Transfer pricing is one of the most important issues in international tax. Transfer pricing happens whenever two related companies – that is, a parent company and a subsidiary, or two subsidiaries controlled by a common parent – trade with each other, as when a US-based subsidiary, for example, buys something from a French-based subsidiary of the same company. When the parties establish a price for the transaction, they are engaging in transfer pricing.
Transfer pricing is not, in itself, illegal or necessarily abusive in fact it is necessary part of international trade and cost accounting. What is illegal or abusive is transfer mispricing and manipulation when there is a substantial valuation misstatement about the economic value of goods or services transferred between related entities. It is estimated that about 60 percent of international trade happens within, rather than between, multinationals: that is, across national boundaries but within the same corporate group.
An Example of Transfer Pricing
For example, take a company called World Inc., which produces a type of food in Africa, then processes it and sells the finished product in the United States. World Inc. does this via three subsidiaries: Africa Inc. (in Africa), Haven Inc. (in a tax haven, with zero taxes) and America Inc. (in the United States). Now Africa Inc. sells the produce to Haven Inc. at an artificially low price, resulting in Africa Inc. having artificially low profits – and consequently an artificially low tax bill in Africa. Then Haven Inc. sells the product to America Inc. at a very high price – almost as high as the final retail price at which America Inc. sells the processed product. As a result, America Inc. also has artificially low profitability, and an artificially low tax bill in America. By contrast, however, Haven Inc. has bought at a very low price, and sold at a very high price, artificially creating very high profits. However, it is located in a tax haven – so it pays no taxes on those profits.
What has happened here? This has not resulted in more efficient or cost-effective production, transport, distribution or retail processes in the real world. The end result is, instead, that World Inc. has shifted its profits artificially out of both Africa and the United States, and into a tax haven. As a result, tax dollars have been shifted artificially away from both African and U.S. tax authorities, and have been converted into higher profits for the multinational.
Designing a Transfer Pricing Policy
Transfer Pricing refers to the allocation of profits between entities that are considered to be related based on the relevant local legislation. This allocation of profits must follow the application of the arm´s length principle which is the basis of every transfer pricing analysis. In essence, prices for services, sales of tangible or intangible assets between related parties must be set as if the referred transactions were undertaken by independent entities.
During recent years, transfer pricing has gained increasing attention from tax authorities as well as taxpayers around the world. Different countries are introducing legislation with detailed requirements for taxpayers to justify and document the application of the arm´s length principle to their intercompany transactions. Globalization has also had an impact on the importance of transfer pricing, as a large part of world trade takes place within multinational groups.
The importance of transfer pricing from the perspective of tax authorities relates to the fact that the setting of prices for the provision of services or the sale of tangible or intangible property has a significant impact on the profitability of the local entity or entities which is the basis for local tax determination. For this reason, tax authorities in multiple jurisdictions have increased control mechanisms to evaluate intercompany transactions.
Some forward-looking businesses also turn their transfer pricing policies into strategic tools for investment and supply chain decisions, as well as for global tax planning. Ideally, you should be thinking about this issue well before any goods are shipped or services provided outside Canada, or any transactions actually occur.
The multidisciplinary team of economists and tax practitioners that comprise our Transfer Pricing Advisory Services practice do more than simply help your business comply with national transfer pricing rules and regulations. They take a larger view and look beyond the present to help you establish policies to that can make your transfer pricing commercially viable and as realistically tax-efficient as possible.
From the perspective of taxpayers, transfer pricing can be seen as a way to accomplish corporate objectives. The process involved can be particularly useful in:
– helping to identify the performance of each entity that belongs to the group;
– anticipating possible double taxation issues;
– identifying areas for supply chain optimization.
Designing a transfer pricing policy provides a multinational group with resources and elements to identify efficiencies throughout their complete range of activities including but not limited to design, manufacturing, sales and distribution and after-sales services.
US Transfer Pricing
A well-documented transfer pricing policy study for intercompany transactions is required compliance with Internal Revenue Code and associated Regulations and therefore avoidance of penalties to multinational groups. The process of documenting transfer pricing transactions involves financial and economic analyses that ultimately evaluate the effective application of arm´s length principles to those transactions. This means as if they were carried on at arm’s length with an unrelated third party. In short, the documentation process allows monitoring the financial performance of each of the entities within the group in light of their roles and responsibilities and the tangible and intangible property owned.
