2013 - Issue 3—Business restructurings achieve economic benefits through a broad array of strategies. Cost savings and operational improvements are often key drivers. The primary mechanisms used to achieve the company's goals involve the redeployment of functions, assets or risks. Therefore, a restructuring exercise may offer significant tax planning opportunities through transfer pricing. The most common type of restructuring strategies in which transfer pricing plays a major role include:
- Migrating valuable non-routine intangibles;
- Creating principal structures outside the U.S.;
- Transforming a full-fledged manufacturer into a contract manufacturer;
- Transforming a full-fledged distributor into a limited-risk distributor; and
- Implementing cost-sharing arrangements for the development of intellectual property.
Tax authorities are particularly concerned about corporate activities that shift the tax base away from their jurisdictions through a transfer of profit drivers to other countries. This article reviews five key areas related to transfer pricing that should be carefully considered when planning a business restructuring.
1. Specific U.S. Tax Regulations Affecting Intercompany Transactions in Business Restructurings
In the U.S., specific tax regulations seek to curb the loss of taxable income through redeployment of functions. Transfer pricing regulations under Section 482 prevent the improper shifting of income to foreign corporations when the transfer occurs between entities that are under common ownership or control.
When the transfer involves intangible property, Section 482 addresses the sale or license of that intangible. Section 367(d) provides a related rule under which compensation, in the form of an imputed royalty stream, is required for an outbound transfer of intangible property in the context of an otherwise nontaxable reorganization transaction. Both sections apply a "commensurate-with-income standard" in determining the correct income for the transferor. Outbound transfers of tangible property to foreign corporations in otherwise non-taxable reorganizations are treated under Section 367 as taxable transfers unless established exceptions apply to restore tax-free transfer status.
The IRS may also assert that a transaction or business restructuring be disregarded or recast if it lacks economic substance under the substance versus form doctrine, as discussed in more detail later in this article.
In 2004, the American Jobs Creation Act introduced anti-inversion rules aimed at preventing earning-stripping and the reduction of taxable income of domestic taxpayers through strategies involving expatriation of parent companies in order to avoid Subpart F and other U.S. international tax restrictions (aka, "corporate inversions").
2. Exit Charges for Shift of Functions
U.S. transfer pricing regulations do not impose a specific exit toll when a function is moved overseas as part of a restructuring exercise. But in practice, the IRS views with skepticism strategies that involve the flight of functions, risks or assets.
Germany enacted exit taxes effective in 2008, requiring taxpayers who transfer assets or functions to another country to pay an amount for loss-of-business-opportunity. This concept is reportedly being used in the development of domestic legislative proposals in several other jurisdictions.
3. Workforce-in-Place and Going-Concern as Intangibles
Whether workforce-in-place and going-concern are treated as intangible assets for purposes of transfer pricing is significant because if they are, they require compensation on their transfer in the course of a business conversion.
In the U.S., workforce-in-place and going-concern are not specifically listed in the current definition of intangible property under Section 482, but this may change in light of recent developments.
In transfer pricing audits, the IRS has repeatedly adopted a position that considers workforce-in-place and going-concern value along with goodwill as intangible property for purposes of U.S. federal income tax. This position was asserted in a 2007 IRS Industry Directive specific to Puerto Rico business operations under Section 936 and the definition of intangible property under Section 367(d). It has also been asserted in public statements made by the IRS.
However, in Veritas Software Corp., the tax court judge disallowed the IRS's inclusion of workforce-in-place, going-concern value or goodwill in the valuation of intangibles for a buy-in transaction of a cost-sharing arrangement because these assets are not explicitly defined as intangibles under Section 482.
The issue has received renewed attention, as the Obama administration's budget proposals for the past three years contained a measure to include workforce-in-place, going-concern value and goodwill in the definition of intangible property under Sections 482 and 367(d). Revised language to Section 367(d) regarding the definition of intangibles is expected in early 2013.
4. Economic Substance Doctrine
A business restructuring may be disregarded or recast by the IRS if it lacks economic substance. The economic substance doctrine was codified in the Health Care and Education Reconciliation Act of 2010 that was signed into law on March 31, 2010. This act added new Section 7701(o) and penalty Section 6662(b)(6) to the Internal Revenue Code.
Under Section 7701(o), a transaction (or series of transactions) is treated as having economic substance only if, apart from U.S. income tax effects, (1) it changes the taxpayer's economic position in a meaningful way and (2) the taxpayer has a substantial non-tax business purpose for entering into the transaction.
Under Section 6662(b)(6), a 20 percent penalty applies to any portion of an understatement attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance if the treatment of the transaction is adequately disclosed on the taxpayer's return or a statement is attached to the return. Otherwise, the penalty increases to 40 percent.
5. When Contractual Terms Differ From Actual Behavior
The IRS is required to respect the terms of a contemporaneous written agreement between controlled persons provided the agreement is consistent with the economic substance of the transactions. When evaluating economic substance, the IRS may give greater weight to the actual conduct and the respective legal rights of the parties. If the contractual terms are inconsistent with the economic substance of the underlying transaction, the Service may disregard such contractual terms and impute terms that are consistent with the economic substance of the transaction.
In the absence of a written agreement, the IRS may impute a contractual agreement between the controlled taxpayers. Also, the IRS will disregard a contractual allocation of risk among controlled taxpayers as lacking in economic substance when made after the outcome of such risk is known or reasonably knowable, so the written contract must generally be contemporaneous to the transaction.
Alvarez & Marsal Taxand Says:
Tax authorities are engaged in a continual effort to prevent the flight of taxable income from their borders. In the fall of 2012, the U.S. Senate's Permanent Subcommittee urged changes to Section 482. Elsewhere, rules affecting the key elements involved in reorganizations are under review. A business reorganization whose primary goal is to reduce effective tax rates is unlikely to withstand IRS scrutiny. On the other hand, a reorganization plan whose architecture follows a clear business purpose is certain to benefit from significant tax advantages through the adequate application of transfer pricing strategies.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the US., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.