Transfer Pricing Rules: Protect Your Business With Proper Planning

As businesses grow into new states or international markets, transactions between related entities can create tax issues that may not arise when operating in a single jurisdiction. One area that deserves particular attention is transfer pricing — the rules governing how affiliated businesses assign prices to transactions with one another.

These transactions can take many forms, including the sale of products, the provision of management or other services, loans between related entities, and the licensing or use of intellectual property. Tax authorities scrutinize transfer pricing because the amounts charged between affiliates can affect where income and expenses are reported — and, ultimately, how much tax is paid in each jurisdiction. Businesses with related entities in multiple tax jurisdictions should understand the rules and maintain appropriate support for how their intercompany prices are established.

Setting Transfer Prices

Transfer pricing regulations are intended to prevent related businesses from manipulating intercompany pricing to shift profits to lower-tax jurisdictions. A complete discussion of these regulations is beyond the scope of this article, but generally speaking, they require the terms of intercompany transactions to be comparable to arm’s-length transactions between unrelated businesses.

There are several methods for setting acceptable transfer prices. For example, the comparable profits method estimates the arm’s-length price by analyzing the profitability of comparable transactions involving similar businesses. Another example is the cost-plus method, which determines the costs incurred by the “supplier” and applies a market-based markup to arrive at an appropriate profit.

Transfer pricing regulations generally require businesses to use the best method based on their circumstances. Some jurisdictions require organizations to furnish documentation to support their transfer prices. But even if not required, it’s advisable for businesses that conduct cross-border business with related organizations to maintain documentation that details the methods they use to set prices. In the United States, if the IRS requests transfer pricing documentation, taxpayers have only 30 days to provide it.

The consequences of noncompliance can be harsh. Under U.S. law, for example, on top of back taxes and interest, companies can be hit with penalties as high as 40% of the tax underpayment (depending on the circumstances).

Staying in Compliance

If you’re concerned about transfer pricing, start by conducting a risk assessment. The higher your risk, the more important it is to invest in transfer pricing compliance.

The next step is to review and evaluate your transfer pricing policies and procedures, if any. Implement policies and procedures that are appropriate based on the nature of your business and incorporate the best methods for determining arm’s-length prices. Finally, document your methodology to help support your position in the event of a transfer pricing audit.

Make Transfer Pricing Part of Your Operational Planning

Transfer pricing shouldn’t be treated as an afterthought once inter-business transactions are already underway. Establishing defensible pricing policies, maintaining thorough documentation and reviewing arrangements as your business evolves can help reduce the risk of tax adjustments, penalties and costly disputes with taxing authorities. If your business conducts transactions with related entities across state or international borders, Kirsch CPA Group can help evaluate your current practices and ensure your transfer pricing strategy keeps pace with your growth.

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