International Tax

Transfer Pricing for Small & Mid-Size Business – What is Important Now and Why

October 22, 2018 by Frank Vari, JD. MTax, CPA

One of the most common questions we at FJV receive from our small business clients is what is transfer pricing and why must we address it now? Many clients – and some practitioners – seek an answer but are overwhelmed by the complex and conflicting information generally available.

If your company plans to expand business operations into the U.S. or expand their U.S. operations into another country at least a basic understanding of transfer pricing is required. Once there is a basic understanding, one can better comply with the legally mandated transfer pricing rules and then create a strategic pricing plan.

To best explain, let’s discuss transfer pricing basics, pricing methods, and documentation requirements.

Transfer Pricing Basics

A “transfer price” is the price at which related companies located in different countries buy and sell goods and services to each other. This is very important to each country’s taxing authority as each country wants to tax a share of these worldwide profits. “Transfer pricing” is generally defined as the legal mechanism that allocates the profit from that related party sale between the competing tax jurisdictions without creating double taxation. This mechanism, as outlined in a variety of laws around the world, allocates global supply chain profits based upon the functions and risks of the related parties. The party which performs the most important and costly functions, e.g., design and manufacturing, and takes the greatest risk, e.g., capital investment and customer credit risks, is entitled to the greater profit.

For example, let’s assume a U.S. entity manufactures medical equipment and sells it to a related party located in Germany. The German entity then resells the equipment to its customers within Germany. The financial elements here are as follows:

The medical equipment is manufactured in the U.S. at a cost of $10,000.
The parent sells this equipment to its German relative for $17,000 realizing a taxable profit in the U.S. of $7,000.
The German entity then resells this same equipment to an unrelated German customer for $20,000 thus realizing a taxable German profit of $3,000.
The total taxable profit for the entire global supply chain is $10,000.

How can the U.S. entity justify receiving 70% of the taxable profits, while the German entity only 30%? In our example, the U.S. entity has performed the costly research, design, and manufacturing functions for the medical equipment. The German subsidiary is only involved in the local German marketing and distribution of the product which requires little capital or investment. Thus, the U.S. entity has performed the greater functions and taken the greater risk which legally entitles them to the greater profit.

This profit split may be challenged by either the U.S. or German tax authorities using their own local transfer pricing laws. However, almost every country, including the U.S. and Germany, requires that each related taxpayer perform and document a transfer pricing analysis of their taxable profit allocation with related parties. No exceptions.

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Transfer Pricing Methods

The IRS first enacted rules back in 1928 to address intercompany profit allocations that have evolved into present-day IRC Code §482. These rules actually empower the IRS to reallocate income or deductions between related parties to prevent tax evasion. If the taxpayer doesn’t perform a properly documented allocation or get it right the IRS will do it for them. Not a good place to be for sure.

IRC Code §482 requires taxpayers to create and document a transfer pricing policy that chooses the best method to justify the transfer price of goods and services. The IRS allows various methods for various types of transactions. Transfers of heavy equipment, software, and consulting services are all sufficiently different that different pricing methods are required.

One of the most common pricing methods – and the one most preferred by the IRS and other taxing authorities – is the Comparable Uncontrolled Price (“CUP”) methodology. In our example, let’s assume our U.S. entity also sells the same type of medical equipment to unrelated Chinese and Australian customers for more than it sells to the German related party. The IRS may – and probably will – argue that the U.S. entity is not charging Germany enough and a greater U.S. taxable profit should be reported. Alternatively, if the U.S. entity sells the medical equipment to all three customers, both related an unrelated, for the same price it could justify the intercompany transfer price between the related U.S. and German entities as an “arm’s-length” price.

IRC Code §482 provides other methods besides the CUP to be used for transfer pricing of goods and services. These methods include the Cost Plus method, the Resale Price method, the Comparable Profits method, and the Profit Split method. Taxpayers can even use an unspecified method if they can support it. Taxpayers must be careful to analyze each of those methods separately and select the “best method” for that particular transaction in order to comply with IRC Code §482.

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Documentation Requirements & Penalties

One very important and often overlooked rule is that taxpayers are required to prepare and maintain contemporaneous documentation that explains in a very detailed and technical manner their transfer pricing methodologies. “Contemporaneous” means this documentation must be compiled at the same time their U.S. tax return is filed. If the IRS requests this documentation, the taxpayer must produce it within 30 days of an IRS request. If the taxpayer fails to do so, two very bad things can happen. First, as noted above, the IRS will go ahead and allocate the related party profits as they see fit. Second, the taxpayer will be subject to the documentation penalty provisions of IRC Code §6662.

If the IRS makes a transfer pricing adjustment resulting in an underpayment of tax and the documentation requirement was not met, IRC Code §6662 permits IRS to impose a 20% or 40% percent non-deductible penalty. The 20% penalty applies if the transfer price adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts. If the transfer price adjustment exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts the IRS may impose a 40% penalty on the adjustment.

