Small and midsized companies are facing increased scrutiny from tax authorities both in the U.S. and in foreign jurisdictions to ensure that the transfer pricing of transactions among their subsidiaries is treated as if they were at arm's length - or what two unrelated parties would pay."Transfer pricing is something that a lot of small and medium-sized companies need to be paying attention to and thought they were under the radar in the past," said Meril Markley, a principal at UHY Advisors in Houston. "But because of FIN 48, they're really going to have to take a close look for the first time."

The Financial Accounting Standard's Board Interpretation Number 48, Accounting for Uncertainty in Income Taxes - an interpretation of Statement 109 - clarifies the accounting for uncertainty in income taxes recognized in financial statements.

According to Markley, FIN 48 requires that companies look at each one of the foreign jurisdictions that they operate in and decide if there's any local tax exposure there. The standard under FIN 48, she said, is that it has to be more likely than not that the taxes that have been estimated or provided for will prevail in the case of an audit.

"Often it's not the Internal Revenue Service that triggers the concern," Markley explained. "It's the foreign tax authority, because in a number of countries, transfer-pricing studies have to be either submitted with the annual tax return or available for the company's statutory financial auditors."

According to a 2005-2006 Global Transfer Pricing Survey released by Big Four firm Ernst & Young, 63 percent of multinational companies have had a transfer-pricing audit in the past three years.

"We see a broad trend of increased vigilance in the area of transfer pricing by tax authorities throughout the world, and it creates an effect of a tug of war for taxable dollars," said Enrique MacGregor, a managing director at Ceteris, a global economic consulting firm specializing in transfer pricing, litigation support and valuation services.


"Ever since FIN 48 requirements became effective last December," MacGregor said, "many clients have asked us whether their transfer-pricing reports are sufficient to prevent companies from having to hit their balance sheet with heavy tax reserves under FIN 48."

MacGregor said it's important to understand that FIN 48 analyses consider a whole spectrum of other factors when determining the risk of a transfer-pricing adjustment and resulting tax exposures. "FIN 48 relates to accurate financial reporting of uncertain positions, and transfer-pricing documentation relates to the support behind one specific position in pricing cross-border transactions," he said. "The transfer-pricing documentation rules and FIN 48 rules are not harmonized."

One of the main effects of FIN 48 on transfer pricing will be to change the frequency with which companies look at their inter-company prices, according to MacGregor.

"Before FIN 48, in theory you could run an operation for an entire tax year without much planning or documentation of transfer prices," he said. "Then, the night before year-end, you figure out the right inter-company prices and you make a year-end adjustment to your books so that the taxable income in your return meets the arm's-length standard. And in the U.S., you don't have to complete your transfer-pricing documentation until you file your tax return, which is due a few months after the end of the tax year. By contrast, under FIN 48 ... there is a significant amount of work that has to be done every quarter."

Implementation is also different, particularly when you first start the FIN 48 process. "To prepare for first quarter FIN 48 requirements, public companies had to look back into all open years to identify any potential exposure created by past positions in transfer pricing," he explained. "For purposes of tax compliance, documentation requirements for past periods had already been met. Yet many companies will find themselves in a scenario where, in spite of a reasonable attempt to comply with transfer-pricing documentation requirements in earlier years, they still have significant exposures when the transaction is revisited under FIN 48."

Requirements for transfer-pricing documentation were conceived many years before FIN 48 was created, MacGregor said, and ultimately they are not designed to protect a company from having to report reserves under FIN 48.

Not surprisingly, the pressure coming down from increased transfer-pricing regulation and FIN 48 implementation is having a dramatic effect on companies. "[It] is a big struggle," said Michelle Johnson, a director at Ceteris and MacGregor's colleague. "Because FIN 48 is so new and because transfer pricing can be so subjective, there's much uncertainty about how whatever companies put together will be perceived once it's scrutinized. Our clients had a lot of headaches this past year trying to figure out what their auditors would accept as a FIN 48 analysis for transfer pricing, as even the auditors didn't quite know what they wanted."

