Basics of International Taxation 2015

Transcription

1 TAX LAW AND ESTATE PLANNING SERIES Tax Law and Practice Course Handbook Series Number D-440 Basics of International Taxation 2015 Co-Chairs Linda E. Carlisle John L. Harrington To order this book, call (800) 260-4PLI or fax us at (800) Ask our Customer Service Department for PLI order number 58281, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

2 13 Transfer Pricing (PowerPoint slides) Neal M. Kochman Caplin & Drysdale, Chartered Steven C. Wrappe KPMG LLP If you find this article helpful, you can learn more about the subject by going to to view the on demand program or segment for which it was written. 415

3 416 Practising Law Institute

4 PLI BASICS OF INTERNATIONAL TAXATION 2015 July 22, 2015 Steven C. Wrappe National Leader, Transfer Pricing & Dispute Resolution KPMG, LLP Neal Kochman Member Caplin & Drysdale, Chartered 417

5 Section 482 and the Arm s Length Principle Transfer Pricing Methods and Their Use Special Considerations for Services and Intangibles Documentation, Advance Pricing Agreements, and Mutual Agreement Procedures Impact of BEPS on Transfer Pricing 2 418

6 419

7 Pricing of transactions between related parties for: Tangible property Services Intangible property Rents Loans 420

8 Governmental interest The related party aspect of the transactions suspends the normal laws of supply and demand Without IRC 482 and similar statues in other countries, related parties could artificially shift income to achieve tax benefits 5 421

9 Transfer pricing planning opportunity Parent (Country A) Sub (Country B) Consolidated Total profit reported on tax return ,000 Tax rate 40% 10% Tax liability before change to transfer price Global effective tax rate (ETR) 31% Effect of transfer pricing change on ETR Total profit after using transfer pricing ,000 to shift 400 of income Tax rate 40% 10% Tax liability after change to transfer price Global ETR 19% 422

10 Exposure to double taxation Parent (Country A) Sub (Country B) Consolidated Total profit reported on tax return ,000 Tax rate 40% 10% Tax liability before Country B transfer pricing adjustment Global ETR 19% Double taxation effect on ETR Total profit after adjustment (increase in profits) ,400 by Country A of 400 (assumes no correlative relief in B) Tax rate 40% 10% Tax liability after Country A transfer pricing adjustment (penalties and interest not included) Global ETR 35% 423

11 Manufacturer Distributor Total Sales Transfer Price 15,000 15,000 COGS < 10,000 > < Transfer Price > < 10,000 > Gross Profit ( %) ( %) 5,000 S, G & A < 1,750 > < 1,250 > < 3,000 > Net Operating Income ( %) ( %) 2,

12 In any case of two or more organizations, trades or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion or allocate gross income, deductions, credits, or allowances between or among such organizations, trades or businesses, if he determines that such distribution, apportionment or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades or businesses. In the case of any transfer (or license) of intangible property (within the meaning of Code Sec. 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. 425

13 Subjective application of the rules Potentially large adjustments and penalties Procedural options Governmental differences Double taxation exposure Figures prominently in financial statement disclosure (ASC 740, formerly FIN 48) OECD Base Erosion and Profit Shifting (BEPS) 426

