By Andrew M. Bernard Jr., CPA, Laurie Dicker, and William Long
In the global economy, businesses often conduct transactions with controlled entities located outside of their state’s or country’s borders. These cross-border transactions frequently involve services, financing, intangible property, or components and finished goods in an overall global supply chain. Determining how the global profit from these transactions is divvied up among the various controlled parties has become a focal point for many tax authorities. Tax rates vary by jurisdiction, and businesses try to legitimately push profits into lower tax jurisdictions, while still adhering to the separate tax laws of multiple jurisdictions.
Transfer pricing refers to the pricing of transactions between commonly controlled entities. The purpose of transfer pricing rules is to ensure that businesses clearly reflect income attributable to controlled transactions as they would with unrelated third parties and to prevent commonly controlled entities from artificially shifting profit or loss between tax jurisdictions. While transfer pricing principles are intended to avoid the artificial shifting of profits between tax jurisdictions, the concept often gets misconstrued in the media as the reason that multinational companies are in trouble with tax authorities.
The Organisation for Economic Cooperation and Development (OECD) recently released revised guidelines outlining how to implement and apply transfer pricing concepts to transactions between commonly controlled entities, and numerous countries have enacted transfer pricing legislation based on these guidelines. In the United States, the rules regarding transfer pricing are codified in Section 482 of the Internal Revenue Code and the Treasury Regulations thereunder (482 Regulations).
Under Section 482, transactions between commonly controlled entities are required to take place on terms consistent with those on which unrelated parties dealing at arm’s length would transact. This is known as the “arm’s length standard.” The arm’s length standard applies to any U.S. outbound or inbound transaction between commonly controlled entities, including the sale or use of tangible property, royalties for the use of intangible property, cost sharing arrangements, loans and advances and related interest, and payment for services. If the transfer price is not arm’s length, the IRS has the authority under Section 482 to make adjustments to reflect the arm’s length standard by reallocating items of gross income, deductions, credits, or allowances to properly reflect income between the controlled entities. There are heavy penalties in the United States for failure to follow the arm’s length standard.
Take a U.S. parent corporation (parent) that is in the business of manufacturing and selling shovels, for example. If the parent sells a shovel to its controlled foreign subsidiary corporation (CFC), Section 482 requires the parent to sell that shovel at an arm’s length price to its CFC as if it was sold to a noncontrolled party. If the parent sells a shovel to an unrelated customer in the CFC’s same country for $35, the parent should sell the shovel to its CFC for $35.
But this is not just an international concept. Section 482 also applies to domestic businesses that are conducting transactions with commonly controlled entities. If the commonly controlled businesses file separate state tax returns, then the rules under Section 482 may apply from a state tax perspective.
Transactions between commonly controlled entities must be analyzed using an appropriate transfer pricing method to determine whether they satisfy the arm’s length standard. Determining the appropriate method to apply to specific transactions is a subjective process, and it requires an in-depth knowledge of the business’s industry, supply chain, strategy, and business judgement.
There are various transfer pricing methods available that are outlined in the Section 482 regulations. The available methods vary by the type of transaction being analyzed (such as tangible products, intangibles, services, interest, etc.) and the risks and functions of the controlled entity being tested. In addition, there are transactional-based and profit-based methods. There is no hierarchy to the available methods; however, the specified methods in the Section 482 regulations should be considered prior to using any unspecified methods. The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result. This is known as the “best method rule.”
To determine which of two or more available methods provides the most reliable measure of an arm’s length result, the primary factors to take into account are the degree of comparability between the controlled transaction and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis. This determination is made by benchmarking and analyzing financial data available through global financial market and industry databases.
To avoid a transfer pricing penalty, a taxpayer must maintain sufficient contemporaneous documentation to establish that the taxpayer reasonably concluded that, given the available data and the applicable pricing methods, the method selected and applied provided the most reliable measure of an arm’s length result. The documentation must be in existence when the tax return is filed, and it must be provided within 30 days of an IRS request.
Many other countries also impose similar documentation requirements. Further, there are master file reporting and country-by-country reporting that may need to be met.
Businesses conducting transactions with controlled parties need to be aware of the transfer pricing regulations.
Businesses should evaluate their transfer pricing policy and positions to determine if they are using the “best method” to determine the arm’s length price for their transactions. In addition, businesses must document and support the transfer pricing method they have selected (with intercompany agreements, work papers, invoices/journal entries, contemporaneous transfer pricing reports, etc.) to avoid penalties.
Andrew M. Bernard Jr., CPA, is managing director of Andersen Tax in Philadelphia and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at andrew.bernard@andersentax.com.
Laurie Dicker is a managing director in the U.S. national tax office of Andersen Tax in Washington, D.C. She can be reached at laurie.dicker@andersentax.com.
William Long is a senior manager with Andersen Tax in Boston. He can be reached at william.long@andersentax.com.
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