international tax

New Transfer Pricing Opportunities in the COVID Environment

September 23, 2020 by Frank Vari, JD. MTax, CPA

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 An existing and unmodified transfer pricing plan is now likely materially incorrect and almost instantly out of date.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.

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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.

Common GILTI Compliance Errors

January 29, 2020 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, CPA, MTax

In our international tax practice, we both prepare and review a large number of Global Intangible Low-Taxed Income (“GILTI”) tax calculations and US corporate and individual tax returns related to same. As is common with most new tax rules, especially those as complex and wide ranging as GILTI, practitioners and taxpayers stumble until they familiarize themselves with calculation and reporting requirements. It is no different with GILTI and this article will help outline some of the more common errors we’ve come across.

GILTI Introduction

It is no longer news that the 2017 Tax Cuts and Jobs Act introduced a new anti-deferral tax on Controlled Foreign Corporations (“CFC”) known as GILTI. Roughly modeled after the taxation of Subpart F income, a US shareholder of one or more CFCs must include GILTI as US taxable income, in addition to Subpart F and other anti-deferral type income, regardless of whether the US shareholder receives an actual distribution.

The GILTI calculation itself can certainly be complex especially where multiple CFCs are involved. Quite basically, GILTI is the excess of a US shareholder’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property or Qualified Business Asset Investment (“QBAI”). US corporate CFC shareholders are given a 50% deduction via IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

GILTI certainly aims for technology and pharmaceutical companies with significant overseas low-taxed income and, at least in theory, discourages them from mobilizing intellectual property to shift profits outside of the US. The issue is that, as written, it really doesn’t just address income from identified intellectual property, at least not in a traditional sense, resulting in unintended consequences for corporate and noncorporate taxpayers with operations outside the US. As such, a wide net has been cast and many taxpayers and practioners are working hard to properly address the GILTI rules.

Now that we’ve discussed the basic rules, what are the errors that we most often come across? This is certainly not an exhaustive list and there is no particular ordering here.

No Individual Taxpayer Rate Reduction

As noted above, individual CFC shareholders are not eligible for either the aforementioned IRC §250 deduction or the use of IRC §902 foreign tax credits against their GILTI liability. Both of these generous benefits are afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions. That’s a big deal to US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions. As we’ve previously written, these issues can be addressed by proper planning but the law itself is rather unforgiving as it is currently written.

No High Taxed Exception

GILTI is somewhat similar to Subpart F as its anti-deferral brethren. However, the commonalities do not include a high taxed exception which, as of now, only belongs to Subpart F. This rule generally excludes from US taxable income any Subpart F income already taxed at a sufficiently high rate in foreign jurisdictions. The kicker here is that it does not apply to GILTI that is already taxed at a high rate offshore and any related foreign tax credits are useless to individuals or corporate taxpayers in an excess foreign tax credit position. Unintended application of the Subpart F high taxed exception to GILTI is an error until the GILTI proposed regulations containing a GILTI high taxed exception become law.

Consolidated Tax Groups

Consolidated returns for US multinational consolidated corporate tax groups are complicated enough without a GILTI calculation. When one considers the typical reorganizations, mergers, and acquisitions that regularly occur for most consolidated taxpayers, one can easily see the room for error when the time comes for the GILTI calculation. Some of the more common consolidated return errors are related to the following:

The allocation/sharing of tested losses by “loss CFCs” with “income CFCs” owned by other consolidated group members;
The allocation/sharing of the consolidated group’s GILTI attributes to its members;
Consolidated group member share basis adjustments (more on that here) via the offsetting of tested income and utilized tested losses; and
Nonrecognition transactions between related consolidated group members where “loss CFC stock” is transferred.

Due the inherent complexity here, more can certainly be written especially when one has to address the US tax reporting requirements. This is certainly an area where experience with consolidated group reporting, international tax, and the GILTI rules is essential to get it right.

GILTI Basis Adjustments

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 any CFC that contributes 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. We’ve written before about this but it remains a complex issue and common error.

