International Tax Monthly – Oct. 2015

IRS Targets Income Shifting Through Improper Transfer Pricing

The IRS recently issued an international practice unit (IPU) showing its examiners how to search for potential income shifting when auditing outbound sales of tangible goods by U.S. units of multinationals.

Specifically the guidance targets sales to foreign affiliates where the price of tangible goods fails to reflect U.S.-owned intangible property, marketing and other services included in the transaction. In general, IPUs identify strategic areas of importance to the IRS and can provide insights to businesses about how examiners may audit a particular transaction.

Under the U.S. tax code, pricing should fall within the arm’s-length results for similar sales between unrelated parties. In those transactions, the price generally is determined by market conditions and is assumed to be at arm’s length. However, in a transaction between controlled (or related) parties, the price of goods may be manipulated in order to shift income to minimize taxes.

Maximizing Profits

According to the IRS, U.S. multinational enterprises (MNEs) may try to maximize after-tax profits by shifting income from a high-tax affiliate to a lower-tax affiliate in transactions that don’t reflect arm’s-length pricing. MNEs may shift income through the sale of tangible goods, the provision of services, loans, and leases and the license or transfer of intangibles.

The U.S. tax code lays out transfer pricing methods for these transactions. Companies must perform a comparability analysis to determine which method is the best. To determine whether a U.S. unit of an MNE undercharged a foreign affiliate, the IRS seeks answers to the following general questions:

1. Is any valuable U.S.-owned intangible property embedded in the tangible goods or otherwise passed to the affiliate other than the right to resell the tangible property?

2. If so, is the U.S. unit charging an arm’s-length price reflecting the values of the tangible and intangible property?

3. Does the U.S. unit provide any valuable services in connection with the sale?

4. If services are involved, is the U.S. unit charging an arm’s-length price?

Examiners’ Mandate

IRS examiners are told to consider the following elements in order to determine whether any intangible value should have been priced separately:

  • Which transfer pricing method was used?
  • Was it the best method?
  • Was the value of the intangible property taken into account in the transfer pricing study?
  • Is the tangible property compensated at an arm’s-length price, given the presence of the intangible property?

If these elements support the use of another transfer pricing method, the examiner must gather evidence to show that. Otherwise, the examiner should evaluate the comparables used to support the pricing of the tangible goods under the best method.

Factual Elements

To determine whether valuable services were conveyed in the sale, examiners are told to consider nearly 40 factual elements, including:

  • Whether the transfer pricing study identifies any marketing services the U.S. unit provided to the foreign affiliate;
  • Whether the foreign affiliate performed its own marketing activities;
  • Whether the foreign affiliate ever outsources marketing services to third parties or provides similar services to third parties;
  • Whether the U.S. unit ever provides marketing services to the affiliate as part of a sales agreement regarding tangible goods;
  • What the contract termination and modification rights are, and
  • Whether the form of the transaction (including written contract terms) follows the substance of the transaction.

Note: In the best case, a U.S. multinational enterprise may have clearly defined the form of these transactions in written legal contracts. In such cases the company may expect the contracts alone to serve as the basis for tax positions it takes on its U.S. income tax return. However, the actual transaction could be inconsistent with the terms of the contracts and warrant a transfer pricing challenge. In fact, the IRS instructs its examiners to “trace the actual conduct” in the intercompany accounts that are reflected in the financial books and ledgers.

According to the IRS, the factual elements should help examiners determine whether a service should be priced separately from tangible goods.

Because standard transfer pricing documentation may not address many of the factual elements, it would be wise for companies to consider additional resources that may be necessary to respond to IRS information requests and to consult with their advisers.

G-20 Finance Ministers to Monitor Cross-Border Tax Rulings

G-20 finance ministers and central bank governors recently committed to monitoring the outcome of the base erosion and profit shifting (BEPS) project, particularly when it comes to the exchange of information on cross-border tax rulings.

BEPS is a project of the Organisation for Economic Co-operation and Development (OECD) that brought together OECD nations as well as additional countries that supposedly all participated on an “equal footing” in the development of the BEPS measures.

Call for an OECD Framework

In a communiqué highlighting the actions required to achieve the international forum’s goals for this year, the G-20 leaders said: “We call on the OECD to prepare a framework by early 2016 with the involvement of interested non-G-20 countries and jurisdictions, particularly developing economies, on an equal footing.”

