The transfer pricing audit environments in the US and other tax jurisdictions are quite active, with no indication of slowing down. Transfer pricing scrutiny is both industry – and country – agnostic and encompasses questions around cross-border, related party activity in these four main categories:
Almost every tax authority around the world has established transfer pricing regulations into their legislation, or follow the guidance provided by the Organisation for Economic Co-operation and Development (“OECD”) in its publication titled OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the “OECD Guidelines”). The OECD is championing collaboration amongst tax authorities, mutual exchange of information, and increased transparency of a company’s transfer pricing via its Base Erosion Profit Shifting, or “BEPS,” initiative. The initiative has been changing the international tax and transfer pricing landscape for multinationals, continuing with the much-awaited proposal released just this week where OECD is proposing a unified approach for countries around the world to tax the digital economy. It appears that it’s only a matter of time before a company engaged in cross-border, related party activity is subject to transfer pricing audit scrutiny.
Large multinational enterprises (“MNE”) are not the only companies at risk. The middle market, privately held, family owned, start-up and emerging technology companies, are all audited for transfer pricing. MNEs may appear to have higher dollars at stake on the surface, but it also takes more resources for tax authorities to challenge them, often taking years to negotiate or litigate in tax court. All companies are expected to transact with affiliates using arm’s length pricing, documented to be contemporaneous to their tax return filings every year. Transfer pricing remains the biggest uncertainty for tax departments, yet one that can be mitigated by focusing on a few key aspects.
#1 Assess and Understand the Health of your Transfer Pricing well in Advance
#2 Remain Current with Annual Transfer Pricing Contemporaneous Documentation
#3 Implement Transfer Pricing Recommendations into Accounting Systems
#4 Building Additional Substance to Support Transfer Pricing
#5 Walk into the Audit in a Position of Strength
To best manage the audit process, it’s essential to have a pulse on your transfer pricing health and potential exposure well in advance of any audit situation or interest by a tax authority. Align yourself with a global transfer pricing advisor early – ideally even before your business crosses its first border into a new country. This way, your transfer pricing structure is established in an efficient way as early as possible, establishing arm’s length pricing, documenting them, incorporating them into your accounting, developing intercompany legal agreements, and settling your intercompany accounts is critical before an audit even begins. Regardless of whether you have a transfer pricing audit currently ongoing, it’s essential to have a transfer pricing professional review your transfer pricing strategy, and advise you on any possible deficiencies that could arise under an audit should one come about.
Transfer pricing documentation is not a “one and done.” The “contemporaneous” language in the regulations means the report and analysis should be prepared every year around the time of your tax return filing, so arm’s length pricing is accurate. There are many comparable firms that will enter and exit the market from one analysis to the next, even a year apart, let alone if taxpayers wait years to update.
The five main advantages of having annual documentation include:
Forms 5471 and/or 5472 are filed with a company’s tax return and disclose the type and dollar value of transactions with affiliated entities operating in different tax jurisdictions. These transfer prices need to be arm’s length during this time, hence the contemporaneous documentation language.
In an audit, the IRS can assess penalties of either 20% or 40% of any proposed adjustment. Presentation of a study prepared contemporaneous to the tax return filing seems to work to prevent those penalties. Since an audit for any fiscal year occurs a few years later, if no transfer documentation was prepared at the time of that tax return filing, it will not be considered contemporaneous nor protect against penalties.
Taxpayer’s enjoy a negotiating advantage when presenting their transfer pricing analysis first. The IRS is required to assess this position and consider this transfer pricing method selected. There is a new directive stating that the IRS will need to get approval before changing the transfer pricing method and performing their own analysis. If the taxpayer does not present its own analysis and report, the IRS really has no choice but to take on an analysis and, it is virtually guaranteed, the results will be less favorable to the taxpayer.
Presenting a stand-alone transfer pricing report each year under audit, ensures there is no commingling of fiscal years, so only information from that specific year is delivered to the IRS. It’s never a good idea to deliver a transfer pricing report for a year not under audit because it is your most current report.
Finally, it gives the Revenue Agent the ability to “check the box” and respond favorably to the very common question on an IDR asking for your contemporaneous documentation. The IRS Revenue Agent asks the question, and it is really a yes or no answer. A yes allows the box check, and the issue may or may not progress from there. A no is a virtual guarantee that the situation will escalate. The Revenue Agent will likely need to contact the transfer pricing economist to participate in the discussion.
Arm’s length transfer pricing that has been independently calculated, and benchmarked to the marketplace, should then be incorporated into your company’s business practices. Including these calculations into your accounting systems adds the real substance behind the study and recommendations. The intercompany accounts between your related parties should not accrue indefinitely, timely settlement is key, preferable monthly or quarterly. Independent firms would not settle for longer payment terms, especially without assessing any interest charges.
Your arm’s length pricing is calculated, it’s implemented into your accounting system, intercompany accounts are settling regularly… congratulations! You have minimized your company’s global tax exposure and potential penalties on income adjustments. But don’t stop there. It’s a great time to integrate transfer pricing practices into a company’s policies and procedures manual, and to draft legal agreements between the parties involved in the intercompany transactions. This builds substance, as both written documents add to your background files and audit trail, reflecting a company with a well-established and executed transfer pricing structure. The intercompany legal agreements further support your affiliates operating at market rates, since two independent parties would have a contract before engaging in business. The agreement will have the same terms as independent contracts, including names/relationship of entities, services provided, timing and settlement, and pricing. Your attorney will find much of the commercial language – as well as the pricing – in your transfer pricing study and include with the required legal language.
It’s game day. The goal is to walk into this transfer pricing audit with confidence, trusting that all your advanced preparation will set you up for success. Planning ahead allows for a much stronger position rather than waiting until you receive notice of an audit, the IDR giving you 30 days to present your contemporaneous documentation, or the actual meeting day. All the preparation you take in 1 – 4 above leading up to this day allows you to walk into your transfer pricing audit with clarity and confidence, and in a position of strength.
For information on assessing the health of your transfer pricing or preparing for an audit, contact our team by filling out the form below.