Transfer Pricing

By Guest Blogger: Rob Trammell, ASL Principal

The IRS recently released a “Roadmap for Transfer Pricing Auditors.” This roadmap lays out IRS policy related to transfer pricing issues, and provides auditors with tools and detailed procedures for how to work a case.

What is Transfer Pricing?

Transfer pricing has always been an issue for multinational companies who transact business across tax jurisdictions. However, due to the frequency of cross-border operations, and the ability to recognize profit in lower tax jurisdictions, the IRS is giving the issue renewed scrutiny.

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 important as the prices charged on these intercompany transactions affect how income is allocated globally.

For example, you are a US distributor of widgets. These widgets are manufactured by your subsidiary in China and then shipped to the US for sale. How much does China charge the US entity for the widgets? Charge too low a price and the Chinese tax authorities adjust taxable income and assess penalties; charge too high a price and the IRS can do the same thing.

How can you protect yourself in the event of an audit?

The best way is to have contemporaneous (at time of filing) documentation to support the intercompany pricing. This documentation would generally include the following information:

  • Functional analysis to include each company’s purpose, assets and risks and corporate structure;
  • Industry analysis that explains how recent developments affect the business;
  • Financial/economic analysis that describes the intercompany transactions and analyzes relevant financial information and pricing; and
  • Demonstrations that transactions are “arms-length” based on benchmarking.

What happens in the event of an adjustment on audit? Well, it depends on whether there is documentation to support your position. Transfer pricing penalties apply on the additional tax payable after a transfer pricing income adjustment. If a contemporaneous documentation report is in place, penalties will not apply. If there is no report in place, the penalties can be as high as 20% or 40% depending on the size of the adjustment.

Statements by the IRS in the roadmap illustrate the importance of documentation. “Transfer pricing cases are usually won and lost on the facts. The key in transfer pricing cases is to put together a compelling story of what drives the taxpayer’s financial success, based on a thorough analysis of functions, assets, and risks, and an accurate understanding of the relevant financial information. An effective story explains the taxpayer’s value chain, competitive position in its industry, and financial results, in a clear and compelling fashion. If indications are that the tax result claimed by the taxpayer is at odds with common sense and economic reality – ‘too good to be true’ – chances are it is a good candidate for further scrutiny. Conversely, if indications are that the taxpayer’s financial results are reasonable, and the taxpayer’s method fits its fact profile, it may not be worth pursuing the issue.”