finacc journal

7/27/2019 Finacc Journal

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Roy Mikhail V. GalvezL2A Finacc

JOURNAL ARTICLE

Post-Transaction Adjustments

Managing global transfer pricing while reducing ripple effects

By: Allan Shapiro, Luis Coronado and Axel NientimpMay 2008Reference: www.journalofaccountancy.com

TRANSFER PRICING ADJUSTMENTS: HOW AND WHEN THEY ARE MADE

If your company is like many multinationals, you set transfer prices at the beginning ofthe year. However, these prices hold true only if all departments meet budgets and all resultsare consistent with projectionsand these stars align infrequently, if ever. The reconciliation of

projections against actual results can drive post transaction pricing adjustments. Changes inthird-party prices also can spark the need for an adjustment.

Another driver new or overlooked transactions that have occurred throughout the year,particularly service related transactions. For example, a company might discover servicesexchanged within a corporate group that haven't been charged and need to be accounted for.China, in particular, presents many challenges with the reporting of service transactions,including: what you can and cannot deduct; value added taxes (VAT); and administrative issuessuch as customs valuation, reporting, and currency exchange.

In the United States and around the world, the requirements for documentation tosupport transfer pricing have become more stringent. Because these documentation rules help

a taxpayer only if prices fall within a certain "arm's length" range, companies increasingly areadjusting their transfer prices to fall within this range.

KEY CONSIDERATIONS

In this area of tax, timing is everything. Post-transaction adjustments can take placeacross the broad continuum of the reporting cycle from before the books have closed to afterthe tax return has been filed.

For U.S. reporting, many companies choose to take advantage of the regulatory andcontractual opportunities during the period before the books have closed, which generally posesthe least amount of caveats and disclosures. During this period, you can increase or decrease

U.S. income and bring it from outside the armslength range to within that range. With a writtencontract, you can even adjust prices within the rangethe only time this is allowed.

The period after the tax return has been filed offers the least degree of latitude. Here youcan only work within penalty regulations to increase U.S. income and bring it from outside toinside the range. Most importantly, because documentation for the additional adjustment is notcontemporaneous, you can still be subject to penalties. Companies making adjustments duringthis phase need to get it right.
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The good news? Once you have a U.S. adjustment, the IRS is required to make acorrelative adjustment to the foreign taxpayer. The company making the post-transactionadjustment only needs to make the change in its U.S. books. Under current IRS interpretations,you will not need to make that adjustment for foreign tax purposes.

Disclosure Requirements. After the books close, disclosure comes into play. During the period

after the books close, but before taxes are filed, you can increase or decrease your U.S.income. However, you will need to disclose this adjustment on your tax return and Schedule M.You may also need to make additional statements under Revenue Procedure 99-32.

What many companies may not realize is that Revenue Procedure 99-32 can work totheir advantage by helping them manage the tax implications of moving cash by permitting themovement or repatriation of cash without further U.S. tax implications. For example, you canavoid paying taxes on money a foreign tax authority considers a dividend or capital contributionbecause the cash was in the wrong place. You can also offset loans or capital contributions bymaking them congruent with the cash coming back to the United States. In addition, you canoffset a dividend being adjusted within the year against the potential transfer pricing adjustment,as long as the dividend is not being used as such for U.S. tax purposes.

Another tactic allowed under Revenue Procedure 99-32 is setting up an interest bearingaccount as of the last day of the year, which can then be settled within 90 days of filing theoriginal amended tax return.

Advance Pricing Agreements (APAs). An APA can help eliminate challenges and thelikelihood of an audit, particularly if you're getting ready to file at year-end and discover asignificant adjustment needs to be made. All you need to do before filing the tax return is notifythe IRS, pay your filing fee, and take approximately 120 days to file your APA request - whichgives you time to thoroughly analyze the transaction and how you plan to seek relief.

An APA reduces surprises by setting pricing (and taxes) at a certain level for an agreed-

upon volume of transactions. Bilateral APAs, coordinated with both the IRS and a foreign taxauthority, can cut back on the surprises from both sides. In certain cases a bilateral APA willallow retroactive adjustments.

