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New Transfer Pricing Opportunities in the COVID Environment

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 Frank J. Vari, JD, MTax, CPA

We have previously written on transfer pricing opportunities in the COVID environment and, as the COVID pandemic continues to impact global supply chains, and our multinational clients in our transfer pricing practice continue to reap economic benefits via proactive transfer pricing adjustments.  Multinational taxpayers that fail to actively change existing supply chain transfer pricing strategies will meet upended treasury strategies where cash needs no longer match cash sources as well as simple tax inefficiencies that can be avoided.  It is our belief that, as we wrote in April, there will continue to be transfer pricing opportunities in the COVID environment with international tax benefits as well.

Global transfer pricing strategies are traditionally built on multi-year models in normal operating times.  It is not uncommon for these transfer pricing plans/policies to only be updated on an annual basis.  None of these plans, or the economic models upon which they are built, were designed to proactively address a seismic supply chain event like the COVID pandemic.  An existing and unmodified transfer pricing plan is now likely materially incorrect and almost instantly out of date.  The question is then what can be done to modify, or create, a transfer pricing strategy that reflects current conditions as well as the opportunities these new strategies present.

Finance and tax professionals should perform a detailed review of the business operations to mitigate TP risks and identify the TP opportunities to help management deal with their cash and operational concerns.

Learn More About Our Transfer Pricing Practice Here

Best Practices For Transfer Pricing Planning

Successful tax strategies are always based on communication and knowledge of the taxpayer’s operating environment.  That has never been truer than now as this is the most dynamic and fast moving international business environment in modern times.  Supply chains are changing very rapidly including the reallocation of associated functions and risks.  Tax professionals must keep track of these business changes in order to ensure that their transfer pricing reflects the new reality and that cash balances and tax bills don’t create problems for the group.

Functions and Risks

The cornerstone of any transfer pricing analysis is the functional analysis that describes the allocation of functions and risks across a global supply chain.  Some functions and risks stand out as significantly impacted by the COVID environment.  Those we see are:

  • Liquidity – This is the most critical factor for many clients as they struggle to balance global cash flows where financial markets are in turmoil, customer orders are imperiled due to global shutdowns, and operating costs rise across the world to meet new safety concerns.
  • Supply Disruptions – Traditional suppliers, internal and external, have been taken offline either by government mandate or workplace safety issues. Alternative suppliers have had to step in at much higher costs to ensure supply chains operate properly if at all.
  • Logistics – Global transportation networks have been placed under significant stress resulting in product shortages in end markets and backed up inventories in production facilities. This has resulted in new supply chains not contemplated by existing transfer pricing plans.
  • Services – Global service providers ranging from legal, HR, IT, and other areas have changed to meet a crisis environment. Services traditionally performed in house have been outsourced, or vice versa, resulting in significantly increased costs for global corporate services as well as new service providers.

The allocation of functions and risks supports the economic underpinnings of a multinational transfer pricing strategy and the related tax and treasury results.

Transfer Pricing Opportunities

The very first step is to review existing transfer pricing documentation to understand any differences in the current environment to those facts supporting the economic comparables in place.   In addition to the documentation, any intercompany contracts agreements for sale of goods, services, or the use or development of intellectual property must be analyzed to understand if unusual or unforeseen risks such as COVID have been covered and how they should be allocated between participants.

One common fact we see changing is the location performing intercompany services.  Government mandated lockdowns and other related factors are forcing these changes.  As a result, the modification of intercompany services contracts must be performed immediately to ensure that documentation and compliance are maintained.  This is but one example of the multiple changes impacting documentation.

Force Majeure Clauses

The documentation review discussed above must consider if each party is able to fulfill their contractual responsibilities under COVID or whether force majeure should be invoked to alleviate either party’s obligations during the pandemic.  This would allow related parties to seek relief from payment of recurring charges such as management fees or royalties. An excellent way to support the arm’s length nature of an intercompany declaration of force majeure is to determine if force majeure provisions have already been invoked with third party suppliers or customers of within the taxpayer’s industry.

