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New Transfer Pricing Opportunities in the COVID Environment

by

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  An existing and unmodified transfer pricing plan is now likely materially incorrect and almost instantly out of date.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

by

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.

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.

 

 

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

by

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.

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Transfer Pricing Methods

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

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

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

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

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Documentation Requirements & Penalties

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

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

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

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

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

Conclusion

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

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

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

 

Why is Personal Goodwill Good for Closely Held Corporation Shareholders?

by

 

Frank J. Vari, JD, MTax, CPA

Personal Goodwill is a popular planning tool for sellers of closely held C Corporations.  This timely article explains this often misunderstood and improperly applied tax planning technique.

In our practice, we see a number of closely held C corporations with shareholders either actively looking to sell and/or examining the possibilities of selling their business.[1]  Many of these shareholders are actively engaged in these businesses and many have been so engaged for long periods of time.  These businesses include, but are not limited to, legal and CPA practices, insurance agencies, medical practices, and other similar entities where the shareholder’s relationships are integral to the business and customer relationships.

What we also see are a potential buyer’s general avoidance of closely held C corporation share purchases largely for tax reasons.[2]  The buyer’s primary tax reason is often goodwill.[3]  As an asset buyer, they will enjoy the tax amortizable goodwill generally resulting from an asset purchase.

For the seller, a C corporation share sale allows them to enjoy lower preferential capital gain tax rates.  On the other hand, an asset sale results in double taxation.  The asset sale proceeds are first taxed at the C corporation level and again at the individual shareholder level when the sale proceeds are distributed.  However, in practice, a C corporation share buyer can be difficult to find which forces sellers to look for ways to lower their tax bill.

For the C corporation shareholder facing a corporate asset sale and the selling shareholder has a strong relationship with his or her customers forming the basis of the business itself, attributing goodwill to the shareholder instead of the business may result in substantial tax savings to the seller.  In essence, the buyer is making two separate purchases.  First, the assets of the business are purchased from the C corporation and, second, the personal goodwill from the shareholder.

The concept that personal goodwill is a separate transferable asset in a corporate asset sale is not new or terribly unique.[4]  In general, to establish personal goodwill, one must support the premise that the goodwill’s value is attributable to the continued presence and/or abilities of a certain person and that this person is the legal owner of this goodwill and, as such, is the only person who can sell or transfer it.  The taxpayer must successfully demonstrate that the value of their personal relationships was far more valuable than the business entity itself without them.  If you envision a long time CPA practice with one primary member who built and sustained the practice you can see where this is quite often the case.

The primary issue with using personal goodwill as part of a business asset sale is that it relies almost exclusively on facts and circumstances.  This means that all relevant facts must be understood and addressed under the prism of tax case law and that the transaction must be supported by adequate supporting documentation in order to withstand audit.  Make no mistake, these transactions are quite frequently audited and the IRS is often successful when favorable facts, misapplied law, and adequate documentation are lacking.

As far as facts and circumstances, the IRS places the burden of proof on the taxpayer to demonstrate the valid separation of corporate goodwill from individual goodwill.  How, in general is this done?  In the seminal case of Martin Ice Cream v. Commissioner[5], the selling shareholder of an ice cream distributor successfully claimed that he had built his distribution business on the foundations of his personal relationships with supermarket owners and, further, that his relationships were still considerably valuable to the business at the time of sale.  One very key fact in Martin was that the selling shareholder had never transferred his personal goodwill to the corporation via an employment agreement or covenant not to compete.  That was, and is, a very significant fact (more about that later).  As a result, this personal goodwill was valued separately and was deemed to be sold separately for tax purposes.  Later cases continue to apply this same logic.

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As noted in Martin and related authority, the existence of an employment agreement or covenant not to compete agreement, or the lack therof, can significantly impact a personal goodwill analysis.[6]  These agreements can be fatal to a personal goodwill position especially where these contracts either restrict the seller’s activities outside of those benefiting the business and/or transferring their goodwill to the business itself.

