U.S. tax law is unusual in the flexibility it allows for classifying entities. For example, a U.S. limited liability company may be treated for tax purposes as a corporation, as a partnership (if it has two or more owners), or as a mere extension of its owner (e.g., a branch or division, if it has one owner). The same choice is available for many types of non-U.S. legal entities. Where the choice is available, U.S. tax law permits the entity or its owners to select the U.S. tax classification of the entity by filing an election form, and in the absence of an election provides for a default classification. The default classification rules for foreign entities are not the same as the rules for domestic entities. The classification election, the socalled “check-the-box” form, must be filed within 75 days of the desired effective date. The optimal classification depends on a number of factors, including the specifics of the taxpayer’s business, the non-U.S. tax rules applicable to the business, and the owner’s U.S. tax position, among other factors. To avoid unexpected tax results, taxpayers should assess entity classification issues upon entity formation or acquisition.
WHY IS TRANSFER PRICING RELEVANT?
Transfer pricing refers to the pricing of property or services transferred from one unit of a group of related business to another unit. Most transfer pricing issues arise in international transactions. The value placed on items transferred can affect income and other taxes. For example, import duty imposed on transferred goods will be misstated if the goods are not priced properly. Similarly, the income of a business unit will be understated if it pays too much for goods purchased from affiliates, or receives too little for goods sold to affiliates. Rate arbitrage may occur if business units are located in jurisdictions with different tax rates. Because of the potential for considerable erosion of the U.S. tax base, the I.R.S. devotes a significant proportion of its audit effort to transfer pricing. Even if tax is understated because a taxpayer’s transfer prices are found to be incorrect by the I.R.S., regulations provide that a penalty will not be imposed if the taxpayer followed certain procedures when establishing the transfer prices.
TRANSFER PRICING FOR SERVICES RENDERED TO A RELATED PERSON
The I.R.S. recently issued revised regulations for determining what constitutes an arm’s length charge for services provided to a related person. With the increasing importance of services to the U.S. economy, the I.R.S. was concerned the old regulations permitted taxpayers to inadequately compensate related service providers for high value services. The new regulations provide more elaborate rules for pricing high value intercompany services.
The prior regulations included a rule that permitted many back-office services to be charged at cost. As the new regulations took shape, U.S. multinationals were concerned the rules would not adequately provide an easily administered method of demonstrating which services are low value, or back-office, for which a charge based on cost should still be acceptable. As issued, the Temporary Regulations include a “safe harbor” allowing a cost-based charge for certain intercompany services described on a list issued by the IRS, if the taxpayer reasonably concludes, in its business judgment, the service does not, in essence, make an important economic contribution to the taxpayer’s business. The Temporary Regulations are generally effective for taxable years beginning after December 31, 2006, except a one-year delay applies to the new method applicable to low-margin and back-office services.
TOTALIZATION AGREEMENTS
The U.S. maintains agreements with numerous countries relating to the imposition of Social Security and the coordination of benefits from such programs. These are referred to as “totalization agreements.” Employees transferring to other countries and their employers should review any applicable Totalization agreement to assess whether double social security taxation can be mitigated.
FOREIGN BANK ACCOUNT REPORT
Under the Foreign Bank Secrecy Act the U.S. Treasury Department requires U.S. persons who hold a financial interest in, signature authority, or other authority over a foreign bank, securities, or other financial account to annually disclose such interest or authority by filing Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, by June 30, for the prior calendar year. No filing is required if the aggregate value of such accounts does not exceed $10,000 at any time during the calendar year. The filing requirement also applies to employees and officers of U.S. corporations and their subsidiaries, unless (a) the corporation’s equity securities are listed on a national securities exchange, or (b) the corporation has more than 500 shareholders, assets of more than $10,000,000, and the individual does not have a financial interest in the account, or own more than 50% of the shares of the corporation (measured by value).