Transfer Pricing & IC-DISC Basics - BKD...• Pricing of these transactions affects the taxable...

Transfer Pricing & IC-DISC BasicsAUG UST 1 2 , 2 0 2 0

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INTRODUCTIONS

Elizabeth HazzardDirector – International Tax Services, Transfer Pricing

Eric FlueckigerDirector – International Tax Services

AGENDA • What Is Transfer Pricing?• Examples of Intercompany Transactions

• Transfer Pricing for Offense & Defense

• U.S. Transfer Pricing Documentation Requirements

• Foreign Transfer Pricing Documentation Requirements

• BKD’s Documentation Offerings

• IC-DISC Overview

• IC-DISC Structure Alternatives

• Benefits of Transactional Analysis

WHAT IS TRANSFER PRICING? A Textbook Definition

• Examines the compensation for goods, services, or intellectual property that are transferred between “related” or “controlled” parties of a multinational or multistate organization across international or state borders Also includes financial transactions such as loans & guarantees

“Control” can occur even with less than majority ownership

• Pricing of these transactions affects the taxable income reported in the countries in which a multinational operates As a result, the IRS & other tax authorities pay close attention to transfer pricing

IRS has the legal authority to adjust taxable income if it thinks the transfer pricing has been done incorrectly

Examples of Intercompany TransactionsIntercompany sale of tangible goods • Sale of finished goods

• Sale of raw materials & work in progress

• Commission & purchasing agent services

• Transfer of production machinery

Transfer price paymentSale of goods

Market price for sale of goods

XYZ U.S.(Manufacturing Co.)

XYZ Japan(Distribution Co.)

Third Parties

Examples of Intercompany Transactions • Provision of intercompany services

Management services• Strategic management• Finance• IT• HR• Marketing• Legal

XYZ U.S. (Head Office) XYZ Canada (Subsidiary)

XYZ Australia (Subsidiary)

XYZ U.K. (Subsidiary)

Management Services

Cost or Cost Plus

• Other services Technical services Development services Manufacturing DEMPE* functions

*Development, enhancement, maintenance, protection, & exploitation

Examples of Intercompany Transactions • Transfer of intangible property (IP)

Transfer of technology IP• Know-how

• Patents

• Processes

• Formulations

• Copyrights

• Trademarks• Trade names• Brand names• Reputation• Customer relationships• Customer lists• Sales force

Payment of royalty (transfer price)

License of technology

XYZ U.S. (Research &

Development Co.)

XYZ Germany (Manufacturing Co.) Third Parties

Market price for sale of goods

Transfer of marketing IP

Specific Issues for Tax-Exempt Entities• Transactions between related exempt & taxable organizations

Primarily provision of services Issues are

• Unrelated business income tax (UBIT)

• Possible loss of exempt status

Related Taxable Entity

Related Tax-Exempt Entity

Provision of Service

Cost or Cost Plus (Transfer Price)

TRANSFER PRICING FOR OFFENSE & DEFENSE

• Transfer pricing offers opportunities for clients to achieve tax savings by Taking advantage of different tax rates in other jurisdictions Using tax attributes of entities within the group to use NOLs & other

methods to lower the effective tax rate Work with the international & domestic tax teams to determine the

approach for structuring projects

• Transfer pricing documentation offers penalty protection when prepared in advance of the filing of the tax return Nearly all developed countries have transfer pricing documentation

requirements

U.S. TRANSFER PRICING DOCUMENTATION REQUIREMENTS

• U.S. has its own set of transfer pricing methodologies & documentation requirements

• Methodologies are dependent on type of intercompany transaction Tangible goods Intangible goods Services Unspecified methodologies

U.S. TRANSFER PRICING DOCUMENTATION REQUIREMENTS

In summary• Company & organizational structure information,

including information on the applicable industry• Detailed description of functions of each party of

the intercompany transaction, risks assumed by each entity, relevant intangible property owned by each entity

• Selection of the best transfer pricing methodology & rejection reasons for all other methodologies

• Economic analysis determining an arm’s-length transfer price Often this is a search for comparable

companies

• The OECD’s base erosion & profit shifting finalized in 2015 issued a new standard of transfer pricing documentation

