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Actionable global tax insights for 2024

Tax Strategy Playbook

Baker Tilly’s inaugural Tax Strategy Playbook discusses the outlook for the new year’s tax policy landscape, outlines how current tax policy impacts your business and discusses opportunities for tax planning and mitigating inherent risks. We delve into various areas within federal, global and state and local tax.

Baker Tilly’s Tax Strategy Playbook covers global tax insights regarding geopolitical considerations, Pillar Two, understanding Moore v. United States, international case law trends and taxation, utilizing the foreign tax credit and more that may impact your organization.

As businesses are forced to consider a growing variety of factors that impact their profits, geopolitical environments are becoming increasingly relevant to forecasting operating environments and potential future risks. A myriad of interconnecting issues impact geopolitics including diplomatic relationships, armed conflicts and political instability across the world. Regulatory guidance and tax legislation are also among the many issues that should be considered. Geopolitical issues can present considerable risk to businesses, and it is essential to consider these environments in planning for potential exposure.

The current volatility in geopolitical environments presents unique challenges in planning for international tax and trade. Some of the most significant current geopolitical challenges include:

U.S.-China relations
  • Emergence of increased political and economic influence of China
  • U.S. legislation aimed at providing relief from double taxation between U.S. and Taiwan
  • Future changes to tariffs imposed by the U.S. on Chinese imports and any corresponding exclusions granted
Energy security
  • Europe’s energy crisis, primarily caused by the Russia-Ukraine conflict
  • Unavailability of inexpensive Russian gas
  • Polarization regarding the role of climate change and energy transition
  • Decreased reliance on foreign competition and supply chains
  • Incentivizing domestic production over outsourcing to foreign countries
  • Risk to critical infrastructure including power grids, supply networks and nuclear power
  • Ability to mitigate escalating cyber risks

In addition to assessing traditional financial and business risks, it is essential for companies to be aware of current and potential geopolitical risks to forecast how current conditions may affect both their profitability and global operations.

It’s critical that U.S. multinational enterprise (MNEs) monitor the adoption and developments of both Pillar One and Two, as these entities are likely to be impacted by the global minimum tax, particularly as an increasing number of jurisdictions around the world adopt both pillars.

The Organization for Economic Cooperation and Development’s (OCED) Inclusive Framework on Base Erosion Profit Shifting (BEPS) has two pillars, including:

  • Pillar One: Focuses on nexus and profit allocation rules with the purpose of assigning a greater share of taxing rights over global business income to market countries.
  • Pillar Two: Focuses on a new global minimum tax which was approved in December 2021 by 141 participating jurisdictions. It provides for a global minimum tax of 15%, applicable for MNE groups with a global turnover of €750 million or more.

The European Union (EU) adopted Pillar Two at the end of last year. Member states are obliged to implement the rules by the end of Dec. 31, 2023. The adoption of the directive means that minimum tax rules have become part of EU law. There are some differences and additions in the EU rules as compared to the internationally agreed model rules, such as a mandatory application for large domestic groups, and a postponement until 2024 (one year later than the international agreement).

The Americas and the rest of Asia Pacific are expected to follow shortly; however, the participation by the U.S. remains up in the air. The adoption of Pillar Two, which never seemed to receive the level of congressional support needed, encountered a significant obstacle in June 2023 when the Joint Committee on Taxation estimated that the U.S. would lose $120 billion under Pillar Two. Though the U.S. may not adopt Pillar Two, U.S. MNEs will be subject to the rules to the extent they operate in participating jurisdictions.

Careful consideration and monitoring of legislative activity across the EU and the world will be important for multinational enterprises to plan for and comply with the application of Pillar Two and the global minimum tax. Affected organizations should work with their tax advisors to identify any opportunities for minimizing effective tax rates, implementing systems for proper reporting and/or reducing compliance costs.

As more jurisdictions adopt and implement the Organization for Economic Cooperation and Development’s (OCED) Inclusive Framework on Base Erosion Profit Shifting (BEPS) Pillar Two, a tax regime that provides for a global minimum tax of 15% for applicable entities, we expect to see an increased impact on multinational enterprise (MNEs).

While applying a 15% minimum tax may sound straightforward, it presents several risks and operational complexities MNEs should be aware of, including:

  • Potential for double taxation: Given that the U.S. has yet to implement Pillar Two and that MNEs will be taxed a 15% rate in various foreign jurisdictions, there is potential risk of double taxation for U.S. companies. This risk will remain unless legislation is passed that introduces provisions that interact with Pillar Two.
  • Structure concerns: In instances where top-up taxes apply, companies will have to revisit their global structures, value chains and the location of their activities to mitigate material impacts as potential tax impact could be significant, increasing cash tax costs and reducing earnings per share.
  • New requirements: MNEs are likely to face new financial statement disclosures and will need increasingly sophisticated data management systems. MNEs are also likely to see a need for process improvements and technology upgrades as well as regulatory changes.
  • Increased cost of compliance: In light of these complex new rules, companies will have to spend sufficient time to strategize, develop proper processes and implement technology solutions to obtain the data points needed to comply with Pillar Two.

