Tariff Refunds Would Threaten Tax, Transfer Pricing Headaches

The Supreme Court’s decision to nix a wide swath of the Trump administration’s tariffs comes with some big tax and transfer pricing questions for tax executives as companies battle to collect refunds from the government.

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The court’s 6-3 ruling sets up what would be a messy refund process, though the justices basically said nothing about it, leaving companies to take their claims to court.

If the refunds come in, businesses will have to figure out how to apportion funds across subsidiaries —sometimes across borders — without breaking transfer pricing rules, which govern the pricing of affiliate transactions and ultimately determine where taxes are owed.

The rules say related-party transfers must be priced as though they were done at arm’s length, in the open marketplace. Companies that don’t do it right risk a tax agency audit.

On this episode of Talking Tax, Bloomberg Tax transfer pricing reporter Caleb Harshberger discusses the sticky tax and transfer pricing issues surrounding tariffs and the possibility of refunds.

Do you have feedback on this episode of Talking Tax? Give us a call and leave a voicemail at 703-341-3690.

This transcript was produced by Bloomberg Law Automation.

David Schultz:

From Washington, I’m David Schultz, and this is Talking Tax.

The dust hasn’t even fully settled after Friday’s Supreme Court ruling invalidating a big chunk of the Trump administration’s tariff regime. But one thing is clear, tax pros are going to have a lot of work ahead of them figuring out what all this means for their multinational companies.

Today we’re going to be talking with Bloomberg tax reporter, Caleb Harshberger, about how tariffs, or now the absence of tariffs, are going to affect taxes moving forward and specifically with regard to transfer pricing. Because it’s not just companies changing their transfer pricing policies to adapt to this new tariff environment, they also need to figure out what to do with any tariff refunds they may or may not be getting.

To start off the conversation, I asked Caleb about how companies changed their transfer pricing schemes when the tariffs were initially put in place last year.

Caleb Harshberger:

There were kind of two parts to that. I think initially when the tariffs came out, companies had to make sure that they were in compliance with transfer pricing rules. And those rules say that you need to price your transactions between your U.S. and your offshore entities as if they were being done between third parties.

David Schultz:

Right. The arm’s length.

Caleb Harshberger:

The arm’s length, right. And when tariffs happened, they had to figure out, okay, do I change the price that I’m charging my offshore entities? And essentially you had to look at, okay, well how am I treating my third parties? And I have to make sure that’s reflected in how I’m treating my related entities. But also you have to look at how are other companies treating their related entities and make sure that you’re following the rules in that way too. And there’s a lot of different methods they can choose.

So kind of step number one was figure out, make sure that these tariffs aren’t requiring me to make a change so that I’m still meeting the arms length standard. Or if they do, that we’re making that change.

David Schultz:

Right.

Caleb Harshberger:

Part two was, okay, we’re compliant. Now we can kind of look at, is there a way to leverage our transfer pricing in a way to mitigate these tariffs? Historically, U.S. companies have liked to put a lot of their profits overseas and attribute a lot of the profit making capacities to entities that they control but that are in lower tax jurisdictions. When the tariffs happened, that kind of put it on its head. And suddenly you have an incentive to say, actually, most of our profits are generated in the United States.

And so within transfer pricing, there’s ranges that you need to fall under. And maybe in the past you want it to be on one end of the range to make it appear as though more profits were coming in from overseas. And now there is an incentive to change that to make it look like more things were done in the U.S. As long as you’re within that range, you know, hopefully that was still compliant.

And there are other things you do too, like moving intangible assets back to the U.S. or emphasizing different, you know, value creating capacities within the U.S. So there’s a lot of ways that you could tweak your transfer pricing in a way to mitigate tariffs.

David Schultz:

Yeah. Okay, so let’s get to what’s happening now after the ruling. I know it’s not this simple, but what is stopping these companies from just sort of taking what they did after the tariffs were implemented and doing the reverse of that, just sort of undoing everything they did? I’m assuming they can’t just, it’s not that easy, right?

Caleb Harshberger:

Right. So there is a rule, there’s the economic substance rules and a few other ones that are like that, which basically say you can’t make big changes for non-business reasons, like to avoid taxes or things like that. So if you made a lot of changes to mitigate your tariffs or to affect your tax bill, you’re going to make the case that, well, no, actually I did that for business reasons. You know, we had this change or this new product or whatever. And the reason that you’re seeing these changes is because of purely business operational reasons.

So if you suddenly unwind these changes just because of this tariff decision, that might look kind of untoward.

David Schultz:

I see. So they have to have a business justification for doing this as opposed to, I’m going to take advantage of the tariffs no longer being in effect.

Caleb Harshberger:

Right. And I mean, the other reason too, though, is most people expect, and we’re already seeing it, the administration, just to find a new way to put these tariffs in place. You know, we’ve already seen the Trump administration put in a, I believe it was a 15% global tariff. They’re talking about using 232 and 301 investigations. That’s a process that they have to go to, but ultimately at the end of it, they can say because of national security reasons, we’re going to put these new tariffs in place.

So I think the bigger reason for companies is you don’t want to do it because it’s just going to come back in a new form and, you know, you might as well just leave things the way they are.

David Schultz:

Yeah. But let’s talk about refunds now. Famously, Justice Kavanaugh noted in his dissent that the process of getting companies refunds for tariffs that they already paid is going to be a mess, and the majority opinion did not really address that at all. How is this going to affect transfer pricing? If and when companies get refunds for tariffs that were levied on them, what role does that play?

