Profit shifting: Effectively connected income and financial statement risks

Multinational corporations could be subject to high levels of tax on effectively connected income.
By Thomas J. Kelley, CPA (retired), MBA; David L. Koontz, CPA (retired); and Jeffery M. Kadet, CPA (retired), MBA

Profit shifting: Effectively connected income and financial statement risks
Image by neyro2008/iStock

In recent years, the financial press, governmental authorities in many countries, the G-20, and the Organisation for Economic Co-operation and Development have increasingly turned their attention to multinational companies (MNCs) that shift income to lower-taxed foreign jurisdictions to avoid taxation. There is a growing sense that certain large blue chip companies have availed themselves of tax planning that relies too much on form and artifice rather than serious and substantive business planning intended to enhance their products, increase market share, and improve profitability.

Companies coming under this scrutiny include those that have "inverted" into foreign ownership, foreign-based MNCs owning a business actively conducted in and managed from the United States, and U.S.-based MNCs. U.S.-domiciled companies alone have reportedly parked more than $2 trillion of their low-taxed foreign earnings overseas ("U.S. Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes," by Richard Rubin, Bloomberg Business, March 4, 2015). Adding in the profits shifted by foreign-based MNCs that otherwise would be taxable in the United States would significantly increase this figure.

Given all this attention, it is now critically important that MNCs ensure that their planning and use of offshore companies fully complies not only with the letter but also with the spirit of the law. If this is the case, then there should be little concern about an IRS examination into transfer pricing or other profit-shifting practices. But this will not be true for companies that have elevated form over substance and have over-relied on internally generated documents and contracts. And as the IRS learns more about MNC profit-shifting techniques, where warranted, it may begin applying Secs. 11, 882, and 884, which impose direct taxation on the effectively connected income (ECI) of foreign corporations, to prevent abuses by MNCs. The IRS's successful application of the ECI rules could have devastating tax and financial statement consequences for any affected MNCs, for two simple reasons:

  • ECI can be taxed at a rate of more than 50% or even higher, often including years that were thought to be closed, and
  • Such taxation would cause significant financial statement tax provisions, especially for the many MNCs that have used Accounting Principles Board 23, Accounting for Income Taxes—Special Areas, to avoid accruing any foreign taxes on shifted profits.

For anyone expecting congressional adoption of a territorial tax system, there will be no comfort since these ECI rules would remain in full effect to directly tax shifted profits when warranted.

This article aims, first, to provide CFOs, in-house tax professionals, and outside auditors or advisers practical guidance to determine whether their companies' and clients' fact patterns would clearly support a finding of having ECI. Second, if those individuals see reason for concern, this article provides practical guidance on the financial statement and tax risks and what to do about them.

While this article focuses on financial statement and tax risks, where the ECI risk is high, any affected company will face a multitude of other concerns, including cash flow issues, compliance with banking and loan agreements, potential effects on awards under employee compensation plans, foreign exchange and currency issues, and potentially even questions about business ethics.

GROWING IRS AWARENESS OF PROFIT SHIFTING AND IMPLICATIONS

The Senate Permanent Subcommittee on Investigations held hearings in 2012, 2013, and 2014 directed at specific companies that it believed had been shifting profits out of the United States. Following the 2014 hearings on Caterpillar, as disclosed in Caterpillar's Form 10-K of Feb. 17, 2015, the IRS in January 2015 issued a Revenue Agent Report proposing tax increases and penalties of approximately $1 billion relating to certain income earned by Caterpillar's Swiss entity, Caterpillar SARL. The basis for most of the IRS claim was application of the substance-over-form and/or assignment-of-income judicial doctrines. Caterpillar is contesting this adjustment and stated in its Form 10-K that the transactions "complied with applicable tax laws and did not violate judicial doctrines."

Microsoft was examined by the subcommittee in 2012. The IRS has attacked Microsoft's transfer pricing involving intangibles in connection with several internal group cost-sharing agreements that played an important part in its profit-shifting efforts. Microsoft testified at that hearing that it "complies with the tax rules in each jurisdiction in which it operates and pays billions of dollars in total taxes." This dispute is ongoing.

Last September, the IRS issued to the Coca-Cola Co. a statutory notice of deficiency for additional taxes of approximately $3.3 billion covering 2007 through 2009. Like the action against Microsoft, the basis for the additional taxes is also transfer pricing in connection with the licensing of intangible property. Coca-Cola said in its Sept. 18, 2015, Form 8-K that the assessments are "without merit."