MNEs have limited time to prepare for the impact of Pillar Two, especially as it’s already effective within the European Union. Proactive planning can help mitigate the potential risks and challenges the global adoption of Pillar Two will inevitably bring.

Lost in the noise of the Organization for Economic Cooperation and Development (OECD)’s implementation of the base erosion and profit shifting (BEPS) 2.0 Pillar Two initiative related to implementing a global minimum tax, the OECD released a public consultation document outlining the design of its Pillar One Amount B. Unless you are a seasoned transfer pricing professional, that might not illicit a response as Pillar One is anticipated to only impact the largest global multinational enterprises (MNEs). However, the implementation of Pillar One, specifically Amount B, may result in the first time the OECD will turn away from the arm’s length standard and shift towards the implementation of a formulary apportionment method to determine income in certain transfer pricing situations.

Pillar One consists of two distinct parts: Amount A and Amount B. According to the OECD, “Amount A of Pillar One has been developed as part of the Two Pillar Solution for addressing the tax challenges arising from the digitalization of the economy. It provides jurisdictions in which consumers and users are located a new taxing right over a portion of the residual profits of the largest and most profitable multinational enterprises in the world.”

Pillar One Amount B, on the other hand, is meant to simplify the allocation of income to baseline functions underlying the digital sales into local markets. Specifically, the fixed returns for marketing and distribution functions that have been proposed will automatically be assigned to the local country based on a set of economic standards and functional differentiators. This is essentially an apportionment of income to certain jurisdictions using a formulary approach rather than an analysis under the arm’s length standard. It is anticipated that the OECD will integrate Pillar One Amount B into the OECD transfer pricing guidelines. What is unclear is to what extent these formulas will be used beyond the scope of Pillar One.

Large and small MNEs that might not rise to the level of Pillar One inclusion should analyze their current transfer pricing models to determine the potential impact of the Amount B formulas on their foreign marketing and distribution functions. For some taxpayers, this may provide an opportunity to limit uncertainty and reduce compliance risks, while for others, might highlight the need to make adjustments to ensure compliance with a potential overreach by foreign tax authorities looking to achieve quick wins in transfer pricing disputes.

In December 2023, the U.S. Supreme Court heard oral arguments in Moore v. United States, a case that challenges the constitutionality of a provision that required U.S. shareholders to pay tax in the U.S. on their attributable share of unremitted accumulated earnings of certain specified foreign corporations in which they were invested. This tax regime, known as the section 965 transaction tax or mandatory repatriation tax (MRT), essentially taxes foreign earnings as if they’ve been repatriated to the U.S. The tax applies to U.S. shareholders who hold a 10% or larger stake in a controlled foreign corporation.

The case

Charles and Kathleen Moore owned a minority stake in a small company headquartered in Bangalore, India, which they invested in at the time of its formation in 2006. From 2006 to 2017, the company grew in revenue, and all earnings were reinvested in the company. The Moores, as minority shareholders, never exercised control over the company and never received any distributions.

When the Tax Cuts and Jobs Act (TCJA) of 2017 introduced the MRT, the Moores learned that they owed a one-time tax amounting to $14,729 for the 2018 tax year. At the time, the Moores were unaware their stake in a foreign corporation would result in a tax liability. The Moores have never received any income from the company, and it did not have sufficient cash to distribute its retained and reinvested earnings.

The Moores sued, seeking a refund of their $14,729 tax payment. The district court denied the refund. The Ninth Circuit Court of Appeals affirmed the denial, stating “[w]hether the taxpayer has realized income does not determine whether a tax is constitutional,” and concluding the taxation of retained profits is constitutional, based on the premise that unrealized gains qualify as income.

The question of law here is whether the 16th Amendment has a realization requirement for amounts to be taxed as income. The outcome of this case could have wide-ranging implications, a fact that gave U.S. Supreme Court Justices some consternation during the first day of oral arguments.

As we await the outcome of Moore, taxpayers who are subject to the MRT should consult with their advisors regarding their individual situation, including the need to make additional payments and/or file a protective refund claim for MRT liabilities paid.

Recent rulings in U.S. Tax Court have shown a trend in the direction of taxpayer-favorable outcomes, particularly as they relate to some of the international regulations that were issued in accordance with the Tax Cuts and Jobs Act (TCJA) of 2017.

As an example, let’s explore the recent ruling in Alon Farhy v. Commissioner and the opportunity it presents for similar taxpayers.

