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Managing Effective Tax
Rate Through International
Tax Planning
William James, Principal
Matthew Campbell, Senior Managing       depth
June 11, 2009

International Tax Update
 Subpart F: Look-through Rule & Country
 of Incorporation Exception
 Subpart F: Section 956 & Limited Relief
 Canada/U.S. Treaty – New Protocol
 Commonly Missed International Form

Subpart F: Look-through
Rule & Country of
Incorporation Exception

Subpart F Issues
    Subpart F Income
            Failure to identify & report foreign personal
            holding company income
            Failure to identify & report foreign base
            company sales income
            Failure to identify & report Section 956
            investment in U.S. property

Foreign Personal Holding
Company Income

Foreign Personal Holding Company Income is generally passive types of
   income earned by CFC
   Interest earned by CFC1 is FPHCI
   Interest paid from CFC2 to CFC1 normally FPHCI
           In 2004, exception for CFC to CFC payments eliminated this as FPHCI
                   The provision was set to expire 12/31/08
                   Extended by 2008 Extenders Act to tax years of CFRCs beginning before 01-01-2010
   Interest paid by CFC3 to CRC2 is not FPHCI
           Deemed not to be abusive because both entities are organized in France (same country

Foreign Base Company Sales

                                                        Sale of finished goods produced by

Foreign Base Company Sales Income
     Sale of product to related party
            Where product was not produced
                     By the seller or
                     In the country of incorporation of CFC and
            For consumption outside the country of incorporation
    Sale by CFC3 to CFC2 is not a problem
            Same country exception (France to France)
    Sale by CFC2 to CFC1 is not a problem
            Product produced by CFC2
    Sale by CFC1 to Third Party is a problem
            CFC1 did not produce property
            Property was produced outside of Switzerland
            Produce is for consumption in Canada

Investment in U.S. Property
(Section 956)

 CFC3 has investment in U.S. property to extent U.S.
 Parent has borrowed
    Notice 2008-91 permits loan to extent it is settled within 60 days
 CFC1’s sale of product to U.S. Parent generally does not
 give rise to investment in U.S. property
    Make sure intercompany account is settled periodically. If
    liability is not settled, there could be deemed loan from CFC1 to
    U.S. Parent

Section 956 – Subpart F through
Investment in US Property
 CFCs normally cannot invest in US
 property without creating current income
 inclusions via Subpart F
 Policy rational is if money is brought into
 U.S., taxation should result because while
 distribution has not been made, taxpayer
 has funds safely the U.S. & further deferral
 of taxation should not continue

Section 956 – Earning Invested
in US Property
 U.S. shareholder’s gross income includes pro
 rata share of any increase in CFC investment of
 CFC earnings in U.S. property
 Items frequently missed as investments in US
    US parent pledges of more than 66.66% of stock in
    Loans by CFC to domestic parent or U.S. affiliate
    Pledges or guarantees by CFC of loan taken by US

Section 956 Inclusion
 Amount included in income is lesser of
    Excess of shareholder’s pro rata share the
    average of amounts of U.S. property held by
    CFC as of end of quarter of such taxable
    year over E&P
    Shareholder’s pro rata share of applicable

Temporary Relaxation of Section
956 Due to Financial Crisis
 Notice 2008-91 provides relief in what is termed
 obligation for purposes of Section 956
 Obligation paid within 60 days of issuance is not treated
 as investment in U.S. property; however exception is not
 applicable on successive 60 day loans if investment in
 aggregate is held more than 180 days in year
 Notice 88-108 previously provided more limited
 exception if obligation is paid within 30 days of being
 incurred & overall was held for less than 60 days in the

Commonly Missed
International Tax Issues

Policy Change with Form 5471
 $10,000 failure to file penalty will be
 imposed whenever there is failure to file a
 Form 5471 when required
 Abatement requests may be filed but likely
 will be more difficult to obtain with this
 change in policy that appears focused on
 tax gap

Commonly Missed International
Tax Issues
 Failure & incorrect reporting of related party transactions
 on Form 5471, Schedule M
 Reporting accounts payable as loans on Form 5471,
 Schedule M
 Failure to report officers & directors on Form 5471, pg. 1
 Incorrect currency conversions on Form 5471
 Failure to file Form 5471, Schedule O when foreign
 corporation is organized or has reorganization
     Failure to add organizational chart
 Failure to attach legal entity organization chart for Forms

Commonly Missed International
Tax Issues
 Failure to report transfer to foreign corporation
 on Form 926
 Failure to allocate & apportion expenses in
 calculating FTC on Form 1118
 Understatement of foreign source income in
 calculating FTC under Section 863(b) sourcing
 Failure to file Form 5713 (international boycott
 form)(Kuwait, Lebanon, Libya, Qatar, Saudi
 Arabia, Syria, UAE, Yemen)