State Taxation

This issue is a quagmire especially for multistate taxpayers. We get many questions here and often have many of our own. In many cases, GILTI represents the states’ first significant venture into the taxation of international income. Most state tax systems were not created to accommodate international income and, as such, uncertainly abounds until state legislatures catch up with GILTI. Often, GILTI is not given a preferential rate and some states will tax GILTI but fail to recognize Foreign Derived Intangible Income (“FDII”) as a proper offset.

For corporate consolidated taxpayers, the state GILTI calculation where the states do not recognize the full current US consolidate tax return regulations are particularly troublesome. Corporate taxpayers must also be aware of states not recognizing the IRC §250 deduction. This existing patchwork of state rules is made even more complex when one considers city and other local income taxes.

QBAI Calculation Errors

A CFC’s QBAI is properly calculated as the average of the aggregate of its quarterly adjusted bases in “specified tangible property” used in its trade or business. It is not simply the year-end balance. Furthermore, to calculate the proper asset basis for QBAI purposes, you must use an alternative depreciation system, i.e., the straight-line method. These are both very common mistakes.

Another QBAI error is that specified tangible property, as defined here, means any property used in the production of tested income. The upstart is that CFCs with tested losses may have a business asset investment but since they do not have tested income and they do not hold any specified tangible property they will not have any QBAI. Please note that this exception does not apply to specified interest expense that still must be considered even if attached to a CFC with tested losses. This is especially painful to our investment fund clients with CFC asset related debt and CFC GILTI tested losses.

No Tested Loss Carryforward Provision

The GILTI rules do not permit the IRC §172(a) Net Operating Loss (“NOL”) deduction. This means that tested losses cannot be carried forward or backward to offset current year tested income. If a CFC’s foreign taxing jurisdiction permits the carryforward of losses, the CFC’s local country taxable income may be significantly limited or be reduced to zero in the year when a local country NOL carryforward or carryback is used. This would limit foreign income tax liability while a large balance of GILTI tested income, includible to a US shareholder, remains. As a result, the amount of foreign tax credit available to offset the GILTI inclusion may be limited which raises the GILTI effective tax rate.

Consideration of Anti-Deferral Provisions

The rule is that a CFC’s gross tested income is its gross income determined without regard to:

Effectively connected income;
Subpart F income;
High-taxed Foreign base company income or insurance income which is taxed at a foreign effective tax rate greater than 90% of the US corporate tax rate;
Related party dividends; and
Foreign oil and gas extraction income.

The problem is that many taxpayers and practitioners fail to properly test for these items. This can create a larger problem on audit where a taxpayer may assume that they have a GILTI inclusion that’s taxed at a reduced rate but they actually have a much higher taxed Subpart F inclusion. The bottom line is that one must still test for all of these items as part of any tested income analysis before the IRS tests for it.

Conclusion

The GILTI rules are certainly complex, wide ranging, and continuing to evolve which creates a near perfect environment for calculation and compliance errors. This article is by no means an exhaustive list of every potential GILTI error out these but just some of the most common we see.

If you would like our assistance or thoughts on any GILTI analysis, please visit our website at fjvtax.com or reach us by phone at 617-770-7286 or 800-685-2324.

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

October 17, 2019 by Frank Vari, JD. MTax, CPA

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.

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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.

International Tax Planning Tools for US Individuals with Foreign Investments

February 4, 2019 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

There is no question that Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act (“Act”), changed the rules governing all US individuals and corporations with foreign businesses and investments. The Act was advertised to reduce taxes and compliance costs for both individuals and corporations and for most parties it has accomplished that goal. However, some of these new rules have had a decidedly negative impact on individual or non-corporate US shareholders of controlled foreign corporations (“CFC”) compared with corporate shareholders. Many non-corporate CFC shareholders actually face an expensive tax increase as well as increased compliance costs.

