Lessons Learned (So Far) on FIN 48 and Transfer Pricing

Q 2 2 0 0 7 1 3 6 INSIDE Lessons Learned (So Far) on FIN 48 and Transfer Pricing Hot Topics in Transfer Pricing About Duff & Phelps Lessons Learned (So Far) on FIN 48 and Transfer Pricing By Ray Brown, Sean Faulkner, Stephanie Graham and Steve Salvati With the first quarter reporting period for adoption of FASB Interpretation Number 48 Accounting for Uncertainty in Income Taxes (FIN 48) 1 behind us, it is time to review what we have learned so far. Company tax managers, independent auditors and other advisors have been hard pressed to understand and apply the principles of FIN 48 to transfer pricing. Compliance has proven to be a significant task that places all aspects of a company s transfer pricing process under extreme scrutiny. We are just beginning to understand the impact of FIN 48, including some of its unanticipated benefits. In this article we share some key lessons learned (so far), which can assist those companies yet to adopt FIN 48 and those that have completed the first quarter adoption period and are preparing for the next reporting period. Lesson 1: Determine the scope of the FIN 48 analysis from the onset There is some variation as to what level of detail the independent auditors will expect or require from a company. Therefore, a good first step is to speak with your independent auditor at the beginning of the process to understand the approach they will follow and the detail they will require. For example, while we found that the independent auditors require a review of all material transactions, the materiality threshold is determined by the independent auditor and is dependent on factors specific to each company. In some situations, the materiality threshold required that virtually every transaction be reviewed, while in other cases, it only required the review of certain transactions among the companies largest affiliates. Companies that have completed the FIN 48 process should correspond with their independent auditors at the beginning of each audit period because expectations and requirements may change as audit firms gain more experience and develop additional procedures relating to the FIN 48 process. Lesson 2: So, what is MLTN? The first step in applying FIN 48 is to assess whether a tax benefit can be recognized in determining the tax provision in the financial statements. To be recognized, a tax position must meet a more likely than not ( MLTN ) (or greater than 50%) threshold of being sustained throughout the tax return examination process (including any appeals and litigation) based on the technical merits, in which the tax examiners are assumed to have full knowledge of all relevant information, and without regard to the risk of detection of the issue. In this regard, we had varied experiences in terms of what criteria the independent auditors relied on to determine if the company met the MLTN threshold. In many cases, the company was able to convince the independent auditor that it satisfied the MLTN threshold if the company was able to demonstrate that the intercompany transaction had economic substance. In other words, if the transaction occurred (i.e., a good was sold or a service was provided) and a payment was made, then the MLTN threshold was met. However, in cases where the company did not have adequate transfer pricing documentation or an effective policy in place, we experienced situations in which the company had to demonstrate to the independent auditor that the transfer pricing method used (i.e., the tax return position) satisfied the MLTN threshold. Therefore, companies that did not have documentation 1 Which is an interpretation of FASB Statement 109 Accounting for Income Taxes and supercedes FASB Statement 5 Accounting for Contingencies with respect to income taxes.

2 Transfer Pricing Insights and/or an established transfer pricing policy in place were at a substantial disadvantage, as recognition became a primary focus of the independent auditors reviews. Another factor to consider in relation to the MLTN threshold is the identification of intercompany transactions that may exist, but for which there is no compensation. While such circumstances are unlikely to occur in situations involving tangible good transactions, they may occur in cases concerning the provision of services or the use of intangibles. These previously unidentified intercompany transactions may require a separate MLTN analysis. Thus, if the MLTN threshold cannot be satisfied, then the company cannot recognize tax benefits from its transfer pricing. In this case, significant tax contingencies would need to be provided, which could materially impact a company s effective tax rate and earnings. Lesson 3: Scenario development - When is enough, enough? The second step in applying FIN 48 is the measurement of the benefit from a tax position in determining the tax provision in the financial statements. The