International business transactions for goods and services are the norm for companies of all sizes, not just large multinational companies. Many small and midsized companies are now active participants in regular international transactions and are making direct foreign investments and opening overseas subsidiaries or affiliates.
For example, a Chinese manufacturer may form a U.S. subsidiary to improve customer support in the U.S market, stock product locally, and also manufacture specialty products for the U.S. market. Another example, a midsized U.S. based CRO may open a European subsidiary to support clinical trials with sites in both the U.S. and Europe. In both examples, issues related to the flow of goods, services, and fees between the related companies, whether large or small, must be addressed. This is known as transfer pricing.
Large multinational companies have extensive resources to address the complex legal and tax issues that are at the core of transactions between related entities. Small and midsized companies typically have limited resources so establishing a transfer pricing agreement in advance is critical since it takes far less resources to address transfer pricing issues proactively compared to after receiving an inquiry from a governmental authority.
A transfer pricing agreement sets prices between related entities for goods and services.
The prices charged to related entities should be adequately planned, analyzed, and documented. The justification for setting transfer prices is commonly tax driven. National tax authorities have increased enforcement and regulation due to companies employing tactics for base erosion and profit shifting (BEPS) (i.e. tax avoidance strategies). However, transfer pricing also benefits smaller companies by assisting management with intellectual property and information flow and increasing efficiencies across the related entities.
Companies should adequately plan and document their transfer pricing policies and procedures, and ensure the appropriate intercompany agreements are in place between their related entities. The Organization for Economic Co-operation and Development (OECD) issued guidelines, named Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Transfer Pricing Guidelines”), to promote international trade while preventing the effects of double taxation in multiple countries. The OECD was established in 1961 and thus far has issued regular updates to these guidelines, the latest one in 2010.
In addition, and to add another layer of complexity, the U.S. Internal Revenue Service (IRS), issues its own federal regulations for companies with a U.S. and international presence. While the goals of the OECD Transfer Pricing Guidelines and IRS regulations are similar, nuances in the execution of transfer pricing policies are critical to understand.
Most critical aspects
One of the most critical aspects of both, the OECD Transfer Pricing Guidelines and IRS regulations, is the arm’s length principle. The arm’s length principle requires related entities to set transfer prices amongst themselves based on prices charged by unrelated and independent entities in similar transactions. Essentially, the principle takes an open-market approach in establishing transfer prices. In theory, the arm’s length principle seems practical and easy to follow. However, challenges arise when implementing the principle in an actual transaction.
In many cases, there is no sufficient data in the marketplace to determine what the appropriate transfer price should be. For example, the price charged by a competing manufacturer may not be readily available or the additional terms and conditions that constitute the overall transaction may be unavailable. When making comparisons between transactions of related entities and those of unrelated entities, some factors to consider include:
- Contract terms and conditions
- Specifics of the goods or services
- Activities performed by each of the entities
- Business and market penetration strategies employed
- Economic and geographic differences in the marketplace
IRS regulations require companies to use the “best method” for setting transfer prices.
In 2010, the OECD Transfer Pricing Guidelines were revised to require the use of the “most appropriate method,” in efforts to align with IRS regulations. The OECD and IRS provide several methodologies for companies to evaluate and determine which methodology works best for their particular transaction. These methodologies include the comparable uncontrolled price method, resale price method, cost plus method, profit split method, transactional net margin method, return on assets method, Berry ratio, and others. Readers should obtain the assistance of a professionally licensed accountant and attorney when reviewing these different methodologies for potential use in their given transaction.
The IRS can assess penalties for insufficient documentation supporting the transfer pricing analysis. To show that the transfer pricing methodology selected and used was reasonable to support an arm’s length transaction, IRS regulations require certain documentation to be produced within 30 days of the request. Therefore, it is critical that the transfer pricing analysis is supported by proper documentation and the corresponding agreement prior an IRS request.
Addressing transfer pricing issues up front will prevent small and midsized companies from having to scramble to complete a thorough transfer pricing analysis while under the microscope of governmental authorities. With the assistance of experienced professional services providers, small and midsized companies can address the complexities of transfer pricing in a cost effective manner proactively instead of reactively.
Article provided by the North Carolina Center for Innovation Network.
The information contained in this article, and in material referenced within, is intended for informational and educational purposes only, and does not constitute legal, financial, accounting, or other professional advice.
