Transfer Pricing Overview Allegheny Tax Society November 16, 2009 Todd Izzo, Deloitte Tax LLP Jeff...

Transfer Pricing Overview

Allegheny Tax SocietyNovember 16, 2009

Todd Izzo, Deloitte Tax LLPJeff Mensch, Deloitte Tax LLP

Copyright © 2008 Deloitte Development LLC. All rights reserved. Tax Learning & Performance Enhancement. Revised 3/08.2

Agenda

The Arm’s Length Standard

Transfer Pricing Methods

Managing Transfer Pricing Risk

Overview of Administration’s International Tax Proposals

Copyright © 2008 Deloitte Development LLC. All rights reserved. Tax Learning & Performance Enhancement. Revised 3/08.

The Arm’s Length Standard


Transfer Pricing -- Overview

• Refers to a body of law designed to prevent the shifting of income between taxing jurisdictions

• It is a multi-disciplinary approach to determine whether cross-border transactions between related parties comply with established guidelines.

• Most tax authorities require taxpayers to comply with the “Arm’s Length Principle.”

• An integral part of an effective Global Tax and Treasury Strategy


Escalation of foreign rules and enforcement

2005 -20092003 -20042001 -20021999 -20001996 -19981995

Uruguay

Finland

Turkey

Vietnam

SingaporePolandNorwayKazakhstanIndonesiaEcuadorDenmarkTaiwanHungaryColombiaMalaysiaThailandPortugalPeruIndiaNetherlandsGermanyRussiaBelgiumVenezuelaArgentinaCanadaUKChinaSlovakiaBrazilJapanItalyNew ZealandMexicoKorea FranceAustraliaSouth AfricaUSA

TaiwanHungaryColombiaMalaysiaThailandPortugalPeruIndiaNetherlandsGermanyRussiaBelgiumVenezuelaArgentinaCanadaUKChinaSlovakiaBrazilJapanItalyNew ZealandMexicoKorea FranceAustraliaSouth AfricaUSA

ThailandPortugalPeruIndiaNetherlandsGermanyRussiaBelgiumVenezuelaArgentinaCanadaUKChinaSlovakiaBrazilJapanItalyNew ZealandMexicoKorea FranceAustraliaSouth AfricaUSA

GermanyRussiaBelgiumVenezuelaArgentinaCanadaUKChinaSlovakiaBrazilJapanItalyNew ZealandMexicoKorea FranceAustraliaSouth AfricaUSA

ChinaSlovakiaBrazilJapanItalyNew ZealandMexicoKorea FranceAustraliaSouth AfricaUSA

AustraliaSouth AfricaUSA

1


Transfer Pricing in the Headlines

• Glaxo Smith-Kline - $3.4 billion• Symantec/Veritas - $1 billion• Motorola - $800 million• Fiji Water - $3 million per day in export

losses• Google – recognizes tax benefit of $90

million due to successful APA • Wal-Mart – share prices climb upon

announcement of bilateral APA with China


Current Environment: The Past is no Guide

• Increased enforcement of transfer pricing regulations by U.S. and foreign tax authorities

• Recognition that transfer pricing permeates the financial statements of many taxpayers

• Emphasis on tying provision amounts to individual transfer pricing “red flags”

• More intense (sometimes contentious) discussions with auditors


Regulatory Background

• Sec. 482 and regulations• Sec 367(d) and regulations• Sec. 6662• OECD Guidelines• Foreign Law / Regulations

• 482 vs. OECD Guidelines


Definition of Related Parties

•Direct or indirect participation in:– Management,– Control or– Capital

•By one entity in another; •By one entity or group of entities in both.


Control

•Related Parties•A corporation and a controlling person•Any two corporations:

– Controlled by the same or related persons– Related directly or indirectly to the same third

corporation/party

•Unrelated Parties•Questions of Fact

• Common mind• Acting in concert• De Facto control


Manufacturing

+

Distribution

Intercompany

Sale

MultinationalMultinational

GroupGroup

MARKET

Arm’s Length Standard



• The Tax Administrator’s “Market Creation” Problem is “solved” by use of the arm’s length standard

• Wording from IRS 1994 regulations:

– ...the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.