In April 2023, the U.S. Tax Court ruled that the IRS did not have statutory authority to assess penalties against a taxpayer who knowingly failed to file Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, for his 2003 to 2010 tax years. The penalty for failure to file Form 5471 was $10,000 for each tax year. In the case under review, Alon Farhy v. Commissioner, the taxpayer owned 100% of a foreign corporation incorporated in Belize during the applicable tax years. The taxpayer was part of an illegal scheme to reduce his income taxes owed during that period. In 2012, Farhy confessed to his involvement within the scheme and was granted immunity from persecution. The taxpayer argued that the relevant code section did not contain any provision that grants the IRS authority to assess the $10,000 penalties. The court ruled in the taxpayer's favor, finding that the penalty is not accessible by the IRS, although it may be collected through civil action.

Though the case’s ruling states that the IRS may not access penalties for failure to file international forms, this does not exempt taxpayers from their obligation to file. This case’s ruling can be used as precedent and applied to numerous foreign related informational forms. Taxpayers who have previously paid a similar $10,000 failure-to-file penalty can make a protective claim for refund; however, the statute of limitations is two years from the time the penalty is paid, so time is of the essence.

Baker Tilly continues to monitor relevant tax court cases for potential impacts on our clients, including trends in rulings related to both domestic and international activity.

There will be significant changes in foreign tax policies stemming from the Organization for Economic Cooperation and Development’s (OECD) base erosion and profit shifting (BEPS) Pillar Two, the transparency demands that align with its adoptions, and more sustainability tax measures worldwide.

Some of the countries driving recent policy changes include:

  • China is continuing to drive policy measures to attract additional foreign direct investment companies, a policy that began in the 2023 tax year. China’s targeted measures include increasing tax incentives for research and development of technology and artificial intelligence (AI)-driven companies. In addition, value-added tax (VAT), goods and services tax (GST) and sales tax bases to export sales are expected to increase.
  • Brazil underwent comprehensive tax reform in 2023. The measures introduced ensure that Brazil will align with OECD guidelines and transfer pricing policies; these adjustments may be helpful as Brazil rallies to become an OECD member.
  • Taiwan implemented a few new tax policies that took effect during the 2023 tax year. Taiwan set up a system to ensure controlled foreign corporation (CFC) rules will apply to any domestic companies that own more than 50% of the shares of a foreign subsidiary in a low tax country. This system requires affected companies to repatriate dividends back to Taiwan to be taxed, similar to the global intangible low taxed income (GILTI) regime under the U.S.

The above represents just some of the countries that have recently implemented new tax policy changes. There are other countries that have done so but are not listed here.

Baker Tilly will continue to monitor global policy, providing clients with updates on significant developments and sharing applicable planning opportunities.

The world is becoming more borderless every day, with technology paving the way to expanding global markets. It’s easier to network, partner, invest and trade internationally than ever before. Though access to these markets has expanded, the legal and regulatory requirements that accompany this type of economic activity are frequently overlooked; sometimes until it’s too late.

As it relates to taxation, a global footprint can often give rise to unfavorable tax burdens, particularly when unwitting taxpayers may have expanded or invested hastily, and in jurisdictions that have the legal authority to tax the same item of income.

In an effort to prevent double taxation on their residents, countries may enter into bilateral agreements, often referred to as double tax treaties or agreements. These treaties also serve to bolster diplomatic and economic relations between two countries and their respective citizens, easing the barrier to trade across borders. The U.S. has entered into agreements with many countries, including Canada, China, Germany, India, Ireland and Mexico to name a few. If treaty qualifications are met, treaty provisions may provide for tax exemptions and/or tax rate reductions, depending on the type of income. Additionally, treaties often more narrowly define if a taxable presence, or permanent establishment, exists providing certainty to residents in treaty countries.

Although there had been a lengthy halt in treaty activity, activity has increased recently. In late 2022, the US and Croatia signed their first income tax treaty. As of January 2024, there is no longer a treaty between the US and Hungary. In July 2023, the Senate Foreign Relations Committee approved the “Taiwan Tax Agreement of 2023,” a bipartisan legislation authorizing the Biden administration to negotiate and conclude a tax agreement between the U.S. and Taiwan. Finally, in June 2023, the Senate voted 95 to 2 in favor of consenting to ratify the tax treaty between the U.S. and Chile. The treaty will enter into force after ratification by both countries.

It’s important to recognize that cross-border investment and trade poses tax risks for the unwary, while thoughtful planning can provide tax savings opportunities. Taxpayers who have or wish to establish a global footprint should consult a knowledgeable tax advisor for assistance with structuring cross-border activity, ensuring regulatory compliance requirements are met, and confirming the proper amount of tax is being paid in each jurisdiction.

