International Income Taxation Chapter 8: TRANSFER PRICING

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1 Presentation: International Income Taxation Chapter 8: TRANSFER PRICING Professors Wells March 28, 2018

2 Chapter 8 Transfer Pricing Code 482 Issues re establishing the arm s length price between related parties in the following situations: 1) Loans 2) Sales of tangible personal property 3) Leases of tangible personal property 4) Licensing of intangibles 5) Providing of services Purpose of these rules is to place a controlled taxpayer on tax parity with an uncontrolled taxpayer. In this analysis, it is assumed that all the facts are known and both related parties are knowledgeable in the industry. 2

3 Why Engage in Aggressive Transfer Pricing? 1) Tax to shift (a) income from the U.S. or (b) deductions into the United States. Worldwide Taxation US Parent 2) Customs duties to reduce inbound price for imports and, therefore, the amount of customs duties. 3) Corporate planning reduce amount of income of a particular subsidiary where employees or JV partners may participate in profits. Income Shifting Foreign Subsidiary Source Country Taxation Deferral Privilege 3

4 Code 482 Essentials Arm s Length Pricing 1) Commonly controlled entities. Worldwide Taxation 2) Apportionment of gross income, deductions, etc. between parties. 3) To prevent evasion of taxes or clearly to reflect the income... A tax accounting provision to facilitate the determination of the true taxable income of a taxpayer. US Parent Income Shifting Foreign Subsidiary Source Country Taxation Deferral Privilege 4

5 Challenge to the Pricing Adjustment by Taxpayer An accounting adjustment therefore ordinarily more deference to the Service s position on the adjustment. Taxpayer has the burden of proving that any IRS adjustment is arbitrary, capricious or unreasonable. Requirement for correlative allocations and deductions for related parties (if possible). Worldwide Taxation US Parent Income Shifting Foreign Subsidiary Deferral Privilege Source Country Taxation 5

6 Defining Control for Code 482 Purposes p. 715 No specific ownership attribution rules. What about a joint venture, particularly where parallelism of interest exists between the two joint venturers? Example: a joint purchasing arrangement for raw materials. X 50% 50% Y JV, Inc. Standard: Control means any kind of control, direct or indirect, whether legally enforceable, and however exercised. 1. Reality rather than formal control is the critical inquiry. A presumption of control exists if income is artificially shifted. 2. Control exists if two or more unrelated taxpayers act in concern for a common goal. 6

Secondary Consequences of Adjustment Under 482 Rev. Rul. 78-83, p. 716 Triangular dividend treatment.

7 Secondary Consequences of Adjustment Under 482 Rev. Rul , p. 716 Triangular dividend treatment. Dividend P Contribution Excessive amount transferred is treated as: X Y 1) Dividend distribution ( 301) upstream to the common parent corporation; this assumes earnings and profits and Excess Value Variations on Rev. Rul ) Capital contribution downstream to the other entity (including foreign) P P Dividend X Y Contribution Dividend X Y I.L.M (Sept. 16, 2013) (can you guess the FTC issue???) 7

8 Impact of Foreign Law Restrictions p. 718 Proctor & Gamble: (1) P&G U.S. owned (2) AG Swiss which owned (3) Espana. Increase the royalty from Espana to AG? Spanish law applied a limitation on the permitted royalties. (Note: This limitation is not permitted under current EU law.) Held: For taxpayer & no income allocation to AG (which would have been Subpart F income). IRS Position: P&G (US) Subpart F inclusion (FPHCI- royalty) Royalty P&G A.G. (Swiss) P&G Espana (Spain) 8

9 Regs. Concerning Foreign Law Restrictions p.719 1) Must be publicly promulgated and generally applied. 2) Taxpayer must exhaust all available local country remedies in seeking a waiver of these rules. 3) The restrictions must prevent receipt. 4) Related parties must not have engaged in arrangements to circumvent the restrictions. 5) Taxpayers must elect to apply this regulation and identify affected transactions on its tax return. Reg (h)(2). 9