benefit amount is measured as the largest amount having a greater than 50% cumulative probability of being realized upon settlement or other resolution, based on an expected outcome analysis of a set of potential outcome scenarios. Here we experienced some conceptual disagreements with independent auditors as to the scenarios we developed to reflect an appropriate and realistic variety of possible transfer pricing methods, critical facts and assumptions and audit risks. However, we were successful in limiting our analysis to a reasonable number of potential scenarios, typically ranging from the tax return position to the worst-case result. In one case, we found it necessary to prepare separate vs. aggregate analyses for two business operations to achieve an appropriate set of scenarios. In addition, computing the amount of the tax benefit under the various scenarios also presented some challenges in terms of obtaining the requisite factual information and financial data as well as creating innovative financial models that computed and presented the tax benefit to be derived from each identified scenario. In the course of review with the independent auditors, we experienced numerous rounds of iterative computations based on slight changes to the facts and assumptions. At some point the law of diminishing returns was realized and the independent auditors agreed that there were enough scenarios to yield a reasonable assessment. Lesson 4: What are the probabilities? After identifying the potential scenarios necessary to complete the measurement process, it is necessary to assign a probability of outcome to each scenario to determine which outcome scenario reaches the more than 50% cumulative probability. Determining the probability of each scenario is the heart of the FIN 48 analysis, as it involves the consideration of many factors, such as: (i) judgment based on the law and the facts and circumstances, (ii) the company s appetite for risk and settlement policy, (iii) the quality and completeness of the company s transfer pricing documentation, (iv) outside advisor opinions, (v) the company s willingness to endure a lengthy dispute resolution process, and (vi) current and prior audit experiences. In concept, and in fact, assigning probabilities presents the greatest challenge in the FIN 48 analysis. In some cases, we found that the judgment of the company s tax manager was sound in this regard, due to their extensive experience with issues specific to their own company. Accordingly, we relied heavily upon the company s judgment, although we did play devil s advocate on occasion to test their conclusions. In other cases, the company s tax managers did not have sufficient knowledge or experience to assign the probabilities, so they relied on our input. In any event, our significant experience dealing with tax authorities on transfer pricing audits certainly added value to this process. In general, we found that while the independent auditors did question the assigned probabilities, they did not challenge them if they were supportable. We should note that in one particularly complex case, we found it appropriate to develop comparative probabilities for each outcome scenario at each level in the dispute resolution process (assessment, appeals/negotiation toward settlement, and litigation). We then combined those probabilities to determine an overall weighted probability for each scenario, which was then used to determine the more than 50% cumulative probability outcome. Lesson 5: What about penalties and correlative relief? It is clear by its terms that FIN 48 requires that penalties (and interest) be taken into account in determining the tax benefit and the potential tax contingency reserves. Furthermore, the possibility of correlative relief under the Competent Authority provisions of a tax treaty (or unilateral relief) must also be taken into account. Both of these items are highly sensitive to the facts and circumstances, and they add yet another level of complexity to the FIN 48 analysis. In this regard, we sometimes needed to create another level of outcome scenarios specific to penalties, interest, and correlative relief to make a proper determination of a more than 50% cumulative probability to complete the FIN 48 analysis. In the case of transfer pricing, the penalty and correlative relief measurement analysis can be as difficult as the tax measurement analysis. Lesson 6: Potential hidden benefits? While many companies initially viewed FIN 48 as a cumbersome task which could only identify additional transfer pricing exposures, some companies quickly realized that performing a robust FIN 48 analysis could create unanticipated value for the company. A few of the potential benefits are provided below: Releasing Reserves In some cases, the FIN 48 analysis suggests that the company over-reserved for certain tax positions, enabling the company to release such reserves.

