TRANSFER PRICING BASICS: RULES & PRINCIPLES FOR TECHNOLOGY & LIFE SCIENCES COMPANIES August 4, 2011 MOSS ADAMS LLP 1 TODAY S PRESENTERS Moderator Rich Croghan, Partner Technology &Life Sciences Group San Francisco, CA Presenters Paul Hoberg, Tax Senior Manager Transfer Pricing, International Services Group Seattle, e, WA Stu Myhill, Tax Senior Manager International Services Group San Francisco, CA SLIDE 2 MOSS ADAMS LLP 2 1
AGENDA Introductions, etc. What is transfer pricing and why do governments/ businesses care about it? Common structures used in strategic transfer pricing Transfer pricing and FIN 48 What is a transfer pricing study? Q&A SLIDE 3 MOSS ADAMS LLP 3 What is transfer pricing and why do governments/businesses care about it? MOSS ADAMS LLP 4 2
WHAT IS TRANSFER PRICING? The system of laws and practices used by countries to ensure that goods and services transferred between related companies are appropriately priced, based on market conditions, such that profits are correctly reflected in each jurisdiction (and not artificially inflated in low tax countries and depressed in high tax countries). From: Joint Committee on Taxation whitepaper submitted to the House Committee on Ways and Means on July 20, 2010 SLIDE 5 MOSS ADAMS LLP 5 WHAT IS TRANSFER PRICING? transactions The system of laws and practices used by countries to ensure that goods and services transferred between related companies are appropriately priced, based on market conditions, such that profits are correctly reflected in each jurisdiction (and not artificially inflated in low tax countries and depressed in high tax countries). From: Joint Committee on Taxation whitepaper submitted to the House Committee on Ways and Means on July 20, 2010 SLIDE 6 MOSS ADAMS LLP 6 3
WHAT IS TRANSFER PRICING? tax jurisdictions transactions The system of laws and practices used by countries to ensure that goods and services transferred between related companies are appropriately priced, based on market conditions, such that profits are correctly reflected in each jurisdiction (and not artificially inflated in low tax countries and depressed in high tax countries). jurisdictions From: Joint Committee on Taxation whitepaper submitted to the House Committee on Ways and Means on July 20, 2010 SLIDE 7 MOSS ADAMS LLP 7 WHAT IS TRANSFER PRICING? US parent company Export sale of finished goods Canadian sales sub Re sale of finished goods HQ support services Canadian customers SLIDE 8 MOSS ADAMS LLP 8 4
WHY DO GOVERNMENTS CARE ABOUT TRANSFER PRICING? 30% to 60% of all international trade occurs between related parties US loses as much as $60B of income tax revenue each year Worldwide, a significant increase in o Countries with transfer pricing rules o Transfer pricing audits, disputes, and controversies o Adjustments o Penalty assessments SLIDE 9 MOSS ADAMS LLP 9 WHY DO GOVERNMENTS CARE ABOUT TRANSFER PRICING? US parent company Export sale of finished goods Canadian sales sub Re sale of finished goods Transfer price =?? Price = $100/unit Per unit costs US Parent Can Sub Manufacturing 40.00 0.00 SLIDE 10 SG&A 20.00 15.00 Canadian customers MOSS ADAMS LLP 10 5
WHY DO GOVERNMENTS CARE ABOUT TRANSFER PRICING? Scenario 1 US Parent Canadian Sub Elim Consol Sales 80.00 100.00 (80.00) 100.00 COGS (40.00) (80.00) 80.00 (40.00) Gross profit 40.00 20.00 60.00 SG&A expense (20.00) 00) (15.00) (35.00) Operating profit 20.00 5.00 25.00 Tax rate 35% 34% Tax liability 7.00 1.70 8.70 SLIDE 11 MOSS ADAMS LLP 11 WHY DO GOVERNMENTS CARE ABOUT TRANSFER PRICING? Scenario 2 US Parent Canadian Sub Elim Consol Sales 65.00 100.00 (80.00) 100.00 COGS (40.00) (65.00) 80.00 (40.00) Gross profit 25.00 35.00 60.00 SG&A expense (20.00) 00) (15.00) (35.00) Operating profit 5.00 20.00 25.00 Tax rate 35% 34% Tax liability 1.75 6.80 8.55 SLIDE 12 MOSS ADAMS LLP 12 Tax liability (Scen 1) 7.00 1.70 8.70 6
