taxnotes U.S. Tax Reform Considera ons for Mul na onal Services Companies international by Thomas Zollo, Mike Moore, Anjit Bajwa, and Tom Chamberlin

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1 taxnotes U.S. Tax Reform Considera ons for Mul na onal Services Companies by Thomas Zollo, Mike Moore, Anjit Bajwa, and Tom Chamberlin Reprinted from Tax Notes Interna onal, April 30, 2018, p. 627 international Volume 90, Number 6 April 30, 2018

2 SPECIAL REPORTS tax notes international U.S. Tax Reform Considerations for Multinational Services Companies by Thomas Zollo, Mike Moore, Anjit Bajwa, and Tom Chamberlin Thomas Zollo is a principal in the international tax group of the Washington National Tax practice of KPMG LLP and based in Chicago; Mike Moore is a partner with the business tax services practice of KPMG and based in Denver; Anjit Bajwa is a principal in the economic and valuation services practice of KPMG and based in Houston; and Tom Chamberlin is a managing director in the international tax practice of KPMG and based in Denver. tzollo@kpmg.com, mmoore@kpmg.com, abajwa@kpmg.com, tchamberlin@kpmg.com These comments represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP. The information herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. In this article, the authors review some provisions of the Tax Cuts and Jobs Act and observe how multinational service companies might be affected. On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (P.L ). The legislation fundamentally changes the taxation of multinational entities and includes several provisions targeting cross-border transactions. It was enacted just over two years after the OECD issued its final recommendations addressing base erosion and profit shifting. As multinational companies grapple with the TCJA s potential effects, it has become evident that doing nothing is probably not an option, especially with the law introducing concepts likely to have different consequences for different industries. This article focuses primarily on U.S.-based multinational service companies (MSCs). MSCs use relatively fewer fixed assets than other enterprises; often operate throughout the world, including in less-developed countries with unorthodox tax systems and limited treaty networks; tend to be globally integrated; and contract with customers locally for services that may be delivered in several countries through an extensive web of intercompany transactions. That fact pattern presents several opportunities and challenges under the revised U.S. tax system. Overview of Relevant TCJA Aspects The centerpiece of the new law is the permanent reduction in the corporate income tax rate from 35 percent to 21 percent. The rate reduction puts the U.S. statutory corporate rate closer to the middle of the pack of statutory corporate rates levied by major OECD countries. At the same time, the TCJA provided a significant tax incentive for the export of goods, services, and intangibles and greatly expanded the scope of the U.S. anti-deferral rules. Thus, the law was designed to reduce tax incentives to locate activities outside the United States. Finally, by providing a 100 percent dividends received deduction for distributions from controlled foreign corporations, the TCJA removed the lockout effect that kept U.S. multinationals from repatriating cash to fund domestic investment. The TCJA also enacted the base erosion and antiabuse tax (BEAT), which imposes a minimum tax computed under an alternative tax base that denies any deductions for base erosion payments made to foreign related persons. Because the base erosion payments generally will include payments from a U.S. taxpayer to subcontract services from a related foreign person, U.S.-based MSCs should be particularly concerned about their possible exposure to BEAT. TAX NOTES INTERNATIONAL, APRIL 30,

3 SPECIAL REPORTS The Regular Tax While the TCJA was promoted as a shift to territorial taxation, it is more properly viewed as implementing an immediate worldwide taxation system for U.S.-based MSCs with limited exceptions. Specifically, the income a U.S.-based MSC earns can be viewed as falling into the following six categories. Residual U.S. Income Unless the income of the U.S. group falls into one of the other five categories, it is subject to full taxation at 21 percent. 1 The effectively connected income of a foreign affiliate also is subject to tax at normal rates. 2 Foreign Branch Income If a U.S. taxpayer recognizes income through a foreign branch (including a check-the-box branch), that income is also subject to U.S. tax at the 21 percent rate. Foreign branch income constitutes a separate foreign tax credit basket with a 10-year carryforward. 3 Subpart F Income The TCJA largely left intact the subpart F rules, under which a U.S. shareholder of a CFC is taxed currently on its share of the CFC s subpart F income at normal rates. If the subpart F income is foreign personal holding company income, it generally will be eligible for an FTC in the passive basket category, with a 10-year carryforward. Other foreign-based company income most significantly the foreign-based company services income of an MSC will also be taxed at normal rates but will be eligible for FTCs in the general limitation category, again with a 10-year carryforward. 