Tax Reform and Transfer Pricing

1. Tax Reform and Transfer Pricing July 18, 2019 Alex Martin Productive Pricing LLC www.productivepricing.com alex.martin@productivepricing.com Personalized Service, Practical Solutions

2. Overview • Transfer pricing from a practical perspective • Assessing common transfer pricing issues • Tax Reform = new incentives for multinationals • FDII export incentive @ 13.125% • GILTI, BEAT and OECD Developments www.productivepricing.com

3. Why is Transfer Pricing Important? $Y transfer price drives taxes payable by country • Inventory, royalties, service charges, loans all impact taxes payable German manufacturer $X profit Retailers Auto parts $Y per unit U.S. distribution subsidiary $Z profit German taxes 30% of $X U.S. taxes 35% of $Z now 21% of $Z (2018) www.productivepricing.com

4. Is Your Company Paying its Fair Share of Tax? • “Why does Starbucks manipulate its accounts to avoid tax?” • - UK Member of Parliament Margaret Hodge

5. Big Picture Goal – companies pay their fair share of tax • “Arm’s-Length Standard” • Principles broadly similar globally (OECD Guidelines) www.productivepricing.com

6. Transfer Pricing – Why Now? High return on investment for tax auditors globally Prior to TCJA, companies minimized US tax footprint • 35% federal rate and worldwide taxation • Lower rates elsewhere Tax Reform changes the dynamic, e.g. • 21% tax rate on C-Corps encourages investments • Possible lower rate for export income – 13.125% www.productivepricing.com

7. When is Transfer Pricing an Issue? Every time a company has a cross-border transaction with related companies • Supply chain changes • Global effective tax rates • Company cashflow • Tax audits www.productivepricing.com

8. How Do Some Companies Approach Transfer Pricing? France U.S. • Company has one cost plus policy • Company operates as one “borderless” business • Can the plant manager earn a higher bonus? Specialty Vehicle Part Parent US Specialty Vehicle Part Subsidiary France Parts Royalty Charge www.productivepricing.com

9. IRS Issues a Transfer Pricing Adjustment Assume a total taxable income adjustment of $10m Additional income tax owed: $10m x 35%* = $3.5m Plus non-deductible penalties of 20% $700,000 $4.2M + interest + US state taxes + potential double tax 20% penalties start at $5m, penalties increase to 40% at $20m NO automatic refund of double tax – 2 Tax Authorities need to agree * Open tax years at pre-tax reform 35% rate www.productivepricing.com

10. Transfer Pricing Documentation Auditors request documentation to evaluate TP • Analysis of how business operates globally • Industry analysis • Financial analysis • Economic analysis demonstrates why transfer pricing is arm’s-length Explain to a tax auditor how the business operates and why the transfer pricing is correct. www.productivepricing.com

11. Information Typically Included in a Study Narrations prepared through interviews – e.g. • Which country developed the product and how? • What cross-border R&D assistance is provided? • Who bears risk of R&D failure? • What process IP is utilized by related companies? Similar interviews with sales, marketing, finance, others on both sides of the border www.productivepricing.com

12. IRS Issues Adjustments with Documentation Assume a total taxable income adjustment of $10m Additional income tax owed: $10m x 35%* = $3.5m Plus non-deductible penalties of 20% $700,000 $3.5M + interest + US state taxes + potential double tax US Report prepared by tax return filing date to be ‘contemporaneous’ Reports do not guarantee tax authority agreement with your position www.productivepricing.com

13. No IRS Transfer Pricing Adjustment? No TP adjustment during an IRS Audit • No adjustment = no additional tax or penalties Possibly a problem from a foreign perspective • Some tax authorities (e.g. Mexico) require annual documentation at a very low threshold • Thresholds vary by country www.productivepricing.com

