How do the U.S. and other countries protect against abuses?
If companies are crossing international borders, the tax rate can be significantly different in each jurisdiction. Each country’s tax revenue is directly impacted by that transfer price and each wants to make sure it gets its fair share. In other instances, the tax rates may be similar, and the taxpayer is merely a stakeholder as the two countries fight it out to determine whether the price is right.
In the U.S., there is no requirement for documentation to be submitted with tax returns, but to avoid penalties, should the company get it wrong, it is required to compile contemporaneous documentation that involves an economic study to analyze the functions, risks and assets performed by each party involved in that transaction. The study applies economic principles to the analysis to come up with a conclusion that the transfer prices assigned by the company are consistent with the arm’s length standard.
If the company fails to prepare that document and the IRS determines on audit that the price is substantially different than the arm’s length price, penalties can be 20 or 40 percent of the tax involved. Other countries, however, such as China, require that certain documents be included with tax returns to substantiate the prices that are being charged.
The IRS has issued new regulations and proposed new tax return disclosure schedules. Effective for 2010, large corporate taxpayers will be required to file a schedule of uncertain tax positions, which would include uncertain results for transfer pricing. Disclosure requirements will be phased in for smaller corporate taxpayers over the next five years.
How can a company get started with compliance?
If you haven’t been doing it correctly for years, there are open years exposed to adjustment by tax authorities. The place to start is to get it right going forward with the most recent year’s tax return.
Most importantly, review and document transactions in advance. Create inter-company agreements. If there is use of intangible property overseas, such as a trademark or process intangible, create a license agreement. That elevates awareness within the company and also helps convince the relevant tax authority that the company has thought about this in a responsible manner. That agreement should establish all the terms for the payment for the use of the covered intangible. Documentation of those transactions should also include the rationale for how the prices were determined.
How do outside advisers assist companies to comply?
A third party expert can assist the taxpayer in preparing a functional analysis by asking the right questions about what assets, services and people are involved in providing essential functions for the business and evaluating what an arm’s length return should be.
In addition, an adviser may be able to identify situations in which a company is reporting too much profit, or suggest ways to alter operations to get better results. There is an upside to planning and there are opportunities to use transfer pricing to improve the bottom line for some companies.
Dick Lam is director of Transfer Pricing Services at Burr Pilger Mayer. Reach him at (925) 296-1066 or [email protected].
