RSM Resources

Who pays the tax, and where, on internationalbusiness transactions can mean millions of dollars to countries and businesses.With more than half the world’s trade occurring within multinationalenterprises, and global trade continuing to rise, companies and governments areincreasingly focused on transfer pricing — where one part of amultinational company sells goods or services to another part of the same company.

By taking control of the sometimes complicatedtransfer pricing process, midsized businesses can save thousands of dollars intaxes and better manage the risk of running afoul of tax authorities.

The key, say tax professionals, is planning ahead,keeping abreast of changing regulations in the countries where you sell andworking with foreign and U.S.tax officials in advance to help ensure that your company is in compliance.

Although transfer pricing laws have been in effectin the United States since the 1930s, they were loosely enforced until the late1970s, when global trade began to make up a larger share of the country’s grossdomestic product. And until recently, some countries such as China and Germany either did not have or didnot enforce transfer pricing regulations.

But whether a country is rich or poor, an emergingplayer in the international economy or an established trading force, itsgovernment will not want its tax base to suffer because of questionabletransfer pricing practices.

Because so much more is now at stake, virtuallyall countries now have and enforce transfer pricing laws. The basic rule ofthumb is that transfer pricing of inter-company transactions should be at"arm’s length," or within a range that would be charged if thecompanies were independent of each other.

But how you establish that arm’s lengthrelationship can have a huge effect on your tax bill — particularly if the taxburden in one country is significantly less than the burden in another.

Take the case of the subsidiary located in countryA that pays 20 percent tax on $100 worth of goods, which it repackages andexports to the parent company, located in country B, at a selling price of$200. The parent company sells the goods for $300. Both entities have a $100profit. But the tax rate in country A is 20 percent, and the tax rate is 60percent in country B, or $60 on a $100 profit. After taxes, the multinationalcompany’s overall profit is $120.

But if the subsidiary sells the goods for $280,and the parent sells them for $300, the multinational’s profit increasesbecause more of the pre-tax profits are shifted to the subsidiary in country A,where the tax rate is lower. The subsidiary now makes $180 profit, with 20percent of that paid in tax. But the parent company earns just $20 on thetransaction. With the tax rate of 60 percent in country B, it pays just $12 intax. The overall after-tax profit rises from $120 to $152.

In theory that’s how a beneficial transfer pricingarrangement works. Here’s how it would work in the real world. Take the case ofa company that produces and exports blue jeans. Tax professionals would likelydetermine whether a transfer pricing arrangement is at arm’s length by usingone of the methodologies prescribed by the IRS such as the comparable profitsmethod (CPM), which examines publicly traded companies that manufacture andexport blue jeans or a similar product. Publicly traded companies are used as ayardstick because, unlike privately held companies, their financial data is readilyavailable to the public.

If the profits from a multinational’s relatedparty fall within the profitability range of comparable companies, themultinational is deemed to be dealing at arm’s length with its related partyand in compliance.

But, by planning ahead, if you find that yourtransfer pricing falls outside the profitability range of comparable companies,you can make adjustments so your operation is in compliance. For example,pricing can be adjusted to ensure that the optimum amount of profit occurs inlower tax jurisdictions. Perhaps a handling charge would be appropriate toraise the cost in one jurisdiction. The time a vice president devotes to aproject, for example, can be assessed in one jurisdiction to reduce the profitthat is taxable in another.

One area of transfer pricing that is receivingmore attention is in assigning the value of intellectual property (IP). Taxprofessionals say it’s critical to first identify a company’s intellectualproperty — even something as basic as managerial know-how. Not only does thishelp a company understand the importance of its IP, but can also help itidentify what leads to the creation of its IP.

And by determining where and what intellectualproperty is being created, tax professionals can use this information tomaximize your company’s tax savings when planning a transfer pricing approach.

Tax professionals recommend that you take thefollowing steps when preparing a successful transfer pricing strategy:

Plan ahead.By incorporating transfer pricing into your planning process, you can helpstructure your operations to ensure that they remain in compliance withapplicable laws and that you maximize your possible tax savings. Do not viewtransfer pricing requirements as simply another compliance issue, but as avaluable planning tool.

Prepare a transfer pricing report. A transfer pricing report provides a corporate overviewand explains the rationale for how you calculated the arm’s-length pricing ofyour inter-company transactions. This document can help you if your company isaudited.

Consider an advance pricing agreement (APA). An APA is an agreement between your company and the IRSthat is designed to reduce your risk of an audit. The agreement between thetaxpayer and the IRS comprises the parameters of prospective inter-companytransactions and the transfer pricing methodology that is appropriate indetermining the pricing of such transactions. Once the agreement has beenreached — and provided its terms are met — the taxpayer is protected from transferpricing adjustments during the term of the agreement. On behalf of yourcompany, a tax professional can contact the IRS and outline facts and detailsanonymously before proceeding with an APA.

By following these basic steps, you can make themost of transfer pricing arrangements — transforming them into money-savingopportunities instead of a compliance issue.