United States: Transfer Pricing Times: U.S. Issues Guidance To Taxpayers On Revised Interest Deductibility Limitations

In this edition: the U.S. Department of the Treasury and the Internal Revenue Service issued Notice 2018-28 to provide additional guidance to taxpayers on the interest deductibility limitations; the German patent box block rule is connected with recent U.S. tax reform; the Internal Revenue Service issued the Announcement and Report Concerning Advance Pricing Agreements; the OECD released new Transfer Pricing Country Profiles; the Australian Taxation Office released Draft Practical Compliance Guidance PCG 2018/D2; and the Japan National Tax Agency ("NTA") released the Revised Commissioner's Directive on the Operation of Transfer Pricing.

U.S. Issues Guidance to Taxpayers on Revised Interest Deductibility Limitations

On April 2, 2018, the U.S. Department of the Treasury ("Treasury") and the Internal Revenue Service ("IRS") issued Notice 2018-28 (the "Notice") to provide additional guidance to taxpayers on the interest deductibility limitations under Section 163(j) until more comprehensive guidance and regulations are issued.

Section 163(j) was amended as part of the U.S. tax reform passed on December 22, 2017 (the "Act," P.L. 115-97). The amendments to Section 163(j) limit net interest expense deductions to 30 percent of the taxpayer's adjusted taxable income, with no specified leverage (e.g., debt-to-equity) threshold requirements.

The Notice clarifies several important aspects of the amendment, some of which are highlighted below.

  • Consolidated Groups:  The Notice clarifies that Section 163(j) applies at the consolidated tax return filing level and therefore, intercompany obligations between entities filing a consolidated return will not be a factor for purposes of determining the limitation. The Notice states that forthcoming regulations will address other issues such as the allocation of the deduction limitation among members of the consolidated group, the treatment of disallowed interest deduction carryforwards when a member joins or leaves the group, stock basis adjustments resulting from the deduction limitation, and the application of Section 163(j) when one or more members of a group conducts a trade or business, which may be exempt from Section 163(j). 
  • Disallowed Interest Carryforward:  The Notice clarifies that taxpayers may carry forward previously disallowed interest under former Section 163(j). Disallowed interest can be carried forward to the taxpayer's first taxable year that begins after December 31, 2017. Any interest carried forward will be subject to Section 163(j) as amended by the Act, as well as the base erosion alternative tax ("BEAT") provision of Section 59A. A summary of the BEAT can be found in the January 2018 edition of Transfer Pricing Times. 
  • C Corporations Business Interest:  The Notice clarifies that the definition of net business interest expense (i.e., interest included in the calculation of the limitation) will include all interest paid or accrued by a C corporation on its indebtedness and all interest that is includable in the gross income of the C corporation. This rule does not apply to S corporations, and forthcoming guidance will address the application of the rule to non-corporate entities, such as partnerships, in which a C corporation holds an interest.
  • Earnings and Profits:  The Notice states that regulations will be issued to clarify that the calculation of a corporation's annual earnings and profits will not be affected by the disallowance and carryforward of a deduction under Section 163(j) as amended by the Act.
  • Partnerships and S Corporations Business Interest:  The Notice clarifies that for the purposes of calculating a partner's annual deduction for business interest under Section 163(j), a partner can only include its allocable share of the partnership's business interest income to the extent it exceeds the partnership's business interest expense. Regulations will be issued to prevent double counting of business interest income at the partner and partnership levels.

Interconnection Between German Patent Box Blocker Rules and U.S. Tax Reform

At the beginning of 2018, a new "patent box blocker rule" ("Lizenzschranke") came into force in Germany. Section 4j of the German income tax act stipulates that royalties paid by a German taxpayer to a foreign related party are only partially deductible for tax purposes, if the foreign entity is subject to a "preferential tax regime" (e.g., a patent box). If a foreign preferential regime for such royalty income leads to an effective taxation of less than 25 percent, then this rule is triggered. Under the rule, the percentage of non-deductibility increases gradually, depending on the effective tax rate of the foreign recipient of the royalty payment, which could lead to total non-deductibility if the tax rate is zero.

