Tariffs are reshaping global supply chains, transfer pricing and IP valuations — creating new challenges for businesses. This episode of “GILTI Conscience” features guests Brooks Allen and Jonathan Welbel, Skadden national security and tax partners, respectively, and Rodrigo Fernandez, principal of transfer pricing at Ryan, who break down the legal, economic and strategic impacts of the current tariff surge. Tune in to hear how companies are navigating uncertainty and planning for the future.
Episode Summary
The stakes are high. That’s how Skadden national security partner Brooks Allen sets the stage for the U.S. Supreme Court case surrounding President Trump’s tariff policy. And that case is just one dynamic in today’s “revolutionary” tariff environment. Brooks joins Skadden tax partner Jonathan Welbel and Ryan principal Rodrigo Fernandez to break down key issues affecting tariffs and transfer pricing. Hosts David Farhat and Stefane Victor moderate the discussion, which includes a look at scenario modeling and analysis, intercompany agreements and the need for coordinated tax and customs planning in today's trade landscape.
Key Points
- Revolutionary Change: Brooks explains that the tariff landscape has shifted in the last nine months, from a situation where the United States had an average tariff rate around 2.4% to well over 10% applied tariffs.
- Valuing IP Rights: Tariffs can significantly impact IP valuations. Rodrigo emphasizes that fluctuations in IP valuation due to tariffs can create significant uncertainty and potential disputes.
- Intercompany Agreements: These will become critical because they govern consequences on both the tax side and the customs side. “For whatever planning is being put in place from a customs perspective, one of the key components is getting the legal agreements in place,” Jonathan observes.
Voiceover (00:02):
This is GILTI Conscience: Casual Discussions on Transfer Pricing, Tax Treaties, and Related Topics, a podcast from Skadden that invites thought leaders and industry experts to discuss pressing transfer pricing issues, international tax reform efforts and tax administration trends. We also dig into the innovative approaches companies are using to navigate the international tax environment and address the obligation everyone loves to hate. Now your hosts, Skadden partners, David Farhat and Nate Carden.
Stefane Victor (00:35):
Hello and welcome to another episode of GILTI Conscience, a Skadden podcast. My name is Stefane Victor, joined by host David Farhat. Today we’re missing Nate Carden and Eman Cuyler, but are joined by Skadden partners, Jonathan Welbel in Tax, and Brooks Allen in the national security group.
(00:51):
We’re also joined by a guest, Rodrigo Fernandez. Rodrigo is a principal at Ryan Company specializing in providing transfer pricing, business and intangible property valuation, and other valuation-related projects to clients in a variety of industries.
(01:05):
We’ll be talking about transfer pricing and tariffs. I’ll start with Brooks and Rodrigo to give us a lay of the land as we lead into our discussion. So Brooks, can you give us a bit of a background into what’s been happening with tariffs?
Brooks Allen (01:16):
Absolutely. So I think first of all, it’s helpful to just step back and kind of take stock of where we are and how far we’ve come over the past nine months. It’s really been revolutionary change. We went from a situation in which the US was one of the lowest tariff jurisdictions on the planet. We had an average tariff rate around 2.4% to being well over 10% applied tariffs. So that’s a huge change. We’re kind of awash in tariffs these days. So yeah, you can’t avoid them. It doesn’t matter where you’re importing from, and so that’s a massive change.
(01:51):
And it’s really, it’s not just a change in the economics, but it’s also a change in the philosophy of President Trump relative to Trump 1.0. It’s interesting, he obviously used tariffs back in his first term. He used the most famously against China. We all remember the China trade war. I was actually at the office of the US trade representative. The USTR back then was involved in that and other trade projects. And so yeah, obviously that was an important part of his trade policy. He used them, but in a targeted way and for discrete purposes.
(02:25):
But I think now, his thinking on that has really evolved and he sees tariffs as being kind of a Swiss Army Knife, if you will, of economic policy. So he uses them now for a whole range of objectives. It’s interesting, and in a way, I would say the tariffs, sorry to my tax colleagues here, guys, but I think that for President Trump, they’re more important to him than tax policy. A little controversial statement there so you may take issue. That’s okay.
David Farhat (02:50):
Hurtful, Brooks. Hurtful.
