If a company is selling goods or providing a service to a related company in another country, the revenue agencies in both countries may examine your books to determine if the price you are charging or paying is reasonable. This is the concept known as “transfer pricing.”
And if your company isn’t documenting its practices in selling goods and services across country borders, it could face substantial penalties, says Henry Grzes, CPA, a director in international tax at SS&G.
“Transfer pricing is the markup on goods and services sold between related entities in different countries,” says Grzes. “For example, it’s the markup a U.S.-based company would charge on a product manufactured here that it would then sell to a related party in Canada or another foreign country, which would then ultimately be resold to the end user.”
Smart Business spoke with Grzes about how transfer pricing works and how to ensure you’re doing it right to stay out of trouble with the government.
How does transfer pricing work?
With transfer pricing, the revenue services are looking to make sure that companies don’t artificially maximize income in a low-taxing jurisdiction for tax savings. To make sure that you’re distributing profits justly, you need to look at a number of factors. Those factors include the different transfer pricing methodologies, the fact pattern of your intercompany sales and the industry you’re in. The most simplistic methodology is the ‘cost-plus’ methodology, in which you simply take the manufacturer’s cost, add a mark-up percentage on to it, and that becomes the sales price. For example, if you have a company in Mexico that is selling the product that you manufacture here in the U.S., you’d take the manufacturer’s cost, multiply it by the mark-up percentage and sell it to that Mexican entity at the cost plus the mark-up percentage.
In addition to cost-plus, what other methodologies are available in transfer pricing?
The resale price methodology begins with the sale price to the consumer and then reduces the sales margin by a comparable gross margin. With the ‘comparable uncontrolled price’ methodology, a company looks at what the taxpayer would purchase the item for in an arm’s length sale from another supplier. The transactional profit methodology is basically a profit-splitting methodology that looks at each transaction. This method considers a lot of different factors and is the most difficult method to use. The profit split methodology considers the total profits earned by the parties in a controlled transaction and then splits the profit between the parties based on relative value of their contribution, and with the ‘transactional net margin’ methodology, a company looks at net margin profits compared to what those of an unrelated corporation are in the same industry.
How does the government approach transfer pricing?
Governments, throughout the world, are taking a closer look at the methods that companies are using and taking a stricter look to make sure that the margins are correct. At a time when governments are looking to find tax dollars wherever they can, transfer pricing has become very profitable for the revenue services.
Many mid-market companies don’t have the resources to undertake a full transfer pricing study or incur the expense to have an outside consultant prepare one on their behalf and they’re not sure where to turn. In some cases, companies have an existing methodology that they have put into place, but they do not continue the documentation to support that it is still applicable.
The IRS requires contemporaneous documentation each year as to transfer pricing. Although it does not need to be provided with a company’s U.S. tax returns, there must be evidence that this documentation existed at the time the tax return was filed. If that documentation is not kept or there is no evidence that it existed at the time the return was filed, a taxpayer risks being assessed a penalty in the amount of up to 20 to 40 percent of the additional tax being charged as a result of any pricing adjustments, on top of the tax itself.
Other countries, however, such as Taiwan, do require that certain documentation be included with tax returns to substantiate the prices that are being charged. As a general rule, as long as a corporation has a reasonable methodology in place, with proper documentation, the government has been willing to accept the transfer pricing method without a full study supporting it. However, more countries are requiring support for transfer pricing methods and their related documentation. Italy has just recently enacted such legislation.
If a company is concerned that it hasn’t taken the right approach to transfer pricing, how can it begin to rectify that situation?
The first thing you need to do is contact your accounting firm and see if you need to have a transfer pricing study and the accompanying documentation. The accounting firm can review your records to make sure that everything has been done appropriately and that you have contemporaneous documentation in place. If you don’t, the firm can advise you on the proper steps to take, whether that is correcting errors of the prior year or taking corrective action in the current year.
Does transfer pricing apply to intellectual property, such as trademarks or formulas developed in the U.S.?
Generally, intellectual property such as trademarks and patents fall under royalty agreements. A company would need to have a separate study done to determine the value of the intellectual property and pay a royalty in accordance with whatever the value of the use of that property were to be.
Henry Grzes, CPA, is a director in international tax at SS&G. Reach him at [email protected] or (800) 869-1834.
