International Tax and Transfer Pricing Update December 2, 2016

Transcription

1 International Tax and Transfer Pricing Update December 2, 2016

2 Circular 230 Disclaimer Any written advice contained in or attached to this document/presentation is not intended or written by WTP Advisors to be used, and cannot be used, by any person for the purpose of avoiding any penalties that may be imposed under the Internal Revenue Code. Page 2

3 Some relevant questions we will answer today How can an IC-DISC can help your exporting clients save U.S. federal income tax and become more competitive? How does the foreign tax credit work to avoid double taxation of foreign profits for passthrough entities and their shareholders? When should a client check the box or uncheck the box? How can Subpart F a turn favorable tax situation turn into a tax nightmare? Why is transfer pricing more important than ever? How can FATCA turn into a withholding tax quandary? Why an LLC is not the best choice for inbound investment? Q&A Page 3

4 Case Study How can an IC-DISC can help your exporting clients save U.S. federal income tax and become more competitive?

5 IC-DISC: Fact vs. Fiction Facts: An IC-DISC is an export incentive found in the Internal Revenue Code Sections Enacted in 1971 Revised in 1984 Basically unchanged since 1984 It is a domestic C corporation with a special election to be taxed as an IC-DISC Any party foreign or domestic can own an IC-DISC An IC-DISC files its own tax return but does not pay tax An IC-DISC can save the owners of a pass-through entity tax on export profit anywhere from 15.8% to 19.6% Tax benefits can be enhanced with detailed transactional computations typically increased by 30% to 75% (sometimes greater increases are possible) Page 5

6 IC-DISC: Fact vs. Fiction Fictions: All export sales can qualify for IC-DISC Only sales to foreign parties qualify Even sales to U.S. customers can qualify even if the U.S. customer further manufactures If a Maquiladora is used, the export sales can still qualify IC-DISC commissions are limited to export sales of $10 million IC-DISCs must receive commissions and pay dividends by December 31 annually IC-DISC commissions can be computed using book income If the exporting entity has an overall loss then there can be no IC-DISC commission expense (The no loss rule ) IC-DISC bank account must always have at least a $2,500 balance IC-DISC dividend is not subject to Section 1411 net investment income tax Page 6

7 IC-DISC Case Study Facts: For 2016, Exporter has $11 million in total sales with $4.4 million being qualified export sales. Exporter has total net taxable income of $0 after paying bonuses to some active shareholders. Exporter makes very large machines each selling for $2 million, therefore there are only machine 5 transactions for the entire year. The other $1 million of sales consist of 1,000 transactions that are only parts sales. Exporter has an IC-DISC in place the entire year. Because Exporter has no income, they have informed you on February 25, 2017 Exporter informs you they do not plan to use the IC-DISC for 2016 because there is no tax benefit. What should your response be? Possible Answers: I agree, it makes no sense to use the IC-DISC. Exporter, that is not correct, you don t know what you re talking about. That may be correct, however, depending on the specific facts, you may still be able to generate a tax benefit. I recommend that you transfer $500,000 to the IC-DISC by the end of February, to preserve the ability to use the IC-DISC for 2016 Page 7

8 Combined Taxable Income Computation Exporter 31-Dec-16 IC-DISC commission computation Domestic Export Export Total Domestic Export Total Machines Transaction 1 Transaction 2 Machines Parts Parts Parts Other Total Sales 6,000,000 2,000,000 2,000,000 10,000, , ,000 1,000,000 11,000,000 Cost of Sales 3,600,000 1,000,000 1,400,000 6,000, ,000 80, ,000 6,200,000 Gross Margin 2,400,000 1,000, ,000 4,000, , , ,000 4,800,000 Other Income 1,000 1,000 Total Income 2,400,000 1,000, ,000 4,000, , , ,000 1,000 4,801,000 Interest Expense 120,000 33,333 46, ,000 12,000 8,000 20, ,000 R&D Expense 1,200, , ,000 2,000, ,000 80, ,000 2,200,000 SG &A Expense 1,382, , ,645 2,304,194 46,084 30,723 76,806 2,381,000 Total Expense 2,702, , ,312 4,504, , , ,806-4,801,000 Combined Taxable I (302,516) 182,634 (384,312) (504,194) 301, , ,194 1,000 (0) -5.04% 9.13% % -5.04% 50.32% 50.32% 50.32% 0.00% Page 8

9 IC-DISC Commission Computation All Export Sales grouped together: Export sales of $4.4 million Loss of $401. IC-DISC commission would be $0. Group Machine export sales together/separate from Parts Machine export sales of $4 million Loss of $201,678 IC-DISC commission would be $0 Parts sales of $400,000 Profit of $201,277 IC-DISC commission of $100,639 Do not group Machine sales/separate from Parts Transaction 1 sales of $2,000,000 Profit of $182,634 IC-DISC commission of $91,317 Parts IC-DISC commission of $100,639 Total IC-DISC commission of $191,956 Page 9

10 IC-DISC Case Study Conclusion Deduct $191,956 on Exporter 2016 tax return Within 90 days of filing Form 1120-IC-DISC $308,044 is paid back to Exporter under the 90 day rule. $191,956 either distributed as a qualified dividend or deferred in IC-DISC in a qualified export asset and continue to defer from tax Assuming 15.8% rate differential, Exporter shareholders save $30,329 in federal income tax. If Exporter were a C corporation, then corporate tax of $65,265 would be permanently saved. Page 10

11 IC-DISC Takeaways IC-DISC commission is based both on profitability and volume. The devil is in the details. The more detail you get into, generally the greater the commission expense will be. IC-DISC rules are old and inflexible. IC-DISC is a prospective only benefit. Can t set up IC-DISC in December and obtain benefits for the whole year; January through November is lost. There are a number of different ways the IC-DISC can be used to generate permanent benefits. In situations were a large percentage of the business is for export consider the impact of timing differences on the IC-DISC permanent benefit. Page 11

