INSIDE. Implications of the

Transcription

1 N O V E M B E R INSIDE Implications of the GlaxoSmithKline Settlement FIN 48 Highlights Issues in Determining Transfer Pricing and Tax Valuation Risks The Services Cost Method of the New U.S. Regulations on Transfer Pricing for Services About Duff & Phelps Welcome to the first edition of Duff & Phelps publication regarding interesting matters in transfer pricing, Transfer Pricing Insights. In each issue of this publication we will convey our views as independent experts on technical transfer pricing topics, cover regulatory developments, highlight industry-specific matters and offer general commentary and observations on issues affecting the market. Transfer Pricing Insights will be distributed periodically as critical news develops. In this issue we will focus on our view of the GlaxoSmithKline ruling, the impact of FIN 48 on transfer pricing and the temporary and proposed regulations issued by the IRS effective January 1, We hope you will find this and future issues of this publication an informative and reliable resource. This past year was quite notable for Duff & Phelps. We dramatically expanded our Transfer Pricing practice through the addition of a number of well respected professionals who have joined our firm. Our expansion was driven by a number of requests by our clients and the clear synergies between transfer pricing and our valuation services. As with our valuation service, we re committed to being the leading independent provider of transfer pricing services. I joined Duff & Phelps in March to lead the Tax Valuation and Consulting practice. In my prior experience as the global managing partner of a Big Four transfer pricing practice, I have assisted numerous large, multinational clients with a broad range of international and state transfer pricing initiatives. I have since engaged a number of top transfer pricing professionals, including many who themselves have been leaders in other professional service firms, in large multinational corporations and in key government positions. Today we have a dedicated team of senior transfer pricing professionals working closely alongside the more than 800 employees of Duff & Phelps to service our clients needs. We will continue to grow our transfer pricing practice rapidly to help meet your needs in all major jurisdictions. Dan Peters Business Unit Leader Tax Valuation & Consulting Services Duff & Phelps Implications of the GlaxoSmithKline Settlement By Tim Reichert, Rodrigo Fernandez and Steve Salvati GlaxoSmithKline ( GSK ) settled its transfer pricing tax dispute with the IRS in September Under the terms of the agreement, GSK agreed to pay $3.4 billion in taxes and interest, covering tax years from 1989 to 2005, and to drop its counter-claims. This represents the largest transfer pricing settlement in the history of the IRS. The dispute largely involved compensation for marketing and advertising expenses incurred at the Research Triangle Park facility, where GSK has a U.S. headquarters. The IRS contended that the U.S. company engaged in highly valuable market

2 2 Transfer Pricing Insights development activities for several highly profitable drugs, and as such was not a routine U.S. distributor of the U.K. parent s global pharmaceutical business. This depiction of the U.S. operation contrasted sharply with the company s characterization, which viewed the U.S. affiliate as a distributor. The IRS argued that U.S. profits were significantly understated a large portion of which were related to sales of Zantac, a blockbuster ulcer drug. Our View: Taxpayers who manufacture offshore and sell into the United States will now need to be particularly careful to separately compensate their U.S. distribution activities and their other services. Careful comparability analysis and clear intercompany contracts specifying risks and responsibilities will be necessary. The outcome of this controversy will affect many multinational corporations, both within and outside of the pharmaceutical industry. The settlement highlights the importance of marketing intangibles to the IRS s strategy toward multinationals transfer pricing. Specifically, the settlement demonstrates that the IRS can have some success when asserting that market development activities in the U.S. market generate substantial economic value, and should therefore be highly compensated. The settlement also indicates that the IRS will continue to assert that economic substance should prevail over the legal form of an intercompany arrangement. The Temporary and Final Services Regulations, issued in August 2006, will also impact how companies view marketing activities (marketing services ). These regulations share common positions with the IRS position in GSK, and a number of examples of taxpayer fact patterns are similar to the GSK fact pattern. Additionally, the new regulations require multinationals to identify, isolate and value contributions made by group members to centrally owned intangibles, as well as various rights to the intangibles. Therefore, under the new regulations, contractual documentation of the respective rights and responsibilities, and behavior that is consistent with the contractual documentation, will be critical for all kinds of transactions. Disagreements with revenue authorities as to tax allocations between related companies in different tax jurisdictions may now be inevitable for a global business. Although the pharmaceutical industry may be under the greatest scrutiny based on the outcome of this case, many multinationals face similar exposures. According to IRS Commissioner Mark Everson, the IRS has consistently said that transfer pricing is one of the most significant challenges for us in the area of corporate tax administration and that the settlement of this case... sends a strong message of our resolve to continue to deal with this issue going forward. FIN 48 Highlights Issues in Determining Transfer Pricing and Tax Valuation Risks By Dan Peters and Clarke Norton FASB Interpretation Number 48 ( FIN 48 ) provides expanded guidance regarding the accounting for uncertainty in income taxes in accordance with FASB Statement Number 109 ( FAS 109 ), Accounting for Income Taxes. FIN 48 becomes effective for calendar years ending after December 31, 2006, but many taxpayers are implementing it immediately. FIN 48 prescribes a two-step process for evaluating the financial risk of any tax position. The first step is defined as recognition. To be recognized, a tax position must meet a more likely than not (or greater than 50%) threshold of being sustained throughout an examination process (including any appeals and litigation process) in which the taxing authority is assumed to have full knowledge of all relevant information. Note that in making this determination, the degree of detection risk of the issue is not a factor. The second step is measurement. Any recognized tax position is then measured to determine the benefit to be recognized in the financial statements. The benefit amount is defined as the largest amount having greater than 50% probability of being realized upon settlement or other resolution. FIN 48 prescribes an expected outcome analysis of potential scenarios to determine this measurement amount. FIN 48 creates clear guidance on properly recognizing and measuring the tax benefit of any tax position an enterprise may take. The nature of transfer pricing matters and by extension any valuation done for tax purposes creates interesting problems for determining appropriate financial statement tax contingency reserves. Our past experience has been that enterprises have used numerous methods for determining what if any reserves should be established for their intercompany transactions. Often these methods are subjective, and do not have the rigor required under FIN 48.