There is one exception to the rule, which refers to the OECD's nexus approach (found in the 2015 Report on Action 5 Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance). Under this exception, a preferential regime compliant with the OECD nexus approach would not trigger the German patent box blocker rule.

The recent U.S. tax reform known as the Tax Cuts and Jobs Act led to the introduction of a Foreign Derived Intangible Income ("FDII") deduction, which in part, resembles patent box regimes found in other jurisdictions. Although some U.S. Treasury officials hold that FDII is "BEPS compliant," it does not appear to contain any nexus requirement. As such, royalties paid by German taxpayers to U.S. entities which are able to claim a FDII deduction, could be in the scope of the German patent box blocker rule. As of now, there is no clear guidance on this matter from the German Federal Ministry of Finance, and the opinions in professional literature differ vastly. Some hold that the term "preferential regime" should be defined very narrowly, as to only include patent boxes, whereas others believe the FDII deduction would lead to an application of the German patent box blocker rule.

Taxpayers should monitor this issue as more guidance becomes available.

IRS Releases Annual APA Report

On March 30, 2018, the IRS issued the Announcement and Report Concerning Advance Pricing Agreements (the "Report") pursuant to § 521(b) of Pub. L. 106-170. Key findings of the report include the following:

  • The median time required to complete an advance pricing agreement ("APA") increased slightly from 32.8 months in 2016 to 33.8 months in 2017. New APAs took nearly four years, at the median, to reach execution while renewal APAs took just under 2 years to be executed at the median.
  • The IRS executed 116 APAs in 2017, up by 30 from the prior year. This represents the highest number of executed APAs in a single since 2013. Of the 116 executed agreements in 2017, 30 were unilateral, 85 were bilateral and 1 was multilateral.
  • Consistent with prior years, the majority of the executed bilateral APAs in 2017 involved the United States entering into mutual agreements with Japan (57 percent), Canada (16 percent), and Korea (9 percent) and involved taxpayers in the following industries: manufacturing (41 percent), wholesale / retail trade (37 percent), and services (10 percent).
  • The primary transfer pricing method used for both the sale of tangible property and use of intangible property was the Comparable Profits Method ("CPM") / Transactional Net Margin Method ("TNMM"). The CPM / TNMM accounted for 87 percent of all transfer pricing methods used, with the operating margin being the most common profit level indicator used to benchmark results.

OECD: Updated Country Profiles

On April 9, 2018, the OECD released new Transfer Pricing Country Profiles for Australia, China, Estonia, France, Georgia, Hungary, India, Israel, Liechtenstein, Norway, Poland, Portugal, Sweden and Uruguay. OECD Transfer Pricing Country Profiles serve as a resource for taxpayers and practitioners seeking to understand the key transfer pricing rules for a given jurisdiction including whether the country has adopted the arm's length principle and how each country's rules adhere to the OECD Transfer Pricing Guidelines more generally.

Profiles for Belgium and Russia have also been updated to reflect revisions to (1) Transfer Pricing Guidelines resulting from the 2015 Reports on Actions 8-10 Aligning Transfer Pricing Outcomes with Value Creation and (2) Action 13 Transfer Pricing Documentation and Country-by-Country Reporting of the OECD/G20 Project on Base Erosion and Profit Shifting.

Now, country profiles available for 44 countries with upcoming profiles to be released include Argentina, Chile, Finland, Greece, Iceland, Italy, Korea, South Africa and Turkey.

For more information, see the OECD's Press Release.

Further Guidance Issued on Australia's New Diverted Profits Tax

In February 2018, the Australian Taxation Office ("ATO") released Draft Practical Compliance Guidance PCG 2018/D2 ("PCG 2018/D2") in relation to their application of Australia's Diverted Profits Tax ("DPT"). Although this guidance is, at this stage, only in draft, based on prior experience it is expected that the final guidance will be consistent with this draft version.