If there is no force majeure clause in the intercompany contract, alternative legal remedies or renegotiating contracts to deal with nonperformance issues or other extraordinary circumstances should be evaluated.  Courts have accepted that renegotiating intercompany agreements is consistent with arm’s-length dealings which, when coupled with the existence of third party force majeure invocation within the industry, provides solid support.  Further, the local tax authorities may understand that a contractual restructuring is a better option than going out of business altogether even if short term profitability is impacted.

Create COVID Specific Policies

In the short term, policies can be created to address major changes and disruptions.  These changes are highly dependent on the operational nature of the business.  They can range from credit protection to expanded compensation for headquarters or shared services.  It is very important to note that any changes must remain arm’s length which places the burden on the taxpayer to monitor developments with third parties and within their industry to determine what allowances are taking place.  .

If the operational changes appear to be longer term, there is likely a case for an overall supply chain restructure.  Many reading this may ask what exactly this new supply chain will look like which is a greet question in the fog of crisis.  However, proactive tax professionals will be looking for the first clearing in the fog to make immediate corrections to global supply chain agreements and economics.

Benchmarking Adjustments

It is probably obvious by now that the use of a multiple year approach may not be suitable for generating reliable comparables in the COVID environment.  A global taxpayer should evaluate whether the use of a year-by-year approach could better capture the effect of dramatic changes in their markets.  There are certainly cases where the use of multiple year averages for years where the taxpayer’s comparables suffered from similar economic conditions that could help to develop a more realistic range.

Another more practical approach may be to expanding the acceptable range of results beyond the current interquartile range.  These changes must be assessed on a case-by-case basis and are very fact dependent and local country transfer pricing rules must be reviewed.

Government Relief Programs & Policies

We are now seeing a number of countries offering relief programs to support faltering economies and we expect to see more if indeed a second COVID wave develops.  Multinational groups must very closely monitor any local country tax news to determine if relief is being provided in some shape or form to their global supply chain.  It may seem like this goes without saying but we do see these programs or policies often being implemented without the tax team’s knowledge and, as such, they are failing to properly evaluate or take advantage of these often very favorable programs.  Specific to transfer pricing, information releases at both the OECD and local country levels must be monitored closely.

Conclusion

As the COVID supply chain effects continue to evolve, we will continue to identify ways to ensure that transfer pricing policies support both tax and treasury goals.  The thoughts and ideas presented here represent just a few of the strategies out there to ensure that goals are met.  Because each strategy is fact specific, no single strategy applies to all.  We encourage multinational taxpayers to stay tuned in this ever evolving environment and remember that the arm’s-length principle comes always comes down to the idea that independent enterprises must always consider the options realistically available to them especially in times of crisis.

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.

Payroll Tax Credits Provide Cash Flow Benefits For Technology Start-Ups With Research Activities

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 Frank J. Vari, JD, MTax, CPA

Our practice serves a number of early and mid-stage technology clients and many have significant research and development (“R&D”) activities and expenses but have not generated taxable income either due to tax planning or net operating losses.  Conventional wisdom has been that these companies cannot claim any tax benefits related to their R&D related expenses because they have no taxable income.  However, these same clients often pay significant payroll taxes and they are often unaware that they can reduce their annual payroll taxes, and improve cash flow, by as much as $250,000 per year by taking advantage of the United States (“US”) R&D payroll tax credit.

Let us explain here how we help our qualifying clients claim these important benefits.

As noted, US businesses historically have not been able to use the traditional US R&D income tax credit in tax years where there was no regular US income tax liability.  However, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made very favorable changes to the research credit that help mitigate the impact of this limitation.  In particular, PATH allows certain small businesses to offset their alternative minimum tax (“AMT”) or payroll tax liability with a research credit.  As a result, small businesses in an AMT or net operating loss (“NOL”) position that cannot claim the traditional R&D credit can now claim tax and cash flow benefits.

