Companies operating internationally, especially those with foreign subsidiaries, face a number of distinctive challenges. Transfer pricing is one of them. 

Generally speaking, transfer pricing refers to the pricing of goods, services or intellectual property exchanged in transactions between related parties within a multinational enterprise. It typically involves parent and subsidiary businesses operating in different countries.

If you are involved in such transactions, you are probably aware tax authorities closely regulate how international companies handle transfer pricing. They tend to be on the lookout for businesses that attempt to unfairly avoid or minimize their tax liability. 

Simplified Example

Transfer pricing can occur under a wide variety of arrangements. Because of this, businesses can get a little too creative and end up potentially violating the rules. For example, let’s say Company A and Company B are related businesses with a common parent. Company A is based in a country with a 30% corporate income tax rate, while Company B is based in a country with a 10% corporate income tax rate.

Company A manufactures widgets at a cost of $2 million per year and sells them to Company B for $4 million, earning a $2 million profit. Company B assembles the widgets into finished products, which it sells for $6 million, also earning a $2 million profit. Company A’s resulting tax liability is $600,000 ($2 million × 30%), while Company B’s tax liability is $200,000 ($2 million × 10%). Therefore, the parent company’s overall tax liability is $800,000.

Now suppose Company A lowers the price it charges Company B for the widgets to $3 million. In this scenario, Company A’s profit is reduced to $1 million, and its tax liability is reduced to $300,000 ($1 million × 30%). Company B’s profit increases to $3 million, and its tax liability increases to $300,000 ($3 million × 10%). Thus, the parent company’s overall tax liability drops from $800,000 to $600,000. The higher tax country in which Company A operates stands to lose significant tax revenue by this change in intercompany pricing — and might initiate a transfer pricing audit. 

Note: This simple example ignores withholding taxes assessed when profits are remitted by Company A and Company B to the Parent Company - another issue you must consider. 

Price-Setting Methods

Tax authorities take various approaches to prevent related businesses from manipulating intercompany transfer pricing to shift profits to lower-tax jurisdictions. A complete discussion of these regulations is beyond the scope of this article, but generally requires the terms of intercompany transactions to be comparable to arm’s-length transactions between unrelated businesses.

International companies can look to several commonly accepted methods for setting acceptable transfer prices. For instance, the comparable profits method estimates the arm’s length price by analyzing the profitability of comparable transactions involving similar companies. 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. The optimal method for any business depends on the specific facts and circumstances of its situation.

Some jurisdictions require companies to furnish documentation to support their handling of transfer pricing. In the United States, for example, the IRS may request documentation under a transfer-pricing audit — and taxpayers have only 30 days to provide it.

If an audit results in a finding of noncompliance, the subject company can be hit with penalties as high as 40% of the tax underpayment on top of back taxes and interest.

Keys to Compliance

International businesses can take a number of steps to guard against non-compliance. The first is to regularly conduct risk assessments. These are formal analyses that consider the nature, size and tax attributes of your transfer pricing transactions. Risk assessments can also evaluate which jurisdictions enforce transfer pricing rules more strictly, including determining which countries require formal transfer pricing studies.

Following each risk assessment, re-evaluate your company’s transfer-pricing policies and procedures — assuming you have them. If you have been essentially improvising these transactions, consider implementing policies and procedures that are appropriate based on the nature of your business. Be sure to incorporate optimal methods for determining arm’s length prices. If you have policies and procedures already in place, bear in mind you may need to update them based on changing circumstances and guidance from taxing authorities.

Finally, ensure all your up-to-date transfer pricing policies and procedures are clearly documented and securely stored. As mentioned, this documentation will help support your position in the event of a transfer-pricing audit.

A Level Playing Field

The transfer-pricing rules are designed to ensure a level playing field for international businesses. Complying with those rules, however, can be difficult, time-consuming and demand substantial resources. The costs should be balanced against the risks involved. There can be different levels of studies used to mitigate your risks. Moore Doeren Mayhew works with various-sized international businesses to help them mitigate these risks. Contact us today to learn more.