International Taxation and Transfer Pricing

For transfer pricing there are a number of links throughout the lecture notes. The one below from PwC will take you to their main Tax research & insights page. Click on Transfer Pricing Perspectives for articles

http://www.pwc.com/gx/en/international-transfer-pricing/requirements.jhtml

On that same page if you scroll down you can download the 2016 Transfer Pricing Perspectives. It is the most recent version. Take the time to look it over.

You will also find an attached file in the Week 7 discussion that has the International Transfer Pricing 2015/16. Although dated it is still relevant and PWC has not issued a more current report.

Transfer pricing requirements around the world

International Transfer Pricing 2015/16 is an easy-to-use reference guide covering a range of transfer pricing issues around the world. It explains why it is vital for every company to have a coherent transfer pricing policy which is responsive to the rapidly changing markets in which they operate. The book not only shows why sound transfer pricing policies should be developed, but also why such policies need to be re-evaluated regularly. It offers practical advice on a subject where the right amount of effort can produce huge benefits in the form of a competitive and sustainable tax rate, and leave the company well positioned to defend against aggressive tax audits.

https://www.pwc.com/gr/en/publications/assets/international-transfer-pricing-guide-2015-2016.pdf

Here’s another link from the JofA on the topic of transfer pricing. It explains transfer pricing, its application, financial reporting and required disclosures.

https://www.journalofaccountancy.com/issues/2013/oct/20137721.html

The next file is from US Transfer Pricing Laws & Regulations…

http://www.ustransferpricing.com/index.html

International Taxation

There is an old expression that “there are two things that you cannot avoid…death and taxes!”

US Supreme Court Justice Oliver Wendell Holmes said, “taxes are the price we pay for a civilized society.”

Taxes…for those of you living here in the States…you pay some or all of those listed below:

Federal tax	State tax
County tax	City/municipality taxes
Payroll taxes – social security and medicare	Property tax
Sales tax	Estate and gift taxes
Gas tax	Hotel taxes
Sin tax – on liquor and cigarettes

Check out the list under Yahoo! Answers website…it’s even longer than my list…

Now move this discussion to the corporate level…

· Taxes are one of the most significant costs incurred by businesses

Taxes are included among the other factors when companies are making decisions regarding foreign operations

· which country should we move or add a location

· legal form

· financing issues…debt or equity

Major types of taxes imposed on profits earned by companies with foreign operations

· income taxes

· withholding taxes

Most countries have a national corporate income tax rate that varies between 20% and 35%. Countries with no or very low corporate taxation are known as tax havens.

MNCs often attempt to use operations in tax haven countries to minimize their worldwide tax burden.

Tax jurisdiction over income is an important issue.

Two factors determine which country will tax which income:

(1) whether a country uses a worldwide or territorial approach to taxation, and

(2) whether a country taxes on the basis of source of income, residence of the taxpayer, and/or citizenship of the taxpayer.

Most countries, including the U.S., tax income on a worldwide basis. The U.S. also taxes on the basis of source, residence, and citizenship.

Overlapping tax jurisdictions results in double taxation.

For example, the income earned by a foreign branch of a U.S. company is subject to taxation both in the foreign country and in the U.S.

Most countries provide relief from double taxation through foreign tax credits (FTC). Foreign tax credits are the reduction in tax liability on income in one country for the taxes already paid on that income in another country.

· Foreign tax credits allowed by the home country generally are limited to the amount of taxes that would have been paid if the income had been earned in the home country.

· The excess of taxes paid to a foreign country over the foreign tax credit allowed by the home country is an excess foreign tax credit. In the United States, an excess FTC may be carried back one year and carried forward ten years to reduce taxes otherwise payable on foreign source income.

· In the U.S., foreign source income must be allocated to two different FTC baskets – a general income basket and a passive income basket. The excess FTC from one basket may not be used to reduce the tax liability related to another basket.

U.S. tax treatment of foreign source income is determined by several factors:

(1) the legal form of the foreign operation (branch or subsidiary),

(2) the percentage owned by U.S. taxpayers (controlled foreign corporation or not),

(3) the foreign tax rate (tax haven or not), and

(4) the nature of the foreign source income.

