Multinational corporations often use transfer pricing to allocate earnings among subsidiary and affiliate companies that are part of the parent organization. The practice is being increasingly regulated to ensure that profits are taxed at the place where value is created. In fact, a global effort is underway to tighten the restrictions and increase the documentation requirements for this practice, adding a significant amount of work and responsibility to the task of the corporate tax professional.
What is transfer pricing?
Transfer pricing is an accounting practice in which a particular division or subsidiary of a company charges a second division or subsidiary of the same company for goods or services. This can provide tax savings for the larger enterprise, as the companies are able to divide earnings among subsidiaries and affiliates. By using transfer pricing, companies can move tax liabilities to jurisdictions with low taxes to reduce corporate tax bills.
The transfer pricing practice can cover not only goods and services but also intellectual property such as research, patents, and royalties. It can be used both domestically and across borders; when used internationally, it can take advantage of varying tax rates in different countries.
Is transfer pricing illegal?
While the act of transfer pricing itself is not illegal, there are several restrictions on the practice that can vary widely between tax jurisdictions. Here’s why it’s attracting government scrutiny: In ordinary pricing, if two independent, unrelated parties negotiate with one another in a financial transaction and eventually reach a price, the transaction will reflect the correct market price. However, when the parties that negotiate a transaction are related, they may set an artificially lower price with the intention to minimize their taxes.
The IRS focuses an eagle eye on transfer pricing, and the possibility of audits can make this practice a risky one. Major multinationals, including Amazon and Microsoft, have courted conflict by using the practice to adjust income numbers, sometimes by as much as a billion dollars. A recent significant court case between the IRS and Coca-Cola is a compelling example. But even smaller businesses may use this practice — and they could get in trouble because of it.
To try to prevent base erosion and profit shifting (BEPS) due to transfer pricing schemes, the Organization for Economic Co-operation and Development (OECD) laid out “the arm’s length principle” in Article 9 of the OECD Model Tax Convention.
What is the arm’s-length principle in transfer pricing?
The arm’s length principle states that two commonly controlled entities that are negotiating transfer pricing must operate as if they are independent companies, holding each other “at arm’s length.” There are real numbers that define what “arm’s length” is; it’s an international standard designed to allow governments to collect a fair share of taxes while multinationals avoid double taxation.
The gist of it is this: When two unrelated parties trade with each other, they’ll decide on a market price for the goods sold. This is an arm’s length transaction, and tax authorities accept it because it is the result of a real negotiation. Multinational corporations are supposed to treat their subsidiaries as if they are separated by an arm’s length. This ensures that they pay the right amount of tax in any jurisdiction in which they operate.
When the arm’s length principle is not observed, these activities can cause big tax losses for international governments. Governing bodies around the world have begun imposing significant transfer pricing documentation requirements to rein in these types of transfer pricing activities.
What is transfer pricing documentation?
The purpose of transfer pricing documentation is to show that the company’s related-party transactions are in accordance with the arm’s-length principle. Good transfer pricing documentation should clearly lay out how the functions, assets and risks are shared between related parties in each related-party transaction in such a way that anyone can understand, whether or not they are familiar with the company.
The IRS has created a list of FAQs to clarify the quality of documentation it requires to comply with its rules for this practice. The FAQs were a response to a concern of the IRS Advisory Council Large Business & International Subgroup about the gradual decline in quality of U.S. transfer pricing documentation.
The IRS FAQ indicates that the agency is looking for “transfer pricing reports that comprehensively document the reasonable selection and application of a transfer pricing method.” Such comprehensive transfer pricing documentation, according to the IRS, makes it easier for the taxpaying companies as well as the regulating agencies to perform efficient transfer pricing risk assessments and audits.
The OECD governs international tax law, and those audit firms operating under OECD purview use its standards to audit multinationals’ financial statements. Some of those standards are meant to reduce domestic tax BEPS, which is a form of tax avoidance involving multinational companies using the differences in countries’ tax systems to profit. Developing countries suffer most from this problem, as they rely more heavily than developed countries on corporate income taxes.
What are the 3 different types of transfer pricing documentation?
For OECD member countries, BEPS guidelines lay out what documentation is needed for intercompany transactions. This documentation is divided into three tiers: a master file, a local file, and a country-by-country (CbC) report.
- The master file is a 360-degree look at the company’s global transfer pricing operations and policy.
- A local file is where the company documents the details of its intercompany transactions in each country. Each company files this document with its jurisdiction’s tax authority.
- Country-by-country reports are snapshot summaries of the activities of the company’s entities that operate within a given jurisdiction.
What are the transfer documentation requirements by country?
Global transfer pricing documentation requirements differ by country, as reflected in the OECD’s profile list of 38 countries.
- In the United States, documentation guidelines are set out in Revenue Code Sections 482 and 6662. Section 6662–6 (iii)(B) lays out the list of principal documents companies must submit, which include descriptions of and reasoning for the methods of accounting selected and alternative methods considered, explanations of why each alternative was not selected, and descriptions of controlled transactions, along with internal data used to analyze those transactions.
- Australia’s documentation requirements are robust: The country demands a master file, a local file, and a country-by-country report, as well as specific transfer pricing returns.
- In Norway, companies just have to submit a country-by-country report and a specific transfer pricing return as laid out by the Tax Assessment Act Sections 8-11 and 8-12.
- Canada, like Norway, requires country-by country reports and a specific return, but also adds a requirement for specific filings about transfer pricing and offshore holdings (on Forms T1141 and T1142).
Countries as diverse as Korea, United Kingdom, Italy, South Africa, and India each have their own requirements for how companies must analyze and report transfer pricing activity.
How to simplify the transfer pricing documentation process
With complex and ever-more-stringent transfer pricing documentation requirements, many tax teams are turning to technology solutions for guidance. With the help of this technology, they can ensure that they are up to date on the latest requirements, are filing the correct documentation, and are remaining compliant in every country in which they do business. Transfer pricing documentation software and expert guidance from ONESOURCE help teams manage and analyze transfer pricing, track evolving global regulations, and centralize company transfer pricing policies.
An end-to-end solution that offers a repeatable process can help your multinational enterprise ensure that it is in compliance with global standards and requirements, helping you pursue transfer pricing with confidence.