The Basics of Transfer Pricing Risk in the US and Consequences of non-Compliance
For multinational enterprises (MNEs), navigating the global tax landscape can be a complex challenge. Transfer pricing, the practice of setting prices for goods, services, and intangibles traded between related parties within an MNE, plays a critical role. But failing to comply with US transfer pricing requirements can expose your company to significant risks, affecting everything from financial statements, tax provision and could even lead to reputational damage.
The Arm’s Length Principle
The core principle of US transfer pricing regime is the “arm’s length principle,” which states that the prices charged between related parties in an MNE should be equivalent to those charged between unrelated parties in similar transactions under similar circumstances. This with the intention that multinational taxpayers do not artificially transfer the tax burden among jurisdictions.
The Risk of Double Taxation
One of the biggest risks for non-compliant MNEs is double taxation. Imagine a scenario where the US and another country disagree on the appropriate transfer price for goods exported from a US entity to a foreign affiliate. Without adequate documentation supporting the economic substance of the transaction, both countries might tax the same income or in special cases could lead to tax controversies in international tribunals.
What steps can a taxpayer take to comply with the transfer pricing requirements and avoid tax audits and adjustments?
The Internal Revenue Service (IRS) takes transfer pricing compliance very seriously. Section 482 of the Internal Revenue Code (IRC) authorizes the IRS to adjust income or deductions of the US taxpayer with related parties to ensure that all intercompany transactions, including the transfer of goods, services, and intangibles, adhere to the arm’s length principle. Non-adherence to the arm’s length principle in the pricing of intercompany transactions can result in significant additional tax liabilities, not to mention extensive penalties and operational disruptions.
The consequences of non-compliance extend far beyond financial penalties detailed in IRC 6662(e), which can range from 20% to 40% of the underpaid tax, depending on the severity of the case. The audit process itself can be very time-consuming and resource-intensive, diverting focus from core business activities. Additionally, transfer pricing disputes with the IRS can lead to lengthy litigation, further draining resources and potentially damage your reputation.
The negative results of faulty transfer pricing analysis do not end there. Should the IRS make adjustments to any of your tax positions with related parties, foreign tax jurisdictions will also claim their share of income, leading to an operationally complex and highly disruptive resource intensive processes encompassing various countries.
Mitigating Transfer Pricing Risk
There are proactive steps MNEs can take to minimize transfer pricing risk. Any MNE operating in the United States should consider following the following as best practice:
- Documentation: Section 6662-6(d)(2)(iii)(B) of the IRC details the specific information required by taxpayers to comply with their transfer pricing documentation requirements. Taxpayers should prepare and retain contemporaneous documentation with robust transfer pricing analyses that justify the economic substance of your tax positions. As per IRC 6662(e) the IRS considers transfer pricing documentation contemporaneous if it exists by the date the transaction takes place, however in practice this date should not be later than the date the tax return is filed. It should, at the very least, include a functional analysis, benchmarking sets for each transaction and a robust economic analysis justifying the arm’s length nature of the transaction. Contemporaneous transfer pricing documentation offers considerable penalty protection and should not be taken lightly. Robust support for intercompany tax positions through high-quality contemporaneous transfer pricing documentation will demonstrate good faith to the IRS and would reduce the intensity of an examination. It is important to note that if the IRS requests Transfer Pricing Documentation during an examination the taxpayer must produce it within 30 days or lose penalty protection.
- Seek Professional Guidance: Navigating transfer pricing regulations can be complex. Consulting with transfer pricing specialists who are well-versed in US and global transfer pricing regimes can help ensure you are on the right track and could save you incalculable hardships across all the jurisdictions you operate in.
Transfer pricing is by nature a multilateral practice where strong support for economic positions is paramount. Compliance to transfer pricing documentation obligations is only the first step to eliminate tax risk. A little planning could mitigate risk but a robust analysis could practically eliminate the possibility of a successful challenge and could even generate significant tax savings across your multinational businesses. Reach out to our top subject matter specialists and see what QCG is capable of doing for you!