Conforming adjustments. When you make adjustments to correct the cash accounts of relatedparties, you will need to reflect that adjustment in accounts receivable and payable beforeclosing the books. You must deal with dividends, capital contributions and Revenue Procedure99-32 relief after closing the books. For example, FASB Interpretation no. 48 (FIN 48) requiresyou to put up cash reserves for potential transfer pricing liabilities. These reserves affectearnings and profits, taxes paid and dividend withholding taxes. Whether you bring the cashback or invoke Revenue Procedure 99-32 as discussed previously, you need to plot anappropriate response, develop a process and understand the consequences.

Customs implications. Post-transaction adjustments also affect customs reporting. Forexample, if prices to a U.S. company increase, their customs value may fall below the transferpricing value. If an import duty has been imposed, this invokes section 1059A regulations,limiting the tax deduction to the customs value. Even in post-transaction adjustments whereduties and section 1059A regulations do not apply, you will need to amend your customsdeclarations if you are reporting a price that is different from the price you reported when theproduct was imported.


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GERMANY AND CHINA: WHAT TO WATCH FOR

Nearly half of the more than 800 respondents in a recent Deloitte Tax Dbriefs webcastsaid they did not conduct post-transaction adjustments because they were unable to adjust theforeign books. In Germany, the sheer amount of compliance work may daunt a U.S. taxpayer,who may discover that IT systems are incapable of efficiently performing the adjustments andlocal tax auditors are inexperienced in transfer pricing. Yet these and other factors should notdeter a company from considering post-transaction adjustments for foreign reporting.

Germany's stricter climate. Even though significant progress has been made incommunicating with German tax authorities, and Germany shares many of the same timingdrivers as the United States - such as the amount and kinds of adjustments that can be made -companies should keep in mind the country's more formal approach to this type of issue. Onekey example is the importance of having a written contract in place in advance. This contractideally includes a calculation process that describes all of the factors used to determine profit orfinal price.

In principle, German tax authorities only allow adjustments with this kind of contract. In

practice, these strict regulatory interpretations often are inconsistent with other areas of Germanlaw, and some areas of German transfer pricing regulations explicitly allow taxpayeradjustments. Within these rules, you may have room to make progress with German taxauthorities on price adjustments, for example, to get inside the range with a proper benchmark.In our experience, German tax authorities are now more likely to accept post-transaction priceadjustments than in the past.

To minimize the consequences of incorrect reporting, you should keep a close eye onthe rules. For example, German tax authorities are very reluctant to accept decreases incustoms value, so theyll try to limit adjustments to upward adjustments. As another example,amendments to the VAT declarations are required within the assessment period in which theadjustment occurs. Finally, because of the amount of compliance work involved, you should

keep up with pricing adjustments throughout the year.

Chinas challenges. In China, post-transaction pricing adjustments have increased largelybecause of how many U.S. taxpayers are setting up for business, using supply chain structuresthat provide contract manufacturers or limited-risk distributors a profit under a transfer pricingmethodology. The companies then make adjustments throughout the year to deliver thesereturns.

However, these adjustments are often easier in theory than in execution. Changing rulesand regulations pose challenges. For example, captive contract manufacturers are nowprohibited from making losses in China. Timing is also not on the U.S. taxpayer's side. Althoughprospective adjustments can be done within specific requirements, retroactive and downward

adjustments are practically impossible to do once the books are closed and the returns filed.

When dealing with service transactions, companies should be prepared for:

A potential business tax of 5%; the inability to deduct management fees.

Special regulations for Chinese holding companies rendering services that benefit

subsidiaries.


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You should be familiar with VAT regulations, particularly due to recent modificationsaffecting refunds and the lack of a 100% relief system. In addition, you should be prepared foradministrative issues, including reporting, related to customs valuation, bonded materials andimport and export amounts. Furthermore, you should make advance considerations with China'sState Administration of Foreign Exchange (SAFE), the governing body for foreign exchange, tosecure sufficient foreign currency for remittance.

