Transfer pricing continues to be one of the most important matters facing multinational companies. The tax situation in any given country can affect whether or not your business sets up facilities or holds intellectual property ownership there. The IRS and numerous tax authorities worldwide are intensifying their focus on how corporations allocate income and expenses among related entities abroad because of the potential to shift income inappropriately to lower tax jurisdictions.
In order to satisfy the IRS and other tax authorities, transfer pricing must generally meet an “arm’s length” standard. In other words, the prices charged in an inter-company transaction must yield results that are similar to what would have occurred if two unrelated parties had engaged in the same transaction under the same circumstances.
Despite the increased scrutiny of transfer pricing, with careful planning there may be opportunities to minimize both your company’s tax liability and your audit exposure. Here are five considerations:
1. Pay special attention to intangible assets. Transfer pricing comes into play when a company transfers tangible assets (such as inventory), intangibles (such as intellectual property and technology) and services to a related entity in another tax jurisdiction.
The IRS has stated that the transfer of intangibles offshore is one of its biggest audit priorities. “The issue spans all industries but controversy is most prevalent in the high technology industry,” the tax agency stated.
Let’s say your U.S.-based company transfers patents, or other intangibles, to an overseas subsidiary. A fair market price or buy-in payment must be paid by the foreign subsidiary to the U.S. parent company. According to the IRS, disputes with taxpayers involving buy-in payments involve issues including:
- The up-front valuation of intangibles.
- The definition and scope of intangible items (for example, technology, goodwill, workforce in place, etc.)
- Determination of the useful life of pre-existing intangibles.
- The type of payment (royalty, lump sum or installment) and when it was made.
- In-process R&D, as well as the rights to further research versus manufacturing and selling rights.
- Third party acquisition buy-in (stock or asset purchase of a company) or license of intangibles from third party.
- Documentation to prove the payment amounts are correct.
Much of today’s global economy revolves around intangible assets, which are inherently difficult to value. Given their increasing importance and the scrutiny of tax authorities worldwide, companies need a strategy to defend their transfer pricing methods.
2. Comply with transfer pricing rules. For example, there are issued regulations that involve transfer pricing transactions between related parties.
They include a way (the “Services Cost Method”) for your company to value at cost back office, low-margin services, which are not integral to the business. These services include payroll, accounts payable, accounts receivable, general administrative, staffing, training and more.Assess your company’s cross border services with related entities to ensure they comply with the rules.
3. Have a transfer pricing study prepared. Contemporaneous documentation is a critical step in complying with laws worldwide and avoiding severe penalties imposed on transfer pricing tax underpayments. A comprehensive Transfer Pricing Study, prepared by your accounting firm, details and justifies the pricing methodology used in inter-company transactions. It can help a company withstand scrutiny from tax authorities, as well as reveal tax planning opportunities.
4. Ask your tax adviser whether your company should enter into an advance pricing agreement. This involves voluntarily entering into a binding contract with the IRS and one or more other governments to resolve actual or potential transfer pricing disputes. Many countries now have APA programs, including Canada, Japan and China. They can provide some measure of certainty about compliance, but they generally take more than a year to complete and require companies to disclose a great deal of information about their operations, ownership, capitalization, worldwide organizational structure and transactions between the related parties.
5. Maximize the tax benefits available to your company with the domestic production activities deduction under Section 199. For qualified businesses, this deduction is one of the most valuable tax breaks available today. To qualify, property does not have to be entirely manufactured in the United States, so companies with foreign subsidiaries can benefit if they meet certain requirements.
Examine how transfer pricing calculations and the allocation of your company’s income and expenses could affect the Section 199 deduction. By planning ahead, you can take full advantage of this tax break.
This article explains general guidelines that apply to transfer pricing. However, the details are complex. In addition, special exceptions and other rules may apply to your business. Contact your international tax adviser for more information.
McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick. MKS&H helps owners and organizational leaders become more successful by advising them regarding their financial, technology and human capital management needs.