Section 482 will usually be applicable in any situation where a United States entity enters into transactions (e.g. sales, loans, provision of management services) with a related foreign entity. The intent of Section 482 is to ensure that, from a United States tax perspective, an arm’s-length price is charged in all related-party multi-jurisdictional transactions. Violation of Section 482 will lead to imposition of the penalties described immediately below.
Potential Penalties
There are two main levels of penalty thresholds which need to be considered; the valuational (transactional) threshold and the net Section 482 adjustment threshold. As described below, each penalty can potentially be computed at either 20% or 40% of the underpayment of tax as a result of a transfer pricing adjustment.
If the valuation of any transfer price is 200% greater or 50% or less of an arm’s-length transfer price or if the net Section 482 adjustment for the particular taxable year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts, then the penalty for exceeding the substantial valuation misstatement threshold is 20%. If the valuation of any transfer price is 400% greater or 25% or less of an arm’s-length transfer price or if the net Section 482 adjustment for the particular taxable year exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts, then the penalty for exceeding the Gross Valuation misstatement threshold is 40% of the underpayment of tax.
Additionally, in regards to whether the 20% or the 40% penalty applies, the following needs to be considered:
Need for Contemporaneous Documentation
In cases where no transfer price at all was charged, then the 40% penalty will generally always apply.
Where no transfer pricing report was prepared contemporaneously, then the 40% penalty will generally always apply.
Where an incomplete transfer pricing report (e.g. a transfer pricing report omitting some of the required 10 principle and supporting documents) is prepared, it is uncertain whether the 20% or the 40% transfer pricing penalty will be applied. Compliance and Documentation – To comply with local fiscal requirements, you should design transfer pricing policies and procedures, and prepare documentation for a strong first-line of defense against Revenue authority audits.
The DHL Corp. v. Commissioner case (involving the reallocation of income between a delivery company and its Hong Kong affiliate) was the first transfer pricing case in which the United States Tax Court upheld a 40% transfer pricing penalty.
As more goods and services flow between countries, many Governments are eager to defend their respective tax bases. They have imposed more strict and complex transfer pricing regulations and stiff penalties for non-compliance. Revenue authorities in countries around the world are shoring up their national tax bases by strengthening local legislation and imposing higher transfer pricing documentation requirements and penalties for noncompliance.
Multinationals must comply with local rules that vary widely while also interpreting model rules set out by the Organization for Economic Co-operation and Development (OECD). They must be able to quickly present arguments upon request that support transfer pricing decisions, are substantiated by thorough economic analysis, and that take into consideration local country rules governing their transactions.
To meet all of these requirements, your multinational business should consider an effective global approach to transfer pricing that encompasses arm’s-length pricing, not just for tangible goods, but also for services and transfers of intangible assets.
Tax Controversies and Dispute Resolution
For United States transfer pricing there is a procedure which can provide a greater degree of certainty for a taxpayer but it is often cost prohibitive, the way that a business can avoid imposition of the transfer pricing penalties is for them to apply for and obtain an Advance Pricing Agreement (“APA”). An APA is an agreement (essentially a contract) whereby the IRS and the multi-jurisdictional taxpayer agree on a transfer pricing methodology to be prospectively applied to apportion income and deductions between the taxpayer and related parties in other taxing jurisdictions. An APA provides the taxpayer with the certainty that the IRS will not challenge its transfer pricing determination for a period of usually three to five years at a time.
When tax disputes arise, it’s important to plan a strong, contemporaneous, detailed response backed by authoritative economic and legal justifications for your existing prices. It’s also very helpful to have assistance from qualified and experienced Transfer Pricing professionals in your dealings with fiscal authorities to look for avenues and options tailored to your needs.
Working with an AG Tax LLP Transfer Pricing Advisor
The preparation of this contemporaneous transfer pricing documentation is often very costly, potentially creating an expense that many multi-national businesses (especially start-ups or smaller businesses) simply feel they cannot bear. Thus, many businesses are left with the choice of being non-compliant with the United States transfer pricing rules, and as such, being liable for severe penalties, or being compliant with these rules and potentially bankrupting their business.
Instead of being paralyzed by fear of costs of an in-depth study, there is another option. Working with AG Tax LLP to build a basic contemporaneous study that meets the minimal requirements to mitigate the possibility of penalties while still allowing the company to live with some level of risk of transfer pricing adjustment and a more acceptable level of professional fees that can be provided for example, by a big four accounting firm.
Furthermore, if you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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