An Introduction to Transfer Pricing

Businesses with international operations and investments have a lot to contend with: managing complex supply chain logistics, leading a distributed workforce, and remaining compliant with the rules and regulations of all the countries involved. 

Transfer pricing is a particularly important topic for global business leaders to be familiar with. In this guide, we’ll explore the basics of the transfer pricing topic, why it’s important in the international tax context, and steps business leaders can take to realize planning opportunities while ensuring compliance with the many rules and regulations. 

What is Transfer Pricing? 

Transfer pricing is all about the amount paid for goods, services, and assets when sold to related parties. Let’s say Company A owns 100% of Company B. If Company B sells 100 widgets to Company A for $100,000, the transfer price is the $100,000 Company A pays to Company B for the goods. The assessment of whether this transfer price is fair relative to how third parties would interact (the so-called “arm’s length principle”) is the foundational principle driving the analyses of intercompany transactions by tax authorities across the globe. 

Why is Transfer Pricing Important in Tax? 

Transfer pricing typically relates to related party transactions between companies in different tax jurisdictions, more commonly across international borders, but also in a domestic sense across state lines. Taxing authorities scrutinize transactions between related parties because there’s potential for so-called profit-shifting abuse. 

Returning to our previous example, let’s say Company A is a U.S.-based corporation subject to a 21% federal income tax, but Company B is a corporation based in the Cayman Islands, where corporate income isn’t taxed. During the course of an examination of the transactions between Company A and Company B, the IRS will work to confirm that the agreed-upon transfer price of goods, services, or assets fairly represents their value. If the price is viewed as being too high or low, the IRS may assume that Company A is improperly shifting profits to a lower-taxed jurisdiction, leading to issues with the U.S. tax authorities. 

Over the last several decades, U.S. and foreign tax authorities have developed substantial rules and regulations that govern transfer pricing and discourage profit shifting: 

• In the United States, the Tax Cuts and Jobs Act of 2017 introduced major changes to the taxation of domestic entities with foreign investments and operations. The global intangible low-taxed income (GILTI), Subpart F, and base erosion anti-abuse tax (BEAT) regimes, among others, make it more difficult to avoid U.S. taxation as a domestic company. 

• Globally, the Organisation for Economic Co-operation and Development (OECD) has helped tax authorities worldwide agree on a shared set of international tax rules that cover transfer pricing. As a result of these efforts, countries are beginning to implement a global 15% minimum tax to reduce the benefit of establishing operations in jurisdictions solely to avoid taxation. 

What Are the Consequences of Transfer Pricing Abuses? 

The penalties applicable to transfer pricing adjustments to taxable income sustained by the IRS during exam are some of the most punitive in the U.S. federal income tax world. Companies that don’t comply with U.S. transfer pricing regulations can be assessed penalties of up to 40% of the additional taxes due to the IRS. 

The heft of these penalties underscores the importance of compliance with transfer pricing rules and regulations. 

How Can I Avoid Transfer Pricing Tax Issues? 

It’s perfectly legal to engage in transfer pricing when a company pays a fair price for the goods, services, or assets received from a related company—not too much or too little. As previously noted, a fair price is generally the amount an unrelated party would pay for the same goods, services, or assets. These transactions between related parties are called arm’s length transactions. 

In practice, it can be difficult to price related party transactions as if they were at arm’s length. Even still, appropriate pricing won’t necessarily stop taxing authorities from inquiring about your company’s transfer pricing practices. That’s why it’s critical that U.S. entities with foreign operations comply with all relevant transfer pricing rules and regulations. 

Due to the immense complexity of these transfer pricing rules, entities with foreign operations and investments are strongly encouraged to vet the arm’s length nature of their transfer pricing policies and practices through the preparation of transfer pricing studies.  

Specialized tax professionals conduct transfer pricing studies by analyzing intercompany transactions to help the entities arrive at arm’s length pricing that complies with regulations. The IRS and other tax authorities provide methods for determining the arm’s length nature of a wide range of intercompany transactions. 

Transfer pricing studies also help companies uncover potential tax planning opportunities. As a business leader, you might learn how to structure related party transactions in a legal, more tax-efficient way. 

The product of a transfer pricing study is extensive documentation that complies with the rules and requirements, which companies can provide in the event of a tax authority inquiry. The presence of external transfer pricing documentation is critical to facilitate a smooth examination process and ensure protection against penalties that would otherwise apply to any additional taxes related to transfer pricing adjustments to taxable income. 

Smith + Howard: Specialists in Transfer Pricing Advisory 

Smith + Howard’s Specialty Tax Services team helps multinational entities navigate complex transfer pricing rules and regulations. Every transfer pricing situation is unique, and the team is adept at analyzing transactions to ensure compliance in all jurisdictions involved. Contact a Specialty Tax Services advisor to start on the path to transfer pricing compliance.