As we look back on the international tax and transfer pricing developments that unfolded during late 2020 and 2021, two underlying themes emerge. The first, and more subtle of the two, is the impression that the U.S. Treasury Department and the Internal Revenue Service (IRS) have issued most (if not all) of the major pieces of guidance covering the international provisions of the law known as the Tax Cuts and Jobs Act of 2017 (TCJA). This may explain the paucity of the TCJA international-related updates in this 2021 year-end tax letter.
The second, and more pronounced, theme emerging from 2021 is that the year may be remembered as the beginning of the largest overhaul of the U.S. international tax provisions since the TCJA itself. A number of factors seem to be influencing these sweeping changes. The first is the need to finance the proposed infrastructure bill being drafted and debated in Congress as this letter was being written. Second, and perhaps for the first time in the history of U.S. tax law legislation, the U.S. tax legislation is being modified to align with certain global standards in the Organization for Economic Cooperation and Development’s (OECD) base erosion and profit shifting (BEPS) provisions. Finally, the U.S. Congress seems to be using the current reform process as an opportunity to correct, refine or clarify issues brought about by the TCJA.
What follows is a high-level outline of international tax and transfer pricing updates, guidance and proposals from late 2020 and 2021 to-date.
Final section 163(j) regulations: international provisions
In January 2021, the Treasury and IRS issued final regulations (TD 9943) covering a number of section 163(j) business interest limitation provisions applicable to foreign corporations and U.S. shareholders. The preamble to the regulations and the regulations themselves comment and provide guidance on certain international issues such as application of the no-negative adjusted taxable income rule and the expanded anti-abuse rule covering intragroup transactions entered into with a principal purpose of affecting a controlled foreign corporation’s (CFC) section 163(j) limitation and limitation on pre-group business interest carryforwards.
The Treasury and IRS also confirmed the minimum 80% ownership by value threshold for determining CFC groups, and they clarified that a CFC group may exist when certain U.S. persons directly own all of the applicable CFCs (as opposed to owning one or more chains of CFCs) and the rule that taxpayers are not permitted to revoke the CFC group election within 60 months after being made. However, the final section 163(j) regulations do not impose a 60-month waiting period where a CFC group election has not been made for the first period the group exists.
With regard to disclosure requirements, the preamble to the final regulations note that a CFC group election is made by attaching a statement to the appropriate income tax or information return. However, the final regulations also now require annual disclosure of the computation of the CFC group section 163(j) limitation in the years a CFC group election is in effect.
We highlight a noteworthy change from prior proposed section 163(j) regulations in that the determination of adjusted taxable income of a relevant foreign corporation is made without regard to a deduction for creditable foreign income taxes. That said, the Treasury and IRS continue to study the method for determining the portion of specified deemed inclusions of a U.S. shareholder that could increase its adjusted taxable income.
In an attempt to reduce the taxpayer’s compliance burden, the final regulations retain the safe harbor election for stand-alone CFCs and CFC groups that have business interest income equal to or in excess of business interest expense. Where the safe harbor election is made, certain calculations are not required — however, no portion of any CFC’s excess taxable income can be included in the U.S. shareholder’s adjusted taxable income.
With regard to foreign corporations with effectively connected income, the Treasury and IRS continue to study the application of section 163(j). The preamble notes that the Treasury and IRS anticipate addressing effectively connected income issues in future guidance.
Proposed global intangible low-taxed income and foreign-derived intangible income regulations
In January 2021, the Treasury and IRS also issued proposed regulations (REG-111950-20) addressing, among other things, the treatment of qualified improvement property (QIP) under the alternative depreciation system (ADS) for purposes of calculating qualified business asset investment (QBAI) pursuant to the global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) provisions. By way of background, QIP generally includes certain improvements to the interior of nonresidential buildings placed in service after the buildings were first placed in service. The intent was that QIP should be classified as 15-year property under the general depreciation system and be in the 20-year ADS recovery period. However, the changes to the statutory language were not made and a technical amendment in the Coronavirus Aid, Relief, and Economic Security (CARES) Act was required to enact the provisions. The proposed regulations cover the provisions announced in Notice 2020-69 that clarify the technical amendment to section 168 enacted in the CARES Act applies to determine the adjusted bases of properties of QBAI as if they had originally been part of the TCJA.
Final and proposed passive foreign investment company regulations
In March 2021, the Treasury and IRS issued final (TD 9936) and proposed (REG-111950-20) regulations covering passive foreign investment companies (PFICs). The regulations address a number of general PFIC issues (e.g., ownership attribution rules, application of the so-called ‘top-down’ approach for ownership involving pass-through entities) and industry-specific guidance (e.g., the qualifying insurance company exception).
Chief Counsel memo discussing relevance in entity classification regime
Chief Counsel memorandum AM 2021-002, released in March 2021, concluded that a foreign eligible entity is classified under the entity classification regulations’ default provisions during the period in which its classification is not relevant (i.e., while its U.S. tax classification does not affect the liability of any person for federal tax or information reporting purposes). As such, the memorandum concluded that the 60-month limitation rule does not apply if the election to change the classification is effective on the first date the classification is relevant.