Tax treaties between two countries govern the way in which individuals and companies living in or doing business in the partner country are to be taxed by that country.

· Most tax treaties include a reduction in withholding tax rates.

· The U.S. model treaty reduces withholding taxes to zero on interest and royalties and 15% on dividends. However, these guidelines often are not followed.

Foreign source income must be translated into home country currency for home country taxation purposes.

· Under U.S. law, foreign branch net income is translated into US$ using the average exchange rate for the year and then grossed-up by adding taxes paid to the foreign government translated at the exchange rate at the date of payment.

· When branch income is repatriated to the home office, any difference in the exchange rate used to originally translate the income and the exchange rate at the date of repatriation creates a taxable foreign exchange gain or loss.

· Dividends received from a foreign subsidiary are translated into US$ using the spot rate at the date of distribution and grossed-up by adding taxes deemed paid translated at the spot rate at the date of payment.

Many countries provide tax incentives, such as tax holidays, to attract foreign investment.

· Tax holidays can provide a significant benefit to MNCs as long as the income earned in the foreign country is not repatriated back to the parent. Upon repatriation, the foreign income becomes taxable in the home country and there is no offsetting foreign tax credit because no foreign taxes were paid.

· Some home countries grant tax sparing for their companies who invest in developing countries, which provides a foreign tax credit for the amount of taxes that would have been paid to the foreign government if there were no tax holiday.

The U.S. has provided a variety of tax incentives to export over the years – Domestic International Sales Corporation (DISC), Foreign Sales Corporation (FSC), and Extraterritorial Income Exclusion Act (ETI).

· U.S. trading partners, especially in the European Union, have objected to each of these export incentive regimes for violating international trade agreements.

· The American Job Creation Act of 2004 repealed the ETI provisions and instead allows companies to deduct a percentage of domestic manufacturing income from taxable income. Manufacturing firms receive this deduction whether they export or not.

Another Perspective on International Taxation

Tax considerations strongly influence business and investment decisions.

Taxation is the second largest expense behind cost of goods sold.

Basic Tax Concepts

· Tax Neutrality

· taxes have no effect on resource allocation decisions (in reality, taxes are seldom neutral)

· Tax Equity

· taxpayers similarly situated should pay the same tax (in reality, there are major disagreements over how to interpret this concept)

Diversity of National Tax Systems

Types of Taxes

· Direct – i.e., income taxes

· Indirect – i.e., consumption taxes

Specific examples….

Corporate Income Tax

Withholding Taxes

· Imposed by governments on dividends, interest and royalty payments to foreign investors.

Value-Added Tax

· Consumption tax in Europe and Canada

Border Taxes

· Customs or import duties

Transfer Tax

· Imposed on the transfer of items between taxpayers.

Tax Burdens

Differences in overall tax burdens are important in international business

· A simple comparison of tax rates is not sufficient for assessing the relative tax burdens imposed by different governments. The method of computing the profits to which the tax rates will be applied (the tax base) should also be taken into account.

Tax Administration Systems

· Classical

· Corporate income taxes on taxable income are levied at the corporate level and at the shareholder level.

· when a corporation is taxed on income measured before dividends are paid, and shareholders are then taxed on their dividends, the shareholders’ dividend income is effectively taxed twice.

· Integrated

· Corporate and shareholder taxes are integrated to reduce or eliminate the double taxation of corporate income.

· The tax credit or imputation system is a common variant of the integrated tax system.

· tax is levied on corporate income, but part of the tax paid can be treated as a credit against personal income taxes when dividends are distributed to shareholders.

· Split-Rate

· Variant of the integrated tax system

· A lower tax is levied on distributed earnings (dividends) than on retained earnings.

Foreign Tax Incentives

- tax free cash grants

- reduced income tax rates

- tax deferrals

- reduction or elimination of various indirect taxes

Some countries offer permanent tax inducements….

Countries offering tax incentives to attract foreign investment; these so-called tax havens include….

