By Michael D. Fisher, CPA, MST
Senior International Tax Manager, PIASCIK
A Statement of the Problem
Legislatures and government tax authorities worldwide have long recognized that affiliated companies under common control sometimes have the ability to exploit differences in tax environments between nations through the artful adjustment of transfer prices within corporate groups constituting integrated enterprises.
To address this phenomenon in the United States, Section 482 of the Internal Revenue Code (“IRC”) authorizes the IRS to adjust the income, deductions, credits, or allowances of commonly controlled taxpayers to prevent evasion of taxes or to clearly reflect their income.
The regulations under Section 482 generally provide that prices charged by one affiliate to another, in an intercompany transaction involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.
A Brief History of U.S. Transfer Pricing Law
In the early part of the 20 th century, Congress gave the IRS the authority to allocate income and deductions among related corporations for the purpose of correctly stating taxable income. The earliest statute authorized the Commissioner to make adjustments to the income accounts of related taxpayers to the extent necessary to prevent tax avoidance and to ensure the clear reflection of income.
In 1935, the regulations promulgated under then Section 45 of the IRC introduced the concept of the “arm's length” standard (“ALS”) as the touchstone for ascertaining “true taxable income.” The regulations addressing how to implement the ALS have undergone multiple refinements in the ensuing decades, most notably in 1968 with the introduction of specific pricing methods and detailed rules applicable to certain classes of intercompany transactions. These pricing methods and rules were supposedly based upon sound generally accepted theory drawn from the fields of microeconomics and the behavioral sciences, but they have proved to be a rich source of controversy and litigation as taxpayers and the IRS have struggled to apply them in real-world settings.
As part of the 1986 Tax Reform Act, Congress amended Section 482 to address the transfer of intangibles with the introduction of a new standard that came to be known as the “commensurate with income” standard or “CWIS.” This was undertaken because Congress was concerned that highly valuable intangibles were being transferred outside the U.S. with less than fair market value consideration and that the pricing methods based on comparability did not adequately address the misallocation.
In 1990, Congress again acted to strengthen the hand of the IRS in transfer pricing controversies with the enactment of the “accuracy-related” penalty provisions now found in Section 6662. Three years later in 1993, Section 6662 was amended to specifically require corporate taxpayers to generate contemporaneous documentation and analysis of adopted transfer pricing policy and to provide such documentation promptly upon demand by the IRS.
Recognizing the international and public finance implications of the transfer pricing issue, the United States has for some time been highly involved in helping to build an international consensus and framework for resolving transfer pricing controversies through promoting the ALS and convergence of language in negotiated treaties. With few exceptions, the tax treaties currently in force with the United States contain language requiring the mutual application of ALS in resolving transfer pricing disputes and equitably allocating income to avoid double taxation when multiple sovereigns have concurrent interest in the same transaction. In particular, the Organization of Economic Cooperation and Development (“OECD”), has embraced the ALS through the promulgation of its 1975 report, “Transfer Pricing and Multinational Enterprises,” and again in the 1995 Transfer Pricing Guidelines. As of 2010, most U.S. trading partners, including those in Europe, Latin America and the Pacific Rim, have made similar progress towards adopting the ALS and convergence of language and frameworks for addressing transfer pricing issues. Additionally, the treaties usually contain a “competent authority” provision that provides the process and forum for the resolution of complex transfer pricing controversies.
Comparability and the Arms-Length Standard
Fundamentally, the ALS is about the application of economic theory to the measurement of fair market values through analysis of functions performed, value added, resources employed and risks assumed by commonly controlled legal entities. It seeks to answer a hypothetical question about controlled observable results by measuring those results against “comparable” uncontrolled results obtained through use of statistical and econometric methods and financial theory such as the Capital Asset Pricing Method (“CAPM”).
