Tax & Assurance Guidance

FAQs—Transfer Pricing Documentation and Benchmarking

Posted on June 26, 2018 by

Clayton & Mckervey

Clayton & McKervey

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Clients often ask, “What type of transfer pricing report should companies prepare?” Transfer pricing documentation rules do vary by jurisdiction, and there can be misunderstandings as to how regulations apply in an audit situation.

Transfer pricing audits by the IRS and tax authorities can be expensive both in terms of time and company resources. Company revenue, the volume of intercompany transactions, and perceived audit risk should drive decisions in this area.

Many multinationals should already be preparing transfer pricing documentation annually to defend against the risk of audits and transfer pricing penalties. However, some companies may be just as well served by alternative approaches.

More specifically, multinationals with relatively smaller volumes of intercompany transactions and less audit risk may want to consider transfer pricing benchmarking as an alternative to documentation.

The following summary explains the differences and factors that should be taken into consideration when devising a transfer pricing strategy.

Transfer Pricing Overview—Companies Paying their “Fair Share” of Tax
Transfer pricing rules apply to goods, services, and royalties – effectively any internal multinational company transaction that crosses borders. Tax authority adjustments to transfer prices can then result in additional tax owed, late payment interest, nondeductible penalties, and possibly double tax.

Transfer pricing is considered the most contentious tax issue for multinationals because two or more tax authorities can audit the same intercompany transaction. Companies prepare transfer pricing analyses to explain why transfer prices are consistent with the “arms-length standard” or what unrelated companies would charge each other.

Transfer Pricing Documentation—Goal: Audit Defense, Penalty Risk Mitigation
Transfer pricing documentation is a thorough explanation of the company’s business and why the cross-border pricing is reasonable or “arm’s-length”. Documentation is the first, and best, way to defend against a tax adjustment during an audit. In fact, some countries require transfer pricing documentation as part of every audit.

From a US perspective, the IRS can assess additional tax and transfer pricing penalties (a) if the taxable income adjustment is a “substantial” or “gross” valuation adjustment and (b) the company has not prepared “contemporaneous” transfer pricing documentation by the time the tax return is filed. The documentation report is not submitted until requested during an audit—with a 30-day deadline.

To clarify, if there are no US transfer pricing adjustments, there are no penalties or additional tax due. Therefore a taxpayer that can argue successfully against an IRS audit adjustment would not owe additional tax or be assessed penalties.

Key Factors
The US transfer pricing documentation rules specify 10 items that need to be included in a report for mitigation of penalty risk, but from a high-level, the following information is most important.

  • Explain the business in detail, including corporate structure (Functional Analysis)
  • Explain how recent industry developments affect the business (Industry Analysis)
  • Analyze financial information and intercompany transactions (Financial/ Economic Analysis)
  • Select the “Best Method” or “Most Appropriate Method” for benchmarking transactions and demonstrate how the profitability or pricing is “arm’s-length” (Financial/Economic Analysis)

Depending on the facts, the economic analysis often benchmarks the profitability margins of the subsidiary company through searches of electronic databases against similar companies. Alternative approaches may include assessing the pricing of third-party transactions or profit splits.

Most transfer pricing documentation reports require interviews with key management to collect facts and analyze the industry as part of drafting the report. These reports can be large documents and must be updated annually to be considered “contemporaneous” penalty protection. Advisor fees for transfer pricing documentation reports are higher due to the extensive interview process.

Transfer Pricing Benchmarking—Entry-level Alternative to Documentation
For companies with limited volumes of intercompany transactions, or lower risk audit situations, a benchmarking study can be a practical alternative. Under this option, searches are conducted for companies to establish a range of profit margins derived from similar companies. Companies often use this benchmark to adjust prices so subsidiaries. While similar to a documentation report, there are a couple of key considerations:

  • The benchmarking is not considered as penalty protection in the event of a large adjustment ($5 million or a 50% change in intercompany prices)
  • Limited fact gathering and no assessment of the company profitability
  • Benchmarking can be adapted into a full report once the company becomes larger or the risks of an adjustment are greater.
  • A full study can still be prepared if the IRS decides to do a transfer pricing audit, however, the company could be at risk of penalties if there is a “substantial” adjustment

For companies that are not at risk for a substantial tax adjustment, a benchmarking analysis may serve as a more cost-effective approach.

Conclusion
Transfer pricing is a controversial issue for a growing number of multinationals and tax authorities, but companies should consider the relative level of risk when investing resources. Practical alternatives such as benchmarking may be just as effective in some situations.

Summary Table—Transfer Pricing Benchmarking vs. Documentation

Benchmarking—Entry Level Guidance Documentation—Test if Transfer Pricing is “Arms-length”
Objective
  • Provide a high-level basis for a company to establish or adjust intercompany pricing.
  • Justify pricing with subsidiary companies by reference to profitability margins earned by companies with broadly similar activities
  • Explain how intercompany pricing results are consistent with the arms-length principle.
  • Analysis requires a detailed functional, industry, financial and economic analysis of intercompany transactions.
  • Ideally justify results to both (or more) tax authorities
Primary Goal
  • Assist in setting pricing for companies with relatively small volumes of intercompany transactions and start-up operations.
  • Lower risk of transfer pricing audits
  • Thorough explanation of pricing to tax authorities as to why no tax adjustment is required under audit
  • Mitigate the risk of transfer pricing penalty assessment if tax authorities do make a tax adjustment
Deliverables Include
  • Fact gathering to compile a high-level business overview
  • High-level Industry Overview
  • Benchmarking of subsidiary profitability margins using electronic company databases
  • Thorough explanation of key functions, assets and risks based upon detailed interviews with selected management (Functional Analysis)
  • Detailed Industry Analysis
  • Financial analysis of actual results of company intercompany transactions or profitability margins
  • Economic Analysis based upon “Best Method” or “Most Appropriate Method” depending on facts-and-circumstances
Audit Protection
  • Not penalty protection.
  • Tax authorities may disagree and issue transfer pricing adjustments, but the taxpayer does have some support for their tax position
  • Company needs to follow benchmarking approach identified
  • Goal is to prevent a tax adjustment if transfer pricing is considered “arms-length” based upon facts-and-circumstances
  • Lowers risk of transfer pricing adjustment, but tax authorities can take a different position
  • No guarantee under transfer pricing audit
Cost Time incurred on benchmarking and writing Time required for interviews and more comprehensive economic analyses required for transfer pricing penalty protection

 

Clayton & McKervey

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