Governments worldwide are concerned that multinationals are shifting profits offshore through inappropriate transfer pricing. Prices charged for goods, services, royalties, and loans across borders drive how much income tax a multinational pays by country.1
1. Companies that do not charge “arm’s-length” prices are at risk of substantial additional income tax, interest, and nondeductible penalties. Transfer pricing is the number one tax issue facing multinationals globally
Tax auditors can raise substantial tax revenues through transfer price adjustments to make sure companies are paying their “fair share” of taxes. In fact, over 100 countries now see transfer pricing enforcement as a top return on investment in auditing resources. The following example illustrates how much tax revenue an IRS economist can raise through a transfer pricing adjustment:2
Beyond the additional tax, interest, and nondeductible penalties, companies also face a double taxation problem. In other words, if one tax authority makes a transfer pricing adjustment, a company normally will not receive a refund on the double tax paid for several years, if ever.
Resolution of transfer pricing audits regularly requires ten-plus years of management time and resources. Furthermore, since transfer pricing audits are largely facts-and-circumstance driven, management in R&D, engineering, sales, marketing, finance, and other critical areas can expect interviews and many detailed information requests.
2. In transfer pricing, companies always need to satisfy two or more tax authorities
Every multinational company faces a transfer pricing dilemma. Charge too high a price on intercompany transactions, and the multinational is questioned for not paying their fair share of tax locally. Charge too low a price, and the company is accused of shifting profits offshore. While almost all countries subscribe to the “arm’s-length principle,” interpretation and application of this principle varies widely in practice.
Whether preparing documentation or undergoing an audit, taxpayers need to demonstrate the intercompany prices charged on goods, services, intangibles, and loans are conducted as if the companies were unrelated. All too often, documentation that meets the needs of one country highlights exposures to another country’s tax auditors. Tax authorities can share transfer pricing documentation under many double tax treaties.
3. The IRS has shifted substantial resources into transfer pricing enforcement, and middle market companies are no longer immune
Starting in October 2012, the IRS launched a new Transfer Pricing Operations practice, centralizing transfer pricing expertise across the agency and redeploying hundreds of auditors from domestic to international issues. This reorganization represents a sea change for middle-market companies. In fact, the IRS Deputy Commissioner for Service and Enforcement noted in introducing these new international initiatives that “I believe many mid-market corporations may have the same issues as larger entities and perhaps additional issues as well.”
4. “Subsidiaries should earn steady levels of profit” – is often an auditor’s starting point
For “inbound” companies, many tax authorities expect to see subsidiaries earning some level of operating profits.3 This expectation is often a surprise to companies struggling through difficult market conditions. Quite often, transfer pricing auditors argue that operating losses should be borne by the parent company or intangible owner. In other words, subsidiaries are characterized as low-risk service providers, with steady levels of profitability.
By anticipating this line of argument before an audit commences, a company can prepare support that losses are commercial, and not due to overcharging on intercompany transactions. In our experience, transfer pricing economists are more receptive to analyses prepared prior to an audit.
5. Transfer Pricing Documentation is your first, and best, opportunity to avoid a transfer pricing audit
Under Treas. Reg. §1.6662, companies can prepare contemporaneous transfer pricing documentation, which is used to prevent penalties from being assessed in the event of an adjustment. The term “contemporaneous” means that the documentation report has been prepared by the filing of the corporate tax return.4 The regulations list ten items that are required for transfer pricing documentation, but essentially a transfer pricing documentation report consists of the following information:
- Explain each company’s functions, assets, and risks in detail, including corporate structure (Functional Analysis)
- Explain how recent industry developments affect the business (Industry Analysis)
- Describe the intercompany transactions and analyze relevant financial information and pricing (Financial/Economic Analysis)
- Select the “Best Method” for benchmarking transactions and demonstrate how the profitability or pricing is “arm’s-length” (Financial/Economic Analysis)
In our experience, transfer pricing auditors expect a clear explanation of how the business operates in the US versus overseas. Reports should also include a straightforward assessment of the company’s results by reference to the selected “Best Method” benchmarking.
The IRS is now required to request transfer pricing documentation as part of every tax audit. Please note a transfer pricing policy or a comparable benchmarking study alone is not sufficient to prevent penalties in the event of an adjustment.
The number one benefit of transfer pricing documentation is that a report is a company’s first and best opportunity to present their explanation of why a company’s transfer pricing position is reasonable. Furthermore, a company with a contemporaneous documentation will be far better positioned to defend itself during a transfer pricing audit.
Bottom line, a proactive approach to transfer pricing can make the difference between a decade-long IRS audit and no action at all.
1 Effectively any intercompany transaction across borders has a transfer pricing issue
2 IRS transfer pricing penalties rise to 40% once adjustments reach $20 million or more
3 Earnings before Interest and Tax (EBIT) is often used to calculate operating profit
4 September 15 for calendar year-end companies, including extensions