Planning options in today’s transfer pricing environment · Page 6 Planning options in today’s transfer pricing environment GILTI US shareholders of any controlled foreign corporation

Planning options in today’s transfer pricing environment

TP/Supply Chain implications of US Tax

Cuts and Job Act

1 March 2018

Page 1 Planning options in today’s transfer pricing environment

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not provide tax advice to any taxpayer because it does not take into account any specific taxpayer’s

facts and circumstances.

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as accounting advice.


Agenda

► Key Tax Cut and Jobs Act (TCJA) provisions impacting

transfer pricing

► Global intangible low-taxed income (GILTI)

► Base erosion anti-abuse tax (BEAT)

► Foreign derived intangible income (FDII)

► Limitations on income shifting through intangible property (IP)

transfers

► Planning considerations:

► Planning considerations for flows

► Planning considerations for common operating models

► Conclusion


Presenters

Bill Macey

Principal – Transfer Pricing

Ernst & Young LLP

Direct: +1 713 750 1283

[email protected]

Michael Masciangelo

Partner – International Tax Services

Ernst & Young LLP

Direct: +1 713 750 5232

[email protected]


Key provisions impacting transfer pricing


Key provisions impacting transfer pricing

► Anti-deferral:

► Global intangible low-taxed income (GILTI)

► Anti-base erosion:

► Base erosion anti-abuse tax (BEAT)

► Export incentive:

► Foreign derived intangible income (FDII)

► Limitations on income shifting through IP transfers:

► New definition of intangible property (IP)

► Aggregation

► Codification of options realistically available


GILTI

► US shareholders of any controlled foreign corporation (CFC) must

include in current income their GILTI.

► GILTI is the excess of US shareholder’s net CFC tested income over

the shareholder’s net deemed tangible income return.

► Net deemed tangible income return is 10% of shareholder’s pro rata

share of qualified business asset investment (QBAI) less interest

expense:

► GILTI = Net CFC tested income – (10% * QBAI – Interest expense)

► QBAI = Book value

► Deemed-paid credit is 80% of foreign taxes paid on GILTI (however

taxed on 100% of the grossup).


GILTI

► GILTI implications/observations:

► Changes cost/benefit calculation of location of functions, assets

and risks:

► As a stand-alone matter, makes the US relatively more attractive:

► Note, however, important interactions with FDII deduction, GILTI deduction

and BEAT – location decisions subject to facts and circumstances

► There are several considerations that affect cost/benefit calculation,

including:

► Current location of IP and, if foreign, applicable tax rate

► Degree of alignment between IP location and the supply chain

► Implications for future movements of IP

► Note that increasing QBAI at foreign affiliates may decrease GILTI:

► Depends on actual returns to QBAI property

► GILTI inclusion will be nil if net deemed tangible income return (10%*QBAI)

less interest expense exceeds aggregate net tested income


BEAT

► Applicable taxpayers required to pay a tax equal to the base erosion

minimum tax amount (BEMTA), which is the excess of a percentage of the

modified taxable income of the taxpayer over the taxpayer’s regular tax

liability reduced by certain credits

► Modified taxable income is taxable income without regard to any base erosion tax

benefit with respect to any base erosion payment.

► Base erosion payments are payments paid or accrued to a foreign related party:

► Included:

► Payments for services (subject to exclusion noted below)

► Payments for royalties

► Payments for interest

► Not included:

► Payments for cost of goods sold (COGS)

► Payments for services that meet the requirements of Treas. Reg. Sec. 1.482-9(b),

without regard to the fundamental success or failure test and only to the extent of the

cost component


BEAT

► Implications/observations of BEAT:

► For BEAT to apply, will require significant related-party payments

to foreign affiliates

► If BEAT applies, makes payments for certain services, royalties,

interest to foreign related parties more expensive

► Applies to both US- and non-US-parented groups

► Need to look at taxpayers’ classification of, and payment for,

services:

► Eligible for services cost method (SCM) or not?

► Separate invoices for services charged at cost and those with a

markup:

► Especially when third-party (pass-through) costs are included


BEAT

► For services with a markup, it is unclear whether cost plus the

markup, or just the markup, is covered by BEAT.

► Third-party (pass-through) costs are covered as BEAT eligible if not

under the SCM.

► The 3% threshold is a cliff:

► Incremental cost of going over 3% threshold is very high.

► Or, alternatively, the incremental benefit from going under 3% is also very

high.

► BEAT calculation of taxable income includes GILTI and FDII inclusion.