HOW TO AVOID MAKING WAVES

The proper tools and ongoing diligence can help ease the post-transaction pricingadjustment process for multinational companies. Because timing is so crucial, you should havea process in place to review transfer pricing throughout the year. You also should consider theopportunities provided by APAs, conforming adjustments, and provisions under FIN 48 andRevenue Procedure 99-32 to pursue additional benefits and manage risk.

Although many countries tax regulations reflect the same drivers as the United States,you need to stay attuned to country-specific nuances. The last thing you want to do in theincreasingly stormy transfer pricing environment is rock the boat and draw unnecessary

attention to your company.

SUMMARY

In this article, the authors discuss why post-transaction adjustments may beadvantageous for companies and outline key considerations for U.S. companies that mightbenefit from them. They compare and contrast rules for post-transaction adjustments in theUnited States with those in Germany and Chinacountries that are at the forefront oftransaction-pricing scrutiny outside the United States. And they offer insights into the transferpricing practices of companies that recently participated in a Deloitte Tax LLP Dbriefs webcast.

Year-end adjustments to intercompany transfer pricing can help international companiessave on taxes. Documentation and proper observance of rules in relevant countries, however,are crucial to success, especially as requirements become more exacting.

Reasons for adjustments can include reconciliation of budgets with actual results andpreviously overlooked transactions to bring them into a range that taxing authorities considerarms-length. U.S. companies can avoid tax return disclosures of adjustments to U.S. incomeand other considerations by making adjustments before the year-end closing of their books.

An advance pricing agreement can help prevent challenges and audits , especially whencoordinated with the IRS and a foreign tax authority. Companies may also want to take

advantage of provisions of IRS Revenue Procedure 99-32 for repatriation of cash.

Other key considerations when making post-transaction adjustments include adjustingaccounts related to cash and establishing reserves for potential transfer pricing liabilities, inkeeping with FIN 48, and amending customs declarations on imports.

Two major U.S. trading partners, Germany and China, provide representative illustrations ofthe types of issues companies face with foreign taxing authorities.


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REACTION

More and more, global companies are discovering that year-end adjustments tointercompany transfer pricing can improve the accuracy of their transfer pricing tax reportingand, potentially, help prevent overpaying taxes by millions of dollars. However, increasingscrutiny by tax authorities in the United States and other key countries makes it imperative thatbusinesses make these adjustments in the right way at the right time and with properdocumentation. The ripple effect of adjustments can have serious implications.

I agree about the authors discussion about the advantage of post-transactionadjustment for companies around the world. Year-end adjustments to intercompany transferpricingcan help international companies save on taxes. I also agree that in this area of tax,timing is everything because post-transaction adjustments can take place across the broadcontinuum of the reporting cycle from before the books have closed to after the tax return hasbeen filed. Specifically in U.S. reporting, Ive learned that during the period where manycompanies choose to take advantage of the regulatory and contractual opportunities during theperiod before the books have closed, which generally poses the least amount of caveats anddisclosures, can increase or decrease U.S. income and bring it from outside the armslengthrange to within that range. And what I found out that is so interesting and advantageous is thatunder current IRS interpretations you will not need to make that adjustment for foreign taxpurposes, because the company making the post-transaction adjustment only needs to makethe change in its U.S. books.

I analyzed the four key considerations. I concluded that these considerations; theDisclosure Requirements, Advance Pricing Agreements, Conforming adjustments and theCustoms implications are all vital factors for post-transaction adjustment, because all of themhave their own advantage. The Disclosure Requirements allows you to disclose after the bookshas been closed. You can increase or decrease your U.S. income. In APA, it can help eliminatechallenges and the likelihood of an audit, particularly if you're getting ready to file at year-endand discover a significant adjustment needs to be made. Next is the Conforming Adjustments.The reflection is needed in adjustment in accounts receivable and payable before closing the

books to correct the cash accounts of related parties. Lastly is the Custom Implications,because post-transaction adjustments also affect customs reporting.

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