4 Foreign-Derived Intangible Income The TCJA created the category of foreignderived intangible income (FDII), which generally includes the income a taxpayer earns from (i) the sale of property for ultimate consumption by an unrelated person outside the United States or (ii) the provision of services to any unrelated person outside the United States, or regarding the property of an unrelated person outside the United States. FDII is reduced by a 10 percent return on any qualified business asset investment (QBAI) allocable to eligible sales and services. QBAI consists of tangible property used in the production of income. 5 FDII is eligible for a 37.5 percent deduction (reduced to percent after 2025), resulting in an effective tax rate of percent (16.4 percent after 2025). 6 Whether FDII is U.S.- or foreignsource income is determined under the normal sourcing rules. As a result, income from services rendered in the United States is treated as U.S.- source income, even though it may qualify as FDII. A special rule applicable to related-party transactions provides that if a U.S. taxpayer renders services to a related party outside the United States, its services will not qualify as FDII (even if the related foreign person might ultimately use the U.S. services to complete its service obligations to unrelated persons outside the United States) unless the U.S. taxpayer can demonstrate that its services are not substantially similar to services the related foreign person provides to persons in the United States. 7 That special rule creates a trap for the unwary MSC. Essentially, it means that if a U.S. taxpayer renders services to a foreign affiliate that itself is engaged in the same business, none of its fees from that foreign affiliate will qualify as FDII if the foreign affiliate derives any income from providing services to a related or unrelated person in the United States. Global Intangible Low-Taxed Income The TCJA significantly expanded the scope of CFC earnings subject to current U.S. taxation by creating a category called global intangible lowtaxed income (GILTI). 8 In general, GILTI refers to 1 Section 11(b). 2 Section Section 904(c), (d)(1)(b), (2)(J). 4 Section 904(c). 5 Section 951A(d)(1). 6 Section 250(a)(1)(A), (a)(3)(a). 7 Section 250(b)(5)(C)(iii). 8 See section 951A. 628 TAX NOTES INTERNATIONAL, APRIL 30, 2018

4 a U.S. shareholder s entire share of a CFC s income above a 10 percent return on associated QBAI other than: effectively connected income; subpart F income; income that would be subpart F income but for the high-tax exception; intercompany dividend income; and foreign oil and gas extraction income. 9 GILTI is eligible for a 50 percent deduction (reduced to 37.5 percent after 2025), resulting in an effective tax rate of 10.5 percent ( percent after 2025). 10 It is a separate FTC basket with no carryforwards. 11 A taxpayer may use only 80 percent of the associated foreign taxes against GILTI, although it must include 100 percent of the associated foreign taxes in income under section 78. In a strange and apparently unintended twist, the section 78 gross-up does not itself appear to fall in the GILTI FTC basket. 12 Although the GILTI deduction might make that income appear to be a relatively desirable category of foreign earnings, the lack of any FTC carryforward combined with the now relatively favorable U.S. tax rate might actually make it less preferable than high-taxed subpart F income (even if the taxpayer does not make the high-tax election) or even foreign branch income. As a result, some taxpayers might want to affirmatively plan into foreign-based company sales or services income. Exempt Foreign Income The TCJA left few categories of foreign CFC earnings exempt from immediate U.S. taxation. Coupled with the 100 percent dividends received deduction provided by new section 245A, those exempt earnings are generally never subject to SPECIAL REPORTS U.S. taxation. 13 Exempt income includes the 10 percent return on QBAI, high-tax subpart F income for which the high-tax election is made, and foreign oil and gas extraction income. Because of the reduction in the U.S. corporate tax rate, a CFC s earnings qualify as highly taxed if they are taxed at a rate higher than 18.9 percent that is, 90 percent of 21 percent. 14 Because many foreign tax rates exceed that threshold, MSCs should consider turning some of their income into foreign-based company services income. Finally, unlike manufacturing companies, MSCs generally operate with limited investments in fixed assets, which leads to lower QBAI and thus higher excess income subject to GILTI tax. The BEAT Under BEAT, an applicable taxpayer is required to pay a tax equal to its minimum tax amount for the tax year. 15 In general, large MSCs likely will need to consider the application of BEAT. The tax generally is equal to 10 percent (5 percent in tax years beginning in 2018) of the taxpayer s normal taxable income increased by its base erosion payments that is, its modified taxable income reduced by its research and development credit and 80 percent of some other credits. FTCs do not reduce BEAT. The term base erosion payments means any amount paid or accrued to a related foreign person that is deductible, including depreciation and amortization on property purchased from a related foreign person. Whether a person is related for BEAT purposes is broadly defined, including not only any 25 percent owner and any 50 percent affiliate, but also any person who is related to the taxpayer under section 482. The section 482 standard is extremely imprecise and 9 Section 951A(a), (b). 