Commonly Missed International
Tax Issues
 Failure to make Section 338 election for
 foreign subsidiary when beneficial
 Failure to make dual consolidated loss
 Failure to identify transfer pricing exposure
 or planning opportunities

Commonly Missed International
Tax Issues
 Failure to file Form 1042, Form 1042-S &
 1042-T (annual withholding tax return)
 Failure to provide for Section 1446 (Forms
 8804, 8805 & 8813) withholding for foreign
 partners whether or not distributions
 made. Form 8813 is required on or before
 15th day of 4th, 6th, 9th & 12th month of
 partnership’s tax year

New Protocol to U.S./Canada
Income Tax Treaty Ratified by
US Senate & In Force
January 1, 2010

New Fifth Protocol to
U.S./Canada Income Tax Treaty
 Prior to ratification of U.S./Canada protocol, a LLC was not
 resident for treaty purposes because it was not “liable to
 tax” (unless it elected to be taxed as corporation for US
 federal income tax purposes).
 As a result, U.S. taxpayer that invested in Canada through
 U.S. LLC was not eligible for treaty benefits, even if owned
 100% by US resident taxpayers
 This caused interest, dividend or royalty payments made to
 a U.S. LLC from Canada to be subject to 25% Canadian
 withholding tax, rather than reduced treaty rates
 In addition, LLCs which carried on business in Canada
 were subject to Canadian income tax even if LLC did not
 have permanent establishment (PE) in Canada

New Fifth Protocol to
U.S./Canada Income Tax Treaty
 Under 5th Protocol ratified by U.S. Senate on September
 23,2008, new paragraph 6 was added that, while not
 defining LLC as taxpaying entity, indicates payments of
 interest, dividends or royalties from Canada to U.S. LLC
 that is wholly owned by U.S. taxpayers would be eligible
 for reduced withholding rates under treaty
 Once Protocol is effective January 1, 2010, dividends
 are eligible for 5% or 15% withholding tax as opposed to
 25% withholding generally
 Interest may be exempt from withholding entirely
 Royalties are subject to10% withholding tax

New Fifth Protocol to
U.S./Canada Income Tax Treaty
 However, under new Protocol no new reduced
 rate of withholding is allowed an otherwise
 qualifying US resident shareholder of Unlimited
 Liability Company (ULC)
 Accordingly, 25% withholding is required as of
 January 1, 2010
 Contact BKD International Tax Services with
 regard to migration strategy for affected

Transfer Pricing

What is Transfer Pricing?
 Analyzes prices for transactions between
 related parties in different tax jurisdictions
    International boundaries
    Certain domestic boundaries
 Transfer prices should be on arm’s length
    As if related parties were unrelated

What is Transfer Pricing?
 Examples of intercompany transactions subject to
 transfer pricing rules include
    Transfer of tangible goods e.g., finished goods, raw
    materials, work in progress, machinery & equipment
    Transfer of intangible property e.g., patents,
    technology, know-how, formulas, trademarks, trade
    names, customer lists, etc.
    Provision of services e.g., technical, management,
    research & development, engineering, etc.
    Financing e.g., loans, guarantee fees, leasing, etc.

Importance of Transfer Pricing
 Companies have expanded internationally
 due to global nature of economy
    Global expansion is no longer limited to
    large companies
    This means more companies are now
    subject to transfer pricing rules around
    globe (approximately 50 countries have
    specific transfer pricing laws/legislation)
    as their expansion is generally through
    creation of related party legal entities

Importance of Transfer Pricing
 Transfer pricing brings obligations &
 potential opportunities
   Companies are obligated to comply with
   transfer pricing rules by preparing adequate
   transfer pricing documentation subject to
   penalties for lack of compliance
   Opportunities are available in certain cases
   to utilize transfer pricing rules to companies’
   advantage by shifting profits from high to low
   tax jurisdiction

Transfer Pricing in Recession
 Unless you don’t read news publications,
 watch TV or have internet access i.e., live
 in a cave we are in deep global recession
 What does that mean with regard to
 multinational company’s transfer pricing
 arrangements resulting tax positions?

