Transfer Pricing and FIN 48: A Practical Guide

Transfer Pricing and FIN 48
A Practical Approach

Verse Consulting LLC
December 2009

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

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.

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

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.

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%).

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

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.

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.

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).

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

p
Implementation
Disclosure as of
(
(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

p
Implementation
Disclosure as of
(
(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.

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.

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”).

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.

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.

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


• 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.


• 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”).


• 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.


• 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.


• 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.


• 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.


• 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?


• 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.

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.


• 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.


• 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.


• 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.

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.

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

Transfer Pricing and FIN 48: A Practical Guide

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