1. Global increase in transfer pricing audits – In 2009 the IRS hired scores of additional agents, particularly international examiners and economists, with the intention of expanding audits of large and mid-size corporate taxpayers – particularly those in the middle-market. The U.S. was not alone. Around the world, tax authorities increased their numbers of cross-border examiners in 2009 and beyond. Of the countries with the most aggressive additions of audit related personnel, key U.S.-trading partners Brazil, Mexico and China have signaled an increase in transfer pricing audits in the coming year. Multinational enterprises must anticipate that IRS initial documentation requests will include a request for transfer pricing documentation and be prepared to respond to such requests within 30 days of the request. Other countries will have similar, if not, shorter response times. Moreover, failing to respond in many cases is tantamount to being non-responsive. The days of “just-in-time” transfer pricing documentation are over.
2. Intellectual property and cost-sharing – On December 31, 2008, the U.S. Treasury released the new temporary cost-sharing regulations under Treas. Reg. §1.482-7T. The Temporary Treasury Regulations are hardly taxpayer-friendly and represent the increased scrutiny U.S. multinationals will face with respect to arrangements to share costs and the global structuring and alignment of intellectual property portfolios going-forward. In order to “grandfather” cost-sharing arrangements in place prior to the January 5, 2009 effective date, taxpayers had until July 6, 2009 to conform their existing cost-sharing arrangements to the requirements contained in the new temporary regulations with certain adaptations. The key for U.S. multinationals in 2010 is to remain vigilant with respect to existing cost-sharing arrangements and events that may trigger an arrangement – particularly important as M&A deal flow likely increases during the coming year in response to a (hopefully) reviving economy.
3. Codification of Economic Substance – The proposed bill codifying the Economic Substance Doctrine is still alive in the House and will likely find its way into law sometime in 2010 – either in the form of the ultimately enacted healthcare bill or in another piece of legislation. U.S. taxpayers must critically examine the transaction structuring and planning which has provided tax benefits and be prepared to produce documentation and other evidence showing the non-tax business purpose justifying the underlying transaction and attendant structuring.

The stakes are rising for multinational enterprises as the world is getting smaller and tax authorities are sharing information at unprecedented levels. Thus, the best defense is a well-crafted offense that is integrated contemporaneously with acquisitions, divestitures and/or restructurings. The days of operational autonomy for multinational enterprises are over.

The so-called Holy Grail of transfer pricing has long been the comparable uncontrolled price (or transaction). The elusive publicly reported transaction between third parties which nearly perfectly matches the facts and circumstances of the related group transaction seldom exists. As such, taxpayers around the world most often rely on a range of results derived from uncontrolled parties – known as comparables – as the basis for determining whether or not the results of the transaction under review satisfy the arm’s length standard. The reference companies selected for comparability need not only meet certain functional and operational criteria in order to be comparable (e.g., functions performed, assets employed, risks borne), but financial standards as well. Differences between revenue, expense, asset, liability and equity treatment between IFRS and U.S. GAAP are significant. In the short-term there may be difficulty establishing comparability between the financial data of companies reporting under IFRS versus those reporting under U.S. GAAP. While the IRS requires U.S. GAAP to be used by all U.S. taxpayers if the comparable companies under consideration are non-U.S. companies traded on foreign stock exchanges the same rules do not apply. As can be seen from the example below, a small difference in the manner in which cost is reported (e.g., above or below the operating income line) can have a major impact on the ultimate result.

For example:

For U.S. taxpayers examining the results of potentially comparable companies from around the world this development means a tremendous amount of extra effort – either the taxpayers must reconcile the financial statements of all potential comparables back to U.S. GAAP in order to perform the analysis or the taxpayer must find and use only those companies who report their results under U.S. GAAP. Ultimately both choices are poor and will lead to less accurate and complete analyses. It remains to be seen to what extent IFRS and U.S. GAAP will impact comparability for transfer pricing purposes and how the lack of convergence will affect U.S.-based multinationals. If recent trends associated with companies adopting IFRS hold, it is likely that net income under IFRS will likely exceed the amount reported under other comprehensive bases of accounting. Given all of these factors, it is likely that – for the foreseeable future – transfer pricing will need to start with local country GAAP reporting rather than IFRS.

