BEAT or GILTI? Tax Reform’s Effect on Transfer Pricing
Author: Will James
On December 22, 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law. The TCJA encompasses the most significant and wide-ranging changes to the U.S. Internal Revenue Code since 1986. The most significant change of note for corporations is the reduction of the corporate tax rate to 21 percent. The reduced rate was largely designed to make U.S. corporations competitive relative to their foreign competitors, as the U.S. corporate tax rate was among the world’s highest rates. The TCJA also contained a number of significant changes to the international tax rules that will affect most multinational corporations (MNC). These changes will likely require the alteration of MNCs’ global tax strategies and, particularly, the need to revisit and revamp their transfer pricing arrangements.
Move from Worldwide Tax System to Territorial Tax System
Prior to the TCJA’s passage, U.S.-based MNCs paid tax on a worldwide basis. If the profits earned by the MNC overseas remained offshore, there was deferral on payment of U.S. tax. When the profits were repatriated to the U.S. in the form of dividends or intercompany payments, they were then subject to tax in the U.S. However, the taxpayer was allowed to offset the payment of U.S. tax on repatriated income through the use of foreign tax credits (FTC). Under the new territorial tax system, a U.S.-based MNC pays tax on its U.S.-sourced income, and dividends from its foreign entities are now exempt from tax in the United States.
Under the former worldwide tax system, many MNCs with controlled foreign corporations (CFC) engaged in complex tax planning in an attempt to defer payment of U.S. taxes on their foreign earnings. This often involved the use of transfer pricing strategies designed to reduce U.S. income while placing profits in the MNC’s CFCs, which often benefited from a lower corporate tax rate than the U.S. entity. Because there is generally a direct correlation between where an MNC’s key intangible property (IP) resides and where the lion’s share of its profits are assigned, one common transfer pricing strategy involved migrating all or a portion of a MNC’s IP out of the U.S. to a low-tax country, such as Ireland. The income that was earned offshore through the exploitation of the IP was deferred and/or permanently reinvested offshore. Under the new territorial system, U.S. MNCs will likely employ transfer pricing strategies to repatriate foreign earnings given the low U.S. corporate tax rate of 21 percent.
For example, under the former worldwide system of taxation with the U.S. corporate tax rate of 35 percent, a U.S. MNC that manufactured products in the U.S. and sold them to its Chinese distribution subsidiary for resale would have been tempted to charge its Chinese CFC a low transfer price on the sale of the goods to leave more profit in its Chinese CFC, where the corporate tax rate is only 25 percent. When the dividend from the Chinese subsidiary’s earnings was ultimately repatriated to the U.S. MNC, the Chinese CFC would have remitted 10 percent in withholding tax to the Chinese government. The remainder of the dividend was then “grossed-up” to the U.S. corporate rate and an FTC for any taxes paid in China was applied to the dividend income to account for the taxes paid in China by the U.S. MNC’s Chinese CFC. However, to avoid the payment of higher taxes in the U.S. compared to China and the payment of U.S. taxes on foreign dividends, most MNCs attempted to structure intercompany pricing arrangements to the detriment of the U.S. and avoided repatriating income back to the U.S. given the dividend would be taxed at a high rate. Moreover, since U.S. MNCs were subject to taxation on a worldwide basis, they faced two levels of tax compared to their foreign competitors located in territorial system countries, which only face one level of taxation on global income. Under the new territorial system with a 21 percent U.S. corporate tax rate, there is now an incentive for U.S. MNCs to bring the income back to the U.S., as the U.S. corporate tax rate is lower than a majority of its trading partners. Using our example above, after tax reform the U.S. MNC would now benefit from selling goods to its Chinese CFC at a higher transfer price, given the tax rate differential between the U.S. and China is now preferential to the United States. It must be noted that the dividend ultimately paid back to the U.S. MNC would not be taxed in the U.S.; however, it would appear there would be no FTC offered in the U.S. to recover the 10 percent Chinese withholding tax paid by the Chinese CFC on the dividend.
According to various sources, Apple has approximately $250 billion in cash located overseas. The TCJA imposes a one-time mandatory repatriation of post-1986 to 2017 foreign accumulated earnings. As a direct result of the TCJA, Apple will have to pay U.S. tax of 15.5 percent on its liquid assets, e.g., cash and cash equivalents, and 8 percent on its illiquid assets, e.g., property, plant and equipment. Given the one-time deemed repatriation of earnings employs rates lower than the 21 percent corporate tax rate, it is essentially a tax holiday similar to the repatriation incentive set forth by President George W. Bush in 2004.
The mandatory repatriation, which applies to noncorporate U.S. shareholders and C corporations alike, assesses the amount of offshore accumulated earnings as of November 2, 2017, or December 31, 2017, whichever is greater. One planning idea to consider would be to make any transfer pricing adjustments resulting in greater income in foreign CFCs in 2017, which could then be repatriated to the U.S. at the low rate, i.e., 15.5 percent.
Base Erosion & Anti-Abuse Tax
The TCJA introduces a new provision, the base erosion and anti-abuse tax (BEAT), which is designed to curb perceived erosion of the U.S. tax base and essentially serves as an alternative minimum tax. The BEAT tax affects both inbound and outbound MNCs, but only applies to MNCs with at least $500 million in consolidated U.S. connected gross receipts in the prior three years, and that have “base erosion” payments to their foreign related parties in excess of 3 percent of adjusted deductions for the current tax year. Specifically, the 3 percent threshold is the aggregate of a taxpayer’s base eroding payments to foreign related parties divided by the aggregate allowable deductions for the taxable year. Base eroding payments are classified as intercompany interest, royalties and service fees (that include a mark-up) and exclude payments related to tangible goods that might be purchased by a U.S. MNC from its foreign related parties.