Brooks Allen (02:51):
I know. I’m sorry about that, David. So we know that he loves his tariffs. He’s going to keep at it, folks. He’s not going to give up on his tariffs. Now we know that the Supreme Court, he’s facing a little bit of a roadblock here with the Supreme Court. Supreme Court is going to be hearing oral arguments in November on a case that’s really targeting a huge chunk of his current tariff program, which are the tariffs that are imposed pursuant to these emergency powers, the IEEPA statute. And so all eyes are on the Supreme Court for that, and stakes are high.
(03:22):
But I think he has a number of tools at his disposal, other tools in the toolkit, in his trade arsenal to impose tariffs maybe in a more targeted way. And he’s going to have to be more active, start more investigations using other tools. But I think he’s not going to go down without a fight and he’s going to be active here. So I think we can expect to see tariffs be an important prominent part of his economic policymaking efforts going forward.
(03:48):
Uncertainty has been kind of the name of the game here for us over the past nine months and constant change. Well, it’s been fun for us who like trade, it keeps us on our toes. But I think from a perspective of our clients and from the perspective of companies operating in this environment, it’s made it incredibly challenging because things change so rapidly. And then of course with the Supreme Court litigation, depending on where that comes out, that’s a huge uncertainty element there. So again, uncertainty I think is unfortunately going to continue.
(04:18):
One other piece I’ll flag on this is you’ve got a huge number of sectoral investigations under this statute called Section 232, which are very impactful. So looking at things like semiconductors and their derivatives, which could include a slew of electronics, computers, tons of things. That order has not come down. That could be incredibly impactful for the economy. Pharmaceuticals, aircraft, huge number of products for these investigations. All these things could be popping up over the next several months down the line. Lots of areas that people need to be focused on and thinking about, haven’t gotten as much press as probably they should have. So lots of things to keep an eye on.
(04:56):
So I think from the perspective of companies, all these things are percolating, a lot of uncertainty, planning is tough. So what do I do? Do I try to restructure my supply chains permanently, irrevocably? Do I try to keep it somewhat nimble? And then I have to think about, well, okay, I have these existing structures and these transfer pricing structures that I’ve put in place for tax reasons, and now I have to fold in a much more kind of impactful tariff reality. And how do I marry these two and how do I think about that? And when I’m thinking about restructuring these supply chains, how do I deal with that? And how do I navigate the trade-offs here between tax protection, if you will, tariff minimization?
(05:39):
And so these are hugely important issues and conversations for companies.
David Farhat (05:43):
Yeah, absolutely, Brooks. And again, as tax people now, we like being tax people and thinking about tax and just tax and always tax. And now we have this tariff thing creeping in that might, as you say, be more important to some of the folks in charge. So we have to adapt and we have to deal with it. And it’s having an impact overall, not just on the tax landscape, but just on the economy as well.
(06:05):
And I think before we dive into talking about the interface between tax, tariffs, and transfer pricing, Rodrigo, if I could turn to you as the economist in the room full of lawyers right now to just talk about some of the impacts on tariffs and what clients we have to think about of this environment that Brooks has described that we have to live with. Tariffs are now a certainty. However, the application of them and how they come about and when they come about may be uncertain. So how is that impacting the economy as a whole as to what we think about? And as we pivot into, as Brooks was talking about, doing our planning for businesses, customs tax, what are some of the things now that we run into?
Rodrigo Fernandez (06:48):
Yeah, sure, David. Thank you for that introduction. From a perspective of an economist specializing in transfer pricing, I’m looking at the tariffs in several dimensions. One is obviously transfer pricing within the supply chain, and there are several sub-components there. The other question is how should companies deal with the uncertainty of tariff levels? We know that there’s a lot of uncertainty. That’s an understatement, but how do you actually deal with those on a practical level? Look, I’ve listened to several podcasts on tariffs and transfer pricing, read several papers, I’ve participated-
David Farhat (07:22):
None will be as good as this one, I promise.
Rodrigo Fernandez (07:24):
Nothing’s as good as this one. I mean, this is smooth. This is smooth. One area that I think is being neglected, at least in the literature that’s out there and the press that’s out there, is how do tariffs affect valuations of IP rights? And whether you’re inbounding IP, bringing it back to the US, or setting up alternative structures, what happens to those IP valuations and IP valuations that you’ve done in the past?
(07:50):
And then with respect to inflation, transfer pricing and inflation have never been spoken in the same sentence unless you’re from an emerging economy. I lived in Chile when inflation rates were in triple digits, a hundred percent, and that’s per month. But now there’s an inflationary effect as well, as well as a lag on that inflation that we need to think about.