WHY DO BUSINESSES CARE ABOUT TRANSFER PRICING? Multinational companies face pressure to o Reduce global effective tax rate & improve earnings per share o Locate cash where needed for business operations o Increase supply chain efficiency (entity structures, geographic locations, and operations) o Comply with accounting and tax rules o Maintain investor and public relations SLIDE 13 MOSS ADAMS LLP 13 WHY DO BUSINESSES CARE ABOUT TRANSFER PRICING? Scenario 3 Irish Principal Canadian Sub Elim Consol Sales 75.00 100.00 (75.00) 100.00 COGS (40.00) (75.00) 75.00 (40.00) Gross profit 35.00 25.00 60.00 SG&A expense (20.00) (15.00) (35.00) Operating profit 15.00 10.00 25.00 Tax rate 12.5% 34% Tax liability 1.88 3.40 5.28 Effective tax rates Scenario 1: 34.8% Scenario 2: 34.2 % Scenario 3: 21.1% SLIDE 14 MOSS ADAMS LLP 14 7
WHY DO BUSINESSES CARE ABOUT TRANSFER PRICING? Google 2.4% rate shows how $60 Billion Lost to Tax Loopholes (Bloomberg) Medtronic fights $2.7 billion in adjustments related to transfer pricing, other issues (BNA Transfer Pricing Report) IBM reports $2 billion 482 adjustment (BNA Transfer Pricing Report) AstraZeneca pays IRS $1.1 1 billion to settle transfer pricing issues (BNA Transfer Pricing Report) SEC filings show $2.7 billion reserved by Sony for APA negotiations (BNA Transfer Pricing Report) SLIDE 15 MOSS ADAMS LLP 15 HOW TO DETERMINE THE TRANSFER PRICE? Arm slengthstandard standard o Results of a transaction between related parties should be consistent with the results that would have been realized if the transaction was between third parties Under the US rules o Some safe harbor rules for intercompany interest t o Certain types of services can be charged at cost SLIDE 16 MOSS ADAMS LLP 16 8
Common Structures used in Strategic Transfer Pricing MOSS ADAMS LLP 17 COMMON STRUCTURES CONTRACT R&D Payment for contract R&D services R&D services Contract R&D service provider(s) Description o Company wants to manage and own IP centrally. Principal o Entity performing R&D is structured as a contract R&D (IP owner) Royalty service provider for Principal. payment o The IP is owned and managed by Principal i who receives royalties or otherwise uses the IP. Typical Operational Drivers o Centralized effective R&D and IP management. License Potential Tax Implications for use of o Lower effective corporate tax rate if Principal is IP located in low tax jurisdiction and IP users are not. Profile of Company o Companies that spend significant amounts on R&D, for example Pharmaceuticals, Telecommunications, and Technology Tax Considerations o Economic substance and conversion issues o Impact on R&D tax credits and incentives o Transfer of IP o Subpart F issues o Withholding tax issues o VAT issues IP user(s) Transfer Pricing Considerations o Determining arm s length compensation for contract R&D services o Determining arm s length royalty rate o Supporting transfer pricing documentation SLIDE 18 MOSS ADAMS LLP 18 9
COMMON STRUCTURES COST SHARING Costs Company A R&D Benefits Company B Costs Benefits Description o Company wants to centrally develop IP o A Cost sharing agreement ( CSA ) is an agreement under which the parties agree to share the costs and benefits of a particular activity, usually the development of IP Typical Operation Drivers o Centralization allows for more effective decision process and cost controls o Distribution of costs and ownership of IP Potential Tax Implications o Lower effective corporate tax rate if one or more CSA participants is located in low tax jurisdiction so can legitimately have a claim on future profits Profile of Company o Companies sharing the costs and benefits of an activity (R&D, services, joint ventures) with other entities Tax Considerations o Economic substance o Impact on R&D tax credits and incentives Transfer Pricing Considerations o IP valuation, transfer and management issues, including valuing initial contributions, buy in/out payments, balancing and true up payments, determining appropriate basis for cost sharing SLIDE 19 MOSS ADAMS LLP 19 COMMON STRUCTURES IP HOLDING COMPANY Affiliates Parent License for use of IP IP Royalty IP Holding CO Description o An Intangible Property Holding Company owns and maintains the IP and pays group companies for the cost of creating them o The Intangible Property Holding Company then licenses the use of the IP to its affiliates in exchange for a royalty y o Structure can be extended by incorporating contract R&D service providers or Cost Sharing Arrangements Typical Operational Drivers o Effective tax management of IP Potential Tax Implications o Lower effective corporate tax rate if Intangible Property Company is located in low tax jurisdiction and affiliates are not Profile of Company o Companies with valuable IP, either existing or in development Tax Considerations o Entity characterization and economic substance requirements o IP transfer issues, including valuation o Subpart F issues o VAT, customs and withholding taxes issues Transfer Pricing Considerations o Buy in payment valuation o Determining arm s length royalty rates o Supporting transfer pricing documentation SLIDE 20 MOSS ADAMS LLP 20 10
