Daily Tax Update - July 22, 2010

TRANSFER PRICING FOCUS OF WAYS AND MEANS HEARING: Today, the House Ways and Means Committee heard testimony from Administration, private sector, and academic witnesses on the issue of transfer pricing in the global economy. The witnesses included: Stephen Shay (Deputy Assistant Secretary for International Tax Affairs, US Treasury Department); Tom Barthold (Chief of Staff, Joint Committee on Taxation); Martin A. Sullivan (Tax Analysts); William Morgan (Managing Director, Horst Frisch Inc.); Reuven Avi-Yonah (Professor, University of Michigan School of Law and also of Steptoe & Johnson LLP), and James Hines Jr. (Professor, University of Michigan School of Law.)

  • Chairman Levin said, “Transfer pricing is a serious issue that has emerged over time to pose a challenge to the enforcement of United States tax laws. According to reports and media stories, multi-national companies are potentially gaming the current system to shift assets and funding within foreign-based entities to avoid paying US taxes. If companies are moving money overseas, they are moving jobs overseas precisely at a time when we must be using the US tax code to promote job creation and strengthen economic security for workers and businesses here in America.” Levin added, “Today’s hearing will not focus on specific proposals to address the issue, but will help give Members of this panel and interested parties a better understanding of the mechanics of transfer pricing and how big an issue this is for the Federal government.”
  • Shay said, “I will focus my testimony today on Treasury’s analysis of the available data relating to the issue of whether profits are being shifted abroad out of the United States for tax purposes through the mechanism of related party transactions or, as the mechanism is more commonly known in the tax policy community, through transfer pricing. We conclude, based on our analysis of available data, that there is evidence of substantial income shifting through transfer pricing. In response, the Administration’s FY 2011 Budget includes proposals that would reduce the incentive to transfer US intangibles offshore to related parties, which is one of the transfer pricing techniques used to shift income out of the United States. In addition, the Treasury Department and Internal Revenue Service have undertaken a series of actions, including updating regulations, focusing enforcement capabilities and working with other countries, to improve the administration and enforcement of transfer pricing rules.”
  • Barthold discussed the JCT’s report “Present Law and Background Related to Possible Income Shifting and Transfer Pricing” which was summarized in yesterday’s Daily Tax Update.
  • Sullivan stated, “My testimony will address the magnitude of the transfer pricing problem, its detrimental impact on the economy, and the need for congressional action to overhaul rules for apportioning profits of global businesses.” Sullivan continued, “To make a real dent in the transfer pricing problem Congress must go beyond the usual mild remedies, such as increasing penalties, requiring more disclosure, and urging more enforcement.” Sullivan added, “Modifying the arm’s length standard will not get the job done. The only credible long-term solution is the defenestration of the arm’s length standard and its replacement with formulary apportionment methods ... have proposed a 10-percent minimum tax on foreign earnings. The proposal is a simplified alternative to the Obama plan. Unlike the Obama proposal all suspect earnings would be subject to a new 10 percent minimum tax (instead of the 35 percent statutory rate). While the penalty rate is lower, the net is cast wider than under the Obama plan. Under the proposed minimum tax, there would be no difference between the treatment of intangible and other types of income (an often impossible distinction to make). And there would be no need for an arbitrary determination of “excessive profits.” Under this plan all foreign income would be required to pay at least 10 percent tax. If the foreign rate is less than 10 percent, the new US tax would make up the difference. This proposal would limit the allure of zero-tax havens and (hopefully along with cut in the US corporate rate) reduce the incentive for income shifting. At the same time the low 10 percent rate would not be a significant impediment to the competitiveness of US multinationals in overseas markets.”
  • Morgan said, “Cost sharing is not meeting its objectives. My experience is that companies are able to license to related parties high value intangibles in transactions more appropriately characterized as a sale of a broader group of intangible property. The simple evidence is the high potential income of the subject intangibles, present on the day of the transfer, which is not captured in the intangible valuations. Solutions, which may require law and regulatory changes, should focus on this issue.”
  • Avi-Yonah said, “The key issue is a transfer pricing one: ... under the cost-sharing regulations as they existed until the recent amendments, it was possible for a US-based MNEs to locate most of the profit from an intangible in an offshore jurisdiction solely because the CFC participated in the costs of developing the intangible. The CFC was not required to participate in the research in any way other than a monetary contribution (which could be a capital contribution from the parent). Recent amendments to the cost-sharing regulations have tightened the requirements for a CFC to participate in a qualified cost sharing arrangement. I believe that these regulations will significantly limit the ability of US-based MNEs to shift profits from intangibles developed in the US to their overseas CFCs. I would support further amending the regulations so that cost sharing would only apply to intangibles developed with substantial participation by the CFC. If a US-based MNE develops an intangible jointly with its CFCs, cost-sharing is an appropriate way of allocating the resulting profit between the related parties. But cost-sharing should not be applied to allocate profits to a CFC that did not actually participate in developing an intangible.”
  • Hines stated, “Transfer pricing rules represent one element of tax base definitions over which countries compete in efforts to secure investment, employment, and the economic benefits that go with them. If the United States or any other country were to impose harsh and arbitrary transfer price regulations that burden business operations with unwarranted compliance costs and tax obligations, then we should expect investment to fall as a result – just as any other tax and regulatory burdens discourage business operations. This is particularly true of investments by multinational firms, which typically have more options than do other companies.” Hines continued, “In evaluating potential changes to the transfer pricing rules, therefore, it is important to consider how the United States is positioned relative to other countries that are major capital exporters and importers. It is widely believed that the IRS is without peer in the tax enforcement realm, as reflected in the quality of its operation and the very high overall US tax compliance rate compared to other countries. That, together with the very strict regulations under Section 482 and other Code provisions, puts the United States at the forefront of enforcing international transfer pricing. Of course if there are clear problems with existing rules or enforcement then they should be addressed, but the danger is that efforts to address perceived abuses may include enforcement measures that overtax firms in some or all situations, thereby inefficiently distorting business behavior and discouraging investment.”
  • For additional information, contact Philip R. Westpwest@steptoe.com, Michael C. Durstmdurst@steptoe.com, or Reuven Avi-Yonah – Ravi-yonah@steptoe.com.

