As we previewed in last year’s update, a theme emerging from 2021 is the potential for a large overhaul of U.S. international tax provisions in alignment with a prospective imposition of global minimum tax rules in implementing jurisdictions around the world. In the time since that last update, there have been a number of notable developments, both in the U.S. and abroad, which we will look to highlight here as it helps frame the continuing evolution (and current state) toward a global consensus.
Before diving into that evolution, our international tax update will begin with an introduction of certain other new guidance released in the U.S. since that last update and, specific to newly issued final foreign tax credit regulations, include areas of needed focus in mitigating risk of potential double taxation under those new regulations. Separately, we will also highlight select changes in the application of already existing enacted laws and filing requirements effective for the 2022 tax year which might warrant a closer look from an impact assessment, planning and resourcing perspective.
We will then close with our transfer pricing update, which first includes an identification of opportunities for Value Chain Alignment planning to help navigate through each of the enacted and proposed tax law changes discussed in the international tax update, as well as other emerging global trends. Finally, we will then conclude our transfer pricing update with select documentation, guidelines and enforcement updates.
What follows is a high-level outline of selected international tax and transfer pricing updates, guidance and proposals from late 2021 and 2022 to date.
Issued final foreign tax credit regulations fundamentally change rules for determining creditability of foreign taxes
On Dec. 28, 2021, the IRS and Treasury Department released final regulations (corrected in April 2022) that include fundamental changes to the definition of a foreign income tax for foreign tax credit purposes. The final regulations in large part finalize earlier proposed foreign tax credit regulations published Nov. 12, 2020.
These new rules will impact the creditability of foreign taxes paid or accrued in taxable years beginning on or after Dec. 28, 2021, as foreign taxes that were creditable under the previous rules may no longer be creditable under the final regulations. The IRS and Treasury had indicated in the preamble to the final regulations that they do not intend on publishing a list of qualifying or nonqualifying foreign taxes, which only lends to the complexity of applying these new regulations.
Although the changes to the definition of a creditable foreign tax were initially motivated to limit the creditability of “novel extraterritorial taxes” (e.g., gross-basis digital services taxes), the final regulations are much broader in their potential impact and require a close review and analysis of where and how foreign taxes are ultimately levied in making creditability determinations under these new regulations. Areas of particular focus might include taxes levied by developing countries more apt to levy extraterritorial taxes, countries that lack tax treaties with the U.S. through which potential relief might be available, countries that do not follow the arm’s-length standard for transfer pricing and countries that do not withhold taxes on a nonresident’s items of gross income based on sourcing rules substantially similar to those in the U.S. (with a potential emphasis on foreign taxes withheld on each payment for royalties and services as well as capital gains taxable to a nonresident on an alienation of shares).
Issued final and proposed regulations provide for aggregate treatment of domestic partnerships for Subpart F and PFIC inclusion purposes
On Jan. 25, 2022, the IRS and Treasury issued final regulations (with a correcting amendment issued on Feb. 24, 2022) that generally align the global intangible low-taxed income (GILTI) and Subpart F rules applicable to partners of domestic partnerships (and, more generally, shareholders of S corporations) by treating such partnerships (S corporations) as aggregates of their partners (shareholders) in computing Subpart F and section 956 income inclusions. Unless taxpayers early adopted the aggregate treatment of domestic partnerships for Subpart F purposes under earlier proposed regulations, the final regulations are effective for taxable years of foreign corporations beginning on or after Jan. 25, 2022, and to taxable years of U.S. persons with or within which such taxable years of foreign corporations end (certain consistency requirements must also be satisfied).
Not all Subpart F inclusion provisions (e.g., previously taxed earnings and profits and basis adjustment transition rules) are addressed in the final regulations, but are anticipated to be addressed in future regulation packages. Aggregate treatment for Subpart F purposes is not applicable to domestic nongrantor trusts and domestic estates.
Also on Jan. 25, 2022, the IRS and Treasury issued proposed regulations that generally treat domestic partnerships and S corporations as aggregates of their partners or shareholders for purposes of passive foreign investment company (PFIC) inclusions and related elections. The proposed regulations generally align the GILTI, Subpart F and PFIC rules applicable to partners and shareholders of these pass-through entities. The proposed regulations would generally apply to tax years beginning on or after the date they are finalized and, if finalized as currently drafted, will require U.S. partners (shareholders) to monitor PFIC elections as they would no longer be made at the partnership (S corporation) level.
More restrictive limitation on deductibility of interest expenses
For the 2021 tax year, the business interest expense deduction was limited under section 163(j) to the sum of the taxpayer’s business interest income, plus 30% of adjusted taxable income (ATI), plus floor plan financing interest expense with the ATI component more closely approximating earnings before interest, taxes, depreciation and amortization (EBITDA). However, effective for the 2022 tax year, the ATI component must be calculated without the add-back for depreciation and amortization (more closely approximating earnings before interest and taxes (EBIT)), meaning a lower limit and smaller interest deductions.
