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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
www.productivepricing.com3
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)
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)
www.productivepricing.com6
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%
www.productivepricing.com7
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
www.productivepricing.com8
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?
www.productivepricing.com9
Specialty Vehicle Part Parent
US
Specialty Vehicle Part Subsidiary
France
Parts
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
www.productivepricing.com10
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.
www.productivepricing.com11
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
www.productivepricing.com12
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
www.productivepricing.com13
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
www.productivepricing.com14
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
www.productivepricing.com15
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
www.productivepricing.com16
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
www.productivepricing.com17
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
www.productivepricing.com19
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?
www.productivepricing.com20
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
www.productivepricing.com21
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
www.productivepricing.com22
“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
www.productivepricing.com23
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%)
www.productivepricing.com24
“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
www.productivepricing.com26
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
www.productivepricing.com27
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
www.productivepricing.com28
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
www.productivepricing.com29
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)
www.productivepricing.com30
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
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
www.productivepricing.com31
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”
www.productivepricing.com32
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
www.productivepricing.com33
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
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
www.productivepricing.com35
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?
www.productivepricing.com36
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
www.productivepricing.com37
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
www.productivepricing.com38
GILTI Calculation without Interest Expense
CFC with 10% tax rate, $1.5M income and $8M in QBAI
www.productivepricing.com39
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
www.productivepricing.com40
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
www.productivepricing.com41
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
www.productivepricing.com42
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?
www.productivepricing.com43
Alex MartinProductive Pricing LLC390 N Harvey StreetPlymouth, MI 48170alex.martin@productivepricing.comwww.productivepricing.com+1 248 752-1190
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Contact Details
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