Transfer pricing is a term used to describe intercompany pricing arrangements relating to transactions between related entities. These can include transfers of intangible property, tangible goods, or services, as well as loans or other financing transactions, which can occur across local, state, or international borders.
Due to growing government deficits, many jurisdictions are putting additional pressure on transfer pricing in order to secure a larger portion of entities' profits for their tax bases. This can result in the risk of tax assessments, double taxation of the same income by two jurisdictions, and penalties for failure to properly allocate income among two or more jurisdictions. Therefore, virtually all large MNCs should regularly review their international transfer pricing strategies and potential risks.
Transfer pricing applies to a wide range of intercompany transactions, including transactions involving:
The international standard for determining the appropriate transfer price is the arm's-length principle. Under this principle, transactions between two related parties should produce results that do not differ from those that would have resulted from similar transactions between independent companies under similar circumstances. This principle is cited in the US transfer pricing rules (Code Section 482 and the Treasury regulations thereunder), the Transfer Pricing Guidelines, and the UN Transfer Pricing Manual for Developing Countries. There are some countries (e.g., Brazil) that do not follow the international application of the arm’s-length principle.
If a transaction between related parties is priced differently than if it were between unrelated parties, the IRS has authority under Section 482 to reallocate income or expenses to reflect the amounts that would have resulted had the transaction been conducted at arm’s length.
The Section 482 regulations are extensive and attempt to address a full range of transactions in light of the arm's-length standard. In practice, however, it is not easy to determine the appropriate arm's-length result based on a given set of facts and circumstances. Transactions in goods and services may embody unique, company or industry-specific elements that are difficult to compare with transactions involving other companies. The Section 482 regulations concede the rarity of identical transactions, and instead attempt to determine the arm's-length results based on the ‘best method’ rule.
The Section 482 regulations provide several methods to test whether a price meets the arm's-length standard, but provide no strict priority of methods., No method invariably will be considered to be more reliable than another. Instead, every transaction reviewed under Section 482 must be judged under the method that, under the facts and circumstances, provides the most reliable measure of an arm's-length result (i.e., the ‘best method’).
The selection of a method also varies depending on the type of transaction. For example, the regulations provide five specified methods for transactions involving tangible property, and six specified methods for service transactions, while only three are specified for transactions involving intangible property. Methods not specified in the regulations are also potentially applicable. Note that while each method is important to understand, an examination of each is beyond the scope of this discussion.
To determine the best method for a particular transaction, the relative reliability of a method must be evaluated on the degree of comparability between the controlled transaction or taxpayers and the uncontrolled comparables applied under the method, taking into account certain factors. While a specific comparability factor may be of particular importance in applying a method, each method requires an analysis of all the factors that affect comparability under that method.
Whether a method provides the most reliable measure of an arm's-length result also depends upon the reliability of the assumptions and the sensitivity of the results to possible deficiencies in the data and assumptions.
The completeness and accuracy of the data affect the ability to identify and quantify those factors that would affect the result under any particular method. Likewise, the reliability of the results derived from a method depends on the soundness of assumptions made in applying the method. Finally, the sensitivity of results to deficiencies in data and assumptions may have a greater effect on some methods than others. In particular, the reliability of some methods depends heavily on the similarity of property or services involved in the controlled and uncontrolled transaction, while other methods rely on broad comparisons of profitability.
The Section 482 regulations recognize that a method is likely to produce a range of arm’s-length results and provide that a taxpayer will not be subject to adjustment if the taxpayer’s results fall within such an arm's-length range. The arm's-length range ordinarily is determined by applying a single pricing method selected under the best method rule to two or more uncontrolled transactions of similar comparability and reliability.
The comparables used for the uncontrolled transactions must be sufficiently similar to the controlled transaction. If material differences exist between the two transactions, adjustments must be made in order for the uncontrolled transaction to have a similar level of comparability and reliability. In many cases, the reliability of the analysis will be improved by adjusting the range through the application of a valid statistical method, often the interquartile range of results.
The Internal Revenue Code imposes penalties if a taxpayer receives an IRS transfer pricing adjustment exceeding certain thresholds. The penalties do not apply, however, if the taxpayer has prepared and documented a reasonable transfer pricing analysis supporting its reported transfer pricing.
Under Section 6662(e), the transfer pricing penalty generally is equal to 20% of the underpayment of tax attributable to the transfer pricing misstatement, but increases to 40% of the underpayment of tax for larger adjustments. Having contemporaneous transfer pricing documentation that satisfies the requirements under Section 6662(e) in place at the time the tax return is filed can help provide protection against these penalties.
Another avenue for avoiding potential transfer pricing penalties can be an advance pricing agreement (APA) – an agreement between a government and a taxpayer that provides prospective ‘certainty’ for a defined term regarding covered intercompany transactions. APAs can be unilateral (between the taxpayer and the IRS), bilateral (with the IRS and another tax authority), or multilateral (with the IRS and more than one other tax authority).