– A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized [by] uncontrolled taxpayers…



• An adjustment under Code §482 is applicable if transfer price charged is not “arm’s length.”

• The regulations authorize the IRS to adjust a taxpayer's income in any way necessary to conform to the arm’s length standard.

• Adjustments under Code §482 directly affect a taxpayer's U.S. taxable income and resulting U.S. federal income tax liability.

Bad motive is not a prerequisite for an adjustment.

13


Service fee

Market power

Return for assuming inventory price risk

Inventory carrying cost

Sourcing fee Process know-how

Location savings

Return for assuming long-term volume risk

Return for assuming operating cost risk

Base toll manufacturing fee

Distributor profit

Trademark & technology intangibles

Each activity or enterprise receives a share of total profits that reflects the contribution of that activity or enterprise to earning those profits.

Profits Relate to Functions and Risks


Best Method Rule

•U.S. Rules require taxpayers to apply the “Best Method”

•There are four important factors in selecting the Best Method:– The degree of comparability between the

controlled transactions and uncontrolled comparables

– The quality and quantity of data– Assumptions used in the analysis– Sensitivity of results to data deficiencies

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U.S. & OECD: Points of Contention

•OECD - professed dislike of CPM, possibly in deference to the low regard of some European and Asian members for it

•OECD - preference for transactions-based evidence, even if the evidence is not highly comparable to the tested transactions

•OECD - considers operating profit-based methods to be a last resort

•Note that, as practically applied, there is little difference between the TNMM and the CPM


Classifying Transactions

•Tangible property•Intangible property•Services•Loans•Mixed Transactions

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Unit of Unit of measurementmeasurement

TangibleTangible IntangibleIntangible ServicesServices OECD OECD GuidelinesGuidelines

PricePrice CUPCUP CUTCUT CUSPCUSP CUPCUP

Gross Profit on Gross Profit on SalesSales

Resale Resale margin margin methodmethod

N/AN/A Gross services Gross services margin methodmargin method

Resale margin Resale margin methodmethod

Gross Profit on Gross Profit on CostsCosts

Cost plus Cost plus methodmethod

N/AN/A Cost of services Cost of services plus methodplus method

Cost plus Cost plus methodmethod

Net Profit of Net Profit of One PartyOne Party

CPMCPM CPMCPM CPMCPM TNMMTNMM

Net Profit of Net Profit of Both PartiesBoth Parties

Profit SplitProfit Split Profit SplitProfit Split Profit SplitProfit Split Profit SplitProfit Split

OtherOther UnspecifiedUnspecified UnspecifiedUnspecified SCM / SCM / UnspecifiedUnspecified

UnspecifiedUnspecified


OECD vs. 482 – Tangible Goods

• U.S. Regulations abandon hierarchy of methods in favor of best method rule

• Under U.S. best method rule, no preference for transactional methods over profit-based methods and no recognition of inherent limits of profit-based methods

• In audits, IRS uses CPM whenever possible• CPM also heavily used by taxpayers in preparing

documentation• CPM not a recognized methodology under the

OECD Guidelines, though practically often equivalent to TNMM


OECD vs. 482 - Intangibles

•U.S. rules require that payment for the acquisition or use of intangible property be “commensurate with the income to be earned from the use of the property”

•Under U.S. rules, legal ownership of intangibles matters

•IRS Cost Sharing Regs


OECD vs. 482 – Finance and Services

•OECD preference against safe harbors•IRS makes extensive use of mechanical rules

and safe harbors in these areas, e.g.:– Mathematical formula for computing permissible

number of interest-free days on intercompany trade receivables

– Safe harbor rates on dollar-denominated loans– Covered Services (Rev. Proc. 2007-13)– IRS requirement to include stock option expenses

in cost base of some methods for charging out services

Managing Transfer Pricing Risk


U.S. Transfer Pricing Penalties

• Treas. Reg. §1.6662-6 provides for penalties of either 20 or 40 percent.