They added that they welcomed the efforts by the International Monetary Fund, World Bank Group, United Nations, and the OECD to provide technical assistance to interested developing economies in tackling the domestic resource mobilization challenges they face, including from BEPS.

The two-year BEPS project is based on a 15-point action plan designed to:

  • Ensure the coherence of corporate tax systems in a cross-border environment,
  • Introduce substance requirements in the area of tax treaties and transfer pricing, and
  • Ensure transparency while promoting certainty and predictability.

The G-20 leaders indicated that they are in the final phase of delivering the BEPS action plan.

In a report to the ministers and central bank governors, OECD Secretary General Angel Gurria noted that the adoption of the final BEPS package will impose minimum standards to “stopping opaque rulings through the automatic exchange of such rulings as well as curbing harmful tax practices, in particular in the area of intellectual property.”

The Road Ahead

The final package of 15 action items is expected to be reviewed at the G-20’s October meeting in Lima, Peru. The final package will be submitted to the G-20 leaders for approval at their November summit in Antalya, Turkey.

The 15 BEPS action items are:

Action 1: Address the tax challenges of the digital economy.

Action 2: Neutralize the effects of hybrid mismatch arrangements.

Action 3: Strengthen rules on controlled foreign companies.

Action 4: Limit base erosion via interest deductions and other financial payments.

Action 5: Counter harmful tax practice more effectively, taking into account transparency and substance.

Action 6: Prevent tax treaty abuse.

Action 7: Prevent the artificial avoidance of permanent establishment status.

Action 8: Assure that transfer pricing outcomes are in line with value creation intangibles.

Action 9: Assure that transfer pricing outcomes are in line with value creation: risks and capital.

Action 10: Assure that transfer pricing outcomes are in line with value creation: other high-risk transactions.

Action 11: Establish methodologies to collect and analyze data on BEPS and the actions to address BEPS.

Action 12: Require taxpayers to disclose their aggressive tax planning arrangements.

Action 13: Re-examine transfer pricing documentation (includes country-by-country reporting).

Action 14: Make dispute resolution mechanisms more effective.

Action 15: Develop a multilateral instrument capable of implementing the tax treaty-related BEPS measures.

Foreign Tax Law Changes Affecting Investors

China and India have announced tax changes that affect investors. China announced that dividend income that certain individual shareholders receive on shares of Chinese companies will be exempt from personal income tax.

In a separate announcement, India said that the minimum alternative tax (MAT) would not apply to certain foreign institutional investors (FIIs) and foreign portfolio investors (FPIs).

Troubled Chinese stock markets

The Chinese measures are the latest in a series of moves Beijing hopes will encourage longer-term investment and halt a slide in Chinese equities. The troubled Shanghai and Shenzhen stock markets have rattled global investors and raised fresh doubts about the strength of the world’s second-biggest economy.

The Ministry of Finance, the State Administration of Tax, and the China Securities Regulatory Commission jointly announced that dividend income received by Chinese investors on certain shares will be exempt from personal income tax. The shares must have been acquired through public offerings or stock transfers. Investors must have held the shares for more than one year.

Dividends on such shares held for less than one month will be taxable. If the shares are held for more than one month and less than one year, 50% of the dividend income will be taxable. In both cases, the uniform Chinese tax rate of 20% will apply.

Indian Controversy

In India, the Ministry of Finance announced that the MAT would not apply to FIIs and FPIs that don’t have a place of business or permanent establishment in India for the period prior to January 4, 2015. The move is aimed at trying to retain and attract foreign investment.

The MAT was originally introduced to levy a minimum tax on “zero tax” companies by deeming a certain percentage of their book profits as taxable income. According to India’s Committee on Direct Tax Matters, many companies were paying marginal or no tax despite showing high profits and paying substantial dividends.

A controversy arose after the Authority for Advance Rules issued inconsistent rulings on the matter. As a result of one ruling, India’s tax authorities attempted to bill foreign investors for years of retroactive taxes under the MAT.

A special advisory committee charged with examining the controversy recommended that the MAT not be applied to FIIs and FPIs that don’t have a place of business or permanent establishment for the period prior to January 4, 2015.

The Next Step

Finance Minister Arun Jaitley said that the government had accepted the recommendation and that he would make the change permanent through legislation in the next session of parliament, which is expected to take place in late November.