COMMON STRUCTURES CONTRACT Description o MANUFACTURING SLIDE 21 A Contract Manufacturer is a manufacturing company that produces goods in its own name and account but upon request of the Principal and according to the Principal s production requirements and specifications. Risk: o The Contract Manufacturer purchases the raw 3 rd Party Capital Investment materials and owns the WIP and finished Manufacturer Working Capital products during and at the end of the Supplier manufacturing process. Accordingly it sells the finished goods to the Principal. Typical Operational Drivers Risk: o Operational cost reduction Inventory Potential Tax Implications Warranty Principal o Lower effective corporate tax rate if Intangibles manufacturing is in high tax location and Working Capital Principal is not Profile of Company o Companies that have, or are expanding, manufacturing operations Tax Considerations Distributor Customer o Economic substance o Conversion issues o IP transfer issues o Subpart F issues Legal title/vat flow o VAT and Customs issues Physical flow o PE Transfer Pricing Considerations o Restructuring issues, including realignment of manufacturing and management functions and location of value drivers o o Determining arm s length compensation for contract manufacturer Supporting transfer pricing documentation MOSS ADAMS LLP 21 COMMON STRUCTURES AGENT Risks: Marketing Price Warranty/Adverse Event Inventory Credit(i.e., bad debt) Volume Principal Commission Agent Legal title/vat flow Physical flow Inventory Customer Description o An agent sells in the name, and on the account, of the Principal. The Principal legally sells the goods to the customers. o An agent receives a fee from the Principal for facilitating the sale Typical Operational Drivers o Cost reduction through simplification of business processes including transfer pricing, intercompany invoicing, and intercompany reconciliation activities Potential Tax Implications o Lower effective corporate tax rate if, commercially, Principal can be located in a lower tax jurisdiction. Profile of Company o Companies that are selling internationally Tax Considerations o PE issues o Conversion issues, including IP transfer issues. o VAT and customs issues. Transfer Pricing Considerations o Determining appropriate arm s length prices for commissions o Supporting transfer pricing documentation. SLIDE 22 MOSS ADAMS LLP 22 11
COMMON STRUCTURES LIMITED RISK DISTRIBUTOR Description o A LRD is a sales company that sells goods in its own name to third party customers o LRDs take title to inventory, but the risks are minimized and transferred to another group company in a taxadvantaged location through the contractual terms Inventory Risk: Principal Marketing Typical Operational Drivers Price o Cost reduction through simplification of business Warranty/Adverse processes including transfer pricing, intercompany Event invoicing, and intercompany reconciliation activities Inventory Potential Tax Implications Credit(i.e., bad debt) Volume Risk: Price(short term) Volume (short term) Flash Title Limited Risk Distributor Legal title/vat flow Physical flow Customer o Lower effective corporate tax rate if, commercially, Principal can be located in tax advantageous tax jurisdiction Profile of Company o Companies that are selling internationally Tax Considerations o Conversion issues, including IP transfer issues o PE issues o Subpart tf issues o VAT and customs issues Transfer Pricing Considerations o Determining arm s length compensation for distribution function o Supporting transfer pricing documentation SLIDE 23 MOSS ADAMS LLP 23 COMMON STRUCTURES SERVICE CENTERS Service Fees Affiliates Service Center Services Description o A MNE establishes an entity in a low tax location (a Service Center) that