By Anthony Diosdi
Introduction
Transfer pricing must be taken into consideration by any business involved in cross-border transactions. Although many have heard of the term “transfer pricing,” few understand how transfer pricing works. This article is designed to provide the reader with a very basic understanding of how transfer pricing works. To understand transfer pricing we must think of the operating units of a multinational corporation. Multinational corporations usually engage in a variety of arrangements of intercompany transactions. For example, a U.S. manufacturer may market its products through foreign marketing subsidiaries. A domestic parent corporation may provide managerial, technical, and administrative services for its subsidiaries, and may license its manufacturing and marketing intangibles to its foreign subsidiaries for commercial exploitation abroad. A “transfer price” must be computed for each of these controlled transactions. Although a transfer price does not affect the combined income of commonly controlled corporations, it does affect how that income is allocated among the group members. Therefore, when tax rates vary across countries, transfer pricing can have a significant effect on a multinational corporation’s total tax costs.
Congress enacted Internal Revenue Code Section 482 to ensure that related corporations report and pay tax on their actual share of income arising from controlled transactions. The regulations under Section 482 adopt an arm’s-length standard for evaluating the appropriateness of a transfer price. Under this standard, a taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under similar circumstances.
To arrive at an arm’s length result, the taxpayer must select and apply the method that provides the most reliable estimate of an arm’s-length price. The reliability of a pricing method is primarily a function of the degree of comparability between the controlled and uncontrolled transaction. The regulations under Section 482 provide specific methods for determining an arm’s length transfer price for various types of transactions, including transfers of tangible property, transfers of intangible property, loans, and services. The regulations provide five specified methods for estimating an arm’s length charge for transfers of tangible property, including the comparable uncontrolled price method, the resale price method, the cost plus method, the transactional net margin method, and the transactional profit split method. In addition to the five specified methods, the taxpayer also has the option of using an unspecified method. However, an unspecified method can only be used if it provides the most reliable estimate of an arm’s-length price.
The Transfer Pricing Methods
The purpose of Internal Revenue Code Section 482 is to ensure that taxpayers report and pay tax on their actual share of income arising from controlled transactions. To this end, the regulations under Section 482 adopt a so-called arm’s length standard for evaluating the appropriateness of a transfer price. Under this standard, a taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under the same or nearly identical situations.
To arrive at an arm’s length result, the taxpayer must select and apply a method that provides the most reliable estimate of an arm’s length price. Thus, the primary focus in selecting a transfer pricing method is the reliability of the result. The reliability of a pricing method is determined by the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis. The principal factors to consider in assessing the comparability of controlled and uncontrolled transactions include:
1. Functions performed;
2. Risks assumed;
3. Contractual terms;
4. Economic conditions and markets;
5. Nature of the property or services transferred in the transaction.
Transfers of Tangible Property
A transfer of tangible property is the type of transaction traditionally considered when evaluating a company’s transfer pricing practices. In many cases, multinational company involved in a cross border transaction involving tangible property must estimate an arm’s length charge utilizing one of the theories discussed in more detail below. We will now walk through the different theories for determining the arm’s length transfer of tangibles.
Comparable Uncontrolled Price (“CUP”) Method
The first method for determining the arm’s length value of a tangible is the comparable uncontrolled price (“CUP”) method. The CUP method generally provides the most direct and reliable measure of an arm’s length transfer. It may be used if the same tangible property is transferred in both the controlled and uncontrolled transactions and only minor differences exist between the uncontrolled and the controlled transactions, provided that these differences have a definite and reasonably ascertainable effect on pricing and that appropriate adjustments are made for them.
The CUP method ordinarily is the most reliable method for estimating an arm’s-length price if there are only minor differences between the controlled and uncontrolled transactions for which appropriate adjustments can be made. See Treas. Reg. Section 1.482-3(b)(2)(ii)(A).
Below, please see Illustration 1 which demonstrates a typical CUT allocation for transfer pricing purposes.
Illustration 1.
