Dealing with the Secondary U.S. Tax Consequences Of Transfer-Pricing Adjustments

Imagine this: the transfer pricing report that has been in process is received after year-end (but before the tax return is due) and the conclusion is that the price the U.S. parent has charged its foreign subsidiary for intercompany transactions throughout the year is too high and needs to be adjusted downward.

What do you do? Let it go and post a make-up adjustment next year, or, affirmatively adjust the year to follow the transfer pricing report and include the corrected amounts in the tax return? You should do the latter because you cannot make beneficial transfer pricing adjustments to the U.S. parent after the tax return is filed. This is not an uncommon situation and this article will provide a summary of the issue, and what to do.

The overall tax consequences of this type of adjustment are a bit more complex than first meets the eye. Proper planning can mitigate adverse consequences and reporting errors especially in situations where estimates were used during the year, but not finalized until after year-end when the transfer pricing study is issued. In situation referred to above, the U.S. parent adjusts downward what it charged its foreign subsidiary. This is referred to as a “primary adjustment.” Since the U.S. parent overcharged its foreign subsidiary, the primary adjustment decreases U.S. taxable income of the U.S. parent. An additional adjustment is necessary, which in this case, creates a distribution (possibly resulting in a dividend from the foreign subsidiary), for U.S. tax purposes. This distribution (or contribution if it goes the other way) is commonly referred to as the “secondary adjustment.”

The following example illustrates this. Assume the U.S. parent charged its foreign subsidiary $100, but the arm’s length amount should have been $90. The $100 is reflected in the books and records of the U.S. parent as of year-end. Before the tax return is filed, the finalized transfer pricing report reflects $90 as the appropriate charge. U.S. parent reduces the price it charged the foreign subsidiary by $10 so that the tax return, as filed, reflects $90. Since the year has ended, and the U.S. actually charged $100 but should have only charged $90, the $10 difference, the secondary adjustment, is a treated as a distribution from the foreign subsidiary (possibly a dividend).

Revenue Procedure 99-32 contains some potential relief from the adverse impact of secondary adjustments ($10 in the above example) when there are taxpayer-initiated transfer pricing adjustments on the tax return. Revenue Procedure 99-32 revised Revenue Procedure 65-17, which did not contain relief for taxpayer initiated adjustments (it potentially applied to only IRS initiated adjustments). Further, Revenue Procedure 99-32 was issued to encourage taxpayers to affirmatively adjust transfer prices with the filing of their timely filed U.S. tax returns although it can still possibly be used for IRS initiated adjustments as well. What Revenue Procedure 99-32 does, is allow a taxpayer to record the affirmative transfer pricing true-up secondary adjustments in its U.S. tax return as an interest bearing loan which has to be repaid within 90 days of the adjustment. If it is not repaid in 90 days, the secondary adjustment stands.

Revenue Procedure 99-32 is elective. The interest bearing loan treatment does not happen automatically unless the taxpayer makes the election. Therefore, taxpayers have to affirmatively elect on their timely filed U.S. tax returns (including extensions), to take advantage of this Revenue Procedure. Section 5 of the Revenue Procedure outlines how to make the election (which cannot be done on an amended return).

Should taxpayers just automatically make a Revenue Procedure 99-32 election on their return? The answer is not necessarily. For example, if the foreign subsidiary does not have current or accumulated earnings and profits, the distribution on the secondary adjustment might be treated as a tax-free return of capital. Further, the loan that is created when electing under the Revenue Procedure, might be treated in this situation as a section 956 loan from the foreign subsidiary (and a deemed dividend). Or, there may be withholding tax on the loan that is created. (Generally, the U.S. exempts less than 183 day loans from U.S. withholding tax.) So, the facts need to be analyzed, to determine if this election is beneficial.

Further, note that making a transfer pricing primary adjustment can have import and customs duty, VAT and withholding tax implications where refunds might be obtained, or payments made, depending upon which way the adjustment goes. Some foreign jurisdictions do not follow these provisions and will need to be analyzed in conjunction with the U.S. implications.

This Revenue Procedure can be applied to U.S.-owned multinationals, foreign-owned U.S. subsidiaries, or foreign-to-foreign controlled party transactions of U.S. multinationals. Revenue Procedure 99-32 can be beneficial, but may not always be. It should be considered when transfer pricing adjustments arise when filing the U.S. tax return. Also, when making a transfer pricing adjustment with the U.S. tax return, there could be secondary adjustments that should to be considered.