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Tuesday, January 15, 2019

How Does Tax Reform Impact Your Transfer Pricing Plans?


The Tax Cuts and Jobs Act (TCJA) made some major changes to the taxation of U.S. companies with operations in foreign countries. The most significant change for U.S. operations is the lower corporate tax rate. The TCJA moved the country from a graduated corporate tax rate structure, which topped out at 35 percent, to one flat tax rate of 21 percent on corporate income. In addition, several international tax provisions such as the base erosion and anti-abuse tax (BEAT), foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) impact international tax and transfer pricing planning strategies employed by many multinationals.

Taxpayers have options when choosing methods to allocate income from multinational operations for transfer pricing purposes. The lower rate, along with these new international provisions means that multinational companies with U.S. tax obligations may want to review their current structures and available options to see if there are alternatives that reduce their overall tax bill. Here’s a high-level look at provisions in the new law that apply to transfer pricing.

FDII and GILTI: An Indirect Impact on Transfer Pricing

FDII provides a lower effective tax rate for U.S. exports of products, intangibles, and services. GILTI subjects U.S. multinationals’ non-U.S. income earned through controlled foreign corporations to current U.S. taxation. Both, among other provisions, attempt to prevent the shifting of profits to foreign tax havens.

FDII encourages companies to develop and keep intellectual property (IP) in the U.S., rather than migrating abroad, in an effort to maintain the higher, non-routine income derived from the IP within the U.S. FDII also effectively creates an export incentive and rewards companies holding IP within the U.S. by establishing a reduced rate on income associated with certain exports (sales/leases of property, royalties, and services to non-U.S. parties).

GILTI, on the other hand, penalizes companies by subjecting foreign income derived from IP in low tax jurisdictions to current U.S. taxation. This introduces an anti-deferral mechanism to the tax law. FDII and GILTI work in tandem so that the IP of U.S. companies (and the income associated with that IP) remains in the U.S., or is migrated back, if held overseas.

FDII and GILTI have more of an indirect impact on a corporation’s transfer pricing. While IP ownership may increase in the U.S., companies still have incentives to support this IP with offshore technology development service centers in markets with low labor costs. Thus, specific tested intercompany transactions may be altered, in addition to the markets of those tested intercompany transactions, but the level of intercompany transactions – and overall need for transfer pricing analyses – will not necessarily change.

BEAT: A More Direct Impact on Transfer Pricing

BEAT functions effectively as an alternative tax on deductible payments made by U.S. taxpayers to related parties overseas. Compared to FDII and GILTI, it arguably has a more direct transfer pricing impact, in that it involves related parties. BEAT requires applicable taxpayers to pay tax equal to the base erosion minimum tax amount (BEMTA). BEAT targets payments from (to) U.S. companies to (from) related foreign parties. It will generally only apply to those companies with significant related-party payments to foreign affiliates, however, the introduction and application of BEAT makes such significant related-party payments more expensive. These are the included and excluded payments, per BEAT:

  • Included - payments for services (subject to certain exclusions), royalties, and interest
  • Excluded - payments for cost of goods sold (COGS), payments for services tested under the services cost method (SCM) (i.e., services that are more general and administrative in nature and do not contribute significantly to the fundamental success or failure of the business), and qualified derivative payments (subject to specific conditions)

 

Taxing Income From Intangibles

The TCJA does contain two direct changes to the U.S. transfer pricing regime. First, it amends section 936(h)(3)(B) to include the following items in the definition of an “intangible asset” for purposes of section 367(d) and 482:

  • Goodwill, going concern value and workforce in place; and
  • “any other item the value or potential value of which is not attributable to tangible property or the services of any individual…”

 

Second, the TCJA amends both sections 482 and 367(d)(2) to allow the IRS to value intangibles on an aggregate basis or by comparison to realistic alternatives, “if the Secretary determines that such basis is the most reliable means of valuation of such transfers.” Furthermore, the TCJA also repeals the longstanding exception to gain recognition under section 367(a) for transfers to a foreign corporation of property that is used in the active conduct of a trade or business outside the U.S.

To understand why the changes were included and what they do, it helps to know a little of the history behind them. Lawmakers were trying to address what some saw as an inaccurate method used by some companies to reduce their U.S. tax obligations. In court cases against Amazon and the medical technology company Medtronic, the IRS suggested that the taxpayers had unfairly lowered their U.S. tax bill by valuing intangible assets using a “comparable uncontrolled transaction” (CUT) method. The IRS argued that it should be allowed to recalculate the companies’ income taxes using a discounted cash flow method for the valuation.

In each case, the court ruled against the IRS, stating that reliance on aggregation and realistic alternatives to support the discounted cash flow method resulted in a value that included amounts for goodwill, going concern, and workforce in place. In the court’s opinion, that method resulted in inaccurate valuations for the taxpayers under the law in effect at the time.

The TCJA added a provision expanding the definition of intangible assets to specifically include the value of goodwill, going concern, and workforce in place. Theoretically, this should address the court’s concern with the IRS’s use of the discounted cash flow method. In addition, the new law states that the IRS can rely on aggregation and realistic alternatives if it determines that these principles deliver the most reliable results. The changes should allow the IRS to use the discounted cash flow method to value intangible assets for transfer pricing purposes. In the Amazon and Medtronic cases, those valuations would have resulted in higher U.S. tax bills.

What Does This Mean for Your Company?

An article like this can only give you a very high-level glimpse of what these new changes do and how they might affect your business. It is no substitute for a close look at the particular circumstances of your company. With so many big changes in U.S. taxation of international operations, it’s important for any business that allocates income based on transfer pricing to sit down with a knowledgeable tax advisor and evaluate options.

For more information, please contact Nghi Huynh, Partner-In-Charge of Transfer Pricing

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