliance, which are considered to result in more successful IRS transfer pricing audits.
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 intercompany 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 have lowered their tax rates in response to the U.S. 21% rate, most notably India, which recently lowered its rate from 35% to 22%.
- 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 principal used to evaluate the appropriateness of transfer pricing applied to intercompany transactions for MNEs.
- 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 principal used to evaluate the transfer pricing of MNEs.
- 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.
OECD BEPS INITIATIVE
As reported elsewhere in this publication, the OECD published 15 action items addressing base erosion and profit shifting 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. First time implementation of this reporting occurred over the last three years, as it was required in OECD members’ jurisdictions for tax years beginning after January 1, 2016, and for U.S. reporting MNEs for tax years beginning after June 30, 2016, if not adopted earlier.
Similar to the OECD reporting template, Federal Form 8975 Country by Country Report, is required to be attached to the U.S. tax return. Form 8975 discloses key information by taxing jurisdiction including: unrelated party and related party revenues, profit or loss before income tax, income tax paid, income tax accrued, stated capital, accumulated earnings, number of employees, and tangible assets other than cash and cash equivalents. Disclosure of entities in each tax jurisdiction is required as well. This provides an increased level of transparency to tax examiners with regard to global intercompany transactions and an opportunity to identify base erosion and profit shifting occurring in the various tax jurisdictions.
As the tax audit cycles come into play for these CbC reporting years, we can expect an increased focus on transfer pricing strategies and communication between various taxing jurisdictions.
What also remains to be seen is the impact of digital services taxes (“DST”). In July of this year, France enacted a three percent DST which retroactively applies to income generated after January 1, 2019, with the first payments due in October 2019. The tax is intended to apply to certain digital services provided to french internet sellers. This tax applies to companies with annual global revenues in excess of Euro 750 million and Euro 25 million in France. The enactment of the DST comes at the same time the OECD is pushing for a global consensus on the establishment of new global tax rules addressing digitalization of the global economy.
IRS DIRECTIVES FOR IRS TRANSFER PRICING EXAMINATIONS
Over the last year and a half, the IRS Large Business and International (“LB&I”) division released 53 directives focused on identifying potential compliance risks. Among those directives are the following, specific to transfer pricing and information reporting:
- Elimination of the requirement that mandatory transfer pricing information document requests (“IDRs”) be issued;
- Appropriate application of the transfer pricing penalties as they apply to contemporaneous documentation;
- Analysis of the best method selection;
- Reasonably anticipated benefits in cost sharing arrangements;
- Treaty and transfer pricing operations;
- Transfer pricing between US MNEs and foreign captive insurance service providers;
- Correctly filing Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations.
The integration and implementation of these directives is aimed at creating more efficiency within the IRS during audit examinations. It also is an attempt to focus more closely on transfer pricing risk and reduce the number of transfer pricing audits conducted by the IRS. The first three of these directives have an impact for most MNEs. The directive with regard to Form 5471 will highlight potential non-compliance for disclosing related party transactions and could result in information reporting penalties as well as transfer pricing audits for non-compliant MNEs.
Although mandatory IDRs will no longer be required to be issued at the beginning of an examination, there are certain cases when an IDR will be required. Taxpayers continue to be required to submit accurate documentation within 30 days of being issued the IDR, to prevent the possible application of penalties of 20 to 40 percent of any transfer pricing adjustment levied.
It would appear that LB&I IRS agents may experience fewer examinations than before the new IDR directive was implemented. However, the new IDR directive does not explicitly state that it exclusively applies to examinations of LB&I taxpayers (taxpayers with assets equal to or greater than $10 million). This leaves it open to interpretation and potentially means that middle-market companies with global operations may feel the effects of the new IDR directive, in which case more transfer pricing examinations will occur.
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 modelling 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. 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.
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:
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 PTI distributions.
- Consider non-CFC entities to house business operations, since the GILTI only applies to CFCs.
- 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.
CbC reporting and the new IRS directives related to transfer pricing should continue to be a focus for MNE taxpayers. With transparency increased and an unknown factor as to whether an IDR will be issued for transfer pricing, 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. How transfer pricing audits will play out relative to the tax reform changes remains to be seen.
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 to identify new opportunities arising from not only U.S. tax reform, but also global tax reform.