(08:11):
So at the simplest level, when you think about the supply chain, and if you look at intercompany P&Ls in a TP structure with tariffs, in its simplest form, you have a routine distributor that would need to increase prices to maintain a “benchmark,” and I use benchmark in quotes, sales margin. Likewise, you would have a routine manufacturer that would need to increase prices to maintain a benchmark markup on total cost, assuming there’s a split in that tariff cost. And we can get into that a little bit later. And you can imagine that’s an iterative process.
(08:44):
So that’s at the simplest, simplest level, and there’s a lot of talk on that issue there with respect to how tariffs can be split within the supply chain between the manufacturer, distributor, and the third party customer. Now questions are, should the distributor bear all the costs? In some cases, yes, but in many cases, no. Should the third party customer bear all the costs? If you can increase the prices, you will. And if you are in a very competitive industry, there is no room for that.
(09:12):
The recent podcast on tariffs and luxury goods was interesting because Giuseppe did mention that they were able to increase prices, these are luxury goods. But there’s other luxury goods makers that are seeing a little bit of headroom, so that lets them allow to keep their margin. But in most industries, outside of maybe luxury goods and certain segments of luxury goods and perhaps pharma and certain segments of the tech industry, most industries are very competitive. So you see a 10% or a double digit cost increase on COGS or anything north of that, and you pretty soon run out of system profit margin. I mean, that’s plain and simple. So it’s an issue that affects economies as well as transfer pricing structures.
David Farhat (09:57):
So Rodrigo, this is really interesting, and I’m sorry to interrupt, but I want to unpack something because I think from the outside looking in, you look at it and say, “Okay, tariffs are another cost. How do we deal with this cost in the transfer pricing system?” But you’ve raised I think two very interesting points. It’s not just the cost of the tariff itself, it’s the impact of the tariff on the economy and the pricing change that comes as a result of that. So if prices are going up, your comparables are changing. So you’re doing your transfer pricing, you’re not just worried about the direct cost, if I could put it that way, of the tariff, but the indirect cost of the tariff on the economy when you’re doing your pricing.
(10:34):
So that’s really, really interesting, but one other thing I want you to unpack that you’ve mentioned is the impact on IP valuation. For some of the folks who are kind of newer to this, can you unpack how the tariff would change that? Because I can see a lot of havoc being caused if I can’t rely on my IP value. Forget just the impact of the tariff on the goods, if now my IP valuation is as problematic, I’ve got a lot of issues.
Rodrigo Fernandez (11:01):
Let me address the second on the IP valuations first, David. So basically when a lot of us do IP valuations, there’s several methods, but the dominant method is a variation of the income methods, the residual profit method. So you basically look at the whole system profit. There’s a certain amount of profit that goes to the routine functions, routine manufacturing, routine distribution. There could be a few other routine functions there, maybe some contract R&D, and the remaining system profit is residual profit. And that residual profit is typically assigned to the IP, in many cases, technology IP.
(11:40):
The first thing you have in that analysis is you look at the gross profit of the system because your COGS increase by double digits percentage-wise, at least 10% or north of that, now your gross margin decreases. Right off the bat, you have a smaller gross margin. Offsetting that though you have routine returns, which if you were able to benchmark comparables in real time, which you can’t, it’s always going to be delayed by at least a year. And let’s say your comparables, like the company that you’re working with, that you’re examining, is tariff impacted.
(12:16):
So those comparables should have lower margins, right? The distributors will have lower margins because they’re absorbing some tariff cost. The manufacturers will have lower margins. That’ll offset that lower gross margin a little bit. But overall, you end up with a lower margin to play with for residual profit. So in most cases, when you arrive at the residual profit and that residual profit stream in that present value, the residual profit stream being the value of the IP, your IP valuations will typically go down, assuming even if the revenue forecasts remain the same. But in some cases, the value of the IP could actually increase.
(12:58):
Let’s imagine a domestic producer that’s not impacted, that domestic producer could simply increase pricing to meet the new higher market price. And that higher market price is due to tariffs, right?Companies are trying to maintain margin. When they can, they’ll increase prices, and the domestic producer will increase the price. I mean, there’s no reason for them not to, right? The market price went up, their costs stayed the same because they don’t have tariffs. Their margins just went up. I’ll take that all day long if I’m a manufacturer.