12 Case Study When should a client check the box or uncheck the box?

13 Pertinent Questions Check the Box What does it mean to check the box? U.S. election to treat a foreign entity as a pass-through entity 2 or more owners Partnership 1 owner disregarded entity No impact on foreign taxation Income or loss flows through to U.S. tax return Converts all foreign taxes paid to Section 901 direct foreign taxes Puts a U.S. individual on the same plane as a C corporation Can I check the box on a foreign entity? Some foreign entities are per se corporations under U.S. law. This means that you can t check the box on this entity to change its U.S. tax classification Page 13

14 Pertinent Questions Check the Box (con t) Should I check the box on an eligible foreign entity? Is this a new entity or an existing entity? If new, only impact is with respect to prospective earnings If existing, checking the box can impact both historic as well as prospective earnings What is the accumulated E&P of the existing entity? What is the tax rate in the local country? The higher the tax rate the more beneficial the impact of the check the box election The lower the tax rate the less beneficial the impact of the check the box election Will the foreign entity generate income or loss? If income, and tax is paid, taxes can be credited in the U.S. If loss, loss can be deducted in the U.S. and the foreign country. How do I make a check the box election? Obtain Federal ID number for foreign entity Complete and file Form 8832 within 75 days of desired effective date If new entity initial election can be changed any time If existing entity election can t be changed for 60 months Unchecking the box also has issues» Section 367(d)» Valuation» Branch loss recapture Page 14

15 Impact of Check the Box Election Foreign Tax Credit Check the Box Facts: U.S. S corporation owns 3 check the box entities; Canada ULC; Japan GK; Singapore Ltd. Dividend payments are subject to dividend WHT in Canada and Japan of 5% S Corp S Corp S Corp Canada Japan Singapore Foreign Earnings 100, , ,000 Foreign Tax 25,000 35,000 17,500 After tax earnings 75,000 65,000 82,500 Dividend 75,000 65,000 82,500 Dividend WHT 3,750 3,250 - US Source Income Foreign Source Income 100, , ,000 Total Income 100, , ,000 US Source Expenses Foreign Source Expenses Total Expenses Net Foreign Source Income 100, , ,000 Total Net Taxable Income 100, , ,000 Total US Tax 39,600 39,600 39,600 Less: Foreign Tax Credit 28,750 38,250 17,500 Net US Tax 10,850 1,350 22,100 Total Tax Paid 39,600 39,600 39,600 Effective Tax Rate 39.60% 39.60% 39.60% Page 15

16 Check the Box Election Results In CERTAINTY Income will be taxed at the higher of the U.S. Rate or the foreign rate Presently the U.S. individual rates are higher than all foreign corporate rates Page 16

17 Tax Reform Tax reform proposals would likely reduce U.S. tax rate on business profits Change would require a re-evaluation of whether Check the box makes sense. Page 17

18 Case Study Use of tax treaty to enhance global tax result vs. Checking the Box

19 Alternative to Check the Box Use of treaty jurisdictions to achieve even better result by effectively using foreign holding companies Obtain qualified dividend income treatment in U.S. Do not add any additional foreign tax to the structure Maintain low tax rate benefits in local country This can add administrative cost to the structure, however usually much less than tax savings. Page 19

20 Check the Box Case Study Facts: U.S. S Corporation owns Singapore CFC. Singapore CFC has accumulated earnings and cash of $5 million. U.S. S Corporation wishes to repatriate $5 million. U.S. is otherwise breakeven for the year. S Corporation comes to you for advice. What advice do you give them? Go ahead and repatriate, the dividend will be taxed at 20% Go ahead and repatriate, the dividend will be taxed at 39.6% Never repatriate, you should move to Singapore Before you repatriate, lets first determine what the E&P of Singapore is, and then lets see if we can t come up with a workable structure using a foreign holding company to reduce the U.S. tax on the repatriation to 20% instead of 39.6% Page 20

21 Check the Box Case Study Foreign Tax Credit CFC vs. Check the Box vs. EU Holdco Singapore Singapore Singapore CFC CTB UK Holdco Foreign Earnings 100, , ,000 Foreign Tax 17,500 17,500 17,500 After tax earnings 82,500 82,500 82,500 Dividend 82, ,500 Dividend WHT US Source Income Foreign Source Income 82, ,000 82,500 Total Income 82, ,000 82,500 US Source Expenses Foreign Source Expenses Total Expenses Net Foreign Source Income 82, ,000 82,500 Total Net Taxable Income 82, ,000 82,500 Total US Tax 32,670 39,600 19,635 Less: Foreign Tax Credit 0 17,500 Net US Tax 32,670 22,100 19,635 Total Tax Paid 50,170 39,600 37,135 Effective Tax Rate 50.17% 39.60% 37.14% Page 21

22 Check The Box - High Tax Country U.S. S Corporation Desire Direct Foreign Tax Credits CTB Planning Single level of tax Foreign tax rate greater than 20.8% Wrong choice can lead to global effective tax rate well in excess of 39.6% Foreign High Tax Opco Page 22

23 Check the Box Low Tax Country U.S. S Corporation Foreign Low Tax Opco Desire Deferral of earnings from U.S. tax Potential double taxation Be Mindful of Subpart F Affirmative use of transfer pricing Foreign tax rate less than 20.8% Eventual repatriation Extension of Qualified Dividend Income Rates is necessary, however, often non-treaty country Wrong choice results in residual U.S. Tax. Page 23

