As businesses grow, they may decide to operate in different states or countries using related entities. This may involve a parent and subsidiary arrangement or brother-sister companies with a common parent. "Transfer pricing" refers to how such related entities price intercompany transactions involving goods, services or intellectual property. This pricing affects income tax liability in applicable jurisdictions — and a taxing authority might audit a business it suspects of using transfer pricing to inappropriately reduce tax liability in its jurisdiction.
In an increasingly global economy, transfer pricing is no longer an issue only for large multinational corporations. Small and midsize businesses with related-party transactions also need to support their pricing decisions with sound policies, appropriate methods and clear documentation.
Here's an oversimplified example that illustrates how transfer pricing can be used to shift profits — and why taxing authorities may scrutinize it. Let's say Company X and Company Y are related entities with a common parent. Company X is based in a country with a 30% corporate income tax rate, while Company Y is based in a country with a 10% corporate income tax rate.
Company X manufactures component parts at a cost of $2 million per year and sells them to Company Y for $4 million, earning a $2 million profit. Company Y assembles the parts into finished products, which it sells for $6 million, also earning a $2 million profit. Company X's tax liability is $600,000 ($2 million times 30%), while Company Y's tax liability is $200,000 ($2 million times 10%). Therefore, the enterprise's overall tax liability is $800,000.
Now suppose that Company X lowers the price it charges Company Y for the component parts to $3 million. In this scenario, Company X's profit falls to $1 million, and its tax liability is reduced to $300,000 ($1 million times 30%). Company Y's profit rises to $3 million, and its tax liability increases to $300,000 ($3 million times 10%). Thus, the enterprise's overall tax liability drops from $800,000 to $600,000.
The problem is, the higher-tax country in which Company X is based stands to lose significant tax revenue from this change in intercompany pricing. And that might initiate a transfer pricing audit.
Transfer pricing rules are intended to prevent related entities from manipulating intercompany pricing to shift profits to lower-tax jurisdictions. A complete discussion of them is beyond the scope of this article, but generally, the rules require the terms of related-party transactions to be comparable to those of arm's-length transactions between unrelated companies.
There are several methods for setting acceptable transfer prices. For example, the comparable profits method evaluates whether an intercompany price produces an arm's-length result by analyzing the profitability of comparable transactions involving similar businesses unrelated to each other. 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.
Typically, transfer pricing rules require businesses to use the most appropriate method given their facts and circumstances. Some jurisdictions require companies to furnish documentation to support their transfer prices. Even if not required, maintaining documentation detailing price-setting methods is advisable for businesses that conduct cross-border transactions with related companies. In the United States, taxpayers that don't provide transfer pricing documentation within 30 days of an IRS request may increase their likelihood of being assessed tax underpayment penalties.
And the penalties for tax underpayment attributable to noncompliance with applicable transfer pricing rules can be harsh. Under U.S. law, a business may be hit with penalties of up to 40% of the tax underpayment, depending on the circumstances, in addition to back taxes and interest.
If transfer pricing is a concern for your company, or could soon become one because of a business expansion, consider 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 — or create them if you're just getting started. Implement policies and procedures that are appropriate based on the nature of your business and incorporate the optimal methods for determining arm's-length prices. Finally, document your methodology to help support your position in the event of a transfer pricing audit.
Transfer pricing is often overlooked during a business expansion or can fall by the wayside once related entities are operational. It's an issue worth addressing and continuously monitoring before a taxing authority starts asking questions. If your business conducts transactions with related entities across state or national borders, or soon will, work closely with your tax advisor to assess your obligations and take practical steps to support your tax position.
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