Besides proper transfer pricing documentation, U.S. taxpayers must comply with other important requirements including:

U.S. taxpayers who have related party transactions with their subsidiaries located outside of the U.S. must report these transactions on Form 5471.
U.S. taxpayers who have related party transactions with their foreign owners and their related parties must report these transactions on Form 5472.
If the related party sale involves a customs or duty filing, the price on the filing must be the same as that reported in the transfer pricing documentation and the Form 5471 or 5572. The failure to “harmonize” these filings can lead to additional penalties.

These are very harsh penalties that are often incurred by U.S. taxpayers who do not perform written transfer pricing studies to properly allocate or report related party profits. The problem is there is really no way around them for small taxpayers. Small taxpayers around the world have long called for exemptions from transfer pricing reporting but there is no significant relief to date.

Conclusion

Transfer pricing is a complicated issue that must be addressed proactively. If properly addressed in a timely manner, transfer pricing can be addressed at a reasonable cost. If not, the penalties kick in and the cost of these penalties coupled with the legal and professional fees of a transfer pricing conflict with any tax authority can be very high.

Our advice to any client with related party transactions that cross a foreign border is to proactively address their transfer pricing issues in a timely manner. Whether they sell tangible property, services, or sell or license intangible property, our advice is the same. At the end of the day, it saves our clients time and money and brings them fully into compliance with the law.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Foreign Derived Intangible Income Deduction – Tax Reform’s Overlooked New Benefit for U.S. Corporate Exporters

September 17, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

This article has been previously published in the Tax Adviser magazine published by the American Society of Certified Public Accountants (AICPA) in the August, 2018 edition.

The newly enacted U.S. tax act has ushered in a number of new rules and, to strategic tax planners, new opportunities. This new opportunity is a preferential tax rate for U.S. C corporations that sell goods and/or provide services to foreign customers. Qualifying income is subject to a rate of approximately 13% which is even lower than the new 21% corporate rate. This new opportunity is IRC §250(a) containing the Foreign Derived Intangible Income (FDII) deduction.

FDII is intended to operate in tandem with newly enacted IRC §951A describing Global Intangible Low-Tax Income (GILTI). GILTI is a new category of income for U.S. taxpayers owning a Controlled Foreign Corporations (CFC). GILTI, similar to the existing Subpart F provisions, is a deemed income inclusion. The interaction of these rules, a benefit for the use of intangible property in the U.S. via FDII and a deemed income inclusion for using intellectual property outside the U.S. via GILTI, has been referred to as a “carrot and a stick” approach to taxing intellectual property on a global basis. However, if the taxpayer does not own a CFC, meaning it has no GILTI exposure, it secures all the carrots without worrying about any stick.

The bottom line is a new benefit to U.S. C corporations for using U.S. based intangible property that they’ve owned all along. Even better, they don’t have to patent, copyright, or even identify the intangible property as the benefit is derived from a deemed return on assets calculation. Because FDII is intertwined with GILTI, many believe it is simply an international tax provision and fail to see the benefits to U.S. exporters with no foreign operations.

The Benefit

The FDII benefit itself is not difficult to understand. FDII produces an effective tax rate, based on the newly enacted 21% corporate tax rate, as follows:

13.125% for tax years beginning after December 31, 2017 and before January 1, 2026

16.406% for tax years beginning after December 31, 2025

Even with reduced corporate tax rates, it is still a benefit well worth pursuing.

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The Calculation

The FDII calculation is rather complex but it can be summarized in steps. First, the U.S. corporation’s gross income is determined and then reduced by certain items of income including any foreign branch income. This amount is further reduced by deductions allocable to such income bringing about deduction eligible income.

Second, any foreign portion of such income is established. This includes any income derived from a sale of property or certain services to a foreign person for foreign use. Please note that here a “sale” is defined very broadly and includes any lease, license (including royalties), exchange, or other disposition. Foreign use is any use, consumption, or disposition which is not within the United States.

Third, the foreign sales and services income from step two above is reduced by expenses properly allocated to such income. The result is foreign derived income.

Fourth, the corporation’s deemed intangible income is determined. This is the excess of the corporation’s foreign derived income less 10% of its qualified business asset investment (QBAI). QBAI is the average of the corporation’s adjusted basis in its tangible property used to produce the deduction eligible income. For this purpose, adjusted basis is determined using straight line depreciation and an annual average using quarterly measures.

For example, assume a domestic C corporation produces widgets for a foreign customer that are used outside of the U.S. The corporation earned $100,000 in deduction eligible income and $20,000 of foreign derived income. QBAI is $120,000 (calculated separately) which results in deemed intangible income of $88,000 ($100,000 foreign derived income less 10% of QBAI, i.e., $12,000). FDII is $17,600 or the deemed intangible income of $88,000 multiplied by the ratio of foreign derived income to deduction eligible income (20% or $20,000/$100,000). The FDII deduction is $6,600 (FDII of $17,600 at a corporate tax rate of 37.5%).

The Corporation is then allowed to deduct 37.5% of FDII against its taxable income. The upshot is taxable FDII of $1,000 and a tax liability of $210 which is an effective tax rate of 13.125% on the FDII of $1,600 and a $126 tax savings.