Some taxpayers were already feeling the stress of a 30% of ATI limitation for the 2021 tax year (down from a 50% of ATI limitation for the 2018 and 2019 tax years under temporary COVID relief provided under the Coronavirus Aid, Relief and Economic Security (CARES) Act), and it is anticipated that many more might experience interest deductibility concerns for the 2022 tax year upon further change to an EBIT-like base for the ATI component. This could prove particularly costly for inbound financing of U.S. subsidiaries of a foreign-parented multinational enterprise (MNE) group for which a cash tax (and, as applicable where valuation allowance recorded for the interest expense carryforward tax attribute, potential financial tax) cost burden arises for the taxation of the foreign lending party’s accrual of interest income for which a corresponding tax benefit of full interest expense might not be available for U.S. tax purposes under this limitation (a situation made all the more worse if the interest paid that foreign lending party is not otherwise exempt from U.S. withholding tax under an applicable income tax treaty for which eligibility for treaty benefits are satisfied). This, taken together with the prospect of an enactment of new section 163(n) interest limitation rules (discussed below) that might work in tandem with the section 163(j) limitation (interest expense limited based on the more restrictive of the two limitations), may necessitate a closer look at potential planning for the rationalization and restructuring of existing debt structures.
New capitalization requirements for research and experimental expenses
Under current tax law, the ability to immediately deduct R&E expenses is no longer available for tax years beginning after Dec. 31, 2021. Instead, in the absence of any legislative relief forthcoming to the contrary, taxpayers will now be required to capitalize and amortize R&E expenses over five years (for U.S. expenses) and 15 years (for foreign expenses) starting with the 2022 tax year.
For foreign-placed R&E activities, these new capitalization requirements can have a pervasive impact on the acceleration of taxable income for U.S. tax purposes given the long 15-year recovery period for deductibility of related expense. R&E activities conducted through controlled foreign corporations (CFCs) of U.S. shareholders are anticipated to be an area of particular focus for many taxpayers due to the potential of an increase and acceleration of deemed inclusion income (and residual U.S. tax liability due) under the GILTI rules. While an emphasis might be placed on CFCs that beneficially own any intellectual property rights that arise from the R&E activities performed (e.g., where the CFC is party to a cost-sharing arrangement), the application of these new capitalization requirements in the context of CFCs performing contract R&D services for some other principal is a bit ambiguous.
“Year Two” of expanded reporting requirements on new Schedules K-2 and K-3
The 2021 tax year marked the initial year for expanded reporting requirements on new Schedule K-2 (an extension of Schedule K used to report items of international tax relevance from the operation of a partnership or S corporation) and Schedule K-3 (an extension of Schedule K-1, generally used to report the share of the items reported on Schedule K-2 to partners or S corporation shareholders for use in their tax or information returns) for Forms 1065, 1120-S and 8865. The new schedules are designed to assist partnerships and S corporations in providing partners and shareholders with the information necessary to complete their returns with respect to the international tax items.
For that initial year of reporting on new Schedules K-2 and K-3, there was transition relief provided from the imposition of penalties for a demonstrated good faith effort made toward compliance with the new reporting requirements, and, separately, a limited exemption from initial year compliance with these new reporting requirements provided to certain eligible taxpayers under FAQ issued by the IRS. In the absence of any further relief granted for Year Two of the expanded reporting, it is anticipated that there will be a large increase in the number of taxpayers needing to comply (more fully comply) with the completion of Schedules K-2 and K-3 as part of their 2022 tax year filings requiring advance planning and budgeted cost for the related data pull and analysis required in completing these schedules.
Biden administration’s Green Book
In March 2022, the Treasury released information about the Biden administration's fiscal year 2023 tax proposals, the annual summary of the current president’s tax proposals is traditionally called the “Green Book.” The Green Book starts from a baseline premise that the international tax proposals set out in the earlier House-passed Build Back Better (BBB) Act will be enacted into law in their existing form unless otherwise modified by the latest proposals contained in the Green Book.
We covered in detail the key international tax provisions included in the BBB Act in earlier alerts, Build Back Better bill: international tax provisions and International tax proposals in House Ways and Means “Build Back Better” draft tax legislation. The international tax provisions previously detailed included, among others, each of the following:
With limited exception, the Green Book leaves those earlier BBB Act international tax proposals substantially unchanged. As we previously discussed in an earlier alert, President Biden proposes tax changes in FY 2023 budget, one notable exception is the administration’s proposal to eliminate the BEAT and replace it with an undertaxed profits rule (UTPR) consistent with OECD proposals. Effective for tax years beginning after Dec. 31, 2023, the UTPR would, subject to certain de minimis exceptions, generally apply to foreign-parented multinational entities that are members of financial reporting groups with global revenue of $850 million or greater in at least two of the previous four tax years. The proposal also includes a domestic minimum top-up tax that would protect U.S. revenues from the imposition of UTPR by other countries. Using a jurisdiction-by-jurisdiction computation based on adjusted financial statement information, the UTPR would disallow certain U.S. tax deductions or require an adjustment to the overall tax liability of the group for member entities not subject to a tax rate of at least 15% in each foreign jurisdiction where the group has a profit.