14 Starbucks paid just 8.6M in U.K. tax over 14 years. BBC News, October 16, 2012 There is a technical term economists like to use for behavior like this. Unbelievable chutzpah. Edward Kleinbard, former Chief of Staff of the Congressional Joint Committee on Taxation, on Apple s efforts to avoid paying taxes. New York Times, May 21, [Google s] highly contrived tax arrangement has no purpose other than to enable the company to avoid U.K. corporation tax. Margaret Hodge, Chair of U.K. PAC, June 12, 2013 Apple pays just 2% U.K. tax as Amazon and Google face questioning. International Business Times, November 5, Google caught in crossfire over French tax planning. Le Figaro, October 19, 2012 International retailers that have lowered U.K. tax by holding trademarks in the Netherlands include not only Starbucks and IKEA but also SABMiller, Nike, Bacardi- Martini, Zara, Speedo and Volkswagen. Het Financieele Dagblad, 15 November 2012 Rampant corporate tax avoidance may not be illegal, but that doesn t make it right or fair. NY Times Editorial, May 25, 2013 From now on I ll be putting away my Kindle and feeding my caffeine addiction somewhere other than Starbucks. We know that Amazon, Google and Starbucks are raking in profits from their economic activity in Britain but using a range of devices to avoid paying their fair share of corporation tax. U.K. Observer, November 18, 2012 Dolce and Gabanna to face trial over tax evasion Milan prosecutors allege the fashion had sold their D&G and Dolce & Gabbana brands to a holding company they set up in Luxembourg in 2004 in order to avoid paying high taxes in Italy. The Telegraph, June 11, 2012 Google insists its Irish headquarters are more than just a post box. Le Figaro, November 6,

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16 Control Arm s length standard Best method rule/ Comparability Transfer pricing methods Arm s length range

17 Any two or more companies owned or controlled by same interests. Definition of controlled in regulations: Reg (i)(4) any kind of control, direct or indirect, whether legally enforceable or not, and however exercisable or exercised, including control resulting from the actions of two or more taxpayers acting in concert or with a common goal or purpose. It is the reality of control that is decisive, not its form or the mode of its exercise. [I]n concert test (B. Forman case (2nd Cir. 1972)) Presumption of control arises if income or deductions have been arbitrarily shifted

18 No hierarchy of methods specified Best-method provides most reliable measure of arm s-length result Best-method varies depending on facts and circumstances If no clear best-method, convergence of results 431

19 Degree of comparability between controlled and uncontrolled transactions Completeness and accuracy of data available Reliability of assumptions Extent of adjustments needed Sensitivity of results to deficiencies in data and assumptions Section examples of application of best-method rule 432

20 Uncontrolled transactions must be sufficiently similar to controlled transactions to provide a reliable measure of the arm s-length result. Five factors: Functions performed Contractual terms Risks assumed Economic and financial conditions Nature of property or services transferred Each transfer pricing method places different degrees of priority on the factors. 433

21 Full range under restrictive rules regarding comparability and adjustments When material differences between comparables and controlled transactions for which adjustments cannot be made, narrowing of range is used to increase reliability of results Generally use interquartile range middle 50% of observations Low Interquartile range High 25% 50% 75% 434

22 435

23 Tangible property Intangible property Services CUP (comparable uncontrolled price method) CUT (comparable uncontrolled transaction method) CUSP (comparable uncontrolled services price method) RPM (resale price method) GSM (gross services margin method) Cost Plus (cost-plus method) CSPM (cost of services plus method) CPM (comparable profits method) (cf. to TNMM in OECD Guidelines) (transactional net margin method) CPM and TNMM (commensurate with income rules) CPM PSM (profit split method) PSM PSM CPS (comparable profit split method) RPS (residual profit split method) CPS RPS CPS RPS Unspecified methods Unspecified methods Income method (coordination with 482-7) SCM (services cost method)

24 Price and cost matching method compares intercompany-controlled transaction to market-based uncontrolled transactions Uncontrolled transaction has either no or minor differences that have definite and reasonably ascertainable effect on price and can be adjusted for; then compare to controlled transaction Similarity of goods and transactions very important 437

25 Controlled price Related mfg Related assembler Internal uncontrolled price Related mfg Unrelated assembler Unrelated mfg Related assembler Unrelated customer Unrelated customer Unrelated customer 438

26 Transactions-based method that measures the value of functions performed Gross profit margin realized is benchmarked against that of comparable uncontrolled transactions Method is not applicable if controlled taxpayer adds significant value to tangible goods (functions differ) (quality vs. quantity) 439

