RSM Resources

For years, transfer pricing was a relatively low-profile topic among international tax and finance professionals. Now an aggressive Internal Revenue Service push to enforce documentation and compliance offers a glimpse of the staggering penalties that can result from inadequate transfer pricing planning.

In a recent case, Symantec Corp.found itself in a $1 billion transfer pricing dispute after it acquired software maker Veritas in 2005. According to the IRS, licensing fees Veritas received from an Irish subsidiary were too low, and the company’s accounting records credited the U.S. operations with too much of the cost of creating certain technologies. Bottom line: That approach increased income at the Irish subsidiary, which operated in a lower-tax environment and allowed the company to lower its U.S. tax bite.

Put simply, transfer pricing is a strategy by which related companies in different taxing jurisdictions exchange products and services tax-efficiently. Effective transfer pricing can enhance a company’s overall profitability and eliminate double taxation, which often results from cross-border transactions. Experts say the Symantec case illustrates the delicate balance between smart business and smart government as businesses seek to minimize tax payments and countries seek to maximize tax revenue.

"Not that long ago, a lot of midsized businesses that didn’t have transfer pricing documentation in place would just roll the dice, because the IRS gave them 30 days to come up with information," says Mark Kral, a managing director with RSM McGladrey’s international tax practice. "But then the IRS started asking for documentation to prove the study had been done for the year under examination. That makes it a lot harder to ignore."

IRS Commissioner Mark Everson noted the transfer pricing crackdown when he testified earlier this year before the U.S. Senate Finance Committee.He expressed concern about the growing gap between "book income" that public companies report to shareholders and taxable income the IRS records. That difference stood at $266 billion in 2003, and Everson said that his agency’s Large and Midsized Business Division has responded by stepping up compliance checks and audits.

"The growing tension created by the desire of corporations on one hand to maximize book earnings, and on the other hand to minimize taxable earnings and increase cash flow, presents incentives that could drive noncompliant behavior," Everson testified. "Those [businesses] who comply with the letter and spirit of the law should know that we are aggressively identifying and pursuing those who do not."

A basic tenet of transfer pricing requires that transactions within a company take place at "arm’s length." That means charging a price for products or services at or near those on the open market. However, the tax liability generated by that arm’s-length relationship can vary dramatically — particularly if the tax burden in one country is significantly less than another. Consider the following example:

Assume a subsidiary located in country A purchases $100 worth of goods. It then repackages, exports and sells those goods to the parent company,located in country B, for $200. The parent company sells the goods for $300. Both entities profit $100. If the tax rate in country A is 20 percent, and the tax rate in country B is 60 percent, the after-tax profit for the company is $120.

Now, consider a transfer pricing approach in which the subsidiary sells the goods to the parent firm for$280, and the parent sells them for $300. In this case, the company’s profit actually increases. Why? Because the subsidiary now posts an after-tax profit of $144, based on the 20 percent tax rate. Since the parent company earns just $20 on the transaction, it pays just $12 in tax (based on the 60 percent tax rate in country B). In this scenario,the company’s overall after-tax profit rises to $152 from $120.

State and local implications of transfer pricing

In addition to the international tax implications, domestic transfer pricing has increasingly become an important component of a company’s effective overall state tax rate. In recent years, states have more aggressively audited and attacked company state tax planning structures, including an increase in the discretionary use of IRS Section 482. This tax regulation allows the IRS to allocate a company’s gross income, deductions, credits or allowances between business units in order to more clearly reflect total income. Local tax authorities are also becoming more assertive about requiring companies to file combined returns to avoid "distortion" for transactions between affiliated domestic corporations.

"Whether a company is defending an audit, implementing a new structure or migrating from an existing structure, a domestic transfer pricing study is essential to ensure that their related party transactions are at arm’s length," says Craig Ridenour, a managing director with RSM McGladrey’s state and local tax practice. "In today’s environment, domestic and international transfer pricing considerations are equally important in supporting and managing a company’s worldwide effective tax rate."

Developing an effective transfer pricing approach

Clearly,effective transfer pricing can be a powerful tool to improve profitability. On the other hand, an ill-considered approach can result in sizable penalties — as much as 40 percent of the underpayment an IRS review determines.

If your company has cross-border operations, is planning to expand internationally or has substantial transactions between affiliated domestic corporations, are you confident in the quality of your company’s approach to transfer pricing? If not, consider some of the following steps:

Establish a game plan. Most experts agree that the best transfer pricing strategies are part of regular business planning. Prior to the start of each fiscal year,set aside time for your company’s tax and finance staff to meet with a qualified professional services firm with deep experience in both international and domestic tax. This meeting should lay the groundwork to define key roles and responsibilities.

Consider an advance pricing agreement (APA). An APA between your company and the IRS serves to reduce your risk of an audit. The agreement between the taxpayer and the IRS comprises the parameters of prospective intercompany transactions and the transfer pricing methodology that is appropriate in determining the pricing of such transactions. After reaching the agreement — and meeting its terms— the taxpayer is protected from transfer pricing adjustments during the term of the agreement. On behalf of your company, a tax professional can contact the IRS to head off any unnecessary red flags by outlining facts and details anonymously before proceeding with an APA.

Conduct a transfer pricing study. If your business does not have the internal resources to handle some of these steps, consider a transfer pricing study. This review, which an independent third party conducts, may be the best method to ensure your company minimizes tax liabilities while complying with revenue requirements in each jurisdiction. It will identify all related parties and transactions,select the best transfer pricing method, determine arm’s-length pricing ranges by reviewing comparable companies, and create documentation to substantiate the overall strategy.

By taking these steps, youcan ensure your business is maximizing its profit potential ininternational markets while reducing exposure to a potentially crippling IRS review.