Transfer Pricing And FIN 48: A Practical Approach

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- Overview of FIN 48.
- Overview of Transfer Pricing.
- Discussion of Transfer Pricing issues in the context of FIN 48.
- Thought leadership, ideas and solutions for companies facing FIN 48 implementation.

Published in: Business, Technology

Transfer Pricing And FIN 48: A Practical Approach

  1. 1. Transfer Pricing and FIN 48 A Practical Approach Verse Consulting LLC December 2009
  2. 2. Table of Contents • FIN 48 Overview Unit of Account Two-Step Process Comprehensive Approach to FIN 48 Compliance FIN 48: U.S. GAAP vs. IFRS • Transfer Pricing Overview Why Transfer Pricing Matters How Transfer Pricing Affects Multinational Enterprises • Transfer Pricing & FIN 48 • Observations & Lessons Learned
  3. 3. FIN 48 Overview • FASB Interpretation No. 48 (“FIN 48”) was issued in June 2006, as a means of improving public companies’ financial reporting by establishing “more likely than not” ( y g y (“MLTN”) as the standard ) for recognizing the benefits of Uncertain Tax Positions (“UTPs”). • FIN 48 removed tax contingencies from the realm of FAS 5 and added new rules to FAS 109. • Ultimately, FIN 48 requires companies to determine the tax benefit likely to be realized on final settlement (including appeals and litigation) with the relevant taxing authority(ies). Note, “tax authority” is not limited to the IRS. FIN 48 is a global issue for multinational enterprises; applies to income taxes only. So, sales & use, property, VAT, etc. are evaluated under SFAS 5 or IAS 37.
  4. 4. FIN 48: Unit of Account • The unit of account (paragraph 5 from FIN 48) Based on the level at which the enterprise prepares and supports the amounts claimed in the tax return Representative of the approach that the enterprise anticipates that the relevant tax authority will take in an examination. • Selection of the unit of account can have a significant impact on the financial results as the MLTN threshold described in FIN 48 is applied at the account level. s app ed t e accou t e e
  5. 5. FIN 48: Two-Step Process • After the unit of account for determining what constitutes an individual tax position has been identified, the tax position must be analyzed under FIN 48’s two-step process. Step 1: Recognition An enterprise must determine whether it is MLTN that a tax position, based on the technical merits, will be sustained upon ultimate resolution in the court of last resort resort. If an enterprise is unable to get to a MLTN level of authority on the technical merits, then a company can take into account widely understood administrative practices for this purpose. The entire tax benefit for a position is not recognized under FIN 48 if the MLTN standard is not met met.
  6. 6. FIN 48: Two-Step Process • If a tax position meets the MLTN recognition threshold the tax threshold, position is evaluated under the second step of the process. Step 2: Measurement For F purposes of this step, the tax position is measured to f thi t th t iti i dt determine the amount of benefit to recognize in the financial statements (i.e., the amount with the highest cumulative probability greater than 50%) 50%).
