Transfer pricing transactions face greater IRS scrutiny

North Texas corporations benefit immensely from buying or selling goods, services or intangible assets with controlled entities abroad. Among other benefits, such intercompany relationships enable organizations to transfer some revenues to countries offering the most favorable tax treatment.

A Canadian subsidiary, for example, may face lower corporate income tax rates than its Texas-based counterpart. By purchasing various services from the Texas corporation, the Canadian firm reduces its net profit and tax obligation.

The Texas corporation also may have a manufacturing subsidiary in China, which has a lower corporate income tax rate than the United States. Paying that subsidiary to produce various goods allows the Texas corporation to reduce its U.S. tax burden.

Such activities, though, are attracting increased attention from the Internal Revenue Service. An Internal Revenue Service strategic plan developed for 2009-2013 cites a rise in multinational corporations from 3,000 in 1990 to more than 27,000 in 2007. The IRS also reports that foreign tax credits claimed on tax returns by U.S. businesses increased by 71 percent from 2000 to 2009.

To investigate potential abuses associated with that increased international activity, the IRS is launching “a robust package of six enforcement initiatives.” Those initiatives include:

• Improved coverage of complex international transactions.

• Increased coverage efforts directed toward smaller international businesses.

The IRS budget request for the 2010 fiscal year also includes funding to hire nearly 800 additional employees for international tax enforcement purposes.

Amidst difficult economic conditions, companies must budget sufficient funds to pay for transfer pricing transactions. Amidst increased IRS scrutiny, companies must also be aware of the regulatory provisions governing transfer pricing, the various transfer pricing methodologies available, and the importance of maintaining accurate, complete documentation.

Transfer pricing regulations

and methodologies

Section 482 of the IRS Tax Code defines regulations regarding transactions among controlled entities. Shareholder or stewardship activities that offer capital investment protection or facilitate compliance with reporting, legal or regulatory requirements for all entities within a controlled group are not subject to any cross charges. Companies may also price “covered” or non-integral services at cost in controlled group transactions.

For most transfer pricing scenarios, though, the IRS requires that an arm’s length standard be applied in setting transfer prices for goods, services, or intangible assets in transactions involving controlled group members.

The transfer price essentially needs to equal what an entity would pay/earn on the open market for the goods, services or intangible assets being purchased/sold. Under a cost-sharing arrangement, related parties may share the costs and risks associated with intangible development in proportion to the benefits each party expects to receive. That enables controlled entities to pool research and development efforts and expenses. Other available transfer pricing methods include:

• Comparable uncontrolled price method.

• Comparable profits method.

• Profit split method.

• Resale price method.

• Cost plus method.

A company must select the best method for determining the appropriate arm’s length price for each transaction. The IRS also allows taxpayers to enter into an advance pricing arrangement, which defines the appropriate transfer pricing methodology to be used for recording transactions. The APA agreement protects the taxpayer from price adjustments during the agreement’s duration.

Accurate, complete documentation

Section 482 regulations require that companies compile “full and reasonable” documentation for transfer pricing claims prior to filing an income tax return. Once a tax return is filed, a corporate taxpayer must respond to an IRS documentation request within 30 days.

A company that fails to comply faces tax, interest and penalty costs beyond expenses incurred with any transfer pricing adjustments made by the IRS. A 20 percent penalty is generally applied in cases where a transfer price was not charged, or where no transfer pricing report was prepared. If the adjustment is large, the penalty increases to 40 percent.

Attaining transfer pricing benefits

While transfer pricing enables North Texas companies to capitalize on differences in international tax rates amidst difficult economic conditions, they must be aware of the increased scrutiny the IRS is focusing on global tax issues. Withstanding that scrutiny requires knowledge and awareness of relevant tax regulations, compliance and the ability to fully substantiate related tax claims.

Mary K. Thomas is the director of international tax services for Fort

Worth-based Weaver LLP.  She can be reached at mkthomas@weaverandtidwell.com.