1. the Bahamas, Bermuda, and the Cayman Islands, which have no taxes at all

2. Barbados, which has very low tax rates

3. Gibraltar, Hong Kong and Panama, which tax locally generated income but exempt income from foreign sources.

The Organization for Economic Cooperation and Development (OECD) is trying to halt tax competition by certain tax haven countries. The United States has also taken steps to do the same.

INTERNATIONAL TAX TOPIC INDEX

The Index is the gateway into the IRS Tax Map designed for taxpayers with international filing requirements. It contains all the tax information in one location; unfortunately, it is no longer available but the link provides maps from previous tax years 2013-2018.

https://taxmap.irs.gov/taxmap/internationalindex.htm

The following link will give you a history of the IRS Tax Map; the IRS stopped publishing in 2019.

https://taxmap.irs.gov/taxmap/about.htm

June 2017 IRS Launches Country-by-Country Reporting Issue #IR-2017-116

The issue provides background information on Country-by-Country Reporting, frequently asked questions and other helpful resources, including a list of jurisdictions that have concluded Competent Authority Arrangements with the United States.

Country-by-Country (CbC) Reporting is part of Action 13 of the Organisation for Economic Cooperation and Development’s Base Erosion and Profit Shifting project, which is intended to enhance transparency for tax administrations by providing them with information to conduct high-level transfer pricing risk assessments.

Here’s the link: https://www.irs.gov/businesses/us-multinational-enterprises

International Harmonization

Given the diversity of tax systems around the world, the globalization of tax policies would seem worthwhile.

Taxation of Foreign Source Income & Double Taxation

Territorial Principle

· Income of resident corporations generated outside their borders is exempt from taxation.

Worldwide Principle

· Resident corporations and citizens’ income are taxed regardless of national boundaries.

Foreign Tax Credit

Under the worldwide principle….

Foreign earnings of a domestic company are subject to the full tax levies of both its host and home countries.

To avoid discouraging businesses from expanding abroad, a parent company’s domicile can elect to treat foreign taxes paid as a credit against the parent’s domestic tax liability or as a deduction from taxable income.

Tax Planning Issues

· Organizational Considerations

· Many taxing jurisdictions focus on the organizational form of a foreign operation.

· Controlled Foreign Corporation and Sub-Part F Income

· Worldwide principle...income of foreign subsidiaries is not taxable to the parent until it is repatriated as a dividend.

· Deferral principle

· Tax havens give MNC’s an opportunity to avoid repatriation.

Tax Planning Issues continued

· U.S. closed this loophole with the Controlled Foreign Corporation (CFC) and Sub-Part F Income provisions.

· CFC – corporation in which U.S. shareholders own more than 50% of its combined voting power or fair market value.

· Only shareholders holding more that 10% voting interest are counted in determining the 50% requirement.

· Shareholders of a CFC are taxed on certain income of the CFC (referred to as tainted income) even before the income is distributed.

· Subpart F income includes certain related party sales and services income.

· Offshore Holding Companies

· A U.S.-based MNC parent company with operations in several foreign countries may find it advantageous to own its various foreign investments through a third country holding company.

· Foreign Sales Corporations

· In 2000 the World Trade Organization (WTO) ruled that FSC’s constitute an illegal subsidy and ordered the U.S. to repeal its FSC provisions.

· The U.S. repealed FSC’s but replaced them with an extra-territorial income exclusion.

· New U.S. law also ruled illegal by the WTO.

· Financing Decisions

· Other things equal, the tax deductibility of debt, which increases the after-tax returns on equity, increases the attractiveness of debt financing in high tax countries.

· Pooling of Tax Credits

· Allows excess credits generated from countries with high tax rates to offset taxes on income received from low tax jurisdictions.

· Cost Accounting Allocations

· Another vehicle to shift profits from high to low tax countries.

· Location and Transfer Pricing

· Location of production and distribution systems offers tax advantages.

· International transfer pricing is the most important international tax issue facing MNC’s.

International Transfer Pricing

According to Investopedia, transfer pricing is the price at which divisions of a company transact with each other. Transactions may include the trade of supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. Also known as "transfer cost".