  7. 7. Comprehensive Approach to FIN 48 Implementation Phase 1 Phase 2 Phase 3 Phase 4 Step 1 p Step 2 p Step 3 p Step 4 p Step 5 p Step 6 p Identify tax Evaluate tax Measure benefit Accrue positions at the Determine Prepare Planning position for interest and appropriate unit classification disclosure recognition to be recognized penalties of account • Assess existingg • Execute a process for p • Analyze and y • Determine • Determine • Determine • Prepare required p q FAS 5 processes identifying highly document Enterprise's policy whether tax accounting disclosures and 404 controls certain and uncertain uncertain tax regarding settlements positions are policies on accrual including tabular roll • Establish project positions by jurisdiction positions with tax authorities permanent or of interest and forward scope and protocols • Determine unit of • Segregate tax • Assess Enterprise’s temporary penalties • Disclose amount • Assemble project account for each positions that tax examination and • Assess whether • Calculate and of unrecognized team and external position meet MLTN settlement policy adjustments will record accrued benefits that would resources • Segregate positions recognition • Prepare cumulative be paid in cash in interest impact effective rate •Determine training between highly certain threshold and probability 12 months • Determine and • Disclose needs and uncertain those that do assessments • Determine record accrued classification and • Review positions not • Reevaluate deferred presentation in the penalties, if amount of interest •Establish criteria for determining identified for • Review tax assets, valuation balance sheet applicable and penalties documentation completeness conclusions allowances, tax return • Prepare • Disclose positions needs • Establish regarding di elections, and other adjusting entries that could change in documentation recognition with decisions impacted by next 12 months •Establish key external steps, timelines, requirements for tax FIN 48 • Disclose open tax positions identified auditors years by jurisdiction responsibilities and communication • Review positions and • Determine protocols expected quarterly reporting documentation with requirements external auditor
  8. 8. Comprehensive Approach to FIN 48 p Implementation An overview of the entire FIN 48 implementation process involves the following f ll i considerations: id ti • Assess the people, the processes and technology needed and available to assist in the project. • Evaluate the Company’s tax filings and work paper documentation for all open years to identify exposure areas. • Assess the need for a subject matter expert in particular tax areas to ensure that pertinent specialty areas are considered in the review (e.g., such as a federal, compensation and benefits, international, transfer pricing, state and local taxation, & R&D credits) to fully assess th validity of t positions t k the lidit f tax iti taken. • Discuss the implementation approach and facilitate communication between management and the Company’s independent auditors, as necessary.
  9. 9. Comprehensive Approach to FIN 48 p Implementation • In assessing various tax p g positions, evaluate the technical g guidance supporting the position and categorize whether an issue is complex, non-complex, or has a high degree of certainty, also considering the materiality of the particular tax position. • Inventory and categorize identified uncertain tax positions. • Evaluate existing documentation and tax analyses. • Close the gap between a tax position and supporting documentation for a position taken. • Summarize the preliminary findings for each material jurisdiction. • Quantify the amount of benefit to be recognized on uncertain tax positions. • Consider the potential risks that could lead to an error in the financial statements and design internal controls to mitigate such risks from occurring. • Create a process to re-evaluate the activity in this area for each reporting period subsequent to adoption adoption.
  10. 10. Comprehensive Approach to FIN 48 Implementation p • Effective dates For public enterprises (as defined in paragraph 289, as amended, of FAS 109) and nonpublic consolidated entities of public enterprises that apply U.S. GAAP, FIN 48 was effective for fiscal years beginning after December 15, 2006. For private companies and non-profit organizations, FIN 48 is effective for fiscal years beginning after Dec. 15, 2008 (that is, 2009 for calendar-year companies).
  11. 11. Comprehensive Approach to FIN 48 p Implementation Interpretation 48 Disclosures Disclosure as to Disclosure as of Date Interim Periods Post- (Paragraph) of Adoption Adoption Ad ti 20. An enterprise shall disclose its policy on Yes (3) Disclose any change in classification of interest and penalties in accordance with classification (4) paragraph 19 of this Interpretation in the footnotes to the financial statements. 21. An enterprise shall disclose the following at the end of each annual reporting period presented: a. A tabular reconciliation of the total amounts of Total amount of Tabular reconciliation not unrecognized tax benefits at the beginning and end of the unrecognized tax benefits required for interim periods period, which shall include at a minimum: as of date of adoption (1). The gross amounts of the increases and N/A Disclose any material decreases in unrecognized tax benefits as a result of tax g changes ( ) g (5) positions taken during the prior period (2). The gross amounts of the increases and N/A Disclose any material decreases in unrecognized tax benefits as a result of tax changes (5) p positions taken during the current p g period