(13:30):
With that higher margin, go back to the residual profit method for valuing IP, with that higher margin, you’re going to have higher IP values. So I think that’s a really interesting area when we’re thinking about ensuring IP or setting up IP structures, whether they’re with mature industries that have been around for a while or emerging industries that are just coming out the Silicon Valleys of this country. So I think that’s something to really look at carefully. Down the road, whenever there’s that level of squishiness with IP valuations, it’ll lead to controversy.
David Farhat (14:08):
I was just about to throw it over to Jonathan on that point as our resident litigator. How does that make you feel, first of all, before you give thoughts?
Jonathan Welbel (14:17):
As Brooks highlighted uncertainty is kind of the world we’ve lived in over the last nine months. And uncertainty tends to lead to litigation one way or another. But I want to in that context also highlight a point that Rodrigo is really honing in on before you even get to the controversy, which is a decision that has to be made. And oftentimes in our world, we think about concepts and let’s, for simplicity, think about US-developed IP and the decision of whether or not to outbound IP. And there’s an entirely different economic analysis that goes into that today that has to be taken into account.
(14:51):
And Rodrigo was picking up on exactly the considerations that our clients are going to have to think through, which is to say, in a pre-tariff world, before the tariff man, if you will, we had different tax rates and reasons why it would make sense oftentimes to outbound and have significant operations outside of the US. Whereas if there’s an opportunity today to leave the product in the US to pursue things like domestic manufacturing and maybe to get the benefit that Rodrigo is describing, right? All of a sudden start, raising prices. And we’re referring to actual prices to third parties. Entirety of the profit pool or the residual is more valuable to our clients if it stays in the US. And I think that’s the calculus that’s completely changed.
(15:34):
So I expect, and this is probably one of the intentions that came with this policy through the administration and President Trump, I expect a lot of companies are going to give a lot of thought to just leaving IP in the US and operating in a way that’s a bit different. Or having a split structure with IP in the US to serve the US market and IP outside of the US to serve the OUS market where you don’t have to worry about tariffs on the inbound sale back to customers here in the US. So it’s a different dynamic and it’s going to require a different calculus. So the companies have to approach these decisions as long-term decisions.
Brooks Allen (16:06):
Those are great points. And just to pick up on what you were saying there, Jonathan, I mean you’re spot on, man. I think from a customs standpoint, your point about on-shoring of IP, US IP, key issue from a customs standpoint here is customs valuation and what that does for your tariff liability. So maybe, Rodrigo, you were kind of getting at some of this, but the way your tariff bill is calculated, it’s a function of the value of the goods that you’re bringing in times the tariff rate. So that’s just very basic math, right?
(16:36):
You’d think that how you calculate the value of those goods should be pretty straightforward, you just look at the invoice and say, “Okay, there it is. That’s the value.” Well, not so. We only wish it were that simple. Customs in its infinite wisdom has created this arcane, incredibly dense hierarchy of methodologies and techniques. We know nothing about that sort of thing in transfer pricing, by the way.
David Farhat (17:01):
Not at all.
Brooks Allen (17:01):
Yeah.
David Farhat (17:02):
Everything in transfer pricing is clean and straightforward.
Brooks Allen (17:05):
Exactly. Yes, exactly. This is the kind of thing only lawyers could love. So yeah, it’s very, very familiar to the tax world. So we have that definitely in the customs realm, but when we think about how you value, a key element here is the value of any royalty payments that are made, royalty payments being made primarily of course in the context of IP. And so when we think about offshore IP, that’s the critical driver for royalty payments, very much. That’s typically what we’re talking about here.
(17:38):
And so the positioning of that IP offshore and the driving of those royalty payments from typically the US importer of goods that are being manufactured offshore for these importation scenarios to that offshore entity that holds the IP, those royalty payments, I mean, you have to run the analysis. They’re not always folded into the customs value, but very often they will be. Those are packed right into that customs value, and they drive that customs value up and they drive your tariff bill up, and that has a direct impact. That’s a significant issue.
David Farhat (18:10):
So Brooks, if I’m following, there’s a conflict then between the interest of the transfer pricing planning in the interest of the tariff planning there with regards to that royalty payment?
Brooks Allen (18:20):
I’m afraid so. Yeah, there really is. And so it’s really just a function of having that conversation and saying, “Okay, we need to figure this out.” And it’s not necessarily a zero sum, but it’s a matter of trying to figure out, reconcile the two. And sometimes there are timing considerations of, okay, we take X approach for this period of time. But it very much is, it’s an issue where you have to just look this trade-off in the face and ensure that the relevant stakeholders within a company are engaged on it and can have those tough conversations.