In the case of Caterpillar, the IRS focused on the company's Swiss tax strategy under which the bulk of its profits from the sale of certain replacement parts was recognized by a Swiss group member rather than by a U.S. group member, as previously had been the case. The Senate subcommittee's report makes clear that although the profits were shifted through various entity and contractual mechanisms, the physical business operations remained unchanged, so that the actual conduct and management of the Swiss group member's business continued to be within the United States. This same fact pattern can be seen in other subcommittee investigations, as well as in other publicly available material. Many other MNCs with one or more businesses managed from operating and headquarters companies in the United States have likely implemented similarly tax-motivated restructurings with a minimum of meaningful operational changes.

In the Caterpillar and Microsoft cases, the IRS pursued, respectively, the substance-over-form and assignment-of-income judicial doctrines and transfer-pricing adjustments, all of which are subjective. However, where an MNC's fact pattern warrants it, the IRS could impose direct taxation on the ECI of the foreign group members that recorded the shifted profits. Under this approach, such taxes could be imposed at rates of up to 54.5% or higher. To the maximum 35% corporate tax could be added the Sec. 884 branch profits tax of 30%, which is imposed on effectively connected earnings and profits (adjusted by changes in U.S. net equity during the year and reduced in some cases by tax treaties) (i.e., 35% corporate tax, plus 30% of the remaining 65% of income, or an additional 19.5%, which totals 54.5%). Where branch profits are protected by some U.S. treaties, the combined rate could be 38.25% or higher.

Furthermore, this approach is statutorily based and more objective in application. It should not only be easier for the IRS to sustain the ECI approach in court, but it will require CFOs and outside auditors to carefully consider this new tax exposure when applying FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes, which importantly requires a presumption that the relevant tax authority has full knowledge of all relevant information.

WHEN COULD AN MNC BE SUBJECT TO THE ECI APPROACH?

The Code and regulations provide detailed rules for calculating a foreign corporation's ECI. In brief, for any foreign corporation that conducts a trade or business in the United States, ECI includes all of that foreign corporation's U.S.-source business income, and it can also include certain foreign-source income. For a detailed description of the ECI tax rules, click here.

The ECI approach potentially applies to any MNC that manages one or more business lines within the United States but records significant profits in low-taxed foreign group members. Here, the broader term "group member" rather than "subsidiary" is appropriate because inverted MNCs and other foreign-based MNCs that conduct such lines of U.S.-managed businesses more typically route transactions and earn profits through group members that are not subsidiaries of U.S. group members. U.S.-based MNCs, of course, conduct such transactions and earn profits through their foreign subsidiaries, which have a special status under U.S. tax rules and are often referred to as controlled foreign corporations, or CFCs.

The following three principal factors may subject an MNC and certain of its business lines to the application of the ECI approach.

Value drivers predominantly performed by U.S. group members. Crucially important value drivers that allow the applicable foreign group members to generate significant income are predominantly performed by U.S. group members rather than by the foreign group members. Such value drivers can include research and development that create new technologies and products, management and detailed control of the product purchase and production processes, and management of and direct participation in the product sales process.

U.S.-located control and decision-making. Often through service agreements or other contractual mechanisms, the U.S. group member performing services for a foreign group member makes business decisions and conducts management activities that in fact represent the U.S. group member's conduct of that foreign group member's business. The extensive U.S.-located control and decision-making go far beyond what would be found in any typical unrelated-party situation.

Lack of foreign group member CEO and management capability outside the United States. Although a person may be assigned to this position in name, there is no real CEO of the foreign group member who conducts the day-to-day trade or business of the foreign group member from one of its foreign offices. There may also be no foreign group member personnel capable of managing the foreign group member's businesses or having the experience, knowledge, and authority necessary to direct the U.S. group member service providers. Further, there may be no foreign group member management personnel or directors located outside the United States who are capable of negotiating or even understanding the terms of critical intercompany agreements such as license agreements, cost-sharing agreements, and service agreements. Rather, U.S.-located group management simply directs the contractual terms of these vitally important agreements.

