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International Tax and Transfer Pricing Dual Licensed Tax Attorneys & CPAs

International Tax and Transfer Pricing Dual Licensed Tax Attorneys & CPAs

Transfer pricing is THE most important international tax issue for large and small multinational businesses and, consequently, it is a frequently audited issue by tax authorities around the world. The tax implications of transactions between related business entities can be significant, either in terms of applying transfer pricing effectively to reduce global taxes or significant taxes and penalties for incorrect management of transfer pricing.

As a result, transfer pricing frequently receives close attention from IRS investigators. If multinational businesses do not maintain detailed documentation to support and justify their transfer pricing, they could end up facing large income tax assessments along with additional related interest and civil penalties over multiple tax years and over all related entities.

To learn more about the benefits and risks of transfer pricing strategies for international tax purposes, contact the dedicated Dual Licensed International Tax Attorneys and CPAs, as well as Economist, at the Tax Law Offices of David W. Klasing today by calling (800) 681-1295.

What is Transfer Pricing and Why is it Important to You?

Transfer pricing is important because it can be an effective way to reduce the overall worldwide tax liability of a group of related companies. This applies specifically when a company faces different tax rates compared to a related company within the same business group.

For instance, let’s say that there are two related companies (Company A and Company B) both located in California, where Company A regularly manufactures products for Company B to sell to its customers. Let's say that Company A decides to charge a lower price to Company B instead of using the arm’s length market price that naturally occurs between unrelated companies. As a result, Company A's sales or revenues are lower because of the lower pricing. On the other hand, Company B's costs of goods sold are lower, increasing their profits. In short, Company A has “transferred” a portion of its profits to Company B through transfer pricing in this situation.

However, let's say that Company A is in a country with a higher corporate tax rate than Company B. The two related companies can save on their total combined taxes by making Company A, in a high tax country, less profitable, and Company B, in a low tax country, more profitable. By making Company A reduce its selling price to Company B, Company A’s profits will be reduced through reduced revenue, and Company B’s profits will be increased through reduced COGS. In other words, Company A's decision to charge a lower price to Company B has effectively “transferred” Company A’s profits, which would have been taxed at a higher tax rate, to Company B, which is now taxed at a lower tax rate. Therefore, transfer pricing has allowed the two related companies to reduce their combined tax liability.

Examples of Transfer Pricing Methods

Effective transfer pricing requires attention to the specific needs of the business. There are several different methods of transfer pricing that account for various circumstances and achieve different goals for your business. When choosing the transfer pricing method that you intend to use, you will want the one that provides the most optimal fiscal benefits while also being defensible if the IRS decides to initiate an audit or investigation in the future. Below are the methods specified by the Treasury Regulations and the IRS as acceptable transfer pricing methods.

Comparable Uncontrolled Price Method

The comparable uncontrolled price (CUP) method establishes a price based on the pricing of similar transactions that have taken place between third parties. When comparable uncontrolled prices exist, this is a reliable transfer pricing method.

The challenge of the CUP method is that the comparability standards for the application of the method is quite strict, and acceptable comparable transactions can be difficult to find. Even differences in a few factors such as quality of the product, contractual terms, or intangible property associated with the product such as brand value can differentiate the cases enough to render the CUP method inapplicable for establishing an accurate transfer price.

Comparable Profits Method (CPM)

When actual transaction data is not necessarily available, margin levels can be helpful in establishing transfer pricing. A business can use the net profits resulting from comparable uncontrolled (third party) transaction to establish a net profit basis. The CPM is based on the notion that similarly situated business operations tend to earn similar returns over time. The CPM typically compares the taxpayer’s operating results over a range of years with those of comparable uncontrolled taxpayers (comparables). The reliability of the results derived from the CPM is affected by the quality of the accounting data of both the taxpayer and the uncontrolled comparables.

Cost Plus Method

The Cost Plus method compares the mark up on costs (gross profit over cost of goods sold) between related party transactions with the mark up on costs between unrelated third party transactions, and adds the third party mark up on costs to the taxpayer's cost of producing the property sold to arrive at the arm's length sale price. This method is most widely used to determine the mark-up earned by manufacturers selling to related parties or services providers providing service to related parties.

Resale Price Method

The Resale Price Method (“RPM”) evaluates whether a transfer price charged in a related party transaction is arm’s length by comparing the gross profit margin realized in the related party transaction with gross profit margins observed in unrelated third party transactions. Gross profit margin is the ratio of gross profit to net sales revenue. RPM is ordinarily used in cases involving wholesale or resale distributors.

Profit Split Method

The profit split method is used when two parties are involved in the development of a product or some other venture in ways that make it difficult to examine each party on its own. Instead, the profit split method uses the combined profitability, or combined potential profitability, of a product or venture and develops a method of splitting the combined profits that is fair to both entities. The allocations used under the profit split method must be made in accordance with either the comparable profit split method or the residual profit split method.

This pricing method comes with challenges because the accuracy of splitting the combined profits may be up for debate.

