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Focus on Manufacturing & Distribution: Transfer Pricing - A Double-Edged Sword

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For federal income tax purposes, related party transactions with foreign entities must be at arms length. Many states have adopted these federal principles. Most foreign countries also have specific transfer pricing rules. The theory of transfer pricing looks at the relative profit and cost recognized by two related parties.
November 9, 2007

Transfer Pricing - A Double-Edged Sword

For federal income tax purposes, related party transactions with foreign entities must be at arms length. Many states have adopted these federal principles. Most foreign countries also have specific transfer pricing rules. The theory of transfer pricing looks at the relative profit and cost recognized by two related parties. So, before you begin dueling with this complex tax issue, the first question to consider is:

Does my business have intercompany transactions where transfer pricing rules apply?

Wherever there is an opportunity to manipulate the recognition of income and expense, transfer pricing rules may be applied. Consider these examples:

  • A US plastics manufacturer sells inventory to its wholly owned European subsidiary, where the income tax rate is 12% lower than the US rate.
  • A transportation company contracts with a Nevada LLC for management services. Both the transportation company and the LLC have the same owners. The management fee income to the Nevada LLC is not subject to state income taxes.
  • A Missouri holding company licenses the company's trade name to its multi-state sales company. The Missouri holding company has significant other expenses and incurs state tax net operating losses.

In each situation, the cost of the product or service can be manipulated by the related parties to cause the profit to be reflected in a lower tax jurisdiction (or even a no-tax jurisdiction). Federal, state, or foreign governments can claim that the transaction does not "clearly reflect income" and adjust the intercompany profit. Therefore transfer pricing can be invoked by the government against you, or used by your business to save taxes.

What penalty will apply if my business loses a transfer pricing duel?

For federal purposes, not only can additional taxes apply, but also there are specific transfer pricing penalties that can be assessed. In addition, if income is increased in one tax jurisdiction, your business may suffer a double tax. It can be very difficult to convince the other taxing jurisdiction to accept the revised intercompany price and lower income tax in their jurisdiction.

What can you do to avoid transfer pricing issues?

Thorough transfer pricing analysis and documentation. For federal (IRS) purposes, if you have a reasonable cause for your actions, you can avoid the penalties from transfer pricing adjustments. Reasonable cause is shown through contemporaneous documentation of transfer pricing practices. This is documentation, at the time of the transaction, of the arms length nature of the transaction. Under IRS rules, the business is required to choose the best method for transfer pricing documentation.

Sound complicated? (That's because it is...)

In order to reduce the risk of adjustment under examination, you may need to obtain a transfer pricing study which includes:

A detailed analysis of the intercompany transactions.

  • A complete functional analysis of the related parties.
  • A review of the possible transfer pricing method and choosing of the best method; and,
  • An economic analysis demonstrating the intercompany transaction is at arm's length.

Transfer pricing can be a valuable defense in shielding your business from income tax risk. RubinBrown has access to transfer pricing services through its affiliation with Baker Tilley International. We can assist you in developing and implementing transfer pricing strategies and proper policies and procedures before your company is involved in an IRS examination or other state or foreign tax dispute.

 

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.

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For more information, contact:

  • Linda Paradis, CPA — St. Louis
  • Partner
  • Tax Services Group
  • 314.290.3300
  • linda.paradis@rubinbrown.com