Transfer pricing applies to organizations that have transactions between multiple entities they own or control and is a mandatory process for United States businesses and not-for-profit organizations that do business outside of the U.S.
Transfer pricing refers to the prices charged between affiliated companies operating in different tax jurisdictions, usually around the world. This includes intercompany activities related to the sales or purchase of products and services; allocation of management, overhead and R&D costs; the use and licensing of intellectual property, technology, marketing or brand-related uses; and intercompany financing or cash pooling.
Transfer pricing tax issues have always existed but has recently become a hot topic simply because governments want additional tax revenue. When a company sets its internal pricing, there is an incentive to recognize income where tax rates are lower and shift costs to where rates are higher. The transfer pricing rules prohibit such shifting if there is no economic basis or valid business reason. In effect, taxes can’t drive the reason for pricing between entities. All else being equal, the price of product by an affiliated foreign manufacturer should be the same regardless of where the related buyer is located.
In the last 20 years, we’ve seen transfer pricing go from behind-the-scenes obscurity to become more upfront and mainstream. While many giant multinationals are in tax court fighting the IRS that is trying to get gazillions of dollars in transfer pricing adjustments, smaller companies are not safe either. The dollars at stake might be lower but smaller and mid-sized companies operating in more than one country are increasingly being fully expected to present their transfer pricing studies and calculations when asked by tax authorities during a tax audit.
Guidelines for these studies are set by the Organization for Economic Co-operation and Development (“OECD”) and the IRS requires “arm’s length” documentation to be included with each U.S. tax return. Steep penalties can be imposed on any transfer pricing adjustments proposed by tax authorities, and the annual documentation study offers penalty protection.
Arms-length pricing is the market rate pricing that usually results from a negotiation between two independent companies with no common ownership or affiliation or other economic interest. The ultimate question is: Would an independent company enter into this same deal that we just made with our related company? Further it is reasonable to expect that an independent company would not incur a loss on behalf of another company in providing a critical service to its operations nor would it operate at breakeven; it would expect to make a profit under normal business conditions.
Dividing the global profit (or loss) pie: Tax authorities around the world do not view a company that has affiliated entities as “one big happy family” but rather as independent stand-alone entities. Despite intercompany accounts being eliminated in consolidation for a global organization’s financial reporting purposes, the individual entities have a tax liability in each jurisdiction. This means that each entity must reflect its own pre-tax profit (or loss) in each respective tax jurisdiction that reflects the functions that company performs, the risks it incurs, and the tangible and intangible assets it employs relative to the other members of the global operations. Transfer pricing looks at the economic substance of a global organization and values the roles each member performs relative to the other members in driving the business, then determines the comparable profits or pricing for that activity. Thus, the role of transfer pricing is to divide the global profit (loss) pie among affiliated entities, telling the story of the economic or commercial reasons – i.e., the non-tax driven reasons – for the way the various members of the organization transact amongst themselves.
This brief description was substantially prepared by Marina Gentile who leads Withum’s global transfer pricing practice and you are welcome to call her for a no obligation consultation, Marina can be reached at [email protected] or (212) 829-3244.
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