Transfer Pricing Update:  Surveying the Landscape of the New Base Erosion Rules

The Tax Reform Act of 2017 (the Act) aims to promote domestic employment using a multi-pronged approach which includes: (i) deductions to income from foreign sales tied to domestic economic activity; (ii) new taxes on income tied to intangible assets held offshore and taxed at low rates; and (iii) new taxes applied to certain types of payments made to foreign related parties.

In addition, several key concepts that were the focus of much debate in high-profile transfer pricing cases have now been formally defined. Taken together, the new law presents a mix of new opportunities and risks. Accordingly, taxpayers should make efforts to fully understand and quantify the meaning of these new changes on their tax positions, whether in terms of their 2017 position or their positions for 2018 and beyond. This article focuses on some of the new international tax provisions and offers some key considerations in the context of transfer pricing.

New Deductions for Income on Foreign Sales from Domestic Activity

The Act introduces a new category of income: Foreign-Derived Intangible Income (FDII), which represents intangible income earned by a U.S. corporation from product sales (or services) income in foreign markets. FDII appears to include interest earned on income from foreign sales or services so long as the interest can be traced to the terms of the sales or services (i.e. interest charge on late payment). Note that intangible income is defined as the excess over a routine return on tangible assets (e.g., 10%). Income categorized as FDII will receive a deduction of 37.5% which, after applying the new corporate rate of 21% yields a reduced tax rate of 13.125%. This effective rate increases to 21.875% for tax years beginning on or after January 1, 2026. Provided an effective rate of 13.125% presents a tax benefit, taxpayers should revisit their transfer pricing policy to determine whether the FDII amount is being maximized. For example, if the value of outbound sales or service transactions with foreign related parties can be increased, taxpayers may be able to reduce the effective tax rate to as low as 13.125% until 2026. Increased income that qualifies for this reduction may require a change to the foreign related parties’ risk profile, so care should be taken to ensure that any new transfer pricing policy is sufficiently supported by the underlying fact profile.

New Taxes for Intangible Income Earned Offshore

The Act also introduces a new category of income known as Global Intangible Low-Taxed Income (GILTI), which refers to foreign earnings that exceed an amount equal to a standard rate of return on tangible assets held offshore (e.g., 10%). This new tax is applied whether the foreign earnings are brought back to the U.S. or not. Until the sunsetting of this provision in 2026, a 50% deduction is applied and, after making other adjustments, the effective rate on GILTI income is 13.125%. Thus, while prior to the Act taxpayers could avoid any U.S. tax by keeping low-taxed intangible income offshore indefinitely, the new effective rate of 13.125% is significantly lower than the 35% statutory rate that would have applied had the income been distributed back to the U.S. as ordinary income. For that reason, taxpayers may still benefit from strategies that transfer intellectual property (IP) ownership to foreign jurisdictions, provided that the applicable foreign rate is no greater than the GILTI rate.

New Taxes to Discourage Base Erosion

Finally, the Act introduces a new Base Erosion Anti-Abuse Tax (BEAT), which is effectively an alternative minimum tax to discourage excessive earnings stripping through deductible payments of interest, royalties, and management fees to foreign affiliates. Imposed on U.S. corporations with at least $500 million in average annual gross receipts over three years, the BEAT applies a minimum tax (5% for 2018, 10% for 2019 through 2025, and 12.5% for subsequent tax years) on a taxpayer’s modified taxable income. Modified taxable income is generally taxable income adjusted to exclude certain base erosion payments (as defined in the new law). The impact of the BEAT presents a challenge for U.S.-based multinational enterprises (MNEs) that implemented transfer pricing policies to optimize deductible payments of interest, royalties, and management fees to foreign affiliates. Significantly however, excluded from the BEAT tax are payments for cost of goods sold (COGS) and payments for certain types of routine services. Accordingly, MNEs should re-evaluate their transfer pricing policy to see whether royalties or services may be properly embedded in COGS. Caution must be taken however, as IRS is granted broad regulatory authority to issue regulations and other guidance to prevent the avoidance of the BEAT.

Expanded Definition of Intangibles

Layered on top of the rules described above is a new definition of intangibles. Intangible property was previously defined through a list of specific types of IP that included patents, copyrights, trademarks and so on that are independent of the services of any individual. Under the Act, the definition of intangibles is expanded so that if an item is not specifically defined as tangible property under the new law, it is to be considered intangible property and possibly subject to taxation. As mentioned above, the Act assigns a 10% standard return on tangible assets, so that any income in excess is to be considered intangible income, and thus subject to the GILTI and FDII provisions.

Clearly, the expanded definition of intangibles, coupled with the new base erosion provisions, is intended to make transfers of intangible property to foreign jurisdictions more expensive and thus, less beneficial from a tax standpoint.

Fundamental Change

The U.S. international tax system has been fundamentally changed. Both U.S.-based and foreign multinational businesses will find it necessary to understand and model the effects of the GILTI, FDII, and BEAT. Based on this reality, many such companies will be reevaluating the underlying economics and tax efficiency of their overall supply chain and considering modifications. As always, transfer pricing is an integral component of such analysis.

The Takeaway

The fundamentals of transfer pricing have not changed. Determining the benefits and risks, however, has become significantly more complex. Accordingly, taxpayers should expect an increase in transfer pricing disputes, especially those initiated in non-U.S. jurisdictions. It is critical that taxpayers assess these new complexities created by the Act and to identify, quantify and manage the risks and opportunities under their specific facts.