24 Check the Box Use of Holding Company U.S. S Corporation Foreign Holding Company Use of Holding Company can be dictated by either foreign or US considerations Holding Company can be a blocker or a pass-through Holding company can be used to accumulate funds offshore with or without incurring US taxation currently Foreign Low Tax Opco Foreign Low Tax Opco Holding company can be used to convert non-qualified dividends to qualified dividends Page 24

25 Case Study How can Subpart F a turn favorable tax situation turn into a tax nightmare?

26 What is Subpart F income? General Rule: U.S. does not tax income of a foreign corporation until the income is repatriated to the U.S. If a controlled foreign corporation: More than 50% of stock owned by U.S. Shareholders U.S. shareholders are those owning at least 10% Deal with anti-deferral rules which are the Subpart F rules Section 956 Investment in U.S. Property Section 951 Subpart F Income If either of these occurs what it the impact? Deemed distribution taxed without repatriation Deemed distribution is taxed as ordinary income Even if actual dividend would be qualified dividend income Can increase global tax on $100 of income over 50% Page 26

27 Section 956 Investment in U.S. Property Issues arise when a CFC has an increase in investment in U.S. property What is considered U.S. property? tangible property located in the United States; stock of a domestic corporation; an obligation of a United States person; or any right to the use in the United States of a patent or copyright, an invention, model, or design (whether or not patented), a secret formula or process, or any other similar right, which is acquired or developed by the controlled foreign corporation for use in the United States. Page 27

28 Section 956 Investment in U.S. Property Investment in U.S. property is the average amount invested in U.S. property by adding the amounts for each quarter and dividing by four (4). amount is then compared to the undistributed Earnings and Profits ( E&P ) of the CFC Lesser of the increase in investment in U.S. property or undistributed E&P is taxed as a deemed distribution. Most common situations: CFC makes a loan to its U.S. parent company CFC has trade receivable to a U.S. affiliate which is not paid timely and becomes a loan for purposes of Section 956 Page 28

29 Subpart F Income If a, CFC earns the following types of tainted income, that income is considered subpart F income: Foreign Base Company Income Foreign Personal Holding Company Income ( FPHCI ) Interest Dividends Certain Rents and Royalties Certain Capital Gains Foreign Base Company Sales Income ( FBCSI ) Foreign Base Company Services Income ( FBCServices ) Foreign Base Company Oil Related Income Full inclusion and deminimis rules and High Tax Exception Full inclusion rule 70% or more of CFC s gross income is Subpart F then 100% is considered Subpart F Deminimis Rule less than 5% of CFC s gross income is Subpart F then 0% is considered Subpart F If effective tax rate on CFC s E&P is greater than 90% of the U.S. highest corporate tax rate (31.5%) then Subpart F income is not taxed in U.S. Page 29

30 FBCSI Sales Income Income earned whether in the form of profits, commissions, fees, or otherwise from: Purchase of personal property, MPGE outside country of incorporation, from related party, and sale of product to unrelated party located outside country of incorporation. Purchase of personal property, MPGE outside country of incorporation from unrelated party and sale to a related party located outside country of incorporation. Page 30

31 FBCSI Services Income Income (whether in the form of compensation, commissions, fees, or otherwise) derived in connection with the performance of technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services which performed for or on behalf of any related person (within the meaning of subsection (d)(3)), and performed outside the country under the laws of which the controlled foreign corporation is created or organized. Exception - shall not apply to income derived in connection with the performance of services which are directly related to the sale or exchange by the controlled foreign corporation of property manufactured, produced, grown, or extracted by it and which are performed before the time of the sale or exchange, or an offer or effort to sell or exchange such property. Page 31

32 Potential Effective Global Tax Rates- Subpart F and No CTB 100% Subpart F China UK Singapore Cayman Local Country Income Total Foreign Tax U.S. Subpart F Income U.S. Tax Subpart F Global Tax Effective Rate 54.70% 51.68% 49.87% 39.60% Section 1411 tax due upon repatriation No foreign tax credit No qualified dividend income Page 32

33 Subpart F Income Case Study Facts Facts: US S Corporation is in the domestic construction business. US S Corporation owns 100% of a subsidiary in Brazil. Shareholders of US S corporation own 100% of subsidiary in Belize. Brazil and Belize are both CFCs. Belize CFC constructed a building in Belize 10 years ago and has been leasing the building to the US Government. US Government now wants to buy the building and Belize is likely to record a capital gain on the sale for US E&P Purposes. Belize has accumulated E&P of $5 million. US S corporation was awarded a construction contract in Brazil. Construction services have been delivered by Belize and its employees. US S corporation has paid Belize for these services. Over the past 3 years Belize has generated extra cash and has loaned $3 million to US S corporation. Belize has recorded $150,000 of interest income annually. Belize has a 10% tax rate. No income of Belize has been taxed in the US. Page 33

34 Subpart F Income Case Study Q&A What are the potential issues? Rental Income Subpart F? No rental income from rental to unrelated party is not Subpart F income. Gain on Sale of Building Subpart F? No gain from sale of property that generates active business income which is not subpart F income does not generate Subpart F income. Interest Income Subpart F? Yes more than 5% of gross income Belize providing construction services in Brazil Subpart F? Yes This is foreign base company services income. Belize loans $3 million to US S corporation Section 956? Yes Belize holds the obligation of a US person. Increase in investment in US property is a deemed dividend. Page 34

35 Subpart F Income Case Study Results Client has numerous deemed dividend amounts in excess of $3 million. US tax liability of at least $1.2 million, plus interest and (penalties?) CPA Associates affiliate now has to evaluate whether to keep the client or not Interestingly, CPA Associates affiliate was concerned about rental income and gain on sale being a problem under Subpart F. Never identified interest, FBCServices Income, or Section 956 as issues. What is the other issue lurking here that has not been identified? TRANSFER PRICING Interest Rate on loan Compensation for construction services Page 35