Two factors heavily influence the manner in which international transfer prices are determined:

(1) corporate objectives, and

(2) national tax laws.

There are a variety of cost, especially tax, minimization objectives that MNCs might attempt to achieve through international transfer pricing. However, MNCs must be careful to comply with national tax laws in setting international transfer prices.

The three bases commonly used for establishing transfer prices, both for domestic and international transactions, are:

(1) cost-based transfer prices,

(2) market-based transfer prices, and

(3) negotiated prices.

Theory suggests that different pricing methods are appropriate in different situations.

There are two types of objectives to consider in determining international transfer prices:

(1) performance evaluation and

(2) cost minimization.

Performance evaluation: Transfer prices affect the reported profit of both parties to an intercompany transaction; revenue for the seller and an expense for the buyer. To fairly evaluate performance, transfer prices should be acceptable to both the buyer and the seller, otherwise dysfunctional behavior can occur.

Cost minimization: Objectives can be achieved by top management using discretionary transfer pricing. Possible objectives include minimization of worldwide income tax, minimization of import duties, circumvention of repatriation restrictions, and improving the competitive position of foreign subsidiaries.

Note: The above two objectives are often in conflict with each other.

National tax authorities have guidelines regarding what is an acceptable transfer price for tax purposes. These national laws often are based on Organisation for Economic Co-operation and Development (OECD) guidelines. The basic rule is that intercompany transactions should be made at an “arm’s length price.”

Note: The OECD is an international organization of 34 countries founded in 1961 to stimulate economic progress and world trade. Their website is www.oecd.org

Section 482 of the U.S. Internal Revenue Code requires intercompany transactions to be carried out at arm’s length prices.

· Section 482 gives the IRS the power to audit and adjust taxpayers’ international transfer prices if they are not found to be in compliance with Treasury department regulations.

· The IRS also may impose a penalty of up to 40% of the underpayment in the case of a gross valuation misstatement.

· U.S. Treasury Regulations establish specific guidelines for determining an arm’s length price for sales of tangible property, licenses of intangible property, intercompany loans, and intercompany services.

The “best method rule” requires taxpayers to use the method that under the facts and circumstances provides the most reliable measure of an arm’s length price.

The two primary factors to be considered in determining the best method are

(1) the degree of comparability between the intercompany transaction and any

comparable uncontrolled transactions and

(2) the quality of the data and assumptions used in the analysis.

One of five specific methods must be used to determine the arm’s length price in a sale of tangible property. These are:

(1) comparable uncontrolled price method,

(2) resale price method,

(3) cost plus method,

(4) comparable profits method, and

(5) profit split method.

The comparable uncontrolled price method is generally considered to provide the most reliable measure of an arm’s length price when a comparable uncontrolled transaction exists.

Four methods are available for determining an arm’s length price for the license of intangible property:

(1) comparable uncontrolled transaction method,

(2) comparable profits method,

(3) profit split method, and

(4) unspecified methods.

Application of a particular transfer pricing method can result in an “arm’s length range” of acceptable prices. Companies can try to achieve cost minimization objectives by selecting prices at the extremes of the relevant range.

An advance pricing agreement (APA) is an agreement between a company and a national tax authority on what is an acceptable transfer pricing method for specified transactions. The tax authority agrees not to seek any transfer pricing adjustments if the agreed upon method is used.

· APAs negotiated with the U.S. IRS most frequently covers the sale of tangible property and the comparable profits method is the method most commonly agreed upon.

· A majority of APAs negotiated by the U.S. IRS have been with foreign parent companies with U.S. operations, rather than U.S. parent companies with foreign operations.

Countries have been stepping up their enforcement of transfer pricing regulations. Transfer pricing is the most important international tax issue faced by MNCs internationally. The United States is especially concerned with foreign MNCs not paying their fair share of taxes in the U.S.

