Transfer Pricing Basics for International Companies

Transfer Pricing Basics 

The concept of transfer pricing addresses the amounts that related parties under common control charge one another for goods, services, or intellectual property. For example, the price charged by a parent company when it sells goods to its subsidiary is referred to as the transfer price. The central issue regarding transfer pricing is the tax obligation that may arise around these kinds of transactions when they cross two or more tax jurisdictions. 

From the tax authority’s point of view, properly documented transfer pricing prevents organizations from “gaming the system” and unfairly shifting profits between entities they control. The principle of “arm’s length transactions” is the prevailing standard for determining whether transfer pricing meets the terms and conditions that would exist between unrelated entities for comparable transactions. 

Transfer Pricing Documentation 

Businesses may face substantial risks if transfer pricing is found to be out of order, including interest and steep tax penalties. The most reliable preventive measure is to maintain documentation recognized by tax authorities – especially by the U.S. Internal Revenue Service. 

Analyzing internal transactions (particularly in a tax audit situation) is a complex process with many variables, but most tax authorities expect documentation to meet these basic standards. 

• A complete explanation of the business and how it operates, including the corporate structure and how all divisions, holdings, and subsidiaries are organized and related. 

• A detailed explanation of the industry in which the business operates, including recent market developments that may or may not influence how internal transactions are structured. 

• A detailed financial analysis of the entire organization, with particular visibility into all intercompany transactions. 

• A “show your work” walkthrough supporting your company’s choice of alternative evaluation methods allowed (and prescribed) under applicable IRS regulations. 

Management interviews may be a significant part of the transfer pricing documentation process. Key leaders will have essential facts and context to contribute for the portions of the business they control. This kind of reporting is extremely detailed and tax authorities expect the documents to be updated annually.  Having contemporaneous transfer pricing documentation in place at the time the tax return is filed can help protect against a penalty if transfer pricing is adjusted by an IRS agent in the case of an audit.   

Not all businesses have the same exposure to transfer pricing tax risks. Preparing and updating full transfer pricing documentation can consume a lot of money and resources. For companies with fewer intercompany transactions or lower audit risk, entry-level benchmarking might be an adequate approach. 

A benchmarking study involves researching similar companies to define a range of comparable profit margins. The resulting benchmark can be used to make pricing adjustments to transactions between subsidiaries. These benchmark studies do not provide any tax penalty protection but may be used as a starting point for full documentation in the event of an audit.  

Common Transfer Pricing Documentation Mistakes 

Business owners should be aware that the IRS has shifted substantial resources into transfer pricing enforcement in the past few years, and middle market companies are no longer immune.  The more complex your transactions are, the more important it is to put a rigorous documentation process in place to monitor transfer pricing. Doing so can reduce the risk of audits or adverse tax events in the jurisdictions where you operate. These are important checkpoints that many companies miss: 

1. Make sure that your industry and company analysis sections are complete and provide enough context for the IRS to see into your business structure and fully understand how you operate. 
2. Fully explain special circumstances (such as an industry downturn or losses from external events) that may impact intercompany pricing. Adjustments may be necessary to separate reality from the expectations going into a particular tax year. 
3. Show how the facts you list about who does what connect in a clear and realistic way to your intercompany pricing decisions. Leaving this connection for the IRS to figure out on their own can be a costly mistake. 
4. Provide detail on how risk allocation is addressed in intercompany agreements. The IRS will look for evidence that risk allocations that manifest in transfer pricing decisions (return of unsold goods, for example) align fully with corresponding agreements. 
5. Ensure your comparability analysis is fully supported by appropriate examples and research findings. IRS regulations provide detailed comparability criteria, such as a defensible match between mid-market brands between a controlled company and a comparison company. 

This is just a high-level overview of transfer pricing basics to introduce the topic and raise awareness of the more common issues that international organizations may face.  

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Clayton & McKervey provides advanced tax planning and consultation services to international companies. We invite you to contact us to discuss your transfer pricing questions.