The DPT is designed to ensure that Significant Global Entities ("SGE") – defined for Australian tax purposes as multinationals with a global turnover in any year in excess of A$1 billion – pay tax in Australia that properly reflects the economic substance of their activities in Australia and that they do not reduce the amount of tax paid in Australia by diverting profits offshore through arrangements with related parties. It also encourages SGEs to provide sufficient information to the ATO to allow for the timely resolution of tax disputes, providing the ATO with the power to effectively issue default assessments (at a tax rate of 40%, payable upfront) in situations where the ATO is of the view that taxes are diverted offshore but information has not been forthcoming from the taxpayer (or its foreign affiliates) to enable a complete assessment to take place. Once issued, the onus of proof rests with the taxpayer to disprove the ATO's position in Court in order to get the tax paid refunded. The DPT applies to income years commencing on or after July 1, 2017 and applies to schemes or arrangements commenced before that time that continue to apply income years commencing on or after July 1, 2017 – in other words, there is no "grandfathering" clause. Also, as the DPT is an anti-avoidance measure, it is not covered by Australia's double tax agreements and therefore an assessment may result in actual double taxation for the taxpayer.

PCG 2018/D2 provides significant insight into the processes that the ATO expects to undertake in assessing taxpayers' DPT risks. The document is thirty-two pages long and provides a multitude of non-exhaustive lists and suggestions for taxpayers to consider as well as ten hypothetical examples to provide further clarification. The ATO provides details as to the key questions that it will pose in undertaking a preliminary DPT risk assessment as well as the issues it will explore in considering the principal purpose of the arrangement(s) under review and in applying the sufficient foreign tax and sufficient economic substance components of the DPT legislation. PCG 2018/D2 also discusses the taxpayers' ability to seek either an advanced pricing agreement or private binding ruling in relation to the arrangement(s) to mitigate its risks.

It is expected that in the first few years the ATO will dedicate significant resources into policing the DPT. However, the ultimate goal of the legislation is that taxpayers will, voluntarily, start to self-regulate and either eliminate inappropriate transactions or ensure that the tax payable on the affected transactions is appropriately attributed between Australia and the overseas jurisdiction. We suggest that the DPT will be a significant compliance issue for SGEs that operate in Australia for the next 3-5 years that it should (and must) be given the appropriate level of attention by taxpayers.

Japan Revises Administrative Guidelines for Low Value-Adding Intra-Group Services and APA Procedures

The Japan National Tax Agency ("NTA") released the Revised Commissioner's Directive on the Operation of Transfer Pricing (the "Revised Administrative Guidelines") on February 23, 2018 to Japan's transfer pricing rules with the OECD's recommendations outlined in the 2015 Reports on Actions 8-10 Aligning Transfer Pricing Outcomes with Value Creation. Some of the highlights are addressed below.

Safe-harbor threshold for intra-group services

The Revised Administrative Guidelines state that a five percent mark-up can be applied for low value-adding intra-group services in certain circumstances. For example, the low value-adding services cannot involve intangibles, significant risk, R&D, and certain other activities or certain industries.

In addition, the Revised Administration Guidelines give additional comments on shareholder activities which cannot give rise to a service charge (e.g., the costs incurred in relation to the coordination of a Country-by-Country Report prepared by the parent entity).

The introduction of a safe-harbor mark-up for low value-adding services is generally a positive step to minimize compliance costs for multinationals in Japan, although the scope of the safe-harbor is still rather limited.

Detailed guidance on the APA regime

Further, the Revised Administrative Guidelines provide some changes to the APA regime in Japan, including:

  • The tax examiner can still perform tax audits for the years that would be covered by the APA while the APA is still under the review process;
  • The APA applicant needs to provide the information requested by NTA within the timeline set by the APA review officer, which shall not exceed 45 days from the information request date.
  • NTA should arrange a pre-filing consultation with APA applicants; and
  • NTA may suspend the review of bilateral APA applications in certain cases.

In general, these revisions to the APA process provides welcome greater clarity, and should be considered carefully by actual and potential applicants.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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