Tax Reform and Transfer Pricing - my-CPE.com · 2019-07-18 · Famous Last Words 25. TAX REFORM...

Tax Reform and Transfer PricingJuly 18, 2019July 30, 2019

Alex MartinProductive Pricing LLCwww.productivepricing.comalex.martin@productivepricing.com

Personalized Service, Practical Solutions1

www.productivepricing.com2

Introduction

• Alex Martin is a transfer pricing economist based in Plymouth, Michigan

• He has been a full-time transfer pricing specialist for 22 years, including 4 years working overseas.

• Alex worked at a Big-4 firm for 12 years, 6 years at a top middle-market CPA firm and 4 years as an independent consultancy.

• Alex’s transfer pricing team was selected as one of the world’s leading transfer pricing consultancies by International Tax Review for the past three years.

Overview

• Transfer pricing from a practical perspective

• Assessing common transfer pricing issues

• Tax Reform = new incentives for multinationals

• FDII export incentive @ 13.125%

• GILTI, BEAT and OECD Developments

Why is Transfer Pricing Important?

$Y transfer price drives taxes payable by country

• Inventory, royalties, service charges, loans all impact taxes

German taxes 30% of $X

German manufacturer

$X profit

U.S. distributionsubsidiary $Z profit

Auto parts

$Y charge

Retailers

U.S. taxes 35% of $Z

now 21% of $Z (2018)

Is Your Company Paying its Fair Share?

“Why does Starbucks manipulate its accounts to avoid tax?”- UK Member of Parliament Margaret Hodge

Big Picture

Goal – companies pay their fair share of tax

• “Arm’s-Length Standard”

• Principles broadly similar globally

(OECD Guidelines)

Transfer Pricing – Why Now?

High return on investment for tax auditors globally

Prior to TCJA, companies minimized US tax footprint • 35% federal rate and worldwide taxation• Lower rates elsewhere

Tax Reform changes the dynamic, e.g.• 21% tax rate on C-Corps encourages investments• Possible lower rate for export income – 13.125%

When is Transfer Pricing an Issue?

Every time a company has a cross-border transaction with related companies

• Supply chain changes

• Company cashflow

• Global effective tax rates

• Tax audits

How Do Some Companies Approach Transfer Pricing?

• Company has one cost plus policy

• Company operates as one “borderless” business

• Can the plant manager earn a higher bonus?

Specialty Vehicle Part Parent

Specialty Vehicle Part Subsidiary

France

Royalty Charge

FranceU.S.

IRS Issues a Transfer Pricing Adjustment

Assume a total taxable income adjustment of $10mAdditional income tax owed: $10m x 35%* = $3.5mPlus non-deductible penalties of 20% $700,000

$4.2M + interest + US state taxes + potential double tax

20% penalties start at $5m, penalties increase to 40% at $20mNO automatic refund of double tax – 2 Tax Authorities need to agree

* Open tax years at pre-tax reform 35% rate

Transfer Pricing Documentation

Auditors request documentation to evaluate TP

• Analysis of how business operates globally

• Industry analysis

• Financial analysis

• Economic analysis demonstrates why transfer pricing is arm’s-length

Explain to a tax auditor how the business operates and why the transfer pricing is correct.

Information Typically Included in a Study

Narrations prepared through interviews – e.g.

• Which country developed the product and how?

• What cross-border R&D assistance is provided?

• Who bears risk of R&D failure?

• What process IP is utilized by related companies?

Similar interviews with sales, marketing, finance, others on both sides of the border

IRS Issues Adjustments with Documentation

Assume a total taxable income adjustment of $10mAdditional income tax owed: $10m x 35%* = $3.5mPlus non-deductible penalties of 20% $700,000

$3.5M + interest + US state taxes + potential double tax

US Report prepared by tax return filing date to be ‘contemporaneous’

Reports do not guarantee tax authority agreement with your position

No IRS Transfer Pricing Adjustment?

No TP adjustment during an IRS Audit

• No adjustment = no additional tax or penalties

Possibly a problem from a foreign perspective

• Some tax authorities (e.g. Mexico) require annual documentation at a very low threshold

• Thresholds vary by country

Best Practices for Managing Transfer Pricing?

Over 100 countries have transfer pricing rules

• One study applicable for multiple jurisdictions

• Update report annually to be contemporaneous

• If a report is not clear to you, it will not make sense to an auditor

Starting Points – What to Review

• Country-by-Country financials- past 3 years

• US Tax Return for most recent year –Form 5471, 5472, 8858 and/or 8865

• US TP documentation – old reports still useful

• Foreign TP documentation reports

How to Assess Transfer Pricing

Review annual profit margins of each subsidiary

• Subsidiary losses/NOLs = Subsidiary tax risk

• Large profits in subsidiaries = Parent tax risk

• All open tax years

EBIT as a percentage of sales for each subsidiary

• Often used in TP analyses

How Would the IRS Audit This Situation?