Jonathan Welbel (18:52):
David and Stefane, I think it’s worth just taking a second to level set on the legal framework that we’re dealing with here. And you mentioned this notion of tension in some ways between transfer pricing and tariffs. Just as a starting point, I think it’s important to recognize that we actually have a statute in the code that’s designed to address this. That’s 1059A. So 1059A I’m going to paraphrase, basically says your customs price will be your transfer price, or a company is only going to be entitled to basis to the extent of their customs import price.
(19:23):
Then there are different exceptions under the regulations to 1059A. There are certain things that I’m going to categorize as easier to deal with like freight and insurance adjustments that can be made for purposes of the transfer price, but then there are other issues that are going to be more impactful. Brooks was highlighting these statutory additions like royalties, which oftentimes can dwarf even the import price.
(19:49):
Then there’s the other issue, and I think a lot of us have been talking about in this notion of the first sale rule, Brooks can provide the context on first sale and how it works. But again, it’s a rule that has been around in the customs space for a long, long, long, long time, and it allows for some space between the transfer price and the customs price when it’s applied appropriately.
Brooks Allen (20:10):
So the first sale rule, it’s kind of an interesting animal. Basically the way it works is when you’re constructing the price that’s predicate for the customs value, customs says that you can ... Let’s say if you’ve got a middleman entity. So if you’ve got a seller that’s making the good, let’s say in mainland China and then it’s selling it to a middleman in Hong Kong that’s in turn then selling a good to the buyer in the US that you can use that cheaper price paid by the middleman to the seller in China rather than that marked up second sale price, the transfer price, let’s say. It’s not a transfer price in this example, but that marked up price, that second sale price, you don’t have to use that. You can use the cheaper first sale price.
(20:52):
And again, this has been around for decades. This is baked into the logic of customs valuation and is very much accepted technique. So yeah, that is exactly what Jonathan was talking about. And this is something, by the way, there is this kind of mad scramble right now because of the explosion of tariffs. You have all these companies that are now like, “Oh my gosh, wow, I’m facing tariffs now. I have to wake up now because my goods ...” Let’s say for example, I’ve been operating in the USMCA Zone, Canada, Mexico, the United States, which used to be this very much kind of duty-free paradise. No longer, we now have all these tariffs now between Canada and Mexico and the United States. And so now I have to really be thinking about these issues.
Rodrigo Fernandez (21:35):
I think what’s really interesting, Brooks Allen, you said, is the word royalty. When you look at royalty studies that we’ve done in the past, and we’re doing all kinds of IP licensing and royalty studies, and if you look at the comparables, those are from five years, sometimes they’re from 10 years ago, and we put those in front of the IRS and they look at those, okay, they’re the best available, that’s a 5% royalty.
(21:57):
If you think about that royalty, the economic theory around royalties, and again, we don’t use this for transfer pricing, but there’s that rule of thumb that everybody’s, “Oh, this 25% rule of thumb. That’s how licensees and licensors split royalties typically.” And there’s literature that supports that. You can’t price transactions like that, but there’s literature that supports that. Now with that added cost, it’s in COGS and that’s in the P&Ls. That margin is now lower, and if that margin is lower, then the royalties should be lower as well.
(22:30):
If we talk about benchmarking distributors and manufacturers, okay, we’ll deal with that in 18 months and find out what really happened just like when we dealt with COVID and that little disruption. But royalties, those are harder to come by. I mean, to really see what today’s royalty should be on a transaction, it’s going to take a lot more work, a lot more digging into transactional evidence of what we’re actually seeing today. Because today, if a tariff-affected company is setting up a royalty structure, and let’s say it’s an unrelated party transaction, so completely market transaction, they’re going to be looking at the real margins.
Jonathan Welbel (23:11):
Your point is also very relevant to companies that pass the cost of their royalties onto their customers because effectively you’re going to be inflating a sales base assuming that the tariff itself isn’t specifically identified as separate from the sales price. And so that becomes part of net sales in a royalty application. It’s going to give the licensor, just from a nominal basis, more profits, which is going eat into the profit pool, to the tune of a higher profit share than what would’ve been expected under let’s say the comparable or the cut to the extent you can identify that sort of information.
(23:44):
So yeah, these are all sorts of interesting questions that we’re going to have to figure out in thinking about whether we use transactions for purposes of, let’s say litigation to help support a position that a company has taken or in just the planning process. Either way, we’re going to have to factor this in and we’re going to see adjustments that materially could make a difference.
