Of course, as a company owner, you prefer your company’s tax liability to be as small as possible. Transfer pricing is a gray area of business tax law that is becoming increasingly more challenging for taxpayers who are multinational enterprises (MNE). Proper transfer pricing practice through strategic tax planning can reduce your overall tax liability while ensuring compliance with government regulations.
To help you remain on the right side of transfer pricing, and to help you avoid an IRS audit as a result of poor transfer pricing planning, we’ve compiled some basic information and direction. In addition, the MKS&H accounting experts are available to answer your specific transfer pricing questions and help you remain compliant.
What is Transfer Pricing?
The price charged between two related organizations (normally a parent and a subsidiary) for international goods or services constitutes a transfer pricing transaction. More specifically (and technically), it’s a profit allocation method for attributing an MNE’s net profit or loss to the tax jurisdiction where it operates its subsidiary. Problems and abuses arise when MNEs use transfer pricing to shift income to lower (or zero) tax jurisdictions.
How do you know when your transfer pricing is appropriate and when it has crossed the line to financial abuse? By comparing the transfer price to the cost of the same transaction with an unrelated company. Controlled transactions refer to transfer pricing between a parent and subsidiary (related entities), and uncontrolled transactions take place between a company and a third party (unrelated entities). Uncontrolled transactions are used as a benchmark to ensure the controlled transactions are fair and equitable.
Let’s say an Ireland-based company has a US subsidiary. Ireland has a corporate tax rate of 12.5 percent, and the US has a tax rate of 35 percent. It would be in the US subsidiary’s best interest to pay a management fee to the parent company in Ireland to decrease the subsidiary’s taxable income in the US. If, for example, the fee is $500,000, the company would save $175,000 (500,000×35%) in US tax and only pay $62,500 (500,000 x 12.5%) in tax to Ireland, creating a net tax savings of $112,500.
To be lawful, the management fee of $500,000 would need to be comparable to the management fee the US subsidiary would pay to an unrelated third party for the same services. If that unrelated company can perform the same exact function for only $100,000, the IRS has reason to be concerned. They may begin to think the company is intentionally shifting $400,000 offshore to evade paying US income tax. And an audit is often the result of that concern.
Why should you be aware of the risks of transfer pricing?
Due to increased scrutiny by the IRS and the potential large dollar amounts involved, multinational organizations often rank transfer pricing as one of their top concerns. According to the 2010 Global Pricing Survey by Ernst & Young, 32 percent of those surveyed ranked transfer pricing as one of their most important tax challenges. And, two-thirds reported experiencing a transfer pricing audit, compared to 52 percent in 2007. In the 2013 Ernst & Young Global Pricing Survey, 66 percent said managing tax risk was their top transfer pricing priority, up from 32 percent in 2007 and 2010.
If you have operations outside the US and are considering utilizing transfer pricing, contact us (LINK). We can complete a risk assessment to see if you could be subject to the transfer pricing rules. We can also provide you with additional financial and tax services, including:
- A financial analysis of your business segments;
- Tax planning around multi-country tax filing; and
- Support if you are audited by the IRS due to your transfer pricing activities.
We can also provide insight if you are as US company considering setting up an operation overseas or a foreign corporation looking to create a company in the US. Transfer pricing affects every company that has operations in both the US and overseas, no matter how large or small the company or the subsidiary.