Talking Expat Taxes #12

Thank you so much, Alex. Um, uh, I'm glad to be on here. Um, my name is Jinkan. Um, I've been doing transfer pricing for a little over 15 years, as Alex mentioned. Um, Alex and I, we connected at Grand Thornton, uh, for the past two years. Uh, I have my own firm where I specialize in providing transfer pricing consulting services, as well as training services, um, which is really applicable to companies that want, uh, some transparency training in order to be able to either do it in-house or it's also applicable to professionals who want to. Learn more about transfer pricing and add that additional service under the same roof for their clients.

I mean, the one unique feature about transfer pricing compared to the rest of the. Fields in taxation is that transfer pricing is purely based on economics. are no, nitty gritty rules that you typically see, um, in the general tax world. Um, rules do not really apply in transfer pricing. Yes, absolutely. Uh, there are separate rules and regulations for transfer pricing purposes, but when you look at those regulations, they are heavily economics oriented. So it's going to be a fun topic to discuss.

sure. Transfer pricing in a nutshell means pricing of intercompany transactions. Um, what does that mean? Uh, uh, like you had mentioned previously, you've been getting a lot of, uh, inquiries from your clients regarding, um, the clients that have, set up in multiple tax jurisdictions, let's say. example, you have US and China, a US parent company with, a related party Chinese manufacturer. Obviously whatever China is manufacturing is going to be sold to the us. Now, what is the price at which the Chinese entities going to sell the products to the US is referred to as transfer pricing?

what I do is I help clients identify that optimal price, that optimal transfer price. At which the Chinese manufacturer would sell the product to the us. And that's what what transfer pricing essentially means. Now, I would also like to add that transfer pricing is not necessarily only applied to cross border transactions, it also applicable to intrastate within the US domestic transactions as well,

exactly. Because the different states have different tax rates, there is always this arbitrage to benefit from

do not have state income taxes whatsoever. So it is also important to note that transfer pricing, while the intent of transfer pricing was to account for cross-border transactions. But over a period of time, it has also been applied to the domestic trans, the domestic transactions as well.

when you are set up in different states and you know, if the tax rates between both the states are the same, then it's not as much of an issue be. Or rather, I must say, if the states where you're transacting in are unitary states. Where you are filing a combined, tax return for

of an issue. However, if it is not, if it is not combined states, it is just unitary states, and especially the states that do not have any state income taxes, then transfer pricing is a big deal, for

So. Ris, um, I was gonna get to the arm's length standard, shortly, but thank you for bringing that up Alex. Pricing of transaction is one thing and what strategy you are using, what fundamental you are using to price that transaction is another right most people. Performing transactions between related parties is. Nothing different from moving money from right pocket to left pocket, right? It's all staying under one consolidated entity. However, if you think about it a bit differently from a tax recipient standpoint, is two different tax jurisdictions, so two different tax collectors, has the right to tax, what plays an even more important role? So in case of Puerto Rico and the US. I don't know off the top of my head what the tax rates are in Puerto Rico, but, you know, it sounds like, based on what you just mentioned, sounds like the tax rates in Puerto Rico are much, much, much lower than what it is in the us

yeah. So now the, the IRS wants to tax you on the fair income that should belong to the us Poor Rico wants to tax on the fair income that belongs to poor Rico. in your situation, you cannot just blindly say, oh, why don't I pay 50% commission and move all of my profits to Puerto Rico?

Yeah. While, while Puerto Rico authorities are going to be happy about it, they're gonna get more income to tax. But the IRS isn't going to be happy about it.

Right. So, IRS is gonna want to know, what policy are you using for this intercompany transaction in the intercompany payment that you're making?

whether it is arm's length or not. So arm's length is the, one defining fundamental, not just the US but globally, that all the tax jurisdictions globally follow. If you have any intercompany transactions, need to be priced on an arm's length basis. What does that mean? Arm's length basis simply means. How much would you charge for a similar transaction to a third party? So, AMS length essentially means what is the market driven price, associated with a particular transaction in question here.

back.

taxpayers want to do, right? They just pick a number. What are the risks associated with it? They don't even think about it, and

it kind of becomes a crucial matter to think about more.