Stefane Victor (24:04):
It seems like there are going to be a lot of timing issues. I think, Jonathan, you mentioned taking a longer term approach. And I’m sure that could be really difficult given the unpredictability of tariffs past nine months, but even in the next year. I think this administration can be described as mercurial and what is today might completely reverse in a week. How can companies take a long-term approach?
Jonathan Welbel (24:29):
I would think about it this way from an economic perspective. There are times in which we’re looking at projections, future cash flows for purposes of, let’s say calculating a royalty rate. And that royalty rate in many cases can kind of be a set it and forget it royalty rate that stays in place throughout the lifetime of the asset. So in a situation like that, when we’re effectively backing into a number based on the economics or an expected profit split, you’ve got to make an assumption.
(24:51):
And look, this is wherever we go tell us, you got to make assumptions all the time when it comes to valuation. But is the assumption that this royalty is going to be in place for three years, four years? Do you have to assume it’s going to be in place for the entirety of the assets expected lifetime?
(25:05):
And again, I think we do these things in the world of valuations all the time, and it’s hard to adopt an assumption different from what today’s reality is. So my gut instinct is you almost have to assume that that tariff is going to be in place throughout the lifetime of the asset, but you could have different scenarios that you play with. Interested, Rodrigo, in your thoughts on how you might do something along those lines.
Rodrigo Fernandez (25:25):
For many, many years now, even before tariffs, we’ve done scenario-based modeling, probability based modeling, Monte Carlo analysis. You have all these variables. You have your revenue forecast, you have cost forecast, et cetera, et cetera. Growth rates, what happens at some terminal? You’re at 3% growth, but then what if there’s a competitive industry or competitive product that comes in and displaces that? How do you forecast that?
(25:52):
Scenario analysis is one way to do it. The other thing, I think, Jonathan, is thinking about recovery options. So there’s a whole little cottage industry now being set up on customs duty recoveries, and Brooks, maybe you guys are familiar with some of that. So you applied this tariff, it got reversed, now we’re going to go recover it. There’s a whole industry around that.
(26:14):
And the other, I think the way I like to think about the physical assets is what can you move and what should you probably not move at all? And that is there’s a simplicity lead time. If you’re setting up a warehouse, okay, that might be the simplest example where that warehouse, you have 12 months to get your building permit. Okay, that’s not short, but that’s the reality. And then you build a warehouse, 18 months you’re on, and you may be doing simple assembly there, and then you can reverse that. If the laws change, then you can reverse it. You can put that warehouse back across the border or where it’s more cost effective.
(26:54):
What we’re dealing with is that there’s other countries that may not have this regime, and they’re making these choices too. All companies around the world are making these choices and everybody’s competing for the same piece of the pie and lowering costs. And if you’re stuck with a domestic high-cost producer after things change, then you want to be in a position at least where you can reverse that, if not mitigate it some other way. So yeah, there’s a lot of crystal balling going on with that, to say the least.
David Farhat (27:25):
So to pivot here a little bit, we’ve got a lot of uncertainty, a lot of crystal balling that you have to do, a lot of this with the change in the royalty valuation and pricing. One thing we know for sure, the tax man is going to want his money. They want to be paid and they have an idea of what they should be paid, and those audits will come about four or five years. How do we deal with that? Because you’re talking about with the royalties, we’re looking at comparables that are five years old.
(27:51):
If I’m a jurisdiction, and we’ve seen increased controversy recently, we’ve seen increased transfer pricing controversy. I think jurisdictions have done a good job of getting rid of some of the loopholes and the arbitrage that taxpayers have been able to do. So now it’s pure, a lot of it is double tax and income allocation. That’s where our planning is.
(28:10):
So I’m a jurisdiction that is used to getting this 5% royalty. Rodrigo, you say you look at the tariffs and say, “Maybe it should be 2.5.” I’m a taxpayer that adjusts it down. How do I explain that to a tax authority that says, “No, I’m looking at comparables and it says 5.”? You’re paying 5 and the jurisdiction that’s paying 5 takes a look and goes, “No, no, no, no, you had tariffs and all that. It should have gone down to 2.5.”
Jonathan Welbel (28:33):
You’re bringing up a very interesting point, but I think there’s an overarching concern that exists amongst our clients now that is even more crude than that, which is to say, under a transfer pricing structure that’s currently in place that uses, let’s say, and this is very common, a limited risk distribution model here in the US, we’re going to have an import of product at a very high price designed to achieve the LRD margin. And that’s going to be subject to duties. That tariff is going to have to be paid as the product comes in.