10 Section 250(a)(1)(B), (a)(3)(b). 11 Section 904(c), (d)(1)(a). As described, foreign branch income constitutes a separate FTC basket with a 10-year carryforward. Why branch foreign taxes qualify for a carryforward while GILTI foreign taxes do not is also unclear. However, the differences between the treatment of CFC and branch income present the opportunity for tax planning based on the taxpayer s individual tax position. 12 See section 904(d)(1)(A), which limits the GILTI basket to section 951A income. 13 Otherwise exempt income is still subject to possible inclusion at the U.S. shareholder level under section 956. This possibility creates an opportunity for well-advised taxpayers (if including the exempt income would carry high foreign tax credits) and a trap for the unwary. 14 Section 954(b)(4). 15 To be an applicable taxpayer, a U.S. MSC must: (1) be a corporation other than a regulated investment company, a real estate investment trust, or an S corporation; (2) have average annual gross receipts of at least $500 million for the preceding three years; and (3) have a base erosion percentage of at least 3 percent. The base erosion percentage is equal to the taxpayer s base erosion payments divided by its total deductions. See section 59A. Some aggregation rules apply for the gross receipts test. Section 59(e)(3). TAX NOTES INTERNATIONAL, APRIL 30,

5 SPECIAL REPORTS generally includes any persons under common control. BEAT is more likely to apply to MSCs than to manufacturing enterprises. Costs included in cost of goods sold are not considered deductions because cost of goods sold is a reduction to gross receipts in computing gross income rather than a deduction from gross income. As a result, when a U.S. taxpayer purchases components or manufacturing services from a related foreign person, its payments are not base erosion payments. For a U.S. service company that subcontracts some services to a foreign related person, however, the payments would be deductions and therefore would be base erosion payments. As a result, managing BEAT could require an MSC to either have its group members contract directly with customers for the performance of services or have a foreign group member act as the general contractor with customers. Overview of a Typical MSC MSCs include companies that perform a range of services, including engineering and construction; oil field services; natural resource exploration, drilling, and extraction; and professional advising. They tend to operate in multiple jurisdictions, including a mix of highand low-tax jurisdictions. 16 To execute its business model, an MSC may have multiple legal entities in a jurisdiction in the form of CFCs, tax-transparent entities, nonresident entities with local permanent establishments, or some combination of the three. Further, because group or consolidated filings are limited or unavailable, an MSC could have multiple tax filing obligations per jurisdiction. MSCs often have a relatively fluid business model to allow the flexibility to win and serve global opportunities. Projects or contracts might be spread over many years, and profitability can vary annually over the life of a contract. Because of timing differences between U.S. and foreign income tax laws, a U.S. MSC whose CFCs generally are subject to high foreign taxes, might still owe residual U.S. tax in a particular year if 16 KPMG International online tax rate data shows that for 2018, the average global corporate income tax rate will be close to 23 percent. significant income is recognized in that year for U.S. tax purposes but not for foreign tax purposes. MSCs often have the local affiliate in the customer s jurisdiction enter into the customer contract, even though the local affiliate might rely on other affiliates to manage and deliver the project. In those cases, the local affiliate might contractually bear the MSC s residual risks of the project even though it does not have the practical ability to control those risks. If the project is unsuccessful, the local affiliate might incur a tax loss. If the affiliate operates in a smaller economy, that loss might not be used for several years, if ever. MSCs tend to be regionally or globally integrated so that appropriate resources are available to deliver on projects. The supply chain for MSCs can be complex. For example, an MSC might manufacture tangible property in costeffective locations and warehouse parts near customer sites where they render services. MSCs might