  12. 12. Comprehensive Approach to FIN 48 p Implementation Interpretation 48 Disclosures Disclosure as to Disclosure as of Interim Periods Post- ( (Paragraph) g p ) Date of Adoption Adoption (3). The amounts of decreases in the Disclose any material unrecognized tax benefits relating to settlements with N/A changes (5) taxing authorities (4). (4) Reductions to unrecognized tax benefits Disclose any material N/A as a result of a lapse of the applicable statute of limitations changes (5) b. The total amount of unrecognized tax Yes, amount as of date of Disclose any material benefits that, if recognized, would affect the effective tax adoption changes rate c. The total amounts of interest and penalties Disclose any material Total amount of accrued recognized in the statement of operations and the total changes (5) interest and penalties as amounts of interest and penalties recognized in the of date of adoption statement of financial position d. For positions for which it is reasonably Disclose any material possible that the total amounts of unrecognized tax benefits Yes, amount as of date of changes (6) will significantly increase or decrease within 12 months of adoption the reporting date: Disclose any material (1). The nature of the uncertainty Yes, as of date of adoption changes
  13. 13. Comprehensive Approach to FIN 48 p Implementation Interpretation 48 Disclosures Disclosure as to Disclosure as of Interim Periods Post- ( (Paragraph) g p ) Date of Adoption Adoption (2). The nature of the event that could occur Disclose any material Yes, as of date of adoption in the next 12 months that would cause the change changes (3). An estimate of the range of the Yes, estimate as of date of Disclose any material reasonably possible change or a statement that an adoption changes estimate of the range cannot be made e. A description of tax years that remain Disclose any material Yes, as of date of adoption subject to examination by major tax jurisdictions changes 1 Disclose date of adoption information. For example, disclose information as of January 1, 2007, for calendar year-end filers in all interim financial statements during 2007. The information should not be updated; however, material changes since the date of adoption should be disclosed. 2 This column refers to interim balances or activity during the current and year-to-date interim periods and takes into account the interim period of adoption. For example, March 31, 2007, for calendar year-end filers. 3 If, upon adoption of Interpretation 48, a registrant changes its financial statement classification of interest and penalties, it should disclose that it made a change i accounting principle and di l d h in ti i i l d disclose it new policy f classification of i t its li for l ifi ti f interest and penalties. Fi t d lti Financial statements presented prior t i l t t t t d i to adoption of Interpretation 48 should not be retroactively restated or reclassed to conform to the newly adopted accounting policy. 4 If, after the first quarter of the year of adoption of Interpretation 48, a registrant changes its financial statement classification of interest and penalties, it should provide the disclosures specified by paragraphs 17 and 18 of FASB Statement No. 154, Accounting Changes and Error Corrections, and file a preferability letter (post-adoption). This change in accounting principle would be retrospectively applied to the first interim period in which Interpretation 48 was applied. 5 If material amounts are recognized or derecognized during the quarter, disclosure in management’s discussion and analysis may be required. management s 6 If material amounts are updated during the quarter disclosure in management’s discussion and analysis may be required and critical accounting policies may need to be updated.
  14. 14. FIN 48: U.S. GAAP vs. IFRS IAS 37 requires a one-step approach to recognizing a provision when: 1. An enterprise has a present obligation as a result of a past event, 2. 2 It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and 3. A reliable estimate can be made of the amount of the obligation. NOTE: The term “probable” is defined in IAS 37 as “more likely than not.” If these conditions are not met, no provision is g recognized.
  15. 15. Transfer Pricing Overview • Transfer Pricing (“TP”) refers to the pricing of transactions by and between members of the same organization Example. ABC Company’s corporate headquarters in the Company s U.S. provide accounting, payroll and management services to its subsidiaries in Canada and Mexico. Example. DEF Company manufactures goods in Taiwan. The goods are sold by the Taiwanese manufacturing division to the U.S. sales and marketing division which sells them in North America. • Based on the internationally recognized and accepted “Arm’s Length” Principle Associated enterprises must deal with each other as if they p y were independent, third parties, (i.e., at “arm’s length”).
  16. 16. Why Transfer Pricing Matters • Typically market forces establish prices for goods and services (i.e., invisible hand). • I the case of transactions within a company the In th ft ti ithi th prices are controlled by the organization not market forces. • Fiscal authorities around the world have established rules and enforcement schemes to prevent multinational enterprises from using transfer prices on cross-border transactions to artificially reduce taxable profits in their jurisdiction.
  17. 17. How Transfer Pricing Affects Multinational Enterprises • Transfer pricing determines how profit is split between related parties. Due to different tax rates transfer prices influence the total tax burden of a group of companies. • Transfer pricing effects other regulatory reporting. How goods and services are charged between related parties has implications for the reporting of VAT, customs and other filings. • Transfer pricing is seen by many tax authorities as a way to raise revenue and close budget deficits. Audits and penalties related to transfer pricing are on the rise around the world world.
