How to Ensure You Comply With Regulations in the US and Abroad
As an international entrepreneur who has business locations in more than one country, it’s vital that you are aware of, and keep up to date with, regulations around Transfer Pricing.
Around 60% of all world trade comprises of transactions between different branches and subsidiaries of multinational companies, and Transfer Pricing rules have been developed to ensure that the right amount of tax is paid on these transactions.
In recent years, Transfer Pricing has become erroneously known as a way for large corporations to avoid paying tax – and associated negative news stories around large companies has added to this perception. The reality is that abiding by Transfer Pricing rules is a requirement for any business that will conduct transactions multi-nationally, and the rules are enforced by individual countries tax authorities as well as internationally via the OECD.
Over the last decade, the rules in many countries have become tighter and higher levels of resources have been dedicated to investigating possible tax avoidance by misusing Transfer Pricing. This is particularly true of the US, where the IRS has developed new teams dedicated to cracking down on companies that manipulate the pricing of transactions to lower their overall tax-costs.
Penalties for not adhering to Transfer Pricing rules can be high – both financially and in the loss of positive public perception should the media report on Transfer Pricing violations. However, because the detailed workings of Transfer Pricing are highly-complex and depend on a range of individual circumstances, it can be easy to fall foul of regulations.
In this guide, we’ll take a look at some of the main features of Transfer Pricing so you can get an overview of how it works.
On This Page
- What is Transfer Pricing?
- What Counts as a Transaction for Transfer Pricing Purposes?
- Why Should You Care About Transfer Pricing?
- Determining a Transfer Price
- Advanced Pricing Agreements (APA)
- Transfer Pricing and the OECD
- Transfer Pricing and US Regulations
- What Sort of Documentation do You Need for Transfer Pricing?
- Transfer Pricing Support & services
- Frequently asked questions (FAQs) about taxes, company formaition, and residency in the U.S.
- Get advice on taxation, company formation, and residency in the U.S.
When a company conducts transactions between subsidiaries that are located in different tax jurisdictions there are rules around how that company prices those transactions. Generally, people consider Transfer Pricing to be relevant when transactions occur internationally (for example a UK branch conducting transactions with a US branch of a company), however, it can apply within the same country in some instances.
The reason that Transfer Pricing rules were developed was that government authorities realized that some companies were using unrealistically low pricing in order to shift profits to places with low tax jurisdiction. This enabled them to avoid paying tax by failing to provide appropriate prices for intercompany transactions.
Transfer Pricing rules state that internal branches and companies must compensate each other for transactions in the same way they would for externally made purchases. This rule is known as the “Arms-Length” rule. It essentially says that transactions within the company in different locations must be priced in the same way they would be priced for any company buying them.
The transactions that are included in Transfer Pricing are essentially ALL types of cross-border transactions. This includes:
- Items such as equipment, parts and other physical products.
- Intangibles. Such as Royalties, Intellectual Property, and License Fees.
- This can include things like consulting, R&D, and manufacturing services.
- Financial Transactions. This can include factors such as intercompany debt and the interest rate on it, cross-border factoring, and guarantees on intercompany operations.
The way that you price transactions can be complex and depend on a range of factors. There are many methods that companies use for Transfer Pricing, which we’ll explain in more detail below.
But first, why should you care about Transfer Pricing?
It’s essential that you pay attention to Transfer Pricing because the costs associated with getting it wrong can be very high.
Penalties in the US vary, depending on how a company has not complied with the rules:
“For a substantial valuation misstatement, the penalty is 20% of the underpayment of tax if an income tax return understates taxable income and reports a transfer price that is 200% or more or 50% or less of the amount determined under Section 482 to be the correct transfer price. For a substantial valuation misstatement, the penalty is 20% of the underpayment of tax if the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $5 million or 10% of the taxpayer’s gross receipts.
For a gross valuation misstatement, the penalty is 40% of the underpayment of tax if an income tax return understates taxable income and reports a transfer price that is 400% or more or 25% or less of the amount determined under Section 482 to be the correct transfer price. For a gross valuation misstatement, the penalty is 40% of the underpayment of tax if the net Section 482 transfer price adjustment for the taxable year exceeds the lesser of $20 million or 20% of the taxpayer’s gross receipts.” – source Aronson.
Other negative consequences of failing to adequately make provision for Transfer Pricing include the risk of local tax law adjustments, secondary tax consequence and an inability to manage investor expectations on Effective Tax Rate.
As mentioned earlier, you could also face an impact on your reputation if you get Transfer Pricing wrong. The media tend to scrutinize tax authorities and the activities they undertake with regards to tax avoidance and are quick to report on tax avoidance issues.
So, how can you get to grips with understanding Transfer Pricing and what you need to do? Let’s take a look at some key elements of creating an effective Transfer Pricing policy.
To adhere to Transfer Pricing regulations you need to be able to come up with a way to create a price that is in line with the arms-length rule.
There are several ways that you can reach a price for transactions between entities located in different areas internationally. Each can vary in complexity and for detailed advice on the best method (or additional methods), you should consult a Transfer Pricing professional.
The OECD has guidelines on five main methods for determining a price in relation to the arms-length rule. These can be split into two main categories – Traditional Transaction methods and Transactional Profit methods.
It is beyond the scope of this article to include every method. To find out more about these methods in detail please consult the OECD guidelines. Below is an explanation of two methods – one from each category.
Traditional Transaction Method – The CUP (Comparable Uncontrolled Price) Method
This method has often been preferred by tax authorities because it is considered to be the simplest and most direct way to apply the arms-length rule.
