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Tax Audit & Controversy

Global Tax Authorities Are Sharing Information – What’s Happening and How to Be Ready

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Frank J. Vari, JD, MTax, CPA

It was not that long ago that a multinational taxpayer could report information differently to one taxing authority than to another even within the same country without significant concern.  How often did a value reported for customs and duties purposes match the transfer pricing value for income tax purposes?  Probably not very often and what difference did it make?  Back then, not very much difference.  Now, it makes a huge difference.

What’s Changed in Information Sharing? 

The road to where we are today has not been difficult to follow for those that have been actively involved in international tax for the last decade or so.  Global tax authorities have been becoming considerably more aggressive for years and that is not a trend that shows any signs at all of abating.  Tax authorities have long sought complete transparency in the taxpayer’s supply chain taxation both in the home country and elsewhere.  It makes their job much easier and it forces multinational taxpayers to full disclosure of their global tax positions.

There have been many governmental bodies actively pushing these efforts for some time now but the three biggest, at least to U.S. taxpayers, have been the Organization for Economic Cooperation and Development (“OECD”), the EU, and the IRS.  Our clients feel this most directly with their Base Erosion and Profit Shifting (“BEPS”) and Foreign Account Tax Compliance Act (“FATCA”) filing requirements.

For U.S. taxpayers, this means a sharing of not only information gleaned from their Form 1120, Forms 5471 and 5472, and customs and duty filings but also what they are reporting on similar non-U.S. filings.  When you add government filed transfer pricing filings to all of this you can see how quickly a very significant database of highly confidential and valuable business and financial information can be created and shared.

The Impact of Electronic Filing

Most multinational taxpayers are slowly becoming attuned to the fact that what they are reporting to one country has a significant impact in other countries as well.  What many are not sufficiently aware of is that their tax and financial information can now be quickly cross-referenced and shared among numerous governmental taxing authorities with the click of a button.

Electronic filings and sophisticated digital data collection methods allow tax authorities to reach deeper than they ever have before into the taxpayer’s supply chain data.  Multinational taxpayers must electronically submit a variety of data that goes beyond tax records in formats specified by different tax authorities often within the same country, e.g., customs, duties, income tax, and VAT.  All of these authorities now utilize sophisticated data analytics engines to discover filing discrepancies and compare data across jurisdictions and taxpayers.  These governments then issue tax and audit assessments based on these analyses.

It is essential that multinational taxpayers understand the shift from a single country filing view to a global filing view.  Tax filings simply have to be viewed as being globally transparent in terms of information sharing, comparative risks, and tax controversy strategy and resolution.  Very little if anything is hidden and not shared.

The drivers behind this are numerous.  Over 100 countries have signed onto the OECD’s Country-by-Country reporting initiative.  The OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) desires to update over 3,000 double tax treaties to incorporate BEPS changes.  It went into effect in July 2018 with 75 countries on board.  The MLI requires a principal purpose test for a multinational taxpayer’s tax positions and creates a simplified limitation of benefits provision to curb treaty abuse.  This means that tax treaty benefits will be denied when procuring a tax benefit was a principal purpose of a business arrangement.

The OECD is offering a new tool aimed at taxpayer certainly in this new environment.  The OECD created International Compliance Assurance Program (“ICAP”) is a voluntary pilot program where, in return for transparency of their tax risks, taxpayers receive some assurance that they will not be targeted by governments participating in the program.  In theory, a successful ICAP result provides multinational taxpayers more certainty and a reduced overall global tax risk profile.  It is a program with promise but it is being rolled out as a pilot program only in the face of an ever more aggressive tax environment that is not a pilot program.

Tax Adviser Rules

One very significant change impacting practitioners both in the U.S. and worldwide is the EU’s recent update of the Directive on Administrative Cooperation (“DAC”).  Under the new DAC rules, intermediaries such as tax advisers, accountants and lawyers that design, promote or implement tax planning strategies are required to report any potentially aggressive tax arrangements directly to the tax authorities.  Very concerning , mainly due to the broad scope of definitions provided in these rules, is that reportable arrangements may include arrangements that do not necessarily have a main benefit of obtaining a tax advantage.  These new mandatory disclosure rules will have material implications for both advisers and their clients.