also develop intellectual property that is owned centrally (for example, in the United States) or regionally and made available to affiliates through licenses. Finally, MSCs might rely on a pool of international employees who are deployed through temporary assignment to project sites. To add to the complexity, an MSC can have multiple business segments, with each having its own supply chain and set of value drivers. In each business segment, the size and riskiness of the project might dictate its project-specific supply chain. For some intercompany transactions commonly observed in MSCs, see the table. Overview Key U.S. Tax Planning Considerations As described, MSCs are more likely than other enterprises to face a BEAT liability. Accordingly, they must carefully structure their intercompany and third-party arrangements with both the normal tax and BEAT in mind. Regarding both tax regimes, however, the foundation of good tax planning is a transfer pricing system that produces predictable and defensible profit allocations among group members. As discussed, the commercial flexibility 630 TAX NOTES INTERNATIONAL, APRIL 30, 2018

6 General List of Intercompany Transactions for a Typical MSC of MSCs has often led them to contract with customers locally and have the local affiliate subcontract performance of most of the services to foreign affiliates. Further, the MSC s key decisions on whether to bid on a project, how to price the bid, and how to staff and execute the project might be made outside the contracting jurisdiction. Yet if the MSC s transfer pricing system rewards all the subcontractor affiliates with limited risk returns, the local contracting affiliate bears all the residual project risk. That risk allocation is inconsistent with the OECD transfer pricing guidelines if it does not align the entrepreneurial profit-and-loss potential to the enterprises that actually manage the related risks. That misalignment of risk and rewards often creates a greater risk of scattered, unbenefited losses because risks are dispersed among various and sundry affiliates rather than being concentrated in the hub jurisdictions where the group s risks are regularly managed. As a result, losses from unsuccessful projects are forced back to contracting entities that might have little potential to use them against other projects. If the residual profits or losses were instead allocated to the hub locations responsible for managing multiple deals, the losses likely would be offset by profits from other projects. The TCJA makes predictability of international transfer pricing even more important because the ultimate U.S. tax consequences will depend on companies being SPECIAL REPORTS Tangible Property Intangible Property General Services Financial Services Equipment Royalties Management Guarantees Parts R&D cost sharing Administrative Loans Engineering Secondments Leasing Marketing/sales Technical services including (i) support; (ii) installation; and (iii) operational maintenance Factoring Cash pooling able to predict how much income will be in each income category and managing the FTC consequences of income allocation. Regular Tax Considerations The TCJA was designed to reduce tax incentives for multinational groups to locate assets and activities outside the United States. The primary domestic incentives were the lower regular tax rate (21 percent) and the lower effective FDII tax rate (initially percent). At the same time, the extension of immediate taxation to GILTI might create a disincentive to move assets and activities offshore. Regarding its domestic operations, qualifying income as FDII will be an important consideration for MSCs. At a high level, a U.S. corporation s FDII is the amount of its deemed intangible income attributable to sales of property (including licenses and leases) to foreign persons for use outside the United States, or the performance of services for persons or property located outside the United States. Thus, the FDII incentive regime extends well beyond income associated with actual intangibles. The FDII deduction encourages companies to keep (or relocate) their value drivers in the United States. It is intended to benefit companies that conduct all their value-driving activities in the United States, but it will not benefit MSCs that create and retain intangible assets and other value drivers, such as the provision of key services, abroad. Also, the higher the margin on export transactions, the higher the FDII benefit. TAX NOTES INTERNATIONAL, APRIL 30,