Introduced in late 2022 and ratified in 2023, Brazil's Provisional Measure No. 1.152/2022 brings its transfer pricing requirements in theoretical alignment with U.S. and Organization for Economic Cooperation and Development (OECD) rules. For the first time, this legislation establishes an arm’s-length requirement governing Brazilian transfer pricing. Brazilian taxpayers had the option to implement the new principle in 2023 but are required to do so in 2024.

The impact to U.S. taxpayers

For U.S. companies with entities in Brazil, the obvious impact is that there will be new requirements to be met, which is expected to bring increased compliance requirements and the possibility of additional tax due. The lack of cohesion between U.S. transfer pricing requirements and prior Brazilian requirements has caused many U.S. companies to put structures in place that will be, at best, tax inefficient, and in some cases, untenable under the new rules.

Arguably, the most consequential impact will be to the foreign tax credit (FTC) recognized by U.S. companies with Brazilian entities. Updated FTC regulations issued in late 2021 provided limitations relating to whether a foreign tax is creditable in the U.S. based in part on whether the jurisdiction’s profit allocation rules are consistent with the arm’s-length principle. Under Brazil’s previous regime, this requirement was a headache for many U.S. taxpayers, as Brazilian income tax was potentially disqualified from being eligible for a credit against U.S. tax.

U.S. taxpayers with Brazilian entities should begin to look at the potential impact of the new legislation to make an informed decision about possible changes to their transfer pricing structure. This may not be a simple or straightforward exercise. Changes made by taxpayers may result in an increase in taxable income and tax liability in Brazil; however, in these instances, the taxpayer may find a benefit in the ability to claim a U.S. FTC.

Global trade is continuously evolving as supply chains shift away from higher duties and strained political ties, moving instead towards alternative nations and incentives that reduce duties and other costs. Recently, the U.S. has been distancing itself from trade relations with China and enhancing incentives for trade partnerships with Europe and Japan.

In March 2023, the U.S. signed an agreement with Japan to bolster our supply chains for critical minerals, as we collaborate with many governments including the European Union (EU), Canada, Japan and others to reduce their dependence on China for critical minerals. This agreement not only highlights the overall ongoing shift in global trade, but also emphasizes the effects of incentives stemming from the Inflation Reduction Act (IRA). The IRA specifies that tax credits can only be realized when sourcing parts and materials from nations with which the U.S. has a free trade agreement (FTA) in place.

Japan does not have a U.S. FTA, which led the U.S. to modify the agreement accordingly. Under the arrangement, referred to as a limited FTA, Japanese suppliers of critical minerals will receive equivalent IRA tax credit benefits for battery components and essential raw materials utilized in electric vehicles. Soon, similar agreements could be signed with the EU, the UK, and possibly Indonesia. This limited-FTA approach differs from the traditional approval process of full-fledged FTAs, circumventing the necessity for congressional approval; this is a significant development as trade agreements can be easily thwarted by congressional opposition.

We continue to monitor the ongoing discussions regarding these limited FTAs, particularly with the EU and UK. Companies connected to suppliers in these regions may be able to take advantage of IRA tax credits.

Customs compliance strategies within global trade tend to focus on duties, tariffs, sanctions and anti-dumping measures. However, U.S. Customs and Border Protection (CBP) has continued to spotlight their efforts to curb products made with forced labor, as CBP is responsible for preventing the entry of products into the U.S. market by investigating and acting upon allegations of forced labor in supply chains.

While CBP has traditionally monitored and enforced rules against forced labor, two factors have heightened their oversight: the enactment of the Uyghur Forced Labor Prevention Act (UFLPA) and the revised criteria of the Customs Trade Partnership Against Terrorism (CTPAT).

In 2022, CBP began preventing goods from entering the U.S. if produced by entities on the UFLPA Entity List which targets companies or people in Xinjiang, China that mine, produce or manufacture merchandise with forced labor. Between June 2022 and May 2023, CBP intercepted 4,269 shipments, with a total value of $1.39 billion, subjecting them to UFLPA reviews and/or enforcement actions.

In 2023, CTPAT’s forced labor requirements became mandatory, including risk-based mapping and proof of compliance. The CTPAT program allows participants in the supply chain to streamline the process by providing documentation on the reliability of their security procedures and those of their business partners. This documentation is now required to specifically identify any imported goods that are at a high risk of being manufactured using forced labor.

We continue to monitor the evolution of CBP's enforcement initiatives against products made with forced labor. Companies that align with or surpass CBP's standards by implementing or enhancing their procedures can reduce both supply chain disruptions and any associated costs. Baker Tilly serves as a strategic ally capable of evaluating compliance and providing guidance on best practices to help companies improve the transparency of their supply chains.

