Tax Reform and Transfer Pricing July 18, 2019 July 30, 2019 Alex Martin Productive Pricing LLC www.productivepricing.com alex.martin@productivepricing.com 1 Personalized Service, Practical Solutions
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. 2 www.productivepricing.com
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 3 www.productivepricing.com
Why is Transfer Pricing Important? Auto parts German U.S. distribution manufacturer Retailers subsidiary $X profit $Z profit $Y charge U.S. taxes 35% of $Z German taxes 30% of $X now 21% of $Z (2018) $Y transfer price drives taxes payable by country • Inventory, royalties, service charges, loans all impact taxes 4 www.productivepricing.com
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) 6 www.productivepricing.com
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% 7 www.productivepricing.com
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 8 www.productivepricing.com
How Do Some Companies Approach Transfer Pricing? France U.S. Specialty Vehicle Specialty Vehicle Parts Part Parent Part Subsidiary US France Royalty Charge • Company has one cost plus policy • Company operates as one “borderless” business • Can the plant manager earn a higher bonus? 9 www.productivepricing.com
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 10 www.productivepricing.com
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. 11 www.productivepricing.com
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 12 www.productivepricing.com
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 13 www.productivepricing.com
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 14 www.productivepricing.com
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 15 www.productivepricing.com
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 16 www.productivepricing.com
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 17 www.productivepricing.com
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%) 18 www.productivepricing.com
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 19 www.productivepricing.com
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? 20 www.productivepricing.com
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 21 www.productivepricing.com
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 22 www.productivepricing.com
“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 23 www.productivepricing.com
Potential Alternative – Benchmarking Study Benchmark Benchmarking study Company EBIT/Sales • Lower-risk situations for Subsidiary Company A 16.3% • Profit margin target for Company B 12.8% subsidiaries Company C 8.2% Adjust TP to reach EBIT Company D 6.3% margin between 5.0% to Company E 5.5% 8.2% for subsidiary Company F 5.0% • CPM/TNMM Approach Company G 0.3% Company H (3.2%) 24 www.productivepricing.com
Famous Last Words “ 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.” 25
TAX REFORM STRATEGIES www.productivepricing.com 26
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 27 www.productivepricing.com
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 28 www.productivepricing.com
What Happens If Transfer Prices Are Increased? Base Case (no FDII) USCo Parent Forco Subsidiary Software Charge Forco $10,000,000 $5,000,000 customers Taxable income Taxable income $2m Royalty Forco taxes US taxes payable at 30% payable at 21% $1,500,000 $2,100,000 What if USCo increases the royalty by $1m? • Increase goods prices, service charges – same effect 29 www.productivepricing.com
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