10 Mechanisms to Reduce Double Economic Taxation p ) Correlative adjustments if all entities are subject to U.S. income taxation. 2) Competent Authority mechanism to challenge the adjustment where cross-border situations. See 2006 U.S. Model Income Tax Treaty, Article 25. Example: What is the transfer pricing adjustment and correlative adjustments? P X $100x (overpriced by $5x) Y $100x Customer $100x Sales Price $ 60x COGS $ 40x Reported profit $100x Sales Price $100x Purchase Price $ 0x Reported profit 10

11 Concepts of Arm s Length Pricing Under Code 482 p. 722 Best method rule. Reg (c)(1). Since a range of economic results can occur parties must examine these factors to determine the comparability of uncontrolled transactions to that of the controlled transaction that is being tested: 1. Functions. 2. Contractual terms between the parties. 3. Economic risks. 4. Economic conditions. 5. The nature of the property or services. See Treas. Reg (d). 11

12 Interest on Debt Between Related Parties p. 724 Use a safe haven rate based on the applicable federal rate if not in the business of making loans. Range of not less than 100% of the AFR nor more than 130% of the AFR. See Treas. Reg (a)(2) (revised 2009). 12

13 Rental of Tangible Property p. 724 Establish an arm s length rental amount based on: 1) The period and the location of use. 2) The owner s investment in the property. 3) Expenses of maintaining the property. 4) The type of property involved. Reg (c). 13

14 Providing Services to a Related Party p. 724 Code 482 determine that amount which would be charged for similar services in independent transactions between unrelated parties under similar circumstances. Treas. Reg (b) & Treas. Reg

15 U.S. Steel Corp. Case p. 725 Services Situation Delaware mining company (activities in Venezuela) & Liberian shipping company (Navios). One planning objective was to limit Venezuelan taxes. US Steel (US) Objective to cause transportation costs to be increased to equalize costs for domestic and foreign ore when sold in the United States. 482 allocation partially approved. CASH Orinco (US) FOB (Venez) Navios (Liberia) Shipping Fees CASH Question: Which entity is entitled to the location savings? Unrelated Customer 15

16 UPS Case p. 732 Customer UPS (US) OPL (Bermuda) Excess Value Charges Insurance Policy Fireman s Insurance? National Union (Fronting Entity) Reinsurance Income from excess value charge deflected from U.S. to Bermuda (with intermediary National Union (independent) & reinsurance with OPL. Court of Appeals held arrangement not a sham transaction and remanded. But, subsequently, a 482 analysis. Section 482 issue: which is the tested party: UPS or OPL? 16

17 Specified Methods For Services Set forth in Treas. Reg p Services cost method, no mark-up (new). 2. Comparable uncontrolled services price method. 3. Gross services margin method. 4. Cost of service plus method. 5. Comparable profits method. 6. Profit split method. 7. Unspecified methods. Note: This is a Two- Sided TP Methodology where both parties are tested and residual profits gets shared between the parties. Note: These are One-Sided TP Methodologies where the tested party gets a routine profit determined under the specified method but importantly the residual profits goes to the untested party. 17

18 Supervisory / Stewardship Expense p. 734 Cf., the cost for management services provided for the benefit of the related/parent corporation. Young & Rubicam case p. 734 No 482 allocation required, since for the benefit of the parent corporation. Compare Treas. Reg (l)(3) with Treas. Reg (e)(4) 18

19 Rev. Rul p. 736 Compare in Same Market Foreign sub sells product to (i) Parent corporation and (ii) unrelated purchasers. P (US) A Market Customer 1) Sub can sell product to unrelated purchasers at a higher price because of market conditions in one jurisdiction as contrasted with another jurisdiction. Price? S X+Y X B Market Customer A Market Customer 2) Higher price to parent corporation than to unrelated purchasers in the same jurisdiction - not an arm s length price. 19

