Transfer Pricing: Using Documentation to Avoid Penalties
If you have transactions with foreign related entities, you need to review your method of documenting your inter-company pricing to avoid substantial penalties.
The determination of the price at which related parties will transact (transfer pricing) provides taxpayers the opportunity to shift profit between jurisdictions. This shift can significantly lower their tax cost, and taxing authorities are taking notice.
Countries across the globe have the authority to combat perceived abuses and tax the controlled transactions using an arm’s length analysis, taking into account all facts and circumstances. In addition, if there are adjustments to the transfer pricing between related parties, taxpayers can be subject to substantial penalties.
Penalties in the United States related to transfer pricing are either 20% or 40% of the tax underpayment, depending upon the type of misstatement. However, the penalties will not be imposed if it can be demonstrated that the taxpayer had a reasonable basis for the pricing and that the proper documentation was maintained.
The IRS recently issued final regulations that require annual country-by-country reporting by U.S. persons that are the ultimate parent entity of a multinational enterprise group. While these new IRS regulations affect multinational enterprise groups with $850 million or more in annual revenue (for the preceding annual accounting period), it’s not uncommon to see these types of regulations adjusted over time to include smaller enterprises.
As such, all multinational enterprises should consider reviewing their documentation practices in order to avoid potential tax penalties.
The regulations (1.6662-6) require that taxpayers maintain an extensive list of documentation and provide it to the Internal Revenue Service within 30 days of a request in connection with an examination. In addition, most of these items are required to be in existence when the return is filed.
In general, taxpayers must provide a detailed summary of the business (including organizational structure) and a detailed description of all controlled transactions. The taxpayer is also required to provide support for the transfer pricing methodology selected, including an analysis of why that method was selected compared to other methods, and the economic analysis supporting that as the best method.
Those concerned with the above documentation requirements and penalty avoidance should consider having a transfer pricing study performed.
Transfer Pricing Studies
Penalty avoidance and the above mentioned documentation are the main reasons taxpayers might elect to have a transfer pricing study performed. However, transfer pricing studies can also help minimize tax by setting optimal prices that the relevant taxing authorities consider reasonable, help improve the taxpayer’s understanding of the economic and business relationships of their companies, and provide analysis and support for their current tax treatment, which a buyer might expect, in the event of a sale of the company.
Further Transfer Pricing Considerations
Through the Base Erosion and Profit Shifting Project, the Organization for Economic Co-operation and Development has made significant recommendations in the transfer pricing area over the last several years. As a result of these recommendations, countries will continue strengthening their requirements, including such measures as country-by-country reporting of their business operations and tax rates. These changes increase the need and benefits to reviewing documentation practices and potentially having a transfer pricing study performed.
The general requirement is that taxpayers operate with related parties using an arm’s length standard. However, the significant documentation requirements and threat of penalties impose serious consequences on taxpayers that fail to meet or support that standard. Taxpayers must operate carefully in the transfer pricing area to avoid substantial penalties and to meet their reporting obligations.