Orange, a domestic corporation, owns 100 percent of peach, a Mexican corporation. Orange manufacturers computers at a cost of $500 per computer and sells computers to unrelated distributors at a price of $750 per computer. Orange also sells computers to Peach, which then resells the computers to unrelated foreign customers for $850 each. The conditions of Orange’s sales to Peach are essentially equivalent to those of the sales made to unrelated foreign distributors. Because information is available regarding comparable uncontrolled sales, Orange and Peach should use the CUP method. Under this method, the estimate of the arm’s length price is $750.
In assessing the comparability of controlled and uncontrolled sales for purposes of the CUP method, the most important factor is product similarity. Other significant factors include the similarity of contract terms and economic conditions. See Treas. Reg. Section 1.482-3(b)(2)(ii)(A).
Resale Price Method
The type of transaction envisioned by the resale price method is a controlled sale of finished goods followed by the related distributor’s resale of the goods to unrelated customers. Under this method, the arm’s length price is the resale price charged by the related distributor, reduced by the arm’s length gross profit margin for such resales, and adjusted for any material differences that exist between the controlled and uncontrolled transactions. The gross profit margin realized by independent distributors on similar uncontrolled sales provides an estimate of the arm’s length gross profit, which is expressed as a percentage of the resale price. See Treas. Reg. Section 1.482-3(c)(2) and (c)(3)(ii)(C).
Below, please see Illustration 2 which demonstrates the resale price method for transfer pricing purposes.
Illustration 2.
Orange, a domestic corporation, owns 100 percent of Bibeer, a Canadian corporation. Acme manufactures computers at a cost of $1,000 per computer and sells the computers to Bibeer, which resells the computers to unrelated foreign customers for $1,500 each. Independent foreign distributors typically earn commissions of 10 percent (expressed as a percentage of the resale price) on the purchase and resale of products comparable to those produced by Orange. Under the resale method, the estimate of the arm’s length price is $1,350 [$1,500 – (10% x $1,500)].
In assessing the comparability of controlled and uncontrolled transactions for purposes of the resale price method, product similarity is less important than under the comparable uncontrolled price method, while the similarity of the functions performed, risks borne, and contractual terms agreed to is relatively more important. See Treas. Reg. Section 1.482-3(c)(3)(ii)(A) and (B).
Cost Plus Method
The type of controlled transaction envisioned by the cost plus method is the manufacture, assembly, or other production of goods that are sold to related parties. Under the cost plus method, the arm’s length price is the manufacturing cost incurred by the related manufacturer, increased by the arm’s length gross profit markup for such manufacturer and adjusted for any material differences that exist between the controlled and uncontrolled transactions. The gross profit realized by independent manufacturers on similar uncontrolled sales provides an estimate of the arm’s length gross profit markup, which is expressed as a percentage of the manufacturing costs.
Below, please see Illustration 3 which demonstrates the Cost Plus Method for transfer pricing purposes.
Illustration 3.
Craftman, a domestic corporation, owns 100 percent of Toolsareus, a foreign corporation. Toolsareus manufactures power tools at a cost of $60 each and sells them to Craftman. Craftman attaches its trade name to the power tool (which has a significant effect on their resale price) and resells them to unrelated customers in the United States for $100 each. Independent foreign manufacturers producing similar power tools typically earn a gross profit markup of 20 percent. Under the cost plus method, the estimate of the arm’s length price is $72 [$60 + (20% x $60)].
Transactional Net Margin Method
The transactional net margin method as described in Treasury Regulation Section 1.482-5, may be used to determine the arm’s length considerations where the CUP method cannot be employed because a comparable uncontrolled transaction has not been identified. The transactional net margin method relies on the general principle that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. In essence, it involves imputing to the related transferee a level of operating profit that would be earned by the unrelated similarly situated transferee. The transactional net margin method determines the arm’s length consideration for a controlled transaction by referring to objective measures of operating profit profit level indicators) derived from uncontrolled persons that engage in similar activities with other uncontrolled persons under similar circumstances.