German parent with USCo subsidiary reseller

• ~$70m US Revenue, Purchases in Euros

• Long sales cycle, facing market downturn

• Minimal profits or losses past 3 years

USCo 2016 2017 2018 Total

Sales $75.2m $70.3m $65.2m $210.7m

EBIT $0.9m $0 ($2.5m) ($1.6m)

EBIT Margin 1.1% 0% (3.8%) (0.7%)

Assessing Subsidiary Transfer Pricing Risk

Does it make sense – a subsidiary incurs losses?

• What happens if outbound TP is lowered?

• What would happen by utilizing tax NOLs?

IRS has a TP audit campaign for subsidiaries

• Middle-market specifically mentioned

Assessing Transfer Pricing – US Companies

How would a foreign auditor react to losses?

• Can you reduce outbound TP to utilize losses?

Foreign subsidiaries earn large profits

• Potential to increase FDII benefit?

• Does the GILTI tax apply?

It’s the Real Thing

• The IRS and Coca-Cola continue to litigate a $3.3 billion transfer pricing case

• Years covered – 2007 through 2009

• IRS argues that foreign licensees earned over $11 billion in operating profits, US only $800m

• IRS thought process – foreign subsidiaries should not earn an excessive return

Practical Observations

IRS requests reports with a 30-day deadline

• Not too late if the deadline is missed

• No TP adjustment = no additional tax due

Most TP studies include multiple years of data

• e.g. 2016-2018 or 2014-2018

Large companies (≥€750m Euros) required to have OECD BEPS Master File/Local Files

“Best Method” or “Most Appropriate Method”

Hold off on assessing methods at this stage

• CUP – Comparable Uncontrolled Price

• Resale Price Method

• Cost Plus Method

• Profit Split Method

• CPM – (Comparable Profits Method) or TNMM

• Other Methods

Potential Alternative – Benchmarking Study

Benchmarking study

• Lower-risk situations

• Profit margin target for subsidiaries

Adjust TP to reach EBIT margin between 5.0% to 8.2% for subsidiary

• CPM/TNMM Approach

Benchmark Company

for SubsidiaryEBIT/Sales

Company A 16.3%

Company B 12.8%

Company C 8.2%

Company D 6.3%

Company E 5.5%

Company F 5.0%

Company G 0.3%

Company H (3.2%)

“They couldn’t hit an elephant at this distance.”—John Sedgwick, U.S. Civil War General – May 9, 1864

• “We will prepare something when the IRS requests it.”• “We did a study a few years ago.”• “Our subsidiaries negotiate over transfer prices already.”• “We have a transfer pricing policy in place.”• “Our Canadian controller said they have a study.”

“It’s due to business conditions and FX issues.”

Famous Last Words

TAX REFORM STRATEGIES

Transfer Pricing and US Tax Reform

The Tax Cuts and Jobs Act (TCJA) changes incentives for multinationals: e.g., for C-Corps

• Tax rate reduced to 21%

• Some export income may be taxed at 13.125%

• Holding IP offshore less beneficial

Observations

Tax Reform designed to:

• Incentivize US investments in value chain

• Incentivize US exports

State tax, VAT, withholding, foreign tax credits, customs duty all important considerations

What Happens If Transfer Prices Are Increased?Base Case (no FDII)

What if USCo increases the royalty by $1m?

• Increase goods prices, service charges – same effect

US taxes payable at 21%

$2,100,000

USCo Parent $10,000,000

Taxable income

Forco Subsidiary$5,000,000

Taxable income

Software Charge

$2m Royalty

Forco customers

Forco taxes payable at 30%

$1,500,000

Increase Royalties Charged to Subsidiary Base Case (no FDII)

USCoParent

Forco Subsidiary

USCoParent

Forco Subsidiary

Royalty Charge $2m $3m

Taxable Income $10m $5m $11m $4m

Tax Rate 21% 30% 21% 30%

Taxes Payable $2.1m $1.5m $2.31m $1.20m

Taxes Payable $3.60 million $3.51 million

Savingsexcludes Foreign Derived Intangible Income (FDII) deductions

$90,000/annually

What Should Multinationals Consider Now? Outbound

Lower tax rates incentivize US investments

• New US R&D activities = higher royalty rates

• New/Upgraded US plant = higher goods prices

Tax benefit – additional US tax, lower foreign tax

• Larger deductions at subsidiaries

Carrots and Sticks Overview

Special rules for “deemed intangible income”