• Masterfile

• Local country file

• Country-by-country (CbC) report

FOREIGN TRANSFER PRICING DOCUMENTATION REQUIREMENTS

MASTERFILE

• Includes the following pieces of information Multinational enterprise’s (MNE) organizational structure Description of MNE’s business or businesses Analysis of MNE’s supply chain Information on MNE’s intangibles Information on MNE’s intercompany financial activities Information on MNE’s financial & tax positions

MASTER FILE

LOCAL COUNTRY FILE

• Supplements masterfile

• Focuses on local intercompany transactions

• Contains the following Financial information related to local country transactions Comparability analysis Application of most appropriate method

MASTER FILELOCAL FILE

COUNTRY-BY-COUNTRY REPORT

• CbC report provides information on entities involved in intercompany transactions For many foreign countries the revenue threshold is €750 million The U.S. revenue threshold is $850 million

• Form 8975

MASTER FILELOCAL FILE

CbC REPORT

BKD’S DOCUMENTATION OFFERINGS

• U.S. transfer pricing documentation Limited scope economic analysis provides the

analysis that determines what is an arm’s-length price, but does not meet all U.S. requirements

Full scope documentation study meets all U.S. requirements

Can be prepared from an OECD perspective to help meet the foreign jurisdiction’s requirements

• OECD three-tier documentation Masterfile

Local country file(s)

Recommend the CbC report is prepared by U.S. or local tax provider

Domestic International Sales Corporations

DOMESTIC INTERNATIONAL SALES CORPORATION

• DISCs can be a company with substance Employees, customers, inventory, etc.

• But, usually a DISC is just a “paper company” with no substance No employees, no inventory, no direct relationship with customers

A U.S. taxpayer (the related supplier) is permitted to pay a commission to the DISC

Statutes describe the maximum amount of the commission

• Generally speaking 4% of gross receipts or

• 50% of the taxable income from the sale of export property

• DISC benefit arises as follows Commissions paid to a DISC reduce taxable profit of related supplier

• Generally speaking a 29.6% benefit for active owners of pass-through entities

• May be additional state benefits

DISC is tax-exempt entity• So it pays no federal income tax on the commission

DISC distributes its earnings to its shareholders• Shareholders are taxed on DISC earnings at lower qualified dividend rates

• Domestic citizens & residents – 20% + 3.8% = 23.8%


WHAT ACTIVITY QUALIFIES?

• Categories of gross receipts Sale, exchange or other disposition of export property

Lease or rental of export property used by the lessee outside the U.S.

Services that are related & subsidiary to any qualified sale, exchange, lease, rental, or disposition of export property

Factoring income

Interest income from producer’s loan

EXPORT PROPERTY FOR DISC

• Manufactured, produced, grown, or extracted in the U.S. by a person other than a DISC

• Held primarily for sale, lease, or rental for direct use, consumption, or disposition outside the U.S.

• Foreign content rule Cost of foreign content used to manufacture product

cannot be greater than 50% of FMV (sales price)

REQUIREMENTS OF A DISC

• Domestic corporation (C corporation) Must be a domestic corporation incorporated under

the laws of any state or the District of Columbia

Cannot be• Tax exempt under Section 501

• A personal holding company

• A financial institution

• An insurance company

• A regulated investment company

• A China trade corporation

• An S corporation


• Domestic corporation (C corporation)

• Must have separate bank account

• $2,500 capital requirement

• Single class of stock

• File timely elections (Form 4876-A within 90 days from beginning of tax year)

• 95% qualified export asset test

• 95% qualified gross receipts test


• DISC compliance DISC must file Form 1120-IC-DISC

• Due 15th day of ninth month following tax year-end, no extension necessary

Must have the same tax year of the principal shareholder

Will report taxable dividends to shareholders on Schedule K

Possible state filing requirements Interest charge on deferred DISC income

reported on Form 8404


• DISC statutes impose an interest charge on the undistributed portion of earnings in a DISC

• Owners are permitted a one year deferral before the interest charge applies

• U.S. T-bill rate used to calculate interest charge Rate for deferrals at 12/31/19 is 2.345% On $1 million of deferred income, the interest charge would be $4,690


• DISC statutes limit the amount of earnings that can stay in the DISC Limited to profits on $10 million of qualifying gross receipts