PRICE WATERHOUSE COOPERS (PwC)

http://www.pwc.com/gx/en/international-transfer-pricing/requirements.jhtml

The PwC website is an extremely informative site…the first page gives you the ability to learn about transfer pricing requirements around the world including a map that provides a global view of transfer pricing in any country you are interested in learned more about. Please take the time to go on their site and read the intro…it is the first five pages of the 900-page document (also referenced at the beginning of the lecture notes).

Another Perspective on Transfer Pricing

International Transfer Pricing: Complicating Variables

The need for transfer pricing arises when goods or services are exchanged between organizational units of the same company.

Generally recorded as revenue by one unit and a cost by the other.

· Tax Considerations

· Unless counteracted by law, corporate profits can be increased by setting transfer prices to move profits from subsidiaries domiciled n high tax countries to subsidiaries domiciled in low tax countries.

· In the U.S., Section 482 of the Internal Revenue Code prevents a shifting of income or deductions between related taxpayers to exploit differences in national tax rates.

· Section 482 requires that intra-company transfers be based on an arm’s length price.

Arm’s-length price is one that an unrelated party would receive for the same or similar item under identical or similar circumstances.

Acceptable methods would include….

1. comparable uncontrolled pricing

2. resale pricing

3. cost-plus pricing

4. other pricing methods.

Additional Complicating Variables re Transfer Pricing

· Tariff Considerations*

· Competitive Factors

· Performance Evaluation Considerations

· Accounting Contributions

*For additional information on tariff basics and strategic planning, check the attached link from the Journal of Accountancy

https://www.journalofaccountancy.com/news/2020/jan/tariffs-trade-war-tips-for-cpas-22557.html

Transfer Pricing Methodology

Arm’s Length Principle

The OECD identifies several broad methods of ascertaining an arm’s-length price.

· Comparable Uncontrolled Price Method

· Comparable Uncontrolled Transaction Method

· Resale Price Method

· Cost Plus Pricing Method

· Comparable Profit Method

· Profit Splits Method

· Other Pricing Methods

Transfer Pricing Practices

Multinational corporations vary along many dimensions and a variety of transfer pricing methods are found in practice.

Recent study of financial executives in U.S. MNC’s identified the most important objectives of international transfer pricing…

1. managing the tax burden

2. operational uses of transfer pricing

3. promoting equitable performance evaluation

4. motivating employees

low on the list…

1. managing inflation

2. managing foreign exchange risk

3. mitigating restrictions on cash transfers

The future and what does it hold…….

Homework Assignments

1. Research your MNC and report on any major issue(s) of international taxation that is (are) addressed in this chapter. Post this assignment in the chapter conference.

2. Discuss how your MNC handles transfer pricing.

Topics of discussion can include but are not limited to: Are transfers from a subsidiary to its parent (upstream)? From the parent to a subsidiary (downstream)? Or from one subsidiary to another of the same parent? Transfer pricing methods? What are the objectives of your MNCs transfer pricing practices? What law(s) govern your MNCs practices? What method is used?

The enforcement of transfer pricing regulations in the country where you MNC is located?

Post your homework in this week’s discussion area. Your initial post reporting on your MNC’s international taxation and transfer pricing must be posted up by nlt Saturday evening in order to give everyone in the class the opportunity to respond.

This week you are also required to respond to at least one other post. Responses are due in by nlt Tuesday evening.

REMINDER:

You are also responsible to individually read the Group Project presentations posted this week in Week 7 discussion and respond to at least two different country posts.

Additional Resources:

Week 7 Deloitte Link re Global Indirect Tax News

Your reference for indirect tax and global trade matters. Issued annually; the link below provides access to the 2018 edition….

https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Tax/dttl-tax-global-indirect-tax-news-february-2018.pdf

Digital Tax

At the bottom of this write up is a link to EY’s website, specific focus is the topic of digital tax, compliments of the UMUC Accounting Department.

It’s a new topic for me and I’ve found the EY link extensive and trust me, there is a lot of important information on their website.

Unfortunately, since our class is only eight weeks in length and we only have one week where we discuss the taxation topic (along with transfer pricing), it’s not something that we will delve into; BUT it is a topic that I wanted you to be aware of…here’s the link…

http://www.ey.com/gl/en/services/tax/digital-tax