Deduction Eligible Income	$100,000
Foreign Derived Income	$20,000

QBAI	$120,000

Foreign Derived Income	$20,000
Less: QBAI Exemption (10% of $120,000)	$12,000
Deemed Intangible Income	$88,000

FDII ($88,000 x ($20,000/$100,000))	$17,600

Taxable FDII (FDII less 37.5%)	$11,000
Corporate Tax (21% Rate)	$2,310
FDII Effective Tax Rate ($210/$1,600)	13.125%
FDII Savings	$1,386

Please do note that the benefit is subject to a taxable income limitation which means the FDII deduction cannot reduce taxable income below zero. Likewise, there is no benefit if deemed intangible income is zero or less.

The taxpayer may take a foreign tax credit against any taxes levied upon the foreign derived income if it otherwise qualifies. The credit will only apply to the taxable FDII within the general limitation basket matching the FDII but all of the associated foreign tax credits should remain available for credit.

Taxpayers wishing to utilize FDII benefits should be aware of rules regarding the involvement of related parties. FDII applies to sales or services rendered to related foreign persons provided that the property is either resold or used in the sale of other property to an unrelated foreign person. Thus, the sale of goods, the provision of services, and the license of intangible property to related foreign persons may yield FDII-eligible income. In the case of services, the related party may not provide substantially similar services to persons in the U.S. or FDII benefits can be limited or eliminated entirely. Service industry corporations should explore these rules in more detail.

The benefits only apply to property sold or services rendered for foreign use. On its face, this appears quite simple. However, the taxpayer must be very careful to support this as special rules apply here. For example, property sold to an unrelated foreign person is not treated as sold for foreign use if it is further manufactured or modified within the United States even if the property is only used outside the U.S. Likewise, services provided to an unrelated person located within the United States are not treated as “foreign use” even if the other person uses such services in providing services outside the United States. Both of these results can be favorably changed with planning but one must make sure their entire supply chain qualifies.

Beneficiaries

The clear beneficiary of these new provisions are U.S. based corporate exporters of goods and services with no CFC ownership. These corporations have long suffered higher tax rates than their multinational competitors who have had the ability to move intellectual property outside of the U.S. to lower tax jurisdictions. FDII is a big step toward eliminating their competitor’s tax advantage. Furthermore, because FDII does not involve intangible asset identification, it avoids cumbersome and expensive valuation and segregation studies as well as complex legal and tax intellectual property undertakings.

The bigger winners will certainly include technology corporations including software developers, pharmaceutical manufacturers, and similar industries. These corporations generate foreign sales including FDII eligible licensing and royalty income with minimal tangible assets. These types of industries generally also produce higher margins which will further increase the FDII benefits.

Issues to Consider

FDII only pertains to C corporations for now. This includes U.S. subsidiaries of foreign-based multinationals that are taxed as C corporations. However, FDII excludes S corporations, REITs, partnerships, LLCs, and individuals.

As of the date of this article, FDII lacks any technical guidance via regulations or otherwise. The IRS has not issued a Notice or other guidance on FDII as they have on other parts of tax reform. A technical corrections bill affecting FDII will be issued but it’s difficult to speculate on when, what it will contain, and in what form it will become law. However, one may reasonably speculate that FDII could be expanded to include pass-throughs and individuals to alleviate some of the corporate centric aspects of the entire act that have drawn scrutiny.

It is possible that FDII will be contested by our foreign trade partners as an impermissible tax benefit. Practitioners who recall the journey of DISC to FSC to ETI will be able to see the clear parallels here. The good news is that if this does occur, it will likely take years to resolve any international tribunal litigation and, in the event FDII is deemed to be illegal, the IRS is unlikely to claw back benefits that have already been claimed by U.S. taxpayers.

Conclusion

FDII is certainly a gift to U.S. C corporations that export goods and services but do not own a CFC. This is particularly true for technology companies with higher margins and limited tangible assets. As with any new comprehensive tax law, uncertainties abound and guidance is limited but there is no doubt that FDII is a benefit worth pursuing.

Has Subpart F Been Greatly Expanded?

July 23, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

For many years, international tax planners took great care to design global tax structures to avoid Subpart F. Now, in what is perhaps an unintended error, Subpart F appears to have been greatly expanded for many multinationals and particularly private equity investors. This potential expansion of Subpart F is a result of new share ownership attribution rules under the Tax Cuts and Jobs Act (TCJA) where U.S. taxpayers that were not considered U.S. Shareholders of certain foreign corporations for purposes of Subpart F may now be liable for those foreign corporation’s Subpart F income beginning in 2017.

The issue that is causing such concern is the repeal by the TCJA of IRC §958(b)(4). Prior to repeal, this Code section prohibited “downward” attribution of stock ownership from a foreign person to a U.S. person. This prevented what would otherwise be Subpart F income being attributed to a U.S. Shareholder via a foreign parent.