36 Case Study Foreign Tax Credits, Transfer Pricing and International Valuation

37 Foreign Tax Credit Intent is to eliminate double taxation of foreign source income Rules are different for C corporations v. individuals C corporations can claim 2 types of foreign tax credits Section 901 direct foreign tax credit Section 902 indirect foreign tax credit Individuals can generally claim only 1 type of foreign tax credit Section 901 direct foreign tax credit. Foreign tax credit limitation is based on foreign source income less foreign source expenses (net foreign source income) divided by total taxable income, times tax liability. Special expense apportionment rules for interest expense and Section 174 R&D Expense Page 37

38 U.S. Foreign Tax Credit System U.S. taxes worldwide income and foreign tax credit system intended to avoid double taxation C corporations can claim direct and indirect foreign tax credits for taxes paid by a foreign subsidiary Withholding taxes on interest, royalties and dividends are creditable Taxes paid by foreign subsidiary are creditable Individuals cannot claim indirect foreign tax credits, only direct foreign taxes can be claimed as credits Withholding taxes on interest, royalties and dividends are creditable Foreign taxes paid by U.S. individual or pass-through entity are creditable Structuring decisions can impact whether or not a foreign tax is considered a direct foreign tax or indirect foreign tax Tax paid by controlled foreign corporation is an indirect foreign tax Tax paid by a check the box flow though foreign entity is a direct foreign tax Page 38

39 Comparison C corporation v. Individual Foreign Tax Credit C corporation v. Individual Facts: US Co owns 100% of German GmbH. GmbH earns 100,000 and pays tax at 33% in Germany. GmbH pays $dividend of after tax earnings to US Co. Dividend in subject to dividend withholding tax (5%). US Co US Co C Corp S Corp GmbH Earnings 100, ,000 German 33,000 33,000 After tax earnings 67,000 67,000 Dividend 67,000 67,000 German WHT 3,350 3,350 US Source Income - - Foreign Source Income 67,000 67,000 Section 78 Gross Up 33,000 Total Income 100,000 67,000 US Source Expenses - - Foreign Source Expenses - - Total Expenses - - Net Foreign Source Income 100,000 67,000 Total Net Taxable Income 100,000 67,000 Total US Tax 34,000 15,946 Less: Foreign Tax Credit 34,000 3,350 Net US Tax - 12,596 Excess Credit 2,350 - Total Tax Paid 36,350 48,946 Effective Tax Rate 36.35% 48.95% Page 39

40 C corporation v. Individual - Findings Indirect credit (Section 902) system is more equitable to US taxpayers. Pay greater of foreign tax rate or U.S. tax rate Direct credit (Section 901) pay foreign tax and U.S. tax on dividend is simply additional tax. The higher the foreign tax rate, the more likely the Section 901 scenario will result in greater foreign tax. Page 40

41 US Individual Foreign Tax Credit Foreign Tax Credit Individual Scenarios Facts: U.S. S corporation owns three controlled foreign corporations; Canada; Japan; Singa Dividend payments are subject to dividend WHT in Canada and Japan of 5% S Corp S Corp S Corp Canada Japan Singapore Foreign Earnings 100, , ,000 Foreign Tax 25,000 35,000 17,500 After tax earnings 75,000 65,000 82,500 Dividend 75,000 65,000 82,500 Dividend WHT 3,750 3,250 - US Source Income Foreign Source Income 75,000 65,000 82,500 Total Income 75,000 65,000 82,500 US Source Expenses Foreign Source Expenses Total Expenses Net Foreign Source Incom 75,000 65,000 82,500 Total Net Taxable Income 75,000 65,000 82,500 Total US Tax 17,850 15,470 32,670 Less: Foreign Tax Credit 3,750 3,250 0 Net US Tax 14,100 12,220 32,670 Total Tax Paid 39,100 47,220 50,170 Effective Tax Rate 39.10% 47.22% 50.17% Page 41

42 U.S. Foreign Tax Credit Limitation A number of variables impact how much foreign tax credit can be claimed by a U.S. taxpayer Foreign Source Gross Income the more foreign source income the better Foreign Source expenses the lower this number the better (Section 861) Total US taxable income the higher this number the better Total US tax the more US tax the higher the potential limitation Foreign taxes available for credit the higher this number the more credits that need to be claimed. Minimizing foreign tax takes pressure off of the foreign tax credit If any of these variables moves in the wrong direction it can limit the amount of foreign tax credit and cause double taxation of foreign profits Page 42

43 Foreign Tax Credit Conclusions The interplay between the foreign tax credit and the qualified dividend income rules can yield very surprising and unpleasant results when non-treaty countries are involved. Need to balance the low rate in the local jurisdiction with the ultimate U.S. tax after repatriation. In the C corporation environment none of this is an issue If client s are expanding outside the U.S. it is important to model out the various scenarios and effective tax rates related to deferral with eventual repatriation vs. Check the box planning. The expected results can change if (1) U.S. tax law changes (2) the foreign operations generate Subpart F income or (3) local tax law changes. Page 43

44 Foreign tax credit case study - Background A US manufacturing company owns a manufacturing entity in Germany taxed as a partnership for US tax purposes German entity also owns distribution subsidiaries in France and the UK The German entity manufactures and sells products to the US, UK and France affiliates Germany has large profits, however both the UK and France entities are loss making Large German tax and dividend withholding tax paid R&D and marketing services have been charged from a related US partnership to Germany Reducing German income and tax Increasing U.S. source income and passive basket foreign source income Shifting the economic ownership of related intangibles to Germany US Company shareholders had approximately $2 million of excess foreign tax credits. Some expiring within 2 years. Shareholders adding to carryforwards annually. Page 44

