There have been several changes to tax laws in recent years, with U.S. tax reform causing many organizations to rethink and revamp their financial strategies. These changes have also had a considerable impact on transfer pricing planning and transfer pricing compliance for multinational corporations. To truly understand this impact, it’s essential you understand the significant changes that occurred as a result of U.S. tax reform.
An Overview Of Significant Changes To U.S. Tax Laws
The Tax Cuts and Jobs Act (TCJA), introduced in 2017, reduced the U.S. corporate income tax rate from 35% to 21% in undoubtedly the most significant change to U.S. tax legislation since 1986. Before TCJA went into effect, the U.S. corporate tax rate was one of the highest among the world’s developed economies. The reduced tax rate is now very competitive—in fact, it’s lower than the Organization for Economic Co-operation and Development (OECD) average.
Prior to this fundamental change, corporations were incentivized to maximize profits outside of the U.S. and to minimize them inside the U.S. Now there is more incentive for multinational corporations to maximize U.S. profits, not only because of the lower corporate income tax rate, but also because of the following new provisions.
Foreign-Derived Intangible Income (FDII)
FDII is a tax break for deemed intangible income in the United States, designed to incentivize companies to develop, retain, or sell intellectual property (IP) from related parties in low-tax jurisdictions back to group entities in the United States. The new tax law assumes a 10% rate of return on deemed tangible assets, and any incremental income is considered to be attributable to intangible assets. This provision enables companies that are highly profitable in the U.S. to get an even lower tax rate than 21%, ultimately encouraging revenue generation from serving foreign markets.
Global Intangible Low-Taxed Income (GILTI)
GILTI is a formulaic approach taken to calculate the income earned by a U.S. corporation’s foreign affiliate. Any excess income above 10% of the firm’s depreciable tangible property is considered global intangible low-taxed income, which has a minimum tax rate. Because companies earning high profits in low-tax jurisdictions will now be taxed a minimum rate, owning IP or having profits in low-tax jurisdictions may no longer be as beneficial from a tax perspective. The intention of the GILTI provision is to discourage U.S. multinationals from earning profits outside the U.S., specifically in low-tax jurisdictions.
Base Erosion & Anti-Abuse Tax (BEAT)
BEAT focuses on deductible payments—such as service payments, royalties, and interest—made from U.S. companies to related foreign parties. The higher the amount of the U.S. outbound payment for those line items, the more likely it is to trigger BEAT, which imposes a minimum tax. BEAT is meant to discourage these types of outbound, international payments.
Included in U.S. tax reform were also revisions to §163(j) of the Internal Revenue Code (“IRC”), which establishes limitations to the level of interest expenses that may be deducted by U.S. companies. Multinational companies with debt financing in their U.S. entities can usually deduct interest payments to reduce taxable income; however, if those deductions exceed 30% of the U.S. company’s earnings before interest, taxes, depreciation, and amortization (“EBITDA”), then a portion of the interest payments are not deductible in the current year. This is intended to discourage multinationals from “base-eroding” their U.S. companies by over-leveraging them.
U.S. tax reform also formally codified two other changes that had been previously introduced through the promulgation of amended IRC regulations.
- The definition of IP under IRC §936(h)(3)(b) was expanded to include (i) goodwill, (ii) going concern value, (iii) workforce in place, and (iv) other items of potential value that are not considered tangible property.
- The aggregation rules under §482-1(f)(2)(i)(C) were amended, requiring transactions to be analyzed in aggregate if that will produce more reliable results. The implication here is that synergistic effects of IP—as well as IP under the new, expanded definition—should be compensated in the event of an IP transfer.
How U.S. Tax Reform Impacts Transfer Pricing
These changes impact transfer pricing planning and compliance both directly and indirectly.
Transfer Pricing Planning
In a sense, what was traditionally thought of as transfer pricing planning is now very different. While multinationals were once predominantly planning into low-tax structures, many of those same companies are now engaged in defensive planning to unwind or minimize the negative impacts of having those low-tax structures. In other words, the companies that once benefited most from the U.S. corporate taxation system aren’t necessarily trying to lower their tax rates—rather, they are trying to minimize the prospective increase in their tax rates. There are still opportunities for certain companies to make operational decisions that result in a lower effective tax rate. But the extent of those opportunities really depends on the profile of a specific company and how aggressive that company’s tax structure and transfer pricing policies were pre-TCJA.
From a planning perspective, in many ways U.S. tax reform is making companies more agnostic as to where profits are taxed. (Tweet this!) In the United States, profitable companies may gain a favorable tax rate of 21% (or lower with FDII). Conversely, foreign profits that are concentrated in low-tax jurisdictions may now be taxed in the United States under the GILTI regime. This indifference has encouraged many companies to take a “wait and see” approach to planning.
Companies with profits offshore in low-tax jurisdictions are more likely to focus on damage control than proactive planning. In fact, many are now seeking to move IP back to a higher tax jurisdiction to improve compliance with the amended OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”), and to avoid triggering the GILTI provision. Even though transferring IP back to U.S. taxpayers was essentially one of the objectives of U.S. tax reform, under certain circumstances, doing so can trigger both GILTI and BEAT.
In addition, there is no guarantee that FDII, BEAT, or GILTI will remain long-term fixtures in the U.S. tax code. Possible successful World Trade Organization (“WTO”) challenges or European Union (“EU”) classification of provisions as “harmful tax practices” are just two possible threats to the status quo. There is also the possibility of a legislative change implemented by a future U.S. president and Congress.