Section 561: Limitation on Treaty Benefits for Certain Deductible Payments

• What it says: “In the case of any deductible (U.S. source item of fixed, determinable, annual, or periodic (“FDAP”) income ) related-party payment, directly or indirectly, any withholding tax imposed under chapter 3 (and any tax imposed under subpart A or B of this part) with respect to such payment may not be reduced under any treaty of the United States unless any such withholding tax would be reduced under a treaty of the United States if such payment were made directly to the foreign parent corporation.” [Emphasis added]
• What it means: 1) The stock ownership threshold for what it means to be a controlled party under IRC section 1563(a)(1) is reduced from “at least 80 percent” to “more than 50 percent”, 2) Withholding taxes cannot be reduced under a U.S.-treaty, unless a direct-payment to the foreign parent corporation would also qualify for such reduced rate of withholding tax. Clearly, the aim is to shut-down inverted companies with inbound financing structures. Given the broad nature of the proposal, however, the collateral consequences may not have been fully considered, as it appears to be a “super-limitation-on-benefits” provision to redress real or perceived abuses in cross-border financing structures. It will likely be more of a clarion call for U.S. trading partners to cry foul, akin to the FIRPTA provisions on the 1980s with respect to treaty benefits. At a time when multinational enterprises are seeking certainty in their cross-border affairs it will likely throw a monkey-wrench in planning and (as currently drafted) have unintended consequences.

Section 562: Codification of Economic Substance Doctrine, Penalties

• What it says: “In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if – (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”
• What it means: The Economic Substance Doctrine, heretofore an amorphous standard molded by the judiciary, would now be on the books as law. Essentially, the government would have a weapon to combat perceived tax shelters even if the taxpayer was technically compliant with relevant law and historical precedent. The language is highly subjective and ambiguous. Given that taxpayers already have the burden of proof, codification of the Economic Substance Doctrine raises the bar even higher, requiring justification not only of the transaction from a legal standpoint, but also from a business and economic position as well both qualitatively and qualitatively and leaves the door open to questions in the event the non-tax aspects of the transaction are unrealized or realized to a lesser degree than anticipated. In addition, the “Reasonable Cause and Good Faith” exceptions under IRC section 6664, would be amended to exclude transactions for which “Economic Substance” was lacking and for tax-shelters. In addition, IRC section 6662 would be amended to increase the 20 percent penalty, to 40 percent for non-disclosed non-economic substance transactions.

Section 563: Certain Large or Publicly Traded Persons Made Subject to a More Likely Than Not Standard for Avoiding Penalties on Underpayments

• What it says: “In the case of any specified person, paragraph (1) shall apply to the portion of an underpayment which is attributable to any item only if such person has a reasonable belief that the tax treatment of such item by such person is more likely than not the proper tax treatment of such item.”
• What it means: Instead of the “substantial authority” standard or reasonable basis plus disclosure test of current law, transactions would be subject to a “more likely than not” (“MLTN”) test. If this proposed legislation is made law in its current form, companies may have to accrue for additional penalties under FIN 48 for positions taken on a tax return where the position did not meet MLTN under the proposed legislation. It effectively raises the bar on affected taxpayers with respect to the current penalty regime under section 6662 by amending the “Reasonable Cause” provisions of section 6664. As currently drafted, the proposed change would pick up privately held corporations with $100 million or more of gross receipts and publicly traded persons.

At the recent LMSB Financial Services industry seminar in New York City, Kathy Robbins, LMSB field operations director (financial services industry) and Stuart Mann, Program Director for Withholding Taxes, noted that cross-border payments and compliance related to those payments will continue to be an area of emphasis and may well become a national program.

A subgroup of IRS personnel is working to develop a matching program for Form 5471 filings and annual Form 1042 filings to cross-reference this information to ensure that proper reporting with respect to Form 1042 has occurred. It also appears that the Form 5471 information will continue to be relevant in other areas as well, such as with respect to transfer pricing documentation. LMSB examiners have often found “gaps” in the information reported on Form 5471 and the taxpayer’s transfer pricing documentation under Section 6662. Thus, taxpayers and their advisors are well advised to review the content of their Forms 5471 filings with their Form 1042 filing and their transfer pricing documentation to ensure that there is consistency in this information.

Bear in mind that there are legitimate reasons for inconsistencies between amounts reported on Forms 5471 and Form 1042 and what is included in the taxpayer’s transfer pricing documentation. For example, transfer pricing documentation includes all intra-group transactions, not just U.S. sourced-fixed, determinable, annual or periodic income (“FDAP”) paid to non-U.S. persons – what is reported on Form 1042.

