“There are lots of tax plans being sold by consultants who say, ‘Hey, you’ve got all these intangibles in the U.S., and we can show you a way to move them to a tax haven offshore,’” notes Janice Lucchesi, vice president of tax for the Chicago-based affiliate of Akzo Nobel NV, a Dutch manufacturer of pharmaceuticals, chemicals, and coatings products. Still, she contends that existing rules already enable the IRS to go after such abuses. “In those cases, ‘TaxhavenCo’ didn’t pay a high enough price for transferring the assets offshore, and the IRS should go back and adjust the toll,” says Lucchesi.
And while the outcome of the Westreco case suggests that the IRS may find that difficult to do, the new rules “cast the net too wide,” says Robert Ackerman, national director of transfer-pricing services for Ernst & Young. He notes that the new rules are riddled with ambiguities that could be turned by the IRS into audit weapons with which to pursue additional revenue from companies that aren’t engaged in abuse. For instance, the IRS says even back-office services may not qualify for cost-plus treatment if they are “high value,” “highly integrated,” or “nonroutine”—all terms that Ackerman and other critics say are woefully ill-defined.
The IRS acknowledges that low-margin back-office functions, such as payroll, accounting, and bookkeeping services, may add little if any value beyond their cost savings. But the agency contends that some services—such as those using internally developed software, for example—might have great value and therefore shouldn’t be evaluated on a cost-plus basis, even if the apparent markup is sizable. “A markup of 30 or 40 percent might in theory be the right number for such a high-value service,” says the IRS’s Breen, “but you wouldn’t necessarily be able to tell based on the metric used for calculating it.” For that reason, the new rules say that if a markup exceeds 10 percent, a company may have to value the service based on the subsidiary’s share of the parent’s profits or another, more-appropriate method.
In the end, the IRS sees potential tax avoidance where companies see cost savings. Many companies, for instance, manufacture in China to take advantage of inexpensive labor. But they do so under contract instead of a license not for tax purposes, but because they don’t want to jeopardize their intellectual property in a country notorious for piracy. “We aren’t trying to avoid tax,” says one tax executive at a multinational with Chinese operations. “We’re simply trying to protect our intellectual-property rights.”
Under the proposed IRS regulations, however, companies such as Akzo Nobel would most likely no longer be able to do both.
Ronald Fink is a deputy editor of CFO.
No Ports in This Storm
The new transfer-pricing proposed by the Internal Revenue Service last September would scrap the current safe harbor for services that are “nonintegral” to a company’s business. Instead, multinational companies’ pricing of such services must reflect not just the cost but also an appropriate markup based on what an independent third party would charge for the services. What’s more, if the markup involved in such a “simplified cost-based method” of transfer pricing exceeds 10 percent, the type of service is one of those specifically excluded from transfer pricing according to this method, or is otherwise deemed not to be the “best method” of determining the price, one of five other methods must be employed. Their characterization below is drawn from an article by Thomas M. Zollo, Christopher P. Bowers, and Jeffrey P. Cowan, all with KPMG, entitled “Transfer Pricing for Services: the New Wave Hits,” published this month by CCH Inc.