Yeah, so many different things going on here. I'll tell you, through my experiences. When I'm talking to a CFO of a company, the CFO is like, why do I even care about transfer pricing? It's right pocket versus left pocket, right? And that's when you have to explain to the CFO or anyone who's asking this question that it's not really about the company, but it's about the taxation authority where all of your companies are operating in and what is the fair share of taxes that they want to be collecting from the. Income associated with that particular country. Right.

your example, you have Puerto Rico and the us. Now obviously in the US we have , a global taxation system, but you're not being taxed until the money is remitted back into the us Right?

of Puerto Rico and the us,

one of the most common scenarios you'll come across. Not just India, I would say pretty much

Uh, cheaper labor, relatively cheaper labor countries where you wanna set up your, back office support functions and whatnot. Obviously for, you know, availing the cheaper labor and, increasing your bottom line.

So in those situations, you have to ensure that transactions are being conducted, let's say India, right in, in your example that you just gave, once upon a time, India had a tax holiday on foreign companies setting up, operations in India. And because of those tax holidays, the US company would think, why do I not, you know, through transfer pricing, why do I not, send all of my profits to India?

I'm not being taxed in the US because on in, on the US' books, you are going to be showing a zero taxable income. And on India's books you'll be showing all of the profits. Right?

correct. So now that, obviously this is a very made up scenario. Uh, so in this situation,

what the companies would want to do. And the CO would be like, Hey, why do I care? It's a right pocket, left pocket. I can, you know, this is just benefiting me from tax standpoint. And the answer to that question, the biggest red flag , is your pricing of that intercompany transaction.

Is it arm's length? Is that the amount of money you being in the US paid to a third party? a similar third party, uh, let's say a similar, company, which is a third party in India. You were to avail outsourcing services from them, would you have paid $200,000 to them? The answer to that question more like, uh, most likely is going to be no.

Right.

to be some amount, whatever that amount is, but it's not going to be moving all of your profit through transfer pricing from the US to India. Right.

that's where, um, you know, I have to educate, the stakeholders of the company. That it's not what you want to do, it's about what the tax authorities, it's, it's about what the tax authorities can charge you on, right?

Can tax you on. And that tax needs to be, on the basis of a fair income that, that, that you need to earn through transfer pricing purposes.

number one. Which is, obviously, you know, it creates a lot of risk. Now assume for a minute,, the tax holiday situation that I just explained, forget about tax holiday.

Let's say in India you have a tax rate of 30% you have a tax rate of 30%. Okay? Now, in that situation, the CFO comes in and says, why do I care about transfer pricing? I'm not trying to. I'm not trying to cheat here. I'm not trying to avail a lower tax rate in any country by moving profit from one country to another.

Right? So why do I even care about transfer pricing that situation, especially if there is no tax arbitrage to avail from whatsoever.

those situations, what happens is, let's say you moved all of your profit to India, right? You're paying 30% tax. In India,

comes in and says, wait a minute, you have not applied transfer pricing on an AMS length manner. You should have. Paid India half of what you paid, right? So I am going to make an assessment on your US tax return as if you earned that income in the US and therefore I'm going to assess your additional taxes on that, right?

one hand already paid 30% tax in India on a hundred percent of the income that you shifted to India.

and we don't wanna say that, you know, you meshed up your transfer pricing or whatever. For whatever reason, you didn't care. Uh, you didn't look into it, you didn't care about it. Just so happened that a hundred percent of your profit moved to India. You paid taxes in India. In the US you showed zero taxable income.

IRS came in, audited you and said, I'm gonna assess taxes on you because your transfer pricing was not uns length. The iris is going to assess taxes on the income that it thinks. It feels is arm's length for us purposes.

You've already paid the taxes in India, right? And now you are going to pay extra taxes in the US based on whatever assessment the IRIS is doing

which is going to be next to impossible because.

Uh, it's a very, very, very lengthy process. You will have to involve experts, consultants,

pay significant amount of money to all of those people, and there is no guarantee that you are going to get the refund, right. The Indian Taxation Authority is going to be like. Hey, uh, you know what? You've paid me already. There's nothing we can do about it in the future. You, correct your transfer pricing calling right now.

are treaties between many countries to avoid double taxation. Um, but regardless of the treaties, you still have to follow the process

knows whether the process is going to work or not, right?

not only is it a lengthy process, it's a very costly process to undertake as well, and. Companies are in the business of doing business. They're not in the business of figuring out the taxation stuff, getting the refund here, getting the refund there.

