U.S. Government Continues to Increase Focus on Transfer Pricing with Increased Controversy Expected

Excerpt from Practical US/International Tax Strategies by Bob Ackerman, David J. Canale, Karen Kirwan, Carlos Mallo, Mike Patton, Leigh Anne Pasak and Peyton Robinson (Ernst & Young LLP)


Transfer pricing will undoubtedly become a more significant focus of attention for the Internal Revenue Service (IRS) in their examinations of multinational corporations (MNCs). In a statement regarding international tax reform on May 4, 2009, President Obama announced that the IRS will “hire nearly 800 more IRS agents” to increase international tax enforcement efforts.

Concurrent with his remarks, the White House issued a press release commenting on the President’s proposal, indicating that the budget would provide the IRS with funds “to hire new agents, economists, lawyers, and specialists, increasing the IRS’s ability to crack down on offshore tax avoidance, often done through transfer pricing and financial products.” Despite the Administration’s recent announcements reflecting greater scrutiny of international tax issues, nevertheless, there may still be a public perception that the President’s plan will not cover transfer pricing. On May 5, 2009, the New York Times published an article citing different sources indicating that transfer pricing was the “one tax loophole open” in the plan. This perception—wholly without merit—may incite Congress to demand that the Treasury Department and the IRS enforce compliance with transfer pricing even more aggressively.

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China Issues Detailed Guidance on Anti-Avoidance Rules

Exerpt from Practical China Tax and Finance Strategies, published by WorldTrade Executive, Inc.

China’s new 2007 Enterprise Income Tax Law, for the first time in Chinese tax history, introduced a set of anti-avoidance rules in its Special Tax Adjustments chapter, which include not only transfer pricing and advanced pricing agreement rules but also rules on cost sharing agreements, thin-capitalization, controlled foreign corporations, and general anti-avoidance.

On January 8, 2009, the SAT released long-awaited Circular Guoshuifa [2009] No 2, Implementation Measures of Special Tax Adjustments (Trial) that details rules on administrating all the aspects of those anti-avoidance rules. If the Special Tax Adjustments chapter represents the first anti-voidance legislation in China, Guoshuifa [2009] No 2 can be viewed as the first comprehensive operating manual of anti-avoidance administrations in China. All the provisions in Guoshuifa [2009] No 2 take retrospective effect from January 1, 2008.

As the starting point of the anti-avoidance administration, Guoshuifa [2009] No 2 restates that all enterprises shall file the following nine forms annually to report related party transactions:

Form 1 - Related party relationships
Form 2 - Summary of related party transactions
Form .3 - Purchases and sales
Form 4 - Labor services
Form 5 - Intangible assets
Form 6 - Fixed assets
Form 7 - Financing
Form 8 - Outbound investments
Form 9 - Outbound payments

Those forms require enterprises to indicate whether they have contemporaneous transfer pricing documentation in place. The forms need to be filed together with the annual enterprise income tax return. For the tax year of 2008, the filing deadline is May 31, 2009.

Read More for a Summary of Transfer Pricing Documentation

Mexico Tax Audits

Excerpt from August 2008 Issue of Practical Mexican Tax Strategies by Jaime González-Béndiksen (Baker & McKenzie)

The Mexican tax administration continues to increase its audit activity in practically all sectors of taxpayers, with special emphasis being paid lately to the pharmaceutical and oil sectors. This article excerpt will briefly discuss some of the transfer pricing issues being raised in recent audits.

Transfer Pricing
Secret comparables. It appears that the tax administration is testing the waters with respect to the use of the so-called secret comparables. These are comparables that the tax administration gathers from its own internal records, such as customs records. The administration gathers information on imports of what it considers to be products similar to those of the taxpayer and, on the basis of such information, rejects the prices paid by the Mexican taxpayer to its related parties abroad. The taxpayer is allowed to review the information gathered by the tax administration and to make notes. It does not, however, have any access to the entire customs files of the administration such that it could confirm whether or not the information gathered by the administration is correct or such that it could locate other information to disprove the administration’s findings. In our view, use of the secret comparables violates Constitutional principles and, as such, should be overturned by our courts when this matter comes to their attention.

