Transfer pricing disputes have become a regular agenda item in U.S. boardrooms and across the globe. in fact, 33 Securities and exchange Commission-listed companies disclosed transfer pricing audits and developments as material financial statement items in March 2013.

Governments see transfer pricing audits as an underutilized opportunity to raise revenue from multinational companies. In what may be a surprise to many multinationals - and their advisors - small and midsized companies are now facing scrutiny, too.

TRANSFER PRICING MADE SIMPLE

Transfer pricing laws govern the prices charged on a multinational's intercompany transactions such as goods, services, royalties and loans across tax jurisdictions. It is a contentious issue because the prices charged on intercompany transactions affect how much taxable income is allocated globally.

For example, if Ford ships U.S.-manufactured cars to its Canadian subsidiary for sale to Canadian dealers, the IRS and the Canada Revenue Agency are concerned about the price charged across the border. Charge too high a price, and the CRA adjusts taxable income and assesses penalties; charge too low a price, and the IRS can do the same thing.

Many companies have limited experience in complying with transfer pricing rules and regulations. Simply stated, every intercompany transaction that crosses borders has a transfer pricing issue. Fortunately, the "arm's-length principle" is the global standard for almost all tax authorities. The critical question is how to identify the most contentious transactions and manage risk accordingly.

Finance executives can be forgiven for leaving transfer pricing off of their list of top priorities in recent years. Although the IRS is now required to request transfer pricing documentation as part of every tax audit -- with a 30-day deadline -- the agency did not necessarily have the manpower or centralized expertise to identify problematic transfer pricing, especially in the middle market. Quite often, just having a hastily compiled transfer pricing report would be enough.

Transfer pricing audits are more invasive and disruptive than most, if not all, audits conducted by tax authorities. It is a highly facts-and-circumstances driven area, and therefore transfer pricing auditors spend substantial time and effort interviewing management and collecting information.

One recent transfer pricing court case filing disclosed that the IRS was seeking to interview 67 employees at eight different manufacturing sites for a 2007-2010 audit, even though the IRS had already conducted interviews with 85 employees at 12 different plants for the 2005-2006 audit.

 

WHAT COMPANIES CAN DO

Fortunately, not every taxpayer faces the risk of 80-plus IRS interviews, but transfer pricing audits can still be an enormous drain on resources for a company of any size. That being said, taxpayers in the U.S. and in upwards of 70 other countries can defend themselves by preparing transfer pricing documentation reports to support their intercompany pricing results. (Companies can also apply for an advance pricing agreement, where taxpayers can reach an agreement with tax authorities on intercompany pricing -- either on a unilateral or bilateral basis. Once agreed, the taxpayer would not face the risk of a transfer pricing adjustment under an audit. However, these are rare, take a great deal of time to complete, and often require high levels of disclosure.)

Under Treasury Regulation Section 1.6662, corporate taxpayers can mitigate the risk of a transfer pricing penalty by preparing a contemporaneous transfer pricing documentation report.

A transfer pricing report justifies the intercompany prices charged across borders through economic analyses by reference to third-party "market," or "arm's-length," prices. More important, a transfer pricing documentation report also serves as the first line of a defense during a transfer pricing audit.

A transfer pricing documentation report is not a guarantee that the IRS will agree with the taxpayer's position. However, a company with contemporaneous documentation will be far better positioned to defend itself during an audit. At a high level, the documentation includes the following information:

  • Explain each company's functions, assets and risks in detail, including corporate structure (functional analysis);
  • Explain how recent industry developments affect the business (industry analysis);
  • Describe the intercompany transactions and analyze relevant financial information and pricing (financial/economic analysis; and,
  • Select the "best method" for benchmarking transactions and demonstrate how the profitability or pricing is "arm's-length" (financial/economic analysis).

Documentation reports of hundreds of pages are not uncommon. However, in my experience, most of the factual information needed can be gathered through 30-to-45-minute interviews with selected company management and readily available internal company materials. To be clear, a comparable benchmarking study alone is not considered penalty protection documentation.
 

RULES OF THUMB

Ideally, a transfer pricing documentation report should include a straightforward assessment of the business and industry, with a thorough analysis of the taxpayers' transactions against independent benchmarks from both a U.S. and overseas perspective. The IRS and tax authorities globally are concerned with the actual results of transactions, rather than the policy or approach adopted.

  • Reports prepared solely for U.S. purposes may actually highlight exposures from an overseas perspective (and vice versa).
  • Checklists and one-sentence summaries in reports may raise more questions and not meet auditor expectations.
  • Reports must be updated annually to be considered contemporaneous for purposes of penalty protection.

In my experience, a company that submits a thorough transfer pricing report, even one prepared after the tax return is filed, is better placed than one with no report at all.
 

RED FLAGS

No set of rules can possibly identify every transfer pricing risk, but there are certain red flags that experienced auditors regularly use to identify problematic pricing. By anticipating a transfer pricing economist's strategy, a company can prepare arguments and analyses to explain intercompany pricing well before documentation is requested.

As a starting point, transfer pricing rules direct where multinationals are allocating profits by country; consequently, profit margins by country and the volume of intercompany transactions are a great starting point for assessing risk. With respect to margins, while reviewing the legal entity profitability of the parent company is helpful, companies should start with the legal entity operating margin of each subsidiary company. In the author's experience, earnings before interest and tax as a percentage of sales is an easily calculated ratio for assessing profitability.

Companies should review each subsidiary's profitability on a single-year and multiple-year basis. Note that EBIT as a percentage of sales is not necessarily the best ratio for benchmarking profitability, as other ratios may be more indicative of an arm's-length result. However, operating margins are a good starting point for assessing risks.

Why start with the subsidiary's profits? A transfer pricing economist may know little about an individual taxpayer, but they normally expect that a subsidiary should earn some level of operating profit. From the local tax authority's perspective, their question is, "Would an independent company continue to transact with the parent company while failing to earn reasonable profits?"

Yes, there can be very good reasons why a subsidiary incurs losses. Start-up costs, substantial reductions in sales volumes, or market prices of commodities can all be commercial reasons for losses. That being said, by identifying potential problem spots, a company can explain these issues well before an audit.

Conversely, a multinational's subsidiaries earning high levels of profits create the opposite exposure. Could an IRS economist question whether a company is shifting most, if not all, profitability overseas by not charging enough on intercompany transactions?

 

BACK TO THE BOARDROOM

Tax surprises are not welcomed in the boardroom or C-suite. While senior management certainly expects some scrutiny of tax affairs, the breadth and invasiveness of a transfer pricing audit will startle even the most experienced of executives. The time and resources required to respond to tax authority charges and the risk of additional taxes and penalties have established transfer pricing as the No. 1 tax issue for multinationals. Transfer pricing should no longer be "just another tax issue."

Bottom line, the best way to avoid a transfer pricing adjustment and penalties is to not get into a transfer pricing audit in the first place. A practical approach to identifying, assessing and mitigating transfer pricing risk can help remove painful transfer pricing audits from the boardroom agenda.

Alex Martin is principal of transfer pricing services at Southfield, Mich.-based accounting firm Clayton & McKervey PC.

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