3 Transfer Pricing Insights 3 Among the transfer pricing issues raised by FIN 48 are the following: Use of transfer pricing documentation A taxpayer today usually creates extensive transfer pricing documentation of its intercompany transactions, often with the help of outside advisors. This documentation selects a best method for testing these transactions, and confirms that the results fall within the intended arm s length range. Its primary purpose is penalty protection. It has been suggested that typical Section 6662 contemporaneous documentation entails a will opinion, as it confirms that the transfer pricing result falls within an arm s length range. A will opinion is a higher threshold than a more likely than not position. However, given the highly subjective nature of transfer pricing, significant audit risk exists despite the preparation of contemporaneous documentation. As a consequence, should a taxpayer have a separate documentation process and FIN 48 opinions for transfer pricing and valuation issues? Our View: Companies should be particularly careful to manage the conflicts that may arise from the opinions in their 6662 transfer pricing documentation and the risk analysis necessary to determine financial statement risks for FIN 48. Treatment of penalties Section 6662 of the Internal Revenue Code prescribes non-deductible penalties to be applied to transfer pricing adjustments above certain monetary thresholds. Foreign fiscal authorities also often have similar onerous penalty provisions. Historically, the IRS has been sporadic in assessing and sustaining penalties; however, recent written guidance and behavior indicates this is changing, and that the existence of contemporaneous documentation does not ensure penalty protection. Accordingly, any fair risk assessment of controversial transfer pricing positions must consider the potential for penalties. Potential double taxation For large multinationals that trade extensively between entities in countries with extensive tax treaty networks, competent authority processes and relatively similar corporate tax rates, the risks of double taxation and financial statement impact due to their transfer pricing has been considered minimal. The GlaxoSmithKline settlement, in which the company announced that there would be no correlative relief from the Inland Revenue, challenges this operating assumption. This potential for double taxation needs to be considered in properly setting financial reserves. Determining the potential scenarios Enforcement of transfer pricing has historically been sporadic. FIN 48 s clarity regarding the expectation that taxing authorities will examine the issue with full knowledge of the facts allows us to execute the measurement process based upon case law, past settlement experience with similarly situated taxpayers and current fiscal authority guidance regarding the issue at hand. Other potential intercompany transactions Another aspect of transfer pricing risk is the potential assessment of tax on transactions that were not priced. Examples include certain transfers of technology or brand rights, or the provision of headquarters services. Recent IRS regulatory guidance puts taxpayers on notice regarding these transactions. Financial risks of such potential transactions must consider penalties and interest. The Services Cost Method of the New U.S. Regulations on Transfer Pricing for Services By Paul B. Burns and Vinay Kapoor On August 4, 2006, the IRS issued temporary and proposed regulations, effective January 1, 2007, dealing with transfer pricing for services and related issues. The package consists of four major components: New rules regarding transfer pricing for services; Modified rules for determining ownership of intangibles, and new rules for determining arm s length compensation to an entity whose activities enhance the value of an intangible it does not own; Additional guidance on when the IRS can determine contractual terms from the economic substance of an intercompany arrangement; and Modified rules for allocation of stewardship expenses. The IRS has requested comments from interested parties on the new regulations, and a public hearing has been scheduled. This article focuses on the new Services Cost Method (SCM), which is intended to replace the cost-based safe harbor for non-integral services under the current regulations. The SCM tests whether intercompany charges are consistent with the arm s length standard by comparing the actual charge to the cost of the services without a markup. When all of the conditions for the use of the SCM are met, it will be deemed to be the best method. The SCM is intended by the IRS to balance two competing considerations: the need to address abuses of the former regulations by taxpayers that used them to charge out highvalue-added services at cost, and the need to minimize the