The R&D Credit

The R&D credit was enacted back in 1981 to stimulate US R&D activities by helping businesses offset some of the costs associated with their qualified R&D activities.  Quite basically, a qualified R&D activity expense qualifying for the credit is one where:

  • The expense is incurred in a trade or business which represent R&D costs in the experimental or laboratory sense;
  • The research is technical in nature including bioscience engineering, computer science including software, chemical/polymer design, manufacturing processes, and other similar activities;
  • The research contains aspects of experimentation related to a new or improved design, function, or performance; and
  • The research is intended to result in a new or improved product or business element for the taxpayer.

Today, there is a regular R&D credit and an alternative R&D simplified credit (“ASC”) option to calculate the benefits.  Qualifying businesses can compare the two methods and choose the more favorable one by making an annual election on a timely filed federal return.  Businesses that have not claimed a regular credit in a prior year may make the election on an amended return for that year.

PATH significantly expanded the R&D credit by allowing certain businesses to claim R&D tax benefits in years when they had no regular US income tax liability.  In other words, before 2015, if a business didn’t have US taxable income, there was no way to claim an R&D credit.  Now, the R&D credit can be used to reduce AMT or payroll tax liabilities.

Although AMT liabilities may also be reduced, our discussion here will focus on the payroll tax R&D credit.

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Which Businesses Qualify For Payroll Tax R&D Credits

In order for a business to offset its payroll tax liability with the R&D credit, the taxpayer must be a Qualified Small Business (“QSB”).  A QSB may be a corporation, partnership, or even an individual with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year.

Example:  For the first five years of its existence, Corporation A had gross receipts of $1,000,000, $7,000,000, $4,000,000, $3,000,000, and $4,000,000.  Corporation A is a QSB for year 5 because its gross receipts are less than $5,000,000, even though its gross receipts exceeded the limitation for a prior year.  However, Corporation A is not a QSB in year 6 due to having gross receipts in year 1.

Gross receipts here are reduced by returns and allowances but also include non-sales related items such as interest, dividends, rents, royalties.  These receipts must also be adjusted to account for predecessor entities meaning that past mergers and acquisitions are relevant to this calculation.  One must also adjust for any entities or individuals treated as a single taxpayer meaning that gross receipts must be aggregated for a controlled group of corporations or for trades or businesses under common control.

Claiming Benefits

A QSB may elect to claim the R&D credit against the Old Age, Survivors, and Disability Insurance (“OASDI”) portion of the employer’s Federal Insurance Contributions Act (“FICA”) payroll tax liability for up to five tax years.  The election to claim the payroll R&D credit must be made on a timely filed US tax return including extensions (please note this differs from the regular R&D credit which can be claimed on an amended return).  The election is reported in Section D of Form 6765 as part of the aforementioned return.  Special rules apply for partnerships and S corporations.

The election must indicate the amount of the research credit that the QSB intends to apply to the expected payroll tax liability.  This amount is the smaller of:

  • A $250,000 cap;
  • The amount of the research credit for the tax year (without regard to the election); or
  • The amount of any business credit carryforward under IRC §39 carried from the tax year of the election, without regard to the election, but only for QSBs that are not partnerships or S corporations.

A QSB that files quarterly payroll tax returns may apply the credit on its payroll tax return for the first quarter beginning after it files the federal return appropriately reflecting the election.  For these quarterly payroll taxpayers, a QSB seeking benefits related to 2019 R&D activities that files that timely files their US income tax return by April 15, 2020 will be able to claim these benefits beginning in the second quarter of 2020 but not before.  If the return is extended, then the timing of the benefits extends as well.  Accordingly, a QSB that files annual payroll tax returns may apply the credit on the first quarter beginning after the date on which the business files its US income tax return containing the election.

When filing the payroll tax return, Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must be completed and attached to the payroll tax return to ensure that the amount of the previously elected credit is limited to the employer portion of the Social Security tax for the period.  Any excess may be carried forward pursuant to future periods.  The credit does not reduce the QSB’s deduction for payroll taxes which provides an additional benefit.

