How the IRS Expects Taxpayers to Deal with Transfer Pricing
Transfer pricing continues to be a hot issue, especially for multi-national companies operating across one or multiple country borders. While this international scenario is the main focus, it’s important to note that the IRS has been increasingly applying Section 482 guidelines in benchmarking the pricing between purely domestic entities where there are tax implications to their interactions. Transfer pricing affects a multitude of intercompany transactions, including transfer of tangible property (products), transfer of intangibles (both technology and marketing related), loans (interest), and provision of services. Here is some guidance on how the US expects taxpayers to deal with their transfer pricing.
The Best Method Rule
The Best Method Rule in the Section 482 regulations states that the method used to analyze the pricing of a controlled transaction must be the method that, given the facts and circumstances, provides the most reliable measure of an arm’s length result. The application of the best method rule establishes an arm’s length range of prices or financial returns against which to test the controlled transactions. If the tested party financial results fall within the middle fifty percent of that range, known as the interquartile range, then the controlled transaction is considered – in theory – to be arm’s length. In practice, however, there is a well-established precedent for the IRS to favor the median point in this interquartile range, as any adjustments they make are typical to this point.
The transfer of tangible property is the type of intercompany transaction that is both common and relatively easier to understand (than the transfer of intangible property, for example), since it involves the transfer of an actual product. A distributer’s intercompany purchase of a tangible product from its affiliated manufacturer is also more obvious to test in many ways. The range of options for that arm’s length pricing is effectively within the narrow range somewhere between the cost to create the product and the price that the marketplace will bear to purchase the product. The arm’s length amount charged in intercompany transactions involving tangible property should be tested under one of the following methods provided and explained in Section 482: the comparable uncontrolled price method, the resale price method, the cost plus method, the profit split method, the comparable profits method, or an unspecified method.
Intangible property refers to both technology-related and marketing-related proprietary assets that the taxpayer develops and owns exclusively. The transfer pricing regulations broadly define intangible property as including:
- patents, inventions, formulae, processes, designs, patterns, or know-how;
- copyrights and literary, musical, or artistic compositions;
- trademarks, trade names, or brand names;
- franchises, licenses, or contracts;
- methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and,
- other similar items.
The “other similar items” makes room for a broad range, so we can essentially consider intangibles as something unique and proprietary that the individual taxpayer develops (whether intentional or not), and benefits from, to drive the superior performance and success of its business beyond a typical routine return. Intercompany transfers of unique intangibles initially caught the attention and scrutiny of the IRS during the 1980s, and ultimately led to the establishment US transfer pricing regulations. In determining the arm’s length price for the transfer of an intangible, there is a choice of four methods: the comparable uncontrolled transaction method, the profit split methods, the comparable profits method, or an unspecified method.
Although many IRS rules deal with the proper amount of, and deductibility of, interest charged between related parties, the transfer pricing regulations have their own twist that applies after the taxpayer has applied the other sections. The transfer pricing intercompany financing regulations generally apply to bona fide indebtedness beginning on the date after the indebtedness occurs, with several exceptions. The exceptions include:
- two months of relief from an arm’s length interest charge for transactions in the ordinary course of business;
- three months of relief from an arm’s length interest charge for a debtor outside the U.S.;
- an unspecified method of relief for the regular trade practice of the creditor’s industry; and,
- relief for property purchased for resale in a foreign country.
There are three main issues to consider when evaluating intercompany financing:
- Does the financing arrangement represent bona fide indebtedness, or is it, in substance, a contribution to capital by the Lender to the Borrower?
- Does the interest on the related party debt meet the “Situs” rule for loans obtained by Borrower at the situs of the Lender?
- Does the interest rate on the related party debt meet the arm’s length standard under the rule set forth in Treas. Reg. 1.482-2(a)(2)?
The arm’s length rate of interest imputed must be between 100 to 130 percent of the Applicable Federal Rate (AFR). For loan terms of six months to less than three years, taxpayers should apply the Federal short-term rate. Loan terms between three years to nine years require the Federal mid-term rate, and loan terms over nine years require the Federal long-term rate.
A member of a controlled group must receive an arm’s length charge for performing marketing, managerial, administrative, procurement, technical or other services for the benefit of another member of the group.