► How to handle implied royalties embedded in COGS (US tax

accounting rules (263A), customs implications, etc.)?

► Benefit to embedding services in COGS.


FDII

► FDII of a US corporation is its deemed intangible income multiplied by

the ratio of its deduction eligible income that is foreign derived:

► Deduction eligible income is gross income less exceptions and allocable

deductions.

► FDII provides incentive for US companies to export property and services.

► Deemed intangible income is deduction eligible income less 10% of QBAI.

► Foreign derived deduction eligible income is deduction eligible income

that is derived in connection with either:

► Property sold to non-US persons for a foreign use:

► If sold to a non-US related party, the property must be on-sold to a non-US third party

for foreign use.

► Services provided to non-US persons:

► If provided to a non-US related party, the service must not be substantially similar to

services provided by the related party to persons in the US.


FDII

► Deductions allow reduction in US rate:

► For tax years beginning after December 31, 2017 and before January 1,

2026, deduction is 37.5%, leading to an effective tax rate on FDII of

13.125%.

► For tax years beginning on January 1, 2026 and thereafter, deduction is

21.875%, leading to an effective tax rate on FDII of 16.406%.


FDII

► Implications/observations of FDII:

► As a stand-alone matter, provides incentives for certain export

transactions:

► Note, however, important interactions with FDII deduction, GILTI deduction and

BEAT – location decisions subject to facts and circumstances

► There are several considerations that affect cost/benefit calculation, including:

► Current location of IP and, if foreign, applicable tax rate

► Degree of alignment between IP location and the supply chain

► Implications for future movements of IP


Limitations on income shifting through IP transfers

► Definition of IP:

► Workforce in place, goodwill and going concern are IP within the meaning

of Section 936(h)(3)(B).

► Use aggregate basis method when it achieves a more reliable result

than an asset-by-asset method

► Codifies use of options realistically available principles


Limitations on income shifting through IP transfers

► Implications/observations:

► The proposal effectively codifies valuation principles espoused by the Treasury and

IRS:

► Do not use labels such as “workforce” or “goodwill” to inappropriately justify transfers of

value without compensation

► “Realistic alternatives” as a valuation principle rather than a recharacterization principle

► PCT (platform contribution transaction) payments (broader “resources and capabilities”

definition) now more clearly subject to CWI (commensurate with income)

► It should not be the case that all aspects of the accounting value of goodwill,

workforce, etc. are necessarily compensable:

► Instead, the determination of appropriate compensation will not simply turn on the

classification of the contribution.

► Depending on the nature of the IP covered in the intercompany transaction,

comparable uncontrolled transactions (CUTs) may be less reliable.

► Income method, properly implemented, is still a potentially appropriate method.


Key planning considerations


Planning considerations for flows

► Overall

► Tangible property

► Intangible property

► Services


Overall

► Focus on US transfer pricing likely to increase:

► From IRS due to expanded definition of IP, as well as move to semi-

territorial system

► From foreign tax authorities/governments as they respond to US changes,

as well as actions that US companies take to modify their supply chains

► Need to evaluate impact on existing advance pricing agreements

(APAs), if any, for example:

► Implementation of existing APA term tests and prospective availability of

term tests that include pre-2018 years in results

► Potential trigger of standard APA critical assumption caused by change in

treatment of previously deducted expenses as COGS for purposes of

BEAT


Tangible property

► Due to BEAT, would be beneficial to evaluate embedding payments

for IP and/or services in COGS:

► Alternatively, need to understand the risk associated with current flows

that have embedded IP and/or services payments

► Evaluate placing asset-intensive low-value routine activities offshore:

► May lower calculated value of GILTI


Intangible property

► Need to evaluate the costs/benefits of current IP strategy

► Key factors in IP decision-making include:

► Location of current IP (US, foreign onshore, foreign offshore):

► Foreign and US tax rates

► Connectedness to business/supply chain/customers

► Substance

► GILTI, FDII, BEAT

► Costs of IP migration/unwind

► New vs. existing IP

► Timing of IP migration possibly impacted by GILTI and BEAT

inclusions


Services

► It is important for companies to understand which of the

services that they pay related parties to meet the

requirements of the SCM (without regard to the

fundamental success or failure test).

