Evolution Tax & Legal’s Week in Review – August 24, 2020

For this week’s in review, we discuss a recent uptick in American Expats renouncing their citizenship, new California law on foreign companies, how companies affected by COVID should be looking to revamp their transfer pricing, and the IRS’s recent release of guidance on the foreign earned income exclusion for its internal practitioners..

Specifically, we will be covering the following this week—

  • Uptick in US Expats Renouncing their Citizenship
  • California’s Debate on Easing “Water’s Edge” Rules for Foreign Businesses
  • How Foreign Inbound Companies Are Utilizing Transfer Pricing to their Advantage in the Wake of COVID-19
  • IRS Large Business and International Concept Unit Releases Guidance on the Foreign Earned Income Exclusion

Uptick in US Expats Renouncing their Citizenship

An recent IRS press release has  caused quite a stir. The IRS’s released suggested that after “a steep decline” in in American’s renouncing their US citizenship recent years, renunciations in the first half of 2020 increased to 5,816, more than twice as many as gave up their passport in all of 2019.

The media has implied that this drastic increase id due to expats frustration with President Donald Trump supplemented by his administration’s mishandling of Covid-19 and quit.

These renunciation numbers however don’t seem to interpret the data correctly. They’re based on a list of names of renouncers published every quarter by the Internal Revenue Service. What is important to note is that the list lags in time and jumbles data. In reality, most embassies and consulates stopped making renunciation appointments this spring, owing to the pandemic. And the dip in prior years, according to experts, was due to backlogs and underreporting.

Really, renunciations have been rising since 2010, when the Obama administration passed the Foreign Account Tax Compliance Act (FATCA). FATCA has increased the reporting obligations on U.S. expats everywhere, and thus their overall cost of maintaining their US citizenship. Most US expats don’t see the benefit of keeping their US citizenship while having to pay a high cost to keep themselves in compliance with US tax law on an annual basis.

The U.S. is almost unique in the world in taxing based on citizenship rather than residency and doesn’t distinguish between various situations. It treats an American living stateside and stashing money offshore and a American married to a German and teaching elementary school in Berlin exactly the same for tax purposes.

Before 2010 America’s citizen-based taxation didn’t necessarily disrupt the lives of expats like this school teacher. But FATCA required them to make new and redundant disclosures or face the prospect of tens of thousands of dollars in fines or even prison. It also required their foreign banks, brokers and insurers to report on them to the IRS, or face draconian sanctions.

Because of the increased reporting required of American expats, many foreign banks and brokers therefore stopped taking “U.S. persons” or green-card holders as customers. So American expats have increasingly been locked out of retail finance in their host countries..

In desperation, several American expats have been taking their struggle to the courts. For example, A French citizen who is also an “accidental American” because he was born in California, wants to invoke the EU’s data-privacy laws to have FATCA declared illegal in Europe. Additionally, U.S.-British dual citizen is trying to crowdfund a legal odyssey to do something similar in the U.K. Another challenge is underway in Canada.

Americans abroad feel ostracized by their own country. Like their fellow citizens back home, they’re caught up in the tribal clash between Republicans and Democrats. But when it comes to acknowledging the hardship of expats, the Democrats have mostly refused to listen. The GOP has since 2016 called for the abolition of FATCA and citizenship-based taxation in its platform. But the few Republicans who’ve tried to effect change have so far failed.

California’s Debate on Easing “Water’s Edge” Rules for Foreign Businesses

Foreign companies that are part of a unitary corporate group and newly taxable in California would be deemed part of the group’s existing decision to be taxed on a water’s edge basis under a bill on Gov. Gavin Newsom’s (D) desk.

California’s water’s edge election is an alternative to the worldwide combined reporting method that allows taxpayers to exclude affiliated foreign corporations from their tax calculation.

A new bill, AB 3372, was recently passed last week. The bill would allow the unitary corporation to maintain an otherwise valid water’s edge election if a foreign affiliate becomes taxable in California.

The recent bill comes off the back of the Franchise Tax Board’s ask of lawmakers to prevent unintended consequences of 2011 changes to California’s definition of doing business.

A foreign affiliate that wasn’t in a corporation’s seven-year water’s edge election may find that it is newly subject to California tax under the new definition of doing business.

California Governor Newsom hasn’t taken a position on the bill, which first passed the Assembly 76-0 June 8, 2020 and passed the Senate with amendments 39-0 August 28, 2020.

How Foreign Inbound Companies Are Utilizing Transfer Pricing to their Advantage in the Wake of COVID-19

The Covid-19 pandemic has been a catalyst for a severe economic downturn in the United States. Transfer pricing, and pricing agreement required for certain intercompany transactions is particularly vulnerable to these uncertain economic conditions, This is the case as taxpayers need to consider not only how to document and defend their current year transfer pricing positions, but also how to adapt to a new environment which may involve reduced profitability and losses, and manage transfer pricing disputes.

