Today’s companies operate in a global marketplace. Many have subsidiaries, affiliates and other related companies located overseas. Transfer pricing can help multinational companies cut their tax bills. With the IRS closely scrutinizing such transactions, however, it’s critical that you understand the rules and requirements. You should also learn how an advance pricing agreement (APA) can help you avoid an audit and all the related repercussions.
Transfer Pricing 101
Transfer pricing generally refers to the price that one affiliate charges another in an intercompany (or “controlled”) transaction involving the transfer of goods, services or intangible assets, such as brands, customer lists and intellectual property. Companies can charge above- or below-market prices in these transactions to assign profits and costs to affiliates to reduce their overall tax liability.
For example, if one affiliate is located in a high-tax country, the corporation can make that affiliate less profitable by charging an affiliate in a lower-tax country below-market prices. The purchasing affiliate ends up with a lower cost of goods sold and higher profits, while the transferring affiliate has lower profits and, in turn, less tax liability.
But Section 482 of the Internal Revenue Code empowers the IRS to distribute, apportion or allocate gross income, deductions, credits or allowances between or among related parties to prevent evasion of taxes or to clearly reflect the income of any parties. Related regulations require that a transfer price yield results consistent with those that would have been realized if the transaction had been between unrelated parties. In other words, the pricing must reflect an arm’s-length transaction.
Best Method Rule
Under the best method rule, a taxpayer must select a pricing method specified in the regulations to determine whether its transfer pricing is arm’s length. 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.
Governments around the world have intensified their documentation requirements to rein in abusive transfer pricing tactics. For example, the IRS requires sufficient documentation that a transfer pricing method was selected and applied in a reasonable manner. However, such documentation doesn’t guarantee automatic protection against penalties.
IRS regulations lay out the specific documentation requirement. The so-called “principal documents” should include:
- 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.
Background documents are used to support the assumptions, conclusions and positions contained in the principal documents.
Important: Despite its name, the documentation requirement isn’t mandatory. It’s nonetheless advisable to collect this information. If the IRS requests transfer pricing documentation, taxpayers have only 30 days to provide it. Moreover, documentation that existed when the taxpayer filed its tax return can reduce the risk of hefty penalties.
The IRS has historically received deficient transfer pricing documentation from companies. For that reason, in 2020, it published best practices for transfer pricing documentation reports. According to the guidance, adequate documentation should include:
- 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.
The tax agency generally wants detailed analysis documentation for complex transactions. Inadequate documentation may expose a multinational company to pricing adjustments by the IRS. It can lead to costly appeals and litigation, penalties and interest, customs adjustments, and the need to amend tax returns.
An APA 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.
The general fee for a new APA is $113,500 ($54,000 for a “small case” APA). A renewal costs $62,000. Companies should evaluate whether the enhanced certainty regarding its U.S. tax liability is worth the IRS fee.
Proceed with Caution
Transfer pricing transactions have historically been 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.