In this issue: The Advance Pricing and Mutual Agreement program released its annual report and announced the introduction of a new Excel-based model which taxpayers that are seeking an Advance Pricing Agreement may be required to complete as part of the APA process; the IRS and U.S. Treasury issued proposed regulations under section 250 of the U.S. Internal Revenue Code; Canada's federal government tabled a budget that included two new measures specific to transfer pricing, reaffirmed Canada's commitment to the OECD/G20 BEPS initiative and included a fourth consecutive wave of additional funding for tax enforcement; India's Ministry of Finance issued a press release announcing the finalization of a bilateral agreement for exchange of Country-by-Country Reports between India and the United States; the Australian Taxation Office issued Practical Compliance Guideline PCG 2019/1 which addresses its transfer pricing compliance approach to inbound distributors; the Vietnam tax authority announced that it has distributed a list to its provincial tax departments of companies that should be subject to transfer pricing audit in 2019; and Duff & Phelps' Canadian Transfer Pricing practice leader, Matt Billings, spoke at the Canadian Tax Foundation's inaugural Transfer Pricing conference.
- IRS Advance Pricing and Mutual Agreement Program Releases Annual Report and Profit Split Model for Certain Taxpayers Seeking APA
- IRS and Treasury Issue Proposed FDII Regulations
- 2019 Canadian Federal Budget Includes New Transfer Pricing Measures
- India and the United States Reach an Agreement on Country-by-Country Report Sharing for Multinational Enterprises
- Final Risk Assessment Framework for Inbound Distributors in Australia
- Vietnam Kicked-Off 2019 Transfer Pricing Audits
- Canadian Tax Foundation Holds Its Inaugural Transfer Pricing Conference
IRS Advance Pricing and Mutual Agreement Program Releases Annual Report and Profit Split Model for Certain Taxpayers Seeking APA
On March 1, 2019, the Advance Pricing and Mutual Agreement ("APMA") program announced the introduction of a new Excel-based model which taxpayers that are seeking an Advance Pricing Agreement ("APA") may be required to complete as part of the APA process. Specifically, where the IRS determines that a taxpayer has two or more related entities that make "material, non-benchmarkable contributions to their intercompany arrangement", the IRS may request that the taxpayer complete this model which it refers to as the "functional cost diagnostic" model ("FCD model"). Overall, the FCD model is intended to mimic the application of a residual profit split method by requiring taxpayers to segment their cost data by function and then indicate for each function whether the activity is routine (e.g., the value is measurable by reference to benchmarks). For non-routine functions, the model capitalizes these costs according to standardized formulas based on certain assumptions (e.g., useful life). The FCD model then produces a pro forma split of residual profits or losses based on the relative contributions of capitalized non-routine costs. The IRS is careful to note that a request to complete this model does not signify that the profit split method will be selected as the best method for taxpayers. Given the existence of the new FCD model, taxpayers that are contemplating an APA that may meet the criteria for such a submission should perform sensitivity testing with this new model to determine the potential outcomes and points of contention before beginning the APA process.
Tax professionals who want the Excel workbook should e-mail a request to email@example.com and include "FCD Model Request" on the subject line.
On March 27, 2019, the APMA release its annual report on concerning APAs and the APMA program. This report shows that the volume of APA applications spiked in 2018 to 203 applications, more than doubling the 2017 application volume. While the report itself does not try to explain the significant increase in applications, Bloomberg Tax's Transfer Pricing Report cites program director John Hughes as attributing the volume increase to the increased uncertainty in the global international tax environment.
A total of 107 APAs were executed in 2018, approximately 40 percent of which were for new (rather than renewal) APAs. Japan (at 39 percent) and Canada (at 20 percent) continue to be the countries most involved in bilateral APAs with the IRS. This will likely change in the future now that the bilateral APA deals may be sought with India. The 2018 report shows that India has 20 percent of pending case volume, compared to 31 percent with Japan and only 9 percent in Canada. Executed APAs are much more likely to involve non-U.S. headquartered companies (52 percent) than U.S.-headquartered companies (22 percent). Executed APAs are most likely to involve tangible (44 percent) or service (35 percent) transactions. The CPM continues to be the dominant transfer pricing method for transactions covered in an APA (86 percent of all tangible and intangible transactions). The most typical term for executed APAs continues to be five years, although there were a significant number of APAs executed in 2018 that had terms of six to ten years (including rollback years). Executed APAs had taken an average of 3.5 years to reach completion, with bilateral APAs taking approximately one year to reach execution than unilateral APAs.