According to the DAC, a “reportable cross-border arrangement” refers to any cross-border tax planning arrangement which bears one or more enumerated features listed in the DAC and concerns at least one EU Member State.  The enumerated features are broadly scoped and represent certain typical features of tax planning arrangements which, according to the DAC, indicate possible tax avoidance.  Certain transfer pricing arrangements must be reported even if they do not have a primary purpose or benefit of obtaining a tax advantage.  This include arrangements that involve hard-to-value intangibles or a cross-border transfer of functions, risks, or physical property.

Creating A Global Tax Risk Strategy

Multinational taxpayers that are relying on traditional global compliance practices and reporting models will ultimately lose control of their own tax narrative.  These antiquated – and now dangerous – practices feature single country income tax reporting that is not coordinated with operational tax reporting like excise taxes and customs reporting.

When one takes into account decentralized management teams, non-integrated mergers and acquisitions, and information systems that are not coordinated or unable to provide required information in a timely manner, one can see the true scale of the problem.  Tax risk must be managed on a global basis.  Local, or even regional, management is simply not sufficient.

As tax reporting becomes even more digitally interconnected, existing problems will only grow creating more economic and legal risks to international business strategies.  What we are now experiencing has been long perceived and is the future of tax and financial reporting.  There really is no getting around it.

 Practical Strategies

We are often asked by our clients how to best manage this new global environment.  We advise that multinational taxpayers strategically address these issues proactively on a global basis.  The risk of not doing so is to hand over important financial data to numerous tax authorities without a clear understanding of how they’ll use it or how it will impact the taxpayer’s core business strategies.

There are steps that can be taken to minimize the impact of these new rules.   in a consistent and strategic way will be better equipped to manage controversies as they arise. Specific steps businesses can take to adopt a more consistent global approach to tax controversy management include:

  • Centrally manage global tax filings to ensure consistency and understanding of what is being disclosed and where.  This involves enhanced communication and processes between global reporting teams that may not have existed before.  This is, in practice, a cultural shift in how global finance teams address tax matters.
  • Modify, update, or create information reporting systems that can timely comply with global reporting rules while still allowing time for appropriate tax leadership review prior to filing.  Never has the need for information systems to be responsive to tax needs been higher.  These systems must not only produce data but do so in a coordinated and strategic manner.
  • Design and implement a global policy relative to tax compliance, reporting, and response to tax authority inquiries.  This policy must not only be nimble but it must fully comply with increasingly complex local rules.
  • Involve senior management, Board leadership, and even internal audit teams to create a corporate governance plan that complies with SOX requirements but also allows swift communication of tax related risks to strategic business plans and financial reports.
  • As an adviser/intermediary or taxpayer, understand when a transaction qualifies as a “reportable cross-border arrangement” under the DAC.  Unless a legal professional privilege applies, disclosure is necessary.  If multiple advisers are involved, each adviser must comply with the reporting obligation unless a report was filed by another adviser.

Even the most sophisticated taxpayers are having trouble keeping up with these new rules and requirements.  It truly represents a cultural shift that has been long coming and shows no signs of abating.  Only by maintaining awareness of new global reporting rules and creating strategies and processes to ensure both conformance and strategic awareness can economic risks be minimized and global business strategies preserved.

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 Asset Tax Compliance and Why It Is Important Right Now

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Frank J. Vari, JD, MTax, CPA

International tax can be a very complex subject but most associate both the topic and the complexity with multinational businesses.  That may be true, but the greatest risk if often borne by individuals who do not properly understand their U.S. reporting obligations for foreign income, assets, and investments.  With the U.S. Internal Revenue Service (IRS) recently declaring that the IRS Offshore Voluntary Disclosure Program (OVDP), which was started in 2009, will close for good on September 28, 2018, taxpayers with unreported foreign assets should immediately determine if ODVP would benefit them before it is gone for good.  At this same time, the IRS has noted that their enhanced enforcement efforts against unreported foreign assets will not end.  Thus, the time is now for taxpayers with unreported foreign assets to formulate a plan for compliance or risk what have been, in certain cases, draconian penalties.