Other amounts are deemed distributed on the last day of the year

Actual distributions then reduce “previously taxed” earnings & profits

OTHER U.S. CONSIDERATIONS

• State income tax considerations

• DISC commissions paid to a DISC to the extent not related to foreign branch profits would generally reduce a U.S. corp’s foreign-derived intangible income as a reduction to its foreign-derived deduction eligible income & its deemed intangible income

• Commission reduces taxable profit passed through to S corporation shareholder (29.6% tax savings)

• DISC is not subject to tax• S corporation shareholders pay

23.8% tax on DISC dividends

POSSIBLE DISC STRUCTURES: PASS-THROUGH

Shareholders

S Corporation

DISC

Commission Dividend

• Commission reduces taxable profit passed through to partners in the LLC

• DISC is not subject to tax• Individual LLC owners pay 23.8%

tax on DISC dividends

Owners

LLC

DISC

Commission Dividend

POSSIBLE DISC STRUCTURES: PASS-THROUGH

• Commission reduces taxable profit of C corporation (21% tax savings)

• DISC is not subject to tax• Individual C corporation

shareholders pay tax at 23.8% on DISC dividend

POSSIBLE DISC STRUCTURES: C CORP

Shareholders

DISC

Commission

Dividend

C Corporation

POSSIBLE DISC STRUCTURES: INBOUND DISC


• DISC is not subject to tax• Conflicting authority as to whether dividend from DISC to treaty

country corporation is subject to U.S. Taxo Treaty – dividend W/H rate*o Sec 996(g) – 21%

• Need to consider tax impact in foreign country

Foreign Shareholders

TreatyCountry

Corporation

U.S. Corporation DISCForeign Customers

Dividend

Commission

Sale of Products

Payment for Products

* Some situations will result in withholding tax on DISC dividend

POSSIBLE DISC STRUCTURES: INBOUND DISC


• DISC is not subject to tax• Conflicting authority as to whether dividend from DISC to

Foreign shareholders is subject to full U.S. Treaty – dividend W/H rate Sec 996(g) – 20%*

• Need to consider tax impact in foreign country

ForeignShareholders

Commission

Dividend

Treaty Country Corporation

U.S. Corporation

DISC

ForeignCustomers

* Foreign individual owners still get capital gain rate if taxable under 996(g)

POSSIBLE DISC STRUCTURES:COMPENSATORY DISC

• Commission reduces taxable profit of related supplier

• DISC is not subject to tax• LLC is not taxable on DISC dividend• Management recognizes dividend income

instead of bonus Dividend taxed at 23.8% Bonus taxed at ordinary rates, 37%

• LLC allocations can be changed annually to reflect annual bonus awards

• Executive compensation converted from salary to qualified dividends

Related Supplier DISC

LLCShareholders

Key Management

Commission

Dividend

POSSIBLE DISC STRUCTURES: DEFERRAL

• Commission reduces taxable profit passed through to S corp shareholders (29.6% tax savings)

• DISC is not subject to tax• DISC makes loan back to S corp in lieu

of dividend• S corp shareholders recognize ordinary

deduction but no dividend income• Interest on producer’s loan should be

charged & create additional benefit

Shareholders

S Corporation

DISC

Commission Producer’s Loan

CALCULATING THE DISC COMMISSION

• DISC profit equals greater of 50% of profits on sale of export property 4% of qualified export receipts, not to exceed 100% of export profits

• The calculations are actually much more complicated Transaction by transaction Marginal costing Special 4% method

CALCULATING THE DISC COMMISSION

TotalExport Sales -- Widgets & Gadgets 1,000,000

Cost of Sales -- Widgets & Gadgets 675,000

Gross margin -- Exports 325,000

Allocable Share of SG&A 125,000

Profit on Exports 200,000

Overall Profit % (OPP) 20.00%

DISC Commission Full Cost 50% Method 100,0004% Gross receipts Method 40,000 (limited to 100% of profit)