Next Steps

The best next steps for any start-up with R&D activities is to take the following steps along with a qualified tax adviser:

  1. Determine qualification as a QSB;
  2. Identify qualifying research activities;
  3. Calculate the amount of the R&D credit and the corresponding payroll tax offset;
  4. Make the appropriate elections and file the requisite income tax and payroll tax forms using the most beneficial methodologies; and
  5. Organize supporting documentation in case of a tax authority examination.

In summary, any tech start-up not claiming these cash flow benefits should be paying attention.

Please let us know how we can help you plan for your tax planning and compliance needs.  Learn more about our business tax practice or our firm by contacting us at FJVTAX.com.

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.

 

The Hidden Passive Foreign Investment Corporation Danger & How To Address It

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The Hidden Passive Foreign Investment Corporation Danger & How To Address It 

 Frank J. Vari, JD, MTax, CPA

Passive Foreign Investment Company (PFIC) is a term that many U.S. taxpayers and practitioners do not understand or recognize but it stands as one of the most significant risk exposures to any US taxpayers with foreign investments of any sort.  Many U.S. taxpayers, primarily individual investors, and practitioners are too quick to conclude that they do not own a PFIC interest.  In our experience, this is because they either don’t understand what a PFIC is or they are daunted by the complicated PFIC rules and reporting requirements.  The common results on audit are unexpected severe tax consequences to unsuspecting and unprepared taxpayers.  When one considers that a PFIC could be anything from a small interest in a foreign corporation to a Bitcoin investment it is easy to see how easy it is to come into contact with the complex and punitive PFIC rules.  This article is intended to provide some basic guidance on the PFIC regime and to address some basic issues.

The PFIC rules were enacted in 1986 as a counterpart to the anti-deferral regime of Subpart F with an intended target of U.S. owners of foreign corporations with primarily passive income or assets.  The PFIC rules, unlike the rules in Subpart F, aim to remove the economic benefit of deferral with respect to any and all U.S. PFIC investors and not just those with significant ownership interests.  Extremely broad and complex, the PFIC rules discourage U.S. taxpayers from investing in PFICs assuming that they can identify whether their foreign investment is a PFIC in the first place.

The PFIC rules are primarily contained within IRC §§1291, 1297, 1298 and related authority.  Primary technical guidance has historically been provided by IRS Notice 88-22 which continues to provide significant guidance to this day.

Generally defined, a PFIC is a foreign corporation that has, during the tax year, at least 75% passive income (“Income Test”) or at least 50% of assets that produce passive income (“Asset Test”).  Passive income is any income that would be Foreign Personal Holding Company Income (“FPHCI”) as defined by the Subpart F provisions in IRC §954(c).  Many conclude that unless the investment is considered a Controlled Foreign Corporation (“CFC) there is no PFIC exposure.  This is an incorrect and false analysis that confuses PFIC with Subpart F.  This is an especially dangerous conclusion when one recognizes that the PFIC rules don’t apply to a CFC after 1997 as part of the PFIC/CFC overlap rule of IRC §1297(d) exempting CFC shareholders from the PFIC regime.

Here for example, are common PFIC investments that we regularly see in our international tax practice.  In any of these or similar situations PFIC testing is required:

Foreign Mutual Funds

The primary investments of a mutual fund are most often passive or generate passive income qualifying the mutual fund itself as a PFIC.

Foreign Holding Companies

Many foreign holding company investments by U.S. shareholders are tailored to avoid CFC rules due to passive share investments.  However, there is often PFIC exposure which often goes untested.  This is a very common PFIC scenario.

Foreign Hedge Funds

Like a mutual fund, a hedge fund is an entity often engaging in passive investment activity.  We work with a number of foreign hedge funds and any U.S. investor in a foreign hedge fund has potential PFIC exposure.

Foreign Trusts

A foreign trust is most often a foreign entity consisting of passive investments generating passive income.  We often see U.S. beneficiaries of foreign trusts, many of which are family trusts established many years ago, that qualify as PFICs and carry significant past tax liabilities with them.

Foreign Bank Accounts

A bank account might also be a PFIC if that account is a money market type investment rather than simply a deposit account as many money market investments are equivalent to fixed income mutual funds.