• Foreign Derived Intangible Income (“FDII”) incentive (13.125% rate)

• Global Intangible Low-Tax Income (“GILTI”) is Mirror

Deemed Intangible income =

• Income minus 10% of Qualified Business Asset Investment (“QBAI”) and interest expense

• The TCJA assigns a “routine” return of 10% on assets, and residual profits are “deemed intangible income”

FDII Export Incentive

Deemed ‘Intangible income’ defined as income greater than 10% of QBAI (business assets)

• What share of 'intangible’ income is foreign? (Foreign derived deduction income/ Total deduction income) x Deemed Intangible Income= FDII Income

FDII income taxed at 13.125%

• Increase transfer prices= increase FDII

Same Numerical ExampleHigher Royalty = Increased FDII Income

USCo ITParent

Forco Subsidiary

VsUSCo

IT ParentForco

Subsidiary

FDII Royalty Income

$2m $3m

Taxable Income(After FDII Calc)

$2m FDII$8m domestic

($10m total)

$5m$3m FDII

$8m domestic($11m total)

Tax Rate 13.125% FDII21% domestic

30%13.125% FDII

21% domestic30%

Taxes Payable $262,500$1.68m

$1.5m$393,750

$1.68m$1.2m

Total Taxes $3,442,500 $3,273,750

Tax Savings $168,750/annually34

FDII Observations

Opportunity is more income at 13.125% rate

• Potential to improve ETR and cashflow

• Must have evidence of foreign use

• Must be substance behind TP changes

TP documentation for audit defense overseas

What Should Multinationals Consider Now? Inbound

Consider reducing inventory prices and royalties

• More US activities = lower transfer prices

• New US plant = lower component prices

Result- More US income/ Less overseas income

• Customs duty savings?

GILTI and BEAT Sticks

Global Intangible Low-Taxed Income (“GILTI”)

• Tax excess income from lower tax countries

• Also applies to some individuals

Base Erosion and Anti-Abuse Tax (“BEAT”)

• Minimum tax for significant royalties and service fees paid to related companies

GILTI Mirrors FDII

Charged on the ‘excess’ income of US CFCs

• Net “tested income” of CFC minus 10% of QBAI, minus interest expense

• Reduces rate differential between the US and low-tax jurisdictions

GILTI Calculation without Interest Expense

CFC with 10% tax rate, $1.5M income and $8M in QBAI

CFC Taxable Income $1.5m

Foreign Taxes Payable @ 10% $150k

Foreign Net Income $1.35m

minus Return of 10% on $8m in QBAI and int. exp. $800k

Equals GILTI “Deemed Intangible Income” $550k

plus Sec. 78 gross-up = (150k/1.35m) x 150k $61.1k

Equals GILTI Inclusion $611.1k

50% Deduction on GILTI Inclusion for C-Corps $305.5k

Additional GILTI Tax at 21% of GILTI Deduction $64.1k

minus Deemed paid foreign tax credit $48.9k

Equals Incremental US Tax $15.5k

Total Taxes Payable on CFC Income $165.5k

Deemed paid FTC80% x Sec. 78 gross-up 80% x $61.1k = $48.9k

Assume $8m in CFC Qualified Business Asset Investment

Effective Tax Rate on CFC Income $165.5k/$1.5m = 11.02%

GILTI Observations

GILTI tax applies to excess CFC profit

• Removes “routine” return based upon QBAI

• Higher assets (QBAI) = less GILTI tax

• CFC with few assets more likely have GILTI tax

• GILTI Tax can be offset by foreign tax credits

BEAT Stick

Base Erosion and Anti-abuse Tax >$500m revenue

• Adds back payments to related companies

• New modified taxable income

• BEAT is 10% of modified taxable income less regular tax liability (5% in 2018)

• Royalties and service payments are greater than 3% of company deductions.

• Inventory purchases not part of calculation

Transfer Pricing Tax Reform Takeaways

Transfer pricing is an integral part of tax reform

• FDII - incentive to increase outbound TP

• Lower inbound TP may be beneficial

Documentation to support changes in TP

Storms on the Horizon

• Tax rate competition

• ‘Nexus’ standards for taxing internet sales

• BEPS Master File/ Local File and CbC Reporting

• More transparency = more aggressive audits

• Can governments resolve double tax disputes?

Alex MartinProductive Pricing LLC390 N Harvey StreetPlymouth, MI 48170alex.martin@productivepricing.comwww.productivepricing.com+1 248 752-1190

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Tax Reform and Transfer Pricing - my-CPE.com · 2019-07-18 · Famous Last Words 25. TAX REFORM...

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