MAJOR ISSUES FOR POTENTIALLY VULNERABLE MNCs

MNCs exhibiting the three factors described above will need to minimize and resolve potential issues on a number of fronts, which include the following:

Risk assessment

CFOs, in-house tax professionals, and outside auditors should seriously assess any tax risk that arises from the possible application of the ECI approach within their own MNC or within their MNC clients. There will often be a steep learning curve because the literature generally, and international tax advisers in particular, appear to have given this risk relatively little attention in published articles or when implementing cross-border profit-shifting structures. Also, since many of these structures have been in place for a decade or longer, the CFOs, in-house tax professionals, and outside advisers who were involved in their implementation may be long gone.

Risk assessment efforts will typically require detailed and time-consuming fact finding to determine exactly how each foreign group member earns its profits and how related group members have aided it in doing so. It seems likely that the country-by-country reporting that will be required soon may become a useful tool in this fact-finding effort. Even where international tax advisers seriously considered the risks of the ECI approach when designing and implementing structures years ago, operational procedures today must still be reviewed closely in light of operational and technology changes since implementation.

In assessing risk, CFOs and in-house tax professionals typically have a different perspective from that of their outside auditor. The former are advocates for the success of their MNCs and are concerned with the position of the MNC and its various stakeholders. The latter must approach issues on the independent basis required of an outside auditor and never as an advocate.

Because of Sarbanes-Oxley mandates, profit-shifting structures implemented within the past decade will likely have involved tax advisers other than those from the MNC's auditing firm. Even if an MNC's outside auditors already understand the ECI technical tax issues, they will normally still have to conduct considerable additional fieldwork to obtain sufficient evidence on exactly how each foreign group member earns its profits and how related group members have aided the foreign group member in doing so.

High tax liabilities and penalties

Besides the corporate tax and possible branch profits taxes involved, interest and penalties could be considerable.

Another, and potentially more significant, aspect of the ECI approach is the number of open tax years available for examination by the IRS. For example, the IRS assessed tax on a Caterpillar U.S. group member for the 2007 through 2009 tax years. This implies that Caterpillar's U.S. income tax returns filed on Form 1120, U.S. Corporation Income Tax Return, for earlier years are already closed and not subject to further IRS examination. However, where the ECI approach is applied so that the taxpayer is the foreign group member and not the U.S. group member, the IRS is free to go back to all years for which the foreign group member has not filed U.S. tax returns on Form 1120-F, U.S. Income Tax Return of a Foreign Corporation. Caterpillar initiated its Swiss tax structure in 1999. Were the IRS to use this ECI approach to challenge Caterpillar's offshore tax planning, it could assess corporate income tax for all years back to 1999 for which Caterpillar's foreign group members have not filed U.S. tax returns.

Financial statement effects

Depending on the level of risk and materiality, financial statements may need to include disclosures and/or reserves for possible taxation, interest, and penalties. Where the ECI approach is successfully applied by the IRS, pretax earnings may be subject to rates substantially in excess of the statutory 35% U.S. corporate tax rate. Accordingly, even if an MNC has accrued a full 35% U.S. residual tax for all years because it is not permanently reinvesting its earnings overseas, there may still be additional taxes in material amounts to disclose and/or accrue. And if the earnings have been treated as permanently reinvested overseas so that no U.S. tax on the repatriated earnings has been accrued, then the amounts of potential taxes, interest, and penalties to be accrued or disclosed could be material.

Any additional taxes, interest, and penalties that must be accrued under applicable accounting rules such as FIN 48 will directly reduce an MNC's reported profits and earnings per share. This will be of concern to the board of directors, management, shareholders, lenders, and others who have a stake in anything that materially affects an MNC's reported earnings. In addition, other regulatory issues may arise, including the potential for restatements of previous-period filings and whether the MNC has in place effective internal controls as mandated for public companies.

Because outside auditors must act independently and follow the full-disclosure presumption of FIN 48, the greater statutory basis provided by the ECI rules may cause outside auditors to require disclosure or accrual for some profit-shifting structures if an MNC's fact pattern reflects high risk. This is in contrast to risks associated with the more subjective judicial doctrines and potential transfer-pricing adjustments, which arguably provide greater leeway in regard to the need for disclosure or accrual of tax.

Reconsidering prior decisions on permanent reinvestment of overseas earnings

Where vulnerabilities exist, senior management should reconsider past decisions made to permanently reinvest certain CFC earnings overseas. Because of such reinvestment decisions, an MNC will have made no accrual of the future U.S. taxes that would be due upon repatriation of its foreign earnings. The level of vulnerability could be a new and important factor that might affect management and the board of directors' thinking on this "permanent reinvestment" decision.