The regulations under Section 482 are an attempt to implement the standard at a detailed level by setting out the factors that determine comparability and then relating the factors to the particular transfer pricing methods and metrics most appropriate in the circumstances. The regulations implicitly recognize that the effort is not an exact science and that the attributions of good faith and reasonableness are more important to achieving the desired objectives than elaborate computation and analysis in support of ersatz precision. Under the regulations, the IRS will not reallocate taxable income if the taxpayer can demonstrate that results fall within a reasonable ALS range. The current regulations provide reasonably straight-forward guidance on how to develop such a range and how to deal with outliers and statistical anomalies.
Additionally, the regulations provide that the ALS principle inherently requires taxpayers to adopt the method that, under the facts and circumstances, will provide the most reliable measure of an ALS result. This is sometimes referred to as the “best-method” rule (“BMR”). To implement the BMR, the taxpayer is required to consider two primary subjective factors in selecting a pricing method: (1) the degree of comparability between the controlled and uncontrolled transaction and (2) the integrity of the sampled data.
Applications to Transfers of Tangible Property
Subject to the overriding principles of the ALS and BMR, the regulations specifically sanction the use of any one of five distinct pricing methods plus an unspecified method in pricing the results of controlled transactions involving tangible property. The five methods are:
- The comparable uncontrolled price method (“CUPM”)
- The resale price method (“RPM”)
- The cost-plus method (“C+M”)
- The comparable profits method (“CPM”)
- The profit split method (“PSM”)
Each of the methods is described in detail in the regulations and there is considerable literature and commentary on the appropriateness and feasibility for their use.
If a taxpayer can demonstrate that none of the five methods is superior under the BMR, and if the taxpayer can make a valid case for use of some other method that does satisfy BMR, then the regulations specifically permit the use of such method.
Applications to Transfers of Intangibles
Similarly to transfers of tangible property, the regulations specifically sanction the use of any one of three methods or an unspecified method in the case of controlled transactions involving intangible property, e.g., the intercompany license of patents or the use of trademarks or technical know-how outside the U.S. The three methods are:
- The comparable uncontrolled transaction method (“CUTM”)
- The comparable profits method (“CPM”)
- The profit split method (“PSM”)
As before, each of the methods is described in detail in the regulations and there is considerable literature and commentary on the appropriateness and feasibility for their use.
As in the case of tangible property, if a taxpayer can demonstrate that none of the sanctioned methods is superior under the BMR, and if the taxpayer can make a valid case for use of some other method that does satisfy BMR, then the regulations specifically permit the use of such method.
Applications to Controlled Services
The regulations under section 482 apply to situations where one member of a controlled group of entities renders a service (e.g., accounting, legal or technical service) to another member of the controlled group that is separable from the transfer of tangible or intangible property. The guidance contained in the regulations generally address the allocation and apportionment of service costs by reference to theactivities that confer a benefit on members of the controlled group through a disaggregation of transactions in the application of the ALS.
Within the parameters of the ALS, the regulations allow that any reasonable method may be used to allocate and apportion activity-based service costs provided there is due consideration given to the relevant allocation bases such as assets, revenues, compensation, time spent or space utilized.
It is common for controlled groups of legal entities to adopt written intercompany management agreements or cost sharing agreements that provide objective criteria for intercompany charges and sharing of costs. Such agreements will normally be honored by tax authorities provided they are reasonable and incorporate due regard for the ALS.
Applications to Intercompany Debt and Accounts Receivable or Payable
The U.S. transfer pricing rules recognize the generally accepted principles governing the time value of money, and therefore it is required under the regulations for controlled entities to use an arm's-length interest rate on intercompany loans, borrowings and advances, however described. To determine an arm's-length rate of interest, the controlled lender must consider all the relevant factors typically used in pricing an extension of credit, including the amount and duration of the loan, the credit standing of the controlled borrower, the prevailing market interest rate available to the controlled borrower in its resident jurisdiction, and any available collateral to be pledged to secure the loan.