How exactly did IRC §958(b)(4) operate prior to repeal? Here is a quick example. In a typical Subpart F avoidance structure, foreign parent (FP) owns 80% of a foreign corporation (FORCO) and 100% of a U.S. corporation (USCO). USCO owns the remaining 20% of FORCO. Prior to repeal, USCO would not be considered a U.S. Shareholder of FORCO for purposes of Subpart F. As such, USCO never considered or included any of FORCO’s income that would have qualified as Subpart F income had FORCO been owned directly by USCO. Quite simply, the IRC §958(b)(4) rules prevented FORCO from ever being a Controlled Foreign Corporation (“CFC”) for U.S. tax purposes.

What has changed? After repeal of IRC §958(b)(4), USCO is, for purposes of determining U.S. Shareholder and CFC status, treated as owning all of FORCO’s stock. USCO now owns 20% directly and 80% constructively (via FP) under newly enacted IRC §318(a)(3) making it a U.S. Shareholder of FORCO and also making FORCO a CFC. As such, USCO is now liable for U.S. tax on 20% of FORCO’s Subpart F income. That’s a really bad answer from both an income inclusion and information reporting standpoint.

This example is not the only situation where this may cause a significant expansion of Subpart F. There are many others out there. In practice, every foreign structure involving a U.S. owner needs to be tested. That’s a tall order, but when the scope of how the repeal of IRC §958(b)(4) operates is considered it’s not something that can be reasonably ignored.

As if Subpart F expansion is not enough to worry about, this also impacts whether a taxpayer is a 10% or more U.S. Shareholder for purposes of calculating the Global Intangible Low Taxed Income (GILTI) inclusion.

The biggest problem is that we simply don’t know if this expansion has really taken place. We certainly do know that IRC §958(b)(4) is gone and we also know the statutory language of IRC §318(a)(3). Thus, the statutes tell us downward attribution is now the rule.

However, the legislative history behind the TCJA states that the repeal of IRC §958(b)(4) was not intended to cause a foreign corporation to be a CFC with respect to any U.S. Shareholder as a result of downward attribution under section 318(a)(3) to any U.S. person that is not a “related person” (as defined by IRC §958(d)(3)) to such U.S. Shareholder. This means that Congress intended this to apply solely to related parties, particularly those involved in inversion transactions, and not to unrelated parties. That’s both logical and simple enough to understand but it is not part of any statute, regulation, or even authoritative guidance for that matter.

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Why hasn’t this been resolved by now? One could reasonably theorize that Treasury feels it lacks authority to limit the scope of these rules via regulation and that a legislative correction, i.e., congressional action, is required to implement the result described in the legislative history. Congress, on the other hand, will find it difficult to enact a comprehensive technical corrections bill in short order considering the scope of the TCJA. In the absence of regulations, technical corrections, or some authoritative guidance, it is extremely difficult to reconcile the statutory language with the intent articulated in the legislative history.

One piece of guidance by the IRS has been regarding Form 5471. You can see where that would be a nightmare under these rules. IRS Notice 2018-13 provides an exception to filing Form 5471 for certain U.S. Shareholders considered to own stock via downward attribution from a foreign person. The Notice also states that they intend to modify the instructions to the Form 5471 as necessary which has not yet occurred.

The uncertainly outlined above has left taxpayers searching for the right approach here. To say there is no good approach is an understatement. For now, here are some of the choices:

Wait for a technical correction, regulation, or other clarifying authority to make clear the intent of these new rules.
File 2017 returns taking a technical position in favor of the legislative intent – on the basis that no other guidance currently exists – and keep your fingers crossed that the position outlined in such legislative authority is ultimately adopted.
Liquidate, or check-the-box, on your U.S. C Corporation that’s contributing to the CFC attribution to have it treated as a disregarded entity.
Liquidate, or check-the-box, on the foreign subsidiary creating the Subpart F income to have it treated as a disregarded entity.

Not a lot of great choices there. However, one could have reasonably anticipated that there would be problems like this as a result of the speed at which the TCJA was enacted. In the meantime, taxpayers must make a choice and prepare for the possibility that these rules may stand as such.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

New U.S. Global Intangible Income Rules – New Opportunities and New Risks

July 14, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

There is certainly a great deal of buzz around the new Global Low Tax Intangible Income (GLTI) and Foreign Derived Intangible income (FDII) rules enacted as part of the Tax Cuts and Jobs Act (TCJA) in late 2017. At this same time, there is a lack of understanding amongst many practitioners and taxpayers as to what this means for them. What follows here is a general explanation of how these new rules work.

GLTI

The TCJA has introduced newly enacted IRC Code §951A as well as the catchy new acronym pronounced as “guilty” by those who want to be hip and cool in tax circles. GLTI requires U.S. CFC shareholders to include in income its GLTI income in a very similar manner to our old friend Subpart F. The entire GILTI amount is included in a U.S. shareholder’s income in a manner similar to Subpart F. Corporate shareholders are allowed a deduction equal to 50% of GILTI for 2018 through 2025, which is reduced to 37.5% in 2026. As a result of the 50% deduction, the effective tax rate will be 10.5% until 2026 and increasing to 13.125% when the deduction is reduced in 2026.