enters into service level agreements with other operating units within the group to provide various support services o The Service Center receives a fee from the other entities for its services Typical Operational Considerations o Costs savings through centralizing of processes and location savings o Efficiency benefits through uniform approach to multiple jurisdiction Potential Tax Benefits o Lower effective corporate tax rate through the movement of functions and risks to the low tax location if commercially feasible Profile of Company o Companies that provide significant global/regional support services Tax Considerations o Economic substance o PE issues o Subpart F issues o VAT issues Transfer Pricing Considerations o Determining arm s length compensation for the Service Center o Supporting transfer pricing documentation SLIDE 24 MOSS ADAMS LLP 24 12
COMMON STRUCTURES LOANS/CREDIT FACILITIES Description o Company wants to fund activities of affiliate Typical Operational Considerations o Repatriation strategy Affiliate 1 o Can be priced with relative certainty Potential Tax Benefits o Lower effective corporate tax rate if lender located in a low tax jurisdiction and borrower is not Profile of Company o Multinational companies with highly leveraged foreign loan/credit facility interest payments subsidiaries o Financial services companies Tax Considerations o Thin capitalization issues o Classification of income for treaty and local country purposes Affiliate 2 o Withholding tax issues Transfer Pricing Considerations o Determination of the appropriate arm s length interest rate o Supporting transfer pricing documentation SLIDE 25 MOSS ADAMS LLP 25 Transfer pricing and FIN 48 MOSS ADAMS LLP 26 13
TRANSFER PRICING & FIN 48 Transfer pricing is by nature an uncertain tax position o In many cases, it may even be the biggest UTP o EVERY FIN 48 analysis should explicitly address transfer pricing in some manner o Is a reserve booked? SLIDE 27 MOSS ADAMS LLP 27 SCHEDULE UTP Who must file? o Five year phase in o For 2010, Corporations with: Greater than $100M in assets Issue audited F/S Have one or more UTPs to disclose o For 2012, threshold h reduced d to $50M o For 2014, threshold reduced to $10M MOSS ADAMS LLP 28 14
What is a transfer pricing study MOSS ADAMS LLP 29 WHAT IS A TRANSFER PRICING STUDY? In 1994, US was the first jurisdiction to introduce transfer pricing related penalties o 20% to 40% of additional tax resulting from transfer pricing adjustment (subject to some materiality thresholds) o Need contemporaneous documentation to avoid penalties Other countries reacted o Canada: penalty equal to 10% of the adjustment (whether or not it results in additional tax) o Australia: 10% to 50% of additional tax o More than 50 countries, and counting SLIDE 30 MOSS ADAMS LLP 30 15
WHAT IS A TRANSFER PRICING STUDY? Contemporaneous documentation now required in US and more than 50 countries o Penalty protection o Initial audit defense Elements of US contemporaneous documentation o Principal documentation : 10 elements across 3 broad categories o Functional analysis o Best method analysis o Economic analysis o Background documents SLIDE 31 MOSS ADAMS LLP 31 WHAT IS A TRANSFER PRICING STUDY? Elements of contemporaneous documentation differ around the world examples: o Canada: 6 elements o Australia: 4 step process o China: 26 elements in 5 major categories SLIDE 32 MOSS ADAMS LLP 32 16
WHAT IS A TRANSFER PRICING STUDY? Planning study o Prospective how to price future transactions o Typically limited to a benchmarking study o May also outline expected functions and risks and expected transaction flows FIN 48 analysis o Provides justification of transfer pricing related i deferred tax assets/liabilities to US GAAP (book) auditors o Transfer pricing related positions for book purposes may differ from those positions taken on a tax return SLIDE 33 MOSS ADAMS LLP 33 QUESTIONS Richard Croghan, Partner Technology & Life Sciences Group (415) 677 8282 richard.croghan@mossadams.com Paul Hoberg, Tax Senior Manager Transfer Pricing, International Services Group (206) 302 6338 paul.hoberg@mossadams.com Stu Myhill, Tax Senior Manager International Services Group (415) 677 8336 stuart.myhill@mossadams.com SLIDE 34 MOSS ADAMS LLP 34 17