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04-27-05
Know Transfer
Pricing to Avoid IRS Difficulty
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HA&W News Archive
By
Mitchell Kopelman and Yelena
Epova
If your company plans to expand operations in the United States or into
other countries, then you need to know about "transfer pricing."
A transfer price is the price at which U.S. and non-U.S. related companies
buy and sell goods and services to each other.
This
is an important issue because the Internal Revenue Service,
as well as the taxing authorities of many other countries,
wants the ability to tax its fair share of such worldwide
profits. Owners and managers of multi-national companies,
on the other hand, want to minimize their exposure to tax
penalties, double taxation and worldwide taxation.
Take our example of a company in France (parent) that manufactures
farm equipment and sells it to a wholly owned subsidiary
(sub) located in the United States. The sub then resells
the equipment to its customers in the United States. The
key elements of Transfer pricing examples are as follows:
- The
farm equipment Is manufactured in France at a cost of
$10.000;
- the
parent sells this equipment to its U,S, subsidiary for
$17,500, realizing a gross profit in France of $7,500;
- the
sub sells the equipment to a U,S. customer for $20,000,
realizing a gross profit of $2,500;
- total
gross profit realized worldwide on the sale is $10,000.
How can the
French company justify receiving 75 percent of the profits, while the U.S.
company only receives 25 percent? One reason is that the parent company
will most likely have significant resources committed to the manufacturing
and R&D process. Since the sub may only be a distribution company, there
is little need for capital in the United States, but significant need for
capital in France. Thus, the parent has much more at risk. The IRS, however,
might believe the sub should recognize more than 25 percent of the gross
profit and, therefore, should be liable for income tax on more than 25 percent.
To address the allocation of global profits between related parties, the
IRS issued Code Section 482. Believe it or not, this actually authorizes
the IRS to reallocate income or deductions between related entities to taxable
income? They can establish transfer pricing strategies, allowable by the
regulations of Section 482, by choosing the best method to justify the transfer
price of goods and services.
Allowed Pricing Methods
One of the most common pricing methods, and the one most preferred by the
IRS, is the comparable uncontrolled price (CUP). In our example, let's assume
the parent also sells equipment to unrelated Italian and Australian companies
for less than it-sells to the U.S. sub. In the IRS' view, the parent may
have overcharged the U.S. sub for the same equipment, which makes the transfer
pricing issue very interesting and difficult to deal with.
If the French company, however, sells the equipment to all three companies
for the same price, it could justify the transfer price between the parent
and the U.S. sub as being equivalent to what is considered an "arm's
length" price charged to the other, unrelated firms.
The regulations also allow other methods to be used for transfer pricing
justification. If more than one pricing method is available, taxpayers must
be careful to analyze those methods and select the "best method,"
as defined under the final Section 482 regulations.
The final regulations describe four other categories of potentially acceptable
transfer pricing methods: the resale price method, the cost plus method,
the comparable profits method and the profit split method.
Documentation Requirements
Generally, taxpayers are required to prepare contemporaneous documentation
that carefully explains their transfer pricing analyses and methodologies
at the time the tax return is filed. Taxpayers must produce this documentation
within 30 days of an IRS request. Failure to comply with IRS requirements
could subject the taxpayer to the penalty provisions of Code Section 6662.
Assuming the IRS makes a transfer pricing adjustment and the documentation
requirement was not met. Section 6682 allows the IRS to impose a 20 percent
or 40 percent non-deductible penalty. A 20 percent penalty is imposed if
the transfer price adjustment exceeds the lesser of $5 million, or 10 percent
of the company's gross receipts. If the transfer price adjustment exceeds
the lesser of $20 million or 20 percent of the company's gross receipts,
the IRS can impose a 40 percent penalty of the adjustment.
By imposing a contemporaneous documentation requirement on taxpayers, the
IRS hopes to improve its access to pricing information and policy, encourage
planning and forethought in establishing pricing policies, and mitigate
audit controversies. Some practitioners and taxpayers, however, view the
documentation requirement as excessive.
A U.S. corporation that is 25 percent or more foreign-owned and has related
party transactions will have to file Form 5472 with its corporate tax return.
A relevant factor that should be addressed is whether the reporting corporation
imports goods from a foreign-related party. If so, the form asks if the
inventory costs of the goods were valued at greater than the customs value
of the imported goods.
If the imported goods are valued at an amount greater than the customs value,
Form 5472 asks if the documents used support this treatment of the imported
goods in existence and are available in the United States at the time of
filing.
Transfer pricing issues can be extremely complicated; every situation is
unique and must be evaluated on a case-by-case basis. While some companies
buy and sell tangible property, as in our example, many companies that buy,
sell or license intangible property have similar issues that need to be
evaluated and analyzed.
Mitchell Kopelman is a
partner with Atlanta-based Habif, Arogeti & Wynne, LLP, and chairs the
firm's International Tax Practice Group. Yelena
Epova is a tax manager with the firm, and can be reached at 404-898-7431.
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HA&W News Archive
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