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On today's podcast, listen for a primer on tariffs and how it intersects with tax. Hello, everyone, and welcome back to the AICPA's Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a senior manager from the Tax Section. I'm here today with Steve Wrappe. Steve is a national technical leader of transfer pricing at Grant Thornton. We also have my colleague Reema Patel. She is a senior manager on
the Tax Policy and Advocacy Team. Welcome to you both. Our topic today is definitely a hot topic, tariffs. As tax practitioners, you may be advising clients who are asking questions. You may be part of a corporate tax department where discussions are being held in this arena. We really thought it would be a good idea to have, I'm going to call it a primer on tariffs and how it intersects with tax. Steve, let's start off. Let's talk about tariffs generally.
A Tariffs 101. What are some basic mechanics on how tariffs apply and how are they collected?
We've had tariffs with us for over 100 years, and they're not usually a big topic of conversation because they're relatively modest, 2, 3%, something like that, not across everything, and a lot of things are tariff-free. The fact that we're talking about it now mostly because tariffs or duties being talked about are in the somewhere above 10% range, and that is impactful for companies, and that's why we're talking about it.
But basically, what it is is it's a form of tax on the value of imported goods at import. Basically, it becomes part of the cost of goods sold usually or possibly operating expenses, and they're very modest. But I think these are anticipated to be mostly categorized as cost of goods sold. It adds to the cost going through the operating income to drastically affect the levels of operating income earned by the distributor.
The distributor is usually the importer of record, and that's who pays the tax, but it is allowed to be shared between the parties.
Thanks, Steve. I think that was very helpful to give just a high-level overview, with the tariffs going on and given that level setting, what are some of the implications for US-based businesses in this environment?
Well, the implications are that it's just a newly developed cost that is substantial in the grand scheme of things, and it has to go somewhere. Possibly going to increase the cost to consumers, and add to inflation. Or it could be possibly somehow shared between the parties in the supply chain to balance it out between manufacturer, distributor, and probably principal in the transactions.
But like I said, it is large enough that it has to be consciously managed to be able to continue to run your business.
You brought up a good point where you said shared between the party chains. When I think of that, I think of transfer pricing. Now if we get into the nitty-gritties of tax, how do tariffs interact with transfer pricing, Section 482 regulations? Can you just speak a little bit about or even more detail? Steve Wrappe: Everything sounds like transfer pricing to me.
But transfer price is something that the related party global chains of corporations have to set the price at a intentionally arm's length amount between them so that they mimic the outcomes between unrelated parties. The reason they do that is because otherwise, governments are quite concerned that the taxpayers would shift the tax to push income to low tax jurisdictions.
That's transfer pricing in a nutshell, and it very closely interacts with tariffs because the transfer price is set by reference to unrelated party transactions, a benchmark, if you will. That once the transfer price is set, the tariff percentage that everybody talks about is applied to the import price.
Well, the import price can be set by a number of methods, but most companies use what they call the transaction method, which is the price paid or payable at import, and that can't be used between related parties because of transfer pricing, unless the circumstances of sale indicate that the relatedness of the parties did not affect the price. That's what transfer pricing purports to do is prove that it's basically an arm's length price.
Most transactions between related parties into this country use transaction value, so the tariff value is equal to the transfer price with some small adjustments. Then the tariff percentage is then applied to the import price, which gives you the tariff, which then frankly, messes up the transfer pricing numbers because it is part of the operating income of the organization.
If you're outside certain norms, it can cause the need for the transfer price to have post importation adjustments for the transfer price, and consequently, to the tariff valuation, which favorably creates a taxpayer opportunity to seek a refund from CBP, and an opportunity to seek a refund from the other country involved through the mutual agreement procedure. Transfer price is very involved in the compliance aspect of it and the substance of the amounts involved.
Just thinking about your clients or your other tax practitioners at Grant Thornton that I'm sure you're helping with this matter, how are you handling those discussions with clients in this environment?