14. Best Practices for Managing Transfer Pricing? Over 100 countries have transfer pricing rules • One study applicable for multiple jurisdictions • Utilize readily-available company information • Intercompany contracts are beneficial • If a report is not clear to you, it will not make sense to an auditor • Update report annually to be contemporaneous www.productivepricing.com

15. Starting Points – What to Review • Country-by-Country financials- past 3 years • US Tax Return for most recent year – Form 5471, 5472, 8858 and/or 8865 • US TP documentation – old reports still useful • Foreign TP documentation reports Note: Penalty increased to $25,000 for not filing 5471s, 5472s, etc. with tax return www.productivepricing.com

16. How to Assess Transfer Pricing Review annual profit margins of each subsidiary • Subsidiary losses/NOLs = Subsidiary tax risk • Large profits in subsidiaries = Parent tax risk • All open tax years EBIT as a percentage of sales for each subsidiary • Often used in TP analyses www.productivepricing.com

17. How Would the IRS Audit This Situation? German parent with USCo subsidiary reseller • ~$70m US Revenue, Purchases in Euros • Long sales cycle, facing market downturn • Minimal profits or losses past 3 years www.productivepricing.com

18. Assessing Subsidiary Transfer Pricing Risk Does it make sense – a subsidiary incurs losses? • What happens if outbound TP is lowered? • What would happen by utilizing tax NOLs? IRS has an audit campaign targeting subsidiaries • Middle-market specifically mentioned www.productivepricing.com

19. Assessing Transfer Pricing – US Companies How would a foreign auditor react to losses? • Can you reduce outbound TP to utilize losses? Foreign subsidiaries earn large profits • Potential to increase FDII benefit? • Does GILTI tax apply? www.productivepricing.com

20. “Best Method” or “Most Appropriate Method” Hold off on assessing methods at this stage • CUP – Comparable Uncontrolled Price • Resale Price Method • Cost Plus Method • Profit Split Method • CPM – (Comparable Profits Method) or TNMM • Other Methods www.productivepricing.com

21. Practical Observations IRS requests reports with a 30-day deadline • Not too late if the deadline is missed • No TP adjustment = no additional tax due Most TP studies include multiple years of data • e.g. 2016-2018 or 2014-2018 Large companies (≥€750m Euros) required to have OECD BEPS Master File/Local Files www.productivepricing.com

22. Potential Alternative – Benchmarking Study Benchmarking study • Lower-risk situations • Profit margin target for subsidiaries Company adjusts transfer prices to reach target of 5.0% to 8.2% EBIT margin for subsidiary • CPM/TNMM Approach www.productivepricing.com

23. Famous Last Words • “They couldn’t hit an elephant at this distance.” • —John Sedgwick, U.S. Civil War General – May 9, 1864 • “We will prepare something when the IRS requests it.” • “We did a study a few years ago.” • “Our subsidiaries negotiate over transfer prices already.” • “We have a transfer pricing policy in place.” • “Our Canadian controller said they have a study.” • “It’s due to business conditions and FX issues.”

24. Tax Reform Strategies www.productivepricing.com

25. Transfer Pricing and US Tax Reform The Tax Cuts and Jobs Act (TCJA) changes incentives for multinationals: e.g., for C-Corps • Tax rate reduced to 21% • Some export income may be taxed at 13.125% • Holding IP offshore less beneficial www.productivepricing.com

26. Observations Tax Reform designed to: • Incentivize US investments in value chain • Incentivize US exports Must “prove” foreign use, no round-trips State tax, VAT, withholding, foreign tax credits, customs duty all important considerations www.productivepricing.com

27. What Happens If Transfer Prices Are Increased?Base Case (no FDII) What if USCo increases the royalty by $1m? • Increase goods prices, service charges – same effect Forco Subsidiary $5,000,000 Taxable income USCo Parent $10,000,000 Taxable income Software Charge $2m Royalty Forco customers Forco taxes payable at 30% $1,500,000 US taxes payable at 21% $2,100,000 www.productivepricing.com

