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The Charted Minefield
of US Company Tax Companies with US operations were in for a rude shock in the early 1990's when the American tax authorities started taking an aggressive approach to the profitability of foreign owned companies. There is a strong belief in the US that foreign owned companies were and are using unfair practices in competing with American business. This was not helped by several studies commissioned by the US Internal Revenue Service which indicate that for foreign owned businesses in the US, the sum of all their expenses was well in excess of their income, and that the amount of tax under payments by them could exceed $12bn. Add to the equation the then current fiscal deficit environment and the fact that US legislators view foreign owned corporations as a giant potential tax cash cow ..... then the legislation and tax controls implemented on foreign owned companies in the US is understandable ..... even if totally unjustified!. Indeed, it could be maintained that the combined enforcement and legislation relating to foreign owned companies is discriminatory and as some companies have discovered, they are in for a very unpleasant ride. The IRS hypothesizes that the under-reporting is derived from related party transactions, deducting market entry costs which should be capitalized, and payment of expenses which properly relate to the foreign related parties. As is often the case, extreme situations are cited to "justify" the authorities' claims - companies incurring losses for 20 years, for example, which, of course, are impossible to defend when they say they have invested in the US for profit motives - and, as is often the case, the innocent tend to get embroiled in the controversy along with the perceived transgressors. For many years, for both domestic and foreign companies, legislation has been in place which enables the Internal Revenue Service to examine related party transactions and if it does not agree with the companies' figures, to substitute its own. This was successful with US companies but not with foreign owned corporations because the IRS did not have access to foreign related books of accounts. But in late 1989 amending legislation was introduced requiring foreign owned businesses in the US to keep records, written in English, of transactions with foreign related parties. A US subsidiary which is at least 25% foreign owned and branches of foreign businesses, in general terms, must file a form 5472 which details certain transactions with related parties. Additionally, the US company must (unless its receipts are less than $10 million for the year or the gross receipts and payments between the entities is less than $5 million and less than 10% of its gross income) keep sufficient records, as defined by US tax law, to justify those transactions. This includes costs billed by the foreign company such as costing records of the foreign company justifying the related party transactions. The records relating to the foreign company have to be produced to the IRS, if they so request. The requirements are very detailed and the penalties on the US parties are such that the taxpayer has no option, but to comply. There are certain safe harbor arrangements and the possibility to make special arrangements with the IRS to pre-agree the records to be kept. In other words, the US foreign owned business must keep the records of the foreign related party transactions in accordance with US rules and regulations, and the IRS is in a position to force companies to produce relevant group books and records from anywhere in the world to substantiate those records, non-compliance will lead to 'smallish fines', together with measures which allow the IRS at its own discretion to disallow expenses (or interpose its own values) relating to transactions with foreign related parties. The tax regulations provide methods for calculating the transfer pricing for - Tangible property, they are:
Intangible property, they are:
Loans
Intercompany Services
In all cases, the "Best Method" should be used. Businesses are required to keep "Contemporaneous" documentation (in other words made at the time the transaction is undertaken). Foreign owned US businesses are covered by section 6038A of the Internal Revenue Code (and related regulations and court cases), Double Tax Treaties and "Mutual Agreement" procedure. Penalties are covered by Section 6662(e) and documentation requirements. All businesses should create a "book" showing how transfer pricing is calculated. This can, in its lowest form, be a note "to the file", but in reality needs to have detailed documentation showing how the calculations are made, in accordance with the law, rules, regulations and court cases. The penalties are severe and can exceed the value of the gross sales. Additionally, the IRS may target expenses incurred in transactions with unrelated third parties which are perceived to be related to the cost of market entry or expansion or of benefit to the foreign related party (for instance the costs of US advertising or other marketing). I believe that that the IRS works on the assumption that any loss-making or marginally profitable business will not have been complying with the rules and it will seek to disallow relevant expenses. That leaves foreign owned business the difficult and costly task of proving to US officials that the expenses are deductible under US tax law and regulations, as well as under the IRS's economic "profitability" standard. This economic standard is a set of criteria which the IRS uses to assess the amount of tax on foreign owned business, includes questions such as, if the US entity had not been related to the foreign entity, would it have undertaken the transactions? Would the financial and commercial arrangements have been the same? For example, in the case of a US importer or distributor, is it usual for them or the manufacturer to bear advertising costs? Would the US distributor have received additional discounts or purchased the merchandise from other lower cost sources? According to this economic theory, an independent corporation would have autonomous management based at its place of business. In the event that legally appointed operating officers are titles held by foreign based employees of the related party, it is possible that the IRS will attempt to hold that the US legal entity is a sham or that it is merely acting as an agent of the foreign company. Consequently, the IRS might attempt to hold that the foreign related party is doing business in the US and is taxable in the US along with the US entity. The legislation has effectively handed the IRS a blank check book signed by foreign companies. Its ultimate purpose is to provide sufficient information for the IRS to derive transfer prices based on its special concepts; the IRS can then, replace the book figures for transactions between related parties with amounts it has computed. Where there are insufficient records, then it will be able to use almost any amount of its choosing. And for many companies there will be no protection under their native country's tax treaty with the US since many allow the US and corresponding foreign governments to decide between themselves the jurisdiction under which the expense will be allocated. At the best of times, it is difficult to assess the certainties of US tax liabilities and their amount. With the introduction of the above mentioned legislation, and during the development stages of the consequential regulations and the special economic concept, it has come a veritable minefield. It is certainly easy to become nervous about the situation, however some cases examined by the IRS have already been settled without change. It is too early to evaluate the ultimate results, but I would say that with diligence and advice from tax specialists, liabilities can actually be minimized. Deliberately overpaying tax in the US is unlikely to help since the authorities may just become suspicious whether there are still additional under-reported taxes. Nor is using the cost basis of foreign related party transactions, because the IRS might well argue that the profit element should be no more than that which would be paid to an unrelated contractor. (For example, it might only include direct manufacturing costs plus a modest single figure mark up for profit. Marketing, advertising and administration costs might all be excluded. The one constraint in all this is that the new tax regime is expensive - the costs of the disruption of productive executive resources during examinations by the IRS, of internal time spent in reviewing records and obtaining additional information from old records, and last, but certainly not least, the costs of professional, legal and accounting advice which is likely to add up because so many transactions can be re-characterized by the IRS in many different ways. In thinking about US Market Entry or analyzing the current US tax position, perhaps the following are the major items to consider:
All this may seem incomprehensible (or should one say unbelievable?), but those truly conversant with US bureaucracy will understand that logic and pragmatic business efficiency have little value within this particular system.
No information contained herein shall be
taken as a professional opinion. In this page or website or any
attachments thereto any comments are not to be taken as professional
advice. The writings are not intended, and cannot be used by you, to
avoid any penalties the Service (or other tax authorities) may impose as
a result of taking any position in this writing.
The author is a past president of the Association of Chartered
Accountants in the US. |