To be honest, it's a little bit difficult because the terminology used for all these things is frequently very different. We've been talking about it for a while, so the wording is settling out a little bit. But I think a lot of people didn't know that the transfer price is often the same as the tariff valuation, but it is. That's the starting point for all these. That part's quite interesting.
Probably a little bit of job security. Seems like a little bit. Another thing we were thinking about as we thought about how tariffs interact with tax is around inventory valuation and inventory costs. Reema, can you talk a little bit about how that might be impacted?
Yes. When Steve gave the 101 on the tariffs, he mentioned cost of goods sold and inventory. Tariffs, at the end of the day, for any inventory piece, it does get booked to cost of goods sold as they are part of inventory cost. For financial accounting purposes and for tax accounting purposes, we book inventory differently. Financial accounting, sometimes, we book it based on market value versus for tax purposes, we book it based on the actual cost.
But how we capitalize those inventory under tax purposes, we do it under UNICAP or uniform capitalization rules. Those capitalization rules and what we follow are under tax is very different than book. I think with tariffs, given the large percentages that are being talked about right now compared to the two or 3% that Steve mentioned earlier, we just have to look just to assess those rates, so we don't have any unexpected large variances towards the end.
Because book and tax is so different, in that format, we don't want any large variances in the book to tax differences at tax return time, because those unexpected large variances can really have underpayment tax penalties and you can have large underpayment tax penalties if you don't pay enough estimated taxes throughout the year. But in addition to just tariffs as part of inventory and how you capitalize it for books, there's also inventory gets booked into cost of goods sold.
Eventually, that's how the flow goes. Higher inventory costs, tariffs being in there, results in higher cost of goods sold. Higher cost of goods sold means lower taxable income. That can be great, but it really depends because if you're on a LIFO method, so some businesses may consider or think about, say, can I switch to LIFO method?
LIFO, last-in, first-out, meaning the last inventory you got into stock is the inventory you're going to book, which has a higher cost, results in lower taxable income. But practitioners should probably keep in mind that maintaining a LIFO cost book can be very administrative burdensome. It can be costly. You have specific methods you have to follow under LIFO. IPIC, for example, link method.
There are specific methods you have to follow to report that on books, but then you also have to maintain a separate LIFO method for financial accounting purposes. Not only do you have two sets of book annually you have to maintain, if you have a large stock of inventory, that can be a lot of tracking.
But if you have IFRS reporting, if you're a US subsidiary reporting to a foreign company, you're going to have foreign financial statements that the foreign parent is subject to IFRS, which is the International Financial Reporting Standards. LIFO is not allowed. You're not allowed to book inventory under LIFO under IFRS.
There are a lot of things that if you're looking to adopt LIFO because of the higher inventory costs right now, or if you're looking to modify LIFO, just practitioners probably take into consideration some of the administrative burden that are associated with the inventory piece, but it's definitely worth looking at it if it's something that businesses are considering.
Thank you very much. Again, our goal today is high level talking about some of the topics that tariffs touch. I think it's really important for us to have this conversation. I'm a silver lining, look for the bright side person. Let's try to do that. Let's try to talk about, what are we seeing with clients and businesses trying to mitigate actual or anticipated costs associated with tariffs?
Is there any practical advice, Steve, that you've been talking about and that you could give our listeners who might be having conversations in this current landscape?
I talked to a lot of clients lately. There's a lot of back-of-the-envelope calculations being made, but not a lot of actions. Part of that's because the rates have been discussed and amplified and deferred and paused and on again. These are large enough tariffs and actions necessary that the companies seem to be waiting until things settle down. Don't be surprised if companies really haven't made their big decisions yet. But there are a few things they have been doing.
They have been looking at stockpiling. With another 90 days, I think you will see more and more goods pressed through transportation from Asia to here. I'm hearing about that in the news, very expensive stuff. Stockpiling is helpful, but it's not a permanent solution. A lot of companies, through their industry groups, are seeking exclusions. There were a fair number of exclusions given to some of these tariffs in the 2017 version.