7 SPECIAL REPORTS The FDII regime could benefit an MSC in a few respects. First, an MSC might find it advantageous to centralize IP ownership in the United States and license the IP to foreign affiliates for foreign use. That structure might be advantageous because the royalties will qualify as FDII if used by the licensees to render services to unrelated foreign customers, and also because it is likely to generate general limitation foreignsource income that may be sheltered with excess credits from other foreign-source income. Second, if the U.S. affiliate provides valuable services to foreign affiliates that permit them to perform their obligations to foreign customers, the income might qualify as FDII. Because the U.S. services might be non-routine contributions that contribute significantly to the profitability of contracts and are essential to managing key risks, MSCs may consider contingent compensation arrangements as opposed to simple cost-plus arrangements that increase the U.S. company s profit potential for its services. Qualifying domestic service fees as FDII does face one major hurdle, however. As discussed, the provision of services by a U.S. corporation to a foreign related party will not qualify as FDII unless the taxpayer can establish that those services are not substantially similar to those provided by the related foreign party to persons in the United States. That rule has two aspects that merit consideration. First, if the related foreign service provider renders any substantially similar services to a person in the United States, whether on the same project for which it receives U.S. assistance or otherwise, the fees received by the U.S. company will not qualify as FDII. Second, the special rule applies on a foreign-affiliate-byforeign-affiliate basis. As a result, an MSC may avoid it by segregating its activities in a country into separate entities so that the entity receiving U.S. services does not employ any of the individuals involved in delivering U.S. services. Despite the incentives to keep or relocate assets and activities in the United States, the most significant concern for MSCs will likely be how to structure their foreign operations from a U.S. tax perspective. While GILTI may at first blush seem desirable, the 20 percent haircut on FTCs and the lack of an FTC carryforward might make GILTI treatment undesirable except for income earned in relatively low-tax environments. Although the legislative history of the TCJA indicates that a foreign effective tax rate of percent that is, 10.5 percent divided by the 80 percent limit on creditable foreign taxes would shield GILTI from residual U.S. tax, it ignores that the allocation of U.S. expenses against GILTI basket income will reduce the foreign taxes actually needed to offset the U.S. tax allocated to the GILTI basket. The lack of an FTC carryforward for the GILTI basket results in any additional foreign taxes being lost. Because MSCs often derive much of their income in medium- or high-tax countries, taxpayers should consider whether they would be better off structuring their income in those countries as foreign-based company services income (either electing out of subpart F income under the high-tax exception or not), or foreign branch income. Creating foreign-based company services income could be relatively simple. For example, suppose the MSC has a U.S. affiliate or one or more regarded CFC hubs enter into third-party contracts to provide services. The MSC could place all its service affiliates under a CFC formed in a country where no services are likely to be performed, and elect to have the service affiliates be disregarded as separate from the CFC. If the regarded contracting entity were then to subcontract the performance of services to the service affiliates, their income would be foreignbased company services income because the regarded CFC would be considered to have rendered services to a related person outside its country of incorporation. As discussed, if the foreign-based company services income has a foreign tax rate of more than 18.9 percent, the U.S. shareholder may elect to exclude the income from subpart F under the high-tax exception. In that case, the income would not be subject to additional U.S. tax and could be repatriated tax-free under the section 245A 100 percent dividends received deduction. Alternatively, if the effective foreign tax rate on the foreign-based company services income were higher than the rate necessary to fully shelter the income under the FTC (for example, TAX NOTES INTERNATIONAL, APRIL 30, 2018

8 percent), 17 the U.S. shareholder might not make a high-tax election. In that case, the subpart F inclusion would create excess FTCs in the general limitation basket that could be used to shelter other foreign-source general limitation income from U.S. tax. That income might include, for example, royalties the U.S. group recognized from licensing IP to the foreign affiliates for use in rendering their services. Finally, if the effective foreign tax rate (including foreign withholding taxes on dividends) were sufficiently high to shelter the income from residual U.S. tax, the United States might elect to have the foreign subsidiaries treated as branches. 18 If so, payments from the United States to the foreign affiliates would become disregarded transactions and reduce the U.S. group s base erosion payments in applying the BEAT. BEAT Planning As described, because U.S. payments to foreign affiliates as subcontractors would create deductions (rather than being treated as part of cost of goods sold), MSCs are particularly likely to have to pay BEAT. Indeed, because the definition of relatedness for BEAT includes any entity under common control under section 482, a foreign person with no overlapping ownership may be treated as related if it is considered to be under practical common control or acting in concert with the U.S. company to reduce U.S. taxes. That loose definition could, for example, cause joint venture partners to be considered related parties. 