Business Restructuring. The tax administration continues to audit business or supply-chain restructurings. It is not that the restructuring, as such, are prohibited. The tax administration’s arguments are basically that the restructuring and, consequently the transfer pricing study to support it, lacks substance. The administration tries to disprov the functions and risks that have arguably being transferred from the Mexican entity to one or more foreign companies within the same group. Regarding functions, the administration generally argues that in fact no functions were transferred abroad. Typically, where the taxpayer argues that purchasing and sales functions are now outside of Mexico, the tax administration looks into whether the foreign entity now charged with the functions has, in fact, employees to carry on these functions and whether or not the Mexican personnel formerly charged with these functions has left the Mexican company or continues to work there. Where managerial functions have reportedly been moved outside of Mexico, the tax administration also looks into whether the employees of the Mexican company formerly charged with the managerial functions in question, have or have not been relocated. On the risks side, the administration looks into whether the Mexican company’s history shows any such risks in fact occurring in the past, such as inventory risks, product liability, bad debts, etc. Its motto is that where there is nothing to lose no risk is being assumed.

These audits, however, typically forget to address the fact that whatever flaws the functions or risks may have, assets have in fact moved. Intangibles are now owned by a foreign member of the group. The production is also owned by a foreign principal who either sells it to a commissionaire in Mexico or sells it to the Mexican company for distribution. No doubt the mere fact that the Mexican taxpayer now owns virtually no assets, calls for a lower return. As mentioned earlier, this is often ignored by the auditors.

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Tax Auditors Look to Substance in Centralized IP Structures

Excerpt from August 2008 Issue of Practical US/International Tax Strategies by John Henshall (Deloitte & Touche LLP)

In the early 1990s the first businesses transformed corporate efficiency, and profitability, by taking a holistic view of their business and optimizing their supply chain networks—the complex web suppliers, production and R&D facilities, distribution centers, sales subsidiaries, channel partners and customers. Typically the best commercial structure involved a centralization of regional activity into “Principal” company supported by “contract” or “toll” manufacturers and “commissionaire” sales or “simple” distributors, supported by “shared service centers” to take care of back-office functions. Today most multinationals don’t derive a significant proportion of their profits from the physical act of making products but rather from the ideas they generate that lead those products, wherever products are made. As this state of affairs evolved so did the centralized business model and IP planning is now a signifi cant element in any business restructuring.

Business restructurings are by their nature an enormous strain on the organization and they are not undertaken purely for tax reasons. Tax is, however, taken into account when deciding where the centralized entity should locate; in most reorganizations high-tax countries then see high-profit activities moving away. These governments are fearful of the fiscal consequences of the more profitable element of their tax base moving offshore and will audit the transition vigorously.

Read More: Why Is Substance Important?

The IRS Fixes Subpart F -- Sort Of

Excerpt from Practical US/International Tax Strategies by Joseph B. Darby III (Greenberg Traurig LLP) and Brainard Patton (Counselor at Law)

Ronald Reagan famously commented that the most scary phrase in the English language is, “We’re from the government and we’re here to help you.”

An even more celebrated saying is, “If it ain’t broke, don’t fix it.”

Now comes the Internal Revenue Service—unquestionably, these people are from the government—and they have decided to “help” us by delving into Subpart F of the Internal Revenue Code and “fixing” some esoteric but very important rules, including rules that address the consequences of contract manufacturing under the so-called “branch rule.” The branch rule is a significant limitation on the so-called “manufacturing exception,” which in turn is arguably the most important exception to the often tangled and always confusing “Subpart F rules” governing controlled foreign corporations (CFCs).

Let’s be frank about this: The branch rule is unquestionably broken, and has been broken for a long time. Now, let’s be even more frank: The branch rule is “broken” primarily because the Internal Revenue Service tried to fix it in the first place. Needless to say, some people—OK, a lot of people—have concerns about sending the IRS to fix a rule that the IRS has made far worse on several previous occasions.

Read More on the Proposed Regulations (free)

Documenting “Benefits” of Intercompany Services Becoming Increasingly Important in Europe as New U.S. Regulations are Implemented

Excerpt from Practical US/International Tax Strategies by Michelle M. Johnson (Ceteris. Inc.)