Transfer Pricing Insights 3 Planning Opportunities A FIN 48 analysis provides an excellent opportunity to identify transfer pricing planning opportunities because it requires the company (or tax advisor) to rigorously review its transfer pricing policies. Audit Plan A thorough FIN 48 analysis can help companies develop a strategic plan to prepare for potential future transfer pricing audits. This includes developing sound economic support for uncertain transfer pricing positions or evaluating the potential benefits of proactively addressing exposure via the Advance Pricing Agreement Program. Lesson 7: Protecting the FIN 48 analysis We learned that companies are concerned about the ability of the Internal Revenue Service (IRS) and other tax authorities to gain access to the FIN 48 analyses. Such access was viewed as a road map to the company s tax issues. The IRS s position on access to FIN 48 analyses is unclear, and the extent and manner by which a company could protect the FIN 48 analyses from IRS discovery is beyond the scope of this article. However, note that in our experience companies desire to communicate FIN 48 analyses in a form and manner intended to protect the communication from discovery. While there have been many lessons learned up to this point, we anticipate even more lessons in the reporting quarter ahead. Both advisors and independent auditors will gain more experience on varying issues, including how changes in facts and circumstances may impact both the recognition and measurement of positions previously analyzed. Our View: The courts are showing increasing willingness to apply transfer pricing concepts outside the tax arena, as a means of policing the way corporations behave toward minority shareholders, licensors of valuable IP, and other supposedly vulnerable stakeholders. Companies dealing with such situations should consider ensuring their related party dealings are consistent with the arm s length principle. IRS View: Commensurate-with-Income Is a One-Way Street in Audits U.S. regulations require that the compensation paid in a related-party transfer or license of intangible property must be commensurate with the income reasonably expected to be earned from the exploitation of the intangible. In a recent Advisory Memorandum to the IRS Appeals Office, the IRS Associate Chief Counsel (International) outlined the IRS views on the application of the commensurate-with-income rule in IRS audits. In the IRS view, taxpayers are not permitted to affirmatively raise commensurate-with-income as an issue in an audit or in Appeals in order to reduce the U.S. taxable income from a transaction. The memorandum also takes the position that it is appropriate for the IRS to second-guess taxpayers up-front pricing decisions with the benefit of hindsight regarding the actual profits earned from the use of the intangible, where taxpayers cannot show that their pricing was supported by such upfront reasonable and conscientious evaluation of projected operating profits Hot Topics in Transfer Pricing By Dan Peters and Paul B. Burns Transfer Pricing Issues in a Non-Tax Context: The Will & Grace Litigation The creators of the hit television series Will & Grace sued the studio that produced the program, and the jury was on the verge of awarding the plaintiffs $49 million in damages when the case was settled. The theory of the plaintiff s case was that the studio, which was commonly owned with the NBC television network, had licensed the series to the network for a less-than-arm s length fee, thereby making the series appear less profitable and reducing the amount of contingent compensation due to back-end profit participants. The case follows on the heels of the landmark Ford Canada case, in which a Canadian court ruled that Ford had unlawfully oppressed the minority shareholders of its Canadian subsidiary by engaging in non-arm s length transfer pricing that caused the subsidiary to earn persistent losses. Our View: The IRS is clearly emboldened by a recent string of high-visibility litigation wins and favorable settlements, and is aggressively seeking to redefine the rules of engagement in the audit process. Further, taxpayer s need to consider greater support for their assumptions and forecasts, and structuring their arrangements properly to allow affirmative adjustments to payments for intangibles. New Chinese Transfer Pricing Law Provides Legal Authority for Cost-Sharing, APAs In March 2007, the People s Republic of China adopted a new Enterprise Income Tax Law. The transfer pricing provisions of this new law are an important update and expansion of the Chinese legal framework around intercompany transactions, which has previously been a hodgepodge of statutory provisions and administrative guidance from the central government (which provincial tax authorities sometimes failed to follow). Article 41 of the new law, which states that costs associated with the joint development of intangible assets must be allocated based on the arm s length standard, clearly

4 Transfer Pricing Insights contemplates that Chinese taxpayers can participate in cost-sharing arrangements. Article 42 of the new law clearly establishes the statutory authority for the Chinese tax authorities to enter into APAs. Articles 43 and 44 of the new law establish the statutory authority for the Chinese tax authorities to promulgate the long-awaited Chinese contemporaneous documentation rules. The new law also includes a thin-capitalization rule that will need to be supplemented by regulations defining the target ratio of debt to equity. Finally, the new law includes a provision (Article 47), that essentially is a general antiavoidance rule similar to (but potentially even more flexible in its application than) similar rules that are in effect in Canada and a number of other countries. Our View: The new law is a useful step in bringing Chinese transfer pricing law and practice more closely in line with generally accepted international norms. Multinationals with significant operations in China should review their existing