um, you know, it's their consultants. They are tax experts who take care of all those things, right? So it becomes very important to consider those points as well. So

Yeah. Abso, I mean,

Comparable analysis. Yes. Uh, I mean, so you, said it correctly. Uh, there are many different components involved here. The first and foremost is conducting what we refer to as what we transfer pricing experts refer to as functional analysis. Functional analysis is a complete, it's a, it's a complete. Understanding of the company's business, right?

business are you in? What, what kind of functions you are performing? Where are those functions being performed, so on and so forth. So in this example, India and the us, you figure out, okay, what is the business that you are in? What are the employees working in the us? How they are structured. What are the employees working in India, how they are structured? What is it that India is doing? So in this particular situation, you identify that India is simply providing you with back office support services, let's say call center services, right? They are inbound, outbound, they're just making calls to random customers. They are answering calls, that are coming inbound, so on and so forth. So in that, that situation, after conducting a thorough function analysis, you have a better understanding of the company. now you are determining what is the intercompany transaction that is being undertaken. The intercompany transaction is India, providing back office support services. Once you've identified the intercompany transaction, the next step is to identify the transfer pricing methodology that you want to use to derive the arm's length transfer price for this particular transaction.

There are many, there are quite a few transfer pricing methods that are available to choose from.

Each method has its own merits and demerits and you know,

your findings and based on the method that you've chosen. There may be a requirement of performing comparable analysis. That's where you are identifying third party comparable companies that are performing functions similar to what your India back office service provider is performing. And then identifying what is the profitability that these third party similar companies, comparable companies, are earning. And you would, you know, typically target, a range, a point within the range that you arrive at. And then the. The typical range that we rely on is referred to as Interquartile Range, and there are specialized databases available in the market

on in order to do this level of research,

all without documentation, none of

Exactly. Exactly.

agree. So documentation becomes extremely critical in supporting the transfer pricing arrangement that you are doing.

With the, in the absence of documentation, you have absolutely nothing, no power whatsoever to be able to negotiate with the IRS. Now, it is quite possible that despite having the documentation, let's say, whoever did the transfer pricing, whatever they were thinking, that transfer pricing was done completely incorrect. Right, but there is documentation in place. The fact that there is documentation in place, the fact that the taxpayer made a good faith effort to look into their transfer pricing arrangement itself gives you some negotiation power, right? Without documentation, you do not get anything whatsoever,

6662. Yeah,

Yeah. I mean, so there are two components here. Um, now obviously you have to consider what is the size of the company you're talking about,

and whether you have to do the cost benefit analysis also, right?

The two components in is one, you are establishing ris, which is called your planning documentation, right?

is your compliance documentation where you are justifying the arrangement that you're using documentation is purely, at least in the us, purely for the purposes of penalty protection. What does that mean? You did your planning study, you have a planning documentation, alright. the planning documentation, let's say in this particular example, India providing, back office support services to the us you're charging a cost plus markup of 10%. You have a planning documentation in place. The IRS comes in, you have a planning documentation and you're applying that transfer pricing arrangement, right?

Three years down the line, the I Iris comes in and says, okay, show me your, transfer pricing, study. Right? They see the transfer pricing study and they say. Oh, by the way, it should not have been 10%. It should have been 5%, means you paid 5% extra markup to India. So then at that point of time, the IRS will say, let me make an adjustment of 5% income in the US and then they will tax you on that 5% income in the us.

Right?

only will you have to pay additional taxes, but you will also have to pay penalties and interest. you do not have that compliance documentation, is

under 66 62 section,

so compliance documentation will help you to protect from penalties. Now, for a smaller company, does it make sense to spend 5,000, $10,000 on compliance documentation every single year, especially if your transactions are worth only $50,000? The answer to that question is probably not right. Absolutely not. So that's when you have to ensure that the planning documentation that you have in place is so robust in nature that it will help you justify the pricing for next 3, 4, 5 years.

a defense exactly.

A better answer end of the day, you got to look into two aspects. One is tax optimization. If through transfer pricing you are able to optimize your taxes. And by optimization I mean obviously minimization of taxes, to get your better, effective tax rates. the second thing is risk mitigation. in the prior example, we saw the double taxation, right?

