introduction to transfer pricing: the basics - · pdf file8/21/2012 1 introduction to transfer...
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8/21/2012
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Introduction to Transfer Pricing: The BasicsDavid Whitmer, Managing Consultant [email protected] Hazzard, Supervising Consultant [email protected]
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• What is Transfer Pricing?• Why is Transfer Pricing Important? • Examples of Intercompany Transactions• Functional Analysis• Overview of U.S. Transfer Pricing Methods• Importance of Good Documentation• Developments in Enforcement• Other
Agenda
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What is Transfer Pricing?
• Analyzes related-party transactions in different tax jurisdictionso International boundarieso State/provincial boundaries (domestic transfer pricing)
• Transfer prices should be on arm’s length basiso As if related parties were unrelated
• Relevant rules/regulationso U.S. – Section 482 of Internal Revenue Codeo Other countries – Have largely adopted OECD’s Transfer Pricing
Guidelines for Multinational Enterprises and Tax Administrations (“OECD Guidelines”)
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• Arm’s length standard o “In determining the true taxable income of a controlled
taxpayer, the standard to be applied in every case is that of ataxpayer dealing at arm’s length with an uncontrolledtaxpayer. A controlled transaction meets the arm’s lengthstandard if the results of the transaction are consistent withthe results that would have been realized if uncontrolledtaxpayers had engaged in the same transaction under thesame circumstances.” (arm’s length result) (Treas. Reg.§1.482-1(b)(1))
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What Is Transfer Pricing?
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• Definition of Control – (1.482-1(i)(4))o “Controlled includes any kind of control, direct or indirect, whether
legally enforceable or not, and however exercisable or exercised,including control resulting from the actions of two or more taxpayersacting in concert or with a common goal or purpose. It is the realityof the control that is decisive, not its form or the mode of its exercise.A presumption of control arises if income or deductions have beenarbitrarily shifted.”
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What Is Transfer Pricing?
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Why Is Transfer Pricing Important?Compliance
• Double taxationo Most transfer pricing adjustments result in double taxationo Mutual agreement (or competent authority) process is slow &
expensive for taxpayers
• Penalties – Failure to prepare & maintain contemporaneous documentation leads to penalties
o Most major taxing jurisdictions have transfer pricing-related penalties U.S. – 20% or 40% of tax adjustment U.K. – Up to 100% of tax adjustment Canada – Up to 10% of transfer pricing (income) adjustment
o Penalties & interest are not deductible in most countries
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Why Is Transfer Pricing Important?Planning
• Planning lowers effective tax rateo Establishes, as opposed to defending, priceso International – Arbitrages between tax rates to place
profits in low tax jurisdictionso States – Lower net income in separate filing states where
company has nexus
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Why Is Transfer Pricing Important? Other Reporting Issues
• Undocumented transactions can present reporting issues
o FIN 48 – Reserving for uncertain tax positions (“UTPs”)o Schedule UTP
Ranking of UTPs for which reserves were recorded Labeling of “T” next transfer pricing issues Identifying individual positions that account for 10% or greater of FIN 48
reserves Phased in between 2010 to 2014 based on total assets of taxpayer
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Polling Question 1
• Per the U.S. Internal Revenue Code, U.S. companiesare expected to abide by which standard?
o High-Five Standardo Knee-Height Standardo Arm’s-Length Standardo Magic 8-Ball Standardo Unsure
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• Intercompany sale of tangible goods o Sale of finished goods o Sale of raw materials & work in progresso Commission & purchasing agent services o Transfer of production machinery
Transfer price paymentSale of goods
XYZ U.S.(Manufacturing Co.)
XYZ Japan(Distribution Co.)
Third PartiesMarket price for sale of goods
Examples of Intercompany Transactions
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• Transfer of intangible property (IP)o Transfer of technology IPKnow-howPatentsProcessesFormulationsCopyrights, etc.
o Transfer of marketing IP Trademarks Trade names Brand names Reputation Customer relationships Customer lists Sales force, etc.