The GLTI deduction is limited when the GILTI inclusion and FDII (described below) exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions. Because the GILTI deduction is limited by taxable income, net operating losses are used first against the gross GILTI amount before any GILTI deduction is allowed. Further, there is no carryforward for the lost portion of the GILTI deduction due to the taxable income limitation.

It is very important to understand who GLTI applies to. In general, when a U.S. person is (i) a 10% U.S. shareholder of a CFC, under the Subpart F constructive ownership rules, on any day during the CFC’s tax year during which the foreign corporation is a CFC; and (ii) the U.S. person owns a direct or indirect interest in the CFC on the last day of the foreign corporation’s tax year on which it is a CFC without regard to whether the U.S. person is a 10% shareholder on that date, then the U.S. person will be required to include in its own income its pro-rata share of the GILTI amount allocated to the CFC for the CFC’s tax year that ends with or within its own tax year. The U.S. shareholder will increase their basis in the CFC stock for the GILTI inclusion, which generally would be treated as “previously taxed income” for Subpart F purposes. This may be a little hard to follow but it is absolutely critical to understand who GLTI applies to.

Individual and noncorporate shareholders are generally subject to full U.S. tax on GILTI inclusions. However, qualifying U.S. shareholders may make an IRC Code §962 election with respect to GILTI inclusions where the electing shareholder is subject to tax on the GILTI inclusion based on corporate rates and may claim foreign tax credits on the GLTI inclusion as if the noncorporate shareholder were a corporation. This is intended, in theory, to place corporate and noncorporate shareholders with a similar tax burden.

GILTI is calculated at the U.S. shareholder level as the excess of the CFCs’ net income over a deemed return on tangible assets. The GILTI inclusion is calculated as the excess of a U.S. shareholder’s “net CFC tested income” over its “net deemed tangible income return,” which is 10% of the CFC’s “qualified business asset investment” (QBAI) reduced by certain interest expense.

“Net CFC tested income” is the excess of the U.S. shareholder’s aggregate pro rata share of the tested income of each CFC for which the shareholder is a U.S. shareholder for such taxable year over the aggregate pro rata share of the tested loss of each such CFC. For this purpose, “tested income” of a CFC generally is described as the CFC’s gross income other than (i) effectively connected income; (ii) Subpart F income; (iii) amounts excluded from subpart F income under the IRC §954(b)(4) high-tax exception; (iv) dividends received from a related person (as defined in Code section 954(d)); and (v) foreign oil and gas extraction income, over deductions allocable to such gross income under rules similar to IRC Code §954(b)(5) or to which such deductions would be allocable if there were such gross income. “Tested loss” is defined to mean the excess of deductions allocable to such gross income over the gross income itself.

“Net deemed tangible income return” is the excess of 10% of the aggregate of each CFC’s QBAI over the interest expense taken into account in determining the shareholder’s net CFC tested income to the extent the interest income attributable to the expense is not taken into account in determining the shareholder’s net CFC tested income. QBAI is determined as the average of the adjusted bases, determined at the end of each quarter of a tax year, in “specified tangible property” that is used in the production of tested income and that is subject to IRC §167 depreciation. The conference explanation states that specified tangible property would not include property used in the production of a tested loss, so a CFC that has a tested loss in a taxable year would not have any QBAI for that year.

If GILTI is includible in a U.S. corporate shareholder’s income, the new law provides for a limited deemed paid credit of 80% of the foreign taxes attributable to the CFC’s tested income as defined above. The foreign taxes attributable to the tested income are determined using a U.S. shareholder level calculation as the product of (i) the domestic corporation’s “inclusion percentage,” multiplied by (ii) the aggregate foreign income taxes paid or accrued by each of the shareholder’s CFCs that are properly attributable to tested income of the CFC that is taken into account by the U.S. shareholder under IRC §951A.

The inclusion percentage is the ratio of the U.S. shareholder’s aggregate GILTI amount divided by the aggregate U.S. shareholder’s share of the tested income of each CFC. This ratio seeks to compare the amount included in the U.S. shareholder’s income to the amount upon which the foreign taxes are imposed, i.e., the tested income, to determine the percentage of foreign taxes that should be viewed as deemed paid for purposes of the U.S. foreign tax credit.

The IRC Code §78 gross-up is calculated traditionally by including 100% of the related taxes rather than the 80% that are allowable as a credit. Although the gross-up amount is included in income as a dividend, it is not eligible for the IRC Code §245A 100% dividend received deduction but is eligible for the GILTI deduction.

There is also now a new separate basket for the GLTI deemed paid taxes to prevent them from being credited against U.S. tax imposed on other foreign-source income. Additionally, any GLTI deemed-paid taxes cannot be carried back or forward to other tax years.

These rules are effective for tax years of foreign corporations beginning after December 31, 2017 and for tax years of U.S. shareholders in which or with which such foreign corporation’s tax years end.