Foreign Pension Funds

PFIC rules can and do apply to passive investments held inside foreign pension funds unless those pension plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country.

Bitcoin / Cryptocurrency

If cryptocurrency is held in via a foreign fund or it is held via a foreign entity maybe a PFIC investment.  The passive nature of these investments always require PFIC testing.

Learn More About Our International Tax Practice Here

As noted above, the PFIC regime is essentially an anti-deferral regime intended to remove any advantage of income deferral provided by a non-CFC offshore investment.  PFIC taxation falls into three elective categories.  First, income can be currently taxed as a Qualified Electing Fund (“QEF”) under IRC §1293 where a U.S. shareholder elects to have their PFIC income taxed annually.  Second, the IRC §1291 “interest on deferral” regime allows annual U.S. taxes on PFIC income to be deferred but requires the U.S. shareholder to pay any tax plus interest on the deferred PFIC income when the shareholder ultimately receives their PFIC income via distribution or disposition.  Third, there is the IRC §1296 mark-to-market regime where the shareholder recognize gains and losses from marketable stock on an annual basis.  The most common taxing regime chosen is a QEF election if PFIC treatment cannot be avoided altogether.

One notable rule around PFICS is the “once a PFIC always a PFIC” rule.  This rule states that if stock in a foreign investment meets the PFIC definition at any time during the shareholder’s holding period it continues to be treated as a PFIC forever even after it no longer meets the PFIC definition.  This requires a lookback for many taxpayers to see if their investment has been tainted as a PFIC at some point in the past even if it clearly no longer qualifies as a PFIC today.  This is not an uncommon event.

This article is not intended to be and should not be treated as a complete description of the PFIC testing and treatment rules.  There is much more to this regime including complex Foreign Account Tax Compliance Act (FATCA) reporting rules which include filing Form 8621 for each PFIC investment.

The bottom line to any U.S. taxpayer or practitioner who believes that a foreign investment is or was a PFIC should immediately research or seek out an experienced international tax practitioner with PFIC experience to help them navigate and limit their PFIC tax exposure.

Please let us know how we can help you plan for your international investments.  Learn more about our international tax practice or our firm by contacting us at FJVTAX.com.

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.

 

 

Beware of GILTI Basis Adjustments

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Frank J. Vari, JD, MTAx, CPA

Much has certainly been written about the recently proposed regulations on IRC §951A known more famously as the Global Intangible Low-Taxed Income (“GILTI”) regime.  What has not been widely publicized are the basis adjustment rules for consolidated groups.  This may not be the most easily understood topic but it may be one of the most important topics to groups that are active or expect to be active in the merger & acquisition arena.  The GILTI basis adjustment rules are a new area of complexity and risk.

Overview

The GILTI basis adjustment rules are rather simple to understand but are very complex in practice.  They require basis adjustments for consolidated group members and Controlled Foreign Corporations (“CFC”) that contribute tested losses to the group.  They are intended to prevent the “double dipping” of tax benefits where a member’s GILTI tested loss is used to reduce a current year consolidated group GILTI income inclusion and then again when the contributing member’s outside tax basis remains high when that group member is sold.  The rule’s required downward basis adjustment which corresponds with the member’s GILTI tested loss ensures the benefit is only taken once.

That all seems simple enough in theory but practice is another matter.  Maintaining regular individual member and CFC federal tax basis calculations is sufficiently difficult and cumbersome that most consolidated groups fail to do it at all.  The price for this is that there is usually a very time crunched calculation performed to model or calculate gain or loss when a group member becomes involved in a proposed transaction.  When you take into account that many states have not decided whether to join GILTI or not, you are left with calculating three separate basis calculations for each group member – US federal tax, state tax, and US GAAP/IFRS – all potentially reflecting differences due to GILTI basis adjustments.