It is not clear whether the negative impact of these new rules was intended or simply the result of constructing very complicated tax legislation in a somewhat short time period. Whatever the cause, where care was taken in domestic legislation to place individual and corporate shareholders on a somewhat equal footing, e.g., new IRC §199A tax benefits offered along with reduced corporate tax rates, the same efforts were not made in the context of international shareholdings.

US individuals with foreign investments must immediately explore their international tax planning options to avoid these negative US income tax effects. We are actively engaged with a number of US based individuals on their individual international tax planning and we hope this article sheds some light on these important issues and related planning opportunities for you or your clients.

CFC Ownership

A CFC is generally defined as any foreign corporation where US persons own 50% or more (directly, indirectly, or constructively) of the foreign corporation’s stock (measured by vote or value) taking into account only those US persons who own at least 10% of the aforementioned stock. These shareholders are each referred to as a United States Shareholder (“USS”).

US individual ownership of CFC shares was always disadvantaged compared to corporate shareholders primarily due to the inability of individuals to use IRC §902 to credit indirect foreign taxes paid by the CFC. US individual shareholders can only use IRC §901 foreign tax credits which are basically limited to withholding taxes associated with the CFC dividend. Where the CFC’s local income taxes are high, the US individual shareholder’s effective tax rate on their CFC income is effectively equivalent to their US individual rate plus the CFC’s effective rate. It’s not uncommon for us to see an individual effective rate exceed 70% in these cases.

The benefit that US individual CFC shareholders did receive was deferral. In other words, unless an anti-deferral regime such as Subpart F was in play, the US individual did not have to recognize the CFC income until it was actually dispersed to them via dividend or otherwise. Further, if the CFC’s local income tax was a low amount, the increase in their overall effective tax rate for taxes not creditable under IRC §901 may have been worth it if deferral had true economic value to them.

Tax Reform Changes

The aforementioned CFC tax regime has significantly changed under the Act. Here are the major changes affecting individuals:

No Transition Tax Relief

IRC §965 requires the inclusion in income for all CFC shareholders of the CFC’s previously untaxed earnings and profits (“E&P”). The Act offered corporate CFC shareholders a reduced transition tax rate to cushion the blow of this unanticipated income inclusion but no such rate forbearance was offered to individual CFC shareholders. They took their inclusion at their regular individual tax rates.

No Participation Exemption

IRC §245A provides a full participation exemption, also referred to as dividends received deduction (“DRD”), for certain dividends received by a US C corporation from a CFC. However, US individuals who own CFC shares are not eligible for this participation exemption. CFC dividends received by individuals remain taxable either as qualified or non-qualified dividends at higher individual rates.

No GILTI Tax Reduction

The Act added IRC §951A which requires a USS to include in their US taxable income their pro-rata share of the CFC’s Global Intangible Low-Taxed Income (“GILTI”) which is treated, basically, as Subpart F income.

The GILTI calculation is complex by any measure. Quite basically, GILTI is the excess of a USS’s pro-rata share of a CFC’s income reduced by an allowable return equal to 10% of the CFC’s adjusted tax basis in certain depreciable tangible property. US corporate CFC shareholders are given a 50% deduction via newly enacted IRC §250 against any GILTI inclusion and can, subject to certain limits, credit IRC §902 taxes paid by the CFC to offset the US tax resulting from the GILTI inclusion.

Individual shareholders of CFCs are not eligible for either of these benefits afforded to corporate shareholders. Instead, they are subject to US tax at their individual income tax rates up to 37% on their GILTI inclusions without any foreign tax credit offsets. It is certainly a bitter pill for US individual CFC shareholders who engaged in sophisticated and expensive international tax planning to avoid Subpart F income only to be hit with similarly taxed GILTI inclusions.