FDII

In connection with the new GLTI tax regime on excess returns earned by a CFC, the TCJA provides a 13.125% effective tax rate on excess returns earned by a U.S. corporation from foreign sales, including licenses, leases, and services, which increases to 16.406% starting in 2026. For tax years 2018-2025, a U.S. corporation may deduct 37.5% of its “foreign-derived intangible income” (FDII). Starting in 2026, the deduction percentage is reduced to 21.875%. The FDII deduction is limited when the GILTI inclusion and FDII exceed the corporation’s taxable income determined without regard to the GILTI and FDII deductions. The deduction is not available for S corporations or domestic corporations that are RICs or REITs.

Generally, a U.S. corporation’s FDII is the amount of its “deemed intangible income” attributable to sales, or leases or licenses, of property to foreign persons for use outside the United States or the performance of services to persons, or with respect to property, located outside the United States. A U.S. corporation’s deemed intangible income generally is its gross income that is not attributable to a CFC or foreign branch reduced by (i) related deductions including taxes and (ii) an amount equal to 10% of the aggregate adjusted basis of its tangible depreciable assets other than assets that produce excluded categories of gross income, such as branch assets.

Thus, a domestic corporation is subject to the now standard 21% corporate tax rate to the extent of a fixed 10% return on depreciable assets and a 13.125%, increased to 16.406% as of 2026, tax rate on any excess return that is attributable to exports of goods or services.

There are special rules for foreign related-party transactions. A sale of property to a foreign related person does not qualify for FDII benefits unless the property is ultimately sold to an unrelated foreign person, or is used by a related person in connection with sales of property or the provision of services to an unrelated foreign person for use outside the United States. A sale of property is treated as a sale of each of the components thereof.

The provision of services to a foreign related person does not qualify for FDII benefits if the services are substantially similar to services provided by the foreign related person to persons located in the United States.

The FDII provisions are effective for tax years beginning after December 31, 2017.

Summary

The GLTI and FDII rules in connection with the new territorial income rules are a seismic shift in the international tax landscape for those who have learned and practiced international tax under the post-1986 international tax regime. This article is really only a primer of these evolving rules. Once official guidance is produced, we will be able to deliver clearer client guidance on these important new rules.

How About VAT!? – Practical VAT Issues for U.S. Based Exporters

July 13, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

One of the most common issues in our international tax practice today is Value Added Tax (VAT). Even with all of the questions around U.S. sales tax in the wake of South Dakota v. Wayfair, at least our U.S. based clients understand the basic U.S. sales tax rules. That’s not always the case with VAT. U.S. based exporters, ranging from software developers to manufacturers, are subject to a VAT. Even those that fully understand compliance don’t often understand how simply complying and not being proactive around the VAT is costing them money and margin.

The most common issue we face with respect to VAT is the U.S. exporter incurring an unexpected VAT liability. It happens a lot and it happens because many smaller U.S. exporters don’t understand, or choose to ignore, foreign VAT rules. When it happens, and the U.S. exporter is charged with a VAT, profits can be reduced or eliminated, and the U.S. exporter can be taken out of the market by having to increase their selling price, or reduce their margins on export sales, due to unrecoverable VAT.

A basic understanding of the VAT is in order here. The VAT is an indirect tax levied on the consumption or use of goods and services. It is charged at each step of the supply chain process. The product’s end consumer bears the costs of VAT while registered businesses collect and account for VAT acting as tax collectors on behalf of the government.

Here’s a basic example of how VAT works within a Euro country with a VAT regime where all of the supply chain members are properly VAT registered and compliant:

A widget manufacturer sells to a wholesaler for €100. Under the VAT, the manufacturer collects a VAT of 5%, or €5, from the wholesaler on behalf of the government. The wholesaler pays the manufacturer a total of €105.

The wholesaler increases the selling price to €200 and sells it to a retailer. The wholesaler collects a VAT of 5%, or €10, from the retailer on behalf of the government whilst receiving a refund of the VAT paid to the manufacturer in the previous step. The retailer pays the wholesaler a total of €210.

The retailer further increases the selling price to €300 and sells it to a consumer. The retailer collects a VAT of 5%, or €15, from the consumer whilst receiving a refund of the VAT paid to the wholesaler in the previous step. The consumer pays the retailer a total amount of €315 and receives no refund of any VAT paid. Thus, the consumer bears the cost of all VAT incurred throughout the supply chain as all others have recovered what they paid.

That example is rather basic but, in practice, it can be very complex when the supply chain crosses multiple borders and VAT regimes, rates, and classifications. Product transformation through the supply chain raises additional issues. That said, it is imperative that U.S. exporters fully understand the VAT rules and their VAT responsibilities. I’ve seen too many U.S. exporters end up with unexpected VAT costs and penalties that eliminate any profits on their foreign sales especially when legal fees are added to the equation.

The most commonly raised question is how do you basically comply with the VAT? In some cases, e.g. the sale of physical goods, the law is rather settled. In the case of other emerging types of business, e.g., online software sales, the law is evolving and is based on each jurisdiction’s rules. With the exception of the European Union (EU), there really is no Uniform Commercial Code (UCC) or uniform rules on this type of activity. That makes it tough to provide general answers that a client can rely on. Only with specific facts can one arrive at specific answers.

