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Shake It Up! Take a Fresh Look at "Common Sense" International Tax Planning
First, let's consider a basic "given" that most of us share: a US-based multinational should maximise income in low-tax jurisdictions and minimise income in high-tax jurisdictions. In many situations, that strategy works well. Given the relatively high US tax rate, it generally means minimising US income and maximising foreign earnings. Taking into account the US concept of deferral, the effect is similar to that of a 401(k). The foreign lower-taxed earnings are available for reinvestment overseas and therefore represent a higher "purchasing power." Of course, we all know that at some point the money must return to the US and suffer at least the statutory tax rate of 35 percent (currently). In theory, the foreign tax credit regime provides a credit for non-US taxes, resulting in a total tax burden essentially equal to the US tax rate. The time value of money makes the eventual US tax less expensive than current tax, leaving most US taxpayers happy to defer US tax on overseas earnings for as long as possible.
With this background, and the US generally representing the "higher tax" jurisdiction, US-based multinationals tend to "hoard" deductions for US-based costs to reduce US taxable income. These deductions often include centrally incurred costs for services, costs for financing the global operations and costs for using and creating intellectual property.
Now, consider three situations in which this basic premise is actually not tax efficient and the US taxpayer would improve its situation by charging out US costs to foreign subsidiaries.
Overall Foreign Loss
First, when the US-based multinational has an overall foreign loss, global tax planning turns upside down. An overall foreign loss is not a permanent condition, but without care and planning it can nearly become one. In recent years, US-based groups have usually borne non-US tax on foreign earnings at a rate lower than the US tax on US earnings (as a result of the relatively high US tax rate). Many taxpayers consider this the ideal and seek to increase non-US earnings. However, since no benefit can be taken for the foreign tax credits on those earnings, the company eventually pays both the US tax and the foreign tax. The effective tax rates to compare are not a 35 percent and a 10 percent rate (for example), but actually a 35 percent and a 45 percent rate (as a result of the eventual double taxation of foreign earnings).
If the company has not provided a deferred tax on these earnings, an unfavorable impact to the effective tax rate occurs when these earnings ultimately become subject to US tax. For companies with an overall foreign loss, the lowest effective tax rate may be achieved by minimising income subject to foreign tax and possibly maximising amounts charged to foreign subsidiaries (taking care to ensure local deductibility). Of course, this assumes repatriation due to cash-flow needs or inclusion due to Subpart F. Often, companies are quite content to continue indefinite deferral. However, this may become a much less attractive alternative -- see US-based debt below.
Not Your Costs (Non-Deductible Costs)
Another situation where it is in the best interest of the US group to charge out costs occurs when the costs are not deductible in the United States. Treasury issued final regulations in 2009 dealing with intercompany services under Section 482 and the allocation and apportionment of stewardship expenses under Section 861. Under these final regulations, an activity that provides a benefit to the recipient must be charged to that recipient.
A company must charge out costs if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position. This may not always be obvious for a couple of reasons. First, an "activity" is broadly defined to include the performance of functions, assumptions of risks, or use of property or other resources, capabilities or knowledge. Second, an activity confers a benefit if an uncontrolled taxpayer in comparable circumstances would be willing to pay an uncontrolled party for the same or similar activities, or if the recipient otherwise would have performed the same or similar activity for itself. Note that the requirement to charge for a service does not mean that every service requires a mark-up or profit component, as some services are considered low-value and may be charged out at cost.
Consider one example from the regulations, where a corporate headquarters in the US performs certain treasury functions for its subsidiaries, including raising capital and arranging medium- and long-term financing for general corporate needs, including cash management. These functions do not duplicate functions performed by the subsidiary's staff. In the example, these services are found to provide a benefit to the subsidiary and must be charged out.
That's right, the presence of US debt may begin to make the argument for US charge outs very compelling. Why, you ask? Revisit President Obama's Green Book proposals, and you may recall that the Administration is contemplating a "deferral" of US-borne interest expense to the extent it is associated with unrepatriated earnings. Depending on the leverage of the global business, the interest in the US can be substantial. In traditional models, where US income is minimised and foreign earnings are maximised, this results in a substantial deferral of US interest expense. That impact starts to make the time value of money benefit to deferral less attractive. If the foreign unrepatriated earnings are "permanently reinvested" as described in APB 23 (Accounting Principles Board Opinion No. 23), the interest expense will also be considered permanently deferred and will result in an unfavourable impact to your effective tax rate (possibly starting January 1, 2011).
Worse yet, because of the "bunching" effect caused by the interest expense deduction becoming available upon a repatriation event, we believe that many taxpayers who do not currently have an overall foreign loss or are in an excess limitation situation will be surprised to find themselves with little to no foreign-source income (or even a substantial foreign loss) when they do have a dividend. What a surprise to declare a dividend and find yourself with another unexpected rate hit because you cannot recognise the benefits of your associated foreign tax credits!
Carefully consider your current methodology for US-based costs and the charging of these costs to foreign subsidiaries. Not only may the appropriate charging of costs reduce your foreign tax burden, but it will also reduce the pool of expenses that are properly allocated and apportioned to foreign-source income, reducing an overall foreign loss or improving your foreign tax credit position. You will also have a way to return cash to the US without a negative impact to your effective tax rate.
For taxpayers with substantial US debt, we see you hurtling toward a brick wall in the form of the proposed deferral of interest expense. If you have not modeled the impact of these provisions, you may be very surprised (and we suggest a multi-year model is really eye-opening). You should be prepared and armed with a plan to implement on "impact" -- or before. One of the tenets of your plan may be a proactive look at intercompany charges. Even without the income residing in the US, intercompany charges may be a powerful tool to manage your deferred earnings.
Work within the appropriate transfer pricing methodologies, and take care to put your global company on solid footing with respect to foreign tax credit utilisation and the big picture of effective tax rate and cash tax cost. In doing so, make sure these costs are deductible in the foreign jurisdiction, and respect that documentation requirements abroad may differ from US expectations.
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