• The 20 percent penalty applies if: – 200 percent or more (or 50 percent or less) of the price

reported on the annual tax return; or– All transfer pricing adjustments are greater than the lesser of

US$ 5,000,000 or 10% of gross receipts.• The 40 percent penalty applies if:

– 400 percent or more (or 25 percent or less) of the price reported on the annual tax return; or

– All transfer pricing adjustments total an amount greater than the lesser of US$ 10,000,000 or 20% of gross receipts.

24


Documentation Requirements

• Penalties may not apply if maintain sufficient contemporaneous documentation.

• The documentation must include the following:1. Overview of the taxpayer’s business;2. Organizational structure;3. Any documentation explicitly required for the application of a

specific transfer pricing regulations;4. Selection of transfer pricing method5. Application/Rejection of alternative transfer pricing methods;6. Controlled transactions / Internal data7. Description of comparables8. Economic Analysis;9. Relevant data obtained after the tax year; and10. Index of principal and background documents.


Risk Management Considerations

• Integration of tax and business planning and objectives– Coordination of risk management & effective tax rate

• Centralization of transfer pricing decision-making– Global documentation/penalty issues: consistency

• Global planning, but focused risk management– Make effort appropriate to what’s at stake

• Defensible economics– Economic substance and procedural requirements

• Risk tolerance– Litigation averse?


Application of Risk Management Principles

• Determine issues and countries with greatest potential exposure– Level of activity– Complex, difficult issues– “Unusual” results– Exit tax issues– Aggressive tax authority


Top 10 toughest tax authorities for transfer pricing risk*

1. Japan2. Germany3. US4. Australia5. France

6. India7. Korea8. China9. Canada10. UK

* TP Week, global survey of tax directors and TP advisors, December 2007.


Determine whether to address highest-risk issues proactively or defensively

• Proactive Strategies– Amended returns or otherwise notify tax authority– Change policy or practice– Advance Pricing Agreement (“APA”)

• Defensive Strategies– Document internal decision-making– Transfer pricing (§6662) studies by third party– Backup support

• Protect institutional memory


After Implementation, It’s All About Maintenance

• Establish solid transfer pricing policy (set rules on intercompany transactions)– Modify transaction flow/scheme of tangible assets– Review intercompany policy on intangible assets– Assess allocation of head office expenses and other

intercompany service charges– Imbed TP policy in financial systems– Consider where decisions are made, economic substance

• Conduct periodic assessment of possible TP risks, and consider countermeasures

• Respond to each country’s documentation rules (prepare TP studies for documentation purposes)

• Take advantage of APA process


Overview of President Obama’s International Tax

Proposals


On September 14, 2009, JCT released their explanation of the international proposals in the Administration’s FY2010 Budget.

On September 8th and 9th, the Administration released their explanations related to the individual income tax, estate and gift tax, and business tax proposals.

JCT’s explanation of the Administration’s Budget is intended to aid members of Congress in their consideration of the Administration’s proposals.

JCT is a non-partisan committee with staff economists and tax lawyers that serves members of Congress in its consideration of tax legislation. It is not a policy making body.

In that role, JCT provides Congress with explanations of tax related budget proposals, the policy pros and cons of budget proposals, and comparisons of an administration’s proposals with other proposals to address a particular issue.

JCT Report


• On August 25, 2009, OMB released a mid-session review of the budget for Fiscal Year 2010 with revised revenue estimates of the Administration’s international tax proposals.