pricing structures to ensure compliance and to determine whether planning opportunities exist. Canadian Court Docket Reflects Increased Aggressiveness of CRA Auditors In recent years, the Canada Revenue Agency (CRA) has emerged as one of the most aggressive tax authorities in attacking multinational companies transfer pricing arrangements. The results of those initiatives are now being reflected in an increase in the number of transfer pricing disputes that find their way to the Tax Court of Canada. What is striking about some of the current cases is that they do not involve exotic structures or unusual transaction flows. Rather, the CRA is aggressively challenging even relatively common arrangements between related companies. For example, in Wyeth-Ayerst, the CRA agreed with the taxpayer that the cost plus method was an appropriate framework for pricing research and development services; however, it attempted to substitute its judgment for the taxpayer s as to the right markup on cost. In Tregasskiss, Ltd., a Canadian manufacturer established an offshore buy-sell distribution subsidiary to service its existing customer base and expand its marketing activities. The CRA has attempted to recharacterize the relationship, asserting that the offshore subsidiary is a mere call center that takes no meaningful market or financial risks and is therefore entitled to only a small markup on its operating costs. Our View: With increasing audit activity and a difficult relationship between the U.S. and Canadian competent authorities, Canada is a particularly difficult environment for multinational taxpayers. Multinationals with significant operations in Canada should expect close scrutiny of their intercompany arrangements, and prepare in advance to defend the appropriateness of their transfer pricing. IRS Focus on Cost-Sharing Issues Continues Issues relating to cost-sharing for intangible development have been a major focus of the IRS transfer pricing enforcement efforts. In an effort to better coordinate field activities, in April the IRS designated cost-sharing as a Tier I issue -- that is, one of the most significant compliance challenges facing [the IRS]. In the IRS view, cost-sharing is often used by taxpayers inappropriately to transfer intangible assets and associated profits offshore. The IRS has designated a centralized Issue Management Team to oversee and coordinate all of its enforcement activities relating to cost-sharing. Examining agents are strongly encouraged to closely follow a checklist of audit techniques that was developed in 2005. The IRS is augmenting its in-house capabilities by engaging a number of outside transfer pricing experts to assist in case development. A Coordinated Issue Paper on the subject is being prepared, and proposed regulations issued in 2005 are expected to be finalized in the near future. Our View: Many multinationals continue to find cost-sharing an efficient way of funding research and development projects that benefit business units in multiple countries. With these potentially taxpayer-unfriendly new regulations on the horizon, taxpayers with existing costsharing arrangements should be running diagnostics to assess potential adverse impacts of the new rules, and taxpayers considering setting up a cost-sharing arrangement should be acting now to position themselves to take advantage of potential grandfathering when the new rules go into effect. Recently, practitioners have also noted that the CRA has begun using transfer pricing principles to challenge intercompany financing arrangements. Historically, CRA auditors have used other statutory provisions, including Canada s strict thincapitalization rules, to police intercompany lending. It is to be expected that some of these cases will be litigated in the future.

Transfer Pricing Insights 5 From transfer pricing compliance and controversies to supply chain planning and intangible property transactions, the Transfer Pricing practice of Duff & Phelps provides trusted analysis and insight on critical issues. With more than 850 people working together across North America, Europe and Asia, Duff & Phelps has the depth and breadth of industry and technical expertise to meet your needs. Get the strength of one of the world s leading independent financial advisory firms. > Financial Reporting Valuation > Tax Services > Real Estate & Fixed Asset Services > Investment Banking > Transaction Advisory Services > Financial Restructurings > Dispute & Legal Management Consulting duffandphelps.com / +1-866-282-8258 Investment banking services are provided by Duff & Phelps Securities, LLC.

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 valuation, tax valuation and consulting, transfer pricing, real estate and fixed asset services, merger and acquisition advisory, financial restructurings, 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. This publication is issued for informational purposes only. It is distributed with the understanding that the publisher is not rendering legal, accounting, tax 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. IRS Circular 230 Notice: To ensure compliance with the requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Transfer Pricing Contacts Dan Peters Ray Brown Nick Foster-Taylor Clarke Norton Timothy Reichert Stephen Salvati Theodor van Stephoudt Paul Burns Joy Dasgupta Sean Faulkner Rodrigo Fernandez Stephanie Graham Ian Gray Vinay Kapoor Justin Smith Zac Costello Jaeyoon Lee Joanne Lennox Maneesha Sharma Jared Walls Joshua Wookey Service Leader Managing Managing Managing Managing Managing Managing (973) 775-8310 (213) 270-2395 +44 (20) 7715 6732 (415) 693-5323 (720) 932-8322 (973) 775-8330 +41 (0) 44 208 3178 (213) 270-2371 (720) 932-8326 (973) 775-8345 (720) 932-8325 (213) 270-2378 (720) 932-8320 (212) 871-5996 (415) 693-5315 (212) 871-5556 (212) 871-0222 +44 (20) 7715 6733 (212) 871-0241 (213) 270-2384 (415) 693-5322 2007 Duff & Phelps LLC. 1221 Avenue of the Americas 44th Floor New York, NY 10020 PRSRT STD U.S. POSTAGE PAID DUFF & PHELPS www.duffandphelps.com