IRS Treatment of Transfer Pricing

Precisely because multinational business entities and related parties can utilize transfer pricing to effectively reduce their combined global tax liability, the IRS and all other tax authorities around the world closely monitor these types of transfer pricing strategies for oversteps and abuses and have set up strict transfer pricing laws and regulations to deter and punish such violations.

Transfer pricing is one of the many strategies that play a key role in supporting the multinational business entities in expanding their business globally and reducing the tax burden. These multinational business entities may take advantage of their global presence to manipulate their transfer pricing to significantly reduce their global tax burden. A large portion of the global market is engaged in related party transactions so as to shift the profit to low taxed jurisdictions. The prevalence of transfer pricing as a tool for reducing global taxes and more importantly as a tool for reducing taxes in specific countries necessitates the strict regulation of transfer pricing by all tax authorities around the world.

Even if you are not the head of a global multinational business group, you may still be subject to transfer pricing audits. For example, you may be an owner of a US company that purchase products from a company in Asia or Latin America that you or your family members own for sales into the US. Or you may be an owner of a US company that produce products for sales to another company in Europe that you or your family own. These transactions are all subject to strict scrutiny by the IRS for potential transfer pricing issues. So, if you own at least two companies in two different countries, you are subject to transfer pricing scrutiny by the IRS and other tax authorities.

The global consensus for regulating intercompany transfer pricing is that transfer pricing should generally reflect the same value between intercompany transactions that would have otherwise occurred had the company conducted a like transaction with an unrelated third party, or what is called “arm’s length” pricing. This standard is also followed by the IRS and all of the Organization for Economic Co-operation and Development (OECD) countries. The US and the OECD have agreed on a set of methods that companies must use for transfer pricing, including comparable uncontrolled price (CUP), resale price method, cost plus method, comparable profits method (or transactional net margin method) and profit split method. Most non-OECD countries also adhere to the “arm’s length” pricing standard for transfer pricing and the same set of transfer pricing methods.

One very important thing to note is that the IRS can adjust your tax income and levy additional tax, penalties and interest even when you had no intention of abusing or even utilizing transfer pricing to lower your global taxes. Your intent is meaningless. You may not even know what transfer pricing is. If the outcome of your intercompany transactions is deemed by the IRS (or any other tax authority for that matter) to not be “arm’s length,” then you are subject to the same scrutiny as a global pharmaceutical company that may have erroneously used transfer pricing to evade billions of dollars in taxes.

To ensure that transfer pricing is reported appropriately, the IRS requires extensive transfer pricing documentation, as well as strict requirements for reporting any intercompany / related party transactions with your tax return. Even if transfer pricing is reported accurately, lacking the necessary documents could result in having to regenerate financial statements or file amended tax returns, and may lead to assessments of significant amounts of additional tax, penalties and interest.

Given the IRS’s strict scrutiny of transfer pricing, incorrect transfer pricing, whether intended or not, could lead to significant costs in the ways of additional taxes and penalties that would eliminate any tax savings resulting from transfer pricing.

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International Tax Laws Will Likely Change in the Near Future

Following the OECD's initiative to stop base erosion and profit shifting (“BEPS”), tax authorities worldwide are seeking more effective ways to protect and ensure that the attribution of profits is aligned with value creation.

Further, various U.S. tax reform provisions in the Biden Administration FY22 budget and the Treasury Department Greenbook explanation of Biden's tax proposals could create adverse tax consequences for certain related-party transactions. Conversely, they may now present planning opportunities. With the exponential rise of comprehensive tax policies and demand for tax transparency in the transfer pricing landscape, there are certainly issues to consider.

One item of concern for the federal government in particular are inversion transactions. Inversion transactions are when a U.S. corporation is acquired by a foreign entity where, among other criteria, the former shareholders of the U.S. corporation would hold at least 60% ownership interest in the foreign entity as a result of the transaction.

This occurs most frequently when domestic entities combine with smaller foreign entities under the banner of a new foreign parent company. This has the effect of reducing the domestic company’s U.S. income tax liability, which is value that substantially outweighs the increase in the costs to operations.

IRC Section 7874 was created to discourage U.S. corporations from using inversion to avoid or reduce their U.S. taxes, particularly by putting limitations on tax benefits for cases where the previous shareholders of the U.S. corporation that underwent an inversion transaction receive 60% or more of the shares of the new foreign parent of the U.S. corporations.

According to the Greenbook analysis, because inversion transactions create the potential for “substantial erosion of the U.S. tax base,” the current administration plans to tighten restrictions on inversion transaction by, among other planned measures, changing the 60% or more threshold for the application of inversion related restrictions under Section 7874 to “greater than 50%,” which would affect the tax treatment of these transactions. While these proposals have not gone further as of yet, significant congressional support suggests that developments like these are expected in the future.

Who Should Prepare a Transfer Pricing Report for You?

