In recent years the IRS has focused more heavily on the transfer pricing of intangible property. Section 482 of the regulations provide guidelines so that these controlled transactions are conducted at an arm’s length when intangible property is owned by one company but used by another related company in another jurisdiction.
In this post, we'll summarize the different types of methods that are available to compare intercompany transactions of intangible property to uncontrolled transactions.
Intangible Property Can Come in Many Forms
Some of the most common intangible property that may be shared between related parties in separate jurisdictions are patents, know-how, trademarks and trade names. The available transfer pricing methods for pricing transfers of intangible property are as follows:
Comparable uncontrolled transaction transfer pricing method: Under this method you would be comparing the controlled transaction (intercompany/related party) to an uncontrolled transaction (unrelated/third-party). The intangible property must be used with similar products/processes in the same industry or market and have a similar profit potential.
An example of this would be if a company had a manufacturing process that it allowed its related company to use as well as an unrelated company in the same country with the same profit potential. For tax purposes, the company will need to prove that they are pricing the uncontrolled and controlled transactions the same. If there are different factors that need to be considered such as risk and an adjustment can be readily calculated, those need to be considered as well.
Comparable profits transfer pricing method: This method is based on profit level indicators. The goal of profit level indicators is to identify the amount of profit which would have been earned in an uncontrolled transaction of a similar taxpayer. Profit level indicators can be based on assets (operating profit / operating assets), sales (operating profit / sales), or expenses (gross profit / operating expenses). The reliability of these indicators can vary depending on size, industry, or relevant product lines, so it is important to understand the nature of the business and the uncontrolled taxpayer(s) with which you are comparing.
Profit split transfer pricing method: There are two ways the profit split method which can be used—the comparable profit split and the residual profit split. In practice, the comparable profit split method is rarely found as it’s based on profit from an uncontrolled transaction involved in similar transactions and activities. As this information is rarely available, the more commonly used is the residual profit split method.
Under the residual profit method, the first step is to allocate a portion of the income to each of the “routine” activities of the taxpayers. Next, the remaining residual profit is divided among the controlled taxpayers based on the value of the non-routine business activities in the process. Routine business activities are considered to be those directly related to the operating profit of the business. Non-routine activities would include the value of intangible property.
Unspecified methods: Used if a method other than those listed above is considered the best for the specific situation.
Avoid Penalties with Contemporaneous Transfer Pricing Documentation
While the implementation of the transfer pricing adjustments into your taxable income is very important, another critical aspect of transfer pricing is the documentation. Transfer pricing documentation on all intercompany transactions, including those on intangible property, must be contemporaneous. This means that it must be in place as of the time the tax return is filed. Without documentation there could be severe penalties of 20-40% of the underpaid tax due on the transfer pricing adjustments that the district director deems reasonable for the intercompany transactions.