The administration has said that they are not intending to give those exclusions this time. It remains to be seen. But what I find is there are a limited number of areas that companies need to think about. Like I said before, it doesn't go away unless maybe you get an exclusion. But if it's there, you need to figure out very honestly how much of it should be passed on to customers? That's a function of what the customers alternative substitutes for the goods are.
That takes some work to figure that out. At the same time, what is the level of discretionary spending by customers? How much are you going to be able to sustain a price increase? That's got a lot to do with inflation. That's one. What you can't push onto consumers probably needs to be shared somewhere back through the chain, and this is a transfer pricing piece of it, in that, transfer pricing allows you to allocate risk between the parties.
You need to basically have facts to support it, you need to have the contracts to support it, and then you need to execute. But to give you an example, if you have $100 item to be imported into the US today, and tomorrow, it's subject to a 25% tariff, the distributor can't afford to pay as much for that good tomorrow as they pay today because it's burdened by an additional cost.
If it were appropriate that the risk of tariff belongs on the manufacturer, then the US distributor would pay 75, and then the tariff, instead of being applied of 100, would be applied to 75. It has a favorable impact on the amount of the tariff, and it is complying with both the tax and tariff rules. That's a possible positive effect. It still doesn't get rid of the 25% tariff, but it does reduce the impact a bit.
You can't control the governments, but you can control yourself, and that's one positive step that you can take. A lot of companies, more than I would have expected, are actually talking about moving operations to the US. What's holding them back is the big fluctuations and deferrals and how much are the tariffs really going to be? Because, to be honest, the US was not a low-cost manufacturer to start with.
There are reasons why, and not all tax, reasons why we manufacture elsewhere in the world. To make a $50 million decision to move manufacturing to the US and then possibly have the tariffs go away in six months, could be devastating for corporate executives making those decisions. It's an important decision. It's the only permanent solution. The question is, is the malady going to be there for which you have the solution? That is unclear. But there are other things, but those are the majors.
I took some Econ 101, sounds like a lot of that for me. Reason I didn't major in economics. I think this was a really helpful conversation around how tax and tariffs are impacting and hopefully it gave you some talking points as you're talking to your clients or helped you get a little bit educated. It definitely helped me. Reema, do you have any other takeaways you'd like to share?
I think one key takeaway is just assess and navigate. Tariffs are going to stay or not stay. Maybe think about how it can be part of your business model in the future to mitigate some of these costs that are coming in. Other than that, it's just yet. It's a tough terrain.
We're still learning. What about you, Steve? Any other takeaways?
The carpenter's rule around here. Measure twice, cut once. Do a lot of thinking so that you're really sure because these are big strategic decisions.
I listened to the webcast you were on yesterday with Bloomberg, and I think one of the themes from that was not making rash decisions, pausing. Especially in this environment, it seems like good advice.
The one thing I agree is the transfer pricing piece of it, is self-correcting. Basically, you ship the risk out of the country so that the US distributors' returns are correct. If the tariffs change tomorrow, the risk is outside the US, so it does not affect that compliance. You're still compliant.
As we're wrapping up, this podcast is titled Tax Section Odyssey, so we like to think about ourself as taking a journey together towards a better profession and a better professional. But in doing that, I like to get a glimpse of my guests other journeys outside of the world of tax. Steve, what's a trip you have on the horizon or what's a bucket list trip that you'd like to share with us about?
One these days, I would like to go skiing in South America. I've skied up here. I'd just as soon try it down there.
That sounds fun. When I struggle with geography, I'm like, I guess there is skiing in South America. What about you, Reema?
We are going to attempt to take our girls to Vegas next week.
That'll be an eye-opening trip for the girls. Can't wait to hear a report from that. Thank you so much, Reema and Steve for joining us today on this topic. It's not easy to have a high-level discussion on tariffs, but I think we did a pretty good job. Again, this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources design, especially for CPA tax practitioners like you in mind.
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