Know Transfer Pricing to Avoid IRS Difficulty
By Mitchell Kopelman, partner-in-charge of Tax, and Yelena Epova, partner-in-charge of International Services
If your company plans to expand operations in the United States or into other countries, then you need to know about transfer pricing. A transfer price is the price at which U.S. and non-U.S. related companies buy and sell goods and services to each other.
This is an important issue because the Internal Revenue Service, as well as the taxing authorities of many other countries, wants the ability to tax its fair share of such worldwide profits. Owners and managers of multi-national companies, on the other hand, want to minimize their exposure to tax penalties, double taxation and worldwide taxation.
Take for example a company in France (parent) that manufactures farm equipment and sells it to a wholly-owned subsidiary (sub) located in the United States. The sub then resells the equipment to its customers in the United States. The key elements are as follows:
- The farm equipment is manufactured in France at a cost of $10,000.
- The parent sells this equipment to its U.S. subsidiary for $17,500, realizing a gross profit in France of $7,500.
- The sub sells the equipment to a U.S. customer for $20,000, realizing a gross profit of $2,500.
- The total gross profit realized worldwide on the sale is $10,000.
How can the French company justify receiving 75 percent of the profits, while the U.S. company only receives 25 percent? One reason is that the parent company will most likely have significant resources committed to the manufacturing and R&D process. Since the sub may only be a distribution company, there is little need for capital in the United States, but significant need for capital in France. Thus, the parent has much more at risk. The IRS, however, might believe the sub should recognize more than 25 percent of the gross profit and, therefore, should be liable for income tax on more than 25 percent.
To address the allocation of global profits between related parties, the IRS issued Code Section 482. Believe it or not, this actually authorizes the IRS to reallocate income or deductions between related entities to taxable income. They can establish transfer pricing strategies, allowable by the regulations of Section 482, by choosing the best method to justify the transfer price of goods and services.
Allowed Pricing Methods
One of the most common pricing methods, and the one most preferred by the IRS, is the comparable uncontrolled price (CUP). In our example, let’s assume the parent also sells equipment to unrelated Italian and Australian companies for less than it sells to the U.S. sub. In the IRS’ view, the parent may have overcharged the U.S. sub for the same equipment, which makes the transfer pricing issue very interesting and difficult to deal with.
If the French company, however, sells the equipment to all three companies for the same price, it could justify the transfer price between the parent and the U.S. sub as being equivalent to what is considered an “arm’s-length” price charged to the other, unrelated firms.
The regulations also allow other methods to be used for transfer pricing justification. If more than one pricing method is available, taxpayers must be careful to analyze those methods and select the “best method,” as defined under the final Section 482 regulations.
The final regulations describe four other categories of potentially acceptable transfer pricing methods: the resale price method, the cost plus method, the comparable profits method and the profit split method.
Generally, taxpayers are required to prepare contemporaneous documentation that carefully explains their transfer pricing analyses and methodologies at the time the tax return is filed. Taxpayers must produce this documentation within 30 days of an IRS request. Failure to comply with IRS requirements could subject the taxpayer to the penalty provisions of Code Section 6662.
Assuming the IRS makes a transfer pricing adjustment and the documentation requirement was not met, Section 6662 allows the IRS to impose a 20 percent or 40 percent non-deductible penalty. A 20 percent penalty is imposed if the transfer price adjustment exceeds the lesser of $5 million or 10 percent of the company’s gross receipts. If the transfer price adjustment exceeds the lesser of $20 million or 20 percent of the company’s gross receipts, the IRS can impose a 40 percent penalty on the adjustment.
By imposing a contemporaneous documentation requirement on taxpayers, the IRS hopes to improve its access to pricing information and policy, encourage planning and forethought in establishing pricing policies and mitigate audit controversies. Some practitioners and taxpayers, however, view the documentation requirement as excessive.
A U.S. corporation that is 25 percent or more foreign-owned and has related-party transactions will have to file Form 5472 with its corporate tax return. A relevant factor that should be addressed is whether the reporting corporation imports goods from a foreign-related party. If so, the form asks if the inventory costs of the goods were valued at greater than the customs value of the imported goods.
If the imported goods are valued at an amount greater than the customs value, Form 5472 asks if the documents used to support this treatment of the imported goods in existence are available in the United States at the time of filing.
Transfer pricing issues can be extremely complicated; every situation is unique and must be evaluated on a case-by-case basis. While some companies buy and sell tangible property, as in our example, many companies that buy, sell or license intangible property have similar issues that need to be evaluated and analyzed.