The following example illustrates the disparate impact of the GILTI regime on an individual CFC shareholder who is also a USS. Assume a CFC operates an active services business in a jurisdiction that imposes a 30% income tax rate. The CFC has no tangible depreciable assets and generates $100 of net taxable income annually that is not otherwise classified as Subpart F income. The following graphic compares the tax consequences to a US corporate shareholder to those of an US individual shareholder:

	C Corporation USS of a CFC	Individual USS of a CFC
GILTI inclusion (IRC §951A)	$100	$100
50% Deduction (IRC §250)	$50	N/A
US Taxable Income	$50	$100
Foreign Income Tax (30%)	$30	$30
US Pre-Credit Tax	$10.5 (21% x $50)	$25.9 (37% x $70)
US Foreign Tax Credit	$24 IRC §960(d) 80% FTC limit	$0 No IRC §902 Credits
US Tax Liability	$0	$25.9
GILTI Effective Tax Rate	30% No GILTI FTC Carryforward	55.9%

Corporate CFC shareholders who utilize foreign tax credits to offset their GILTI tax expense are not only limited by the 80% IRC §960(d) limitation but also the inability to carryforward or carryback GILTI basket foreign tax credits. However, the IRC §78 gross-up still applies to 100% of the foreign tax expense. Even with these limitations, corporate shareholders get a much better deal than individual shareholders under the GILTI rules as a whole.

No FDII Benefits

The Act introduced, via IRC §250(a), the Foreign Derived Intangible Income (“FDII”) regime which provides C corporations with export sales important new tax benefits. These export benefits provide a reduced US tax rate on income attributable to intangible assets owned within the US in a similar manner to how the GILTI rules create income inclusions for the same activities conducted offshore. For a detailed description of the FDII rules, please see this recent article we authored on this topic.

The FDII rules were theoretically intended to provide tax benefits to offset the impact of GILTI inclusions. The result is a new benefit to US C corporations for using US 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. It’s all good but it does not apply to individuals, S Corps, or partnerships. As a result, individuals take a harder hit from the GILTI rules with no corresponding relief from the FDII regime.

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Planning Options

For a US individual with existing or planned CFC ownership, there are various options available to mitigate some of these new provisions but each involves different steps with different side effects. We continue to see new options arise depending on the facts and circumstances of each particular taxpayer but here are some of the most common planning options we’ve been using thus far:

Contribute CFC Shares to a C Corporation

The logic here is easy enough to understand. Once the CFC shares are held by the C corporation, the corporation can utilize IRC §902 credits for taxes paid by the CFC, use offsets to the GILTI provisions provided under IRC §250 and elsewhere, and utilize the FDII regime. However, double taxation still occurs to the individual shareholder and there can be considerable complexity and costs in restructuring the CFC’s ownership chain.

Making an Annual IRC §962 Election

An IRC §962 election is a rarely utilized election employed to ensure that an individual taxpayer is not subject to a higher rate of tax on the earnings of a foreign corporation than if he or she had owned it through a US C corporation. This is an annual election with respect to all CFCs for which the individual is a USS including those owned through a pass-through entity.

The primary benefits of this election are that it provides a 21% corporate tax rate on any GILTI or Subpart F inclusion as well as allowing the use of IRC §902 credits. The individual taxpayer also does not have to endure the administrative burden of actually creating a C corporation holding structure for the CFC(s). However, in addition to having to make an annual election, the election does not allow the taxpayer to take the GILTI IRC §250 deduction or utilize the FDII export incentive regime.

Check-The-Box / Disregarded Entity Election

The taxpayer may also solve many of the problems created by the Act by using the now commonly exercised tool of a CFC check-the-box or disregarded entity election. This changes the CFC into a disregarded entity or foreign branch for US tax purposes while leaving it unchanged for local country purposes.

This has long been an instrument for individuals invested either directly or indirectly, via S corporations or partnerships, in a CFC. The primary benefits have been to allow individuals to benefit foreign tax losses in the US and to convert IRC §902 taxes into creditable IRC §901 taxes thus significantly reducing their individual tax burden on foreign earnings. Now, however, a disregarded entity election also allows the US individual shareholder to escape both GILTI and Subpart F inclusions

Prior to the Act, the main downside of a disregarded entity election by an individual was that it eliminated foreign deferral via the CFC. The conversion of a CFC to a disregarded entity could also be very expensive due to rules around CFC conversion. Most of the expense and complexity are due to a disregarded entity election being treated the same as a CFC liquidation.