27 Unrelated mfg Related mfg Distributor Unrelated customer Distributor gross margin analysis of similar products purchased from related and unrelated mfg Distributor 3 rd party revenue - Related party COGS Related party gross profit Vs. Distributor 3 rd party revenue - Unrelated party COGS Unrelated party gross profit 440

28 Transactions-based method dependent on similarity of functions performed, risks borne and contractual terms Gross profit markup realized is benchmarked against that of the comparable uncontrolled transactions. Method is used in cases involving manufacture and assembly. Note: Manufacturers tend to use cost-plus in practice to establish prices. 441

29 Unrelated supplier Manufacturer Unrelated distributor Related distributor Manufacturer cost mark up analysis of similar products sold to related and unrelated distributors Manufacturer unrelated revenue - 3 rd party COGS Unrelated party gross profit Vs. Manufacturer related revenue - 3rd party COGS Related party gross profit 442

30 Benchmarks profitability of tested party against that of comparable companies Generally applied to the controlled party that is the least complex and has the fewest valuable intangibles Can adjust comparable companies financial data for differences in functions, risks and accounting methods Method tests transfer prices indirectly 443

31 Business experience Business or product life cycle Management efficiency Property, plant and equipment age IP (as in ) Lines of business Size of business Asset mix 444

32 Based on operating profit comparison Operating profit compensates for: Assets and resources invested Risks assumed Functions performed, to a lesser degree Product differences not as important as in other methods Cost structure, business experience and management efficiency very important 445

33 Operating margin: Operating profit divided by sales Return on assets: Operating profit divided by value of assets actively employed in the business (usually tangible assets) Return on invested capital: Operating profit divided by the value of assets actively employed in the business, minus noninterest-bearing liabilities Berry Ratio: Gross profit divided by operating expenses Mathematically, represents a markup on operating expenses Markup on total costs: Operating profit divided by total costs (include COGS, as well as operating expense) Markup on COGS: Gross profit divided by COGS 446

34 May be used for tangible and intangible property Evaluates whether the allocation of the combined operating profit or loss attributable to controlled transactions is arm s-length by reference to the relative value of each controlled taxpayer s contribution to that combined operating profit or loss Treasury regulations provide for two types of profit splits: Comparable profit split: Rarely used because information on how other related parties are splitting profits is generally not available Residual profit split: Two-step process: (1) allocate a routine profit to basic functions and (2) split any residual profit according to each controlled party s contributions of intangible property to the relevant profit 447

35 Two-step approach: Assign a market return to routine functions Allocate residual profit based on the relative value of contributions of intangible property Methods of approximating relative value include: Relative expenditures incurred in developing intangibles in recent years External benchmarks Capitalized R&D expenditures over a period of years 448

36 For tangible property, intangible property or services Any other method Must provide most reliable measure under best-method rule Additional burden 449

37 Controlled group loans must carry arm slength interest rate from date of loan Rate that would be charged in unrelated transactions under similar circumstances Results of transactions comparable to uncontrolled transactions Interest-free period applies to intercompany trade receivables 450

38 Between 100% and 130% of applicable federal rate (AFR) If actual < 100% or >130% of AFR, IRS to adjust to 100% and 130%, respectively Does not apply to foreign currency loans Does not apply if related-party lender regularly engages in trade or business of making loans or advances to unrelated parties 451

39 General benchmarking methodology Credit rating of borrower Maturity of loan Currency Halo effect increase in entity credit rating because of parent Payment frequency Subordination Fixed v. floating rate Jurisdictions of lender and borrower 452

40 Debate whether guarantees are compensable Debate whether guarantee is provision of service Services regulations exclude guarantees from cost-based treatment; however, likely treatment will not be as a service but handled under forthcoming regulations for global dealing and other financial products In the short term, still options: Guarantee service with no total or actual costs (TAM ) Considered part of passive association benefit However, if guarantee is a significant transaction to the overall fact pattern, more analysis is necessary May require credit and interest rate differential analyses Compensatory guarantees can be useful planning tool as well 453