Since 2018, the U.S. has imposed tariffs that add between 7.5% and 25% duties to certain products imported from China. The tariffs were the result of a Trade Act of 1974 section 301 investigation that found some of China’s practices to be in violation of the act and potentially harmful to U.S. commerce. The tariffs apply to a broad range of products and have been imposed in four rounds issued as “lists.” Over the past several years, the range of products affected by both tariffs and exclusions has fluctuated, and although each tariff and exclusion come with an expiration date, there's the possibility of extensions or retroactive re-activation.

As expected, the imposition of these tariffs can have a material impact on the economics of the importer’s business. Accordingly, there’s great value in avoiding these additional duties, when possible. One way for importers to avoid these additional costs is to use tariff exclusions, which can be applied by either matching the Harmonized Tariff Schedule (HTS) classification or meeting specific product specifications. The Office of the United States Trade Representative (USTR) grants these exclusions by considering factors such as national interest, economic considerations and circumstances affecting a particular industry. Exclusions apply generally to specified products, and any party importing a product covered by an exclusion may file a claim.

Current section 301 tariff exclusions encompass various industrial components like pumps and electric motors, specific car parts, chemicals, bicycles and vacuum cleaners. However, exclusions fluctuate. The timing surrounding the creation and extension of exclusions can be unpredictable, which provides significant obstacles to planning and executing an effective strategy.

Baker Tilly possesses the expertise to advise clients on the implications of section 301 tariffs. Our team assists with planning, confirms the applicability of section 301 tariffs on our client’s imports and assesses the eligibility of exclusions for their products. We’re able to help our clients navigate the intricate USTR listing of exclusions and extensions while tracking our client’s products against tariff expirations, extensions and retroactive actions. If you import products potentially subject to section 301 tariffs, we can discuss how to potentially help you eliminate any unnecessary import expenses.

Many international provisions provided by the Tax Cuts and Jobs Act (TCJA) of 2017 are currently scheduled to expire at the end of 2025. There are tax planning strategies some taxpayers should consider to mitigate tax liabilities, as various international provisions will become more restrictive.

Below is a brief discussion of some of the most impactful changes we’re anticipating:

Global intangible low-taxed Income (GILTI)
  • Before the TCJA, only certain foreign earnings of U.S. companies would be taxed annually. This included the subpart F and section 956 anti-deferral regimes. If foreign earnings did not run afoul of the anti-deferral rules, those foreign earnings were generally not taxed by the U.S. unless they were repatriated. Now, many more companies are taxed on their foreign earnings under the GILTI regime on an annual basis.
  • In 2026, the overall effective tax rate on GILTI will rise from 13.125% to 16.406% for many U.S. companies.
Base erosion and anti-abuse tax (BEAT)
  • In general, BEAT is a 10% minimum tax that prevents foreign and domestic corporations operating in the U.S. from avoiding domestic tax liability by shifting profits out of the U.S. by making certain types of intercompany payments. BEAT’s application is generally limited to large multinational enterprises with gross receipts of $500 million or more. BEAT also does not apply unless “base erosion” payments — payments that corporations based in the U.S. make to related foreign corporations — exceed 3% (2% for certain financial firms) of total deductions taken by a corporation.
  • In general, the BEAT rules require an applicable taxpayer calculate a modified taxable income (MTI) amount. The BEAT rate is applied to the MTI. The BEAT amount is then an additional tax separate from a U.S. corporation’s regular tax liability equal to the amount the BEAT liability exceeds the U.S. corporation’s regular U.S. tax liability.
  • In 2026, the BEAT rate will increase from 10% to 12.5%.
Foreign-derived intangible income (FDII)
  • FDII is a provision that potentially allows a domestic corporation to take a deduction on certain income generated from selling goods, services or intellectual property (IP) to customers outside of the U.S. For a domestic corporation, the law allows a deduction equal to the sum of 37.5% of the FDII for the tax year, subject to certain limitations.
  • The tax deduction for FDII is set to be reduced from 37.5% to 21.875% after 2025.

Now is the time to plan for these upcoming sunsets. Thoughtful and proactive planning opportunities can potentially mitigate or eliminate a taxpayer’s exposure to these detrimental changes.

In January 2022, final regulations were published aligning the treatment of domestic partnerships and S corporations invested in controlled foreign corporations (CFCs) for subpart F and section 956 (income inclusions related to foreign investment in U.S. property), with how they are treated for global intangible low-taxed income (GILTI) purposes.

Historically, when a domestic partnership or S corporation was a U.S. shareholder of a CFC that earned subpart F or section 956 income, it was included in the taxable income of the pass-through entity, that was then included in the distributive shares of the partners or S corporation shareholders. This is referred to as the entity approach because the analysis is performed at the entity level.

When GILTI was established under the Tax Cuts and Jobs Act (TCJA) of 2017, it implemented the aggregate approach rather than the entity approach. Under GILTI, income is only included in a partner’s or S corporation shareholder’s taxable income if they are a taxpayer, not a pass-through entity. The final regulations adopted the same aggregate approach used in GILTI to apply to subpart F or section 956 income; as a result, owners of pass-through entities will only have subpart F income if they are considered a U.S. shareholder of the applicable CFC.

