The Bottom Line: International Tax Considerations
Alexander H. Martin, Clayton & McKervey P.C.
Throughout the past couple of decades, many mold builders have established operations outside of the United States. Some have found the experience to be opportunistic, increasing margins beyond what they experience at home. Others have found the experience to be difficult and wrought with quality issues. Regardless of the economic outcome, those who have ventured beyond U.S. borders often struggle with unfamiliar foreign tax regimes.
Many companies venturing overseas find that the most contentious issue occurs because every country chases its “fair share” of income tax. Governments worldwide are concerned that multinational companies are avoiding tax by shifting income through cross-border pricing for goods, services, royalties and loans. This internal transfer pricing across borders drives how much income tax a company pays by country.
Stopping multinationals from shifting profits overseas is a politically popular policy, and many companies have been caught in the crossfire. Minimal tax payments for multinational companies such as Google, Starbucks and Apple have generated calls for action against all multinationals across the globe. Smaller companies, including mold builders, are now facing the same questions as the Fortune 500 multinationals.
Why is Transfer Pricing Important?
Transfer pricing has become a top concern of governments and companies in more than 100 countries worldwide. With the exponential growth in international trade, multinationals have become a lucrative target in an era of shrinking tax revenues. Tax authorities have found that auditing companies for shifting taxable income offshore offers a high return on investment. That is, significant tax adjustments can be made as a result of auditing the cross-border transactions of multinationals.
When it comes to transfer pricing, companies must charge market prices on transactions with related companies. In other words, what would an “arm’s-length” party charge for the same transaction, under the same circumstances? Companies that do not charge arm’s-length pricing risk substantial tax adjustments, interest, nondeductible penalties and double-tax risks.
For example, if an overseas subsidiary pays too high a price on intercompany purchases, the subsidiary is questioned for not paying its fair share of tax locally. Conversely, U.S. companies charging too low a price to subsidiaries are accused of shifting profits out of the U.S. Fortunately, almost all countries subscribe to this arm’s-length principle for intercompany pricing. However, interpretation and application of this principle varies widely.
We find that many companies are facing transfer pricing auditors for the first time. After raising billions of dollars in tax revenue through transfer pricing audits of large companies, tax authorities have expanded into the middle market. In fact, the IRS Deputy Commissioner for Service and Enforcement stated, “I believe many mid-market corporations may have the same issues as larger entities and perhaps additional issues as well.” To support this initiative, the IRS recently launched a dedicated Transfer Pricing Operations practice to improve knowledge sharing while redeploying hundreds of auditors to address more international issues. The IRS has also unveiled a 24-month “Audit Roadmap” for assessing transfer pricing of multinational companies.
Many middle-market companies, including mold builders, have difficulty justifying transfer pricing to auditors. Some transfer-pricing policies (for example, one that establishes cost plus 10 percent on exports) may have been established by management decades ago, when tax exposures were not a major consideration. Other strategies include preparing an analysis once notified of an audit. Unfortunately, the wait-and-see approach has become increasingly untenable. Most tax authorities now expect that transfer prices should be reviewed on an annual basis.
In our experience, many auditors select company targets based on the volume of intercompany transactions, profit margins earned by companies on a country-by-country basis and where companies have tax net operating losses. To assess your risks, we suggest reviewing the operating margins for each company subsidiary (defined as earnings before interest and tax as a percentage of net sales). This evaluation should address every open tax year that can be audited.
From a high level, an overseas transfer-pricing auditor may not know much about your company, but that auditor can assess how much profit the local subsidiary generates and pays in tax. Conversely, an IRS transfer-pricing auditor can see if the overseas subsidiaries are generating too much profit, thus shifting profits outside the U.S. Expectations of “normal” profitability levels will vary by industry and country.
Tackling Transfer Pricing
Many companies prepare transfer-pricing documentation to explain and defend a company’s transfer pricing results. Essentially, a documentation report consists of the following information:
• Functional analysis: Explain each company’s functions, assets and risks in detail, including corporate structure.
• Industry analysis: Explain how recent industry developments affect the business.
• Financial/economic analysis: Describe the intercompany transactions, and analyze relevant financial information and pricing.
• Financial/economic analysis: Select the best method for benchmarking transactions, and demonstrate how the profitability or pricing is arm’s-length.
Transfer pricing documentation is a company’s first and best opportunity to explain why its transfer pricing results are reasonable. One rule of thumb: If a transfer pricing report does not make sense to you, it will not be convincing to a tax auditor.
Documentation is not necessarily required in every situation, however. In the U.S., we find that companies with lower volumes of intercompany transactions, or start-up operations, may be well-served with a profit benchmarking study. A benchmarking study provides guidance for intercompany prices while reducing the cost of compliance. Generally, this type of economic analysis calculates a range of target profit margins for subsidiaries. A transfer pricing policy document alone is usually not considered evidence that intercompany pricing is correct.
In all cases, we suggest that companies prepare and execute intercompany contracts for transactions (contracts of goods or services between related entities) to clarify roles, responsibilities and intangible property ownership for each company involved in an intercompany transaction.
Is There Any Good News?
Yes. While transfer pricing is considered the top tax risk for multinational companies, transfer prices also impact the global effective tax rate and company cash flow. We find that companies may identify cash savings opportunities through corrections to transfer pricing while also reducing risks. Many companies can benefit from utilizing tax net operating losses when modifying intercompany prices. Bottom line: Proactive compliance with transfer pricing rules can be beneficial from both a tax-risk perspective and to the company’s bottom line.
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