Transfer Pricing in Recession
 During recession, the following goals will
 become especially critical for taxpayers with
 cross-border activities
    Avoid trapped profits in foreign countries (unable to
    use foreign tax credits)
    Conserve cash
    Avoid excessive tax payments in some countries
    while there may be losses in others
    Mitigate risk of tax adjustment which would result in
    double taxation
 Managing all of these goals involves reviewing
 existing transfer pricing arrangements

Transfer Pricing in Recession
 During recession, tax authorities will likely increase
 scrutiny of companies with cross-border activities to
 raise revenues as coffers dwindle
    Will likely target corporations as they do not vote
    Will more likely target inbound companies
    Will scrutinize loss-making companies
    President Obama & IRS have publicly stated transfer pricing
    enforcement will become critical
    Other countries have also indicated & demonstrated that they
    will step-up enforcement
    IRS has hired & will hire large number of economists & issue
    specialists to enforce transfer pricing compliance
    Tax authorities likely to challenge changes to transfer pricing

Transfer Pricing in Recession
 Depending upon taxpayer’s profile, economic downturn
 may represent opportunity or threat from a tax
    Will largely be threat
        Tax structure which contemplates residual profit to entrepreneur
        (or principal) can face adverse consequences in recession as
        other entities are often guaranteed profit
        Risk of audits increases as treasury coffers dwindle & tax
        authorities fight for revenues
        Can review TP arrangements & comparables to compensate for
        or to mitigate certain threats given unrelated parties may
        renegotiate pricing arrangements in severe recession

TP in Recession –Threat
 Example 1 - Recession may trap profits in certain entities
      Taxpayer’s historical TP strategy has been largely neutral as it
      was largely able to utilize any foreign tax credits
      U.S. parent now in loss & may not be able to take foreign tax
      credits & even be in net operating loss carryforwards (NOLs)
      situation for present & future tax years
      Overseas related party distributors are at statutory tax rate
      roughly similar to U.S.
      Distributors are to earn operating margin (OM) of 3% - 6%
      based upon comparables determined during period of economic
      growth & stability
      Taxpayer’s revenues have rapidly declined & its costs have
      increased in all of its legal entities including its distributors
      Existing TP arrangement leaves too high of return in distributors
      given current economic climate

TP in Uncertain Economy –
                  Distribution Example – Distributor Profit & Loss Statement
                              Pre-Transfer Pricing Adjustment
                          Pre-Recession Year       Recession Year

 Sales                           $100                   $75           Decline
 COGS (Transfer
                                 $71                    $42
 Gross Profit                     29                     33

 SG&A                             25                     30           Increase
 Targeted Operating
                                   4                     3
 Targeted Operating
                                 4.0%                   4.0%
 Margin per CPM
                                                                      Decrease to U.S.
 Transfer Price                  $71                    $42

TP in Uncertain Economy –
 Need to mitigate adverse consequences of
 company’s existing TP policy
      Existing policy now creates lower TP from the U.S.
      parent company given
            It has to essentially guarantee profit at distribution entity
            Distribution entity’s revenues have decreased & its costs
            have increased leading to lower price from U.S. to ensure
            Was not much of issue before as U.S. was largely able to
            take foreign tax credits - with losses may not be able to
            take foreign tax credits

TP in Uncertain Economy –
Possible Solutions
    Look at revised comparables and make
    adjustments to transfer prices accordingly
          Use financial data from comparables that
          includes recession years – would reduce OM
          Commonly employed methodologies take
          into account historical data, which is used to
          set future transfer prices
          Use loss-making comparables

TP in Uncertain Economy -
                     Distribution Example – Distributor Profit & Loss Statement
                           Pre - and Post - Transfer Pricing Comparison
                             Recession Year -         Recession Year -
                               Unadjusted                Adjusted
Sales                               $75                     $75

COGS (Transfer Price)               $42                     $44            Increase

Gross Profit                        33                      31
SG&A                                30                      30
Targeted Operating
                                     3                       1
Targeted Operating
                                   4.0%                    1.3%            Decline
Margin per CPM
                                                                           Relative increase to
Transfer Price                      $42                     $44
                                                                           U.S. Revenues

TP in Uncertain Economy -
    Result - Increased transfer price leads to:
          Increased revenues for U.S. company
          Increased profits in U.S. which may be shielded by
          Somewhat aids the foreign tax credit position of the
          U.S. company
          Decreased tax in overseas distribution entities
          Even though decreased sales and increased costs,
          the adjusted TP serves to mitigate the adverse
          impact on the company’s tax position

TP in Uncertain Economy –
 Example 2- Taxpayer with services fees
    U.S. Parent company (USP) is trying to bring cash
    back to service debt & overseas entities are
    USP has charged management fee for head office
    services to affiliates at cost based upon 1968
    services regulations (i.e., no mark-up)
        Perceives they should use Services Cost Method (SCM)
        (cost safe harbor) under relatively new temporary services
        regulations but has yet to undertake analysis