The BEAT tax is 5 percent in 2018, 10 percent for tax years 2019 through 2025 and 12.5 percent for tax year 2026 and thereafter. In essence, the BEAT tax “adds back” the otherwise deductible related-party payments to the taxpayer’s income for purposes of the application. The BEAT tax due is applied to the excess of the MNC’s U.S. corporate taxable income after adding back the base erosion payments less the MNC’s U.S. tax liability at the regular corporate rate, inclusive of the base erosion payments and allowable credits.
U.S. taxpayers with global consolidated revenues in excess of $500 million will want to analyze their nontangible property intercompany transactions to determine if they have BEAT tax exposure. There may be a need to modify, recharacterize or restructure these intercompany transactions to mitigate the risk of BEAT tax exposure.
Global Intangible Low-Taxed Income
The introduction of the global intangible low-taxed income (GILTI) tax is similar to BEAT in that it is designed to curb the erosion of the U.S. tax base by MNCs. Unlike BEAT, which applies to both inbound and outbound MNCs, GILTI is only applicable to U.S. MNCs with CFCs. It is designed to target CFCs with profits in excess of a certain target return and is specifically targeted at CFCs of U.S. MNCs that own valuable IP or operate sales and services businesses that do not employ significant tangible assets. Similar to the Subpart F rules, GILTI serves to “reach in and grab” profits in overseas jurisdictions. The GILTI calculation is complex, but is roughly calculated as the CFC’s net income less a 10 percent rate of return on its tangible assets.
The tax rate for C corps on GILTI income is 10.5 percent (50 percent of the corporate tax rate) for tax years 2018 to 2025 and 13.125 percent (62.5 percent of the corporate tax rate) thereafter. S corps are subject to the full GILTI rates, as they are not entitled to the 50 percent and 62.5 percent GILTI tax rate reduction unless their shareholders make an election to be taxed as a C corp on GILTI income. U.S. C corps can claim 80 percent of the FTC attributable to the CFC’s foreign income.
U.S. MNCs with IP offshore will no doubt want to assess whether retaining the IP offshore or migrating it to the U.S. produces a better tax result from an overall global perspective. Given that the GILTI tax also affects an MNC’s CFCs that do not employ significant tangible assets (most likely services and sales businesses), considerations also will have to be made to avoid or mitigate the GILTI tax. One such strategy to help reduce the GILTI tax is to invest in significant tangible assets offshore.
Modification of the Definition of Intangible Property
In a further attempt to curb base erosion centered on the migration of IP from the U.S. to more favorable tax countries, the TCJA expanded the definition of intangible property under Section 936(h)(3)(B) to include “goodwill, going concern, workforce in place, and any other item the value or potential value of which is not attributable to tangible property of the services of any individual.” In the Amazon and Veritas cases, one of the disagreements the tax court had with the IRS’s position was the use of an aggregated valuation approach, which included workforce in place, going concern value and goodwill as part of the value of the IP that was transferred to Luxembourg (Amazon) and Ireland (Veritas). The tax court opined that the definition of IP under the pre-TCJA tax rules didn’t include goodwill and going concern. The augmentation of the definition of IP, coupled with a modification to the outbound transfer rules under §367(d) and the U.S. transfer pricing rules that now require a U.S. taxpayer to value IP on an aggregated basis or on the basis of realistic alternatives to such transfer, will likely increase the value of any IP that an MNC wishes to move offshore.
Foreign-Derived Intangible Income
While BEAT and GILTI appear to be unfavorable provisions for MNCs, the foreign-derived intangible income (FDII) provision provides an incentive for U.S. corporations to retain their IP in the U.S., while encouraging export activity. FDII offers a reduction of the tax rate on income a U.S. corporation earns when it exports goods or services that are performed overseas involving IP owned by the U.S. corporation. FDII is comparable to the patent box regimes already employed in countries or regions such as Belgium, France, Italy and the United Kingdom. The special tax rate is 13.125 percent (a 37.5 percent reduction of the corporate tax rate), which increases to 16.41 percent (a 21.875 percent reduction of corporate tax rate) in 2026 and thereafter. The derivation of the tax is similar to that of the GILTI calculation, and there is an interplay of any GILTI tax when computing FDII.
U.S. corporations that export a significant amount of goods and/or perform IP-intensive services overseas should evaluate whether their critical IP should reside in the U.S. to take advantage of the tax benefits FDII offers.
The TCJA did not contain any significant modifications to the U.S. transfer pricing rules. However, the reduction of the U.S. corporate tax rate and the introduction of BEAT, GILTI and FDII require that all U.S. taxpayers with cross-border activities, i.e., both inbound and outbound MNCs, model out different tax structuring and supply chain alternatives to develop the optimal tax strategy.
It also must be noted that tax authorities overseas are now more likely to challenge the transfer pricing arrangements of MNCs with U.S. operations, as they may begin to suspect that the transfer pricing strategy is designed to place more profits in the U.S. to take advantage of the lowered U.S. corporate tax rate. Moreover, the European Union (EU) is considering bringing a challenge to the World Trade Organization (WTO) related to certain newly introduced international tax rules, and finance ministers from the five largest EU countries sent a letter to Treasury Secretary Steven Mnuchin voicing their concerns that the rules are discriminatory and violate WTO trade rules. Therefore, having robust transfer pricing documentation will become even more critical in the defense against transfer pricing adjustments, penalties and interest. Moreover, MNCs with cross-border activity also are facing increased compliance obligations related to comprehensive transfer pricing documentation requirements that were recently introduced or expanded in a number of countries. While the TCJA introduced a number of tax reduction opportunities for MNCs operating in the U.S., a tax war between the U.S. and everyone else is heating up, and MNCs should be prepared.