Inside this Edition: APA Results for the U.S. and Chinese Programs; Brazil Transfer Pricing Changes; and Services Analyses: A Common Area of Overlap between Transfer Pricing and International Tax.
APA Results for the U.S. and Chinese Programs
The end of 2012 saw promising results for both the re-vamped US Advanced Pricing Agreement (“APA”) program and the recently developed Chinese APA Program. Some key highlights:
On January 16, 2013, Richard McAlonan, director of the Advance Pricing and Mutual Agreement Program (“APMA”) in the United States, noted in a Bloomberg BNA interview that the Internal Revenue Service (“IRS”) closed 140 cases in 2012, more than triple the number of applications approved in 2011. This marks a successful beginning for the re-vamped APA program in which McAlonan implemented several changes, notably: (i) ranking cases according to difficulty; (ii) assigning teams according to geography, with separate teams formed to focus on cases with Canada, Japan, and the rest of the world; and, (iii) rapidly increasing headcount.
The APMA team received 130 APA applications in 2012, meaning that the number of cases concluded outpaced the number of cases coming in. Of the cases closed in 2012, 23 had been in the program’s inventory for more than five years. McAlonan attributed the improvement in the APA program to a number of factors, but drew special attention to the increases in headcount of the APMA division, which has allowed the team to reduce average workloads and increase efficiency. McAlonan indicated that the APMA team will continue to focus on pressing issues such as bringing down processing times from the current average of 41 – 42 months, and providing clear guidance for APA renewals. With the 2012 results of the re-vamped APMA, as well as ongoing efforts at further improvements, the IRS hopes to restore confidence in the APA process.
As previously reported, the APA program in China has undergone rapid development since 2009. In December 2012, China released its third annual China Advance Pricing Arrangement Annual Report (“China APA Report”)1, highlights of which are presented below:
- APA countries – From January 2005 to December 2011, the Chinese tax authorities received 99 written requests or formal applications for bilateral APAs. The countries involved included Japan, Korea, the U.S., Denmark, and Singapore, among others.
- Number of APAs executed increased in 2011 – After seeing a decrease year-over-year from 2009 to 2010, the Chinese APA program rebounded slightly in 2011 to complete 12 APAs.
- No multilateral APAs – For the seven-year period (2005-2011), China signed 53 unilateral APAs and 20 bilateral APAs. China has not signed any multilateral APAs to date. However, the number of bilateral APAs is accounting for an increasing percentage of Chinese APAs, so the extension to more than two countries may not be far behind.
- Transaction type – The purchase and sale of tangible assets accounted for approximately 64 percent of total concluded APAs in the 2006-2011 period, consistent with the previous study. The transfer or use of intangible assets and the provision of services both accounted for approximately 18 percent of the total. However, intangible asset transactions in particular make up a higher share of new APA applications in China.
- Processing time – Of the unilateral APAs the Chinese tax authorities signed in 2011, the vast majority were completed within two years from time of submission. Bilateral APAs were completed within three years of submission. This is consistent with the prior year’s average processing times.
- Transfer pricing methods applied – Between 2005 and 2011, the Transactional Net Margin Method was the most commonly used Transfer Pricing Method, accounting for 67 percent of signed APAs. The cost-plus method was the second most popular. The most commonly used Profit Level Indicators were the Return on Sales ratio and the Full Cost Mark-up ratio.
In an effort to further provide guidance to taxpayers, Chinese tax authorities also included in the 2011 China APA Report a list of State Administration of Taxation contacts by province, as well as a brief description of the APA program operation in 2011.
Brazil Transfer Pricing Changes
After enacting new transfer pricing rules in September of 2012, the Brazilian tax authorities followed up at the end of December with guidance on how to apply the new rules. At around the same time, the government also issued some clarification on sections of the September 2012 release dealing with financial transactions, although many questions remain on that topic.
This year-end Brazilian activity continued a months-long process of rethinking transfer pricing approaches in that country. Among the more significant changes to the general transfer pricing rules are the following:
- Tightening of Profitability Safe Harbor: Previously, Brazilian taxpayers earning pre-tax margins above 5 percent in outbound transactions with related parties were exempt from Brazilian transfer pricing rules. The profitability threshold has been increased to 10 percent under the new guidance. In addition, this safe harbor will not apply if a taxpayer’s net revenue from related-party transactions is more than 20 percent of their total net revenue.
- Back-to-Back Transactions: In response to a variety of opinions previously expressed among Brazilian taxpayers, the government has clarified that transfer pricing rules do apply to back-to-back transactions.
- Margin of Difference: The new rules retain the 5 percent margin of difference safe harbor between the actual intercompany transaction price and the arm’s length price as determined by application of the appropriate transfer pricing method (i.e., no adjustment if the difference is 5 percent or less). That margin of difference is adjusted to 3 percent in the case of commodity transactions. (As reported last May, there are new transfer pricing methods prescribed for the export and import of commodities.)
