United States

New transfer pricing development impacts US flow through entities

TAX ALERT  | 

In a recent Chief Counsel Advice (CCA 201349015), the IRS asserted that it may use transfer pricing principles to disallow foreign tax credits for foreign taxes paid by branches or subsidiaries of U.S. taxpayers. In particular, the CCA states that it may use transfer pricing rules to adjust the income tax base of a foreign branch or subsidiary to prevent a taxpayer from allocating "too much" income to foreign branch or subsidiary and thereby incurring additional foreign tax that the taxpayer claims as a foreign tax credit on its U.S. returns. This CCA illustrates yet another reason why U.S. taxpayers must use appropriate transfer pricing to price transactions with both foreign subsidiaries and foreign branches or disregarded entities.

The CCA states that "U.S. transfer pricing principles may be relevant in determining whether non-arm's length transfer prices result in noncompulsory payments of foreign tax . . ." Under Treasury regulations, a foreign tax is a non-compulsory payment (and therefore not a creditable foreign tax) to the extent that the amount paid exceeds the amount of foreign tax determined in accordance with a reasonable interpretation of foreign tax law and applicable tax treaties. The CCA clearly shows that it is now the view of the Treasury and the IRS that such a taxpayer must apply transfer pricing concepts to determine whether all or a portion of its foreign tax constitutes a non-compulsory payment.

U.S. taxpayers operating as flow-through entities, such as S corporations, partnerships and limited liability companies, are especially at risk of an IRS challenge based on this development. Many of these taxpayers operate outside the U.S. through branches, disregarded entities and partnerships to optimize foreign tax credits of individual owners. Some of these taxpayers have managed transfer pricing risk by setting intercompany prices to overstate foreign profits. By overstating foreign profits, such taxpayers reduce the risk of a foreign transfer pricing challenge, avoid the cost of a transfer pricing study, and recoup overpaid foreign taxes via the foreign tax credit. Because foreign profits are currently taxable in the United States anyway, this presents no U.S. tax risk as long as taxpayers may claim a credit for all foreign tax. This same technique may also minimize importation tariffs in the foreign jurisdiction by understating dutiable value.

The CCA makes clear that the IRS will apply transfer pricing standards to foreign subsidiaries (CFCs) and their foreign branches and subsidiaries and will challenge a taxpayer's foreign credit claim for taxes paid through its foreign subsidiaries.

CCA 201349015 may signal the reversal of the IRS' long-standing policy of not challenging foreign tax credits based on transfer pricing principles. Taxpayers operating offshore through branches, disregarded entities and partnerships are well-advised to review their transfer pricing methods and practices and modify them if they do not conform to the arm's length standard. Although U.S. transfer pricing regulations and most foreign transfer pricing rules are based on the arm's length standard and Organization for Economic Cooperation and Development (OECD) guidelines, variations in interpretation and practice exist among many countries. Accordingly, taxpayers should engage the services of qualified transfer pricing specialists who are familiar with both U.S. and foreign transfer pricing rules and practice.

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This publication represents the views of the author(s), and does not necessarily represent the views of RSM LLP.  This publication does not constitute professional advice.

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