45 Analysis We identified ways to increase foreign source income: Section 863(b) -- US manufactured goods sold with foreign title passage generates 50% foreign source income Section 862(a)(6) Foreign manufactured goods sold with foreign title passage generates 100% foreign source income Intercompany charges for R&D properly belonged in the general foreign tax credit basket as foreign source income We identified ways to decrease foreign source expenses: R&D expenses are apportioned under % geographic apportionment to place of performance 50% apportioned based on worldwide sales Cost Segregation Study on foreign building reduced expenses of Germany for US tax purposes without increasing German tax We helped obtain dividend withholding tax refunds from Germany: This reduced the taxes needing to be credited Page 45

46 Result We amended three years of returns to apply the revised income and expense sourcing $750,000 in tax refunds for three prior years Two years of claiming current year and carryforward foreign tax credits on originally filed returns. Results are as follows: All excess foreign tax credits have been monetized by the shareholders via foreign tax credit claims resulting in US tax refunds No longer have excess foreign tax credits No more double taxation of profits Page 46

47 Entity valuation Net Sales ( IC commissions) 346, , , , , , ,000 Selling Expenses 314, , , , , , ,000 SG&A 45,000 47,000 48,586 50,529 53,000 47,000 47,000 Operating Income (13,000) (12,000) (13,686) (14,233) (18,000) (12,000) (14,000) Tax Net profit/(loss) (13,000) (12,000) (13,686) (14,233) (18,000) (12,000) (14,000) Discount rate: 25 percent Value indication: ($49,894) Conclusion of value by the company: Zero Net sales were commissions received from the entity s German affiliate What is your impression of the company s approach? What risks has the company created for itself? Page 47

48 Case Study Transfer Pricing on Sales into Canada

49 Distributor entity case study - Background Local entity is a distributor Product Line A: Products sourced by the home country but purchased directly by the local entity Product Line B: Products sold from the parent entity to the local distributor (local entity is the exclusive distributor) Parent company owns the product and marketing intangibles and supplier relationships Page 49

50 Value chain Third Party Suppliers Principal Company (US) B Principal Co. key responsibilities may include: Sourcing / purchasing Working capital Inventory risk Warranty risk Manufacturing Intangibles (own and manage) Third Party Suppliers A Distributor (Canada) Third Party Customers Physical Product Flow Page 50

51 Value chain Product line A Principal Company (US) Services and intangibles / Entrepreneur Management services Sourcing / purchasing Marketing intangibles (brands and know-how) Third Party Suppliers A Distributor (Canada) Third Party Customers Physical Product Flow Services and Intangibles Transfer pricing policy: Sourcing fee (percentage of COGS) Management fee (markup on total costs Royalty (percentage of net sales) Page 51

52 Value chain Product line B Third Party Suppliers Principal Company (US) B Manufacturer / Entrepreneur Sourcing / purchasing Working capital Inventory risk Warranty risk Manufacturing Intangibles (own and manage) Distributor (Canada) Third Party Customers Physical Product Flow Transfer pricing policy: Markup on total costs Costs are fully loaded operating costs (COGS + OH) Page 52

53 Entity segmented P&Ls Local Entity Segmented P&L Home Country Segmented P&L Product A Product B Total Product A Product B Total Consolidated Revenue 20,000,000 10,000,000 30,000,000 Revenue Product sales 8,775,000 8,775,000 Sourcing fee 1,200,000 1,200,000 TM Royalty 400, ,000 Management Fee 856, ,000 Total Revenue 20,000,000 10,000,000 30,000,000 Total Revenue 2,456,000 8,775,000 11,231,000 30,000,000 COGS 15,000,000 8,775,000 23,775,000 COGS 6,500,000 6,500,000 21,500,000 Gross Profit 5,000,000 1,225,000 6,225,000 Gross Profit 2,456,000 2,275,000 4,731,000 8,500,000 Gross Margin 25.0% 12.3% 20.8% 25.9% SG&A 1,500,000 1,000,000 2,500,000 Non -allocable costs 200, , ,000 3,000,000 Sourcing Fee 1,200,000 1,200,000 Sourcing/ procurement 500, , ,000 TM Royalty 400, ,000 TM Related 100, , ,000 Management Fee 856, ,000 Management 800, , ,000 Operating Expenses 3,956,000 1,000,000 4,956,000 Operating Expenses 1,600, ,000 1,900,000 4,400,000 Operating Profit 1,044, ,000 1,269,000 Operating Profit 856,000 1,975,000 2,831,000 4,100,000 Operating Margin 5.2% 2.3% 4.2% Operating Margin 34.9% 22.5% 25.2% 13.7% Markup on COGS 35% Operating Profit Profit Split Local Entity Profit 1,269, % Sourcing fee 8% Parent Entity Profit 2,831, % TM Royalty 2% Total supply chain profit 4,100, % Markup on Management Services costs 7% This slide is for illustrative / discussion purposes only Page 53

54 Entity segmented P&Ls Local Entity Segmented P&L Home Country Segmented P&L Product A Product B Total Product A Product B Total Consolidated Revenue 20,000,000 10,000,000 30,000,000 Revenue Product sales 7,800,000 7,800,000 Sourcing fee 750, ,000 TM Royalty 200, ,000 Management Fee 840, ,000 Total Revenue 20,000,000 10,000,000 30,000,000 Total Revenue 1,790,000 7,800,000 9,590,000 30,000,000 COGS 15,000,000 7,800,000 22,800,000 COGS 6,500,000 6,500,000 21,500,000 Gross Profit 5,000,000 2,200,000 7,200,000 Gross Profit 1,790,000 1,300,000 3,090,000 8,500,000 Gross Margin 25.0% 22.0% 24.0% 16.7% SG&A 1,500,000 1,000,000 2,500,000 Non -allocable costs 200, , ,000 3,000,000 Sourcing Fee 750, ,000 Sourcing/ procurement 500, , ,000 TM Royalty 200, ,000 TM Related 100, , ,000 Management Fee 840, ,000 Management 800, , ,000 Operating Expenses 3,290,000 1,000,000 4,290,000 Operating Expenses 1,600, ,000 1,900,000 4,400,000 Operating Profit 1,710,000 1,200,000 2,910,000 Operating Profit 190,000 1,000,000 1,190,000 4,100,000 Operating Margin 8.6% 12.0% 9.7% Operating Margin 10.6% 12.8% 12.4% 13.7% Markup on COGS 20% Operating Profit Profit Split Local Entity Profit 2,910, % Sourcing fee 5% Parent Entity Profit 1,190, % TM Royalty 1% Total supply chain profit 4,100, % Markup on Management Services costs 5% This slide is for illustrative / discussion purposes only Page 54

