by David Canale, Washington, EY Global & Americas Leader, Transfer Pricing Controversy Services, Frank Ng, member of EY’s Tax Controversy and Risk Management Services group in Washington, DC and Jay Camillo, EY Americas Operating Model Effectiveness Leader
One of the key goals of the US Tax Cuts and Jobs Act (TCJA) is to encourage companies to invest and create more jobs in the US. The new tax law contains several international tax provisions that work as “carrot” or “stick” to encourage the expansion and relocation of business functions, assets and intellectual property activities in the US, while discouraging their location elsewhere.
These legislative changes, combined with a complex and evolving global tax environment, have widespread implications for how and where businesses operate, invest, and deliver products and services.
One area that will require greater attention as a result is transfer pricing. A lower US corporate income tax rate, new anti-deferral and anti-base erosion provisions, combined with export incentives and changes to the definition of intangible property, will affect companies’ decisions about where they locate their physical assets, intangible property and people. The end result could be more uncertainty, tax risk and controversy.
Key TCJA changes affecting transfer pricing
Multinational corporations (MNCs) should examine the following TCJA international tax changes closely, as they may lead to greater risk in the transfer pricing area:
- Newly enacted limitations on income shifting through intangible property (IP) transfers, including a new broader definition of intangible property and codification of certain principles that give the Internal Revenue Service (IRS) more authority in choosing the method to value the transfer of intangibles
- The Base Erosion Anti-Abuse Tax (BEAT) — a type of alternative minimum tax targeting companies that make significant payments to related foreign parties, effective for tax years beginning after 31 December 2017
- The Global Intangible Low-Taxed Income (GILTI) provision — a global minimum tax on certain companies’ foreign low-taxed income, effective for tax years of foreign corporations beginning after 31 December 2017
- The Foreign-Derived Intangible Income (FDII) deduction — a reduced US tax rate on qualifying income received for foreign use, intended as an incentive for US companies to export property and services, effective for tax years beginning after 31 December 31 2017
Taken separately, each of these international tax elements might suggest one path forward for a given MNC, but when considered together, the tax outcome may shift, with changes to one area triggering issues in another.
Intangible property tax changes
The TCJA placed new limitations on income shifting through intangible property transfers. Under the new law, there is a greater focus on the return on IP, with less emphasis on capital at risk and more emphasis on functions (control over IP and local sales). The changes have lessened the tax rate differential on IP returns generated in the US vs. offshore for most US MNCs, and they provide an incentive to locate IP activities in the US while discouraging the expatriation of IP. This makes it important for MNCs to take a fresh look at the costs and benefits of their current IP strategy.
Specifically, the TCJA changed the definition of intangible property in Section 936(h)(3)(B) to include goodwill, going-concern value and workforce in place.
The law also confirmed the position the IRS has taken since 2008, codifying the aggregation and “realistic alternatives” principles and stating that IP transfers can be valued on an aggregate basis or a realistic alternative basis. The law supports and strengthens the IRS’s longstanding position on what IP needs to be valued in an intercompany IP transfer to provide the most “reliable means” of valuation. The TCJA added the following sentence to Section 482: “For purposes of this section, the Secretary shall 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.”1
Under the new law there may be potential opportunities to more closely align IP ownership and return with current and future business plans. Among the responses companies are considering are repatriating IP to the US, onshoring IP to a foreign location or onshoring income to the US but maintaining IP offshore.
Among the factors MNCs need to examine when making IP decisions going forward are the location of their current IP; the foreign and US tax rates and incentives that apply; the connectedness to their business, supply chain and customers; and economic substance issues. They should also factor in the effects of GILTI, FDII and BEAT, as well as the cost of IP migration and whether they are examining existing or new IP. Additionally, the cost and timing of IP migration could be affected by GILTI and BEAT inclusions.
