How Obama will use transfer pricing to cut US deficit

“Notwithstanding the transfer pricing rules,” said the reform proposal, “there is evidence of income shifting offshore, including through transfers of intangible rights to subsidiaries that bear little or no foreign income tax. Under the proposal, if a US parent transfers an intangible to a controlled-foreign corporation (CFC) in circumstances that demonstrate excessive income shifting from the US, then an amount equal to the excessive return would be treated as subpart F income.”

Subpart F income applies to CFCs and is income that is relatively movable from one taxing jurisdiction to another and is that subject to low rates of foreign tax. Income under subpart F is subject to taxation even if it is not repatriated into the US.

“This is likely to lead to intractable disputes with tax authorities in other countries concerning how much income should be earned in the country to which the intangibles have been shifted,” said Michael Flaherty of WTP Advisors. “It is likely going to be easy to side-step this provision by avoiding entities that do not fit the definition of CFC.”

Flaherty said the question of what is excessive is going to arise, though, and is going to be difficult to determine unless Congress creates a bright line test or safe harbour : “The likely result will be more disputes between taxpayers and the IRS and a need for more uncertain tax position filings.”

The proposals plan to cut a further $1 billion over 10 years by limiting the shifting of income through intangible property transfer.

The proposals suggest a clarification of the definition of intangible property for the purposes of the special rules relating to transfers of intangibles by a US person to a foreign corporation (section 367(d) of the Internal Revenue Code (IRC)) and the allocation of income and deductions among taxpayers (section 482, IRC) would be clarified to prevent inappropriate shifting of income outside the US.

“Any expansion of the definition of intangibles made to limit US taxpayer’s ability to shift income through transfers of intangibles out of the US is likely going to work against the Treasury when foreign multinationals utilise their foreign-owned intangible property, to strip earnings from the US,” said Flaherty.

Because of the high US tax rates (35%), structural tax complexities and regulatory constraints, foreign and domestic multinationals and investors are already looking for ways to avoid owning or developing intangibles, located within the US, and are actively moving valuable intangibles to offshore locations when they can.

“These proposals will only encourage greater efforts to develop and locate valuable intangibles, and jobs, outside of the US,” said Flaherty.

Finally the document recommend a limit to earnings-stripping by expatriated entities: “Under the proposal, the rules that limit the deductibility of interest paid to related persons subject to low or no US tax on that interest would be amended to prevent inverted companies from using foreign-related party and certain guaranteed debt to reduce, inappropriately, the US tax on income earned from their US operations.” This is expected to reduce the deficit by $4 billion over 10 years.

“The earnings stripping provisions represent a further attack on inversions, namely US parent companies inverting to foreign parent companies,” said Mike Lebovitz of DLA Piper. “Numerous provisions already exist to police this perceived abuse.”

“As with the other international provisions, the President and Congress would be better served by addressing the underlying reasons why companies invert through comprehensive tax reform. The earnings stripping proposal and, indeed, the international proposals together are an attempt to treat the symptom rather than the underlying sickness,” Lebovitz added.

The proposals are essentially the same as those included in the President's Green Book presented earlier this year. Taken together, they raise over $100 billion in new taxes on US multinationals over the next 10 years.

The proposals come as a disappointment to US business, however, because they are simply revenue raisers, rather than an overhaul of the corporate tax system that companies hope for. But, they show that transfer pricing is an increasing focus for the government.

"Given that the portion of the administration’s $120illion proposed budget associated with transfer pricing-related matters, such as the excess returns issue and the definition of intangible property, has increased from 13.6% to 17% in the 2012 version, one can infer that transfer pricing has continued to escalate in importance as a potential revenue source in US budgeting discussions," said Katherine Kimball of Charles River Associates.