55 Implications for local entity valuation Example 1 Example 2 Example 2* Entity Operating Profit 1,269,000 2,910,000 2,910,000 Effective Tax Rate 20% 20% 20% Tax 253, , ,000 Profit after tax 1,015,200 2,328,000 2,328,000 Discount rate 20% 20% 25% Growth rate 5% 5% 5% Implied value based on capitalization of after tax earnings 6,768,000 15,520,000 11,640,000 *Higher discount rate to reflect potential tax risks This slide is for illustrative / discussion purposes only Page 55

56 CRA versus IRS perspectives Single year full range versus three year weighted average interquartile range Value of management services? Value of Brand? Page 56

57 Entity valuation double taxed cash flows Local Entity Segmented P&L Home Country Segmented P&L Product A Product B Total Product A Product B Total Consolidated Revenue 20,000,000 10,000,000 30,000,000 Revenue Product sales 8,775,000 8,775,000 Sourcing fee 1,200,000 1,200,000 TM Royalty 400, ,000 Management Fee 856, ,000 Total Revenue 20,000,000 10,000,000 30,000,000 Total Revenue 2,456,000 8,775,000 11,231,000 30,000,000 COGS 15,000,000 8,775,000 23,775,000 COGS 6,500,000 6,500,000 21,500,000 Gross Profit 5,000,000 1,225,000 6,225,000 Gross Profit 2,456,000 2,275,000 4,731,000 8,500,000 Gross Margin 25.0% 12.3% 20.8% 25.9% SG&A 1,500,000 1,000,000 2,500,000 Non -allocable costs 200, , ,000 3,000,000 Sourcing Fee 1,200,000 1,200,000 Sourcing/ procurement 500, , ,000 TM Royalty - TM Related 100, , ,000 Management Fee - Management 800, , ,000 Operating Expenses 2,700,000 1,000,000 3,700,000 Operating Expenses 1,600, ,000 1,900,000 4,400,000 Operating Profit 2,300, ,000 2,525,000 Operating Profit 856,000 1,975,000 2,831,000 4,100,000 Operating Margin 11.5% 2.3% 8.4% Operating Margin 34.9% 22.5% 25.2% 13.7% Markup on COGS 35% Operating Profit Profit Split Local Entity Profit 2,525, % Sourcing fee 8% Double Taxed Profit (1,256,000) -30.6% TM Royalty 2% Parent Entity Profit 2,831, % Markup on Management Services costs 7% Total supply chain profit 4,100, % Denied deductions This slide is for illustrative / discussion purposes only Page 57

58 Implications on ETR and tax costs Example 1 Entity Operating Profit 1,269,000 Additional Taxable Profit 1,256,000 Total Taxable Profit 2,525,000 Tax Rate 20% Tax 505,000 Effective Tax Rate 39.8% Profit after tax 764,000 Profit after tax before double taxation 1,015,200 Cost of double taxation (251,200) Page 58

59 Case study 367(d) Analysis

60 Background The Company The Company provides cost-effective, high-quality, and timely solutions to an array of demanding international customers in the lucrative but challenging Iraq market The Company provides procurement, construction, and other services to the Iraqi government, the U.S. government and its subcontractors and independent companies in Iraq Local offices provide on the ground support 100 percent of the Company s revenues are derived from the Iraq market Page 60

61 Background (continued) In late 2011, the Company established an entity in the UAE to become the Company s new headquarters for certain business units In 2012, the Company began relocating additional functions in the Mideast to better serve its market The Company s centralization of functions in the Mideast continued through FY 2014, as BU leaders relocated and capabilities of the local teams in Iraq and the UAE were strengthened and supplemented Page 61

62 Background The Group Sister Co.* (Iraq) U.S. Co (U.S.) UAE Co. (UAE) * This is not a subsidiary of U.S. Co, but is a controlled entity through relationships Page 62

63 Intercompany transactions Sister Co.* (Iraq) Support services U.S. Co (U.S.) Deemed transfer of IP under IRC 367(d) as part of the restructuring Support services UAE Co. (UAE) Page 63

64 Recommendations IRC 367(d) The Company should perform an analysis of the potential impact of IRC 367(d) IRC 367(d) imposes tax consequences on an outbound transfer of IP similar to the tax consequences that would have been imposed on an outbound transfer in the form of either a: Deemed sale of IP, or License of IP in consideration for a deemed royalty The outbound transfer of IP is subject to IRC 482 To withstand scrutiny from the IRS, the Company should analyze and properly document the transfer of IP for tax reporting purposes Page 64

65 IRC 367(d) Analysis The steps in the analysis are: Identify IP that the Company may transfer from the U.S. to UAE Analyze whether such IP is considered Company IP subject to IRC 367(d) Business goodwill, personal goodwill and foreign going concern value are not subject to tax under IRC 367(d) [1] Company IP such as know-how and customer list are subject to IRC 367(d) [1] Note that on September 14, 2015, the IRS released final, temporary, and proposed regulations on the outbound transfers of intangibles under IRC 367 to expand the definition of IP to include goodwill Page 65

