“The more things change, the more they stay the same,” is a reference to circumstances where there appears to be a significant change, but many fundamental aspects have, in fact, not changed. This would seem to apply to transfer pricing fundamentals via the U.S. Tax Cuts and Jobs Act of 2017 where, technically, almost nothing has changed and yet, everything has changed. In order to create the most beneficial transfer pricing policy, businesses need to understand transfer pricing regulations and plan accordingly.
What Stayed the Same with Tax Reform and Transfer Pricing
According to Brian Jenn, U.S. Treasury's deputy international tax counsel, the changes made by the Tax Cuts and Jobs Act do not alter the arm’s-length standard or best method rule, two globally-accepted transfer pricing principles. The Tax Cuts and Jobs Act did amend the Internal Revenue Code Section 482 to say the IRS must “… require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers,” In other words, the IRS should utilize the realistic alternatives principle introduced by the 1994 § 1.482 regulations and akin to the U.S. cost sharing regulations under § 1.482-7.
As a result, from a technical perspective, nothing really has changed. Taxpayers still need to determine the arm’s-length price that a related party would pay for a given intercompany transaction, and they still need to prove that the method they use to justify said price is the best method possible. The Tax Cuts and Jobs Act just affirmed in the Internal Revenue Code what has been in the regulations since 1994, nothing to see here, right? If only things were that easy.
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How Transfer Pricing Has Been Changed by Tax Reform
U.S. Corporate Tax Rate Reduction
The Tax Cuts and Jobs Act brought broad changes to the U.S. international tax system, creating a modified territorial system where there once was a worldwide tax system. Focusing on the changes related to transfer pricing, let’s start with the easiest: a reduction of the stated U.S. corporate tax rate from 35 percent to 21 percent.
Prior to the Tax Cuts and Jobs Act, the U.S. corporate rate was one of the highest in the world. It now ranks toward the middle among major economies. Under the prior rates, a U.S. taxpayer might have had an incentive to move functions and risks, and thus higher operating profit, to lower tax jurisdictions; however, that taxpayer might now have an incentive to keep, or move, functions and risks to the United States. Where an inbound investor once sought to minimize the functions and risks of their U.S. enterprise in order to minimize U.S. corporate tax, that taxpayer might now consider expanding the functions and risks of the U.S. entity.
Global Intangible Low-Taxed Income (GILTI)
Under Tax Cuts and Jobs Act, a U.S. shareholder of any controlled foreign corporation has to include GILTI in gross income. GILTI is defined as the excess of the shareholder’s net controlled foreign corporation tested income over the shareholder’s net deemed tangible income return (10% of the shareholder's pro rata share of qualified business assets of the controlled foreign corporation).
Here’s what you need to know about transfer pricing opportunities post tax reform.
GILTI is treated as Subpart F income, which has the intent of penalizing U.S. taxpayers’ foreign income related to “intangible property” by including it in U.S. income to be taxed at U.S. rates. Note the use of quotation marks around intangible property, as this is the first example of U.S. lawmakers defining income from intangible property as income above a 10% return on a foreign corporation’s business assets (i.e., tangible property used in a trade or business).
C corporations are allowed a 50% percent deduction of GILTI through 2023 and 37.5 percent thereafter, while individual shareholders, including participation through partnerships and S corporations, are not allowed this deduction, unless a Section 962 election is made, which creates two layers of tax.
One of several exclusions in calculating GILTI is Subpart-F income generated in a jurisdiction where the corporate tax rate is greater than 80 percent of the U.S. corporate tax rate (i.e., greater than 18.9 percent) which qualifies for the high-tax exception. Under proposed regulations, this has the potential to be extended to GILTI income that is not Subpart-F income.
Transfer pricing plays into GILTI in several ways. As companies attempt to minimize GILTI, they should consider in their international entity structure planning where best they locate high-value functions and risks, specifically considering whether to locate (or relocate) them in the United States. U.S. multinationals can take advantage of the high-tax exception for subpart-F income by utilizing structures that fit this scenario. Finally, as companies consider moving intangible property back to the United States, thought will need to be given to the value of those intangibles as the country no longer taxing that income will be very focused on ensuring the transaction is completed with arm’s-length pricing. Transfer pricing is a global issue, and other countries’ laws must be considered.
Foreign Derived Intangible Income (FDII) Deduction
Where GILTI is the stick negatively incentivizing companies to keep high-value functions and risks in the United States, FDII is the carrot providing positive incentives to move them. FDII, which is available only to C corporations, is the amount of a corporation's deemed intangible income that is attributable to sales of property to foreign persons for use outside the United States. It can also apply to the performance of services for foreign persons or with respect to property outside the United States. Coupled with the 21% tax rate for domestic corporations, the FDII deduction results in a potential 13.125 percent effective tax rate on FDII.
FDII is the U.S. version of a patent-box regime, which is used by certain foreign countries to offer companies a lower tax rate for income derived from intangibles owned in that country. As companies consider expanding globally, FDII will be a primary factor in determining where intangibles are owned and along with GILTI, how the global supply chain is designed. For companies that already have global operations, careful consideration should be given to where intangibles should be located and the applicable foreign transfer pricing rules.
Base Erosion Anti-Abuse Tax (BEAT)
BEAT is an additional minimum tax on foreign related party payments, that applies only to C corporations whose annual gross receipts for the three-taxable-year period ending with the preceding taxable year, are $500 million or greater, with a “base erosion percentage” of 3 percent or greater (2 percent for banks or groups with registered securities dealers).
The proposed regulations provide detailed guidance regarding which taxpayers will be subject to BEAT, the determination of what is a base erosion payment, the method for calculating the base erosion minimum tax amount, and the required base erosion and anti-abuse tax resulting from that calculation. If BEAT rules apply, the additional minimum tax rate is 5% for 2018, 10% for 2019 through 2025, and 12.5% thereafter.
One taxpayer-friendly provision in the proposed regulations is the ability to exclude certain “covered” intercompany services that qualify for the services cost method under § 1.482-9, thereby allowing taxpayers to charge only for the cost without a markup. Covered services, in general, are considered low-margin (i.e., routine or non-value-added) and must meet certain requirements. A taxpayer that currently pays a foreign related party for services can perform an analysis to evaluate and support inclusion of these services under the services cost method, removing them from the calculation of the taxpayer’s BEAT calculation and avoiding an additional 10 percent minimum tax. Finally, it’s important to note that any transfer price within the arm’s-length range is acceptable, and taxpayers subject to BEAT should reexamine their intercompany pricing to see if a change within the range would reduce their potential additional tax.
Planning Is Key
Tax reform’s impact is still being felt in a variety of businesses, including those seeking to do business internationally. There are transfer pricing opportunities for taxpayers to explore to both reduce global effective tax rates and risk.
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