Transfer Pricing: It's The (Tax) Law 
by Jerry Jonckheere & Matt Bussa
Universal Advisor, 2008 Issue No. 2 

Middle-market companies with international parents or subsidiaries need to understand how transfer pricing affects these relationships. Penalties for failure to set appropriate pricing can be 20–40 percent!

Transfer pricing is an area of the tax law that’s becoming increasingly important for middle-market companies. It covers transactions between companies that are part of a multinational group, such as a parent and subsidiary, or between “brother-sister” companies within the group. The United States and most of its trading partners have adopted tax laws that prohibit inappropriate shifting of profits between related international companies by entering into non-arm’s length transactions.

What Is Transfer Pricing?

Transfer pricing refers to the allocation of taxable profits between companies in a multinational group. For example, a profitable U.S. parent may buy component parts from a Korean subsidiary. The price paid by the U.S. parent will determine how profitable it will be and how profitable the Korean subsidiary will be for national and local taxation. If the U.S. parent pays a low price for the components, the Korean subsidiary may appear to be financially distressed, and the Korean taxing authority may determine that insufficient taxes were paid. If the U.S. parent pays a high price for the components, the IRS may determine that taxes being paid to the United States are insufficient.

In determining what the correct intercompany price should be, most governments have adopted regulations that require contemporaneous documentation that indicates how arm’s length prices were determined. 

How Is an Arm’s Length Price Determined?

The arm’s length principle states that the price charged between two related companies should be the same as the price charged by two independent companies. U.S. regulations (and similar regulations in foreign countries) provide a framework for determining acceptable arm’s length prices and identifying requirements for contemporaneous documentation.

The U.S. regulations identify five methods that a taxpayer may use to determine whether related companies are using an arm’s length price. The regulations also require that the taxpayer use the “best” method in determining the arm’s length price. 

What Are the Five Methods?

The five acceptable methods rely on finding “comparable” transactions or “comparable” companies. Whether a transaction or company is comparable depends on several factors.

Transactions are considered comparable when products and the terms of the transaction (quantities, credit terms, etc.) are similar. The three methods that focus on transactions are (a) Comparable Uncontrolled Transactions, (b) Cost Plus Method, and (c) Resale Discount Method.

These methods focus on transactions in which the company sells identical or comparable products to related and unrelated companies. When comparable transactions are found, the arm’s length price is influenced by the sales price or methodology to unrelated parties.

When comparable transactions aren’t available, a company may use the Comparable Profits Method. This method compares the profit indicators (gross margin, return on assets, etc.) of comparable publicly traded companies to the tested company. If the profitability of the tested company is similar to comparable publicly traded companies, transactions with related parties are assumed to meet the arm’s length standard. Comparability is based on companies having similar functions and risks.

Finally, the Profit Split Method allocates profit to related companies in a complete supply chain based on the relative contributions (material, labor, and technology) provided by each of the parties. 

What Documentation Is Required?

To reduce exposure to penalties, regulations require that documentation be prepared prior to filing the tax return (i.e., contemporaneous). Documentation must provide the IRS with an understanding of the worldwide legal structure of the organization, a description of each company’s functions and risks, and a description of all applicable intercompany transactions (products, services, intangibles, and financial transactions). In addition, the writer must demonstrate knowledge of acceptable methods and must determine the “best” method. Lastly, the applicable comparisons or analyses must be completed. 

Why Is This Important to Middle-Market Companies?

The IRS and authorities in other countries have significantly increased their audits of transfer pricing documentation as part of their strategy to increase compliance in international transactions. Penalties for failure to use an arm’s length price can be significant (20–40 percent).

Companies should review their intercompany pricing practices and consider retaining a professional services firm to perform a transfer pricing study to prepare documentation meeting IRS and foreign requirements. For more information on transfer pricing and how it affects your organization, feel free to give us a call.