Sheet1

Marginal Costing - Example

TotalWidgetsGadgets

Export Sales -- Widgets & Gadgets1,000,000500,000500,000

Cost of Sales -- Widgets & Gadgets675,000300,000375,000

Gross margin -- Exports325,000200,000125,000

Allocable Share of SG&A125,00055,00070,000

Profit on Exports200,000145,00055,000

Overall Profit % (OPP)20.00%

DISC Commission

Full Cost 50% Method100,00072,50027,500

4% Gross receipts Method40,00020,00020,000

(limited to 100% of profit)

50% Method Using Marginal Costing50,00050,000

Highest Commission122,50072,50050,000

Sheet1 (2)


TotalWidgetsGadgets

Export Sales -- Widgets & Gadgets2,250,0001,250,0001,000,000

Cost of Sales -- Widgets & Gadgets1,500,000750,000750,000





DISC Commission

Full Cost 50% Method225,000175,00050,000





Sheet2

Sheet3

IC-DISC BENEFITS EXAMPLE:PASS-THROUGH STRUCTURE

Tax Benefit of DISC Commission Example ExampleActive Shareholders Passive Shareholders

DISC Commission reduces Operating Income (100,000) (100,000)Presumed Tax Rate on Operating Income 29.6% 33.4%

(29,600) (33,400)

Taxable Income from DISC Dividend 100,000 100,000Tax Rate on Disc Dividend Distributions 23.8% 23.8%

23,800 23,800

Net (Benefit) from DISC (5,800) (9,600)

Sheet1

Tax Benefit of DISC CommissionExampleExample

Active ShareholdersPassive Shareholders

DISC Commission reduces Operating Income(100,000)(100,000)

Presumed Tax Rate on Operating Income29.6%33.4%

(29,600)(33,400)

Taxable Income from DISC Dividend100,000100,000

Tax Rate on Disc Dividend Distributions23.8%23.8%

23,80023,800

Net (Benefit) from DISC(5,800)(9,600)

Sheet2

Sheet3

IC-DISC BENEFITS EXAMPLE:C CORP STRUCTURE

*Note §250(a)(1)(A) foreign-derived intangible income deduction may reduce U.S. corporate tax rate on export sales by 37.5% (21% x 62.5% = 13.125%)

Tax Benefit of DISC CommissionC Corp With DISC C Corp Without DISC*

Income 100,000 100,000Tax on Income - 13,125 Dividend 100,000 86,875Tax on Dividend 23,800 20,676Net Cash to Shareholder 76,200 66,200 10,000

Sheet1

Tax Benefit of DISC Commission

C Corp With DISCC Corp Without DISC*

Income100,000100,000

Tax on Income- 013,125

Dividend100,00086,875

Tax on Dividend23,80020,676

Net Cash to Shareholder76,20066,20010,000

Sheet2

Sheet3

CALCULATING THE DISC COMMISSION(TRANSACTION BY TRANSACTION)

Marginal Costing - ExampleTotal Widgets Gadgets

Export Sales -- Widgets & Gadgets 1,000,000 500,000 500,000

Cost of Sales -- Widgets & Gadgets 675,000 300,000 375,000

Gross margin -- Exports 325,000 200,000 125,000

Allocable Share of SG&A 125,000 55,000 70,000

Profit on Exports 200,000 145,000 55,000

Overall Profit % (OPP) 20.00% 29.00% 11.00%

DISC Commission Full Cost 50% Method 100,000 72,500 27,5004% Gross receipts Method 40,000 20,000 20,000 (limited to 100% of profit)50% Method Using Marginal Costing 50,000 50,000Highest Commission 122,500 72,500 50,000

Sheet1


TotalWidgetsGadgets

Export Sales -- Widgets & Gadgets1,000,000500,000500,000

Cost of Sales -- Widgets & Gadgets675,000300,000375,000




Overall Profit % (OPP)20.00%29.00%11.00%

DISC Commission

Full Cost 50% Method100,00072,50027,500





Sheet1 (2)


TotalWidgetsGadgets

Export Sales -- Widgets & Gadgets2,250,0001,250,0001,000,000

Cost of Sales -- Widgets & Gadgets1,500,000750,000750,000





DISC Commission

Full Cost 50% Method225,000175,00050,000





Sheet2

Sheet3

SUMMARY OF IC DISC BENEFITS

Pre TCJA Post TCJA Pre TCJA Post TCJAOrdinary Income 39.60% 29.60% 43.40% 33.40%Qualified Dividend Income -23.80% -23.80% -23.80% -23.80%Net Benefit from DISC 15.80% 5.80% 19.60% 9.60%