In late May (2008) the Tax Court of Lombardy reversed a previous judgment of the Provincial Tax Court of Milan regarding a taxpayer’s intercompany services charges. The Milan judgment had ruled in favor of the taxpayer by recognizing the deductibility of services charges related to the “provision of market information useful to manage the sales process and management control” by the parent company. These first degree judges had concluded that these services were “necessary” or at least “useful” in improving the management of the business of the Italian-controlled entity, thereby warranting the deduction.

The Tax Court of Lombardy overturned this decision in favor of the Italian tax authorities’ original position that no deduction should be allowed since there was an absence of a specific connection to the interests of the recipient. Even though the parent had calculated the services’ cost shares among its subsidiaries based on proportion of turnover, the appeal-level judges ruled that in the case of the Italian subsidiary this was not representative of the actual benefit received.

This ruling is just one example of issues that U.S.-headquartered taxpayers might encounter as they seek to comply with the new U.S. transfer pricing regulations for intercompany services. These new regulations are prompting U.S. taxpayers to examine their headquarters operations with greater scrutiny as they seek a more comprehensive approach to evaluating fully-loaded cost pools that may relate to activities that benefit non-U.S. subsidiaries. For many companies, implementing these new regulations has resulted in an increased amount of services charges made to foreign affiliates.

Read More: Best Practices to Reduce Your Risk of Disallowed Deductions (free)

OECD Transfer Pricing Guidelines

Excerpt from Practical European Tax Strategies by Peter Hann (KPMG in the UK)



The OECD has been moving rapidly with its projects to revise the transfer pricing guidelines and to issue a new version of the Model Tax Convention. Revised transfer pricing guidelines will be issued within the next few years, while the new version of the Model Tax Convention is expected to be finalized as soon as June 2008. The main issues relating to transfer pricing are summarized below.


Transfer Pricing Guidelines

Profit-based Methods

Following consideration of the responses to a consultation held in 2006 on transactional profit methods, in January 2008 the OECD published “issues notes” on various aspects of profi t based methods as part of a further consultation exercise.

The OECD working party has been examining the status of the transactional profit methods (transactional net margin method and profit split), which are at present regarded as methods of last resort in the OECD guidelines. The working party has tentatively concluded that the correct guidance on the approach to the selection of a transfer pricing method is to emphasize that the method used should take into account the appropriateness of that method in view of the functional analysis and comparability analysis, and also taking into account the strengths and weaknesses of the OECD recognized methods. This should also involve consideration of the availability of reliable information, especially of uncontrolled comparables, and the degree of comparability including the reliability of comparability adjustments that would need to be made.

The OECD Working Party takes the view that the traditional transactional methods (comparable uncontrolled price (CUP), resale price method and cost plus) have intrinsic strengths. Their latest proposal in these issues notes would, however, remove the exceptional status of the profit methods and put more emphasis on the functional analysis to determine the appropriate transfer pricing method and on the consideration of the relative strengths of the different methods in a particular case.

Owing to the intrinsic strengths of the traditional transactional methods, the OECD still considers that when a traditional transactional method and a transactional profit method can be applied in an equally reliable manner, the traditional transactional method is to be preferred.


Read More on the issues addressed in the “issues notes” published as part of the consultation:

FAS 123R and Cross-Border Tax Issues

Excerpt from Practical US/International Tax Strategies by Albert W. Liguori, Michael Murphy and J.D. Ivy (Alvarez & Marsal Taxand, LLC)

Most public companies provide some form of stock compensation to their executives and employees and as a result must grapple with the tax and financial statement treatment of such equity compensation awards. Crossborder employment situations further complicate the tax and financial statement treatment of these awards.

The impact of recent developments in the transfer pricing arena as they relate to how equity compensation is treated under Statement of Financial Accounting Standards No. 123R (FAS 123R) and FAS 109 have now become natural opportunities for companies to determine not only whether they are in compliance with the financial statement and transfer pricing rules but also to undertake some tax-efficient planning.