As outlined in the example above, the global theme is that the seller is the one who bears the responsibility for paying the VAT. In practice that works in many different ways, depending on the rules of the specific jurisdiction. For a U.S. exporter, some of the most important practices and issues are:

For physical goods, the importer of record usually incurs the VAT. If the U.S. exporter can get the foreign buyer to be the importer of record they can usually pass on VAT issues altogether.
If the foreign buyer is a VAT registered business, they may be responsible for collecting any VAT and remitting it if they know the seller is offshore or not VAT registered. This “reverse charge” mechanism is a rule in the EU and various other jurisdictions as well. In many instances, the U.S. seller need not worry about VAT if they are aware that the foreign customer is VAT registered and they have the foreign customer’s VAT number on file. That’s great from a compliance perspective but the U.S. seller still ends up economically bearing the VAT expense that the buyer is just passing along on their behalf. Also keep in mind that most individuals don’t have a VAT registration.
In the EU, there is a common reporting system where a non-EU company can register in one EU country, e.g., Ireland, and then run all of their EU sales through that single registration. That has merit solely for sales to EU customers where there is common reporting system.
If the seller has a number of clients in one country with “VATable” sales, the seller should strongly consider registering there to properly collect and remit VAT. Many clients do this in places where they have sales and where VAT problems can bring serious criminal charges. They may even set up a shell company (rare) for this purpose because if there is no company than the VAT cannot be used or credited in the future by the seller due to lack of a VAT registration. Otherwise, the unrecoverable VAT paid simply becomes a sunk cost.
A U.S. exporter may try using an intermediary. For example, the U.S. exporter can sell directly to an EU VAT registered intermediary who, in turn, sells to non-EU countries. In this case, the intermediary is the one who bears the burden for the VAT compliance in non-EU countries. Many small U.S. exporters seek out independent foreign distributors for this reason.
Keep in mind that VAT classification is very important as different countries apply VAT at different rates to different products. For example, software for medical imaging or educational purposes may be rated differently than software for gaming. This is very similar to customs classifications. Freight forwarders often fail their clients here. A freight forwarder will make sure the VAT is paid but it is not their job, and nor do they feel it is their job, to make sure the VAT is paid at the lowest available rate. We see that a lot.
Customs & Duties is always an issue as well even though it is out of this article’s scope. You always want to make sure that all foreign exports comply with local customs & duty rules and regulations. Even for online sales, some countries do levy import duties on, for example, imported software licenses.

These practices and issues are the ones we see most often but they are certainly not an exhaustive list or all possible outcomes. The real problem is the lack of global or regional uniformity as well as the ever evolving nature of the rules. When you couple the obvious complexities with aggressive enforcement, especially against non-resident importers, you see that it doesn’t take much for real problems to arise even for very small U.S. exporters.

VAT violations can be very nasty. Goods and inventory can be seized, a company be barred from a market and, in some countries, officers, directors, or employees can face criminal penalties including prison. I’ve been a part of criminal VAT cases and it is not for the faint of heart.

The bottom line is that the cost of upfront VAT compliance is much cheaper than defending a nasty VAT audit or trying to free impounded inventory. Don’t let VAT drag your profits down or be a barrier to profitable export sales. Contact us today to help you with your VAT and international tax questions and issues.

Maximizing IC-DISC Benefits After Tax Reform

July 9, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Those that have followed the journey of the Interest Charge Domestic International Sales Corporation (IC-DISC) through the winding legislative process behind the Tax Cuts and Jobs Act of 2017 (TCJA) know by now that it has survived intact. Those that have followed these export tax benefits from the 1970’s DISC, whose enactment was somewhat contemporaneous with the unrelated peak of disco music, to FSC to EIE and now back to IC-DISC know that it has really been quite a legislative and judicial journey for these important export tax benefits. Now that we can be sure that IC-DISC benefits have survived, where exactly do we stand post-tax reform and what can we do to maximize IC-DISC benefits?

IC-DISC one of the last remaining export incentives provided to U.S. based taxpayers. It’s been an important part of tax planning for closely held companies since the Jobs and Growth Tax Relief Reconciliation Act of 2003 cemented into law reduced capital gains tax rates making IC-DISC a profitable tax strategy. As an added bonus, it is not currently on the World Trade Organization’s radar unlike some other current U.S tax incentives, i.e., the Foreign Derived Intangible Income (FDII) regime, so IC-DISC beneficiaries can rest assured that they are playing nice with our trade partners which is comforting. Also, don’t forget that IC-DISC is probably the last remaining tax planning technique where the IRS is willing to look past substance over form, at least a little bit – more on that later, which is not something seen too often.

Everyone probably knows the bad news by now that the reduction in U.S. individual tax rates has also reduced the IC-DISC benefits. To corporate shareholders, it still provides a hefty 13.2% tax rate benefit to individuals which is only a slight reduction from the pre-TCJA rate of 15.8%. The difference is the 2.6% top individual tax rate drop from 39.6% to 37%. If the business is a pass-through, and assuming newly enacted §199A is available to the taxpayer, it still provides a 6% rate benefit. Thus, even post TCJA, IC-DISC remains an important planning tool for businesses of all types.