66 Intangible property review and analysis The term intangible property in IRC 367(d)(1) is defined by a cross-reference to IRC 936(h)(3)(B), which in turn defines intangible property broadly as any: 1. patent, invention, formula, process, design, pattern, or know-how; 2. copyright, literary, musical or artistic composition; 3. trademark, trade name or brand name; 4. franchise, license or contract; 5. method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; and 6. any similar item. Page 66

67 Intangible property review and analysis The term intangible property in IRC 367(d)(1) is defined by a cross-reference to IRC 936(h)(3)(B), which in turn defines intangible property broadly as any: 1. patent, invention, formula, process, design, pattern, or know-how; 2. copyright, literary, musical or artistic composition; 3. trademark, trade name or brand name; 4. franchise, license or contract; 5. method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; and 6. any similar item. Page 67

68 Distributor Method Analysis A method under the income approach used to value customer relationships that are considered a supporting asset Considered an unspecified method under Section 482 Steps: 1. Identify revenue at time of sale of customer relationships 2. Determine and apply revenue growth rates to customer relationships existing at time of sale 3. Determine customer attrition rates and apply these rates to projected revenue of customers under analysis Page 68

69 Distributor Method Analysis Steps: (continued) 4. Determine industry average distributor EBIT percentage margins and apply these percentages to projected revenue stream 5. Subtract returns on supporting assets (i.e., contributory asset charges) Working capital PP&E Work force 6. Determine and apply an appropriate pre-tax discount rate to account for the time value of money and the risk of the cash flows 7. Calculate the NPV of future pre-tax cash flows Page 69

70 NPV of cash flows generated by UAE Co. customers that originally contracted with U.S. Co. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Projections Revenue 21,000 22,100 23,200 24,400 25,600 26,900 28,200 29,600 31,100 % of revenue remaining after attritiion 92.0% 84.6% 77.9% 71.6% 65.9% 60.6% 55.8% 51.3% 47.2% Revenue after attrition 20,000 18,705 18,066 17,480 16,872 16,311 15,731 15,191 14,684 EBIT EBIT margin 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% Return on supporting assets Working capital (100) (94) (90) (87) (84) (82) (79) (76) (73) PP&E (100) (94) (90) (87) (84) (82) (79) (76) (73) Workforce (300) (281) (271) (262) (253) (245) (236) (228) (220) Total return on supporting assets (500) (468) (452) (437) (422) (408) (393) (380) (367) Net pre-tax cash flow Period Pre-tax industry WACC 25.0% Discount Factor 89.4% 71.6% 57.2% 45.8% 36.6% 29.3% 23.4% 18.8% 15.0% NPV of cash flow NPV of pretax cash flows Page 70

71 Summary Subject interest Valuation purpose Intended users Standard of value Premise of value Report form Method applied Calculated value Customer relationships deemed sold from U.S. Co to UAE Co. Determine the value of the customer relationships that were deemed sold from U.S. Co. to UAE Co. under Internal Revenue Code 367(d) as part of the Company s restructuring of certain business units The Company and the U.S. Internal Revenue Service ( IRS ) Arm s length standard Continued use as part of a going concern Calculation report Distributor Method under the Income Approach (unspecified method) $350 K (rounded) Page 71

72 Case Study Transfer Pricing IRS Controversy

73 Situation: Background Fabric Co (or the Company ) is a $60 million global manufacturer and supplier of fabrics for home furnishings The Company s current organizational structure developed over time as the business evolved and grew (i.e., no tax planning) Fabric Co US was audited for its 2010 and 2011 tax years The audit was closed without transfer pricing being raised as an issue The Company thus erroneously assumed the IRS had signed off on the Company s existing transfer pricing policies The Company did not analyze its transfer pricing policies or results and did not prepare documentation for any years Page 73

74 Situation: Current structure Fabric Co US (HQ and manufacturing) Product sales (cost + 3%) Fabric Co Asia (Manufacturing) Product sales (cost + 20%) Canada (Distribution) Headquartered in US ( Fabric Co US ). Manufacturing operations in the US and China ( Fabric Co Asia ) Fabric Co Asia also provides sourcing functions (such as identifying and managing suppliers and contract manufacturers), design functions and other support Right of final approval for any significant business decision or activity is given by the Fabric Co US The Company sells product to unrelated distributors in Canada and Mexico Mexico (Distribution) Page 74

75 Situation: Transfer pricing audit In 2015, Fabric Co US was under a transfer pricing audit for 2012 The IRS has issued a memorandum proposing adjustments for: Fabric Co Asia s use of fabric designs ( IP ) developed by Fabric Co US Fabric Co US s provision of market development, design, and a number of other management services to Fabric Co Asia The IRS determined that Fabric Co US underreported nearly $2 million of 2012 income due to non-arm s length transactions Since Fabric Co US did not have contemporaneous transfer pricing documentation in place, the IRS memorandum noted that the taxpayer is subject to penalties Moreover, the team anticipated tax years 2013 and 2014 would be audited. Since the company did not have transfer pricing documentation, penalties and interest on any adjustments would apply in these years as well. Page 75

76 Summary of proposed IRS adjustments IP Services Total Proposed adjustments 550,000 1,400,000 1,950,000 Additional US tax 35% 192, , ,500 US penalty exposure 40% 77, , ,000 Interest 25,000 60,000 85,000 Total exposure 294, ,000 1,040,500 Penalties and interest are non-deductible Page 76