19 As a result, U.S.-based MSCs should consider various techniques to reduce their base erosion payments, which could include some combination of the following: If a project will be delivered using foreign resources, the MSC should try to have a 17 Because the foreign-based company services income would be burdened by an allocation of U.S.-level expenses, the foreign effective tax rate necessary to shelter the tax on the net foreign-source income would be less than 21 percent. 18 Alternatively, the U.S. shareholder could elect the high-tax exception and trigger an income inclusion under section 956 to access the associated credits. 19 See, e.g., B. Forman Co. v. Commissioner, 54 T.C. 912 (1970), aff d, 453 F.2d 1144 (2d Cir. 1972). SPECIAL REPORTS foreign affiliate enter into the customer contract and subcontract some of the services to the United States instead of having the U.S.-based MSC enter into the contract and subcontract to the foreign affiliates. Even if the U.S. affiliate is involved in negotiating the customer contract, it may do so as an agent for the foreign principal. 20 As discussed, if the U.S.-based MSC uses a foreign affiliate in a high-tax country as a subcontractor, it could elect to have the foreign affiliate treated as a foreign branch. That election would eliminate the base erosion payments resulting from the use of that affiliate as a subcontractor, and the U.S. tax on the branch might be sheltered by FTCs. However, because the alternative would bring the foreign affiliate s income into the U.S. tax net, it would be exposed to future increases in the U.S. corporate rate. Thus, this technique should be used with caution. A less dramatic approach would be to consolidate the employment of international assignment employees in a U.S. subsidiary. That international assignment company would create PEs in the countries where its employees operate, the U.S. group members would be relieved of having to make base erosion payments for those services, and the foreign services would create foreign-source income, presumably in the branch basket. Services that qualify for the services cost method under section 482 regulations, or that would qualify for the method if the business judgment rule regarding services that contribute significantly to the business risk of success or failure did not apply, are not treated as base erosion payments. In general, services qualify for the services cost method if they are covered services and are not specifically excluded services. Covered services include those identified in the Rev. Proc , C.B. 295, as qualifying services and low-margin services attracting 20 The use of a dependent agency arrangement may cause the foreign principal to be considered engaged in a U.S. trade or business. However, if the foreign principal renders all its services outside the United States, its income should not be effectively connected income. TAX NOTES INTERNATIONAL, APRIL 30,

9 SPECIAL REPORTS a median markup of less than 7 percent. Excluded activities include manufacturing and production; extraction, exploration, or processing of natural resources; construction; R&D, engineering, and scientific services; and financial transactions, including guarantees, insurance, or reinsurance. If a foreign affiliate is procuring goods or services from third parties that are used directly by the U.S. entity, the affiliate should act as a purchasing agent on behalf of the U.S. entity instead of bundling the third-party costs into its charges as a service provider. If possible, the third party should bill the U.S. company directly. In this case, the third-party passthrough costs should be excluded from BEAT. This approach would not apply if the foreign affiliate is purchasing goods or services used in its own business of providing goods or services to the U.S. entity. The intercompany invoicing should separately state passthrough costs and not bundle them with other expenses. The U.S. entity should also pay a separate agency fee to its foreign affiliate. If the services relate to inventory property held by the U.S. affiliate, consideration should be given to whether those services may be capitalized to inventory under the uniform capitalization rule. If those costs were not previously included in cost of goods sold, the taxpayer should consider whether to file for a change in accounting method. The TCJA imposes significant additional restrictions on interest deductions. Under revised section 163(j), a U.S. group s annual interest deductions are limited to 30 percent of income before interest, tax, depreciation, and amortization (reduced further to 30 percent of income before interest and taxes after 2022). If a U.S. group has outstanding debt with foreign affiliates, it should consider whether to repay or capitalize the debt to reduce its base erosion payments. Base