Transfer pricing Case 18.3

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Transfer pricing Case 18.3

• Priyanka Tyagi
• Shalini Singh
• Madhuri Chakraborty
• Jisha Nambiar
• Jinashree Rajendrakumar

2
Explain Foreign Sales corporations ?

• Foreign sales corporation, a subsidiary of a U.S.
  corporation that is established offshore to
  handle foreign sales.
• The U.S. tax code allows a tax exemption for
  exports generated by a FSC.
• An estimated 3,600 companies, including Boeing,
  Microsoft and General Motors, have set up such
  subsidiaries in tax havens such as the U.S.
  Virgin Islands
• FSCs can be formed by manufacturers, export
  intermediaries, or groups of exporters.
• FSC can function as principal, buying and selling
  for its own account, or as a commission agent.

3
Formation Requirements

• The entity must be incorporated and have its main
  office in the U.S. Virgin Islands, American
  Samoa, Guam, the Commonwealth of the Northern
  Mariana Islands, or a qualified foreign country
• It must have at least one director who is not a
  U.S. Resident.
• It should not have more than 25 shareholders.
• It should not have any preferred stock.
• The FSC also cannot be a member of a group which
  includes a Domestic International Sales
  Corporation.
• The foreign corporation must make an election to
  be taxed as an FSC.
• Ref
• 1. http//www.lectlaw.com/files/buo05.htm
• 2. http//library.lp.findlaw.com/articles/file/003
  37/005239/title/Subject/topic/Taxation--20Federal
  _Income20Taxation-20Income20Taxable/filename/ta
  xation--federal_2_5806

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Nature of the benefits to U.S exporters

• Income tax benefits under the discontinued
  Domestic International Sales Corporations (DISC)
  rules have been reincarnated, with greater
  benefits, under the Foreign Sales Corporations
  (FSC) 1
• FSC rules are in Internal Revenue Code sections
  921 through 927 and the corresponding
  regulations.
• FSC helps to shift what would otherwise be a
  taxable export profit to a distributing FSC where
  only a portion of the profit is taxed.
• The US exporters tax rate on overall profit
  reduces since the FSC is closely held by the
  exporter as shareholder.
• US exporter can reduce federal income tax on
  export-related income
• The tax exemption can be up to 15 on gross
  income from exporting. At 35 corporation tax
  rate companies can keep 5.25 more of their
  revenue. 2

• References
• Vocovec, Mayotte Singer (1999) Foreign Sales
  Corporations. Website http//library.lp.findlaw.c
  om/articles/file/00337/005239/title/Subject/topic/
  Taxation--20Federal_Income20Taxation-20Income2
  0Taxable/filename/taxation--federal_2_5806
• http//www.lawandtax-news.com/html/us/juslatcorp.h
  tml
•  

5
Conditions for exempt income of U.S exporters

• There are 2 economic process requirements to earn
  income exemption from tax for any export
  transaction 1
• a transaction is any sale, lease, or furnishing
  of services
• FSC, or its agent, must participate, outside the
  U.S., in any of the following in export
  transactions
• 1) solicitation (other than advertising),
• 2) negotiation,
• 3) contracting
• Specific of the transaction costs must be
  "foreign direct costs," incurred by the FSC for
  activities performed outside the U.S 1
• foreign direct costs incurred by the FSC must
  equal or exceed 50 of the total direct costs of
  the transaction (5 activities) 2
• 1) Advertising and sales promotion
• 2) Processing of customer orders and delivery of
  export property
• 3) Transportation of goods from the time of
  acquisition to delivery
• 4) Final billing and receipt of payment or
• 5) Assumption of credit risk.
• 85 or more of direct costs incurred in each of
  any two of the five activities

• References
• http//www.lectlaw.com/files/buo05.htm
• Vocovec, Mayotte Singer (1999) Foreign Sales
  Corporations. Website http//library.lp.findlaw.c
  om/articles/file/00337/005239/title/Subject/topic/
  Taxation--20Federal_Income20Taxation-20Income2
  0Taxable/filename/taxation--federal_2_5806
•  

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Nature of the benefits to U.S exporters

• The sources and types of income which actually
  comprise a US exporters foreign trade income
  must be one of the 5 types of Foreign Trading
  Gross Receipts (FTGR) 1
• The sale, exchange, or other disposition of
  export property
• The lease or rental of export property for use
  outside the U.S
• Services related to a sale or lease of export
  property
• Engineering or architectural services on projects
  outside the U.S
• Managerial services for an unrelated FSC or DISC
  in support of its foreign trade.
• No other type of gross foreign trade income
  qualifies as FTGR and, accordingly, cannot
  qualify as tax exempt income.

