tax reform and transfer pricing - my-cpe.com · 2019-07-18 · famous last words 25. tax reform...
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Tax Reform and Transfer PricingJuly 18, 2019July 30, 2019
Alex MartinProductive Pricing [email protected]
Personalized Service, Practical Solutions1
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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.
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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
www.productivepricing.com3
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Why is Transfer Pricing Important?
$Y transfer price drives taxes payable by country
• Inventory, royalties, service charges, loans all impact taxes
www.productivepricing.com4
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)
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Is Your Company Paying its Fair Share?
“Why does Starbucks manipulate its accounts to avoid tax?”- UK Member of Parliament Margaret Hodge
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Big Picture
Goal – companies pay their fair share of tax
• “Arm’s-Length Standard”
• Principles broadly similar globally
(OECD Guidelines)
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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%
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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
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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?
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Specialty Vehicle Part Parent
US
Specialty Vehicle Part Subsidiary
France
Parts
Royalty Charge
FranceU.S.
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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%)
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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
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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?
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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
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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
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“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
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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%)
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“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
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TAX REFORM STRATEGIES
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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
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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
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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
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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
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Increase Royalties Charged to Subsidiary Base Case (no FDII)
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USCoParent
Forco Subsidiary
Vs
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
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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
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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”
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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
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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)
$4m
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
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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
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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?
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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
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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
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GILTI Calculation without Interest Expense
CFC with 10% tax rate, $1.5M income and $8M in QBAI
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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%
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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
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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
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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
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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?
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Alex MartinProductive Pricing LLC390 N Harvey StreetPlymouth, MI [email protected]+1 248 752-1190
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