Transfer Pricing: Issues, Options, and Remaining in Compliance

Transfer Pricing 101

Referring to the price that an affiliate charges another in an intercompany (or “controlled”) transaction, transfer pricing involves the transfer of goods, services, or intangible assets. To reduce their overall tax liability, companies use these transaction prices at above- or below-market prices to assign profits or costs to affiliates.

Typically, companies can take advantage of one affiliate located in a high-tax country by making them less profitable by charging an affiliate in a lower-tax country below-market prices. The purchasing affiliate ends up paying less for the goods sold (higher profits), while the transferring affiliate has lower profits (less tax liability).

However, the Internal Revenue Code (Section 482) empowers the IRS to adjust these transactions to yield a transaction that is more consistent with a transaction executed between unrelated parties. The IRS has and can distribute, apportion, or allocate gross income, deductions, credits, or allowances to prevent the evasion of taxes or to clearly reflect the income of any parties.

So, how do you stay within the law while still benefitting from transfer pricing?

Best Method Rule

Under this rule, a taxpayer must select a pricing method specified in the regulations to determine whether its transfer pricing is as though it would be through a transaction between unrelated parties. When determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the primary factors are:

• The degree of comparability between the controlled transaction and any uncontrolled comparables, and
• The quality of the data and assumptions used in the analysis.

The method chosen should provide the most reliable measure compared to other potential methods.

Documentation Requirements

Additionally, governments around the world have intensified their documentation requirements to rein in abusive transfer pricing tactics. Here in the States, the IRS requires documentation that a transfer pricing method was selected and applied in a reasonable manner. However, the documentation doesn’t guarantee automatic protection against penalties. The Department of the Treasury lays out specific documentation requirements — Reg. § 1.6662-6(d)(2)(iii)(B) — for so-called “principal documents” which include, among others:

• Descriptions of the methods selected and alternative methods considered;
• Explanations for why the selected method was chosen and others weren’t; and,
• Descriptions of controlled transactions with internal data used to analyze those transactions.

The documentation requirement isn’t mandatory, but it is highly advisable to collect this information and have ready should the IRS request transfer pricing documentation. After all, taxpayers only have 30 days to provide it and showing the documentation existed when the taxpayer filed helps show good faith and can reduce the risk of hefty penalties.

Best Practices

In 2020, the IRS published best practices for transfer pricing documentation reports based, in part, on past documentation received. Adequate documentation includes:

• Clear industry and company analysis sections that provide context for related-party transactions,
• Robust functional analysis narratives that link facts to analysis,
• Risk analysis that’s consistent with intercompany agreements,
• Support for best method selection, as well as the reason for rejecting specified methods,
• Complete comparability analysis, and
• The effects of differences in risks or functions between the tested party and the comparable companies.

Generally, make sure you have detailed analysis documentation for complex transactions. Conversely, inadequate documentation may expose a multinational company to pricing adjustments by the IRS which leads to costly appeals, litigation, penalties and interest, customs adjustments, and the need to amend tax returns.

Advance Pricing Agreement (APA) Basics

One strategy companies can take is through an APA. This is a voluntary process by which a taxpayer and one or more tax authorities reach a mutual agreement on transfer pricing issues that are ongoing or have already arisen. APAs usually are prospective, but they also can cover the same tax issue in “rollback years.”

Once an APA is entered, the taxpayer only needs documentation to demonstrate compliance with the agreement during the covered period, substantially reducing its documentation burden. The risk of a lengthy and resource-intensive audit on transfer pricing also is eliminated, and the taxpayer may be able to avoid uncertain tax position reporting.

There is generally a fee associated with these agreements and renewal fees. Companies should evaluate whether the enhanced certainty regarding its U.S. tax liability is worth the IRS fee.

Proceed with Caution

Transfer pricing transactions are an IRS hot button. Recent legislation has significantly expanded the IRS budget for the next eight years—and much of the incremental spending is expected to go toward enforcement efforts. With transfer pricing enforcement likely on the upswing both domestically and internationally, now is a good time to take the necessary steps to ensure compliance.