Many individual taxpayers, including those from outside the U.S. who are not educated in U.S. tax reporting rules, own assets located in different countries.  Some of these assets are as benign as a bank account they hold with an elderly relative to those with a Swiss bank account fully intended for shelter from the U.S. tax and legal system.  In practice, most all of these cases lean toward the former, however, they all are covered by pretty much the same rules.

This article is intended to provide a quick overview of the issue and the avenues available to taxpayers to maintain or obtain compliance with the rules.

Reporting Basics

It is probably not news to any practitioner that a U.S. taxpayer has to report all of their income on a global basis.  It is also probably not news that many individual clients do not fully disclose, or fully understand the law to disclose, each and every non-U.S. income stream.  That, at a minimum, must be done even if it takes some digging to gather all of the appropriate information.

Reporting assets located outside the U.S. is a bit more tricky.  Not only from an asset identification perspective but from a where and how to report perspective.  For example, a U.S. taxpayer may have a small longtime family home somewhere in Europe that they occasionally rent to friends.  It’s simple enough to understand that the income must be reported on Schedule E, but what about the real estate itself?  More on that later but you see the issue.

Foreign Bank Account Reporting (FBAR)

U.S. residents or citizens must report a financial interest in, or signature or other authority over, specified bank and other accounts in a foreign country on Financial Crimes Enforcement Network (FinCEN) Form 114 (the successor to the beloved Form TD 90-22.1), i.e., FBAR, if the accounts aggregate maximum values exceed $10,000 at any time during a calendar year.  Please note the “aggregate” and “at any time” language.

FBAR requirements apply to individuals, corporations, partnerships, trusts, estates, and LLCs as well as entities disregarded for tax purposes.  The regulations under Sec. 6038D require that a specified person look through a disregarded entity for reporting foreign assets on Form 8938 (discussed below).  However, the FBAR requirements impose a separate, independent reporting obligation on such entities.

There are plenty of traps for the unwary here.  The most simple may be a U.S. taxpayer who has signatory authority to co-sign with an elderly relative located outside the U.S.  More difficult to identify is the reporting obligation of a U.S. corporate executive who has signatory authority, likely along with many others, over a long dormant overseas corporate bank account or accounts exceeding $10,000 at some point during a calendar year.  It is a very common situation that is difficult to identify and, hence, ensure compliance.  Add fiscal years and foreign currency translation to the equation and you see where the simple becomes difficult even for sophisticated taxpayers.

Form 8938

Specified U.S. individuals with foreign financial assets may need to file Form 8938, also known as the Statement of Specified Foreign Financial Assets as part of their annual income tax return. A “specified individual” is a U.S. citizen, a resident alien of the U.S., or anon-resident alien filing a joint U.S. income tax return.

The “financial assets” which must be reported includes foreign bank accounts, assets held for investment by a foreign institution, foreign retirement plans, and jointly owned foreign financial assets.  It is not uncommon for a business executive who has moved to the U.S. to have an interest in a foreign pension plan from a former employer.  Items like this must be considered.

The Form 8938 reporting thresholds range from $50,000 of foreign financial assets on the last day of the year or $75,000 at any time during the year for unmarried U.S. individuals to $400,000 on the last day of the year and $600,000 at any time during the year for married joint filers living abroad.  Be sure to reference the detailed Form 8938 reporting requirements once the assets themselves are identified.

Besides the individual nature of Form 8938, it is important to note one critical difference between Form 8938 reporting and FBAR. Form 8938 does not require reporting of financial accounts held in foreign branches or held in foreign affiliates of a U.S.-based financial institution.  However, such accounts are considered financial accounts for purposes of FBAR reporting because they are located in a foreign country.