With respect to financial transactions, the September rules required a fixed spread over LIBOR for all intercompany loans, not just those not registered with the Brazilian Central Bank as had previously been the case. Brazil then published a Normative Ruling on December 31, 2012, ostensibly to guide the application of the new approach. However, the Ruling raises more questions than it answers. Limits on interest payments – maximums or minimums, depending on the direction of the payments – are the combination of a base rate (e.g., sovereign Brazilian bond yields) and a margin or spread. However, no detail is provided as to what that margin should be for different types of loans. (The September rules had suggested a fixed 3 percent over LIBOR, but there was no specific mention of this in December.) Additional guidance will be needed from the Ministry of Finance, which has indicated that the margin should reflect a “market average.” This could indicate that Brazil is joining most other countries (and the broad OECD standard) in pricing loans commensurate with the credit risk of the borrower. However, if what the Ministry has in mind is instead a revised schedule of fixed margins, for instance, there could remain significant divergence between the Brazilian view and that of other countries.
Most of the new Brazilian rules become effective for fiscal years beginning on or after January 1, 2013, though taxpayers may elect to apply them for fiscal year 2012.
Services Analyses: A Common Area of Overlap between Transfer Pricing and International Tax
U.S.-based multinationals that have significant headquarters activities often perform a services analysis to meet transfer pricing requirements under Internal Revenue Code (“IRC”) Section 482, and then again separately to meet the requirements of IRC Section 861 from an international tax perspective. While the concepts addressed under IRC Sections 482 and 861 are distinct, an overlap exists that provides both opportunities and risks. We examine this overlap, and its implications, in further detail below.
Transfer Pricing – Section 1.482-9
In 2009, the Treasury Department and the IRS issued the final service regulations (“Section 1.482-9” or the “Service Regulations”), which provide U.S. multinationals with substantive transfer pricing guidance to evaluate the arm’s length nature of intercompany services transactions. A transfer pricing services analysis enables a company to identify and charge service expenses to benefiting foreign affiliates. A properly documented analysis will provide the taxpayer with transfer pricing penalty protection in the United States and is typically required in order to support foreign deductibility of the service charges.
International Tax – Section 861
The IRS also requires that U.S. companies determine the sources of income for tax reporting purposes. Specifically, IRC Section 861 identifies items that are treated as income from U.S. sources (e.g., interest, dividends, personal services, rents, and royalties) and addresses how to allocate and apportion income (and expenses) between the different categories (i.e., U.S.-source versus foreign-source income). The sourcing of income and expenses is particularly important to multinational companies as it is a key component in computing foreign tax credit limitations which affect the overall tax profile of the company. To the extent that expenses are allocated to income connected to the conduct of a U.S. trade or business (or vice versa), it may create higher overall tax benefits within the organization.
Once relevant service expenses have been allocated among the related parties as part of the transfer pricing analysis, it is necessary to determine the source of those expense / income items for purposes of IRC Section 861. The process of properly completing an analysis under IRC Section 861 significantly overlaps with conducting a Section 482 analysis. The primary distinction, however, relates to the evaluation of non-beneficial (or stewardship) expenses. For purposes of transfer pricing, simply identifying and quantifying non-beneficial expenses is sufficient. However, IRC Section 861 requires that taxpayers go one step further and allocate or apportion all expenses, including non-beneficial expenses, to foreign- or U.S.-source income. This requires an understanding of the definition of non-beneficial expenses (for purposes of Section 482) and stewardship expenses (for purposes of Section 861), as well as an appreciation for the definitional nuances between the two.
For instance, the Service Regulations include four classifications of “non-beneficial” activities or services: (i) Indirect or Remote Services, (ii) Duplicative Activities, (iii) Shareholder Activities, and (iv) Passive Association. In comparison, IRC Section 861 operates under a more narrow (yet related) definition for non-beneficial services, wherein stewardship expenses result from “oversight” functions undertaken for a corporation’s own benefit as an investor in a related affiliate’s business. As such, for Section 861 purposes, stewardship expenses include two of the four categories of non-beneficial activities relevant to transfer pricing analyses: duplicative activities (as defined in §1.482-9(l)(3)(iii)) or shareholder activities (as defined in §1.482-9(l)(3)(iv)). Under Section 861, expenses associated with these oversight functions shall be considered allocable to dividend income received, or to be received, from the related affiliate. This becomes important when calculating a US company’s foreign tax credit limitations, impacting its US taxable income. It is therefore necessary to specifically identify subsets of non-beneficial costs under IRC Section 861 and allocate those expenses to offset foreign-source income in order to compute the correct amount of U.S. income tax.
For both the IRC Sections 482 and 861 analyses to be effective, it is important that the conclusions have a strong factual basis. Therefore, conducting functional interviews with relevant company personnel is critical to ensuring that sufficient information is gathered to satisfy the requirements under both sets of regulations. This takes a strong technical understanding of Sections 482 and 861 as well as a working knowledge of the company. To make certain that these analyses are completed correctly, it is also important to have the right professionals assisting with the completion of each analysis (i.e., experienced transfer pricing practitioners may be knowledgeable in the area of Section 861, but it is preferable to bring in a specialist to assist with this portion of the analysis).
An integrated approach to headquarter services analyses brings together expense allocations, foreign tax credit planning, financial statement support, and transfer pricing, resulting in cost and time efficiencies. Such an approach can also mean reduced audit risk as coordinating these analyses aligns transfer pricing documentation and other tax forms / positions, which is a critical step that is often overlooked by taxpayers.
1For more information: 2011 China APA Report