Under FAS 123R, stock based compensation, which includes stock options and restricted stock units, must be valued at grant date and recognized as an expense for book purposes over the equity compensations’ vesting period. The vesting period is also known as the “service period” for which an employee earns the right to benefit from such equity compensation. Naturally, the amount expensed must be tax-effected. However, most foreign jurisdictions as well as the U.S. do not allow a tax deduction for equity compensation until the vesting is complete or the equity compensation is exercised. This difference in time (i.e., expense now, deduct later) results in deferred tax accounts. When accounting for these deferred taxes, it is important to know if and where a deduction will ultimately become available for the stock compensation, a task easier said than done.

Read More on FAS 123R

Transfer Pricing and Customs Valuation

Excerpt from Practical US/International Tax Strategies by Peter E. Kirby (Fasken Martineau DuMoulin LLP)

While the income tax authorities in Canada and the U.S. have spent the last twenty years developing, refining, and explaining their policies for testing transfer pricing decisions, the customs authorities in these countries have been slower to come to grips with the issue. That has now changed and the customs authorities in Canada and the U.S. have begun to look more carefully at transfer pricing. As a result of that scrutiny, two things have become clear. First, a transfer price that may be acceptable to the income tax authorities may not be acceptable to the customs authorities. Second, a transfer price study that confirms the acceptability of transfer prices for income tax purposes is, in most cases, irrelevant for the purposes of customs valuation.

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Spain’s Draft Regulations on Transfer Pricing Rules

excerpt from Practical European Tax Strategies written by Pedro Aguarón (Baker & McKenzie Barcelona, S.L.)

As a result of the new Law for Avoidance of Tax Fraud (LATF) enforceable in 2007, the Spanish transfer pricing legal framework has changed significantly.

One notable change is that the LATF introduced specific transfer pricing requirements. The taxpayer is required to properly document that the price used in related transactions is arm’s length and make this documentation available at the tax authorities’ request.

Read More (free)

Transfer Pricing in Latin America

In a recent discussion, PricewaterhouseCoopers' John Salerno joined the editors of Practical Latin American Tax Strategies to talk with ADM's Robert Frable and Sony's Marc Lewis about their tax operations in Latin America, their new procedures for dealing with FIN 48 and transfer pricing procedures. Following is and excerpt from the interview with Marc Lewis, the second in a series of excerpts from that exclusive interview:

Strategies: You had mentioned earlier some of the benefits of taking a regional approach to managing the Latin American tax burden. Is there anything specifically that you have been doing within your company to regionalize the approach to tax planning?

Lewis: Transfer pricing is probably a good way to illustrate a regional approach. It is important for a company to be consistent about its transfer pricing both regionally and globally, and I think it is important for many reasons. A regional approach is a good approach for transfer pricing because it forces you to look at things on a 50,000 foot level in the Americas, for instance. There are requirements now in pretty much every country, and you ask yourself, if I’ve got limited resources in my department, how am I going to tackle this kind of project.

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Retrospective Adjustments of Intercompany Prices for Goods Sold into Russia

Excerpt from Russia Eurasia Executive Guide by Kurban Nepesov and Natalia Volkovskaya (KPMG)

In general, transfer pricing in Russia is not particularly complex, although for those importing goods from a related party, the balancing act between Russian customs and their local tax inspectorate can be challenging -- the two authorities are driven by opposing fiscal interests. For example, an increase of intercompany prices at which the Russian subsidiary purchases goods from its foreign affiliate should in principle lead to an increase of customs duty and import VAT and, therefore, to a decrease of its Russian profits tax liabilities (as the increased expense erodes the margin) for the importer. Thus, adjustments to established intercompany prices can lead to disputes with either the Russian customs or tax authorities -- or both!

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Managing Tax Risk in Latin America

In a recent discussion, PricewaterhouseCoopers' John Salerno joined the editors of Tax Strategies to talk with ADM's Robert Frable and Sony's Marc Lewis about their tax operations in Latin America, their new procedures for dealing with FIN 48, and transfer pricing procedures. This excerpt from that interview takes a look at their strategies surrounding FIN 48:

Strategies: What has your overall experience been in managing the implementation of FIN 48 in the region?

