More and more, global companies are discovering that year-end adjustments to intercompany transfer pricing can improve the accuracy of their transfer pricing tax reporting and, potentially, help prevent overpaying taxes by millions of dollars. However, increasing scrutiny by tax authorities in the United States and other key countries makes it imperative that businesses make these adjustments in the right way at the right time and with proper documentation. The ripple effect of adjustments can have serious implications.
In this article, we discuss why post-transaction adjustments may be advantageous for companies and outline key considerations for U.S. companies that might benefit from them. We compare and contrast rules for post-transaction adjustments in the United States with those in Germany and China—countries that are at the forefront of transaction-pricing scrutiny outside the United States. And we offer insights into the transfer pricing practices of companies that recently participated in a Deloitte Tax LLP Dbriefs webcast.
TRANSFER PRICING ADJUSTMENTS: HOW AND WHEN THEY ARE
If your company is like many multinationals, you set transfer prices at the beginning of the year. However, these prices hold true only if all departments meet budgets and all results are consistent with projections—and these stars align infrequently, if ever. The reconciliation of projections against actual results can drive post transaction pricing adjustments. Changes in third-party prices also can spark the need for an adjustment.
Another driver: new or overlooked transactions that have occurred throughout the year, particularly service related transactions. For example, a company might discover services exchanged within a corporate group that haven't been charged and need to be accounted for. China, in particular, presents many challenges with the reporting of service transactions, including: what you can and cannot deduct; value added taxes (VAT); and administrative issues such as customs valuation, reporting, and currency exchange.
In the United States and around the world, the requirements for documentation to support transfer pricing have become more stringent. Because these documentation rules help a taxpayer only if prices fall within a certain "arm's length" range, companies increasingly are adjusting their transfer prices to fall within this range.
In this area of tax, timing is everything. Post-transaction adjustments can take place across the broad continuum of the reporting cycle from before the books have closed to after the tax return has been filed.
For U.S. reporting, many companies choose to take advantage of the regulatory and contractual opportunities during the period before the books have closed, which generally poses the least amount of caveats and disclosures. During this period, you can increase or decrease U.S. income and bring it from outside the arm’s–length range to within that range. With a written contract, you can even adjust prices within the range—the only time this is allowed.
The period after the tax return has been filed offers the least degree of latitude. Here you can only work within penalty regulations to increase U.S. income and bring it from outside to inside the range. Most importantly, because documentation for the additional adjustment is not contemporaneous, you can still be subject to penalties. Companies making adjustments during this phase need to get it right.
The good news? Once you have a U.S. adjustment, the IRS is required to make a correlative adjustment to the foreign taxpayer. The company making the post-transaction adjustment only needs to make the change in its U.S. books. Under current IRS interpretations, you will not need to make that adjustment for foreign tax purposes.
Disclosure Requirements. After the books close, disclosure comes into play. During the period after the books close, but before taxes are filed, you can increase or decrease your U.S. income. However, you will need to disclose this adjustment on your tax return and Schedule M. You may also need to make additional statements under Revenue Procedure 99-32.
What many companies may not realize is that Revenue Procedure 99-32 can work to their advantage by helping them manage the tax implications of moving cash by permitting the movement or repatriation of cash without further U.S. tax implications. For example, you can avoid paying taxes on money a foreign tax authority considers a dividend or capital contribution because the cash was in the wrong place. You can also offset loans or capital contributions by making them congruent with the cash coming back to the United States. In addition, you can offset a dividend being adjusted within the year against the potential transfer pricing adjustment, as long as the dividend is not being used as such for U.S. tax purposes.
Another tactic allowed under Revenue Procedure 99-32 is setting up an interest bearing account as of the last day of the year, which can then be settled within 90 days of filing the original amended tax return.
Advance Pricing Agreements (APAs). An APA can help eliminate challenges and the likelihood of an audit, particularly if you're getting ready to file at year-end and discover a significant adjustment needs to be made. All you need to do before filing the tax return is notify the IRS, pay your filing fee, and take approximately 120 days to file your APA request - which gives you time to thoroughly analyze the transaction and how you plan to seek relief.
An APA reduces surprises by setting pricing (and taxes) at a certain level for an agreed-upon volume of transactions. Bilateral APAs, coordinated with both the IRS and a foreign tax authority, can cut back on the surprises from both sides. In certain cases a bilateral APA will allow retroactive adjustments.
Conforming adjustments. When you make adjustments to correct the cash accounts of related parties, you will need to reflect that adjustment in accounts receivable and payable before closing the books. You must deal with dividends, capital contributions and Revenue Procedure 99-32 relief after closing the books. For example, FASB Interpretation no. 48 (FIN 48) requires you to put up cash reserves for potential transfer pricing liabilities. These reserves affect earnings and profits, taxes paid and dividend withholding taxes. Whether you bring the cash back or invoke Revenue Procedure 99-32 as discussed previously, you need to plot an appropriate response, develop a process and understand the consequences.
Customs implications. Post-transaction adjustments also affect customs reporting. For example, if prices to a U.S. company increase, their customs value may fall below the transfer pricing value. If an import duty has been imposed, this invokes section 1059A regulations, limiting the tax deduction to the customs value. Even in post-transaction adjustments where duties and section 1059A regulations do not apply, you will need to amend your customs declarations if you are reporting a price that is different from the price you reported when the product was imported.