The charge for the performance of services is generally the total cost incurred regarding the services, plus an arm’s length markup. These costs include both direct and indirect costs. Direct costs constitute expenses that are directly attributable to the services performed, for example, the compensation paid and travel expenses of employees performing the services, material supplies consumed, telecommunications expenses, and similar items pertaining specifically to that service. Indirect costs constitute an allocation of a broad range of overhead/general & administrative type of expenses amongst different entities who benefit from those services.
To be considered a controlled service, a benefit must be provided as defined under the Benefits Test in the regulations. Essentially, the Benefits Test asks the question: Does this service benefit the company in a way that it would need to pay an independent entity to perform this same service, if its affiliate no longer provided it?
The regulations specify six transfer pricing methods for controlled party services. They are: the simplified cost method, the comparable uncontrolled services price method, the gross services margin method, the cost of services plus method, the comparable profits method, and the profit split method. The simplified cost method, in part, replaces the 7% safe harbor in prior services regulations, and gives the taxpayer the option to pass a series of applicable costs along to their related party with no markup. These applicable costs are typically general and administrative in nature, and are included in the IRS “white list”.
The IRS has the authority to impose penalties with any income adjustment they deem necessary. If the IRS determines that 1) an intercompany transfer price was less than 50 percent or more than 200 percent of arm’s length price or 2) the transfer pricing adjustment increases taxable income by $5 million or more, a penalty equal to 20% of the additional tax may be assessed. The penalty increases to 40% if 1) the intercompany transfer price was less than 25 percent or more than 400 percent of an arm’s length price or 2) the transfer pricing adjustment is $20 million or more.
Is there a way to get out of these steep penalties? Yes. The IRS provides that no penalty shall be imposed if the taxpayer had reasonable cause and acted in good faith with respect to the deemed underpayment of tax based on its transfer pricing. Specifically, the taxpayer would fall under the reasonable cause and good faith exception if they maintain contemporaneous documentation to show adherence and compliance with the arm’s length standard. A transfer pricing report, prepared at the time of the taxpayer’s tax return filing, and including the 10 principal items required to be considered documentation, not only protects the taxpayer from a penalty assessment, but often persuades the IRS that a transfer pricing adjustment is not necessary. For this reason, annual contemporaneous documentation is the best defense to eliminate IRS penalties, as well as to benchmark and defend the arm’s length nature of a taxpayers transfer pricing to decrease the potential for any IRS adjustment itself.
The simplest scenarios for expanding a business globally, with multiple entities, may bring transfer pricing problems to a Tax Director. This article lays out the general foundation for the IRS expects taxpayers to deal with their transfer pricing. Although the transfer of tangible property is the most obvious, transfers of intangible property, loans in the form of extended payment terms, and the provision of services may also cause problems. Fortunately, annual transfer pricing documentation, including a benchmarking analysis, as well as the ten items required within a documentation report, is the best way to test your transfer pricing to be sure it meets the arm’s length standard, as well as eliminate penalties on any proposed adjustments by the IRS.
For additional information on transfer pricing and the services offered by Withum, please contact Marina Gentile, Lead Global Transfer Pricing at firstname.lastname@example.org.
Ask the Experts
|Kimberlee S. Phelan, CPA, MBA
Partner, Practice Leader, International Services
T (609) 520 1188
|Marina Gentile, iMBA
Lead, Global Transfer Pricing
T (203) 559 5376
1 One domestic scenario includes transactions between a US for-profit entity and its affiliated US not-for-profit entity. Another domestic scenario includes transactions between a US entity operating in a relatively lower state tax jurisdiction and its affiliated US company operating in a relatively higher state tax jurisdiction.
2 The list of services that one affiliate can provide to another is exhaustive and, at times, unique to the industry.
3 See Rev-Proc 2007-03 for a list of applicable services that can be passed along at cost under the Services Cost Method https://www.irs.gov/irb/2007-03_IRB/ar13.html.
4 Research for this article was taken from Treas. Regs. §1.482-1(b) through (f), Treas. Regs. §1.482-2(a) through (b), Treas. Regs. §1.482-3(a), Treas. Regs. §1.482-4(a) through (b), Treas. Regs. §1.482-9(a) through (m), Treas. Regs. §1.6662-6(b) and (d), Rev. Proc. 96-53, 1996-2 C.B. 375, Notice 98-10, 1998-6 I.R.B. 9, and A Study of Intercompany Pricing under Section 482 of the Code, Notice 88-123, 1988-2 C.B. 458.
To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.