Industries: International Business
Services: International Business
In the news
Transfer pricing has become a top target for the IRS with the recent launch of multiple campaigns targeting alleged abuses in transfer pricing among U.S. taxpayers. In addition to the campaigns, the aggressiveness of the IRS on transfer pricing can be seen through some high-profile cases including, most recently, the suit against Facebook for $9 billion for unpaid taxes, interest, and penalties for alleged noncompliance with U.S. transfer pricing rules. There have also been cases against Apple, Ikea, Microsoft, and Starbucks, all in 2019 alone. Furthermore, Democratic presidential candidates raised the issue of transfer pricing, either verbally or through their campaign websites, as a target for raising tax revenue. Transfer pricing continues to be a hotly-contested and highly-scrutinized tax issue both in the U.S. and around the world.
What is transfer pricing?
Transfer pricing refers to how transactions between related parties (entities within the same company) are priced. These transactions can involve tangible goods, services, intellectual property, loans, or other financial transactions. Be careful though, sometimes a tax authority may identify an intercompany transaction even though the taxpayer doesn’t think one exists. For example, the U.S. subsidiary of a foreign parent manufactures and sells products to U.S. customers. There may be no exchange of goods or services between the U.S. subsidiary and the foreign parent, but if the manufacturing know-how used by the U.S. subsidiary was developed by the foreign parent (as is often the case for subsidiaries), a tax authority would impute an intellectual property licensing transaction.
Tax authorities scrutinize transfer pricing aggressively because it directly affects the amount of income tax paid for an entity. The impact to the bottom line is especially apparent with distributor entities and service-provider entities – notably, these are two targets of the IRS’s new campaigns.
Countries have developed transfer pricing rules to prevent profit shifting. Without the rules, companies could lower their tax bill by shifting income to entities located in low tax-jurisdictions. A U.S. distributor, for example, could buy products from its related party in Ireland at artificially high prices to reduce its taxable income in the United States, thereby shifting profit to Ireland to take advantage of the low tax rate there.
What are the rules?
Most tax authorities have the authority to allocate gross income, deductions, credits, and other allowances between two or more related entities, and they also have the authority to penalize taxpayers for underpayments. Many countries, including the U.S., have developed comprehensive regulations to specifically address transfer pricing and ensure that related taxpayers engaging in cross-border transactions do so at arm’s length.
Transfer pricing rules around the world generally require adherence to the “arm’s-length principal,” which means that pricing used between related parties should be similar to pricing used between unrelated parties under comparable circumstances. The trick is in proving this and documenting adherence to the arm’s-length principal. In the U.S., for example, proving that pricing meets the arm’s-length principal is a comprehensive exercise. The transfer pricing rules laid out in the Treasury Regulations require the selection of a transfer pricing method (there are specific methods described in the rules), an explanation of why that method was chosen over other methods, and an analysis of the functions performed, risks assumed, and assets employed by the entities participating in the transaction.
Are you at risk?
Almost every country has transfer pricing rules that apply to all companies filing a tax return in those countries. Some countries have thresholds regarding reporting requirements that apply if a company’s revenue or related party transaction amounts fall above a certain level. But even when those thresholds are not met, the transactions must still meet the standard of the “arm’s-length principal,” or else companies will be at risk for an adjustment to their taxable income, potential penalties, and double taxation. In the U.S., penalties can reach 40% of the additional tax assessed, and often, the IRS will use the full statute of limitations to reach back a number of years.
What can you do?
Not every company needs a comprehensive transfer pricing analysis, but any company with related party transactions should at least evaluate its risk and take strategic steps to ensure compliance with the rules to mitigate the risk of adjustment, penalty, and double taxation. One size does not fit all when it comes to transfer pricing compliance, so make sure you talk to a transfer pricing specialist that takes a practical approach and tailors the analysis to your company’s size, strategy, and risk factors.