Payment of royalty (transfer price)
License of technology
XYZ U.S. (Research &
Development Co.)
XYZ Germany (Manufacturing Co.)
Third Parties
Market price for sale of goods
Examples of Intercompany Transactions
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• Provision of intercompany serviceso Management & administrative services Strategic management Finance IT HR Marketing Legal Administrative, etc.
o Other services Technical services Research & development services Value-added services Other support services
XYZ U.S. (Head Office)
XYZ Canada (Subsidiary)
XYZ Australia (Subsidiary)
XYZ U.K. (Subsidiary)
Management Services
Cost or Cost Plus
Examples of Intercompany Transactions
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• Financingo Provision of intercompany loanso Guarantee fees by parent companyo Leasing of tangible property
XYZ Luxembourg (Finance Co.)
Loan
Repayment of Principal & Interest
XYZ U.S. (Debtor Co.)
Examples of Intercompany Transactions
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• Functionso Executive functionso Core business functions – Manufacturing/distributions/services/
construction/extractiono Sales, general & administrative functionso Research & development or value-added engineering or
technical support functions• Risks
o Market risks – Customers/customer relationshipso Vender risks – Supply chaino Inventory risks – Product liability/warrantyo Financial risks – Bad debts
• Assets utilized (tangible/intangible)
Functional Analysis
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Overview of U.S. Transfer Pricing Methods –Specified Methods
Tangible Goods Intangible Goods ServicesComparable Uncontrolled Price Comparable Uncontrolled Transaction Comparable Uncontrolled Services PriceResale Price Profit Split Gross Services MarginCost Plus Comparable Profits Method Cost of Services PlusProfit Split Profit SplitComparable Profits Method Comparable Profits Method
Services Cost Method
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• “The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.” (Treas. Reg. §1.482-1(c)(1)).
• No hierarchy of methods• Need to document why method chosen is “best method” & why
other methods were not applicable• In determining best method, need to consider the following:
o Degree of comparability between controlled & uncontrolled transactionso Quality & completeness of underlying data & assumptions used in analysis
Overview of U.S. Transfer Pricing Methods –Best Method Analysis
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Polling Question 2
• Transfer pricing is more art than science.o Trueo Falseo Unsure
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Importance of Good Documentation – Penalties
• Internal Revenue Code §6662 imposes accuracy-related penalty for underpayment of tax attributable to improper transfer pricing (valuation misstatement)
Penalty Transactional Net AdjustmentSubstantial Valuation
(20% penalty)Gross Valuation (40% penalty)
Price or value is 200% or more (50% or less) than
Net adjustment exceeds the lesser of $5 million or 10%
Price or value is 400% or more (25% or less) than
Net adjustment exceeds the lesser of $20 million or 20%
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• Good documentation provides penalty reliefo Reasonably applied 482 to determine transfer pricingo Documentation is in existence at time of tax return filingo Documentation is provided to IRS within 30 days of request
• Less expensive than IRS or foreign tax authority audit defense• Contemporaneous vs. noncontemporaneous
o Ideal for documentation to be in place at time tax return is filed o Potential penalty for noncontemporaneous documentationo Documentation eases pain of transfer pricing audito Shortens length of audit – no (or poor) documentation irritates auditors o Third-party specialists provide more credibility o Formally explains events. e.g., losses, now that might trigger audit in the
future
Importance of Good Documentation – General
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1. Overview of taxpayer’s business including economic & legal factors which affect pricing
2. Description of organizational structure covering all related-party transactions
3. Any specific documents required by Section 482 regulations, e.g., cost-sharing agreements or market penetration
4. Description of selected method & explanation of rationale for selecting method
5. Description of unselected methods considered & explanation of why they were not selected
Importance of Good Documentation –Requirements
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6. Description of controlled transactions, including terms of sale & any internal data used to analyze those transactions
7. Description of comparables used, how comparability was evaluated & adjustments made
8. Explanation of economic analysis & projections used in developing method
9. Summary of relevant documents collected between end of tax year & date return was filed
10. General index of principal & background documents & recordkeeping of those documents
Importance of Good Documentation –Requirements
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• Executive summary• Scope & use of study• Description of controlled transaction(s) • Description of taxpayer’s business• Organization structure • Industry analysis• Functional analysis• Regulatory framework• Selection of appropriate or “best” method• Economic analysis• Relevant exhibits
Importance of Good Documentation –
Typical Study Format
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Polling Question 3
• Transfer pricing documentation must be prepared by which time to receive penalty protection?
