Howard B. Epstein
If your company has a U.S. subsidiary, you will most likely have some transfer pricing considerations that need to be addressed. Transfer pricing can be one of the more complex tax issues affecting multi-national businesses. The goal for this post is to educate you about some of the transfer pricing related issues and terms and some of the documentation you’ll want to have on hand.
What is Transfer Pricing?
Transfer pricing principles apply to related company transactions that cross borders. These principles try to align the value and the income from operations within a jurisdiction where the relevant functions are performed and risks taken. Perhaps one of the clearest examples is to compare two companies that assemble, finish and sell wooden furniture.
Company 1 is located entirely in the U.S. and buys the wood that it will assemble and finish from unrelated companies. Company 2 is the U.S. subsidiary of a Canadian parent and it buys all of the wood that it assembles and finishes at its U.S. location from the parent company. Assuming that Canadian tax rates are lower than U.S. tax rates, Company 2 would seek to minimize its income in the U.S. to reduce its global tax burden.
This could be accomplished by having the Canadian parent supply the wood to them at a high cost, resulting in a high cost of goods sold in the U.S. that would reduce taxable income there.
Transfer pricing rules are designed to ensure that the price the Canadian parent charges its U.S. subsidiary is comparable to the price that its U.S. subsidiary would pay had it purchased wood from an unrelated party in an “arm’s-length” transaction.
Transfer pricing principles stipulate that the U.S. subsidiary would be required to have on hand contemporaneous documentation that the price it paid for the wood from its foreign parent was comparable to an arm’s-length price.
While this very basic example focused entirely on cost of goods sold, these same rules apply to all related party transactions such as charges for administrative support, royalties, interest and similar types of charges between a foreign parent and its U.S. subsidiary. Additionally, these rules work in alternate situations where the transactions are between a U.S. parent and a foreign related entity.
Transfer Pricing: Theory and Practice
In theory, transfer pricing is about making sure that income and value are recorded in the country and localities where the corresponding operations of the business are performed.
In practice, the U.S. and foreign governments audit transfer pricing with an eye toward making sure that multi-national businesses have apportioned profits related to operations in a manner that ensures these businesses pay the full amount required in their respective countries. Businesses, on the other hand, focus on managing international operations to minimize the amount of profits generated in higher tax countries.
The critical point for businesses is not that you should try to contort your numbers in order to minimize your U.S. tax burden when you file a return. More than anything else, you need to consider the possibility of cross-border commerce from the start of your business. Plan growth in a manner that provides optimal support for operations in other countries while minimizing income that could be apportioned to high tax jurisdictions. If transfer pricing is not considered until your tax preparer is working on your U.S. tax return, you won’t be able to do much to manage the impact in the current year.
The U.S. rules require that the rationale for your related party transaction pricing be documented thoroughly at the time the return is filed. That documentation is not sent with the return, but it must be made available to the IRS in the event of an audit.
What’s at Stake If a Transfer Price Is Revised?
In addition to owing additional income tax related to the adjustment from the transfer price, U.S. law also provides for penalties in this area. Penalties for inaccurate transfer pricing can range from 20% to 40% of the tax related to the understatement of the income that resulted from the transfer prices used by the taxpayer. In addition, depending on tax treaties or the tax policy in the parent company’s home country, the changes could result in double taxation of certain income. If the U.S. determines that more income should be subject to tax in America, the parent company’s home country may not accept a corresponding decrease in taxable income calculated there.
The analysis, calculations and documentation required to accurately set and support transfer pricing policies within a company should always be performed or supervised by a professional with considerable experience in the field. Given the significant penalties that can be assessed if transfer prices are determined to be inaccurate, few businesses can afford to run the risk of miscalculating these numbers.
Documenting a Transfer Price
U.S. tax regulations provide a specific list of the documentation needed to support a transfer price calculation. The rules do not require that all of this information be filed along with the tax return, but they do require that the calculation of the transfer price and the creation of the related documents occur during the process of preparing the tax return. If your return is selected for audit, the IRS will ask for these documents and the rules require that you provide them within 30 days of the request.
Proper documentation for a transfer price calculation on a U.S. tax return includes:
- An overview of the taxpayer’s business.
- A description of the taxpayer’s organizational structure covering all related parties engaged in transactions that may include transfer pricing.
- Any documents specifically required by regulations.
- A description of the transfer pricing method selected and an explanation of why it was selected.
- A description of alternative transfer pricing methods that were considered and an explanation of why they were not selected.
- A description of the transactions between the parent and controlled parties.
- A description of how the transfer price was compared to relevant alternatives.
- An explanation of the economic analysis and projections used to develop the transfer pricing method.
- A description or summary of any relevant data obtained by the taxpayer after the end of the tax year and before the filing of the return that would help determine if the taxpayer selected and applied the transfer pricing method in a reasonable manner. And,
- A general index of the principal and background documents and a description of the recordkeeping system used for cataloging and accessing those documents.