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Transfer Pricing

Transfer Pricing for Small & Mid-Size Business – What is Important Now and Why

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Frank J. Vari, JD, MTax, CPA

One of the most common questions we at FJV receive from our small business clients is what is transfer pricing and why must we address it now?  Many clients – and some practitioners – seek an answer but are overwhelmed by the complex and conflicting information generally available.

If your company plans to expand business operations into the U.S. or expand their U.S. operations into another country at least a basic understanding of transfer pricing is required.  Once there is a basic understanding, one can better comply with the legally mandated transfer pricing rules and then create a strategic pricing plan.

To best explain, let’s discuss transfer pricing basics, pricing methods, and documentation requirements.

Transfer Pricing Basics

A “transfer price” is the price at which related companies located in different countries buy and sell goods and services to each other.  This is very important to each country’s taxing authority as each country wants to tax a share of these worldwide profits.  “Transfer pricing” is generally defined as the legal mechanism that allocates the profit from that related party sale between the competing tax jurisdictions without creating double taxation.  This mechanism, as outlined in a variety of laws around the world, allocates global supply chain profits based upon the functions and risks of the related parties.  The party which performs the most important and costly functions, e.g., design and manufacturing, and takes the greatest risk, e.g., capital investment and customer credit risks, is entitled to the greater profit.

For example, let’s assume a U.S. entity manufactures medical equipment and sells it to a related party located in Germany.  The German entity then resells the equipment to its customers within Germany.  The financial elements here are as follows:

  • The medical equipment is manufactured in the U.S. at a cost of $10,000.
  • The parent sells this equipment to its German relative for $17,000 realizing a taxable profit in the U.S. of $7,000.
  • The German entity then resells this same equipment to an unrelated German customer for $20,000 thus realizing a taxable German profit of $3,000.
  • The total taxable profit for the entire global supply chain is $10,000.

How can the U.S. entity justify receiving 70% of the taxable profits, while the German entity only 30%?  In our example, the U.S. entity has performed the costly research, design, and manufacturing functions for the medical equipment.  The German subsidiary is only involved in the local German marketing and distribution of the product which requires little capital or investment.  Thus, the U.S. entity has performed the greater functions and taken the greater risk which legally entitles them to the greater profit.

This profit split may be challenged by either the U.S. or German tax authorities using their own local transfer pricing laws.  However, almost every country, including the U.S. and Germany, requires that each related taxpayer perform and document a transfer pricing analysis of their taxable profit allocation with related parties.  No exceptions.

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Transfer Pricing Methods

The IRS first enacted rules back in 1928 to address intercompany profit allocations that have evolved into present-day IRC Code §482.  These rules actually empower the IRS to reallocate income or deductions between related parties to prevent tax evasion.  If the taxpayer doesn’t perform a properly documented allocation or get it right the IRS will do it for them.  Not a good place to be for sure.

IRC Code §482 requires taxpayers to create and document a transfer pricing policy that chooses the best method to justify the transfer price of goods and services.  The IRS allows various methods for various types of transactions.  Transfers of heavy equipment, software, and consulting services are all sufficiently different that different pricing methods are required.

One of the most common pricing methods – and the one most preferred by the IRS and other taxing authorities – is the Comparable Uncontrolled Price (“CUP”) methodology.  In our example, let’s assume our U.S. entity also sells the same type of medical equipment to unrelated Chinese and Australian customers for more than it sells to the German related party.  The IRS may – and probably will – argue that the U.S. entity is not charging Germany enough and a greater U.S. taxable profit should be reported.  Alternatively, if the U.S. entity sells the medical equipment to all three customers, both related an unrelated, for the same price it could justify the intercompany transfer price between the related U.S. and German entities as an “arm’s-length” price.

IRC Code §482 provides other methods besides the CUP to be used for transfer pricing of goods and services.  These methods include the Cost Plus method, the Resale Price method, the Comparable Profits method, and the Profit Split method.  Taxpayers can even use an unspecified method if they can support it.  Taxpayers must be careful to analyze each of those methods separately and select the “best method” for that particular transaction in order to comply with IRC Code §482.

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Documentation Requirements & Penalties

One very important and often overlooked rule is that taxpayers are required to prepare and maintain contemporaneous documentation that explains in a very detailed and technical manner their transfer pricing methodologies.  “Contemporaneous” means this documentation must be compiled at the same time their U.S. tax return is filed.  If the IRS requests this documentation, the taxpayer must produce it within 30 days of an IRS request.  If the taxpayer fails to do so, two very bad things can happen.  First, as noted above, the IRS will go ahead and allocate the related party profits as they see fit.  Second, the taxpayer will be subject to the documentation penalty provisions of IRC Code §6662.

If the IRS makes a transfer pricing adjustment resulting in an underpayment of tax and the documentation requirement was not met, IRC Code §6662 permits IRS to impose a 20% or 40% percent non-deductible penalty.  The 20% penalty applies if the transfer price adjustment exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.  If the transfer price adjustment exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts the IRS may impose a 40% penalty on the adjustment.

Besides proper transfer pricing documentation, U.S. taxpayers must comply with other important requirements including:

  • U.S. taxpayers who have related party transactions with their subsidiaries located outside of the U.S. must report these transactions on Form 5471.
  • U.S. taxpayers who have related party transactions with their foreign owners and their related parties must report these transactions on Form 5472.
  • If the related party sale involves a customs or duty filing, the price on the filing must be the same as that reported in the transfer pricing documentation and the Form 5471 or 5572. The failure to “harmonize” these filings can lead to additional penalties.

These are very harsh penalties that are often incurred by U.S. taxpayers who do not perform written transfer pricing studies to properly allocate or report related party profits.  The problem is there is really no way around them for small taxpayers.  Small taxpayers around the world have long called for exemptions from transfer pricing reporting but there is no significant relief to date.