• References
• 1. Vocovec, Mayotte Singer (1999)
  Foreign Sales Corporations. Website
  http//library.lp.findlaw.com/articles/file/00337/
  005239/title/Subject/topic/Taxation--20Federal_In
  come20Taxation-20Income20Taxable/filename/taxat
  ion--federal_2_5806
•  

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Nature of the benefits Methods for calculating
tax exempt income

• Arm's length prices method- assumes the prices
  paid by the FSC for goods from its related U.S.
  supplier true fair market value. 1
• foreign trade income exempt from U.S. taxes under
  the FSC rules is set at 32 for individuals and
  30 for corporations.
• remainder of the FSC's foreign trade income falls
  outside the scope.
• Statutory formula method - offers 2 options for
  allocating foreign trade income between the FSC
  and the U.S supplier. 1
• 1. Based on FSC's gross receipts gross
  income rule
• Based on combined taxable income of the FSC and
  the related U.S. supplier combined taxable
  income rule
• foreign trade income 1.83 of the FSC's gross
  receipts from the sale of export property.
  Limited to a maximum of 46 of the combined
  taxable income of the FSC and the U.S. 15/23
  (approx 65 per cent) of the FSC's foreign trade
  income is exempt from US tax. Thus, exemption is
  up to 30 per cent (46 x 15/23) of the total
  combined taxable income or 1.2 of gross receipt
• Foreign trade income 23 of the combined net
  taxable income of the FSC related U.S. supplier
  from the sale of export property 15/23 (approx
  65 per cent) of the FSC's foreign trade income is
  exempt from US tax .ie. 15 ( 15/23 x 23)

• References
• Vocovec, Mayotte Singer (1999) Foreign Sales
  Corporations. Website http//library.lp.findlaw.c
  om/articles/file/00337/005239/title/Subject/topic/
  Taxation--20Federal_Income20Taxation-20Income2
  0Taxable/filename/taxation--federal_2_5806
• http//www.law.georgetown.edu/iiel/cases/US-FSC(pa
  nel).pdf
•  

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• Why have corporations in the European Union
  disputed the existence of these corporations?

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US and EU

• US and EU economically interdependent
• EU one of the top two markets for the US.
• 40 of US investment abroad and 20 of US
  exports goes to the EU
• The EU is source of 50 of foreign investment in
  the US.
• Up to 3 million highly paid jobs in the US are
  due to EU investment.
• http//www.lowtax.net/lowtax/html/offon/usa/usacor
  p.html

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Why EU disputed US FSCs?

• U.S. tax laws not in compliance with WTO rules
• US violates the SCM Agreement
• - a subsidy exists if government revenue that
  is otherwise due is forgone or not collected.
• Illegal subsidies benefits US corporations
• - US corporations kept 5.25 more of their
  revenue
• Fierce competition in key sectors
• Amount of subsidies granted is substantial
• - In 2000, subsidies of 4 billion according to
  the US Budget proposal.
• http//www.mindfully.org/WTO/EU-WTO-Sanctions-US.h
  tm
• http//www.lawandtax-news.com/html/us/juslatcorp.h
  tml

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The story so far

• Nov 2000, FSC replaced by the Extraterritorial
  Income Exclusion (ETI)
• With ETI Act export subsidy scheme still existed
• EU challenged it before the WTO
• Jan 2002, the WTO confirmed that the ETI Act
  constituted prohibited export subsidy
• May 2003, the WTO endorsed the EU for
  counter-tariff of US 4 billion
• The EU, set 1 March 2004 as deadline for the US
  Administration and Congress to repeal ETI.

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The story so far

• May 2003, short-term substitute for the ETI
  legislation introduced
• March 2004, EU imposed a counter-tariff on US
  goods starting at 5
• As of mid-2004, it remains to be seen what bill
  will emerge from the reconciliation process.

