Transfer Pricing: Why You Should Care

By Baker Newman Noyes August 18, 2016

In an era of globalization and continued growth of international trade, inter-company pricing has become an everyday necessity for many businesses. But why has transfer pricing become such a hot tax issue?

Transfer prices (prices charged between related parties) directly affect the allocation of groupwide taxable income (and therefore taxes) across national tax jurisdictions. From a multinational company’s perspective, transfer pricing can help an organization to identify opportunities for business optimization. It can influence cash flow streams (e.g. less corporate tax imposed by the tax authorities will increase the resources at hand), investment decisions (e.g. a jurisdiction with frequent changes of the transfer pricing legislation may bring uncertainty, leading to a decision to exit a country) and key performance indicators (e.g. less corporate tax increases the profitability a company could offer to its shareholders). This opportunity to shift income from one jurisdiction to the other is however viewed as a threat by the tax authorities worldwide; no country – poor, emerging or wealthy – wants its tax base to suffer because of transfer pricing.

The Organisation for Economic Co-operation and Development (“OECD”), a key player in the area of international taxation, notes that transfer pricing is not an exact science. This represents a window of opportunity for tax authorities to impose transfer pricing adjustments and recalculation of taxes to be paid. This, together with fiscal shortfalls, has encouraged governments to identify transfer pricing as a soft target with the potential to produce large tax revenues.

In the US, Section 482 of the Internal Revenue Code gives the IRS the authority to adjust taxable income between two related parties to more accurately reflect the income earned by each party. Ever since the IRS settled a landmark case in 2006 in which GlaxoSmithKline Holdings Inc. agreed to pay $3.4 billion to resolve the largest tax dispute in the history of the IRS at that time, the IRS has continuously increased its enforcement efforts. In September 2015, the Large Business & International (“LB&I”) division was reorganized to include the Treaty and Transfer Pricing Operations Practice Area to address transfer pricing issues. The IRS has recently hired economists to expand its enforcement team. Amazon, AOL, Adobe, Hewlett-Packard, Microsoft, and other multinationals have made headlines because of transfer pricing disputes, with income adjustments ranging from tens of millions to upward of a billion dollars.

However, the tentacles of transfer pricing are not designed exclusively to reach large multinational companies. In fact, the IRS is now expanding its scope to include mid-sized and smaller companies. Late last year, acting director of the IRS’s transfer pricing group David Varley noted that this initiative includes middle-market foreign-owned businesses, foreign parent companies that operate limited-risk distributors in the U.S., and entities based in the U.S. with assets that range between $10 million and $250 million.

Although it has not been officially announced, the IRS has shared informally that even small taxpayers with less than $25 million in revenue might be targets, because agents are finding easy adjustments with utterly unprepared companies.

Thus, even what may appear to be a harmless intercompany management fee, if not adequately priced/documented, may attract the attention of the tax authorities who could challenge the amount of the fee or even its deductibility. The significant penalties and interest on overdue tax that follow, potentially in addition to double taxation (where income has already been taxed elsewhere), make transfer pricing a risk worth managing.

Unfortunately, this topic is barely on small and mid-sized company leadership’s radar, but when it comes to transfer pricing, ignorance is not bliss. Failure to act could cost hundreds of thousands of dollars in legal fees. Surveys of small and midsized enterprises suggest that a transfer pricing dispute could cost between $250,000 and $499,999.¹

For most global companies, the question is not if they will get audited, but when. As such, financial executives should focus their attention on mitigating transfer pricing related risks where and when possible. But what can you do?

In the transfer pricing arena, proactivity is key. The most popular and cost efficient way a multinational company can alleviate transfer pricing risks is to obtain a transfer pricing study reviewed by each jurisdiction it is designed to cover.

A transfer pricing study is an in-depth review of the company’s pricing policies and related documentation. It is usually conducted by a third party provider and it can produce a number of benefits including:

• Reducing taxes and penalties by ensuring that the company’s transfer pricing policies comply with all requirements in the local jurisdiction, including meeting local documentation rules;
• Providing support for recording no tax liabilities for tax exposures in the company’s financial statements pursuant to FIN 48;
• Identifying opportunities to reduce the company’s global effective tax rate by restructuring multinational operations; and
• Identifying ways to increase global supply chain efficiency by relocating operations or reorganizing legal entities.

Transfer pricing is certainly subject to challenge. However, if properly approached and documented, results generally stand up to audit.

Baker Newman Noyes has a team that focuses on transfer pricing issues and can assist in the documentation and planning for such transactions. Please contact Stuart Lyons, lead of BNN’s international tax practice, at 1.800.244.7444 if you would like to discuss further.

¹Habif, Arogeti & Wynne, LLP’s (HA&W) transfer pricing survey of small and mid-tier manufacturers.