20 Bausch & Lomb Irish Mfg. Sub. p. 738 Irish sub was organized to manufacture and sell contact lenses. Product sold to Parent for $7.50 but the manufacturing cost was only $1.50. B&L (US) Sub also paid royalty to Parent of 5 percent to use the spin cast manufacturing process developed by the parent. B&L (Various) $7.50 $ % Royalty B&L (Ireland) $1.50 cost Held: OK to use Irish subsidiary and $7.50 was an acceptable market price. But, the court then looked at royalty rates and engaged in a profit split approach. CUPS Lombart American Hydron American Optical Hydrocurve 20

21 Current Pricing Rules for Tangible Personal Property p. 746 Best method rule (Reg (c) and -8) Reg choices: 1) Comparable uncontrolled price method; 2) Resale price method; 3) Cost plus method; 4) Comparable profits method (or CPM); based on profit level indicators; 5) Profit split method. Note: This is a Two-Sided TP Methodology where both parties are tested and residual profits gets shared between the parties. Note: These are One-Sided TP Methodologies where the tested party gets a routine profit determined under the specified method but importantly the residual profits goes to the untested party. 21

u a l Compaq Parent Compaql Parent Inter-Company Computer Sales

22 One-Sided Transfer Pricing Methodologies: Compaq Computer (p.749) R es Before TP: Cost + 5% Tested Party After TP: Cost + 5% i d u a l Compaq Parent Compaql Parent Inter-Company Computer Sales Residual Profits Compaq (Asia) PTE. LTD. (Singapore) TP: Residual

23 Speakerhouse Problem p. 749 Basic tax planning issue: What is the best pricing method when taxpayer wants the lowest possible price that can withstand examination by the IRS? 1) Comparable uncontrolled price ($150 if US Distributor sales are comparable) 2) Resale price method ($150 gives Swisterco a 25% GPM- the same GPM as on its RT3000 sales) 3) Cost Plus ($150 sales price less $120 cost gives 25% GPM to Speakerhouse- the same GPM as it earns on its S24 sales to US distributors) 4) Comparable profits (we don t have profitability information for Soundsgood) 5) Profit split (50:50 profit split gives $155 price, but split is unclear) Speakerhouse (US) $150 US Distributors $200 US Customers Price? Swisterco (Switzerland) $200 European Distributors RT3000 Net Profit $75 $10 Extra Cost for Packaging S24 & Advertising S24 23

24 Problem 2 p. 750 Comparability? USM sells gismos: (1) delivered to foreign subs and (2) FOB factory to unrelated parties. Same price. Applicability of comparable sales method? Do transportation and insurance costs have a reasonably ascertainable impact on price so as to enable appropriate adjustments? USM (US) FOB US FOB Europe Unrelated Foreign Distributors Related Foreign Distributors 24

25 Problem 3 p. 750 Impact of Trademark? USM sells gismos: Trademark on gismos sold to subsidiaries but not when sold to unrelated distributors. Is the effect on price of the trademark probably material and, therefore, not reasonably estimated? Therefore, the CUP method is probably not reliable here. USM (US) FOB US FOB US +TM Unrelated Foreign Distributors Related Foreign Distributors 25

26 Problem 4 p. 750 Different Area Markets USM sells gismos: Subsidiaries sold to European customers but unrelated distributors sold in Asia. If geographic differences have definitive and reasonably ascertainable effects for which adjustments can be made the CUP method may be acceptable. USM (US) FOB US FOB US Unrelated Asian Distributors Related European Distributors 26

27 Problem 5 p. 750 Foreign Sales Sub Compco (US) sells items - $70 each to Singapore sub to distribute item in Asia. $2 shipment cost (and net $68 to U.S. corp.). Sales to unrelated distributors for distribution elsewhere with terms of sale at $80 FOB factory. Net $68? Compco (US) Pacifico (Singapore) $80 FOB US US Distributors Is the effect to transfer income to the foreign subsidiary and therefore an adjustment should be made? 27

