1. U.S. Transfer Pricing Overview
Presented by Glen MacMillan – Adams & Miles LLP

2. U.S. Transfer Pricing Agenda
General background
Rules and Regulations
Penalties
Contemporaneous Documentation
Transfer Pricing Methods
IRS Compliance and Enforcement
Competent Authority
Advance Pricing Agreements
Questions?

3. U.S. Transfer Pricing – General Background
U.S. transfer pricing regulations are among the most complex and comprehensive in the world.
Compliance with U.S. rules is a material concern for all companies looking to enter the US market place.
IRS audit activity has increased substantially in the past decade.
IRS assessing positions are generally considered aggressive. More and more IRS transfer pricing assessments are ending up being referred to competent authority for resolution.
The requirement for arm’s length transfer pricing is not a recent development; the requirement has been around for decades. It is the codification of transfer pricing methodologies, penalties, documentation requirements, etc. that is a recent development.

4. U.S. Transfer Pricing – Rules and Regulations
Treasury Regulation (b)(1):
“In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction meets the arm’s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”

5. U.S. Transfer Pricing - Rules and Regulations (cont)
Under IRC Section 482, the IRS has the power to:
distribute, apportion or allocate gross income, deductions, credits, or allowances among businesses controlled directly or indirectly by the same interests.
Make allocations necessary to prevent the evasion of taxes or clearly to reflect the income of businesses.
Treasury Regulations are the main source of interpretation and implementation of the IRC section 482 arm’s length standard (see briefing notes for further details).

6. U.S. Transfer Pricing – Rules and Regulations (cont)
Regulations provide for the concept of a range within which an arm’s length transfer price may fall.
No adjustment may be made to a company’s transfer price if the amount falls within the accepted range.
An arm’s length range can arise if more than one bona fide arm’s length comparable is identified.
If a company’s transfer price is outside an arm’s length range, the IRS will generally assess to the mid point of the range.

7. U.S. Transfer Pricing Rules – Rules and Regulations (cont)
The US transfer-pricing regulations provide several methods for determining intercompany prices and require that the “best method” be employed to determine the arm’s length standard for intercompany transactions”.
The best method is defined as the method that produces the most reliable measure of an arm's-length result for the controlled transaction when all of the facts and circumstances of that transaction are taken into account.
Two primary factors must be considered in order to determine the best method
(i) degree of comparability between the related party transactions and uncontrolled transactions and
(ii) the quality and completeness of underlying data and assumptions used in the analysis.
Regulations cite several possible methods for determining whether intercompany transactions are conducted at arm's length.
The best-method rule does not provide for a prescribed hierarchy in the use of methods; no method is deemed to be more reliable than another.

8. U.S. Transfer Pricing – Penalties
Transactional Penalty
A 20% transaction penalty on a tax underpayment applies if the transfer price reported in the company’s tax return is 200% or more, or 50% or less, than the arm’s length price.
Penalty increases to 40% if transfer price reported in the company’s tax return is 400% or more, or 25% or less, than the arm’s length price.

9. U.S. Transfer Pricing – Penalties (cont)
Net Adjustment Penalties
A 20% net adjustment penalty on a tax underpayment applies if net adjustment exceeds the lesser of:
$5 million or
10% of the company’s gross revenue
Penalty increases to 40% of a tax understatement if net adjustment exceeds the lesser of:
$20 million or
20% of the company’s gross revenue

10. U.S. Transfer Pricing – Penalties (cont)
A company will not be assessed both a transactional penalty and a net adjustment penalty.
If an adjustment is subject to both penalties, the company will be assessed the higher penalty.
Penalties may be avoided if company can demonstrate:
reasonable grounds existed to believe its transfer price reflected an arm’s length standard,
the company’s transfer price analysis was documented at the time its tax return was filed, and
the company’s transfer price documentation is provided to the IRS within 30 days of being requested

11. Contemporaneous Documentation
Minimum documentation required to support a company’s transfer pricing analysis should include:
Detailed description of the company’s business, the markets within which it operates, legal and regulatory factors that may affect transfer pricing.
An internal organizational structure and external corporate structure along with a detailed “who does what” within the structure.
Analysis of executive and employee functions, sales and administrative support, which company assumes market risks, currency risks, supply chain risks, warranty risks, bad debts, etc.
Summary of all transfer pricing methods that were considered and an analysis of why the selected method was determined to be most representative of an arm’s length standard.
A description of all arm’s length comparable transactions identified and an analysis of consistencies and variances between the arm’s length comparables and the company’s transactions.
The company’s arm’s length analysis should be supported with verifiable arm’s length documentation, such as purchase or sales invoices, publicly available financial data, etc.
Note: Contemporaneous documentation provides protection from penalties but does not protect the company from a transfer pricing adjustment.