Actions to mitigate risk: The past

As noted earlier, under the ECI approach, the IRS is free to go back and assess tax for any earlier year for which the foreign group member had not filed U.S. tax returns on Form 1120-F. Further, if returns have not been filed, the IRS may calculate tax payable without allowing a taxpayer to claim certain deductions and tax credits under Regs. Sec. 1.882-4(a)(3)(i). This is why the actual tax rate could be even higher than 54.5%. (Note that including required disclosures about a foreign group member on Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, filed within a U.S. parent company's Form 1120 does not constitute having previously filed U.S. tax returns for the foreign group member.)

If a risk assessment suggests an exposure to ECI, CFOs and in-house tax professionals must consider the pros and cons of now filing U.S. tax returns for their foreign group members for some or all prior years. And, if a decision is made to file those returns, what exactly should be reported on them? Should they be prepared showing income and paying tax? Or should the filings be made on a "protective basis" to merely start the running of the statute of limitation? Further, what uncertain tax position (UTP) disclosures should be made to the IRS, either on the returns filed for each foreign group member or within the U.S. MNC's tax returns? Any filings of returns or required UTP disclosure statements will, of course, alert the IRS to issues that it may choose to examine.

A further consideration is that the higher-than-expected 35% corporate tax rate and ability to assess tax on early years may place the IRS in a more favorable bargaining position to effectively force possible compromise settlements on MNCs. It seems likely that compromises would most often involve an MNC agreeing to treat some amount of foreign group member income as being the income of a U.S. group member to avoid the higher direct taxation of its foreign group members applicable under the ECI approach. In addition, since only the more recent years of U.S. group members would remain open, a compromise would likely protect any foreign group member earnings from earlier years.

Because substantial amounts might have to be accrued or disclosed in an MNC's financial statements, there is a good chance that further public disclosures will be triggered. With this in mind, an MNC's financial and tax personnel will normally want to alert management and the board of directors as soon as possible. This suggests covering the risk assessment and mitigation process in early presentations to management and the board. These presentations should also include the basis for the MNC's prior tax planning strategies.

Actions to mitigate risk: The future

If an MNC's management determines that its profit-shifting structures involve considerable risk of the IRS's applying the ECI approach, it should immediately consider mitigating this risk. Note that if the United States enacts international tax reform including a territorial tax system, the risks associated with the use of the ECI approach would remain.

First, could any structural or intercompany contractual changes be made to reduce the potential risks? For example, if a service agreement between foreign and U.S. group members is priced on a simple cost-plus service fee basis that does not recognize the value that the U.S. group member is providing, perhaps the cost-plus fee could be replaced by some other, more realistic pricing formula or mechanism.

Second, since high risk arises primarily from the above-mentioned value drivers and control and decision-making occurring within the United States by U.S. group personnel, any effort to mitigate risk must include consideration of operational modifications that would change the location of those value drivers and management functions.

Third, recognizing that operational management may be less than enthusiastic about any meaningful operational changes that would truly add substance to and strengthen a profit-shifting structure, the CFO and in-house tax professionals must include in their analyses the possibility of unwinding the existing structures that are determined to be high-risk.

Equity-based compensation plans may encourage MNC management to aggressively pursue profit-shifting structures. These compensation arrangements incentivize management to reduce an MNC's effective tax rate to increase after-tax earnings and share prices. Although this is not a direct approach to minimizing the risk from current profit-shifting structures, boards of directors should consider the relevance of this issue to their MNC's equity-based compensation plans and, where appropriate, amend them to measure effectiveness and results in some pretax manner.

In summary, after careful consideration of the foregoing, MNCs and their advisers should take action to mitigate risk for past years as well as to mitigate risk for future years. In some cases, it may be appropriate to unwind existing profit-shifting structures.


About the authors

Thomas J. Kelley (tjkelley48@gmail.com) is a retired CPA who worked in the former Soviet Union and has taught at Seattle University. David L. Koontz (dlkoontz@aol.com) is a retired CPA who worked in an international accounting firm in Hong Kong, Japan, and Singapore. Jeffery M. Kadet (jeffkadet@gmail.com) is a retired CPA who worked in public accounting internationally and as a lecturer in the University of Washington Law School.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.


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