For those interested in reading this report, it can be found here.
IRS and Treasury Issue Proposed FDII Regulations
On March 4, 2019, the Internal Revenue Service and U.S. Treasury issued proposed regulations under section 250 of the U.S. Internal Revenue Code. The stated purpose of the proposed section 250 regulations is to "neutralize the role that tax considerations play when a [U.S.] domestic corporation chooses the location of intangible income attributable to foreign market activity."
The statutory calculation of the section 250 deduction through calendar year 2025 is as follows. The deduction is equal to 37.5 percent of a U.S. domestic corporation's FDII, plus 50 percent of the sum of: 1) its GILTI and 2) dividends received under section 78 attributable to GILTI. For years 2016 and later, these percentages reduce to 21.875 percent and 37.5 percent, respectively. The FDII portion of this calculation requires taxpayers to determine deduction eligible income ("DEI"), and the qualified business asset investment ("QBAI") associated with that DEI, to arrive at its deemed intangible income ("DII"). The share of DII that is determined to be "foreign derived" is the taxpayer's FDII.
The proposed section 250 regulations clarify how to compute FDII by defining its components. These proposed regulations also provide ordering rules for the impact of other factors that can limit the section 250 deduction, such as the interest limitation under section 163(j), and provide rules for partnerships, tax-exempt corporations, individuals and consolidated groups.
The proposed regulations clarify that corporations must calculate the section 250 deduction at the consolidated group level, and then allocate the deduction based on each group member's contribution to foreign derived deduction eligible income ("FDDEI") and GILTI. The proposed regulations also define FDDEI by providing the meaning of property or services sold for "foreign use". Property sold for foreign use includes, for example, tangible products sold to customers outside the U.S. and intangible property that generates revenue from foreign customers. Specific rules are provided for products sold to be manufactured abroad, and then sold back to the U.S. market. For services, the assessment for whether sales qualify for foreign use requires categorizing the services as one of four types (e.g., property services, proximate services, transportation services and general services), with specific rules applying to each.
The proposed rules for whether sales of products or services qualify as foreign use also consider related-party transactions. When a foreign related party resells product purchased from its U.S. related party, the resale must ultimately be to an unrelated party for foreign use. Similarly, when property is sold to foreign related party for it to manufacture or provide services, the taxpayer must reasonably expect that at least 80 percent of the revenue of that foreign related party will be FDDEI transactions. For services, the proposed regulations provide two tests (the "benefit test" and the "price test") to determine whether, or what portion, of services provided by foreign related parties should qualify as foreign use. These tests use specific formulas, but generally, they serve to prevent services provided to U.S. persons as counting towards FDEII.
The proposed regulations provide certain requirements regarding documentation taxpayers must maintain if they wish to claim a tax benefit from FDDEI. In order for the documentation to be relied upon, it must be obtained by the FDII filing date. These documentation requirements are associated with demonstrating that income in question is, in fact, foreign-derived (i.e. that the income is associated with transactions that were ultimately for goods and services that were for foreign use).
The proposed regulations can be found here. Any written comments on the proposed regulations must be received by the IRS by May 6, 2019.
2019 Canadian Federal Budget Includes New Transfer Pricing Measures
On March 19, 2019, federal Finance Minister Bill Morneau delivered the Liberal government's budget proposal for 2019-2020, which included two measures specific to transfer pricing. Canada's transfer pricing rules apply to transactions (or series of transactions) between Canadian taxpayers and non-resident persons with whom the taxpayer does not deal at arm's length.
The budget proposed a new measure that would place priority on applying the transfer pricing rules within section 247 of the Income Tax Act ("ITA"), before the application of any other provisions of the ITA. Unlike other provisions of the ITA, the transfer pricing rules specifically embody the arm's length pricing principle, and lead to automatic consideration of penalties if transfer prices are eventually adjusted beyond certain size thresholds. If that size threshold is exceeded, then exemption from transfer pricing penalties requires the taxpayer to demonstrate it had made "reasonable efforts" to determine and use arm's length prices, including by preparing contemporaneous documentation.
The new ordering rule could lead to more tax audit adjustments being made through the transfer pricing provisions, potentially leading to greater exposure to transfer pricing penalties, and increasing the importance of maintaining contemporaneous transfer pricing documentation reports.
This provision would apply to tax years beginning on or after March 19, 2019.