Additionally, the administration’s proposed increase in the corporate tax rate to 28% would raise the GILTI effective tax rate to 20% (from 10.5% as currently enacted, and increased from the 15% rate contemplated under the BBB Act). Also, in line with OECD proposals and proposed changes under the BBB Act, GILTI would be applied on a country-by-country basis. These changes would be effective for taxable years beginning after Dec. 31, 2022, with a transition rule provided for fiscal-year taxpayers.
Inflation Reduction Act signed into law
On Aug. 16, 2022, President Biden signed the Inflation Reduction Act into law. Among other things, that enacted legislation created a new 15% corporate AMT which, in final enacted form, resembles in large part that which was previously included in the House-passed BBB Act. The AMT is effective for tax years ending after Dec. 31, 2022, and requires that corporations apply complex aggregation rules to determine if the $1 billion AFSI threshold (and, as applicable to a U.S. corporation of a foreign-parented group, the incremental $100 million AFSI threshold for the U.S. group) is met as prerequisite to imposition of the new tax.
Prospective legislation that might enact into law the other key international tax proposals set forth in the House-passed BBB Act, as modified by the additional proposals contained in the Green Book, remains uncertain at the time of this release as we await the outcome of the November midterm elections to see if the requisite votes needed in the House and Senate are available to pass any such prospective legislation. What remains abundantly clear is the amount of pressure on the U.S. to adopt the additional measures needed (e.g., proposed amendments to the GILTI rules, a new UTPR rule in replacement of BEAT) to align with, and help advance implementation for, the OECD global minimum tax framework.
OECD update on Pillar One and Pillar Two
The OECD released the OECD/G20 Inclusive Framework on base erosion and profit shifting (BEPS) Progress Report on Oct. 4, 2022. The report comments on progress made between September 2021 and September 2022 and addresses an update on the implementation of the Two-Pillar Solution to Address the Tax Challenges Arising from the Digitalization of the Economy agreed in October 2021. A summary of progress for Pillar One and Pillar Two contained in the Progress Report are included below.
The OECD Progress Report comments that significant progress was made on the design of the technical rules for reallocation of taxing rights under Amount A that relates to the residual profits of the largest multinational enterprises. MNEs with global revenues above 20 billion euros and profitability above 10% will be covered by the new rules, with 25% of profit above the 10% threshold to be reallocated to market jurisdictions using an innovative, formulaic approach. The new rules for Pillar One and taxing rights for Amount A will be negotiated through a Multilateral Convention (MLC) through which Amount A will be implemented. The work on the detailed provisions of the MLC and its Explanatory Statement are expected to be completed so that a signing ceremony of the MLC can be held in the first half of 2023, with the objective a 2024 entry into force, once a critical mass of jurisdictions, as defined by the MLC, have ratified it.
Pillar Two consists of the Global Anti-Base Erosion (GloBE) Rules and a treaty-based Subject to Tax Rule (STTR). The GloBE Rules introduce a 15% global minimum tax that applies to MNE groups with consolidated revenues of at least 750 million euros. They consist of a coordinated system of rules, under a common framework, which ensures in-scope MNE groups pay at least the agreed minimum level of tax on the income arising in each of the jurisdictions in which they operate. The minimum level of tax may also be imposed locally under a qualified domestic minimum top-up tax. The STTR allows source jurisdictions to impose limited source taxation on certain related-party payments that are subject to tax below a minimum rate.
Following a public consultation, held at the end of April 2022, the OECD/G20 Inclusive Framework commenced work on the GloBE Implementation Framework that will facilitate the coordinated implementation of the GloBE Rules. The GloBE Implementation Framework will be used to establish a peer review process, produce further administrative guidance, agree on a common filing and information exchange architecture, develop safe harbors to minimize compliance costs and provide capacity building and technical support to tax administrations. The GloBE Implementation Framework is anticipated to be released by the end of 2022. Work on the STTR has focused on the development of a draft model tax treaty provision and its commentary, which is expected to be released for public comment later in the year.
Anti-Tax Avoidance Directive (ATAD) 3 update and substance
On Dec. 22, 2021, the European Commission adopted a proposal for an ATAD 3 that targets the misuse of shell entities for tax purposes. This new directive seeks to provide direction on minimum levels of substance that are required to carry out the intended business activities of particular entities. While the concept of substance is not necessarily new, this directive puts pressure on European Union member states to deny certain treaty benefits and tax benefits to companies that fail to meet minimum substance requirements.