It is important to understand the effect this may have on an interest in a CFC through your domestic partnership or S corporation. Owners of an indirect interest in a CFC through a pass-through entity should work with their tax advisors to understand and plan for their subpart F income inclusion where applicable.

U.S. multinational enterprises (MNEs) often operate outside the U.S. through foreign branches, or foreign entities that the U.S. MNE elects to treat as foreign disregarded entities (FDEs) for U.S. tax purposes. Foreign branches (FBs) and FDEs are required to maintain separate books and records and are also typically required to file local country income tax returns in the country where they operate.

For U.S. tax purposes, the U.S. MNE, as owner, includes the income of the foreign branch or FDE in its own U.S. return. This income is subject to U.S. tax at the rate of tax applicable to the owner. U.S. taxpayers who pay both U.S. and non-U.S. income taxes on the same income typically are permitted to reduce their U.S. tax liability by claiming a tax credit for the foreign taxes paid on the double-taxed income.

Recently, the income sourcing rules changed from determining the source of income based on where title passed, to determining the source of income based solely on the location of where the inventory is produced or manufactured. Under these new rules, income attributable to and reported by the FB or FDE on local country (non-U.S.) sales of the products manufactured by the U.S. MNE will not be characterized as foreign source; but rather, will be characterized as U.S. source income. The net effect of this change is a reduction or elimination of the available foreign tax credit (FTC) for many affected entities, due to a lack of adequate foreign source income.

U.S. MNEs that manufacture products in the U.S. and sell the products through their FBs or FDEs should examine potential FTC implications and consider legal structure changes or certain potential treaty positions to mitigate any issues.

Some U.S. multinational S corporations, or other pass-through entities (PTEs), take the position that, because income or loss from foreign operations is picked up by the U.S. company, transfer pricing does not materially impact the group’s tax calculation. In today’s global economic and tax environment, where laws and regulations are in constant flux, this couldn’t be further from the truth.

Today, U.S. pass-through entities with multinational operations need to consider the following issues related to transfer pricing and the global allocation of income amongst the group’s affiliates, regardless of U.S. tax treatment.

  • Local country regulations: Does the foreign affiliate follow the transfer pricing regulations in the jurisdictions in which it does business? Depending on the functions performed, risks incurred and assets used (tangible and intangible), the income or loss earned by the foreign affiliate should be supportable from an arm’s length transfer pricing perspective. This perspective can be different for each jurisdiction and a failure to address can lead to local country transfer pricing issues.
  • Foreign tax credit utilization: Just because the income of the foreign affiliate flows through to the U.S. parent does not necessarily mean that the taxes paid on foreign income will be creditable against the foreign income that will be taxed in the U.S. Transfer pricing results of the foreign affiliates that are not aligned with the U.S. transfer pricing regulations can impact the ability to credit the foreign taxes paid.
  • Deductibility of certain related party charges: The jurisdiction in which foreign affiliates operate may limit the ability to deduct payments to related parties in certain circumstances. From the foreign perspective, payments for management fees, royalties or interest expense may not be deductible due to hybrid mismatch rules that only look to the tax treatment of the payment as applied to the U.S. PTE. Additional consideration needs to be given to show how the income will be ultimately taxed in the U.S. to sustain the deduction in the foreign entity.

As with most issues related to transfer pricing, failure to properly analyze and implement proper transfer pricing structures for U.S. S corporations (or other PTEs) can ultimately lead to double taxation. For the owners of a U.S. PTE this can result in effective tax rates well over 50%. Through proper analysis and planning, transfer pricing professionals can limit this potential exposure.

The requirement for U.S. multinational enterprises (MNEs) to prepare detailed transfer pricing documentation was one of the most significant outcomes of the base erosion and profit sharing (BEPS) initiatives undertaken by the Organization for Economic Cooperation and Development (OECD) in 2016. OECD Action Item 13 sought to develop and implement rules on transfer pricing documentation to enhance consistency and transparency with respect to multinational companies’ global transfer pricing policies. This initiative suggested a three-pronged global transfer pricing framework, which included a master file, local files by jurisdiction and a country-by-country (CbC) report.

While the original framework suggested an exemption threshold of €750 million of revenue, many jurisdictions have adopted much smaller thresholds (e.g., €50 million). MNEs who exceed these thresholds trigger the need to file one, or some combination, of the three reports. These transfer pricing documentation requirements continue to be a complex area of global compliance for U.S. MNEs. As new jurisdictions adopt OECD Action Item 13 into their regulations, often with thresholds and information requirements that differ from the model regulations, U.S. MNEs run the risk of not meeting their documentation obligations.