TP in an Uncertain Economy –
 Opportunity - Consider analyzing certain
 services under SCM & others with mark-
    High value services – can be marked-up
    using net cost plus (NCP) profit level
    Low value services – at cost
    Or even consider marking-up all services

TP in an Uncertain Economy -
 Results from Example 2 – leads to
    More cash in U.S.
    Lower profits in subsidiaries due to higher deductions
    associated with “marked-up” service fees
 Issues to be overcome
    Challenge “benefit” of services by recipient country
    Challenge implementation of mark-up (previously none) by
    recipient country
    Determination of appropriate allocation keys
    Ensuring that stewardship costs are not included

TP in Uncertain Economy – Effects
of Certain TP Methods?
 Comparable Uncontrolled Price (CUP) - transfer prices
 should automatically adjust since they are based on
 taxpayer’s market prices
    May mean constant refinement

 Comparable Profits Method (CPM) encourages
 averaging of years to derive arm’s length transfer price
    Latest year of comparable data would likely include recession
    year & would result in lower targeted TP margin
    May take longer for effect recession to come into play due to
    lag of available data on databases & only one year of recession
    data that is averaged with two good years of stable profits

TP in Uncertain Economy –
 Plan now – tax planning could be in serious jeopardy
 Taxpayers should routinely reexamine their transfer
 pricing arrangements
    On annual basis for certain jurisdictions
    This includes examining comparables
 In economic downturn, comparable companies & tested
 party should be affected in same manner
    Comparables are used to determine transfer prices & should be
    reflective of market conditions
    Need to evaluate if comparables are faring in similar manner as
    tested party – not always in same industry segment

TP in Uncertain Economy – Lessons?
 Consider adjustments & changes to comparables
    Reexamine existing comparable set by using subset of
    comparables in same industry or eliminate those that did not
    experience same relative sales decline
    Conduct new comparable search with companies experiencing
    the same downward sales trends – broader search
        Consider loss-making comparables, if appropriate
    Employ different averaging periods – use only years when
    recession was in effect for comparables or longer averaging
    period e.g., 10 years
    Regression analysis to adjust comparables (correlation
    between sales growth profitability)
    Use of other statistical methods to refine range
    Consider using specific point in interquartile range e.g., low end

TP in Uncertain Economy – Lessons?
 Should reexamine industry analysis
    May allow taxpayer to justify certain results through
    industry analysis
 In third party situation, parties may reassess a
 contract during recession
    More willing to renegotiate to achieve fair result to
    ensure both parties are profitable – maybe even
    share in loss
    Tax authorities often argue a licensee might seek to
    reduce or even eliminate royalty during period of

TP in Uncertain Economy – Lessons?
 Review removal or imposition of mark-ups on
 Consider conversions to avoid risk
    Example 1 - Convert loss-making, full-fledged
    distributor into limited risk distributor
    Example 2 - Convert manufacturers into contract
 If you were considering migrating intangible
 property (IP) to low tax jurisdiction, now would
 be opportune time given values for IP should be

TP in Uncertain Economy – Lessons?
 Royalty rates may be able to be reduced
 due to low profit potential under
 Commensurate with Income principle
 Having robust documentation will be key
    More likely to face challenges to TP
    arrangements in economic downturn
    Especially if there was need to refine or alter
    existing TP arrangements

 Summary – Annus Horribilis
    Increased number of countries with TP
    rules & economic recession will continue
    trend of increased audit activity
    What should multinational company do?
            Assess its current TP position
            Be proactive with regard to tax planning & TP
            Be diligent now more than ever in preparing
            TP documentation

Countries with Effective Documentation
*Country has specific legislation or regulations requiring transfer pricing
documentation or other guidelines strongly suggest transfer pricing documentation
should be in place
Argentina           France              Netherlands         South Korea
Australia           Germany             New Zealand         Spain
Belgium             Hungary             Norway              Sweden
Brazil              India               Peru                Taiwan
Canada              Indonesia           Poland              Thailand
China               Israel              Portugal            Turkey
Colombia            Japan               Romania             United Kingdom
Denmark             Kazakhstan          Russia              United States
Ecuador             Lithuania           Singapore           Uruguay
Estonia             Malaysia            Slovakia            Venezuela
Finland             Mexico              South Africa        Vietnam

 Key Takeaways
    If U.S. Taxpayer has Canadian ULC, large unexpected
    taxes are on the horizon beginning 1-1-2010 if
    distributions are made unless a planning option is
    Be aware of complexities in determining whether
    Subpart F income exists
    Be wary of CFC pledges or guarantees of U.S. parent
    debt as they or U.S. parent pledges of more than 2/3 of
    CFC stock all create Subpart F income

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 Contact Information:
 Will James, Principal

 Matt Campbell, Senior Managing Consultant


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