The draft directive sets out a seven-step minimum substance test to determine whether an entity is to be regarded as a “shell” and it applies to all undertakings resident in an EU member state, regardless of their legal form. Criteria which are considered to be indicators of low substance are: 75% of an entity’s income is “passive income” over a two-year lookback period; 60% of the book value of an entity’s assets are located outside the EU member state of which it is resident or 60% of its income is from outside the EU member state, over a two-year lookback period; and the administration of day-to-day functions and decision-making is outsourced. An entity with at least five full-time employees carrying out the income-generating activities of the entity is exempt from the minimum substance test.
The consequences of an entity being considered a shell include: it will not be issued a tax residence certificate by the EU member state that it is considered resident in or it will come with a warning to prevent its use for claiming double taxation; the entity will be denied relief under measures designed to prevent double taxation; reporting requirements in EU member states; and a minimum 5% penalty on an entity’s turnover will apply if an entity is found to be noncompliant with reporting requirements.
The proposed directive has not yet been passed but it is expected to pass through the legislative process and should come into effect from Jan. 1, 2024. Given that effective date and in consideration for a two-year lookback period, compliance with these new minimum substance requirements might be evaluated from Jan. 1, 2022.
As the global economy continues to navigate the follow-on financial impacts of the recent COVID-19 crises, a number of global supply chain trends continue to evolve and impact MNEs’ global transfer pricing models. The following explores a few trends and topics that remain top of mind for taxpayers, some of which are more prevalent than others depending on the industry.
Environmental, social and corporate governance (ESG) is a C-suite level agenda item that has continued to come into closer focus during 2022. A company’s strategy for ESG and how it responds to and manages both external forces in the market and its own internal reporting around ESG can lead to financial impacts across the organization. It has become more critical for companies to also assess their overall transfer pricing strategies as they relate to ESG financial impacts. For example, understanding which entities in a global organization incur significant costs, realize revenues (or declines in revenues) or are the beneficiaries of various ESG-related tax incentives may have a direct impact on the results of a company’s transfer pricing framework. As ESG plays a more prevalent role in how companies manage their global supply chains and inform corporate strategies, there will be increasingly more opportunities for taxpayers to evaluate their transfer pricing models to account for these changes.
Onshoring and near-shoring are strategies that companies continue to explore as global supply chain issues continue to impact business models across various industries. As taxpayers consider strategic investments in new manufacturing, distribution or other key supply chain hubs, various transfer pricing model considerations come into play.
Digital and e-commerce trends as well as the continued evolution of cryptocurrencies and blockchain technology remain areas of development in the transfer pricing and Value Chain Alignment space. As the economy evolves and the creation and exploitation of value changes from its traditional forms, transfer pricing analyses and the standard prescribed methods for analyzing transfer pricing issues continue to be challenged. Issues around intangible property valuation and the development of value across global networks put pressure on company transfer pricing policies for those operating in these industries.
Global mobility and work-from-anywhere trends also continue to impact global transfer pricing models and Value Chain Alignment as companies compete for top global talent and hire strategic resources wherever they can locate them across the globe, sometimes regardless of the relevant tax or transfer pricing model consequences. Companies prioritize talent and operating their business models at the highest level, but will need to continue to evaluate the alignment of their value chains and the impact to their tax and transfer pricing risk profiles.
Finally, as the global economy continues to evolve and as taxing authorities around the globe continue to look at corporate income taxes as one significant element of their government’s fiscal strategy (perhaps even more so following COVID), let’s not forget about the ongoing global transfer pricing documentation and compliance requirements. These requirements have not gone away, and more countries continue to adopt more strict requirements. It is important that taxpayers continue to focus their efforts on documenting their global transfer pricing positions in various countries to avoid potential double taxation and related tax penalty risk. The IRS, in particular, was recently allotted significant funds from the Inflation Reduction Act, part of which is to be used to step up tax enforcement efforts. We expect that the IRS and other foreign taxing authorities will continue to step up their enforcement related to transfer pricing issues.
The OECD Transfer Pricing Guidelines provide guidance on the application of the “arm’s-length principle,” which represents the international consensus on the valuation, for income tax purposes, of cross-border transactions between associated enterprises. In today’s economy where MNEs play an increasingly prominent role, transfer pricing continues to be high on the agenda of tax administrations and taxpayers alike. Governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein, and taxpayers need clear guidance on the proper application of the arm’s-length principle.
This latest edition consolidates into a single publication the changes to the 2017 edition of the Transfer Pricing Guidelines resulting from:
For more information on this topic, contact our team.
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.