The IRS is beefing up its scrutiny of transfer pricing and, if your company isn’t documenting its practices in selling goods and services across divisions or subsidiaries, it could face substantial penalties, says Dick Lam, director of Transfer Pricing at Burr Pilger Mayer.
“The IRS has determined that, either inadvertently or by design, many companies have not been properly reporting transfer pricing,” says Lam. “Compliance has always been required, but with the hiring of 600 to 800 additional examiners at the IRS, there will be a heightened emphasis.”
Smart Business spoke with Lam about how to handle transfer pricing to stay on the right side of taxing authorities.
What is transfer pricing?
A transfer price is an internal price determined by a business for the transfer of goods, services or other products between divisions or units. Because it is an internal price, it is generally not controlled directly by market forces.
The most obvious example is the transfer of tangible goods between a manufacturer and a related distribution company, but transfer pricing also applies to services. For example, if a parent company sends a manager overseas to set up a plant, the value of those services must be charged to that foreign entity. Likewise, if you’re advancing funds, there needs to be interest charged on most loans and advances.
The most difficult transactions to evaluate relate to intellectual property, such as the use of the parent company’s trademark overseas or industrial processes and formulas developed in the U.S. Intercompany charges for intellectual property are frequently overlooked, but the IRS is looking to recover the cost of developing those intangibles and expects the U.S. party to receive fair compensation for the use of that property overseas.
When both divisions or units operate and are taxable in the U.S., there is not generally much tax impact on which entity reports the revenue. Internationally, however, there can be large differences in tax rates and both countries involved want to make sure they’re getting their fair share of tax revenue.
How can companies determine a fair transfer price?
Following the arm’s length standard, companies are supposed to create a price that represents the price that would have been negotiated had those two units been dealing with each other as if they were unrelated. That is obviously an artificial construct, because they can never be truly at arm’s length, but they can look at indicators in the marketplace as to what the price of that good or service should be.