Many countries have transfer-pricing regulations that require that a company provide an economic analysis - the core of a transfer-pricing study - and other pieces of documentation to make sure that the inter-company transaction is at arm's length from a tax perspective, according to Johnson. From a FIN 48 perspective, those transactions and arm's-length prices not only have to be understood, but companies also have to take an inventory of what arguments tax authorities could make to challenge how they came up with their arm's-length price.

"If it's their first time doing the analysis since the FIN 48 standard came out, they're usually looking back at anywhere from between three to six years of data," she explained. "Once you understand what transactions there are, you need to put a lot of thought into what type of support is out there for the pricing of those transactions. For example, is there documentation that satisfies tax authorities for all jurisdictions involved? How could tax authorities challenge the way you priced your transactions? What is the likelihood that the company would have to pay more tax due to transfer-pricing adjustments upon resolution of the audit?"

Transfer-pricing documentation - which includes an overview of the company's business; a functional and risk analysis related to the inter-company transactions; an economic analysis that provides an objective basis for a transfer-pricing methodology; and a conclusion comparing the arm's-length pricing with the company's actual prices - has never guaranteed protection from a tax authority claiming that more income should have been attributed to their jurisdiction.

MacGregor added that under Section 1.6662 of the IRS Treasury Regulations, there are 10 specific categories of principal documents that need to be in place in order to satisfy the transfer-pricing documentation requirements. The report has to be prepared on a contemporaneous basis and provided to the IRS within 30 days of a request.


The problem, however, is that transfer-pricing studies are often expensive, and many smaller companies don't see the value in making the investment.

"Our client base typically is not that familiar with transfer pricing, and just does not understand that even though they are selling $5 million of product between parent and subsidiary, whichever way it goes, that the price they charge may be challenged by one or both tax authorities," said James Erdekian, tax director at Feeley & Driscoll PC in Boston, adding that his firm serves only private companies, mainly in manufacturing and technology. "So the first thing we do, especially when we get a new client, is we have to educate [them] about this whole transfer-pricing issue."

Erdekian also tells his clients that the IRS is "very hot" on international issues, and not just auditing public companies, but private companies, as well. "So we have to get that through to them. Then they say, 'Okay, what does a transfer-pricing study cost?' And this is where they freak." He said that the price tag of a study can vary. A "barebones" study could cost $15,000, but a full-blown study, depending on what's happening within the company, could cost upwards of $75,000. "Three quarters of them will say, 'I'll wait. I think what I'm doing is right anyway, so therefore I'll take my chances,'" said Erdekian.

To deal with the pressure of managing the documentation, companies are seeking out help by engaging both CPAs and attorneys to make sure they are prepared and are in compliance.

The first thing CPAs can do to help clients with transfer-pricing issues is to identify the inter-company transactions of the client and assess the relative risk of a possible adjustment by the IRS or a foreign taxing jurisdiction. Then, documentation needs to be prepared in accordance with U.S. and foreign tax rules to protect the client from penalties if it is subsequently determined that the inter-company pricing is not in accordance with the arm's-length principle, according to Jeffry A. Neuenschwander, managing partner of U.S. transfer-pricing services at Deloitte Tax LLP.

Once that information is available, according to UHY's Markley, the CPA can also assist the client to undertake more systematic tax planning, armed with the information gleaned from the transfer pricing study. "For example, making even small changes to how business is done and how risk is allocated could achieve a beneficial shift of income from a higher-tax country to a lower-tax country," she said.

To implement FIN 48, Anthony Curtis, a senior economist and principal in PricewaterhouseCoopers' global transfer-pricing services group, said to designate one point person to spearhead the process, "where the people involved in the different divisions can filter up their thoughts. That way upper management has a chance to make sure there is consistency with application of FIN 48."

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