(29:02):
Now, what happens when we have the lag, the lag that we are very familiar with in the tax world? That intercompany transaction doesn’t get audited until 3, 4, 5 years later. And the IRS comes in and says, “No, no, no, that import price was way too high. It should have been much lower because there should be much more profit in the US.” So now the IRS comes in and reduces the transfer price materially. In that case, more tax is going to be owed, but the duty’s already been paid years before. And as far as I know, there’s no system in place that’s going to allow a company to say, “Hey, you got me on the taxes, I’ll pay more taxes. But what this means is I paid way too much in tariffs five years ago.”
(29:38):
So somehow we have to figure this out. I mean, what we really need, David, is a customs and tax competent authority proceeding. There’s no system in place right now, and that is going to be a big problem down the line. We’re years away from it because as we know, the tax audits don’t happen for a long time. Brooks, at least my understanding on the tariff side is some of these things get figured out a lot faster, meaning you have to pay the tariff upfront and then maybe there’s some sort of an audit process, but it can happen very quickly as opposed to our tax world, we’re living four or five years behind.
Brooks Allen (30:05):
No, you’re right. In the customs world, it’s a lot faster. So the way it works is you bring the goods in, “enter them” into US Customs territory, you pay an estimated tariff, and it’s an estimate, by the way. US Customs, typically within 314 days after entry, will issue what’s called a liquidation order, which is the definitive final termination of what that liability is. And sometimes they can go beyond that, but that’s typically the window. So again, a much more expedited timeframe in terms of when the declaration of what that final liability is. So again, yes, much quicker, much quicker turnaround than in the tax realm, and there is that possibility of there being that disconnect.
(30:46):
Now, you may have a situation though where again, the value for customs purposes that you declare may be different from what you’re actually paying on the ... So for example, if you have a first sale, you may be declaring that cheaper first sale, but that second sale price, you may be still paying that. So the IRS may be focused on maybe that second sale. So there still could be okay if customs accepts that first sale, but you’re not always going to have a first sale. So you still may have that same issue. So yeah, you’re absolutely right, Jonathan, that temporal disconnect, it’s an issue. It’s a big issue.
Jonathan Welbel (31:20):
Taxpayers facing transfer pricing adjustments years from now are going to have to give real thought to whether there’s a judicial procedure which would allow them to sue for tariff refunds. I don’t know if we’ve figured that out yet. But that’s, I think, a reality of how this is going to play out in the next few years.
David Farhat (31:36):
And I think now thinking about you’re in an APA or competent authority process up front, you want to bring customs and tariff issues to the table now to lock that in.
Jonathan Welbel (31:48):
I’ve had that, David, I don’t know if you’ve had that. I’ve had folks at APMA that I work with regularly on APA and MAP matters ask me questions like, “Hey, what’s your client thinking about the tariffs or how are you factoring it into the economics? Is it going to get passed on to the customer?” And this is also the sort of thing for APAs that are currently in place where you may have to at some point have a disclosure of some sort in your annual report that there’s been a material change in circumstances. So I think taxpayers certainly have to be thinking about how this affects their competent authority matters.
Rodrigo Fernandez (32:16):
The interesting thing that you said, Brooks, is the real time versus the lag time. The real time’s interesting because as a customs expert, you’re not only seeing related party transactions, but you’re seeing unrelated party transactions as well. And there’s several very interesting industries to look at. The automotive industry, the parts supplier industries in the Southeastern part of this country, for example, that’s full of all these suppliers to the OEMs and they’re in a tariff-heavy space. Those independent parties are negotiating the split of those costs.
(32:51):
So let’s just say, look, there’s a reg section and the transfer pricing regs that say, “Hey, look, you set your price based on what you needed today. Okay, let’s just go with that, and let’s say you had a 25% tariff and you’re good to go.” And now you’re thinking, “So how do we split this at arm’s length?” Well, you could go to those observations with the clients that you’re working with that are manufacturers that are non-related. I think that’s one way to get around the potential audit issue. Because we could say, “Hey, listen, we’re going to split this tariff cost 50/50 between the manufacturer and the distributor.” And then you can go to the IRS with that and say, “Look, this is how companies were transacting at arm’s length. This is market evidence of the split of the tariffs.”