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Transfer pricing

• Definition
• The determination of an exchange price when
  different
• business units within a firm exchange products or
  services.
• Alignment with SBU management
• Affects strategic objectives of firm (value chain
  decision)
• Requires coordination among various functions.
• Determination of transfer price is desirable from
  a management perspective and tax purposes.
• Minimize taxes locally and internationally

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Transfer Pricing Methods

• Variable cost sets the transfer price equal to
  the variable cost of the selling unit.
• Full cost sets the transfer price as the
  variable cost plus allocated fixed cost for the
  selling unit.
• Market price Set the transfer price as the
  current price for the selling units product in
  the market.
• Negotiated price involves a negotiation process
  and sometimes arbitration between units to
  determine the transfer price.

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Role of FSC in transfer pricing

• A portion of the income of a foreign sales
  corporation (FSC) is exempt from tax. The
  exemption is available with respect to income
  allocated to the FSC under special transfer
  pricing rules.
• Concerns about FSC avoiding US taxes prompted IRS
  tools to enforce tax assessment and collection
  against foreign companies and to provide greater
  penalties for companies understating U.S. tax
  liabilities. These regulations are Transfer
  Pricing provisions.
• The transfer pricing provisions authorize the IRS
  to reallocate income, expenses and deductions
  amount related organizations, trades or
  businesses in order to prevent the evasion of
  taxes or clearly to reflect the income of any
  such organizations trades or businesses.
• The transfer price is used to allocate foreign
  trading gross receipts from the sale of export
  property or from certain services between the FSC
  and its related supplier

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Role of FSC in transfer pricing

• The transfer prices are based on either of two
  optional administrative pricing rules or the
  arm's-length pricing rule
• Under the administrative pricing rules, transfer
  prices such that the FSC taxable income will not
  exceed the greater of
• (i) 23 percent of the combined taxable income of
  the FSC and its related supplier or
• (ii) 1.83 percent of the gross receipts derived
  from the sale of property by the FSC.
• The arms- length standard sets transfer prices
  to reflect the price independent parties would
  have set
• The difficulty with transfer pricing is
  determining what is an arms length fair fee,
  particularly in the absence of a third party
  willing to perform exactly the same activity.

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Management Accountants responsibility regarding
FSCs

• A company subject to tax in more than one
  jurisdiction compounds management's
  responsibility.
• Tax-planning strategies must be applied to taxes
  in each jurisdiction. Plus, it is entirely
  possible that the strategies will conflict.
• Management Accountant should find a strategic
  balance among these conflicting objectives(E.g.
  Custom charges, currency restrictions,
  expropriation etc)
• Management Accountant should determine the proper
  transfer price, which minimizes taxes locally and
  internationally.
• A task force comprising financial accounting,
  tax, and other management personnel is needed to
  develop its strategies.
• The task force must ensure that the data for
  calculating deferred taxes is gathered
  efficiently.

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Deferral Temporary Differences

• Deferral - The period between the earning of
  income by the subsidiary and the transfer to US
  parent of a dividend is called deferral.
• The difference between taxable income and
  accounting income occurs from 2 sources
• 1. Permanent differences Items of revenue,
  expense, gain or loss that are reported for
  accounting purposes but never enter into the
  computation of taxable income.
• 2. Temporary differences- wherein an item of
  revenue, expense, gain or loss arises in
  determining accounting income in one period and
  for taxable income in another period.

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Contd

• For temporary differences whose reversal periods
  cannot be determined objectively (e.g.,
  warranties, bad debts), procedures for building
  an experience base that will guide the allocation
  of amounts to future periods may be necessary.
• A procedure for monitoring and evaluating
  proposed or enacted changes in each tax
  jurisdiction may be needed as changes in the laws
  have an immediate, direct effect on the deferred
  tax provision in SFAS 96.
• The SEC staff has indicated that, in its view,
  intent or lack of intent should not be allowed to
  justify the management of reported results.
• If the facts were not available when the
  statements were published, retroactive
  restatement would seem inappropriate.

Reference 1. Tax-planning strategies for SFAS
96. (Statement of Financial Accounting Standard)
by McGrath, Neal T - http//www.nysscpa.org/cpajou
rnal/old/07916798.htm
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Questions?