Rev. Proc. 2021-26: CFCs changing methods of accounting to ADS
In May 2021, the IRS issued Rev. Proc. 2021-26 containing procedures for certain foreign corporations to obtain automatic consent to change their methods of accounting for depreciation to the ADS method. The revenue procedure also modifies certain of the special rules applicable to foreign corporations under existing method change procedures in Rev. Proc. 2015-13 and is intended to reduce the tax compliance burden associated with implementing the final GILTI regulations by enabling taxpayers to conform their income, earnings and profits and GILTI computations more easily.
New Schedules K-2 and K-3
In June 2021, the IRS issued draft 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. Schedule K-2 and Schedule K-3 are new for the 2021 tax year (2022 filing year).
Modifications to Forms W-8 series
Certain of the forms in the Form W-8 series have been modified to incorporate their use by, and claim of tax treaty benefits of, foreign transferors of an interest in a partnership subject to withholding under section 1446(f) and to indicate that a foreign tax identification number is not legally required. Other modifications include guidance on the use of electronic signatures.
Biden administration’s Green Book
In May 2021, the Treasury released information about the Biden administration's tax proposals for the American Families Plan and the American Jobs Plan, the annual summary of the current president’s tax proposals are traditionally called the “Green Book." The Green Book described sweeping modifications to the GILTI regime (which is referred to as the global minimum tax regime in the document) such as the elimination of QBAI and the high-tax exception, increasing the rate to 21% from 10.5% and applying GILTI on a country-by-country basis. This latter modification would eliminate the ability to blend excess foreign tax credits from high-tax jurisdictions against GILTI inclusions from low-tax jurisdictions. The Green Book describes some of these proposals as “…nearing a comprehensive agreement on jurisdiction-by-jurisdiction global minimum taxation…” (i.e., the OECD’s income inclusion rule (IIR) proposed under Pillar Two (discussed below)).
The Green Book would also repeal the base erosion and anti-abuse tax (BEAT) and replace it with a “stopping harmful inversions and ending low-tax developments” (SHIELD) rule. SHIELD would deny tax deductions for certain related-party payments to a member in the same financial reporting group where the recipient member is in a low-tax jurisdiction.
Other notable international tax proposals in the Green Book include the repeal of the deduction for FDII and the imposition of a 15% minimum tax on worldwide book income in excess of $2 billion. The Green Book stated that the resulting revenue from repealing the FDII would be used to encourage research and development (but no mention was made of any specific R&D enhancements).
Wyden’s international tax proposals
In August, Senate Finance Committee Chair Ron Wyden, D-Ore., and fellow panel Democrats released draft legislation and a summary of their international tax overhaul proposals including a country-by-country approach to GILTI. However, there are stark differences between the Green Book and Wyden’s proposal in that GILTI would require application of a mandatory high-tax exclusion function in order for the regime to operate as a top-up tax.
The Wyden proposal would also replace the current FDII rules and replace them with a “domestic innovation income” regime designed to incentivize domestic research and development expenditure and worker training. Finally, the proposals would amend BEAT to incorporate the purposes and policies of the SHIELD proposal put forth by the Biden administration in the Green Book.
House Ways and Means international tax proposals
In September 2021, the House Ways and Means Committee released draft legislation, which included amendments to the GILTI, FDII, BEAT and foreign tax credit rules. A number of these proposals would bring the U.S. international tax principles more in line with analogous OECD BEPS global minimum tax proposals.
With regard to GILTI, the Ways and Means proposals would apply a tax rate to GILTI of 16.56% (17.43% inclusive of a foreign tax credit haircut which would be reduced to 5% from 20% of allowable credits) and eliminate the taxable income limitation for the section 250 deduction (potentially resulting in a net operating loss). GILTI would also be calculated on a country-by-country basis and allow for tested losses to carry forward to subsequent periods. Additionally, QBAI would be reduced to 5% (10% in U.S. territories), excess foreign tax credits could be carried forward for five years and section 861 expense apportionment (e.g., interest and stewardship) to the GILTI foreign tax credit basket would be eliminated.
The Ways and Means proposals would also make profound changes to the foreign tax credit regime as a whole. For example, the proposals would require application of the foreign tax credit calculation and limitation provisions in all baskets on a country-by-country basis (with a repeal of the separate foreign branch limitation category). Similarly, the provisions would repeal the carryback of excess foreign tax credits and limit the carryforward period to five years.
The Ways and Means proposals would substantially modify the BEAT to include components of cost-of-goods sold as base erosion payments, phase out the separate 3% (2% for certain financial services taxpayers) base erosion percentage safe harbor in determining an “applicable taxpayer,” narrow its application by excluding from base erosion payments any amounts subject to a sufficient minimum level of tax (i.e., not less than the BEAT rate, or 15% on a fully phased-in basis), and allow for full credits in reduction of regular tax liability and corresponding base erosion minimum tax amounts.