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42 Added to the Code in 1986, as a response to taxpayers taking advantage of transferring valuable intangibles with high profit potential to related parties in low tax jurisdiction without being appropriately compensated for the transfer Requires that actual profit experience realized from the use of the intangibles be considered in determining arm's length compensation The amount shall be adjusted over time to reflect changes in the income attributable to that intangible periodic adjustments Whitepaper: Viewed this as arm's length, as parties often renegotiate IRS has now adopted the theory that it rectifies information disparities One way street for IRS to use later financial performance Taxpayer can rebut adjustment by showing original assumptions were valid given all available information

43 Where the intangible is transferred for more than one year, the consideration charged is subject to an annual adjustment to assure that the amount is commensurate with income Determination based on relevant facts and circumstances on the whole period of use A determination in an earlier year that the royalty amount is arm's length does NOT preclude an adjustment in later years Statute of limitation does not bar adjustment in future years, even though the tax year of the transfer is closed The power to make a CWI adjustment is with the IRS; taxpayer may not affirmatively use CWI to make a downward adjustment to the payment. See GLAM

44 Primary tax benefit of cost sharing is all participants are considered owner of an interest in the intangible, precluding the transfer pricing rules for intangibles Practical alternative to cross-border licensing New cost-sharing regulations significantly limit use of a cost-sharing arrangement (CSA) on a practical basis 457

45 An agreement between participants (related only) to share costs and risks of developing intangible property The result is a form of co-ownership, typically territorial The arrangement must meet a number of requirements in order to qualify for the regs treatment: Two or more participants Contemporaneously recorded written agreement that contains specific provisions (e.g., duration of arrangement) Identifies intangibles to be developed Provides method to calculate each participant's share of costs consistent with reasonably anticipated benefits (RAB), with adjustment mechanism

46 Control Definitions service Benefit Methodologies Cost only Cost pool and allocation keys 459

47 If activity results in identifiable increment of economic or commercial value, or is reasonably anticipated to do so, recipient would be willing to pay; no benefit if only indirect and remote effects Duplicative activities generally no benefit, unless duplicative activity itself provides additional benefit Shareholder activities no benefit if the sole effect of activity is to protect renderer s investment or facilitate renderer s regulatory compliance Passive association not a benefit 460

48 Services cost method (SCM) Comparable uncontrolled services price (CUSP) Gross services margin similar to resale price Cost of services plus similar to cost-plus Comparable profits Profit split 461

49 An elective provision Evaluates arm s-length price for certain covered services by reference to total services costs with no markup Services eligible for SCM treatment: Specified covered services (white list) listed in Rev. Proc (functional descriptions) Low-margin covered services median of interquartile range 7% Services not eligible for SCM treatment: Key advantages, core capabilities, fundamental risks (in taxpayer s business judgment) Excluded list (black list): manufacturing, production, extraction, construction, distribution, R&D, engineering, guarantees and insurance 462

50 463

51 US transfer pricing penalties may be avoided by meeting requirements under Treas. Reg. Section (d): Taxpayer established transfer pricing result was determined in accordance with methodologies under Section 482 regulations, and taxpayer s use of the method is reasonable. Taxpayer has documentation that sets forth the determination of the transfer price or result in accordance with such method, and that taxpayer s use of the method was reasonable. Documentation is contemporaneous to the time the return was filed and is provided to the IRS within 30 days of its request. 464

52 Substantial valuation (20% penalty) Gross valuation (40% penalty) Transactional Net adjustment Price or value is 200% or more (50% or less) than the correct amount Price or value is 400% or more (25% or less) than the correct amount Net adjustment exceeds the lesser of $5 million or 10% of gross receipts Net adjustment exceeds the lesser of $20 million or 20% of gross receipts 465

