Importance of transfer pricing in mitigating tax-related risks
Transfer pricing deals with the pricing of related-party transactions – an area the IRS and other tax authorities are increasingly scrutinizing.
When the Internal Revenue Service (IRS) audits a company with international operations, transfer pricing is often one of the top areas agents look at. Many tax authorities in foreign jurisdictions and states are also looking more closely at transfer pricing: the way companies price transactions between related parties.
The IRS expects a company to establish and/or test the prices it applies to transactions with related parties through a transfer pricing analysis (also known as a transfer pricing study) based on contemporaneous market information. These transactions should be priced at “arm’s length” – as they would be between two independent, unrelated entities. A transfer pricing study uses a variety of information to decide on the arm’s-length price for transactions for goods, services, financing and intangibles such as intellectual property or marketing assets.
Transfer pricing study can mitigate tax exposures
Without a transfer pricing analysis, the penalties for improper transfer pricing can be as high as 40% of the discrepancy between the company’s pricing and the arm’s length pricing, as determined by the IRS. Taxpayers should keep in mind these penalties are not deductible for tax purposes. Further, in order to correct transfer prices, the company must make a permanent income adjustment, which will result in an increase in U.S. income tax.
Transfer pricing has been the subject of some of the most notable tax disputes in U.S. Tax Court history. For example, in 2006, the IRS settled with GlaxoSmithKline for $3.4 billion in additional tax, penalties and interest in a transfer pricing dispute — the largest single payment made to-date to resolve a tax dispute. Another transfer pricing case currently in U.S. tax court alleges that The Coca-Cola Company underpaid its U.S. taxes by more than $9 billion in transfer pricing adjustments.
A proper transfer pricing study helps show the IRS that pricing was established with reasonable cause and in good faith. If an IRS audit concludes transfer prices were not priced at arm’s length, then a transfer pricing analysis may help reduce penalties.
A well-supported and documented transfer pricing report allows the examining IRS agent to rely on the company’s analysis of functions, risks, intangibles, value drivers, etc., saving both the taxpayer and the IRS time examining transfer pricing issues. In particular, identifying and documenting the company ‘s activities and related risks that reasonably support the selected transfer pricing methodologies can help show low compliance risk. This, in turn, may reduce the likelihood that the IRS will further scrutinize transfer pricing as part of the company’s examination.
Rules require documentation of pricing strategy via a transfer pricing analysis
The rules around transfer pricing are, largely, documentation rules. Compliance requires that companies be able to “show their work” – the analysis they used to arrive at the arm’s length pricing they applied. The documentation should show the company was reasonable in its selection and application of a transfer pricing method.
Because companies do not report or file a transfer pricing analysis with the IRS (although some foreign jurisdictions require this), some don’t realize they are expected to have the study. For U.S. tax purposes, a transfer pricing study should be completed by the time tax returns are filed for the year in which the transaction took place. It should also be applied fairly and consistently across all related-party transactions. The transfer pricing study is generally required to be produced within 30 days upon request by the tax authorities.
Financial reporting rules also require transfer pricing consideration
Financial reporting rules under Accounting Standards Codification (ASC) 740 require companies to identify and report on their financial statement certain uncertain tax positions over a minimum recognition threshold. Given the potential size of transfer pricing issues and the IRS scrutiny of transfer pricing transactions, transfer pricing has become one of the most significant uncertain tax positions.
International tax rules and many states require transfer pricing studies
The Organisation for Economic Co-operation and Development (OECD) and The United Nations (UN) have their own guidelines for transfer pricing, which most countries have adopted. Documentation and record-keeping are a key part of compliance with these rules.
Companies may also use a transfer pricing analysis to seek advance pricing agreements with tax authorities. This allows the business to establish an approved method for calculating transfer prices and mitigate the risks of double taxation. Additionally, it can mitigate the risks of future examinations requiring restatement of taxes related to transfer pricing.
In addition to foreign tax jurisdictions, most U.S. states have transfer pricing and documentation requirements. States have increasingly been focused on pricing of related-party transactions as a means to capture additional revenue. If a company has entities in multiple states, consider a transfer pricing analysis to address any related-party transactions.
Mitigate tax-related risks with transfer pricing study
While there is nothing wrong with companies following markets to gain efficiencies, tax authorities don’t want organizations to underpay taxes by improperly shifting profits to lower-tax jurisdictions. Transfer pricing analysis can help companies properly price related-party transactions minimize the risks of tax disputes.
Kaufman Rossin’s international tax team helps companies design and implement a transfer pricing structure that satisfies documentation requirements, helps mitigate tax exposures, and identifies opportunities and strategies to optimize their worldwide effective tax rate. Contact our transfer pricing team to learn more about a transfer pricing study for your company.