BAUCUS RELEASES SMALL BUSINESS JOBS ACT SUBSTITUTE: Yesterday, Senate Finance Chairman Max Baucus offered a substitute amendment to “The Small Business Jobs Act of 2010.” The Senate is expected to resume consideration of the bill today.

  • Among the changes in the substitute amendment is a provision on source rules on guarantees. According to the Committee’s summary, “Under current law, the treatment of guarantee fees under the source rules is unclear. If guarantee fees are sourced like services, they are sourced according to the location in which the services were performed. If the guarantee fees are sourced like interest, they are sourced by reference to the country of residence of the payor. A recent court case determined that guarantee fees should be sourced like services. Sourcing guarantee fees in a manner similar to services would permit US subsidiaries of foreign corporations to engage in earning stripping transactions by making deductible payments to foreign affiliates (thereby reducing their US income tax liability) without the imposition of US withholding tax on the payment. The substitute would provide that amounts received directly or indirectly for guarantees of indebtedness of the payor issued after the date of enactment will be sourced like interest and, as a result, if paid by US taxpayers to foreign persons will generally be subject to withholding tax. No inference is intended with respect to the treatment of guarantees issued before the date of enactment. This provision is estimated to raise $2.025 billion over ten years.”

UNEMPLOYMENT BENEFITS EXTENSION PASSES – EFFORT TO REPEAL ESTATE TAX PERMANENTLY FAILS: Last night, the Senate voted 59-39 to extend unemployment benefits until November 30. The House is expected to approve the jobless benefits bill today.

  • The Senate voted 39-59 against a motion by Sen. Jim DeMint (R-SC) to waive Senate rules so he could offer a motion to recommit the jobless benefits bill back to the Finance Committee with a provision providing for a permanent repeal of the estate tax. Two Democrats supported the estate tax provision and three Republicans voted in opposition. The Democrats who supported abolishing the estate tax were Senators Blanche Lincoln and Ben Nelson. The Republicans who voted against the proposal were Senators Olympia Snowe, Susan Collins, and George Voinovich.

HOUSE OFFSET INCREASES CORPORATE ESTIMATED TAX PAYMENTS FOR 2014: Yesterday, the House passed an offset to “The US Manufacturing Enhancement Act” (H.R. 4380), which would raise corporate estimated tax payments by 0.75 percentage points in the third quarter of 2014 to 101 percent of what would otherwise be owed for corporations with assets of $1 billion or more. The provision would be effective in 2014. The Senate has not acted on the provision.

S.3621: A bill to amend the Internal Revenue Code of 1986 to provide for an exclusion for assistance provided to participants in certain veterinary student loan repayment or forgiveness programs.
Sponsor: Sen Johnson, Tim [SD] (introduced 7/21/2010) Cosponsors (11)

S.3623: A bill to amend the Internal Revenue Code of 1986 to extend the payroll tax relief under the HIRE Act, and for other purposes.
Sponsor: Sen Schumer, Charles E. [NY] (introduced 7/21/2010) Cosponsors (None)

As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

Steptoe & Johnson LLP has one of the largest and most diverse law firm tax practices in the country. The practice covers the entire spectrum of federal taxation, including representation of businesses before the Congress, Treasury and the national office of the IRS; transactional planning for domestic and multinational corporations; complex audit and controversy work for corporations and other business interests contesting IRS adjustments; litigation before the Tax Court, Court of Federal Claims, district courts, courts of appeals and the Supreme Court. The firm's tax practice also encompasses all aspects of employee benefits (ERISA), executive compensation, tax-exempt organizations and charitable giving. Steptoe has an extensive state and local tax practice, representing an array of business clients on complex sales and use tax, corporate income tax and property tax matters, both advising those clients and handling audits, administrative appeals, and litigation for them. Read more information on Steptoe's tax practice.