As a result, U.S. MNEs can get buried under the burden of requirements from the OECD, as well as various local country regulations related to transfer pricing. Failure to adhere to global transfer pricing documentation requirements, including master file and local file requirements, can lead to significant penalties for noncompliance. To stay on top of these requirements, U.S. MNEs need to develop a regular cadence for reviewing the size and scale of their global operations, checking global and local revenue thresholds and analyzing the size of their intercompany transactions relative to the local legislative landscape.

Understanding how the various thresholds apply and how to take a globally consistent, but pragmatic, approach to meeting the requirements is challenging. It’s imperative to have a trusted advisor who is intimately aware of the global requirements and has the capability to assist you with creating a strategic plan to meet your transfer pricing documentation obligations.

There are numerous types of potential financial statement exposures, many of which can be spotted by tax advisors when reviewing tax returns. Identification of these issues allows companies the opportunity to investigate and take corrective action as needed to avoid possible financial misstatements and erroneous tax filings.

For example, below are two different scenarios describing risks, each associated with subsidiary distributors.

Subsidiary distributors

Subsidiary distributors deliver a parent’s product for a fee. These entities should be profitable each year. Reporting losses on the distribution of intercompany products and maintaining a balance due from the distributor to the parent are indications of a transfer pricing issue.

  • Situation 1: U.S. companies with foreign ownership. In this scenario, a U.S. C corporation that distributes product for a foreign parent and is paid a fee for that service. The risk here is that improper transfer pricing leads to the U.S. C corporation to understate its financial statement and tax return income. If there are excessive intercompany charges, such excess amounts paid to the non-U.S. owner may be characterized as dividends and require informational return reporting and possibly withholding.
  • Situation 2: U.S.-based multinational enterprises. In this scenario, a U.S.-based multinational enterprise (MNE) has a non-U.S. subsidiary that functions as a distributor for its products; the foreign sub is paid a fee for this service. The risk here is that improper transfer pricing could cause the U.S. C corporation to overstate its income and the non-U.S. subsidiary to understate its income. These pricing errors result in incorrect U.S. and local country tax provisions being posted to the financial statements, differences in projected global cash taxes, and incorrect tax return filings.

Circumstances such as these should be addressed with your tax advisor, who can help you assess and reduce the risks associated with bad transfer pricing, including: possible misstatement of local county income for each of the foreign companies in the group, the related global tax provision, a potential shortfall in projected cash taxes, and filing incorrect tax returns.

The foreign tax credit (FTC) is a credit available for applicable foreign taxes paid or accrued by a U.S. taxpayer on income that has also been taxed in the U.S. Ultimately, the FTC provides taxpayers with relief from double taxation. Understanding which taxes are eligible for the FTC and how the credit is applied is crucial for proper tax planning when taxpayers are operating or investing internationally.

Generally, a taxpayer can claim a credit against its regular U.S. tax liability for “income, war profits, and excess profits taxes” paid or accrued during a tax year to any foreign country or U.S. possession. The FTC is limited based on the lower of the amount of foreign taxes paid, or the amount of US taxes paid. The calculation is based not only on the U.S. tax and foreign tax paid on the income in question, but a taxpayer’s total foreign source taxable income, worldwide taxable income, and total U.S. tax liability, each of which have an effect on the ultimate tax credit.

The FTC is also broken into baskets for the FTC limitation calculation. Previously, there were two baskets: Passive income or general income. Beginning in 2020, the FTC further stratified into two additional limitation calculation baskets, adding: foreign branch income and 951A or global intangible low-taxed income (GILTI) income.

In 2021, the IRS provided additional guidance that further complicated the calculation of the FTC. The guidance added significantly more complex tests for each element of the net gain requirement, which include realization, gross receipts, cost recovery and the introduction of an attribution requirement. The attribution requirement has parameters are especially difficult to meet for countries that do not have a tax treaty with the U.S.

It is extremely important that you understand your foreign income, foreign taxes and the impact this has on your foreign tax credit. Instrumentally, you want to ensure that you are earning income in the same bucket that you are incurring taxes, as you do not want to have taxes built up that you cannot use. Reaching out to your tax adviser early will allow you to plan properly.

Taxpayers are affected both domestically and from a global perspective by recent changes to the interest expense limitation, which limits the interest deduction available for impacted taxpayers.

Taxpayers with business interest expense deduction are limited to the sum of the taxpayer’s business interest income, plus 30% of the taxpayer’s adjusted taxable income (ATI) for the year, plus floor plan financing interest expense. Effective for 2022 and subsequent tax years, the ATI component will be calculated based on a formula closely approximating earnings before interest and taxes (EBIT). Previously, ATI had been calculated based on earnings before interest, taxes, depreciation and amortization (EBITDA). The implementation of this new standard means a substantial number of taxpayers will have larger limitations, resulting in smaller interest deductions.