► Changing a service transaction to a tangible goods

transaction may help to minimize BEAT:

► Toll manufacturing vs. contract manufacturing

► Procurement services vs. buy-sell

► Commission sales vs. buy-sell distribution


Planning considerations for typical operating models

► Overall

► US IP company

► Foreign IP company

► Domestic exporter

► Foreign principal

► Foreign procurement company (buy-sell)

► Foreign procurement company (service fee)

► Foreign (inbound) supply chain management company

(SCMCo)


Reshaping of operating models

Impact category How might the Tax Cuts and Jobs Act reshape supply chains?

Capital/financing ► Change acquisition and investment decisions (e.g., immediate “expensing” of new investments in depreciable assets)

► Change global capital structure — impact on interest deductibility and limitations on net interest expense re: US debt

coupled with cash from repatriated profits in the US

IP ownership ► Incentivize Research & Development (“R&D”)/IP activities in the US

► Possibly discourage expatriation of IP (valuation method and expanded definition of intangibles)

► Encourage driving up the tangible asset base in the CFCs to mitigate impacts of GILTI but driving down for FDII to

optimize income subject to 13.125%

► Use aggregate basis method when it achieves a more reliable result than an asset-by-asset method

Foreign operations ► Possibly encourage expansion/relocation of assets, functions and risk to the US:

► Review Earnings & Profit (“E&P”) and tax profiles of foreign subsidiaries for potential targets

► Evaluate local country exit risk/loss of credits and incentives (business and tax)

► Consider rate arbitrage with foreign hubs taxed at less than 21% to balance US and foreign operational footprint

► Impact decisions in global supply chain strategy (e.g., suppliers and production)

Transactional model ► Change transactional models between the sale of products/services

► Discourage “round tripping” activities with foreign entities (i.e., the process whereby a product/tangible good with partial

origin in the US is sent out of the US and then brought back in as an import)

IRS and global

controversy landscape

► Increased compliance risk and accounting requirements

► Transfer pricing controversy as supply chains re-base in the US

► Result in more aggressive posture from foreign tax authorities

► Result in possible challenges by trading partners to certain provisions (e.g., BEAT)

Effective dates ► Companies need to nimbly respond to immediate implementation of provisions.

► Companies need to take into account implementation and sunset dates for certain provisions when planning going

forward.


Common operating modelsImpact of anti-deferral/base erosion provisions

Model type BEAT GILTI FDII

1) US IPCo ✓ ✓

2) Foreign IPCo ✓ ✓

3) Domestic exporter ✓ ✓

4) Foreign principal

operating company✓ ✓

5) Foreign procurement

company (buy-sell)✓

6) Foreign procurement

company (services fee)✓ ✓

7) Foreign (inbound)

supply chain

management company

✓

Indicates model likely

impacted by provision✓

Key


1) US IPCoOverview

Foreign

OPCos

US

ROW

Overview:

► US parented group.

► US IPCo owns IP and licenses it to foreign OPCos

(CFCs) for their use in making products or licensing

outside the US.

► Foreign OPCos pay US IPCo a royalty for their use of the

IP.

TCJA:

► BEAT does not apply (no payment to foreign related

party).

► US IPCo taxed on 50% of GILTI (grossed-up under

Section 78) earned by CFCs, i.e., income in excess of

10% return on tangible assets.

► Residual US tax rate on GILTI is between 0% and

10.5%, depending on foreign tax rate.

► USCo royalty income will be FDII effectively subject to

tax at 13.125% (vs. 21%).

Modeling assumptions (see next slide):

► US IPCo:

► Has taxable income (pre-GILTI) of $400m

► Receives $300m of its income from royalties and

$100m from US domestic sales

► Has tangible asset base of $100m

► Foreign OPCos:

► Have aggregate taxable income of $100m

► Pay aggregate taxes of $25m

► Have tangible asset base of $50m

US IPCo

Legend

Royalty payment

Related parties


1) US IPCoPlanning rules of thumb

► Undertake IP scrub of intangible assets in order to determine location

of ownership of IP for tax purposes and planning guiding principles

► Continue to develop IP in the US and license outside to foreign

distributors and manufacturers for use outside the US — income

earned from licensing of US IP to foreign third parties or affiliates

effectively taxed at 13.125% vs. 21% with the FDII

► Anticipate foreign taxing jurisdictions’ reaction to FDII provision that

might subject the FDII to foreign tax


2) Foreign IPCoOverview

US

OPCo

US

ROW

Structure:


► Foreign IPCo (CFC) owns global IP and licenses US

rights to US OPCo.

► US OPCo pays a royalty to foreign IPCo.

► All US OPCo sales are to US third-party customers.