Ultimately, no two companies will be impacted by U.S. tax reform in precisely the same way. Moreover, determining how to respond to the objective and mechanical provisions of U.S. tax return requires subjective judgments about the likelihood that these provisions will exist in the long run. The following sets forth some examples of common issues faced by taxpayers post-U.S. tax reform.
Under BEAT, the characterization of intercompany transactions is also important for taxpayers to consider. While Cost of Goods Sold (COGS) are not considered to be BEAT payments, other types of outbound payments, such as royalties and service fees, may trigger BEAT. This distinction raises potential defensive planning opportunities for U.S. importers of finished goods from related parties. U.S. importers of tangible goods from related parties may consider embedding royalties and service expenses into the transfer price of the tangible good rather than paying these expenses separately. The economic substance of the transaction is the same in either case. But the choice to aggregate the expenses (or not) can have significant consequences.
BEAT also specifies that when there are low-value intercompany services, the cost of performing them is incurred by the non-U.S. entity and should not apply to BEAT; however, any profit earned by the non-U.S. entity goes toward the BEAT calculation. In other words, companies with too much profit on services combined with royalties may trigger BEAT. As a result, companies are now incentivized to lower the profit margins of their non-U.S. entities—or even to eliminate those profits entirely. Any company that might potentially trigger BEAT should consider how they price intercompany services, as they now have motivation to put as low of a markup on them as possible.
Another factor to consider in your transfer pricing planning is the new, expanded definition of intellectual property. That change should result in higher valuations of IP because it captures things like goodwill that did not necessarily require compensation before U.S. tax reform went into effect. In the past, lower IP values were preferable when the IP was sold to offshore related parties in low-tax jurisdictions. U.S. tax reform has completely flipped this notion on its head. Now as offshore IP is transferred from low- or no-tax jurisdictions to higher tax jurisdictions, there may be a tax benefit to transferring the IP at a higher value. While a gain on the sale of IP has little or no tax consequence in a low- or no-tax jurisdiction, a company can often obtain an amortization deduction in the (higher tax) purchasing entity jurisdiction. If the purchaser is a U.S. company, the changes to the definition of IP actually facilitate taxpayers in establishing higher IP values. As long as onshoring the IP does not trigger negative tax consequences, such as GILTI or BEAT, the new definition of IP can be advantageous to a company’s global tax position.
For your company to truly understand the impact of U.S. tax reform on your transfer pricing activities, it’s essential to plot out how each of the TCJA provisions will interact with one another, as they’re all interconnected. In doing so, some companies may find that it doesn’t make sense to bring IP back to the U.S., while others may determine that it is the optimal approach, all things considered.
There’s no magic bullet for transfer pricing planning in the wake of U.S. tax reform—what works for one company won’t necessarily work for another. (Tweet this!) Today, planning opportunities are much more company-specific than ever before. For example, where moving IP to low-tax jurisdictions was almost always a good idea from a tax perspective, blanket statements like that are no longer the case. Instead, it’s necessary to model out the potential impacts as they apply to your specific organization. When modeling out tax positions, pay attention to where your pricing for intercompany transactions falls in the acceptable arm’s length range as determined by the transfer pricing method of choice. Companies with results in the higher end of the arm’s length range may see a tax benefit from being at the bottom end of the arm’s length range.
Transfer Pricing Compliance
In many ways, U.S. tax reform was a reaction to transfer pricing reform outside the U.S.—particularly the OECD BEPS project, which emphasizes where employees are located and which entities have the financial wherewithal and the ability to control and mitigate risk. The OECD’s emphasis on functions and risks in determining profit allocation is contrary to traditional transfer pricing theory, which suggests that entrepreneurial, non-routine profits should, in principle, accrue to the entity that invested the requisite capital (ordinarily the IP owner).
Under BEPS, large multinationals are now required to file country-by-country (CBC) reports, disclosing where both their profits and employees are located throughout the organization. This compliance measure puts further pressure on the diverging transfer pricing views of the United States and the OECD, as it gives tax authorities around the world a roadmap to identify capital intensive entities that have few or no employees.
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In an apparent affront to BEPS, U.S. tax reform provisions are largely formulaic and mechanical in nature. For example, it doesn’t matter where employees are located or why a company thinks its profits should be located in a certain jurisdiction. Rather, if companies trigger BEAT or GILTI, they trigger it—no amount of explanation will reverse it. The incompatibility of BEPS and U.S. tax reform does mean that taxpayers will need to more carefully structure and document their intercompany transactions. It is necessary for multinational companies to proactively plan around both BEPS and U.S. tax reform to avoid double taxation, which can sometimes occur as a result of the divergent global rules.
In a post-U.S. tax reform world, documentation has become extremely important—not necessarily because of the changes to U.S. tax laws, but because of how those changes interact with BEPS. Companies are finding themselves performing a tremendous balancing act as they try to make changes that both benefit them from a tax perspective and can be framed in a way that’s compliant with OECD BEPS regulations. These fundamental changes to the tax and transfer pricing industries require careful consideration by multinational corporations.
We’ll Help You Ensure Compliance With Evolving Tax Regulations
Ever-evolving tax regulations are often complex and confusing. At Valentiam, we specialize in developing innovative, client-specific solutions to transfer pricing challenges. Our senior partners—who have all held executive positions at each of the legacy Big 4 accounting firms—work directly with our clients, collaborating to arrive at client-centric solutions that meet each company’s distinct needs. If you’re tasked with ensuring compliance with all national and international tax laws—and overwhelmed as you try to navigate the process—let’s talk. Schedule a discovery call with one of our seasoned transfer pricing advisors to learn more about our unique approach to transfer pricing planning and compliance.