Because controlled foreign corporation (CFC) tested income for global intangible low taxed income (GILTI) purposes is computed according to the U.S. taxable income, section 163(j) limitation for business interest expense must be considered for certain foreign corporations.

For U.S. multinational enterprises with foreign investment, taxpayers may want to consider making a CFC group election to potentially optimize interest expense deductibility at both the CFC level (reducing GILTI) and at the U.S. shareholder level (for an increase in ATI). We recommend carefully modeling the global impact of a potential CFC group election before implementing this strategy, as the CFC group election is nonrevocable for a five-year period after it’s made.

Historically, the costs incurred for research, whether performed domestically or abroad, were generally deductible when incurred or paid unless a taxpayer elected to amortize. The Tax Cuts and Jobs Act (TCJA) of 2017 altered the general rule for current deductibility beginning in 2022. Currently, qualifying research expenditures under section 174 cannot be deducted; they must be capitalized and amortized over either five or 15 years. The amortization period is based on where the research activities are being conducted, with U.S. costs being amortized over five years and others over 15.

An issue arises with U.S. multinational groups when a U.S. parent company contracts with a foreign subsidiary to conduct research on its behalf. The qualified expenses arising from this contract work create the potential for double capitalization of the research expenditures, increasing tax liabilities for both domestic taxable income and global intangible low taxed income (GILTI) and accelerated erosion of any available tax attributes. From a GILTI standpoint, the increased tested income resulting from the capitalization may pull entities that would have otherwise been excepted under the GILTI high-tax exclusion election into a non-high-taxed position with an effective tax rate of less than 18.9%.

Since the effective date of Section 174, additional guidance has been issued providing some relief for this double capitalization issue. U.S. multinational groups should carefully consider these rules and consult tax advisors to determine if the available relief can be applied or if intercompany research contracts may need to be restructured to prevent negative tax implications.

In May 2023, the IRS released proposed regulations applicable to subsequent events that would apply when a U.S. person (transferor) transfers intangible property (IP) to a foreign corporation pursuant to an applicable nontaxable exchange.

The old regulations address tax treatment in scenarios that arise when the foreign corporation (foreign transferee) that initially received the IP subsequently transfers the IP back to a U.S. person “transferee.” Prior to the proposed regulation, when the U.S. transferor would recognize gain upon the repatriation of the IP was dependent upon the required annual income inclusions and the useful life of the intangibles. Under the proposed regulations, the timing of the U.S. transferor’s gain and income inclusion now depends on what type of transaction the IP is repatriated back under as well as who the U.S. person is receiving the repatriated IP.

Under new proposed regulations, if the IP is considered “transferred basis property” the transferee foreign corporation does not recognize any gain. The updated guidance also provides U.S. persons that are considering repatriating previously outbound IP some relief as the inclusion to the original U.S. transferor is terminated when the foreign corporation repatriates the IP back to a qualified domestic person and the U.S. transferer meets certain filing requirements.

The new regulations offer an opportunity for previously outbound IP to be repatriated back to the U.S. without any gain recognition from the transaction.

In July 2021, the European Union (EU) introduced significant changes to the value-added tax (VAT) obligations for direct-to-consumer (D2C) e-commerce sellers who sell directly to EU-based consumers. In addition to sellers, marketplaces that provide fulfillment and delivery services are impacted; much like in the U.S., marketplaces are now responsible for remitting VAT on sales made through their platforms. The three main changes are:

  1. The VAT one-stop shop (OSS) return: Under the new rules, VAT must be collected by non-EU established businesses based on the country rate in the ship-to address of the customer and can be reported via a single EU VAT return filed with one EU member state.
  2. Goodbye to VAT-free imports: The previous de minimis VAT exemption was removed. Now, VAT must be collected and remitted on all shipments to the EU. Whether the VAT can be collected from the customer in advance depends on the value of the shipment, and whether goods are taxed as they enter the EU depends on if the VAT has been collected in advance.
  3. Marketplaces become responsible for VAT collection: Marketplaces are included in the VAT reform as they allow for easier compliance checks by EU tax authorities. The EU definition of a marketplace is one that is “facilitating” a transaction using an electronic platform to assist sellers and consumers to come together and conclude a contract for the supply of goods on a cross-border basis.

To meet the challenges created by these changes, U.S. businesses need to assess their physical supply chain to determine new registration requirements, pricing strategies and the impact on profitability and technology to manage data and compliance. An experienced VAT advisor can guide businesses through the assessment processes and can work with operations, logistics and third-party logistics (3PL) to identify need changes and assist with implementation.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments. Baker Tilly US, LLP does not practice law, nor does it give legal advice, and makes no representations regarding questions of legal interpretation.

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