Wright suggests it’s safe to assume that roughly the same profit-and-tax analysis applies to multinationals in such industries as technology and chemicals. Many, in fact, besides drugmakers have marketing operations in the United States, which under current rules can be reported at cost or at a modest markup (or “charged out” for tax purposes) without challenge by the IRS—as long as the services performed are nonintegral. Not so under the proposed regulations.
Experts say the IRS’s obvious targets are U.S. companies that have set up manufacturing operations in tax havens. Under the new rules, they could get hit with big tax bills based on the profits generated there, if they are deemed to have transferred engineering know-how in the process. In that case, the IRS may require the parent company to report not the cost of the compensation of employees who transferred the engineering know-how plus a markup, but a share of the profit that would reflect the value of a license agreement that a third party would pay for the intangible asset involved, even when the actual terms of the arrangement are contractual.
“The idea,” says John Breen, a senior technical reviewer in the international division of the IRS, “is to bring the rules for transferring intangibles embedded in services into line with those for transferring intangibles in general.”
Foreign jurisdictions see things differently, at least at present. The current IRS rules are similar to those in the 29 other members of the Organization for Economic Cooperation and Development (OECD). And that means that, should the new IRS rules be ratified, one or more of those foreign tax authorities could add insult to injury. If another OECD member disagrees with the IRS interpretation of proper transfer pricing, the parent or subsidiary in that country would still owe tax on the portion of profit subject to tax in the United States—subjecting that amount to double taxation.
The United States and other OECD members agree that double taxation is unfair, but the process for seeking relief can take up to five years even under current regulations. And because of the additional complications of the proposed rules, says Cognizant’s Silvestri, “you’re going to add to that [period] by several years.”
Some experts nonetheless concede that the existing rules governing intercompany services, created in 1968 and amended in 1996, are out of date. In essence, these observers say, the IRS is trying to overcome a legal precedent set by the U.S. Tax Court in 1992 in a case involving Westreco, a U.S. subsidiary of Switzerland-based Nestlé, the chocolate giant. At issue was contract research that Westreco did for Nestlé that the latter reported to the IRS at cost plus a percentage markup. While the tax service argued that the reported markup was too low based on the value of the R&D, the court sided with Nestlé.
Now the IRS worries that such arrangements have only grown more numerous as corporate profits increasingly reflect the value of services rather than products. Even some critics of the new rules acknowledge that some companies have engaged in tax abuse by compensating foreign affiliates for valuable services at a much higher price than is appropriate. One reportedly common abuse is to contract with an R&D affiliate in a high-tax country on a cost-plus basis at the outset of the work, and then to restructure the terms once the R&D is successful to provide a subsidiary in a tax haven with much of the profits.