The Tax Cuts and Job Act (TCJA) tax overhaul signed into law on December 22, 2017 was cheered by businesses who have long struggled with the burden of a 35 percent federal tax rate. Many companies are now assessing the potential impacts of the most significant US tax policy change in a generation. While the 21 percent corporate tax rate is a momentous change in the tax environment for companies with US operations, multinationals may not realize the full benefits of the new law with an outdated transfer pricing system. In addition, numerous anti-abuse provisions may create problems for companies unaware of the details in the new tax law.
How does tax reform apply to transfer pricing?
The cross-border prices charged on inventory, royalties, services and loans all have an impact on where taxable income is realized within a multinational company. Consequently, incorrect transfer pricing may result in a reduced benefit from the change in US federal tax rates.
For instance, a foreign-parent company overcharging its US subsidiary would overpay taxes in the home country, and pay too little income tax in the US. Similarly, a US parent company that undercharges subsidiaries would also overpay foreign taxes and underpay US income taxes, potentially resulting in a higher global net effective tax rate.¹
Companies are often lax about regularly reviewing their transfer pricing approach. Intercompany pricing is either justified after year-end in transfer pricing documentation, or overlooked until examined during a tax audit. In fact, some companies rely upon the same transfer pricing policies for years. In these situations, corrections to transfer pricing may be a wise option for realizing these tax savings.
Transfer pricing rules still apply
For most countries, transfer pricing rules and regulations are based upon the “arm’s-length standard”, and a lower US tax rate does not reduce the compliance burden for multinationals in the US or internationally. Transfer pricing adjustments are still a great return on investment for tax authorities, and it is anticipated that many tax authorities will be on the lookout for multinationals taking advantage of the lower tax rate through transfer pricing.
Taxpayers should take this opportunity to prepare defense documents for the company’s transfer pricing approach and profit results in expectation of an audit. A best practice is to have transfer pricing documentation which meets the requirements for tax authorities on both sides of the border and is contemporaneous with the company’s tax return filing.
How can companies optimize their transfer pricing approach?
As a first step, review the company’s profit margins on a country-by-country basis for the past three years and budgets for the current year. Also, review intercompany transaction volumes by category across the company. Large intercompany transactions and companies in jurisdictions appearing to be earning overly generous profit margins are often good starting points for a reassessment of inventory, services, and royalty prices.
Taxpayers should reevaluate whether the existing pricing approach is reasonable considering the activities and risks borne by each counterparty to a transaction. Royalty rates charged for intellectual property utilized on a cross-border basis should be a priority for review. For example, a US company that has generated valuable intellectual property through large R&D investments may be justified in charging higher royalties. Alternatively, a US company may not be charging for valuable services rendered to related entities. In both instances, a multinational company would be warranted in making adjustments to comply with transfer pricing regulations in the US and internationally.
More Complications- the “BEAT” “GILTI” and “FDII” Tax Rules
Unfortunately, the headline tax rate reduction to 21 percent is not the end of the story. The new tax law also institutes new complicated provisions aimed at (a) discouraging companies from shifting taxable income to even lower tax jurisdictions while (b) assessing a lower rate of tax on US profits derived from serving foreign markets.
Regulations for TCJA have not been issued yet, and a more detailed analysis of these new rules will be the subject of another news briefing. However, some noteworthy changes include:
- Base Erosion and Anti-Abuse Tax (BEAT) is designed to curb excess “base erosion” outbound payments, such as royalties and services, to related companies offshore. From a high-level, the BEAT effectively creates a minimum tax on payments to foreign related corporations that are part of large multinational groups.
- Global Intangible Low Taxed Income (GILTI) taxes a defined level of “excess income” generated offshore in low-tax jurisdictions. The rule taxes offshore earnings in a similar manner as the “Subpart F” inclusions.
- Foreign-Derived Intangible Income (FDII) – A new IRC Section 250 of TCJA lowers the 21 percent tax rate to an effective tax rate of 13.125 percent on excess returns derived from foreign sources.
Clearly the TCJA has been designed to improve the tax environment for companies with cross-border transactions, and transfer pricing is an essential factor in managing their global effective tax rate. Meanwhile, there are still potential pitfalls lurking for taxpayers navigating a new tax environment. Going forward, we recommend including transfer pricing as a key consideration when reviewing the implications of tax reform.
If you have questions regarding the impacts of transfer pricing in light of tax reform, contact Clayton & McKervey.
¹ Please note that issues such as tax net operating losses, loan interest deductibility, operations in lower tax jurisdictions and transfer pricing rules, among others, are also important considerations when assessing a company’s global effective tax rate.