Over the last 20 years, multinational enterprises (MNE) have understood that maintaining robust transfer pricing documentation is important. However, two recent seminal events have amplified this concept: the Organisation for Economic Co-operation and Development’s (OECD) base erosion and profit shifting (BEPS) initiative and the Tax Cuts and Jobs Act (TCJA).
OECD BEPS Initiative
In 1993 the IRS issued proposed regulations—Section 6662(e) and (h)—requiring U.S. taxpayers with cross-border related-party transactions to maintain contemporaneous transfer pricing documentation. These regulations, which were subsequently finalized in 1994, mandate that if an MNE taxpayer cannot produce contemporaneous documentation to the IRS when requested, the taxpayer is subject to a 20 percent or 40 percent penalty. During this era, large U.S. MNE taxpayers scrambled to prepare transfer pricing documentation, as the new requirements were effective for tax years beginning after October 6, 1994.
Although the OECD published its “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” (OECD Guidelines) in 1979, it was not until 1995 that they were approved by the OECD Council. With the notable exception of the U.S., many countries adopted the OECD Guidelines as the basis of their transfer pricing rules. However, guidance on the scope and composition of transfer pricing documentation requirements within the OECD Guidelines was vague and not well defined. Therefore, from the late 1990s to late 2000s, numerous countries adopted their own transfer pricing documentation rules in fear of MNEs shifting profits out of their country and into low-tax countries or countries with more stringent transfer pricing documentation rules to avoid penalties in those countries. As a consequence, documentation requirements and penalties were not uniform across the globe. This onslaught of transfer pricing documentation requirements forced many MNEs, including small and midsize MNEs, to prepare transfer pricing documentation.
Fast forward to 2013. In response to the public perception that MNEs were not paying their fair share of taxes and in a bid to protect their respective tax bases, the G-20 countries commissioned the OECD to examine the existing international tax and transfer pricing rules and identify methods of combating perceived BEPS by MNEs. Thus, the OECD’s BEPS initiative was born. In 2015, the OECD released its final version of “Action 13: Transfer Pricing Documentation and Country-by-Country Reporting.” The deliverable enacted a new three-tiered approach to documentation: a master file, local file and Country-by-Country (CbC) Report.
The goal of the new OECD documentation requirements was to increase transparency of MNEs’ transfer pricing practices. The master file outlines the big picture of an MNE’s business, including an overview of the industry or industries in which it operates and its transfer pricing practices, supply chain, legal entity structure and value drivers. The local file concentrates on the particular facts involving an MNE’s local country/intercompany transactions, including transfer pricing practices, results and a comparability analysis. The CbC Report is a reporting template that generally is applicable to MNEs with global revenues in excess of 750 million euros. The CbC Report typically is required to be filed in the MNE’s home country and contains detailed information for each legal entity within the MNE group, such as revenues (related and third party), profit, income tax paid, assets, number of employees, functionality, etc.
Given that many countries adopt the OECD Guidelines as the basis of their transfer pricing rules, this three-tiered approach to documentation forced most countries to revamp their transfer pricing documentation requirements. While the BEPS initiative was designed to help promote consistent rules among member states, it actually created chaos, as countries chose to base the requirement for preparing the master file and local file on varying thresholds. These thresholds often are based on a combination of global MNE or local country revenues and the volume of local country/intercompany transactions. Thus, the requirements to prepare the master file and local file often are not uniform within each country. The OECD’s revised documentation requirements have led MNEs to substantially augment and, in most cases, redo their transfer pricing documentation to meet the new master file and local file requirements. Moreover, the new documentation standards mandate that MNEs prepare additional information that previously was not required under the former OECD documentation requirements. It is imperative that MNEs prepare the necessary master file and local files in the countries where they are required to do so, as many tax authorities have increased their enforcement efforts regarding transfer pricing.
While the TCJA introduced a welcome reduction to the corporate tax rate for C corporations from 35 percent to 21 percent, it also raised the stakes for U.S. MNEs that have inadequate or delinquent transfer pricing documentation. The TCJA also introduced three new concepts that will affect the transfer pricing arrangements between MNEs and U.S. entities—the base erosion and anti-abuse tax (BEAT); the global intangible low-taxed income (GILTI); and foreign-derived intangible income (FDII). These three concepts serve to either penalize U.S. taxpayers who make “excessive” payments to foreign related parties or have substantial offshore earnings in low-tax countries or incentivize U.S. taxpayers to export products abroad or earn income from overseas activities related to the provision of services, licensing of intangible property or generation of interest income.
BEAT is a minimum tax that penalizes U.S. taxpayers that make certain payments (base erosion payments) to their foreign related parties. Taxpayers are subject to the 10 percent BEAT tax if they have average annual consolidated revenues of at least $500 million over a rolling three-year period or if their BEAT payments to foreign related parties are equal to 3 percent or more of their deductions. U.S. MNEs with annual revenues in excess of $500 million will be tempted to reduce their payments to foreign related parties to ensure that the total BEAT payments are less than 3 percent of deductions. This could include reducing (or even eliminating) the markup on service fees paid by the U.S. entity. U.S. taxpayers attempting to reduce their payments to foreign related parties to avoid the BEAT tax will create exposure in the corresponding countries where the income is received and taxed. No doubt, foreign tax authorities will scrutinize payments received from their U.S. related parties to discern if the transfer pricing methodologies have been altered and if they no longer conform to local transfer pricing rules.
GILTI is a tax designed to penalize U.S. MNEs with subsidiaries in low-tax countries. In general, a GILTI liability will be triggered if the U.S. MNE has a subsidiary in a low-tax country and the subsidiary does not have any significant tangible assets. Under the GILTI rules, the GILTI liability is offset through a 10 percent return on its qualified business assets investment. Therefore, GILTI is designed to target technology or service companies with subsidiaries that do not have significant tangible assets and are located in low-tax countries. C corps can reduce their GILTI liability by only including 50 percent of the GILTI liability and the allowance of foreign tax credits of 80 percent to offset the GILTI tax. Like BEAT, U.S. MNEs that are subject to GILTI will be tempted to manage their GILTI liability through the structuring of their transfer pricing arrangements. U.S. MNEs that migrated intangible property (IP) to low-tax countries may even consider moving their IP back to the U.S. to negate the effect of GILTI. Again, foreign tax authorities, even in business-friendly countries such as Ireland, will likely be suspicious of the transfer pricing practices of U.S. companies operating in their countries, as they may attempt to reduce their GILTI liability through their transfer pricing arrangements.
Foreign tax authorities are already lying in wait to pounce on U.S. MNEs with subsidiaries in their country as a result of FDII. FDII is an incentive for U.S. companies to export products or collect revenues from services or IP used abroad. FDII is taxed at the advantaged rate of 13.125 percent instead of the normal corporate tax rate of 21 percent. Given that there is now an incentive to maximize income on outbound foreign transactions, MNEs may attempt to maximize the transfer price on goods exported to related parties and increase or introduce new service fees and royalties charged to their non-U.S. related parties. While FDII is expected to provide a significant tax benefit to U.S. MNEs, it also will create a heightened risk of being subjected to a transfer pricing audit in foreign jurisdictions where U.S. MNEs have related parties.
As a result of the new OECD transfer pricing documentation requirements and enactment of the TCJA, MNEs (especially U.S. MNEs with foreign subsidiaries) face significant risk associated with audits of their transfer pricing arrangements. It is critical for MNEs to have robust documentation that conforms to the OECD Guidelines to successfully navigate a transfer pricing audit in a global climate where tax authorities are increasingly adversarial to MNEs.
For more information, contact Will or your trusted BKD advisor.