Caleb Harshberger:

It was funny. Leading up into this decision, we were talking to a lot of practitioners who were raising these issues that if these refunds come in, there are going to be all these tax and transfer pricing questions. And it comes back to that arm’s length standard we talked about earlier, that you get this influx of cash and you need to figure out where it all goes.

Like the importer of record is the one who pays the tariff, they’re the one who’s going to get the refund. But once you get it, you have to realize these companies didn’t just pay the tariff and eat the cost in the US. They probably distributed the cost throughout their supply chains, whether by raising prices on their suppliers, and that includes related party suppliers that they control and third party suppliers, raising prices on customers, and just distributing the cost throughout their supply chains offshore and in the US.

So the question then becomes, do you take that refund money and distribute it according to the cost borne and the risks there? And talking to folks, practitioners trying to figure out what folks are going to do, it seems like companies wouldn’t want to give refund money back to third parties or to customers or to folks. They want to keep that in the company. But then that gets into tricky arm’s length questions of, well, if your supplier in whatever offshore jurisdiction bore that cost and you want to reimburse them with this refund money, you could imagine a tax authority looking at that and saying, okay, well, you treated your related entity in this way. You’re supposed to treat your third parties in this way, too.

And that’s when it kind of gets into disputes almost between governments, where a tax authority in another country is going to say, we bore this cost, or your entity in our jurisdiction bore this cost. We lost out on these profits that we would have taxed, and now you get this refund. According to an arm’s length principle, you should be filtering that back into our jurisdiction where we could enjoy those taxes.

So it gets really hairy pretty quickly. And you got to look at the contracts between the related entities, the contracts between the third parties.

David Schultz:

Yeah. You wrote a story on Friday right after the decision came down. And one of the things that I noticed in that is that your sources that you talked to said, you really need to have this all really well-documented, or have had it well-documented, because now you need to go back through the invoices and find out who paid the tariff money and where did it go. And then that can determine where the refund goes and who pays the taxes. So it’s all about sort of documentation, right?

Caleb Harshberger:

Yeah. I mean, the folks that are going to have it the easiest are going to be the folks who had seen this coming, or at least realized that this was a possibility. And in the contract said, if refunds happen, X, Y, and Z happens. And we all knew that. We all agreed to that. And we’re good.

What a lot of people are probably going to run into is we didn’t think about this when we wrote these contracts. We all just kind of assumed we were on the same page. And the practitioners I talked to said, there’s going to be a lot of lawsuits. There’s going to be people saying, you should have passed this on to me. And companies saying, we don’t want to. And even consumer lawsuits saying, you charge us these higher prices because you had this new cost. It turns out you didn’t have this new cost. And there’s questions of, is there legal standing there? What does that look like? And then for companies, they just need to figure out, are we willing to rupture these relationships and take the reputational hit? That’s separate from tax, obviously. But there’s going to be a lot of tricky questions companies need to answer here.

David Schultz:

You had a quote in your story from Senator Elizabeth Warren who said that for companies to be able to get refunds for these tariffs, they’ll need armies of lawyers. It sounds like this is why. Because this stuff is so complicated. And it sounds like for medium-sized or smaller businesses, they might not be able to manage this, right?

Caleb Harshberger:

Yeah, I talked to some practitioners who said they might just think, this isn’t worth it. And the refunds aren’t a done deal. They might not. I mean, for all we know, we’ll see how it shakes out. Companies have to sue for these. They have to go into litigation. There’s questions about when you had to get in by or deadlines or things like that. If you get that money, then that’s when all these other conflicts could start. So it’s like a multistage process of suing different folks and getting into all these legal battles. But if you’re a small to medium-sized business, you might think, I don’t know if I’m going to have any money left after this if I go down that road.

David Schultz:

Finally, I want to get into the consequences here, why this matters because of the audit risk. And you kind of hinted at that a little bit when you were talking about foreign countries, that they might want a piece of the refunds that these companies get. Tell me a little bit about what could happen if companies get this wrong, that they could incur some audit risk, both overseas and here at home.

Caleb Harshberger:

Yeah. So here at home, you kind of have a two-part audit risk, I guess, where, like we’ve said in the past, companies had a tax incentive to offshore profits, and now you have this customs incentive to bring it back. Well, that’s two separate agencies, and they both have auditing functions and teams kind of looking at different things. And the customs folks want to make sure you’re not understating the value of the things that you’re importing, and the tax folks need to make sure you’re not overstating it to raise your costs and reduce your taxable profits. So you kind of have the two-sided audit risk there.

And then overseas, we’ve seen tax authorities really ramp up their ability to audit transfer pricing specifically, and to make sure that companies aren’t doing funny things with profit shifting and things like that. So I think even beyond tariffs, the transfer pricing audit risk has never been higher overseas. So you really have to make sure you get it right, and to figure out who should you invest more resources in understanding and protecting against or even appeasing, because the IRS in the United States, they’ve really seen a reduction in resources. Customs is, I’m told, kind of getting up to speed, but a lot of the practitioners are telling me, we don’t know what the probability of an audit is when these agencies are so under-resourced. And maybe overseas, they have less of that as an issue.

David Schultz:

That’s really fascinating. All right. Well, that was Caleb Harshberger talking with us about transfer pricing and tariffs, or the lack of tariffs, I guess. Caleb, thank you so much for talking. I really appreciate it.

Caleb Harshberger:

Thank you.

David Schultz:

And that’s it for today’s podcast. You can find up-to-the-minute news on the latest tax and accounting developments at our website, news.bloombergtax.com. That website, once again, is news.bloombergtax.com.

Today’s episode was produced by myself, David Schultz, and our editor was Vandana Mathur. From Washington, I’m David Schultz. Thanks for listening.