The interplay among the different elements of the TCJA may result in some potential outcomes and incentives that policymakers did not intend. How a given MNC will fare under the GILTI, BEAT and FDII provisions will depend on specific circumstances, which makes careful scenario modeling critical in the wake of the tax changes. Furthermore, what may produce a positive tax outcome for one of the new tax provisions (BEAT, GILTI, FDII) may end up worsening the tax outcome for another, so the effects and interactions of all three need to be examined and weighed together.
For example, the FDII creates an incentive to locate IP in the US and license it offshore. Under this scenario, the controlled foreign corporation could make payments to a US corporation that would be subject to a lower FDII tax rate for the use of the US IP, but there would also be BEAT implications: when US IP is moved offshore, the US entity would likely have to make payments to the foreign entity over time. Those payments would likely be considered base erosion payments and, as such, would be subject to the BEAT.
Contrary to policymakers’ stated intent, there are also potential dynamics among these provisions that incentivize the placing of tangible assets offshore. Looking at the GILTI in isolation makes the US seem more attractive as a location for business functions and assets, but interactions among the FDII, GILTI and BEAT may change the equation. Increasing the qualified business asset investment at foreign affiliates may decrease GILTI; under the statute, the GILTI inclusion will be nil if the net deemed tangible income return minus interest expense exceeds the aggregate net tested income.
These dynamics may cause MNCs to evaluate placing asset-intensive, low-value, routine activities offshore, as this may lower the calculated value of GILTI.
As MNCs consider how these provisions apply to their situations and the different options for supply chain location under the new US tax law, there may be an increased risk of transfer pricing controversy and audits. These risks may increase both inside and outside the US as tax authorities in other countries may presume that a company’s actions are in response to US tax reform, prompting closer scrutiny. Existing and future advance pricing agreements (APAs) could be affected, and there may be transition implications if transfer pricing structures are modified.
Ultimately, the TCJA’s tax policy changes are not occurring in a vacuum. US tax reform is just one element within a more interconnected tax environment in which it is necessary to manage tax controversy risk more globally. Foreign governments, some of which have already voiced displeasure about the TCJA, may respond to US law changes and potential US company actions to modify supply chains. It is possible that other countries’ tax authorities will take robust tax postures or that US trading partners will challenge certain TCJA provisions such as the BEAT.
Timing is everything
MNCs also need to take into account implementation and sunset dates for certain provisions and be nimble in their responses. The US Treasury Department aims to release proposed regulations on some of the international tax provisions by the end of 2018 and to finalize guidance by the end of June 2019. If guidance is finalized within 18 months of enactment, it can be retroactive to January 2018 (See Internal Revenue Code Section 7805 (b)(2), p. 3726.2
However, until guidance is finalized, there will be a great deal of uncertainty for companies. What may seem the best course of action today may shift depending on the interpretations that emerge later in administrative guidance.
Given all of the moving parts, MNCs need to take an integrated approach to assessing the impact of the TCJA on transfer pricing. There is no one-size-fits-all solution, and it will be important to evaluate costs and benefits of current flows that have embedded IP and of broader supply chains, as well as the costs of potentially migrating or unwinding IP.
Uncertainty and risk will continue to be a hallmark of the interconnected global tax environment in the years ahead, and companies that address the issues proactively with a strategic and global mindset will be better able to prevent and address potential controversies. Among the ways MNCs can begin addressing this uncertainty:
- Model scenarios based on current and future business plans and the alternatives under consideration
- Integrate tax into the overall business and supply chain planning process
- Analyze potential strategies to optimize after-tax benefits of initiatives or mitigate risks
- Consider the impact of US tax reform on the current state operating model
- Examine the transition implications of any tax planning or structuring on prior years, and be prepared to provide enhanced documentation that includes an explanation of the business purpose for any changes
- Take a holistic approach to tax controversy management with global oversight of existing and potential tax audits, robust documentation, analyses and conclusions on tax positions, and appropriate tax compliance and reporting processes across the organization
Reproduced with permission from Copyright 2018 The Bureau of National Affairs, Inc. (800-372-1033) www.bna.com