Is transfer pricing broken? Does the IRS/Congress need to adopt a new model to tax U.S. Multinational Corporations’ income earned worldwide?

Through this Blog, I have previously written about how US Multinational Corporations (USMNCs) have routinely utilized “tricks of the trade” (Transfer Pricing, Inversions and Earnings Striping) to minimize their U.S. tax liabilities.  I have also suggested some changes to the existing system (i.e., expatriation tax etc.)

Perhaps change is on the horizon.  In one of the keynote addresses at the 16th Annual Global Transfer Pricing Forum held in New York (September 22-23, 2016), Professor Edward Kleinbard (USC Gould School of Law, and the former chief of staff of the Joint Committee on Taxation), advocates for “The End of Transfer Pricing”.  See the Presentation slides here.

Professor Kleinbard begins his presentation by discussing the Apple “facts” as examined by the EU Commission in the recent Irish state aid case.  He highlights the following facts:

  • APPLE had $115 billion of income over a 10 year period;
  • APPLE paid Ireland only .05% per year during the same period;
  • APPLE paid other EU countries roughly $385 million in taxes over the same period;
  • APPLE’s effective tax rate was 3.5% not the statutory rate of 35%.
  • APPLE had pre-tax profits of $91.5 billion. 

Professor Kleinbard concludes that the arm’s length standard is no longer viable if APPLE can receive such beneficial treatment through its subsidiaries in Ireland.

Professor Kleinbard then discusses how the world is aware of the abusive nature of transfer pricing and that progressing with the fiction of transfer pricing and the arm’s length model is untenable, specifically, he cites the following examples:

Because of this pushback, Professor Kleinbard advocates for a change to the existing system.

More specifically, he advocates for the following changes to the Corporate tax rate:

  1. Statutory Rate reduced to 25%;
  2. Repealing Section 199 (deduction for income attributable to domestic production activities;
  3. Repealing the Alternative Minimum Tax (AMT;
  4. Destination Based Cash Flow Tax

He states that by reducing the corporate rate to 25% will eliminate the need for transfer pricing games, because US tax rate will be in the middle of the pack, and playing games will be unnecessary. 

Note: Professor Kleinbard has stated, “Transfer pricing is dead” since 2008.  See this Tax Analyst Article about his debate with Willard B. Taylor of Sullivan & Cromwell LLP at the International Tax Institute.

To Clarify, Professor Kleinbard actually stated that Transfer Pricing enforcement has been dead since 2007.  See this article by Michigan Law Professor Reuven S. Avi-Yonah.  Professor Avi-Yonah proposes three different approaches for Congress to revitalize transfer pricing enforcement:

  • adopting a unitary taxation regime;
  • ending deferral; and
  • adopting anti base erosion measures.

Unitary Taxation Regime:  This proposal suggests that Congress can adopt a unitary tax system, namely, treating each USMNCs as a single unit and disregarding the “formal distinctions” among the subsidiary corporations.  The advantages are: 1) a better model for taxing USMNCs because of the way they currently operate; and 2) the unitary tax applies the same treatment to all USMNCs and does not depend on the location of the parent corporation.

Professor Avi-Yonah believes that this is the best solution, but pragmatically speaking will be difficult to achieve.

Abolishing Deferral:  This proposal proposes to prevent USMNC from parking profits offshore (something subpart F of the Internal Revenue Code was originally designed to accomplish, but has failed to do so).

Professor Avi-Yonah believes this is a good approach, but that it will require countries to adopt this goal, which may be difficult to achieve.

Adopting Anti-Base Erosion Measures:  This proposal suggests limiting deductible payments to related foreign parties, including cost of goods sold, interest and royalties.

Professor Avi-Yonah believes adopting this proposal in conjunction with abolishing deferrals will eliminate the impetus to undertake transfer pricing by USMNCs.

Finally Professor Avi-Yonah advocates for the adoption of a mixture of these measures, similar to Senator Baucus’ proposal with option Y.  See analysis of Senator Baucus’ proposals here. (NOTE: Senator Baucus is now the U.S. Ambassador to China).  Under Option Y, income from foreign sales would be taxed at 80% of the US rate with a credit for foreign taxes paid.  This would ensure tax would be geared toward the ultimate destination of the sale of the goods (i.e. taxing where the goods are ultimately sold, or similar to Kleinbard’s destination cash flow tax.)

It will be interesting to see if any of these proposals will gain traction with the pending presidential election and with one of the key backers now a U.S. ambassador to China. 

If you have specific and credible information of a company undertaking transfer pricing and want to report the company for shifting its profits offshore, CONTACT US, to discuss your tax whistleblower claim.  The IRS is paying an award (between 15-30% of the collected taxes, interest, penalties, and additional amounts) for information it utilizes in adjusting a corporation’s income tax due to information provided by a whistleblower.

Facebook and its Transfer Pricing Issues

In addition to Google having European leaders questioning the validity of its transfer pricing models and shifting profits from France, Facebook is also having IRS inquiries about its transfer pricing practices.