4 4 Transfer Pricing Insights compliance burden on taxpayers that charge out routine back-office services. Our View: While the issue of whether to mark-up routine services is important, many taxpayers will find greater concern in the expansion of the definition of the services that need to be charged-out to affiliates. Many taxpayers and foreign tax authorities have not considered services on the white list as requiring compensation from affiliates. A useful way to conceptualize the SCM is to think in terms of a four-part test, all four parts of which must be satisfied in order for the SCM to apply. First, the services in question must be covered services. The temporary regulations describe two categories of covered services: specified covered services and low margin covered services. Specified covered services are services identified on a white list set forth in an IRS revenue procedure. Low margin covered services are services for which the median comparable markup on cost is seven percent or less. The new rules present numerous interpretive challenges, and may prove difficult to apply, especially since they differ substantially from the rules of the United States major trading partners. Those issues include: Is the SCM mandatory or elective? What is the significance of the statement? How should taxpayers reconcile the white list and the black list? Will the IRS field defer to taxpayers business judgments? Does the SCM actually encourage taxpayer noncompliance? It seems quite clear that despite all of these issues, the temporary regulations as currently written will go into effect on January 1, Companies that are potentially affected should take action now to ensure that they understand the new rules and are prepared to deal with them. Second, the taxpayer s books and records must be adequate to permit verification of the total services costs incurred and must include a statement evidencing the taxpayer s intention to apply the services cost method. Third, the services in question must not relate to a transaction that is on a nine-item black list. Fourth, the taxpayer must: reasonably [conclude], in its business judgment, that the covered services do not contribute significantly to key competitive advantages, core competencies, or fundamental risks of success or failure in one or more trades or businesses of the [service provider], the recipient, or both. Conversely (or so it would seem), if covered services do contribute significantly to key competitive advantages, core competencies or fundamental risks of success or failure, then an arm s length markup would be required. Obviously, the proper administration of this rule depends critically on IRS auditors deferring to taxpayers reasonable business judgments.

5 Transfer Pricing Insights 5

6 6 Transfer Pricing Insights About Duff & Phelps Duff & Phelps is one of the world s leading independent financial advisory firms serving client needs in the areas of valuation, investment banking and transaction advice, and dispute consulting. We are the foremost provider of industry focused, independent and objective valuation insight and advice. Our services include financial reporting and tax valuation, transfer pricing, real estate and fixed asset services, merger and acquisition advisory, fairness and solvency opinions, due diligence and dispute consulting. Our professionals bring practical experience, responsiveness and a collaborative approach to satisfy our clients needs with the rigor and independence that the market demands. When our clients can t afford to get their analysis wrong, they look to Duff & Phelps to get it right. With more than 800 employees serving clients worldwide through offices in the United States, Europe and Asia, Duff & Phelps is committed to delivering insightful advice and service of exceptional quality, integrity and objectivity. If you would like to learn more about Duff & Phelps, visit our Web site at or call us directly at This publication is issued for informational purposes only. It is distributed with the understanding that the publisher is not rendering legal, accounting or other consulting advice and assumes no liability in connection with its use. Investment banking services are provided by Duff & Phelps Securities, LLC, an NASD registered broker-dealer. Copyright Duff & Phelps LLC. Transfer Pricing Contacts Dan Peters Nick Foster-Taylor Victor Miesel Clarke Norton Timothy Reichert Stephen Salvati Ray Brown Paul Burns Joy Dasgupta Stephanie Graham Ian Gray Vinay Kapoor Zac Costello Brandon De la Houssaye Sean Faulkner Rodrigo Fernandez Jaeyoon Lee Joanne Lennox Maneesha Sharma Jared Walls Joshua Wookey Service Leader Managing Managing Managing Managing Managing (973) (20) (212) (415) (720) (973) (213) (213) (720) (213) (720) (212) (212) (312) (973) (720) (212) (20) (212) (213) (415) Avenue of the Americas 44th Floor New York, NY PRSRT STD U.S. POSTAGE PAID DUFF & PHELPS