US individuals may not use IRC §332 to effectuate a tax-free CFC liquidation. Instead, they must rely on IRC §331 where a liquidating distribution is considered to be full payment in exchange for the shareholder’s stock rather than a deemed dividend distribution. These shareholders generally recognize gain or loss in an amount equal to the difference between the fair market value (“FMV”) of the assets received, whether they are cash, other property, or both, and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholder’s hands, the transaction qualifies for capital gain or loss treatment. The detailed tax effects of an IRC §331 CFC liquidation are outside the scope of this document but they are important and must be addressed thoroughly as part of any related analysis.

For a corporate USS, IRC §332 will generally apply to provide tax-free treatment but IRC §367(b) steps in and requires that the liquidating corporate USS include, as a deemed dividend, the CFC’s “all earnings and profits” amount (“All E&P Amount”) with respect to the CFC. The All E&P Amount generally is the corporate USS’s pro rata share of the CFC’s E&P accumulated during the USS’s holding period.

What’s important to note here is that the corporate USS’s All E&P Amount is reduced by E&P attributable to previously taxed income (“PTI”). The CFC’s E&P subject to the IRC §965 transition tax distribution, which is likely now in the past, becomes PTI. A corporate USS’s PTI amount resulting from the transition tax will likely equal the shareholder’s All E&P Amount and therefore reduce the required All E&P Amount inclusion to $0. If the All E&P Amount is $0, the disregarded entity election will not trigger any incremental US income tax to the electing corporate shareholder.

Here, we may actually have an instance where the IRC §965 transition tax, likely already incurred by the corporate shareholder, will serve to greatly reduce the cost of a disregarded entity election by making the deemed liquidation much less expensive. It’s an unusual situation for sure but one that allows a low-tax way for corporate USS’s to escape GILTI and Subpart F inclusions.

Here again we have another distinct advantage provided to corporate CFC shareholders but not individuals.

Here is a basic example of how CFC earnings are taxed to corporate, individual, and individual assuming the CFC is now treated as a disregarded entity:

	C Corporation USS of a CFC	Individual USS of a CFC	Individual Shareholder of a Disregarded Entity
Foreign Entity Income	$100 Dividend	$100 Dividend	$100 Pass-Through Earnings
Foreign Income Tax (assumed 30%)	$30	$30	$30
US Pre-Credit Tax	$21 (21% x $100)	$25.9 (37% x $70)	$37 (37% x $100)
US Foreign Tax Credit	$30	$0 No IRC §902 Credits	$30
US Tax Liability	$0	$25.9	$7
Effective Tax Rate	30% Possible FTC Carryforward	55.9%	37%
Tax on $70 Corporate Dividend to Individual Shareholder	$16.7 (23.8% x $70)	$0	$0
Post- Distribution Effective Tax Rate	46.7%	55.9%	37%

Conclusion

The US tax reform rules are certainly not advantaged to individuals as originally enacted. There is certainly the possibility that the Act will be amended to balance the negative effect on individual CFC shareholders but there is no guarantee. In the interim, there are some planning tools that the taxpayer can utilize to offset the negative impact of these new rules. This is not and is not intended to be an exhaustive list of each planning opportunity that we see or that we will see. What each shareholder should do depends upon a detailed analysis of the taxpayer’s unique facts coupled with sophisticated modeling to confirm the planning benefits. Anything short of that is likely to fail in some regard.

We’ve authored other articles on GILTI that you may find helpful by clicking here.

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.

Beware of GILTI Basis Adjustments

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

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.

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

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

Frank J. 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.

Learn More about FJV’s Transfer Pricing Practice by Clicking Here

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.

Learn More About FJV’s International Tax Practice By Clicking Here

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.