28. Increase Royalties Charged to Subsidiary Base Case (no FDII) www.productivepricing.com

29. What Should Multinationals Consider Now? Outbound Lower tax rates incentivize US investments • New US R&D activities = higher royalty rates • New/Upgraded US plant = higher goods prices Tax benefit – additional US tax, lower foreign tax • Larger deductions at subsidiaries www.productivepricing.com

30. Carrots and Sticks Overview Special rules for “deemed intangible income” • Foreign Derived Intangible Income (“FDII”) export incentive (13.125% rate) • Global Intangible Low-Tax Income (“GILTI”) is Mirror Deemed Intangible income = • Income minus 10% of Qualified Business Asset Investment (“QBAI”) and interest expense • The TCJA assigns a “routine” return of 10% on assets, and residual profits are “deemed intangible income” www.productivepricing.com

31. FDII Carrot– C-Corp Export Incentive Deemed ‘Intangible income’ defined as income greater than 10% of QBAI (business assets) • What share of 'intangible’ income is foreign? (Foreign derived deduction income/ Total deduction income) x Deemed Intangible Income= FDII Income FDII income taxed at 13.125% • Increase transfer prices= increase FDII www.productivepricing.com

32. Same Numerical ExampleHigher Royalty = Increased FDII Income

33. FDII Observations Opportunity is more income at 13.125% rate • Potential to improve ETR and cashflow • Must have evidence of foreign use • Must be substance behind TP changes TP documentation for audit defense overseas www.productivepricing.com

34. What Should Multinationals Consider Now? Inbound Consider reducing inventory prices and royalties • More US activities = lower transfer prices • New US plant = lower component prices Result- More US income/ Less overseas income • Customs duty savings? www.productivepricing.com

35. GILTI and BEAT Sticks Global Intangible Low-Taxed Income (“GILTI”) • Tax excess income from lower tax countries • Also applies to some individuals Base Erosion and Anti-Abuse Tax (“BEAT”) • Minimum tax for significant royalties and service fees paid to related companies www.productivepricing.com

36. GILTI Mirrors FDII Charged on the ‘excess’ income of US CFCs • Net “tested income” of CFC minus 10% of QBAI, minus interest expense • Reduces rate differential between the US and low-tax jurisdictions www.productivepricing.com

37. GILTI Calculation without Interest Expense CFC with 10% tax rate, $1.5M income and $8M in QBAI Assume $8m in CFC Qualified Business Asset Investment Deemed paid FTC 80% x Sec. 78 gross-up 80% x $61.1k = $48.9k Answer: ETR on CFC Income $165.5k/$1.5m = 11.02% www.productivepricing.com

38. GILTI Observations GILTI tax applies to excess CFC profit • Removes “routine” return based upon QBAI • Higher QBAI = less GILTI tax • CFC with few assets more likely have GILTI tax • GILTI Tax can be offset by foreign tax credits www.productivepricing.com

39. BEAT Stick Base Erosion and Anti-abuse Tax >$500m revenue • Adds back payments to related companies • New modified taxable income • BEAT is 10% of modified taxable income less regular tax liability (5% in 2018) • Royalties and service payments are greater than 3% of company deductions. • Inventory purchases not part of calculation www.productivepricing.com

40. Transfer Pricing Tax Reform Takeaways Transfer pricing is an integral part of tax reform • FDII - incentive to increase outbound TP • Lower inbound TP may be beneficial Documentation to support changes in TP www.productivepricing.com

41. Storms on the Horizon • Tax rate competition • ‘Nexus’ standards for taxing internet sales • BEPS Master File/ Local File and CbC Reporting • More transparency = more aggressive audits • Can governments resolve double tax disputes? www.productivepricing.com

42. Contact Details Alex Martin Productive Pricing LLC 390 N Harvey Street Plymouth, MI 48170 alex.martin@productivepricing.com www.productivepricing.com +1 248 752-1190