White House5/2009 Projection

JCT 6/2009 ProjectionWhite House

8/2009 Projection

Reform check-the-box rules for foreign entities 86.5 31.1 36.5

Defer certain U.S. income tax deductions 60.1 51.5 52.9

Foreign tax credit reform: single pool of §902 credits

24.5 45.6 24.5

Foreign tax credit reform: matching foreign income and taxes

18.5 10.2 18.4

Foreign tax credit reform: dual capacity taxpayers

4.5 7.2 4.9

Definition of “intangible property” for §367(d) and §482 purposes

2.9 1.0 1.0

Repatriation of earnings in certain cross-border reorganizations

0.3 0.4 0.3

Repeal of 80/20 Company Rules 1.2 0.8 1.3

Earnings stripping 1.2 1.5 1.2

Prevent avoidance of dividend withholding taxes in equity swaps, securities loans, repos

1.4 1.2 1.2

Enforcement proposals (effective beginning after Dec 31 of year of enactment)

8.7 8.8 8.7

Total for all international proposals 209.8 159.3 150.9

Overview of Revenue Estimates


Key Potential Legislative Changes

Proposal Application Practical EffectsJCT Recommendations

And Comments

Expiration of §954(c)(6)

Look through treatment on certain payments between related CFCs may no longer be available

Restricts efficient cross border financing and licensing transactions

The look-through rule can encourage indefinite deferral of U.S. tax on foreign income through continued reinvestment of foreign earnings. It may also affect the timing and utilization of foreign tax credits by facilitating the separation of high and low tax foreign source income.

Deferral of U.S. Income Tax Deductions

Foreign related deductions of U.S. person (e.g., interest expense) deferred unless foreign source income is taxed currently

Increases the cost of capital

Increases cost of performing SG&A in the United States

Encourages movement of jobs offshore

JCT noted that absent Section 864(f), the proposal would overcorrect for the “timing mismatch” between the U.S. deduction of interest expense and the taxation of foreign earnings such borrowing supports.

Single E&P and Tax Pool (for purposes of repatriation)

Deemed paid foreign tax credit computed based on a pro rata share of all foreign taxes of all foreign subsidiaries multiplied by the ratio of distributed foreign E&P to total E&P of all subsidiaries qualifying for the deemed paid credit

Increases the cost of repatriating earnings to the United States

Incentive for companies to retain more earnings abroad

JCT provides additional details regarding proposal ‘s scope, including that proposal applies to pre-effective date E&P and taxes of foreign subsidiaries. JCT raises questions regarding the separation of high and low tax pools through the use of branches and lower than sixth tier subsidiaries.


Key Potential Legislative Changes

Proposal Application Practical EffectsJCT Recommendations

And Comments

Classification of Foreign Entities

Foreign eligible entities with a single member treated as corporations for U.S. tax purposes, unless: (1) entity and the single member are created or organized in, or under the laws of, the same foreign country; or (2) disregarded entity is a first-tier entity wholly owned by a U.S. person, except in the case of “U.S. tax avoidance”

Restricts efficient cross border financing transactions

Increases foreign tax imposed on U.S. multinationals

JCT suggests that Congress may consider the treatment of other hybrid entities, such as U.S. LLCs, DRCs and entities with tax residence outside of their country of organization

Repeal of 80 / 20 Companies

Full repeal of 80/20 Companies JCT suggests using a more targeted approach rather than full repeal.

Modification to section 356

Repeal of boot within gain limitation for purposes determining the income included following an asset reorganization

Restricts tax efficient repatriation

JCT suggests clarification is needed; for example what is the source of accumulated E&P from which the deemed dividend is generated (i.e., E&P of both the transferor and transferee, or only the transferor).


Classification of Foreign Entities

36

Provision Classification of Foreign Entities

Revenue Raised $36.5 billion

Application

• Foreign eligible entities with a single member treated as corporations for U.S. tax purposes, except:

– entity and the single member are created or organized in, or under the laws of, the same foreign country; or

– disregarded entity (“DRE”) is a first-tier entity wholly owned by a U.S. person, except in the case of “U.S. tax avoidance”

Practical Effects

• Restricts efficient cross border transactions• Increases foreign tax imposed on U.S. multinationals

Significant Issues / Observations

• Conversion from DRE classification would be determined under current Treasury regulations and tax principles resulting in springing transactions – springing debt, 304 deemed dividends, deemed asset sales

