Transfer Pricing – Loans

(from “A Primer on Transfer Pricing” by Robert J. Misey, Jr., updated by Kimberlee S. Phelan)

Reminder of the example: NJComanufactures and sells widgets in the U.S. due to increased widget orders from Canadian customers and also decides to form a Canadian distribution subsidiary (“CanSub”). Although CanSubdoes not have any manufacturing functions,theyemploy its own administrative and sales staff while using NJCo’s unique distribution software to ensure that there are not any distribution problems. In an effort to make sure that CanSubis financially solvent, CanSubhas payment terms to NJCo of six months and, iftheir customers do not pay,the companyenjoys the use of NJCo’s collection staff, which is comprised of former defensive linemen from Rutgers.

Loans

Although many rules deal with the proper amount of interest charged between related parties, the transfer pricing regulations have their own twist that applies after the taxpayer has applied the other sections. [i] In our hypothetical, NJCohas a trade receivable from CanSub for six months. The transfer pricing loan regulations generally apply to bona fide indebtedness beginning on the date after the indebtedness occurs, with several exceptions. [ii] 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.

Assuming that NJCocannot show that it is the custom of the widget industry to provide six month payment terms, NJCoshould receive imputed interest for the three months beyond the three months of relief for a debtor (CanSub) located outside the U.S. [iii]

The arm’s length rate of interest imputed must be between 100 to 130 percent of the applicable federal rate. [iv] Because the payment terms of six months are less than three years, NJCo 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.