Doing business in the United States: Transfer pricing

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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:

  • tangible goods (e.g., manufacturing, distribution)
  • services (e.g., management services, sales support, contract R&D services)
  • financing (e.g., intercompany loans, accounts receivable, guarantees, debt capacity)
  • intangible property (e.g., licenses, royalties, cost sharing transactions, platform contribution transactions, sales of intangibles).

The international standard for determining the appropriate transfer price is the arm's-length principle. Under this principle, transactions between two related parties should not produce results that 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.

1. Best method rule

The Section 482 regulations provide several methods to test whether a price meets the arm's-length standard. Although there is no strict priority of methods, and no method invariably will be considered to be more reliable than another, 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.

2. Comparability factors

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 uncontrolled comparables, 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.

3. Quality of data and assumptions

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.

4. Arm's-length range

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.

5. Penalties and documentation

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 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).

Tax readiness insight: The Act generally does not alter the arm’s-length standard as reflected in US domestic law and relevant treaties, although it does alter the statutory language for the definition of intangibles and for certain valuation methods in the context of intangible transfers. Thus, the related-party components of the calculations under the BEAT and the GILTI calculations still will require compliance with the arm’s-length standard. From a foreign perspective, companies also must also weigh forthcoming BEPS and OECD initiatives in the context of revisiting their operating models and capital structure. Finally, the US move to a lower corporate tax rate may invite scrutiny of foreign jurisdictions to the extent changes are made to existing intercompany policies.
Tax readiness insight: The Act added Section 367(d)(4) to include in the definition of intangible property, for purposes of Sections 367 (relevant to outbound restructurings) and 482 (intercompany transfer pricing), workforce in place, goodwill, going concern value, and any other item of intangible value.
The Act also amended Sections 367 and 482 to codify certain valuation principles reflected in the current Section 482 regulations with respect to transfers of intangible property. Specifically, the Act authorizes the IRS to apply the ‘realistic alternatives’ principle and to value transfers of multiple intangibles (or intangibles and services, for example) on an aggregate basis. These changes apply to transfers in tax years beginning after December 31, 2017.
The expanded definition of intangibles and codification of the IRS’s preferred valuation principles could particularly affect IRS scrutiny of transactions or restructurings involving high-value or hard-to-value intangibles, including those involving multiple interrelated elements (such as the implementation of a cost-sharing arrangement). The changes for the most part reflect provisions already incorporated in the current Section 367 and Section 482 regulations, but the IRS may be further encouraged in its efforts by the fact that these valuation principles, coupled with an all-encompassing definition of intangibles, will now be set forth in the statute. A potential issue arises to the extent the positions the IRS may take under the new statutory authority and intangible definition may create tension with international standards such as the OECD Transfer Pricing Guidelines, which apply under the domestic law of many countries as well as under US income tax treaties.

Christopher Kong

US Inbound Tax Leader, PwC US