If an arm's-length interest rate can not be determined, a controlled lender may price an extension of credit to a controlled borrower using a safe-harbor rate based on the “applicable federal rate” for loans of similar terms, risk and duration. However, the safe harbor provisions are not available for loans not denominated in the U.S. dollar.
Short term intercompany trade receivables and payables fall under an exception provided they arise in the ordinary course of business, are not evidenced by a written agreement requiring an interest charge and are settled within certain time limits set out in the regulations. Specifically, if a controlled debtor is located outside the U.S., it is not necessary to accrue interest or finance charges provided the balance is settled before the first day of the fourth month following the month in which the balance arose. If the controlled borrower is a U.S. person, arm's-length interest or finance charges must be charged beginning with the first day of the third month following the month in which the balance arose. If a controlled creditor can demonstrate that it normally allows more liberal credit terms to unrelated parties, it may be possible under the regulations to also extend similar terms to its controlled debtors.
What's at Risk: The Penalty Provisions of IRC Section 6662
If taxpayers ever had an inclination to regard the transfer pricing issue lightly, the penalty provisions of IRC Section 6662 surely disabused them of their folly. This somewhat obscure section of the code, found in the arcane Subtitle F “Procedure and Administration” of the Code, has been the bane of many tax practitioners since its enactment in 1989.
In general, Section 6662 is used in examinations to impose either a transactional penalty or a net adjustment penalty .
A transactional penalty is imposed at 20% if a transfer price is determined to be 200% or more or 50% or less of what the IRS determines to be the correct arm's length price; the transactional penalty is imposed at 40% of any gross valuation misstatement which applies if the observed transfer price is 400% or more or 25% or less than the correct price as determined by the IRS.
A net adjustment penalty is imposed at 20% of the taxpayer'snet Section 482 transfer price adjustment for a year that the adjustment exceeds $10 million; the penalty is imposed at 40% if the adjustment for a year exceeds $20 million.
While there are provisions for escaping the penalty in narrowly defined circumstances, the main force of this statute is to impel taxpayers towards compliance with a 10-point document test described in the regulations. This test is geared to the so-called 10 types of “principal documents” described in Regulation Section 1.6662-6 that have come to be recognized as a kind of safe-harbor for taxpayers who wish to avoid the penalty. According to the published guidance, these ten documents must exist at the point in time when the taxpayer files the U.S. tax return for the year.
Risk Management and the Transfer Pricing Study
The U.S. Internal Revenue Service continues to place increasing emphasis on transfer pricing issues as part of its ongoing efforts to close the so-called compliance gap. This has important implications to multinational enterprises (“MNE”) doing business in the U.S. and filing U.S. income tax returns. Contemporaneous documentation requirements under current U.S. transfer pricing rules are being strongly enforced and the IRS has shown no hesitation to imposes the Section 6662 penalties whenever they can. The U.S. affiliates of an MNE must be prepared in order to reduce the likelihood of double taxation and avoid the potential assessment of penalties.
Under Section 482, U.S. taxpayers are required to prepare a Transfer Pricing Study (“TPS”) supporting the ALS attribution of cross-border transfer prices in use with related parties. The TPS is the single most effective way to comply with the regulations and avoid the section 6662 penalties.
The TPS process implies that a taxpayer has made a good faith effort towards self-compliance, including creating and maintaining contemporaneous documentation consisting ofprincipal and background documents as defined in the regulations. Under the contemporaneous standard, the rules require that the documents exist when the tax return is filed and must be provided to the IRS within 30 days of a formal request.
For larger MNEs that are publicly traded or prepare audited financial statements, FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”) provides guidance on the proper measurement and recognition of income tax liabilities, including the recognition of tax contingency reserves in certain circumstances. A well executed TPS can help an MNE comply with the complex financial reporting standards by providing support for tax return positions and the related tax provisions that affect reported financial results. Moreover, the TPS is often a key tool for MNEs needing to manage complex tax strategies and minimize effective tax rates.