TCJA:

► US OPCo royalty payment potentially subject to BEAT,

i.e., excess of 10% (5% in 2018) of modified taxable

income (add back payment) over tax liability on regular

income.

► US OPCo taxed on 50% of GILTI (grossed-up under

Section 78) earned by CFCs, i.e., income in excess of

10% return on tangible assets.

► Residual US tax rate on GILTI income is between 0%

and 10.5%, depending on foreign tax rate.


► US OPCo:

► Has US taxable income (pre-GILTI) of $100m

► Pays $500m royalty to foreign IPCo

► Foreign IPCo:

► Has pretax income of $265m

► Pays foreign tax of $15m

► Has negligible income from other sources

Foreign

IPCo

Legend

Royalty payment

Related parties


2) Foreign IPCo Planning rules of thumb

► Profits attributable to non-tangible assets earned in CFCs will be

subject to minimum tax of 13.125%, meaning that low-tax IPCos will

be most impacted.

► Drive up tangible assets base to mitigate impacts from GILTI.

► Hybrid entities with IP and royalty income should be reviewed for

impact of anti-hybrid provisions.


3) Domestic exporterOverview

Legend

Payment for RM/finished goods

Related parties

USCo

SalesCos

Customers

US

ROW

Suppliers

Overview:


► USCo primarily purchases RM, manufactures and sells

FG to US customers or to ROW SalesCos (CFCs) that

sell to ROW customers.

► All IP is owned in the US.

TCJA:

► BEAT does not apply (no payment to foreign related

party).

► USCo taxed on 50% of GILTI (grossed-up under Section

78) earned by CFCs, i.e., income in excess of 10%

return on tangible assets (aggregate).



► USCo income from sales of FG to SalesCos will be FDII

effectively subject to tax at 13.125% (vs. 21%).


► USCo:

► Has taxable income of $800m derived 50/50 from

sales to US customers/related SalesCos

► Has tangible assets of $800m

► SalesCos:

► Have tangible asset base of $0m

► Have taxable income of $40m

► Pay foreign tax of $10m

Customers


3) Domestic exporterPlanning rules of thumb

► Optimize FDII so that income is taxed at 13.125% vs. 21%:

► Expand domestic production for sale outside the US

► Expand services provided outside the US

► Continue to develop IP in the US and license outside to foreign distributors and

manufacturers for use outside the US

► GILTI/FDII:

► Drive up low-return tangible asset base in CFCs to mitigate potential GILTI

inclusion

► Integrate tax strategy with supply chain strategy:

► Foreign hubs remain tax effective where tax rates are equal to or less than US rate. If foreign

tax rate on GILTI is above 13.125%, there is no residual US tax.

► Consider potential conflicts with indirect tax planning

► Evaluate state tax impact of GILTI/BEAT on determining of federal taxable

income


4) Foreign principal operating companyOverview

Overview:


► USCo purchases RM, manufactures and sells FG to US

customers or to Principal (CFC) to sell to ROW

customers. USCo also purchases FG from Principal for

sale in the US.

► Principal owns ROW IP, purchases RM, uses related toll

or contract manufacturers (CFCs) to produce finished

goods, and sells to distributors (CFCs) for sale to ROW

customers.

TCJA:

► BEAT does not apply to COGS.


78) earned by CFCs, i.e., income in excess of 10%




► USCo income from sales of FG to Principal will be FDII

effectively subject to tax at 13.125% (vs. 21%).


► USCo:

► Has revenue of $1,000m

► SELLS $500m to Principal for sale to foreign third

party customers

► Has taxable income of $300m (50/50 from sales to

US customers/Principal)


► Principal has taxable income of $100m.

► Distributors and Manufacturers have taxable income of

$50m.

► Total foreign tax is $15m.

► CFCs have tangible asset base of $800m.

Legend


Payment for services

Related parties

Customers

Customers Manuf.

Dist. Principal

USCo

Suppliers

US

ROW


4) Foreign principal operating company Planning rules of thumb

► BEAT:

► Minimize payments for outbound services and royalties

► Evaluate whether payments for services or IP can be included in COGS

► Evaluate services payments to determine whether they can be bifurcated into (1) those that qualify for SCM and

(2) those that do not

► Keep base erosion percentage under 3%

► GILTI/FDII:

► Drive up low-return tangible asset base in CFCs to mitigate potential GILTI inclusion

► Consider re-basing assets and functions in the US to optimize exports/FDII and mitigate impact of GILTI:

► Evaluate foreign conversion implications

► Integrate tax strategy with supply chain strategy:

► Foreign hubs remain tax effective where tax rates are equal to or less than US rate. If foreign tax rate on GILTI

is above 13.125%, there is no residual US tax.