Other Common Reporting Forms

The FBAR and Form 8938 are the most widely used foreign asset reporting forms but not the only ones.  There are a number of others that capture different kinds of foreign asset activity.  These are:

  • Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, for reporting transfers of property to foreign corporations;
  • Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts;
  • Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, for reporting affiliations with foreign trusts or the receipt of gifts from non-U.S. persons;
  • Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations;
  • Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business, for reporting interests in foreign controlled corporations and reporting transactions with foreign corporations; and
  • Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, for reporting interests in foreign partnerships.

Each of these forms captures different types of investments and may apply to both individuals and businesses in different forms.

Penalties

The IRS has identified unreported foreign assets as a key element of U.S. tax evasion.  So too have foreign tax authorities.  As such, the IRS has enacted significant penalties which, coupled with aggressive enforcement, creates a perilous environment for individuals and entities who fail to accurately file these forms. The penalties are very severe, especially considering the fact that the IRS has not made it easy for those with foreign assets to clearly understand what must be reported and how.

The penalties can be very high and reach upwards of $10,000 per form per year.  If the IRS establishes that the taxpayer willfully decided not to file the form, their can be criminal penalties as well as civil penalties reaching upwards of millions of dollars depending on the value of the overseas assets.

For practitioners who know, or reasonably should know, of these unreported or underreported foreign assets, Circular 230 still stands to require disclosure with its penalty provisions.

Resolution Options

Once the issue is identified, the appropriate course of action must be determined.  If the IRS has identified the issue first or the taxpayer has engaged in willful failure to report, the only option is constructing a legal defense.  Those that have experienced this know it to be a potentially very costly experience and more so if criminal penalties are involved.

The most reasonable option to those who otherwise have unreported foreign assets is the  OVDP program.  Taxpayers who voluntarily come forward and provide the IRS with the nature and extent of their undisclosed foreign assets and income are given assurances that the IRS would recommend against criminal prosecution of these taxpayers.  In addition, taxpayers are required to pay all outstanding taxes, interest, and a 20% penalty on the amount of previously unpaid taxes for up to 8 years of noncompliance.  Other various penalties apply depending on the form and the facts and circumstances of the case.

These OVDP penalties, while still sometimes steep, pale in comparison with potential penalties if the taxpayers do not enter into the OVDP and are identified by the IRS.  In addition to potential criminal sanctions, taxpayers could pay up to a 75% fraud penalty for any previously undisclosed income and the greater of $100,000 or up to 100% of the entire foreign bank account balance for each year of willful noncompliance with FBAR requirements.

It is important to note that the OVPD is not the only option available as the Streamlined Procedures Program still exists.  The appropriate option for the taxpayer depends again on the facts and circumstances.

What to do Now

As noted above, the IRS fully intends to continue increasing the number of criminal prosecutions of taxpayers involved in failing to report overseas assets.  Additional disclosure methods continue arising and include foreign banks, e.g., UBS, continuing to enter into non-prosecution agreements with the U.S. Department of Justice.  Additional tools ranging from international tax information sharing agreements to data mining will continue to aggressively identify non-complaint taxpayers.

It is very important for taxpayers who believe they may have issue to immediately determine a plan of compliance and if OVDP is their best option.  Failure to fully evaluate their options before OVDP expires this fall could be very costly.

To learn more about FJV’s foreign tax compliance and tax audit and controversy practices which have 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.

This article was previously published by the Massachusetts Society of Certified Public Accountants (MSCPA).

The BEPS & FATCA Impact on Transfer Pricing – Prepare for the Future or Return to Basics?

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Frank J. Vari, JD, MTax, CPA

There is certainly no shortage of publicity regarding the impact of BEPS and FATCA on transfer pricing and how to best address these significant new requirements.  This has spurred considerable attention to predicting exactly what the future holds and how to prepare for it.  At this same time, many new rules are similar to historic requirements that a taxpayer maintain global transfer pricing positions that are supported with logic, facts, and documentation.  As we continue to see how these rules will be applied, the question remains whether multinationals in today’s environment should focus entirely on the future or return to basics?