The CUP method compares the price of transactions between branches and subsidiaries of a company with the price of transactions that external parties enter into for comparable transactions.
This method collects two sets of data – The Internal “CUP” and the External “CUP”.
The internal CUP looks at the company and the pricing for either purchases it has made from independent suppliers in comparable circumstances, or the transaction it has supplied to independent customers in comparable circumstances.
The external CUP looks at transactions made between independent parties under comparable circumstances.
Traditional Transaction Methods – Transactional Net Margin Method (TNMM)
This method measures net operating profits that are gained from controlled transactions. It compares the profit level to that realized by other independent enterprises who engage in comparable transactions.
This Transfer Pricing method requires that transactions are broadly similar to qualify, which means they don’t have to be identical to the controlled transaction. This makes this method beneficial for some as they have a wider range of situations and transactions that can be used in the calculation.
As with the CUP method, the TNMM method can either be internal, or external.
One way for you to avoid potential future disputes with the tax authorities on Transfer Pricing is to use an Advanced Pricing Agreement (APA). This agreement covers around five tax years and part of its feature is to agree in advance what the price of an international transaction will be.
The agreement is between the taxpayer and the tax authorities. The taxpayer can include the company and associated enterprises and the tax authorities may include foreign tax authorities and domestic tax authorities. In the US, the tax authority would be the IRS, but other agencies can be involved. Therefore, the APA can be either bilateral or unilateral.
Participation in this agreement is voluntary but it is a useful strategic tool that can be used to save headaches further down the line. Some of the advantages to an APA include decreasing the burden of tax authority compliance, providing clarity around Transfer Pricing methods and the fostering of more co-operative relationships with tax authorities.
The Organization for Economic Co-Operation and Development (OECD) is a group of 34 member countries including America, UK, Switzerland, Germany, France, and Ireland. Amongst its aims, the OECD seeks to eliminate Tax Avoidance (which they say costs world economies between $100 and $240 billion each year).
One of the OECD’s roles is to develop and deliver guidelines to follow with regards to Transfer Pricing. Detailed guidelines about Transfer Pricing can be found on the OECD (Organisation for Economic Co-operation and Development) website. The OECD also regulates international tax laws and can audit firms and financial statements in international locations
When it comes to understanding the regulations around Transfer Pricing you should be aware of the regulations that the OECD sets down, but also any regulations that are in place in the country where your main business is located. So you should be aware of US-specific regulations as you establish your business in America.
In 2017, the US introduced the Tax Cuts and Jobs Act, which was a comprehensive reform of the Internal Revenue Code (IRC). One of the amendments made was to IRC transfer pricing provisions which affect transfers of intangible property.
The US has rules and regulations around Transfer Pricing that are relevant at the Federal and State level. At the Federal level, section 482 of the IRC includes the arms-length principle by authorizing adjustments of taxable income of a controlled taxpayer to reflect the income that would have been realized if the transaction has taken place between uncontrolled parties. There are also rules around intangible property that state that income with respect to intangible property must also comply with the arms-length standard.
It’s also important to remember that in the US there are local and state laws which set their own regulations and rules around tax. Each state has its own power to set rules around Transfer Pricing that can override the conclusions of the IRS. Therefore, you must check the rules in the state that you intend to operate from and comply with their guidelines.
Transfer Pricing can become incredibly complex, especially as operations expand to more areas and more countries get involved. This is because different countries may view transactions differently. The OECD guidelines are adopted by many countries, but some countries modify the guidelines, and as we have seen, you also need to be aware of rules in the country where the main business is located.
For this reason, you should start to create a Transfer Pricing File as soon as possible. In the US you have an obligation to prepare a Transfer Pricing Documentation file and have it available for the tax authorities upon their request. This documentation should be completed well ahead of the time your tax return is due. Having the correct documentation can help you to avoid future issues such as pricing penalties and adjustments.
Documentation should include:
- A Company Analysis explaining the business in detail, including the corporate structure.
- An Industry Analysis to explain how recent industry circumstances affect the business and the transfer price.
- A Functional Analysis – which includes assets employed, risks assumed and the functions performed in the transaction.
- An Economic Analysis – this shows the best method for benchmarking the transaction alongside the explanation for why the pricing adheres to the arms-length rule.
In this guide, we’ve covered some of the main basic elements of Transfer Pricing. As you can see, it is a highly complex area and requires careful planning to navigate. One of the reasons it’s so complex is because there is a huge range of factors that need to be addressed individually and which may be unique to each business.
In a nutshell, effective Transfer Pricing planning ensures:
- You are able to satisfy the arms-length rule
- You can maximize opportunities to reduce your Effective Tax Rate
- You can minimize risk from Tax Authorities
Creating an effective Transfer Pricing strategy and ensuring you comply with all the elements you need to requires the support of skilled professionals who are highly experienced.
Transfer Pricing services can include support with:
- Documentation gathering, compliance, and assessment
- Support should you get audited
- Comparable analysis and functional analysis to help you choose and implement the best pricing method
- Advice and support with creating AP’s
- Studies and data on Transfer Pricing
The team at Mount Bonnell Advisors have run businesses in Europe and the US, and have experience with ensuring compliance with Transfer Pricing rules. We work alongside experienced professionals who can help you to develop sound Transfer Pricing policies that protect you whilst enabling you to maximize opportunities to reduce your ETR.
If you would like to find out more about how we can help you with Transfer Pricing, please don’t hesitate to get in touch with one of our experienced advisors today.
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