Pre TCJA Post TCJA Pre TCJA Post TCJATax on Corporate Income 35.00% 13.13% 0.00% 0.00%Tax on Qualified Dividend 15.47% 20.68% 23.80% 23.80%Corporate & Shareholder Tax 50.47% 33.80% 23.80% 23.80%

A C B D

Net Benefit from DISC 26.67% 10.00% = A - B = C - D

Pass-Through - Active Owners

Pass-Through - Passive Owners

C Corp Without DISC C Corp With DISC

Sheet1

Assumes highest federal Corporate, Ordinary and Qualified Dividend rates

Assumes all shareholders are subject to NIIT

Assumes all activity qualifies for 20% pass thru deduction

Assumes no state income tax benefit or cost

Assumes all exports qualify for FDII deduction in C Corp scenarios

Pass-Through - Active OwnersPass-Through - Passive Owners

Pre TCJAPost TCJAPre TCJAPost TCJA

Ordinary Income39.60%29.60%43.40%33.40%

Qualified Dividend Income-23.80%-23.80%-23.80%-23.80%

Net Benefit from DISC15.80%5.80%19.60%9.60%

C Corp Without DISCC Corp With DISC

Pre TCJAPost TCJAPre TCJAPost TCJA

Tax on Corporate Income35.00%13.13%0.00%0.00%

Tax on Qualified Dividend15.47%20.68%23.80%23.80%

Corporate & Shareholder Tax50.47%33.80%23.80%23.80%

ACBD

Net Benefit from DISC26.67%10.00%

= A - B = C - D

Sheet2

Sheet3

IC-DISC BENEFITS POST-TCJA

• Permanent tax savings in pass-through structures has decreased for shareholders Consider ways to increase the DISC commission by transactional analysis, product grouping,

& detailed SG&A allocations

Consider ways to create temporary benefits by deferring DISC dividend income via producer’s loan or factoring receivables

Consider using DISC for compensatory purposes

• Lower corporate tax rates plus addition of FDII could create a very low effective tax rate with C corp structure Consider conversion from pass thru structure to C corp structure

DISC provides an opportunity to distribute cash to C corp shareholders in a tax efficient manner

Questions?

Elizabeth [email protected]

Eric [email protected]

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Thank You!

The information contained in these slides is presented by professionals for your information only & is not to be considered as legal advice. Applying specific information to your situation requires careful consideration of facts & circumstances. Consult your BKD advisor or legal counsel before acting on any matters covered

Transfer Pricing & IC-DISC BasicsTo Receive CPE CreditSlide Number 3Agenda�What is Transfer Pricing? � A Textbook Definition�Examples of Intercompany TransactionsExamples of Intercompany Transactions Examples of Intercompany Transactions Specific Issues for Tax-Exempt EntitiesTransfer Pricing for Offense & DefenseU.S. Transfer Pricing Documentation RequirementsU.S. Transfer Pricing Documentation RequirementsForeign Transfer Pricing Documentation RequirementsMasterFileLocal Country FileCountry-by-Country ReportBKD’s Documentation OfferingsSlide Number 18Domestic International Sales CorporationDomestic International Sales CorporationWhat Activity Qualifies?Export Property for DISCRequirements of a DISCRequirements of a DISCRequirements of a DISCDomestic International Sales CorporationDomestic International Sales CorporationOther U.S. ConsiderationsPossible DISC Structures: Pass-ThroughPossible DISC Structures: Pass-ThroughPossible DISC Structures: C CorpPossible DISC Structures: Inbound DISCPossible DISC Structures: Inbound DISCPossible DISC Structures:�Compensatory DISCPossible DISC Structures: DeferralCalculating the DISC CommissionCalculating the DISC CommissionIC-DISC Benefits Example:�Pass-Through structureIC-DISC Benefits Example:�C Corp structureCalculating the DISC Commission�(Transaction by Transaction)Summary of IC DISC BenefitsIC-DISC Benefits Post-TCJAQuestions?Continuing Profession Education (CPE) CreditCPE CreditThank You!

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