Tax Reform and Transfer Pricing July 18, 2019 July 30, 2019 Alex - - PowerPoint PPT Presentation

Tax Reform and Transfer Pricing

July 18, 2019 July 30, 2019

Alex Martin Productive Pricing LLC www.productivepricing.com alex.martin@productivepricing.com

Personalized Service, Practical Solutions 1

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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

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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

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German taxes 30% of $X German manufacturer $X profit U.S. distribution subsidiary $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)

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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 France U.S.

IRS Issues a Transfer Pricing Adjustment

Assume a total taxable income adjustment of $10m Additional income tax owed: $10m x 35%* = $3.5m Plus 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 $20m NO 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,

• thers on both sides of the border

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IRS Issues Adjustments with Documentation

Assume a total taxable income adjustment of $10m Additional income tax owed: $10m x 35%* = $3.5m Plus 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%)

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 Subsidiary EBIT/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

Increase Royalties Charged to Subsidiary Base Case (no FDII)

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USCo Parent Forco Subsidiary

Vs

USCo Parent 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 Savings

excludes 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

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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 Example Higher Royalty = Increased FDII Income

USCo IT Parent Forco Subsidiary

Vs

USCo IT Parent Forco 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% FDII 21% domestic 30% 13.125% FDII 21% domestic 30% 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/annually

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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 FTC 80% 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

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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 Martin Productive Pricing LLC 390 N Harvey Street Plymouth, MI 48170 alex.martin@productivepricing.com www.productivepricing.com +1 248 752-1190

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