► Consider the impact of expanded definition of intangibles and proposed valuation methods if

expatriating IP

► Consider potential conflicts with indirect tax planning

► Evaluate state tax impact of GILTI/BEAT on determining federal taxable income


5) Foreign procurement company (buy-sell)Overview

Legend


Related parties

USCo

ProcureCo

Customers

US

ROW

Suppliers

Overview:


► Foreign ProcureCo purchases FGs and/or RM from

foreign suppliers and sells to USCo.

► USCo makes and/or sells finished goods to US

customers.

TCJA:

► BEAT does not apply to COGS.


78) earned by ProcureCo, i.e., income in excess of 10%





► USCo:

► Has taxable income of $400m

► Purchases $800m of product from ProcureCo


► ProcureCo:


► Pays $10m of tax

► Has no tangible assets


5) Foreign procurement company (services fee)Overview

USCo

ProcureCo

Customers

US

ROW

Suppliers

Overview:


► USCo purchases RM/FG from foreign unrelated suppliers

and pays a service fee or commission to ProcureCo.

► USCo makes/sells FG to US customers.

TCJA:

► USCo services payment potentially subject to BEAT,

i.e., excess of 10% (5% in 2018) of modified taxable

income (add back payment) over tax liability on regular

income.


78) earned by ProcureCo, i.e., income in excess of 10%

return on tangible assets.




► USCo:


► Pays ProcureCo a service fee of $200m


► ProcureCo:


► Pays $10m of tax

► Has no tangible assets

Legend

Services payment


Related parties


5) and 6) Foreign procurement company (buy-sell and services fee) Planning rules of thumb

► BEAT:

► Maximize buy-sell vs. services as COGS not included

► Keep base erosion percentage on service payments below 3%

► Evaluate embedding payments for IP and/or services in COGS

► Evaluate services payments to determine whether they can be bifurcated into (1) those that

qualify for SCM and (2) those that do not

► GILTI:

► Drive up tangible asset base (that generates tested income) in CFCs to mitigate potential GILTI

inclusion

► Consider potential conflicts with indirect tax planning if breaking out royalties/services

as a component of COGS, e.g., exclusive distribution right (EDR) planning

► Evaluate state tax impact of GILTI/BEAT on determination of federal taxable income

► Consider sourcing from domestic suppliers vs. foreign suppliers or from a US affiliate of

a foreign supplier

► Purchase from foreign third party versus foreign related party


7) Inbound supply chain management companyOverview

SalesCo

SCMCo

Customers

US

ROWSuppliers

Overview:

► Foreign parented group.

► SCMCo purchases RM, uses a related US toll

manufacturer and sells FG to US SalesCo to sell to US

customers.

► IP is owned outside the US.

► There are no CFCs in the group structure.

TCJA:

► No impact from BEAT – COGS excluded

► No GILTI as USCos have no CFCs


► SCMCo:


► Pays US manufacturer $200m for toll manufacturing

services

► Pays foreign tax of $20m

► US Manufacturer:


► Has tangible asset base of $500m

► US SalesCo:


► Pays SCMCo $300m for FG

► Has no tangible asset base

Manuf.

Legend


Payment for services

Related parties


7) Inbound supply chain management company Planning rules of thumb

► BEAT:

► Maximize buy-sell vs. services as COGS not included

► Keep base erosion percentage on service payments below 3%

► Evaluate services payments to determine whether they can be bifurcated into

(1) those that qualify for SCM and (2) those that do not

► Evaluate embedding payments for IP and/or services in COGS

► Evaluate expanded definition of intangibles and valuation methods before

outbounding any US IP

► Consider potential conflicts with indirect tax planning, as well as potential

opportunities to save customs duties through the use of first sale planning

► Evaluate state tax impact of BEAT on determining of federal taxable income


Conclusion


Conclusion

► Almost every supply chain and associated transfer pricing

methods are impacted by the TCJA (some positively and

some negatively)

► Along with global OECD/BEPS/MLI/ATAD2 pressures

offshore, approach to activity centralization and profit

aggregation may change

► Long term modeling is essential to make the best short

term and long term decisions

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Planning options in today’s transfer pricing environment · Page 6 Planning options in today’s transfer pricing environment GILTI US shareholders of any controlled foreign corporation