In what appears to be an attempt to cure one of the unintended consequences of the TCJA, the proposals would retroactively reinstate the prohibition of downward attribution from foreign persons under former section 958(b)(4) to determine CFC status and enact new section 951B to address perceived abuses the repeal of downward attribution was intended to prevent.
Finally, new section 163(n) would limit the deduction of interest expense of certain U.S. corporations in financial groups with non-U.S. corporate members to a share of reported net interest expense on an applicable group financial statement in proportion to the U.S. corporation’s relative share of book earnings before income, taxes, depreciation and amortization. The new rules would work in tandem with the interest expense limitation under current section 163(j). Assuming that both provisions are applicable during the taxable year, the smaller amount of interest expense deduction allowance of the two would apply.
Additionally, disallowed interest expense under either sections 163(j) or 163(n) could only be carried forward for five years (contrast with an indefinite carryforward currently available under section 163(j)). Finally, section 163(n) does not allow for the carryforward of any excess limitation.
OECD statement regarding global minimum tax proposals
In July 2021, the OECD issued a statement covering its BEPS Pillar Two initiatives including that for the Global Anti-Base Erosion (GloBE) regime, which contains an IIR and an undertaxed payment rule (UTPR). The GloBE’s IIR would imposes top-up tax on a parent entity for low-taxed income of an affiliated entity on a country-by-country basis. Further, the UTPR would deny deductions or require an equivalent adjustment to the extent the low-taxed income of an affiliated entity is not subject to tax under an IIR.
The IIR and UTPR are similar in many respects to the GILTI and BEAT rules, respectively, as envisioned under the Ways and Means proposals discussed above. Additional developments and considerations pertaining to the global minimum tax follows below in the transfer pricing update.
Transfer pricing remains an ever-increasing area of focus for global tax authorities and a topic that stimulates some of the largest tax controversy issues around the world. Tax authorities and treasury departments in the United States and around the globe continue to advance their local legislation and auditing approaches to stay up to date with the changing global economy, including the accelerating shift to digital business platforms. Perhaps of most importance, and an area to watch closely, is how the BEPS 2.0 initiatives keep progressing. As of early October 2021, more than 130 countries reached an agreement to set a minimum tax rate of 15%. Watching how this area grows and how countries ultimately develop legislation to adopt the OECD recommendations will have an impact on how to strategically manage transfer pricing. What follows are some of the other key transfer pricing updates from the last year.
IRS priority guidance
In September, the IRS and Treasury Department issued their 2021-22 priority guidance plan, outlining where they will allocate resources in the plan year from July 1, 2021 through June 30, 2022. The plan included four projects related to transfer pricing:
EU Public CbCR Directive
The European Union (EU) adopted the proposed public country-by-country reporting directive. The directive would continue the trend from the EU and OECD around public transparency around companies’ financial and tax positions globally. Global companies with total consolidated revenue of more than 750 million euros in each of the last two consecutive financial years may be required to make these public disclosures following the proposed directive.
OECD view on transfer pricing implications of COVID-19
On Dec. 18, 2020, the OECD released a report containing guidance on the transfer pricing implications of the COVID-19 pandemic. The report notes that the unique economic conditions arising from COVID-19 and government responses to the pandemic have led to practical challenges for the application of the arm’s-length principle. According to the report, the arm’s-length principle and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (OECD TP Guidelines) should continue to be relied upon by tax administrations and multinational enterprises when performing a transfer pricing analysis, including under the possibly unique circumstances introduced by the pandemic.
The report discusses how the arm’s-length principle and the OECD TP Guidelines apply to issues that may arise or be exacerbated in the context of the COVID-19 pandemic, rather than on developing specialized guidance beyond what is currently addressed in the OECD TP Guidelines. The report focuses on four priority issues where it is recognized that the additional practical challenges posed by COVID-19 are most significant:
(i) Comparability analysis
(ii) Losses and the allocation of COVID-19 specific costs
(iii) Government assistance programs
(iv) Advance pricing agreements (APAs)
Transfer pricing court cases
In November 2020, a Tax Court decision was upheld against Coca-Cola related to $9.8 billion in transfer pricing adjustments, which was calculated under a comparable profits method (CPM) under the assumption that the activities of Coca-Cola’s supply points were routine in nature and did not give rise to intangible-related returns associated with marketing intangibles.
The Coca-Cola case highlights that the IRS continues to be aggressive in challenging cases involving profitability earned in global supply chains related to intangible assets.
In August 2021, Amgen Inc., a U.S.-based pharmaceutical company, stated in its company earnings release that the IRS issued a notice of federal tax deficiencies of $3.6 billion (not including interest or penalties) for the years 2010, 2011 and 2012. The transfer pricing structure under dispute involves the amount of intercompany royalties paid by the Amgen Puerto Rican manufacturing entity to the Amgen U.S. parent company.
This case was another in a long history of IRS challenging taxpayers’ intangible-related transactions.
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.