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A Primer on Transfer Pricing

A transfer price is the price charged for intercompany transactions. The principles of I.R.C. Section 482 require that intercompany transactions be priced at arm’s length. Although ostensibly a simple concept, the arm’s length standard has spawned thousands of pages of regulations, rulings and opinions. In its most basic form, the arm’s length standard requires taxpayers to ask the question: Would an independent company agree to this same pricing that occurs with an affiliated company?

Transfer pricing continues to be a hot issue for multi-national companies, as well as domestic entities with transactions between related parties, including for-profit and not-for-profit entities. Transfer pricing affects a multitude of intercompany transactions, including but not limited to: transfer of tangible property (products), transfer of intangibles (covered in further details later), loans (interest), and provision of services.

The remainder of this article will review how the U.S. transfer pricing regulations affect the intercompany transactions between for-profit (“FP”) and not-for-profit (“NFP”) related entities.

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 to be arm’s length.

In determining the most reliable measure of an arm’s length result, FPs and NFPs should consider the degree of comparability between controlled and uncontrolled transactions by analyzing the functions, contractual terms, risks, economic conditions, and the nature of goods and services supplied. In the event that this analysis requires numerous or sizable adjustments to meet comparability, the comparable price may be deemed not be reliable.

Tangible Property

The transfer of tangible property is the type of intercompany transaction traditionally contemplated when reviewing transfer pricing. The arm’s length amount charged in intercompany transactions involving tangible property should be tested under one of the following methods: the comparable uncontrolled price method, the resale price method, the cost plus method, the profit split method, and the comparable profits method.

Intangible Property

Intangible property refers to both technology-related and marketing-related proprietary assets of the taxpayer. 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.

FP’s use of NFP’s unique software (or vice versa), for example, regardless of whether the software is patented, constitutes a method, program, or system and is the transfer of an intangible. Intercompany transfers of unique intangibles initially caught the attention and scrutiny of the I.R.S. during the 1980s, and ultimately led to the establishment U.S. transfer pricing regulations. In determining the arm’s length price for the transfer of an intangible, FP (and/or NFP) has a choice of three methods: the comparable uncontrolled transaction method, the profit split methods, and the comparable profits method.

Intercompany Financing

Although many I.R.S. 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 loan 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:

  1. Does the financing arrangement represent bona fide indebtedness, or is it, in substance, a contribution to capital by the Lender to the Borrower?
  2. Does the interest on the related party debt meet the “Situs” rule for loans obtained by Borrower at the situs of the Lender?
  3. 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. For loan terms of six months and less than three years, taxpayers should apply the Federal short-term rate. Terms between three and nine years require the Federal mid-term rate and 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, 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 are both direct and indirect costs. Direct costs constitute 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

the profit split method

The simplified cost method that, in part, replaces the cost-only safe harbor and gives the taxpayer the option to pass these costs along to their related party with no markup, provided they are included in the IRS “white list” (i.e., typically basic general and administrative type expenses).


If the I.R.S. 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 twenty percent of the additional tax may be assessed. The penalty increases to forty percent 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.

Additionally, a 20% penalty is doubled to 40% if proper transfer pricing documentation is not contemporaneously maintained. Transfer pricing documentation not only protects the taxpayer from an increased penalty, but often persuades the I.R.S. that a transfer pricing adjustment is not necessary.

Many multinational companies have employed advanced pricing agreements to establish stability and avoidance of penalties. In the advanced pricing agreement (“A.P.A.”) process, the taxpayer and the I.R.S. prospectively agree to the taxpayer’s facts, transfer pricing methodology and an arm’s length range of results. The A.P.A. will include a set of critical assumptions that, if followed, will not result in an examination of transfer pricing in the future. The burden is on the taxpayer, however, to present an annual status report to the I.R.S. reflecting the fact that there have been no substantial changes in its business since the signing of the A.P.A., and that they indeed complied with the agreed-upon operating results in that year. Although A.P.A.s have traditionally been the purview of large companies, the I.R.S. recently issued streamlined procedures to make the process more cost efficient for smaller companies.


The simplest scenarios for expanding a business with multiple entities may bring transfer pricing problems to a Tax Director. 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, several planning tools, such as documentation and A.P.A.s, can prevent unexpected surprises while avoiding adjustments and penalties.1

To learn more about transfer pricing and how it affects your business, please reach out to a member of Withum’s International Services Team by filling out the form below.

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