Expanded Definition of "Transaction", for Purposes of Extended Reassessment Periods
The second measure proposed to change the definition of the word "transaction", within a provision of the ITA that determines if additional tax years remain open for reassessment, in a way that would allow the longer reassessment period to apply to a broader range of scenarios. For a corporate taxpayer, the normal reassessment period typically ends either three or four years after receiving a notice of assessment for a given tax year. An extended reassessment period, three more years, is allowed for tax reassessments arising because of certain types of international transactions.
The transfer pricing rules within section 247 define "transaction" broadly, including "an arrangement or event". The Budget proposed revisions to the ITA such that this broader definition of "transaction" would also be used for purposes of the extended reassessment period. This could make it more likely that the extended reassessment period applies to arrangements involving a Canadian taxpayer and an arm's length counterparty, if a foreign non-arm's length counterparty is also involved.
This change would apply to taxation years for which the normal reassessment period ends on or after March 19, 2019.
A more in-depth analysis of the transfer pricing implications of the abovementioned measures can be found here.
India and the United States Reach an Agreement on Country-by-Country Report Sharing for Multinational Enterprises
On March 15, 2019, India's Ministry of Finance ("MOF") issued a press release announcing the finalization of a bilateral agreement for exchange of Country-by-Country ("CbC") Reports between India and the United States (U.S.).
Sub-section 4 of Section 286 of the Income-tax Act, 1961 ("the Act") requires that a constituent entity of an international group, resident in India (other than a parent entity or an alternate reporting entity of an international group, resident in India), shall furnish the CbC Report in respect of the said international if the parent entity of the said international group is resident of a country or territory:
- Where the parent entity is not obligated to file the CbC Report;
- With which India does not have an agreement provided for exchange of the CbC Report; or
- Where there has been a systemic failure of the country or territory and the said failure has been intimated by the prescribed authority to such constituent entity.
Prior to this agreement, taxpayers were faced with the possibility of local filing of the CbC Report in both India and the U.S. However, this agreement along with an underlying Inter-Governmental Agreement, have now been finalized and will be signed on or before March 31, 2019. These agreements enable India and the U.S. to exchange CbC Reports filed by the ultimate parent entities of international groups in the respective jurisdictions, pertaining to the financial years beginning on or after January 1, 2016. As a result, Indian constituent entities of U.S. headquartered groups, which have already filed CbC Reports in the U.S., would not be required to file the CbC Reports of their international groups in India.
A full copy of the press release from India's MOF can be found here.
Final Risk Assessment Framework for Inbound Distributors in Australia
The Australian Taxation Office ("ATO") has now issued Practical Compliance Guideline PCG 2019/1 ("PCG 2019/1") which addresses its transfer pricing compliance approach to inbound distributors. "Inbound distributors" are multinational entities involved in the distribution of both tangible goods purchased from foreign related parties or digital products or services where the intellectual property in those products or services is owned by foreign related parties. PCG 2019/1 replaces the draft guidance in PCG 2018/D8 issued late last year.
PCG 2019/1 is similar to PCG 2018/D8 with only minimal changes being made to the guidance following public consultation. In particular, the risk-ratings and profit-markers for the various types of distribution activities identified in PCG 2018/D8 have not changed. The ATO has released PCG 2019/1EC as a compendium to the risk assessment guidance that addresses the issues raised as part of the public consultation and the ATO's assessment of those comments. PCG 2019/1 applies to all inbound distributors except (i) small distributors eligible for application of the Simplified Transfer Pricing Record Keeping rules provided in PCG 2017/2; or (ii) companies which have their transfer pricing arrangements covered under Advanced Pricing Agreements ("APAs"), decided upon via an ATO settlement, a court or Administrative Appeals Tribunal decision, or where the ATO has previously reviewed and considered the arrangement as low risk.
PCG 2019/1 can be summarized as follows:
- The ATO's profit-markers are identified from its internal benchmarking analysis (which will not be made public). They determine the prima facie risk profile of inbound distributors. The profit-markers are calculated using a earnings before interest and tax ("EBIT") margin calculated over a five-year period;
- The ATO provides a general distributor range of profit-markers as well as industry specific markers for life sciences companies, information and communication technology companies ("ICT"), and motor vehicle importers. Significantly, the guidance provides different risk-rating ranges for various levels of activity and intensity in the local life sciences and ICT companies operations. The definitions of these various categories of inbound distributors remain loosely defined and will no doubt be contentious.
- General distributors earning an EBIT margin below 2.1% will be considered high risk. High-risk distributors are likely to be the subject of an investigation and the ATO has stated it will prioritize the review of taxpayers that have an average loss over the preceding three-years.