28 Problem 6 p. 750 Foreign Sub Pays Too Much? U.S. corp. sells items for $70 each to Singapore sub to distribute item in Asia. $2 shipment cost (and net $68). Net $68? Compco (US) $60 FOB US US Distributors Sales to unrelated distributors for distribution elsewhere with terms of sale at $60 FOB factory. Taxpayers cannot invoke 482 to make an adjustment. File an amended income tax return based on different prices? Pacifico (Singapore) 28

29 Problem 7 p. 683 Foreign Sub Adds Its Own Trademark to Products Comco affixes its valuable trademark on the products sold to Pacifico but none of its US distributor sales have a trademark. Issue: What is the result now? Price? Compco (US) Pacifico (Singapore) $80 FOB US US Distributors 29

30 Intangible Property Transfers p. 751 Definition: Patents, copyrights, trademarks, confidential know-how, trade secrets. Transfer accomplished either by sale or licensing. Licensing can be either co-extensive with the life of the property or for a shorter period. 30

31 Intangible Property Transfers Regulations p. 754 Best method rule for applicable methods: Comparable uncontrolled method (CUT) Comparable profits method Profit split method (comparable profit split and residual profit split) Unspecified methods. Further consider the super-royalty provision in Code 482 requiring periodic adjustments using the commensurate with income test. P

Cost Sharing Arrangements p. 755 Reg. 1.

Tested Party US-Owned MNE Apple TP: Cost +

32 Cost Sharing Arrangements p. 755 Reg T Agreement to share costs and risks of research and development. Foreign-Owned MNE Nestlé TP: Residual Foreign-Owned Parent No royalties paid since each participant in the cost-sharing arrangement is an owner. Residual Profits CSA US Domestic Subsidiary Tested Party US-Owned MNE Apple TP: Cost + 5% Parent (US) Products Customers No Code 482 adjustments if the arrangement is a qualified cost sharing arrangement. TP: Cost + 5% CSA Owner/Developer (Ireland) TP: Residual 32

33 Administration of Transfer Pricing Issues p ) Report and Contemporaneous Documentation Requirements A & 6038C. 2) Penalty Provisions (e). Accuracy Related Penalty of 20% is increased to 40% if price adjustment exceeds $20 million or 20% of the taxpayer s gross income. A reasonable cause exception only exists if there were reasonable cause for the position plus documentation was developed establishing that the taxpayer reasonably used one of the methods as of the date that the tax return was filed. 6662(e)(3)(B). 33

34 APAs p. 760 Rev. Proc ( ) Factual items: 1) Measurements of the profitability and the return on the investment; 2) Functional analysis of the economic contributions of each party; 3) Industry pricing studies; 4) Competitors and financial data; 5) Criteria concerning comparables. Further: Identify critical assumptions? 34

35 Alternatives for Apportionment p ) Formulary approach State taxation apportion on the basis of three factors: (i) labor costs, (ii) asset values, and (iii) sales receipts. 2) Production sharing arrangements in the natural resource context. Each party is entitled to a quantity of the product produced. 35

36 Transfer Pricing Approach for Global Trading p. 762 Notice p. 693 Global trading of commodities and derivative financial products. Functionally fully integrated operations concerning centralized management of risk and personnel. Use profit split method to allocate income of related operations between taxing jurisdictions. 36

37 Arbitration of Intercompany Pricing Disputes p ) In the U.S. between the IRS and the taxpayer. Using baseball arbitration? Tax Court Rule ) Between the taxing authorities of several countries e.g. Germany, Netherlands, Canada & Belgium treaties, and other newer treaties. 37

MP&S DECOSIMO GLOBAL TRANSFER PRICING DOCUMENTATION, CONSULTING AND ARMS-LENGTH PRICE DETERMINATION

MP&S DECOSIMO GLOBAL TRANSFER PRICING DOCUMENTATION, CONSULTING AND ARMS-LENGTH PRICE DETERMINATION TRANSFER PRICING DOCUMENTATION, CONSULTING AND ARMS-LENGTH PRICE DETERMINATION Transforming global problems into global solutions Transfer pricing is a term used to describe all aspects of intercompany