In one landmark case[7], a dentist sold his C corporation practice that he had built and maintained for years.  He took the position that his personal goodwill was integral to the business and was his to sell separately to the buyer.  Points well taken, but the dentist had executed a covenant not to compete with his corporation where he was restricted from practicing with fifty miles of his corporate practice’s location.  In this case, the IRS was victorious by arguing that, by virtue of this agreement, his goodwill with his existing patients was almost nil as they would likely not travel over fifty miles to retain him as their dentist.  Even though the dentist, as sole shareholder, could have renounced this agreement prior to the sale he failed to do so.  The bottom line here is to understand all of the facts and especially any written agreements that could impact the value of personal goodwill and that a little upfront planning goes a long way.

What must a practitioner do to ensure the tax benefits of a personal goodwill sale are realized and will withstand IRS audit scrutiny?  Here are some hallmarks of a successful personal goodwill analysis:

  • Begin any personal goodwill analysis in advance of any sale discussion. This is easier said than done but trying to perform a thoughtful analysis during the timeline of negotiations is difficult and inherently dangerous particularly when the detailed analysis of historical data is required.
  • Thoroughly understand the history and the substance of the personal relationships involved in the business. Facts and circumstances are often unclear and documentation can be ambiguous.  It is absolutely essential that time and effort be taken to understand all of the facts and that they are appropriately documented.  You never want facts to come out during audit that you did not address and/or fully consider their impact.
  • Understand the authority around personal goodwill. This is especially true of authority that addresses your specific facts and circumstances that you are relying upon to support your personal goodwill position.  As with facts, you never want the IRS for any taxing authority to outline negative authority that you’ve not previously evaluated.
  • Discover and understand any existing legal agreements, written, oral, or otherwise that impact the position that the shareholder’s personal goodwill belongs exclusively to them and that this goodwill is a considerably valuable asset at the time of the sale. Is it possible that you need a lawyer’s opinion that the goodwill does not belong to the corporation and is exclusively the shareholder’s transferable legal property?    If you do, please proceed in that direction.
  • Have the buyer separately contract with the selling shareholder for the purchase of their personal goodwill. This contract should be as separate and distinct as possible from the corporate asset purchase and should recognize the personal goodwill as separate and distinct from any corporate goodwill.
  • Obtain a separate independent valuation of the seller’s personal goodwill. This valuation should be performed in accordance with Generally Accepted Valuation Principles and should properly measure both the value and ownership of the goodwill.
  • One should also consider performing an overall valuation of the entire business asset values including and excluding the selling shareholder’s personal goodwill. You may want to do this to ensure that the asset values support the economic value of the transaction.  For those that have performed IRC 1060 asset value allocations, one knows that although those allocations are binding on the taxpayers, they are not binding on the IRS per the longstanding Danielson[8]  This valuation can provide valuable substance to the transaction.
  • Analyze securing a covenant not to compete agreement with the buyer contemporaneous with the sale. Properly constructed, this helps support the position that the seller had a valuable asset that the business requires to maintain its value.
  • Raise the personal goodwill issue with the potential buyer early in the process. The buyer will likely need time to consider it with their advisors and its simply bad practice not to raise it if it will be the seller’s course of action.

Personal goodwill is a popular planning tool and is very effective at lowering a selling shareholder’s tax bill when the facts are right and the transaction is properly structured and supported.  Understanding these rules and practices will make sure your clients can enjoy this valuable tool with minimal risk.

[1] This may also apply to S corporation with earnings and profits or an S corporation subject to the built-in gains tax.

[2] There are also driving legal concerns particularly avoiding legacy legal issues around the selling corporation.  This is especially often true of smaller closely held corporations.

[3] Other tax reasons include a “stepped up” basis in depreciable assets and avoiding any undisclosed tax liabilities within the selling corporation.

[4] see Thompson v. Thompson , 576 So.2d 267 (Fla. 1991); Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998); Norwalk, TC Memo 1998-279.

[5] id.

[6] see Kennedy, T.C. Memo. 2010-206.

[7] Howard v. US, 106 AFTR2d 2010-5533 (DC WA, 2010).

[8] Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967); see also Peco Foods, Inc., T.C. Memo. 2012-18.

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

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Frank J. Vari, JD, MTax, CPA

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

This article was previously published by the Tax Career Digest.