- However, the ATO notes that a high-risk rating "does not necessarily mean that your inbound distribution arrangements fail to comply with Australia's transfer pricing rules." That said, the onus is clearly on the taxpayer to prove that its financial results are arm's length outcomes.
- Although the profit-markers enable taxpayers to self-assess their transfer pricing risk, the ATO states that they should not be viewed as a set of transfer pricing safe harbours and that low-risk taxpayers should not reduce their profits over time back to the minimum low-risk level.
- Returning a low or medium risk-rating does not alleviate the taxpayer from its compliance obligations and particularly the need for taxpayers to prepare documentation to evidence their compliance with the Australian transfer pricing rules.
- The ATO acknowledges that some taxpayers may wish to transition their arrangements to the green-zone and provides some "voluntary disclosure concessions" in relation to such arrangements: however, in such situations the ATO is looking for prior-period adjustments to be made.
- The ATO is encouraging all inbound distributors (irrespective of their risk-rating) to enter into APA discussions.
Electronic versions of PCG 2019/1 and the link to PCG 2019/1EC can be found here.
Vietnam Kicked-Off 2019 Transfer Pricing Audits
The Vietnam tax authority has recently announced that it has distributed a list to its provincial tax departments of companies that should be subject to transfer pricing audit in 2019 – refer Decision No. 133/QĐ-TCT and Decision No. 134/QĐ-TCT of General Department of Taxation. Although the names of the companies identified have not been made available, the existence of the list is public knowledge. This announcement indicates that increased transfer pricing compliance activity is imminent in Vietnam.
New transfer pricing regulations, specifically Circular 41/2017/TT-BTC ("Circular 41") and Decree No. 20/2017/NĐ-CP ("Decree 20"), were introduced – with effect from May 1, 2017 – to combat transfer pricing and the loss of tax revenue in the state budget. These new regulations require taxpayers with related party transactions to comply with new annual contemporaneous documentation and documentation requirements, consisting of:
- Transfer Pricing Forms 01, 02 and 03, to be submitted together with the annual corporate income tax (CIT) return;
- The localized Master file (with summarized content in Form 02);
- The Local file (with summarized content in Form 03); and
- The Country-by-Country (CbC) Report (similar to Form 04). If a taxpayer is unable to obtain a copy of the group CbC Report from their ultimate parent company, the taxpayer must formally explain the reasons why it cannot obtain that Report from its parent entity to the Vietnam tax authority.
The three-tiered documentation should be prepared prior to the submission of the taxpayer's corporate income tax return as any request for that documentation in an audit situation must be satisfied within 15 working days of the request. It is therefore imperative that taxpayers have their transfer pricing documentation in place prior to receiving any audit notification.
Given these new reporting obligations and the expected increase in transfer pricing audit activity in Vietnam, it is recommended that multinational taxpayers proactively review their local transfer pricing positions, understand their documentation and compliance obligations and ensure that they have the processes in place to manage their transfer pricing risks.
Canadian Tax Foundation Holds Its Inaugural Transfer Pricing Conference
On March 27, 2019 in Toronto, the Canadian Tax Foundation (CTF) hosted its inaugural Transfer Pricing Conference, which brought together experts and delegates from diverse fields of practice, including law firms, professional services firms, multinational taxpayers, the Canada Revenue Agency ("CRA") and the Organisation for Economic Co-operation and Development ("OECD"). The morning panel featured Duff & Phelps' Canadian transfer pricing leader, Matt Billings, alongside representatives from the CRA, law firms, industry and the Tax Court of Canada.
The format of the conference allowed for discussion and debate, which served to highlight certain different perspectives held by tax administrations as compared to tax advisors. Topics included:
- To what extent certain OECD Base Erosion Profit Shifting ("BEPS") measures are consistent with Canadian transfer pricing law, especially example 16 from the July 2017 OECD Guidelines with respect to intellectual property transactions;
- Whether any apparent deviations from the arm's length standard within the BEPS initiatives effectively reintroduce notions such as formulary apportionment;
- Updates on Canada's administrative programs and their effectiveness;
- The mechanics and advantages of various dispute resolution procedures;
- Tax court developments, including the introduction of expert witness "hot-tubbing";
- How transfer pricing litigation differs from other tax litigation;
- Valuation methods for "hard-to-value" intangibles, including the use of hindsight (and whether there are any "easy-to-value" intangibles); and
- Tax challenges specific to the digital economy, and related developments in international policy.
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.