What many taxpayers are missing is that there are planning tools out there that can make IC-DISC an even better tax planning vehicle without increasing shareholder risk. Some are more complex than others but here are some that we’re using with our IC-DISC clients:

Ensuring IC-DISC Compliance

If an IC-DISC is not properly qualified there are no benefits and there are likely penalties. This is pretty simple to understand but it is very often a problem. IC-DISC is an attractive planning tool but it is often adopted by taxpayers who don’t want to deal with the complexities of IC-DISC qualification or by an inexperienced practitioner who fails to properly implement or advise their client on the importance of these rules. I have been part of many acquisitions of middle market companies where the seller’s IC-DISC was determined to be defective during due diligence as a result of taxpayer error. Similarly, the IRS understands this very well and disqualifies many IC-DISC benefits on this basis. It is never good when an IC-DISC fails this way but in practice many do. Please don’t be the advisor that has to tell your client their IC-DISC has been disqualified.

Utilize IRC §482 Transfer Pricing

IC-DISC is one of the few areas where the IRS cannot force a taxpayer to use IRC §482 arm’s length principles to determine the profit allocation between related parties. However, IRC §482 is best used here proactively by the taxpayer. Most IC-DISC taxpayers that I work with use the 4% of export gross receipts methodology. For many taxpayers that’s a mistake. Most often, their IC-DISC advisor doesn’t fully understand how IRC §482 works and is unable to even model what the answer would be so the taxpayer doesn’t get to see what the options truly are. By addressing the IRC §482 options, or consulting with an IRC §482 expert, an IC-DISC may see greatly enhanced profits. It is certainly fact dependent, but I’ve seen it deliver enough benefits that is part of every IC-DISC analysis we perform.

Grouping Transactions vs. Transaction by Transaction (TxT)

For those of us that practiced in the FSC days, TxT was one of the most popular tax planning tools out there and was used by FSCs with literally millions of individual transactions. We all know that FSC is long gone but the TxT method is alive and well but is a little of a lost art since the very large companies had to stop doing it. Most of the IC-DISCs out there utilize grouping(s) of transactions. Grouping is a proper methodology and it can be the best and is certainly the easiest to apply. However, like transfer pricing above, TxT often produces significantly better benefits. It requires that each individual transaction be treated separately which is beyond the capabilities of many IC-DISC practitioners. At a minimum, grouping vs. TxT must be modeled to ensure that the taxpayer is obtaining, or maintaining, maximum benefits.

Appropriate Expense Allocations

In order to properly determine the profitability of foreign sales, the taxpayer must utilize the principles of IRC Treas. Reg. §1.861-8 and its relations. These rules can certainly be complex and they are not often applied properly. For example, many U.S. based exporters spend large amounts on things like interest and selling expenses which are, in practice, mostly directed toward U.S. activities. By improperly overallocating these expenses to foreign sales they are artificially dampening IC-DISC profits. The IRC §861 expense allocation rules are not optional and it is imperative that the practitioner fully understand them.

IC-DISC for the Foreign Owned U.S. Company

There are many closely held U.S. companies with foreign shareholders that export. Please keep in mind here that sales to Canada and Mexico are also exports. Many of these corporations do not utilize IC-DISC but many should. Especially those that reside in treaty countries with low dividend tax withholding rates. This can be difficult because to properly model the results you need to understand the shareholder’s resident country tax laws as well as the shareholder’s tax posture. That said, I’ve seen this benefit work for foreign shareholders often enough that I always consider it when I see these facts.

Utilizing a Roth IRA

This has been a somewhat popular planning tool utilizing a Roth IRA to avoid annual contribution limits. The Roth IRA value grows while the IC-DISC profits are not taxed. Simple enough but it is not a risk free strategy. The IRS feels that this is a violation of substance over form and argued that, albeit unsuccessfully, in Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17). My view is that the IRS argued this case wrong but that’s another article. If you live in the 6^th Circuit, good for you. The primary risks here are that the IRS does not like this and Summa Holdings predated the enactment of IRS §7701(o) which codified the economic substance doctrine. Until the IRS makes another run at this you certainly have substantial authority for this position where it makes sense.

IC-DISC as Non-Qualified Executive Retirement Tool

You don’t see this one too often but it makes sense. I advised with a practitioner whose client was retiring along with a sibling from a leadership position in a successful family business. IC-DISC itself made sense as a planning tool but it also played a neat part in the transition of the business by placing the IC-DISC ownership in the hands of the retiring executives. Keep in mind that the IC-DISC does not have to be held by the same shareholders as the related supplier. This planning, in essence, permits the related supplier a full tax deduction and the retired executives enjoy reduced qualified dividend tax rates.

Summary

The bottom line here is that IC-DISC remains alive and well for the foreseeable future courtesy of the TCJA. Thus, it is time to start considering using IC-DISC again and, more importantly, maximizing IC-DISC benefits with proven and reliable strategies. We help our IC-DISC clients on these and other tax planning issues. Let us help you or your clients.

To learn more about FJV’s IC-DISC or transfer pricing practices and our considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.