Tax Agencies Start Circling on Transfer Pricing

Corporate transfer pricing—that is, the price a company records for subsidiaries trading goods and services with each other—has become a target for tax authorities around the world as they turn over every rock in search of revenue.

Transfer pricing happens all the time, especially among multinational companies. Where such exchanges cross international borders, however, tax authorities take great interest in whether they are priced “at arm’s length” to assure income isn’t being shipped offshore to avoid taxation.

A recent report from KPMG’s transfer pricing group says scrutiny is mounting in every part of the world around corporate transfer pricing. The global recession has decimated corporate profits, which in turn has drained national tax coffers of revenue. At the same time, market volatility has left pricing policies open to new interpretation.

All that means tax authorities are pouncing, says Stephen Fortier, principal at KPMG and leader of the firm’s transfer pricing group. “Governments are fighting over a smaller pie, and they’re fighting for a bigger piece of that pie,” he says.

Norton

Clarke Norton, co-head of the transfer pricing practice at law firm DLA Piper, says both enforcement efforts and new rules are brewing in numerous major economic powers: the United States, China, Germany, France, Russia, Sweden, and Australia, to name a few. In the United States, the Internal Revenue Service has nearly doubled its number of economists and hired hundreds of new auditors, she says.

The overall goal is to keep profitability at home and consequently collect more tax on it. “You see it everywhere,” Norton says.

Transfer pricing is a target for raising revenue because there’s so much gray area involved, says Ken Crutchfield, vice president for Thomson Reuters. “There’s a degree of subjectivity in how you go about demonstrating that an inter-company transaction is at arm’s length,” he says. “There’s an art to it as much as there is a science.”

Fortier

Companies typically employ transfer pricing agreements based on careful studies to back up their pricing, so their numbers can stand up to a tax audit. Yet even those are subject to greater challenge these days, Fortier says.

“Companies are clearly facing more scrutiny of their inter-company prices,” he says. “Companies need to tell a compelling story as to why a level of profit or loss is appropriately recorded in a particular company. You’ve got to pay attention to the business drivers.”

Companies can rely on two different types of agreements to support transfer pricing: an inter-company agreement to provide documentation to support an audit, or an advance-pricing agreement that represents a binding contract between a company and one or more tax authorities.

“Governments are fighting over a smaller pie, and they’re fighting for a bigger piece of that pie.”

—Stephen Fortier,

Principal,

KPMG

Any agreement should be revisited annually—especially in periods of market volatility—to assure the pricing can be supported, says Mike Corrente, managing director for CBIZ Tofias. “There is no absolute when dealing with the IRS to be sure agreements will be accepted,” he says. “The best way to do it is to continually update your transfer pricing.”

Corrente

Conducting an entirely new study every year might not be the most cost-effective approach, Corrente says, and isn’t always necessary. But companies should be able to demonstrate they’ve at least looked at economic circumstances and comparable prices to assure the company’s transfer pricing still makes sense.

Don’t Transfer Into Trouble

Norton says companies should stay on top of transfer-pricing issues now more than ever, and assure they can support their inter-company prices. If companies are using benchmarks such as profitability, royalty rates, or other publicly available data, “you can pretty well guess that’s going to be all over the place for a few years,” she says. “You can assume comparables for 2008 will be the same in 2009 and 2010.”

There are other good reasons to revisit the numbers contained in pricing agreements, Fortier says. Sometimes companies establish binding price agreements that guarantee a certain level of return to a certain jurisdiction as a way to win favor and certainty about their obligations with tax authorities. Those guarantees may make sense when the company is in an overall profitable position, he says, but not so much when the company is losing money.

For example, a company may have a unit in one country that’s obligated to guarantee a return to another unit in a different country, even if the company overall is losing money. That means one business is showing profit and paying tax on it when the business overall is not profitable. “That’s typically going to have a detrimental tax outcome,” he says.

IRS ON TRANSFER PRICING

Below is an excerpt from an Ernst & Young study examining the IRS’ new interest in corporate transfer pricing.

The IRS administers taxes in the United States. Generally, while some administrative and coordination functions are centralized, IRS transfer pricing resources are largely decentralized. All international taxation matters, including transfer pricing, are primarily handled by International Examiners (IEs), supported by economists at the audit and examination level. All IEs work for one of the five Industry Directors. Industry Directors are responsible for the direction and assignment of the work done by IEs.

The IRS has established a Transfer Pricing Council to collect information, drive consistency and recommend changes in transfer pricing regulations or legislation, as necessary. The Transfer Pricing Council is composed of 10 representatives from the Large and Mid-Size Business (LMSB) Division and two members from Associate Chief Counsel (International). This group is composed of IRS subject matter experts and key IRS decision-makers to establish a coordinated approach to transfer pricing enforcement strategies and policies. The group evaluates the strategic decisions that the IRS has to make in transfer pricing cases, what resources are available to the IEs and how those resources can be aligned with the IRS’ needs.

As of March 2009, the IRS had approximately 475 IEs (mostly accountants), supported by approximately 120 economists and10 attorneys. The economists and attorneys are transfer pricing specialists. The attorneys belong to the office of the Associate Chief Counsel (International) and additionally engage in providing advice to taxpayers and drafting administrative guidance. Approximately 33 specialist transfer pricing FTEs are dedicated to the APA program, working almost exclusively on resolving transfer pricing issues, though generally not examinations.

While the number of IEs has remained largely consistent, the number of economists has increased by 50% over the last two years. The existing level of resourcing is expected to grow in the next two years, subject to attrition due to retirement and the IRS’ ability to replace such individuals. The APA program is also expected to hire additional attorneys, program analysts and economists. The IRS places emphasis on timely training so current and incoming transfer pricing resources have a strong background in all international issues, including transfer pricing.

Source

E&Y Resources for Transfer Pricing (2009).

As a solution, companies might adopt a model based on a profit split instead of a guaranteed return. “That provides for a similar outcome in an environment where the company suddenly is not doing particularly well,” he says. “You get the upside and the downside so the companies are sharing more equitably in that situation.”

Tax authorities will be concerned about these agreements too, says Fortier, because they don’t want losses shuttled over to their jurisdictions. “Countries wanted income in the good years, so they would argue for a higher share of the company’s value chain,” he says. “Yet in a situation where there are losses, governments are going to try to minimize the loss if that hits their tax jurisdiction.”

Matias Pedevilla, a partner with PricewaterhouseCoopers who focuses on Latin America, says companies can improve their success in navigating transfer pricing issues if they show careful compliance with multiple country requirements, if they provide plenty of documentation, and if they tell a consistent story to tax authorities regardless of jurisdiction.

“We’re seeing taxing authorities are exchanging information,” Pedevilla says. Mexico and Argentina, for example, regularly compare notes on taxpayers and plan audits accordingly, he says. “Having a single story for the region is critical.”

Locking down transfer pricing would go a long way to helping companies comply with financial reporting requirements as well, Crutchfield says. Companies are already required to disclose in their financial statements where they may have uncertainty in their tax positions. Crutchfield says that among his firm’s clients, transfer pricing represents some two-thirds of the uncertainty companies confess.

Norton says companies can employ advance pricing agreements or even prospective agreements with tax authorities as a way to resolve some of that uncertainty and possibly even release some of the reserves that must be booked related to uncertainties. “If you and your financial auditor are in a disagreement, talk to the IRS and get an advance pricing agreement,” she says. “Then that can be done.”