It is during these times that key transfer pricing considerations related to the potential impact of Covid-19 on foreign-based multinational enterprises (MNEs) operating in the U.S. need to be reevaluated to put the companies most affected in a better position moving forward.

HOW TO REPOND TO UNEXPECTED OPERATING CIRCUMSTANCES IN LIGHT OF COVID-19

For many MNEs, the Covid-19 implications entail a significant decrease in demand and potential increase in costs, resulting in unanticipated losses impacting the MNEs’ financial results.

Revisiting Data Use for 2020 Benchmarking and Beyond. Taxpayers are still analyzing the business performance of the first two quarters of 2020. Because of the uncertainties associated with Covid-19, including limited easing of restrictions and continued supply chain disruptions, taxpayers are generally unable to forecast business performance for the rest of the year.

One of the challenges in transfer pricing analysis for 2020 taxpayers is to find evidence regarding the financial performance of independent companies that are as susceptible to Covid-19 as their tested parties. The comparable companies selected for a “normal” year are not usually evaluated for their resilience with respect to rare and sudden demand and supply disruptions like those brought on by Covid-19. This type of approach is consistent with the sort of analysis the IRS likes to see in economic downturns.

Many companies that set their transfer prices for individual products at the start of the year target an arm’s-length result based on expectations at that point in time. If a company wants to take the position to keep their transfer prices unchanged, they likely need to demonstrate to the IRS that, in their industry, similarly situated unrelated parties did not change prices in response to the Covid-19 crisis. This, however, needs to be based on data prevalent in the global market.

Where can transfer pricing practitioners find evidence of financial performance in the face of substantial demand or supply shocks? With Covid-19 resilience likely to be an important criteria for a reliable transfer pricing benchmark for 2020, it may be necessary to revisit original search strategies.

A reasonable starting point might be to evaluate the historical data of potentially comparable companies going back to the Great Recession of 2008 and the earlier recession of 2001, as well as other instances of industry-specific downturns.

Additionally, the current Covid-19 crisis may also provide similar evidence, but data coming after year end for publicly listed companies, and about a year later for privately held companies, may come too late for managing 2020 transfer pricing. Therefore, it may make sense to start with the historical data and build the appropriate screening criteria and analysis methods, and then update that analysis as 2020 financial data becomes available.

Properly Implementing Transfer Pricing Changes. In order to account for the new economic outlook based on new data used for benchmarking, the implementation of these transfer pricing requires a revisiting of intercompany agreements, corporate policy pronouncements, and the taxpayer’s historical course of conduct.

First, taxpayers should identify whether there are any provisions in intercompany agreements or company policies for changing transfer pricing in response to the economic impact of the Covid-19 crisis. If a taxpayer’s current framework allows for transfer pricing changes, the next step would be to incorporate the anticipated changes within that framework.

Once a path forward is identified, the next consideration would be the change itself.  A formal written memorandum of understanding between different affiliates of MNEs, drafted in consultation with the taxpayer’s legal and tax advisors and agreeing to potential changes in transfer pricing policies such as the benchmark range of profitability used for transfer price setting and testing, may assist in managing transfer pricing uncertainties later in the year.

A written memorandum of understanding also helps document that any future changes in transfer pricing policy have been carefully considered and mutually agreed between related parties and may be helpful in the event of renegotiation between or among uncontrolled parties. The timing of the memorandum of understating would also document that the changes were provided for when the exact outcome of the risks associated with Covid-19 were not yet known.

Wrapping Up. Now is the right time for MNEs with the U.S. operations to start planning for potential transfer pricing changes for 2020 and 2021. Given that 2020 is a unique year, the transfer pricing benchmarking for 2020 (and perhaps also 2021) may need to be built specifically to address the significant supply and demand disruptions introduced by Covid-19. Such benchmarking can and should be built in advance using historical data and updated once the 2020 financial data becomes available.

IRS Large Business and International Concept Unit Releases Guidance on the Foreign Earned Income Exclusion

Recently, the IRS’s Large Business and International Concept Unit (LB&I) release internal guidance on who qualifies for the Foreign Earned Income Exclusion (FEIE).

The FEIE provides qualifying US taxpayers an exclusion for certain amounts of income, earned while working and living overseas, from US taxation.

The recent IRS guidance laid out an US taxpayer’s qualification for the FEIE. According to the IRS, to qualify for the exclusion, a taxpayer must (1) have foreign earned income, (2) have a tax home in a foreign country, (3) either be a bona fide resident of a foreign country or physically present in a foreign country or countries for 330 days, and (4) make a valid election.

The IRS pointed out that foreign earned income is income received for services performed in a foreign country during a period in which an individual qualifies for the foreign earned income exclusion.

Finally, the IRS guidance noted that not all overseas locations are “foreign countries”. For example, Antarctica, U.S. territories and insular areas, and certain other locations such as international waters and the air space above them, the IRS cautioned.

See the IRS guidance for yourself.