Lewis: It is hard to say that the Latin American region presents something that is unique within FIN 48 implementation versus some of the other regions but I think one thing to consider is how much reliance a taxpayer can place on the availability of Competent Authority or APA relief. To a certain extent, it is dependent upon how active the Competent Authority is between different countries and how active the APA programs are between different countries. Latin America, Mexico and probably some others have pretty robust activities. However, in other countries, it is just building up, so I do not think you are at the same level as you see in some of the countries in Europe, Japan and other places where you can rely upon a Competent Authority or APAs in the assessment of uncertain tax positions.

Frable: FIN 48 was an interesting experience with this being the implementation year. I think everybody was surprised at how much time they ended up spending on the implementation. It took away from your day-today responsibilities. I think it is going to get better; tax departments, controllers and even outside auditors had to work through a learning curve.

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Managing Transfer Pricing Risk in Brazil

Brazil, the ninth largest economy in the world, has developed a unique set of transfer pricing rules that differ from the Organization for Economic Cooperation and Development (OECD) based approach adopted by most countries around the world. As result of this uniqueness, multinational corporations (MNCs) face a number of transfer pricing difficulties which may range from an increased burden on compliance activities to double taxation. Further, Brazilhas signed several Tax Information Exchange Agreements with foreign tax authorities (including one recently with the U.S.) that increase the exposure of MNCs to transfer pricing issues.

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Canada-US Tax Protocol Will Impact Transfer Pricing Disputes

One of the most important and novel changes made by the new Protocol to amend the US-Canada tax treaty is the mandatory arbitration procedure. The provision is called “mandatory” in the sense that it is binding on the tax authorities of the United States and Canada. Taxpayers will have an opportunity to decide whether invoking the arbitration procedure is in their best interests.

Under the Protocol and diplomatic notes, intercompany transfer pricing issues are among those that can be submitted for arbitration. In addition, both competent authority cases already under consideration of competent authorities at the time of the Protocol entering into force and new cases, submitted after the Protocol enters into force, will qualify for submission to the arbitration (provided certain requirements are met).

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Japan Transfer Pricing Issues and Intangible Assets

The Japanese tax authorities increasingly have been concerned with transfer pricing issues related to intangible assets as a result of the advanced globalization of business activities. Newspapers have reported cases where significant tax assessments have been made when the underlying disagreement with the tax authorities related to the value and location of intangible assets.

The Revised Transfer Pricing Administration Guideline and a collection of Case Studies have been published as additional guidance. The revised Guidelines give specific examples of intangible assets, which should be investigated in transfer pricing audits.



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Tax Reform in Japan 2007

An interview with Al Zencak (Zeirishi-Hojin PricewaterhouseCoopers, Tokyo)


As reported in the previous issues of Practical Asian Tax Strategies, 2007 has brought significant tax reform for Japan. To get a better understanding of what this means for your multinational operations, we went to the experts at PricewaterhouseCoopers to discuss the major changes that were made and what opportunities and challenges these changes mean, along with some actions that your company should be taking to position itself to benefit from these recent changes.


View Excerpt from this Interview

New Transfer Pricing Developments in China

Despite the continuing delays in the release of the China Transfer Pricing Contemporaneous Documentation Ruling, there have been further key developments in China’s transfer pricing environment. Some of these developments were included in the tax reform measures passed by the National Peoples Congress in March. However, more immediate issues have arisen from new circulars issued by the State Administration of Taxation (“SAT”) and actions being taken by some major tax jurisdictions in China. These developments indicate that transfer pricing continues to be a key focus area for the SAT.

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International Operations to Receive Close Scrutiny in IRS Examinations

The IRS is placing high priority on some types of cross-border transactions in future examinations. Targeted transactions include transfers of intangibles offshore to related foreign affiliates, use of international hybrid instruments, and claims of foreign tax credits. While the new priority system will probably result in more exams, it offers companies an opportunity to anticipate and plan for an IRS examination.



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Korean Transfer Pricing Regulations and Income Tax Changes for Non-Residents

Codification of the “Substance over Form” Rule


Recently, the Ministry of Government Legislation announced significant amendments to the regulations of the Law for the Coordination of International Tax Affairs (LCITA) which regulate international transactions. The primary reasons for revising the LCITA are to prevent tax evasion through the codification of the “substance over form” rule, improve consistency with globally accepted taxation guidelines and promote the overseas investments of Korea based companies.



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