53 Sufficient to establish that taxpayer reasonably concluded that the method selected (and applied) satisfied the bestmethod criteria Types of documentation: Ten principal documents (no extension of 30-day requirement) Background documents (IRS may extend 30-day requirement) 466

54 What is an APA? Advance issue resolution program as alternative to administrative process; program recently combined with US Tax Treaty Office to form new APMA Program to handle both APAs and double-tax allocation cases. Binding, written contract between the taxpayer and the IRS (and possibly a foreign tax authority) regarding: Covered Transactions Transfer pricing method target, application of test Term Critical assumptions clauses that release taxpayer and IRS from APA Annual reports Legal effect: IRS (and foreign tax authorities, for a bilateral APA) will regard the APA results as satisfying the arm's length standard Prospectivity vs. rollback Unilateral vs. bilateral APA process multi-functional teams; stages in process

55 Allocate taxing jurisdiction Avoid double taxation Permanent establishment & business profits Arm's length standard Mutual agreement procedure Treaty-based dispute resolution process to avoid double taxation Treaty Article 9 establishes arm's length principle Treaty Article 25 allows competent authorities to endeavor to resolve cases of taxation not in accordance with treaty, e.g., double taxation Mutual Agreement Process (MAP)

56 Rev. Proc Invoke any time adjustment quantified If you resolve case by written agreement (870-AD or 906) CA will only negotiate for a correlative adjustment File in both jurisdictions Government-to-government process - efforts only Lengthy Result Non-binding on taxpayer Inter-governmental agreement Local agreements (e.g., closing agreement) New US treaties now provide for binding baseball arbitration after 2- year stalemate (Belgium, Germany, Canada, France) Binding on governments Not binding on taxpayer

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58 Challenges of a Digital Economy Hybrid mismatch arrangements Strengthen CFC rules Limit base erosion via interest deductions and other financial payments Counter harmful tax practices taking into account transparency and substance Prevent treaty abuse Prevent artificial avoidance of PE status Releases Out Coherence Substance Transparency Assure transfer pricing outcomes are in line with value creation intangibles Assure transfer pricing outcomes are in line with value creation risks and capital Assure transfer pricing outcomes are in line with value creation high risk transactions Establish methodologies to collect and analyze data on BEPS Require disclosure of aggressive tax planning arrangements Re-examine transfer pricing documentation Make dispute resolution mechanisms more effective Multilateral Instruments 471

59 Objectives Risk Assessment Appropriate Consideration in Setting Prices Contemporaneous Penalty Provide Information Needed to Audit Approach Master File Local File Country by Country (CbyC) 472

60 CbyC Template Page 1* Revenue Country Related Party Unrelated Party Total Profit (Loss) Before Income Tax Income Tax Paid (on Cash Basis) Income Tax Accrued Current Year Stated Capital Accumulat ed Earnings Number of Employee Tangible Assets Other than Cash and Cash Equivalents Country A X X X X X X X X X X Country B X X X X X X X X X X CbyC Template Page 2* (Onwards) Activities R&d Holding or Managing IP Purchasing & Procurement Manufacturing & Production Sales, Marketing & Distribution Administrative, Management & Support Services Provision of services to unrelated parties Internal Group Finance Regulated Financial Services Insurance Holding shares or other equity instruments Dormant Other Country Constitue nt Entities Resident in Country Country of Organisation or Incorporatio n if different from Country of Residence Country A Entity A Country B Entity B *Information obtained from Annex III to Chapter V of OECD/G20 Base Erosion and Profit Shifting Project: Guidance on Transfer Pricing Documentation and Country-by-Country Reporting 473

61 Greater transfer pricing risk in more countries from C-by-C information Exposure to double tax is increased, without substantial increase in resources to resolve Greater risk may encourage more centralized management of global transfer pricing by taxpayers - Consistency - Efficiency In turn, centralized management may encourage additional in-house staffing and software - Efficiency - Control 474

62 NOTES 475

63 NOTES 476