77 Analysis and support: Royalties We reviewed the facts and countered that: 1. No royalty should be paid by Fabric Co Asia for using the United States headquarters intellectual property: The intellectual property was essentially a series of copyrights on various patterns; there were no brand names, trademarks or logos of any kind associate the patterns; A royalty would be redundant to the IRS s proposed management services charges. 2. The implementation of an unsupportable royalty creates risk of double taxation as the royalty may not be deductible in China. Page 77

78 Analysis and support: Management services The Comparable Profits Method (CPM) that the IRS used was appropriate, however their calculation was incorrect. The IRS multiplied the weighted average operating margin percentage of five U.S. services companies by the company s China manufacturing 2012 gross revenue to derive its proposed adjustment to Fabric Co U.S. s income We advised the company that the calculation was erroneous and that the IRS proposed assessment essentially constituted an additional royalty. We identified the more appropriate method for measuring the payment due to the US headquarters for providing management services. The method was based on the costs of the management team involved in establishing the China operations, and marking up these costs by an appropriate arm s length rate. This amount was significantly less than the adjustment proposed by the IRS. Page 78

79 Analysis and support: Tangible goods We informed the company that the IRS s approval of a four percent markup on costs of goods sold earned by the China manufacturer on its sale of products to the United States could be problematic. We advised that this markup will almost certainly be considered low, and possibly aggressive by the China tax authorities. Increasing the markup of tangible goods sales for 2012 would decrease the net IRS adjustment to the US headquarters income. In addition, adjusting Fabric Co Asia s compensation would minimize risk in China. However, amending the China operation s 2012 tax return to reflect this increase could attract scrutiny by the China tax authorities, who may investigate, and begin to examine other years. Page 79

80 Proposed adjustments and results Transaction IRS Proposed Adjustments Our Proposed Adjustments 2012 Negotiated Result Management Services 1,400, ,000 Royalty 550,000 0 Tangible Goods 0-250,000 Total adjustments 1,950, , ,000 TBD TBD 13% of the original assessment Page 80

81 Some key takeaways Small and mid-sized companies are not immune from IRS (and other tax authority) investigation and adjustments. Just because a company has been audited in the past does not mean the IRS has signed off on its later year or current transfer pricing policies and results. Audits and resulting adjustments to taxable income typically involve multiple years these adjustments over multiple years can add up quickly. Transfer pricing has (at least) two sides and it is advisable to incorporate input from local transfer pricing specialists. It is better to be prepared with transfer pricing support when the tax authorities walk in than to be caught unprepared. It is less costly to develop and maintain transfer pricing documentation updated annually rather than having to react to transfer pricing adjustments (or suffer double taxation and non-deductible penalties and interest). Transfer pricing audits are time consuming and expensive and can be a slippery slope, in that adjustments in one jurisdictions can create issues and interactions with tax authorities of other relevant jurisdictions. Page 81

82 Case Study Puerto Rico Act 20 Analysis

83 Background Franchisor is a pioneer in a new franchise business model, with locations across the US that offer one-stop-shop convenience The company recently moved its headquarters to Puerto Rico The company needed to determine the portion of the value of the Company s franchise fee attributable to its brands. Income associated with branding is excluded from beneficial treatment under Act 20 Page 83

84 Purpose The purpose of this engagement is to determine the value of franchise services provided versus the value of the use of the brand Our analysis and recommendations are based on the arm's length standard under US Treas. Reg Under Treas. Reg (b), a controlled transaction meets the arm's length standard as defined under the US Regulations if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result). Page 84

85 Key facts The Brands are immature and are not considered a value driver for the Company Rather, the Company s unique business concept, systems and relationship with a national retailer represents its key value drivers Accordingly, we determined that the CPM utilizing a return on the total costs of branding as an appropriate method to measure the value contribution of the Brands CPM Analysis Results PLI 25 th Percentile Median 75 th Percentile Branding Activities ROTC 7.4% 8.4% 11.6% Page 85

86 Analysis to determine profit attributable to the Brands Prior two years of branding costs 275, Web sites 3,000 Legal / registration and protection 8,000 Marketing deprt 300,000 Operations (a portion of her time) 25,000 A portion of the owner's time 30,000 Subtotal 643,016 Overhead allocation 75,000 Total Costs 718,016 Identified total branding costs spent in 2015 and YTD 2016 These are costs associated with the time spend by Company personnel on branding and marketing activities This is an estimate of the overhead to allocate to the Company s branding and marketing activities Markup First Quartile 7.4% 53, Median 8.4% 60, Third Quartile 11.6% 83, Profit attributed to the brand 60, Page 86

87 Reasonableness review Operating profit Percentage of profit Percentage of Revenue Total Operating Profit 2,500, % Leasing Operating Profit (350,000) -14.0% -6.5% Operating Profit 2,150, % Branding activities 60, % 1.1% Retailer relationship 25% 537, % 10.0% Know-how / business model 30% 645, % 12.0% Personal goodwill 907, % 16.9% Total 2,150, % 40.1% After netting out the profit attributable to leasing, the net profit of $2.15 million associated with the core franchising business Our $60 thousand estimate represents approximately 1.1 percent of core business revenue and 2.8 percent of profit The personal goodwill is the residual value These are reasonable estimate of the portion of value of the business Page 87

88 Conclusions Based on the assumptions below, we estimate the profit attributable to branding is approximately $60 thousand. This equates to approximately: 1.1 percent of revenue 2.8 percent of total profit The other 97.2 percent of profit is attributable to the services, business model, key relationships (e.g., rational retailer) etc. Key caveats and assumptions The percentage of time each employee spends on marketing needs to be estimated. Note: As the Brands become more established and recognized in the market, it will become more appropriate to use a market-based method (instead of the cost based method we applied in this report) to estimate their arm s length returns. We have seen data that indicates that mature brands can represent 15 to 30 percent of franchise business value. Page 88

89 Summary