Transfer pricing analysis is a combination of tax law analysis and economic analysis. Ideally, your transfer pricing advisor should be an expert on international tax and transfer pricing regulations but should also be an experienced economist who can handle the economic aspects of transfer pricing. A transfer pricing report prepared by an economist or a CPA who does not have detailed knowledge of the relevant tax law and does not have experience dealing with IRS transfer audits, or a transfer pricing report prepared by a tax lawyer who does not have the capability to perform the required economic analysis to satisfy the “arm’s length” standard for transfer pricing, could expose the taxpayer to significant risks in a tax audit. The IRS will be represented by IRS revenue officers, international tax specialists and its own economists who specialize in transfer pricing. You, as taxpayer, should have access to the same resources.

At the Tax Law Offices of David W. Klasing, we are uniquely qualified to assist our clients in these efforts. Our Dual Licensed International Tax Lawyers and CPAs and Economists have experience in transfer pricing tax documentation preparation, defending against IRS transfer pricing audits and legal representation on transfer pricing issues. Rather than having to go to multiple firms to meet all your transfer pricing needs, you can reap the benefits of having one centralized source for all of your transfer pricing and international tax needs.

Meet Our International Transfer Pricing Specialist, Rap Choi, PhD, Esq

Dr. Rap Choi has over 30 years of transfer pricing experience, including TP documentation, TP controversy, competent authority and APAs, working as a partner in Big 4 firms and law firms, both in the US and in Korea.

Rap Choi is fluent in both English and Korea and has been voted as the Top TP advisor in Korea by various global tax publications, and has extensive experience dealing with the Korean tax authorities on various tax matters, not just TP.

Rap Choi is a PhD economist as well as a tax lawyer, and thus has the capabilities for providing the highest quality TP services which require the ability to perform high level economic and financial analyses as well as legal skills as a tax lawyer.

Rap Choi’s TP clients have included global companies such as Samsung, LG, Kia, Coca Cola, Morgan Stanley, Goldman Sachs, and the Gap, and he has experience in diverse industries such as banking, finance, manufacturing, distribution, high tech, pharmaceutical and entertainment.

Get Transfer Pricing Help from the Tax Law Offices of David W. Klasing Today

When you need transfer pricing & international tax help, you will want to engage a firm with the experience and resources to assist you in all international tax matters, no matter what step you find yourself in the process. To schedule an initial reduced-rate case evaluation today, call the Tax Law Offices of David W. Klasing at (800) 681-1295.

Frequently Asked Questions about Transfer Pricing

What is Transfer Pricing?

Transfer Pricing is the price charged for goods, services, intangibles or interest rates charged between related entities, typically entities in different countries with different tax rates. The word transfer has been added to distinguish these prices from market prices because they are between related parties sharing the same interest who can set the price to be whatever they want it to be to achieve that interest, e.g., reducing the total combined tax for the related parties. In contrast, market prices are between unrelated parties with different interest and therefore cannot be easily manipulated. Because without restrictions on transfer pricing related entities can agree to charge whatever “transfer” price they want to minimize their combined global taxes, transfer pricing is both a powerful tool for global businesses to reduce their global taxes and a critical internal tax issue that every country’s tax authority, including the IRS, needs to monitor and challenge in order to collect their fair share of taxes.

Does the IRS penalize you when your Transfer Pricing is wrong? What are the penalties?

If the IRS determines that your Transfer Pricing is wrong, it can adjust your income and assess taxes, and can also levy accuracy related penalties of up to 40%.

Who should prepare a Transfer Pricing report?

Transfer Pricing analysis is a combination of tax law analysis and economic analysis. Ideally, your transfer pricing advisor should be an expert on international tax and transfer pricing regulations but should also be an experienced economist who can handle the economic aspects of transfer pricing

Is Transfer Pricing only important for large global corporations?

In the past, the IRS had targeted large global corporations for potential transfer pricing abuse. However because most of the largest global corporations have already ramped up their transfer pricing defense with extensive documentation and advance pricing agreements (APAs). The IRS is now focusing on smaller companies who are less prepared, with no transfer pricing documentation. From the IRS’ perspective, smaller companies with cross-border related party transactions but no transfer pricing documentation are easy targets because such companies are not equipped to deal with IRS transfer pricing audits and the IRS can easily make income adjustments and assess taxes on them. In addition, the IRS can add transfer pricing penalties of up to 40% of the taxes assessed.

Do I need to have Transfer Pricing documentation?

Companies with cross-border related party transactions are required to have transfer pricing documentation to support their transfer pricing in order to avoid penalties of up to 40% when they are assessed taxes for incorrect transfer pricing. Such documentation must be “contemporaneous,” meaning that the transfer pricing documentation must be prepared and in the possession of the taxpayer before the taxpayer submits its tax return for the relevant year. More importantly, if a company does not have transfer pricing documentation, they are easy targets because such companies cannot defend against the aggressive positions that the IRS can take in transfer pricing audits and as a result, the IRS can easily adjust their transfer pricing, assess taxes on them, and add penalties when applicable.