Common practice is not always the best practice. Often times, companies find themselves relying on common practices within their industry, and while that may come as a benefit to some (why reinvent the wheel, right?), it may also be a detriment to others (keep reading). In this instance, we look at the Transfer Price (or transfer cost). It can occur when related entities transact with each other during the trade of tangible property, intangible property, services, and financing—in short, it can involve almost any conceivable type of transaction—and may occur whether the company and its related companies (or subsidiaries) are in the same country or abroad. This may not be problematic in most instances but when the costs of the goods sold differs greatly from the fair market value, companies can manipulate these transactions to change the tax liability of the respective companies in advantageous ways by shifting profits and losses
to different taxing jurisdictions. Take, for example, a Germany company (parent) manufacturing lawn equipment and selling 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 in this example are as follows:
The lawn equipment is manufactured in Germany at a cost of $5,000.
The parent sells this equipment to the sub. for $12,250, realizing a gross profit in Germany of $7,250.
The sub sells the equipment to a U.S. customer for $14,500, realizing a gross profit of $2,250.
The total gross profit realized worldwide on the sale is $9,500.
In such an event, the German company would attempt to justify receiving 75 percent of the profits, while the U.S. company only receives 25 percent, emphasizing the significant resources spent on manufacturing and R&D. The IRS, however, will likely see things differently and conclude that the U.S. company should claim a higher percentage in gross profit and be liable for income tax on more than 25 percent.
In broad strokes, this method gives companies a false sense of having gained a market and tax advantage by manipulating the prices they charge to move goods and services between entities under share ownership. In other words, companies are left blindsided thinking they have uncovered a loophole when in fact the IRS or other regulators are turning their attention to them. With the increase in U.S. and other related companies’ international footprint in recent years, transfer pricing has gained more attention. As such, this issue continues to raise an on-going battle between owners and managers of multi-national companies, seeking to minimize their exposure to tax penalties and/or double taxation; and, taxing authorities (e.g., IRS) wanting the ability to tax fair share of such worldwide profits.
To address the allocation of global profits between related parties, Code section 482 was issued by the IRS providing the authority they need to reallocate income or deductions between related entities to taxable income. This allows the agency to establish transfer pricing strategies, pursuant to section 482 regulations, by choosing the “best method” to justify the transfer price of goods and services. These methods allow companies to arrive at an arm's-length price (which eliminates the shifting of profits from one country to another by underpricing or overpricing intercompany transactions) for tangible property, intangible property, cost sharing, and intercompany services transactions. The arm's length amount charged in a controlled transfer of tangible property must be determined under one of the six following methods: the comparable uncontrolled price method, the resale price method, the cost-plus method, the comparable profits method, the profit split method, and unspecified method. Should taxpayers determine that more than on pricing method is available, they must carefully analyze these methods and select the “best method”.
Taxpayers are generally required to prepare contemporaneous documentation that carefully explains their transfer pricing analyses and methodologies at the time the tax return is filed. Should the IRS make a transfer pricing adjustment and find that documentation requirement was not met, they may impose a 20 to 40 percent non-deductible penalty. Should you have any question surrounding the complication of Transfer pricing, given the case-by-case basis evaluation of these situations, do not hesitate to contact VAdam Law, PLLC at office@vadamlaw.com or by phone (954) 451-0792.