In order to, mitigate the risk of, potentially being hit by double taxation. You have to ensure that not only your transparency is done ac accurately, but you have all the appropriate documentation and justification for that. then whether or not you want to do the compliance documentation is something that you can figure out over a period of time, right?

and you brought up a very good example, Alex, where, you and I, worked for this client. We went in, they had a cost plus in place. Not only was it an incorrect methodology to use to begin with, but even with the incorrect methodology, they had used the wrong cost base. They had used the wrong mockups and whatnot,

in, we did the whole functional analysis. As you recall. We discussed every single thing about the company, who's performing what, what are the functions being performed, in which country and whatnot. And then we arrived at a methodology that was entirely different from the costless methodology. And the answer that we came up with was not only, justifiable, but it gave them a huge tax benefit. obviously, you know, you're mitigating risk automatically by having this and documentation, right? So that would be a classic example. And in this company we are talking about, uh, had revenues of about $2 million, right? So not significant amount of profits, for this company, but. I mean, hey, whatever profits that you have, you got to ensure that you are, paying only the taxes that you should be paying. You shouldn't be paying more taxes.

Exactly.

you don't,

a situation where, the auditor comes in, Hey, how did you choose this? I don't know. I stuck my finger in the air and I felt like using this thing or, my, consultant told me to use this. Okay. If your consultant told you to use this particular methodology,

the proof for that?

Show me the documentation.

have it at that point of time, you are already fighting a lost battle, right? You are just going to be hit with whatever taxes, penalties, interest that the tax authority wants to do, and the penalties. Could really creep up. In the US it's 20% or 40% of the assessed taxes, but globally it can potentially go as high as 400% of additional taxes assessed.

So

play your cards really, really, really right.

Exactly.

other point I would also add to what you said is you are not getting small and medium, business. Right. getting audited every single year. Audit needs to happen once,

For the IRS or any taxation authority to come in and challenge your transparency arrangement. If you don't have anything, then you're screwed to begin with. But if you have something, then it gives you some justification, you know, some leverage to negotiate on. But once you get audited, let's say 10 years down the line, you're getting audited. And the IRS for whatever reason, finds out that there is, all they have to do is say there is a fraud here.

You moved all of your income to a low taxing jurisdiction, or whatever the case may be. Right? In that situation, the statute of limitation go out of window. They are applying the transfer pricing adjustment to the beginning of time,

all they have to do, I mean, there could be a, there could be a chance, right?

Where, you know, a

company, they're never going to catch me. Let me just move all of my in, in your example of Puerto Rico and the US let me just, charge a 50% commission. That way all of my US profits are going, sitting in Puerto Rico.

when you will realize like, maybe eight, nine years, you're not getting caught.

But that one year, year, if you are getting caught. It would be a fraudulent case, and then all of the, the backyards will be open. There won't be any statute of limitation, which in the US we have three years by the way. But in case of fraudulent cases,

going to be any statute of limitation, which means for each of the 10 years, not only will there be additional taxes assessed, but there will be significant amount of penalties and interest. For all the tax payments that you should have made but you never made,

amount could essentially be equivalent of the entire value of your business.

don't have business. Essentially the next

bankrupt.

discuss. Discuss with your advisors, you

with your advisors. You do not necessarily have to perform a study in every single case, having some kind of handholding your advisors, some kind of, support justification from your advisors to be able to be in a better negotiation. Phase with the, with the taxation authority, very similar to what we did with the client that you and I are talking about, Alex, right?

They didn't want to pay, tens of thousands of dollars to, to prepare a detailed transfer pricing study. We came up with a very simpler approach, but even with the simpler approach, we were able to justify the transfer pricing arrangement as well as give them a better tax answer,

they can reach out to you directly, Alex, they can reach out to me, they can email me at, Jinkan dot which is a pretty long email. You can just visit my website, cap consulting. You'll see, you can just reach out to me from there. But the best way to reach out would be through Alex as well.

Alex and I, we work very closely. But before we close out, one, one point I would like to raise, and I cannot stress it enough, at least have a discussion. know many small and medium sized companies, they don't wanna spend money, especially on compliances. Do not consider transfer

pricing as a compliance.

it is an extremely efficient planning tool available to the small and medium sized businesses, all types of business businesses, really,

where you can really optimize your tax position and minimize risks drastically.

at least have a discussion. Do not worry about preparing a study right away. At least have a discussion to see what kind of risks are associated for not doing it. And what kind of benefits you will get to do it.

We should talk about tariff at some point of time.

a lot, Alex, for inviting me.

Thanks.