Conclusion

Transfer pricing is a complicated issue that must be addressed proactively.  If properly addressed in a timely manner, transfer pricing can be addressed at a reasonable cost.  If not, the penalties kick in and the cost of these penalties coupled with the legal and professional fees of a transfer pricing conflict with any tax authority can be very high.

Our advice to any client with related party transactions that cross a foreign border is to proactively address their transfer pricing issues in a timely manner.  Whether they sell tangible property, services, or sell or license intangible property, our advice is the same.  At the end of the day, it saves our clients time and money and brings them fully into compliance with the law.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning.  FJV Tax has offices in Wellesley and Boston.  The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324.  You can learn more about FJV Tax at fjvtax.com.

 

The BEPS & FATCA Impact on Transfer Pricing – Prepare for the Future or Return to Basics?

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Frank J. Vari, JD, MTax, CPA

There is certainly no shortage of publicity regarding the impact of BEPS and FATCA on transfer pricing and how to best address these significant new requirements.  This has spurred considerable attention to predicting exactly what the future holds and how to prepare for it.  At this same time, many new rules are similar to historic requirements that a taxpayer maintain global transfer pricing positions that are supported with logic, facts, and documentation.  As we continue to see how these rules will be applied, the question remains whether multinationals in today’s environment should focus entirely on the future or return to basics?

Since the first transfer pricing guidelines were issued by the IRS and OECD, most countries, including the US, have adopted a contemporaneous documentation requirement which remains relatively unchanged as other global transfer pricing rules have greatly evolved.  Multinational corporations prepare this documentation for each taxing jurisdiction where there is either a registered subsidiary or a permanent establishment.  This same documentation also provides compliance with SOX 404 and financial statement reporting requirements including FIN 48.

A key element of the contemporaneous documentation requirement is a risk analysis that describes and allocates business risks amongst the related parties.  This risk allocation is the foundation of the intercompany profit allocation where the related party bearing the majority of the risks in the economic relationship is entitled to the lion’s share of the profits.  The better the quality of the overall documentation and the closer the nexus between this risk analysis and the income allocation the stronger the taxpayer’s position becomes.

Progressive taxpayers have long understood that creating and maintaining strong and appropriate transfer pricing documentation ensures that the taxpayer controls any narrative of its pricing and business practices.  This prevents a tax authority from creating alternative theories about a taxpayer’s intercompany relationships and standards of comparability.  To the extent a taxpayer presents a taxing authority with documentation that does not support or accurately reflect their facts or reporting positions the higher the chances are of a unilateral transfer pricing adjustment and related penalties being forced upon them.

Like existing rules, the new rules address risk allocation.  Specifically, the OECD BEPS Guidelines set out this analytical risk framework:

STEP 1 – Identify the economically significant risks of the business.

STEP 2 – Determine how the economically significant risks are contractually assumed.

STEP 3 – Perform a detailed functional analysis of the economically significant risks to determine which entity controls the risk and has the financial ability to bear the risk.

STEP 4 – Consider whether the contractual assumption of risk identified in Step 2 is consistent with the entities’ conduct identified in Step 3.

STEP 5 – Where the contractual assumption of risk is not consistent with the entities’ conduct, reallocate the risk to the party that assumes it based on conduct in Step 3.

STEP 6 – Perform a transfer pricing analysis based on the delineated transactions after re-allocating risk.

These specific requirements as laid out above may be new but they don’t materially depart from what taxpayers have been historically required to do.  The real change will be to taxpayers that have not adequately analyzed and documented their facts and performed a risk analysis on a jurisdictional basis in a sufficiently detailed manner to defend their existing intercompany profit allocations.

For all multinational taxpayers, the immediate focus should be a renewed understanding of intercompany relationships requiring the tax team to have an even closer relationship with the business product development, operation, and supply chain teams.  This ensures that detailed facts and risks are understood and, more importantly, support the taxpayer’s tax positions.  The need for an ongoing and close relationship with business teams cannot be understated due to the fluid nature of global business practices and the problems that can arise when these practices deviate from reported tax positions.  Taxpayers must now be able to adjust and adapt tax positions at least annually in potentially multiple jurisdictions or risk having any deviations pointed out on audit.

This updated risk analysis requirement is woven into a bevy of new information reporting requirements under both FATCA and BEPS.  A cursory glance at the new business and financial data that now must be filed annually significantly exceeds the information historically reported and certainly that which is publicly reported.  Gathering and reporting this newly required jurisdictional data is loaded with practical difficulties well beyond the scope of this article but it is important to note that information that is now required greatly exceeds a simple updated transfer pricing report.

What remains unchanged is that tax leadership cannot allow any deviation from their actual business practices and the newly required intercompany reporting disclosures to shift control of the transfer pricing narrative away from the taxpayer and give a taxing authority room to create their own models of intercompany profit allocation.  Agreement of all reported information with intercompany profit allocations is necessary.  It is not a new goal but it has certainly become tougher to meet due to significantly increased annual reporting requirements.

This article posed the basic question whether BEPS or FATCA requires a look to the future or a return to the transfer pricing basics?  The answer is mixed.  The requirement of a detailed functional fact and risk allocation analysis tailored to the local country is not new nor is the knowledge that much more detailed information may be required in the event of an actual audit or examination.  What is new is the significantly increased level of detail now required to be reported annually and how to best gather and present that data.  That is a very big change and one that will keep tax departments busy now and for some time to come.

To learn more about FJV’s  transfer pricing practice and our considerable experience with this important topic and how it impacts your business and tax positions, please contact FJV Tax or visit us at fjvtax.com.

This article was previously published by the Tax Career Digest.