Business is global – and so are taxes. Companies that are connected by common control and share resources across borders need to ensure they address transfer pricing when goods or services change hands. We wanted to share some expertise in this area through this Q&A, and you can also view an educational webcast on where transfer pricing may come into play and the best methods to use for different scenarios.

Q. What is transfer pricing?

A. Simply put, if income or deductions shift between taxpayers in different tax jurisdictions, transfer pricing comes into play. The goal from the perspective of the IRS and other tax authorities is to prevent companies from shifting income between entities in a way that may evade taxation.

For companies that have operations in different regions – whether as part of the core organization or through subsidiaries – transfer pricing is an important piece of tax law. In basic terms, transfer pricing is the determination of the price or compensation for transactions conducted between separate taxpayers based on similar arm’s length transactions with third parties. They can be directly owned companies, affiliates, brother or sister companies or entities under common control, and they can be in different parts of the U.S. or operating across international borders.

Q. How do I know if transfer pricing applies to me?

A. If you and another company have common ownership or are under common control and are transacting business together, you’ll want to be very aware of transfer pricing. A couple examples are:

A U.S.-based company with an R&D subsidiary in Israel

Here’s a case in which the level of activity abroad is a big factor in determining transfer pricing. The higher the level of risk, assets and functionality, the higher the pricing will be.

A UK company with a sales outlet in India

Again, this is not just a U.S. initiative – tax authorities worldwide consider transfer pricing a hot area. The transfer pricing level is driven by the level of operations within each jurisdiction and between such taxpayers, with slightly different rules amongst different global jurisdictions.

A US company based in Massachusetts with a manufacturing subsidiary in CA

Transfer pricing affects transactions across any borders, both internationally and between states. This situation would be analyzed in the same fashion as transactions across international borders.

Q. If we’re dealing with cross-border operations, how can we be sure the U.S. transfer pricing terms apply to the countries in which we’re doing business?

A. The transfer pricing established for transactions must meet the criteria set forth in the taxing jurisdictions of both taxpayers. Because this is a global issue, the Organization for Economic Cooperation and Development (OECD) has established guidelines on which member countries have generally based their standards. It’s not a hard and fast universal standard, but it does help promote consistency.

Q. How do I figure out what pricing to use?

A. The rules for determining transfer pricing vary depending on a number of different scenarios, and companies will need to choose the best way to proceed based on a list of approved methods. Companies may be pricing around the transfer of tangible assets, intangible assets, intercompany services like marketing and technical disciplines, or financing between related entities. There is a distinct set of recommended methods, so the method which is most appropriate depends upon the facts of your particular situation.

Q. What kind of documentation is required?

A. In the US there are 10 requirements, and we’d like to stress that they need to be met to ensure penalties are not assessed by the US tax authorities. The documentation should be in place prior to filing tax returns in order to reflect the established transfer pricing on transactions. Below is a partial list, so be sure to consult someone on the full requirements. That said, documentation includes items such as:

- Business Overview including an analysis of economic (functions and risks) and legal (contractual) factors

- Explanation of your economic analysis and projections that are relied upon

- Description of the method used to determine transfer pricing and an explanation of why that method was selected

Q. What kind of consequences could we face for skipping transfer pricing?

A. Penalties for misstatements of transfer pricing are among the harshest in the U.S. They start at 20 percent of your underpayment, and jump up to 40 percent for gross valuation misstatements. But with the right documentation established prior to filing tax returns, you’ll have the situation under control.

This entry was posted on Monday, June 16th, 2008 at 8:00 am and is filed under Globalization, Transfer pricing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.