The Basis Adjustment Rules

Let’s take a look at the basis adjustment rules in detail.  As noted above, the basis adjustments relate to the use of tested losses by the group.  The Proposed Regulations provide a complex set of rules intended to prevent US consolidated groups from receiving dual benefits for a single tested loss that results if a domestic corporation benefiting from the tested losses of a tested loss CFC could also benefit from those same losses upon a direct or indirect taxable disposition of the tested loss CFC.

The rules apply to any domestic corporation – not including any Regulated Investment Company (“RIC”) or Real Estate Investment Trust (“REIT”) – that is a US shareholder of a CFC that has what the Regulations call a “net used tested loss amount”.  The US group must reduce the adjusted outside tax basis of the member’s stock immediately before any disposition by the member’s “net used tested loss amount” with respect to the CFC that is attributable to such member’s stock.  Please be further aware that if this basis reduction exceeds the adjusted outside tax basis in the stock immediately prior to the disposition then this excess is treated as gain from the sale of the stock and recognized in the year of the disposition.

The term “net used tested loss amount” is the excess of:

  • the aggregate of the member’s “used tested loss amount” with respect to the CFC for each US group inclusion year, over;
  • the aggregate of the member’s “offset tested income amount” with respect to the CFC for each US group inclusion year.

The amount of the used tested loss amount and the offset tested income amount vary depending on whether the member has net CFC tested income for the US group inclusion year.

For a very basic example, let’s take a US group member with two CFCs.  In year one, CFC1 has a $100 tested loss that offsets $100 of tested income from CFC2.  In year two, CFC1 has $20 of tested income that is offset by a $20 tested loss from CFC2.  The rules tell us that the $100 used tested loss attributable to the CFC1 stock from year one is reduced by the $20 of CFC1’s tested income from year two that was used to offset CFC2’s tested loss.  The result is a net used tested loss amount of $80 to CFC1 at the end of year two.  If we changed the facts a bit and assumed that CFC1 and CFC2 were held by separate US consolidated tax group members you can see the true complexity emerge regarding outside tax basis determinations at both the CFC and consolidated group member levels.

The Proposed Regulations provide guidance for tracking and calculating the net used tested loss amount of separate CFCs when those CFCs are held through a chain of CFCs.  In certain cases, a disposition of an upper-tier CFC may require downward basis adjustments with respect to multiple CFCs that are held directly or indirectly by the upper-tier CFC.  Further, the Proposed Regulations provide guidance with respect to tracking and calculating the net used tested loss amount with respect to a US shareholder attributable to stock of a CFC when the CFC’s stock is transferred in a nonrecognition transaction or when the relevant CFC is a party to an IRC §381 transaction.

Conclusion

There is no need to detail any and all adjustments here because the regime is simply too complex to easily summarize.  The point is that the outside basis calculation for CFCs and consolidated group members before GILTI has just become much more difficult and complex.  Consolidated tax group contemplating current or future transaction activity are well advised to maintain these basis adjustments annually lest they be forced to perform these very difficult – yet meaningful – calculations in the crunch time of a transaction.

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.

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.

 

New Tax Benefits for Pass-Through Entities – What’s There to Know?

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By FJV Tax Staff

There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about.  That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.

This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate.  For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.

The motivation for the new deduction is rather simple.  It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform.  Income earned by a C corporation has always been subject to double taxation.  The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend.  Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%.  Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.

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In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level.  Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates.  Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.

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What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear.  As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS.  Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.  What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.

One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction.  Service businesses are the real problem.  Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”.  That definition cast a pretty wide shadow.

Proposed regulations have come to the rescue at least a little bit.  The proposed regulations clarified several questions related to specified service businesses.  First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above.  Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business.  These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.

Some of the most complicated areas are services related to health, consulting, and real estate businesses.  Here are examples of the application of Section 199A from each of these businesses:

Health and Health Care

A qualifying health care business means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.  It excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient.  An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.

Consulting

Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems.  However, these services do not disqualify larger businesses that only involve small levels of consulting.  Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product.  For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.

Real Estate

Brokerage services are specifically excluded from Section 199A benefits.  This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers.  The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.

As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships.  As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution.  Many questions still remain.

Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to.  To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.