With the recent US tax reform, many have asked me about some of the transfer pricing implications of the Tax Cuts and Jobs Act (“TCJA”) passed in late December 2017. The TCJA is a complex piece of legislation, created largely as a response to the BEPS initiatives formulated by the OECD, that will most likely take years to sort out all the loopholes and ambiguities. While the IRS recently stated that it was looking to provide further guidance (they have already issued twenty-four news releases in 2018 alone as of May 1). The implications of the TCJA on international tax and transfer pricing planning are still somewhat muddied, predicated on which country is on the other end of the related party transaction. However, based on existing information, we can surmise a few key points.
The one aspect of the TJCA that impacts transfer pricing the most is BEAT payments, which act as a sort of alternative minimum tax for US companies that make related party payments to foreign affiliates. While the BEAT only impacts larger multinational corporations (you need to have revenues greater than US$500 million and base erosion payments of more than 3% of qualified expenditures), it can have a dampening effect on related party payments to affiliates in that certain base erosion payments are added back to calculate “modified taxable income” and thus may result in a higher tax liability than otherwise.
From both a compliance and planning perspective, it is important to understand the types of payments which are included as “base erosion payments” and which are excluded. To further muddy the waters, there is a lack of clarity on what types of service transactions might be exempt. The BEAT is also intertwined with other provisions of the TCJA such as the GILTI tax and interest expense limitations, so to understand your BEAT exposure, you also need to have done analysis in the other areas.
The takeaway if you have BEAT exposure is that you will need to pay closer attention to the exceptions to base erosion payments, namely cost of goods sold (i.e., inventory purchased), certain derivative instruments, and certain services which qualify for the SCM exception. Depending on your situation, and in which country the foreign affiliate resides, it might be beneficial to structure your organization so that lower risk suppliers and service providers are transacting with your US company. In addition, companies may be incentivized to unbundle transactions to isolate charges that are base erosion exceptions.
Interest Expense Limitations
The TCJA limits interest expense deductible by US corporations to 30% of EBITDA (earnings before interest taxes depreciation and amortization). In 2022, this changes to 30% of EBIT. This provision of the TCJA is notable since, unlike Canada and many other OECD nations, the limitations are applied against all interest deductions, not just those from related parties.
The interest provision of TCJA impacts MNEs that use related party debt structures. In the past, the US used a type of thin cap regime to limit interest deductions. Under the new rules, all interest is limited based on a ratio of interest to cash flows. This has several ramifications. First, US entities that rely on third party debt, may have little ability to further absorb intercompany debt if full deductibility of interest is desired. Second, even if third party debt is a non-factor, intercompany debt in US-based limited risk entities (which presumably have a low EBITDA) might become problematic. At least with the EBITDA measure, asset-intensive companies might initially get some reprieve before EBIT becomes the primary metric.
The other two provisions of the TCJA, GILTI and FDII, do not directly impact US transfer pricing but will indirectly impact both international tax and transfer pricing planning initiatives. GILTI and FDII are, in many ways, ugly cousins of one another in that they serve to incentivize (or alternatively disincentivize) similar activities. In the past, many MNEs kept intellectual property outside of the US due to the high tax rates. With the tax reform, GILTI punishes high intangible value in controlled foreign affiliates while FDII incentivizes US-companies to own and exploit intellectual property and provide high value services to their CFCs.
These provisions are intended to ultimately incentivize companies to increase functions and risks in US domiciled companies, reversing a several decade trend where most transfer pricing schemes worked to “de-risk” US companies. This also follows a trend in many other countries such as the United Kingdom who have introduced “patent box” type of tax incentives. (On a side note, Canada is very much behind the curve in this regard.)
After the TCJA, the US corporate tax rate is approximately 21%. This renders the US more competitive than it was previously. With the various other provisions in the tax reform, previous transfer pricing strategies which de-risked the US and placed intellectual property and high-value services outside the US may have to be rethought on a going forward basis. In addition, with new interest limitation rules, US companies will have to further consider how much they level their companies with both third-party and related-party debt.