Under this method, the profitability of comparable companies is used as a benchmark for determining an arm’s length net profit for one of the controlled parties (the “tested party”) and then a transfer price is established that leaves the tested party with the amount of net profit. See Treas. Reg. Section 1.482-5(b)(1). The methodology for developing an arm’s length profit involves the following seven steps:
1. Determine the tested party- the tested party should be the participant in the controlled transaction for which the most reliable data regarding comparable companies can be located. This is likely to be the least complex of the controlled parties and the controlled party that does not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparable companies.
2. Search for comparable companies and obtain their financial data- the key factors in assessing the comparability of the tested party to comparable companies are the resources employed and risks assumed. Because resources and risks usually are directly related to functions performed, the functions performed must also be considered to determine the degree of comparability between the tested party and comparable companies. Another important factor is the consistency between the accounting methods used by the tested and comparable companies to compute their operating profits. Adjustment must be made for any differences between the tested party and the comparable companies that would materially affect the profitability measures used.
3. Select a profit level indicator (“PLI”)- examples of PLIs that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses. To enhance the reliability of a PLI, the taxpayer should perform a PLI, the taxpayer should perform a multiyear analysis which generally should encompass at least the taxable year under review and the two preceding years.
4. Develop an Arm’s Length Range of PLIs- the arm’s length range of PLIs is the interquartile range (the middle 50%) of the PLIs of the comparable companies. The interquartile range is the range from 25 percent to 75 percent percentile. More specifically, the 25th percentile is the PLI when at least 25 percent of the results are at or below that PLI. The 75th percentile is the PLI when at least 25 percent of the results are at or below that PLI.
5. Develop an arm’s length range of comparable operating profits- to construct an arm’s length range of comparable operating profits, the selected PLI (e.g., the ratio of operating profits to operating assets) for the comparable companies in the arm’s length range is applied to the tested party’s most narrowly identifiable business activity for which data incorporating the controlled transaction is available (e.g., the operating assets used in the manufacture and sale of inventory).
6. Determine if an adjustment must be made- an adjustment is required if the tested party’s reported profit lies outside the arm’s length range of comparable operating profits developed in step 5.
7. Adjust the transfer price for the controlled transaction- if the tested party’s reported profit lies outside the arm’s length range, an adjustment is made equal to the difference between the tested party’s reported profit and the benchmark arm’s length profit, such as the mean or the median of the arm’s length range of comparable operating profits.
Below, please see Illustration 4 which demonstrates a transactional net margin method for transfer pricing purposes.
Illustration 4.
E, a foreign corporation, owns 100 percent of U, a domestic corporation. E manufactures consumer products for worldwide distribution. U imports E’s finished goods for resale in the United States. U’s average financial results for the last three years are as follows:
Sales $50 million
Cost of goods sold $40 million
Operating expenses $9 million
Operating profit $1 million
U is selected as the tested party because it engages in activities that are less complex than that of E. An analysis of seven comparable uncontrolled U.S. distributors indicates that the ratio of operating profits to sales is the most appropriate PLI. after adjustments have been made to account for material different between U and the uncontrolled distributors, the average ratio of operating profit to sales for each uncontrolled distributor is as follows: 3%, 4%, 4.5%, 5%, 4%, 6%, and 7%.
The arm’s length of PLIs is from 4% to 6% (the interquartile range includes the PLI at which 25 percent of the results are at or below and 75 percent of the results are at or below) with the median at 5 percent. The PLI of operating profits to sales for U is only 2 percent ($1 million of operating profits divided by $50 million of sales), which is below the low part of the range. Applying these percentages to U sales of $50 million yields an arm’s length range of comparable operating profits of $2 million to $3 million with a median of $2.5 million.
Because U reported operating profit of $1 million lies outside the arm’s length range, an adjustment is required. The median of the interquartile range of comparable operating profits (i.e., $2.5 million) is determined to be the arm’s length profit for U. Therefore, the transfer prices that U pays E for its inventory are reduced by $1.5, which equals the difference between U’s reported profit of $1 million and the arm’s length profit of $2.5 million. This adjustment increases U’s U.S. taxable income by $1.5 million per year, with a corresponding decrease in E’s taxable income.