erosion payments also include amortization and depreciation on property a U.S. corporation purchased from a related foreign person after the effective date of the BEAT rules, which is the U.S. company s first tax year beginning after December For calendar year taxpayers, therefore, the rules apply now, but taxpayers should be careful to exclude from BEAT amortization and depreciation on assets purchased before the effective date. Fiscal year companies may still have a preeffective-date window to consider whether to purchase assets currently leased or licensed from foreign related persons. International Other Tax Considerations U.S. tax reform could further increase tax authorities focus on transfer pricing and international tax avoidance, already heightened as a result of the BEPS initiative. The focus of BEPS is on aligning the profits of multinational groups with their value-creating activities. By reducing domestic rates and expanding the reach of U.S. anti-deferral rules, the TCJA reduces some of the incentives U.S.-based multinationals had to shift profits into low-tax jurisdictions with limited substance. Even so, MSCs may consider changing their supply chains, contractual arrangements, and risk allocations in response to both the TCJA and BEPS. Those changes must be reported as part of BEPS action 13 compliance under country-bycountry reporting, as well as master- and local-file requirements. As a result, an MSC s CbC form for 2018 may look very different from its form for The MSC will also have to describe any business restructurings in the master file. Those changes could result in local review of the changes for possible exit taxes. Foreign tax authorities also will be concerned that U.S. taxpayers might, to manage their BEAT exposure, reduce payments to related parties with no corresponding change in the underlying functions, risks, and assets involved. Similarly, the IRS will be concerned with the use of transfer prices to reduce U.S. tax exposure on foreign income, both under the regular tax and BEAT. Indeed, the expansion of the U.S. anti-deferral rules under GILTI may result in the IRS more closely examining transactions between foreign 634 TAX NOTES INTERNATIONAL, APRIL 30, 2018

10 affiliates. Those concerns might result not only in more examination activities, but also in increased activity in mutual agreement proceedings under tax treaties and increased reliance on advance pricing agreements, including APAs with rollbacks. The TCJA s expanded definition of intangibles might also strengthen the IRS s case against companies and lead to more audits of U.S. multinationals. Proponents of the new legislation might argue that broadening the definition of intangibles covers more activity and therefore presents fewer opportunities to contest whether something is taxable. For example, companies and tax authorities previously argued over whether workforce in place the value of having a group of assembled and trained employees is an intangible asset. Under the new rules, workforce in place is clearly an intangible asset. But that definitional change could simply mean that disputes will now arise over how, rather than whether, to value workforce in place. Tax reform planning may increase pressure on issues already visible to IRS compliance campaigns (recently launched independently of tax reform). Those campaigns, for example, subject inbound distributors to increased scrutiny regarding the appropriate level of U.S. profits, both of the distributor itself and, potentially, of the U.S. PE exposure of a foreign principal. State and Local With the drop in federal rates, state and local taxes will represent a more significant portion of SPECIAL REPORTS the total U.S. tax cost. Not all states piggyback on the federal rules, and they can adopt changes to move away from the federal system. States are determining whether, from fiscal and competitive perspectives, they can afford to conform to federal-level incentives. State tax compliance is expected to be messy while rules are in flux. On a more positive note, some states might follow the federal government s lead and implement new incentives to compete for investment and jobs. Conclusion The TCJA has transformed the U.S. international tax paradigm. It requires MSCs to ask whether changes to their existing intercompany and third-party arrangements are appropriate to manage their tax liabilities under the new U.S. regime and the emerging international rules being developed in response to the BEPS project. That review should begin with a fresh look at the functions, assets, and risks that determine the MSC s profits. The operating model selected should, as required by BEPS, align the intercompany commercial arrangements and profit allocation to the MSC s value-adding activities. Within that constraint, the MSC should reconsider its legal structure and contractual arrangements with the new tax regime in mind. Finally, because the interaction of the new rules is complex, the MSC should carefully model the resulting tax consequences under various reasonably foreseeable operating outcomes. TAX NOTES INTERNATIONAL, APRIL 30,