  18. 18. FIN 48 & Transfer Pricing • What about “Contemporaneous Documentation” already in place for transfer pricing? Generally does not conclude on certainty or on probability of sustaining a given of TP position. Prepared for compliance purposes and may provide penalty protection. • TP is inherently bilateral if not multilateral; consideration of each taxing jurisdictions’ rules and practices is important. • Disregarded entities matter in cross-border transactions. transactions
  19. 19. FIN 48 & Transfer Pricing • Myth “As long as the Taxpayer’s results are within arm’s length range we don’t have to worry about FIN 48.” don t 48. • Reality Consideration needs to be given to where the tested parties result lies relative to the arm’s length range and where arm s management would ultimately settle – within or outside the range.
  20. 20. FIN 48 & Transfer Pricing • Example ForCo, a subsidiary of USCO, charges its related parties for intercompany services rendered. The intercompany service charge is at the lower-end of the arm’s length range. Management may decide based on judgment, administrative practices, relevant law in ForCo, and the relevant facts and circumstances, that the largest amount of cumulative benefit greater than 50% likely of being realized upon ultimate settlement with the tax authorities is at the median of the range. Management may determine that the ultimate amount would be based on another method and/or a different profit-level-indicator (“PLI”).
  21. 21. FIN 48 & Transfer Pricing • Factors relevant to determining ‘Units of Account’ for Transfer Pricing: No bright line rules. UTPs evaluated and measured based on the appropriate UoA for that position. Generally the level of account that management expects to engage the tax authority with regard to a tax position. Need to determine level of disaggregation for intercompany results or transactions. lt t ti Relevant considerations include facts & circumstances around each intercompany arrangement. Factors influencing UoA determination include: Treatment and disclosure in Taxpayer’s tax returns; Relevant Tax authorities’ approach to examining the position; and significance and materiality of the position to management.
  22. 22. FIN 48 & Transfer Pricing • UoA Could consist of a particular intercompany transaction (e.g., management fees). • Alternatively, UoA could be based on overall results of that entity (e.g., Sales and Service organization) if management expects that they would effectively settle with a tax authority on that basis. • Generally, UoA will be determined on separate jurisdictional bases and on a gross basis (e g before Competent Authority adjustments) (e.g., adjustments). Depending upon the nature of the UTP, transactions or results could be combined into one unit. Example: Management determines that the IRS is likely to review the entire cost base used to charge out management fees to foreign operations, that cost-base could form the basis for one UoA.
  23. 23. FIN 48 & Transfer Pricing • Probability Tables required for UTPs associated with TP matters? Where more than one settlement position use of probability tables may be helpful in determining the largest amount of tax benefit cumulatively greater than 50% likely of being sustained on ultimate settlement with a tax authority. Where management have identified alternative settlement positions for a UTP, they will have to determine individual probabilities for those settlement positions and probability tables will generally be helpful.
  24. 24. FIN 48 & Transfer Pricing • Assignment of Probabilities Key Dependencies include: 1) Facts & Circumstances; 2) Management s Management’s knowledge and experience regarding tax authorities’ position on a transaction; and 3) Experience and knowledge of industry peers regarding settlement strategies and their related experience. With respect to TP, most companies take into account the foregoing qualitative aspects of a given outcome and assign varying probabilities to those outcomes based on the foregoing factors. Or, they call a Vegas bookie and ask for assistance.
  25. 25. FIN 48 & Transfer Pricing • How does Competent Authority (“CA”) impact UTPs? Adds complexity to an already complex subject area. Under FIN 48 offsetting positions must be separately disclosed. In assessing whether a CA adjustment should be taken into account, account management needs to: Consider the UoA; Which CAs are involved – they are not the same; What is the likelihood management actually would pursue CA resolution; What is management’s historic track record with regard to pursuing CA? Do the benefits of CA justify the cost?
