Transfer pricing has become a key area of focus for tax authorities around the world. Maintaining appropriate documentation to support a company’s transfer pricing policies mitigates the risk of a potential tax adjustment during a transfer pricing audit and eliminates the risk of potentially substantial penalties.
Taxpayers should proactively develop support for their intercompany transactions and carefully develop a defensible strategy that complies with each country’s requirements.
Transfer pricing is the price at which related entities transact with one another. The price may relate to the sale/purchase of tangible property, fees for services, license fees for the use of intellectual property, or interest expense on an intercompany loan.
An entity operating in multiple taxing jurisdictions is treated and reviewed by each local country’s/state’s taxing authority as a stand-alone entity responsible for its own performance and profits. Transfer pricing is based on an arm’s length standard which means that a taxpayer is expected to realize the results in a related party transaction that are equal or similar to results that would have been realized if the taxpayer engaged in the same transaction under the same circumstances with a third party.
Most countries have local transfer pricing regulations that require taxpayers to analyze and document their intercompany transactions. In the U.S., the Internal Revenue Service (IRS) requires taxpayers to complete a transfer pricing documentation study contemporaneous with the filing of the tax return. Taxpayers that cannot demonstrate reasonable cause or good faith in documenting their transfer prices and cannot produce transfer pricing documentation within 30 days of a request by the IRS may face substantial penalties, up to 40% of any tax underpayment resulting from an IRS examination.
Transfer pricing is more than just a compliance requirement; it is often used as a planning tool to develop strategies that align with the company’s overall objectives (tax optimization, cash flow, etc.). For example, realignment of the supply chain or relocation of certain activities from one taxing jurisdiction to another may result in significant tax savings. Tax planning associated with the creation and ownership of valuable intellectual property is an often overlooked area that may create favorable tax results as well.
For instance, developing an effective manufacturing model in a low cost, low tax jurisdiction, may result in the realization of certain competitive advantages which may contribute to the success of the business, i.e. manufacturing know-how. This type of intangible property is often not fully appreciated as an important value driver for a manufacturing and distribution business that should be compensated for in a manner which is commensurate with its economic value. An arm’s length level of compensation for the development and use of such intangible property may lead to a more tax-efficient distribution of profit within a multinational group.
BEPS refers to inappropriate tax planning strategies used by companies to shift income to low or no tax jurisdictions where no real or economic substance exists. The Organization of Economic Co-operation and Development (“OECD”) published its plan to address BEPS which entails significant information reporting requirements for fiscal years starting on-or-after January 2016. Local tax authorities, including the IRS, have adopted and published their own requirements related to BEPS.
In light of the foregoing, taxpayers should plan ahead and analyze their existing transfer pricing policies to mitigate potential areas of exposure and to capitalize on potential planning opportunities.