Transactional Profit Split Method
If members of a controlled group are engaged in a functionally integrated business and each member uses valuable intangibles, it will normally be difficult to identify comparable uncontrolled transactions and comparable uncontrolled transfers of comparable intangibles that can be used to determine arm’s length pricing for particular tangible transfers. Without comparable transactions or comparable uncontrolled holders of similar intangible rights, the above discussed methods cannot be used. In this situation, a transactional profit split method may be applied.
Treasury Regulation Section 1.482-6 describes transactional profit split methods. The basic approach of a transactional split method is to estimate an arm’s length return by 1) comparing the relative economic contributions that the parties make to the success of a business venture and 2) dividing the returns from that venture between them on the basis of the relative value of such contributions. The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity, consistent with the comparability provisions of Treasury Regulation Section 1.482-1(d)(3). Such an allocation is intended to the division of profit or loss that would result from an arrangement between uncontrolled taxpayers, each performing functions similar to those of the various controlled taxpayers engaged in the relevant business activity.
Two transactional profit split methods are available: the comparable profit split and the residual profit split. A comparable profit split is derived from the combined operating profit of uncontrolled taxpayers, the transactions and activities of which are similar to those of the controlled taxpayers in the relevant business activity. Each uncontrolled taxpayer’s percentage of the combined operating profit or loss is used to allocate the combined operating profit or loss of each controlled taxpayer involved in the relevant business activity. See Treas. Reg. Section 1.482-6(c)(2).
The residual profit split method determines an arm’s length consideration in a two-step process, using the other methods discussed above, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount is then allocated between the parties on the assumption that this residual is attributable to property contributed to the activity by the controlled taxpayers. Using this assumption, the residual is divided based on the estimate of the relative value of the parties’ contributions of such property. Since the fair market value of the intangible property usually will not be readily ascertainable, other measures of the relative values of intangible property may be used, including capitalized intangible development expenses. The transactional profit split method is the most complicated of the specified pricing methods for transfers of tangible property and, therefore, is difficult to apply in practice.
Penalties Associated With Transfer Pricing and the Documents Needed for Transfer Pricing
The IRS takes transfer pricing seriously. It can assess a transactional penalty and net adjustment penalty if a taxpayer does not follow the transfer pricing rules. Both penalties equal to 20 percent of the tax underpayment related to a transfer pricing adjustment made by the IRS. The transactional penalty applies if the transfer price used is 200 percent or more of the amount determined under Section 482 to be the correct amount. The net adjustment penalty applies if the net increase in taxable income for the taxable year as a result of a Section 482 adjustment exceeds the lesser of $5 million or 10 percent of the gross receipts. Both penalties increase to 40 percent of the related underpayment if the transfer price used is 400 percent or more of the amount determined under Section 482 to be correct or if the net adjustment to taxable income exceeds the lesser of $20 million or 20 percent of the gross receipts.
The penalties associated with transfer pricing are no joke. Adequate preparation is key to avoiding IRS scrutiny. The following information should be gathered before a transfer pricing arrangement is considered.
1. An overview of the business.
2. A description of the organizational structure covering all related parties engaged in potentially relevant transactions.
Prior to executing a transfer pricing arrangement, counsel should gather, prepare and review the following with his or her client:
1. Any documentation required by the regulations of Section 482;
2. A description of the pricing method selected and an explanation of why that method was selected;
3. A description of the alternative methods that were considered and an explanation of why that method was not selected;
4. A description of the controlled transactions;
5. A description of the comparables used.
6. An explanation of the economic analysis and projections used in the pricing transfer method selected.
Conclusion
Selecting the proper method of transfer pricing is no easy task. We devote a large part of our practice to the U.S. federal income tax rules applicable to U.S. businesses operating outside the United States, as well as foreign companies investing in the United States.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.