GERMANY AND CHINA: WHAT TO WATCH F OR
Nearly half of the more than 800 respondents in a recent Deloitte Tax Dbriefs webcast said they did not conduct post-transaction adjustments because they were unable to adjust the foreign books. In Germany, the sheer amount of compliance work may daunt a U.S. taxpayer, who may discover that IT systems are incapable of efficiently performing the adjustments and local tax auditors are inexperienced in transfer pricing. Yet these and other factors should not deter a company from considering post-transaction adjustments for foreign reporting.
Germany's stricter climate. Even though significant progress has been made in communicating with German tax authorities, and Germany shares many of the same timing drivers as the United States - such as the amount and kinds of adjustments that can be made - companies should keep in mind the country's more formal approach to this type of issue. One key example is the importance of having a written contract in place in advance. This contract ideally includes a calculation process that describes all of the factors used to determine profit or final price.
In principle, German tax authorities only allow adjustments with this kind of contract. In practice, these strict regulatory interpretations often are inconsistent with other areas of German law, and some areas of German transfer pricing regulations explicitly allow taxpayer adjustments. Within these rules, you may have room to make progress with German tax authorities on price adjustments, for example, to get inside the range with a proper benchmark. In our experience, German tax authorities are now more likely to accept post-transaction price adjustments than in the past.
To minimize the consequences of incorrect reporting, you should keep a close eye on the rules. For example, German tax authorities are very reluctant to accept decreases in customs value, so they’ll try to limit adjustments to upward adjustments. As another example, amendments to the VAT declarations are required within the assessment period in which the adjustment occurs. Finally, because of the amount of compliance work involved, you should keep up with pricing adjustments throughout the year.
China’s challenges. In China, post-transaction pricing adjustments have increased largely because of how many U.S. taxpayers are setting up for business, using supply chain structures that provide contract manufacturers or limited-risk distributors a profit under a transfer pricing methodology. The companies then make adjustments throughout the year to deliver these returns.
However, these adjustments are often easier in theory than in execution. Changing rules and regulations pose challenges. For example, captive contract manufacturers are now prohibited from making losses in China. Timing is also not on the U.S. taxpayer's side. Although prospective adjustments can be done within specific requirements, retroactive and downward adjustments are practically impossible to do once the books are closed and the returns filed.
When dealing with service transactions, companies should be
- A potential business tax of 5%; the inability to deduct management fees.
- Special regulations for Chinese holding companies rendering services that benefit subsidiaries.
You should be familiar with VAT regulations, particularly due to recent modifications affecting refunds and the lack of a 100% relief system. In addition, you should be prepared for administrative issues, including reporting, related to customs valuation, bonded materials and import and export amounts. Furthermore, you should make advance considerations with China's State Administration of Foreign Exchange (SAFE), the governing body for foreign exchange, to secure sufficient foreign currency for remittance.
HOW TO AVOID MAKING WAVES
The proper tools and ongoing diligence can help ease the post-transaction pricing adjustment process for multinational companies. Because timing is so crucial, you should have a process in place to review transfer pricing throughout the year. You also should consider the opportunities provided by APAs, conforming adjustments, and provisions under FIN 48 and Revenue Procedure 99-32 to pursue additional benefits and manage risk.
Although many countries’ tax regulations reflect the same drivers as the United States, you need to stay attuned to country-specific nuances. The last thing you want to do in the increasingly stormy transfer pricing environment is rock the boat and draw unnecessary attention to your company.
Why Companies Hesitate
Despite the potential benefits, many U.S. taxpayers are not making post-transaction adjustments. In fact, only 42% of respondents to a recent Deloitte Tax Dbriefs webcast survey indicated that they had made such adjustments. Those that had not cited the following reasons:
- 45% couldn’t adjust the foreign books.
- 20% cited Schedule M-1 disclosure as a concern.
- 17% reported adverse U.S. Customs implications.
- 17% reported adverse foreign customs and VAT implications.
As the need for post-transaction adjustments increases, we anticipate more companies will be comfortable with such adjustments.
" The Risks of Being Global," Dec. 06, page 53
n Transfer Pricing: Rules, Compliance and Controversy, by Marc M. Levey and Steven C. Wrappe, CCH (#CC005316P0100D)
n Transfer Pricing Methods: An Applications Guide, by Robert Feinschreiber, John Wiley and Sons (#WI573604)
For more information or to make a purchase, go to www.cpa2biz.com , or call the Institute at 888-777-7077.
Deloitte Dbriefs webcasts, http://deloitte.com/dtt/section_node/0,1042,sid%253D5456,00.html
n Year-end adjustments to intercompany transfer pricing can help international companies save on taxes. Documentation and proper observance of rules in relevant countries, however, are crucial to success, especially as requirements become more exacting.
n Reasons for adjustments can include reconciliation of budgets with actual results and previously overlooked transactions to bring them into a range that taxing authorities consider arm’s-length. U.S. companies can avoid tax return disclosures of adjustments to U.S. income and other considerations by making adjustments before the year-end closing of their books.
n An advance pricing agreement can help prevent challenges and audits, especially when coordinated with the IRS and a foreign tax authority. Companies may also want to take advantage of provisions of IRS Revenue Procedure 99-32 for repatriation of cash.
n Other key considerations when making post-transaction adjustments include adjusting accounts related to cash and establishing reserves for potential transfer pricing liabilities, in keeping with FIN 48, and amending customs declarations on imports.
n Two major U.S. trading partners, Germany and China, provide representative illustrations of the types of issues companies face with foreign taxing authorities.