• No definition provided for “U.S. tax avoidance” for U.S.-owned DREs


Foreign Tax Credit Reforms

37

Provision Single Pool of Section 902 Credits


Application

• Deemed paid foreign tax credit computed based on a pro rata share of all foreign taxes of all foreign subsidiaries multiplied by the ratio of distributed foreign E&P to total E&P of all subsidiaries qualifying for the deemed paid credit

Practical Effects

• Increases the cost of repatriating earnings to the United States

• Incentive for companies to retain more earnings abroad

• Potential incentive for the use of highly taxed branches


• Foreign subsidiary E&P includes all companies qualifying for the §902 deemed paid credit (i.e., includes 10/50 companies)

• §901 credits would still be determined under current rules

• How to spring deferred 902 credits versus utilizing 904 credit carryforwards?

• High-tax exception determined on an entity by entity basis for Subpart F?


Deferral of Certain U.S. Tax Deductions

38

Provision Deferral of Certain U.S. Tax Deductions


Application

• Expenses allocated and apportioned to foreign source income deferred to the extent the foreign source income associated with the expenses is not currently subject to U.S. taxation.

• R&E expenses not subject to deferral

• Deferred deductions carried forward and not lost

Practical Effects

•Increases the cost of capital

•Increases cost of performing SG&A in the United States


• Treatment of first-tier foreign branches/hybrid branches/export transactions?

• Foreign source income not currently subject to taxation includes all 10/50 companies and CFCs.

• Repeal of worldwide interest allocation rules (§864(f))?

• How are historical OFLs treated?


Todd A. Izzo

• Partner, International Tax - Pittsburgh Office – Deloitte Tax LLP

– Experience: Todd specializes in international taxation, with a focus on global tax optimization, financial products and instruments, international mergers, acquisitions, reorganizations, tax treaties, foreign tax credit planning and other areas of U.S. corporate and international taxation. Prior to joining Deloitte & Touche in 2000, Todd worked in the area of international and corporate tax for five years in the Washington, D.C. office of Dewey Ballantine and served as a law clerk for one year in the chambers of Judge Ed Becker of the U.S. Third Circuit Court of Appeals.

– Education: Todd received a B.S. degree with highest distinction in accounting from Penn State University, a J.D. degree summa cum laude from the University of Pennsylvania Law School and an LL.M. in taxation summa cum laude from Georgetown University Law Center. Todd was awarded the May 1991 Alexander E. Loeb Gold Metal award for the high score in Pennsylvania on the CPA exam and the Elijah Watt Sells Award for one of the top scores in the U.S.

– Professional and Civic Affiliations: Pennsylvania and District of Columbia Bars; American Institute of Certified Public Accountants; Pennsylvania Institute of Certified Public Accountants; American Bar Association (Tax Division); Penn State Alumni Association; Pittsburgh Tax Club; Allegheny Tax Society.

•Office: (412) 338-7606

•E-mail: [email protected]


Jeffrey J. Mensch

• Senior Manager, International Tax - Pittsburgh Office – Deloitte Tax LLP

– Experience: Jeff specializes in international tax and transfer pricing, with a focus on global tax and treasury optimization through the coordination of legal and financing structures with the pricing of intercompany flows. Jeff has extensive experience assisting taxpayers to design, implement and execute structures within operational and treasury constraints that facilitate tax-efficient financing, intellectual property development and supply chain optimization. Jeff began his career working for six years in the Transfer Pricing group of Deloitte’s National Tax practice in Washington, D.C. Since 2001, he has been a member of the International Tax group in Deloitte’s Pittsburgh office.

– Education: Jeff received a B.S. in Economics with a concentration in Finance and Marketing from the University of Pennsylvania’s Wharton School of Business. He also has received his J.D. degree cum laude from the Georgetown University Law Center.

– Professional and Civic Affiliations: Pennsylvania Bar; American Bar Association (Tax Division); Leadership Pittsburgh; United Way Young Leaders Group.

•Office: (412) 338-7948

•E-mail: [email protected]

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