(33:32):
Because I think that’s going to be a big issue, and I’ve seen, well, it should be the principal who takes all the costs, or maybe if it’s a fully-fledged distributor, it should take all the costs. I’m not sure that’s right. I think if you observe how companies negotiate with each other, that’s the comp right there. That’s a comp.
Brooks Allen (33:49):
In the customs world for related party transactions, we have actually a different test for determining what’s arm’s length. So it’s kind of maddening. So I know, obviously I talk with Jonathan and my tax colleagues about this. So it has some similarities with the TP arm’s length pricing approach, but it is different. In customs, it has a couple of different approaches and tests. One is sort of infamous, all costs plus profits test, which is basically simply just looking at a selling entity within the corporate chain, its operating profit, and comparing that to the parent company’s operating profit essentially, which sounds like a somewhat absurd, from an economic perspective, binary approach in just seeing if the selling entity’s operating profit is equal to or greater than.
(34:34):
Or you can do a kind of benchmarking approach, essentially, an industry study. But there it’s somewhat different because you’re really looking at just, it’s not just functionally are these entities similar to functional benchmarks? It’s much more focused on the goods industry that are being sold. Functionality is really secondary. So it’s different enough that you can’t just take a TP study and wave it in front of customs and say, “Hey, we’re good.” They say, “No, no, you’re not. You have to do this additional analysis. You have to run all these different comps and you have to do this additional layer of analysis,” which I know drives everyone mad, but it’s different enough. It requires this totally different analysis.
(35:15):
But I guess I say all that by way of saying that when we do this analysis, we have to run the customs analysis and the tax analysis, where we’re looking at how do we establish the intercompany pricing? And we try to come up with a number and we think about it, let’s say, from the side of a customs standpoint. Companies are looking at this and they’re saying, “Okay, well, we want to make sure we’re within the range from the customs standpoint.” And then they may say to themselves, “Well, hey, we may have some risk from a tax standpoint. How do we reconcile these things?”
David Farhat (35:44):
But you both bring up a practical point, we’re going to have to do these analyses, and I think we’re going to have a record of this to present to both customs and tax jurisdiction. Because I think the tax folks will be sympathetic to some of it if they can see the on-time documentation of this, the contemporaneous documentation of this and the study of this. And it’s not just, okay, it’s five years down the road, and now I’m making an excuse for why I did what I did. But really looking into, okay, what do I have in my audit file, in my audit preparation and my competent authority preparation to show that, hey, listen, no, a full-fledged distributor wouldn’t always do this, and this is what I did at the time. I’m not looking in a time machine and saying I know something now, so I’m thinking about it. I think it’s havoc at every turn. But go ahead, Johnathan.
Jonathan Welbel (36:36):
David, beyond the studies themselves, those of us in the tax world are acutely aware of the focus in recent years, in court decisions on intercompany agreements. So those intercompany agreements are going to become critical, and they’re going to govern both the consequences on the tax side and on the customs side. And for whatever planning is being put in place from a customs perspective, one of the key components is getting the legal agreements in place.
(37:03):
This is going to be a problem or challenge for all of our clients for, in part, the reason Rodrigo highlights a moment ago. In some ways, you got to have it buttoned up. So you got to take a position, and it’s one thing just to say, “Well, we’re going to figure this out based on what our studies eventually tell us parties do at arm’s length.” That’s one way you could try to approach this.
(37:23):
But I think a lot of our clients are asking us, “All right, what do we say in the contract? Does the principal bear the cost of the tariff? Does the service provider bear the cost of the tariff? If we’re going to split it, how do we split it? And how precise do we need to be in our contract?” And we’re doing this all before we know how market participants are going to be acting over the next few years. So at the end of the day, it puts a lot of pressure to take a position and then think about how eventually that might impact pricing.
(37:48):
But for now, we’re in a little bit of a catch-22, right? What comes first, chicken or the egg? And at least from my perspective, from the legal side of it, thinking about how the world of taxes has evolved in litigation, and if there’s a world where we’re litigating tariff cases in the future, I want an intercompany agreement. I don’t want to say, “Hey, we didn’t put one in place because we didn’t know what to do. We need a legal agreement.” So people are going to have to make decisions. And how much wiggle room we can allow ourselves for adjustments is a big question.
David Farhat (38:14):
Well, gentlemen, this was a great one. I had to look up at the clock and I was shocked at where we were. So thank you all and this has been another episode of GILTI Conscience.
Voiceover (38:24):
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