Since the first transfer pricing guidelines were issued by the IRS and OECD, most countries, including the US, have adopted a contemporaneous documentation requirement which remains relatively unchanged as other global transfer pricing rules have greatly evolved.  Multinational corporations prepare this documentation for each taxing jurisdiction where there is either a registered subsidiary or a permanent establishment.  This same documentation also provides compliance with SOX 404 and financial statement reporting requirements including FIN 48.

A key element of the contemporaneous documentation requirement is a risk analysis that describes and allocates business risks amongst the related parties.  This risk allocation is the foundation of the intercompany profit allocation where the related party bearing the majority of the risks in the economic relationship is entitled to the lion’s share of the profits.  The better the quality of the overall documentation and the closer the nexus between this risk analysis and the income allocation the stronger the taxpayer’s position becomes.

Progressive taxpayers have long understood that creating and maintaining strong and appropriate transfer pricing documentation ensures that the taxpayer controls any narrative of its pricing and business practices.  This prevents a tax authority from creating alternative theories about a taxpayer’s intercompany relationships and standards of comparability.  To the extent a taxpayer presents a taxing authority with documentation that does not support or accurately reflect their facts or reporting positions the higher the chances are of a unilateral transfer pricing adjustment and related penalties being forced upon them.

Like existing rules, the new rules address risk allocation.  Specifically, the OECD BEPS Guidelines set out this analytical risk framework:

STEP 1 – Identify the economically significant risks of the business.

STEP 2 – Determine how the economically significant risks are contractually assumed.

STEP 3 – Perform a detailed functional analysis of the economically significant risks to determine which entity controls the risk and has the financial ability to bear the risk.

STEP 4 – Consider whether the contractual assumption of risk identified in Step 2 is consistent with the entities’ conduct identified in Step 3.

STEP 5 – Where the contractual assumption of risk is not consistent with the entities’ conduct, reallocate the risk to the party that assumes it based on conduct in Step 3.

STEP 6 – Perform a transfer pricing analysis based on the delineated transactions after re-allocating risk.

These specific requirements as laid out above may be new but they don’t materially depart from what taxpayers have been historically required to do.  The real change will be to taxpayers that have not adequately analyzed and documented their facts and performed a risk analysis on a jurisdictional basis in a sufficiently detailed manner to defend their existing intercompany profit allocations.

For all multinational taxpayers, the immediate focus should be a renewed understanding of intercompany relationships requiring the tax team to have an even closer relationship with the business product development, operation, and supply chain teams.  This ensures that detailed facts and risks are understood and, more importantly, support the taxpayer’s tax positions.  The need for an ongoing and close relationship with business teams cannot be understated due to the fluid nature of global business practices and the problems that can arise when these practices deviate from reported tax positions.  Taxpayers must now be able to adjust and adapt tax positions at least annually in potentially multiple jurisdictions or risk having any deviations pointed out on audit.

This updated risk analysis requirement is woven into a bevy of new information reporting requirements under both FATCA and BEPS.  A cursory glance at the new business and financial data that now must be filed annually significantly exceeds the information historically reported and certainly that which is publicly reported.  Gathering and reporting this newly required jurisdictional data is loaded with practical difficulties well beyond the scope of this article but it is important to note that information that is now required greatly exceeds a simple updated transfer pricing report.

What remains unchanged is that tax leadership cannot allow any deviation from their actual business practices and the newly required intercompany reporting disclosures to shift control of the transfer pricing narrative away from the taxpayer and give a taxing authority room to create their own models of intercompany profit allocation.  Agreement of all reported information with intercompany profit allocations is necessary.  It is not a new goal but it has certainly become tougher to meet due to significantly increased annual reporting requirements.

This article posed the basic question whether BEPS or FATCA requires a look to the future or a return to the transfer pricing basics?  The answer is mixed.  The requirement of a detailed functional fact and risk allocation analysis tailored to the local country is not new nor is the knowledge that much more detailed information may be required in the event of an actual audit or examination.  What is new is the significantly increased level of detail now required to be reported annually and how to best gather and present that data.  That is a very big change and one that will keep tax departments busy now and for some time to come.

To learn more about FJV’s  transfer pricing practice 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.

This article was previously published by the Tax Career Digest.