  26. 26. FIN 48 & Transfer Pricing • What documentation is necessary to support an entity’s analysis of its Transfer Pricing related UTPs? Ultimately depends on many factors including: 1) Nature of the UTPs; 2) Complexity of the matters involved and the materiality of those matters; and 3) Management consultation with external auditors to determine what level of documentation will be required. Transfer pricing is inherently uncertain. It is the exception for transfer pricing documentation to be accepted on examination. Taxpayers should expect that the ultimate amount paid to settle may well differ from the arm’s length range in the documentation. Losses are not necessarily a taxpayer’s f i d ’ friend.
  27. 27. Observations & Lessons Learned • Client’s need to start early to prepare FIN 48 documentation for their external auditors. Management can look at this process as an opportunity to find out what’s really going on overseas. • Materiality is a consideration, but an analysis is still required; if a company is doing business internationally management needs to accept the increased risk and mitigate it accordingly. • Many material weaknesses and significant deficiencies came about due to SOX and FIN 48 for public companies. • Where there’s smoke there’s fire: People, property and sales create business risk and uncertainty for tax p p y purposes. Careful evaluation of “Permanent Establishment” (“PE”) risk and its attendant consequences is a Critical Success Factor. PE is a treaty-based construct and varies county-by-country. Also, no treaty means no PE protection; default to domestic law – it’s a rhetorical question now it s now.
  28. 28. Observations & Lessons Learned • Careful assessment of tax return reporting and positions taken is critical: State tax nexus; Evaluation/Tolling of SOL running – watch IRC Section 6501(c)(8) in this regard – penalties are assessable and IRS is required to assess those on exam. FIN 48 only applies to income taxes, but SFAS 5 applies to everything else. Consider other liabilities especially in non-filing situations bot do est ca y a d te at o a y both domestically and internationally as failure to file a ue e typically tolls SOLs.
  29. 29. Observations & Lessons Learned • Things to consider Payroll taxes – Employer and employee portion VAT and Customs duties – Lower threshold than PE to be triggered internationally and are gross-basis taxes/duties Foreign Corrupt practices act (“FCPA”) – Watch especially “independent agent” commission rates and check against the agreement and the published guidance regarding normative rates. Supply Chain – If vendor qualification for payments to non-U.S. payees is “loosey-goosey” significant risk of defalcation and failure to withhold on U S source FDAP payments – make sure U.S. companies are filing Form 1042/1042-S – IRS is piloting a matching program. FBARs – Be sure the U.S. entity has filed these for the previous 6 y p years and if not, get them filed ASAP.
  30. 30. Observations & Lessons Learned • Disregarded entities are not a panacea and they do matter from a FIN 48 point of view – each jurisdiction stands on its own. • Deconsolidating the financial statement is required for FIN 48 purposes – need to apply concepts/principles from APB 28 and FIN 18. • Carefully review Form 5471/5472 information (Schedule M) and align with transfer pricing documentation domestically and internationally to ensure consistency of both amounts and types of transactions reported. • FIN 48 can be management’s friend or foe ► It’s all in the planning and management’s attitude. ► If it’s too hard to deal with don’t go international it s don t international.
  31. 31. The Fine Print The information contained in this presentation is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Verse Consulting. Further, this information is not intended to constitute tax advice which may be relied upon to avoid penalties under any federal, state, local or other tax statutes or regulations, and do not resolve any tax issues in your favor. This material may not be applicable or suitable for the viewer’s specific circumstances or needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors. While all reasonable attempts have been made to ensure that the information contained herein is accurate, neither Verse Consulting nor any of its affiliated firms accepts any responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies upon it.
  32. 32. About Us Based in Houston, Texas, Verse Consulting is an international transaction consultancy that helps multinational enterprises rapidly extract the value of their cross-border transactions while protecting themselves from enterprise risk. Th fi specializes i d i k The firm i li in developing t l i transfer pricing solutions which f i i l ti hi h intrinsically align tax, legal, finance, accounting and IT strategies with operational strategies to ensure transactions are positioned to withstand scrutiny and implemented on time. y p Verse Consulting LLC 1200 Smith Street, Suite 1600 , Houston, Texas 77002 713-353-3964 (main) 713-353-4601 (fax) http://www.verseconsulting.com h // li

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