As noted in this Reuters' article, the IRS is looking at whether Facebook transferred its intangibles to its Irish subsidiary at too low of a price.  As stated in the Reuter's article, by raising the transfer price of the intangible to the Irish subsidiary, Facebook could have increased taxable profits in the US. The article quotes the complaint which alleges that Facebook may have understated the intangible by billions of dollars.  Facebook was advised in the transaction by Ernst & Young.

Recent news also indicated that Facebook has hired Baker & McKenzie to fight the IRS in this transfer pricing dispute.  As you will recall, Baker & McKenzie just won a major victory against the IRS in the Medtronic case.

In Medtronic, IRS challenged the profit split calculation paid to Medtronic's Puerto Rican subsidiary, by stating that the Puerto Rican subsidiary was nothing more than a contract manufacturer for Medtronic.  Medtronic claimed that its Puerto Rican subsidiary was instrumental in its efforts because it oversaw the quality of Medtronic's products.  The Court determined that IRS's method (valuing the Puerto Rican subsidiary as solely a contract manufacturer) was arbitrary and capricious and therefore IRS abused its discretion. However, the Court didn't stop there, it also stated that Medtronic's proposed model was a better approach (Medtronic chose a comparable transaction involving a competitor and argued that it was actually due a refund), but adjusted the model to better match Medtronic's business.  The Court ended up with the rate the parties had previously agreed to in prior settlements of their transfer pricing dispute.  See these articles: Wall Street Journal and BNA.

While it is refreshing to see that the IRS is challenging US Multinational Corporations at their use of transfer pricing, the question remains whether these challenges will be upheld.  See prior blogs regarding transfer pricing, inversions and earnings stripping.

If you know of a corporation undervaluing assets in its transfer pricing models, contact our firm to discuss filing a tax whistleblower claim.  IRS will pay an award between 15-30% of collected proceeds (tax, penalties, and interest) to whistleblowers who provide substantial and credible information used by the IRS in prosecuting the alleged tax violators.


Why the Panama Papers matter

As a primer, this blog discussed the release of documents from the Panamanian law firm Mossack Fonseca, known as the Panama Papers, which disclose a network of shell corporations and entities established by the Panamanian law firm to assist clients in hiding funds and avoiding taxes.

In the news today, as found in this NY times article, the U.S. Justice Department (“DOJ”), through its Kleptocracy Asset Recovery Initiative (for more information about this unit see this NY times article), has begun a forfeiture action against properties in the U.S. acquired by Malaysian individuals whom allegedly embezzled funds from the 1 Malaysia Development Berhad (“1MDB”, Malaysia’s sovereign wealth fund, designed to be used for investment that would return profits to support the Malaysian people).  

The DOJ is trying to seize $1 billion in assets including the $30.6 million penthouse at the Time Warner Center in Manhattan, a $39 million mansion in the Los Angeles hills, and a $17.6 million tear down home in Beverly Hills.  The DOJ is alleging that the individuals diverted over $3 billion funds from 1MDB for their own use.  The key individuals referenced are the stepson, close friends and associates of the prime minister of Malaysia.  There are even allegations that some of the funds diverted were used to fund the film “The Wolf of Wall Street” and also to purchase paintings from Picasso and Monet. 

The DOJ’s seizure action raises two questions:

  1. Why isn’t the government getting tough in preventing US Multinational Corporations (US MNCs) from shifting their profits offshore to avoid U.S. taxes; and
  2. Why are US banks allowing individuals to hide money in the U.S.

As previously discussed in this Blog, US MNCs have utilized transfer pricing, earnings stripping and inversions to shift profits from the U.S. to low tax jurisdictions to lower the effective tax rates paid by the US MNCs.  This recent news story (DOJ seizure) raises the question why isn’t the government utilizing more aggressive techniques to stop the US MNCs from shifting this income when the government is seizing asset allegedly begotten from embezzled funds of other nations.  Shouldn’t we first stop US tax income from flowing to low tax jurisdictions, then worry about US assets acquired by other nations’ stolen funds?

The Second question goes to the nature of the Panama papers and the uses of shell corporations to mask the identity of the owners of the shell corporations.  There is now an effort by the government to require banks to know the owners of the shell corporations.  See this NY Times article.  According to the article, the US Treasury is requiring US branches of foreign banks to know whom the beneficial owners of the shell corporations.  While the US Treasury’s plans have not actually translated to actual rules requiring banks to obtain the identities of the owners of the shell corporations it appears as if it is likely to get legislation passed through Congress to enact the more stringent requirements on banks. 

If you have specific and credible information about a U.S. MNC shifting its profits offshore using transfer pricing, inversions or earning stripping, or anyone not paying their taxes by using shell corporations through banks, contact our firm to discuss filling a tax whistleblower claim.  As a reminder, the IRS pays between 15-30% of the collected proceeds (tax, penalties, interest, and other amounts collected) based on the information provided and used by the IRS to stop tax violators.