12. U.S. Transfer Pricing Methods
Goods
Comparable Uncontrolled Price (open market price)
Resale Price (gross margin of a distributor)
Cost Plus (gross margin of a manufacturer)
Comparable Profits Method (net profit expected from a company in a comparable uncontrolled business)
Profit Split (allocates overall profit between the related companies on a reasonable basis)

13. U.S. Transfer Pricing Methods (cont)
Services
Comparable Uncontrolled Services Price (open market price)
Gross Services Margin (gross profit margins of comparable uncontrolled companies)
Cost of Services Plus (profit margins on same services provided to third parties)
Profit Split (allocates overall profit between related companies on a reasonable basis)
Comparable Profits Method (net profit margins of comparable uncontrolled companies)
Services Cost Method (applicable to low margin “back office” support services)

14. U.S. Transfer Pricing Methods (cont)
Intangibles
Comparable Uncontrolled Transaction (open market price)
Profit Split (allocates overall profit between the related companies on a reasonable basis)
Comparable Profits Method (reference to net profit margins of comparable uncontrolled companies)

15. IRS Compliance and Enforcement
Form foreign companies owned by U.S. companies
Form US companies owned by foreign companies
Forms 1120-F and foreign companies earning treaty-protected income from a US trade or business
$10,000 penalty may potentially be applied to each unreported transaction.

16. IRS Compliance and Enforcement (cont)
IRS international audit activity has increased substantially in recent years.
IRS is reviewing Forms 5471 and 5472 far more closely today than in past years and assessing penalties more often.
The U.S., like most Western countries, is running deep deficits and still recovering from 2008 recession.
U.S. lawmakers and U.S. taxpayers, rightly or wrongly, perceive international companies to be underpaying their fair share of U.S. tax.
Raising tax revenue from foreign companies rather than domestic voters is great politics.

17. IRS Compliance and Enforcement (cont)
Potential red flags for an IRS transfer pricing audit:
Foreign companies with low U.S. profitability – why are these companies are in the U.S. market if they aren’t making money?
Companies that file amended tax returns – suggests possible retroactive tax planning to the IRS.
Transactions involving related party services – intercompany services are traditionally far more difficult to price than intercompany goods.
Transfers of intangibles (such as intellectual property) to a non-U.S. entity

18. U.S. Competent Authority
US tax treaties include mutual agreement provisions that require each country’s competent authority to seek relief when the actions of the IRS or a foreign tax authority may lead to double taxation.
For example: the IRS denies a domestic company’s deduction for a management fee charged by a foreign parent. Unless the foreign parent is allowed to reverse the income, the amount will have been subject to tax by both countries.
Each country’s competent authority will review the quantum of the management fee and seek agreement on how much should be taxed in each country.
competent authority can be a time consuming, expensive process but it does generally eventually provide relief from double-taxation.
Review statute of limitation deadlines in both countries and ensure all applications are made within the time limits that allow for competent authority adjustments.
Many treaties extend a country’s domestic limitation deadlines - therefore an adjustment is often possible even if a domestic limitation period has expired.

19. U.S. Advance Pricing Agreements
APA application requires substantial detailed information and supporting documentation be supplied before the IRS will grant an APA.
If granted, an APA with the IRS provides assurance that the IRS will not adjust a company’s transfer price, provided the company conducts its transaction in accordance wit the terms of the APA.
If APA is granted, the company must annually report to the IRS the quantum of the APA on that year’s transactions, any changes in facts or assumptions that could affect the accuracy of the APA methodology, etc.
Current APA application fee is $10K to $50K, depending on the complexity of the request.

20. U.S. Advance Pricing Agreements (cont)
An APA with the IRS does not necessarily provide protection from double taxation.
APA is binding only on the IRS, not on a foreign tax authority.
The company may make a request of the competent authority that the IRS APA be agreed to by the other treaty country – i.e., convert APA from a unilateral to a bilateral APA.
A unilateral APA with the IRS can be problematic if a double taxation dispute arises with another country.
A unilateral APA might restrict a competent authority’s ability to provide relief from double taxation.
If a company chooses to pursue an APA application, it is advisable to obtain a bilateral APA .

21. Questions?