o Before (audit year) tax return is filedo After (audit year) tax return is filedo After IRS completes audito Unsure
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• Given economic crisis, IRS will vigorously investigate U.S. multinational enterprises, which are seen as “shopping for best tax deals” – according to Commissioner Douglas Shulman
o Will need tax revenues to fund bailouts & other stimulus spending
o There will be “increased public pressure of corporate taxpayers to adhere to not only the letter of the law, but the spirit of the law in their home country law”
IRS Enforcement Developments
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• January 2003 IRS LMSB* Commissioner issued directive launching new transfer pricing compliance initiative
• Directive instructs agents to o Request transfer pricing documentation at opening
conference of all auditso Enforce 30-day deadline for providing documentationo Provide documentation to IRS International Examiner or IRS
economisto Penalties cannot be waived unless documentation was
prepared & submitted timely & approved by Penalty Review Board
* Large and Mid Size Business Division (now called Large Business & International Division) – Companies with assets over $10 million
IRS Enforcement Developments –Transfer Pricing Compliance Initiative (Overview)
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• IRS continuing to audit more small & mid-size companies as part of mandate
• IRS routinely requests “transfer pricing studies” as opposed to listing TP documentation requirements under Section 6662
• IRS enforcing requirement that TP documentation be contemporaneous
• IRS interviewing individuals who prepared documentation & taxpayer personnel
• Challenging taxpayer’s documentation
IRS Enforcement Developments –Transfer Pricing Compliance Initiative (Results)
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• Imposition of penalties• Reviewing Form 5471/5472s for data consistency• IRS will audit taxpayer for subsequent tax year if they find
adjustment• Can no longer ignore U.S. TP documentation requirements
o Documentation should be kept current
IRS Enforcement Developments –Transfer Pricing Compliance Initiative (Results)
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• December 2009: IRS Commissioner Douglas Shulman announced “Transfer Pricing Practice” within Large and Mid-Size Business (LMSB) Division of IRS
• October 2010: LMSB becomes Large Business and International (LB&I) Division
• New key positions o International Business Compliance (IBC) Directoro Transfer Pricing Directoro Chief Economist
• IRS plans to add 2,000 staff to expand international audit coverageo Economists to increase from 80 to 120o Transfer Pricing Specialists (non-Competent Authority) to increase to 1,000
IRS Enforcement Developments –IRS Reorganization
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• Inbound companies with low profitability• All companies with cost sharing arrangements• Companies with amended tax returns• Services transactions• Transfers of intangible property for nil or insufficient
compensation
IRS Enforcement Developments –Areas of Focus
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Polling Question 4
• The IRS has decreased transfer pricing enforcement efforts since the 2008 recession.
o True o Falseo Unsure
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• Disclosures Covered in Tax Returns? o Short answer – yes
• Disclosure formso Form 5471 – U.S. Entity Owns Foreign Subsidiary
Schedule M details transactions between foreign entities o Form 5472 – Foreign Entity Owns U.S. Subsidiary
• Form should be filed with income tax return of affected shareholder
• $10,000 penalty for failure to file per instanceo IRS has recently started to vigorously assess penalties for improper filings
U.S. Tax Return Disclosures
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To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, & cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
IRS Circular 230 Disclosure
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David Whitmer | Managing Consultant | 281.501.4946 | [email protected]
Elizabeth Hazzard | Supervising Consultant | 314.231.9844 | [email protected]
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