Given the IRS’ recent success with its withholding efforts and the fact that withholding is now a tier-I LMSB initiative, taxpayers and their advisors would be well advised to consider reconciling the information on Forms 5471/5472 with the information contained in their transfer pricing documentation, as unaccounted for items on Forms 5471/5472 may give rise to penalty exposure in the event of an adjustment on examination.

For the uninitiated, Bikram Yoga is a series of twenty-six postures (called asanas) developed by Yogiraj Bikram Choudhury performed in a room heated to about 105 degrees Fahrenheit. While Al-Qaeda members get sent to “Gitmo” to be put into stress positions in extreme heat for free, I pay for the privilege. But, I digress…

How did Bikram Yoga teach me about finance, tax and transfer pricing risk management?

Focus

The single most important aspect of yoga is focusing on breathing. By setting your objective at the outset, focusing on yourself in the mirror and centering your energy and attention on a single point, you are able to accomplish a tremendous amount of very hard work in 90 minutes. As a consultant, I work with companies who have many, many strengths, but often lack the ability to focus clearly on a single point or aspect of their business or strategy. Why? Because of the frenetic pace of business activity and the daily crises that are a way of life for every multinational enterprise. Consequently, the state in which most in-house finance, transfer pricing, tax and legal professionals operate is somewhat ad hoc in nature; akin to fire-fighting. As in yoga, the ability to successfully filter the surrounding chaos in order to identity the underlying matter/challenge-at-hand and at the same time hold-in-check everything else that is going on, is the only way to succeed individually or organizationally. It is thus a great balancing act that requires constant stretching and adjustment to remain in balance.

When practicing yoga, the focus is on maintaining the breath. If you hold your breath you cannot sustain the postures. If you panic and start to breathe erratically the “fight or flight” instinct kicks in and you lose your ability to concentrate and maintain your postures. In finance, transfer pricing, legal, and tax matters, the focus has to be on designing, developing, implementing, maintaining and sustaining the strategy that supports the business objectives of the organization; which are dynamic. Focus is the single most important tool of the corporate or consulting professional. You cannot manage enterprise risk if you are constantly distracted from the purpose. We have a saying in East Texas: “When you’re up to your neck in alligators, it’s tough to remember that the objective was to drain the swamp.”

Balance

My favorite pose in the Bikram series is Dandayamana-Dhanurasana (try saying that five times fast…). Standing Bow Pulling Pose is possible because you are kicking your foot back and at the same time stretching forward – it is a balancing act. The same is true for finance, tax, legal, operations, and transfer pricing-risk management. No matter how well-run the business or excellent the planning and implementation, the company will have risk. How that risk is allocated, managed and aligned operationally around the world impacts the organizations’ success. No Board of Directors or Senior Officer wants to hear that an organization has significant unmitigated risk. However, risk is an inherent part of what we deal with as professionals. In finance, transfer pricing, legal, operations and tax, balancing risk means understanding the full benefits and challenges of the enterprises’ operations and keeping those pros and cons in tension – pulling in some places and stretching in others. Balance is critical for enterprise risk management.

Everything Working Together

In the series of standing postures, yogis work up to a master pose – Trikanasana, the Triangle Pose. Triangle is a challenging asana that involves every muscle, tendon and ligament in the body working together. Finance, legal, transfer pricing, and tax are fundamentally issues of facts and circumstances. For a corporate finance or consulting professional to add value, he or she must understand how the organization works both in terms of individual product or service lines and collectively as a business. Finance, tax, legal and transfer pricing cannot exist in a vacuum where decisions are made without a foundation in the business substance and strategic objectives of the enterprise. In many ways, transfer pricing is the “master pose” of a multinational enterprise: It involves understanding the operations and inner-workings of an enterprise from its most basic and fundamental levels up to its global corporate objectives and then translating that understanding into a structure with accompanying processes and procedures that support the objectives while being as financially efficient as possible and at the same time minimizing enterprise-related risk. It is the multinational enterprise equivalent of the Triangle Pose.

Ultimately, yoga has taught me to breathe in difficult and challenging situations, to not lose sight of the vision and objective (no matter how distinctly unpleasant the circumstances), to keep balance between stretching forward and pulling back, and to bring many components together to achieve a singular objective while respecting the individual parts. All of these skills and abilities help me to be a better consultant, advocate and advisor for my clients and colleagues.

-          EAS